China’s Role in the Global Economy and Technological Catch-Up

The growth performance of the Chinese economy has been very strong over the last decade, even in the time of the current financial crisis that has hit Western economies. China’s GDP growth has been averaging well over 9 percent since 2008, while the US and European economies slowed down considerably. Related to its growth performance, a number of other economic factors have also received particular attention internationally. These include China’s export performance, its role as a host for inward foreign direct investment and the growing importance of innovative activity. This article argues that these three factors are importantly related to each other. In order to sustain the growth performance and to ensure China’s role as a global player, policy needs to focus on all of these aspects.

China has, since the opening up of its economy, tremendously increased its export performance. According to the World Trade Report 2012 China accounted for just over 10 percent of world-wide exports in 2011, making it the world’s top exporter ahead of the US and Germany. Although China’s exports have continuously grown at a high rate, the strong increase in exports by 20 percent between 2010 and 2011 during which a great part of the Western economies struggled through economic recession is especially remarkable. This suggests that overseas demand for China’s export products is somewhat crisis-resistant, indicating positive qualitative improvements. Indeed, China’s rapid export growth is not only reflected in the expansion of the trade volume, but also in the steadily increasing export product sophistication. The fact that its export basket contains more high tech goods than would be expected on the basis of pure comparative advantage arguments is well documented in economic research.

The increasing export product sophistication indicates that China’s ascent to being a big player in the global economy went hand-in-hand with a rapid improvement in its technological capability. For this, inward foreign direct investment plays a crucial role. Over the past decades China has become one of the most important host countries for inward foreign direct investment, as evidenced by data from the World Investment Report 2012. By 2011, about 14 percent of all foreign direct investment flows went into the Chinese economy, placing it second in the ranking of host economies after the US. FDI inflows into China grew by nearly 8 percent between 2010 and 2011. It is also ranked as the top host economy for future investments by multinational companies in a recent UN survey of companies.

Investments into Chinese firms by foreign multinationals bring not only access to financial resources, but also a transfer of new technology from outside China. This new technology is not only available within the foreign-invested firm, but also dissipates to other Chinese firms through day-to-day business relationships. The importance of foreign direct investment for China as a channel to boost technology and growth is well recognized by the government. Indeed, the Director of the National Development and Reform Commission of China was recently cited in the People’s Daily as saying that the Chinese government is "actively encouraging foreign investments in high-end manufacturing, high-tech industries, modern service industry, and international environmental industry".

In order to absorb and apply the advanced technology from abroad efficiently, and generate new innovations based on domestic technology and knowledge successfully, the Chinese government has increasingly encouraged companies in China to engage in own large-scale R&D activities. It has also continuously expanded the higher education system since 1999 to increase the human capital supply.

Recent data from the R&D Magazine show that R&D expenditures as a percentage of GDP are estimated to be 1.6 percent in 2012 – making it comparable to many industrialized countries. This represents a phenomenal increase, given that this ratio was at only 0.5 percent in 1996. Based on this estimate, China would account for around 14 percent of all R&D expenditure world-wide, placing it second after the US in terms of spending on R&D.

In line with the strong increase in companies’ R&D engagement, the local human capital stock has been expanded dramatically. There were about 22.3 million university students in total in 2010 compared to just 3.4 million in 1998. In 2010, almost six million students graduated from university, more than six times the corresponding number in 1998. As a result, China has significantly improved its position in human capital supply worldwide. In 2008 China (with 20.2 million university students) got ahead of the US (18.2 million) and the European Union (19.0 million) with respect to the number of university students according to statistics from NBSC and Eurostat. Moreover, the share of newly enrolled students in engineering and natural sciences in China is about 42 percent, a share that is much higher than in Western economies.

The combination of the substantial increase in R&D expenditure and the expansion of the local human capital supply contribute to China’s catch-up in innovation, which is evidenced by an increasing number of patent applications. Recent figures from the World Intellectual Property Organization show that the number of domestic invention patents filed with the Chinese patent office have increased at an average annual rate of over 32 percent over the period 1999 to 2006. The corresponding annual growth rate between 2007 and 2010 is somehow lower but still around 25 percent. As a result, innovators in China applied for about 295,000 invention patents in 2010 – almost twelve times the number of domestic invention patent applications in 2000.

Based on statistics from China’s State Intellectual Property Office, the number of domestic invention patent applications did not only increase in absolute terms. Its weight in overall domestic patent applications (which include also the less technologically sophisticated utility model patents and external design patents) has continuously increased since 2000. In 2010 the number of domestic invention patent applications accounted for more than 26 percent of all domestic patent applications, compared to 18 percent in 2000. Statistics also show that companies are now the most innovative economic agents in terms of patent applications in China, having taken over this dominant role from university based research.

