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 opinions vary on whether government intervention helps or hurts in the long run. Many Chinese, Japanese, and other government innovation policies have fallen short in the past, while centers of invention such as Silicon Valley and Austin, Texas, have often succeeded with limited government intervention.

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 currently 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 that of advanced economies in specific industries, China’s trade competitiveness in innovative products, and two-way payment flows for the use of intellectual property.

Quarterly Assessment and Outlook

Gauged by changing IVA shares, China is making solid progress toward becoming a more innovation-oriented economy. The current pace of structural adjustment in this direction has increased since 2015, accelerating convergence with OECD innovation patterns. Most industries that make up our aggregative innovation index are growing value-added faster than the headline IVA growth rate of 7.9% in 2Q2017. Intellectual property payment flows, both credits and debits, are rising. Trade patterns are not reflecting a definitive shift in China’s comparative advantage however, particularly as the nation clings to sunset industries and thus diverts resources that could be repurposed for advanced sectors.

On the other hand, current innovation strength is still nascent, and partly results from supply-side restructuring in old-line industries and other macroeconomic factors. If China reverts to 2011–15 average IVA adjustment rates, it still has years to go before it gets to where the United States was in 2011. But policymakers are keenly aware of this and are intently focused on promoting innovation. Massive resources are being directed at that goal.

Policy dynamics this quarter emphasized state direction for innovation, especially in promoting the Made in China 2025 plan, and notably a new focus on civil-military cooperation. While helping hands from the state can be supportive, they also run the risk of being counterproductive. China’s trading partners have been increasingly vocal about concerns with Chinese industrial policy, and this is likely to lead to trade frictions. Chinese innovation policies are predicated on international demand, but foreign memories of disruptions caused by previous programs such as solar panel manufacturing promotion are likely to color attitudes toward new energy vehicles, aircraft, and other high-value offerings from China. And despite the evident rise in the share of innovative IVA in China, growth rates are falling and the legacy costs of past subsidies and government-driven development plans are swelling rapidly.

In the coming quarters, we expect cross-border payment for IPR use to grow – in both directions – even if overall Chinese innovative adjustment slows. While the quantitative indicators of innovation policy in China provide important evidence, the policy tone in international relations in the fall of 2017 will be crucial as well. Because innovation “systems” today are more global than they have ever been, for China to become a fully innovative economy will require enhanced globalization, rather than a retreat to nationalism, protectionism, or mercantilism.

This Quarter's Numbers

China’s IVA from innovative industries (defined based on Made in China 2025, Beijing’s top-level plan for innovation policy) continued a rising trend seen since 2015 to reach a new peak in 2Q2017. Innovative IVA now accounts for 32.5% of the total. On a four-quarter moving average (4qma) basis, this was the seventh consecutive quarter of rise, with an accelerating trend over the past year. Yet this growth spurt may be temporary. The biggest contributors to innovative IVA growth at present are autos and the information and communications technology sector (communications, computers and other electronics). While IVA in most other innovative industries has been positive and rising, our data for Industrial Value Added Growth Rates for Specific Innovative Industries show that growth is comparable to overall IVA, so their share of total IVA is relatively stable, rather than taking offTransportation innovation-led growth excluding autos, for example, is shrinking.

Nonetheless, based on the published data, at the current rate of change, China will reach parity with U.S. levels (2011–14 average) of innovative IVA by end of 2018. This on the surface seems remarkable. But a more granular look at this through our data presented in (Volatility in Innovative Industry shows, the current rate (more than 30 basis point growth per quarter, for greater than a full percentage point increase a year) has not been typical. At the 2011–15 average rate of innovative IVA growth, this parity point would not arrive until 2022; at the 2015 average, it would take 13 years, at which point the United States is also likely to have moved up the scale as well.

This demonstrates real uncertainty about the likelihood and the timing of Chinese innovation convergence with advanced economies. Strong cyclical ups and downs in IVA growth are evident over our five-year window for all of China’s innovative sectors, suggesting that macroeconomic conditions are driving the story at least as much as specific industrial policies. The prevalence of these cyclical patterns suggests that current innovative IVA levels are at the top of a five-year range and may not be sustained. Of further note, this IVA strength has come at a time of weak performance by old-line Chinese industries. Supply-side reform programs in traditional industries are meant to rationalize capacity in sectors such as steel, thus boosting pricing power and in turn elevating their share of value-added in the years to come. These factors provide further caution in making straight-line assumptions about ever-increasing innovative activity in total output. More policy work will need to be done. Finally, China is moving toward an era of high-tech competition that should in principle mean increased advanced product and service imports too: if domestic innovators don’t have equal access to non-locally produced inputs, they will be at a severe disadvantage.

At the current rate of change, China will reach parity with U.S. levels (2011–14 average) of innovative IVA by end of 2018.

