But almost every congratulatory note contains a swipe in the postscript: The Chinese model does not, cannot, innovate. Its high-speed trains are stolen technology. Its “indigenous” aircraft are stuffed with foreign components. Its apparel designs are copies, variations or spoofs of foreign competitors. Its entertainment is censored, derivative fluff.
Still, of all the dangerous delusions held by China’s economic competitors, the idea that Chinese firms compete without innovating is the least defensible. Hidden behind factory walls, Chinese firms have been busy building better, cheaper mousetraps, and in the process have become both innovative and competitive in ways Western firms once used to leap up the value chain.
“To deny that China is innovative is completely ludicrous,” said Derek Sulger, partner at Lunar Capital Management, a private equity firm that focuses on investments in western China. “I think people who talk about China not innovating have blinders on … Getting to this point required enormous innovation.”
Even so, it is innovation that has frequently occurred despite, rather than because of, the country’s policy environment. Beijing’s policies to encourage innovation remain clumsy and are in some cases counterproductive. Chinese factory managers’ under-appreciated creativity has helped them gain a key advantage in manufacturing processes, but that advantage is insufficient. Even processes need protection; without fair enforcement of intellectual property (IP) laws, China risks sabotaging the next phase of its industrial development.
The policies in the Central Committee’s officially published list of suggestions for the upcoming 12th Five-Year Plan is no exception. The word “innovation” appears 46 times, more than “sustainable” (nine), and “intellectual property” (three).
“Technological innovation ability is still not strong,” the text reads. “[The government must] strengthen independent innovation capability, develop the pool of innovative talent … improve the quality of workers’ innovation in management, and accelerate the construction of an innovative country.” The document also suggests target industries: agriculture, equipment manufacturing, environmental protection, energy resources, information networks, new materials, health care, electronic devices, large-scale integrated circuits, system software, genetically modified organisms, and medicine.
The idea that Beijing should play a large, interventionist role in stimulating innovation from the top down enjoys a wide degree of support.
“Government support for innovation should include support for the whole ‘innovation chain’ to make innovation more convenient, lower risk and lower cost, with a higher success rate,” said Wang Qin, deputy director of the Research Unit for Innovation and Development (RUID), at the Chinese Academy of Social Sciences (CASS).
He also said that Beijing should view innovation as a “platform” for overall industrial development serving the wider interest, not just a means to profit for individual firms. Wang sees the issue in starkly nationalist terms.
“Competition between countries is not only between competitive business entities,” he said. “In the machine tool industry, for example, the competition is not just Chinese and German machine tool producers, but also between the R&D systems in the two countries, including skilled workers, training, and professional standards in the university system.”
Wang’s opinion is echoed in state media and by many private firms. Electric vehicle manufacturer BYD (1211.HK) spokesman Lin Mi said his company hopes the government will play the role of “chairman” in coordinating innovation across the industry. He said the government should also mediate in the case of disputes with foreign companies.
While popular, the effect of all this policy support has often been counterproductive. Policies requiring government agencies to prefer “indigenous innovation” over foreign products have given wide cover to protectionist movements in China’s key export markets. Nor has forced technology transfer from foreign firms been helpful across the board: It has drawn resources away from Chinese internal R&D teams and frequently become a crutch. Worse, policies providing subsidies and tax breaks to domestic firms with approved patents have engendered a surge of patent applications without necessarily improving competitiveness.
That Chinese patent applications have exploded is undeniable. In 1999, inventors in China filed approximately 134,000 patent applications. In 2009 they filed 977,000. These numbers include foreign firms filing in China, but the domestic share of applications has also grown.
According to statistics from the State Intellectual Property Office (SIPO), Chinese applicants were granted 434,303 patents in the first seven months of 2010, with 87% of applications approved. Foreigners were granted 43,476, with a 67% approval rate, in the same period.
However, the business value of many of these patents is low in most cases. An IP manager at a major multinational firm operating in China who requested anonymity said that most Chinese firms focus on filing utility model and design patents – which are lightly examined, cheap to file and short in duration.
“Sometimes these companies spend less on filing the patent than they receive in subsidies, so they can make money just by filing a patent,” he said.
“They can also get huge tax reductions – from 25% tax on revenue down to 15%, across the board – if they are granted ‘high tech status.’ The key thing for being granted this status is to have intellectual property.”
Mr Shi, a design manager at Shanghai Zhongyi Furniture Design Center, said that the patent-filing craze has even infected low-tech industries like furniture design. “Some companies require designers to apply for a certain number of patents every year, but only in order to meet targets. Actual sales are not directly affected because their patent has no practical use to speak of.”
Shi’s criticism is supported by the numbers. Domestically, invention patents – those requiring the most rigorous examination, and which are generally considered the most valuable – only accounted for 10% of domestic patents approved by SIPO by July 2010, compared with 75% of foreign patent approvals. The rest were utility models and designs. According to statistics from the World Intellectual Property Organization (WIPO), China also accounted for the majority of international utility-model applications in 2008 and 2009.
“This actually is very inefficient,” said Wang Jiaomao, a professor of economics at the China Europe International Business School (CEIBS) in Shanghai. “A significant part of R&D in China is wasted going after subsidies and low-end patents – garbage patents. If the patent is really valuable, it should be able to make a return from the market.”
In China, pursuit of utility-model patents has become the business equivalent of Olympic gold medals: An emphasis on volume, in the service of national pride, with little concern for practical use.
The pursuit of patents for patents’ sake has certainly distracted companies, but the gravity of the policy error should not be overstated. Chinese firms have profited, and continue to profit, from other forms of business creativity.
