The Story So Far
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 within an economy 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 United States such as Silicon Valley, Boston, and Austin have succeeded with limited government policy support. In other cases, innovation interventions have helped, at least for a while.
- The 2013 Third Plenum released a series of decisions aiming at improving the innovation environment in China. Compared with previous innovation strategies, the Third Plenum placed a greater emphasis on market forces, calling for “market-based technology innovation mechanisms” while announcing that the “market is to play a key part in determinizing innovation programs and allocation of funds and assessing results, and administrative dominance is to be abolished.”
- In May 2015, China officially launched Made in China 2025 (MC2025), a 10-year strategic plan for achieving new levels of innovation in emerging sectors. The MC2025 agenda diluted the Third Plenum’s emphasis on market mechanisms with more elements of central planning. The blueprint set performance targets for 10 key industries in the proportions of domestic content and domestic control of intellectual property. An associated implementation road map document laid out specific benchmarks for global market share to be achieved by Chinese firms in emerging sectors, generating significant international backlash.
- Recognizing the prevalence of subsidy abuses and excess capacity related to its industrial policy programs, Beijing announced in December 2017 that it would gradually phase out some subsidy programs, such as for photovoltaic power generation and new energy vehicles (NEV).
- In March 2018, the U.S. Trade Representative’s Section 301 Report concluded that key parts of China’s technology push, including MC2025, were “unreasonable or discriminatory and burden or restrict U.S. commerce.” The United States then imposed trade tariffs on $250 billion worth of Chinese imports over the course of 2018, including some products related to MC2025 and many that were not.
- In May 2019, the U.S. Trade Representative raised tariffs from 10% to 25% on nearly $200 billion of goods from China and started to review tariffs on the remainder of imports from China. Beijing retaliated by raising tariff rates on some imports from the United States. The U.S. Department of Commerce also added several Chinese high-tech manufacturers to its “Entity List”—a list of companies believed to present national security risks to the United States—effectively restricting those firms’ access to U.S. exports.
Quarterly Assessment and Outlook
We downgrade our assessment of innovation reform for the first time since the inception of the China Dashboard. Dismal auto sector performance significantly dragged down China’s overall innovative industry growth.
Weakening domestic and external demand growth is weighing on innovative industries: all but one industry we track are trending downward in 2Q2019.
Beijing committed to making the market more open and competitive, stopping forced technology transfer, and protecting intellectual property (IP). But major implementation uncertainties, and a parallel emphasis on technology self-control, obscure the outlook.
This Quarter's Numbers: Parity with the United States Reached
China’s innovative industries are no longer certain to outperform the rest of the economy. Our primary indicator, Innovative Industry Share in Industrial Value-added (IVA), showed no change at 33.5%, ending its 14-quarter growth streak. Six out of the seven innovative industries we track saw value-added growth slow from 1Q2019. Three industries (autos, universal equipment, and special purpose equipment) also underperformed overall IVA growth.
The auto sector was the single biggest drag on China’s industrial innovation performance: auto IVA growth fell to an all-time low of −2.8% (or 0% on a four-quarter moving average basis, see [Industrial Value-added Growth Rates for Specific Innovative Industries[(#industrial-value-added-growth-rates-for-specific-innovative-industries)). The auto sector has been in decline since 2017, though in 2Q2019 stricter emissions standards for carmakers contributed to an especially weak quarter.
Even industries that are better able to weather slowing economic growth due to state presence and strong policy support faltered in 2Q2019. Two such sectors—universal equipment and special purpose equipment—slowed especially sharply. Universal equipment IVA growth slowed to 2.4% in 2Q2019 from 14.1% in 1Q2019, while special purpose equipment IVA slowed to 4.3% from 16.4%. Because these two industries typically supply capital goods (e.g., machine tools) to other manufacturing industries, their weakening performance suggests slowing industrial activity across the board.
