Innovation drives economic potential, especially as incomes rise and workforce and investment growth moderate. Promoting innovation is more difficult than cutting interest rates or approving projects. Innovativeness is an outcome reflecting education, intellectual property rights (IPR) protection, marketplace competition, and myriad other factors. Some countries have formal innovation policies and some do not, and opinions vary on whether government intervention helps or hurts in the long run. Many Chinese, Japanese, and other innovation policies have fallen short in the past, while centers of invention such as Silicon Valley, Boston, and Austin have often succeeded with limited government policy.
China’s goal is to grow innovative industries and prune low-value sunset sectors. Indicators such as patent filings are increasing, but analysts question their quality. To measure progress, we estimate the industrial value-added (IVA – a measure of meaningful output) of innovative industries as a share of all IVA in China, which tells us how much innovative structural adjustment is happening. Because China does not presently publish all IVA data details, we use an indirect approach to do this. Our supplemental gauges look at value-added growth rates in specific industries, China’s performance compared with advanced economies in specific industries, China’s trade competitiveness in innovative products, and two-way payments flows for the use of intellectual property.
Quarterly Assessment and Outlook
As in previous quarters, our assessment of innovation reform remains modestly positive in the review period. China’s 2013 Third Plenum Decisions aspired to promote innovative industries in the country’s industrial economy and to utilize market forces to a greater degree in guiding innovation outcomes. Promoting innovation is critical as China seeks to drive up employment and rebalance growth toward consumption and services. Our primary innovation indicator looks at the share of innovative industries in the industrial sector. The data show that all innovation-oriented sectors, except for non-auto transportation equipment, continued growing above the industrial average this quarter, with the information and communications technology (ICT) sector growing the fastest. Innovative industries are outpacing traditional ones, an apparent success for innovation reform. Our data show that the country is set to catch up to the 2012–2015 U.S. average level of innovation intensity by the end of this year.
On the policy front, Beijing remained committed to using industrial policies to achieve innovation success, even in the face of international pushback. The government reduced support for producers in automotive manufacturing and solar power, though many other protections for domestic producers remain in place in both sectors and, in some instances, new ones were offered. As Beijing lifted mandatory equity caps in automotive production, for example, it also imposed a new ban on the production of fossil-fuel-powered vehicles and set high standards for licensing approval for new energy vehicle (NEV) plants. The government also tightened restrictions on the export of domestically produced research & development (R&D) data and required more of those data to be submitted for regulatory review. These policies are likely to intensify the debate among China’s trading partners over how to counter the country’s state-engineered innovation successes.
China’s IPR imports reached $9 billion in 1Q2018, an all-time high and up from $7.3 billion in the last quarter.
This Quarter's Numbers
The economic weight of China’s innovative industries reached another new high in this Dashboard review period. Our primary indicator, which measures the share of innovative industrial value added (IVA) in total IVA, hit 32.9% on a four-quarter moving average (4qma) basis, up from 32.6% in 4Q2017. A trend of steady growth in the share of innovative industries in IVA has now continued for 10 consecutive quarters. Almost all innovative industries in our dataset grew above the industrial average of 6.0% in 1Q2018, despite an across the board slowdown in industrial activity. Though it slightly decelerated from 14% last quarter, ICT continued to lead China’s high-end manufacturing sectors with 13.2% growth. Non-auto transportation equipment, which has consistently been the slowest-growing among all innovative industries (partially due to tight local fiscal conditions that are slowing railway transportation investment, see our Fiscal Affairs cluster), slowed to 5.9% from last quarter’s 6.2%, slightly below the overall industrial average (see IVA Growth Rates for Specific Innovative Industries).
At the current rate of growth tracked in our primary indicator, China will reach parity with the 2012–2015 U.S. level of innovation intensity by the end of 2018 (see Volatility in Innovative Industry). On the surface, this appears to be a major achievement aligned with longer-term reform aspirations to gear the Chinese economy more toward high technology, R&D, and innovation. This achievement comes with caveats though: indicators throughout the rest of our Dashboard suggest state interventions and industrial policies supportive of innovative sectors drove these outcomes more than market forces. In other words, boosting innovation through nonmarket means contradicts other goals such as reforming the state sector, improving financial efficiency, and treating private and foreign firms fairly (see Financial Reform, Competition, Investment, and SOE). Policy efforts underway since 2017 to cut production overcapacity in heavy industry are also reducing the share of industrial activity derived from traditional manufacturing industries and, by definition, increasing the share for innovative sectors. The strength of commitment to continue cutting heavy industry capacity will determine whether this trend will continue in future quarters.
