China’s Innovation Ecosystem
Issue 2 - China Matters
Not that long ago, the notion that China could ever become a global innovation center was considered laughable. Among the reasons cited by the Western punditocracy were China’s conformist Confucianist traditions, rigid education system, rampant patent infringement, heavy-handed government interference, and, at that time, the oft-heard charge that the Chinese are somehow culturally incapable of innovation. This was always nonsense, of course. For starters, several of the most important inventions in history came from China, including the compass, gunpowder, paper, and printing. In addition, China was already quite innovative, not yet in new-to-the-world inventions, but in adapting global products to their domestic market, developing low-cost processes, and adapting business models to local market conditions. And it was already quite clear that China would become an innovation leader in industries where it would likely catch up to world-class standards first: information and communications technology and all things digital.1
Fast forward to today and we see a vibrant Chinese R&D system that now offers many advantages, including the number and variety of collaboration partners, inventive scientists, the fast pace of commercialization, and, of course, the size of the market itself.2 In a growing number of industries, it is no longer enough to stay one or two generations of technology ahead of local Chinese competitors who are themselves increasingly approaching the cutting edge. In response, foreign multinationals (MNCs) increasingly use their China-based innovation capabilities as much to localize global products as to create new products and are integrating local innovation work with their global efforts.
However, these local advantages do differ by sector.3 In other words, China’s R&D environment is a microcosm of its overall market – it is not for everyone. Foreign firms in favored sectors open to foreign investment are likely to be optimistic about Chinese R&D ecosystem (e.g., chemicals, automotive, machinery) whereas firms in sectors with increasingly capable local champions have become quite pessimistic about their prospects (e.g., information and communications technology).
In favored sectors, market and political forces are increasingly pulling R&D into China, as foreign firms must tailor their products to meet the requirements of highly demanding Chinese consumers to remain competitive, which requires local R&D. Market forces are also a chief driver of why larger MNCs locate their R&D centers in cities such as Shanghai and Shenzhen that offer a more open business environment as opposed to one of the special innovation zones, whose subsidies and favorable tax benefits are offset by the costs of isolating R&D activities from end-customers and other operational activities. In addition, there is a growing political need to localize innovation to mitigate the impact of cross-border disruptions (e.g., US-China trade and technology wars) as well as to meet official demands from China’s cybersecurity regime and unofficial expectations for “autonomous and controllable” value chains and localized R&D that will not be subject to foreign export controls or sanctions. Finally, onshoring decisions may be influenced by China’s divergence from international technical regulations and standards.
MNCs in favored sectors must determine whether to adopt an “all-in” or a “hedged bets” strategy. For example, in sectors where Chinese firms are at or near technological parity, the all-in approach may be necessary to remain competitive. MNCs in these sectors view China’s R&D ecosystem as an innovation accelerator enabling them to develop products in China that can then be rolled out globally. In sectors where Chinese firms are still lagging, it may be more sensible to leave some of the most critical R&D at home to mitigate potential technology leakage. These tend to be sectors that are crucial but not particularly “high-tech” and feature niche technologies (e.g., precision industrial equipment). MNCs in these sectors recognize the risks of undertaking R&D in China but believe they will always be one or two steps ahead of their Chinese competitors. In this context, it is important to note that China’s IPR protection system is increasingly mature for patent filing and enforcement, but still lags in trade secrets, especially in cases where local employees go to work for competitors in violation of non-compete clauses that are rarely enforced.
Multinationals that prefer to hedge their bets recognize the importance of developing products specifically for the China market but focus on localization and seeking out complementary local technology to enhance their local and global product offerings. For example, AB Volvo entered into a joint venture with Shandong Lingong (SDLG) to develop hydraulic excavators specifically for local Chinese customers as well as, over time, other emerging markets, such as India. Similarly, General Motors set up a joint venture with local producer, CATL, for batteries in China, while leveraging its existing partnership with Korean powerhouse, LG Chemical, in the rest of the world. Such hybrid strategies are especially important for SMEs who manufacture and develop only one or two crucial technologies and for whom the risks are immeasurably higher, as IP leakage would not only be extremely difficult to counter but could also result in losing their primary competitive advantage altogether.
In conclusion, China’s R&D market is not for everyone, and careful strategic planning is an important first step in determining if/how much MNCs should invest in China-based R&D activities.
1Can China Innovate? (John Jullens, Strategy+Business, 2014)
2See also AI Superpowers (Kai-Fu Lee, Houghton Miflin Harcourt, 2018)
3China’s Innovation Ecosystem: Right For Many, But Not For All (EUCC/MERICS, 2022)