China aims to supplant U.S. leadership in innovation race?

A century ago, prevailing microeconomic theories defined economies as a continuous flow of spot transactions between individual buyers and sellers. But in practice, Nobel laureate economist Ronald H. Coase observed in the 1930s, market economies are organized into firms, which consist of individuals coming together to conduct economic activities according to plans and priorities set by management. The reason, he concluded, is that market transactions are not costless, and firms are better equipped than individuals to minimize those costs.

As any multinational well knows, the reduction of transaction costs not only leads to higher profits; it also facilitates greater investment back into the firm. Many companies – especially technology giants, such as Apple and Huawei – direct a significant share of such investments toward research and development in order to produce more profitable innovations.

In 2022, Apple’s R&D spending amounted to $26.25 billion – 37.7% of its total revenue, 57% of which came from overseas markets. Similarly, Huawei spent $21.95 billion – 25% of its total revenue, of which 37% came from overseas – on R&D. The benefits are enormous: according to Boston Consulting Group, the return on equity (ROE) for the world’s 50 most innovative companies surpasses that of the broader market by 3.3% per year.

At the country level, the United States accounts for the highest share of global R&D spending (according to 2020 data) – 31% of the total. But this figure, which stood at 69% in 1960, has declined significantly in recent decades. The decline can be at least partly attributed to the surge in R&D investment by other countries, especially China, which is now the world’s second-largest investor in this area.

In 2022, total Chinese R&D spending surpassed CN¥3 trillion ($410 billion), an increase of more than 10% from the previous year. This surge can be largely attributed to private firms, which accounted for over 76% of such spending over the last decade.

But Chinese firms are encountering limitations in investment. While China’s investment as a share of GDP stands at 42%, roughly twice the global average of 21%, it has remained stagnant since 2008. Moreover, the median return on invested capital for urban investment platforms has dropped from 3.1% in 2011 to 1.3% in 2020.

This decline in returns, together with China’s high savings rate, explains why Chinese firms have been looking to overseas markets for investment opportunities. The Belt and Road Initiative serves as a prime example. Unfortunately, there are also constraints on the global front, beginning with weak global growth.

According to the World Bank, the global economy’s «speed limit» – the highest long-term rate at which it can grow without triggering inflation – is projected to fall to a 30-year low by 2030. By hampering corporate profits, this trend threatens to undermine R&D investment, with implications for everything from ROE to productivity growth. In Western markets, the challenge is compounded by American and European sanctions targeting Chinese industry giants such as Huawei, BYD, and Midea.

Small and medium-size enterprises (SMEs), which account for more than 90% of China’s 48 million firms, might be able to circumvent some of these barriers. Not only are SMEs less likely to be sanctioned, but as the German Mittelstand model showed, they are also well suited to compete in niche markets. With this in mind, China’s government has sought to cultivate its own «hidden champions« – «specialized, fine, unique, and innovative» medium-size enterprises with the potential to expand into overseas markets.

Meeting that potential is no easy feat. According to an e-works Research Institute report, the biggest challenges lie in localization, risk management and compliance, team building and staff training, strategic planning, and organizational and institutional integration. But Chinese SMEs also have an important strategic advantage: they can use Hong Kong, an international financial and logistics hub, as a springboard for their overseas expansion.

Hong Kong’s common law-based regulatory framework is aligned with global standards. Its internationally connected banking system provides trade credit and commercial insurance. Moreover, its internationally recognized accounting and legal services can act as important resources for Chinese SMEs seeking to enter overseas markets, as well as foreign SMEs moving into China.

Moreover, the Greater Bay Area – which encompasses Hong Kong, Macao, and nine cities in the Guangdong province, including Shenzhen – is rapidly evolving into a major global innovation and supply-chain hub, providing a platform for SMEs seeking to leverage China’s manufacturing advantages on global markets. With the Hetao Cooperation Zone for Science and Technology Innovation – recently approved by the State Council – China’s government is working to enhance the Greater Bay Area’s dynamism even further.

The small but important Hetao Cooperation Zone is set to integrate two industrial parks – a 300-hectare park in Shenzhen and an 87-hectare park in Hong Kong – located on either side of the Shenzhen River. This will facilitate cross-border flows of talent, capital, logistics, and data, while making the most of each side’s strengths: manufacturing and technological skill on Shenzhen’s side; an internationally connected, low-tax business environment, and world-class universities on Hong Kong’s side.

Such cooperation zones take Coase’s theory of the firm to the next level, bringing together a wider and more diverse array of economic actors to reduce transaction costs, attract talent, and foster entrepreneurship and innovation. But if they are to reach their full potential and facilitate innovation that benefits all, access to global markets – and a stable world economy – are essential.

Copyright: Project Syndicate, 2023. www.project-syndicate.org

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