As innovative industries play a larger role in growth, intellectual property rights (IPR) are becoming increasingly important to China’s economy. Our data on Intellectual Property Flows show China’s IPR imports reached $9 billion in 1Q2018, an all-time high and up from $7.3 billion in the last quarter. Exports held at $1.3 billion, the same as 4Q2017, which was also an all-time high. As China upgrades to higher-end industries, the country’s IPR inflows should increase, as those industries tend to require intellectual property imports from abroad. Growing IPR imports could also signal improvement in China’s IPR protection regime. But here too there is a major caveat: the country’s IPR imports would still be much higher if it had adequate IPR protections and strong enforcement. IPR inflows are far from levels commensurate with China’s economic size and stage of development. This shortfall is a growing focus of international concern and a source of trade risk, as evidenced by the Trump administration’s imposition of a 25% tariff on $34 billion of imports from China on July 6 under Section 301 of U.S. trade law.
In 2012, China’s solar energy capacity was less than 5% of total global capacity. In 2017, it was 33%.
Beijing refined its industrial policy approach in the review period; it cut state support for the solar industry and lifted equity caps for foreign investment in domestic automotive manufacturing. Both are aligned with reform intentions and supportive of more stable trade and investment relations at the margins, though Beijing reduced solar subsidies out of a need to correct the distortive excesses of industrial policy more than as a concession to interlocutors abroad. The government also imposed new and even stronger requirements for access to domestically produced R&D data, in a move that will kindle international tensions.
On May 31, the National Development and Reform Commission (NDRC), Ministry of Finance (MoF), and National Energy Bureau (NEB) jointly announced that effective immediately, government subsidies for solar power production (as measured by the feed-in tariff rate per kilowatt hour paid for solar power fed into the country’s electricity grid) would be cut by 6%–13% depending on locale. The government also said that it would not approve any new solar power plants for the rest of the year and would mandate a competitive bidding process for companies to benefit from solar subsidies. Domestic industry analysts argued that the adjustments would significantly curtail the amount of new solar generation capacity brought online in China this year (see our Environmental Policy cluster).
The move comes after nearly a decade of heavy state support for the solar industry, which resulted in rapid production growth and, eventually, overcapacity and a massive solar supply glut. In 2012, China’s solar energy capacity was less than 5% of total global capacity. In 2017, it was 33%. Beijing publicly acknowledged as early as 2013 that domestic solar subsidies were a major driver of misappropriated public funds. The government is now clawing back subsidies. Doing so should help rationalize the allocation of resources in China’s solar sector and eventually facilitate a price recovery for both domestic and international producers, though significant supply distortions will take perhaps years to correct.
The automotive sector is another critical, innovative industry where Beijing is shifting its approach. China announced a series of foreign direct investment opening measures in April, including gradually removing the 50% mandatory equity cap for foreign automakers, canceling the limit of two joint ventures (JV) per foreign investor, and cutting whole-car import tariffs (previously 20%–25%) to 15% and auto parts (previously 8%–15%) to 6%. These policies were used (effectively) to protect domestic car companies from foreign competition. By phasing them out, Beijing is making progress toward its announced goals of letting the market drive resource allocation in innovative industries and open more fully to foreign players. But this comes with a big caveat that will curtail some type of foreign investments. A draft of updated regulations for the auto sector issued in May banned new fossil-fuel car production capacity for the rest of this year and set high standards for licensing approval for NEV plants. Criteria included that an investor must be able to produce 10,000 cars per year, which is a high, although not impossible, bar (Tesla, a U.S.-based NEV manufacturer, landed a deal in July to open a plant in Shanghai that can produce 50,000 cars per year), and have proprietary intellectual property in critical technologies.
Beijing also imposed new restrictions on the export of data by Chinese companies, parallel to like-minded efforts underway in the United States. On March 17, the State Council released new regulations on the management of scientific data that took immediate effect. The regulations restrict the export of certain types of scientific data and also require that data generated by R&D conducted in China be submitted to government data centers even if the government does not fund that R&D if it involves “state secrets, national security or societal and public interests.” The requirements also apply to R&D activities conducted by foreign research personnel and foreign-invested enterprises in China. Beijing’s intent to increase official access to R&D data, including data produced by foreign firms, will invigorate protests from foreign governments and businesses to China’s industrial policies.
On a similarly worrying note, on April 25 the National Drug Administration (NDA) published a draft regulation on drug-testing data protection. The regulation set the “protection period” during which companies can keep their data confidential for drug-testing generated outside of China to roughly a half of the time such data can be kept confidential if it is generated inside China (6–12 years depending on the product). This policy provides an incentive for foreign pharmaceutical firms to conduct their R&D activities in China and, under the new data submission requirements discussed above, may give the government access to any ensuing data and findings. These requirements represent the types of non-tariff trade barriers China utilizes to achieve the innovative outcomes depicted in our indicators.