R&D heads into China

The nerds have their revenge. China's scientific and technological elites – bade by Mao to slop pigs and clean latrines during the Cultural Revolution – now run the country, and China has become the most thoroughly technocratic major nation on earth. All nine members of the current Politburo Standing Committee were trained as engineers, while over three-quarters of all ministers, provincial Party secretaries and governors have degrees in the natural sciences or engineering.

Lab coats are in; Mao suits are out. Little wonder, then, that China's rulers – beginning with Deng Xiaoping, who set the nation's remarkable technocratic transformation in motion – have given such high priority to the development of S&T. Beijing has not been shy about its vision of China as a technology powerhouse capable of competing globally, and has pursued that goal with characteristic pragmatism. FDI, especially in high-tech industries, is aggressively courted. Returnee scientists and researchers are lavishly feted. R&D on the technological cutting edge is amply funded.

When the results came in last year from the OECD's biennial Science, Technology and Industry Scoreboard – a study that included R&D metrics for non-member countries like Brazil, India and China for the first time – the findings for China raised eyebrows: R&D spending was ratcheting up fast, its universities churning out legions of scientists and engineers, and its exports were becoming increasingly high-tech. Keen interest prompted the organization's Directorate for Science and Industry to commission another report dealing specifically with China.

Not surprisingly, most studies on China's R&D boom have focused on the impact of globalization on China's tech ambitions. Hardly a week passes without the announcement of another multinational setting up a high-tech R&D center in China. Lucent Technologies' recent commitment to invest another US$70 million in its Nanjing 3G research center was typical. Indeed, topping that just last month, Motorola said it planned to invest US$90 million in a new research facility in Beijing to focus on mobile phone user interfaces.

China now boasts a total of 600 R&D centers – 200 more added every year, says the Ministry of Science and Technology – with a total of over US$4 billion already invested.

Show lab days are over
And while many of those set up in years past were mere "show" labs doing more localization of products than real R&D, built to curry favor with Chinese officials, increasingly MNCs are shifting real R&D resources to China to capitalize on low labor costs and to be close to one of the world's largest and most dynamic high-tech consumer markets. According to an UNCTAD report, nearly 80% of Fortune 500 companies had sunk money into some 2000 projects in technology-based industries in China by 2001, and the trend has only accelerated since.

China's R&D capabilities are advancing rapidly. But the consensus among analysts – both western and Chinese – who have examined the impact of foreign high-tech R&D on China's own technology base is that high-tech spillover to date has not amounted to a lot: far less than what China's rich-world competitors had feared, and far short of what the Chinese had hoped. Kathleen Walsh, author of an extensive Stimson Center research paper looking at the information and communication technology (ICT) sector, concludes that while they are giving a boost to China's high-tech growth, the new R&D centers "are contributing as much or more under newly consolidated, wholly foreign-owned R&D enterprises to foreign companies' high-tech development and production capabilities and thus, to the US economy."

The Chinese Academy of Social Sciences (CASS) comes to essentially the same conclusion: a report called "Use of Foreign Investment of and Improvement of China's Innovation Capacity" issued in late 2003 found that most foreign-funded enterprises (FFEs) were technology end-users, not makers, and that local Chinese staff were being trained on new technologies, but not on how to create them.

The report went as far as to say that R&D by foreign-funded enterprises is crippling China's own efforts to create a technology base, perpetuating China's technological dependence on the West. "China is not yet an influential global leader in R&D," says Yang Qiquan, a researcher at the National Research Center for Science and Technology for Development (NRCSTD). "Our own assessment is that China ranks 25th to 30th in the world – comparable to India or Brazil."

So far, then, China's high-tech industrial policy providing substantial tax incentives for firms doing high-tech R&D, nurturing local champions, hasn't borne fruit. The trees may have been planted on the Chinese side of the fence, but the fruit seems to be falling mostly in the yards of the FFEs, who dominate China's high-tech exports picture (see page 50).

