Toward an Innovative Nation

Toward an Innovative Nation

30 Years of China’s Reform Studies Series Editorial Board

Chief Editor: Shi Zhengfu Members Chen Ping

Hu Ruyin

Chen Qiwei

Lin Yifu

Chen Weishu

Qin Xiao

Chen Xin

Shi Zhengfu

Cui Zhiyuan

Shi Jinchuan

Fan Gang

Zhang Jun

Hong Yinxing

Zhou Zhenhua

Toward an Innovative Nation KOU Zong-lai

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Toward an Innovative Nation Kou Zong-Lai

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Table of Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxii Chapter 1 The Legacy of the Planned System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1 The Strategy of “Concentrating Efforts on Addressing the Key Issues” 2 1.2 The Strategy of “Self Reliance” for Scientific and Technological Development 9 1.3 Freeing the First Wave of Productivity 10

Chapter 2 A New Dawn for Science in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.1 Emancipating the Mind and “Righting the Wrongs” 21 2.2 Restoring Order within Science and Technology Research 24 2.3 Active Experimentation and Searching for the Way Forward 29

Chapter 3 Facing the Main Battlefield of Economic Construction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3.1 Stage I (1985–1992): “Blocking One End and Opening One Side” 43 3.2 Stage II (1992–1998): “To Steady One End, to Free the Majority” 55 3.3 Stage III (1998–2005): “Invigorating the State through Science and Education” 60 3.4 Stage IV (2006 to Date): Encouraging Independent Innovation 63

Chapter 4 The Rationale behind the Reforms to China’s Science and Technology Management System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 4.1 A Market-based Solution 68 4.2 The Organizational Reconstruction and Restructuring 83 4.3 Construction of an Industrialized Environment 95

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Chapter 5 The Development of the Hi-tech Industry in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 5.1 The Policies Supporting the Development of the Hi-tech Industry in China 112 5.2 The Development of the Hi-tech Industry in China 120 5.3 Conclusion 149

Chapter 6 The Development of the Automotive Industry in China . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 6.1 The Situation of the Chinese Automobile Industry before the Reform 153 6.2 The Development of the Automobile Industry after the Reforms 157 6.3 China’s Automobile Industrial Policies and Their Effects 174 6.4 Conclusion 186

Chapter 7 Intellectual Property Rights: Barriers Faced by Chinese Enterprises Seeking an Entry into the Global Marketplace . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 7.1 DVD Patent Dispute 191 7.2 Cisco’s Litigation against Huawei 196 7.3 Comparison and Analysis of the Two Cases 201 7.4 How to Respond to the Intellectual Property Litigation? 205 7.5 Enhancing the Protection of the Intellectual Property Rights: Weal or Woe? 208

Chapter 8 Analysis of the Performance of China’s National Innovation System (NIS). . . . . . . . . . . 211 8.1 Inputs and the Evolution of Scientific and Technological Activity 211 8.2 Output and the Evolution of Scientific and Technological Activity 223 8.3 Conclusion 239

Chapter 9 Epilogue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

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Introduction The Occurrence of a “Miracle”:  Years of Chinese Economic Reform and Transformation There is an old Chinese saying regarding the inevitable nature of change; literally translated, it reads “30 years on the east of the river, 30 years on the west of the river.”1 Thirty years ago, the Chinese economy, which was still reeling from the destructive effects of the Great Leap Forward and the Cultural Revolution, was on the verge of collapse. In contrast, since the initiation of the market-oriented reform and opening up in 1978, it has witnessed over 30 years of unprecedented economic growth. In 1978, China’s GDP amounted to RMB 364.52 billion whereas China’s GDP per capita stood at only RMB 381. By 2005, China’s GDP had reached approximately RMB 18.39 trillion with the GDP per capita being RMB 14,040.2 The international ranking of the key indices of the Chinese economy over the years is given in Table I. By 2005, China’s total GDP had already exceeded that of the United Kingdom (UK), raising its ranking from No. 10 in 1978 to No. 4. This put the Chinese economy just below the economies of the United States (US), Japan, and Germany. Meanwhile, China’s foreign exchange reserves rose steadily, with China catapulting in the ranking from No. 40 in 1978 to eventually eclipsing Japan in 2006. This gave China the largest foreign exchange reserves in the world. Given that the above ranking is calculated on the basis of the official exchange rate, we could always use the more “objective” purchasing power parity (PPP) method to make the comparison. In this case, the trend is further augmented.3 According to the PPP calculations made by the World Bank on September 14, 2007, China’s economic aggregate, denominated in “Trillion International Renminbi,” had already reached 1. The Yellow River often changes its course. The saying implies that even if one does not move, one’s relative position to the Yellow River will change. 2. The above data are sourced from the China Statistical Yearbook (2006) and are not price adjusted. 3. The rising strength of China’s economic aggregate seems to have rather subtle geopolitical implications. From the point of view of Westerners that subscribe to the “China threat theory,” China, a powerful yet politically centralized economy, would be a serious challenge to the existing world structure as its ideology and political system differ from those of other major industrial countries. In contrast, the Chinese government and some other scholars emphasize the “China opportunity theory,” which posits that a prosperous China would bring more opportunities to other countries in the world. The interesting aspect is that the Chinese government and most Chinese insist that China’s economic aggregate has been virtually magnified through international comparison on the basis of PPP, although the great revival of the Chinese Nation has been a goal that the Chinese people have been earnestly longing for since modern times.

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Table I The international ranking of the key indices of the Chinese economy over the years (in terms of US dollars and the official exchange rate)

GDP GDP Per Capita Total Amount of Import and Export Export Amount Import Amount Foreign Direct Investments Foreign Exchange Reserve

1978

1980

1990

2000

2003

2004

2005

2006

10 175 27 28 27 — 40

11 177 25 28 22 60 37

11 178 16 14 17 12 7

6 141 8 7 9 9 2

7 134 4 4 3 2 2

7 132 3 3 3 2 2

4 128 3 3 3 3 2

4 128 3 3 3 5 1

Source: “International Statistical Data,” National Bureau of Statistics of China (NBSC), cited from NTSC’s website.

10.05. According to this calculation, China was second only to the “superpower” United States (13.20) and had become the world’s second economic power. In comparison, the countries ranking from No. 3 to No. 10 were India (4.25), Japan (4.13), Germany (2.62), UK (2.11), France (2.04), Italy (1.79), Brazil (1.71), and Russia (1.70), respectively.4 As the above data show, great achievements attracting world-wide attention have been made during the period of reform and opening up. In earlier times, the economic boom of Japan and the Asian “Tigers” was labeled as the “East Asian miracle.” The current rapid emergence of the Chinese economy is known as the “Chinese miracle” (Lin, Cai, and Li 1994).5 In addition to aggregate statistics, there exist many concrete examples, which give insight into the widespread importance and consequences of the Chinese miracle. Thirty years ago, the Chinese were facing severe famine under the failed People’s Commune and extreme equalitarianism systems. However, the implementation of the household contract responsibility system in the initial stages of the reform period essentially resolved the famine issue. Thirty years ago, the Chinese economy was constrained under the planned system. There was a high degree of centralization, extreme rigidity, and widespread public ownership. Subsequently, the implementation of reform measures such as the “decentralization and interest concessions,” “contract responsibility system,” and the “stockholding system” stimulated the development of the private and quasi-private sectors. Township enterprises quickly developed and thousands of 4. “World Bank Statistical Database,” http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDPPPP.pdf. 5. In 2008, Lin Yifu was appointed as the chief economist of the World Bank, a position just below that of the president of the World Bank. Th is position had typically been occupied by famous economists from the Unites States and European countries. Many critics believe that this position being awarded to Lin Yifu is in recognition of the effectiveness of the Chinese growth experience by the international community.

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privately-owned enterprises emerged and expanded. These jointly provided the impetus for the continuous prosperity of the Chinese economy. Thus, these flourishing enterprises laid the foundation for the rapid growth of the economy. Table II shows the country distribution, turnover, and profit of the Fortune 500 Corporations in 2005. With 20 enterprises on the list, China ranked No. 6, a level commensurate with its economic prowess. In comparison with the other BRIC economies (Brazil, Russia, and India), China-based enterprises held a significant lead. China’s noteworthy achievements in the past 30 years should without doubt be attributed to the market-oriented reform and opening-up policies. Indeed, once competition was introduced into the Chinese economy through these reforms, micro-level actors obtained a level of decision-making autonomy unheard of under the planned economy. This not only provided them with more efficient production and innovation incentives but also enabled the decentralized information held by these actors to be disseminated more effectively and efficiently throughout the Chinese economy. Ideologically, the Chinese government had broken from the shackles of the planned economy and had resolved the dilemma of whether to adopt socialism or capitalism. The government no longer considered the market economy to be inherently capitalist—it Table II The Fortune 500 companies

Countries and Regions

Number of Companies

Turnover (US$ 100 Million)

Amount of Profit (US$100 Million)

170 70 38 38 35 20 14 14 12 12 10 6 5 4 65 498

68,168.7 23,283.5 16,149.5 15,553.3 16,499.9 6,174.5 2,684.8 8,216.7 4,024.3 4,813.9 4,273.0 1,204.0 1,577.0 1,153.9 18,401.6 188,243.5

4,561.0 1,074.3 977.1 847.9 670.6 424.9 197.8 589.3 226.6 413.0 339.8 81.9 313.8 152.6 1,765.0 12,087.1

United States Japan France United Kingdom Germany China Canada Netherlands South Korea Switzerland Italy India Russia Brazil Other Total Source: “Fortune,” 2006-7-31 (Edited Version).

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now advocated and developed a socialist market economy with Chinese characteristics. Indeed, the economic opening-up policy not only allowed China to introduce cutting-edge technology and management concepts from abroad but also enabled it to progressively participate in the internationalized division of labor. The previous heavy-industry oriented “catching up and surpassing” strategy was abandoned; instead, a balanced development strategy playing to China’s strengths was adopted (Lin, Cai, and Li 1994). Just as the collapse of the Soviet Union was considered to be one of the most significant events of the twentieth century, many people predict that the emergence of China will be one of the most significant events of the twenty-first century (Kristof 1993). Lessons regarding the uniqueness of the Chinese miracle can be clarified when comparing these two events. Both the nations were similar in the sense that they were transiting from planned to market economies. However, the Chinese economy achieved 30 years of rapid growth, whereas, in stark contrast, the Soviet Union and Eastern European countries experienced a long-lasting economic depression characterized by sharp declines in the GDP.

Miracle or Myth: How to Make the Extensive Growth Sustainable? Few question the achievements made by China in the past 30 years; however, the sustainability of this rapid growth is widely debated. As an advocate of the Chinese miracle’s sustainability, Lin YiFu predicted that “If the Chinese economy keeps moving along the path of the ‘Eleventh Five-Year Plan for Economic and Social Development,’ such growth rate is likely to be sustainable for another two or even three decades.” He further stated that “By 2030, China will become the most economically powerful country in the world” (Chinese Business Times, May 30, 2006). However, not everyone is as optimistic about China’s economy. In 1994, Paul Krugman published an influential article in Foreign Affairs titled “The Myth of the Asian Miracle.” In it, he argues that the much hyped Asian miracle is a myth and sustaining it is almost impossible. At the end of the article, he writes, “That’s a hard answer to accept . . . but economics is not a dismal science because the economists like it that way; it is because in the end we must submit to the tyranny not just of the numbers, but of the logic they express.” The “tyranny of numbers” Krugman refers to in the article is a tip of the hat to a controversial thesis by Alwyn Young (1995) titled “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Economic Growth Experience.” In this paper, Young conducted a detailed total factor productivity (TFP) analysis and examined its effects on the economic growth of four economies in East Asia; namely Hong Kong, Singapore, South Korea, and Taiwan. He discovered that large-scale factor 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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accumulation—the rapidly increasing labor participation rate, rising education levels, and high saving and investment rates corresponding to the East Asian culture—was the primary driver of the rapid economic growth witnessed in these economies (excluding Hong Kong). Technological progress measured by Alwyn’s calculations of the TFP made little contribution to this growth. The tyranny of logic is but a small step forward from the tyranny of numbers. Given their high labor participation rates, limits to the expansion of higher education, and already astonishingly high saving and investment rates, East Asian economic growth was based on extensive factor mobilization. Sooner or later, factor mobilization would reach its limits and the economies would encounter an inevitable growth bottleneck. Initially, widespread consensus viewed Krugman’s warning as pure exaggeration— simply an economist being controversial for the sake of controversy. However, the small step in the logic provided by Krugman was later considered to be a huge step in economic forecasting. Three years later in 1997, a devastating economic crisis broke out in Asia. Consequently, several people were impressed by his prescience. Krugman did not focus on China in his article, but China is now facing the same issues as the other East Asian economies. While the Chinese economy has experienced 30 years of unprecedented economic growth, it too is in the vein of extensive factor accumulation. Indeed, whether this growth experience is a miracle or just a myth remains to be seen. In order to address this question, we can examine the factor decomposition for the Chinese economy. Table III displays one such decomposition, conducted by Hu and Kahn (1997) examining the period 1952–1994. They argue that capital accumulation Table III Sources for the output and production growth r ate (%) of the Chinese economy (1952–1994) 1953–1994

1953–1978

1979–1994

7.2 6.8 2.6 2.1 55.6 14.9 29.5

5.8 6.2 2.5 1.1 65.2 16.8 18.0

9.3 7.7 2.7 3.9 45.6 12.8 41.6

Output Growth Capital Input Growth Labor Input Growth TFP Capital Contribution Labor Contribution Labor Productivity Growth Source: Hu and Kahn 1997, 116.

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played a key role in China’s economic growth. However, they refuse to discount the significance of TFP increases during the post-reform period. Judging from this data, TFP should have made a great and fundamental contribution to China’s economic growth. Their extrapolation of TFP growth presents an even more optimistic future for China. They believe that if China would maintain and deepen its reform and open-door policies, the contribution of the TFP to China’s economic growth would continue to increase, and China would become the largest economy in the world over the next few decades. Unfortunately, these decade-old extrapolations have not played out. Since then, there have been drastic and confusing changes in the Chinese economy. While China’s growth trend continued as explained earlier, TFP contribution to the Chinese economic growth declined markedly between 1998 and 2003 (as compared to the TFP contribution between 1993 and 1998).6 Assuming that the figures are accurate, the tyranny of logic suggested by Krugman holds. China’s current economic growth may rely heavily on large-scale factor mobilization instead of the previously emphasized technological progress heralded by economists and policymakers alike. As shown in Table IV, as compared to labor investment, capital investment has made greater contribution to economic growth. The growth rate of capital productivity has also plummeted throughout 1983–2003, even contracting. In order to compound the bad news, compared to the two stages prior to 1993, the contribution of the labor input to the economic growth sharply declined. According to Lin, Cai, and Li (1994), the emergence of the Chinese miracle should be attributed to two fundamental causes. Initially, the abandonment of the strategy that prioritized the development of heavy industry allowed the growth of more labor-intensive industries. Subsequently, targeted government development strategy promoted further growth in these labor-intensive industries where China possessed a comparative advantage. If we consider China to be a developing country, rich in labor and scarce in capital, the changing trend shown in Table IV may require deeper analysis. The pattern of China’s economic growth, which corresponds to the decline revealed by the above TFP results, seems to have all the features of extensive factor mobilization: extremely high saving and investment rates, rapid expansion in higher education, and substantial rural-urban migration. If we consider industrial development as being achieved at the cost of environmental pollution, then environment quality too can be viewed as factor mobilization. Currently, environmental pollution in China, both air and water pollution, has become a very serious issue. This suggests that this type of factor mobilization is also reaching its limits. Therefore, there is considerable doubt as 6. Th is is in accordance with the report announced by the secretariat of the World Trade Organization (WTO).

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TABLE IV Sources for China’s economic output and productivity growth (%) (1983–2003)

Output Capital Labor Labor Productivity Growth Labor/Output Capital Productivity Growth TFP Structural Changes Education Residual

1983–1988

1988–1993

1993–1998

1998–2003

12.1 5.0 1.5 8.9 3.3 2.7 5.6 2.2 1.0 2.4

8.9 4.5 1.0 6.7 3.3 0.4 3.4 0.8 0.9 1.7

9.8 5.5 0.3 9.2 5.1 −0.6 4.1 −0.3 0.9 3.4

8.0 4.9 0.3 7.4 4.6 −1.2 2.8 0.5 1.1 1.3

Source: Secretariat of the WTO (calculated on the basis of OECD data [2005a]). Note: The data in the table is rounded off ; hence, the sum of the decomposed items may not equal the summation.

to whether the Chinese economy will be able to continue providing the environmental factor mobilization required for growth.

Is the Chinese Miracle Really a Myth and Thus Impossible to Sustain? The reliability of these TFP calculations can be questioned given the intricacies involved in compiling such information. Theoretically, inductive logic can be employed to disprove the Chinese miracle. However, the disproof itself should also be subjected to questionability. While the existence of a black swan may invalidate the proposition that all “swans are white,” should a sighting be considered an ironclad disproof? Indeed, there should still be some skepticism over the validity of the sighting. The mere claim to have seen a black swan is subject to misrepresentation on the part of the witness; a more trustworthy disproof would involve multiple sightings or witnesses. If the sighting is unrepeatable and solitary, then the conclusion that non-white swans exist would at best be unconvincing, if not false. Further, should the sighting of a black swan be repeatable, more subtle questions may arise. For a rigorous disproof, one would reasonably expect that we verify that the black swan is really a swan, instead of simply being another bird species. In order to use the TFP analysis to judge whether the Chinese economic growth is an extensive one with the character of factor accumulation or an intensive one supported by technological progress, we must first ask the following question: Can the technological progress of an economy actually be captured by changes in the TFP? Although the TFP has historically been equated with technological progress, Lipsey and Carlaw (2004) TOWARD AN INNOVATIVE NATION

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recently pointed out that technological progress is, by nature, an unexpected fortune. In contrast, the existing TFP analysis assumes that it is the result of intentional investment. In the regular factor decomposition analysis of the economic growth, TFP changes measure only the excess proceeds of an economy, after the deduction of research and development’s opportunity cost. This is, thus, unlikely to measure real technological progress. The abandonment of the exogenous assumption of the technological progress allows for the following contention: Insignificant TFP growth in an economy does not imply technological stagnation. Using a pragmatic approach, which takes into consideration that time-lags and uncertainty are inherent characteristics of research and development returns and furthermore, that these returns exhibit increasing returns to scale, we ought to seriously consider the possibility of technological progress without TFP growth. Another questionable premise of the TFP analysis is that contributions to economic growth by factor inputs, such as technology, capital, and labor, are easily divisible. In most cases, technological progress is inherently embedded in capital goods, making it difficult to disentangle technology from the capital aggregate. Another problem is that the emergence of new technology may skew the figures themselves: A result of new technology is decreased costs and thus decreased product price. Consequently, new technology may have flow effects that impact the measurement of GDP and GNP that cause chronic underreporting of its effects. Likewise, research and development and relevant technological progress would be ineffective without improvement in education levels and the accumulation of human capital. Regarding environmental pollution as factor mobilization, it might simply be a necessary cost required for economic growth, as suggested by the Kuznets proposition.7 Besides, even if policymakers were to embrace the TFP analysis, translating it into workable policy initiatives is not easy. For instance, if the analysis shows that technological progress was an insignificant contributor to China’s economic growth, then what specific policy implications does one draw from that conclusion? The TFP analysis is undoubtedly a useful tool for grasping growth patterns, the quality of economic growth, and its sustainability; however, it is just one of the tools available. Since data sources, analysis methods, and underlying philosophical concepts may vary, people’s opinions naturally vary when they consider whether such tools are appropriate to measure real technological progress. Further, even if they agree regarding the appropriateness of the measure, they may question the correctness of its usage in

7. According to the Kuznets proposition or assumption, there is an inverted U-shaped relation between economic development and environmental pollution; that is, the environmental condition will keep worsening at the initial stage of economic development; however, when the economic development level exceeds a threshold, the environmental quality will improve and continue improving as the economy develops.

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specific instances. Therefore, one can argue that the relation between China’s economic growth and technological progress during the past 30 years remains uncertain.

Stepping into the “Black Box”: Research Methods Employed in this Book Indeed, as economists and policymakers emphasize, technological progress is the critical factor that drives sustained economic growth. However, we should not view technological progress as “manna from heaven.” It is the result of intentional investment, which is an endogenous variable determined by an economy’s competitive environment, incentive structures, and level of economic development. Therefore, in order to reveal the linkages between technological progress and its contribution to China’s economic growth, we must delve into the technological “black box” defined by neoclassical economics and question the assumptions therein and their origins. As technological progress is a complicated evolutionary process involving a broad spectrum of sectors, its internal structure, behavioral dynamics, and performance is best analyzed through an effective, encompassing, theoretical framework. Such an analytical framework is provided on the basis of the National Innovation System (NIS) theory. The NIS concept was initiated by the breakthrough researches conducted by Freeman (1987) for Japan. Today, this concept has been refined by Lundvall (1992), Nelson (1993), Metcalfe (1995), and Edquist (1997) and is advocated strongly by government and policymakers. Since the 1990s, the NIS concept has been used by the Organization for Economic Cooperation and Development (OECD 1997) to analyze and evaluate the function and performance of the innovation policies of different countries and regions. Before continuing, it is important that we take into account the variations in the definition of this model. The OECD (1997) itself uses five core definitions on the nature of NIS. Freeman (1987) regarded it as “a system network where a public-private division performs activities and interactions at the core of new technology creation, importation, modification, and communication.” In the opinion of Lundvall (1992), NIS was “composed of such components and structures that they are located or rooted in some country, where they have close connections and interactions when creating, diffusing, and utilizing new knowledge with economic value.” Nelson (1993) defined NIS as “a set of interactive systems for determining the innovation efficiency of a country’s enterprises.” Patel and Pavitt (1994) thought that NIS is “a country’s system, incentive structure, and innovation capability that are used to determine this country’s speed and direction of the technology learning.” Finally, Metcalfe (1995) defined NIS as “characteristic institutional arrangements independently or jointly affecting new technology TOWARD AN INNOVATIVE NATION

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development and diffusion, on which the government may rely to make and implement different sorts of policies that may affect the innovation processes.” Thus, it must be noted that subtle differences in opinions regarding the specific definition and meaning of the NIS framework abound.8 Despite these differences, there is a consensus on two points: First, scientific and technological knowledge are increasingly critical to economic development, whether reflected in human capital development or embedded in material capital. Second, in order to analyze innovation efficiency, systematic analysis methods should be used. Consideration must be given to the complex interaction among all interior components of the innovation system. Innovation can be divided into two layers: technological innovation and system innovation. While both are inter-determinant in the long run, in order to drive effective analysis, we will accept the view that system innovation is more important than technological innovation. Technological innovation is the direct factor in driving economic growth, but it is the incentive structure and exterior environment through which technological innovation is nurtured. System innovation is thus the underlying driver of technological growth and is treated as such throughout this book. In order to consistently examine the context and nature of China’s technological reforms, we needed to utilize an appropriate analytical framework. The movement to market-driven growth, performance differences, and the evolutionary motive of China’s NIS before and after the reform were important factors that needed to be included in the scope of this model. For this purpose, a NIS model was built on the basis of Liu and White’s (2001) model as the framework for analysis. As shown in Figure I, the model includes four layers. The first layer consists of the basic activities corresponding to each link of the innovation process (the production, diffusion, and application of knowledge), which includes education, research and development, production, consumption, and coordination. These basic activities essentially exist in any economy, being necessary regardless of whether or not NIS is intentionally implemented. The second layer comprises the basic actors performing these basic activities, which include enterprises, research institutes, universities, individuals, and other intermediate organizations. Each basic actor can and may conduct several basic activities concurrently. Further, different basic actors can cooperate on a basic activity. We believe that it is essential to take into account these cooperative linkages between agents and the concurrent activities if our goal is to understand the evolution of NIS. The third layer consists of the government, 8. Surprisingly, uncertainty abounds with many economic terms. For example, people currently question the defi nitive meaning of the word “country” considering the increasingly high international flow of knowledge. Then, taking the cue from economic geography, should researchers concentrate more on “regional” innovation systems due to the existence of the cluster effect?

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System

(10)

(9)

(2)

(5)

Basic Actor

(1) (3) Innovation Factor (Capital)

Government

xvii

(6)

(4) Basic Activities

(8)

(7)

Innovation Performance

FIGURE I A general model of the national innovation system

including both the central and the local governments. The fourth layer is the system, which includes ideological norms, laws, and regulations. Finally, we have outlined two additional layers to evaluate the total performance of the innovation system: innovation capital including funds, talent, and knowledge; and innovation performance, which includes output measurements such as the quantity of patent, profit level, and the quantity of research papers produced. As the flowchart in Figure I explains, every component in the innovation system is closely connected and interacts with the other components. In the flowchart, the solid lines represent the physical transfer processes, that is, of material objects, whereas, the dashed lines represent the transmission process of decisions or ideas. The arrows indicate the directionality of the transmissions process. Essentially, a one-way arrow indicates a one-way transmission process while a two-way arrow indicates a more responsive, two-way transmission process. The transmission mechanisms in the flowchart are numbered. Below is a brief description of these mechanisms: 1. Policy instructions for the different innovation elements allocated by the government 2. Instructions given to the basic actors and the feedback from the basic actors to these instructions 3. The system, on the basis of which the basic actors obtain nongovernmental innovation elements, the most important system being the market system 4. Different decisions made by the basic actors when participating in basic activities 5. The effect of existing ideas, laws, and regulations on the basic actors 6. The involvement of innovation elements in each basic activity process and how these basic activities affect the innovation elements TOWARD AN INNOVATIVE NATION

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7. The relationship between each basic activity and the innovation output 8. The influence of the innovation performance on the basic actors 9. The direct effects of the innovation performance on government behavior 10. The interaction between the government and institutions. On the one hand, the evaluation criteria developed by the government for the innovation performance may be determined by ideology and therefore institutions influence the government behaviors. On the other hand, laws and regulations can be enacted and revised by the government that will in turn constrain and influence the government behavior after they come into effect. All this may appear rather complicated and confusing; however, 1–10 mentioned above simply describe the direct effects between each part of the innovation system. Further complications arise in this system as there are multiple methods for indirect effects to occur. For example, should the government wish to reallocate the innovation factors, it has many choices regarding the manner in which to enact this policy. The government could simply directly interfere with the allocation of the innovation factors. However, if the government wants to prevent distortions or increase a policy’s efficiency, it could instead alter the system; for example, by enacting new tax breaks on research and development. This change would affect the basic actors’ decisions regarding the number of innovation factors to obtain and would thus accomplish the original goal. Similarly, complexities may arise from other layers in the system. Basic actors may indirectly affect the system by affecting the government, even though technically they are not able to directly alter the existing system. This indirect transmission method is quite typical with regard to China’s gradual reform experience. It is quite common for the basic actors to implement pilot reforms in a spontaneous or semi-spontaneous manner. Should these reforms be considered by the government to successfully influence the performance of innovation, the pilot reforms can be systemized. The reforms can be cast as a new layer of laws, policies, and regulations; or perhaps, the existing system can simply be amended and made more flexible. Finally, we should point out that NIS is an open system even though this is not explicit in Figure I. This can easily be observed given the international flow of innovation capital and output. Theoretically, it is easy to understand that for a country lacking capital and advanced technology, the integration of foreign capital, technology, and knowledge will help increase the marginal productivity of domestic factors (primarily, labor). Meanwhile, developing a global market-oriented economy via international trade allows the evasion of various constraints caused by the domestic system. From this viewpoint, we see that it has been and remains critical for the Chinese government to harness the opening up and reform efforts simultaneously, allowing the reforms to accelerate 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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the opening-up efforts and vice versa, as these two parts complement each other and neither should be neglected or abolished. In our model, the mort important part(s) of NIS is(are) its coordination instrument(s), which govern how innovation resources are allocated to various basic activities. That is, the coordination instrument is most critical among all the four layers. Of key importance is not whether a specific basic actor must or should perform a set of basic activities; it is whether each of these basic activities are performed effectively and efficiently and whether these basic activities are effectively connected to each other. Thus, we see that the static characteristics of NIS rest on how and under what system the innovation factors are allocated to each innovation process link; a different allocation method for innovation factors means that a different NIS is in place. Given the multiple feedback relations in the system described, our model can also be used to analyze the dynamic changes to NIS. Therefore, we are able to analyze and compare the changes to China’s NIS before and after the reforms, as well as the driving mechanism behind these changes, within this unified model framework. After the founding of the People’s Republic of China in 1949, a highly centralized NIS was established in China, and the allocation of the innovation resources was mostly carried out by different administrative decrees. While China had media for innovation—such as universities, scientific institutions, and enterprises as in other countries—they were essentially affiliated with different levels of the government and were subject to administrative decrees issued by them. Therefore, they were bereft of substantial decision-making autonomy, ensuring the dislocation of links in the innovation process and the inefficiency in resource allocation for innovation. Over the past 30 years, the core of the reforms regarding science and technology institutions in China have worked to accelerate and strengthen the lateral ties in the innovation process by promoting more autonomy and introducing a market regulation approach. This is reflected in the promotion of organic integration between technology and production. In the Eleventh Five-Year Plan issued recently, the Chinese government highlighted the importance of independent innovation for economic sustainability, and has placed the development of a highly efficient NIS as a strategic target in its attempt to construct an innovative nation. In order to examine these changes we must remember that “history is a mirror reflecting the vicissitudes of life.” Only when the past is properly evaluated can we analyze the current system and its efficiency and reasonably forecast its future. Therefore, we must chronologically examine the formation and evolution of China’s NIS to discuss whether or not China is an innovative nation and how it should move ahead to become innovative. TOWARD AN INNOVATIVE NATION

x x INTRODUCTION

Plan of the Book It is difficult to describe and analyze the significant changes in China’s NIS during the last 30 years. It is natural to choose a chronological style to describe the process of the reforms that allows for a detailed discussion of significant events on a yearly basis. However, broader trends may be hidden, making it difficult for us to handle the evolution of policies logically. In comparison, a biographical, topic-oriented description contains such specific issues at its core, allowing a broader view of the 30 years of policy evolution. This too has shortcomings, in that it becomes difficult to decipher the connections between different issues. Given that both the methods have shortcomings, this book aims to synthesize the two; we conduct both a general analysis as well as an evaluation of the evolution of China’s NIS and further develop this analysis in a chronological manner. In addition, we specifically analyze the effect of different reform measures and innovation policies on some typical industries and representative enterprises. In Chapter 1, we review and summarize the formation and basic characteristics of China’s centralized NIS during the pre-reform period. We take an in-depth look at the structure, behavior, and performance of the centralized science and technology system, while also analyzing the effect of this reform on the science and technology management system in China. In Chapters 2 and 3, we review the historical path of reform related to the science and technology management system in China since 1978. For this period, the “Decision Concerning the Reform on the Science and Technology Management System” issued and implemented by the Central Committee of the Communist Party of China in 1985 is of great significance. Prior to that, correcting ultra-leftist errors induced by the polity had been the major focus of China’s science and technology management system reform. While scientific research institutes and local governments had made useful attempts and discoveries regarding the introduction of the market system, these were tentative and couched carefully within the public-relations terms that the basic framework of the centralized science and technology management system had not been touched. After the “Decision Concerning the Reform on the Science and Technology Management System” was issued, China’s science and technology management system underwent marketization processes driven by the central government. However, the particular focus of each period may differ slightly from those outlined by previous landmark policies and documents. In Chapter 4, we provide a novel economic interpretation for reforms in the science and technology management system in China. As the imbalance between technology and the economy was the obvious weakness of a centralized planned system, these reforms concentrated on enhancing the integration of technology and the economy. Here, we examine major policy measures including the technology market initiatives, 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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speeding up the internalization of the technology trade, and building the environmental system for accelerating activities related to innovation. In Chapters 5 to 7, we conduct a micro-level analysis of China’s NIS since the reform period. We also review the effects of industrial policies, intellectual property rights policies, and foreign direct investment (FDI) policies on technological innovation. More specifically, the development of the Chinese high technology industry is analyzed in Chapter 5. The development of the Chinese automobile industry is analyzed in Chapter 6. The barriers posed by intellectual property rights to Chinese enterprises in the process of globalization are analyzed in Chapter 7. Chapter 8 examines the performance of China’s NIS when reviewed from the viewpoint of input and output. Finally, a brief conclusion and summary of the main findings are presented in Chapter 9.

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Acknowledgments For this book, I am grateful to the Center for New Political Economy at Fudan University for its generous research funding. I am indebted to Professor Shi Zhengfu and Professor Zhang Jun for their insightful discussions. The Center coordinated the translation of the original Chinese edition of this book into English. It must have been a very time- and energy-consuming task. I requested my friend Brown Campbell, a student at Fudan University, for a literal revision and correction based on the original translation. He did an excellent job. I greatly appreciate his assistance. Finally, I must thank Tanmayee Bhatwadekar, the project editor for this book at Cengage Learning Asia, and Neil Sebastian D’Souza, the copy editor of this book. They spent a lot of time going through all the chapters and have greatly improved the language and overall flow of the book.

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The Legacy of the Planned System Prior to the reforms and opening up, China adopted the Soviet science and technology management system, striving to build China into a socialist power. The “Four Modernizations” were proposed as a “catching up and surpassing” strategy using highly centralized national initiatives—the central government tried to use incentives to attempt to catch up and surpass the high-level technology of the developed countries within the shortest time possible. This produced mixed results. On the one hand, the formation and implementation of such a catching up and surpassing model brought minor achievements but was far from meeting its targets. It was the combination of the international environment and the situation of China at the advent of these reforms that worked against the optimism of the policymakers. The failure also embodied the inherent weaknesses of science and technology development in a centrally planned economy due to the effect of the “horizontal barrier” between technology and the economy. Central planning made the provision of effective incentives for technological progress almost impossible. Thus, it was extremely challenging to provide the continuous drive in technological progress that was essential for economic growth. On the other hand, the actual achievement during this period was the establishment of a nearly complete industrial system as well as a fledgling scientific and technical system in China within a short span of time that would provide a solid foundation for the rapid growth of the Chinese economy after the reforms. This chapter uses the benefit of hindsight to analyze the direction of China’s National Innovation System (NIS). This includes examining the processes leading to its formation and analyzing the operating mechanisms of China’s centralized science and technology management system for the duration of the planned economy. There are two reasons for doing so. First, it allows us to lay a strong base to analyze the mechanism that drove

2 THE LEGACY OF THE PLANNED SYSTEM

the reforms of the science and technology management system and understand how this system evolved. Second, although the reforms were carried out in a gradual manner, some ideological or institutional characteristics of China’s centralized science and technology management system that developed as a result of the planned economy may still hold some sway today.

. The Strategy of “Concentrating Efforts on Addressing the Key Issues” The strategy termed as “concentrating efforts on addressing the key issues” conceptualizes the essence of the practices from the long-lasting revolution of the Chinese Communist Party (CCP). Under the guidance of this strategy, the CCP triumphed in the civil war and successfully completed a socialist reconstruction. Therefore, the CCP believed that this strategy could be universalized, and so it was widely applied in all practical fields. Accordingly, the strategy of concentrating efforts on addressing the significant issues was the basis of the construction of China’s science and technology management system as well as the economic system. China’s centralized science and technology management system was an inevitable outcome of its historical environment; it formed a critical component of the entire planned economic system. This centralized system was a concrete realization of the CCP’s strategy of concentrating efforts on addressing the key issues. Therefore, the logic of the formation, development, and evolvement of China’s science and technology management system should be analyzed with the specific political, economic, and social environment in mind. This is virtually the cornerstone of the “systematic” characteristic that is the focus of the NIS framework.

1.1.1 Industrial Structure: Heavy Industry over Light Industry, Military Industry over Civilian Industry After the foundation of the People’s Republic of China (PRC) in 1949, the central government faced multiple issues such as the recovery and development of the economy, the improvement of living standards, and the consolidation of the new regime. With the recovery stage of the national economy being almost complete by the end of 1952, the central government set out to develop and implement the First Five-Year Plan. The industrial plans laid out the pattern of China’s industry wherein heavy industry was to be given greater emphasis than light industry, and similarly, the military industry was deemed more important than the civilian industry. The basic mission specified by the First Five-Year Plan was developed in accordance with the general political consensus 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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during this interim period. It aimed at pooling all resources for industrial construction that involved 694 construction units, including 156 units assisted by the Soviet Union, laying the foundation for China’s industrialization. It also aimed at developing a productive agricultural society based on collective ownership, while developing the Handicraft Producer’s Cooperatives to establish the initial foundation for the socialist transformation of the agriculture and handicraft industry. Again, the idea here was to achieve the socialist transformation of the privately owned industrial and commercial enterprises by incorporating the capitalist industrial and commercial enterprises into different types of state capitalistic enterprises. In the early period following the foundation of the PRC, China faced tight economic circumstances with outdated technology and severe talent shortage; therefore, all limited resources were employed on core issues targeted by the First Five-Year Plan. The central government undertook critical measures to ensure concentrated efforts and the strategic allocation of resources. The first such measure was the financial management system characterized by the separation of government revenue from expenditure and the classified administration. At the beginning of the founding of the PRC, there was a serious disconnect between revenue and expenditure due to huge defense expenditure. Financial order and price stability were threatened by the issue of excessive currency that was used as a short-term measure to close the gap. Shortly thereafter, the central government implemented the centralized financial management system in order to overcome these difficulties, stabilize the market, and control inflation. According to the “Decision on Unifying the National Financial and Economic Efforts” issued in March 1950, all major materials were to be handled and allocated by the State. Further, all tariffs, salt tax, excise duty, commercial and industrial tax, and the income of state-owned enterprises (SOEs), excluding a few local taxes, were to be allocated and used by the central government. At the same time, currency was to be issued by the State, and all cash that was to be dispersed to enterprises, institutions, and armies would have to be submitted to the People’s Bank of China (PBC) for unified administration and centralized allocation. Although such a financial system of unified revenue and expenditure played an essential role in the rapid stabilization of inflation and the financial environment, it greatly restricted local initiatives and delayed the utilization of funds destined to treat local issues. In order to solve these problems, after 1951, the central government began the implementation of a new financial management system titled the “Government Revenue and Expenditure Partition and the Classified Administration.” Under this system, there were three financial management layers—the central government, the provincial level, and the county level. The central government planned and implemented this three-tier financial management system. The partition of the revenue and expenditure scope of TOWARD AN INNOVATIVE NATION

4 THE LEGACY OF THE PLANNED SYSTEM

the central and local governments and the multi-level responsibilities were defined with this implementation. The second measure used to concentrate resources was the “scissors gap” opened between industry and agriculture. China’s industrialization took place in an economy that had a dominant agricultural sector. The accumulation of a huge amount of funds necessary for broad-scale industrialization without outside injections of funds became an essential issue. The solution to this problem was proposed by the Soviet economist Preobrazhensky in his book New Economy (1965), and had been implemented earlier in the Soviet Union. Preobrazhensky suggested that in order to create a huge amount of capital necessary for the development of the heavy industry, a planned economy could distort the prices of industrial and agricultural products. The central planners could then take advantage of the scissors gap to deprive the agricultural sector of surplus thus ensuring that the excess surplus generated by the industrial sector could be reinvested by the government. As in the case of the Soviet Union, China used its strong central government to create the scissors gap between industry and agriculture. In order to bring about the scissors gap between industry and agriculture, the central government advocated state monopoly over the purchasing and marketing of food supplies. This was to be done at an artificially low price fixed by the State. In order to ensure that this was effective, the government also severely cracked down on the private trade of food supplies. However, the Chinese authorities claimed to have avoided some of the mistakes that the Soviet Union had made during its implementation of the policy. The Chinese central government assured citizens that both the benefits of the farmers and the government would be taken into consideration when implementing state monopoly over the purchase and marketing of food supplies. The approach of requisitioning excessive grain supplies from farmers was in principal opposed; yet, the fundamental character of developing industry by compromising on agriculture was not altered at all. The scissors gap policy exerted significant influence on the industrial structure of the Chinese economy as well as on accelerating and deepening the urban-rural divide. The third critical factor in resource allocation was the socialist transformation of the state economy. The central government believed that the socialist transformation was essential for all economic units. As such, most organizations were nationalized or reorganized into collectively owned organizations, either of which could be highly planned. The State undertook several measures to ensure this; some of these were confiscation, redemption, and public-private partnerships. Meanwhile, a significant number of large nationalized enterprises were built surrounding the 156 aid projects begun by the State. This greatly strengthened the level of public-owned output in the national economy. During the period of the First Five-Year Plan of 1952–1957, the 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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5

proportion of the output value of the state-owned industry increased from 41.5% to 53.8%; that of the collectively owned industry, from 2.2% to 19%; and that of the public-private partnership industry, from 4% to 26.3%. The output value of the privately owned industry decreased from 30.6% to 0.1%, and individual output declined from 20.6% to 0.8%. By 1957, the total production value of public-owned and controlled industries had reached 99.1%, assuming a dominant position in the national economy (China Statistical Yearbook 1984). While it appears that these above-mentioned aspects are not directly relevant to China’s science and technology management system, the economic and system environment in which the science and technology management system took shape, developed, and functioned was virtually determined by the nature of the economy. Indeed, to some extent, the basic form of China’s science and technology management system was determined immediately after the formation of the Chinese planned economic system.

1.1.2 Bring the Parts Together and Manage in a Concentrated Way Before the founding of the PRC, China’s science and technology was not highly valued and could not be developed due to the protracted chaos that followed the war. In addition, the economic depression and corruption combined to present a hostile background for scientific development. When the PRC was formed in October 1949, only 50,000 individuals nationwide were engaged in science and technology research. The number of individuals specializing in the natural sciences was no more than 500. Lacking sufficient and stable income, the researchers could barely carry on many projects as they were unable to obtain sufficient funding and equipment. The conditions for scientific research were appalling. Only approximately 30 research institutions existed, with many institutions operating in name alone. Cooperation and coordination among these institutions was nearly nonexistent, with the system characterized by disorderly, inefficient, and isolated endeavors. Obviously, with scientific research institutions few and far between, without recourse to reforms, the prodigious efforts to build a powerful socialist economy and military would have failed at the onset. Chinese science and technology lagged behind that of the world; therefore, the central government decided that in order to catch up, every favorable advantage needed to be leveraged to the hilt and that meticulous planning was needed to direct research. The policy of “concentrating efforts on addressing the significant issues” was thus adopted. With this strategic direction, the central government was able to concentrate scarce resources on science and technology for national defense—represented by the “Two Bombs (A-bomb and H-bomb) and One Satellite” approach. A few other strategically important scientific and technical researches were TOWARD AN INNOVATIVE NATION

6 THE LEGACY OF THE PLANNED SYSTEM

also conducted. China’s science and technology management system was finally restructured and rebuilt to meet these targets. A centralized science and technology management system corresponding to the planned economic system was finally established. Centralization was reflected in two synchronized approaches: the centralization of talent and scientific and technological resources and the centralization of the management and decision-making authorities with regard to science and technology. After the PRC was founded, the government immediately established the Chinese Academy of Sciences (CAS), which was directly under the Government Administration Council (GAC). The Chinese Academy of Sciences is the top academic center of the State and the top administrative institute for national science and technology undertakings. Immediately after its founding, CAS began operating effectively in many aspects. Primarily, it set out to make the existing research institutes more efficient by eliminating repetition, refocusing on the central issues, and enhancing planning. It streamlined the original 24 institutional units into 17 units. Also, four additional institutes were simultaneously brought on line, leading to a total of 21 institutes. Many excellent scientists in China were assigned to the CAS system, which built the foundation for conducting strategic research. Meanwhile, CAS exerted great efforts in persuading scientists and students of Chinese origin in the West to return to serve China. Concurrently, CAS also dispatched students to study in the Soviet Union and the Eastern European countries in order to alleviate the extreme shortage of the science and technology talent. Although CAS was the highest academic center of the State, from the First Five-Year Plan in 1952, CAS encountered administrative problems in adapting to the increasingly challenging situation of managing the science and technology system. The accelerated growth of the Chinese economy required the rapid development of science and technology with more demanding requirements. The rapid expansion of the scientific institutions and teams caused CAS to become increasingly incapable of conducting the complex administrative oversight of the science and technology management system. By the end of 1953, CAS had expanded to 36 institutions with over 1,700 specialized scientific and technical staff, significantly exceeding its original size. In 1952, under the orders of the center, extensive adjustments were made to the higher-learning institutes. The scientific research institutes and teams of each industrial department were also substantially expanded; these changes enormously increased the complexity of managing this system. It appears that CAS failed to effectively coordinate its relationship with the higher-learning institutes and other scientific research units, making it difficult to effectively plan and organize nationwide science and technology work. Ultimately, CAS underperformed when it came to linking scientific research theories with their plausible industrial applications. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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The Constitution of the PRC and the Organic Law of the State Council that was enacted in the second half of 1954 altered the nature of CAS. This law diluted the administrative function of CAS in national science and technology affairs and shifted the focus to enhancing its function as an academic center. In June 1955, the CAS academic divisions were established, acting at the highest scientific level in China. After discussion and consultation, 233 members were elected to act in the divisions framework based on three criteria: academic achievements, administrative successes in the sciences, and loyalty to the communist ideology. The members of the divisions belonged to various institutions: 159 were from the old CAS system, while the rest were representative scientists from other major scientific research institutes throughout the country. There were four sub-divisions in this new organization. The members were divided as follows: 48 members were in the math, physics, and chemistry sub-division; 84 members in the biology and geography sub-division; 40, in the technology and science sub-division; and 61, in the philosophy and social science sub-division. The establishment of the CAS divisions was a critical step in China’s march toward a centralized science and technology management system. One of the key purposes of establishing the divisions was to strengthen the planning of science and technology development in China. According to the regulations, the major mission of the CAS divisions was to develop both long-term and short-term plans for the development of scientific output on the basis of the prevalent situation in China and the requirements of nation building. In January 1956, a conference concerning the issue of intellectuals was conducted by the central government. During the conference, Premier Zhou Enlai emphasized the role of science and technology in socialist development, pointing out that science was a decisive factor in national defense, economy, and culture. He also called on all the Chinese people to march toward science and technology development, announcing that the State Council had commissioned the State Planning Commission to spearhead the formulation of the first long-term science development plan for China. This plan was known as the “Outline of the Prospective Development of Science and Technology (Draft)” (hereafter referred to as the Twelve-Year Plan). Institutional changes emerged from this conference in the form of many new organizations. The Science Planning Commission of the State Council was established after the conference and was responsible for the conceptualization of the prospective plan. On May 12, 1956, the State Technology Commission was established. In October 1958, to coordinate scientific research and technology development in a better manner, the State Technology Commission and the Science Planning Commission of the State Council merged and became the State Science and Technology Commission, TOWARD AN INNOVATIVE NATION

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while local Science and Technology Commissions were established in all provinces, autonomous regions, and municipalities. In addition, to coordinate the increasingly complicated tasks of military research in a better manner, the National Defense Science and Technology Commission was established in October 1958 by the merger of the Aviation Industry Commission and the Fifth Department of the Ministry of National Defense, which was previously responsible for the development of conventional weapons.

1.1.3 Prioritizing Development and Endeavoring to Catch Up The enactment and implementation of the Twelve-Year Plan marked the establishment of a truly centralized science and technology management system. Under this system, five different types of institutions performed scientific research activities; these were the scientific institutions from the CAS system, the research institutions of the industrial divisions, the higher-learning institutes, local institutions, and the national defense science and technology research institutions. Apart from the national defense science and technology research institutions, the hierarchical relationship among the other four types of institutions was outlined in the Twelve-Year Plan: CAS was the core of academic leadership; the research institutions of the industrial divisions and the tertiary institutions were two major forces; and the local research institutes were the indispensable assistants. The Twelve-Year Plan specified 57 tasks that covered 616 core issues faced by almost every critical area of science and technology development at that time. However, considering the shortage of human capital in China, the Twelve-Year Plan was implemented through the spectrum of prioritizing development and endeavoring to catch up. Scientific and technological development was undertaken to shore up the needs of state construction. The consensus regarding the potency of science and technology to drive the nation and its potential to speed up growth were kept firmly in mind, and policymakers took into consideration the experience of several nations while advancing their scientific and technological prowess, particularly Soviet Union’s experience during the development of science and technology. A historical perspective was also maintained, with China’s experience of the technological development during the initial stages of industrial development also being taken into account. These diverse factors caused policymakers to refine the 57 tasks into 12 focal points to be given priority while allocating human and material resources. The 12 focal points included the development of nuclear power, wireless electronics, jet technology, production process automation and precision instruments, oil and resource exploration, metallurgy, heavy organic chemistry synthesis, the development of new and large machines, and fundamental theoretical issues in the natural sciences. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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. The Strategy of “Self Reliance” for Scientific and Technological Development Soon after its inception, the PRC implemented a “one-sided” policy toward the Soviet Union, importing several technologies from the socialist countries and the Soviet Union, in particular, and also sought assistance from them on many projects. However, the unstable domestic situation and the resulting deterioration of the Sino-Soviet relationship, made it almost impossible for China to obtain technology from external sources. Consequently, China advocated a strategy of “self-reliance” for the development of science and technology. Before the current marketization of the science and technology management system, China witnessed two large-scale introductions of technology. The first was that of the 156 major projects supported by the Soviet Union during the First Five-Year Plan period. The scale was massive and of great significance, basically transforming the Chinese industrial structure into a full-scale industrial system, giving heavy industry priority. As mentioned above, most of these projects were the development of basic or national defense industries. With respect to investment composition, the energy industry accounted for 34.3%; the metallurgy industry, 22%; the machinery industry, 15.7%; the chemical industry, 7.9%; and the defense industry, 12%. Among the projects completed during the First Five-Year Plan period, the energy industry accounted for 28.6%; the metallurgy industry, 22%; the machinery industry, 18.5%; the chemical industry, 7.8%; and the defense industry, 14%. There were 694 construction units deployed around the construction center. With the completion and the operation of these projects, the first large-scale modern enterprises were established in China, greatly strengthening the capabilities of the Chinese heavy and defense industries. In addition, it served to fill some of China’s knowledge gaps in the domain of production technology. During the course of this technology introduction, the Chinese government emphasized and supported domestic adaptation and application, achieving some good results. First, while importing equipment, the Chinese government had also imported over 5,000 science and technology successes from the Soviet Union and the East European socialist countries. Chinese scientists had actively cooperated with the Soviet Union to conduct 122 major scientific and technological studies. Second, the Chinese government enhanced interaction with the scientific and technical personnel in other socialist countries by implementing the “bringing in and going out” approach. Under this approach, the Chinese government sought out foreign scientists to provide technical instruction to their Chinese counterparts by inviting them to China, while simultaneously dispatching Chinese students to study abroad. These students, usually sent to the Soviet TOWARD AN INNOVATIVE NATION

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Union, would undergo training, thereby developing their human capital. Not only did they obtain scientific and technological knowledge but also developed experience and insight into the management of science and technology in the Soviet Union. Despite the deterioration of the Sino-Soviet relations and the extremely difficult domestic economic situations, the Chinese government continued to invest tremendous amounts of human and physical capital in the national defense science and technology researches, focusing mainly on developing the atomic bomb. Eventually, China successfully exploded its first atomic bomb in October 1964, soon after the first hydrogen bomb was successfully tested. Obviously, these achievements greatly elevated China’s international position and played a critical role in enhancing the reputation of China’s armed forces and instilling pride in the hearts of China’s citizens. On January 5, 1973, the State Planning Commission submitted the “Report Requesting Instructions on Increasing Equipment Import and Enhancing Economic Communication,” proposing the purchase of complete sets of equipment worth US$4.3 billion in the next three to five years. The proposal came at a time when China was quasi-autarkic; thus, it represented a breakthrough with regard to Chinese foreign trade. The total amount of foreign trade in 1973 was 2.4 times that in 1970; the total amount of foreign trade in 1974 was 3.2 times than that in 1970. The introduction of complete sets of equipment and the integrated cutting-edge technology facilitated the growth of the basic industry in China, developing among others, the metallurgy, chemical fertilizer, and petrochemical industries. However, as compared with the 156 projects, this proposal laid a greater emphasis on the introduction of complete sets of equipment and ignored the introduction of a single underlying technology or equipment. In addition, it there was no comprehensive support for this technical introduction; few technical personnel had been sent abroad and few foreign experts had been invited for communication.

