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

China’s 2013 Third Plenum reform commitments included explicit goals encouraging “market-based technological innovation” and “giving free rein to the market” in guiding technology research & development (R&D). Successfully promoting innovative industries is critical for China as it seeks to generate a new era of higher-end employment for Chinese workers by catapulting from its position as the world’s factory floor into a higher value-added technology and services-oriented economy. Our primary innovation indicator looks at the role of innovative industries in industrial value added (IVA) in the economy. The data show that China continued to achieve innovation progress this quarter, though our other assessments in areas including competition, financial, and investment policy all suggest these gains were driven more by state directives than liberalization and market-based reform, as was Beijing’s stated intent in 2013. As a result, Western governments are rejecting the means to China’s innovation ends, as evidenced by concerns about China’s Made in China 2025 policy and the recent Section 301 announcement of tariffs on selected Chinese imports by the United States. Nonetheless, our indicator shows that China will catch up to the 2012–2015 average of U.S. innovation intensity in less than a year. All innovation sectors grew above the industrial average this quarter, with the information and communications technology (ICT) sector growing the quickest and non-auto transportation equipment accelerating from last quarter.

Industrial policies to promote high-end innovation in sectors such as integrated circuits and transportation equipment were a major focus at the National People’s Congress (NPC) in March. The government’s intellectual property regulator was also given a wider remit at the NPC, in a sign of growing attentiveness to intellectual property rights (IPR) protection. Beijing took concerted industrial policy action in the review period, including renewing its new energy vehicle (NEV) subsidy programs and announcing a detailed roadmap for promoting artificial intelligence (AI). These policies are consistent with top-level designs to advance innovation, but they will only accelerate U.S. and other foreign actions targeting China’s industrial policies and IPR practices.

Our data on Intellectual Property Flows show China’s IPR exports reached $1.3 billion in the fourth quarter and totaled $4.8 billion for full-year 2017, a historic high.

This Quarter's Numbers

Given newly available OECD data, we were able to update the international comparison benchmarks in Innovative Industry Share in Industrial Value-Added and Volatility in Innovative Industry. Stylized comparisons now incorporate annual data from U.S. 2012–2015, EU 2012–2016, and Japan 2012–2016.

The role that innovative industries play in China’s economy reached a new high in this Dashboard review period. Our primary indicator, which measures the share of innovative IVA in total IVA, hit 32.6% on a four-quarter moving average (4qma) basis, up from 32.2% in 3Q2017. This continues a trend of steady growth in the share of innovative industries in the overall industrial structure over the past nine quarters. Every innovative industry in our dataset grew above the industrial average of 6.2% in 4Q2017. ICT led China’s high-end manufacturing sectors; it accelerated to 14% from 13.3% in 3Q2017. Non-auto transportation equipment, which was below the industrial average rate of growth last quarter, notably accelerated above it this quarter (see IVA Growth Rates for Specific Innovative Industries). IVA from the automobile sector decelerated but remained high – at 11.7% from 13.6%, on a 4qma basis.

At the current rate (see Volatility in Innovative Industry), China will reach parity with 2012–2015 U.S. innovation industrial value added by the end of 2018. This transformation is taking place against the backdrop of the government’s supply-side structural reform (SSSR) agenda, which mandated production capacity cuts that slowed lower value-added industrial activity in 2017 – by definition raising the share of industrial IVA coming from innovative industries. This rapid pace of improvement in our indicator may prove fleeting if traditional industrial production comes back online. At the March NPC, the government signaled that SSSR efforts would focus more on promoting innovative industries than implementing capacity cuts. That suggests the share of lower value-added industries in overall industrial growth might rebound in the coming quarters.

Other indicators reflect the increasing importance of IPR in China’s economy – a positive shift but one that increases exposure to IPR-related trade action from OECD economies, such as the set of new tariffs on Chinese imports announced in March by the Trump administration under Section 301 of U.S. trade law. Our data on Intellectual Property Flows show China’s IPR exports reached $1.3 billion in the fourth quarter and totaled $4.8 billion for full-year 2017, a historic high. This may be a low level by OECD standards, but it means that China’s IPR exports grew by 311% in 2017. Related data show the increasing importance of IPR imports to China’s economy: total IPR imports were $7 billion in the fourth quarter and $28.6 billion for the entire year of 2017, a historic high and up from $24 billion in 2016. The net IPR deficit remained high but stable at $6 billion, up from $5.7 billion previously.