The presence of foreign-funded technologies hasn't resulted in significant diffusion of know-how to Chinese firms. China can still only boast a handful of home-grown high-tech firms – including telecom equipment vendors Huawei and ZTE – capable of competing internationally. Beijing's dream of creating what it calls a "national system of innovation" has yet to become a reality.

There are several reasons why China's FDI-friendly strategy hasn't worked out as planned. Since China's accession to the WTO, the once-common practice of strongarming foreign firms into entering JVs and acceding to technology transfer agreements doesn't fly.

Today over 65% of FDI comes from WFOE – wholly-owned foreign enterprises – and R&D done by them stays, for the most part, with them. Furthermore, most high-tech MNCs aren't outsourcing to China so much as off-shoring: setting up subsidiaries taking on portions of R&D work for the parent company – usually non-sensitive processes, given China's notorious record on IPR infringement, conducted in secure labs. Technology transfers tend, then, to be "soft transfers" ? know-how carried with personnel leaving WFOE and going to Chinese enterprises.

For OECD countries, the message isn't that there's nothing to worry about – just that it's still early for real panic. Spillover might not be bolstering China's technological capabilities to the extent Beijing had hoped, but that realization has made the urgency for domestic innovation all the greater.

Radical policy overhaul
In 1998, China began the radical overhaul of its research institutions, urging them to launch commercially-viable spin-off companies and pushing those toward development of market-friendly products. Budgets in key cutting-edge industries ? bio and nanotechnology, for instance – have been bumped up considerably. China's biotech budget for the 10th five-year period (2001- 2005) increased, for example, by 400% from the previous five-year period to reach an annual US $1.2 billion.

Granted, even with increased state spending, basic and even applied research together – the R in R&D – still account for a small percentage of China's total R&D spending, while the D still dominates. China's innovations in D tend, furthermore, to be lower no-tech, playing to China's strong suit: inexpensive, skilled labor. "The focus is on process design, with a distinct labor-using bias that saves on capital and energy," explained economist Gary Jefferson of Brandeis University. The sophistication of R&D outputs might not compare with advanced economies, but given China's level of development and its comparative strengths, it's a rational strategy.

It's also one that has worked to keep China's broader R&D ambitions funded: development of efficient, labor-intensive production processes creates profits that are then plowed back into R&D – a "virtuous circle," in Jefferson's words, and one that has China's R&D spending spiraling steadily upward toward a critical mass, at which China will achieve what Jefferson terms an "S&T takeoff." This happens, he suggests, when R&D intensity – the ratio of R&D spending to GDP – goes from less than 1% to over 2% in the course of a decade. "The seven largest OECD countries all exhibit this phenomenon of S&T take-off, and share the characteristic of having made this transition, on average, within a period of a decade," he says. "They now all have sustained ratios of R&D to GDP of more than 2%." China – with an R&D intensity that surged from 0.6% in 1996 to over 1.3% in 2003, and is on track to achieve the government's stated goal of 1.5% in 2005 – could well be next.

The increase in spending in absolute dollars is even more startling when you consider China's GDP growth during that same period. An OECD study released in 2003 puts China's R&D spending at US$60 billion dollars – adjusted for purchasing power parity – for the year 2001. That puts China third in the world, ranking behind the US at US$282 billion and Japan at US$104 billion. Significantly, 60% of this spending came from the private sector, up from only 28% in 1991.

The size of China's S&T workforce is staggering: China employs 743,000 people in research, according to the OECD study second only to the US, with 1.3 million, and ahead of Japan, with 648,000. The gap is closing, too. China graduates five times the number of engineers each year as the US, with 325,000 graduating this year alone. Are they as good as the American engineers? Who knows? But with their low salaries – a well-paid Chinese engineering PhD starts at a WOFE for US$1,200 a month – no one is complaining about quality. Besides, as more opportunities for researchers open up in China, with research institutes, universities or in industry, the China brain drain has shown signs of slowing. Fully a quarter of the science and engineering PhDs awarded to foreign students in the US go to Chinese citizens each year, and luring them back home has become a priority.