“As Beijing’s old innovation model—top down, selective, and often distortionary—finally started to lose momentum, policymakers and political leaders in mid-2019 began to reexamine China’s industrial policies.”
Policy Analysis
The slowdown in China’s innovation-related industrial activities may be a wakeup call for Beijing to rethink its innovation strategies. Policymakers in the past often admitted weakness and flawed designs, but the urgency to act was never too great because headline growth was still strong. As Beijing’s old innovation model—top down, selective, and often distortionary—finally started to lose momentum, policymakers and political leaders in mid-2019 began to reexamine China’s industrial policies. Authorities acknowledged existing problems and pledged some market-oriented improvements, such as nondiscrimination and intellectual property protection for all entities, but the message is not fully consistent.
The Deepening Reform Commission, the institutional decision maker on China’s reforms, issued an "Opinion on Promoting Deep Collaboration and Synchronized Development between Advanced Manufacturing and Modern Services" in early September promoting industrial upgrading by deepening linkages between the service sector and the manufacturing sector. Several days later, while touring a state-owned equipment manufacturer in Henan province, President Xi Jinping reemphasized the importance of indigenous innovation, a phrase associated with technology self-dependence and the pursuit of techno-nationalistic practices such as forced technology transfer in the past. These statements underscore Beijing’s determination to ascend the high-tech curve in manufacturing, as a technology decoupling with the United States becomes increasingly real. Our primary indicator does not distinguish between indigenous or other drivers of innovation and so could improve even if Beijing turned more concertedly toward a tech self-sufficiency model.
The impacts of U.S.-China high-tech decoupling are still taking shape. In trade, China’s information and communication technology (ICT) and machinery exports to the United States decreased by 8% year-on-year (yoy) in the first half of 2019 but increased to the rest of the world, which at least partially offset the loss of U.S. demand and prevented China’s total exports of these tech-intensive goods from contracting. In the investment space, while Chinese foreign direct investment (FDI) to the United States dropped sharply in 2019, Chinese venture capital investment, which is more concentrated in tech and IP, has held up far better even though heightened U.S. regulatory scrutiny has added uncertainty. More important for China’s innovation outlook is how global manufacturing supply chains will shift. While we expect decoupling will accelerate supply chain migration from China to other destinations, the actual impact on China’s innovation capability will be contingent on China’s domestic policy response, as well as the outcome of bilateral talks.
On the positive side, the government acknowledged significant market distortions for foreigners caused by the nation’s industrial policies and pledged to change. In September 2019, the Development and Research Center (DRC) of the State Council and the World Bank published a joint report (“Innovative China: New Drivers of Growth”) recommending a reshaping of China’s industrial policies to foster innovation. Specially, the report emphasized that industrial policies should not preclude market competition or fair treatment. While this report alone is insufficient to facilitate substantial reform of China’s industrial policies, it is an important, if long overdue, government acknowledgment of the existence of favoritism, distortions, and anticompetitive regulations in industrial policy formation and implementation.
Other recent policy signals suggest stronger momentum toward reforming industrial policies. The October 8 State Council Executive Meeting passed a draft “Ordinance on Optimizing the Business Environment,” which aims to ensure “all types of business entities have equal access” to key inputs like credit, land, and licenses and “enjoy state support policies equally” (see Competition for more details). Such language appears to directly address discriminatory elements of China’s innovation-boosting strategy, which typically disqualifies foreign and domestic private investors from accessing preferential financing or state aid. The State Council Executive Meeting one week later (October 16) went one step further by announcing that no level of government should “force foreign investors and companies to transfer technology, explicitly or implicitly,” suggesting more central oversight over local interference in business transactions. The measures also promise to establish a national platform for protecting market entities’ rights and interests, including property rights. In late October, the State Council formalized the draft with a January 1 effective start. While this regulation is laudable and nontrivial, institutional incentives behind forced technology transfers require time and more than just administrative measures to resolve.
Methodology
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 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.