. Freeing the First Wave of Productivity 1.3.1 Regional Partition and Horizontal Barriers China had a highly centralized NIS before 1978, where innovative elements were controlled and administered by government organizations. Meanwhile, every basic actor was subject to the strictures of the hierarchical system. Basic activities were mainly arranged according to government instructions and thus, basic actors lacked sufficient horizontal connections. As shown in Figure I of Introduction, the allocation of the resources for innovation was mainly achieved by channels (1) and (2); basic actors did not have many opportunities to interfere in the allocation of the innovation resources through channel (3); as for channel (4), it was nothing but a minor subset of channel (2). 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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In order to clarify this process in greater detail, we ignore the institution, innovation elements, and innovation performance in Figure I. Instead, we show the specific content of the basic actors and activities to create a simplified model indicating the Chinese NIS prior to the reforms (Figure 1.1). Under this system, each basic actor may only conduct specified basic activities according to the plan. Typically, basic actors did not have independent decision rights and could only execute policy instructions given by their superiors. Theoretically, each stage of the innovation process was supposed to have close connections. However, in practice, actors performing different basic activities could not have effective or direct connections with each other under this system. When the connections were essential, the actors reported to their superiors who then coordinated and arranged the desired connections. However, the complexity of the corresponding science and technology management structure greatly increased as forces from all five areas performed the scientific and technical activities under the original science and technology management system. Managing interactions between the scientific institutions in CAS, the research institutions of the industrial departments, the tertiary institutions, local institutions, and the national defense scientific and technical research institutions was difficult. First, the national defense scientific and technical activities were relatively independent, administered under the Commission of Science, Technology, and Industry for National Defense. Second, the Commission of Science, Technology, and Industry for National Defense directly controlled all the scientific research institutes of the central and local academies of science; it did not have direct administrative authority

Government Department at All Levels

Higherlearning Institutes

Scientific Research Institutes

Manufacturing Enterprises

Circulation Enterprises

Consumers

Education

Research and Development

Production

Circulation

Consumption

FIGURE 1.1 Simplified model of the original NIS

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over the research institutes belonging to the higher-learning institutes or the industrial departments. These were under the administration of the State Education Commission (later renamed the Ministry of Education) and the related industry ministries and commissions (such as the Ministry of Metallurgical Industry and the Ministry of Machinery Industry), respectively. Third, as the highest administration institution for the scientific and technical activities, the State Science and Technology Commission was responsible for developing all national science and technology plans; however, it lacked effective decision-making power to implement those plans as it was required to coordinate with other ministries and commissions under the State Council; these included the State Economic Commission, the State Planning Commission, the State Education Commission, and other industry ministries and commissions. This coordination was supposed to have helped monitor and implement these science and technology plans; however, it caused considerable bureaucratic headaches. The centralized science and technology management system was designed to allocate scientific and technical resources in a planned and balanced manner, in order to serve economic development more effectively. The integration of science and technology efforts and the industry was particularly emphasized in many documents issued by the central government. Indeed, every link in the innovation process was to be closely connected. The effectiveness of the scientific and technical activities should have been determined by the effectiveness of their contribution to economic growth. However, the system’s major flaw was that the basic actors allocated to the innovation process did not enjoy the freedom to make independent decisions; they had to obey the administrative orders from their superiors. Hence, problems occurred in obtaining the elements required for innovation or in the allocation of the innovative output. This resulted in two isolated layers in the science and technology sector and the economy sector, as well as two isolated layers in the military sector and the civilian sector. According to Kornai (1989), a planned economy ultimately corresponds to a shortage economy. Most production levels are generally kept at a level where demand exceeds supply. This ensures that any product can be sold as long as it is produced, as the consumers can no longer vote with their feet and thus cannot put pressure on the manufacturers. Therefore, manufacturers have no motivation to be concerned about consumer feedback and thus have weak incentives to ensure product effectiveness. Normal horizontal connections between producers and consumers are blocked, resulting in a lack of quality incentives unlike production in a market system. This pattern can be easily seen in the market for innovation in China under the planned economy. Under the original system, the input and output of manufacturers and scientific research units were allocated voluntarily by State plans. As the supply side of technology, 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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there was no need for scientific research units to be concerned about the real requirements of enterprises as they were irrelevant to their rewards. On the demand side of technology, the manufacturers (particularly, the factories) lacked consumer pressure. Consequently, there was no need for them to improve product quality or reduce production cost. Thus, under a planned economy, the normal horizontal connections between research and development and production were stifled. An additional horizontal barrier operated in the national defense sector of research and technology. Economic construction and national defense are two highly interdependent spheres. On the one hand, powerful military forces can provide people with national defense (unique public goods) and a stable environment for development. National defense ensures that a nation’s economic fruits are safe from outside military forces and thus investment incentives are enhanced. On the other hand, defense expenditure is necessarily derived from tax revenue that always creates cost to the taxpayer and can skew resource allocation, irrespective of whether this tax is flat or proportional. Considering these factors, defense expenditure needs to be maintained at a reasonable level. This relationship is more complicated and subtle if a large proportion of the defense expenditure is used for research and development in the military technology. Given a limited number of scientific and technological personnel, if more human capital is assigned to military research and development, fewer scientific and technological personnel remain for other economic activities. This reinforces the importance of the reasonable allocation of research and development resources between military and civilian purposes. Of course, this resource conflict is inherently easier to resolve should military science and technology research and development effectively spillover into civilian science and technology. There is an old Chinese saying, “The finest weapons of a state should be kept confidential.” This accurately indicates that the effectiveness of defense technologies relies largely on the confidentiality of their capabilities and them being proprietary technology. Secrecy enables military victory, while proprietary defense technology enables the strategies involved to be more effective. However, one of the key features of war is that a country will “maintain an army for a thousand days to use it for an hour.” This indicates that the military is predominately an underutilized resource. Thus, a strategy of secrecy and proprietary technology may yield extraordinary returns with correct investment. On the other hand, if the threat of war does not appear to be serious, it is easy to understand why underutilized military research and development should be effectively implemented in civilian applications despite the loss of secrecy. During the Cold War, both the Soviet Union and the United States invested heavily in the “arms race” and developed various advanced military technologies independently. However, while the Soviet Union encountered economic collapse and the disintegration TOWARD AN INNOVATIVE NATION

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of the State, the US economy enjoyed prosperity. One of the direct reasons that had a hand in dragging down the Soviet Union vis-à-vis the United States was that the former failed to apply its military technology to civilian applications. Making huge investments into military research and development over time without tailoring the resultant technology to suit civilian purposes was akin to a person losing blood without being nourished. This intensified the structural distortion of the Soviet Union economy, resulting in its inevitable collapse. In comparison, the United States while naturally ensuring the confidentiality of its military technology, allowed greater spillover of military technology into the civilian technology. This is also because the United States had a relatively decentralized science and technology management system. Although the United States had state laboratories similar to the Los Alamos National Laboratory, confidentiality agreements allowed the universities, high technology (hi-tech) companies, and these laboratories themselves to share innovation capital. Scientific and technical personnel, laboratory equipment, and the movement of scientific and technical information between sectors allowed for the spillover of military technology to civilian technology. Meanwhile, the US government or the Ministry of Defense used government procurement to contract out large amounts of research and development activities for military purposes to privately owned large companies with substantial scientific and technological prowess. Although usually, confidentiality agreements were strictly followed, these big companies often acted as the medium between the military and civilian technology. They were motivated to apply the military technology to civilian applications, in order to maximize the profit received from the various technologies that they controlled. For example, many space technologies derived from military scientific research could be applied to civilian aviation with minimum adjustment. Indeed, considering the inconsistency between the interests of the private companies and the State, the US government would typically conduct technological inspection over the export of such hi-tech products, to prevent them from being sold to their rivals. This flow of technology, from the military into the public domain, in the United States is in stark contrast to what occurred in the PRC. After the PRC was founded, China invested huge science and technical resources into defense undertakings, particularly focusing on the Two Bombs (A-bomb and H-bomb) and One Satellite plan. Large numbers of scientific institutions and personnel were put under centralized management by the Commission on Science, Technology, and Industry for National Defense (COSTIND); indeed China witnessed civilian-to-military transformation in order to preserve scientific and technical resources for these projects. Since the scientific and technical resources were significantly devoted to military applications, if the military-to-civilian transformation had occurred, it would have been of particular significance to Chinese economic development. However, China did not perform well in the military-to-civilian transformation before the reforms due to the overly 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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strict confidentiality system and the regionally segmented science and technology management system. This ensured that cooperation between military and civilian science and technology would not occur, and the benefits from the synergistic development of resource and personnel sharing were thus foregone. As mentioned above, the original science and technology management system was mainly designed as a means of concentrating efforts on addressing the significant issues. This finally resulted in a relatively poor performance with regard to innovation, which was reflected in the serious disconnect between the level of science and technology and the economy. The two isolated layers greatly restricted the role of science and technology as a predominant driver of productivity. According to fundamental Marxist theory, productive capacity is ultimately determined by productive forces, which is the most dominant factor; on the other hand, productive capacity intensely counteracts productive forces. Several decades of economic practices have shown that the existing rigescent productive capacity had seriously hindered the development of productivity. The aims of China’s science and technology reforms were to break this deadlock by using the market mechanism, and to improve the overall performance of the innovation system by strengthening the organic connections among the myriad chains of innovation. This was reflected in the following aspects: the acceleration of the horizontal connections among all the chains of the innovation process by reforming the economic system and the science and technology management system, particularly, the phenomenon of the two isolated layers of science and technology and the economy; the decentralization of the power and the revitalization of the scientific institutions via the decentralization reforms, in order to further improve the operational efficacy of the scientific institutions; the introduction of foreign funds and advanced technology by opening up to the outside world; and the incorporation of China into the international specialization structure as well as the leveraging of China’s comparative advantages.

1.3.2 Decentralization and Marketization In the book Whither Socialism (1996), Stiglitz used information economics to criticize the main schools of economic thought at the time; namely, neoclassical economics and socialism as advocated by Lange. These two schools appeared to be opposed to each other (their advocates were debating heatedly during the 1930s), with one theory represented by economists such as Hayek and Mises advocating market economics, while the other theory represented by economists like Lange and Lerner supporting market socialism. However, both the theories had a common shortcoming in that they assumed the availability of perfect information. Indeed, in a world with perfect information, if there are no externalities or economies of scale, perfect competition will result in a social Pareto optimal result (as stated in the first theorem of welfare economics) and thus, the TOWARD AN INNOVATIVE NATION

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Neoclassicists would be correct. Then, in this case of perfect information, the government can simply imitate the price system resulting from market competition and implement the social Pareto efficient allocation (as stated in the second theorem of welfare economics) by a one-time gross taxation.1 However, due to the complexity of the real world and the imperfect nature of actual markets, issues such as incomplete information, asymmetric information, and economies of scale cause serious economic distortions in a vast majority of markets. All these make the Arrow-Debreu model described in neoclassical economics a Utopian fantasy—at best, extremely difficult to achieve; at worst, unobtainable. Consequently, a purely socialist approach appears likely to fail, and this may be the reason for the failure to achieve a socially optimal outcome by adopting a planned economy in China.2 By this token, in a world with incomplete information, it is the formation of the price system and its adjustments—rather than the price system itself—that have caused the overall performance of the market system to supersede that of the planned system. Although Hayek (1945) advocated spontaneous economic order, he admitted and emphasized that all the economic activities were actually the results of some type of planning. Hayek divided planning into three layers. First, the term “plan” usually refers to a central plan—where one authority develops all the plans on behalf of society. Second, the term “competition” usually refers to a situation wherein the plans are developed in a decentralized environment. Finally, there exists a situation that lies between the above two situations—where the plans are developed by “monopolizing” industrial divisions or enterprises. In Hayek’s opinion, the essence of building a reasonable economic order lies in the method of using decentralized knowledge to ensure effective resource allocation; the decentralized market system may provide enough motivation for all microagents to take better advantage of their decentralized knowledge. Under a planned system where the decision-making rights are highly centralized, if the governments wish to make targeted and proper decisions for practical situations, they are required to seize all relevant information in a sufficient, accurate, and timely manner. This is next to impossible in reality. As a result, as compared to the market system, the price system under the planned economy is usually quite inflexible and has difficulty in accurately reflecting the relative scarcity of various products and factors of production. Innovation means breaking away from convention. This actually indicates that innovation cannot be planned in advance. Therefore, an inflexible price system cannot respond to output from technical innovation in a timely and effective manner under the planned system. The resulting inefficiency impairs people’s passion for innovation 1. Of course, this may require some technical conditions; that is, the production technology should be convex. 2. Obviously, in Stiglitz’s opinion, the planned economy is almost as good as socialism.

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and stifles activities such as the improvement in the quality of products and services. Obviously, when people are unable to gain rewards from innovation accordingly, their motivation to innovate is severely impaired. Further, in order to successfully develop and implement a multitude of plans, the central planners are required to gain sufficient control over all the resources. The planned system would inevitably be transformed into a highly centralized system. Under such circumstances, all the micro-agents would lack control over any resources (not only capital, labor, and land but also technical knowledge), and thereby lose the freedom to innovate. In essence, the distinction between the planned and market systems lies in the fact that under a highly centralized planned system, people are not permitted the freedom to act, whereas, under a highly decentralized market system, people can act with impunity. If this logic is correct, it is easy to see how the market system is more favorable for innovation. Of course, the above analysis neither implies that the planned system is useless, nor does it indicate that there would not be any innovation under such a system. Actually, both China and the Soviet Union made an array of scientific achievements and technical inventions of great significance during the planned-economy era; these include the launch of man-made satellites, the crystallization of insulin, and the continental theory of petroleum origin. According to the theory of innovation by Schumpeter, the critical factor of the innovation process is entrepreneurship—the capability of finding opportunities and undertaking risks to gain big profits in the marketplace. According to this train of thought, we can simplify the innovation process into two stages: The first is finding the right opportunities and creating innovative ideas and the second is mobilizing all kinds of forces to realize and commercialize the innovative ideas. The author believes that under a highly centralized planned system, if the central planners fail to seize certain opportunities, all the factors in the community would be potentially mobilized via the planned measures thus realizing such a technical opportunity in a more effective manner. This is essentially the essence of the strategy of concentrating efforts on addressing the significant issues. However, in many cases, it is more critical to identify issues than to solve them. As discussed above, a centrally planned system is bereft of autonomous decision making. Due to information leakage, distortion, and asymmetry, the central planners are in no position to obtain and take full advantage of the decentralized knowledge held by each micro-agent, which undoubtedly hinders the possibility of central planners “creating” innovative ideas. In comparison, under the highly decentralized market system, each micro-agent enjoys decision-making autonomy, positioning himself or herself well to take full advantage of the decentralized knowledge that he or she possesses (whether such knowledge is in terms of technology supply or technology demand). Individual market actors can also propose and implement various innovative ideas. Thus, it follows that the reason for better innovation TOWARD AN INNOVATIVE NATION

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performance of the decentralized market system is that its structure permits a more effective application of decentralized individual knowledge.

1.3.3 Market Failure and Government Intervention The market system is not always perfect. In the presence of factors such as externalities and monopolies, market failure emerges. Due to the uniqueness of the innovation process, failure in the market for innovation will generally be more common and severe. First, the spawn of innovation (particularly, basic research results) typically possesses the characteristics of common goods (non-exclusiveness and non-competitiveness); usually, the private benefits gained by the innovators are less than the social benefits that they have created. Such a public goods effect will result in insufficient motivation for innovation in the market. On the other hand, in some cases, the market itself may cause excessive investment in innovation. A typical example is patent competition—only the one who completes the innovation first can win the patent and reap the rewards. Under such a “winner-takes-it-all” reward structure, each innovator wants to be the first to get his or her innovation to the market; however, from the social planners’ perspective, society is unconcerned with who has brought the innovation to the market and places greater weight on whether or not the innovation has been completed. Thus, when individual innovators increase their investment in research and development, their actions are viewed as a negative externality to other innovators (reducing their opportunities to access the patent). This may ultimately make the private benefits of each innovator greater than the social benefits, resulting in an excessive investment situation. This corresponds to the so-called public land effect. Irrespective of whether the public goods effect or the public land effect dominates, the innovation process is inherently uncertain in terms of its results. It is impossible for people to develop a complete marketplace to decentralize the risks that come with innovation. Further, there is a long time lag between the initiation of innovation investment and its fruition. All these characteristics inevitably dampen the innovators’ incentive to innovate. In order to deal with the long time lag, a series of response mechanisms evolved in developed countries; these include a more complete credit market, the NASDAQ Stock Market, and venture capital. In contrast, in developing countries like China, the financing and risk mitigation measures that innovators can avail of from the market are very limited. Finally, in market situations, innovation always goes hand in hand with the formation of monopolies. On the one hand, the excessive profits generated from monopoly motivate people to innovate, concurrently resulting in the loss of social welfare. Thus, society must implement various policies and measures to achieve a reasonable balance between the provision of incentives to innovate while preventing the post-innovation distortions due to monopolization. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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In conclusion, opposing the planned system does not mean opposing government intervention. On the contrary, when there is market failure, timely and appropriate government intervention increases social welfare and motivates innovation3 through policy measures such as research and development subsidies, market admittance, intellectual property rights protection, and anti-trust legislation.

3. On the other hand, when the market failure is caused simply by information asymmetry, the government can usually do nothing about it. The reason is very simple—if individuals in the market are unable to obtain some private information, we cannot assume that the government will be able to assuage the problem. Under such circumstances, resource allocation can only attain the status of limited Pareto optimality—the optimal resource allocation that a social planner facing the information constraint can achieve.

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A New Dawn for Science in China With the conclusion of the Cultural Revolution, China welcomed a new dawn for science.1 This chapter has two key themes. First, we will review the efforts made by the central government after the Cultural Revolution with a view to righting the wrongs, and the subsequent recovery of the original science and technology management system. Second, we will review the spontaneous attempts made by all levels of government to overturn the original science and technology management system. With this in mind, we will cover the period from 1978 to 1985, beginning with the National Conference on Science and Technology in 1978 and ending with the implementation of the “Decision on the Reform of the Science and Technology Management System.” The period encompasses the “National Outline for Scientific and Technological Development Planning (1978–1985).”

. Emancipating the Mind and “Righting the Wrongs” 2.1.1 National Conference on Science and Technology (1978) In March 1978, an unprecedented conference—the National Conference on Science and Technology—was held in Beijing. During this conference, criticism was leveled at the extreme leftists who had interfered with scientific and technical work in earlier years. Critically, a conclusion ascribing science and technology as the driver of productivity was made, allowing the contributions of scientists and intellectuals to be recognized. 1. During the National Conference on Science and Technology in 1978, Guo Moruo, the president of the Chinese Academy of Sciences (CAS) made an ardent speech regarding the dawning of a new era for Chinese science under the thought-evoking title “The Spring of Science.”

2 2 A NEW DAWN FOR SCIENCE IN CHINA

This construction of an ideological foundation allowed for the later recovery of the science and technology order as well as for the effective implementation of the policy of “righting the wrongs.” During this conference, Deng Xiaoping pointed out: “It has always been Marxism’s view that science and technology are productivity. The development of modern science and technology has made the relations between science and production much closer. Science and technology are giving much more significant effect on productivity.” He continued, “One question should be answered before admitting that science and technology are productivity: How can we view scientific research as mental labor?” (Deng 1994, 2:88) Since science is becoming an increasingly important productivity driver, should those who are involved in scientific and technical development be regarded as laborers? To this question, he responded “Generally speaking, however most of them [scientists and engineers] are intellectuals of the working class, and workers themselves; therefore, we may say that they are already part of the working class. The difference between these individuals and labor workers lies only in the social division of labor. Both labor workers and mental workers are workers for the socialist society” (ibid., 89). He also talked about integrating advanced foreign technology into the Chinese economy, indicating that to him, independence did not imply an attenuation of international relations. Self-reliance did not mean excluding internationalization and was therefore consistent with China’s implementation of the opening-up policy and allowed the introduction of advanced foreign technology in the years to come. Deng Xiaoping further clarified the past requirement of having both political integrity and professional competence as the criteria for talent. He severely refuted irrational arguments proposed by the Gang of Four, such as “The more the knowledge, the more conservative” and “Rather a worker without any knowledge.” Deng said that “scientific undertaking is an important part of the socialist undertaking; dedicating and contributing to the scientific undertaking of the socialist society surely represents professional competency; furthermore it also represents political integrity in some aspects” (ibid., 92). In particular, he pointed out that scientific and technical personnel should exert their utmost effort in scientific and technical work and that they should ensure that at least five-sixth of their time is invested in their core competency. Finally, regarding the issues about how the scientific research institutes would realize the administrative division of responsibility under the Party Committee, he said, “The leadership of the Party Committee is mainly a political leadership; the leadership of the science and technology business should be designated to the Directors and the Deputy Directors” (ibid., 98). 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Thus, Deng allowed the formation of a science and technology management system where experts were leading the experts.

2.1.2 The Third Plenary Session of the Eleventh Central Committee of the Communist Party of China In December 1978, the Third Plenary Session of the Eleventh Central Committee of the Communist Party of China (CCP) was held in Beijing. This session was of high significance with regard to China’s reforms. The core outcome was to shift the key tasks of the party to economic development or socialist modernization. During the plenary session, issues regarding the ideological lines of the party were discussed and a general future guideline on the principle of “emancipating the mind, mulling things over, seeking the truth from facts, uniting as one looking to the future” was formulated. During the plenary session, the discussion on the criterion of truth was highly valued; the incorrect guideline of “all two” was firmly criticized; the guideline of “class-struggle as the center” was decidedly terminated; and the strategic decision of “focusing on the economic development” was made. It was the first time since 1957 that the CCP explicitly addressed shifting of the work focus, indicating that leftist errors made during and before the Cultural Revolution were to be completely corrected. This address was the most essential effort toward righting the wrongs on the political front by the CCP. The plenary session also indicated that in order to realize the Four Modernizations, productivity should be greatly increased. In order to bring this into effect, those administrative aspects of production that had previously failed to fit the development of productivity had to be altered in various aspects. Thus, inappropriate management methods, behavior patterns, and ideology could now be adjusted to efficiently increase productivity. This was an extensive and profound revolution. As for economic reconstruction, the plenary session wanted to ensure that the new policies did not follow the incorrect ones of the past that hoped to achieve quick results. The session desired a new policy to resolve the significant imbalances in the critical areas of the national economy and to conduct an array of important and new measures. The plenary session required serious and thoughtful reforms to the economic management system that included the following policies: actively conduct economic cooperation with other countries on the basis of equality and mutual benefits, endeavor to introduce advanced technology and equipment from abroad, and greatly enhance the scientific and educational tasks necessary to realize modernization. Led by this thinking, the CCP initiated the policy of “opening up to the outside and invigorating the domestic economy.” TOWARD AN INNOVATIVE NATION

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. Restoring Order within Science and Technology Research 2.2.1 The Outline of the Eight-Year Plan The National Conference on Science and Technology also approved the “National Outline for Scientific and Technological Development Planning (1978–1985) (Draft)” (hereafter referred to as the Eight-Year Plan), providing specific arrangements to set the objectives and tone for the scientific and technical tasks in the coming eight years. The fundamental guidelines of the Eight-Year Plan were to mobilize all resources to achieve the goal of catching up and surpassing; the target set by the guidelines included the following four aspects: 1. Important advanced science and technology domains should equal the level of those in the advanced countries during the 1970s. 2. The number of professional scientific research personnel should reach 800,000. 3. A block of modern scientific experiment bases should be developed. 4. The reconstruction of the national scientific and technological research system should be conducted. Further, according to the policy of “overall arrangements and highlighting the focus,” the Eight-Year Plan outlined eight key sectors of development (agriculture, energy, materials, computers, lasers, space technology, high energy physics, and genetic engineering); furthermore, 108 key research programs were expected to accelerate the high-speed development of science and technology and the national economy as a whole by concentrating efforts on addressing the significant issues. In order to achieve these goals, the central government proposed the following 10 steps: 1. Reform scientific research institutes and establish a scientific research system. 2. Open all avenues for talent and select talent without favoring only one format. 3. Establish a system where scientific and technical personnel would be cultivated, assessed, promoted, and rewarded. 4. Allow hundred schools of thought to contend with each other. 5. Learn from advanced foreign science and technology and promote international academic interchange. 6. Guarantee the working period of scientific research. 7. Modernize experimental measures and record keeping. 8. Promote incorporation and co-operation between divisions. 9. Accelerate the application and popularization of scientific results and new technology. 10. Attempt to popularize science. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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2.2.2 Expanding the Cultivation of Talent and Improving the Efficiency of Usage Without talent, science and technology cannot be developed. On May 24, 1977, Deng Xiaoping delivered an important speech in which he called for people to respect knowledge and competent people. He explicitly indicated that, “The key to the realization of modernization is the development of science and technology. Unless we pay special attention to education, it will be impossible to develop science and technology. Modernization can never be realized by empty talk. Knowledge and talent are always necessary” (Deng 1994, 2:40). In September of the same year, the National Institutes of Higher Learning Work Conference was held by the Ministry of Education. The “Opinions on the Enrollment Work of the Institutes of Higher Learning of 1977” was drafted during this conference and was approved by the State Council in October, allowing it to be implemented. The long abolished college entrance exams system was officially resumed. In 1978, the “Opinions on the Enrollment Work of the Tertiary Institutions and the Specialized Secondary School of 1978” was issued and on the basis of the previous years’ experience, the range of enrollment was expanded, limitations on the entrance exam applications were loosened, and a unified national examination paper was adopted. Due to a huge backlog, more than 6.1 million graduating students and educated youth nationwide took the National Matriculation Exam that year with approximately 402,000 freshmen being enrolled. The restoration of the senior matriculation system was of great significance to both the Chinese economy and the development of science and technology. During the decade of the Cultural Revolution, the so-called recommendation system was used to select suitable candidates for college enrollment in China. Worker-peasantsoldier college students were mainly enrolled in this period when there was scant regard for aptitude. This was carried out under the principle of allowing “voluntary application, recommendation by the masses, approval by the supervisors, and reviews by the colleges.” Guided by the ideology of “putting politics in command,” the entrance criterion was reduced to a minimum, resulting in the poor educational level of those worker-peasant-soldier college students enrolled by the universities and colleges. Some had not even attained primary school-level education before enrollment. Thus, the Cultural Revolution left a huge gap in the talent structure of China. After the restoration of the senior matriculation system, the selection of students was put back on track, with universities implementing a policy of admitting the best students. This increase in enrollment meant that the talent shortage was relieved to some extent. In addition to the restoration of the senior matriculation system, the State demanded that CAS, some higher-learning institutes, other production sectors with necessary

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conditions, and all the local research institutions restore the enrollment work for post-graduates and also cultivate their own talent pool equipped with independent scientific and technological research competence. A similar attempt had been made by CAS in the past. In 1955, CAS had begun enrolling post-graduates; enrollment was terminated with the advent of the Cultural Revolution in 1966. On August 8, 1977, Deng Xiaoping delivered a speech during the Symposium on Science Education. On September 5, on the basis of Deng’s speech, CAS submitted the “Report on Some Issues Concerning the University of Science and Technology of China” to the State Council, proposing to set up the Graduate School of the University of Science and Technology of China with an interim size of 1,000 people. On September 10, CAS submitted the “Report for Approval Concerning the Enrollment of the Post-graduates,” entrusting the University of Science and Technology of China with the task of structuring the graduate school in Beijing. The report gained approval at the end of the month; the State decided to restore the post-graduates system within 66 institutes affiliated with CAS and four universities. In January 1978, the Ministry of Education and CAS decided to combine the post-graduate enrollment work of 1977 and 1978, and called it the “Post-graduates of 1978.” On March 1, 1978, the Graduate School of the University of Science and Technology of China (Beijing) was formally established. The first graduate school in China had a total enrollment of 1,015 students with 130 specializing in foreign languages in order to travel overseas. Further, during this time period, the Science and Technology University of China enrolled 107 post-graduates, 25 of who were selected to study abroad. In order effectively use scientific and technical talent, two other measures were put into play. First, for those scientific and technical personnel influenced by the Cultural Revolution, either their original positions would be restored or they would be allocated to some new and appropriate positions. Data reveals that a total of 340,000 scientific and technical personnel nationwide—forced to be idle—were allowed back to their positions by 1982. Second, the State expended greater efforts to deal with situations wherein scientific and technical talents were not assigned to areas of their specialization. Under the original system, all tasks were assigned and controlled by the State; thus people were unable to choose their work according to their own preferences and specialties. In addition, during the course of the socialist transformation of the intellectuals under the extreme leftist line, they were required to learn from workers and peasants, causing most to be employed in agricultural production rather than scientific research. Data reveals that in some provinces, the number of undergraduates trained since the foundation of the PRC accounted for only 2% of the province population and that onethird of them were assigned to areas irrelevant to their specialization. In work units in the municipality of Beijing, more than 8,000 scientific and technical specialists were experiencing such a situation (Chen, Zhao, and Guan 1994, 294). 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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2.2.3 Regulation and Reconstruction of Scientific and Technological Institutions The primary action to reconstruct scientific and technological order consisted of restoring those science and technology management institutes at all levels that had been damaged and stunted by the Cultural Revolution. On September 18, 1977, the central government decided to reconstruct the State Science and Technology Commission. It was after this that all local Science and Technology Commissions such as the Chinese Institute of Science and Technology and several other special institutes were either restored or established. In 1979, the CAS Academy Divisions were formally restored, and members were added to the academic divisions. As of 1980, 106 special institutes had been restored and reconstructed. The irrational structure of the scientific and technological research institutes was the central area of concern regarding the science and technology management system— the poorly-defined character of disciplines resulted in a poor leadership system and an unclear orientation of the units’ tasks. The adjustment and reconstruction work were intended to transform the national science and technology research system into a system with complete disciplines, supporting measures, a reasonable structure, coordinated development, a combination of specialists, and better collaboration between military and civilian agencies. Aiming at disciplines without adequate coverage, CAS, all departments of the State Council, and the higher-learning institutes restored or reconstructed a number of key scientific research institutes. Meanwhile, local provinces and municipalities directly under the central government and autonomous regions also established or enriched several scientific institutions, with the CAS branches or local academies of science established successively. At the same time, either individually or jointly, the industrial and mining enterprises and the public service units established their own institutes and/or conferences. In order to overhaul the leadership system and clarify the opaque task assignments in some scientific institutions, all the scientific institutions were required to implement a system wherein the director would assume overall responsibility for these decisions; however, this was still under the leadership of the party committee. As mentioned in Chapter 1, the overemphasis on ideology according to the policy of “putting politics in command” during the Cultural Revolution implied that the management of the scientific institutions had the obvious characteristics and negative effects associated with experts being directed by non-experts. In order to change this unfavorable situation, it was critical to rectify the leadership of the scientific institutions; that is, transfer those who were pure political enthusiasts without any professional knowledge and introduce leaders who were eager about actual scientific development. At the same time, as the TOWARD AN INNOVATIVE NATION

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leaders in their professions, directors and deputy directors were endowed with greater decision-making power. In order to address the issue of scientific research being put under the squeeze and accorded lower priority in the past due to frequent political upheavals, the Chinese government specifically required all scientific institutions to ensure that the scientific and technological personnel would spend at least five-sixth of their time in professional work. Scientists were provided with assistants to guarantee top researchers more research time by lessening their administrative workload. In order to standardize the daily scientific research activities, all scientific institutions began to implement these rules and regulations. As a precursor, CAS enacted and implemented the “Interim Regulations of the Institute of Chinese Academy of Sciences (Draft),” whereby procedures and systems for research were specified in detail; these included procedures for instrument operation, registration and verification systems for the experiment data, technical archiving system implementation, an appraisal system for research achievements, and a tighter laboratory administration system.

2.2.4 Reconstructing the Academic Reward System With regard to the issue of sharing the same reward regardless of the performance, all scientific institutions expended greater efforts to develop a system for cultivating, assessing, promoting, and rewarding scientific and technical personnel. Mainstream economics now emphasizes recognition by academic peers as the most powerful medium of circulation in the scientific community. Similarly, technical titles represent the academic standards of an individual that can help foster ties between scientific and technical personnel, resulting in academic exchanges both internationally and domestically. Therefore, restoring the review system for technical titles helped motivate the scientific and technological personnel. Being a scientific institution where most scientific and technological talents gathered, CAS promoted a large number of scientific and technological elites in the two years after the Gang of Four was toppled. According to the remaining incomplete statistics, over 4,000 personnel were promoted to the level of assistant researcher and engineer, and over 400 personnel were promoted to the level of research associate. It should be noted that, in accordance with Deng Xiaoping’s guiding ideology—“To find, select, and develop excellent talent by unconventional approaches” (Deng 1994, 2:95)—some young and middle-aged scientific and technological personnel with outstanding contributions were rapidly promoted up the chain. For example, Chen Jingrun, the assistant researcher at the Academy of Mathematics, CAS, received an unprecedented promotion to the post of research fellow due to his breakthrough achievements in the Goldbach Conjecture; Yang Le and Zhang Guanghou 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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received similar promotions from the posts of research assistants to those of associate research fellows due to their extraordinary contribution to the theory of function value distribution. While the technological titles system was being restored, the State began to provide various material rewards to scientific and technological personnel who made significant contributions; however, such rewards were in accordance with the reward principle of “moral encouragement first, material rewards second.”

. Active Experimentation and Searching for the Way Forward 2.3.1 Adjustment, Reform, Rectification, and Improvement With the implementation of the core propositions of the National Science and Technology Conference and the goals of the Eight-Year Plan, China’s science and technology management system was quickly restored from the ruins of the Cultural Revolution. However, since eliminating the extreme leftist ideology and righting the wrongs of the bygone era were the most pressing issues at that moment, China’s decision-makers were not ready to recognize the inherent disadvantages of the original plans. Therefore, although the restoration of scientific and technological order during this stage involved some innovation, on the whole, the restoration attempt was based on the foundation of the centralized science and technology management system that had its roots in the 17 years after the foundation of the PRC. Simple comparisons show that the Eight-Year Plan had, to a great extent, simply responded to and repeated the policy target and the implementation measures of the Twelve-Year Plan of 1956. During the course of the Great Leap Forward and the Cultural Revolution, the pace at which science and technology around the world developed had changed dramatically. In 1978, when China looked beyond its borders, there was a dismal realization that the economic, scientific, and technological development in the developed world was several decades ahead of that in China. Facing this unpalatable situation, China could be neither conservative and complacent nor ignorant and boastful; in order to change the practices of pure self-reliance, advanced technology needed to be introduced and integrated into the existing system. Such opinions were undoubtedly the right way forward; however, they had extremely modest real effects when implemented because they were merely a quick fix. Since the foundation of the PRC, the proportion of the heavy industry in the Chinese economy has been abnormally high due to the long-term development strategy of focusing more on the heavy industry than the light industry. This was supposed TOWARD AN INNOVATIVE NATION

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to be revised in time. However, as the above infrastructure investment was mainly in the heavy industry such as the steel, petroleum, and chemicals, the imbalance in the industrial structure was further intensified. In 1978, China’s accumulated funds increased by 30.6% year on year and consumption increased by 8.4%; however, the capital accumulation ratio increased to 36.5%—comparable to that witnessed in 1958 during the Great Leap Forward. In the same year, China’s infrastructure investment amounted to approximately RMB 48 billion, 31.5% more than that of the previous year, accounting for about 41% of the state revenue that year. In order to expedite the introduction of new technology, China signed technology-introduction contracts for 22 large-scale projects in 1978 with a total contract value of US$7.8 billion that included a contract for BaoSteel Group. The cost of these projects greatly exceeded China’s capacity to pay (in terms of foreign exchange). Consequently, the nation witnessed a huge balance of payments deficit. This impractical attitude was concurrently witnessed in scientific and technical research. The Eight-Year Plan was drawn in the belief that as long as the approach of “overall arrangements and highlighting the focus” was to be implemented and the policy route of “concentrating efforts on addressing the significant issues” was undertaken, the planned targets could be achieved during 1978 and 1985. This would then ensure that scientific and technical domains that were most critical to China’s future growth and development would attain a level closer to that of the rest of the developed countries in the 1970s. This gap could be narrowed down to a decade, building a solid foundation for the overall catching up and surpassing in the 15 years to come. The reality of the situation was far from this. In 1982, the departments including the National Science and Technology Commission united the experts from all domains to make adjustments to such impractical targets set in the Eight-Year Plan. Eventually, the 108 major projects specified therein were pared down to 38 major projects that were more in keeping with China’s real capacity for scientific research. In order to prevent further deterioration in the poorly balanced economic structure and the balance of payments deficit, the Third Plenary Session of the Eleventh Central Committee of the Communist Party of China held in December (1978) required the removal of the erroneous trend of hoping to achieve quick results. Further, it addressed issues that included the significant imbalance in the national economy. After that, a Special Work Conference was held on April 5, 1979, by the Central Committee of the Communist Party of China to correct the impractical policies that were a deviation from the ground realities of China’s scientific development. Regarding the serious imbalance in the national economy, the consensus arrived at the conference was to implement a new policy of “adjustment, reform, rectification, and improvement” for the overall national economy in the three years from 1979 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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onward, 2 the focus being the commitment to constantly fine-tune the strategy in the realm of progress, reforms, and rectifications and improvements. In order to implement the new policy in the science and technology domain, the National Science and Technology Commission approved documents including “Opinions Regarding the Adjustment and Rectification of the Scientific Institutions” in October 1979. It also drafted the “Outline of the Report on the Scientific and Technological Development Policy in Our Country,” which was transmitted and implemented by the Central Committee of the Communist Party of China and the State Council, outlining the specific policy for the development of science and technology in the period that ensued. The key elements of the policy included the coordinated development of science and technology with economic and social development to ensure that promoting economic development remained the primary task, the enhancement of technical research, correct technology selection, the formation of a reasonable technological structure, the enhancement of technological development, and the promotion of the industrial and mining enterprises. In addition, it ensured that basic research would be developed under stable conditions and took the learning and assimilation of foreign scientific and technological achievements as a critical approach to develop Chinese science and technology. Furthermore, in order to implement this policy, the National Science and Technology Commission proposed to grasp four transformations: transferring the science and technology focus from laboratory benches to production lines, transferring science and technology for purely military use to both military and civilian applications, transferring science and technology from the coastal areas to the interior parts of the country, and enabling the diffusion of science and technology from overseas into the country. However, the foundation of the original Chinese science and technology management system had not been altered despite the wide-ranging efforts—from the establishment of the new policy of “adjustment, reform, rectification and improvement” to the “Decision on the Reforms of the Science and Technology Management System” by the Central Committee of the Communist Party of China that was enacted and implemented later. A host of economic actors—scientific institutions, regional governments, and the industry—were actively following a process of trial and error in the search for the way 2. In comparison, the Central Committee of the Communist Party of China established the policy of “adjustment, consolidation, enrichment and improvement,” formally ending the three-year practices of the Great Leap Forward that began in 1958 causing serious damage to the economy. In order to implement this policy in the domain of industry, science and technology, and education, the committee successively enacted and implemented the “Measures for the State-owned Industrial Enterprises (Draft)” (Abbreviated as the Seventy Clauses for Industry), “Fourteen Opinions Concerning the Current Tasks of the Natural Scientific Institutions (Draft)” (Abbreviated as the Fourteen Clauses for Science), and the “Interim Regulations for the Institutes of Higher Learning under the Direct Control of the Ministry of Education (Draft)” (Abbreviated as the Sixty Clauses for Higher Education).

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forward in order to improve the operational efficiency of the science and technology management system. Pilot projects were carried out in a few scientific research units in Sichuan Province and Shanghai, where efforts were made to promote the vigorous development of scientific institutions by adopting a flexible policy toward the right to self-governance and to incentivize their entering into partnerships with production units. In order to address the issue of insufficient motivation for scientific and technological personnel, in cities and provinces like Beijing, Shanghai, Shanxi, Hubei, Liaoning, Jiangxi, and Shaanxi, several scientific institutions piloted the responsibility system of scientific research projects as well as the contract responsibility system. In order to improve the efficient use of funds for scientific research, pilot measures were implemented in some cities and provinces. The disbursements for the scientific research projects that were likely to yield a profit were converted into loans, while a partial reimbursement system was also implemented. In order to change the “common big rice pot” (absolute equalitarianism whereby everyone gets the same pay and benefits irrespective of performance) mentality in the allocation of funds for scientific research, CAS pioneered the division of scientific research work funds into a two-part funds system including personnel and project funds. It also conducted classification management for scientific research activities, established the public-bidding funds system, and opened up some laboratories to the market forces.

2.3.2 The Responsibility System for Scientific Research Projects For a long time, the common big rice pot system existed in China’s science and technology management system causing inefficiency at both the macro and micro levels. First, units benefited from this system. Funds for the scientific institutions came from financial appropriation by the State and these institutions could obtain such funds regardless of the outcome; that is, regardless of whether or not their scientific and technological achievements brought economic benefits. This made them unwilling to promote science and technology, further aggravating the disconnect between the economy and science and technology. This is referred to as the two isolated layers. Second, individuals also benefited from the common big rice pot. Basically, professional titles were assessed according to an individual’s qualifications, seniority, and the year of graduation. The contribution to scientific research by individuals could not be accurately assessed and recognized; bonuses would be awarded to all staff members due to the prevalence of absolute equalitarianism, and no incentives were developed to encourage scientific breakthroughs. Akin to scientific institutions, the common big rice pot effects had severe consequences on the farming communes set up in rural China before the reforms. An individual putting in more effort was not guaranteed a proportional increase in compensation and could even get lower compensation. The peasants lacked serious enthusiasm for 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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work; they would simply wait for the work signals, flock to the fields, work as a mob, and be critical of each other’s work. This eventually resulted in insufficient grain supply for the whole country. The household contract responsibility system was intended to break the commune system. By contracting production quotas to individual households, as long as the peasants delivered the required amount of grain to the State and the community, they could keep the rest for themselves. This was a typical high incentive contract, according to which the peasants then became the risk takers in agricultural production and their enthusiasm for work was fully activated. The household contract responsibility system enjoyed great success after it was implemented; it was of great significance and aided in the promotion of pilot reforms such as the responsibility system for scientific research. The following question naturally ensues: Given that the household contract responsibility system was so successful in addressing the common big rice pot issue in communes, why was this issue in the scientific institutions not tackled with the responsibility system for scientific research? In order to address the issue that individuals in scientific institutions benefited from the common big rice pot, a reform of the responsibility system for scientific research was carried out spontaneously in some regions. In the fourth quarter of 1981, the Beijing Municipal Science and Technology Commission carried out pilot reforms on the responsibility system for scientific research in four scientific institutions directly under the municipality. The core of the reform was to adopt measures for scientific research management within scientific institutions by combining the responsibilities, rights, and benefits into a performance bonus for scientific research personnel, apart from a standard salary that they were usually paid. Although the sum of this bonus was not very large (only about half of the standard monthly salary), it still brought about some positive effects. Importantly, such practices were economically sound, representing the principle of more labor, more benefits. In February of the following year, the four pilot institutes signed scientific research contracts with departments higher up in the hierarchy (or supervising departments); thus, the responsibility system for scientific research evolved into the responsibility system in contract form. In the responsibility system for scientific research, responsibility implied responsibility for the tasks allocated to the scientific institutions by the supervising departments. These had to be accomplished in the time specified and in accordance with the specified quality and quantity. This included various measures such as workload indicators that were schedules and requirements specified in the plans provided by the supervising departments or by contracts and achievement indicators with which the quantity and quality indicators of scientific research achievement were measured against the specifications required. It also included the quantity of application and promotion of the achievements in scientific research as well as technological transfers TOWARD AN INNOVATIVE NATION

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and economic and benefits indicators. Further, it began to use business indicators, where people were rewarded for increasing revenues and cutting costs. Operation management quality and talent cultivation were also assigned indicators to permit rewards for these actions. Rights implied decision-making autonomy that scientific research units had when conducting scientific research tasks—mainly financial administration and personnel administration rights. In the case of the financial administration rights, institutes had to give 10% of their net income to the supervising departments as reward funds, while the remaining 90% was to be allocated at the institute’s discretion without the superior bureaus’ interference. Scientific institutions could use these funds to develop scientific research undertakings, maintain collective welfare, and give rewards to individuals, as well as to pilot new measures such as job allowances, variable pay, achievement rewards, and income commissions. It could also provide appropriate rewards to scientific and technical personnel who had made significant contributions. With respect to personnel administration rights, institutes were authorized to add, merge, or cancel research offices and optimize and combine the scientific research personnel according to the requirements of research offices and groups. Research personnel could also find jobs on their own by retaining their positions with their salaries suspended; meanwhile, institutes could provide moral encouragement and physical rewards to scientific research personnel with outstanding performance, allowing the improvement of the internal incentive structure of the institutes. The specific approaches of moral encouragement included granting various honorable titles to outstanding scientific research individuals, institutes, and offices. Material rewards included bonuses, variable pay, job allowance, promotion, and the update of technical titles. The funds for physical rewards could come from two sources: one was reward funds controlled by the supervising bureaus mentioned above and the other was the retained income that could be allocated freely by the institutes. However, during the course of the pilot reform, people held different views on whether or not the responsibility system ought to be implemented in scientific institutions. The antagonists suggested that scientific research activity constituted a unique production process because its products would be knowledge that could not be measured and assessed by standard methods. On the one hand, the production of knowledge may rely highly on the inspiration and creativity of the scientific research personnel, which would make it difficult to measure and assess in terms of simple input indicators such as working hours. On the other hand, since the essence of the scientific research activities is to explore unknown subjects, there would be great uncertainty involved. Scientific research personnel would have to wait for a long time before any innovative scientific

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research achievements could be made; these cannot be accomplished without years of efforts. If the scientific research personnel were evaluated simply in terms of their scientific research achievements, they would have to bear excessive risk that could impair the appeal of the scientific research work. In order to avoid the scientific research risks of quantified assessment, the personnel would choose smaller scientific research projects with obvious results within a shorter period rather than long-term research projects of greater significance but substantially greater risks. Besides, many scientific research results had large externalities; their social value could hardly be fully represented locally or within a short period of time. This would pose a great challenge to the assessment of the scientific research results. The advocates of the responsibility system believed that the science and technology research being carried out by a substantial proportion of China’s scientific institutions and research personnel was not revolutionary. They were simply applying the existing scientific and technological knowledge to the real world issues. Innovation was required in fewer areas than most people imagined. In such cases, there was essentially no difference between the common big rice pot in most scientific institutions and in communes or other enterprises. The key issue was that the scientific research personnel had no incentive to work and did not take into consideration the economic and social benefits of their scientific research achievements, if at all. Therefore, as long as the performance of the scientific research personnel could be assessed in a reasonable manner—with the implantation of the reward and punishment system related to the responsibilities and rights—the operational efficiency of the scientific institutions could be effectively improved. It is undeniable that the opinions of both the sides were reasonable; the key to the debate lay in whether the scientific research activities could be accurately quantified. It was rather difficult for those scientific research institutes conducting innovative and highly risky scientific research activities (such as fundamental theoretical analyses) to implement the responsibility system. In such institutes, laying too much emphasis on quantified assessment would not improve the motivation of the scientific research personnel. It could, however, impair the long-term scientific and technological prowess of the State. However, for those institutes that mainly conducted practical scientific and technical development, the responsibility system could help to improve the motivation of the scientific research personnel as well as accelerate project initiation, development, and transfer of the scientific and technological breakthroughs. The opinions of the two sides could be integrated in such a way that different scientific research management models could be adopted according to the distinct characteristics of the scientific research activities, which was the very path subsequently adopted by the reforms.

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2.3.3 The Onerous Contract System for Technology The responsibility system for scientific research focused mainly on the issue of individuals benefiting from their unit’s common big rice pot; however, it did not involve the issue of units benefiting from the State’s common big rice pot, which was also very common in the science and technology management system. On the one hand, the main income of the scientific research units still came from funds appropriated by National Finance. This was a safe and secure source regardless of the conditions. This resulted in scientific research units having no vested interest in the reform of the science and technology management system itself. On the other hand, even if the scientific institutions were willing to conduct the internal reform, budget constraints and a poor incentive structure ensured an inadequate redressal of the issue. In some regions, a logic similar to that of the responsibility system had been followed; the belief was that the key to address the dilemma of the units benefiting from the State’s common big rice pot lay in two aspects: First, the autonomy rights of the scientific research units would have to be expanded and the administrative attachments between the units and the supervising departments would need to be attenuated; second, it would be necessary to push the units toward the market, making them independent operational entities and less financially reliant on their supervising departments by diversifying their income sources. In 1984, some technical development institutions in Beijing initiated the pilot reform that combined the funds appropriation system and the onerous contract system, in order to further improve the operational efficiency of the science and technology management system. The onerous contract system meant that the rights and responsibilities of the two parties providing the technological products in the technological transaction process should be specified in the contracts; government and/or other enterprises should not obtain any scientific or technical breakthroughs until they have paid for them in accordance with the relevant contracts; while the scientific research units should also provide the government and/or other enterprises with technological products according to the contract within the time specified in the contract. Meanwhile, the State would also change the undertaking’s expenditure appropriation, which used to be freely allocated to the scientific research units, into projects supporting funds, and the previous administrative management would be transformed to contract management. The onerous contract system implemented in Beijing mainly included the following aspects. First, the scientific institutions should sign contracts before carrying out the key scientific research tasks assigned by the State or the supervising departments, as well as the research tasks commissioned by the departments and units at the same level. These scientific institutions should specify in the contract the content of technical research the economic indicators of the technology, the delivery schedule and the 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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ownership of the results, the allocation of the research funds and the proceeds, as well as the responsibilities and obligations to be undertaken by each party. Second, the science and technology management departments at all levels should maintain the following: funds for the scientific and technological development, sources largely arising from scientific research undertaking expenditure that used to be allocated freely to the scientific institutions, the three types of expenditures for science and technology management (fees for the trial production of new products, interim experiment fees, and the subsidy fee for the key scientific and technological projects), and other funds. Should the scientific institutions carry out technical development for the State or the supervising departments, the funds specified in the contracts should be appropriated from the funds for scientific and technical development; otherwise, the funds should be provided by the units or enterprises that have assigned the scientific research tasks. The contracted funds for scientific research included salaries, overhead costs, and welfare funds for the project team, as well as the utility bills including water, electricity, gas, and transportation. Third, the decision-making autonomy of the scientific research units was further expanded. The director responsibility system was implemented for the internal organization structure. The director had to report to the supervising department on behalf of the institutes and was authorized to determine the structure of the institute and the decisions of appointments and dismissals of the personnel (including the deputy director and the assistant chief engineer), as well as all the critical work carried out in the institute including the business, finance, human resources, interim experiments, production, and operation. The scientific units did not have to transfer their net income to the supervising departments; instead, such income could be disbursed into the three types of funds maintained by the units, namely the scientific and technological development funds, the collective welfare funds, and the reward funds. The implementation of the onerous contract system streamlined the operations of the scientific institutions. With the changes to the disbursement models, the amount of undertaking expenditures allocated freely by the states was subsequently reduced. This forced the scientific institutions to attempt acquiring more contract funds from enterprises for their normal operating expenses and even survival. This brought about several benefits. First, in order to acquire contract funds from the enterprises, scientific institutions needed to pay careful attention to the real needs of the enterprises for technological development. This facilitated the horizontal linkage between science and technology and the economy. This was important as under the former science and technology system, science and technology and the economy operated as two isolated layers. Second, with the diversification of the income sources of the scientific institutions, they could rely less on national financing, and the State could invest these surplus funds into TOWARD AN INNOVATIVE NATION

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other areas. Third, since all scientific institutions were striving for “horizontal” funds, their operation efficiency naturally improved as well. As the decision-making autonomy of the scientific institutions was enhanced, they could provide a wider range of rewards for scientific research personnel who made greater contributions. This went on to improve the enthusiasm of the scientific research personnel with regard to their work. In 1984, the National Science and Technology Commission and the State Commission for Restructuring the Economy jointly enacted the “Opinions Concerning the Reform Pilot of Transforming the Undertaking Funds Expenditures to the Onerous Contract System for Development and Research Units” to accelerate the overall implementation of the onerous contract system.

2.3.4 The Delivery of the General Policy of Science and Technology Work Since the Third Plenary Session of the Eleventh Central Committee of the Communist Party of China, the Chinese government had established the policy of “focusing on the central task of economic construction.” China’s Reform process was akin to “crossing the river stone by stone,” and it was a process of continuous trial, error, and rectification. With regard to the real issues, the typical approach was that of individuals or local governments initiating the pilot reforms in a spontaneous or semi-spontaneous manner leading to good or bad performance and ultimately successes or failures. After that, the Chinese government would acknowledge the successful experiences and practices and could implement them nationwide. The reforms of the science and technology management system in China followed the same approach. With the experience gained in the pilot reforms of the science and technology management system, people gradually realized that the main area where there was opportunity for reform in the science and technology management system was the expansion of the autonomous rights of the scientific institutions. This could be achieved by introducing the market mechanism to accelerate the horizontal linkages between science and technology and the economy. In October 1982, the central government delivered the general policy regarding scientific and technical work: “The economic construction should rely on science and technology, while the scientific and technological work should be oriented toward economic construction.” The central government also believed that the main purpose of the reform of the science and technology management system was to address the serious disconnect between science and technology and economic construction under the previous system. The delivery of this general policy of the scientific and technological work marked the beginning of the orientation of China’s reform of the science and technology management system to that of “facing the main battlefield on economic construction.” This indicated fundamental changes to the guiding ideology and the strategic policy 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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of scientific and technological work. Prior to this, the Chinese government paid great attention to scientific and technical research and emphasized that the disciplines of science and technology should be integrated with production practices that served economic construction. Measures such as “task-driven disciplines” and “revolution of design” were also adopted to facilitate the integration of science and technology and the production practices. However, in general, the guiding ideology focused more on the “technology-driven” aspect of economic development, while the “demand-oriented” aspect of technological development was ignored. This resulted in technological development losing its orientation and resulted in a phenomenon of the “two isolated layers” of science and technology and the economy. The essence of the general policy during the period was to integrate the “demand oriented” and the “technology driven” in order to guide technological development by concentrating it on economic construction and to use technological progress as the driving force for economic development.

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Facing the Main Battlefield of Economic Construction Following the Third Plenary Session of the Eleventh Central Committee of the Communist Party of China, the Chinese economy adopted the market-oriented reform and opening-up policy. In rural areas where the economic reform was first carried out, the household contract responsibility system, in which remuneration was linked to output, was very successful. This buttressed the Chinese government’s confidence in decentralization and the adoption of the market mechanism. The Chinese government realized that the previous rigid system could no longer adapt to the development of social productivity with major weaknesses of the system being reflected in many arenas. There was no clear division between the responsibilities of the government and the enterprises; strong regionalism prevailed; enterprises were overtly governed by the State; commodity production, valuation, and the market mechanism were neglected; and there was pure equality in distribution that negated incentives. This resulted in a lack of the right to autonomy, which enterprises were technically supposed to enjoy. Furthermore, the enterprises benefited from the State’s “common big rice pot” and had soft budget constraints with their employees enjoying similar benefits. The outcome was a severe dampening in the motivation levels, the seizing of opportunities, and creativity of both enterprises and their employees. On October 12, 1984, the “Decisions on the Reform of the Economic System” (hereafter referred to as the Decisions) by the Central Committee of the Communist Party of China were approved during the Third Plenary Session of the Eleventh Central Committee of the Communist Party of China. The Decisions required the further implementation of the policy aimed at invigorating the domestic economy and opening up to the outside world. This transferred the focus of economic reform to urban and industrial areas since the disadvantages of the former system were mostly caused by the State’s strong oversight and interference in the affairs of the enterprises. The enhancement of dynamism in the enterprises became the central goal of economic reform in urban areas.

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The economic reforms increased the flexibility of many manufacturing enterprises that began to actively seek technology to improve their profits. However, scientific institutions that were accustomed to vertical appropriation as their major source of funds behaved in the same manner as they had prior to the reforms. All the research schemes and projects were subject to administrative orders by the bureaucracy; thus, they lacked the autonomy they were supposed to have. As such, they were unable to respond quickly to the changing market demands. It was obvious that the implementation of economic reforms required that the science and technology management system be subject to reforms in keeping with the new ground realities. As a matter of fact, when the Central Committee of the Communist Party of China was considering the reform initiatives for the economic system, it did incorporate the issue of reform of the science and technology management system into the agenda. However, considering that it was such a significant issue, it decided to organize a broad survey and draft an individual reform decision. Therefore, the Decisions did not describe in detail the issues surrounding the reform of the science and technology management system. Instead, they made one important statement: “The reform of science and technology and education plays a very important role in the development of the national economy. With the reform of the economic system, the reform of the science and technology management system as well as that of the education system has become an increasingly urgent strategic task that needs to be addressed immediately. The central government will discuss such issues and make decisions accordingly.” On March 13, 1985, the Central Committee of the Communist Party of China formally issued the “Decision on the Reform of the Science and Technology Management System by the Central Committee of the Communist Party of China” (hereafter referred to as the Decision), marking the shift in the Chinese reform of science and technology management system from the pilot and spontaneous exploring stage since 1978 to an overall implementation stage, accelerated by the Chinese government. The Decision primarily acknowledged and re-emphasized the general strategic policy proposed in 1982: “Economic construction should rely on science and technology, while the scientific and technical work should be oriented to economic construction.” It required the reform to be a complete overhaul and done in a piecemeal fashion. Its ultimate aim was to quickly and broadly apply the scientific and technological achievements to production, in order to optimize the role of the scientific and technological personnel, greatly emancipate the productivity of science and technology, and accelerate the development of science and technology and the society. The manner in which to implement the reform on the science and technology management system was explicitly stated in the Decision. Operationally, the appropriation system was to be reformed and the market for technology was to be used more extensively. Previous shortcomings, including the management of scientific and technological research solely via administrative measures 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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and excessive centralization by the State, had to be overcome. While the key projects of the State remained under the centrally planned management, economic leverage and market adjustment had to be applied to most projects, providing science and technology institutions with the capability of self-development as well as the flexibility to automatically serve economic construction. Certain aspects of the organizational structure needed to be changed. Too many research institutions were separated from the enterprises. Research, design, education, and production were disconnected. The civil-military, departmental, and regional divisions needed to be bridged. The interim steps between the technological application and the development capability needed extensive enhancement by the enterprises, and the transformation of the technological achievements into the production capability was planned to facilitate the collaboration and association among the research institutions, design institutions, higher-learning institutes and the enterprises. This would also establish reasonable and sufficient dissipation of scientific and technological forces at all levels. As for the personnel system, it was necessary to overcome the leftist influence; further, situations wherein there were too many constraints for the scientific and technological personnel and where their talents were not fully utilized had to be overcome. Intellectual work needed the respect that it deserved, in order to create a good environment where a continuous flow of talent would emerge and where they would engage themselves in fields where they would be the most productive. The issuance and implementation of the Decision was highly significant. It established the fundamental framework for the reforms to China’s science and technology management system for many years to come; other reform measures were mostly conducted with the focus on the promotion and implementation of the targets outlined within it. In this chapter, we briefly review the historical path of the reforms and its effects on China’s science and technology management system since the Decision was enacted. Therefore, we will divide the reform of China’s science and technology management system into four stages on the basis of unique events. The reform varies in terms of policy orientation and different focuses at different stages.

. Stage I (–): “Blocking One End and Opening One Side” During this stage, the central guiding ideology for scientific and technological development was to put in place the general policy—“the economic construction should rely on science and technology, while the scientific and technological work should be oriented toward economic construction”—with the specific policy measures of “Blocking one end and opening one side.” Blocking one end referred to the reform of the appropriation TOWARD AN INNOVATIVE NATION

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system, which meant firmly cutting down vertical financial appropriation to scientific and technological development institutions. This forced these institutions to seek horizontal funds, in order to achieve the purpose of serving the economy. Opening one side meant freeing the scientific institutions as well as the scientific and technological personnel.