Beijing recognizes that being the world's leading exporter of DVD players doesn't qualify it as global technology leader. That is obvious every time a DVD player is sold, and US$15 to US$20 – roughly 20% of retail price on average units – is paid to the various US, European and Japanese holders of proprietary licenses for DVD technology.

China's recent assertiveness in creating and attempting to propagate standards in key technologies grows from protectionist impulses, resentment of high royalties paid to IP rights holders, and plain nationalism. The ability to set standards has become, in the eyes of the techno-Mandarinate, the sine qua non for China to take its place at the table of big-league technology powers. "Creation of internationally-accepted technology standards is a rational, legitimate and attainable goal," says Yang of NRCSTD. "There's no reason standard-setting should be exclusively in the hands of the U.S. and Japan."

And so Beijing has promoted a whole range of would-be standards, but the results so far have been mostly disappointing. The 3G standard TD-SCDMA has been accepted by the ITU, but none of China's four major telecom carriers – let alone foreign 3G operators – is too interested, and Beijing has signaled its intention to let carriers make their own choice.

China, possibly in collaboration with South Korea and Japan, is reportedly working on an open source operating system and office suite to challenge Microsoft, but nothing has come of that yet. In its most aggressive standards move to date, Beijing threatened to close domestic markets to WLAN vendors that didn't comply with China's WAPI encryption standard, but in April Vice Premier Wu Yi announced in Washington that the plan had been postponed.

A next-generation video disk technology called EVD, meant to supplant DVD, was launched last year with great fanfare but floundered because of a lack of content – relative to the huge range of mostly pirated DVDs. So far, China's biggest standards success has been in its high-definition television (HDTV) standard, which has gained some currency in the domestic market.

"To be able to implement a standards strategy, you need companies that can back it up by not only inventing the technologies but producing them commercially and making lots of money at them," says George Gilboy, author of a recent Foreign Affairs article that downplays China's near-term prospects for emergence as a technological power. "That's what the Japanese did, and that's what the Americans do all the time. A standard becomes the standard because of its commercial viability, and not because someone declares that it's the standard."

Ultimately, Beijing is aware that the race will eventually go to countries with solid foundations in basic and applied research, and in all research measures, China still lags. But metrics such as numbers of patents can be misleading. R&D outputs of FIEs, for instance, are registered with the home country: software coded in Hangzhou can be e-mailed back to Palo Alto and the patent application filed from there.

The high proportion of Chinese patents relating to product design, and not the included technology, also skews the numbers. In any case, as Walsh points out, patents and that other major output metric, published scientific papers, "are not necessarily what China is going after." But China's patent gap with the US and Japan remains large: China's biotech industry, for example, only holds three independent drug patents.

What's holding China back? Mu-ming Poo, a Berkeley neurobiologist and director of the Institute of Neuroscience at the Chinese Academy of Science in Shanghai, commented recently in Nature that he believes what's preventing Chinese research institutes from doing world-class science are cultural (read: Confucian) and not economic factors: lack of critical exchanges, for example, as well as reflexive deference to authority.

But Gilboy points instead to more concrete – and contemporary – political realities that have created a peculiarly Chinese "industrial strategic culture" that has hobbled technological advance. One problem lies with a system which encourages enterprise managers to cultivate relationships with Party patrons, thereby discouraging them from creating horizontal linkages with other key industry players – institutes, universities, peer enterprises – so critical in the dissemination and absorption of technology. The other related problem is China's shifting regulatory environment, which discourages managers from making the kinds longer-term investments in R&D.

Its technological advance may well be hobbled, but China is hobbling forward faster than most can run, and even relatively pessimistic observers grant that prognostication is impossible. "There's absolutely no shortage of creativity in China today," says Gilboy. "And for all its faults, one of the great strengths of the system is that it is creative, experimental, and demonstrates learning. The state is willing to do local experiments, and let them run their course: what works gets applied."

"I hold out real possibility for the Chinese to surprise us," says Walsh. "People who were skeptical about China's technological capabilities just a few years ago are much less so now. To underestimate China, given its inherent resources and assets, would be foolish."