Testimony of Dr. Dieter Ernst , Senior Fellow, East-West Center (EWC), Honolulu, HI
To the U.S.-China Economic and Security Review Commission Hearing on China’s Five Year Plan, Indigenous Innovation and Technology Transfers, and Outsourcing
June 15, 2011
Mr. Chairman and members of the Commission:
Thank you for the opportunity to testify today on China’s “indigenous innovation” policies and possible challenges for America. This issue is of great concern to my organization, the EWC, that seeks to promote better relations and understanding between the US and Asia.
The Commission, since its first report in 2002, has addressed China’s innovation policy years before this policy made it into the media headlines. The hearing records contain valuable data and insights for scholars, business people and policy makers. Nevertheless, our understanding of how serious a challenge China’s innovation policies are for America is still “work in progress”.
My own research examines how China’s innovation policy affects innovative capabilities and innovation strategies of Chinese companies. In a study that has just been published, I explore how China uses standardization as a tool for indigenous innovation. Specifically, the study reviews China’s recent policy initiatives on four hot button policy issues: i) China’s definition of indigenous innovation products; ii) the treatment of foreign companies in government procurement; iii) new regulations for patents included in standards; and iv) China’s approach to Information Security Standards and Certification, with a focus on the National Information Assurance Policy Framework Multi-Level Protection Scheme [MLPS][1].
Based on this research, I will argue that China’s innovation policy is not a threat to US leadership in science and technology. As demonstrated in the first part of the statement, the US retains a strong lead in overall innovative capacity, and China still has a long way to go to close the innovation gap.
Instead, China’s progress in innovation should be seen as a wake-up call for America. Rather than fearing China and blaming it for our problems, we need to focus research and policy debates constructively on how this relationship can be improved. As discussed in parts 2 and 3 of the statement, both the US government and the private sector need to join forces to develop and implement:
- a proactive and smart trade diplomacy that understands the diverse forces and their conflicting agendas that drive China’s innovation policy; and
- a national strategy to upgrade America’s innovation system in order to cope with the challenge of China’s innovation policy from a position of strength.
Both trade diplomacy and national innovation strategy are interrelated, and hence we need to pursue them simultaneously. Corrective action needs to start now, but there is still time to adjust policies and corporate strategies to the new challenges of an increasingly multi-polar global knowledge economy.
1. Evidence on China’s progress in innovation and its persistent innovation gap
China’s innovation policy has produced massive investments in R&D infrastructure and Higher Education ”…on a scale and speed never seen before.”[2] Since 2000, China has increased R&D spending roughly 10% each year—a pace the country maintained during the 2008-2009 recession. This sustained commitment to a rapid expansion of R&D sets China apart from the crisis-induced cuts in the US. As a result, China’s share in global R&D spending has increased from 9.1% in 2008 to 12.3% in 2010, while the US share has declined from 35.4% to 34.4%. China’s share is projected to grow further to 12.9% in 2011, overtaking Japan as the second largest R&D investor. (see slide 1[3] )
Since 1998, the number of colleges has doubled, and the number of students has more than quintupled, from 1 million in 1997 to ca 6 million in 2007. This contrasts with the situation in the US where state universities are suffering the impact of budget cuts. What matters is that China's domestic science and engineering doctorate awards have increased more than tenfold since the early 1990s, to about 21,000 in 2006, nearing the number of S&E doctorates awarded in the United States ( slide 2 ).
Furthermore, China is now one of the four leading countries in science and technology publications, with particular strengths in materials science (especially nano-technology[4]), analytical chemistry, rice genomics, and stem cell biology. China’s share in scientific publications and co-authored articles has exploded, catapulting China as the second largest source country behind the US ( slides 3,4 ).
Of particular interest is China’s patent boom. In terms of total patenting activity, China has overtaken Korea and Europe, and is catching-up with the US and Japan[5]. ( Slide 5 ) Domestic patent applications by Chinese nationals have overtaken foreign applications since 2003. ( slide 6 ) In 2009, Chinese nationals accounted for nearly 90 percent of patent applications in China. This indicates that China’s innovation policy has been successful, at least in quantitative terms.
Nearly three quarters of resident applications in China are for utility model and industrial design patents. ( slide 7 ) Some observers consider utility model patents as “junk”[6]. However, innovation economists have emphasized that utility model patents have played an important role in fostering earlier catching-up processes in Germany, Japan, Korea and Taiwan[7]. What matters is that China’s utility model patents facilitate low-budget forms of innovations[8]. An example of this type of successful low-cost innovations are no-name shanzhai (unlicensed) handsets that are estimated to have at least a 40 percent share of the Chinese handset market. The situation however is changing fast - the recent Revision of China’s Patent Law in October 2009 seeks to discourage utility patents and shifts the emphasis on invention patents.