3.1.1 The Reform of the Appropriation System The Decision made significant reforms to the appropriation system that had, until then, violated the spirit of the overall reform of the science and technology management system. Under the original system, most of the funds for scientific institutions were appropriated from the State’s finances. These were then allocated from the State to the topmost departments in the hierarchy and then down the chain of command. Scientific institutions were subject to the whims of the supervising departments in all respects; thus, they lost the autonomy that they were supposed to have. On the other hand, as long as they obeyed the orders from above, they could obtain the finances for anything regardless of the risks and responsibilities of the scientific research projects. Thus, research continued independent of its success or failure. The reform to the appropriation system was intended to change the financial dependence of the scientific institutions on the administrative departments, forcing technology and scientific research to actively engage with the economy. By applying market rules to rectify the arrangement of scientific forces, the reform enabled the expansion of scientific investment by society and accelerated the commercialization of the scientific and technological achievements. The principal content of the reform on the appropriation system consisted of two main areas. First, in terms of the total funding value, the Decision required that government appropriation for science and technology be increased gradually, at a pace faster than that of regular financial revenue growth. It also encouraged the departments, enterprises, and social groups to invest in science and technology. Second, in terms of allocating and using these funds, the Decision required earmarking the funds according to the features of the different types of scientific and technological activities. Although the total volume of investment in science and technology was critical, the core of the reform on the appropriation system was the differentiation between the different types of research activities. This meant that scientific research activities with different characteristics were treated differently by decreasing or increasing the financial appropriation, in order to improve the overall operational efficiency of the science and technology management system of China. First, for those research institutions primarily conducting technical development and applied research tasks that were expected to result in profitable and marketable 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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products in the near future, the State would implement a technology contract system. This enabled them to gain revenue and accumulate funds while creating economic benefits for the society in multiple ways, such as contracting for the planned projects of the State, undertaking commissioned research, transferring technological achievements, developing via joint ventures, developing their export capability, and providing consultancy services. The State would gradually cut down and cancel the earmarking of funds for such scientific institutions within three to five years, in order to harden the budget constraints confronted by them. Thus, this would exert stringent pressures on them to survive and achieve the horizontal integration between science and technology and the economy. Second, the State provided funds to research institutions engaged in public welfare undertakings such as medicine and health, labor protection, family planning, hazard control, and environmental science; it also provided funds to institutions that engaged in the scientific and technical services such as those related to the areas of intelligence, standards, measurement, observation, as well as some fundamental technical work. However, an overall rationing system for funds was implemented. In the case of key scientific and technical research and development projects and the planned construction projects of key laboratories and experiment bases, both central and local government financial funding was allowed for. Open tendering and contract systems, used in the civilian domain, were progressively introduced. Third, in the case of basic research and some applied research tasks, the funds system for science was gradually introduced. The primary source of funds was that allocated by the State. By establishing the National Natural Science Foundation and other such science and technology foundations in keeping with the State’s scientific and technological development plans, applications to these foundations were received from all sectors of society and peer reviews were organized to support competitive selection. Finally, in the area of high-technology (hi-tech) development that was characterized by rapid changes and high risks, some venture capital investment was established to support such work. Institutions engaging in multiple types of research work could have their fund sources addressed through multiple channels according to the merits of their situation. The investment in capital construction by various research institutions was addressed as per the channels specified for them by the State’s management system. Banks also actively carried out business with the science and technology sector. They were also supposed to supervise and manage the use of scientific and technological funds. In order to carry out the reform on appropriation, in 1986, the State Council divided the 56 departments in the civil sector and the 2,680 scientific research units under the jurisdiction of each province, autonomous region, municipality directly under the jurisdiction of the central government, and the cities specifically listed in the State’s TOWARD AN INNOVATIVE NATION

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plan into three main categories: technological development, social services, and basic research. According to the policy resulting from the Decision, the technology contract system would be implemented for the research institutions in the technological development category and the earmarked funds would be reduced progressively. In the case of the research projects in the social services and other categories, the funds system would be implemented in order to enhance the competition in the application for the funds as well as the survival of the fittest. The total amount of funds provided to the institutions was to be incrementally increased. However, the funds going to the research institutions in the technological development category were reduced. This meant that the funds gained by the scientific institutions in the social services and basic research categories were actually increased. The scientific research academies and institutions had been used to the planned system for several decades, and they lacked the experience to obtain technological development income from the market. Due to a long period of isolation, many scientific research academies and institutions were isolated from global cutting-edge science and technology and were unable to rival the surge of foreign competitors with advanced technologies. When preparing for the Decision, the Chinese government realized that cutting down the earmarked funds would inevitably result in the poor performance of some scientific research academies and the unemployment of multitudes of personnel. However, as a strategy for the quick implementation of the reform, the Decision was able to deliberately overcome this issue—these issues would be addressed once the new system was formed and upon the emergence of competition among the scientific research units and the reduction of benefits from the common big rice pot. However, we need to emphasize that the objectives of the reform of the appropriation system were to forcefully cut off the government funds allocated to scientific institutions belonging to the scientific and technological development category, harden the budget constraints faced by them, force scientific research academies and institutions to fight for survival, and capitalize on the opportunities for survival and growth. After around three years of experimentation, in 1988, the State Council enacted the “Decisions on Some Issues Concerning the Deepening of the Reform on Science and Technology Management System” and further required it to have the appropriation for scientific research undertaking funds reduced or totally cut off by 1990. While appropriation was being reduced in a forced manner, the State also enacted an array of supporting measures (the content related to the technical market is discussed separately later). The National Science and Technology Commission successively enacted 26 key supporting policies from 1986 to 1990. Meanwhile, the Chinese government also coordinated with the relevant stakeholders of the finance, tax, and banking departments, enacting many supporting policies and measures by joint issuance, in 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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order to practically promote the successful implementation of this reform. For example, in 1987, the State enacted incentive policies where the range of the reduction was linked with the bonus tax. In 1989, many policy reforms were implemented, including new calculation and levy methods for the “two funds,” exemption from income tax for interim test products, great increase in the scientific and technological loan facilities, and the implementation of a scientific and technological circulating funds policy. Thanks to the efforts made by all the parties, by 1991, all the scientific research units at the central level had achieved the target of reducing the amount of funds earmarked for scientific research. These had dropped to 80% among local provinces and cities. Further, 75%–80% of the scientific research units in the scientific and technological development category had taken into account the reductions in the appropriation coming their way. Among the 5,074 natural science research institutions under the jurisdiction of the government departments above the county level in the country, 1,186 units no longer needed this funding.

3.1.2 The Market for Technology In order to carry out the reform of the appropriation system smoothly, it was critical to establish a market for technology. Only after the development of an acceptable and welldefined system of intellectual property rights would the scientific institutions be able to obtain the necessary income for their profitability via market transactions. One of the most important reflections of the disadvantages in the original science and technology management system was that the cost of the scientific and technological development was undertaken by the government via the transfer of funds for the same and the scientific and technological development achievements were owned and utilized by the government. In such cases, given that the rewards to innovation were irrelevant to the efforts made, the lack of incentives was severe. As early as the late 1970s and the early 1980s, there was already a spontaneous emergence of a primary market for technology in some areas of China (such as Wuhan). A few local governments (such as those of Wuhan and Tianjin) also approved the establishment of some industrial entities engaging in the technology business. In February 1981, the Party’s Group of the National Science and Technology Commission approved the “The Report Outlines Regarding the Scientific and Technical Development Policy of Our Country,” where the important policy of developing science and technology, the economy, and the society in a coordinated manner and giving highest priority to accelerating economic development was established. This required the application and promotion of scientific and technological achievements by transfer of technology being compensated. In September of the same year, the Ministry of Finance and the National Science and Technology Commission jointly enacted the “Regulations Concerning the TOWARD AN INNOVATIVE NATION

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Handling of the Financial Issues of the Transfer of Technology with Compensation,” so that technology transfer payments for scientific and production technology among the regions, enterprises, and government units would have regulations to follow. This greatly facilitated the promotion of scientific and technological breakthroughs as well as advanced technologies. On July 1, 1982, the “Law of The Peoples Republic of China on Economic Contracts” was enforced, where a scientific and technological collaboration contract (that included scientific research, trial-manufacturing, results dissemination and transfer, and technological consultancy services) became one of the 10 economic contracts, so that the commercialization of technological achievements and technology market activities would have some legal basis. In January 1985, the State Council enacted the “Provisional Regulations on Technical Transfer” to develop more specific regulations on seven aspects including the technology and commodity market, the technological transfer fee, the technology transfer contract, the rights and interests of the technology transfer, the payment of the technology transfer fee, the tax revenue of the technology transfer, and the use of the technology transfer proceeds (Chen, Zhao, and Guan 1994, 311). On the basis of these initial efforts, the Decision made exploiting the market for technology the most important supporting measure to realize the reform of the appropriation system, requiring that the market for technology be constructed and perfected nationwide. Following this, the Chinese government enacted a series of related laws, administrative regulations, and ordinances that established a more solid legal and systematic foundation for the establishment and future development of the market for technology. On April 1, 1985, China’s first patent law—Patent Law of the People’s Republic of China (hereafter referred to as the Patent Law)—was enacted and executed. The First Article specified that the purpose of the Law was “to protect patent rights for inventions/creations, to encourage inventions/creations, to foster the spread and application of inventions/creations, and to promote the development of science and technology for meeting the needs of socialist modernization.” The Patent Law specified the principles regarding the application, rights and interests, protection, termination, and compulsory license for the exploitation of patents. Depending on the importance of the invention, the patent rights are divided into three types, amongst which invention patents are granted only to critical inventions for a duration of 20 years; the patents for models and designs are granted to relatively minor inventions with a duration of 10 years. As one of the most important intellectual property rights in recent years, patent rights should grant the inventors the right of exclusive production and sales for a particular product within a certain period. After all, the value that the patent rights can bring to their owners should be determined by whether or not the patented products can meet people’s needs 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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and the size of the market. Therefore, the patent system itself is an incentive system to facilitate the integration of technology and the market, and the establishment of the patent system is of great significance to the establishment of the technology market. In many cases, the technical developers themselves had no motivation to industrialize or were incapable of industrializing the outcome of their creative endeavors. It is thus quite reasonable to assume that if they were allowed to sell their “creativity” to enterprises that were able to mass produce them, there would be welfare benefits to the concerned parties and society as well. In order to encourage and regulate such activities, on June 23, 1987, the Chinese government enacted the “Law of the People’s Republic of China on Technology Contracts” that outlined the development, implementation, modification, and rescission of the technology contracts. The technology contracts were subdivided into several types including technology development contracts, patent technology transfer contracts, and the non-patent technology transfer contracts. For each type of contract, the “Law on Technology Contracts” specified the responsibilities and rights of the contracting parties and regulated the arbitration and litigation procedures for any contract disputes that may have arisen. In order to implement the “Law on Technology Contracts,” on March 21, 1988, the National Science and Technology Commission enacted the “Provisional Regulations on the Administration of the Technology Contracts,” emphasizing that technology contracts were the basic legal form of the commercialization of technological breakthroughs involving different sectors including technology, economy, industrial and commercial administration, finance, and tax revenue. This required that the technology commissions, industrial and commercial administrations, and other administration departments coordinate the administrative burden of technology contracts at all levels. For technology contracts confirmed by and registered in the technology contract registry, the related departments should provide favorable loans, taxes, and rewards according to the State’s regulations. Later, on March 15, 1989, the National Science and Technology Commission enacted the “Regulations of the People’s Republic of China for the Implementation of the Law on Technology Contracts” that was approved by the State Council. This specified more detailed explanations and described some issues that could arise during the implementation of the Articles in the “Law on Technology Contracts.” The formation of the market for technology greatly facilitated the integration of technology and the economy as well as greatly changed the mindset of the technological personnel. Under the original system, scientific research activities were considered as completed when studies were published and models were developed. The technological personnel were neither willing nor able to know whether or not the achievements could TOWARD AN INNOVATIVE NATION

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be industrialized and whether they would satisfy the real needs of the people; they also did not know how to promote these achievements. However, with the scientific institutions being freed and the market for technology and intellectual property rights system being established, the technological personnel began to review the potential market value of their research achievements. This accelerated the integration of technology and the economy.

3.1.3 Liberating Scientific Institutions Irrespective of how we view the reform of the appropriation system or the establishment of the technology market, success would depend on whether or not the scientific institutions had decision-making autonomy. This further required the State to free scientific institutions. Therefore, the Chinese government made great adjustments to the science and technology management system by separating the duty of the government and research institutions for all the departments of the State Council and decentralizing the scientific institutions. The administration of the scientific institutions by the State transformed direct control to indirect management. In accordance with the Decision, the Chinese government began to make adjustments to the organizational structure of the science and technology management system, intending to enhance horizontal collaboration among the research institutions, educational institutions, design institutions, and production units. This change was to intensify the capability of the enterprises for technology assimilation and development, encouraging CAS, the higher-learning institutes and the research institutions engaged in the technological research to establish all types of horizontal collaborations with the enterprises and design institutions according to the principles of voluntarism and mutual benefits. This resulted in several key changes. The technological development institutions could now be developed into independent economic entities. In addition, an offshoot of horizontal collaboration was that enterprises engaged in production could now merge with the scientific institutions and the scientific institutions could also expand into the domain of production and automatically evolve into technology and production enterprises. Finally, considering the importance of the scientific institutions with regard to National Defense under the original system, the Chinese government emphasized the development of civilian applications using military technology, encouraging the establishment of a new military-civil integrated system. With the completion of the defense tasks guaranteed, the transference of military technological achievements to civil applications would be accelerated with the drive brought about by economic reconstruction and civilian products developed and researched with greater effort.

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At the same time, the State also encouraged technological personnel to establish privately owned technological enterprises that would be engaged in technological development, transfer, consultancy, services, as well as technology-industry-trade integrated and technology-agriculture-trade integrated businesses, according to the principles of self-financing, voluntarism, independent operation, being responsible for their own profits and losses. In this manner, they would become a vital force in the hi-tech industry external to the system. Since these newly established privately owned technology enterprises did not have any historical burden, their management would be more flexible and their technological development activities would be more market and demand oriented.

3.1.4 Building Hi-tech Development Zones The hi-tech development zone was a comprehensive base that relied on intensive intelligence, with the purpose of developing advanced technology and exploiting new industries by facilitating the integration of scientific research, education, and production, as well as boosting the coordination and development of technology, economy, and society. Since the 1980s, with the development of global technology and the economy, many countries and regions were planning their hi-tech research and development. All of them made the establishment of hi-tech industrial development zones the cornerstone of their strategy to develop high technology and to exploit the new industries. With regard to this, the Decision pointed out that, in order to accelerate the development of emerging industries, several talent-intensive zones should be selected and unique policies should be implemented for them in order to progressively create emerging industrial development zones with different characteristics. In April 1985, the National Science and Technology Commission delivered the report on the pilot operation of the new-technology development zones, preparing to select several regions and projects in the country. This would allow them to garner experience, take exploratory measures, and carry out trials to establish the hi-tech development zones. Meanwhile, studies on soft science projects were organized in Beijing, Shanghai, Nanjing, and Wuhan, to initially discuss the experience of other countries as well as their development path, policy, and planning for the hi-tech industrial development zones in China. In July, China’s first hi-tech industrial zone—the Shenzhen Science and Technology Industrial Park—was jointly established by CAS and the Shenzhen government. In May 1988, the State Council issued the “Decision on Several Issues Concerning the Deepening of the Reform of the Science and Technology Management System.” It explicitly pointed out that in talent-intensive large cities, there should be active creation of conditions for piloting the new-technology industrial development zones with

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supporting policies developed accordingly. During the same month, the State Council also approved the establishment of China’s first State-level, hi-tech development zone— the Beijing Experimental Area for Developing New-technology Industries—with 18 policies concerning this area. This was the foundation of the development of the hi-tech industrial development zones in China. In August 1988, the implementation of a guiding program for the development of the hi-tech industries was begun; it was called the “Torch Program.” It specified the primary target of creating an appropriate encompassing environment for driving the commercialization and industrialization of the high- and new-technology breakthroughs and was given the key task of establishing the hi-tech industrial development zones. The construction and development of the hi-tech industrial development zones would then become a critical part of the State’s general plan for the development of the hi-tech industries. The core of the policies for the hi-tech industries included three aspects: preferential tax policies, preferential foreign exchange allocation policies, and decentralization measures. The construction of hi-tech industrial development zones resulted in substantial chaos with everyone seeming to want a development zone in their neighborhood. Apart from the state-level development zones that were approved by the State Council, there were development zones built by provinces, autonomous regions, and municipalities directly under the central government. Some were built by the county-level cities and even townships. Many local governments built large-scale development zones regardless of the local environment and characteristics of the desired hi-tech industries that were characterized by a highly intellectual workforce, high risks, and high investment. This violated the rules of economic and technological development, resulting in a considerable waste of labor, materials, funds, and land. To remedy the situation, the State undertook the development of restrictive and control measures through various policies. In August 1993 the State Council expressly required that development zones without the approval of the State council would not enjoy the preferential policies for State-level hi-tech industrial development zones. The main institutional arrangements for the reform of China’s science and technology management system from 1985 to 1992 are listed in Table 3.1. It should be noted that the institutional arrangements involved substantial changes, including the establishment and reorganization of institutions, the decentralization and adjustment of power structures, the construction of a legal system environment, and the reasonable flow of technological personnel. Meanwhile, these arrangements also involved the boards of government institutions, including the State Council and all the ministries and commissions, as well as the independent decisions by individual institutions and collaborative coordination decisions by multiple institutions. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 3.1 Main institutional arrangements of the reforms of China’s science and technology management system (1985–1992) Year

Institutional Arrangements

Policy-making Body

1985

Experiment in building the post-doctoral station Implementation of the system to retain professional and technical professionals Reform of the appropriation system for science and technology Implementation of the “863 Program”

National Science and Technology Commission, Ministry of Education, CAS State Council

1986 1986 1986

1986 1986 1986 1987 1987

1987

1988

1988

1988

1988

Establishment of the National Natural Science Foundation of China Expansion of the autonomous rights of the scientific institutions Facilitation of a reasonable flow of technological personnel Boosting scientific research units into large and medium-sized enterprises Examination and Approval of the “Law of the People’s Republic of China on Technology Contracts” (that came into force on November 1, 1987) Enactment of the “Provisional Procedures for the Approval and Registry of the Technology Development Enterprises” Reaffirming the opinions regarding technological personnel accepting part-time jobs Selecting and developing different types of technological personnel from peasants, workers, and other laborers

Issuance of the “Provisional Regulations of the Management of Technology Contracts” The Beijing Municipality’s decision to build an experimental area in the Haidian District for the development of the new technology industry and the issuance of the “Provisional Regulations of the Beijing Municipality on the Experimental Area for the Development of the New Technology Industry”

State Council National Science and Technology Commission, Commission of Science, Technology and Industry for National Defense State Council State Council State Council State Council Standing Committee of the National People’s Congress of the Communist Party of China

National Science and Technology Commission, State Administration for Industry and Commerce National Science and Technology Commission

National Science and Technology Commission, National Economic Commission, Ministry of Labor and Personnel, All-China Federation of Trade Unions, China Association for Science and Technology National Science and Technology Commission

Beijing Municipality

continued

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Table 3.1 (continued) Year

Institutional Arrangements

Policy-making Body

1988

The implementation of the development model of “One Academy, Two Systems” by CAS “Provisions regarding the Th ree Foundations Established by the Scientific Research Units” Enactment of “Several Provisions on the Economic Accounting System Carried Out by the Scientific Research Units ” Issuance of the “Regulations for Implementation of the Law of the People’s Republic of China on Technology Contracts” Opening of the Research Laboratories

China Academy of Sciences

1988

1988

1989

1989 1989

1989

1990 1990 1991

1991

1991

1991

National Science and Technology Commission, Ministry of Finance National Science and Technology Commission, Ministry of Finance National Science and Technology Commission

Enactment of the “(Provisional) Measures for the Administration of the Technological Development Loan Projects” Issuance of the “Detailed Rules for the Implementation of the Measures on the National Spark Program Award” Issuance of the “Provisional Measures for the Administration of the Technology Fair” Enactment of the “Copyright Law of the People’s Republic of China ” Enactment of the “Conditions and Measures for the Designation of High- and Newtechnology Enterprises in National High- and New-technology Industrial Development Zones” Enactment of “Several Policies in National High- and New-technology Industrial Development Parks” Enactment of the “Tax Policy for the National High- and New-technology Industrial Parks” Issuance of the “Provisional Rules for the Administration of the Arbitration Organs for the Technology Contracts”

CAS, National Science and Technology Commission National Science and Technology Commission, Industrial and Commercial Bank of China National Science and Technology Commission

National Science and Technology Commission Standing Committee of the National People’s Congress of the Communist Party of China National Science and Technology Commission

National Science and Technology Commission

State Administration of Taxation

National Science and Technology Commission

Source: National Science and Technology Commission. White Paper on Science and Technology, no.1 (1986), no.2 (1987), no.3 (1988), no. 4 (1989), no. 6 (1995). Scientific and Technological Literature Publishing House.

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. Stage II (–): “To Steady One End, to Free the Majority” In the early 1990s, the political milieu, both at home and abroad, changed dramatically. leftist ideology returned with a vengeance in China. The Chinese reforms and its policy of opening up to the world were at a crucial juncture. From January 18 to February 21, 1992, Deng Xiaoping made his tour of southern China and pointed out that both “planning” and the “market” were measures for economic regulation and that the market was neither the defining characteristic nor the sole province of capitalist economics. In October of the same year, the Fourteenth National Congress of the Communist Party of China expressly advanced that China should build “socialist market economics with Chinese characteristics,” bearing testament to the fact that the reform of the Chinese economy had moved into a new phase. This also eliminated ideological hedging. This clarified several issues such as the confusion among many on whether the science and technology management system was the province of socialism or capitalism. During this stage, the guiding ideology for the reform of the science and technology management system had been adjusted, expanded and expressed in three ideas: facing, relying on, and climbing the peaks. These three terms spoke volumes about the state of technological development in China. They implied that while the development of technology faced the challenges of economic reconstruction, the State also focused on the development of the technology sector as well as on the strengthening of the basic research; thus, the State could be relied upon to surmount the peaks. Such policy changes were due to the insufficient recognition given to basic research when the previous reforms on science and technology management system were carried out. This had impaired the long-term technological development capability of China. In terms of specific policies, the policy orientation of this stage was “To Steady One End, To Free the Majority,” requiring the policy to boost the development of the integration of the technology and economy by diversifying talents and adjusting organizational structures. The policy of steadying one end embodied two levels of meaning. The first was to consolidate basic research and conduct hi-tech research, including measures to support the key research and development efforts concerning economic construction, social development, and the long-term development of national defense undertakings whereby China could gain superiority and endeavor to attain significant breakthroughs. This would enhance the nation’s overall technological prowess and technological level, and would help in developing reserve strength in order to maintain elite research teams capable of working at the cutting edge of science. The second was to classify and position research institutions, allowing the prioritization of the structure and distribution of

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the institutions engaged in basic scientific research, providing those scientific research academies and institutes ready to be steadied with organizational models of modern scientific research academies and institutes. In order to achieve the goal of steadying one end, on July 1, 1993, the National People’s Congress approved the first law on basic research for science and technology in China—the “Science and Technology Progress Law of the People’s Republic of China”—that was put into effect on October 1 1993. This law expressly required that the research and development funds of the State should account for an appropriate proportion of the GDP and that this proportion should be increased gradually. Further, it required that the growth rate of the State financial funds applied to science and technology should be higher than that of the recurring income of the State. Freeing the majority implied freeing research and development institutions that directly served economic construction and social development. It also meant that these institutes were to be market-oriented and aimed at boosting the commercialization and industrialization of their technological achievements, in order to transform their efforts into quantifiable means of economic construction and social development. The main policy measures were as follows: •

•

• • •

Encourage all types of technological organs to conduct technological, industrial, and trade integration operations or collaborate with enterprises on development, production, and operation, encouraging technological organs to conduct industrialization management. Conduct independent accounting according to the business finance regulations and become economically self-reliant and responsible for their own profits and losses in a progressive manner. Grant management rights of state-owned assets to qualified scientific research organs. Support research organizations for investing in the establishment of technology enterprises. Conduct merges or investments (including technical investments) in the enterprises and legally enjoy the investment yields.

The policy continued to support qualified scientific research organs to enter into the large and medium-sized enterprises or enterprises groups and facilitated the setting up of scientific institutions for public welfare. These were granted the status of a new type of legal entity. The operation of such institutions would mainly rely on policy-type investments by the State, public support, and the technological business revenue generated by these institutions themselves. This was based on the operational model of the non-profit institutions in other countries. The system of self-accumulation, self-operation, and self30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 3.2 Main institutional arrangements of China’s science and technology management system (1992–1997) Year

Institutional Arrangements

Policy-making Body

1992

“Provisional Measures of the Contract System of the Technology Economy for the Nationalowned Technological Development-type Scientific institutions” Enactment of the outlines for the long- and medium-term science and technology development of the State Implementation of the “Program of Scaling-up the breakthroughs of Science and technology” Enactment of the “Provisional Regulations on Several Issues Regarding the Establishment of the High- and New-technology Corporations in National High- and New-technology Industry Development Zones” Enactment of “Several Opinions on the Issues of Branching of Talent, Adjusting the Structure, and Further Deepening of the Reform of the Science and Technology Management System” Implementing the “Industry, Universities and Research Institutions Program”

National Science and Technology Commission, Ministry of Labor and Personnel, Ministry of Finance, State Administration of Taxation

1992

1992 1992

1992

1992

1992

1993

1993

1993

1993 1993

1993

Conducting a comprehensive reform pilot scheme on the urban technology and economy management system Issuance of “Regulations for Several Issues Regarding the Development of the Privately Owned Technology-type Enterprises” Approval of the “Law of The Peoples Republic of China on Scientific And Technological Progress” (Came into effect as of October 1, 1993) Approval of the “Law of The People’s Republic of China on the Popularization of Agricultural Technology” (Came into effect as of July 2, 1993) Implementation of the “211 Program” Enactment of “Several Opinions on Accelerating the Development of the Technology Consultancy Business in Our Country” Enactment of the “Provisional Measures for Granting the Rights of Import and Export of Technological Products of the Scientific Research Academies and Institutes”

State Council, National Science and Technology Commission National Science and Technology Commission National Science and Technology Commission, State Commission for Restructuring the Economic System

National Science and Technology Commission, State Commission for Restructuring the Economic System

State Economic and Trade Commission, State Education Committee, China Academy of Sciences National Science and Technology Commission, State Commission for Restructuring the Economic System National Science and Technology Commission, State Commission for Restructuring the Economic System Standing Committee of the National People’s Congress of the Communist Party of China

Standing Committee of the National People’s Congress of the Communist Party of China

State Education Committee National Science and Technology Commission

Foreign Economy and Trade Committee, National Science and Technology Commission continued

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Table 3.2 (continued) Year

Institutional Arrangements

Policy-making Body

1993

Establishment of the Productivity-promoting Center Enactment of “China’s Agenda 21” and the implementation of the sustainable development strategy Enactment of the “Implementation Keypoints in Adapting the Socialist Market Economy and Deepening the Reform on the Science and Technology Management System” “Decisions on Further Enhancing the Protection of Intellectual Property Rights” Enactment of “Several Opinions on the Development of the Scientific and Technological Industry in Institutions of Higher Education” Enactment of “Several Opinions on the Further Development and Cultivation of the Technology Market” Enactment of “Several Opinions on Speeding up the Transformation of Scientific and Technological Results and The Structure Optimization of the Export Commodities” Enactment of “Several Regulations on Speeding Up the Popularization of Science and Technology” Establishment of the New and High Technology Innovation Service Center Issuance of the “Notice for Further Carrying out the Protection of Intellectual Property Rights ” “Decisions for the Deepening of the Reforms of the Science and Technology Management System During the ‘Ninth Five-year Planning’ Period” Enactment of the “Outlines of the National Plan for Poverty Relief by Science and Technology” Enactment of the “Outlines for Scientific and Technological Progress of the Township Enterprises During the Ninth Five-year Planning Period” Approval of the “Law of the People’s Republic of China on Accelerating the Transformation of Scientific and Technological Results”

National Science and Technology Commission

1994

1994

1994 1994

1994

1994

1994

1994 1995 1996

1996

1996

1996

State Council

National Science and Technology Commission, State Commission for Restructuring the Economic System State Council State Education Committee, National Science and Technology Commission, State Commission for Restructuring the Economic System National Science and Technology Commission, State Commission for Restructuring the Economic System State Economic and Trade Commission, Ministry of Finance, National Science and Technology Commission, Foreign Economy and Trade Committee Central Committee of the Communist Party of China, State Council National Science and Technology Commission General Office of the State Council State Council

National Science and Technology Commission

Ministry of Agriculture, State Planning Commission, State Economic and Trade Commission, National Science and Technology Commission, State Education Committee Standing Committee of the National People’s Congress of the Communist Party of China

continued

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59

Table 3.2 (continued) Year

Institutional Arrangements

Policy-making Body

1996

Enactment of the “Conditions and Measures for the Designation of High- and Newtechnology Enterprises outside the National High- and New-technology Industry Development Zones” Implementation of the Technological Innovation Program Enactment of the “Provisional Regulations on Several Issues Regarding the Demarcation of the Collective Science and Technology Enterprises” Enactment of the “Measures for the Administration of the Spark Program (For Trial Implementation)” Enactment of the “Measures for the Administration of the Circulating Fund” Enactment of the “Measures for the Administration of Three Types of Expenditures for Science and Technology (For Trial Implementation)” Issuance of the “Opinions on Speeding Up Technological Progress of the Township Enterprises”

National Science and Technology Commission

1996 1996

1996

1996 1996

1996

1996

1996

1997

1997

1997

Enactment of the “Provisional Regulations on the Qualification Recognition for the Agencies Engaging in the Demarcation Business of the Property Rights of the Collective Enterprises ” Enactment of the “Proposed Regulations on the Demarcation of the Property Rights of State Property in the Collective Science and Technology Enterprises and Coping with Property Rights Disputes ” Enactment of the “Keypoints in the Efforts to Invigorate Cities through Science and Education During the Ninth Five-Year Planning Period” Enactment of the “Regulations on Several Issues Concerning the Use of High- and New-technology Achievements As Investment for Shares” Issuance of the “Financial System for the Institution Units of Science and Technology”

State Economic and Trade Commission, National Science and Technology Commission National Science and Technology Commission, State Administration of State Property

National Science and Technology Commission

National Science and Technology Commission, Ministry of Finance Ministry of Finance, State Planning Commission, State Economic and Trade Commission, National Science and Technology Commission Ministry of Agriculture, State Planning Commission, State Economic and Trade Commission, State Education Committee, National Science and Technology Commission National Science and Technology Commission, State Administration of State Property

National Science and Technology Commission, State Administration of State Property

National Science and Technology Commission

National Science and Technology Commission, State Administration of Industry and Commerce

Ministry of Finance, National Science and Technology Commission continued

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6 0 FACING THE MAIN BATTLEFIELD OF ECONOMIC CONSTRUCTION

Table 3.2 (continued) Year

Institutional Arrangements

Policy-making Body

1997

Enactment of the “Provisional Regulations for the Administration of State Property during the Transition of the Existing System of the Stateowned Scientific Institutions into Enterprises” Enactment of the “Provisional Measures on the Establishment of the Sino-foreign Joint Equity Research and Development Institutions and the Sino-foreign Cooperative Research and Development Institutions” Enactment of “Several Opinions Concerning the Enhancement of the Management Knowhow regarding the Turnover of Technological Personnel” Accelerating the Granting of the Automatic Registration of Import and Export Trading Rights to the Scientific Research Academies and Institutions and to the High- and New-technology Enterprises

State Administration of State Property, National Science and Technology Commission

1997

1997

1997

National Science and Technology Commission

National Science and Technology Commission

State Economic and Trade Commission, National Science and Technology Commission

Source: National Science and Technology Commission. White Paper on Science and Technology, no.6 (1995), no.7 (1997). Scientific and Technological Literature Publishing House.

development was to be built in order to conduct social supervision and management. In the case of those organizations that provided services and performed business activities that benefitted society and that were devoid of purposefully seeking profits, income tax and value-added tax would be exempted by the State, and the proceeds thereof would be used to support more internal business development.

. Stage III (–): “Invigorating the State through Science and Education” During this stage, substantial adjustments were made to the strategy of technology development and to the reforms of the science and technology system. “Invigorating the State through Science and Education” became the cornerstone of the State’s strategy. This strategy was conceived in May 1995 when the Central Committee of the Communist Party of China and the State Council issued the “Decision to Speed up the Progress of Science and Technology.” However, this strategy was only implemented after 1998. The key thrust of the policy was the construction of the state innovation system and the acceleration of the industrialization of technological breakthroughs. The policy provisions mainly focused 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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61

on aspects such as facilitating the transition of the system in the scientific institutions and promoting the innovative capabilities of enterprises and industries.

3.3.1 Promoting Reforms in the Research Institutions With the acceleration of the reforms of the state government institutions, by the end of 1998, the State Council decided to reform the management systems of 10 scientific institutions under the management of the State Bureaus administered by the State Economic and Trade Commission. This aimed at transforming the structure of industry by putting into play forces whereby enterprises sought to grow organically in their technical prowess. The purpose of such a reform was to reduce the number of independent applied research institutions under the management of the State Bureaus, while encouraging enterprises to establish applied research institutions of their own, thus transforming them into technologically savvy enterprises. In order to smooth the reform process, in 1999, the government enacted a series of related policies, such as continuing the appropriation of regular undertaking funds so that the enterprises enjoyed the same treatment as the quasi-state-supported technology enterprises. Income tax for these enterprises was exempted for five years; the proceeds from technology transfer were exempted from business tax; and land use tax on land for the purpose of scientific research in cities and towns was repealed. After that, other quasi-technological development scientific institutions under the management of the State Council departments also successfully carried out the transformation of the industrialization mechanism. Meanwhile, they also started to employ the mechanisms used to reform public welfare scientific institutions on the non-profitable institutions.

3.3.2 Promoting the Transformation of the Scientific and Technological Breakthroughs In order to promote the transformation of the scientific and technological achievements, in May 1996, the Standing Committee of the National People’s Congress examined and approved the “Law of the People’s Republic of China on Accelerating the Transformation of the Scientific and Technological Achievements.” In March 1999, in order to fulfi ll the spirit of the “Law of the People’s Republic of China on Scientific and Technological Progress” (1993) and the “Law of the People’s Republic of China on Accelerating the Transformation of the Scientific and Technological Achievements,” seven ministries including the Ministry of Science and Technology, the Ministry of Education, the Ministry of Personnel, and the Ministry of Finance jointly enacted “Several Regulations Concerning the Acceleration of the Transformation of the Scientific and Technological Achievements.” The regulations had three purposes. The first was to encourage the development of high- and new-technology research and the TOWARD AN INNOVATIVE NATION

6 2 FACING THE MAIN BATTLEFIELD OF ECONOMIC CONSTRUCTION

transformation of breakthroughs into marketable products. The second purpose was to ensure the management autonomy of hi-tech enterprises, and the third was to create a conducive environment via nurturing conditions for the transformation of new technological breakthroughs. As compared to the past, the regulations gave greater freedom for awards bestowed upon technological personnel involved in technological transformation. When the scientific institutions and the higher-learning institutes transformed the scientific and technological breakthroughs made by individuals holding positions in the research and development institutions, awards were granted by law to the individual who was responsible for the same. This was also extended to other personnel who made significant contributions to the transformation process. When rewarding a scientific or technological breakthrough made by its employees, the unit was to use not less than 20% of the net income obtained from the transformation of the achievement as a one-time award to its employees. When the transformation was implemented at their own discretion or by cooperating with others, the scientific institutions or the higher-learning institutes were to take as rewards, for a period of three to five consecutive years after the project was successfully in the production phase, not less than 5% of the annual net income obtained from the transformation. Instead, the institute could be instead granted one-time rewards according to this proportion. When the transfer was implemented by joint stock enterprises, these enterprises could take not less than 20% of the amount of the share prices when technological breakthroughs were used as investments for shares. The shareholder would then share the yields as per the number of stocks owned. The total share in the reward for personnel that made major contributions to the technological development and transformation of the breakthrough was not to be less than 15% of the total amount of the reward.

3.3.3 Enhancing Technological Innovation, Developing Advanced Technology, and Industrialization In August 1999, the Central Committee of the Communist Party of China and the State Council enacted and implemented the “Decision on Enhancing Technological Innovation, Developing Advanced Technology and Industrialization” (hereafter abbreviated as the Decision). This policy greatly promoted the development of the hitech industry and the industrialization of technological breakthroughs in China. With regard to the reform of the science and technology management system, the policy provision of the Decision included the following aspects: facilitating enterprises to become the drivers of technological innovation, promoting quasi-applied scientific institutions, implementing the industrial system transfer for design units, substantially boosting the development of the technology-oriented enterprises, enhancing the development of the 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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63

State high- and new-technology industrial development zones to serve as the basis of high- and new-technology industrialization, supporting the development of the privately owned technological enterprises of different types, and substantially developing technology agencies and service institutions. With regard to public policy, the Decision required that favorable policies regarding taxation, finance, and talent development be implemented for hi-tech industries and those engaged in the industrialization of technological breakthroughs. It was believed that this created an industrial environment favoring the development of hi-tech industries and the transformation of the technological breakthroughs into products. The Ministry of Science and Technology, the State Planning Commission, the State Economic and Trade Commission, the Ministry of Finance, the People’s Bank of China, the State Administration of Taxation, and the China Securities Regulatory Commission issued “Several Opinions Concerning the Establishment of the Venture Investment Mechanism” in November 1999. Their goal was to realize the essence of the Decision—cultivating a capital market that would favor the development of high- and new-technology industries and establishing venture capital investment in a staggered manner along with the sound regulation of the venture capital industry with sound risk management guidelines in place. In the same year, in order to promote the development of small and medium-sized technology enterprises, the State Council approved the innovation foundation for small and medium-sized enterprises concentrating on technology. In order to accelerate the development of the software industry and the integrated circuit industry in China, in June 2006, the State Council printed and distributed “Several Policies on Encouraging the Development of Software Industry and the Integrated Circuit Industry.”

. Stage IV ( to Date): Encouraging Independent Innovation On February 9, 2006, the State Council issued the “Outline for the Long and Medium-term Science and Technology Development of the State (2006–2020)” (hereafter abbreviated as the Outline) that decided the development strategy of “Independent Innovation, Key Spanning, Development Supporting, Leading the Future.” Apart from regulations in a few key domains and prioritized subjects, the outline provided an in-depth exposition of the reforms to the science and technology management system and the construction of a national innovation system. It included the following aspects: first, supporting and encouraging enterprises to become drivers of technological innovation; second, deepening the reforms in scientific institutions TOWARD AN INNOVATIVE NATION

6 4 FACING THE MAIN BATTLEFIELD OF ECONOMIC CONSTRUCTION

and establishing systems for modern scientific research academies and institutions; third, promoting the reform of the science and technology management system; and fourth promoting the construction of the national innovation system with Chinese characteristics in a holistic way. In order to meet the targets set by the outline in totality, the State announced a series of supporting policies and measures that were meant to enhance the standing of intellectual property rights and technological standards in China. Encouraging the enterprises to engineer a path to independent innovation by moving away from importing innovations was also a crucial aspect of the outline. The supporting policies proposed 60 adjunct policies with 10 main criteria, which included technological investment, tax incentives, government acquisitions, import and innovation, creation and protection of intellectual property rights, construction of technological talent teams, education and technological popularization, the creation of technological innovation bases and platforms, and ensuring overall coordination. The policies included the following aspects: • • • • • • • • • • • • •

ensuring the stable growth and optimizing the structure of financial investment in science and technology employing preferential tax policies to encourage enterprises to expand research and development investment enhancing financial support and services for independent innovation establishing a system under which financial funds could be used to acquire independent innovation products limiting blind and repeated imports; supporting enterprises as well as industries, universities, and institutions to conduct collaborative import and innovation supporting enterprises to develop, attract, and introduce innovative talent reforming and perfecting the personnel system in scientific research institutions establishing a talent evaluation and reward system to incentivize independent innovation fully capitalizing on the role of the higher-learning institutes in independent innovation greatly developing and reforming vocational education; promoting quality education developing large undertakings aimed at popularizing science intensifying the construction of experimental bases, infrastructure, and basic research platforms putting more effort into supporting the stabilization of the public welfare scientific institutions

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• • •

65

intensifying the construction of independent innovation bases for enterprises and scientific institutions with transformed industrialized systems establishing an overall planning mechanism for the reasonable deployment of technological resources establishing a coordination mechanism for government acquisition, technology import, and innovation, as well as for the facilitation of a coordination system for military-civil integration.

The outline reflected the new political reality both home and abroad after almost 30 years of rapid growth of the Chinese economy. At this point, while the State still emphasized the necessity and importance of technology import, the State also realized that some key technologies could not be obtained through technology import; they could only be obtained through independent innovation. Besides, with the deepening of globalization and the reduction in the tariff barriers, intellectual property rights were increasingly becoming the most important barrier to the Chinese enterprises when expanding in the international market. Therefore, the outline particularly emphasized the standards for intellectual property rights. We believe that owning intellectual property rights and the standards in products and industries is the key to independent innovation. Meanwhile, only when the capability of independent development is in place will the response to constantly fluctuating market conditions be optimal. Only then can China avoid sinking into the vicious circle of lagging behind the developed world and then catching up with them in the production cycle.

TOWARD AN INNOVATIVE NATION

C

APTE

4

R

H

The Rationale behind the Reforms to China’s Science and Technology Management System If technology can be deemed as one of the factors of production, the allocation of this factor can be settled by either the market or internal plans. The former approach triggers transaction costs associated with the price system, while the latter triggers the internal management cost of enterprises. According to new institutional economics, an enterprise reaches its optimal size when the two cost types are equal.1 Given this, with respect to the transaction and management costs within specific systems and industrial environments, if the size of the enterprise exceeds the optimal size, efficiency could be improved by reducing its size. This implies allowing part of the resource allocation functions to be conducted by the market instead of planning for them. Conversely, if the size of the enterprise is less than optimal, efficiency could be improved by expanding its size, which implies allowing the allocation functions to be conducted via plans rather than the market. In the previous chapters, we presented a brief chronological summary of the reforms made to the science and technology management system in China. In this chapter, we will analyze the effects of the reform on the evolution of this system in China.

1. For the sake of simplicity, one can consider that the cost of market transactions is not concerned with enterprise size and that the management cost increases with an increase in the size of the enterprise.

6 8 THE RATIONALE BEHIND THE REFORMS

Government

Production and Sales Unit

Research Institute

Production and Sales

Research and Development

FIGURE 4.1 China’s innovation system under the planned economy

As Figure 4.1 shows, when China was under the planned system, some units were represented by the research institutes engaged in technological innovation, the industrial and mining enterprises engaged in production, and the sales units focused on sales. The government played the role of a coordinator through its plans and instructions. The solid lines in the figure indicate the instructions delivered by the superiors to those lower down in the hierarchy (the arrow indicates directionality); the dashed lines indicate information feedback to the superior. It is plausible that since the chain of transmission is very long, there could be serious information leakages and distortions in either the delivery of instructions or information feedback. This would result in decision failures and delays. Therefore, the efficiency of resource allocation by this system is doomed to be extremely low. Regarding the allocation of the technological factors, the fatal flaw of China’s science and technology management system under the planned economy was mainly reflected in the almost complete separation between technological innovation and industrial production.

. A Market-based Solution New institutional economics posits that the allocational efficiency of the original system—the instructions approach—with regard to technology was quite poor. Hence, replacing it with the market approach, in order to improve allocational efficiency, 30 YEARS OF CHINA’S REFORM STUDIES SERIES

THE RATIONALE BEHIND THE REFORMS

Enterprise

Technology

Production and Sales

69

Research Institute

Research and Development

FIGURE 4.2 Horizontal barriers and the market-based solution

seemed only natural. Accordingly, the Chinese government initiated a market-based reform, attempting to intensify the horizontal links between the research institutes and the enterprises. The central argument for the reform was that although the creators and users of technology already existed under the prevailing system, they lacked the incentives to build mutually beneficial relationships. In particular, the technological innovators were unable to gain returns that could match their efforts because of a nonexistent pricing mechanism for innovative technology. Given these concerns, the policies stemming from the “Decision on the Reform of the Science and Technology Management System” were pioneering in that they altered the appropriation system thus attempting to promote the establishment of a market for technology and the transfer of technological breakthroughs to the public domain via these markets. Based on the analysis in the previous chapter, we know that the Chinese government had taken the following measures: First, with regard to the demand for technological products, the government allowed the enterprises to become residual owners of their business decisions thereby motivating them to introduce new technologies and improve operational efficiency. Second, to address the supply of technology, the government greatly cut down the financial appropriation allocated to institutions, thereby forcing them to look to the industry to fill the vacuum by monetizing their products and services through means such as technology transfer fees, consultancy fees, and training fees. In order to obtain these external funds, these institutes would have to focus on all kinds of technical problems that the other economic actors (such as the enterprises or consumers) had encountered (Gu 1999, 19–20). This can be seen in Table 4.1. We elaborate on the columns in the table. The state financial appropriation for science and technology was divided into the central financial appropriation and the local financial appropriation for science and technology. These were further TOWARD AN INNOVATIVE NATION

1,228.8 1,138.4 1,230.0 1,409.5 1,701.0 2,004.3 2,204.9 2,262.2 2,491.2 2,823.8 3,083.6 3,386.6 3,742.2 4,642.3 5,792.6 6,823.7 7,937.6 9,233.6 10,798.2 13,187.7 15,886.5 18,902.6 22,053.2 24,650.0 28,486.9 33,930.3 40,422.7

64.59 61.58 65.29 79.03 94.72 102.59 112.57 113.79 121.12 127.87 139.12 160.69 189.26 225.61 268.25 302.36 348.63 408.86 438.60 543.90 575.60 703.30 816.22 944.6 1,095.3 1,334.91 1,688.5

27.33 24.12 26.39 35.42 42.45 44.35 49.63 50.6 54.05 59.13 63.48 73.32 89.41 106.56 114.22 136.02 155.01 189.97 189.90 272.80 277.20 359.60 398.60 416.60 483.98 609.69 779.94

20.95 22.72 23.85 26.66 32.28 32.00 34.56 29.50 35.65 38.45 44.44 54.15 57.16 65.59 87.9 96.86 109.66 127.12 151.92 168.10 189.00 223.10 269.85 300.80 335.93 389.14 483.36

11.32 10.46 11.17 10.59 13.04 18.83 20.30 22.87 19.70 17.91 17.47 18.40 24.55 33.95 36.06 38.00 48.55 42.74 47.28 52.90 61.50 63.40 69.99 80.20 95.90 112.50 134.40

4.99 4.28 3.88 6.36 6.95 7.41 8.08 10.82 11.72 12.38 13.73 14.82 18.14 19.51 30.07 31.48 35.41 49.03 49.50 50.10 47.90 57.20 77.78 147.00 179.49 223.58 290.80

5.3 5.4 5.3 5.6 5.6 5.1 5.1 5.0 4.9 4.5 4.5 4.7 5.1 4.9 4.6 4.4 4.4 4.4 4.1 4.1 3.6 3.7 3.7 3.8 3.8 3.9 4.2

Science and Technology Appropriation as a Percentage of the Total State Financial Expenditure

Source: China Science and Technology Statistics, “China Main Science and Technology Statistic Indices Database,” http://www.sts.org.cn.

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Capital Construction Expenditure for Scientific Research Other

The state fiscal appropriation for science and technology and its structure (RMB 100 million)

State Financial Expenditure Appropriation for Science and Expenditure Total State for Scientific for Science and Technology Financial Undertakings Promotion Year Expenditure Technology

Table 4.1

— — — — — — — −3.9 −5.0 −2.7 2.8 8.1 8.9 3.5 −1.4 −0.9 8.3 15.5 8.2 25.6 3.7 19.7 15.4 12.8 8.4 17.0 22.5

Actual Growth of the State Appropriation for Science and Technology (%)

THE RATIONALE BEHIND THE REFORMS

71

subdivided into expenditures for scientific undertakings, science and technology promotion, and capital construction for scientific research. Actual growth refers to the growth rate calculated in real terms using the GDP deflator. Expenditure for undertakings refers to the expenditures for the scientific undertakings under the centralized management of the science and technology departments at all levels, as well as the funds from the Chinese Academy of Social Sciences (CASS) and high technology (hi-tech) research plans. Expenditure for science and technology promotion refers to funds for new product development, allowances for pilot experiments, and subsides for major research projects. Capital construction expenditure for scientific research refers to the portion of capital construction expenditure arranged by the State Planning Commission used for major State scientific projects; that is, the funds for the independent scientific research units and the scientific research funds for the higher-learning institutes and enterprises. Table 4.1 shows that from 1987 to 2006, the nominal value of the state financial appropriation for science and technology was increasing, accelerating after 1999. This seems to indicate that the Chinese government met its target. However, once inflation is taken into consideration, the state financial appropriation for science and technology actually declined during 1987–1989 and 1994–1995. Based on this, one can conclude that in the early stages of the reform of the appropriation system, the budget constraints for many scientific and technological development institutions were hardened. If we look at the composition of financial appropriation, the proportion of capital construction expenditure declined; the proportion of the undertaking expenditure was almost unchanged; whereas the proportion of the expenditure for science and technology promotion increased. This indicates that the focus of financial appropriation was increasingly skewed toward supporting product development, pilot experiments, and major research projects. Figure 4.3 shows the appropriation for science and technology as a percentage of the State’s financial expenditure during 1980–2006. This figure peaked at 5.6% in 1983 and 1984. However, with the issuance of the “Decision on the Reform of the Science and Technology Management System” in 1985 and the implementation of the reforms to the appropriation system, this percentage started to decline dramatically. In early 1990s, it initially increased before a continuous decline after 1993, this trend not reversing until 2000. Relatively speaking, the declining percentage of financial appropriation would harden the budget constraints of the institutes, causing them to pay more attention to market demand. If the technological progress of the institutes that used to enjoy financial support was to be regarded as a “science-push” type, then, after the financial support diminished substantially, the technological progress of every scientific academy and institute would progressively transform to a “demand-pull” type. TOWARD AN INNOVATIVE NATION

7 2 THE RATIONALE BEHIND THE REFORMS 6 5.5

Percentage

5 4.5 4

2006

2005

2004

2003

2001

2002

2000

1999

1998

1996

1997

1994

1995

1992

1993

1991

1989

1990

1988

1986

1987

1985

1984

1983

1981

1982

3

1980

3.5

Year

FIGURE 4.3 Science and technology appropriation as a percentage of the total state financial expenditure Source: National Bureau of Statistics of China, “China Yearly Science and Technology Statistics,” http://www.stats.gov.cn/.

Table 4.2 shows the total amount and composition of the national technology funds raised during 1990–2006. The amount of the funds raised in 2006 was 20 times greater than that in the 1990s, mainly due to the great increase in funds raised by enterprises. However, apart from the continuous increase in the percentage of these funds, the percentage of other components basically declined. By 2006, the percentage of enterprise funds accounted for more than half (55%) of the overall funds raised; that of the government funds declined from their peak of 37.6% (in 1990) to 22%; while the percentage of the loans also declined from the peak of 17% (in 1993) to 6%. As mentioned above, the pivotal aspect of the reforms to the appropriation system was hardening the budget constraints of the research and development institutions, forcing them to obtain horizontal funding from the market. Assuming that a technological institution needed to raise money to bankroll technological development, the budget constraint posed by government funding would be the softest (no reimbursement required) whereas that posed by financial institutions would be softer. These loans were to be reimbursed nominally; however, this was only practicable when the recipients of the loan had made profits. In this sense, the loans and government appropriation were essentially the same; therefore, some Chinese scholars described such loans as the policy burden of the banks. However, one can argue that obtaining horizontal funds 30 YEARS OF CHINA’S REFORM STUDIES SERIES

TOWARD AN INNOVATIVE NATION

301.3 427.0 557.3 675.5 788.9 962.5 1,043.2 1,181.9 1,289.8 1,460.6 2,346.7 2,589.4 2,938.0 3,459.1 4,328.3 5,250.8 6,196.7

Year

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

113.3 126.4 160.0 175.4 218.1 248.7 272.0 309.9 353.8 473.0 593.4 656.4 776.2 839.3 985.5 1,213.1 1,367.9

Government Funds 37.60 29.60 28.70 25.96 27.65 25.84 26.07 26.22 27.43 32.38 25.29 25.35 26.42 24.26 22.77 23.10 22.07

Percentage of Government Funds (%) 103.5 121.6 162.5 185.7 234.4 305.2 312.8 348.4 402.5 510.3 1,296.4 1,458.4 1,676.7 2,053.5 2,771.2 3,440.3 4,107.0

Enterprise Funds 34.35 28.48 29.15 27.49 29.71 31.71 29.99 29.47 31.21 34.94 55.24 56.32 57.07 59.37 64.02 65.52 66.28

Percentage of Enterprise Funds (%) 43.2 71.9 89.9 118.8 121.5 127.1 149.8 155.2 171.0 128.8 196.2 190.8 201.9 259.3 265.0 276.8 374.3

Loans Made by Financial Institutions 14.34 16.85 16.13 17.59 15.40 13.20 14.36 13.13 13.26 8.82 8.36 7.37 6.87 7.50 6.12 5.27 6.04

Percentage of Loans (%) 41.3 107.1 145.0 195.6 214.9 281.5 308.6 368.5 362.5 348.6 260.7 283.9 283.2 306.9 306.6 320.7 347.6

Others

13.71 25.07 26.01 28.96 27.25 29.25 29.58 31.18 28.10 23.86 11.11 10.96 9.64 8.87 7.08 6.11 5.61

Percentage of Funds from Other Sources (%)

Note: According to the statistical terminology in China, technology funds imply funds raised from all sources to carry out technology-related activities. These activities are divided into the following categories: technological research and pilot development activities, application of research and development breakthroughs, and technological service activities. The scope of the survey for technology funds raised in China include research and development institutions under the management of the government departments, large and medium-sized industry and construction enterprises (abbreviated as enterprises), as well as the higher-learning institutes, excluding the small-sized enterprises.

Source: China Science and Technology Statistics, “China’s Major Science and Technology Statistic Index Database,” http://www.sts.org.cn.

Amount of Technology Funds Raised

Table 4.2 The technology funds raised in China (RMB 100 million)

THE RATIONALE BEHIND THE REFORMS

73

74 THE RATIONALE BEHIND THE REFORMS

from the market could pose the hardest budget constraints because this would require research and development institutions to provide those who needed technology with products that they could use. Thus, we can infer that given the great decline in the availability of government funds and loans, the budget constraints for the technological development institutions were greatly hardened over the period considered. Figure 4.4 depicts the changes in the trading volume of the national technology market during 1989–2005. Prior to 1991, this amount was not more than RMB 10 billion, with neither the total volume nor the growth rate being of any significance. However, in 1993, and particularly in the late 1990s, the transaction volume of the technology market increased dramatically. In 2005, the index almost reached RMB 160 billion. Table 4.3 indicates the number of contracts transacted in the national technology market. The number of technology contracts between 1999 and 2005 increased rapidly. By 2005, the total number of contracts was thrice that in 1999. The proportion of the four types of technology contracts stayed roughly the same over the seven-year period. Technology development contracts accounted for 40% of the total number of technology contracts; technology transfer contracts, 20%; technological consultancy contracts, 6%; and technology services contracts, 30%. This implies that during the period under consideration, the transaction structure of the technology market in China remained relatively unchanged. In this seven-year period, however, there were significant changes to who were selling the technological contracts—the most notable change was that the percentage 180 160

(RMB billiion)

140 120 100 80 60 40 20 0

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Year

FIGURE 4.4 Transaction volume of the technology market in China Source: China Science and Technology Statistical Yearbook (2005, 2006).

30 YEARS OF CHINA’S REFORM STUDIES SERIES

Table 4.3 The contract transaction amount of the Chinese technology market between 1999 and 2005 1999

2000

2001

2002

2003

2004

2005

1. Classified as per the 5,234,544 6,507,519 7,827,489 8,841,713 10,846,727 13,343,630 15,513,694 Type of Contract (RMB 10,000) Technology 38.58 36.96 39.57 41.05 39.28 38.14 36.72 Development (%) Technology 17.42 24.26 26.05 22.89 22.70 22.09 23.21 Transfer (%) Technology 6.30 5.87 5.50 6.12 6.59 6.28 6.13 Consultancy (%) Technology 37.70 32.91 28.88 29.93 31.43 33.49 33.94 Service (%) 2. Classified as per the 5,234,544 6,507,519 7,827,489 8,841,713 10,846,727 13,343,630 15,513,694 Type of Seller (RMB 10,000) Scientific Research 31.31 25.56 23.21 21.16 17.64 14.27 15.34 Institutes (%) Universities and 11.90 16.98 11.04 8.22 9.84 8.74 7.90 Colleges (%) Industrial 20.86 21.92 36.49 40.56 47.82 56.52 59.24 Enterprises (%) Technology and Trade 18.97 15.91 13.83 15.69 13.50 11.24 9.22 Facilities (%) 2.20 3.14 1.66 0.84 0.71 0.61 0.58 Individuals and Individual Partnerships (%) Others (%) 14.76 16.50 13.77 13.53 10.48 8.63 7.72 3. Classified as per the 3,310,761 Type of Enterprise Buyer (RMB 10,000) State-owned 50.91 Enterprises (%) Collectively owned 14.43 Enterprises (%) Privately owned (%) 6.38 Limited Liability 19.02 Companies (%) Corporations (%) 6.24 1.01 Hong Kong-, Macaoand Taiwan-funded Enterprises (%) Foreign-funded 2.02 Enterprises (%)

4,573,520 5,736,291 6,420,039 8,007,481

10,066,279 11,707,816

38.81

31.00

29.86

26.75

21.93

25.28

8.80

5.04

3.66

3.64

4.00

2.40

3.28 28.37

3.47 35.64

4.50 37.36

4.29 41.88

2.76 50.58

3.61 46.51

7.84 1.72

11.36 3.54

12.29 1.31

14.02 0.73

12.94 0.64

11.41 1.10

11.18

9.96

11.01

8.69

7.15

9.68

Source: National Bureau of Statistics of China, “China Yearly Science and Technology Statistics (edited),” http://www.stats.gov.cn/.