“Innovation is misunderstood a lot of times,” said Ram Deshpande, assistant vice president and expert in Chinese IP at Evalueserve. “People think of it as game changing, a flash of brilliance, but it’s not. A lot of the small process improvements are small points of genius.”
Sulger of Lunar Capital pointed out that while Chinese firms’ ability to make things cheaply and (relatively) reliably is rarely called innovative in the West, such discipline nevertheless requires creativity of a different sort. “At minimum, China must have some of the best factory managers in the world, but I would argue that you also have innovation here that goes unrecognized in terms of processes, management, human resources.”
It’s easy to forget that for all of the American reputation for creativity in design and new technology, much of that country’s industrial success lay not in inventing new products, but in finding ways to make products more efficiently. Henry Ford, for example, did not invent the automobile; he invented the manufacturing process by which cars were made affordable. Apple (AAPL.NASDAQ) did not technically invent the iPod; it took over an expired patent from a British inventor and added a snazzy interface. And much of Japan’s economic success was thanks to its assimilation and improvement of American manufacturing processes.
Today, foreign companies have for the most part outsourced their manufacturing processes to China, giving Chinese factory managers the opportunity to establish clear competitive advantages derived from constant tinkering with how products are made.
Sulger highlights the case of Foxconn (a unit of Hon Hai Precision Industry; 2317.TPE), which provides components and assembly services to Apple, among others.
Granted, Foxconn is a Taiwan-founded company, but Sulger has other examples. He noted that BYD attained global leadership in batteries largely due to relentless innovation in manufacturing.
It’s starting to bear fruit in the company’s cars as well: From the outside, every one of BYD’s cars is a copy of a Toyota (TM.NYSE, 7203.TYO, TYT.LSE) model. But like Henry Ford, BYD founder Wang Chuanfu has relentlessly focused on perfecting the way his cars and batteries are made, as opposed to the way they look. As a result, BYD’s electric cars can sell for half the price of their competitors.
“[BYD] is a clear sign that prowess in manufacturing is beginning to pay innovative dividends,” said Sulger.
There are plenty of smaller stories of factory-floor cleverness. Sophia Mendelsohn, sustainability leader for emerging markets at furniture manufacturer Haworth, said that Chinese operations staff at one of the company’s mainland factories invented a new way to recycle industrial waste. “When you powder-coat a product, you pass electricity through it and paint powder sticks to it. A lot of that paint falls on the floor; it gets ugly; we can’t use it. But there are a lot of people who can use that powder for other things.” Haworth’s Chinese operations managers decided to gather the powder and resell it to companies who didn’t care about how it looked, offsetting manufacturing costs with a small new revenue line and reducing environmental impact.
Nor is all Chinese process innovation focused on cost. Telecom equipment maker Huawei, for example, is considered by many Westerners to be no more than a cheap copycat version of Cisco (CSCO.NASDAQ). However, the company also competes on its empathy with telecom customers in developing markets.
An executive at a multinational firm in China with experience in India said that Huawei has focused on designing hardware that is not only affordable to purchase but also easy to maintain in markets short on skilled engineers.
“An Indian manager told me that Western equipment runs beautifully when it’s maintained correctly, but after a year in India it’s usually ruined because you can’t find qualified people to take care of it,” he said. “But an inexperienced Indian engineer can run Huawei machines, no problem.”
Another advantage of improving manufacturing techniques is its wider applicability to industries not generally considered “innovative.” While the electronics and telecommunications equipment sector is the largest single employer in China, hiring around 8% of Chinese workers and producing a similar proportion of the country’s industrial output, the majority of jobs and GDP growth is still provided by traditional industries like textiles, smelting, raw chemicals and food processing. Efficiency improvements in these industries can reduce energy utilization, improve profitability and produce higher tax revenues in provinces that are short on sophisticated industrial sectors.
Unfortunately it’s far more difficult to quantify the quantity and quality of process innovation. Processes may be patentable and qualify as inventions, but in China and most other countries, companies usually pass on patenting them for a simple reason.
“Process innovation is so difficult to track,” said Deshpande of Evalueserve. “It is not detectable, in that you can’t immediately see infringement. If an employee takes a process from your plant to another plant, it’s difficult to prove.”
This means there is little benefit to publicly documenting process improvements, even in an environment with rigorous IP enforcement. It also helps explain why Chinese officials so rarely boast about this class of innovation: It doesn’t produce much in the way of impressive statistics.
However, even if China’s process expertise is less lauded than it should be, it is no substitute for the ability to invent new products, nor does it always serve the wider interest. Such cleverness, when misapplied, also results in product scandals that involve the removal of key quality controls, the evasion of environmental safeguards and product counterfeiting. Increasing wages and factor costs have only aggravated the phenomenon.
Wang of CEIBS blames Beijing. Because the central government has granted regional governments control over IP enforcement, he said, regions that lack firms with high-tech status are highly motivated to protect local companies – and the tax revenue they produce – from lawsuits, even if their business is founded on systematic violation of the IP of Chinese companies in other provinces. This encourages companies to focus on developing manufacturing techniques and methods they can hide, instead of developing new products.
Wang says there could be opportunities for change in the next five-year plan, if the central government takes the initiative: First, seize control of the IP enforcement mechanism from local governments. Second, offset the loss of tax revenues by increasing transfer payments so local governments can continue to meet their social service obligations.
This would be ambitious reform, entailing a profound redrafting of the contract between the center and the provinces, and would doubtless put a lot of well-connected companies out of business.
But there is little real choice in the matter. Political risk has kept the planners busy trying to avoid the unavoidable, but procrastination is not a strategy.
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