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Innovation Ecosystem in China

4 months 5 days ago

Innovation requires talent, capital and ecosystem. With world second largest economy spending more than 2.2 percent of GDP on R&D (above the average for EU), and world largest education machine producing five million STEM graduates per year, China generally does have the talent and capital to drive innovation. The key for long term success is to have a productive open innovation ecosystem for the innovative culture to thrive.

There are very diverse views about innovation in China. In a previous post, I wrote about a framework presented by Dr. Geoffrey Garrett, Dean of the Wharton School at the time. He succinctly summarized the China economic development in three stages: low cost manufacturing (1980-2000), middle class consumers (2000-2015), and innovation driven economic development (2015 forward). The often cited successful innovative examples from China include high-speed trains, e-commerce, mobile payments, and commercial drone. An increasing number of Chinese firms are at the global technology frontier. The restriction placed by the previous US administration created more urgency in China to transform its economy through a national focus on technology and indigenous innovation which will likely result in China developing its own advanced domestic technology. The development could have significant implication on global supply chains & businesses costs of operations later in the decade. The recent announcement of China’s goal of carbon neutral by 2060 has driven a rush to energy transition focus while the US ban on technology export naturally resulted in a significant increase in technology investment in computer chip technology. 

Similar to the early phase development of many other economies such as Japan and Korea, China went through the phase of development from imitation to innovation. Nonetheless, increasing numbers of Chinese products have gained world recognition by competing successfully in the global markets or competing with global brands in massive China market in terms of speed, cost, and innovativeness. With that said, there are some fundamental differences between the innovation ecosystem in China vs. that in the United States or European countries. Here are a few areas I would like to highlight in terms of the unique characteristics of the innovation ecosystem in China.

Innovation driven by government policy

There are still debates whether Chinese economy is market economy or commend economy. While multinational companies generally make their business decisions based on their own business strategy, businesses priorities or even strategic directions can be directly or indirectly influenced by government policy at the macro economic level. Government generally does not interfere with business decisions at microeconomic level, yet many business decisions, especially at state owned enterprises (SOE), are implicitly influenced by government policies. Innovation is no exception. In fact, performance indicators for government officials, including those at state owned enterprises, are often directly tied to implementation of government policy such as GDP target, environment compliance, innovation, and energy consumption etc.

In contract, the diffusion of power in America between different levels and branches of government and between the public and private sectors is why it at times looks messy, and why it has endured. Government alone can not and would not impose its will on the rest. With that said, government driven innovation is nothing new. Similar policies played active roles for the emergence of Japan, Korea, and other Asia economy post WWII. Even moon landing, space shuttle, Manhattan project in the United States were all successful government funded major innovation programs. Of course, moon landing and Manhattan program were not driven by pure economic reasons. The reality is that government driven programs, while effective, are typically not efficient in pure economic term. As a result, measuring them in economic term is missing the fundamental point. If you look at in that lens, many of the government innovation programs in China, while not necessarily economically efficient, are driven by political consideration including the intersection of national security and economic policy. It is debatable how much a large economy such as China can continue relying on “managed” innovation to sustain long term competitiveness. Judging from two indirect indicators of innovations: patents which show the number of inventions and venture capital which provides the financial backing to turn those inventions into products, China is gaining ground. However, R&D spending and maturity in managing innovation in private sector is still far lagging behind advanced economy. The declining of the growth of total factor productivity (TFP), which fell sharply from 2.7 percent in the early 2000s to only 1.1 percent in 2008–2017, is a challenge for Chinese government. As an example, the vast investment in high speed train benefits the public tremendously but the investment hardly has a return a business would expect. The high speed train Corporation is burdened with heavy debt, yet it recently announced further expansion of high speed freight train as part of its comprehensive transport system development by 2035. In the end, one can not expect to measure the success of government projects with the same criterion as a private investment in terms of financial return on investment. With the inherent inefficiency of government driven innovation, it remains to be seen if the increased investment in science, technology and innovation would be able to fundamentally change China’s innovation trajectory in the coming years. In order for China to avoid the so called middle income trap, China not only needs to innovate, but private companies and entrepreneurship culture have to play a more vital role in innovation.

Innovation driven by unique China market size

Every society is unique and China is unique in its own way. First of all, with 18.5% of world population,17.5% of the world GDP, 800 millions internet users, the sheer size of the market allows business opportunities unimaginable in most other smaller countries. The estimated 700 millions middle class population in China with increasing spending power will create unique enormous innovation opportunities for businesses. The recent government policy, which is expected to boost domestic consumption by 2030 by increases in household income and growth of urban areas, will further increases market attractiveness in China. Secondly, China as a country has a relatively unified regulatory and legal system across the country which facilitate the easiness of entry for multinational companies. Thirdly, the fast development based on GDP in the last forty years, equivalent to about 200-300 hundred years of development for many European countries, can obscure many underlining gaps in basic structural gaps in the society to be bridged. With the size of the overall market in China, entrepreneurs who can identify those opportunities early and provide bridges for those gaps can have enormous upside potentials. For example, while China has the world best high speed train system and high way infrastructures, the tourist industry is still very fragmented. While the mobile payment system is a major development in China, consumer credit system is very limited. China leapfrogged into the smartphones from telephones, or no phone at all, pretty quickly. This allowed internet companies to innovate in a way their counterparts in the West haven't been able to.