China produced more than 600,000 NEV passenger cars in 2017, more than the rest of the world combined.

Policy Analysis

Industrial policy to promote innovation was a major focus of the NPC in March. The government work report targeted the promotion of a range of innovative and advanced industries such as integrated circuits, the 5G communication network, aircraft engines, NEVs, and new materials. The NPC also approved a bureaucratic reshuffling that included a restructuring of the State Intellectual Property Office (SIPO), expanding the body’s mandate to include trademark and origin mark regulations that were previously under the authority of two other agencies. The SIPO will now report to a newly established State Administration for Market Regulation (SAMR). These changes give China’s primary IPR regulator wider coverage but also push it down the bureaucratic hierarchy – the SIPO previously reported directly to the State Council.

Industrial policies remained focused on promoting innovation and domestic industry during the 4Q2017 review period. On December 14, the Ministry of Industry and Information Technology (MIIT) rolled out a three-year (2018–2020) development program for AI, which has relevance to a broad set of manufacturing industries. The MIIT program identified eight areas as priorities: intelligent connected vehicles, intelligent service robots, intelligent drones, medical imaging supplemental diagnostic systems, video imaging biological identification systems, intelligent voice intercommunication systems, intelligent translation systems, and intelligent household products. The plan called for local governments, research institutes, and market players to coordinate their efforts in promoting these industry segments.

NEVs remained a focus of industrial policy efforts. On December 27, MIIT, the Ministry of Science and Technology, the Ministry of Finance, and the State Administration of Taxation jointly extended the vehicle purchase tax exemption for NEVs by three years. The original tax exemption started in 2014 and was set to conclude at the end of 2017. The extension means that tax incentives for NEV purchases will be even more attractive in 2018, as NEVs remain tax exempt while the normal vehicle purchase tax rate increases from 7.5% to 10%.

Long-standing NEV producer subsidies were also extended (at lower rates) in February 2018, despite some speculation that they might be phased out. The new subsidy schedule lowers the maximum central fiscal subsidy per passenger car from RMB 150,000 ($24,000) in 2017 to RMB 100,000 ($16,000) in 2018. Local government subsidies usually match up to 30%–50% of central subsidies, meaning that the total subsidy granted to a NEV producer for each unit sold could still be close to RMB 150,000 ($24,000) in 2018. This number does not even account for government spending on NEV-related infrastructure, such as charging stations.

These heavy subsidies risk becoming the latest cautionary tale of how Beijing’s interventions drive production overcapacities and supply gluts in key industrial segments, with global implications. But for now they are driving rapid growth in China’s NEV market: China produced more than 600,000 NEV passenger cars in 2017, more than the rest of the world combined (see our Environmental cluster).

The Dashboard focuses on current indicators inside China, but this quarter merits a word on how international innovation policy tensions could impact China’s long-term potential. In August 2017, the United States launched a Section 301 investigation into Chinese intellectual property practices, alleging that China’s innovation relied on pressuring foreign firms to transfer technology, manipulation of administrative processes, intellectual property theft including cyber theft, and state-directed outbound direct investment. These concerns are shared by other advanced economies. In our view, each of these accusations is valid, but complicated. Beijing claims the decision to transfer technology is “voluntary,” made by foreign firms in order to gain position. Perhaps, but Chinese leaders promote that bargain by maintaining arbitrary investment barriers. Subsidized finance played a part in China’s global semiconductor company buying spree. That is not prohibited or coercive, but it is nonmarket. The U.S. Trade Representative’s 215-page, March 2018 Findings on this investigation is arguable in places but for the most part compelling in stating that the alleged activities play a significant part in promoting Chinese technological advancement.

For international relations, the question of whether these practices violate obligations or just push the limits is crucial; however, for the purposes of our Dashboard the relevant question is different: whether Chinese innovation would be materially set back if the United States and other advanced economies were to shut down channels of intellectual property flow. This is a speculative question. However, a 2016 assessment of the impact on China of the exclusion of foreign participation in the information and communication technology sector (The Price of a Digital Divorce, with the U.S. Chamber of Commerce) calculated that China’s GDP would be $3 trillion less, annually, by 2025, due to the exclusion of foreign ICT.

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