China News: Its a Lumbering Behemoth That Desperately Needs to Learn How to Innovate

In 2007, Time Magazine’s January front cover sounded the alarm on the arrival of a “new superpower” — China. The United States and much of the world were caught up in a mammoth economic and financial bubble which would burst later that year. The hubris on China even challenged America’s free-market system and democratic politics. Much like the vogue of fascism during the 1920s and 1930s in the U.S., similar voices urged Americans to consider the benefits of a state-managed economy.

While China did relatively well through the recession, its economy has stalled lately. Growth slowing is expected to be around 7.5% this year, down from 10.4% in 2010. President Xi Jinping has tried to allay concerns by saying this is a “controlled” slow-down and that there is a no risk of a hard landing. Now being realized is the expectation that China has reached a pivotal moment in its development — and emphasis is shifting to begin large-scale structural reforms for the next stage of development. However, there are concerns that the political will is weak when it comes to creating conditions that will foster the economic competitiveness that is essential for sustained growth.

Traditionally, China has played a game of “catch-up” where copying or reverse-engineering other’s technology and replicating it for much cheaper on larger scales provided huge growth. That model seems to have reached its limitations. China’s leaders recognize the need to pivot and change economic policy towards one that is more innovative. In fact, “innovation” is the word of the day at many high-profile government and business functions. At a recent press conference, Chinese politicians and leaders used the word “innovation” no fewer than 43 times.

Premier Li Keqiang stated recently that innovation should be one of the major driving forces of China's ongoing economic reforms and development in the future. He was noticeably absent however from an opening ceremony to launch a very high-profile project to foster and accelerate innovation. This disconnect between rhetoric and action highlights the fundamental struggle between the impulse of Chinese leadership towards the traditional state-led growth model and one which requires much less state interference — less control from authorities — to allow innovation to grow.

The launch of the Shanghai Free Trade Zone (SFTZ), a tent pole event to kick off a campaign for wider economic reform has led many to question Chinese understanding of the term “free-trade zone.” Over 1,000 industries and sectors have been banned or excluded from foreigners in the zone. Furthermore, restrictions on the internet and selling of antiquities remain along with high corporate tax rates.

This “addiction to control” by Chinese authorities is completely incompatible with growth in innovation and economic development. Not only does this approach stifle new ideas but it encourages consensus around mediocre strategies and methods.

Innovation is further hampered by a lack of protections on intellectual property and government-sanctioned monopolies which present high barriers of entry by state-owned firms. This in turn snuffs out “curiosity-based” innovation.

Some point to China’s large R&D spending — globally number two behind the U.S. to emphasize China’s catching up. This ignores that the U.S. spends 19% of its R&D on basic science (vs. 5% for China), the kind which spans new fields over time. Much R&D is spent by the Chinese state, whereas in the U.S., public spending is dwarfed by private-sector R&D spending.

The private sector in the U.S. is quickly growing in areas held tightly by the state in China. Space, for example, is an area where the commercial sector is quickly growing in the U.S. NASA used less than 1% of the U.S. budget on Space research and even this is shrinking. The space shuttle program has almost entirely been privatized. This not only creates opportunity for new industries, but also shrinks the burden on the tax-payer.

Contrast this with other industries such as telecom, where state control in China allows immense power over what ideas make it commercially or in the public space by government policy rather than the marketplace. This tight control chokes out curiosity and ultimately opportunity.

Contrast this with the U.S. system of strong intellectual property protections and enforcement, a flexible labor market and open and free exchange of ideas both online and offline. This allows for a fertile market and gives the U.S. its competitive edge.

This of course doesn’t mean that China can’t change if it embraces a more open society, fewer restrictions and strong rule of law. It also doesn’t mean the U.S. can’t erode its competitive edge through misguided regulation and high taxes. In fact, the past couple of years have seen notable examples of lax U.S. enforcement of monopolistic tendencies in certain industries. This can lead to rent-seeking behavior which is just as dangerous to innovation as heavy state intervention.