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 measured by the changing shares of IVA in industry, innovation remains the primary reform indicator cluster of those we monitor where China is making the most progress. This was evident in 2Q2017 and continues in this quarter. Our data suggest that China will catch up to the 2011–2014 levels of U.S. contribution from innovative industries to the industrial structure in the quarters ahead. Based on our methodology, structural adjustment toward innovation is taking place in China, backstopped by serious policies for both promoting innovation and suppressing sunset industries.

At the current rate, China will reach parity with 2011–2014 average U.S. innovation industrial value-added in a matter of months.

The automotive sector leads China’s industrial innovation growth, though other innovative sectors including information and communications technology (ICT) and instruments and meters are also growing more rapidly than overall industrial output. We also observe a moderate, but important, improvement in China’s share of global trade in high value-added industry. However, there are some important caveats. First, the increased share of innovative industries in IVA is in part driven by a sharp drop in the contribution of less innovative sectors to IVA, as a result of the government’s push to cut overcapacity in heavy industry. And second, other innovation indicators tell a more cautious tale, such as China’s ongoing deficit in payments for intellectual property. Speaking holistically, China is not yet a global innovation leader.

On the policy side, Beijing rolled out industrial policy plans for new energy vehicles (NEVs) and artificial intelligence (AI). These plans are likely to accelerate trade tensions with the United States and Europe, where governments are looking critically at China’s state support for domestic industry and its policy toward outbound acquisitions of foreign technology. The State Council also approved a shift in the GDP accounting system to include local spending on R&D as part of investment, rather than an expense – a change made for national-level statistical reporting entities a year ago. This is likely to further promote R&D outlays locally, since officials are still graded partly on GDP results.

This Quarter's Numbers

Beijing recently made several years of historic mining industry data available. In our inaugural update, we relied on estimates of past growth rates for these years. We now have a more accurate understanding of China’s innovation progress. The updated data largely confirm our earlier assessments. After incorporating new data, our primary reading for 2Q2017 is now 31.8%, just below the 32.5% in the original update. Meanwhile our supplemental indicator Volatility in Innovative Industry moved up one basis point from 34 to 35. Simply put, China’s innovation level in 2Q2017 was slightly lower than our initial estimate, but the pace of relative growth in innovative industries was also slightly faster. This 3Q2017 update has incorporated these revisions.

China’s industrial innovation intensity reached a new high in our five-year monitoring window in the third quarter. Our primary indicator, which measures the share of innovative industrial value-added in total IVA, hit 32.2% on a four-quarter moving average (4qma) basis, up from 31.8% in 2Q2017. This continues a trend of steady growth in the share of innovative industries over the past eight quarters. Every innovative industry in our dataset, except for non-automobile transportation, grew above the industrial average of 6.3% in 3Q2017 (see IVA Growth Rates for Specific Innovative Industries). IVA from the automobile sector cooled slightly but still grew by 13.6% on a 4qma basis in the third quarter. This is down from 15.9% in 2Q2017 but still leads all industrial sectors. ICT closely followed, growing by 13.3% in 3Q2017, up from 12.5% in the previous quarter. Instruments and meters grew by 13.2%, up from 12% in 2Q2017.

At the current rate (see Volatility in Innovative Industry), China will reach parity with 2011–2014 average U.S. innovation industrial value-added in a matter of months. Yet, the current pace of rapid change may be misleading and fleeting, and China’s innovative IVA may even fall in coming quarters. Part of the reason that China’s innovation share of industrial output is growing so quickly is that the share of non-innovative industries in IVA is falling, as a result of the ongoing supply-side structural reform (SSSR) agenda. The mining industry, for example, recorded negative IVA year-on-year (yoy) growth since 3Q2016 due to government-directed production cuts. It is unclear if these production cuts will be permanent, although the Communist Party’s Central Economic Work Conference (CEWC), held in December 2017, did call SSSR the “main line” for policy in the year ahead, suggesting these cuts will remain a primary focus of policy. Data in 2017 also show that steel and coal producers resume production when prices rise after a round of government-driven factory closures brings supply off the market.