76 THE RATIONALE BEHIND THE REFORMS

contribution of industrial enterprises doubled from about 21% in 1999 to 60% in 2005. Meanwhile, the relative importance of the other sources of innovation was declining with the contribution of scientific institutions declining from 31% to 15%; the percentage of technology and trade facilities declining from 19% to 9%, and the percentage of universities and colleges declining from a peak of 17% to 8%. This seems to indicate that after years of reforming the science and technology management system, enterprises now dominated China’s technology market. Table 4.3 also shows that the percentage of the value of contracts—where the enterprises were the buying party—was gradually increasing. In recent years, this percentage has largely hovered around 75%. On closer examination, one can decipher a clear trend wherein, as technology buyers, the state-owned and collectively owned enterprises have reduced their participation with their contribution falling dramatically from 51% and 14% in 1999 to 15% and 2.4% in 2005, respectively. Conversely, limited liability companies and limited liability corporations have significantly increased their participation from 19% and 6% in 1999 to 46% and 11%, in 2005, respectively. We may propose two explanations for this trend. First, with the extensive reform of property rights, some former state-owned enterprises and collectively owned enterprises became limited liability companies; second, in the case of companies with more explicit property rights, the management had stronger motivation to pursue profits leading these companies to have greater technological demands. The structure of the value of the contracts in the market for technology is considered in Table 4.4. First, we observe that the technological service contracts were the most valuable but assumed a downward trend year after year. The percentage of technological development contracts ranked second and assumed an upward trend year after year; as for technological transfer contracts and technological consultancy contracts, their percentage was basically unchanged. Second, from point of view of the sellers of the contracts, the percentage of the number of contracts with the scientific research institutes, universities, and colleges was basically unchanged, while that of industrial enterprises progressively increased—from 13% in 1999 to 35% in 2006. In comparison, the percentage of technology trade institutions declined from 36% to 17%, which was similar to the previous results indicating that the importance of industrial enterprises within the data period was increasing. Finally, from point of view of the buyers, the trends in Table 4.4 mirror those in Table 4.3: The percentage of the contracts by state-owned, collectively owned and privately owned enterprises kept declining, while that of the contracts by limited liability companies, corporations, and foreign-funded enterprises increased dramatically, particularly that of the contracts by the limited liability companies that had increased their contract share from 5% in 1999 to 50% in 2005. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 4.4 Number of contracts traded in the technology market in China between 1999 and 2005 1999

2000

2001

2002

2003

2004

2005

1. Classified as per the Type of Contract Technology Development (%) Technology Transfer (%) Technology Consultancy (%) Technology Service (%)

264,496

241,008

229,702

237,093

267,997

264,638

265,010

16.40

19.64

19.78

20.42

21.86

25.12

28.67

13.73 16.97

11.46 18.43

11.16 18.87

9.59 20.58

9.37 22.11

8.77 21.24

10.31 18.29

52.90

50.48

50.19

49.41

46.65

44.87

42.73

2. Classified as per the Type of Seller Scientific Research Institutes (%) Universities and Colleges (%) Industrial Enterprises (%) Technology and Trade Facilities (%) Individuals and Individual Partnerships (%) Others (%)

264,496

241,008

229,702

237,093

267,997

264,638

265,010

25.22

25.92

24.71

21.96

22.38

20.88

22.70

12.37

12.95

12.87

13.18

14.17

14.85

15.89

13.01 35.94

16.98 28.58

20.54 29.27

24.24 28.49

27.38 27.65

33.78 22.58

34.78 17.61

3.98

2.38

2.40

2.04

1.72

1.27

1.34

13.19

10.22

10.09

6.69

6.63

7.67

3. Classified as per the Type of Enterprise Buyer State-owned Enterprises (%) Collectively owned Enterprises (%) Privately owned Enterprises (%) Limited Liability Companies (%) Corporations (%) Hong Kong-, Macaoand Taiwan-funded Enterprises (%) Foreign-funded Enterprises (%)

150,212

155,999

164,044

175,093

196,605

196,050

193,796

46.41

42.11

34.01

30.08

22.87

21.70

20.25

24.77

15.56

14.59

9.30

8.97

7.01

6.33

14.17

11.08

5.86

7.43

9.91

6.59

7.73

9.33

22.34

32.63

39.17

43.84

49.51

50.48

4.42 0.42

6.97 0.83

11.33 0.54

12.31 0.61

12.86 0.47

13.26 0.59

12.83 0.76

0.48

1.11

1.03

1.09

1.08

1.33

1.61

9.49

Source: National Bureau of Statistics of China, “China Yearly Science and Technology Statistics (consolidated),” http://www.stats.gov.cn/.

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7 8 THE RATIONALE BEHIND THE REFORMS

We can compare the relative magnitude of the contract value of different types of the technological transactions by consolidating Tables 4.3 and 4.4. Specifically, we may divide the contract amount by the contract quantity (matrix) (the percentage of the contract amount to the total amount divided by the percentage of the contract quantity to the total number of contracts). Thus, we obtain Table 4.5 where we uncover some results and trends different from the previous ones. From the point of view of the contract types, either in terms of the total amount of the contracts or in terms of the total quantity of contracts, technological development contracts accounted for the largest percentage; however, on average, the per transaction value of contracts assumed a downward trend year after year. The per transaction value Table 4.5 Relative magnitude of the transaction amount of the contracts of China’s technology market between 1999 and 2005 1999

2000

2001

2002

2003

2004

2005

1. Classified as per the Type of Contract Technology Development Technology Transfer Technology Consultancy Technology Service

2.35 1.27 0.37 0.71

1.88 2.12 0.32 0.65

2.00 2.33 0.29 0.58

2.01 2.39 0.30 0.61

1.80 2.42 0.30 0.67

1.52 2.52 0.30 0.75

1.28 2.25 0.34 0.79

2. Classified as per the Type of Seller Scientific Research Institutes Universities and Colleges Industrial Enterprises Technology and Trade Facilities Individuals and Individual Partnerships Others

1.24 0.96 1.60 0.53 0.55 1.56

0.99 1.31 1.29 0.56 1.32 1.25

0.94 0.86 1.78 0.47 0.69 1.35

0.96 0.62 1.67 0.55 0.41 1.34

0.79 0.69 1.75 0.49 0.41 1.57

0.68 0.59 1.67 0.50 0.48 1.30

0.68 0.50 1.70 0.52 0.43 1.01

1.10 0.58 0.45 2.04 1.41 2.40

0.92 0.57 0.30 1.27 1.12 2.07

0.91 0.35 0.59 1.09 1.00 6.56

0.99 0.39 0.61 0.95 1.00 2.15

1.17 0.41 0.43 0.96 1.09 1.55

1.01 0.57 0.42 1.02 0.98 1.08

1.25 0.38 0.47 0.92 0.89 1.45

4.21

10.07

6.67

10.10

8.05

5.38

6.01

3. Classified as per the Type of Enterprise Buyer State-owned Enterprises Collectively owned Enterprises Privately owned Enterprises Limited Liability Companies Corporations Hong Kong-, Macao- and Taiwan-funded Enterprises Foreign-funded Enterprises Source: Consolidation of Tables 4.3 and 4.4.

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of technology transfer contracts increased sharply. From 1999 to 2005, the relative magnitude was basically reversed. As for the other two types, namely, technological consultancy and technological service contracts, the relative magnitude of the transaction amount was unchanged. Therefore, one can conclude that the two parties involved in the technological transactions focused more on the transfer of technological property rights over time, which may reflect the impact of environmental improvements such as the protection of intellectual property on technological transaction activities. From the point of view of the seller, the most notable feature was the relative increase of the per transaction value of the technological contracts of the industrial enterprises, while the amount of the technological contracts of other innovative subjects declined in comparison. This implies that the technological contracts provided by industrial enterprises dominated not only in terms of absolute quantity and value but also in terms of their relative amount—their contracts were of the largest as well. This seems to further indicate that the industrial enterprises have become the major force in the technology market in recent years. Further, from the point of view of the enterprise sellers, Table 4.5 sheds light on some trends that differ from the previous tables. While the percentage of the transaction quantity and the amount of technological contracts of the state-owned enterprises in the total transaction quantity and amount had been declining year after year, the relative amount of the technological contracts that they were involved in purchasing was rather large. In comparison, the sharp increase in the total amount of contracts of the limited liability companies was due to the increase in the total quantity of contracts because the relative magnitude of their contract transactions assumed a downward trend year after year. The part that warrants most attention is that while the percentage of the foreign-funded enterprises in the total quantity was not very large on the buying side of the technology transfer contracts, the relative amount involved in each transaction far exceeded that in the other types of transactions. If the magnitude was considered to reflect quality to some extent, we may draw the following conclusion from the above analysis: On average, the foreign-funded enterprises were involved in the higher end of the technology market; the state-owned enterprises and the Hong Kong-, Macao-, and Taiwan-funded enterprises were involved in the intermediate technology market; and the privately owned enterprises, collectively owned enterprises, and limited liability companies were concerned with the lower end of the technology market. After 2006, the definition of the number of contracts completed in the technology market on the basis of the types of the buying and selling parties underwent a recalibration. Due to this, a direct comparison with the amount prior to 2005 became impossible. Since the recalibration exercise provided new indices, we carry out a separate analysis for the situation in 2006. As Table 4.6 shows, the basic situation as per the contract types was similar to TOWARD AN INNOVATIVE NATION

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Table 4.6 Transactions in China’s technology market (2006) Contract Amount

Number of Contracts

Relative Amount

1. Classified as per the Type of Contract Technology Development (%) Technology Transfer (%) Technology Consultancy (%) Technology Service (%)

18,181,813 39.44 17.67 4.66 38.23

205,845 31.38 5.64 17.40 45.58

1.26 3.13 0.27 0.84

2. Classified as per the Type of Seller Legal Persons of Government Units (%) Institutional Legal persons (%) Hereinto: Scientific Research Institutes (%) Higher-learning Institutes (%) Medical Care, Health (%) Others (%) Legal Bodies of Mass Organizations (%) Enterprise Legal Persons (%) Natural Persons (%) Other Organizations (%)

18,181,813 2.22 12.38 7.75 3.57 0.04 1.02 0.39 84.04 0.27 0.70

205,845 0.34 33.41 21.41 8.94 0.23 2.82 1.52 63.22 0.16 1.36

6.53 0.37 0.36 0.40 0.17 0.36 0.26 1.33 1.69 0.51

3. Classified as per the Type of Enterprise Buyer State-owned Enterprises (%) Collectively owned Enterprises (%) Privately owned (%) Limited Liability Companies (%) Corporations (%)

15,248,273

159,470

77.38 0.75 9.03 0.48 12.36

93.28 0.51 3.52 0.76 1.93

0.83 1.47 2.57 0.63 6.40

Source: National Bureau of Statistics of China, “China Yearly Science and Technology Statistics (Consolidated),” http://www.stats. gov.cn/.

that in 2005. However, there was an exception in that the relative amount of technological transfer contracts further increased. From the viewpoint of the nature of the buying party, domestic-funded enterprises were the subjects of the contract; however, the relative amount of the technological contracts was rather small. Some concern should exist that the percentage of technological purchasing by overseas enterprises ranked second; however, the relative amount of their contract per unit far exceeded those of the other types, which also indicates that they may be paying more attention to the higher end of the technology market. The above analysis shows that the technology market has played an important role in improving the issues with horizontal disconnections between technology supply and 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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demand. As an alternative measure for the planned allocation of the technological resources, the establishment and development of the technology market added a strong link between the economy and technology as compared with the original innovation system. However, it is clear from Figure 4.4 that while the technology trade has assumed an upward trend in recent years, in the early stage of the reforms to the science and technology system, the speed of development was relatively slow. This is due to the attributes of technology trade as well as the unique environment in China. First, as compared to other products, it is more difficult to price technology trade. As an intangible asset, technology itself does not have any value; only when it integrates with the market will it generate real profits.2 Therefore, the evaluation of the product market by examining parties to the technology trade may vary dramatically. Marketization has not been completed in China; further, several markets, particularly, the factor market, were completely opened up. Consequently, technological products lacked an accurate cost benchmark. Meanwhile, since local protectionism is prevalent, there still exists severe regional segmentation in China’s internal market. This in turn leads to a lack of demand benchmark in the pricing of technological products. In addition, after several decades of a planned economy, the individuals, enterprises and/or institutes were all accustomed to operating as per government orders, and were not familiar with the market adjustment model. Therefore, they had to learn how the new system functioned. Second, a unique challenge of the technology trade is related to the so-called Arrow’s Paradox. Only when a technology receiver understands the technology content can he accurately evaluate its market value; however, when he knows the technology content, he may have no motivation to buy this technology as he can simply reconstruct it. Facing this challenge, technology owners may have to develop the technology on their own; however, the problem is that they may not have the necessary specialties or the comparative advantage in the development domain. The patent system is an important solution to Arrow’s Paradox. According to the empowerment requirement, the innovators should disclose the content of their technology in detail if they want to apply for the patent so that other people in the industry who may want to duplicate the patented products or technologies may do so according to the information disclosed. This greatly reduces the cost of searching for a “match” between trading parties because the party demanding the technology may evaluate the value of the technology in advance according to the information disclosed publicly, and can find the party that holds the technology rights by way of “self-selection.” Further, the exclusiveness of patent protection also addresses the issue of possession. Although the inventor has publicly disclosed 2. Although technological products can be sold directly, their prices should be determined by the fi nal market value.

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his technology content, he can still use legal measures to prevent others from using this technology. While theoretical analysis and experimental data from other countries indicated that the patent system could promote technology trade in a market, it was only in 1985 that China issued and implemented the first Patent Law. What was worse was that even after the issuance, the Patent Law was not actually implemented because of the slack enforcement of the Law and China’s traditional lack of understanding regarding intellectual property rights. The process of implementation and enforcement of the laws on intellectual property rights and ideas required some time. Third, the difficulty of the technology trade was related to the non-rivalry of technological knowledge. In regular trade of physical products, once the supplier transfers the ownership of the products to the buyer, the supplier no longer controls these products. Technology trade is different. Due to the non-rivalry of technological knowledge and labor, even if the technology suppliers have nominally transferred the technological property rights, they still possess the underlying technological concepts. Due to this, technology trade faces the serious issue of commitment or the so-called opportunism issue (Williamson 1975). Generally, the market value of a technology is negatively correlated with the number of producers who control the technology in the market. If the contract is not binding in a strong sense, the technology demander is uncertain as to whether the technology suppliers will resell the same technology to a third party after the transaction. Actually, even if the technology suppliers make a commitment to not sell this technology to the third party, they could still take advantage of the technological knowledge that they have retained to develop alternative technology with minor horizontal or vertical differences. While such behavior is not exactly the duplication of the original technology according to the Law, it reduces the market power and the profits gained by the technology demander. Expecting such results, the technology demander is unwilling to offer a high price for the technological product, which hampers the technology trade. In fact, the data indicates the intense effect of the above-mentioned three difficulties on the model of technology trade. If classified as per contract types, technological services contracts were affected the least by Arrow’s Paradox and the issue of commitment. Technological services have a close relation with the attributes of the enterprise—there is no issue of commitment. The buyer is unconcerned if the technology supplier sells to a third party after the transaction; meanwhile, since the technology supplier has the professional skills in services, even if the demanders know the content of the services, it would be costly for them to conduct such activities on their own. Thus, the effect of Arrow’s paradox is not severe. Table 4.4 shows that the quantity of the contracts of technological services accounted for a large percentage in the total quantity of contracts. Indeed, just as we have mentioned above, this percentage assumes a downward trend over time. While it may reflect the improvement in 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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the external legal environment, such as intellectual property protection, it may weaken the commitment issue faced by other technological contract modes.

. The Organizational Reconstruction and Restructuring As mentioned above, the attributes of technological knowledge make the coordination and allocation of technological factors by the technology market difficult. When the market faces the issues of asset specificity or opportunism, long-term contracts, integration, or internalization are typically the solutions to the problem. For instance, according to Joskow (1985), in the United States, several coal-fired power plants are located adjacent to coal mines, resulting in a strong symbiotic relationship between them. While this may be best with regard to technological efficiency, it provides possibilities for opportunism. Before the coal-fired power plant is established, it can buy raw materials from coal mines at a reasonable price; however, once the coal-fired power plant is established, its investment becomes a sunk cost. If the nearby coal mine raised the price of coal, the coal-fired power plant would have to accept it.3 In order to avoid this kind of a situation, the coal-fired power plants could specify the quantity, price, and quality of the products by signing long-term future contracts with the coal mines. They could also transform into one company by forward or backward integration, in order to address the issues of opportunism in future transactions. We can imagine that if the future is knowable and the effective execution of the contracts could be guaranteed by law, then we could always take advantage of long-term contracts to duplicate the results of integration. However, due to practical difficulties, contracts wherein every contingency is accounted for are rarely possible. Therefore, contracts are always incomplete. This is an especially serious drawback with respect to long-term contracts. Due to the incompleteness of contracts, the results of long-term contracts will differ significantly from those of integrating the two entities. Under a long-term contract scheme, when some unexpected situations not mentioned in the contracts arise, both sides of the trade will need to re-negotiate to determine whether to continue trading. Reallocating the yields, if the trade conditions are to be maintained, may cause considerable difficulties. However, under the integration scheme, the power or authority to deal with such unexpected situations is held by the owners of the property rights. In this case, the property rights are essentially the residual rights of control. In conclusion, 3. Of course, the price of coal from the coal mine close to it should not exceed the price paid for the coal by the coal-fi red power plant from another coal mine; else, it would ensure that the coal-fired power plant would be running at a loss. In such a scenario, shutting down would be considered an optimal option.

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if something unexpected were to occur in the future, long-term contracts will appeal to the market, whereas the integrated entity will rely on the owner’s authority. Both setups have their respective advantages and disadvantages. As compared to a long-term contract scheme, the integration process may itself generate additional costs (such as organizational conflicts); however, it can save on future negotiation costs. Therefore, from the point of view of efficiency, if future uncertainty is low, then a long-term contract model is appropriate; else, integration is more appropriate. Given the imperfection in China’s legal system and intellectual property rights protection—facts that are exacerbated by the great uncertainty in the technology market—the long-term contract model for such arrangements in China is neither appealing nor practical. While under the planned system, the State could not effectively allocate technological resources via instructions due to the high management cost, it did not exclude the effective coordination of technological innovation and industrial implementation via instructions within the enterprises. The process of the transformation of the technology and economy management system was actually a process of continuous recognition and learning by the Chinese government. When the Chinese government realized that the horizontal engagement issues were impossible to address or could not be addressed in a short period by a single technology market scheme, it began to appeal to the organizational reconstruction model, encouraging in-house research and development activities. Table 4.5 shows the target and operation model of organizational restructuring. First, similar to the planned system depicted in Figure 4.1, the in-house resource allocation of the enterprises that was being implemented via top-down instructions. However, the biggest difference was that the instructions were now being given by the

Management

Production and Sales Department

Research and Development Department

Production and Scales

Research and Development

FIGURE 4.5 In-house research and development

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management of the enterprises themselves and not the government. This change was critical. When enterprise operators have some residual claims over the yields of enterprises, they will be more willing to develop policies more suited to the enterprises, which include the decision to conduct research. As compared to the government, the management of an enterprise knows more about the conditions of the enterprise, and they will have more informational advantages when making decisions. This was accentuated as the chain of command had been shortened dramatically; thus horizontal communication and correlation among the departments of production, research and development, and sales became easier and faster. Second, another difference from the technology market scheme shown in Figure 4.2 was that at this point, all the production, sales, and research and development activities were performed within the same enterprise. The flow of technological factors was carried out via the instruction model, which avoided the difficulties in market pricing for technological factors as well as those in trade.

4.2.1 Merger of the Enterprises and Institutes Realizing that the production department and the research and development departments had already coexisted under the original system, one of the in-house schemes was to encourage the merger of the enterprises and the institutes as shown in Figure 4.6. It has been posited that the merger of two market subjects (either by horizontal or vertical integration) does not eliminate their individual gain. Further, due to the incompleteness of contracts, the distribution of the residual rights of control (property rights) after the merger is very important. From the point of view of social efficiency, the residual control rights should be granted to the party most affected by the merger. As a pragmatic approach, the Chinese government adopted a merger scheme under which the institutes were merged by the enterprise. Management

Enterprise

Research Institute

Production and Sales Department

Research and Development Department

Production and Sales

Research and Development

Production and Sales

Research and Development

FIGURE 4.6 The merger of the enterprises and institutes

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After the enactment and implementation of the “Decision on the Reform on the Science and Technology Management System,” in order to further free the scientific institutions, promote horizontal research collaborations, and produce in multiple layers and variety, the State Council issued the “Regulations for Several Issues Concerning the Further Promotion of Horizontal Economic Collaboration” in 1986. This contained regulations for eight areas including the purpose and principles of horizontal economic collaboration, the maintenance of autonomous rights for horizontal economic collaboration of enterprises, the improvement of planned management and statistical methods, the promotion of the horizontal circulation of materials, the development of horizontal financing, the adjustment of tax collection measures, and the guarantee of legal rights and interests of organizations in economic collaborations. In January 1987, the State Council issued the “Regulations for Further Promoting the Reform on the Science and Technology Management System,” which required that all the departments under the State Council separate the roles and responsibilities of the government and the institutes. This was to streamline administration, decentralize the system, and gradually transfer the scientific institutions to enterprises, industrial groups, industry, and key cities. The administration of scientific institutions by the State was to be transformed from direct control into indirect management, providing guidance and coordination services. The Regulations further stated the following: “the majority of scientific institutions conducting technological development work, particularly those scientific institutions engaged in product development, should gradually merge with enterprises and industrial groups or collaborate closely with them; we should progressively rely on the enterprises or industrial groups to extract the research and development funds from total sales.” At the same time, the State Council also issued the “Regulations for Promoting Scientific Research Business Units to Merge with the Large and Medium-sized Industrial Enterprises,” requiring that large and medium-sized enterprises and industrial groups be equipped with effective and reliable technology-development institutions. In order to do this, they could either enrich their own research and development institutions or establish relatively stable collaborations with the existing independent academies, institutes, and the higher-learning institutes. However, due to the economic situation at that time, the State mainly encouraged the existing independent academies and institutes to integrate with the enterprises, and issued a series of flexible preferential measures. For instance, the scientific research and design units still enjoyed their original tax treatment after merging with large or medium-sized industrial enterprises. The proceeds from their technological achievements could be provisionally exempt from income tax, while the technology-development institutions of the enterprises could be exempt 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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from income tax when transferring technological breakthroughs. In order to reduce the merger costs to the system, after the scientific research and design units had merged with the large and medium-sized enterprises or industrial groups, they could incorporate appropriate personnel from the related enterprises or groups. They could also allow the enterprises or groups to make comprehensive alterations to personnel inappropriate for conducting research and development and design work, as well as make production and logistics personnel redundant. Although the State issued many preferential measures, in practice, the progress of mergers between the enterprises and institutes was slow on account of the following reasons. First, as state-owned enterprises, the large and medium-sized enterprises usually had considerable monopoly power; consequently, the emphasis on technological progress was not very strong. According to Arrow (1962), enterprises face the so-called replacement effect during a technological upgrade; enterprises with greater monopoly power gain from the original technology and are less motivated to adopt new technologies. On the other hand, if the product market in which the enterprise operates is highly competitive, its original profits are lower and its motivation to adopt new technology will be higher. Second, the overall research caliber of scientific research academies and institutes was not good enough. The enterprises hoped to employ scientists and engineers with substantial expertise in the realm of scientific research. Unfortunately for them, they had to take on staff that lacked the requisite skills. This added to substantial pressures in compensating an augmented workforce. Assigning the new personnel to the appropriate job was also a problem. Balancing the cost benefit analysis of the situation would have revealed that signing technology contracts with scientific research academies and institutes would have been an easier and cheaper move for the enterprises. Given this, when China started opening up to the outside world, many enterprises preferred to import the technology that they needed to be competitive. Since this mechanism of voluntary collaboration was relatively unsuccessful, in recent years, the Chinese government has started promoting the desired transformation of the scientific institutions by force under the management of different ministries. Three schemes have been adopted to transform the scientific research academies and institutes: First, they can be merged with the state-owned large and mediumsized enterprises and become business units within big companies. Second, they can be transformed into technology enterprises and incorporated into the state-owned large and medium-sized enterprises, akin to subsidiary companies; and third, they can be transformed into technology enterprises by being incorporated into the Chinese Academy of Sciences (CAS), universities, ministries, and commissions. The percentage undergoing the first type of transformation scheme is the highest thus far. Regionally, TOWARD AN INNOVATIVE NATION

8 8 THE RATIONALE BEHIND THE REFORMS

the transformation followed the proximity principle. However, from the ownership aspect, the entire system transformation was essentially restructuring and incorporation among the internal institutions of the original ministries and commissions.

4.2.2 In-house Research and Development Departments Newly Established by the Enterprises In many cases, it would have been better for the enterprises to establish internal research institutions instead of merging with the existing ones. As outlined above, if an enterprise wanted to obtain assets or technological personnel that would augment its research, it could merge with the scientific research academies and institutes. However, doing so would mean that the enterprise will have to incorporate a large quantity of redundant personnel thus taking on huge unnecessary costs. In comparison, establishing an inhouse research department is much easier as it comes about by simply employing new employees from the labor market. Initially, the new recruits might lack sufficient experience and professional skills. However, with the passage of time, the labor market would deepen allowing the enterprises to retain the technological personnel they need and avoid incorporating redundant personnel by “poaching talent from other companies.” Another advantage of establishing new in-house research and development institutions is that it helps the centralization of the residual rights of control. According to the “Regulations for Promoting the Scientific Research Business Units to Enter into the Large and Medium-sized Industrial Enterprises,” even after independent scientific research and design units have merged with large and medium-sized enterprises or industrial groups, their relative independence is possible. They may enjoy autonomous rights and continue to conduct independent economic accounting. Further, they can continue to carry out scientific research and design tasks commissioned by the State and its departments as well as industrial technology management tasks. Under the premise of completing State mandatory plans and technological development tasks assigned by the enterprise, they may take on scientific research, design, and consultancy tasks external to the enterprise that they have merged with, with the distribution of this part of income between the enterprises and the scientific research and design units being negotiable. Although the intention of this policy was to reduce the cost of enterprises merging with the institutes, it actually impaired the residual rights of the control of enterprises. In response, in order to centralize the residual rights of control, many enterprises would rather establish research and development institutions within the enterprises. Figure 4.7 shows the structure of the enterprises that established their in-house research and development departments. Under the original planned system, enterprises were engaged in production and sales activities, while institutes were engaged in research and development activities. The restructuring of in-house research and 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Enterprise

Enterprise

Research Institute

Production and Sales Department

Research and Development Department

Research Institute

Production and Sales

Research and Development

Production and Sales

Research and Development

Research and Development

FIGURE 4.7 In-house research and development departments newly established by the enterprises

development departments in enterprises kept them away from the problems associated with merging with the existing institutes. According to the explanation provided by Stiglitz (1996), the main reason for the failure of the centrally planned system was that it could not address the informational requirements in a system as complex as the modern economy. Due to information asymmetries, information leakages, and distortions, it was difficult for central planners to accurately grasp, in real time, the actual state of the economy, and they were thus unable to develop a pricing system that could properly reflect the scarcity of resources and the quality of products. Without exception, the planned system was extremely rigid and lacked innovation and the means to provide appropriate incentives. Relatively, although the market system had many disadvantages, its biggest advantage was that issues concerning information and motivation had been addressed through decentralization. In the opinion of Alchian and Demsetz (1972), production is characterized by team work, and the essence of the enterprise was to grant the residual claims to the supervisors, so that they would be motivated to collect, process, and use information thus addressing the free-rider problem during collaboration. Just as we have emphasized, right from production to the application of knowledge, every link of the innovation process is closely related and comprises a complicated feedback system. Under an effective innovation system, if there were changes to consumers’ preferences, factor supply, and technology, or if these were affected in some way, then research and development, production, and the marketing activities of the enterprises ought to be adjusted accordingly. In other words, irrespective of whether the market approach or enterprise orders were applied, the entire innovation process should be linked together effectively and organically. However, it can be expected that while the market system was not perfect, TOWARD AN INNOVATIVE NATION

9 0 THE RATIONALE BEHIND THE REFORMS

2005

2006

2004

2002

2003

0

2001

Percentage

10 2000

5,000 1999

20

1998

10,000

1997

30

1995

15,000

1996

40

1994

20,000

1993

50

1991

25,000

1992

60

1989

30,000

1990

70

1987

35,000

1988

Number of Enterprises

the internalization of innovation (including research and development) would enable rapid responses to the changes in supply and demand. Figure 4.8 provides a snapshot of the technological activities of large and mediumsized enterprises. From 1987 to 2006, the total number of large and medium-sized enterprises in China had increased from 9,681 to 32,647; however, from 1998 to 2003, this number was basically stagnant. Only after 2004 did growth begin to take off. In comparison, the absolute quantity of large and medium-sized enterprises equipped with scientific departments attained its peak in 1993 (9,510). Thereafter, there was a continuous downward trend. Only after bottoming out in 2003 did it start to increase slowly. However, by 2006, it had not regained its historical peak of 1993. Perhaps, a proportional index could indicate the trend in a better manner. From 1987 to 2006, except for an uptake in the first three years and in 1993, the percentage of the large and medium-sized enterprises in China that had established technological development departments assumed a continuous downward trend. This development trend cannot be explained by simply saying that the technological level of large and medium-sized enterprises in China fell during the period under consideration. What it actually indicates is that they may have obtained more diversified channels to acquire technology. In brief, enterprises could obtain technology through independent

0

Year Total Number of Enterprises Total Number of Enterprises with Scientific Research Institutes Percentage of Enterprises with Scientific Research Institutes (%)

FIGURE 4.8 Snapshot of the large and medium-sized enterprises in China that have established technological departments Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www. sts.org.cn.

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research and development activities or via the market. As China began to open up to the world, many large and medium-sized enterprises abandoned their own research and development activities and turned to the market, obtaining cutting-edge technologies from other countries. According to a field survey that we conducted in Shanghai, localizing advanced technologies from other countries through joint ventures had become the basic rule for many large and medium-sized enterprises to survive in the market. We can further analyze the changes in the trend on the basis of the data in Table 4.7. We find that prior to 2003, expenditure incurred in introducing technology accounted Table 4.7 Research and development expenditure spending in large and medium-sized enterprises in China

Year 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Expenditure on Technology Percentage of Expenditure on Introduction Expenditure Technological (RMB 100 on Technology Transformation (RMB 100 Million) Introduction (%) Million) — — — — 322.8 — 622.2 — 1,137.8 1,249.9 1,102.4 919.6 845.6 1,132.6 1,264.8 1,492.1 1,896.4 2,588.5 2,792.9 3,019.6

— — — — 27.95 — 25.59 — 31.72 25.77 21.45 23.36 24.54 21.67 22.60 24.96 21.38 14.22 10.63 10.61

82.53 81.10 82.17 92.80 90.23 116.06 159.23 266.70 360.89 322.06 236.48 214.85 207.55 245.42 285.90 372.50 405.41 368.00 296.80 320.43

Percentage of Expenditure Assimilated in the Expenditure on Technology Introduction (%)

Percentage of Domestic Technology Purchased in the Expenditure on Technology Introduction (%)

— — — — 4.54 — 3.89 — 3.63 4.22 5.75 6.80 8.72 7.42 6.86 6.90 6.68 14.67 23.38 25.55

3.42 4.11 3.97 4.41 4.14 — 2.96 4.95 7.06 8.01 6.18 8.46 6.66 10.77 12.70 11.52 13.40 19.02 28.10 27.29

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www. sts.org.cn.

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9 2 THE RATIONALE BEHIND THE REFORMS

for over 20% of the expenditure for the technological transformation of large and medium-sized enterprises in China. Yet, this declined sharply to less than 14% in 2004 and even further to 11% in 2005 and 2006. This gives us some idea as to the outcome we observe in the figure above. After 2003, the total number of enterprises having scientific departments started to increase gradually. Table 4.7 also shows that the sources of technology for large and medium-sized enterprises in China were mainly imports from other countries. Prior to 2003, expenditure on domestic technology acquisition accounted for less than 15% of the total expenditure on technology imports. However, after 2004, this percentage rapidly increased and remained in the range of 20%–30%, and the percentage of expenditure on the assimilation of technology shared a similar evolutionary process. One interesting phenomenon was that with the declining percentage of expenditure for technology assimilation and the acquisition of domestic technologies in the expenditure for technology imports, the proportion of expenditure for technology import in the overall expenditures for technology transformation decreased as well. This seemed to indicate that as the Chinese government focused on and encouraged independent innovation after 2004, the intensity and effect of the in-house research and development of the large and medium-sized enterprises in China increased.

4.2.3 Expansion of the Institutes into the Domain of Production and Distribution As shown in Figure 4.9, such a model implies that some institutes that used to be engaged in research and development activities now expanded into the domain of production and distribution. In practice, the expansion of technological development into the domain of production in China was usually realized by intellectual asset stripping performed by

Enterprise

Enterprise

Research Institutes

Enterprise

Production and Distribution Department

Research and Development Department

Production and Distribution

Research and Development

Production and Distribution

Production and Distribution

Research and Development

FIGURE 4.9 The stripping of institute assets

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some technological personnel in institutes or universities plunging into the commercial milieu to establish high- and new-technology enterprises. This organizational restructuring model has a typical Chinese background. Since the issuance and implementation of the “Decision on the Reform of the Science and Technology Management System,” the government greatly reduced the financial support to institutes, making institutes that were engaged in technological development face substantial pressure and hard budget constraints. This forced them to search for horizontal funds in the market. As mentioned earlier, there are many ways for horizontal collaborations to occur when we consider technology and the economy: Institutes could sell technological products and services to enterprises through the technology market or they could merge with the enterprises. However, there are inherent difficulties in both the approaches. Under the technology market scheme, technology developers would receive awards and bonuses from the institutes, which addressed incentive issues. However, in general, the mechanism of individuals benefiting from the collective’s “common big rice pot” had not been thoroughly eliminated. Technology developers often did not get a sufficient share of compensation and their enthusiasm for work was thus not fully mobilized. Although this issue had already been identified, it was impossible to fully implement a principle of distribution according to the merits of one’s contribution within the institutes. First, due to the team-oriented character of a technology development task, there was no way to find an objective and accurate index to measure the contribution that different personnel had made to a research project. Therefore, the evaluation and compensation of every project participant would rely on subjective judgments by the heads of the institutions, which would definitely arouse the suspicion of bias. Second, from the point of view of contract theory, it was necessary for an effective incentive system to not only award successful technological developers but also punish those who failed in technological development tasks. However, due to the constraints of the limited liability, meting out such punishments was usually impossible. Third, from the point of view of in-house resource allocation of the departments, if opportunities to participate in technological development projects were scarce, then simply granting awards to the participants would be regarded as lacking basic justice. An employee not included in the task could easily question the basis for the judgment of his capability since he was deprived of the opportunity to participate. If technological development activities were usually in need of complementary investment funds by the institutes, then it would be even more complicated to accurately measure the contributions of the technological developers. Finally, after several decades of the planned economy, the paradigm of “large-scale and public ownership of the people’s commune and equalitarianism” was deeply rooted in people’s minds. While implementing the system of distribution according to the merits of one’s contribution might have motivated some people, it might have TOWARD AN INNOVATIVE NATION

9 4 THE RATIONALE BEHIND THE REFORMS

induced feelings of disdain in other people, resulting in conflicts and poor cooperation among the internal personnel of organizations. Therefore, a number of technology development institutions or technological personnel chose the approach of expansion to the production domain (as shown in Figure 4.9), forming new enterprises that integrated research and development, production, and distribution. It would be possible to compete with the existing enterprises in the market. As compared to the original enterprises, the new ones had great disadvantages in terms of market positioning, distribution channels, and government resources. However, their advantages were unique. First, they did not have any historical burdens, making them flexible and quick to respond to the market. They could apply brandnew incentive schemes within the enterprise. Since it was quite difficult for the newly established enterprises to obtain financial help from the government, they would have to take decisions that entailed several risks; therefore, the survival of the fittest played a fundamental role for the new enterprises and their employees. Second, new enterprises had a more important advantage—selection bias. Technical personnel willing to break away from scientific academies to start an enterprise had a strong entrepreneurship drive. These people were not only competent at technological development but also had great intuition for the market, were sensitive to market demands, and could provide feasible technological products and services. Because of this, the new enterprises were able to leverage and garner victory against the established enterprises despite the overwhelming odds against them. In order to intensify the linkages between technology and the economy, the Chinese government encouraged and promoted the model of internal research and development departments by adopting a series of measures, in which the Torch Program played a critical catalytic role. On revisiting the past, we notice that although the development process was arduous, the internalized model achieved great success with the emergence of a number of outstanding hi-tech enterprises. The star enterprises that benefited from the Torch Program include Lenovo, Founder Group, Stone Group, Hisense, ZTE, UFIDA, Tsinghua Tongfang, Huawei, Datang Telecom Technology, Amoi Electronics, Hundsun Technologies, Neusoft Group, Haier Group, Aucma Group, and Changhong. It should be noted that in the early stage of their establishment, these star enterprises usually focused on emerging industries in which there were few state-owned enterprises; thus, they obtained a fair market environment for competition. Unlike regular transformed enterprises, the founders of these enterprises usually had a strong technical background and preferences; they valued the strategic importance of research and development activities in the development of the enterprises. For example, Huawei set its sights on becoming the world’s premier equipment supplier and invested 10% of the annual revenue to research and development activities. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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. Construction of an Industrialized Environment In the analysis mentioned above, we followed the thinking espoused by the new institutional economics and divided the modes linking technology and the economy into market trade (among the enterprises) and planned mandates (within the enterprises). In response to the different situations, the relative cost of these two types of resource allocation modes determined the boundaries of the enterprises. However, besides their relative scale, absolute levels were also very important because when transaction costs are high, some technological transactions that would otherwise be beneficial to society would not occur, and there would emerge the so-called transaction lock. In his book The Rise of the Western World: A New Economic History, North believes that the reduction of transaction costs was critical to economic development. Because of this, while invigorating the enterprises and institutes, the Chinese government also committed to the construction of an industrialized environment.

4.3.1 The Spark Program In the late 1970s, the Chinese government first promoted the reform of the economic system in rural areas. If the success of the household responsibility contract system was not enough of a surprise, then the burgeoning of the township enterprises was completely unexpected. Since the 1980s, the industrial township has developed rapidly and the agricultural economy has witnessed unprecedented activity. The specialization and commercialization of agricultural production enabled the peasants to realize the importance of science and technology. There was a need for science and an aspiration to understand science in the rural areas that engendered more enthusiasm for it than witnessed in a large number of state-owned enterprises. Subsequently, the twin policies of orienting science and technology toward building a strong economy and relying on science and technology for economic construction, coupled with the issuance and implementation of the “Decision on the Reform of the Science and Technology Management System” by the Central Committee of the Communist Party of China, unleashed market forces within the domain of science and technology. This led to a number of scientific academies and institutes, together with technological personnel, to be driven by the market forces ultimately orienting themselves toward the rural economy, promoting technological achievements, and developing the economy in the rural areas. In May 1985, the National Science and Technology Commission made a proposal to the State Council regarding the promotion of local economic rejuvenation by focusing on a number of technological projects characterized by small investment and instant returns, in order to promote the Spark TOWARD AN INNOVATIVE NATION

9 6 THE RATIONALE BEHIND THE REFORMS

Program. The implication was that the spark of science and technology achievements could be used to ignite and revitalize the rural areas in China. In early 1986, the Chinese government approved the implementation of this program, intending to introduce advanced and applicable technology into the rural areas, lead the peasants to develop the rural economy by relying on technology, lead the technological progress in township enterprises, promote the improvement of the overall competence of rural laborers, and promote the steady, fast, and sound development of agriculture and the rural economy. In terms of the operation, by issuing the State and Local Spark Program, establishing the Spark technology-intensive zones, and identifying the central industries in the Spark regions, the Spark Program dedicated itself to promoting advanced and applicable technological projects that used rural resources and required small investments but gave instant returns to the rural areas. It also helped to facilitate the technological development of the township enterprises, update industry, and scale management. The Spark Program developed different kinds of training plans to cultivate technology management talent in rural areas along with cultivating peasant entrepreneurs and developing the rural socialized services system. The implementation of the Spark Program promoted the diffusion of science and technology into rural areas and township enterprises. By the end of 1995, 66,736 Spark Program projects had been organized and implemented nationwide, covering over 85% of the counties in China; a total of 35,254 Spark Program projects were completed, accounting for 52.9% of the total projects that had been initiated, and the total input into the Spark Program was RMB 93.76 billion. In 1995, the output value of the China Spark Program reached RMB 268.27 billion, with total profits and tax amounting to RMB 47.39 billion and foreign exchange, of US$8.89 billion. As of 1996, there were 127 State-level Spark technology-intensive districts and 217 Spark regional pillar industries built nationwide. Table 4.8 provides an overview of the implementation of the Spark Program during 1997–2005. We can see that in recent years, the State-level new projects and total planned investment had not increased much while the profit and tax and the foreign exchange saved and earned assumed a downward trend. This kind of decline in performance was most likely related to intense market competition. Meanwhile, the number of training bases, training inputs, and training classes increased dramatically, which seemed to indicate that the Spark Program was increasingly focused on the training of its personnel.

4.3.2 The Torch Program In August 1988, the National Science and Technology Commission began organizing the implementation of the Torch Program after its approval by the State Council. As a guidance plan for the development of China’s high- and new-technology industries, the purpose of the Torch Program was to implement the strategy of invigorating the country 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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1,104 1,057 1,093 1,056 1,042 1,025 1,264 1,692 1,737

112.4 122.1 138.5 136.7 167.0 268.1 134.5 183.6 178.6

— 2,990 4,611 1,431 1,855 884 — 1,550 1,665

— 480.7 838.8 800.4 346.3 144.3 — 341.0 310.2

— 60.0 139.4 122.2 44.6 16.9 — 32.1 1.4

— 3,662 5,575 3,413 5,924 6,181 6,867 — 6,500

Foreign Exchange Saved Number of and Earned Profit and (100 Million US Training Tax (RMB Bases 100 Million) Dollars) — 1,440 1,3887 1,5372 2,1410 2,3135 3,8091 6,2550 8,0671

— 10,7340 13,9739 10,5781 98,472 96,957 11,3000 120,000 494,322

Training Investment Number of (RMB 100 Training Classes Million)

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts.org.cn.

1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

Total Investment of the Newly Number Initiated Stateof Newly Output level Projects Initiated Value (RMB State-level (RMB 100 100 Million) Million) Projects

Table 4.8 Overview of the Spark Program

— 1,039.3 1,118.2 941.2 908.2 861.2 1,662.7 2,399.0 1,536.7

Training Person-time (10,000 Persons/time)

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97

9 8 THE RATIONALE BEHIND THE REFORMS

through science, technology, and education, in order to implement a general policy of reform and opening up; to take advantage of the strengths and potential of China’s technological prowess; to be market-oriented and promote the commercialization of the high- and new-technological innovations, the industrialization of the high- and newtechnology commodities, and the internationalization of the high- and new-technology industries. The main content of the Torch Program included the following steps. First was the building and completion of the industrial environment appropriate for the development of both high- and new-technologies. The Chinese government enacted and implemented a series of policies and regulations supporting the development of these technology industries, which were at the core of the Torch Program. These policies and regulations aimed at establishing a management system and operation mechanism suitable for the development of hi-tech industries, helping the enterprises to exploit funding channels, establishing the venture investment mechanism, helping to exploit the information channels both at home and overseas, and building the information network. The second was building the high- and new-technology industry development zones (abbreviated as the hi-tech zones) and innovation service centers. The overall environment for industry and innovation therein was poor in China. Given this, the aims of establishing hi-tech zones in China were encouraging the development of hi-tech industries through different preferential policies, gathering the hi-tech enterprises in order to take full advantage of the effect of agglomeration, and generating a center of growth for hi-tech development before it could eventually spread throughout the economy. The high- and new-technology innovation service centers were the social public welfare technological service institutions, established on the basis of the successful experience of similar incubators in other countries. The goals of the service centers were to make use of the policies enacted by the State and the necessary conditions provided by the government at all levels to create a local optimal environment, promote the commercialization of the high- and new-technology breakthroughs, incubate the high- and new-technology enterprises, and provide comprehensive services for the high- and new-technology enterprises to start business. Table 4.9 shows the basic state of the State-level development zones. Obviously, the entire index had increased greatly during 1992–2005; however, investment in capital construction increased even more in recent years, which indicates that the construction of hi-tech districts was developing from simply extending the existing facilities to intensive development. Table 4.10 shows the basic operational situation of the State-level development zones. It can be seen that during 1989–2005, the high- and new-technology enterprises in China flourished. The number of enterprises in the development zones increased 27 times— from the original 1,690 to 45,828. Other indices, such as employees, total output value, total revenue, and total profits and tax, substantially increased. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 4.9 A snapshot of the state-level development zones

Year

Investment in Capital Construction (RMB 100 Million)

Area Developed (KM2)

Area Completed (10,000 M2)

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

— 175.74 216.20 181.10 184.87 190.80 272.66 367.30 441.97 592.05 951.20 1,549.15 1,572.50 1,960.20

93.09 151.57 132.94 148.30 206.22 223.10 272.36 335.65 408.15 432.87 549.30 651.22 705.30 —

392.86 968.24 1,882.80 2,386.21 3,456.02 4,363.32 5,400.12 7,324.25 8,269.22 11,058.44 12,512.32 15,500.40 22,323.35 28,781.50

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts. org.cn.

Table 4.10 is based on Table 4.11. It illustrates the development trend of enterprises in the high- and new-technology development zones from 1989 to 2006. First, as a measure of labor productivity, the output per capita of the enterprises in the hi-tech development zones increased yearly averaging around 15%, substantially higher than the inflation rate of the same period as well as the growth rate of GDP. Therefore, it can be observed that the average technological content of the enterprises in the hi-tech development zones has increased gradually over time. Meanwhile, the percentage of the product sales revenue in total income has also increased gradually, basically staying at a high level of around 80% in recent years. This seems to indicate that initially, the enterprises in the hi-tech development zones relied heavily on scientific research income; however, with changes in the market environment, they became more reliant on their own technological industrialization. Since enterprises in hi-tech development zones enjoyed preferential tax policies, as compared to other enterprises, they may have gained some income from arbitrage by reselling commodities. It must be noted that the data indicates that as the level of independent industrialization improved, the enterprises in the hi-tech development zones relied less on arbitrage income. Finally, the percentage of technology-related income in total income tended to form a U-shaped curve, declining dramatically in the beginning before increasing again in recent years. TOWARD AN INNOVATIVE NATION

1,690 1,652 2,597 5,569 9,687 11,748 12,937 13,722 13,681 15,935 17,498 20,796 24,293 28,338 32,857 38,565 41,990 45,828

— — — — 55 80 98 129 148 180 221 251 294 349 395 448 521 574

— — — — 447 853 1,382 2,142 3,109 4,094 5,944 7,942 10,117 12,937 17,257 22,639 28,958 35,899

30 76 87 231 564 943 1,512 2,300 3,388 4,618 6,775 9,209 11,928 15,326 20,939 27,466 34,416 43,320

8 12 17 26 53 58 71 105 133 202 256 401 491 746 1,100 1,592 2,050 2,825

11 43 45 151 346 645 1,093 1,801 2,752 3,793 5,593 7,633 9,954 12,483 17,190 22,803 29,089 36,134

8 18 24 42 137 184 262 315 412 517 745 928 1,091 1,555 1,863 2,291 1,931 2,221

Commodity Technology Sales Revenue Product Sales Sales Revenue Revenue (RMB (RMB 100 (RMB 100 Million) 100 Million) Million)

— — — — 5 13 29 43 65 79 119 186 227 329 510 824 1,116 1,361

Total Annual Export Amount (US$100 Million)

4. Technology sales revenue refers to the income from technology transfer, technology contracting, technology consultancy and services, technology appraised as capital stock, pilot products, and the income from the scientific research activities commissioned by units external to the institutions. Product sales revenue refers to the income from the sales of all the fi nished goods and semi-fi nished goods, as well as from the rendering of services during the year by the enterprise. The commodity sales revenue refers to the sales revenue from selling products (produced by other enterprises) that are purchased for the purpose of selling.

4 11 12 34 74 110 175 238 350 445 737 1,057 1,285 1,568 2,119 2,662 321 4,106

Total Profit and Tax (RMB 100 Million)

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts.org.cn.

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Total Employees Total Output Revenue Value (RMB (RMB 100 Number of (10,000 100 Million) Million) Year Enterprises People)

Table 4.10 A snapshot of the enterprises in the state-level development zones4

10 0 THE RATIONALE BEHIND THE REFORMS

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Table 4.11 Development trend of the enterprises in the hi-tech development zones Percentage of Product Percentage of Commodity Percentage of Sales Revenue in Total Technological Revenue Sales Revenue in Total Output Per Revenue (%) Total Revenue (%) Year Capita (RMB 10,000) in Total Revenue (%) 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

— — — — 8.18 10.71 14.04 16.59 21.08 22.72 26.89 31.65 34.37 37.10 43.65 50.48 55.57 62.57

26.28 15.81 19.63 11.32 9.46 6.19 4.71 4.56 3.94 4.38 3.78 4.35 4.11 4.87 5.26 5.79 5.96 6.52

37.27 56.31 51.27 65.23 61.30 68.46 72.31 78.29 81.23 82.13 82.55 82.89 83.45 81.45 82.10 83.02 84.52 83.41

26.55 24.36 27.46 18.24 24.38 19.50 17.36 13.70 12.15 11.20 11.00 10.08 9.14 10.15 8.90 8.34 5.61 5.13

Source: Consolidated on the basis of Table 4.10.

Table 4.12 provides information regarding the incubators formed during the 2001– 2005 Torch Program. It is evident that all the variables including the number of incubators, the area of the sites, the total amount of incubator funds, and the number of enterprises in the incubation process increased greatly. The technological incubators comprised mainly of innovation service centers and all kinds of professional incubators (other types of incubators included the Overseas Student Pioneer Park and the Science and Technology Park for university students). In addition, we understand from the technology statistics report by the Ministry of Science and Technology5 that according to the statistics from 45 local departments of science and technology and 54 national hi-tech development zones, there were 548 5. Development and Planning Department of the Ministry of Science and Technology 2007. Science and Technology Statistical Report No.13 (Publication No. 404).

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Table 4.12 Science and technology incubators

Year

Number of Incubators

Number of Innovation Service Centers and All Kinds of Specialized Incubators

Incubator Site Area (10,000 m2)

Total Incubator Funding (RMB 10,000)

Number of Enterprises Being Incubated

2001 2002 2003 2004 2005

372 436 489 506 583

280 334 386 464 534

685.6 776.1 1,937.3 1,993.5 —

— 10.9 33.0 72.1 —

— 23,373 31,385 38,191 —

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts.org.cn.

science and technology enterprise incubators of various types in China, 14 more than in 2005. Among the 548 incubators, there were 168 State-level incubators recognized by the Ministry of Science and Technology, accounting for 30.7% of the total number. Among the 548 incubators, there were 41,434 enterprises in the process of incubation, 8,221 more than the previous year, with a growth rate of 2.7%. In 2006, 8,944 enterprises moved into the incubators, accounting for 21.6% of the total enterprises in the process of incubation. As of 2006, the total number of enterprises graduating from the professional incubators attained a value of 19,896, most of which were playing pivotal roles in each hi-tech development zone and in the local economic development in China. In 2006, 2,789 enterprises graduated from a variety of incubators and moved into the State hi-tech development zones, some of which began to show marked progress. Besides, in 2006, the 548 science and technology enterprise incubators attracted 13,336 personnel from overseas who possessed work experience or qualifications from abroad. This was 938 more than the previous year with a growth rate of 7.6%. Among these personnel, 5,098 people returned from the United States; 2,112, from Japan; and 2,342, from Europe. Among these 13,336 personnel, 9,591 held university diplomas or above. The Torch Program projects were under two levels of management: the State level and the local level. The Torch Program Office of the State Science and Technology Commission (Ministry of Science and Technology) was responsible for processing the matters of application, review, project initiation, tracking and management, and the project acceptance for the State-level Torch Program projects. The funds for the State-level Torch Program projects would follow the principle of matching the State, local regions, and the project-undertaking units, and actively introducing private and foreign capital at the same time, among which capital invested by the State mainly came from bank 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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loans. The review index for the application of the Torch Program projects included six features; namely, the technology level, market prospects, economic effects, maturity level of the project, social benefits, and industrial foundations. Since the overall operational efficiency of the capital market of China was still quite low, it was difficult for many entrepreneurs to obtain venture capital and State loans through the usual channels. This greatly constrained the development of high-tech industries in China. With the implementation of the Torch Program, the capital difficulties that the hi-tech enterprises encountered when starting their businesses were mitigated to some extent. Figure 4.10 provides insight into the initiation of the State-level projects of the Torch Program. According to the report on the Torch Program by the High Technology Industrial Center of the Ministry of Science and Technology, as of the year 2006, 5,514 projects were being implemented, and this accounted for 37% of the total projects initiated. Further, 1,423 projects were being implemented in the State hi-tech development zones, accounting for 25.8% of the total in-process projects, while in the State hitech development zones, one-fourth of the enterprises were implementing State-level Torch Program projects. Within the 5,514 projects, 4,540 projects were on schedule, accounting for 82.3% of the in-process projects, in which 261 projects were ahead of the 1,800 1,600

Number of Projects

1,400 1,200 1,000 800 600 400 200 0

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Number of New State-level Projects Initiated that Year

FIGURE 4.10 The number of the state-level projects in the Torch Program Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www. sts.org.cn.

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schedule, accounting for 4.7% of the in-process projects. A total of 713 projects were behind schedule, accounting for 12.9% of the in-process projects. Table 4.13 shows the different factors influencing the implementation of the projects (note: the influencing factors played their role in different periods); the most influential factors in a descending order of importance were poor availability of funds, market changes, and strategic adjustment. The “Implementation of the State-level Torch Program Projects in 2006” also provides the details of the 5,514 projects under different classifications. If classified as per the characteristics of the project’s undertaking unit, the joint ventures had 2,933 projects with product sales revenue of RMB 1,41.1 billion, accounting for 47.3% of the total product sales revenue. Privately owned enterprises ranked second with 1,297 projects; the products sales revenue reached RMB 47.96 billion, accounting for 16.1% of the total sales revenue. A total of 61 projects were undertaken by the scientific research academies that had been transformed into enterprises, with product sales revenue of RMB 1.31 billion and four projects undertaken by the higher-learning institutes had product sales revenue of RMB 6 million. Table 4.13 Different factors influencing the implementation of the Torch Program projects

Project Failing to Meet the Planned Schedule Influencing Factor

Technological Changes Planned Adjustment Equipment and Materials Not in Place Influence of the Coordination Effects in Collaborative Projects Funds not in Place Market Changes Changes in Top-flight Technical Personnel Improper Project Initiation Force Majeure Factors Other Factors

Number of Projects

Percentage of the Number of Projects Considered (%)

713

12.90

71 174 66

1.30 3.20 1.20

60

1.10

349 260 52

6.30 4.70 0.90

2 56 258

0.04 1.00 4.70

Source: Implementation of the State-level Torch Program Projects in 2006, Science and Technology Industry of China, Publication No. 8, 2007.

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If classified as per the technological sources of the project, the private technological projects of the enterprises ranked first with 4,430 projects, and their product sales revenue reached RMB 240.89 billion, accounting for 80.8% of the total product sales revenue. There were 1,050 domestic technological projects (CAS, higher-learning institutes, state-owned large and medium-sized enterprises, other kinds of enterprises, other units in China, the academies and institutes under the management of ministries and commissions and the local government, and technology introduced to enterprises for assimilation), with product sales revenue of RMB 55.04 billion, accounting for 18.5% of the total amount. There were 34 foreign technological projects with product sales revenues of RMB 2.29 billion, accounting for 0.7% of the total amount. If classified as per the revenue scale of the enterprises, the enterprises that had undertaken the most projects were those with the revenue scales between RMB 10 and 50 million. There were 2,276 projects in total, accounting for 41.3% of the total projects undertaken. The projects undertaken by the enterprises with revenues less than RMB 5 million ranked second—1,235 projects, accounting for 22.6% of the total projects, with product sales revenue of RMB 2.02 billion. As for those enterprises with revenues over RMB 0.1 billion, although only 491 projects were undertaken, they generated the highest product sales revenue of RMB 170.1 billion, accounting for 57% of the total amount.

