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 in the Unites States 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 that of 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

Our assessment of China’s innovation progress in 2Q2018 remains modestly positive. The Chinese government is pursuing a broad set of industrial policies meant to promote higher value-added industries, with explicit goals to compete globally in high-technology sectors over the coming decades. Our primary indicator reveals that Beijing is succeeding: the contribution of innovative industries to IVA is on track to catch up to the 2012–2015 U.S. average by the end of this year. All innovative sectors we track, with the exception of non-auto transportation equipment, grew above the industrial average this quarter, with the information and communications technology (ICT) sector growing the quickest. This is the 11th consecutive quarter where China’s innovative industries outpaced overall industrial growth – the longest streak in our observation window – and it depicts an increasing role for innovation in the country’s industrial structure.

On the policy front, Beijing continued to deploy an array of traditional industrial policy tools like fiscal subsidies and state-backed preferential financing to promote investment into innovative industries and bolster consumer demand for related products. This support likely explains, at least in part, why innovative industries are outperforming other industries in China despite ongoing deleveraging efforts that have raised capital costs for industry, and an associated cooling in economic growth. However, in the review period we detect some evolution in China’s industrial policy approach, with the government relying more on market-oriented instruments, such as “government guided funds” (GGFs) to invest into targeted industries.

This is the 11th consecutive quarter where China’s innovative industries outpaced overall industrial growth, and it depicts an increasing role for innovation in the country’s industrial structure.

This Quarter's Numbers

Our data this quarter show that China’s innovative industries are outperforming other sectors of the economy despite uncertainty over a trade war with the United States and the higher capital costs resulting from deleveraging efforts (see Financial System). The aggregated weight of innovative industries reached another new high in this review period. Our primary indicator, which measures the share of innovative IVA in total IVA, moved up to 33.2% in 2Q2018 on a four-quarter moving average (4qma) basis, up from 32.9% in 1Q2018. At 11 consecutive quarters, this is the longest streak of consecutive growth in our review window, which dates to 2010. All but one innovative industry grew above the industrial average of 6.9% in 2Q2018. ICT continued to grow the quickest of the innovative industries, with a 13% year-on-year (yoy) growth on a 4qma basis, down just slightly from 13.2% in 1Q2018 (see IVA Growth Rates for Specific Innovative Industries). IVA from automobile manufacturing accelerated to 11.5% in the second quarter, up from 10.9%. Non-auto transportation equipment, a sector that is sensitive to infrastructure investment trends, was the only high-end manufacturing sector that grew below the industrial average at 4.9% (down from 5.9% last quarter), as the government’s ability and willingness to finance infrastructure projects at past levels are stifled by serious fiscal constraints (see Fiscal Affairs).

As we have noted in previous editions, data show that at the current pace of industrial growth, China is on track to reach parity with the 2012–2015 U.S. level of innovation intensity by the end of 2018 (see Volatility in Innovative Industry). This is consistent with Beijing’s industrial upgrading goals. This does not mean that China and the United States now have an equivalent level of innovative capacity in general terms; it does mean that innovative industries like ICT, high-end machinery, and automotive will soon play as big of a role in overall industrial output in China as they do in the United States today.

However, what this indicator does not reveal is the cost required to achieve this level of growth. Our analysis in other sections (see Financial System, Competition, and Trade) reveals the extent to which these outcomes are funded inefficiently by nonmarket tools, inciting advanced economy pushback to China’s industrial policy regime. This has been a consistent complaint from the Trump administration amid the ongoing U.S.-China trade war.