Other indicators suggest Beijing’s progress toward becoming an innovation-led economy is more modest. For example, our data on Intellectual Property Flows look at China’s balance of payments credits and debits for IPR. In 3Q2017, China had its highest level of IPR exports in our five-year window, at US$1.3 billion (up slightly from US$1.28 billion in 2Q2017). This is a low level by OECD standards, though it reflects an improvement from five years ago when IPR exports were just US$200 million. Yet China still imported more than four times the IPR that it exported. Total imports were US$7 billion in 3Q2017, down from a record high US$7.8 billion in 2Q2017, leaving China with an IPR deficit of US$5.7 billion.

China’s position in global trade value chains seems to be evolving toward producing more innovative goods, though at a moderate pace. Data on the Share of Global Exports in Innovative and Non-innovative Industries compare trends in China's global export share in one innovative and one non-innovative sector. China’s shares in the global trade of apparel and textiles (a typically non-innovative industry) dropped to 44.4% in 3Q2017, from 45% in 2Q2017, although still predominant. Meanwhile, China’s global export share in electric equipment (a typically innovative industry) increased modestly to 28.4% on a 4qma basis, up from 28% in 2Q2017.

China still imported more than four times the IPR it exported.

Policy Analysis: 3Q2017

On September 9, Ministry of Industry and Information Technology (MIIT) Vice-Minister Xin Guobin announced that China was considering a timetable to phase out gasoline cars. China is not the first country to have such plans. Earlier in 2017, the UK and France announced plans to phase out gasoline cars by 2050 and 2040, respectively. The MIIT did not announce a specific date for China to achieve this goal. But the plan is in line with the government’s aggressive push for the use and production of NEVs, which was identified as a priority in the Made in China 2025 plan.

Domestic manufacturers and policymakers have long argued that NEVs offer China a rare opportunity to catch up with developed markets in the automotive industry. On September 29, MIIT announced an NEV energy efficiency credit system (“Parallel Credit System for Passenger Vehicle Average Energy Consumption and New-energy Vehicles”). Effective April 2018, the new credit system will require car manufacturers in China, both domestic and foreign joint-venture, to earn credit by either improving their gasoline car energy efficiency or producing more NEVs. Manufacturers can trade credits among themselves. A failure to earn sufficient credits could result in penalties, up to and including the cancellation of production permits.

China has a long history of using these kinds of industrial policies to encourage domestic production. The challenge is the risk of overcapacity. Despite the consistent high growth of automotive IVA in China, car sales are flattening and inventory is rising. This raises concern that NEVs could become China’s next case study in how industrial policies risk undermining corporate profits and cause trade tensions by flooding an emergent sector with subsidized products – as happened previously with solar panels and several other products.

The State Council also issued a national blueprint for the development of AI on July 8 (“New Generation AI Development Plan”). The plan included three main targets: (1) catch up with global AI leaders by 2020, (2) achieve significant AI breakthroughs and become a global leader by 2025, and (3) lead global AI development (theory, technology, and applications) by 2030. The plan included a dozen supporting policies, one of which was to “provide convenience and services for competitive [Chinese] AI companies in overseas M&A, equity investment, starting-up, and establishing R&D centers.” In another document issued on August 18 (“Opinion on Further Guiding and Regulating Overseas Investment”), the State Council encouraged Chinese companies to invest in high-tech and advanced manufacturing sectors overseas. This suggests it will likely be easier for Chinese investors in AI assets overseas to obtain foreign currency transaction approvals from the State Administration of Foreign Exchange (SAFE).

Beijing’s push into NEVs and its reach for foreign AI knowhow show that China’s leaders are determined to boost the innovative capability of domestic firms in promising emerging technologies. But doing so with heavy state backing will also likely cause U.S. and European governments to upgrade national security reviews of Chinese investments, including mergers and acquisitions in these and other high-technology sectors.

In 3Q2017, China also applied a technical adjustment in local GDP accounting, which has consequences for future R&D spending. The State Council formally approved the National Bureau of Statistics’ (NBS) proposed new GDP accounting methodology on July 12, allowing for nationwide implementation. Following international standards, the NBS started to record R&D expenditures under capital formation instead of intermediate cost at the national level in 2016, but it did not apply that methodology to local GDP accounting until the State Council’s formal approval in the third quarter of 2017. The change makes China’s GDP tally larger but leaves historical growth rates largely unchanged, since R&D accounted for only about 2% of GDP. With R&D now positively related to final GDP expenditures, local governments will likely encourage greater R&D spending, not only to meet economic growth targets but also to showcase local innovation competitiveness.

Explore the Reforms

Photo Credit: Shaun Curry/AFP/Getty Images