4.3.3 The Productivity Promotion Center The Productivity Promotion Center is a key part of the National Innovation System— the science and technology intermediary service organization for deepening the reform of science and technology management system and promoting the technological innovation of the enterprises, especially medium and small-sized enterprises. With the deepening of the social division of labor, the importance of intermediary service organizations in strengthening the integration of technology and the economy was increasing. In 1992, the Fourteenth National Party Congress of the Communist Party of China expressly stated that a socialist market economy system should be established. Subsequently, the Productivity Promotion Center—the science and technology services organization that aided technological innovation in medium and small-sized enterprises under market economy conditions—emerged as the times required. In 1995, the Central Committee of the Communist Party of China and the State Council stated in the “Decision Concerning the Acceleration of the Scientific and Technological Progress” that there was a need to establish and perfect the technological service organizations such as the Productivity Promotion Center, to provide technology and information services for the medium and small-sized enterprises. Accordingly, the former National Science and Technology Committee issued “Several Opinions Concerning the Enhancement of the Construction TOWARD AN INNOVATIVE NATION

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Table 4.14 Snapshot of the productivity promotion centers 1997 Number of Institutes Number of National Industrial Productivity Promotion Centers Local Productivity Promotion Centers Employees on the Job Total Assets (RMB 100 Million) Total Input (RMB 100 Million) Government Input (RMB 100 Million) Non-government Input (RMB 100 Million) Consultancy Services (10,000 Items) Technical Services (10,000 Items) Information Services (10,000 PCs) Personnel Introduced (Person) Technology Introduced (Item) Number of Technology Trades Training Services (10,000 persons time) Number of Scientific and Technology Enterprises Fostered Number of Enterprises Served (10,000) Number of Scientific Institutions Contacted Number of Specialists Contacted Service Revenue (RMB 100 Million) Number of Projects Introduced Projects Funds Introduced (RMB 100 Million) Sales Amount Increases for Enterprises (RMB 100 Million) Profit and Tax Increases for Enterprises (RMB 100 Million) Societal Increases in Employment (10,000 Persons)

1999

2000

160 13

450 —

581 65

701 70

2001

865 74

2002

1,071 80

2003

1,218 80

2004

142

—

58

73

98

146

194

8,108 27.8 6.1 4.3

9564 31.2 3.86 2.34

11,220 60.8 10.2 6.5

14,198 67

15,300 66 14.45 10.04

1.8

1.52

3.7

— — — —

9,719 17.6 — —

—

—

— — — — — — —

— — 400 — — — 58

1.83 0.43 813 2,177 1,112 693 33

2.69 0.93 884 3,229 1,006 888 33.9

3.53 1.78 1,976 4,770 2,657 1,764 88

0.7 0.15 1,432 5,666 2,027 1,537 145.8

8.36 2.02 2,324 13,365 2,213 2,404 173

—

—

1,177

1,608

3,636

5,246

7,309

3.41

4.96

7.83

6.45

9.2

—

4,704

5,063

7,875

9,107

10,487

119000 — — —

— 4.5 — —

9,467 8.87 347 10.4

10,655 11.3 — —

17,311 10.2 1,079 61.9

20,613 13.6 946 37.2

23,503 19.1 1,106 51.8

94

155

388

407

300

477

644

57

68.9

44.6

66

89

28

34.5

48.1

150.2

175

0.94 —

18.5 5.6

4.9

— 11

8.37

4.41

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts. org.cn.

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of the Productivity Promotion Center” and the “Measures for the Administration of the Productivity Promotion Center.” Further, it enacted the “Outlines for the Planning of the Development of the Productivity Promotion Center during the Ninth Five-Year Planning Period,” organizing activities to create the State-level model of Productivity Promotion Centers and initiating the construction of the National Productivity Information Network. Most recently, the “Outlines for the Planning of the Medium and Long-term Science and Technology Development of China (2006–2020)” stated that a social and Internet science and technology intermediary service system must be built; all sorts of science and technology intermediary service organizations must be cultivated and developed; and science and technology intermediary service organizations should be led to the direction of professionalization, appropriate scale, and standardization. Table 4.14 shows the development of the Productivity Promotion Centers. It can be seen that the Productivity Promotion Centers are divided into two types: the Statelevel centers and the local-level centers. In recent years, the number of the Productivity Promotion Centers has been increasing rapidly, and the number of local organizations has been increasing much faster. The intermediary activities performed by the Productivity Promotion Centers included consultancy services, technological services, information services, technology trade agencies, training services, and the cultivation of quasi-technology enterprises.

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C

APTE

5

R

H

The Development of the Hi-tech Industry in China Science and technology are intellectual assets and the market value that their commercialization brings increases with market size. Therefore, with increasing integration into the world economy, technological innovation is becoming increasingly crucial for competing at both the domestic and the international levels. As compared with the traditional industrial sectors, the high technology (hi-tech) industry is an emerging industrial sector with few entrenched monopolies. This provides room for potential entrants to gain profits from innovation. Simply put, innovation in the hi-tech domain witnesses substantial demand-pull effects. Further, a typical feature of the hi-tech industry is that few technologies have matured or been finalized; therefore, a wide range of opportunities exist for improvement enabling innovation. Due to the rapid development of science and technology, a wide variety of new technologies emerge in succession. This provides a huge technology-push effect. The result of the demand-pull and technology-push effects is an increasing threat to the survival of some powerful market participants. With several alternative technologies in existence, they are likely to disappear quickly if they fail to adopt the appropriate technology and market strategy. On the other hand, some obscure companies may replace large market players in a short span of time, if they possess more advanced technologies, novel operation concepts, or more suitable market strategies. Generally, it is believed that the hitech industry has huge positive externalities—this may increase the technological value of traditional industries during the development process. The information technology (IT) industry is a typical example. With the deepening of the information age, the traditional manufacturing industry is becoming increasingly flexible (such as in machine tools); in addition, traditional service industries are also become more efficient. Due to the above-mentioned reasons, many technologically undeveloped countries, including

110 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

China, believe that strategic interactions with the hi-tech industry may allow them to catch up with and surpass the developed countries. Nevertheless, at least in the economics community, there is no consensus on whether technologically undeveloped countries should develop their hi-tech industries. Generally speaking, the comparative advantages of the developing countries lie in labor-intensive products and industries, while hi-tech industries are usually concentrated in the capital and knowledge-intensive economies. Therefore, there are many who believe that hitech industry specialization is out of sync with the comparative advantages of developing countries. They posit that the resulting development of the hi-tech industry would slow down the pace of economic growth in these countries as the concentrated attempts to develop the hi-tech industry would be fraught by costly errors. These economists believe that strategic industrial policy will seriously distort the allocational efficiency of resources. However, advocates of strategic industrial policy for technological development think that due to factors like economies of scale and product differentiation, the comparative advantage of a country is not purely exogenous. Instead, it is endogenous and can be changed with appropriate policies. A country may obtain strategic technological advantages in the market through an appropriate industrial and innovation policy. In order to analyze the hi-tech industry, we must first identify its basic attributes. Just as its name implies, the hi-tech industry refers to an emerging industry developed from the commercialization of high technology. Its attributes include an intense concentration of high technology, high investment, high risks, and high output. However, the crucial aspect for an enterprise to be a hi-tech one is that the intensity of research and development activity is noticeably higher than that in other industries. In 1986, the Organization for Economic Cooperation and Development (OECD) selected 22 manufacturing industries according to the International Standard Industrial Classification (ISIC) developed by the United Nations (UN); further, it calculated the research and development expenditure intensity of these industries during 1979–1981 for 13 typical member countries. The weighting method (by adopting figures proportionate to the output value of each country in the total output value as the weight), defined six industries whose research and development expenditure intensity was obviously higher than other industries as hi-tech industries. These six industries were the aviation and aerospace manufacturing industry, computer and office equipment manufacturing industry, electronics and communication equipment manufacturing industry, medicine manufacturing industry, special scientific instruments manufacturing industry, and the electrical machinery and equipment manufacturing industry. However, with the rapid development of science and technology, the composition of hi-tech industries has changed significantly. In 1994, the OECD re-evaluated 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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the 22 manufacturing industry sectors mentioned above and redefined the hi-tech industry by using three indexes that included the percentage of total and direct research and development expenditure in gross industrial output value and the percentage of direct research and development expenditure in industrial value added. On the basis of the data from 1973 to 1992 for 10 typical member countries, the OECD calculated the above three indexes for 22 manufacturing industry sectors according to the ISIC for each year. The results showed that the aviation and aerospace manufacturing industry, computer and office equipment manufacturing industry, electronics and communication equipment manufacturing industry, and the medicine manufacturing industry remained classified as hi-tech industries. However the special scientific instruments manufacturing industry and the electrical machinery and equipment manufacturing industry were considered as medium hi-tech industries, as their research and development intensity was no longer higher than that of the other industries. The method used by the OECD to define a hi-tech industry is simple and concise. All the data is broadly representative and appropriate for making international comparisons. It considered not only the direct research and development expenditure of these industrial sectors but also indirect research and development expenditure, which reflected the research and development intensity of each industry quite accurately. Due to these reasons, the definition, classification, and directory provided by the OECD are generally recognized and applied by the international society. China also follows these standards to classify the hi-tech industries. We ought to underscore at this point that the hi-tech industry is essentially a relative concept. This is obvious from the adjustment made to the classification criterion by the OECD. From the point of view of the industry life cycle, when an industry emerges, its products and technology are not mature, and there might be substantial room for improvement and innovation. Therefore, it has relatively high technological intensity and can be classified as being hi-tech. As the production technology matures over time, the scope for product improvement is gradually reduced, and cost replaces innovation as the basis of competition in this industry. Thus, the technological intensity of an industry is reduced gradually, and it may ultimately lose the basic attributes of a hi-tech industry. It can be seen that high technology is, at its core, a relative, dynamic, and developing idea. Even in a hi-tech industry, each industry contains different technological layers that include enterprises engaged in high-end as well as low-end technology. When some industries are classified as hi-tech industries according to the above criterion, enterprises and products with much lower technological intensity are likely included to be included in the industry sector. Similarly, some high-end technology and products in other industries are likely to be excluded. This relativity and the gaps in classification TOWARD AN INNOVATIVE NATION

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must be taken into account when the State enacts and implements the industrial policy for the hi-tech industry. In this chapter, we will review the development and basic features of China’s hi-tech industry since the reform. In Section 5.1, we will review policies that supported the development of the hi-tech industry in China. In Section 5.2, we will provide statistical data to reveal stylized facts regarding the development of the hi-tech industry in China. We will provide a brief summary in the Section 5.3.

. The Policies Supporting the Development of the Hi-tech Industry in China 5.1.1 Developing the Base for Advanced Technology Research and Realizing its Industrialization Being the initiator of market reform in China, Deng Xiaoping greatly emphasized the contribution of science and technology to economic development. He vigorously pursued his famous point of view that science and technology are the primary productive forces. The reform of China’s science and technology management system was developed around the emancipation and enhancement of productivity where the most critical target was integrating the economy and technology. The development of the hi-tech industry in China is closely related to the great emphasis placed on it by Deng Xiaoping and his efforts to facilitate its development. Since the 1980s, a wide variety of new technologies have emerged and flourished as witnessed in the areas such as information technology, biological technology, and materials science. These developments asserted a profound influence on the economy, societies, cultures, politics, and military of nations across the world. Advanced technology and the hi-tech industry have become the primary instruments for competition between countries, especially among the major competitors on the world stage. Accordingly, many countries regard the development of advanced technology as an important component of the State’s development strategy and have made substantial investment in capital, human resources, and materials, hoping to gain a large lead over their competitors. For a nation, an advanced position in the technology domain would enhance its global strategic initiatives in both political and economic matters. For example, the United States brought out the Strategic Defense Initiative (Star Wars Program) in 1983; two years later, the Eureka Program was proposed in Europe; the member countries of the Council for Mutual Economic Assistance (CMEA) proposed a general outline for the scientific and technological progress for 2000; and Japan launched the policy to “revitalize science and technology in the next decade.” 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Given the strategic initiatives for the advancement of technology undertaken by several other countries and economic systems, on March 3, 1986, four venerable scientists (Wang Daheng, Wang Ganchang, Yang Jiachi, and Chen Fangyun) wrote a letter to the Central Committee. They proposed tracking the level of the world’s advanced technology and developing a hi-tech industry in China. Deng Xiaoping immediately approved of this proposal and provided instructions for its undertaking. In the next six months, the Central Committee of the CCP, together with the State Council, organized more than 200 experts to study and deploy a strategy for the development of advanced technology. After three rounds of strict scientific and technological deliberation, the Central Committee and the State Council approved the “Outline for the Program of the Research and Development of the High Technology.” Since the proposals by the four scientists and the approval by Deng Xiaoping both occured in March 1986, the program was named the “863 Program.” The originators of the 863 Program believed that as a developing country China could not invest the large quantities of human resources, materials, and capital needed to extensively develop advanced technology. It would be impossible and unnecessary to compete with the developed countries for advantages in advanced technology. Hence, China needed to begin with the existing advanced technology trends from across the world and address the actual needs and ground realities in China. Adhering to the policy of limiting the targets and focusing on the key points, they selected seven domains and fifteen subjects as the focus of hi-tech research and development work in China. This included biology, space technology, information technology, lasers, automation technology, energy sources technology, and materials science. The policy called for the organization of an elite technological force, endeavoring to realize the key targets within 15 years. These targets were supposed to track the international level of science and technology in several critical hi-tech domains and endeavor to make breakthroughs in domains where China had inherent advantages. In addition, the policy was supposed to create favorable conditions for economic development and national security in the late twentieth and early twenty-first centuries, build an advanced technological foundation for economic development and national defense construction in the early twenty-first century, and create favorable conditions for the development of high technology itself. This was to be accomplished by closely linking research achievements from different areas with other promotion and application plans and rapidly transferring research achievements into productivity gains and translating this into economic benefits. Regarding strategies for hi-tech development, Deng Xiaoping also specifically proposed that advanced technology should be developed and harnessed in order to achieve industrialization. He expected that in addition to the government, other economic TOWARD AN INNOVATIVE NATION

114 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

entities should be encouraged to be actively involved. Therefore, the Chinese government put forth the Torch Program aimed at promoting the industrialization of high technology, along with a series of preferential policy measures. Unlike the mandated 863 Program, the Torch Program was a plan that provided guidance. In August 1988, the Torch Program was approved by the State Council and implemented by the former State Science and Technology Commission. Its main purpose was to use the market for promoting the commercialization of new technological achievements, the industrialization of hi-tech commodities, and the internationalization of the hi-tech industry. Under the background of the strategy of rejuvenating the country through science and education, on August 20, 1999, the Central Committee of the Communist Party of China and the State Council enacted the “Decision Concerning the Enhancement of Technological Innovation, the Development of High Technology, and the Realization of Industrialization,” which was a master plan that revealed the target, direction, and policies for the development of the hi-tech industry in China. The purpose of developing high technology and realizing industrialization was to activate the technological resources, enhance market-oriented research and development, promote and apply high technology and other applicable technologies, transform technological achievements into commodities with a competitive edge in the market in a quick and effective manner, and transform the traditional industries. This would develop the existing high- and new-technology industries and allow the formation of a number of emerging industries led by technological innovation. Therefore, the Chinese government emphasized that during the promotion of technological innovation and commercialization, market demands, social demands, and national security demands should be the basic priorities for research and development activities. The status of technological innovation in enterprises would be enhanced, and the market mechanism would play a fundamental role in allocating technological resources and guiding technological activities. The majority of technological forces would be driven into the market for innovation and entrepreneurship. The Chinese government expected to promote the construction of a National Innovation System by deepening the reforms of the economic system, the science and technology management system, and the education system. These reforms became an effective guarantee of future value, allowing the commercialization and industrialization of hi-tech achievements. On the one hand, the role of the technological innovation of the enterprise needed to be enhanced whilst taking full advantage of the market mechanism doctrine of the survival of the fittest. On the other hand, the government needed to retain control at the macro level through overall planning and focus on development. It wanted to optimally select within the technological and industrial domains, a number

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of key projects that were of broad industrial relevance; possessed good market prospects; and were likely to address hot spots and difficult issues, concentrate forces, tackle key issues, and result in breakthroughs. The Chinese government also stressed the importance of an open economy, international cooperation and communication, and market competition in the development of high technology. It began advocating that independent research and development should be combined with the introduction and assimilation of foreign advanced technologies thereby avoiding the redundant development of low-level research and development, emphasizing instead the improvement of the technological integration capability in order to realize a technological leap and generate more independently developed and owned intellectual property rights. Realizing that China was still a technologically undeveloped nation, the Chinese government adopted a strategy of prioritizing its goals. In order to promote the development of hi-tech industries, the Chinese government concentrated on developing preferential policies for industries and enterprises with strategic significance and superior market prospects. The Chinese government identified which hi-tech sectors to cultivate, expecting to enhance technological innovation and form a number of new technology enterprises with independently developed and owned intellectual property rights. These new industries would, hopefully, enjoy competitive advantages in the domains of electronic information (particularly in the aspects of integrated circuit design and manufacturing), network and communications, computers and software, and digitalized electronic products. Core high technological industry domains such as biological technology, pharmaceuticals, material science, new energy, aerospace, and ocean technology were also targeted for development. The Chinese government stressed the externalities arising from hi-tech industries and encouraged the integration of IT and biological technology with traditional agriculture, traditional industry, and the services industry. It encouraged the extensive development of new products with competitive advantages that were likely to succeed in both the domestic and international markets, and result in the improvement of the quality level and the technological value added by the products. The government promoted enterprises that developed and applied advanced manufacturing technology, techniques, and equipment, and dramatically improved the level of home-made technological equipment. The Chinese government sped up the application and promotion of high technology in service domains including finance, consultancy, trade, and culture, and improved the competence and knowledge of the service industry in China by greatly promoting the development of several emerging service industries such as e-commerce and remote education.

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5.1.2 The Financial Support Policy The Chinese government required financial departments at all levels to increase the investment in science and technology and transform financial investment from general support for scientific institutions and scientific personnel to special support focusing on individual projects. The national scientific research plans were directed at adopting a task-oriented system, extensively promoting project bidding and intermediary evaluation systems. For hi-tech enterprises in their early stages, survival relied on whether they were able to strike gold in this new competitive marketplace. Many small enterprises closed down as they were unable to attract initial investment in this period. In order to provide capital support for the transformation of new technological achievements, the State established an innovation fund for small and medium-sized hi-tech enterprises. The Chinese government concomitantly undertook a government acquisition system, to guide and encourage government departments, enterprises, and public service units to acquire domestically produced high technology, as well as their equipment and production capabilities, by budget control and project bidding. With regard to finance, the Chinese government established an authorization and credit-granting system to perfect capital management measures, increase credit variety, increase stability in the industry, and stimulate technological credit investment. Technological projects that qualified and were capable of providing legal surety were given priority in being granted these loans. The terms of loans granted were more favorable for those technological breakthroughs and innovation that were able to substitute for imports and had market prospects, high technological content, and good economic benefits. They were even provided with the interest make-up support. Since the hi-tech industry is both a high-risk and highyield industry, perfect capital markets and sound venture investment systems are critical for its development. Therefore, the Chinese government has attempted to introduce a venture investment system in recent years in order to facilitate the prompt entry of capable hi-tech enterprises into the domestic and international capital market.

5.1.3 The Preferential Tax Policy The preferential tax policy introduced for the hi-tech industry included the following aspects: technology transfer, technology development, and relevant technological consultancy and services would be exempt from business income tax; for software products produced by enterprises, value-added tax would be levied at 6%; the expenditure for the wages of software engineers could be deducted prior to corporate income tax at actual 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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amount incurred; and for the import of the high- and new-technology products, a policy of zero value-added tax would be implemented. Given the centrality of the high- and new-technology districts in the development of the hi-tech industry in China, the Chinese government also enacted and implemented a series of relevant preferential tax policies. For instance, according to the “Notice of the State Administration of Taxation Concerning the Issue of How to Apply the Preferential Policies by the High and New Technology Enterprises” (Issuance of the State Administration of Taxation [1994] No. 151), corporate income tax was reduced to 15% for foreign-funded hi-tech manufacturing enterprises that were operational for a period of no less than 10 years. In the case of the new foreign-funded hi-tech manufacturing enterprises that had been operational for no less than 10 years, exemption from income tax for the first and second profitable years would be admissible. Their corporate income tax rate would also be reduced to 7.5% from the third to the fifth year. After the expiration of this tax reduction and exemption, where enterprises remained as advanced technological enterprises, corporate income tax rates reductions (to a rate of 10%) could be extended to three years, with approval from the relevant departments. According to the “Notice Concerning Several Preferential Policies on the Corporate Income Tax” jointly issued by the Ministry of Finance and the State Administration of Taxation in 1994, the corporate income tax rate of domestically-funded hi-tech enterprises in designated high- and new-technology districts would be reduced to 15%. Newly started hi-tech enterprises would be exempted from income tax for two years beginning from the year of production.

5.1.4 The Designation of the High- and New-technology Enterprises In order to support the “Decision on Enhancing Technological Innovation, Developing High Technology and Realizing Industrialization,” in 2000, the Ministry of Science and Technology implemented the “Conditions and Measures to Recognize High- and New-technology Enterprises in the National High- and New-technology Industry Development Zones” (hereafter referred to as the Measures), where the scope of high technology in China was defined according to worldwide scientific trends and the technological, economic, and social development strategy of China. These hi-tech industries included the following industries: electronic and information technology, bioengineering and new medical technology, new material and application technology, advanced manufacturing technology, aviation and aerospace technology, modern agriculture technology, new energy and energy conservation technology, environmental protection technology, ocean engineering technology, and nuclear application technology. It also encompassed other new process and technologies applied to the transformation of traditional industries. TOWARD AN INNOVATIVE NATION

118 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

In order to create incentives for hi-tech industries, the Measures further codified the following conditions for an enterprise to be considered as a hi-tech enterprise in China: 1. The enterprises should be engaged in research, development, production, and technological services in one or more hi-tech industries within the scope of the high technology in China, which does not include pure commercial trade. The hi-tech products must be assessed by the provincial and municipal technological administrative departments according to a pre-established catalog. 2. The enterprise should have attained corporate status. 3. The total number of technological personnel holding junior college degrees or above should account for no less than 30% of the total number of employees. The number of technological personnel engaging in research and development work for hi-tech products should account for no less than 10% of the total number of employees. For labor-intensive hi-tech enterprises engaging in production or service delivery, the number of technological personnel holding junior college degrees or above should account for no less than 20% of the total number of employees. 4. The annual research and development expenditure of the enterprises on hi-tech and related products should account for no less than 5% of the gross sales of that enterprise for that year. 5. The sum of the income garnered from technology products and the sales revenue of hi-tech products should account for no less than 60% of the total enterprise income for that year. The input of the newly established enterprises in the highand new-technology domain should account for no less than 60% of the total input. 6. The head of the enterprise should possess relevant expertise and be familiar with product research, development, production, and business operations, and should value technological innovation. On January 1, 2008, the Ministry of Science and Technology, the Ministry of Finance, and the State Administration of Taxation jointly issued the new “Measures for the Administration of the Recognition of Hi-tech Enterprises” (hereafter referred to as the New Measures), and the definition criteria for high technology and hi-tech enterprises were revised. The original Measures were rescinded. The hi-tech domains to be supported by the State were identified in the New Measures; these included: electronic and information technology, biology and new medical technology, aviation and aerospace technology, new material technology, hi-tech services industry, energy sources and energy reservation technology, resources and environmental technology, and traditional industry transformed by high- and new-technology. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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119

The New Measures stipulated that the enterprises should be recognized as hi-tech enterprises only when the following conditions were satisfied: 1. The enterprises should be registered in China (excluding Hong Kong, Macao, and Taiwan) and should have independently developed and owned the intellectual property rights of the core technologies of their major products and/or services by independent research and development, transfer, donations, mergers, and acquisition in the previous three years, or by exclusive license for no less than five years. 2. The products and/or services should be specified in the high- and new-technology domains focused on and supported by the State. 3. The number of technological personnel holding junior college degrees should account for no less than 30% of the total employees of that enterprise that year, in which the number of research and development personnel should account for no less than 10% of the total number of employees of that enterprise for that year. 4. The enterprises should be continuously performing research and development activities in order to obtain new scientific and technological knowledge (excluding the humanities and the social sciences), creatively applying this acquired knowledge, or substantially improving the technology, products, and/or services. The percentage of their total research and development expenditure as a percentage of their total sales revenue in the previous three fiscal years should be as follows: (i) 6% for enterprises with sales revenue less than RMB 50 million in the previous year. (ii) 4% for enterprises with sales revenue between RMB 50 million and RMB 200 million in the previous year. (iii) 3% for enterprises with sales revenue over RMB 200 million in the previous year. Of these, the total research and development expenditure incurred by the enterprises in China should account for no less than 60% of their total research and development expenditure. For enterprises that started only three years ago, it should be calculated as per their actual operational duration. 5. The hi-tech products and/or services sales revenue should account for no less than 60% of the total enterprise income for that year. 6. Indexes including the organization and management level of research and development, the capability in transferring scientific and technological achievements, the quantity of independently developed and owned intellectual property rights, and the characteristics of the growth of the sales and the total assets should meet the requirements of the “Guidelines for the Administration of the Recognition of Hi-tech Enterprises.” TOWARD AN INNOVATIVE NATION

12 0 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

We can see that after several years, the Chinese government’s understanding of the characteristics of the hi-tech industry underwent subtle changes. First, the New Measures stressed that hi-tech enterprises should develop independently and/or own the intellectual property rights of their major products and/or services. Multiple ways of obtaining this were recognized; these included independent research and development, transfers, accepting donations, mergers, and acquisitions in the last three years, or exclusive licenses for no less than five years. Second, the New Measures revised the hitech domains supported by the State to eight; the original ocean engineering technology and nuclear application technology were excluded. More detailed regulation was put in place for each hi-tech domain. Third, considering the natural variations in the demand intensity for research and development activities, the criterion regarding the proportion of research and development expenditure for an enterprise to be considered as hi-tech had been revised. For instance, considering that research and development activities may have economies of scale, enterprises with larger sales revenues may show a lower proportion of research and development expenditure.

. The Development of the Hi-Tech Industry in China According to the “Circular Concerning the Catalog for Hi-tech Industrial Statistics Classification” published and issued by the National Bureau of Statistics of China in July 2002, hi-tech industries in China included the aviation and aircrafts manufacturing industry, the electronic and telecommunications equipment manufacturing industry, the computer and office equipment manufacturing industry, the pharmaceutical manufacturing industry, and the medical equipment and instruments manufacturing industry. Since the 1980s, the hi-tech industry has been developing rapidly and has become the foundation for the Chinese economy, playing an increasingly important role in promoting growth, expanding exports, and comprehensively enlarging the nation’s clout.

5.2.1 General Performance: Rapid Growth The enterprises are indispensable to the development of industry. Table 5.1 provides a snapshot of the high-end, hi-tech industrial enterprises in China from 1995 to 2006. As of 2006, their total output value, value added, sales revenue, and the export value had reached RMB 4,199.6 billion, RMB 1,005.6 billion, RMB 4,158.5 billion and RMB 2,347.6 billion respectively, with growth having attained or surpassed their 1995 level 10 times over. Meanwhile, the number of high-end, hi-tech industrial enterprises reached approximately 20,000. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 5.1

121

A snapshot of the high-end, hi-tech industrial enterprises in China

(1995–2006)

Year

Number of Enterprises

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

18,834 18,909 17,411 9,348 9,493 9,758 10,479 11,333 12,322 17,898 17,527 19,161

Total Output Value Value Added Sales Revenue (RMB 100 Million) (RMB 100 Million) (RMB 100 Million) 4,098 1,909 5,972 7,111 8,217 10,411 12,263 15,099 20,556 27,769 34,367 41,996

1,081 1,272 1,540 1,785 2,107 2,759 3,095 3,769 5,034 6,341 8,128 10,056

3,917 4,497 5,618 6,580 7,820 10,034 12,015 14,614 20,412 27,846 33,922 41,585

Export Value (RMB 100 Million) 1,125 — — 2,042 2,413 3,388 4,282 6,020 9,098 14,831 17,636 27,476

Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts. org.cn.1

Given this rapid development, the hi-tech industry in China is playing an increasingly critical role in the economy of China. Figure 5.1 shows that between 1995 and 2006, the percentage of value added by the hi-tech industry in China increased from 1.78% to 4.77%. The percentage of value added by the manufacturing industries grew rapidly from 6.2% to 13.9%—a growth rate that more than doubled—with the annual growth rate also being approximately 20%. Figure 5.2 shows the overall performance of hi-tech industry in terms of total profits, taxes, and the labor employed. From 1995 to 2005, the total profits and taxes for the hi-tech industry in China increased rapidly from RMB 32.6 billion in 1995 to RMB 209 billion in 2005, which is 6.4 times higher. In contrast, the number of personnel fluctuated considerably; it started to decline in the late 1990s, yet has assumed a rapid upward trend in the recent years. Perhaps, this phenomenon reflected the dynamic nature of the hi-tech industry. Since high capital intensity is a distinguishing feature of the hi-tech industry, its capability to absorb labor is inevitably limited. However, as technologies began to mature, the capital intensity of industries or enterprises that were previously given a hi-tech classification started to decrease. Instead, they began to increasingly resemble labor-intensive industries and their capability to absorb labor forces consequently increased. For example, although the computer industry has been classified as 1. Unless specifically indicated, the data referred to in this chapter are all sourced from this database.

TOWARD AN INNOVATIVE NATION

12 2 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA 16 14

Percentage

12 10 8 6 4 2 0

1995

1996 1997 1998 1999 2000

2001

2002 2003 2004 2005 2006

Percentage of Value Added by the Hi-tech Industry in GDP (%) Proportion of Value Added by the Hi-tech Industry in Value Added by the Manufacturing Industry (%)

FIGURE 5.1 Percentage of the value added by the hi-tech industry to the value added by the manufacturing industry and GDP (1995–2006) Source: China Science and Technology Statistics, “Data on the High Technology Industry in China,” http://www.sts.org.cn.

2,500

700 Profit and Tax

600

2,000

500 400

1,500

300

1,000

200

500

100 0

1995 1996 1997 1998 1999 2000 2001 2002

2003 2004 2005

0

Annual Average Number of Employees (10,000 Persons) Total Amount of Profit and Tax (RMB 100 Million)

FIGURE 5.2 Total number of personnel, profits, and taxes of the hi-tech industry (1995–2005)

a hi-tech industry, the majority of Chinese computer industry enterprises were simply engaged in assembly that is more labor-intensive in nature. Table 5.2 shows the various economic indices of the high-end, hi-tech industrial enterprises during 1995–2006. We notice that in each time period, the labor productivity 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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12 3

Table 5.2 The economic benefits of the high-end enterprises in the hi-tech industry 1995 1996 1997 1998 1999 2000 2001 2002 Overall Labor Productivity of the High-end Enterprises in the Manufacturing Industry (RMB 10,000 / Person)

1.7

2.1

2.4

3.0

3.5

4.3

4.9

5.7

Overall Labor Productivity of the High-end Enterprises in the Hi-tech Industry (RMB 10,000 /Person)

2.4

2.8

3.6

4.5

5.5

7.1

7.8

Value added Ratio of the High-end Enterprises in the Manufacturing Industry (%)

25.1

26.5

26.3

25.6

26.3

26.2

Value added Ratio of the High-end Enterprises in the Hi-tech Industry (%)

26.4

25.9

25.8

25.1

25.6

25.5

2003 2004 2005 2006 7.0

8.1

9.6

11.4

8.9

10.5 10.8

12.3

13.5

26.4

26.8

26.8 26.1

26.3

23.9

25.2

25.0

24.0 23.0

23.7

23.9

Ratio of Profits and Tax to the Output Value of the High-end Enterprises in the Manufacturing Industry (%)

8.22

6.78

7.16

7.00

8.04

8.92

8.91

9.25

9.52 6.63

6.08

6.21

Ratio of Profits and Tax to the Output Value of the High-end Enterprises in the Hi-tech Industry (%)

7.96

7.80 8.66

7.80

8.68

9.93

9.03

7.72

7.13 6.42

6.8

6.21

Proportion of the Hi-tech Industry in the Output Value of the High-end Enterprises in the Manufacturing Industry (%)

8.4

9.5

10.0

11.9

12.8

13.9

14.5

15.4

16.1 15.8

15.8

15.3

Proportion of the Hi-tech Industry in Sales Revenue of the High-end Enterprises in the Manufacturing Industry (%)

8.5

9.81 10.4

12.0

13.1

14.0

15.0

15.5

16.5 16.2

15.9

15.4

Proportion of the Hi-tech Industry in Value Added by the High-end Enterprises in the Manufacturing Industry (%)

8.9

9.4

9.8

11.7

12.5

14.0

13.9

14.3

14.8 13.9

14.2

13.9

Proportion of the Hi-tech Industry in the Value of Exports of the Highend Enterprises in the Manufacturing Industry (%)

14.9

—

—

19.4

21.5

23.9

27.0

30.6

34.3 37.1

37.5

39.2

TOWARD AN INNOVATIVE NATION

12 4 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

of the hi-tech industry was 20% to 65% larger than the overall level of the high-end manufacturing enterprises. We could make two assumptions to account for the differences in productivity. First, if all the high-end enterprises shared similar capital intensities, it would imply that the average level of human capital in the hi-tech industries was higher. Second, if different industries shared similar production technologies, with little variation in capital and labor, this would mean that the hi-tech industries had higher capital intensity and the increase in the capital stock would explain the increase in the marginal productivity of labor.2 Of course, some combination of the two situations mentioned above is likely to occur. By comparing the third column with the fourth, we notice that as compared to the overall level of the high-end manufacturing enterprises, the hi-tech industry does not possess an advantage in terms of the value added. In fact, except for a few isolated years, their performance is worse. By definition, the value ratio = value added/total output value;3 therefore, it reflects the market profit capability of an industry or enterprise, similar to the Lerner Index.4 The relatively low amount of value added by the hi-tech industry may be due to either technological or market aspects. First, innovation creates product differentiation, regardless of whether it is horizontal or vertical differentiation; an innovation may cause an enterprise to gain some monopoly power. Therefore, in industries with high innovation levels, there may be, on average, relatively poor substitution between products of competing enterprises. This allows each enterprise to realize higher product “value added” by being able to sell at high prices. However, technological innovation is not the only source of market power. In some cases, the government may regulate entry in some industries, which may allow established market players to avoid competitive threats from new potential entrants, allowing monopoly pricing. Typically in China, government-regulated entry barriers exist for new hi-tech industries (such as the IT industry.) However, in some traditional industries, due to the large number of state-owned enterprises, protective administrative barriers are quite common. Therefore, although hi-tech industries 2. In the general analysis, it is assumed that the production function F(K,L) has the following features: FK>0, FL>0, FKK<0, FLL<0, FKL>0, which implies that the marginal product of both the inputs is positive while exhibiting diminishing returns. Further, there is complementarity between the inputs. 3. The value added by the high-end, hi-tech industrial enterprises refers to the value generated during the industrial production process of the industrial enterprises within the reported period. It reflects the actual level of industrial production within a certain period, and it is a critical index for calculating the pace of industrial development. There are two methods to calculate the industrial value added: one is the production method and the other is the income method, also known as the factor distribution method. They are arrived at as follows: (1) in the case of the production method (input method), the industrial value added ⫽ total industrial output ⫺ interim industrial input; (2) for the income method (distribution method), the industrial added value ⫽ fi xed assets depreciation ⫹ labor reward ⫹ net product tax ⫹ earning surplus. As compared to the total industrial output value, the industrial value added is not subject to double counting, and so it may reflect the actual level of industrial production and the economic benefits of the enterprises. The industrial added value was used to calculate the pace of industrial development in China since 1993. 4. Lerner Index ⫽ (Price ⫺ Cost)/Cost.

30 YEARS OF CHINA’S REFORM STUDIES SERIES

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12 5

show relatively poor performance in their value-added ratios, we should not conclude that the technological innovation levels are relatively low. The ratio of profits and tax to gross output value (the profits and tax generated by unit output value) is an important index to measure the contribution of an industry to the national economy. By comparing the fifth and sixth columns, we discover that as compared to the overall level of the high-end manufacturing enterprises, the ratio of profits and tax to the gross output value of the hi-tech industry hardly differs from and may even be lower than that of the other high-end industries. It even assumed a rapid downward trend in recent years. This could be due to two reasons: One is that the Chinese government has adopted preferential tax policies toward the hi-tech industries and another is that there is increasing competition within the hi-tech industry itself. Due to the existence of economic externalities, the ratio of profits and tax to the gross output value of the hi-tech industry may not fully reflect their contribution to the overall economy. For instance, the development of the IT industry has greatly improved the production and operational efficiency of other industries; however, these are not completely reflected in the pricing of IT products and services. Actually, according to Moore’s Laws, the processing speed of the CPU has doubled every 18 months; however, due to severe market competition, the price of computer products assumes a downward trend year after year. The last three columns describe the contribution of the hi-tech industry to the various economic indexes related to the high-end manufacturing enterprises. To some extent, it shows the externalities that hi-tech industries create. In general, the share of the hi-tech industry grew rapidly during 1995–2006, whether in terms of output value, sales revenue, value added, or export value of the enterprises.

5.2.2 Microstructure: Uneven Development Some criteria regarding the general performance of China’s hi-tech industry were revealed in the tables above. Next, we will examine the microstructure of the industry. As mentioned above, under the existing statistical criteria, the hi-tech industry in China included five major industries: the aviation and aircraft manufacturing industry, the electronic and telecommunication equipment manufacturing industry, the computer and office equipment manufacturing industry, the pharmaceutical manufacturing industry, and the medical equipment and instruments manufacturing industry. Table 5.3 and Figure 5.3 show the total number of high-end, hi-tech industrial enterprises and their distribution. During 1995–2006, there were no great changes in the distribution of the total number of hi-tech enterprises in each industry in China. Relatively, however, the number of computer and office equipment manufacturing enterprises TOWARD AN INNOVATIVE NATION

12 6 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.3

The number of high-end, hi-tech industrial enterprises above designated size (classified as per the industry)

Year

Number of High-end Enterprises in the Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

18,834 18,909 17,411 9,348 9,493 9,758 10,479 11,333 12,322 17,898 17,527 19,161

5,388 5,396 5,028 3,280 3,272 3,301 3,488 3,681 4,063 4,765 4,971 5,368

219 185 185 177 183 176 169 173 148 177 167 173

7,202 7,148 6,552 3,666 3,807 3,977 4,294 4,709 5,166 8,044 7,781 8,606

715 699 707 506 484 494 543 630 810 1,374 1,267 1,293

5,310 5,474 4,939 1,719 1,746 1,810 1,985 2,140 2,135 3,538 3,341 3,721

100

Percentage

80 60 40

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

0

1995

20

Year Pharmaceutical Manufacturing Industry Aviation and Aircraft Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Computer and Office Equipment Manufacturing Industry Medical Equipment and Instruments Manufacturing Industry

FIGURE 5.3 The distribution of high-end, hi-tech industrial enterprises above designated size (classified as per the industry) 30 YEARS OF CHINA’S REFORM STUDIES SERIES

THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

12 7

increased considerably; yet, the number of pharmaceutical manufacturing enterprises and medical equipment and instruments manufacturing enterprises decreased. Table 5.4 and Figure 5.4 show the total output value of the high-end, hi-tech industrial enterprises and their industrial sales. During 1995–2006, the total output value of the high-end, hi-tech industrial enterprises rapidly increased in terms of volumes; yet the relative size of the pharmaceutical manufacturing industry and the aviation and aircraft manufacturing industry had reduced. The proportion of medical equipment and instruments manufacturing industry remained almost unchanged, while the proportions of the electronic and telecommunication equipment manufacturing industry and the computer and office equipment manufacturing industry increased. Table 5.5 and Figure 5.5 show the value added by the high-end, hi-tech industrial enterprises and their industrial sales. It can be seen that the proportional contribution of the pharmaceutical manufacturing industry and the medical equipment and instruments manufacturing industry to the overall value added greatly decreased. In contrast, the proportional contribution of the computer and office equipment manufacturing industry increased dramatically.

Table 5.4

Total output value of the high-end, hi-tech industrial enterprises (classified as per the industry) (RMB 100 Million)

Year

Total Output Value of the High-end Enterprises in the Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

4,098 4,909 5,972 7,111 8,217 10,411 12,263 15,099 20,556 27,769 34,367 41,996

961 1,151 1,262 1,373 1,497 1,781 2,041 2,378 2,890 3,241 4,250 5,019

269 286 313 323 333 388 469 535 550 502 797 828

TOWARD AN INNOVATIVE NATION

Electronic and Telecommunication Equipment Manufacturing Industry 2,182 2,504 3,172 3,847 4,709 5,981 6,900 7,948 10,217 14,007 16,867 21,218

Computer and Office Equipment Manufacturing Industry 354 581 797 1,121 1,203 1,677 2,200 3,479 5,986 8,692 10,667 12,511

Medical Equipment and Instruments Manufacturing Industry 331 386 427 447 474 584 653 759 911 1,327 1,785 2,421

12 8 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA 100 90 80 Percentage

70 60 50 40 30 20

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

0

1995

10

Year Pharmaceutical Manufacturing Industry Aviation and Aircraft Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Computer and Office Equipment Manufacturing Industry Medical Equipment and Instruments Manufacturing Industry

FIGURE 5.4 Total output value of the high-end, hi-tech industrial enterprises (classified as per the industry)

In addition, Tables 5.6 and 5.7 show the sales revenues and the export value for the high-end, hi-tech industrial enterprises as well as their respective industrial sales. The trends are similar to the total output value of the enterprises. Table 5.8 shows the industrial characteristics of overall labor productivity in the high-end, hi-tech industrial enterprises. In concert with Table 5.2, high-end, hi-tech industrial enterprises in China during 1995–2006 showed an increase in overall labor productivity, which rose rapidly from 24,000 RMB/person to 135,000 RMB/person. Within the hi-tech industries, the performance of the pharmaceutical manufacturing industry and the electronic and telecommunication equipment manufacturing industry was approximately average and the performance of the aviation and aircraft manufacturing industry and the medical equipment and instruments manufacturing industry was far lower than average. In contrast, the computer and office equipment manufacturing industry led in terms of overall labor productivity. Further, Table 5.9 shows the difference in overall hi-tech labor productivity between China and other countries. The first column gives the data for China in 2004, while 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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12 9

Table 5.5

Value added by the high-end, hi-tech industrial enterprises (classified as per the industry) (RMB 100 Million) Value Added by the Up-scale Enterprises in the Hi-tech Industry

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

265 360 412 433 515 634 722 835 1,025 1,173 1,530 1,808

80 74 98 87 92 106 124 149 141 149 209 241

543 588 729 870 1,122 1,471 1,623 1,939 2,572 3,366 4,016 5,118

1,081 1,272 1,540 1,785 2,107 2,759 3,095 3,769 5,034 6,341 8,128 10,056

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

93 137 181 266 241 374 432 604 1,022 1,226 1,824 2,111

100 113 121 129 137 174 193 242 275 427 549 777

100

Percentage

80 60 40

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

0

1995

20

Year Pharmaceutical Manufacturing Industry Aviation and Aircraft Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Computer and Office Equipment Manufacturing Industry Medical Equipment and Instruments Manufacturing Industry

FIGURE 5.5 Value added by the high-end, hi-tech industrial enterprises (classified by industry) TOWARD AN INNOVATIVE NATION

13 0 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.6

Sales revenue of the high-end, hi-tech industrial enterprises (classified by industry) (RMB 100 Million)

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Sales Revenues of the High-end Enterprises in the Hi-tech Industry 3,917 4,497 5,618 6,580 7,820 10,034 12,015 14,614 20,412 27,846 33,922 41,585

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

903 1,043 1,178 1,264 1,379 1,627 1,924 2,280 2,751 3,033 4,020 4,719

262 294 300 323 324 378 444 500 547 498 781 799

2,053 2,255 2,934 3,507 4,458 5,871 6,724 7,659 9,927 13,819 16,646 21,069

379 550 801 1,068 1,199 1,599 2,296 3,442 6,306 9,193 10,722 12,634

321 355 405 418 460 558 628 734 880 1,303 1,752 2,364

Table 5.7 Value of exports of the high-end, hi-tech industrial enterprises (classified by industry) (RMB 100 Million)

Year 1995 1998 1999 2000 2001 2002 2003 2004 2005 2006

Value of Exports of the High-end Enterprises in the Hi-tech Industry 1,125 2,042 2,413 3,388 4,282 6,020 9,098 14,831 17,636 23,476

Pharmaceutical Manufacturing Industry 127 147 163 168 183 204 300 343 439 539

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

16 23 22 31 64 46 55 42 78 121

712 1,192 1,527 2,158 2,526 3,287 4,402 7,260 9,410 12,131

Computer and Office Equipment Manufacturing Industry 219 577 608 904 1,355 2,320 4,137 6,846 7,195 9,998

Medical Equipment and Instruments Manufacturing Industry 50 103 93 127 154 163 204 339 514 688

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Table 5.8 Overall labor productivity of the high-end, hi-tech industrial enterprises (classified by industry) (RMB 10,000/person)

Year

Overall Labor Productivity of the High-end Enterprises in the Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

2.4 2.8 3.6 4.5 5.5 7.1 7.8 8.9 10.5 10.8 12.3 13.5

2.9 3.0 3.6 4.2 5.2 6.4 7.0 7.9 8.9 10.3 12.4 13.9

1.4 1.0 1.8 1.7 1.9 2.3 3.0 3.8 4.1 5.5 6.9 8.1

Electronic and Telecommunication Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

3.0 3.3 4.2 5.3 6.7 8.5 9.2 10.1 11.5 11.1 11.6 13.0

6.6 9.5 10.6 12.4 11.5 15.7 14.7 15.6 17.2 14.8 18.0 17.4

1.3 1.5 1.7 2.5 2.9 3.7 4.1 5.1 6.1 7.3 8.9 11.2

Table 5.9 Overall labor productivity of the hi-tech industry in some countries (as compared to that of China in 2004) China (2004) Manufacturing Industry Hi-tech Industry Pharmaceutical Manufacturing Industry Aviation and Aerospace Crafts Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Computer and Office Equipment Manufacturing Industry Medical Equipment and Instruments Manufacturing Industry

United States (2003)

Japan (2003)

Germany (2002)

France (2002)

Italy (2002)

9.8 13.0 12.4

9.8 10.9 23.0

8.1 7.7 21.9

5.3 3.9 —

6.4 6.1 10.5

4.2 4.3 7.5

6.6

18.3

12.2

—

16.6

12.3

13.4

9.1

6.9

3.9

3.1

3.0

17.9

8.1

4.0

3.5

4.0

1.7

8.8

11.8

7.2

5.5

7.5

5.0

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13 2 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

the other columns provide the labor productivity ratios for other countries albeit for different years. For instance, in 2004, the labor productivity of the manufacturing industry in the United States was 8.1 times larger than that in China. Although great progress has been made in recent years in China, compared to the developed countries, there still exists a huge gap in overall labor productivity. The gap between the hi-tech industry in China and the developed world is similar to that between the manufacturing industry in China and the manufacturing industries in the developing world. However, if we look at the industrial segments, the data suggests that China has an obvious comparative advantage in the IT industry, and a comparative disadvantage in pharmaceutical manufacturing and aviation and aircraft manufacturing. These comparative advantages have shown up in a sharp increase in the IT industry’s share in the hi-tech industries in recent years. As mentioned above, the value added ratio reflects the market profit-making capability of enterprises in an industry. Table 5.2 shows that as compared to general high-end manufacturing enterprises, the performance of the hi-tech industries in China is relatively poor, and has been assuming a downward trend year after year. According to the information in Table 5.10, the main sector responsible for this downward trend is the computer and office equipment manufacturing industry. During 1995–2006, the value added ratio of the highend enterprises in this industry declined from 26.3% to 16.9%. However, comparing this Table 5.10 The value added ratio of the high-end, hi-tech industrial enterprises (classified by industry) (%)

Year

Value Added Ratio of Highend Enterprises in the Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

26.4 25.9 25.8 25.1 25.6 26.5 25.2 25.0 24.0 23.0 23.7 23.9

27.6 31.3 32.6 31.5 34.4 35.6 35.4 35.1 35.5 36.2 36.0 36.0

29.7 25.9 31.3 26.9 27.6 27.3 26.4 27.8 25.6 29.7 26.2 29.1

24.9 23.5 23 22.6 23.8 24.6 23.5 24.4 25.2 24.0 24.0 24.1

26.3 23.6 22.7 23.7 20.0 22.3 19.6 17.4 17.1 14.1 17.1 16.9

30.2 39.3 28.3 28.9 28.9 29.8 29.6 32.0 30.0 32.0 31.0 32.1

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with Table 5.8, in the same period of time, the overall labor productivity of this industry nearly tripled. We can conclude that this decline in value added may not be due to poor labor productivity; instead, it may be the result of intensifying competition. Figures 5.6 and 5.7 provide specific information on the value added by the hi-tech industries on the basis of enterprise ownership and scale. The Chinese-funded and Medical Equipment and Instruments Manufacturing Industry Computer and Office Equipment Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Aviation and Aircraft Manufacturing Industry Pharmaceutical Manufacturing Industry Overall Hi-tech Industry 0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

State-owned Enterprises

Foreign-funded Enterprises

FIGURE 5.6 Distribution of the value added by the hi-tech industry on the basis of the enterprise ownership type (2004)

Medical Equipment and Instruments Computer and Office Equipment Electronic and Telecommunication Equipment Aviation and Aircraft Pharmaceutical Hi-tech Industry 0

20

40

60

80

100

Percentage

Large-sized Enterprises Small-sized Enterprises

Medium-sized Enterprises

FIGURE 5.7 Distribution of the value added by the hi-tech industry on the basis of the scale of the enterprise (2003)

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13 4 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

foreign-funded enterprises have assumed a dominant status in the IT industry, while they basically share the same proportion with state-owned enterprises in the medical and pharmaceutical industries. In the aviation and aircraft manufacturing industry, the state-owned enterprises have assumed the dominant status. However, as shown in Figure 5.6 (which is consistent with Table 5.5), since the value added by the hi-tech industries in China is generated mainly from the IT industry, we can conclude that foreign-funded enterprises played a critical role in China’s hi-tech industries. On the other hand, this may explain the results shown in Table 5.9 in another light: As compared with the developed countries, the IT industry in China had reflected its comparative advantage within all sectors in the hi-tech industry because it has incorporated more foreign-funded enterprises consequently improving the labor productivity of the IT industry throughout China. This has narrowed the technological gap between China and the developed countries. Here, we must stress that this conclusion does not imply that the technological gap between Chinese domestic IT enterprises and the developed countries had also narrowed. The introduction of foreign funds exerted twin effects on Chinese domestic enterprises. On one hand, due to competition, model effects, and technology spillovers, the introduction of foreign-funded enterprises improved the technological capabilities of the Chinese enterprises. On the other hand, after foreign-funded enterprises were introduced, the Chinese IT enterprises faced a more fragmented market thus resulting in a crowding out effect. Ultimately, the effect of the introduction of foreign-funded enterprises on the technological capabilities of Chinese domestic enterprises remains an issue that merits further study. As compared with the IT industry, the aviation and aircraft manufacturing industry in China is a relatively closed industry, which relates closely to international politics. On the one hand, the Chinese government does not permit foreign-funded enterprises to enter into these domains, which are of national strategic significance. On the other hand, for the purpose of restraining Chinese military technology, some developed countries may not permit their relevant enterprises to carry out production and research and development activities in China. Table 5.11 shows the details of the ratio of profits and taxes to the gross output value of the high-end, hi-tech industrial enterprises in recent years, which are classified by industry. It can be seen that the pharmaceutical manufacturing industry, aviation and aircraft manufacturing industry, and medical equipment and instruments manufacturing industry assumed a strong upward trend in this index; however, the IT industry assumed a sharp downward trend in this index, regardless of whether or not we view the electronic and telecommunication equipment manufacturing industry or the computer and office equipment manufacturing industry as a part of it. It lags behind other industries in terms of absolute quantities. It should be noted that in recent years, the 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 5.11 Ratio of profits and taxes to gross output value of the high-end, hi-tech industrial enterprises (%)

Year

Profits and tax Ratio of Highend Enterprises in the Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

7.96 7.75 8.66 7.8 8.68 9.93 9.03 7.72 7.13 6.42 6.08 6.21

10.58 11.06 11.82 11.89 13.32 14.74 15.33 15.38 15.46 14.8 13.8 12.81

5.21 5.52 6.13 5.76 3.78 4.44 4.47 5.24 5.07 5.12 5.58 7.34

7.95 7.33 7.87 7.53 8.3 9.9 8.59 6.76 6.6 6.14 5.5 5.98

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

3.27 4.81 8.39 4.62 5.79 6.18 4.86 4.25 3.51 3.1 3.1 2.87

7.66 6.65 7.51 7.03 8.54 9.9 11.36 11.49 11.52 11.16 11.33 11.52

proportion of the IT industry in China’s hi-tech industries has dramatically increased (see Table 5.4 and Figure 5.4). The above analysis indicates that in recent years, the ratio of profits and taxes to gross output value of the hi-tech industries as a whole shows an obvious downward trend.

