Archive for the ‘Innovation’ category

Role of the Government

May 20, 2009

I have previously opined in this blog that issues such as the exchange rate of the RMB and the size of the bilateral trade deficit are matters upon which have been lavished far too much attention by the US Congress and others (and if I have not made this explicit before, I should have).  In terms of the US-China economic relationship and the future of China’s economy itself, a much more important question is the scope and nature of the role of the Chinese government in its domestic economy and international trade and investment. 

A central issue facing China’s leaders in this regard revolves around questions of industrial policies and how best to promote innovation in China.  I have previously in this blog noted my view that while the US needs to “re-regulate” our financial services industry, China needs to continue to deregulate in virtually all areas.  The recent tendency of the Chinese government to continue, or increase, the use of industrial policies in certain industries runs in the opposite direction.

I have also noted that over the long run I believe a greater use of competition, transparency of regulations, strong IPR protection, freer flow of capital, etc. will help China best achieve its goal of promoting innovation.  An approach that has government bureaucrats picking winners from the vast array of emerging technologies and companies and nurturing them with government supports and protective policies is a sure loser in my view.  Yes, increased competition, etc. will improve the access for foreign companies in the China market, but I happen to believe this is ultimately to the benefit of China.

Having stated these views previously, some friends (and some not-friends) have cited the example of Japan to argue that industrial policies can be successful in propelling a country to the front ranks of technology.  In response, I have noted that I think China wants to develop an economy as dynamic and innovative as the US, not Japan, and anyway, outside of autos, how many successes has Japan had in becoming a global leader in industries due to its industrial policies?

With all of this background in mind, I direct readers to a fascinating article in the NYT today ( that examines issues related to industrial policies (in the US and Japan) and assesses its benefits and (substantial) limitations.  (Note:  When I say “fascinating” I mean it supports my previously stated positions.

One of the very points made in the article is the following:

“…Problems [with industrial policies], [economists] say, are typically byproducts of what economists call “political capture.” That is, an industrial sector earmarked for special government attention builds up its own political constituency, lobbyists and government bureaucrats to serve that industry. They slow the pace of change, and an economy becomes less nimble and efficient as a result.

Economists say the phenomenon is scarcely confined to nations with explicit industrial policies and cite the history of agricultural subsidies in America or military procurement practices.”

I agree with the analysis of US agricultural subsidies and military procurement practices.  However, I would note the scope of “industrial policies” in the US (until very recently, as discussed in the article) has been exceptionally limited, even when compared with Western European economies, not to mention China.

To me, continued broad government involvement in the economy and use of industrial policies by China will undermine China’s efforts to develop the dynamic, innovative economy it wants.  It will also lead to increasingly sharp trade frictions with the US and other trading partners.

I believe China’s leaders broadly recognize that in a country where the government’s role in the economy is huge the opportunities for “political capture” are also huge (just substitute “corruption” for “political capture” in this sentence).   The question is:  can those who specifically understand the damaging role industrial policies play in this equation overcome the substantial pressure that well-connected Chinese special interests are already bringing to bear?  For the sake of China’s continued economic development and the smooth development of bilateral economic relations, I hope the answer is yes.

We’re Not Perfect, But…

May 15, 2009

I just read an article in the Washington Post ( which details some of the depressing fallout from the “Buy America” provisions of the US stimulus package. Interestingly, the article focuses on problems faced by Canadian companies (!) under those provisions. Here’s the opening paragraph of the article:

“Ordered by Congress to “buy American” when spending money from the $787 billion stimulus package, the town of Peru, Ind., stunned its Canadian supplier by rejecting sewage pumps made outside of Toronto. After a Navy official spotted Canadian pipe fittings in a construction project at Camp Pendleton, Calif., they were hauled out of the ground and replaced with American versions. In recent weeks, other Canadian manufacturers doing business with U.S. state and local governments say they have been besieged with requests to sign affidavits pledging that they will only supply materials made in the USA.”

I, and I gather, Canadian companies, had assumed the provisions in the bill that required that all measures taken under it would be consistent with US treaty obligations, would spare the Canadians and other signatories of the WTO Government Procurement Agreement (GPA) from pain. Apparently not. According to the article:

“…[I]n recent weeks as federal authorities drafted broad guidelines for implementing the law and hundreds of states and towns have begun preparing for stimulus-related projects, Canadian companies have been surprised to discover that while some federal contracts are still open to Canadian materials and equipment because of trade treaties, most of those issued by state and local governments are not.