Intellectual property rights (IPR) protections and forced technology transfers are among the primary advanced economy concerns regarding China’s industrial policies. Our supplemental indicator Intellectual Property Flows tracks China’s import and export of IPR. China’s IPR imports hit an all-time high of more than $10 billion in 2Q2018, up from $9 billion in the previous quarter, and a 67% jump from $6 billion in the same quarter last year. IPR exports also reached another all-time high of $1.5 billion, up from $1.3 billion last quarter. The increase in IPR imports shows that China is doing a somewhat better job in fairly compensating international firms for the domestic use of intellectual property, though these flows remain well below what would be expected for an economy of China’s size and level of advancement. According to World Bank data and our own estimates, in 2017 China accounted for 25% of the global high-tech exports but only 7% of global IP payments, suggesting IP underpayment. At the current pace, China’s share of global IP payments might increase to 9%–10% by the end of 2018. Increased IPR exports meanwhile show that Chinese firms are making some headway in developing their own IP and selling it abroad – a success for industrial policy aspirations even if today’s flows are still at relatively low levels.

The government is increasingly deploying a more market-based tool, government guided funds, to invest in emerging innovative industries.

Policy Analysis

Policy developments in the review period showed Beijing recalibrating industrial policies to address market distortions; however, this was done without any wholesale change in its state-led approach to promoting innovation. In the automobile sector, the National Development and Reform Commission (NDRC) announced on September 1 that it would soon issue a new “Automobile Industry Investment Regulation.” A draft version was released in July for public comment. According to the draft, NDRC would prohibit any new investment in gas-powered car production and significantly increase investment threshold requirements for new energy vehicle (NEV) investments – a move meant to consolidate the nascent NEV sector and limit overcapacity. The Ministry of Industry and Information Technology (MIIT) also warned 30 NEV manufacturers (out of more than 200 nationwide) in early September for failing to meet production requirements. If these requirements are left unmet, the MIIT threatened to cancel production permits, forcing consolidation on the NEV industry.

The telecommunications sector meanwhile remained a major focus of industrial policy efforts, and an area where Beijing showed willingness to continue pursuing stated goals despite growing international pushback. The NDRC and MIIT jointly released a “Three-Year (2018–2020) Plan to Expand and Upgrade Information Consumption” on August 10, prioritizing development of the 5G communications network with supportive measures including preferential funding, tax relief, and financing. This came despite pushback from Australia, India, and the United States in the past year to prohibit Chinese telecom manufacturers such as Huawei and ZTE from participating in local 5G development due to their strong state backing and associated national security concerns.

While continuing to pursue aggressive industrial policies in high-technology industries, we did see some signs of a slight recalibration in China’s industrial policy approach in the review period that will bear monitoring in future quarters. The government is increasingly deploying a more market-based tool, GGFs, to invest in emerging innovative industries. GGFs are funds of funds, financed by the government using fiscal resources. The GGF typically partners with private capital to invest in strategic industries, as identified by state policies such as Made in China 2025. GGFs are not entirely new, but their use has been growing rapidly in recent years. According to data from China Venture, in 2012, there were 179 GGFs with RMB 176 billion ($25.4 billion) in total assets (fund of funds and sub-funds). But by the end of June 2018, there were 1,171 GGFs with RMB 5.8 trillion ($836.9 billion) in assets. This equates to a compounded annual growth rate for total capital invested into the GGF fund of funds of an astonishing 45% from 2012 to 2018.

GGFs have important distinctions from Beijing’s traditional use of direct subsidies and state-backed financing. By partnering with private investors, the vehicle multiplies the government’s ability to deploy seed funding into emerging technologies. In theory, it also is less likely to aggravate excess capacity presumably because investments are dictated more by the market given the active involvement of private investors. This approach would be consistent with Beijing’s 2013 Third Plenum promise to “let the market play a decisive role” in resource allocation and in boosting innovation.

However, political pressure on GGF investment decision-making appears strong, contravening a more decisive role for the market. On August 30, the NDRC published new evaluation metrics for GGFs that state that “policy assessment” accounts for 50% of their performance evaluation, while “investment return” accounts for just 10%. Therefore, GGFs are more incentivized to comply with state policies than to chase investment returns. At the same time, given their use of government resources and heavy political scrutiny, GGFs appear to have a lower risk tolerance than private players. Anecdotal and media reports suggest that many GGFs are struggling to spend available resources given these constraints.

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