5.2.3 The Scientific and Technological Activities of the Hi-tech Industries in China Table 5.12 provides an overview of the scientific and technological activities of the hitech industries in China. In terms of the inputs into scientific and technological activity, labor employed in research and development activities assumed a fluctuating upward trend—the total amount by 2005 was more than thrice that in 1995. Research and development expenditure and new products development expenditure increased rapidly and progressively. By 2005, they amounted to 20 times and 12 times their levels in 1995, respectively. Corresponding to the dramatic increase in inputs, the sales revenue of the new products had increased from RMB 5.38 million to RMB 69.14 million (an increase of around 12 times), and the patent application amount had increased from 612 to 16,823 TOWARD AN INNOVATIVE NATION

13 6 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.12 Overview of the scientific and technological activities of the hi-tech industries in China

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Manpower for Research and Development Activities (Person/ Year) 57,838 90,594 96,089 70,879 92,589 91,573 111,572 118,448 127,849 120,830 173,161

Research and Development Expenditure (RMB 10,000) 17.8 31 42 56.5 67.6 111 157 187 222.4 292.1 362.5

New Product Development Expenditure (RMB 10,000) 32.3 41.3 52.6 70.8 94.4 117.8 134.5 169 207.6 258.8 415.7

New Product Sales Revenue (RMB 10,000)

Number of Patents Applied for

538.4 698.7 805.2 1,207.3 1,525.7 2,483.8 2,875.9 3,416.1 4,515 6,099 6,914.7

612 545 713 1,076 1,482 2,245 3,379 5,590 8,270 11,026 16,823

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

(27 times). It can be seen that during 1995–2005, the scientific and technological activities of the hi-tech industries in China made enormous progress both in terms of their input and output. High technological intensity, high input, high risk, and high yield are the main characteristics of the hi-tech industry. The gross index reviewed may not explicitly reflect the technological intensity of the hi-tech industries in China. Due to this, we need to use relative indices, in which research and development expenditure intensity is a key index to measure the technological intensity of industry. Table 5.13 shows that during 1995–2006, whether reviewed as a whole or with respect to each sector, the intensity of the research and development expenditure fluctuated within a band without showing any obvious trend increases. Within the hi-tech industries, the expenditure intensity of the aviation and aircraft manufacturing industry is obviously higher than that of the other industries. This can be seen by comparing the data with those in Figure 5.6. This may be due to it being a relatively closed industry, as it was mainly state-owned enterprises without any technological introduction from outside. Therefore, its technology is sourced mainly from independent research and development activities. In contrast, since other industries have a higher ratio of foreign-funded enterprises and relatively diversified technological sources, enterprises may purchase or introduce technology 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 5.13 Research and development expenditure intensity of the hi-tech industries in China (%)

Year

Proportion of R&D Expenditure of Large and Mediumsized Enterprises in the Hi-tech Industry in Output Value

Proportion of R&D Expenditure of Large and Mediumsized Enterprises in the Hi-tech Industry in Added Value

Pharmaceutical Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0.7 1.1 1.2 1.3 1.3 1.8 1.8 1.7 1.3 1.3 1.05 1.09

2.6 4.1 4.7 5.0 5.2 6.7 7.3 7.1 5.5 5.9 4.46 4.53

2.6 2.8 2.8 2.9 2.9 3.5 4.1 3.9 4.0 3.8 2.6 2.9

Electronic and TelecomAviation munication and Aircraft Equipment ManufaManufacturing cturing Industry Industry 8.5 13.3 9.7 7.5 10.0 14.2 13.7 15.5 16.2 18.0 13.3 13.82

1.4 3.1 4.0 5.8 5.6 7.2 8.6 7.8 6.4 6.7 5.85 5.4

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

1.0 3.4 9.1 3.0 5.7 8.9 4.0 6.4 2.8 3.7 2.4 3.45

3.0 4.7 3.9 4.3 4.7 5.3 5.9 5.5 6.7 5.6 3.0 2.67

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

from outside sources, instead of investing large amounts of capital and human resources to support development. Further, since the main purpose of foreign capital entering into China is to carry out production by using cheap labor whilst keeping the research and development activities in their home countries, the relatively lower level of research and development expenditure intensity in the hi-tech industry is not surprising given their higher openness. Table 5.14 contrasts the research and development intensity of China’s hi-tech industries and with that of those in other countries. The first column shows the research and development intensity of China in 2005; the other columns show the ratio of the research and development intensity of other countries to that of China. For instance, the second column of the table shows that in 2003, the research and development intensity of the manufacturing industry in the United States was 2.7 times more than that in China. It can be easily noted that there is a huge gap between China and those countries in terms of the research and development intensity in the hi-tech industries. However, since different countries have different specializations, the relative gaps among different industries and TOWARD AN INNOVATIVE NATION

13 8 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.14 Research and development intensity of the manufacturing industry and the hi-tech industry in some countries

Manufacturing Industry Hi-tech Industry Pharmaceutical Aviation and Aircraft Electronic and Telecommunication Equipment Computer and Office Equipment Medical Equipment and Instruments

United Kingdom (2003)

South Korea (2003)

China (2005)

United States (2003)

3.2

2.7

3.2

2.4

2.3

2.3

0.7

2.3

5.6 4.0 13.9 6.9

5.2 5.2 2.2 3.9

4.6 6.0 0.9 2.2

4.3 — — 5.4

5.1 6.8 2.1 8.3

4.9 13.0 2.3 4.0

2.0 1.5 1.3 2.6

3.3 1.1 — 3.4

2.7

12.2

35.4

6.4

5.9

0.9

3.0

1.6

6.3

6.7

5.2

2.4

2.6

1.1

1.4

1.7

Japan (2003)

Germany (2002)

France (2002)

Italy (2002)

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

countries vary. Taking the United States as the benchmark and the Chinese manufacturing industry as a whole, the relative gap was less than that in the hi-tech industry, while within the hi-tech industry, the electronic and telecommunication equipment manufacturing industry assumed the largest relative gap. From the point of view of comparative advantage, such a gap is very natural; developed countries represented by the United States have comparative advantages in capital and technology-intensive industries, while developing countries represented by China have a comparative advantage in the labor-intensive industries. Table 5.15 provides the details of the expenditure on new product development in each industry within the hi-tech industries in China. One obvious trend is that the IT industry’s contribution to the total expenditure on new product development in the hi-tech industry gradually increases; the contribution of the pharmaceutical industries remains almost unchanged; and the contribution of the aviation and aircraft manufacturing industry shows a continually declining trend. The cause for the above-mentioned development trend was that IT industries constitute the driving sector in China’s hi-tech industry, which parallels the distribution of value added shown in Figure 5.5. However, if we consider the percentage of the sales revenue contributed by the new products in total products sales revenue, the aviation and aircraft manufacturing industry greatly outperforms the other hi-tech industries, while several of the other industries 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 5.15 Expenditure on new product development of the hi-tech industry (1995–2005) (RMB 100 Million)

Year

Hi-tech Industry

Pharmaceutical Manufacturing Industry

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

32.3 41.3 52.6 70.8 94.4 117.8 134.5 169 207.6 258.8 415.7

4.6 6.6 7.7 7.6 10 14.8 14.1 19 22.9 26.5 44.8

Aviation and Aircraft Manufacturing Industry 10.2 11.5 9.9 11.5 12.4 11.4 10.4 19.5 19.9 22.9 30.2

Electronic and Telecommunication Equipment Manufacturing Industry 12.2 17.3 23.3 42.2 51.4 73.7 88.1 101.1 118.8 144.8 261.1

Computer and Office Equipment Manufacturing Industry 1.5 2.6 6.9 5.2 15.5 13.3 16.5 23.3 37.9 56.6 61.8

Medical Equipment and Instruments Manufacturing Industry 3.7 3.3 4.8 4.3 5.2 4.6 5.4 6.1 8.1 8 17.8

face similar situations. This is noted by a simple comparison between the various industries to show that the performance indicator is consistent with the research and development expenditure ratio shown in Table 5.13. With the increasing integration in the world economy, the right to exclusively produce certain products—namely, intellectual property rights (especially patents)—is becoming crucial. In this situation, the number of patents applied for and granted is becoming an important indicator of measuring the efficiency of the research and development activities performed by enterprises. As shown in the last column of Table 5.13, the number of patent applications increased explosively in recent years and reached 16,823 in 2005, almost 27 times more than that in 1995. In 2006, there were 24,301 applications for patents by the hi-tech industry in China, which was 44.5% more than those in 2005. There were 8,141 patents for inventions, which was 22.3% more than those in 2005. In terms of the number of patents for inventions, the electronic and telecommunication equipment manufacturing industry held 3,807 patents for inventions in 2006 that accounted for 47% of the number of the patents for invention held by the hi-tech industry. The pharmaceutical manufacturing industry held 1,965 patents for invention that accounted for 24% of the number of patents for invention. The computer and office equipment manufacturing industry, TOWARD AN INNOVATIVE NATION

14 0 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.16 Percentage of revenue from the new product sales of the hi-tech industry in total products sales revenue (%)

Year

Overall Hi-tech Industry

Pharmaceutical Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

2001 2002 2003 2004 2005

23.9 23.4 22.1 21.9 24.0

10.5 10.9 11.0 12.8 17.5

21.6 28.6 39.3 42.6 44.7

Electronic and Telecommunication Equipment Manufacturing Industry 27.9 28.8 29.5 29.1 26.7

Computer and Office Equipment Manufacturing Industry

Medical Equipment and Instruments Manufacturing Industry

27.4 21.9 15.1 14.6 20.6

11.2 8.9 13.1 9.9 20.4

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2007),” http://www.sts.org.cn.

aviation and aircrafts manufacturing industry, and the medical equipment and instruments manufacturing industry held 1,174, 228, and 967 patents for invention, respectively, accounting for 17%, 3%, and 9%, respectively, of the number of patents possessed by the hi-tech industries (See Figure 5.8). If we go by the scale of the enterprises, 2,185 patents for invention were held by large-scale enterprises in the electronic and telecommunication equipment manufacturing industry, which was 1.3 times more than those held by the medium-sized enterprises. The computer and office equipment manufacturing industry held 729 patents for invention, which was 1.6 times more than those held by the medium-sized enterprises; the number of patents for invention held by large-sized enterprises in the aviation and aircraft manufacturing industry was more than that held by mediumsized enterprises; and in the pharmaceutical manufacturing industry and the medical equipment and instruments manufacturing industry, the number of patents for invention held by the large-sized enterprises was obviously less than that held by the medium-scale enterprises (See Figure 5.9). Further, as shown in Figure 5.10, the number of patents for invention held by foreignfunded enterprises, in the domain of electronic and telecommunication equipment manufacturing industry, computer and office equipment manufacturing industry, and medical equipment and instruments manufacturing industry, was more than that held by the state-owned and the state proprietary enterprises, whereas the converse was true for the other industries.

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7%

9%

141

17% 3%

64% Pharmaceutical Manufacturing Industry Aviation and Aircraft Manufacturing Industry Electronic and Telecommunication Equipment Manufacturing Industry Computer and Office Equipment Manufacturing Industry Medical Equipment and Instruments Manufacturing Industry

FIGURE 5.8 Situation of the patents for invention held by the hi-tech industry in China in 2006 (classified as per the industry) Source: Report on the Development of Science and Technology in China (2006).

Item 3,500 3,000 2,500 2,000 1,500

Large-scale Enterprises

Medical Equipment and Instruments Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

Aviation and Aircraft Manufacturing Industry

500 0

Pharmaceutical Manufacturing Industry

1,000

Medium-scale Enterprises

FIGURE 5.9 Number of patents for invention held by the hi-tech industry in China in 2006 (classified on the basis of the scale of the enterprise) Source: Same as that of Figure 5.8.

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14 2 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA 1,400 1,200 1,000 800 600 400

Medical Equipment and Instruments Manufacturing Industry

Computer and Office Equipment Manufacturing Industry

Electronic and Telecommunication Equipment Manufacturing Industry

Aviation and Aircrafts Manufacturing Industry

0

Pharmaceutical Manufacturing Industry

200

State-owned and State-holding Enterprises Foreign-funded Enterprises

FIGURE 5.10 Number of patents for invention held by the hi-tech industry in China in 2006 (classified on the basis of enterprise ownership) Source: Same as that of Figure 5.8.

5.2.4 The Import and Export Situation regarding Hi-tech Products Since the reform and opening up, the Chinese economy has witnessed tremendous progress. A crucial driver of the smooth integration of the Chinese economy with the international system of specialization is that China has not strayed from its comparative advantage in the production of labor-intensive products. As mentioned above, foreign-funded enterprises are critical players in China’s hi-tech industry. One of the prime motivations for entering into China was to utilize its cheap labor force, which has made China earn the moniker of the world’s factory. Also, foreign trade has provided the impetus for economic growth in China. This is particularly obvious in China’s hi-tech industry. Table 5.17 provides an overview of China’s imports and exports of hi-tech products during 1999–2006. The following characteristics should be noted during the period covered: first, the total quantity of exports and imports, the growth rate of imports, and the growth rate of exports grew approximately 10 times; second, the export growth rate grew 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Table 5.17 Overview of China’s imports and exports of hi-tech products 100 Million US Dollars

1999

2000

2001

2002

2003

2004

2005

2006

Export Amount Import Amount Total Import and Export Amount Balance Trade Specialization Coefficient

247.0 376.0 623.0

370.4 525.1 895.5

464.5 641.1 1,105.6

678.6 828.4 1,506.9

1,103.2 1,193.0 2,296.2

1,653.6 1,613.4 3,267.1

2,182.5 1,977.1 4,159.7

2,814.5 2,473.0 5,287.5

−128.9 −0.21

−154.6 −0.17

−176.6 −0.16

−149.8 −0.10

−89.8 −0.04

40.2 0.01

205.4 0.05

341.5 0.06

70

Percentage

60 50 40 30 20

Italy

Australia

Canada

Sweden

Brazil

China

Switzerland

Mexico

World

France

Japan

South Korea

Thailand

United Kingdom

Netherlands

United States

0

Singapore

10

FIGURE 5.11 Percentage of exports of the hi-tech industry in the exports of the manufacturing industry of some countries (2001) Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003),” http://www.sts.org.cn.

quicker than the import growth rate, transforming China from a net importer to a net exporter of hi-tech products. The trade specialization coefficient (TSC) (Net Exports/ Total Imports and Exports) of the hi-tech product increased from −0.21 to 0.06. However, a cross-country comparison in Figure 5.11 shows that the percentage of exports of the hi-tech industry in China as a part of the manufacturing exports is still lower than the world average. This is mainly because the capital intensity of the hi-tech industry is higher than of the general manufacturing industry, whereas China’s comparative advantage lies in the labor-intensive products. Figure 5.12 shows the model of trade for China’s hi-tech products. It can be seen that feed processing and processing and assembling dominated the total share of around 90%. The feed processing trade accounted for 70% of the share. In the feed processing TOWARD AN INNOVATIVE NATION

Percentage

14 4 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA 100 80 60 40 20 0

1998

1999

2000

2001

2002

Others Processing and Assembling Trade

2003

2004

2005

Feed Procesing Trade General Trade

FIGURE 5.12 Export of hi-tech products in China (distributed according to the trade type) Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

100 Percentage

80 60 40 20 0

1998

1999

2000

State-owned Enterprises Sino-foreign Joint Venture Enterprises Others

2001

2002

2003

2004

2005

Sino-foreign Cooperative Enterprises Soley Foreign-funded Enterprises

FIGURE 5.13 Export of hi-tech products in China (distributed according to the type of enterprise) Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

trade, raw materials are provided by foreign exporters to be processed by enterprises in China according to the variety and quantity specified. The enterprises in China then collect the processing fees from the exporter. In this trade, import is regarded as one deal and processing and export are regarded as a separate deal—they are unconnected in the import and export contract. In the processing trade, the import of materials and the export of finished goods are usually regarded as one deal or two relevant deals. The provider of raw materials is usually the party that accepts the finished goods. Figure 5.13 shows the modes of distribution of the exports of the hi-tech products according to the type of the enterprise. It can be seen that foreign-funded enterprises 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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were the main contributors of hi-tech products in China; by 2005, they contributed over 90% of the products. The contribution of the state-owned enterprises and the Sino-foreign joint ventures has declined year on year. In contrast, the proportion of solely foreign-funded enterprises has been increasing successively. Based on Figures 5.12 and 5.13, we may easily conclude that feed processing by solely foreign-funded enterprises has constituted the major form of exports of hi-tech products in China.

5.2.5 High- and New-technology Industrial Development Zones Considering the successful experience of Silicon Valley in the United States, the Chinese government undertook a similar experiment in developing hi-tech industrial zones. For hi-tech development zones, the Chinese government adopted the development policy of focusing on the industrial development, the utilization of foreign funds, the exports in foreign currencies, and the development of high- and new-technology industries. Simply put, they greatly developed the processing and manufacturing industries and hi-tech industries, and took the lead in exploring a socialist market economy operating mechanism by actively introducing foreign funds, advanced technology, and management experience. In 1984, the State Council established 14 state-level economic and technological development zones; by the end of the Tenth Five-Year Planning period, 49 state-level economic and technological development zones were established, and five other state-level industrial parks enjoyed similar policies as state-level economic and technological development zones throughout the country. After 20 years of rapid development, the hi-tech development zones in China became export-oriented industrial parks. They were more intensive in their land use, followed modern manufacturing practices, were outstanding in industrial agglomeration and the intensity of foreign investment, and became a major force in promoting the rapid development of the Chinese economy. Table 5.18 provides a picture of the overall development of the high- and new-technology industrial development zones in China. Each relevant indicator increased several fold during 1998–2005. As compared with the 1998 levels, the number of enterprises in 2005 increased by 2.6 times; the number of employees, 2.8 times; the industrial gross output, 6.7 times; the industrial value added, 6.4 times; the total operating revenue, 7.1 times; earned profits, 6.3 times; profit and tax delivery, 7.3 times; and exports, 13.1 times. In addition, according to the “Report on the Development of Science and Technology in China (2006),” in 2006, the total amount of funds raised by the enterprises in the hi-tech development zones for the purpose of scientific and technological activities in China reached RMB 176.54 billion, in which funds raised by enterprises amounted to RMB 146.83 billion. Funds from the financial institutions amounted to RMB 11.83 billion; from the government departments at all levels, RMB 9.02 billion; from the public TOWARD AN INNOVATIVE NATION

14 6 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.18 Overview of the enterprises in the high- and new-technology industrial development zones in China

Number of Enterprises Number of Employees at Year End (10,000 Persons) Total Industry Output Value (RMB 100 Million) Industry Added Value (RMB 100 Million) Total Operating Revenue (RMB 100 Million) Realized Profit (RMB 100 Million) Amount of Tax Paid (RMB 100 Million) Amount of Foreign Exchange Earned through Exports (US$ 100 million)

1998

1999

2000

2001

2002

2003

2004

2005

16,097 184

17,498 221

20,796 251

24,293 294

28,338 349

32,857 395

38,565 448

41,990 521

4,334

5,944

7,942

10,117

12,937

17,257

22,639

28,958

1,061

1,476

1,979

2,621

3,286

4,361

5,542

6,821

4,840

6,775

9,209

11,928

15,326

20,939

27,446

34,416

256

399

597

645

801

1,129

1,423

1,603

221

339

460

640

766

990

1,240

1,616

85

119

186

227

329

510

824

1,117

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2003–2007),” http://www.sts.org.cn.

services units, RMB 1.33 billion, and from overseas, RMB 3.22 billion. Research and development expenditure spending of enterprises in the hi-tech development zones amounted to RMB 105.4 billion, accounting for 2.4% of total operating revenue, 2.9% of products sales revenue, and 8.7% of GDP. From the aspect of the research and development expenditure, expenditure input from foreign-funded enterprises in 2006 was the highest, amounting to RMB 29.54 billion, while limited liability companies accounted for RMB 28.21 billion in expenditure; corporations spent RMB 16.8 billion; and funds from state-owned enterprises accounted for RMB 11.44 billion. In 2006, among the 30,403 high- and new-technology enterprises in the hi-tech development zones, the expenditure input for research and development activities amounted to RMB 94.67 billion, an increase of 32.1% as compared to the same period in the previous year. This accounted for 3.0% of the total operating revenue and 89.8% of the expenditure input for total research and development activities in the hi-tech development zones. In 2006, there were 32,600 patents possessed by the hi-tech development zones, increasing from 16,188 in 2005, with a year-on-year rise of 101.4%. A total of 10,169 patents was held mainly by foreign-funded enterprises; 7,255, by limited liability companies; and 4,918,

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by corporations. In the hi-tech development zones, there were 5.68 patents per thousand employees. Further, Table 5.18 provides insight into enterprises in the high- and new-technology industrial development zones classified on the basis of their registration type. We may see from each index that joint-stock enterprises and foreign-funded enterprises were the leading forces in the hi-tech development zones. However, on average, the operating revenue, gross industrial output, value added, and the exports of the foreign-funded enterprises were much higher than those of the other types. Table 5.20 shows the revenue structure of the hi-tech development zones in China. Product sales revenue is the main source of revenue of the enterprises regardless of their scale; however, enterprises with higher total operating income usually have a higher percentage of product sales revenue. Conversely, with a reduction in the size of the total operational revenue, the importance of technology income and commodity sales revenue increases. Furthermore, Figure 5.14 provides information on enterprise product sales revenue in the hi-tech industrial development zones distributed according to technology domains. It can be seen that electronic information products are the main sources of revenue. This is consistent with the situation of overall hi-tech industries in China, where the IT industry has assumed a dominant position. Table 5.19 Enterprises in the high- and new-technology industrial development zones classified according to their registration type (2005)

Employees at Year End Number of (10,000 Enterprises Persons) Total State-owned Enterprises Collectiveowned Enterprises Corporate Enterprises Foreign-funded Enterprises Other Types

Total Operating Revenue (RMB 100 Million)

Total Industry Output Value (RMB 100 Million)

Industry Value Added (RMB 100 Million)

Total Amount of Foreign Exchange Earned through Exports (US$100 Million)

41,990 1,607

521 54

34,416 2,738

28,958 2,106

6,821 615

1,117 27

825

13

673

638

187

13

22,840

256

14,020

10,909

2,882

112

6,269

157

15,550

14,298

2,875

946

10,449

41

1,435

1,006

261

18

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2005),” http://www.sts.org.cn.

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14 8 THE DEVELOPMENT OF THE HI-TECH INDUSTRY IN CHINA

Table 5.20 Revenue structure of the high- and new-technology industrial development zones in China (2005)

Total Revenue ≥ 100 Million Renminbi 10 Million Renminbi ≤ Revenue < 100 Million Renminbi 5 Million Renminbi ≤ Revenue < 10 Million Renminbi Revenue < 5 Million Renminbi

Total Operating Revenue (RMB 100 Million)

Technological Revenue (%)

Product Sales Revenue (RMB 100 Million)

Commodity Sales Revenue (%)

Others (%)

34,415.6 30,487.3

5.96 4.94

84.52 86.04

5.61 5.12

3.91 3.89

3,318.7

12.43

75.04

8.69

3.84

321.2

19.15

63.64

12.17

5.04

288.5

23.74

55.84

14.38

6.03

Source: China Science and Technology Statistics, “Chinese Hi-tech Industry Data (2005),” http://www.sts.org.cn.

21.86% 40.26%

4.28%

7.26% 12.00%

14.34%

Electronic Information New Material Optical, Mechanical, and Electronic Integration Biological Technology New Energy Resources Others

FIGURE 5.14 Products sales revenue of the enterprises in the high- and new-technology industrial development zones distributed according to technology domains (2005) Source: China Science and Technology Statistics. “Chinese Hi-tech Industry Data (2005),” http://www.sts.org.cn

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. Conclusion The hi-tech industry exhibits the characteristics of high intensity, high input, high risk, and high yield. Developing the hi-tech industry further is proving to be a conundrum for China. China’s comparative advantage lies in labor-intensive industries and products given its substantial labor force. However, by nature, comparative advantage is essentially endogenous and dynamic. If China is able to enter into and develop its hi-tech industries or early-stage products, it is likely to endogenize its comparative advantage in certain hi-tech industries. The Chinese government has determined that the hi-tech industry is to be accorded priority in its development for strategic reasons. A series of strategic preferential policies to create an industrial environment favorable for hi-tech development will come into force in time. The classification of the hi-tech industry is fluid and is a matter of debate; this can be seen from the reclassification of the hi-tech industrial domains in China. From the point of view of the industrial life cycle theory, there are four development stages for hi-tech achievements to be utilized on an industrial scale. These consist of the pioneering, growth, expansion, and stabilizing and maturing stages. In the early stages of industrial development, enterprises compete in the arena of technical innovation. This bears greater relevance for the hi-tech industry. However, with the maturing of technology and products, innovation becomes more difficult. Firms then tend to compete on the basis of cost and price, a characteristic seen more often in the traditional industry. Meanwhile, even within the same industry, the products manufactured by different enterprises vary in terms of quality and technology—some engage in high-end production where innovation is the measure of core competence, while others engage in lowend production where cost is more critical. As shown in Figure 5.15, there are four positions in the pecking order that an economy can find itself in on industrializing; these are the low-end traditional industry, the high-end traditional industry; the low-end, hi-tech industry; and the high-end, hi-tech industry. In the opinion of the author, whether a state or enterprise can achieve higher product value addition should be determined by whether it is able to reach the higher end of an industrial chain, which is typically capital and technology-intensive. In this way, the effectiveness of the hi-tech industrial policies in China will be determined

Traditional Industry High and New Industry

Low-end I II

High-end III IV

FIGURE 5.15 Classification of industry and industrial hierarchy

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by whether or not they are favorable to the Chinese industries. All industries climb from the lower end of this hierarchy to the higher end, regardless of the existence of hi-tech industries or traditional industries (through the spill-over effects of the hi-tech industry). The Chinese hi-tech industry has been developing rapidly since the 1990s, when China implemented a series of preferential policies for promoting the hi-tech industry. This can be seen in terms of the number of the hi-tech enterprises, the number of patents, the amount of technology trade, and the exports of hi-tech products. Statistical data in recent years also suggests that ever since China joined the World Trade Organization (WTO), export industries with the most rapid growth were not labor-intensive industries like the textile industry, as people had anticipated; instead, they were the office equipment and IT products industries represented mainly by electronic products. If we consider Figure 5.15, we realize that the major function of these preferential policies was that they changed the relative advantage of traditional and hi-tech industry in China in a way such that innovation elements—whether capital, labor, or knowledge—were allocated to the hi-tech industries. As mentioned above, there are different tiers within the same industry, and with the increase in the openness of industry, more foreign capital entered into China. As compared with the Chinese enterprises, foreign enterprises have more capital and technical advantages, enabling them to enter the hi-end of each industry. For this reason, we should be prudent in examining the rapid development of China’s hi-tech industry and the capability of independent innovation within this hi-tech industry.

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6

R

C

E

H

The Development of the Automotive Industry in China Ever since China opened up to the world in 1978, the economy has witnessed a healthy growth rate. Concurrently, a subset of Chinese enterprises and domestic brands has progressed enormously. In certain industries, Chinese enterprises, such as China Petroleum and China Mobile, are now Fortune 500 companies. Others, such as Haier and Midea in the electrical home appliance industry and the Shanghai Zhenhua Port Machinery Company (ZPMC) in port machinery, have gained international recognition. In some industries, although the Chinese enterprises (e.g., Huawei and Lenovo in the IT industry) are still market followers, their rapid development constitutes a threat to the market leaders and they have caught the attention of their rivals. After implementing the opening-up policy, advanced technology and competitors from other countries were introduced into China, and Chinese enterprises gained access to large foreign markets. Concomitantly, the improvement of Chinese income levels has given rise to an enormous domestic market that is the foundation for the development of many home-grown enterprises. In the early stages of the reforms and opening up, it was the aspiration of a typical Chinese family to own the “three regular pieces”; namely, a television set, a refrigerator, and a washing machine.1 This even became a precondition for marriage. Due to this huge demand, the electrical home appliance industry boomed, increasing both output capacity and introducing new products. Such severe market competition rattled the industry and only some well-managed and technologically superior enterprises, such as Haier and TCL, survived the tumultuous period. 1. Note that the term “three regular pieces” held a different connotation in different periods of time. Earlier in the 1970s or 80s, when the Chinese had just experienced the “Cultural Revolution,” the people were deprived of material possessions, and had very low levels of consumption, the “three manjor pieces for marriage” were the sewing machine, bicycle, and watch, which were much more basic and low end.

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Now, with further improvements in income and consumption levels, the three appliances are considered as necessities and people have revised their wants to three upgraded possessions: a house, a car, and wealth. It is plausible that the desire for these new possessions will necessarily create huge market opportunities requiring a largescale reorganization of industry. With the marketization and monetization of housing consumption, the real-estate industry experienced staggering developments, becoming a key proponent of GDP growth in China. On the one hand, the quantity and quality of housing has dramatically increased and improved, respectively; on the other hand, housing prices have been climbing fast. Due to the ties of the construction industry with the financial sector, the boom in the real estate market was closely related to China’s macroeconomy. Entangled with issues such as the appreciation of the renminbi, the factors behind this growth are very complicated. This chapter intends to analyze the automobile industry in China, one of the new desirables, without going into much detail regarding the real estate sector. However, we need to recognize that the long-lasting boom in the real estate market is unimaginable without the support of consumption and the strong desire for improving residential conditions, very similar to the development of the automobile industry in China. In recent years, the automobile industry in China, particularly the sedan segment, has been developing rapidly. Only few years ago, a sedan was considered to be a luxury, well beyond the means of an ordinary family. Now, private sedans are possessed by many Chinese families. As the entry policy into the Chinese automobile industry underwent adjustments, multiple new competitors entered the market through measures such as the Sino-foreign joint ventures. However, domestically owned enterprises thrived as well, resulting in severe competition in the sedan segment, with the price declining rapidly and new types of cars rolling off the production line with high frequency. The sedan segment in China has developed into a battleground since then. This parallels the development of the Chinese electrical home appliance industry during the 1980s. In hindsight, although it was criticized severely at the time, the severe competition in the Chinese electrical home appliance industry eventually created many Chinese behemoths. While it is difficult for us to accurately predict, one might posit that a similar situation could evolve in the automobile industry. However, one thing is for certain: When developing a complicated product such as a car and facing foreign brands, if the Chinese enterprises had failed to accumulate sufficient technology and competence in innovating immediately, they would have been eliminated quickly. The bad news is that currently, the existing automobile enterprises in China still lack the technology to compete and operate at the low-end of the market. They are not only constrained by highend competitors, but are also being toppled by new entrants. The good news is that after many years of development, many automobile parts manufacturing enterprises have 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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been formed in China and they have accumulated considerable technological competence during their provision of goods for multinational enterprises, which constitutes a long-lasting driver for the development of the Chinese automobile industry. The development of the Chinese automobile industry (and the sedan segment in particular) will be analyzed in this chapter. First, we briefly review the history and status quo of the development of the Chinese automobile industry. Then, we examine the main policies relevant to the automobile manufacturing industry and analyze the main effects of these policies on the market structure and enterprise behavior. Finally, we summarize our findings.

. The Situation of the Chinese Automobile Industry before the Reform Before the foundation of the People’s Republic of China (PRC), China did not have its own automobile industry. All domestic automobile-related consumption relied completely on imports. After its foundation in 1949, China was greatly supported by the USSR and established a relatively complete industrial system. In order to quickly change the undeveloped situation of transport in China, the development of the automobile manufacturing industry gained priority. In January 1950, Mao Zedong and Zhou Enlai met with the leaders of the Soviet Union and sought their support in constructing a number of key industrial projects, including a modern truck manufacturing plant. In March 1950, a team was formed to guide the development of the Chinese automobile industry and the first conference of the automobile industry was held to discuss in detail the policy and steps for the construction of an automobile industry. The conference decided to first manufacture cargo trucks and retain Soviet specialists to undertake the design of an automobile factory. In March 1951, the Central Finance and Economics Committee approved the establishment of the First Automobile Works (FAW) in Changchun and listed it as one of the 156 key projects during the First Five-Year Planning period arranged by the State. In late 1951, the initial design for the automobile works was completed by the All Soviet Union Automobile and Tractor Industrial Design Academy under the Soviet Ministry of Automobile and Tractor Industry. Mao Zedong paid great attention to the construction of FAW and issued the “Instruction of the Central Committee of the Communist Party of China Concerning the Efforts of Completing the Construction of the Changchun Automobile Works in Three Years” in June 1953. The Ministry of the First Machine Building Industry also developed a master plan for the construction of FAW in three years and submitted it to the Central Committee. The Central Committee directed the TOWARD AN INNOVATIVE NATION

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local government and the relevant departments of the State to mobilize all forces in China to support the construction of FAW, while the three-year construction targets for FAW were developed. They were mainly concerned with producing automobiles, developing human capital, and gaining the relevant production experience. On July 15, 1953, the construction of FAW began. On July 13, 1956, the targets set up by the “Instruction of the Central Committee of the Communist Party of China Concerning the Efforts of Completing the Construction of the Changchun Automobile Works in Three Years” were completed and China’s first home-made CA10 4-ton cargo truck under the Liberation brand was launched successfully. This marked the beginning of China’s independent automobile manufacturing industry. In 1958, FAW imitated the first CA71 sedan under the Dongfeng brand. Another branded, advanced, home-made sedan—the CA72 Red Flag—was launched; it was specially designed for the party leaders. Further, since 1957, FAW has also independently designed and developed the CA30 a 2.5-ton tri-axial, off-road cargo vehicle. By 1965, FAW was capable of manufacturing cargo vehicles, off-road vehicles, and sedans. Shortly after the construction plan for FAW had been confirmed, Mao Zedong gave instructions for the construction of Second Automobile Works (SAW). The construction of FAW was very successful; however, SAW was developed haphazardly. Although this investment project was outlined in the First Five-Year Plan, due to political, funding, and location constraints, the SAW construction plan had to go through times rounds of disapproval and two rounds of approval. The project was eventually located in Shiyan, Hubei Province, and began operations in 1969.2 In 1975 and 1978, the Dongfeng 2.5-ton off-road vehicle and Dongfeng 5-ton cargo truck were launched, respectively. It so happened that in the second half of 1979, the State’s finances were in dire straits due to the flawed policies. Therefore, the Chinese government implemented a new policy of “adjustment, reform, rectification, and improvement.” The State Council listed SAW as a ceased and deferred project. Therefore, SAW submitted the proposal “to spend within our means, to raise funds by ourselves, and to resume the construction of the SAW” to the State Council and it was approved. Since 1980, under the premise of delivering all profits, taxes, and depreciation allowances to the State, SAW raised RMB 330 million by itself. Thus, it completed construction and renovation, and began to export Dongfeng automobiles. In April 1981, based on the focus of SAW, with the Dongfeng series as the common factor, SAW established a cross-division and cross-province Dongfeng Automobile Industry Affiliated Company, which began the concepts of “single 2. The city of Shiyan lies at the intersection of the three provinces of Hubei, Sichuan, and Shaanxi. It is located in the heart of the Chinese mainland and transportation to and from it is rather inconvenient. From its location, SAW appears to be a typical third-line construction. At that time, due to the military considerations by the Chinese government, the heavy industry projects were located inland and in mountainous areas where they would be shielded from possible attacks from the air.

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variety,” “creating competition amongst the automobile brands,” and “being small and stand-alone in the automobile industry in China,” and the Dongfeng series was further developed. By the end of 1982, the Dongfeng Automobile Affiliated Company produced various types of automobiles—50 types in 13 segments. By 1986, SAW had realized a production capacity of 100,000 vehicles annually, in excess of FAW, while Dongfeng automobiles manufactured by SAW became the leading brand in the country. Apart from FAW and SAW, China had also developed other small-sized automobile works before the reforms began with the Great Leap Forward movement in 1958. At that time, transportation was sparse throughout the country, there were outstanding conflicts due to insufficient transport capability, and automobile production demand greatly exceeded supply. Central, provincial, and municipal industrial authorities organized and arranged automobile production by imitation. In early 1960s, in order to correct the immense harm that the Great Leap Forward had caused the National economy, the Chinese government implemented the policy of “adjustment, consolidation, enrichment, and improvement,” conducting technological transformations on four automobile manufacturing and auto parts factories that were in better condition. These formed the following four automobile works apart from FAW: Nanjing Automobile Works (NAW), Shanghai Automobile Works (SAW), Beijing Automobile Works (BAW), and Ji’nan Automobile Works (JAW). From the end of the 1950s to early 1960s, all the automobile works in China designed, developed, and produced home-made sedans by imitating models from other countries. The brands of the home-made sedans included the Jing Gang Shan, Beijing; Dong Fang Hong, Beijing; and the Phoenix and Shanghai, Shanghai. By the mid-1960s, the annual capacity of automobile manufacturing in China reached 60,000 vehicles, which included nine segments like the cargo vehicles, off-road vehicles, and sedans. Meanwhile, China had also built a number of automobile spare parts factories to support the automobile brands manufactured accordingly, as well as some locations that refitted buses and special vehicles using the home-made automobile chassis. In the late 1960s, with the effects of the central policies of “to bring the central and local initiatives into play” and “to construct the local industrial system,” there was a total of 100 automobile works located in China, covering almost all the provinces, municipalities, and autonomous regions. There were three or four automobile works in some provinces, and up to 14 in individual provinces. The number of automotive works alone may not mean anything; the critical issue was that these automotive works imitated the existing home-made vehicle types, resulting in serious overlaps in construction and manufacturing. For example, more than 20 automotive works manufactured the Jiefang, Yuejing, and Beijing brand, medium- and light-duty cargo vehicles, and about 10 automobile works manufactured the Beijing Jeep. TOWARD AN INNOVATIVE NATION

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In conclusion, the industrial structure of the automobile manufacturing industry of China before the reforms can be summarized as follows: FAW was the leader of the overall industry, while all the other automotive works were formed by imitating and altering the leading products of FAW. With regard to the ownership structure, all the enterprises were large and medium-sized state-owned enterprises, and their sources of funding, output quantity, research and development investment, and sales channels were all subject to the arrangement of the state or local programs. Therefore, the enterprises themselves lacked the decision-making autonomy that they were supposed to have. With regard to the scale of production, the output capacities of all the automobile works (including FAW) in China were not sufficient to operate with the economies of scale. Meanwhile, since operational performance was closely related to their own benefits, automobile works lacked sufficient motivation to innovate, resulting in multiple imitations of single brands of automobiles. Since the beginning of production, there were few technical changes to Jiefang automobiles, and products remained almost unchanged for many years. This was the situation for FAW, but the major task of other automobile works was to imitate and duplicate FAW’s automobile products. The sedans analyzed later in this chapter were deemed as luxuries and were for senior government officials only. Thus, these products were unrelated to consumer demand. On the one hand, the State did not actively advocate this in its policies. On the other hand, there was no mass consumption or demand foundation due to the low level of income and poor living standards of the people. We can view the development of the automobile industry in China before the reforms bearing history in mind. If we consider the lowly beginnings of China’s automobile industry—starting from scratch and growing to a large number of enterprises capable of manufacturing vehicles such as cargo truck, tractors, sedans, and buses—it would all seem impressive as it laid the foundation for the further development of the automobile industry in China. However, if a comparison is drawn with the other major countries during the same period, there would be nothing worth mentioning as China was far behind the times both in terms of the speed of development and quality. Technology in the automobile industry in China progressed so slowly that there were hardly any new models of automobiles launched and almost no progress in product quality. During the same period of time, the Japanese automobile industry developed at a fantastic pace and soon Japanese automobile brands gained world-wide recognition. They competed on a unique mix of fuel-economy, speed, and convenience, and the products successfully competed in the US market—a country that boasted of living on wheels. With the petroleum crisis in the 1970s, Japanese automobiles became world beaters, tending to replace their US counterparts and became the leaders in the industry. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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. The Development of the Automobile Industry after the Reforms Since the 1980s, with the deepening of the reforms and opening-up policy, the Chinese automobile industry has had the opportunity for rapid growth. On one hand, the rapid growth of the Chinese economy had generated intense demand for infrastructure including transportation. On the other hand, market and decentralization reforms had improved the freedom of economic decision-making, enabling micro-entities to take reasonable economic actions against imbalances in market demand and supply, finally transforming market opportunities into substantial economic benefits. Particularly, when the central government gradually loosened the entry constraints into the automobile industry, many provinces and local governments chose the automobile industry as the industry that would be extended priority support and development.

6.2.1 Analysis of the Gross Output Table 6.1 shows the number of manufacturing enterprises over the years in China classified as per automobile products. It can be seen that as far as the number of enterprises is concerned, the 1980s witnessed the most rapid growth with many new enterprises entering the market. For instance, from 1980 to 1990, the number of automobile manufacturing enterprises had increased from 56 to 117 and the number of the engine manufacturing enterprises increased from 33 to 64—both numbers had almost doubled. The interesting feature was that, after this period, the number of many automobile products and manufacturing enterprises remained unchanged, some even assumed a downward trend. This was probably due to the increasing intensity of market competition. While the change in the number of the enterprises is a key indicator, in the absence of measures of the scale of the enterprises, it cannot be used to measure the growth of the automobile industry in China. Indeed, the mergers and acquisitions between enterprises must be taken into consideration. A decrease in the number of enterprises could indicate consolidation within the industry as well as an outcome of the natural process of the survival of the fittest. Tables 6.2 and 6.3 show changes in automobile output over the years in China. The data in the two tables are not completely consistent due to varying data sources and statistical classification. However, it is evident that except for some individual years and products, the quantity of automobile products witnessed rapid growth. Figure 6.1 provides a dynamic snapshot of the changing trends in China’s gross automobile output by consolidating the data in Tables 6.2 and 6.3. This gives us a TOWARD AN INNOVATIVE NATION

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Table 6.1 The number of manufacturing enterprises in China over the years classified as per automobile products (1981–2006) (in units)

Number of Enterprises in Automobiles Year the Country 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

2,379 2,427 2,456 2,727 2,811 2,904 2,422 2,358 2,509 2,596 2,596 2,643 2,555 2,462 2,442 2,479 2,423 2,474 2,426 2,362 2,326 2,401 2,436 2,443 2,536 2,637 2,751

56 57 58 65 82 114 99 116 115 119 117 120 124 124 122 122 122 119 119 118 118 116 117 115 117 117 117

Refitted Automobiles 192 198 202 207 248 314 338 347 386 464 459 486 479 552 536 516 520 540 521 546 542 525 558 551 554 470 470

Relative Automobile/ Supporting Industry for Vehicle Motorcycle Automobiles Motorcycles Engines Parts 24 26 26 34 38 47 50 55 81 65 62 59 72 75 91 109 130 143 102 107 138 148 156 154 147 147 147

33 34 34 50 58 63 58 63 63 63 64 65 63 61 55 61 62 54 56 51 48 54 65 56 48 54 52

2,076 2,112 2,136 2,371 2,385 2,366 1,877 1,777 1,864 1,885 1,894 1,913 1,817 1,650 1,638 1,671 1,589 1,618 1,628 1,540 1,480 1,558 1,540 1,567 1,670 1,849 1,971

— — — — — — 437 515 512 510 523 500 473 363 403 376 289 331 258 256 202 215 186 168 146 173 181

Source: Statistical Data of China, Infobank.cn.

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Table 6.2 Automobile output over the years in China (1980–1999) (in units)

Year

Total Output of Automobiles

Cargo Vehicles

Off-road Vehicles

Passenger Vehicles

Sedans

Vehicle Chassis

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

222,288 175,645 196,304 239,886 316,367 443,377 372,753 472,538 646,951 586,936 509,242 708,820 1,061,721 1,296,778 1,353,368 1,452,697 1,474,905 1,582,628 1,629,026 1,831,596

135,532 108,261 121,789 137,100 179,846 236,934 218,863 299,356 346,000 342,835 269,098 361,310 460,274 623,184 613,152 571,751 537,673 465,098 483,419 581,990

28,034 19,536 18,883 22,510 21,588 25,173 23,739 27,781 36,384 48,934 44,719 54,018 63,373 59,257 72,111 91,766 77,587 59,328 40,901 36,944

— — — 6,211 6,990 11,897 9,189 20,461 50,922 47,639 23,148 42,756 84,551 142,774 193,006 247,430 267,236 317,948 366,553 418,272

5,418 3,428 4,030 6,046 6,010 5,207 12,297 29,865 36,798 28,820 42,409 81,055 162,725 229,697 250,333 325,461 391,099 487,695 507,861 566,105

48,321 39,986 42,541 62,263 85,348 114,069 81,262 92,260 136,234 103,896 90,574 122,873 199,162 171,769 169,106 161,808 167,651 178,644 195,653 228,285

Source: China’s Auto Market Almanac (2000).

better understanding of the dynamics of change. If we consider 1980 as the base year, then China’s gross automobile output grew 32 times. This can be seen from the bar graph in Figure 6.1. This is equivalent to the doubling of the base year gross output each year. However, this increase was not evenly distributed over the years. Obviously, since China’s entry into the WTO at the end of 2001, China’s gross automobile output has been growing rapidly. This indicates that China’s entry into the WTO had great influence on the development of the automobile industry in China. The line graph in Figure 6.1 shows the real growth rate, which is computed as follows: (current year’s output – previous year’s output)/previous year’s output). We can see a very interesting phenomenon here: The growth of the automobile output underwent intense fluctuations before 1994, while the fluctuation moderated during 1994–2004. However, from 2001 to date, the fluctuations have grown larger again. One of the greatest increases TOWARD AN INNOVATIVE NATION

16 0 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

Table 6.3 Automobile output over the years in China (1991–2006) (in units) Year

Total Vehicles

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

708,820 1,061,721 1,296,778 1,353,368 1,452,737 1,474,905 1,582,628 1,627,829 1,831,596 2,068,186 2,341,528 3,253,655 4,443,491 5,070,452 5,707,688 7,279,726

Chassis 122,873 199,162 171,769 169,106 162,713 167,651 178,644 206,325 229,113 252,063 317,946 425,601 381,116 398,351 381,183 442,201

Cargo Vehicles

Passenger Vehicles

452,023 626,414 774,868 785,876 721,822 688,614 659,318 661,701 756,312 751,699 803,076 1,092,546 1,228,157 1,514,869 1,509,893 1,752,973

175,742 272,582 292,213 317,159 405,454 395,192 435,615 459,025 509,179 709,042 834,927 1,068,347 1,177,469 1,243,022 1,430,073 1,657,259

Sedans 81,055 162,725 229,697 250,333 325,461 391,099 487,695 507,103 566,105 607,445 703,525 1,092,762 2,037,865 2,312,561 2,767,722 3,869,494

Source: China’s Auto Market Almanac (2007).

took place during 2001–2002, while a greater decline took place during 2003–2004. The analysis indicates that this was closely related to China’s policy changes regarding its automobile industry. Two major policies concerning the automobile industry were enacted and implemented in 1994 and 2004. Also, China’s entry into the WTO took place at the end of 2001. Corresponding to the rapid growth of the automobile industry, as is shown in Figure 6.2, since the 1990s, the proportion of the gross output value of the automobile industry in China in national industrial gross output value increased dramatically, and attained its peak of 6% in 2003.

6.2.2 Structural Changes The above analysis on the gross output underscores the rapid development of the Chinese automobile industry and provides an overall picture of growth. However, the pace of development of different types of automobiles may differ. Corresponding to Table 6.2, Figure 6.3 shows the changes in the percentage of cargo vehicles, buses, and sedans in the gross output of automobiles during 1991–2006. Although the absolute 30 YEARS OF CHINA’S REFORM STUDIES SERIES

161

8,000,000

60

7,000,000

50 40

6,000,000

30

5,000,000

20 4,000,000 10 3,000,000

0

2,000,000

–10

1,000,000

–20

0

–30

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Automobile Output (in units)

THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

Year Total Automobile Output

Growth Rate

FIGURE 6.1 Changing trends of the automobile gross output in China (1980–2006) Sources: China’s Auto Market Almanac (2000); China’s Auto Industry Almanac (2007).

quantity of the various types of automobiles increased dramatically during this period, the percentage of cargo vehicles declined rapidly from 64% to 24%, the percentage of sedans increased sharply from 11% to 53%, and the percentage of buses fluctuated slightly staying at around 25%. Thus, it can be seen that the rapid growth of automobile output in China in recent years was mostly represented by the rapid growth in sedans. According to China’s Auto Industry Almanac (2007), cargo vehicles can be further subdivided into heavy-duty, medium-duty, light-duty, and mini. Figure 6.4 indicates that the structure of cargo vehicles showed substantial changes over time: the percentage of medium-duty vehicles greatly declined, while that of light-duty and heavy-duty vehicles showed an upward trend year after year. Similarly, passenger vehicles were also classified into large passenger vehicles, medium passenger vehicles, light passenger vehicles, and mini passenger vehicles. Figure 6.5 shows the changes in the output of passenger vehicles in China during 1991–2006. It is evident that light passenger vehicles and mini passenger vehicles have accounted for the majority of passenger vehicles, over 90% after 1994. During 1991–1998, the percentage of light passenger vehicles declined sharply while that of TOWARD AN INNOVATIVE NATION

16 2 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA 7 6

Proportion (%)

5 4 3 2

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

1

Year Proportion of the Total Automobile Industry Output Value in China’s Total Industrial Output Value

FIGURE 6.2 Proportion of the gross output value of China’s automobile industry in national industrial gross output value Source: China’s Auto Industry Almanac (2007).

mini passenger vehicles increased dramatically; following that period, the structure of the passenger vehicle products in China remained unchanged. On the whole, 1998 represented a break point, in the trend. The passenger vehicle products in China underwent rapid growth in gross output prior to that year, and miniaturization emerged as a trend. Thereafter, since 1998, there was growth in the gross output with a basically stable structure. In order to further understand the characteristics of the automobile industry in China, its internal structure needs closer inspection. Table 6.4 shows the percentage of large and medium-sized automobile enterprises in the industry in 2006. Although seen from the number of enterprises, the large and medium-sized accounted for only half of the industry; however, their contribution to the automobile industry in terms of the gross output value, sales output value, and value added exceeded 90%. The number of employees and the technical personnel employed by them was also close to 90% of that of the industry. Thus, the automobile industry in China suffered from a very high degree of industrial concentration. However, our prior policy analysis shows that the concentration was the result of the market entry policy. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

16 3

70 60

Percentage

50 40 30 20

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

10

Year Cargo Vehicles

Passenger Vehicles

Sedans

FIGURE 6.3 Changes in the structure of the automobile industry products in China (1991–2006) Source: China’s Auto Industry Almanac (2007).

Further, Figure 6.6 shows the composition of several above-mentioned major economic indicators of the large and medium-sized enterprises of the automobile industry in China classified on the basis of the types of ownership (enterprises with foreign investment; enterprises funded by Hong Kong, Macao, and Taiwan; and the domestic-funded enterprises). As shown in the figure, the domestically funded enterprises and the enterprises with foreign investment dominate in all indicators, while the overall importance of the enterprises funded by Hong Kong, Macao, and Taiwan can almost be neglected. However, as far as each indicator is concerned, the relative importance of the enterprises with foreign investment and the domestically funded enterprises differs from each other. One obvious rule is that the domestically funded enterprises had higher percentages in terms of the numbers of the enterprises and the employed personnel, which indicates that the enterprises with foreign investment had higher productivity: although they accounted for only one quarter of the number of enterprises, the proportion of their contributions to the automobile industry in China to gross output value, sales output value, and value added exceeded 40%. TOWARD AN INNOVATIVE NATION

16 4 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA 100

Percentage

80

60

40

Heavy-duty

Medium-duty

Light-duty

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

20

Mini

FIGURE 6.4 Structural changes in China’s cargo vehicle segment (1991–2006) Source: China’s Auto Industry Almanac (2007).

100

Percentage

80

60

40

Large Type

Medium Type

Light Type

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

0

1991

20

Mini Type

FIGURE 6.5 Structural changes in China’s passenger vehicles Source: China’s Auto Industry Almanac (2007).

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16 5

Table 6.4 Percentage of large and medium-sized automobile enterprises in the industry (2006)

Number of Enterprises Total Automobile Industry Output Value (RMB 10,000) Automobile Industry Sales Output Value (RMB 10,000) Value of Exports (RMB 10,000) Value Added by the Automobile Industry (RMB 10,000) Total Employees at Year End (person) Number of Technical Personnel in Employees (person)

Proportion of Large and Medium-sized Enterprises in the Industry (%)

Overall Industry

Large and Medium-sized Enterprises

2,751 139,375,342

1,407 128,602,790

51.15 92.27

137,469,137

126,891,302

92.31

12,347,671 33,626,974

11,488,531 30,316,266

93.04 90.15

1,855,096 219,903

1,644,841 1,95,176

88.67 88.76

Source: Consolidated from China’s Auto Industry Almanac (2007).

100

Percentage

80

60

40

20

0

Number Total Automobile of Automobile Industry Sales Enterprises Industry Output Output Value Value Foreign-funded

Value of Exports

Employees Value at Added of the Year End Automobile Industry

Hong Kong-, Macao-, and Taiwan-funded

Number of Technical Personnel

Domestically funded

FIGURE 6.6 Composition of several major economic indicators of the large and medium-sized enterprises of China’s automobile industry classified by ownership type Sources: Statistical Data of China, Infobank.cn

TOWARD AN INNOVATIVE NATION

16 6 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

6.2.3 Imports and Exports of China’s Automobile Industry With an increase in the openness of the Chinese economy, the foreign trade of the automobile industry in China also developed rapidly. Under the open economic system, analyzing the impact of trade on the automobile industry in China will help us grasp the relative advantages of the automobile industry in China. Considering that there were also several varieties of products within the automobile industry, trade analysis would help us understand in which products China has relative advantages. Table 6.5 shows the import statistics of automobile products in China for 1983–2005. It can be seen that the growth in absolute numbers was considerable either in terms of Table 6.5 Import statistics of automobile products in China (1983–2005)

Year

Automobile Population (Units)

Cargo Vehicles (Units)

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

41,575 16,077 25,156 88,743 353,992 150,052 67,182 99,233 85,554 65,430 98,454 210,087 310,099 283,060 158,115 75,863 49,039 40,216 35,192 42,703 71,398 127,513 171,710 175,480 161,324

20,770 7,730 8,445 28,047 11,492 64,570 17,554 14,201 12,587 18,395 18,578 42,005 72,935 68,269 12,037 6,256 7,424 4,373 2,685 3,085 3,138 6,692 9,862 8,078 3,032

Sedans (Units) 1,401 1,101 5,806 21,651 105,775 48,276 30,536 57,433 45,000 34,063 54,009 115,641 180,717 169,995 129,176 57,942 32,019 18,016 19,953 21,620 46,632 70,329 103,017 116,085 76,542

Amount of Automobile Parts (10,000 US Dollars)

Total Amount of Automobile Products (10,000 US Dollars)

3,594 6,080 13,576 16,651 28,848 27,708 1,885 33,913 34,750 34,740 58,263 87,071 97,065 68,794 85,469 107,757 92,800 80,492 100,425 211,281 261,767 231,236 738,430 867,960 768,494

30,536 22,511 43,259 104,821 293,689 195,459 121,431 161,240 132,732 120,293 165,992 353,523 535,143 471,482 257,549 250,018 207,821 205,789 258,018 404,750 470,326 659,985 1,483,964 1,686,001 1,543,392

Source: China’s Auto Industry Almanac (2002; 2006).

30 YEARS OF CHINA’S REFORM STUDIES SERIES

THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

16 7

the import volume of cargo vehicles and sedans or in terms of the gross value of the automobiles. In order to get a clearer picture, Figure 6.7 provides us with the changes in gross volume, the quantities of the cargo vehicles and sedans that China had imported during 1981–2005. The following characteristics can be observed: First, automobile importing in China suffered from periodic fluctuations—three import peaks occurred in 1985, 1993, and 2004. Second, prior to 1984, the imports of cargo vehicles accounted for a major proportion of the gross import volume; however, sedans later became the main automobile products imported into China. Particularly after 1995, the import volume of cargo vehicles accounted for a small proportion of the total volume. All these indicate that sedans began to occupy an increasingly superior position in China’s automobile industry. Of course, while China was importing a large number of automobile products, it also began gradually exporting the automobile products to other countries. Table 6.6 provides the export volumes and value statistics of China’s automobile products during 1990–2005. A comparison with Table 6.5 shows that for the same period of time, the export volumes of Chinese automobiles greatly underperformed the import volumes. 400,000 350,000 300,000

Units

250,000 200,000 150,000 100,000

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

0

1981

50,000

Year Automobile Population

Cargo Vehicles

Sedans

FIGURE 6.7 Gross volume of automobile imports, cargo vehicles, and sedans (1981–2005) Sources: China’s Auto Industry Almanac (2002; 2006).

TOWARD AN INNOVATIVE NATION

16 8 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

Table 6.6 Export volumes and value statistics of the automobile products in China (1990–2005)

Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Total Automobiles (Units) 4,431 4,108 6,375 11,116 18,648 17,747 15,112 14,868 13,627 10,095 27,136 26,073 21,960 45,777 75,999 164,258

Cargo Vehicles (Units)

Sedans (Units)

Automobile Parts (10,000 US Dollars)

3,254 2,253 2,243 4,534 10,234 9,070 6,256 8,297 6,306 3,868 7,093 8,527 10,520 26,142 52,796 100,153

73 789 914 2,866 784 1,413 635 1,073 653 326 523 763 969 2,849 9,335 31,125

8,170 10,138 12,395 17,165 24,580 37,609 38,207 44,718 48,960 70,689 112,540 163,215 166,134 542,035 794,603 988,949

Total Value of Automobile Products (10,000 US Dollars) 12,784 15,284 30,615 42,422 51,520 72,138 81,650 98,784 88,343 118,727 247,854 271,227 335,890 802,642 1,241,912 1,677,028

Source: China’s Auto Industry Almanac (2006).

From the global standpoint, the automobile industry in China is still undeveloped as a whole. Based on the above table, Figure 6.8 illustrates the changes in the gross exports of Chinese automobiles, cargo vehicles, and sedans. As shown in the figure, each indicator fluctuates, but the range of fluctuation is relatively small. However, after China’s entry into the WTO, each indicator trended upward very rapidly. Cargo vehicles have accounted for the majority of exports by volume, which is the exact opposite of the imports shown in Figure 6.7. Therefore, with regard to the different automobile segments, China’s comparative advantage lies in cargo vehicles. If we subtract the data in Table 6.6 from the corresponding data in Table 6.5, we arrive at Table 6.7—the net export volume and value statistics for automobile products in China. The negative sign in the table is indicative of imports exceeding exports. We have highlighted the positive figures to make them easier to spot. As is shown in Figure 6.9, in the time period considered, China was mainly a net importer of automobile products. However, the situation has changed over time. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

16 9

180,000 160,000 140,000

Units

120,000 100,000 80,000 60,000 40,000

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

1990

20,000

Year Total Automobiles

Cargo Vehicles

Sedans

FIGURE 6.8 Gross export volumes of Chinese automobiles, cargo vehicles, and sedans (1990–2005)

From 1996 onward, China shifted from being a net importer of cargo vehicles to a net exporter country, with the net export volume assuming a strong upward trend. This can also be seen in the above two figures: Since 1995, China has basically been a net importer of sedans with an obvious fluctuating trend in quantity, this being mainly caused by fluctuations in the import volume. The above analysis has further verified our earlier conclusion: As far as the automobile industry itself is concerned, China has a greater relative advantage in terms of cargo vehicles. In particular, it should be pointed out that by 2005, the net import volume of sedans declined dramatically (from 106,750 units to 45,417 units) and the net export volume of cargo vehicles increased rapidly—for the first time, China had become a net exporter of automobiles in terms of gross volumes. On the basis of the data mentioned above, we may analyze the proportion of automobile parts in the imports and exports of the automobile products. As shown in Figure 6.10, in general, during 1981–2005, the ratio of the imported number of automobile parts to the imported number of automobile products in China attained an upward trend year after year, from 10% in 1981 to 50% in 2005, whereas the ratio of the exported number of automobile parts to the exported number of automobile products fluctuated TOWARD AN INNOVATIVE NATION

170 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

Table 6.7 Net export volume and value statistics of China’s automobile products (1990–2005)

Year

Total Automobiles (units)

Cargo Vehicles (units)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

−60,999 −94,346 −203,712 −298,983 −264,412 −140,368 −60,751 −34,171 −26,589 −25,097 −15,567 −45,325 −105,553 −125,933 −99,481 2,934

−15,141 −1,6325 −39,762 −68,401 −58,035 −2,967 0 873 1,933 1,183 4,008 5,389 3,828 16,280 44,718 97,121

Sedans (units)

Automobile Parts (10,000 US Dollars)

Total Amount of Automobile Products (10,000 US Dollars)

−33,990 −53,220 −114,727 −177,851 −169,211 −127,763 −57,307 −30,946 −17,363 −19,627 −21,097 −45,869 −69,360 −100,168 −106,750 −45,417

−26,570 −48,125 −74,676 −79,900 −44,214 −47,860 −69,550 −48,082 −31,532 −29,736 −98,741 −98,552 −65,102 −196,395 −73,357 220,455

−107,509 −150,708 −322,908 −492,721 −419,962 −185,411 −168,368 −109,037 −117,446 −139,291 −156,896 −199,099 −324,095 −681,322 −444,089 133,636

Source: China’s Auto Industry Almanac (2006).

substantially between 40% and 70% without any obvious upward or downward trend. Therefore, if automobile manufacturing and automobile parts manufacturing are regarded as two different types of products, then China has a relative advantage in terms of automobile parts. Indeed, while manufacturing products as complicated as automobiles, the capability of integrating processes is critical. With regard to this aspect, there was a huge gap between the Chinese enterprises and the multinational corporations. It should be noted that after 1994, the percentage of the automobile parts imported, accounting for the automobile products imported, saw constant growth with some fluctuations. According to the policy analysis that we will cover in later sections, this was related to the great expansion of the quantity and capacity of the automobile manufacturing enterprises, including the foreign-invested and the Sino-foreign invested enterprises, toward manufacturing automobiles in their entirety. We can find a very interesting substitutive phenomenon by comparing Figures 6.10 and 6.7: As China’s import volumes declined, the relative ratio of the automobile parts imported into China increased. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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171

150,000 100,000

Net Export Volume

50,000 0 –50,000 –100,000 –150,000 –200,000 –250,000

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

–350,000

1990

–300,000

Year Total Automobiles

Cargo Vehicles

Sedans

FIGURE 6.9 Net export volumes of China’s automobile products (1990–2005) Source: China’s Auto Industry Almanac (2006).