Behind this positive development in innovation and patenting in China there are some concerns, however. Firstly, there is a concern as to whether the sheer number of patents reflects also a correspondingly strong improvement in the quality of the research output. Indeed, many scholars argue that most of the innovation in China is currently merely incremental in nature and not at the forefront of current technological development. In this case, Chinese exporters’ competitiveness in the global market may not be as strongly enhanced as would be expected in the case of substantial innovation success. Secondly, there is a concern that most of the new patents are accounted for by a very small number of firms, as recent research undertaken at the University of Nottingham suggests (Eberhardt, M, C. Helmers and Z. Yu, 2011, Is the dragon learning to fly? An analysis of the Chinese patent explosion, GEP Research Paper, University of Nottingham).

Whether these leading companies can encourage and support innovation and upgrading activities of other companies through, for example, knowledge spillovers via customer-supplier linkages remains a question. Thirdly, there is a concern as to whether the substantially expanded human capital supply is indeed sufficiently and efficiently deployed by companies in China to support their innovation activities. Recent media reports suggest that many university students cannot find adequate jobs corresponding to their qualifications. In this regard, establishing a well-functioning labour market that supports companies in China to find the right persons for innovation is substantially important.

All in all, the ability to successfully upgrade technology to provide highly competitive products with innovative and attractive features but comparably low prices, and the globalization process are importantly related. One aspect is that, Chinese firms need to continuously improve production processes and develop and apply new technology in order to remain competitive on export markets and move into the more high value end of products. Major reasons for this are, for example, that rising wages and a stronger Renminbi make Chinese exports more expensive compared to low wage countries such as Vietnam, Cambodia etc. Wages in China have increased by 14 percent on average in the last decade, while the Renminbi has appreciated by more than 30 percent since 2005. This has put tremendous pressure on the international competitiveness of Chinese exports, in particular in lower value goods where exports compete almost exclusively on prices. Hence, in order to sustain China’s export performance, one must think of another aspect that may make China’s export products attractive even in the wake of rising prices: a shift away from low value products that compete on price to producing highly innovative products that are high up the value added chain.

Another aspect of the globalization process is that, inward investment is an important source of funds and know-how for innovation and new technological developments, as shown in research undertaken at the Kiel Institute for the World Economy (Girma, S., Y. Gong, H. Görg and S. Lancheros, 2012, Foreign ownership structure, technology upgrading and exports: Evidence from Chinese firms, Working Paper, Kiel Institute for the World Economy). Current reforms favouring innovation in China establish an advantageous base with high R&D expenditure and expanded human capital supply. This improves further the attractiveness of China as a basis for foreign multinationals. It also enhances the absorptive capacity of local companies to more efficiently learn from and apply imported advanced technologies. However, economic studies find that the real improvement in economic agents’ innovation capability reflected in their patenting outcomes seems to be lower than expected. Substantial innovation success can rather be observed in only a small proportion of firms. Moreover, the expanded human capital supply has not yet been deployed efficiently to support the enhancement in absorptive capacity and indigenous innovation capability. Such development hinders a more efficient learning and application of advanced technologies and knowledge obtained from overseas.

Quality improvements and new product innovations are key for sustaining Chinese producers’ competitiveness in the global market and for supporting long-term economic growth in China. Setting up a goal like the one of the National Patent Development Strategy 2011–2020 that plans a growth in the total number of patents from around 1.2 million in 2010 to 2 million in 2015 will not be sufficient, however. Instead, to achieve substantial quality improvements and to develop innovative products sustained investments in local research and development activity, and inflows of new technology via foreign multinationals are required. Economic agents in China have done well in increasing their R&D investment in the past decade. China is also well set in attracting foreign multinationals.

What remains to be done is to find ways to efficiently transform the innovation inputs into valuable products that are competitive in the global market. In addition, it is crucial to have a larger pool of innovators that enables a more comprehensive improvement in product quality along its production value chain.

The fact that currently a small share of firms in China is responsible for an overwhelmingly large share of innovation may be a result of financing difficulties faced by especially small and medium-sized firms. Recent research undertaken by the Kiel Institute for the World Economy stresses that an efficiently operating banking sector is necessary to allow firms to access loans and other financial products in order to fund R&D (Hanley, A., W.-H. Liu and A. Vaona, 2011, Financial development and innovation in China: Evidence from the provincial data, Working Paper, Kiel Institute for the World Economy). This suggests that the Chinese government may need to make more efforts in further reforming China’s banking system to help firms deal with financing problems to encourage more firms to engage in costly innovation activities. Last but not least, the labour market needs to be functioning well, providing highly skilled graduates with up-to-date knowledge imparted on them by their university and/or vocational education. Providing human capital with skills and qualification truly needed by innovation-oriented companies ensures a better application and diffusion of advanced technology and knowledge obtained from overseas investors and enables a more likely transformation of knowledge into valuable products for the global market.

Dealing with these challenges at the same time is not an easy task. However, how well and efficiently China can cope with all these interrelated challenges will strongly affect China’s role as a global player in the world economy in the future, thus determining its long-term economic development.

(English version of an article published on September 1, 2012, in “Chinese Social Sciences Today”).