The term ‘made in China’ has enjoyed a digital economy revamp and makeover. Two decades ago, the nation was the low-cost “factory of the world”, selling apparel, footwear, toys and plastics to generate volume growth. Fast-forward to 2018 and the export basket of the world’s second largest economy is made up of mobile phones, computers, automobiles and semiconductors.

This change is the result of a concerted drive by the Chinese state – a drive which has managed to push the country’s economy up the value chain. China has started to compete for value, as opposed to volume, in more sophisticated segments of the global market.

Old economy appearance versus innovative reality

But, while China’s rapid economic convergence is well-documented, the similar catch-up seen in the realm of innovation has often gone unnoticed. This is partly because of China’s developing country status, a moniker not usually given to countries where cutting-edge technology is being developed.

In fact, while the traditional image of the Chinese economy is one of old smokestacks, fettered by debt, overcapacity and asset bubbles, the reality is rather different.

According to the latest Global Innovation Index by the World Intellectual Property Organization (WIPO)[1], China ranks among the top 20 of the world’s most innovative countries[2], beating many developed nations, such as Canada, Norway and Australia, and it is also ranked first among its middle-income peers.

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New household names

At the micro level, rapid growth in high-tech industries has created companies, like Alibaba, Tencent, Baidu and Huawei, which are not only household names in China but are also starting to compete globally with giants such as Amazon, Facebook, Google and Apple.

The graph below further underscores this point by presenting some common metrics of a nation’s innovative capacity. China appears as an outlier in research and development (R&D) spending compared to its level of income (LHS-Exhibit 1). At 2.1% of GDP, China’s R&D spending is above the Eurozone average, of 1.9%, and is second only to the US, in absolute terms[3].

Exhibit 1

Such investments in R&D have allowed China to catch up rapidly on innovation output. In 2016, China produced just under 500,000 research publications, again second only to the US. While the quality of these publications – as measured by the number of citations and the H-index [4] , represented by the size of the bubble in MID-Exhibit 1, is still behind the US, China appears comparable to innovation leaders such as the Netherlands and South Korea, and is not far behind Japan.

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From innovation to output

Taking a step further down the innovation production chain, China is doing even better in turning R&D into patents. WIPO data shows that China has made its way to the top in both patents filed and granted globally in 2016 (RHS-Exhibit 1).

This effectiveness of turning innovation inputs – defined as investments in human capital and infrastructure – to outputs has earned China the number three ranking in innovation efficiency in the latest Global Innovation Index.[5]

The significant efforts to move China up the tech ladder are not just manifesting in the rising number of journal publications and patents but also in real economic impacts.

If you look at some of the key areas of the digital economy, it is clear that China has already made great strides. For example, within clean tech, China has installed 250gw of renewable power, almost double the 130gw currently installed in the US. Its e-commerce market , which currently stands at $725bn also dwarfs that of the US (currently around $395bn), although this is at least partly linked to its significantly greater population. High speed rail is another area of clear difference, with China currently operating 35,650km of high speed rail lines, to the US’s 845km. However, the US remains dominant in a number of areas, including the number of companies focused on artificial intelligence, as well as the number of ‘unicorns’ or privately held $1bn companies. There are 127 in the US, compared to only 59 in China. However, while China’s recent achievements on innovation have been nothing short of stellar, and should reinforce the direction of technology changes in the future, there are three main threats the country needs to tackle, if it wants to ensure that its technology sector continues to flourish.

Ensuring the innovation well doesn’t run dry

China’s tech development has strengths and weaknesses, with risks at both ends. What it has done exceptionally well is bridging new technology with traditional industries, using the so-called ‘internet +’ model to deliver efficiency and value. E-commerce (internet and retailing), Fintech (internet and banking) and ride-sharing (internet and transportation) are just some examples of China’s outstanding achievements against competition. The success in these sectors has attracted significant capital and talents, resulting in a lopsided distribution of Chinese tech firms, compared to that of the US. China appears to be making concentrated bets on the future of technology, which can be risky if these sectors fail to deliver.

Compared to its strength in connecting on-and-off-line businesses, China still lags the US in inventing ground-breaking new technology. This is true, even in areas where China has done exceptionally well, where the original technology is quite often developed elsewhere. China is simply the best adaptor of that technology for its vast domestic market. Economically, there is nothing wrong with being a good innovator but not a true inventor. Think of Apple, which has grown to be one of the world’s largest companies for being a successful integrator of existing technology, with little in the way of original invention.[6]

In fact, what China is doing is essentially “technology transfer”, which according to classical economics, is how an emerging economy can grow faster than a developed one. But as China approaches the technical frontier, sooner or later it will have to push the boundary, like developed countries do. The lack of investment in basic research to build that knowledge reserve and inventive capability could hinder China’s technological progress sometime down the road.

Getting out from under the shadow of the state

The extensive government involvement in technological development can be a risk if the side-effects are not properly managed. Some parts of the government’s involvement, such as provision of tax incentives and protection of intellectual-property rights are necessary for sustaining healthy growth of the sector.

But when it comes to policies interfering with market forces, the risk for undesirable outcomes can be much higher. One example is the boom and bust of China’s solar panel industry, which was led by changes in the government’s subsidy policies, as opposed to supply and demand of the market.

Another related concern centres around Chinese companies’ acquisition of foreign technology and assets. These acquisitions have come under increasing scrutiny of the foreign governments on the grounds of national security, as Chinese buyers are often seen as conduits of the Chinese state. With rising global protectionism, especially within high-tech sectors, the image of public-private-interconnection could undermine China’s ability to transfer technology and obstruct future growth.

Don’t forget the valuations

Finally, for investors, the Chinese tech companies are not cheap compared to their global peers. The average market cap of Chinese “unicorns” is higher than that of the US[7], and the overall market valuations (trailing price-earnings ratios) of the SME and ChiNext boards of the Shenzen Stock Exchange are above that of the NASDAQ. While these valuations have corrected substantially from their 2015 peak, further declines are not impossible, particularly if the US enacts tougher sanctions against Chinese firms. An increase in the tech war currently ongoing between the US and China could therefore present a major risk for investors of the sector.

Genuine change, but headwinds remain

Obviously, it is premature to draw any general conclusions on who might win the tech-race between the world’s two largest economies, especially as it is based on such a narrow set of metrics and industries. Likewise, there are a number of headwinds pushing against the continuation of the pace of innovation growth in the country. But China’s achievements in transforming itself into an innovative nation are genuine and pervasive – and we believe they should be recognised as such.

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Notes:

[1] World Intellectual Property Organization “Global Innovation Index 2018, Emerging the World with Innovation” 12/07/2018

[2] China ranks No. 17 in the 2018 Global Innovation Index, after ranking 23rd and 25th in the previous two years respectively.

[3] R&D spending by China has grown four times faster than the US over the past five years.

[4] The H-index is an indicator that shows how productive and influential a researcher is. For example, a researcher has index h, if h number of the many published papers have at least h citations each

[5] China ranks after Luxembourg and Switzerland, but is well ahead of the US, which takes 21st place.

[6] https://www.forbes.com/sites/sap/2011/12/12/steve-jobs-didntreally-invent-anything-really/#272470241fa8

[7] Although valuations of BAT – Baidu, Alibaba and Tencent – are comparable to those of Facebook and Google but significantly below Amazon and Netflix.