6.2.4 Main Enterprises in China’s Automobile Market According to Table 6.1 and Figure 6.1, the number of automobile manufacturing enterprises in China has not changed much in recent years; however, the quantity of the automobile products has increased sharply. Obviously, this is mainly due to the intensive expansion of existing automobile capacity. However, relative to the existing market players, new entrants do not have great influence on the overall market output. Table 6.8 shows the 2006 industrial output and the distribution of large and medium-sized automobile enterprises in China. There were 89 large and mediumsized automobile enterprises in China; however, the output share of the top three automobile enterprises were heavily skewed in their favor—FAW accounted for 18.1% and Shanghai Automobile Works and Dongfeng Automobile Works accounted for about 15% each. Their nearest competitor, the fourth-ranking Chang’an Group, only accounted for 4.44%. The automobile industry in China thus has a very high industry concentration ratio: the concentration ratio for the top three manufacturers was 47.52%; for four manufacturers, 51.96%; for eight, 63.22%, while for sixteen manufacturers, it was 74.12%. TOWARD AN INNOVATIVE NATION

17 2 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA 80 70

Proportion

60 50 40 30 20

0

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

10

Year Proportion of Automobile Parts in Automobile Products (Import) Proportion of Automobile Parts in Automobile Products (Export)

FIGURE 6.10 Percentage of automobile parts in imports and exports of automobile products Source: China’s Auto Industry Almanac (2006).

Table 6.8 Output of the large and medium-sized automobile enterprises in China (2006)

Industry Ranking

Name of the Enterprise

1

China FAW Group Corporation Shanghai Automotive Industry Corporation (Group) Dongfeng Motor Corporation China Auto Co., Ltd. Guangzhou Honda Automobile Co., Ltd. Beijing Hyundai Motor Company

2

3 4 5 6

Automobile Industry Output Value (RMB 10,000)

Proportion in Total Industrial Output Value (%)

17,856,538

18.13

144,94,177

14.72

14,450,191

14.67

4,370,097 4,106,922

4.44 4.17

2,923,543

2.97 continued

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17 3

Table 6.8 (continued) Industry Ranking

Name of the Enterprise

7

Beiqi Foton Motor Co., Ltd. China National Heavy Duty Truck Group Corp., Ltd. Weichai Power Co., Ltd. Anhui Jianghuai Automobile Co., Ltd. Chery Automobile Co., Ltd. Jin Bei Motor Co., Ltd. Guangzhou Toyota Motor Co., Ltd. Harbin Hafei Automobile Industry Group Company Ltd. Jiangling Motors Co., Ltd. Nanjing Automobile (Group) Corporation Shaanxi Automobile Group Co., Ltd. Zhejiang Geely International Corporation Jiangmen Dachangjiang Group Co., Ltd. Zongshen Industrial Group Co., Ltd. Guangxi Yuchai Machinery Corporation Lifan Industry (Group) Co., Ltd Other 68 Companies

8

9 10 11 12 13 14

15 16 17 18

19

20 21

22 23–89

Source: China’s Auto Industry Almanac (2007).

TOWARD AN INNOVATIVE NATION

Automobile Industry Output Value (RMB 10,000)

Proportion in Total Industrial Output Value (%)

2,069,059

2.10

1,992,724

2.02

1,782,478

1.81

1,527,291

1.55

1,517,626

1.54

1,357,966

1.38

1,195,614

1.21

1,131,004

1.15

1,126,214

1.14

1,100,608

1.12

961,166

0.98

902,564

0.92

892,991

0.91

876,820

0.89

845,310

0.86

738,135

0.75

20,264,267

20.58

174 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

. China’s Automobile Industrial Policies and their Effects The automobile industry is one of the most important industries in developed countries. All world economic powers are automobile powers; in a sense, the extent of the development of the automobile industry serves as a proxy for the industrialization level, economic power, and the technological innovation capacity of a country. Since it is of such significance to the national economy, the Chinese government has paid particular attention to the development of the automobile industry. The State had issued some general policies relating to the automobile industry, represented in the “Outline of State Industrial Policies for the 1990s.” The State had also enacted and implemented a series of special policies related to the automobile industry. Policies of great influence include the policy of “Three Large Automobile Manufacturers and Th ree Small Automobile Manufacturers” (abbreviated as Th ree Large and Th ree Small), which was put forth during the Bei Dai He Conference in 1987. Later, the “Policy of the Automobile Industry” was enacted and implemented in 1994, and the “Policy of the Development of the Automobile Industry” was enacted and implemented in 2004.

6.3.1 Industrial Structure Stemming from the “Three Large and Three Small” Policy In the mid-1980s, the Development Research Center of the State Council, the National Planning Committee, and the National Economic Commission organized two meetings successively—in Shi Yan (the location of SAW) and Changchun (the location of FAW)—of senior-level officials to wrangle out a policy for the development of China’s automobile industry. During these meetings, they agreed upon the idea that China should develop a sedan industry, such that each family would own a sedan. The participants realized that China’s development of a sedan car industry would be an uphill task as it was acknowledged that truck manufacturing was likened to studying at the primary school level and sedan manufacturing, at the university level. The difficulty was expressed in the idea that small works manufacture large vehicles and large works manufacture small vehicles. Regarding the development strategy of the automobile industry, the meetings rejected the recommendation of beginning from scratch. It was decided that the sedan industry would rely on the existing automobile industry. For the first time, the Chinese government publicly acknowledged in 1986 that the automobile industry was to be the pillar for the development of the national economy. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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17 5

According to the “The Seventh Five-Year Plan of the People’s Republic of China for the Development of the National Economy and Society (1986–1990),” the State accorded the automobile manufacturing industry the status of being the pillar of the national economy that would follow the ideals of high standards, scale manufacturing, specialization, and joint development, which would be led by the key enterprises and the establishment of the automobile manufacturing bases, which included the Changchun FAW, Hubei SAW, Ji’nan Heavy Duty Automobile Works, and the military industry departments. Also, there would a focus on rebuilding and expanding a group of manufacturing enterprises specializing in the automobile components and parts manufacturing with advanced technology.” In August 1987, the State Council held a meeting in Bei Dai He, confirming the development of three locations to manufacture sedan cars, which included the First Automobile Works, Second Automobile Works, and the Shanghai Automobile Works. It further confirmed that sedan manufacturing should follow the ideals of high standards, scale manufacturing, and specialization, focusing on automobile parts and components manufacturing and accelerating the development of related industries to improve the localization rate. In 1988, the State Council clearly put forth the strategy of “Three Large and Three Small” for the structure of sedan manufacturing in the “Circular about Strictly Controlling the Locations for Sedan Cars Manufacturing.” The State would only support three large manufacturing bases—FAW, SAW, and Shanghai Automobile Works (the “three large”)—and three small manufacturing locations, Beijing, Tianjin, and Guangzhou (the “three small”). There would be no approval of other manufacturing locations, with the only exception being Alto and Yunque as they belonged to the military system. In March 1989, the State issued the “Key Points of the Industrial Policy” and listed the sedan manufacturing project on the National Key Support Project. In 1990, the State Council issued the “Outline of State Industrial Policies for the 1990s” in order to speed up the development of the mechanical industry, electronics industry, the petro-chemical industry, the automobile manufacturing industry, and the construction industry, making them pillars of the national economy. It held that the automobile industry should operate in a few areas but produce output on a large scale to garner a large market share in order to shore up their domestic market share and international competency. In order to carry out this target, the “Outline of State Industrial Policies for the 1990s” also developed an economic scale criterion for fixed asset investment projects. In the first batch of 22 control projects, there were seven projects relevant to the automobile industry, including sedan cars, light-duty cargo vehicles, light passenger vehicles, heavy passenger vehicles, gasoline engines, diesel engines, and motorcycles. TOWARD AN INNOVATIVE NATION

176 THE DEVELOPMENT OF THE AUTOMOTIVE INDUSTRY IN CHINA

Table 6.9 Outline of the State industrial policies for the 1990s concerning the economic scale for the fixed asset investment projects of the automobile industry Serial No.

Product Name

Economic Scale of the Construction Project (Annual Production Capacity)

15

Sedans

Newly constructed, renovated, and expanded projects, and technological updating projects for engine displacements under 1600cc: 150,000 units and above

16

Light-duty Cargo Vehicles

Newly constructed, renovated, and expanded projects, and technological updating projects: 100,000 units and above

17

Light Passenger Vehicles

Newly constructed, renovated, and expanded projects, and technological updating projects: 50,000 units and above

18

Heavy-duty Trucks

19

Gasoline Vehicle Engines

20

Diesel Vehicle Engines

21

Motorcycles

Newly constructed, renovated, and expanded projects, and technological updating projects: 10,000 units and above Newly constructed, renovated, and expanded projects, and technological updating projects for engine displacements under 2500 cc: 150,000 units and above Newly constructed, renovated, and expanded projects, and technological updating projects for engine displacements under 3500 cc: 100,000 units and above Newly constructed, renovated, and expanded projects, and technological updating projects for engine displacements under 150 cc: 200,000 units and above

Remarks Newly constructed, renovated, and expanded projects, and technological updating projects should be approved by the State Council. Newly constructed, renovated, and expanded projects, and technological updating projects should be approved by the State Council. Newly constructed, renovated, and expanded projects, and technological updating projects should be approved by the State Council.

The State specified the minimum output for each project, and new manufacturing, renovation, and expansion projects, as well as technical reforms relevant to sedans, light duty cargo vehicles, and light passenger vehicles, were to be submitted to and approved by the State Council. It could be seen that the relevant departments were attempting to strictly control and maintain the automobile industry structure in line with the “three large and three small” that were confirmed earlier through the market entry policy when they were developing the “Outline of State Industrial Policies for the 1990s”. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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6.3.2 China’s Automobile Industrial Policy (1994) Based on the “Outline of State Industrial Policies for the 1990s,” the Chinese government issued and implemented the “Industrial Policy for China’s Automobile Industry” in 1994, endeavoring to build the automobile industry (including the motorcycle industry) into a pillar of the national economy as soon as possible. This was done by addressing the issues of decentralized investment, overly small-scale production, and the low-quality products, while enhancing the development capability of the enterprises, improving product quality and technical equipment levels, and promoting the rationalization of industrial organization and realizing economies of scale. As far as we know, this was the first time the Chinese government developed specific industrial policies for a specific industry, underscoring the emphasis that the government placed on the automobile industry. China’s automobile industrial policy summarized the issues that plagued China’s automobile industry as follows: too many manufacturing locations with decentralized investment, disordered project approvals, introduction of redundant low-level products, slow construction of designated factories, and localization (basically, production was decentralized, disordered, low-level, and slow). In order to address the above issues, the Industrial Policy for China’s Automobile Industry attempted to promote the development of the following: automobile parts and components: the key parts and components of sedans; passenger vehicles (Category M): economic sedans, special chassis for large and medium passenger cars; cargo vehicles (Category N): special vehicles, new types of engines; motorcycles (Category L): engines; technical equipment: molds; and basic parts: casting and forging of rough pieces. The policy outlined several policies, which included the industrial organization policy, industrial technology policy, investment and financing policies, utilizing foreign capital policy, import and export administration policies, localization policy, consumption and price policies, relevant industries and social security policies, industry policy, planning and project management policies, and some other regulations. Next, we review the industrial organization policy, the policy of utilizing foreign capital, and the policy of localization because these policies had the greatest influence on the development of China’s automobile industry. Policy of industrial organization Industrial organization policy was designed to promote enterprise grouping, enhance production specialization of the automobile industry, and realize high investment concentration and industrial reorganization of the automobile industry in a staged manner. Specifically, during the Eighth FiveYear Planning period, projects for the entire vehicle as well as parts and components that had been approved by the State were supported and put into production as a TOWARD AN INNOVATIVE NATION

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priority. Prior to 2000, support was also forthcoming for two to three automobile manufacturing enterprises to become large-sized enterprises with considerable power, six to seven automobile manufacturing enterprises to become the backbone of domestic enterprises, and eight to ten motorcycle manufacturing enterprises to became key enterprises oriented toward the domestic and overseas market. Against this backdrop, a production system with fewer locations and larger output emerged, with market competition among the few large-sized enterprises that enabled the domestic market share of the three largest companies to exceed 70%. Meanwhile, large-sized enterprises and backbone enterprises were guided to make win-win combinations in the hope that the three large automobile enterprises and three to four large motorcycle enterprises would attain high levels of international competency before 2010 and that independent exploration, production, sales, and development would be realized along with the ability to compete internationally. In order to achieve the above-mentioned goals quickly, the Industrial Policy of China’s Automobile Industry developed preferential policies that were supported by the State for enterprises or enterprise groups. If they were to develop the above-mentioned automobile products by new manufacturing, reformation, and expansion, they would enjoy several preferential policies from 1996 onward. They would be exempted from fixed asset investment regulation taxes; priority would be given to the issuance and listing of their stocks and bonds; active support from the banks would be given in terms of loans; priority would be given when utilizing overseas capital; and policy-related loans would be extended for economy class sedans and the key components of sedans including the molds, casting, and forging projects. The finance companies within the enterprises groups could also expand their business scope with the approval of the relevant departments of the State. Undoubtedly, the enterprises or enterprises groups supported so generously by the State had gained competitive advantages due to the above-mentioned preferential policies, which objectively intensified the market concentration of China’s automobile industry. However, the market entry policy proved to be most influential with regard to the market structure of China’s automobile industry. The policy fully reaffirmed the market entry policy stated in the “Outline of State Industrial Policies for the 1990s,” requiring that all automobile products and entire vehicle and engine manufacturing projects (including the Sino-foreign funded and cooperative projects) newly approved by the State were in principle to be subject to the economic scale criterion specified in Figure 6.9. Practically, the market entry policy restricted the amount of new market entrants by administrative approval measures that maintained the monopoly status of the original enterprises. This exerted the most significant influence on the development of China’s automotive industry later. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Policy of utilizing foreign capital We can see from Figure 6.6 that in the early 1990s, the market demand for sedans in China increased greatly. However, the capacity and quality of the domestically produced sedans significantly lagged behind, resulting in a great increase in the volume of sedan imports. In order to quickly realize import substitution, the “Industrial Policy of China’s Automobile Industry” encouraged the automobile industrial enterprises to develop the Chinese automobile industry using foreign capital. It required the State to guide automobile industrial enterprises into taking full advantage of domestic and foreign capital in order to expand and exploit the domestic and international markets. Enterprises were encouraged to develop by adopting a high-volume and a multi-specification production approach, aiming to make gross automobile output satisfy over 90% of the domestic market demand by 2000, with the output of sedans reaching more than half of the gross automobile output. This would basically satisfy domestic demand. For the output of motorcycles, it was necessary that the export volume level was attained, conditional on first satisfying the domestic demand. In order to introduce advanced technologies from other countries, the “Industrial Policy of China’s Automobile Industry” outlined constraints regarding the qualification of foreign investors in setting up joint ventures or contractual joint ventures. They were required to own independent product patent and trademark rights, product development technology and manufacturing technology, independent international sales channels, and possess sufficient financing capability. The Sino-Foreign Equity Joint Ventures and Sino-Foreign Cooperative Joint Ventures were required to manufacture products representing the international technological level of the 1990s, and the companies were to independently address the balance of income and expenditure in foreign exchange by using the export of the products manufactured by the enterprises themselves as the main business. Companies were required to establish in-house technology research and development organizations that were capable of developing substitution products. Under the same conditions, the Cooperative Joint Ventures were to prioritize home-made components and parts. Meanwhile, to ensure that the control rights lay with the Chinese party, the percentage of the share of the Chinese party in the SinoForeign Equity Joint Venture and Sino-Foreign Cooperative Joint Venture was to be no less than 50%. Localization policy In order to promote the localization of automobile products, the “Industrial Policy of China’s Automobile Industry” stated a special localization policy (localization refers to production in the People’s Republic of China). The automobile industry enterprises should not import bulk parts for assembly and production by SKD (semi-knocked down) and CKD (completely knocked down) units. After product manufacturing technologies were introduced, the automobile industry enterprises were to TOWARD AN INNOVATIVE NATION

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carry out product localization. The “Industrial Policy of China’s Automobile Industry” also encouraged the localization of automobile products by preferential tariff policies. Specifically, different preferential tax rates could be enjoyed when the following criteria for localization were satisfied: the localization rate of the products by importing entire vehicle technology of passenger vehicles reaches 40%, 60%, and 80%; the localization rate of the products by importing the entire vehicle technology of the cargo vehicles and motorcycles reaches 50%, 70%, and 80%; and the localization rate of the products by importing assembly and key components and parts technology of the cars and motorcycles reaches 50%, 70%, and 90%.

6.3.3 Development Policy of the Automobile Industry (2004) Since the enactment and implementation of the “Industrial Policy of China’s Automobile Industry,” the Chinese automobile industry has progressed enormously. There were, however, issues that had long been criticized that remained almost unchanged, such as the industry being decentralized, disordered, and inefficient; weak in independent research and development; and facing an unfavorable consumption environment. Also, the original industrial policies contained policies inconsistent with the WTO’s regulations. Taking this into consideration, in May 2005, the National Development and Reform Commission abolished the “Industrial Policy of China’s Automobile Industry” that had been in place for a decade and replaced it with the new “Policy of the Development of the Automobile Industry.” As compared to the original industrial policy, the major revisions to the “Policy of the Development of the Automobile Industry” included the cancellation of commitments inconsistent with the WTO’s regulations, such as the requirement of foreign exchange balance, localization proportions, and export performance. It greatly reduced administrative approvals, emphasized the reliance on laws, regulations, and technical criteria, and led the industry to sound development. It put forward the strategy of branding and encouraged the development of products with independently developed and owned intellectual property rights, guided the merger and restructuring of existing automobile manufacturing enterprises, and promoted the enlargement and strengthening of domestic automobile enterprises groups. The policy required that automobile manufacturing enterprises focus on brand building through sales and service systems in order to eliminate consumers’ future concerns. Looking to the future, it encouraged the development of energy-saving and environment-friendly automobiles and alternative fuel cars and proposed advice on creating a better consumption environment. Similar to the “Industrial Policy of China’s Automobile Industry,” the “Policy on the Development of the Automobile Industry” focused on market concentration—the major target for the adjustment of the industrial structure. However, it incorporated 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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some more specific policy measures in order to increase the competitive advantages of large-sized automobile enterprises. According to the policy, automobile enterprises could be deemed as large-sized automobile enterprises if they were characterized by unified planning, independent product development, independent product trademarks and brands, and integrated sales and service management systems; if the domestic market share of automobile products manufactured by their core enterprises and sole subsidiaries, share-holding subsidiaries, and the Sinoforeign equity joint venture were over 15%; or if their annual sales revenue of entire automobiles accounted for no less than 15% of the sales revenue of the entire automobiles of the overall industry. While the long and medium-term development plans of large-sized automobile enterprises can be implemented on approval by the National Development and Reform Commission, other enterprises were subject to the State Council for approval and implementation issues. The issuance of the criterion of 5% was to promote mergers and restructuring among the Chinese automobile enterprises and to realize economies of scale. However, it is interesting to note that when the “Policy of the Development of the Automobile Industry” was announced, there were only three enterprises that satisfied or almost satisfied the 15% criterion; namely, the Shanghai Automobile Works, the First Automobile Works, and the Dong Feng Group. Another key policy target for the “Policy of the Development of the Automobile Industry” was to prevent the automobile industry from over-heating, which was addressed by two aspects of the policy measures. First, entry barriers for automobile projects were further elevated. Under the new record-keeping and sanction system (the former approval system), the total project investment amount for investment projects of newly established automobile manufacturing enterprises could be no less than RMB 2 billion, of which the equity funds could be no less than RMB 800 million and product research and development organizations needed to be established with investment of no less than RMB 500 million. The investment projects of newly established enterprises for manufacturing passenger vehicles and heavy-duty cargo vehicles had to include engine manufacturing support for the entire automobile. The total project investment of newly established enterprises for the manufacturing of automobile engines could be no less than RMB 1.5 billion, of which equity funds could be no less than RMB 500 million. Again, research and development organizations needed to be established and product quality levels were to satisfy the increasingly stringent mandatory requirements of the national technical code. Regarding the scale of production, the production capacity of the newly constructed heavy duty vehicle projects could be no less than 10,000 units, while that of the four-cylinder engine passenger vehicles should be no less than 50,000 units; and the capacity of six-cylinder engine passenger vehicles could be no less than 30,000 units. The second policy to decrease over-heating was the establishment TOWARD AN INNOVATIVE NATION

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of the withdrawal system for the entire vehicle automobile and motorcycle industries. Disclosure by the manufacturing enterprises when they failed to sustain regular production and operations was called for. The production qualification could not be transferred to non-automobile and motorcycle manufacturing enterprises or individuals. The State encouraged such enterprises to be transformed into producers of special vehicles, automobile parts and components, or to conduct asset restructuring with other automobile entire vehicle manufacturing enterprises. It is clear that such a withdrawal system was essentially an entry barrier, restricting other industrial capital from flowing into the automobile industry.

6.3.4 Analysis of the Effects of the Automobile Industrial Policies As shown above, the Chinese automobile industry has progressed enormously after the reforms and opening up; however, this success was not mirrored in China’s automobile industrial policies. Although the Chinese automobile industrial policies exerted significant influence on the development of the automobile industry in China, in hindsight, it was basically a failure. The biggest drawback of the Chinese automobile industrial policy was that it used administrative measures instead of the market mechanism, forcibly imitating the industrial structure of countries whose industries evolved after years of market competition and considering the outcome of all the development as development measures themselves. Some departments overemphasized industry concentration and economies of scale when formulating China’s automobile industrial policies. They restricted market entry and competition by the abovementioned market entry policies, particularly restricting privately operated capital from entering the market, which finally became the tools to protect vested interest groups. The theoretical basis for considering the enhancement of industrial concentration as a policy target was that the automobile industry had obvious economies of scale; in order to reduce the average cost of production and marketing, production was to be concentrated in only a few enterprises. Evidence for such a theory is forthcoming when one considers today’s leading automobile enterprises; all have annual production and sales scales of one million cars or more. The resulting economies of scale are the main source for their competitive advantage in the market. In comparison, Chinese automobile enterprises operate at a smaller scale and at a lower technological and specialization level. Since there are no economies of scale, the average manufacturing cost for each car is very high and the profitability is low, further constraining research and development and technological innovation. Consequently, the Chinese government put forth the policy requiring high level, large volumes, and specialization, trying to enhance the scale of production and market concentration through market access policies. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Industrial concentration is usually the result of market competition at the enterprise level, instead of a policy target pursued in advance. Indeed, it does not matter whether we examine the modern American, Japanese, Korean, or European automobile industries—the production and sales of automobile products in all these countries are highly concentrated in a few multinational enterprises. However, we should note that these are natural outcomes brought about by automobile enterprises facing domestic and international competition. Actually, all the automobile industries in developed countries have experienced a stage with excessive competition early in their development, and the existing multinational corporations are the winners that have emerged from this severe market competition. Consider Japan for instance. The Ministry of International Trade and Industry (MITI) of Japan has always facilitated mergers among enterprises in order to enhance the competitiveness of the Japanese industry worldwide and has even restricted excessive competition among domestic enterprises. However, since Japan’s industry is export-oriented, its automobiles have already faced severe international competition. In comparison, the original intention for the development of the Chinese automobile industry was import substitution rather than export promotion. Hence, restricting domestic competition has made the Chinese automobile industry lose out on a fair competitive market environment between economic entities. What is worse is that the market monopolies may turn into groups with vested interests and administrative monopolies. They further enhance such administrative monopolies through political lobbying. Both the automobile industrial policies of China, in 1994 and in 2004, are consistent in the policy of excluding new competitors by reducing market access. Such an approach is not difficult to understand considering the enactment process of the Chinese industrial policies. Consider the “three large and three small” as an example. All the enterprises there were typical state-owned enterprises at first. Any fixed asset investment they carried out involved national finances; therefore, the industrial administrative departments would take various measures when developing industrial policy to prevent potential losses to national financial investment caused by redundant investment and vicious competition. However, irrespective of whether viewed theoretically or practically, this was more of a loss than a gain. Although administrative monopoly measures may improve market concentration and help bring the economies of scale into play, it is at the cost of high prices, low outputs, and huge social welfare losses. More seriously, market monopolies gain enormous yields by simply exercising their monopoly power as they have no potential competitive threats, and this diminishes the drive for technological innovation. We believe that the Chinese automobile industry will eventually witness an increase in concentration, and production will become concentrated in enterprises with the highest production efficiency. However, no individual or institution—including the TOWARD AN INNOVATIVE NATION

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government—is capable of knowing in advance which enterprises are efficient. As compared to the planned system, the biggest advantage of the market system may lie in the survival of the fittest paradigm to address the issues of information asymmetry and uncertain options. Only entrepreneurial, innovative, and organized enterprises can survive and grow under severe market competition. Due to this, when the State enacts the industrial policy, it should provide a fair competitive environment instead of simply selecting its market winners. Evidence proves that such an approach is nothing but monopoly protectionism that leads to backwardness. Lacking independently developed and owned brands and the capacity to innovate is a major weakness of the Chinese automobile industry. Consider the situation of “decentralized investment, excessively small production scale, and backward products,” in accordance with the guidelines of “high level, large volume, and specialization.” The Chinese automobile industrial policy set a development strategy of introducing a market for technology, by introducing advanced products and technology from other countries by Sino-foreign joint ventures. This in turn facilitated technological assimilation through localization policies and ultimately achieved the target of independent innovation. On the one hand, as a developing country, it is both necessary and economical to introduce and absorb advanced foreign technology to develop an independent automobile industry. On the other hand, the huge automobile market in China is attracting foreign automobile enterprises. All these improved the success potential of the market for technology strategy. Unfortunately, after years of joint venture practices, this potential failed to materialize. The Chinese automobile enterprises involved in joint ventures not only failed to develop a technologically accumulated platform but also lost their desire and motivation for independent technological innovation. The Chinese automobile industry policy is definitely to be blamed for these results. Policymakers have long regarded large-sized automobile enterprises as a possibility, expecting the Chinese automobile industry to become bigger and to develop independently via joint ventures. There are two necessary preconditions for the market for technology strategy to be effective. First, foreign enterprises need to be willing to enter China and believe that transferring technology to Chinese enterprises is in their best interests. Second, Chinese enterprises must possess the incentives and platforms for technology assimilation. The following analysis shows that under industrial policies that exclude competition and protect monopolies, these two conditions conflict and cannot be satisfied concomitantly. The automobile industrial policy excluded potential entrants through the administrative approval approach. Its purpose was to allow the designated large-sized automobile enterprises (such as the First Automotive Works, Shanghai Automotive Works, and Dong Feng Group) to go unchallenged with their market monopoly 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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positions. It is deemed that this policy measure killed two birds with one stone. On the one hand, production concentration helps market monopolies to quickly attain a production scale sufficient for the development of automobile products. On the other hand, the huge profits generated by the monopoly not only attract high-level foreign automobile enterprises to enter China to undertake joint ventures but also help the Chinese enterprises participating in the joint venture/cooperative enterprises to accumulate capital that is sufficient for technological development. From the industrial policymakers’ point of view, independent development of automobile products would have sounded like pie in the sky in the absence of sufficient scale of production. For example, in the words of the leaders of a Chinese automobile enterprise (who had great influence on the development of policy), “The automobile industry is a scale business; the research and development activities are possible only when a certain scale is reached; manufacturing 80 thousand or 100 thousand units is definitely different from manufacturing 1 million units. Now, domestic enterprises are not capable of independent development. The key reason is scale, which the automobile industry needs to sustain itself. Currently, the development of the Chinese automobile industry is addressing the issue of localization by an assimilation approach, and this is the status quo of China.” Apart from the access policy, the automobile industry policy specified the proportions in joint ventures and the localization rate. In order to allow Chinese enterprises to obtain advanced technology and operational control rights, the automobile industrial policy required that the share of the Chinese enterprise in a joint venture or cooperative enterprise should be no less than 50%. In order to force foreign enterprises to transfer technology to the Chinese enterprises and in order to make Chinese enterprises willing to assimilate the technology introduced, the State had developed a preferential tax rate for import tariffs on the basis of the localization rate of the automobile industrial products. However, there was a huge gap between the actual effect of the policy and the expectations of the policymakers. The Chinese enterprises participating in the joint ventures had two basic channels to develop new products: one was to introduce new products from other countries and the other was to develop independently. Obviously, in joint ventures, the former choice entailed lower risk and higher reward; therefore, the Chinese automobile industry unanimously chose the route of the joint venture. After they accumulated a huge amount of profit, their motivation to innovate diminished. They assumed that independent development was a high-risk strategy and unnecessary. However, as in the case of any complicated product, the key technological capacity for the production design and integration of the automobiles could only be obtained from “learning while doing.” Therefore, although there have been dazzling new products introduced by various joint ventures, when Chinese enterprises lost their platform and TOWARD AN INNOVATIVE NATION

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motivation for independent development due to the joint ventures. Consequently, their independent capacity to innovate has not improved. The localization rate policy has had some positive effects. In reality, the upstream and downstream chain effect is an important channel for technology transfer from foreign-funded enterprises. As a complicated product, automobiles include many components. Under the policy of localization, foreign-funded enterprises had to buy local automobile parts in order to make their products conform to the technical criteria and quality for the entire vehicle. This forced them to transfer the technology to local enterprises. Therefore, if there are any achievements of the market for technology strategy, it is that it obviously promoted the development of a Chinese automobile parts and components industry. However, the effect of the policy of localization was restricted by two aspects. First, as per China’s automobile industrial policy, as long as the automobile parts were manufactured within China, they satisfied the requirements of the localization rate. This meant that foreign-funded enterprises could avoid technology spillover by producing on their own within China. Second, the policy of the localization rate violated the WTO’s regulations and has been removed in the new automobile industrial policy.

. Conclusion Since the reforms and opening up, the Chinese automobile industry has become a pillar of the national economy. It is anticipated that the automobile industry will remain the main force in driving the rapid development of the Chinese economy, as it has the characteristics of high industrial correlation, extensive employment coverage, and strong capital accumulation capability. On the other hand, the rapid development of other industries, the improvement in people’s standard of living, and the constant improvement in infrastructure will provide few opportunities for the further development of the Chinese automobile industry. However, there are still some issues that need to be addressed within the Chinese automobile industry—blind investment and low-level redundant construction, a decentralized and disordered organizational structure, weak capacity for independent development, incomplete automobile consumption, and automobile use effects on the environment. In order to tackle these issues, the Chinese government developed the automobile industrial policy to regulate and guide sound development, in which market access policies and joint venture policies exerted a critical influence. Originally, the Chinese government intended to improve the market concentration of the Chinese automobile industry and thus enable the Chinese automobile enterprises to grow stronger by excluding potential entrants and restructuring enterprises. Also, the Chinese government tried to improve the technological level 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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and innovative capacity of Chinese automobile enterprises by introducing the market for technology strategy. However, things went contrary to the outcome envisioned by the government. The automobile industrial policy eventually became an instrument of monopoly power and stunted the growth of this infant industry. The Chinese automobile enterprises gradually lost their ability and motivation to innovate independently during the course of their joint ventures with foreign automobile manufacturers. Decentralization, disorderliness, and inefficiencies characterize the Chinese automobile industry; however, this should not be an excuse for excluding competition or creating monopolies. On the contrary, in order to promote the sound development of the automobile industry, the Chinese government should encourage competition and allow and encourage access to private capital. The dominance of state-owned capital in the automobile industry resulted in industrial policymakers restricting excessive competition to avoid losses to national financial investment projects. In this sense, encouraging private capital and other industrial capital to flow into the automobile industry will improve the enactment of industrial policies. We believe that in order to promote the sound development of the Chinese automobile industry, the Chinese government should focus on constructing a market environment with fair competition instead of selectively protecting market monopolies. To some extent, excessive competition is a necessary precondition for the sound development of an industry. Only in this manner, can the market select enterprises that possess the talent for entrepreneurship, have the capacity for innovation, and are the future of the Chinese automobile industry.

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Intellectual Property Rights: Barriers Faced by Chinese Enterprises Seeking an Entry into the Global Marketplace Under the WTO framework, especially the framework of the “Agreement on Trade-related Aspects of Intellectual Property Rights” (TRIPS), tariff barriers are being reduced. However, intellectual property rights (especially patents) being used as barriers are increasing, making them a key factor for determining market competition. Patents can be regarded as a type of confidential exchange contract provided to potential innovators by governments, where it is the innovator’s duty to publicly disclose his/her private technical information while having the right to obtain a market monopoly for a certain duration (This also corresponds to a governmental obligation because under the premise of information disclosure, other competitors can easily duplicate patented material when there is no legal protection). For this reason, patent protection is not to protect technical information; instead, its purpose is to prohibit other people from producing and selling products manufactured using this technology. With the increasing globalization, the potential market scale of products is expanding exponentially, and the market value of the right to exclusively produce certain products (i.e., the intellectual property rights represented by the patents) is increasing proportionately. With the enhancement of economic power and the increasing saturation of the domestic market, many Chinese enterprises are starting to expand into overseas markets. Relying on cheap domestic labor, the low price strategy of Chinese enterprises constitutes a huge threat to the market share of foreign enterprises. Under such circumstances, foreign enterprises seek to leverage both political and economic measures to

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protect their vested interests, and an intellectual property rights lawsuit is an important competitive measure to raise the cost to competitors. According to the industrial life cycle theory, in the initial stages of industrial development, there is great room for improving products while innovation advantages dominate. When industry matures, the products are basically finalized and cost advantages dominate. Generally, it is believed that developed countries possess advantages in innovation, while developing countries have cost advantages. Therefore, at least in mature industries, the Chinese enterprises may carve a niche for themselves through their cost advantages. This is a seemingly reasonable but incorrect idea. The key problem is that when the technological advantages of the developed countries become institutionalized, through the enhancement of intellectual property rights, the cost advantages that the developing countries have may be restricted by the innovation advantages of the developed countries. Apart from their cheap labor force, another important way for developing countries to acquire cost advantages is that the cost of technological imitation is lower than the cost of innovation. Seen from a purely technical perspective, the imitation expenditures are definitely lower. However, under the existing intellectual property system, technological imitation may constitute an infringement of the existing patents. This implies that patent owners may, according to the needs of market competition, choose to institute legal proceedings against infringement by competitors. If the patent owner wins the litigation, he may immediately expel competitors from the market with the aid of legal injunctions or the competitors must pay considerable royalties to the patent owner, which dramatically increases the competitors’ cost and impairs their cost advantages. It can be expected that Chinese enterprises striving to enter the global market by using a low price strategy will encounter the strategic use of intellectual property rights by enterprises in developed countries. A series of events that took place in recent years, including the cases of the DVD patent dispute and the lawsuit by Cisco against Huawei, is a concrete demonstration of the same. Historical experience shows that after the economic growth of Japan, Korea, and Taiwan, their enterprises also experienced the strategic use of intellectual property rights by enterprises in the developed countries (such as the United States) during their expansion into the global market, the costs of which were enormous. Although the DVD patent dispute and the lawsuit by Cisco against Huawei are isolated incidents, they simply underscore the intellectual property rights issues that Chinese enterprises will encounter when seeking to expand beyond the domestic market. Therefore, learning how to respond to and effectively breaking through the barriers imposed by intellectual property rights is an important issue. Past mistakes should be lessons learned for the future. The cases of DVD patent dispute and the lawsuit by Cisco against Huawei are two interesting cases that are similar in nature but with totally different outcomes. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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The purpose of this chapter is to compare and study these two cases, analyze their similarities and differences, and review intellectual property rights barriers facing Chinese enterprises and the specific forms they take. Analysis shows that whoever gains control over the core technology and the corresponding intellectual property right gains control over leadership of the market. If the nature of the competition between the developed and developing countries takes the form of competition between cost advantages and innovation advantages, then under the WTO’s framework—especially TRIPS—developed countries that have control over innovations will gain the initiative in the market with the enhancement of the protection of intellectual property rights. Today, many large multinational companies profit from technology specialization, patent standardization, and criterion monopolization. Intellectual property rights are powerful instruments to hinder (potential) competitors and protect high monopoly profits. We have discovered that Sino-foreign intellectual property right disputes usually follow an interesting and standard pattern: With the increasing saturation of the domestic market, the Chinese enterprises begin to expand into overseas markets leveraging their cost advantages that seriously threaten the vested interests of the foreign enterprises. However, the final litigation results vary widely depending on whether the Chinese enterprises have sufficient intellectual property right reserves and independent innovation capabilities. To some extent, the Chinese DVD enterprises fared poorly whereas the Huawei case provides us with a successful litigation experience.

. DVD Patent Dispute The digital versatile disc is abbreviated as DVD. As a substitute for VCDs, it has advantages with regard to the volume of data storage and the audio and visual quality. There exists a large number of DVD-related patents, basically belonging to several companies or unions: 6C Union (Toshiba, Mitsubishi, Hitachi, Panasonic, JVC, and Time Warner), C Union (Philips, Sony, and Pioneer), 1C (Thomson), and MPEG-LA (comprising 16 patent entities), as well as multinational companies such as Dolby and DTS. It should be pointed out that only some patent owners (such as Philips) produce DVDs themselves. The following analysis will show that these differences are key factors that influence the lawsuits regarding intellectual property rights. Since the Chinese DVD manufacturing enterprises lacked the core technology for DVD production, they had to not only import the core components from the abovementioned companies but also obtain intellectual property rights (or could simply use the above technology “illegally”). Due to this, the fate of the Chinese DVD industry and the strategy and moves of those foreign companies were closely linked. According to the strategy of foreign corporations and the responses to them by the Chinese TOWARD AN INNOVATIVE NATION

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enterprises, the development of the Chinese DVD industry can be briefly divided into the following stages.

7.1.1 “Pumping in Water to Breed Fish versus Technological Pragmatism” (1997–2001) Since 1997, the Chinese DVD industry progressed rapidly with the growth rate of annual DVD output increasing by 400%. By 2001, the gross output reached 19.945 million units. A typical characteristic at this stage was that DVD rights holders never levied royalties on the Chinese enterprises; even when they claimed to levy such royalties, they were unable to undertake the necessary measures. Correspondingly, the Chinese DVD enterprises pursued a use doctrine for DVD technology without taking the potential risks into consideration. The DVD products have strong network externalities; that is, the utility gained from the consumers purchasing DVD players is positively correlated with the number of consumers purchasing DVD players.1 Just as Katz and Shapiro (1985) pointed out, when two kinds of products with network externalities compete, the final market results are determined by differences in compatibility, technical performance, and the installed base. If the system products are incompatible with each other, the final result will be a winner-takes-it-all scenario. Prior to the emergence of the DVD, the mainstream product was the VCD (responsible for the demise of the VCR), which had an extensive installed base. If the DVD standards were incompatible with the VCDs, then consumers could be locked into the VCD products. In order to substitute the VCD quickly, the DVD unions adopted a backward-compatibility strategy, which meant that DVD players could play VCDs; however, the DVDs could not be played on VCD players, rendering the problem of the installed base unimportant. However, when the DVD was first introduced, it was relatively costly. Therefore, in order to overwhelm the VCD system, the first issue facing the DVD unions was how to quickly increase the provision and consumption of the DVD players. Obviously, the lower the price of 1. According to the analysis by Katz and Shapiro (1985), a network externality can be divided into direct and indirect network externalities. The telephone is a typical example the number of the former. The more the telephone owners, the more of people you can contact when you install another telephone. Thus, the utility gained is greater. Obviously, the number of consumers who have already installed telephones may “directly” determine the utility of installing an additional one. One typical example of this is the computer system. Tom will not directly increase the utility of the Windows system used by Dick when Tom is using the Windows system. However, with an increasing number of consumers using the Windows system, there will be more individuals or enterprises developing various kinds of applications based on this system. Th is will “indirectly” increase the utility for any consumer who uses the Windows system. Similarly, when more consumers are buying the same type of sedans (e.g., Buick), more maintenance stations for Buicks will emerge, which will be more convenient for other Buick users. Obviously, the network externality of DVD products is an indirect network externality; with the increase in the number of DVD player consumers, more discs based on the DVD technology will emerge in the market. Thus, the utility of DVD player owners will increase because they can watch more DVD fi lms.

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the DVD players, the easier this target could be achieved. Since labor costs are high in developed countries, an ideal strategy for DVD unions would be to encourage Chinese enterprises to produce DVD players on a large scale.2 At first, Chinese DVD enterprises mainly supplied the Chinese domestic market, while major markets for the overseas competitors were not in China. Therefore, there was no direct market conflict between the two sides. Due to the non-competitiveness of the knowledge products, the infringement of their patented technologies by domestic enterprises did not entail any added costs. Actually, as domestic DVD enterprises needed to import the key components of the DVDs from foreign companies, the quicker the DVD products became popular in China, the more the profits the patent owners could earn from the key components. Of course, another key factor for foreign enterprises to not get into litigation at this stage was the poor protection of intellectual property rights in China. For investments of any kind, including the litigation activities, people need to estimate the cost and benefits of litigation. Given that China had not entered the WTO and protection of intellectual property rights was poor, safeguarding intellectual property rights was economically unviable at this point.

7.1.2 “Casting the Net to Catch Fish versus Dancing with Wolves” (2002) With the increase in output capacity, the domestic market for the Chinese DVD industry was close to saturation, Hence, they were forced to export to the overseas markets for further expansion. Due to lower labor costs, the DVD products produced by the Chinese enterprises enjoyed a great price advantage in the overseas markets. For example, in 2001, the retail price of DVD players made in China was US$80 in the US market, while the price of similar products produced by foreign manufacturers was US$200. Due to this huge price difference, the export volume of Chinese DVD enterprises increased by 275% to 10.5 million units, making China the biggest producer of DVD equipment. However, the Chinese enterprises grabbing market share on this differentiator interfered with the vested interests of foreign DVD manufacturers (such as Philips). Therefore, they began to restrain the momentum of overseas expansion by calling upon intellectual property rights. Also, other DVD patent owners wanted to profit from the substantial patent royalties that were due to them. At the same time, after China’s entry into the WTO at the end of 2001, China had to provide intellectual property rights at 2. The model by Bernhardt and Joshua (1998) with soft ware piracy as an example, provides a very interesting result. Assuming that soft ware products have an intensive network externality and that consumers can be divided by soft ware manufacturers into commercial and family users (the former with a high willingness to pay and more likely to be detected if they use pirated soft ware), then to connive at the use of pirated soft ware by the family users will potentially be of benefit to the manufacturers profits. Th is is because when a person gets used to a certain soft ware at home (as a family user), he will still buy (of course, at the company’s account), the same soft ware when he is in the company (as a commercial user).

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Table 7.1 An overview of the royalty payable by the Chinese DVD enterprises (2002) Patent Organization

Member

6C 3C 1C DTS Dolby Company MPEG-LA Royalty Collection Company

Hitachi, Panasonic, JVC, Mitsubishi, Toshiba, Times Warner Sony, Pioneer, Philips Thomson — — —

Royalty (US Dollars) 4.0 5.0 1.0 10.0 1.5 4.0

Source: http://news.zol.com.cn/2002/0514/40704.shtml.

a “minimum level”3 according to TRIPS. This provided foreign patent owners with an institutional guarantee to levy patent royalties. In June 1999, six core DVD manufacturing enterprises announced the formation of a “DVD Patent Pool.” These enterprises included Toshiba, Panasonic, JVC, Mitsubishi, Hitachi, and Time Warner. In November 2000, the 6C Union issued the “DVD Patent License Incentive Plan” and began to negotiate with Chinese DVD enterprises regarding the payment of royalties. The Chinese DVD Enterprises League appointed the China Electronic Audio-Video Industry Association to negotiate with the 6C Union. On January 9, 2002, 3,864 DVD units exported to the United Kingdom by the China Shenzhen Pudi Company were detained by Philips through the local customs office. On February 21, the DVD machines exported by Huizhou Desay Electronics were also detained by German customs. On March 8, the 6C Union delivered an ultimatum, stating that the Chinese DVD enterprises must agree to pay the royalty before March 31—the royalty was US$20 per DVD unit. On April 19, the 6C Union reached an agreement with the China Electronic Audio-Video Industry Association that for every DVD player exported by the Chinese companies, US$4 shall be paid in royalties. In October, the China Electronic Audio-Video Industry Association reached an agreement with the 3C Union (Sony, Pioneer, and Philips) that for every DVD machine exported by the Chinese companies, US$5 shall be paid in royalties.4

3. Th is “minimum level” was actually higher than the existing level for the protection of intellectual property rights in China. 4. All the figures mentioned above were the highest prices for exports royalty. Thereafter, the Chinese DVD enterprises successively signed royalty agreements with foreign companies including Thomson, Dolby, MPEG-LA, or the royalty companies. Table 7.1 shows the royalty payable by the domestic enterprises.

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7.1.3 “Profiting from the Conflict among Others verus Seeking Change in the Midst of Predicament” If the DVD patent owners were also the DVD producers (such as Philips), then levying royalties on Chinese enterprises was like killing several birds with one stone. On the one hand, they gained considerable royalties; on the other hand, levying royalties increased the marginal cost (which equals the production cost plus the royalty per unit) of their competitors (the Chinese enterprises), which in turn reduces their market profits. Under such a two-pronged attack, the profit margins of several Chinese DVD enterprises vanished and enterprises had their business disrupted or changed. Correspondingly, the export volumes of Chinese DVD enterprises declined sharply, many of which completely exited both the domestic and overseas markets. However, after the overseas market stabilized, some multinational corporations began to enter the Chinese domestic market with extremely low prices. Under the patent stick wielded by the foreign enterprises, the seemingly prosperous Chinese DVD industry was soon close to collapse. Crisis often precipitates change. Indeed, some Chinese enterprises expected to break the patent monopoly of the multinational companies by using other technological standards, and Enhanced Versatile Disk (EVD) was one standard that emerged. The principal patent owner was Beijing E-State Company. It was deemed as the industry standard for CD and CD players and independently researched and developed with the ownership of intellectual property rights (however, about US$2 would actually be paid to US companies as royalties). Next, we analyze the advantages and disadvantages of the EVD standards with regard to three aspects. The first aspect is the technical quality. The EVD had better visual quality and its definition was five times that of a DVD. However, although seemingly advanced, as far as the technical level was concerned, the EVD embodied only a minor innovation without any revolution breakthroughs as compared with the DVD. Further, the human eye could not distinguish the superior definition of the EVD, and the visual quality of the DVD was high enough. Due to this, the technical advantages of the EVD did not satisfy consumer demands. The second aspect concerns royalties and the installed base. The owner of the core technology of the EVD was a Chinese enterprise (yet the foreign owners had control over some core technology). This was a critical factor for the EVD and attracted great attention. Once accepted by the market, it would address the technological sources for the Chinese home appliance enterprises in domains such as digital audio-video products and family network products. As mentioned above, network externality and the installed base are critical when there is competition between systems and standards. As noted in the earlier section, there was an extremely wide installed base of DVD TOWARD AN INNOVATIVE NATION

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players, which provided the EVD camp with an almost insurmountable task. If EVD was expected to use the installed base of DVD players, then its products would have to be compatible with the DVD format. However, the EVD producers would have to pay royalties to both the owners of the EVD technology and those of the DVD patent. This would result in obvious cost disadvantages. However, if the EVD camp chose not to make their products compatible with the DVD format in order to avoid costly royalties, they would lose their competitive advantages by having no installed base. The third aspect is the source. Let us consider the medium and the content of the disc separately. It is obvious that the EVD has no advantages in these aspects. First, when a product has a network externality, its production and consumption would not be at a stage of rapid development until a quantity threshold was exceeded. Before that, no producer would be willing to pay for content provision because of lack of consumer demand. On the other hand, few consumers were interested in EVD players as the EVD format lacked content. In order to break this vicious circle, it was critical to have support from large syndicates; unfortunately, the EVD camp did not have this. Second, as compared with single-sided and single-layered technology for producing normal DVD discs, the single-sided and multi-layered technology for producing the EVDs was much more complicated, which was unfavorable for the provision of EVDs. While piracy is illegal, under the current environment in China, pirated discs are critical to VCDs, DVDs, and EVDs alike. The large number of pirate manufacturers has been an important driving force for the popularization of the DVD player. Since the technology for EVD discs was more complicated, it would be more difficult to pirate, which would mean that the EVD lacked the “grey drive” that the DVD had. In conclusion, although EVD standards have certain technological advantages over DVDs and are strongly supported by the Chinese government, we are not optimistic that Chinese DVD enterprises can escape the issue of royalties with the aid of EVDs. Even if the EVD becomes China’s or even an international standard, its success is not guaranteed. It is the market that will decide and that is more important in becoming the real market standard. Issues regarding technology, installed base, and sources indicate that it will be very difficult for EVDs to substitute DVDs.

. Cisco’s Litigation against Huawei Cisco is a leading global Internet equipment company mainly providing network hardware products, Internet Operation Systems (IOS) soft ware, network design and implementation, as well as professional technical support and training for industry. Cisco has made huge profits through its innovation advantages and its leading 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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position in the market. Since it produced its fi rst router in 1986, Cisco has ranked No. 1 or No. 2 in terms of the market share in every domain that it has entered; it is now the market leader in a real sense. Since its listing in 1990, Cisco’s annual yield has soared from US$69 million to US$22.29 billion as of 2001. Established in 1988, Huawei Technologies was a major equipment supplier in the Chinese telecommunications market, with its business scope extending to the research, development, production, and sales of telecommunications network technology and products; providing telecommunications operators with network solutions for optical networks, fixed networks, mobile networks; and value-add in the business domains. It has successfully accessed the global telecommunications market. In 2003, the sales revenue of Huawei Technologies reached RMB 1.7 billion. As an up-and-coming enterprise in Internet equipment, Huawei focused on the construction of independent research and development capability and the accumulation of intellectual property rights. Currently, Huawei leads Chinese enterprises in patents owned. As compared with Cisco, Huawei has a lower research and development capability; however, Huawei has accumulated solid technological prowess in quick response to changing market demands. Since Huawei can harness cheap labor force in China more effectively,5 its products and services are priced far lower than Cisco’s. Cisco realized that Huawei, with its strong research and development capacity and low product cost, constituted the biggest potential threat to its profitable global monopoly. Cisco wanted to contain this potential danger and make efforts to stop Huawei’s moves and ambitions from decreasing Cisco’s market share. On January 23, 2003, during the Chinese spring festival, Cisco filed a lawsuit in the United States against Huawei. It accused Huawei of the following: plagiarizing Cisco’s IOS source code, technical documentations, and the command line interface of the IOS software, as well as the infringement of at least five patents in Cisco’s routing protocol and illegal duplication of its operation software. It was a strategic decision for Cisco to choose the spring festival to file a lawsuit because this may have struck Huawei when it was unprepared. Nevertheless, Huawei quickly responded, stating that it not only respected the intellectual property rights of others but also emphasized protecting its own intellectual property rights. Several days later, taking this strategy into consideration, Huawei removed from the US market products that were suspected of infringement and suspended its progress in the US market. This could be interpreted as Huawei holding out an olive branch to Cisco for reconciliation. However, Huawei also stated that if reconciliation failed, it would file a counterclaim in China against Cisco’s abuse of monopoly power. 5. The salaries of Chinese engineers are also lower as compared to those of their counterparts in the developed countries.

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Cisco’s consideration was very subtle. In order to sustain and expand its benefits in China, it had to value its relationship with the Chinese government as well as maintain its brand image in the Chinese consumers mind. Therefore, although Cisco filed a powerful lawsuit against intellectual property rights on Huawei, there were indications that Cisco did not intend to make things too complicated. One typical instance was that Cisco refused to allow the FBI to interfere in this case to conduct criminal investigations into Huawei. Similar to any litigation case, the proof of intellectual property rights infringement is very complicated and critical to the final results. On March 18, 2003, an ex-employee from Huawei claimed in the documentation submitted to the Marshall District Court of Texas that the software produced by Huawei was very similar to that produced by Cisco—the biggest global network equipment provider—and that they even had the same defects. Obviously, this was bad news for Huawei and its global image was severely damaged for a while. The US media and the public believed that the secret behind Huawei’s unstoppable victories worldwide was reckless coping and plagiarizing of Cisco’s intellectual property rights. In such an unfavorable situation, it was useless for Huawei to defend itself. However, considering that adhering to the advice of a third party was sane, Huawei began to seek third party alignment to circumvent these difficulties. On March 20, 2003, Huawei and 3COM of the United States established a joint venture. The joint venture was headquartered in Hong Kong, China, and Huawei became the majority shareholder. The alignment with 3COM provided Huawei the support to react to Cisco’s litigation. 3COM used to be the IT industry leader in the United States. It carried out many significant technology innovations and owned a large number of core patents, with a high reputation in the minds of the Americans. However, in recent years, with the emergence of Cisco, the operational performance and market share of 3COM were declining. Therefore, it would be advantageous for 3COM to align with Huawei in order to reverse its downward slide. After a strict and careful investigation, on March 25, 2003, the CEO of 3COM Claflin testified before the court that he did not believe Huawei’s technology constituted an infringement against Cisco. Similarly, neither did the independent technical specialists think that Huawei’s code constituted an infringement against Cisco. 3COM’s CEO pointed out that although the products of Huawei and Cisco did share a small quantity of common codes, this did not mean that Huawei had plagiarized Cisco. The root cause was that the both the companies had used independent third party software at the same time. On June 7, 2003, the Court of Texas issued the Preliminary Injunction, adjudicating that Huawei should, at Cisco’s proposal, cease the use of some controversial router software source code, operation interface, and online help. On June 11, 3COM requested the 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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court to adjudicate that the products produced by the joint venture between Huawei and 3COM did not constitute an infringement. On October 2, Cisco temporarily suspended the lawsuit against copyright infringement on Huawei and both the parties reached a preliminary agreement. On April 6, 2004, Cisco postponed litigation on Huawei and their attorneys filed an application on March 31, requesting the court to have the trial adjourned for six months. On July 28 of the same year, Cisco abandoned the lawsuit against copyright infringement on Huawei, marking the formal closure of this litigation that lasted for 18 months. Although Cisco’s litigation against Huawei resulted in reconciliation between the two parties, as outsiders, we are not privy to the specifics that led to this reconciliation. To Huawei, reconciliation meant success. Reconciliation meant that in future, Cisco should not file any lawsuit on Huawei pertaining to this case or similar matters. This removed the biggest obstacle in Huawei’s path to the overseas market in the future. As compared to the DVD enterprises, the performance of Huawei in this litigation against Cisco was excellent because of the following reasons: First, Huawei has well-qualified research and development capability. As mentioned above, Huawei emphasized the development of independent technology and ranked No. 1 in Chinese enterprises for its patent ownership. After Cisco filed its litigation for patent infringement, Huawei immediately organized a research and development team to make improvements to the areas questioned by Cisco. A well-qualified, independent research and development capability was the most important factor for Huawei being able to bargain with Cisco. Second, the response to litigation was appropriate. Huawei responded actively after Cisco filed litigation by removing the products suspected of infringement from the US market within a short time. As leverage, it targeted Cisco’s interests in the Chinese market announcing that if reconciliation failed, it would file a countersuit in China regarding Cisco’s monopoly position there. Although the reconciliation reached by both the parties was the result of multiple factors, one of the most successful steps was this threat issued by Huawei. When facing Cisco’s accusation, Huawei’s response was reasonable. First, it denied duplicating Cisco’s source code; second, regarding the other infringement that it was accused of by Cisco, Huawei admitted to having used Cisco’s proprietary protocol; and third, Huawei pleaded that the use of Cisco’s proprietary protocol be limited to a reasonable scope (outside the protection zones of the proprietary protocol) with the purpose of satisfying users’ needs. This proprietary protocol, namely, the nonstandard protocol, refers to the protocol developed and implemented by an enterprise itself without disclosure and unwillingness to do so, without adoption and approval by an international and national standardization organization, and with the characteristics of non-publicity, exclusiveness, and monopolization. TOWARD AN INNOVATIVE NATION

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The manner in which the proprietary protocol should be protected is a controversial issue. By nature, the proprietary protocol is the standard adopted by manufacturers for internal development. Usually, other manufacturers are not permitted to use this protocol unless they are authorized to do so. It is easy to understand that market pioneers can often attain certain monopoly positions by using a proprietary protocol. This forms a driver for technological innovation. However, the excessive protection of a proprietary protocol will lead to unnecessary market access barriers that may not only impede reasonable market competition but also restrict technological progress. Imagine that some sort of network equipment with proprietary protocol accounted for a considerable proportion in the existing network and users. In that case, equipment provided by other competitors (usually market followers) would have to follow this nonstandard protocol to ensure interconnection and inter-compatibility among equipment. On the other hand, if other manufacturers are not able to use this proprietary protocol, they will lose the opportunities to reasonably compete with other monopolies in other dimensions. This leads to great distortions due to monopoly. Monopolies also reduce the drive for further innovation as they drive down competition. A key point in Cisco’s litigation against Huawei was how to handle Cisco’s protection of the proprietary protocol. As a market leader, Cisco already had the majority share of the global network equipment market. According to unofficial statistics, in China alone, Cisco’s routers already had a market share up to 70%, in which 10% was on public data networks. In enterprise networks such as finance, waterway transportation, and taxation services networks, its market share had exceeded 50%. In the event that it would be necessary to expand and update the original networks without losing compatibility, the new equipment would have to adopt Cisco’s proprietary protocol. It can be seen that Cisco’s proprietary protocol has virtually become an industrial standard already, and other competitors have no choice but to use this protocol. If Cisco disallowed the other competitors from using its proprietary protocol, it would be suspected of abusing its monopoly position, and this behavior would conflict with the basic requirements of interconnection and inter-compatibility among telecommunication products. Based on this point, Huawei threatened to file an anti-monopoly litigation against Cisco in China, which promoted reconciliation to some extent. Third, the alignment with 3COM greatly strengthened its negotiations. Established in Silicon Valley, California, in 1979, 3COM is a NASDAQ-listed company, specializing in the digital telecommunication products. 3COM was one of the leading companies in the global computer network equipment industry until the mid-1990s. It had made great contributions to industrial progress in the domains of LAN and WAN. After reaching an agreement, the president of 3COM testified before the court for Huawei, where he not only denied the accusation that Huawei’s products had infringed on 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Cisco’s intellectual property rights but also considered that Cisco’s litigation against Huawei was anti-competitive. Initially, Cisco’s litigation against Huawei may have been considered by the uninformed as a cat and mouse game between the innovator and the infringer. This put Huawei in a very awkward position in the US judicial system where common sense is the basis for law. However, with great support from 3COM—a famous US company—Huawei soon got rid of the above quandary. Since 3COM owned a large number of technologies and patents, with the aid of the Huawei-3COM (the joint venture founded by Huawei and 3COM), and by using the approach of cross technology authorization, Huawei could, by taking advantage of 3COM’s channels, prevent its digital telecommunication products from encountering potential technology property rights bottlenecks put in place by Cisco. Finally, 3COM knew the patent protection system in the United States better than Huawei did, which was very helpful in responding to Cisco’s litigation. In conclusion, Cisco sought to forestall Huawei via litigation. It expected Huawei to perish under the pressure of its infringement of intellectual property rights allegations. However, Huawei found a novel way out by reconciling with Cisco, thereby clearing obstacles for its future development in the overseas market.