Social networking driven innovation

In innovation and entrepreneurship, access matters as much as capital and capabilities. China as a society is much more connected in a social sense than typical western culture. Although interpersonal business relationships are universal, Chinese culture has certain characteristics that make them different from networking relationships in a western context. It stems from Confucianism, which emphasizes the importance of relationships, trust and social harmony. While some scholars have argued that individualistic cultures nurture more invention over collective societies such as China, advantages of distributed collaboration, informal information flow supported by digital tools, augur extremely well for China’s innovation. Relationship allows fast access to capabilities and resources for collaborative innovation which typically takes much longer in the western world. People or organization built on social trust can develop framework based on informal relationship, rather than starting with air tight legal agreements. The large social network with highly engaged and mobile-savvy users is a powerful enabler to take advantage of the increasingly democratized manufacturing capabilities to facilitate the translation of innovative ideas to practice.

As an example, Wechat, launched ten years ago, has grown from a messaging app into a huge digital ecosystem, all in one super app. Social media, digital payment, search engine, location mapping and millions of commercial, municipal and corporate services have been exploited through their ecosystem of Mini programs. Total transactions generated on Wechat Mini Programs grew more than 100% in 2020 to USD 247 billion from USD 123 billion in 2019. Wechat has been playing an enormous role during the pandemic to keep businesses and lives rolling in countless ways.

Innovation driven by unique business model

Partly due to the unique characteristic of the China market, partly driven by consumer behavior, many mass market business models developed in the western markets would not be directly transferable to China market. Companies have to take the time to localize not just their products but also how products are being positioned to connect with the over saturated market. As an example, as the ongoing pandemic has limited abilities to travel abroad, the cross-border e-commerce platforms, which now have become the only channel for many domestic consumers who seek for overseas products, have become a highland for foreign brands who want to keep consumers in the world's second-largest economy.

Availability of cheap yet skilled labor, combined the vast supply chain, and large number of mobile-savvy users create unique opportunities for entrepreneur to create new business models which are economically less sustainably in the mature markets. Developed economy tends to have a lot of rules and regulations, creating friction around these services that in China the government simply hasn't gotten around to regulate. The recent sage about Ant financial is a perfect of example of Jack Ma’s attempt to fill a gap for consumer finance while the regulatory framework for capital requirements is still lagging.

What does this mean for multinational companies?

In order to be successful in the increasingly dynamic and innovative business environment in China, multinational companies have to adjust their overall innovation strategy. In addition, competition is fierce in China because it attracts players around the world, being able to compete in China is a ticket to competing in the global market.

Keep an agile growth strategy. Even with the increasing advocacy for disengagement, there is no indication many companies would retreat or abandon the China market. If China market is fundamentally important for your business, companies not only need a China strategy but also need to be an agile one to be adaptive to the rapidly changing business dynamics. As an example, Mercedes-Benz, BMW and Audi all logged record-high sales in China last year, a striking contrast to their significant declines in overall global sales. China's share of global sales at each company ranges between 36% at Mercedes, 33% at BMW and 43% at Audi. Obviously success in China is fundamentally important for those companies. At the same time, to have an agile growth strategy means that they need to avoid being blindsided by the rapid transition to EV and other developments resulting from the somewhat unexpected ambitious commitment of achieving carbon neutrality by 2060.

Shift R&D focus from cost savings to knowledge-based research. Many companies with R&D in China are largely focused on “end of development” activities, working on products close to commercialization, or product applications. The availability of talent pool and fast market development increasingly call for technology development in China to be closer to the consumers and allows fast response to customer needs and market dynamics. China market not only provides a unique scale advantage for products, but also a source of inspirations for innovations for new products and new business models due to its dynamic nature. One of the key for success is to attract and retain talents for them to have the ability to learn and develop, to be given greater responsibility.

Sustain competitive advantage by continuous innovation. Protecting IP is important and the China legal system has made significant progress. However, the only way to ensure continued success is to continue innovation, rather than taking a conservative approach to only focus on defense. Many multinationals, especially in the consumer markets, make more revenue in China than in America and their bosses turn to there, not to California or Paris, to see the latest in digital marketing, branding and logistics.

Innovation aligned with country ESG priorities. There is a strong push from government to encourage and motivate private businesses to enhance environmental compliance and increase sustainability focus, any product innovation including a company’s waste, pollution, natural resource including energy conservation would not only improve company operation but also help company or product brand in the market place. It is often beneficial to build relationships with university researchers and government research institutes by working on such effort jointly, preferably ones that aligned national or local government priorities, ideally integrating them in an organic way with other factors at the company level. Chinese universities and institutes are part of a broader innovation ecosystem. This can include open innovation: collaborating with outside bodies to develop innovations; commissioning research projects for specific purposes; and partnering with a university and company to qualify for central government research funding.

In summary, it is too early to project how the innovation drive in China would sustain and thrive in the long term but companies would be wise to keep up this rapidly developing innovation ecosystem. While not necessarily mature, the sheer ability to invest upfront with speed, guts of Chinese business leaders, customer centric innovation, lack of corporate bureaucracy are putting Chinese innovation quickly forward. I will close by sharing a quote from a recent article in The Economist magazine, "there is a pattern to how the West thinks about Chinese innovation. From electronics to solar panels, Chinese manufacturing advances were either ignored or dismissed as copying, then downplayed and then grudgingly acknowledged around the world. Now it is the Chinese consumer’s tastes and habits that are going global. Watch and learn." While this is an oversimplification, it certainly should catch the attentions of companies that are looking to compete in China.

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