China Needs a Better Innovation Ecosystem

The United States has long dominated much of the knowledge economy, not least owing to an innovation environment that has proved highly attractive to foreign talent. But China has been watching carefully, adapting crucial lessons from the US to the local context. And its efforts are bearing fruit.

America’s lead is significant. In 2000-19, the US had far more Fortune Global 500 companies than any other country. In 2000, the US boasted 179, compared to 107 for Japan and just ten for China. Though China surpassed the US in 2020, the US companies have retained an absolute advantage in market capitalization, profitability, and technological innovation.

American tech giants – such as Microsoft, Apple, and Nvidia – are especially dominant, having expanded faster internationally and outsourced their operations more broadly than their counterparts from China, the European Union, Japan, and India. Crucially, they have also attracted more of the world’s talent.

In fact, the US is the top destination for global talent, accounting for nearly half of the highly skilled immigrants entering OECD countries. According to the QS World University Rankings, one-third of the world’s top 100 universities, and four of the top ten, are in the US. These elite universities attract talented non-US students, who are likely to remain after graduation to start their careers.

As a result, the US is now home to one-third of the world’s high-skilled immigrant population. And this population is playing a leading role in shaping America’s business and innovation environment. For example, Indian CEOs oversee American companies – including leading firms like Adobe, Alphabet and its Google subsidiary, Microsoft, and IBM – that are collectively valued at $6 trillion.

Chinese cities have been working hard to replicate this success. Shenzhen is a case in point. Within living memory, this southern Chinese city was a small fishing village, with few world-class universities nearby. But since 2000, the city has been transformed into a leading tech hub, thanks to its support for local universities and the establishment of satellite campuses by highly rated universities such as Peking University HSBC Business School, Tsinghua University, and the Chinese University of Hong Kong.

Cities attract top talent by offering an appealing lifestyle, a supportive business environment, and strong supply-chain connectivity. Industrial parks – which are being embraced by many developing economies – can bolster this effort, though establishing them is no easy feat, as they require talent in tech, corporate management, and government services, as well as supporting services in areas like finance, law, and logistics.

Financing is another crucial piece of the puzzle. A thriving innovation ecosystem cannot exist if high-tech firms cannot get the funding they need to grow. But for Chinese firms, it is becoming increasingly difficult to secure foreign investment. Since 2018, hundreds of Chinese companies – including Huawei and BYD – have confronted new sanctions or restrictions from the US and Europe. Many multinationals have decided to «decouple» from Chinese supply chains in order to comply with home-country regulations, despite the higher production costs this implies.

Yet foreign capital is not essential. In Silicon Valley, innovative tech companies turn to private-equity (PE) and venture-capital (VC) funds to finance their growth. These US funds are constantly investing in the next generation of «unicorns» (private companies with a valuation above $1 billion), often using their gains from the last generation. The National Venture Capital Association reports that about 80% of US PE funds invest in companies in the growth and development stages.

But in China (including Hong Kong), such funds tend to be smaller than their counterparts in the US: in 2021, the average PE fund size in the US approached $1 billion, compared to some $20 million in China. Moreover, Chinese PE/VC funds lack experience and specialist knowledge when it comes to frontier technologies.

This implies a serious challenge for China. From a macro-policy perspective, PE/VC funds are critical catalysts of supply-chain upgrading through new technologies and management knowhow. So, as Chinese companies seek to adopt new technologies, increase productivity, expand, and develop overseas markets, much of their risk capital will be financed primarily by these funds, rather than conventional banks or public financial markets.

But tech investments tend to have shorter-term horizons, and PE/VC funds rely on liquid stock markets to exit their positions. Transparent, resilient, and liquid capital markets are also needed to attract long-term institutional investors capable of taking on bigger risks in alternative or non-traditional financial instruments. Mobilizing insurance, pension, and social-security funds – which have the long-term savings and investment horizons to fund technological innovation (as well as infrastructure investments) – is essential.

So far, China’s leaders have struggled to build the innovation ecosystem the country needs, including a liquid and transparent public and private funding mechanism. In the context of the Sino-American rivalry, this amounts to a massive disadvantage. To compete with the US, China needs to foster its own tech unicorns and build global platforms that match their American counterparts in speed, scale, and scope.

Copyright: Project Syndicate, 2024. www.project-syndicate.org

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