Continuous government support for private sector growth is of strategic importance to China if it is to build up an enterprise-led technological innovation system, says a World Bank report released on Thursday. "In China's existing national innovation system, state-owned enterprises and research institutes are the main performers of innovation activities; in the future, however, China's success in technological catching-up is likely to rely more on the capacity of its private sector, especially large private firms", the report concludes.

The report entitled Promoting Enterprise-Led Innovation in China is the result of a recent World Bank study designed to assist the Chinese government in implementing its strategy of "enterprise-led innovation". It notes that China has dramatically scaled up its investment in R&D since mid-1990s, with total R&D expenditure increased by 5.5 times in real terms during 1995-2006. China has also experienced a transition in which industrial enterprises replaced government-owned research institutes and universities to become the main performing sector of R&D activities. While industrial enterprises increased their spending on R&D, the relative importance of technology importation has declined significantly, the report shows.

Despite remarkable achievements such as expanded manufacturing capacity, greater ability to innovate at home and increased knowledge intensity of the economy, the World Bank study sees China still a late-comer in technological catch-up, facing substantial gap from international technological frontier. The global competitiveness of China's leading manufacturing sectors rests upon low input costs, scale of production, technology absorption, speed of response to market demands and customer orders, and increasing attention to the quality of products, according to the report. To ensure sustainability, Chinese enterprises will have to derive their competitiveness more from innovation. "In today's highly globalized economy, innovation has become the key driver for growth and competitiveness. The capability to innovate will be increasingly a crucial determinant of the global competitiveness of nations over the coming decades", says Mr. Vikram Nehru, the World Bank Chief Economist for the East Asia and Pacific Region.

While innovation-driven growth is critical to the sustainability of China's development and poverty reduction, its national innovation system remains in a transition from traditional government-led model to an enterprise-led and market-based one, the report points out. In addition to weak capacity and limited role of the private sector in innovation, market institutions are found not fully developed to spur and guide innovation, demand side incentives such as government procurement and standard setting are yet to be fully utilized, and the domestic venture capital industry operates in a rudimentary ecosystem, which points to the difficulties for innovative firms to gain access to external risk capital.

The severity of the challenge in innovation is compounded by the need for job creation. As the report emphasizes, Chinese enterprises must not only innovate to sustain competition in the global market, but also create jobs to ensure full employment of a labor force of over 750 million workers, of whom more than 80 percent do not have an education attainment higher than junior secondary school. "This is like to solve a set of simultaneous equations", says Mr. Chunlin Zhang, the task team leader of the World Bank study. "The best solution, that is, the set of technologies that maximize both competitiveness and job creation capacity of Chinese enterprises, can only be found and installed by the collective action of the private sector and the market". The government could promote innovation by refraining from involvement in microeconomic decisions on innovation, the report recommends. "There is certainly a role for the government to play, but it should start at the point at which enterprises and the market cannot do more or better."

The report also recommends that the government ensures the right balance between technology creation on one hand and adaptation and adoption on the other, recognizing that China, as is the case for India, stands to gain from a broad interpretation of innovation and sustained efforts in promoting technology adaptation and adoption. Further more, the government is encouraged to put a stronger emphasis on the effectiveness and efficiency of R&D spending, especially public R&D spending, given the fact that China's spending on R&D as a share of GDP is already the highest in the developing world.

A series of policy recommendations are made by the report on creating the right incentives, strengthening the capacity of private small and medium enterprises, and improving the ecosystem for domestic venture capital industry. In addition to continuous private sector development, the government is advised to further strengthen corporate governance and scale down the scope of state ownership. It is also recommended that the State Council formulate a special regulation to enforce Article 7 of the Anti-Monopoly Law, which requires the state to regulate SOE operations to "protect consumers' interest and promote technological progress." As to fiscal incentives, the report proposes that pooled R&D efforts, such as research consortia and joint programs with local or foreign higher education institutions, be encouraged, and the ceiling on tax-deductible training expenditures of enterprises, currently 2.5 percent, be reviewed. "The government could consider policy measures to allow for institutional investors to begin investing more in domestic venture capital institutions", the report further recommends, and adds that "recognizing that the risks of venture capital investing are high, the first step could be to develop a short- and medium-term action plan that would provide a roadmap for institutional investors to invest in private equity and venture funds". A range of programs aiming to enhance innovation capacity of small and medium enterprises are also recommended.

(China Development Gateway May 14, 2009)