Framework Conditions for Innovation in China, Part 1

Research indicates that there are certain conditions that have a strong impact on innovation: education, competition, corporate governance, and financing of innovation. It's difficult to say beforehand which framework conditions are going to have the stronger impact because it depends on context. There’s a lot of room to improve these framework conditions so that innovative activity improves in China.

The Chinese education system is largely oriented towards passive learning. Some argue that it's oriented towards rote learning. Assessment of performance is predominately exam-based. Attention need to be paid to fostering students’ innovative thinking, creativity, and entrepreneurship.

Product market competition is an important stimulus for innovation because it causes suppliers of S&T to be incentivized to create technologies or scientific products that are acceptable in the market place. Although China is moving toward a market-oriented economy, it's not there yet. There are still problems which destroy competition; administrative problems, sometimes illegal conduct and local protectionism. For these reasons, government is required to intervene and to correct market failures. Marketing situations also are relatively under-developed and inadequate, resulting in inadequate rewards for innovative activity. The transition to a more innovation-driven growth based on strong intellectual property rights requires a modern, properly enforced anti-trust law so that those enterprises that do win in the competitive landscape are sufficiently rewarded for their efforts.

Corporate governance shapes the incentives of business executives and thus their decision-making within an organization. This has a significant impact on innovation performance in the business sector. Government should lead in innovation activity at the early stages of scientific development but then the business sector should take the lead.

Many Chinese firms are unfamiliar with innovation although the situation is changing, particularly regarding large firms. Companies are becoming more aware of the profits to be gained from innovative activity. In state-owned enterprises, management has insufficient incentives to undertake long-term, risky investment in R&D because funds are coming from the state and the state rewards reliability and predictability much more than innovation. Innovation is expensive, time consuming, and risky. The outcomes are not known in advance. These disincentives are further exacerbated by a severe lack of professionals with experience in managing R&D projects.

The top-down approach in place in state-owned enterprises results in R&D activity that is inefficient and weakly related to demand. A top-down approach means that the enterprise is told by the state what it needs to change, what areas and what products. State-owned enterprises are, generally speaking, not very efficient producers and users of knowledge. Government policies favoring state-owned enterprises are also not very helpful because it crowds out support to non-state-owned small or medium sized enterprises that are more likely to engage in innovative activity. However, the situation is changing. New enterprises have emerged which have less reliance on the state and theoretically should be more willing to engage in innovative activity. State-owned enterprises themselves are being restructured to be more market-oriented with great incentives to invest in innovation.

As the economy becomes more market-oriented, a more modern system of R&D funding is gradually emerging. State-owned enterprises or other enterprises will be allowed to get funding from other sources aside from the state. At the moment, the financial system is dominated by state-owned banks and they generally give loans to large state-owned enterprises that often lose money. The funding needs of private firms, most notably small to medium sized enterprises, are not met for general day-to-day running and for S&T. The capital market is underdeveloped. Small and medium sized enterprises (SMEs) find it difficult to secure loans outside of state-owned banks. They have to depend mostly on self-funding and private funds rather than formal sources of funding. This lack of capital for financing new ventures means that innovative enterprises (or more risk-taking type of enterprises) are less likely to emerge.

China lacks both the expertise and the necessary legal and regulatory conditions for an adequately functioning venture capital system. In many advanced economies, a venture capital system supplements the funding that firms get from banks. Domestic venture capitalists do exist but they have been established by the government at the national or provincial levels and these officials do not always have adequate technical, commercial, or managerial skills to be able to identify which ventures are most worthy of receiving the funds. Although there's sufficient liquidity in the system because there are a large number of wealthy business people and foreign venture capital firms looking for investments in high-tech, innovative, or risk-taking firms, there are few professionals with the experience to identify and invest in those firms that are both most needy and worthy of their investments.

There's also a shortage of firms and businessmen that are prepared to invest in sectors such as Biotech, in which an investment may take a long time to yield return. China is still theoretically a socialist country and investors aren’t sure how the political structure will play out. Transition in leadership may have an impact on their investments. The number of private domestic and foreign venture capital firms has been increasing but funds are still short.

The Long Term Science and Technology Strategic Plan 2006-2020 proposed to address the issue of financing innovation by the establishment of policy banks and commercial banks. Policy banks are especially set up to fulfill needs arising from policy objectives. Several other initiatives have been undertaken to increase access to funding for high-tech SMEs and start-ups.
from Coursera course, Science and Technology and Society in China. Week 2. by Naubahar Sharif, The Hong Kong University of Science and Technology