In fact, a handful of leading Chinese firms and research institutes have moved beyond incremental innovations and are developing portfolios of higher-quality patents ( slides 8 and 9 )[9]. The test flight of China’s next-generation stealth fighter J-20 during Defense Secretary Gates’ January 2011 China visit highlights the accelerating development of China’s defense science, technology, and innovation capabilities.
Another prominent example of innovation progress is that China now has the world’s fastest supercomputer at the National Supercomputing Center in Tianjin . ( slide 10 ).That machine not only has greater computing capacity than the second ranked US Department of Energy Oak Ridge National Laboratory , but it also consumes considerably less energy. What is interesting is that the Tianjin super computer is an architectural innovation that relies on US technology[10]. The Tianjin machine uses energy-saving graphic processors supplied by Nvidia, a chip design company based in Santa Clara/Ca., but the Chinese engineers have changed the way these processors work together.
And yet the gap in innovation capacity persists, and China’s leadership is very conscious that the US retains a strong lead in R&D and per capita number of scientists and engineers ( slide 11 ), and in patent applications ( slides 12-14 ). A telling example is that no Chinese company is among the top 20 global R&D spenders in the IT industry ( slide 15 )[11]. According to WIPO, China owns just two percent of worldwide patents, with 95% of China’s patents being in force in China only. And all 15 leading companies with the best record on patent citations are based in the United States (9 in the IT industry).
Root causes for China’s persistent innovation gap range from severe quality problems in education to plagiarism in science, and barriers to entrepreneurship and private R&D investment. An important weakness of China’s innovation policy are elaborate lists of products and technologies that are constructed to assess compliance with China’s standardization and certification requirements. These lists risk being quickly outdated and bypassed. Even more important for China’s objective to foster indigenous innovation is that such control lists focus on existing technologies, rather than on the future innovations that they are designed to promote.
In addition, China’s progress in innovation is likely to be stifled by China’s policy on Information Security Standards and Certification. In its current form, this policy would create unintended disruptive side effects for the upgrading of China’s innovation capacity and could create potentially serious trade conflicts (Ernst, 2011, chapter II).
2. A proactive and smart trade diplomacy
China’s innovation policy no doubt has increased technology-related trade conflicts between the US and China, adding further to contentious disputes about exchange rates and foreign direct investment. The US government considers China’s innovation policy to be “discriminatory”, because it “unfairly favor[s] domestic producers at the expense of foreign firms, … [and]… because of …[its]… threat to global intellectual property protections, fair government procurement policies, market competition and the freedom of U.S. companies to decide how and when to transfer technology.”[12] And the US Chamber of Commerce argues that China’s innovation policy “ …restricts the ability of American companies to access the market and compete in China and around the world by creating advantages for China’s state-owned enterprises and state-influenced champions, … [and has]… the potential to undermine significantly the innovative capacity of the American economy in key sectors, and, consequently, harm the competitiveness and livelihood of American business and the workers that they employ.”[13]
America has the right to insist on safeguards against forced technology transfer through policies like compulsory licensing, information security standards and certification, and restrictive government procurement policies. For the US government, this implies that there is no escape from the day-to-day grind of trade negotiations. But an activist and smart trade diplomacy requires substantial investments and a much improved capacity of government agencies for monitoring, intelligence gathering and research.
For US business, this implies that it needs to contribute to the necessary funds, given the severe restrictions on public budgets. In addition, US private industry needs to be more forthcoming in providing the US government with information and evidence especially on employment effects (both at home and overseas) of its manufacturing and R&D activities in China, as well as on cyber security violations, IP theft, and other proven costs and damages of Chinese policies.
To be effective, America’s trade negotiations with China need to be based on three pillars:
- Understand diverse stakeholders and their conflicting agendas
- Examine what might induce policy adjustments
- Establish shared benefits and reciprocity.
i) Understand diverse stakeholders and their conflicting agendas
It is essential that both the US government and private industry support research on the diverse stakeholders and their conflicting agendas that drive China’s innovation policy.
From outside, China’s innovation policy often seems to present a homogenous picture of a top-down “model of neo-mercantilist state developmental capitalism.”[14] The official message is that China’s leadership is convinced that indigenous innovation is the key to removing poverty and for catching up with the US, EU and Japan. Indigenous innovation is considered essential not only for moving beyond the precarious export-oriented growth model. At stake really is the survival of the system. According to government projections, China’s economy must grow by more than seven to eight per cent a year if social unrest is to be kept under control[15]. Chinese leaders understand that export-led growth can no longer guarantee such rapid growth. Hence they place all their bets on indigenous innovation as a catalyst for industrial upgrading.