The Government Accountability Office estimates that state or local officials will administer about $280 billion in stimulus spending, including about $50 billion for transportation projects. But federal authorities have determined that construction projects even partially funded with stimulus dollars must also buy American, dramatically increasing the universe of affected contracts.”

This is really awful stuff and particularly bad in terms of our economic relationship with China. The US has for a long time been pushing China to accede to the GPA and one of the incentives pushing China forward toward this goal (albeit very slowly) is to get access to the government procurement market in the US. But if even Canada is facing increased obstacles, surely China will see this incentive withering. And in the meantime, the proponents of “indigenous innovation” and industrial policies in China continue to use government procurement as a tool to support national (or local) champions in ways damaging to foreign companies (and China’s long-term development).

In addition, this type of US action enters some kind of an amplifier/distortion device when it reaches China . The result is that the overall openness of the US economy gets short shrift, while the voices of Chinese protectionism and industrial policies summarize the situation as: “the US practices protectionism to promote its interests, so we should too.”

This brings me to my final point: in my past incarnation as a government official representing the US before Chinese audiences I would often wince as I had to explain actions such as those discussed here. I’d usually try to explain the political dynamics behind the measure without perverting my principles by defending them. That said, I never felt defensive on these issues. I would usually sum up my comments on a policy like this by noting that while it might be seen as protectionist and bad economics, when looked at overall, the US economy remained the most open major economy in the world for trade and investment and this was a key element of our economic success. Left unsaid was the idea that even with these new measures, China had a huge distance to go before its level of trade and investment barriers were reduced to anything near that of the US.

I can never remember who said that one measure of a person’s intelligence is the ability to hold two contradictory thoughts in their mind at the same time. Not sure if this qualifies as a test, but to me: 1) the Buy America provisions in the stimulus package are awful. If we can’t roll them back, at a minimum we need to continue to press the fight to prevent the further growth of protectionism in the US; and 2) we are still the most open major economy in the world; China would benefit from keeping that element of our economic success foremost, even as it (correctly) criticizes individual wrong-headed US policies.

What They Said

May 14, 2009

I previously offered my view that over the past decade or so the US financial system was under-regulated but that China’s government continues to operate at the opposite extreme, ie, by getting involved far too much in all aspects of China’s economy (and other matters).  I have also noted that the “industrial policy” model of government bureaucrats selecting champions from among Chinese companies and then tailoring policies to support them is not an effective path to spur the innovation that China wants.  (see my post “Who Decides”)

I just saw the following press release on a new World Bank study on the topic of innovation in China.  I provide the full text of the World Bank press release below (with bolded sentences reflecting my added emphasis, not the original).  The entire report is available here:


Private Sector Development Crucial to China’s Innovativeness, says a World Bank Report


Li Li, 86-10-5861 7850

BEIJING,May 14, 2009 – 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 today. “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. 


Readers will note the references above to use of government procurement and standard setting to promote innovation that seem to justify current Chinese policies.  Full report makes clear this is quite the opposite.  The following is a paragraph from the full report (page 41) regarding the use of government procurement:

“Government procurement can help or hurt innovation (box 2.3). The key to success lies in open competition, as indicated by case studies of OECD countries. The government of China is still in the early stages of implementing innovation-supporting procurement policies. One may anticipate a number of issues that may require further policy action down the road.”

This emphasis on “open competition” is precisely what the US and others have been urging China to adopt.

With regard to the use of technical standards the report (page 69) says:

 “Outmoded standards or, even worse, use of standards for motives other than to promote innovation, would be a disservice to China. An analysis by Porter (1990) of the OECD experience shows that “regulation undermines competitive advantage . . . if a nation’s regulations lag behind those of other nations or are anachronistic. Such regulations will retard innovation or channel the innovations of domestic firms in the wrong directions.”

For instance, limits on biotechnology research are considered to have threatened Germany’s agrochemicals and pharmaceuticals sectors.  As for competitiveness in export markets, “the practice of using idiosyncratic local regulations to protect a domestic industry will only work to ensure that its competitive success is domestic””

Interesting stuff.