On the intangible front, our data outlined in Intellectual Property Flows show China’s balance of payments, credits, and debits for IPR, with Chinese receipts in dark blue and payments abroad in light blue. Both numbers set new highs this quarter, reflecting the growing importance to China of IPR as both an import and an export. As with other intangible payment flows, some observers believe these flows in part disguise transfer pricing or capital control circumvention. The net IPR payments deficit set a record of USD 6.5 billion for the quarter. Note that both imports and exports of IPR are positive indications of longer term policy success in innovation.

Finally, we turn to trade for another barometer of change in China’s innovation conditions. Long a dominant player in low value-added light manufacturing and assembly work, China’s goal is structural adjustment in its trade patterns so that trade-related jobs and industries in which China has lost comparative advantage will be replaced with those in which it is competitive or can attain competitiveness through policy support. Our Share of Global Exports in Innovative and Non-Innovative Industries) compares trends in China's global export shares in one innovative and one non-innovative sector. China’s shares in both global apparel and textile (a typically non-innovative industry) and electrical equipment (a typically innovative industry) decreased modestly this quarter. In 2Q2017, China claimed 45% of global apparel and textile exports and 28% of electric equipment exports. We expect China’s apparel export share to fall further from this still extraordinarily high level as rising wages price China out of this low-end sector. Successful innovation should, on the other hand, sustain higher value-added electronics exports.

Policy Analysis: 2Q2017

Made in China 2025, China’s 10-year innovation plan, was announced in mid-2015 and is at an initial stage of implementation. Early steps were taken in August 2016 (announcing Ningbo as the first city for local pilot programs under the plan). This quarter we observed movements in three areas: (further) top-down policy design, local pilot programs designation and initiation, and additional industrial policy elaboration.

The prevalence of these cyclical patterns suggests that current innovative IVA levels are at the top of a five-year range and may not be sustained.

On June 20, President Xi Jinping chaired the first meeting of a new Central Military-Civilian Integration Development Committee. Three other Politburo Standing Committee members (Li Keqiang, Zhang Gaoli, and Liu Yunshan) attended the meeting, reflecting its high importance. According to the official readout, Xi emphasized the importance of “utilizing existing resources and optimizing the allocation of new resources” so that “the maximum benefits of deep military-civilian integration can be achieved.” This emphasis on the interplay of military and commercial innovation is a new theme, at least as an explicit direction. Innovation with Chinese characteristics therefore means directing resources into security priorities such as military applications of artificial intelligence, nuclear energy, and space technology. While this is not so different from military-industrial cooperation in OECD economies over past decades, this thrust in Chinese innovation policy may create unease in some nations, particularly in the absence of any global rules governing dual-use technologies.

To support military-civilian integration, an RMB 150 billion government innovation fund was set up on May 17. Initial funding came from the Beijing municipal government, major SOEs, and commercial banks. The fund is under the guidance of state enterprise overseer State-owned Assets Supervision and Administration Commission of the State Council (SASAC) and led by the China Aerospace Science and Technology Corporation, the commercial arm of China’s space program. The primary focus of the fund is military-civilian integration programs in space, nuclear technology, and ship construction.

In terms of local pilot programs, the Ministry of Industry and Information Technology (MIIT) announced new locations to follow a dozen pilot cities and city clusters already established: Huzhou in Zhejiang Province was announced on May 3, Zhengzhou-Luoyang-Xinxiang in Henan Province on May 25, and Hefei in Anhui Province on June 15. “Industrial upgrading” was a common theme in these plans, though each emphasized different priorities. Being designated for an MIIT pilot program gives local officials flexibility to experiment with new policies and earmarks additional fiscal support from the center.

The final emphasis in current innovation policy design is industrial policy. This area is the most relevant to short-term economic performance because it shapes market conditions, influences winners and losers and hence is prone to political rather than market direction. At center stage this quarter was the automobile industry. On April 25, MIIT, the National Development and Reform Commission (NDRC), and the Ministry of Science and Technology (MOST) jointly announced a medium and long-term development outline for this industry. The outline specified new energy vehicles and smart cars as targets for “breakthrough” progress by car manufacturers in China. Manufacturers that can produce preferred products will receive sizable subsidies and preferential tax treatment. While foreign brands producing in China are ostensibly qualified to enjoy these incentives, there is skepticism that the playing field will indeed be level. Other economies including the European Union and the United States are looking closely at the fairness and legality of these inducements, raising questions of international reciprocity.

Chinese officials routinely wave off foreign concerns about their industrial policies. During a State Council press conference on May 24, Xin Guobin, the MIIT deputy minister, tried to assure foreign investors that “the relevant policies apply to all companies in China” – not just home-grown ones. He made references to General Electric’s participation in the making of the C919, a made-in-China passenger jet. Xin further said that the Chinese government “does not instruct” Chinese companies to acquire foreign counterpart companies to gain technology advantages. Despite these assurances, most OECD governments are increasingly concerned at this prospect, as reflected in the policy responses of various of their foreign investment regulatory authorities to particular Chinese foreign investment trends.

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