Such a high-level strategic commitment cannot be easily changed through external pressure, especially for policies that China’s leaders think are successful. While “…blaming China for our economic problems …is tempting”, this may “ultimately…[be]…an empty gesture.”[16] A proactive and smart US trade diplomacy needs to take a closer look at the surprisingly fragmented Chinese innovation system that involves diverse stakeholders with conflicting interests. Identifying those diverse stakeholders might help to improve the leverage of US trade diplomacy.
Three main groups of stakeholders can be distinguished. First, China’s exporting industry is a strong supporter of compliance with WTO commitments. This position reflects China’s deep integration into global corporate networks of production and innovation[17]. Support for greater compliance with international standards also comes from leading Chinese ICT firms which have accumulated a critical mass of intellectual property rights, like Huawei, ZTE, Lenovo and Haier.
Second, strong support for developing China’s indigenous innovation capabilities can be found in research labs, parts of the domestic hi-tech industry with limited export exposure, as well as in the military, the CCP, and large parts of the general public. This coalition of domestic stakeholders is supporting, for instance, policies on patent licensing for standards that seek to reduce licensing fees to foreign patent holders , as embodied initially in the Draft Rules on Patents included in Standards , issued by the Standard Administration of China (SAC) in November 2009.
Third, China’s security and military establishment plus top leadership echelons view information security and certification regulations as an integral part of China’s innovation strategy. Recent policy initiatives (especially China’s National Information Assurance Policy Framework Multi-Level Protection scheme [MLPS], issued by the Ministry of Public Security in June 2007; and CNCA’s Information Security Testing and Certification Regulations) are driven by fears that China’s critical information networks provide an easy “target of attack, sabotage, and terrorism by hostile forces and elements.”[18]. A strategic assumption is that control over standards and a strong Chinese information security industry are necessary to protect China’s information security.
It is difficult for outsiders to assess which of these three stakeholder coalitions has most leverage in shaping decisions on China’s innovation policies. A detailed analysis of recent developments of China’s innovation policies finds a fairly consistent pattern of China’s response to foreign complaints[19]. In round one, PRC government regulations start out with quite demanding requirements that exceed established international norms. This typically gives rise to a wave of criticism from foreign enterprises and business organizations, but also from Chinese companies that have established a significant position in the international market and that have begun to accumulate a reasonably broad portfolio of intellectual property rights. In response to this criticism, round two then leads to some adjustments in PRC government regulations that combine a selective relaxation of contested requirements with persistent ambiguity.
This raises the question: What is going to happen in further rounds of negotiation? In the run-up to the 18th party congress, there are signs that Chinese policy-makers are moving towards a more dogmatic position on economic policies, political ideology, internal control policies, and geo-strategic and foreign policy positions. It is unclear at this stage whether this shift towards greater dogmatism is a temporary tactical move dictated by the power struggles in the run-up to the party congress. Some observers see a growing role of security considerations in China’s innovation policy[20]. Or can we expect, once the congress is over, a strategic shift, albeit very gradually, to greater openness and transparency, as China needs foreign technology and as it needs to adjust to the requirements of its deep integration into the global economy?
ii) What might induce policy adjustments?
To identify areas where adjustments in policy implementation might be possible, the US needs to put in place a process of continuous monitoring and in-depth research on how Chinese innovation policies are evolving over time. An important insight that could structure this research is that “China is approaching the issue of technological leadership from a position of weakness, not strength.”[21] I agree. China’s main weakness is the persistent innovation gap with the US, the EU and Japan described in part one of this statement. Combined with China’s deep integration into international trade and global networks of production and innovation, this provides a powerful rationale for at least tactical compromises with foreign complaints.
This highlights a fundamental dilemma for China that could provide leverage for US trade diplomacy: How can China reconcile the primary objective of strengthening indigenous innovation with the country’s leading role in international trade and its deep integration into global corporate networks of production and innovation? And specifically, what compromises are necessary in China’s policies and regulations to avoid> unintended disruptive effects on China’s still critically important export drive?
Overall, I share Scott Kennedy’s assessment that, when push comes to shove on how to implement China’s indigenous innovation policy, “… the most mercantilist elements are regularly rebuffed, and given the array of interests in favor of a more open innovation strategy, that pattern is unlikely to change….[As]… Chinese companies and officials are engaging – if not fully embracing – global regimes for intellectual property, standards, and even government procurement…, a socialization process is gradu