. Comparison and Analysis of the Two Cases On the basis of the analysis mentioned above, we will review the similarities and differences between the two cases. We will also refi ne our arguments more specifically for the comparison.

7.3.1 Similarities First, intellectual property rights barriers assume various forms with increasingly important functions. With the increasing unification of the world economy, the potential market value of any single technology has increased, which inevitably increases the incentive for imitation among other competitors. In response, developed countries have begun to employ different approaches, such as via the WTO and TRIPS, to transform their technological advantages into intellectual property rights advantages. In this manner, they not only gain considerable royalties but also deter competitors and build market access barriers. However, usually, any single patent can be easily breached by competitors; therefore, building solid and intransigent barriers for intellectual property rights has become a practical competition strategy of multinational companies. In the DVD patent dispute case, the multinational companies established patent pools. These patent pools included 3C, 6C, and MPEG-LA. In the case of a single patent, it is more difficult for the competitor to break through intellectual property rights barriers that TOWARD AN INNOVATIVE NATION

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are in the form of patent pools. The competitor will either have to prove that all these patents are void or work around these patents by innovating in order to ensure that there are no restrictions by patent injunctions. According to exclusiveness of patent protection, as long as one of the patents is effective, the owners of the patent pool are paid royalties. Assuming that all the patents are breached to some extent, the patent pool can be deemed as a kind of benefit sharing and risk undertaking system established by the patent owners. In the case of Cisco’s litigation against Huawei, Cisco had also built diversified barriers of intellectual property rights, which included different forms of intellectual property rights such as patents, copyrights, and commercial secrets. Second, Chinese enterprises marching into the overseas market with a low price strategy may have triggered the intellectual property litigation. Broadly speaking, we might as well regard the intellectual property litigation as a costly investment activity; only when the return on investment is no less than one can the owners of the intellectual property rights carry out such an investment. Due to factors such as culture and the economic development level, the protection in developing countries is usually lower, and multinational companies are not ready to initiate intellectual property litigation in these countries. Due to the non-competitiveness of intellectual property rights, as long as the infringement acts of developing countries do not affect the vested benefits of multinational companies, their litigation incentives are much lower. In comparison, since developed countries have higher levels of intellectual property protection, the intellectual property infringement litigations are more likely to happen there. Obviously, when the Chinese enterprises expand into overseas markets with low price advantages, they infringe upon the vested interests of the enterprises in the developed countries, and intellectual property litigation is easily triggered. Third, the essence of the conflict is that enterprises in the developed countries expect to restrict the cost advantages of the enterprises in the developing countries through systematic technological advantages. Both these cases took place between the Chinese enterprises and multinational companies. Prior to the intellectual property disputes, Chinese enterprises had cost advantages, while the foreign enterprises had technological advantages. According to the theory of the industrial life cycle, in the early stage of industrial development, technological advantages dominate. The enterprises of developed countries may gain the market by continuously improving product quality. However, after an industry becomes relatively mature, the possibilities of continuous product improvement reduce and the cost advantage becomes the leading factor determining market competition. At this point, with the advantage of a cheap labor force, Chinese enterprises may be superior competitors. Nevertheless, with technological advantages being increasingly represented as intellectual property rights, there will be new changes to this analysis: Enterprises in developed countries may restrict the cost advantages of enterprises in the developing countries with the aid of intellectual property rights. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Fourth, there is a similar development trend. Both the cases took place shortly after China’s entry into the WTO. According to TRIPS, each WTO member country needs to provide a basic level of intellectual property rights protection, which is higher than the existing protection level in China. In order to merge with the world economy, the Chinese government must abide by its promises: gradually improve the level of intellectual property rights protection and enhance judicial execution. For this reason, we anticipate that there will be more litigation involving intellectual property rights by foreign enterprises against the Chinese enterprises.

7.3.2 Differences The first difference between the two cases is the reserves of intellectual property rights of the companies. Difference in the reserves of the intellectual property rights is the root cause for the totally different results of the two cases. It can be understood that the probability of the defendant and the plaintiff to win lawsuits in the court is determined by intellectual property rights reserves of both the litigation parties as well as the accused infringers’ capacity for independent innovation. If the results of the court judgment are taken as trendsetters, this will further determine the magnitude of royalties that the defendant is to pay to the plaintiff when reconciliation is reached between the two parties. As compared with the Chinese DVD enterprises, Huawei possessed a strong sense of intellectual property rights since its establishment. Before Cisco filed a lawsuit against Huawei, Ren Zhengfei, the President of Huawei, released the famous article “Huawei’s Winter” within the company, urging Huawei’s staff to be aware that “the wolf has really come” and to “discuss extensively about crises.” It could be said that Ren Zhenfei had already anticipated crises similar to Cisco’s litigation against Huawei and the lawsuits were just a matter of time. Therefore, being different from the majority of Chinese enterprises, Huawei had set up a department in charge of intellectual property rights-related affairs, so that it would be ready for sudden litigation on intellectual property rights. Since 10% of the annual income is allocated to research and development activities, Huawei has accumulated huge reserves of intellectual property rights and independent innovation capacity. Since 2002, the annual rank of Huawei in the number of patents held by a Chinese enterprise has been No. 1. Perhaps, the more important factor was that most of these patents were invention patents with a high technical level. Since Huawei has a strong capacity for independent innovation, when facing intellectual property rights litigations, Huawei could modify its products at any time according to the practical requirements, in order to improve its position in the negotiations. For example, in the case of the copyright litigation by Cisco, Huawei quickly modified the operation interface of the original products. Regarding the patent litigation by Cisco, Huawei quickly modified the source code of the programs. In comparison, the majority of the Chinese TOWARD AN INNOVATIVE NATION

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DVD enterprises are simply assembly plants without any core DVD technologies or research and development capabilities. Eventually, the development track of the Chinese DVD industry was completely controlled by multinational corporations. Therefore, the Chinese DVD enterprises were forced to be passive during license negotiations. They lacked the competitive negotiation advantages of intellectual property rights and independent innovation capacity. As mentioned above, the strategic alignment of Huawei and 3COM expanded the reserves of intellectual property, which was a turning point leading to final reconciliation. Unfortunately, such a cooperative strategy is something that the DVD manufacturing enterprises could not duplicate. Actually, before the DVD patent dispute began, there were foreign enterprises seeking partners in China, but not a single DVD enterprise was willing to cooperate. Due to their lack of core patents and independent innovation capacity, the cooperation on the part of Chinese DVD enterprises with foreign enterprises would inevitably be passive. The second difference is the market structure. As the barriers for access are low, the Chinese DVD manufacturing industry is basically perfectly competitive. Due to a huge number of manufacturing enterprises with similar products, the price became the most critical competitive measure among enterprises. On the other hand, due to violent price competition, each manufacturing enterprise was unable to accumulate sufficient capital to conduct technology production and product differentiation, leading to a vicious circle of low level technology–low price. In comparison, the telecommunications equipment industry requires a very high fixed investment. Once these investments are made, they become sunk costs. Anticipating this, few enterprises are ready to enter into such an industry. The postinvestment exit barrier is transformed into a pre-investment entry barrier. For this reason, the industrial structure of the telecommunications equipment industry is normally monopolized by large companies. Since there is no competitive pressure from domestic enterprises, Huawei is able to strategically improve its research and development investment, as well as enhance and increase its independent innovation capability and intellectual property reserves. The market structure also exerts influence on the realization of economies of scale. According to Marshall’s theory, economies of scale are divided into internal and external types. It shows that external economies of scale are realized in the DVD industry, which implies that with an increase in the number of DVD manufacturers, the average cost for each manufacturer will be reduced, but none of the enterprises gain competitive advantage over other enterprises. However, in the telecommunications equipment industry, the internal economies of scale function. This means that Huawei is able to improve its productivity from the learning by doing effect and knowledge accumulation. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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. How to Respond to the Intellectual Property Litigation? There is no doubt that increasing the intellectual property reserves is the fundamental approach for the Chinese enterprises to break through the intellectual property barriers set up by the multinational companies. However, given that intellectual property litigation has already taken place and that there is little possibility for Chinese enterprises to make technological improvements, familiarity and application of intellectual property laws will be critical to protect Chinese rights and interests. According to the patent law, a patent can be granted for innovation only when it has satisfied the requirements of practical applicability, novelty, and inventiveness—the “three requirements.” However, there are no objective and accurate standards for these requirements. Therefore, there will be some vagueness during implementation, leading to two types of mistakes: first, rejecting valid claims for innovation patents or granting patents for pursuits undeserving of patent protection. In this manner, if evidence can be provided to show that certain patents fail to satisfy the three requirements (i.e., the patent office has made the second type of mistake during examination), then such a patent will become a void patent, and infringement issues are off the table. Novelty means that before the date of filing, no identical invention or utility model has been publicly disclosed in publications in the country or abroad or has been publicly used or made known to the public by any other means in the country, nor has any other person filed previously with the patent administrative organ under the State Council an application, which described an identical invention or utility model and was published after the said date of filing. Inventiveness means that as compared with the technology existing before the date of filing, the invention has substantive features and represents notable progress. Practical applicability means that the invention or utility model can be used and can produce effective results. Among the three requirements, there are usually no constraints on the requirement of practical applicability and it can be basically ignored. Given that an innovation has passed the examination and acquired a patent, it is usually very difficult to challenge its inventiveness. According to Li Zhaoyang (2002), the most appropriate way of challenging the effectiveness of existing patents is the requirement of novelty. If patent technology has been publicly disclosed before the date of filing, then such a patent (at least part of the rights thereof) is void. The most cost-effective way is to search for information that has been publicly disclosed such as in patent literature and conference papers. Cisco’s litigation against Huawei verifies the above analysis. According to Cisco’s accusation, Huawei had copied part of Cisco’s software, while the source code analysis made later showed that Huawei’s Versatile Routing Platform (VRP) may have contained TOWARD AN INNOVATIVE NATION

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some codes in the modules of Cisco’s Enhanced Interior Gateway Routing Protocol (EIGIRP), putting Huawei in a very unfavorable situation for a period of time. However, Huawei did not give up and had finally proved that the codes suspected of infringement were actually derived from a third party’s open source code. Further, faced with an effective patent, challengers may also gain benefits by checking the protection scope of such patents. Therefore, we need to consider the basic process of patent application, examination, and approval. In order to acquire a patent, the inventor must submit to the patent authorities documentation including applications, specifications summaries, as well as the patent claim. The patent claim should be developed on the basis of the specifications and should clarify the scope of rights that require patent protection. After examining the application, the patent authorities may approve or reject the granting of the patent. Generally, it is not a one-step process; from patent application to approval, there may be several rounds of negotiations between the applicant and the examiners. The examiners may reject the entire application or some requests for rights of the applicant; in order to acquire the patent, the applicant may have to make some modification to the application documents accordingly. However, the modification to the application documents for the invention and utility model shall not exceed the scope recorded in the original specifications and the patent claim. The modification to the application documents for design patents shall not exceed the scope illustrated in the original pictures or photos. In addition, according to the principle of prosecution history estoppel, if the patentee has narrowed its patent application scope for the purpose of acquiring the approval for the patent during the course of patent application, the patentee shall never reclaim the part abnegated. Facing intellectual property pressure from market leaders, followers may refer to special provisions in the patent laws. For example, many countries (including China) have regulated in their patent laws that in the case of some technologies that are concerned with the national economy and livelihood of the masses, if the patent owners are unwilling to grant the patent at a reasonable royalty, other enterprises may ask the government for a mandatory license. However, usually, countries will not issue mandatory licenses easily. Since a single patent is quite easy to breach, multinational companies often have their intellectual property barriers reinforced by constructing a patent pool. In the DVD affair, neither 6C Union nor 3C Union used the regular form of single licenses; instead, they used joint licenses. It is very difficult to break through patent pools by providing evidence to demonstrate that the patents have failed to satisfy the three requirements. This is because as long as one patent is effective, the patent pool can levy royalties from infringers or apply patent injunction to force it to cease production. Regarding intellectual property barriers in the form of patent pools, it might be a more effective way 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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to break through by appealing to anti-monopoly laws to inspect whether or not patent owners have abused their market power. The practice of other countries has provided a basis for making judgments on whether patent pools breach anti-trust laws. Generally, if there is no substitute relationship among each patent in the patent pool (medium-sized or complementary), then from society’s point of view, the emergence of this patent pool will promote social welfare. In such cases, organizing the patent pool will not enhance the monopoly power of patent owners, but it can dramatically reduce the negotiation costs for the patent license protocol to be reached. Perhaps, more importantly, if these patents are complementary, then helping to establish the patent pool might internalize the externality among different patents, which would be beneficial to all parties (including the licenser and the licensee). However, if the patent technologies composing a patent pool are substitutable with each other, then the emergence of this patent pool will reduce the competitive level among each substitutable technology, which may breach anti-trust laws. Taking the DVD patent dispute as an example, if the Chinese DVD manufacturing enterprise could have provided evidence that the patent pool of 6C Union or 3C Union had the characteristic of restricting competition, the law indictments based on these patent pools would have lost validity. In addition, even when it is impossible to clarify whether there exists a substitute relationship among the patents of the patent pool members, enterprises may use the most favored clause of the patent license for benefits. According to the most favored clause, the patent owners should not exercise price discrimination against other market entities on levying royalties; otherwise it is deemed as illegal. As mentioned above, with the increasing unification of the world economy, multinational companies wished to transform technology advantages into intellectual property advantages by codifying them in law, so as to enhance and extend their market power. After China’s entry into the WTO, China had to follow these international laws, respecting intellectual property both in thought and deed, in order to protect the legal rights and interests of the multinational companies. Nevertheless, no rights should be unconstrained; the monopoly right derived from intellectual property rights is no exception. Let us look at the example of the United States. On the one hand, it has the strictest laws in the world for intellectual property protection. On the other hand, it has the strictest anti-monopoly laws in the world as well. As far as the current international competition structure is concerned, China will remain a net importer of technology for a long time in the future. During this period, with successive enhancements of competitiveness of the Chinese enterprises, there will inevitably be increased intellectual property litigations by enterprises in the developed countries against Chinese enterprises. TOWARD AN INNOVATIVE NATION

2 0 8 INTELLECTUAL PROPERTY RIGHTS: BARRIERS FACED BY CHINESE ENTERPRISES

Cisco’s litigation against Huawei has revealed that enacting and implementing anti-monopoly laws will help Chinese enterprises in responding to intellectual property litigation filed by multinational companies, which will become a critical force in constraining and balancing the technological advantages of multinational companies. After 14 years of arduous effort, China’s first anti-monopoly law finally came into effect on August 1, 2008. Many people regard anti-monopoly laws as having an economic constitution and have high expectations from it. However, until now, China’s anti-monopoly law only rests on the principle statement layers, which are abstract. Without detailed rules for implementation, its final effect remains unknown.

. Enhancing the Protection of the Intellectual Property Rights: Weal or Woe? According to TRIPS, all WTO member countries must provide a minimum level of protection of intellectual property, which is higher than the existing protection in China. However, the law holds no weight unless implemented effectively. In this sense, even under the framework of TRIPS, the Chinese government has sufficient policy freedom: Given the strict laws of intellectual property, the government may adjust the essential level of the protection of intellectual property by adjusting the level of enforcement according to the real situation. Thus, a basic decision facing the Chinese government will be whether or not the level of the law enforcement of intellectual property in China should be improved. The DVD patent dispute and Cisco’s litigation against Huawei have provided us with certain revelations. First, enhancing intellectual property rights may expand the monopoly power of international corporations in China’s domestic market, thereby increasing the cost for domestic enterprises to accumulate independent innovation capability through imitation. There are two ways to accumulate independent innovation capability: one is self-reliance and the other is imitation. According to research by Mansfield, Schwartz, and Wagner (1981) and Levin et al. (1986; 1987), imitation cost is only 60% of the innovation cost on average. Considering the huge technology gap between China and the developed countries, imitation is a more effective way to accumulate independent innovation capability. In addition, according to research by David, Cowan, and Foray (1998), technological knowledge can be divided into encoded knowledge (explicit knowledge) and implicit knowledge. Encoded knowledge relates to public knowledge in a general sense, which can be obtained freely by anyone whereas implicit knowledge relates to knowledge that

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is beyond words. In other words, explicit knowledge has the nature of public knowledge, while implicit knowledge is private, and competitive advantages among enterprises are more dependent on implicit knowledge.6 Explicit knowledge can be easily obtained via books, while implicit knowledge can only be experienced within the same scenario; that is, it can only be obtained by doing the same thing as others. Therefore, Aghion and Howitt (1999) considered imitation as a step to innovation; there will be no innovation without imitation. However, enhancing the protection of intellectual property rights will expand the monopoly of multinational companies in China, enhancing their power in negotiation during intellectual property litigation, increasing the cost of imitation for Chinese people, and slowing down the speed of the accumulation of independent innovation capabilities. Second, enhancing the protection of intellectual property will help to improve incentives for Chinese enterprises to conduct research and development. The fundamental cause of the existence of the intellectual property system is that it can facilitate research and development investment. If innovation achievements can be seized freely by other people, it will be impossible for innovators to recover their innovation costs and no one will be willing to make innovation investments. China is a developing country and its level of intellectual property protection should be the result of balancing the above two effects. When domestic enterprises have weak capabilities for independent innovation, they should implement lower levels of intellectual property protection and reduce technological imitation costs, in order to help accumulate independent innovation capabilities by imitating at lower costs. At this point, if the level of the implemented intellectual property protection is too high, it will simply enhance the monopoly power of foreign enterprises without any effect on innovation promotion. However, when imitation reaches a certain stage, the level of intellectual property protection should be improved by increasing innovation profits in order to stimulate independent innovation. Our basic view is that for an open economy, the optimized intellectual property policy of developing countries (including China) should be adjusted according to ground realities and independent innovation capacity. They must find an optimal adjustment path between encouraging imitation to stimulating innovation.

6. We can probably better understand why a technology or system (explicit) that is effective at one place becomes unsuccessful when transplanted to another place: It is because of the lack of the implicit knowledge that is needed for implementation.

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C

APTE

8

R

H

Analysis of the Performance of China’s National Innovation System (NIS) Scientific and technological activity can be regarded as the process of knowledge production, diff usion, and application. Inputs include physical capital, as human capital, and the level of existing knowledge. The output is scientific and technological knowledge that in some cases, is embodied by new products and processes. Like other activities, scientific and technological research is the result of rational investment decisions, while the input and output of research and development activities reflects the efficiency of a national innovation system (NIS). In a country with a higher technological level of development and an environment more conducive to innovation, enterprises or individuals are more motivated to invest in developing technology and innovating. China is a developing country and its scientific and technological resources are relatively scarce. In order to achieve economic development and become a developed country, it is critical to build an effective NIS. In this chapter, we review, with regard to input and output, the basic characteristics of China’s NIS that followed the reforms.

. Inputs and the Evolution of Scientific and Technological Activity 8.1.1 Raising Funds for Scientific and Technological Expenditures According to the existing categorization in China, scientific and technological activities consist of three fields: scientific research and experimental development (research and development) activities, research and development application, and scientific and technological services.

212 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 7,000 6,000

RMB 100 Million

5,000 4,000 3,000 2,000

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

0

1988

1,000

Year

FIGURE 8.1 Total funds raised for national science and technology expenditures (1988–2006) Source: China Science and Technology Statistics, “China Major Science and Technology Statistics Index Database,” http://www.sts.org.cn.1

Figure 8.1 shows that the gross amount of funds raised for scientific and technological expenditure in China are rapidly growing, increasing from RMB 26.5 billion in 1988 to RMB 619.7 billion in 2006. This works out to a compound annual growth rate of over 15%, which is higher than the average growth rate of GDP in China compared over the same period. After 2000, the gross amount of funds raised for scientific and technological expenditure underwent rapid growth. Funds raised for China’s scientific and technological expenditure are mainly sourced from government funds, enterprises funds, and loans from financial institutions. Different fund-raising structures exert a great influence on the manner and efficiency of fund application. The government funds are usually financial appropriations granted to scientific research institutes, higher-learning institutes, scientific research funds, and strategic projects. Although the application process is extremely competitive, once these funds are granted, the supervision of applicants by the state is limited. Therefore, government funds are often used for research and development activities with public welfare characteristics alone. In comparison, enterprise funding into investment 1. Unless otherwise indicated, all the data in this chapter are sourced from the China Major Science and Technology Statistical Index Database.

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focuses more on profits maximization. The research and development activities of an enterprise are often closely related to activities such as production and sales, the success of which usually influences the profit levels and even the survival of an enterprise. Therefore, it usually corresponds to the application and industrialization of research and development achievements. It can be seen that in addition to the gross amount of funds raised, the fund-raising structure is very important. Considering the inefficient situation when science and technology institutes benefited from the State’s “common big rice pot” under the planned system, we may even say that the fund-raising structure is more important than the gross amount of funds raised. Figure 8.2 clearly shows that while the gross amount of the funds raised for China’s scientific and technological expenditure increased dramatically, there were essential changes to its source structure. The period 1999–2000 is a watershed period. Prior to 2000, all fund sources in the total funds raised remained at a relatively constant proportion, in which government funds, enterprises funds, and other funds accounted for about 30% each, while bank loans accounted for about 10%. However, after that period, enterprise funds soared rapidly from 35% in 1999 to 55% in 2000, and continued increasing to 66% in 2006. Since the Chinese government enhanced the support to 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Government Funds

Financial Institution Funds

Enterprise Funds

Others

FIGURE 8.2 Fund-raising structure of the national scientific and technological expenditure

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scientific and technological activities in recent years, government funds still accounted for 20%–30%. The percentage of bank loans and other funds declined sharply. We can conclude by considering the situation illustrated by Figures 8.1 and 8.2 and the above analysis that in recent years, the gross amount of the funds raised for China’s scientific and technological expenditure increased dramatically and that enterprises became the major source of funding.

8.1.2 Disbursement of Funds for Research and Development Activities Research and development activities refer to the systematic and innovative activities in the scientific and technological domains for the purpose of increasing the total amount of knowledge and applying this knowledge to new areas. These include fundamental research, applied research, and experimental development. Within the current statistical system, research and development expenditures are actual internal expenditures related to activities by enterprises and non-profit organizations involved in the survey, including the direct expenditures on research and development projects, and the indirect expenditures on research and development activities such as administration expenditure, service expenditure, capital construction expenditure related to research and development activities, as well as the outside processing expenditure excluding the productive expenditures. Expenditure on loan payments and those transferred to other parties for research and development activities via cooperation with external organizations or via commission to the external organizations are also taken into account. As compared with the science and technology activities mentioned earlier, research and development activities focus more on the production and application of new scientific and technological knowledge. Figure 8.3 shows the total expenditure on China’s research and development activities and the changing trend of the growth rate. Corresponding to the total funds raised for scientific and technological expenditure, the gross amount of research and development expenditure in China has been growing rapidly in the same period. In recent years, its actual growth rate was close to or exceeding 20%, significantly higher than China’s GDP growth rate for the same period. Comparing Figures 8.1 and 8.3, we find that the proportion of the total amount of China’s research and development expenditures accounted for about 50% of the total amount of funds raised for scientific and technological expenditure. In conclusion, research and development activities can be divided into fundamental research, applied research, and experimental development according to their purpose or how far they are from being commercialized. The purpose of fundamental research is to explore the fundamental principles of the phenomenon. When conducting fundamental research, people are either unclear about the actual application prospects of 30 YEARS OF CHINA’S REFORM STUDIES SERIES

35

3,000

30

2,500

25

2,000

20

1,500

15

1,000

10

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

1990

0

1989

5

1988

500

215

Percentage

3,500

1987

RMB 100 Million

ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

Year Research and Development Expenditure Spending (RMB 100 Million) Real Increase over the Same Period Last Year (%)

FIGURE 8.3 China’s total amount of research and development expenditures and the actual growth rate

their achievements, or although they are certain about application prospects, they are not aware of the specific methods and technical approaches to achieve the application targets. Applied research consists of inventive activities that develop theories into practical applications, and these activities have explicit and specific targets. Finally, the experimental development refers to systematic activities performed for producing new products, materials, and devices; establishing new processes, systems, and services; as well as making substantial improvements on the above items that have been produced and established, by using the existing knowledge obtained from fundamental research, applied research, and practical experience.2 The above three research activities are complementary to each other and are necessary to society. Society would lose the resources for technological development if there was no fundamental and applied research; on the other hand, if there was no experimental development, it would be 2. Of course, there will be some limitations if the research activities are divided according to their purposes. Some researches are not only pioneering in their exploration of the natural laws but also have enormous practical value. For instance, three scientists of the Bell Lab were granted the Nobel Prize in Physics for the first crystal triode they had successfully invented. During the invention process, they also were also clearly aware of the practical application of the crystal triode: The use of the transistor to replace the electron tube would not only reduce volume and energy consumption but also greatly improve stability.

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impossible for fundamental and applied research to promote economic development. The huge amount of investment in science and technology would be difficult to maintain. Figure 8.4 shows that, during 1987–2006, although the total amount of China’s research and development expenditures increased dramatically, there were no great changes to its structure. Fundamental research remained at the level of 5%–6%, and applied research remained at around 25% prior to 2000. It declined to about 20% after that. Further, experimental development accounted for the majority of China’s expenditures, reaching 78% in 2006. Based on the above analysis we can conclude that as seen from the types of research and development activities, China’s research and development expenditures are mostly in experimental development and that the expenditures on fundamental research are relatively small. Under the original planned system, the Chinese scientific and technological landscape consisted of five main institutional types: the scientific research institutes under the Chinese Academy of Sciences (CAS) system, research institutions under the industrial departments, higher-learning institutes, local institutions, and National Defense 100

Percentage

80

60

40

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

0

1987

20

Year Fundamental Research

Applied Research

Experimental Development

FIGURE 8.4 The research and development expenditures (classified as per the types of activities)

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science and technology research institutes. Due to this rigid segmentation, the original science and technology management system had low efficiency. The Chinese government conducted major reorganization to enhance the integration of technology and the economy. This included transforming science and technology research institutions into science and technology enterprises, encouraging mergers between enterprises and institutions, encouraging enterprises to establish in-house research and development organizations, and encouraging research personnel to bring innovation to hi-tech enterprises. These reform measures greatly changed the behavior of agents engaged in science and technology in China. Figure 8.5 shows the structure of China’s research and development expenditures. In 1990, the proportion of science and technology institutes reached 50%, higher-learning institutes accounted for 10%, while enterprises accounted for no more than 30%. After 2006, while the proportion of the expenditures of the higher-learning institutes remained basically unchanged, the proportion of science and technology institutions reduced to less than 20%, and the proportion of enterprise expenditure increased to 70%. This shows that after two decades of development, enterprises were gradually replacing the science and technology institutions to become the principal agents of China’s research and development expenditure. 100 90 80 70

Percentage

60 50 40 30 20 10 0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year Research Institutes

Enterprises

Higher-learning Institutes

Other Departments

FIGURE 8.5 The research and development spending (classified as per the execution departments)

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218 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

8.1.3 Human Input into Research and Development Activities Research and development activity is a process of production and application of new knowledge, which requires innovative human capital. Therefore, the amount of expenditure and the number of high-level scientists and engineers are crucial for the success or efficiency of research and development activities. If we assume a knowledge production function that includes the factors of physical capital and labor capital, then according to the standard assumptions, the increase of labor capital will improve the marginal productivity of physical capital. In addition, scientific and technological activities also have obvious externalities. When the quantity of high-level research increases, there are more opportunities for researchers to exchange knowledge that would improve the scientific research efficiency of each individual. Under the current criteria adopted in China, research and development personnel refers to full-time research and development personnel (person per year) participating in research and development projects, managers of research and development projects, as well as direct service staff. Figure 8.6 shows that during 1987–2006, the number of research and development personnel and research and development scientists 18

140

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6

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Persons per Year

10,000 Persons per Year 160

Year Research and Development Personnel (10,000 Persons per Year) Research and Development Scientists and Engineers (10,000 Persons per Year) Research and Development Scientists and Engineers in 10,000 Personnel (Persons per Year)

FIGURE 8.6 The number of personnel engaged in research and development activities in the country

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and engineers increased dramatically. However, since differences between the two parts remained unchanged, it could be concluded that the increase in research and development personnel was mainly reflected in the increase in the number of scientists and engineers. For this reason, in Figure 8.6, the number of research and development scientists and engineers per ten thousand workers per year has increased from 4.6 in 1987 to 15.8 in 2006. This indicates that after the reforms and opening up, not only did the personnel engaged in the research and development activities increase in number, but also the proportion of scientists and engineers increased continuously. Next, we review the personnel engaged in research and development activities classified as per department. Since different departments have different target trends and evaluation systems, the environment for research and development personnel will definitely exert a significant influence on their behavior. For example, research universities stress innovative fundamental theory research, where the reward and promotion opportunities of the research personnel are dependent on recognition by their academic peers and whether they can publish articles in high-level periodicals and journals. Therefore, they usually do not focus on the practical applications of research. On the contrary, the research and development personnel in enterprises are mostly concerned about whether their scientific research results have economic value and can result in profits for their enterprises and themselves. In many cases, research achievements that are theoretically innovative are not always of economic value, while the research achievements that have great market value have almost little theoretical value. Figure 8.7 shows the personnel engaged in research and development activities classified as per their department. Obviously, its changing trend is similar with the expenditures shown in Figure 8.5. Among all the research and development personnel, the enterprises’ proportion increased from 22% in 1987 to 66% in 2006. The proportion in research institutions decreases from 52% in 1987 to 15% in 2006. Apart from the fact that the proportion of the higher-learning institutes remains at 20%, it also seems to be assuming a slightly downward trend. This indicates that based on research and development activities classified by department, enterprises are increasingly replacing scientific institutions and becoming the agents of research and development activity in China.

8.1.4 Per Capita Indicator of Research and Development Expenditures in China and a Cross-country Comparison We have analyzed the sources of funding and labor input of China’s research and development activities. Based on this, we can review two major indicators that are used to measure research and development intensity. One is the per capita research and development expenditure of research and development personnel and the other is the proportion of TOWARD AN INNOVATIVE NATION

2 2 0 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 100

Percentage

80

60

40

2006

2005

2004

2003

2002

2001

2000

1999

1998

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1996

1995

1994

1993

1992

1991

1990

1989

1988

0

1987

20

Year Research Institutes

Enterprises

Higher-learning Institutes

Others

FIGURE 8.7 Personnel engaged in the research and development activities in China (classified according to department)

research and development expenditures in GDP. Unlike common production activities, the results of research and development activities are highly uncertain, and it is difficult to conduct process supervision. In order to address the moral hazard of research and development personnel, it is necessary to let them undertake risks to generate results. According to the premise of the efficiency wage theory, if research and development personnel can gain sufficient rewards, they have no motivation to dawdle, as this will increase the probability of research and development failure and result in job loss. It shows that with a given research and development input, it is not always true that having a larger pool of research and development personnel improves matters. This explains why the per capita research and development expenditure indicator has important economic implications. The purpose of research and development activities is to gain new knowledge or new technology. This implies that the research and development activity shares characteristics with games instead of being an isolated endeavor. The profits people gain from research and development activities is not only relevant to their own investment and effort but also dependent on the investment and efforts of the competing research and development personnel. In science, such game performance is represented by priority 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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2 21

competition; only those individuals who first discover some phenomenon or put forth some theory can earn the highest academic honors (such as Nobel Prizes or the Fields Medal). In the technology domain, the game is represented by patent competition—only those applicants who complete technological innovation first will be granted patent rights and can enjoy monopoly profits. Further, in many countries, some industries (such as the hi-tech industry) are supported and developed from a national economic perspective. Therefore, from the country’s viewpoint, the benefits of research and development activity are interdependent. Whether a country may obtain competitive advantages in technology is dependent not only on independent research and development investment but also on the research and development investment of other countries. Due to the abovementioned reasons, when analyzing the research and development activities of a country, it is important to consider the absolute quantity indicator as well as the relative indicators. In practice, the proportion of research and development expenditure in relation to GDP is an indicator that is taken as a reference. It measures the research and development intensity of a country in general and since it is dimensionless and unaffected by factors such as the exchange rate, it is appropriate for cross-country comparative analysis. Since the reforms and opening up, the evolution of the measurement for research and development intensity by the proportion of the research and development expenditure in the GDP of China can be divided into two different stages. As shown in Figure 8.8, prior to 1999, this indicator was basically around 0.6%–0.7%. However, after 2000, it started increasing rapidly and reached 1.42% in 2006. However, it is still far from the target level of an innovative country that was set by the “Outline of National Plan for Medium to Long-term Scientific and Technological Development (2006–2020).” In comparison, the per capita research and development expenditure of the research and development personnel maintained a steady upward trend during this period, reaching RMB 18.1 thousand per person/year in 1987 and RMB 200 thousand per person/year in 2006, which was a very high growth rate even adjusting for inflation. However, a cross-country comparison in Table 8.1 shows that there still exists a huge gap between China and the developed countries. Let us review the proportion of research and development expenditure in terms of GDP first. In 1987, the research and development intensity of China was only 0.61% while that of the United States reached 2.69%; Japan, 2.81%; and OECD, 2.23%—all four times higher than that of China. Even India, a similar developing country, had a much higher expenditure than China. However, since this indicator of developed countries remained almost constant, the gap is narrowing due to the rapid progress made by China. By 2006, China’s research and development intensity had reached half the level of that in the developed countries, exceeding that of Russia and India. Second, let us review the number of research and development scientists and engineers per 10,000 total workers. Table 8.1 shows that although this indicator has maintained a TOWARD AN INNOVATIVE NATION

2 2 2 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 25

1.6

RMB 10,000 per Person per Year

1.4 20 1.2 1

15

0.8 10

0.6 0.4

5

0

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1987

0.2

Year Per Capita Research and Development Expenditure of Research and Development Personnel Research and Development Expenditure to GDP

FIGURE 8.8 Per capita research and development expenditure of the research and development personnel and the proportion of research and development expenditure in GDP

Table 8.1 A cross-country comparison of China’s research and development activities Research and Development Scientists and Engineers in 10,000 Personnel (Person/Year)

Research and Development Expenditure/GDP (%)

China United States Japan Russia South Korea India OECD

1987

1990

1995

2000

2006

1987

1990

1995

2000

2006

0.61 2.69 2.81 — — 0.98 2.23

0.67 2.65 2.99 2.03 — 0.85 2.26

0.57 2.51 2.92 0.85 2.37 0.71 2.07

0.90 2.74 3.04 1.05 2.39 0.86 2.22

1.42 2.62 3.32 1.07 2.98 — 2.25

— 73.3 84.4 — — — 53.0

6.3 — 91.3 — — 152.0 56.7

7.6 77.4 101 83.7 48.2 — 55.5

9.6 89.6 95.7 70.7 49.0 — 63.0

14.6 93.1 106.0 62.8 75.7 — 69.9

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very high growth rate, from 6.3 per person/year in 1990 to 14.6 per person/year in 2006, there still exists a huge gap between China and the other countries listed in the table in terms of absolute quantities or in terms of absolute increases. Let us take the example of India; in 1990, its number of research and development scientists and engineers per 10,000 total workers reached 152. A large number of highly qualified and low-wage earning engineers was one critical factor for the rapid development of India’s software industry.

. Output and the Evolution of Scientific and Technological Activity As compared with the research and development input, the measurement and evaluation of research and development output is more difficult. Unlike the standard production processes, the results of research and development activities are scientific and technological knowledge. Complicated intermediate steps and long time spans are essential before the economic and social benefits of research and development can be realized, and it is difficult to record these or even measure them. Sometimes, research and development activities have obvious direct effects, such as the improvement of product quality or the reduction in production cost, so that they can be measured through the profits of manufacturers and changes in consumer surplus. In other cases, the results of research and development activities may be the changes in the manner in which people think, the restructuring of social organizations, and changes in production methods, which are difficult to record and measure. For example, with the emergence of the Internet technology, the cost of information collection and processing has reduced dramatically, exerting profound influence on the social organization structure. According to new institutional economics, the organization boundary is determined by the relative size of the market transaction cost and internal management cost. In this way, since information technology has reduced the market transaction costs, the organization size should be declining. On the other hand, information technology has reduced the internal management cost, which should result in an increase in organization size. Although these changes to organization structures can be deemed as the outcome of information technology research and development activities, it is very difficult to measure and evaluate them. In addition, research and development is always used as a strategic measure for market competition. For market monopolies, research and development investment may deter potential entrants in order to sustain the market monopoly positions. On the other hand, in the case of market entrants, research and development investment may become the means to overcome market monopolies. However, there are great differences between the private and social benefits of research and development investment. Therefore, indicators such as GDP or profits are not good TOWARD AN INNOVATIVE NATION

2 2 4 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

indicators for measuring the yields of research and development activities because they result in either overestimates or underestimates. Based on the reasons metioned above, the direct output of scientific and technological activities should be mainly studied when evaluating scientific and technological input efficiency in international science and technology research domains, in which the absolute number of papers and the number of citations of scientific papers and patents are most commonly used. Although these indicators are inherently insufficient, they can basically reflect the key achievements of scientific and technological activities in countries all over the world. They are not only convenient for statistical and quantitative analysis, but are also convenient for international comparisons.

8.2.1 Indicator for Scientific Papers Scientific literature is an important form of the direct output of scientific and technological research as well as an important reference for the global science and technology community to identify and evaluate scientific contributions, as it reflects the efforts that a country has made in fundamental research and applied research, as well as its communication with the scientific society in other countries. Scientific research is a very specialized activity, and its quality can only be judged by the academic community rather than by society. Periodicals have provided an academic with a platform for information screening. Usually, only papers that have attained a certain academic level can be accepted and published; therefore, the fundamental scientific research capability of a country will be measured by the absolute number, level, and the number of citations of the papers published. As mentioned before, priority competition is a behavioral norm that governs scientific research activity—only those who are the first to initiate some theory or discover some phenomenon can attain a high academic position. Since publicly published academic papers and conference papers are the most critical academic standards for judging quality, scientists are motivated to disclose research achievements as early as possible. However, since scientific research is a process of innovation accumulation, these papers published publicly become the foundation of future scientific and technological researches. Currently, there are three major statistical systems for scientific and technological papers in the international community: the Science Citation Index (SCI), the Engineering Index (EI), and the Index to Scientific and Technical Proceedings (ISTP). The SCI system was established by the Institute for Scientific Information (ISI) in 1961, incorporating scientific and technological literatures in the disciplines of life sciences, medicine, biology, physics, chemical, agriculture, and engineering technology. It is the most authoritative system in the world for evaluating fundamental research and applied scientific research. The EI data are always used for conducting comparative research on the technological competency of each country, incorporating literature that includes 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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application research and engineering technology, the content of which includes the following engineering technology domains: biology, civil engineering, geology, environment, mining, petroleum, metallurgy, machinery, fuels, nuclear energy, automobile, cosmonautics, electrical, electronics, control, chemical industry, foodstuff, agriculture, industrial management, mathematics, physics, and instruments. The ISTP is an important complement to the periodical literatures, incorporating science and technology conference literature published in the world. Table 8.2 shows the Chinese scientific and technological papers incorporated in the three major international systems. During 1987–2006, the total number of Table 8.2 The number of Chinese scientific and technological papers incorporated in the three major systems and their international ranking Total Number of Chinese Science International and Technology Ranking Papers Embodied in Papers in the Three Major International Embodied Embodied Embodied Embodied in in the SCI in the ISTP in the EI the SCI Year Systems 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

9,017 11,854 12,232 13,352 11,783 15,700 20,218 24,584 26,395 27,569 35,311 35,003 46,188 49,678 64,526 77,395 93,352 111,356 153,374 171,878

4,880 5,590 6,776 7,945 6,630 6,224 9,617 10,411 13,134 14,459 16,883 19,838 24,476 30,499 35,685 40,758 49,788 57,377 68,226 71,184

TOWARD AN INNOVATIVE NATION

1,774 2,940 2,139 2,398 2,780 5,272 4,503 4,802 5,152 3,963 5,790 5,273 6,905 6,016 10,263 13,413 18,567 20,479 30,786 35,653

2,278 3,214 3,187 2,840 2,146 3,970 6,058 9,371 8,109 9,147 12,638 9,892 14,807 13,163 18,578 23,224 24,997 33,500 54,362 65,041

24 17 15 15 15 17 15 15 15 14 12 12 10 8 8 6 6 5 5 5

International Ranking in Papers Embodied in the ISTP

International Ranking in Papers Embodied in the EI

14 9 13 13 13 9 10 10 10 11 9 10 8 8 6 5 6 5 5 2

10 9 8 9 9 6 5 4 7 6 4 5 3 3 3 2 3 2 2 2

2 2 6 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

Chinese scientific and technological papers incorporated increased 19 times, in which the number of papers incorporated in the SCI increased 15-fold, with China’s ranking elevated from No. 24 to No. 5; the number of papers incorporated in the ISTP increased 20-fold, with its world ranking elevated from No. 14 to No. 2; and the number of papers incorporated in the EI increased 28-fold, with its rank elevated to No. 2. While the domains of the papers embodied in the three major systems are different from each other, the quality of different papers may vary greatly; hence, it would be misleading to make a quantity comparison alone. However, as long as the same calculation methodology is used, we are able to compare the relative development speed of China in terms of papers embodied in the three major systems. Taking the total number of papers embodied as gross volume, we may get Figure 8.9 (below) from the above table. It can be seen that the SCI has been of the highest percentage, accounting for 40% of the gross volume; after 2000, its relative proportion decreased successively. It can be seen from Table 8.1 that this was mainly because the number of Chinese papers embodied 70 60

Percentage

50 40 30 20

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

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0

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10

Year Proportion in Papers Embodied in the SCI Proportion in Papers Embodied in the ISTP Proportion in Papers Embodied in the EI

FIGURE 8.9 Composition of the Chinese scientific and technological papers embodied in the three major systems (%)

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in the EI has been increasing greatly in recent years. It indicates that in recent years, the industrialization capability of the Chinese research and development activities has rapidly improved. Table 8.3 further provides an international comparison of the scientific and technological papers embodied in 2006. The first row includes the number of US scientific and technological papers embodied, which is standardized as 1, and the rows that follow provide the ratio of the number for other countries to the total number in this index. It can be seen that the United States leads the field in the total number of scientific and technological papers embodied in the three major systems, obviously having the advantage of leadership over other countries. As compared with the United States, China has the narrowest relative gap in the EI papers and the biggest relative gap in the SCI papers, indicating that China is relatively weak in fundamental and applied research, and is relatively strong in aspects of its industrialization capability. Apart from the international periodicals, there exists a large number of Chinese periodicals in China. Due to research interest, academic capability, and language factors, for most Chinese research personnel, these Chinese periodicals are a more important academic platform for publishing papers. Figure 8.10 indicates that since 1999, the number of papers published in Chinese periodicals increased rapidly and reached 404,858 papers in 2006, far more than the total number of papers of China embodied in the three major systems (171,878 papers). Since Chinese is not a widely spoken language internationally, Table 8.3 The top-ranking countries in terms of papers (2006) International Total Number Ranking of Science and in Papers Technology Papers Embodied Embodied Embodied Embodied in Embodied in the SCI in the ISTP in the EI the SCI United States China Japan United Kingdom Germany France Italy India Russia

International Ranking in Papers Embodied in the ISTP

International Ranking in Papers Embodied in the EI

590,807

378,690

139,278

72,839

1

1

1

0.29 0.25 0.23

0.19 0.23 0.26

0.26 0.21 0.16

0.89 0.43 0.25

5 4 2

2 3 5

2 3 5

0.23 0.16 0.13 0.08 0.07

0.23 0.16 0.13 0.08 0.06

0.18 0.12 0.12 0.03 0.05

0.28 0.20 0.16 0.17 0.15

3 6 8 12 14

4 6 7 18 12

4 6 10 9 8

TOWARD AN INNOVATIVE NATION

2 2 8 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 450,000 400,000

Number of Papers

350,000 300,000 250,000 200,000 150,000 100,000

2006

2005

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2003

2002

2001

2000

1999

1998

1997

1996

1995

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1993

1992

1991

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0

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50,000

Year

FIGURE 8.10 The number of papers published in the domestic Chinese periodicals

high-level Chinese scientists tend to contribute their high-level papers to English journals so that they are recognized by their international peers, while high-level scientists in other countries are unlikely to contribute to Chinese journals; consequently, the average quality of academic papers in domestic Chinese periodicals is not very high. There are serious issues of low-level repetition and even plagiarism; hence, we should not make a simple quantity comparison with international periodicals.3 Despite this, the study of the situation of papers published in the Chinese periodicals in China will help us understand some of the structural problems. The papers published in the domestic Chinese periodicals are divided into five major classifications according to discipline: basic disciplines; health and medicine; farming, forestry, animal husbandry, and fishery; industrial technology, and others. We can observe from Figure 8.11 that based purely on the quantity, Chinese papers are focused in the domains of industrial technology, basic disciplines, and health and medicine. Prior to 2000, the distribution structure of all the papers remained almost unchanged in each 3. Actually, since the rewards and the promotion of the scientific research personnel are all closely related to the quality of the papers published, once some domestic Chinese journals are labeled as low-quality periodicals in the evaluation system, people will be more unwilling to contribute their high-level papers to these journals, forming a vicious circle akin to bad money driving out good money.

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100

Percentage

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60

40

2006

2005

2004

2003

2002

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2000

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1998

1997

1996

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1994

1993

1992

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0

1990

20

Year Basic Disciplines

Health and Medicine

Industrial Technology

Farming, Forestry, Animal Husbandry, and Fishery

Others

FIGURE 8.11 Papers published in domestic Chinese periodicals in China (classified by discipline)

domain. Thereafter, the percentage of the papers in the health and medicine domain started to increase dramatically. We may deduce from the following analysis that this was mainly because hospitals were becoming pivotal in publishing academic papers. Figure 8.12 provides an overview of the publishing of papers in the domestic Chinese periodicals from the viewpoint of the publishing unit. Throughout the period under consideration, the higher-learning institutes drove the publishing of academic papers with a contribution amounting to about 60% of the papers published. However, the contribution of the scientific research institutes diminished over time with the hospitals gradually taking over. The number of papers published by hospitals has increased dramatically. This is related to the structural adjustment of the higher-learning institutes in China, where many hospitals have been turned into universities. Therefore, the quantity and the quality of the papers published are becoming increasingly important to the career aspirations of doctors. We can conclude on the basis of our analysis above that the higher-learning institutes are a major force in the production and publishing of the scientific and technological papers in China, with industrial technology being the major research discipline. TOWARD AN INNOVATIVE NATION

2 3 0 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 100

Percentage

80

60

40

2006

2005

2004

2003

2002

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0

1990

20

Year Higher-learning Institutes

Scientific Research Institutes

Enterprises

Hospitals

Others

FIGURE 8.12 Papers published in domestic Chinese periodicals (classified according to publishing units)

8.2.2 The Patent Index The patent system is one of the most important systems in a modern society to promote industrial innovation and technological progress. Innovations have the characteristics of a public good; although their initial production cost is high, once they emerge, they can be easily duplicated and mimicked at low cost. Therefore, no one in the market is willing to perform research and development activities until patent protection is in place.4 The rationality of the patent system is that it can stimulate research and development activities and technological innovation by granting monopoly rights to inventors for a certain duration. Not all inventions and technological innovations can obtain patent protection. In order to apply for patents, the inventors must fully disclose their technological information; further, for the patent to be awarded, the invention and technological innovation must satisfy specific conditions, namely practical applicability, novelty, and inventiveness. 4. Th is conclusion is possible only under the assumption that knowledge is a pure public good. The fact that there exists a large number of commercial secrets proves that in fact, this assumption is very likely to be true. On the other hand, even if there is no patent protection, commercial secrets can also provide some innovation stimulation to certain activities.

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2 31

Due to such entry conditions, the numbers of patents partially reflect the technological innovation capability of a country or enterprise. Of course, there are inherent defects in using patent numbers as the output indicator of research and development activities. However, the most critical issue is calculating the number of patents. The most direct method is to calculate the total number of patents, with the number reflecting the magnitude of research and development output or the level of innovation capability. However, if all the patents are considered on an equal footing, then the market value distribution is large, indicating that there is a problem in calculating this total number. Majority of the patents do not have any market value, while a few patents are valuable. For this reason, many economists have recommended using patent citation data instead of direct patent quantity because high-value patents are more likely to be cited by future patents. Unfortunately, no such data are available in China. Therefore, we still use the method of calculating the total number in this chapter. Figure 8.13 provides the general outline of the number of patents applied for and granted in China, in which the granting ratio equals the ratio of the number of patents granted/ number of patents applied for. Although eventually only patents granted can bring exclusive market monopoly to the innovators, the number of patents applied for is still a significant output indicator, which may reflect information in terms of research and development investment, application incentives, and the protection of intellectual property rights. 600,000

90 80

500,000 70 400,000

60 50

300,000 40 30

200,000

20 100,000

2006

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0

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10

Year Total Number of Patents Applied for

Total Number of Patents Granted

Granting Ratio

FIGURE 8.13 General situation of the patents applied for and granted in China

TOWARD AN INNOVATIVE NATION

0

2 3 2 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

Apart from patent protection, commercial secrets are also an important means of protecting the gains from innovation. Although it is not exclusive, as long as it is not disclosed, there is no time limitation for its effectiveness. Coca Cola’s recipe is a typical instance of a corporate secret. Obviously, only when the expected yield of the patents applied for by the innovator is higher than the profits from keeping it a corporate secret will an inventor decide to apply for a patent. The size of patent profits is closely related with the intensity of intellectual property protection. For instance, the stronger the measures taken against imitation and piracy, the larger will the profits from the patent be. The level of patent requirements may also exert a subtle influence on the size of patent profits. On one hand, after intellectual property rights conditions are improved, the difficulty for innovators to gain patents will increase, and people’s incentives to innovate will diminish. However, the better the conditions, the more difficult will it be for substitute patents to emerge, and the expected monopoly profits of patent holders will be higher. Consequently, the incentive for innovation will be greater. According to the analysis mentioned above, we provide two complementary hypotheses for patent granting ratios: first, comparing different types of patents (such as the invention, utility model, or design described later), if there is a systematic difference in the patent application granting ratio, then the higher the granting ratio that patent types have, the weaker the corresponding conditions will be. Second, corresponding to specific types of patents (such as invention patents), since the conditions are given, the fluctuation in the granting ratio over time represents the fluctuation in the quality of technological innovation in patent applications. According to China’s Patent Law, patents include patents for invention, utility models, and design. Invention implies new technical solutions proposed for products and approaches or the improvement thereof. The duration of patents for invention is 20 years, and the patent-granting condition is that the patents must have “outstanding material features and outstanding progress as compared to the existing technology before the date of filing.” A utility model patent means that new and practical technology solutions are proposed for the shape and construction of a product. The legal protection duration of patents for utility models is 10 years, and the patent-granting condition is that the patent must have more material features and progress as compared to the existing technology before the date of filing. Obviously, the conditions for granting patents for utility models are less stringent than in the case of patents for inventions; therefore, they are usually called a “petty patents.” Finally, design patents means patents for new designs with aesthetics for industrial application made in different shapes, patterns, or a combination of the two, as well as specific combinations of color, shape, and patterns. The protection duration of patents for design is also 10 years. From the definition above, we can see that the patent for invention is the strongest patent, while the other two are minor patents. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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Figure 8.14 shows the changes in the number of patents applied for in China classified as per the types of patent. In 1987, two years after the enactment of the first Patent Law in China, the utility model accounted for the majority of patents both in terms of the number of patents applied for and in terms of the number of patents granted. The proportion of invention patents applied for remained almost unchanged at about 20%–40% of the total amount, while the proportion of design patents kept increasing, reaching approximately 40% by 2006. Our explanation for such a changing trend is that the intensity of competition among the enterprises is increasing with the Chinese economy transforming from a sellers market to a buyers market. The enterprises are increasingly motivated to seek product differentiation through research and development activities, in order to avoid ruinous price competition among themselves. Figure 8.15 further depicts the situation of the number of patent applications in China classified by patent types. Its changing trend is basically similar to the number of patents applied for, but with some obvious differences. Given its substantial innovative content, patents for invention are more difficult to be awarded; therefore, as compared with the number of patents applied for, the percentage of patents for invention in the total amount of patents granted has decreased.

100

Percentage

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Patents for Utility Model Accepted

Patents for Design Accepted

FIGURE 8.14 Changes in the structure of the number of patents applied for in China (classified by patent type)

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2 3 4 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 100 90 80

Percentage

70 60 50 40 30 20

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2002

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Year Patents for Invention Granted

Patents for Utility Model Granted

Patent for Design Granted

FIGURE 8.15 Changes in the structure of the number of patents granted in China (classified by patent type)

Since patent protection has regional characteristics, in order to protect the technological advantages or monopoly positions in China, foreign enterprises or individuals need to apply for patents in China. Consequently, research and development personnel can be divided into domestic and overseas patent applicants. It can be seen from Figure 8.16 that minor patent applicants in China are basically from domestic research and development personnel, while the percentage of overseas applicants for design patents is no more than 10%. The percentage of utility models is no more than 1%; however, as for patents for invention, the percentage of overseas applications is very high, reaching a peak of 62% in 1997. In recent years, although the percentage of overseas applications declined, the number of domestic applications has dramatically increased; however, overseas patent applications remain above 40%. Except for the proportion of applications from China and foreign countries, a more significant point is the differences in innovation capability between the Chinese and foreign applicants. According to an analysis on the intellectual property rights conditions mentioned above, the differences in certain specific patents granted to domestic and overseas applicants reflects the quality difference in inventions for which patents are applied. This further illustrates the differences in innovation capabilities. Since both 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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235

70 60

Proportion

50 40 30 20

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2002

2001

2000

1999

1998

1997

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1995

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1993

1992

1991

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10

Year Invention

Utility Model

Design

FIGURE 8.16 Proportion of overseas applications for the three patents

the utility model and design patents are minor patents with their applicants basically being domestic research and development personnel, we only review examples of patents for the invention here. As shown in Figure 8.17, although there are significant fluctuations in the quality of technological innovations of Chinese and foreign applicants, the range of fluctuation for foreign applicants is greater. A comparison of Figures 8.16 and 8.17 shows that the ratio of grants to foreign applicants for the patent for invention is significantly, negatively correlated with the percentage of applications of foreign patents for invention. In other words, the higher the application proportion, the lower is the grant ratio. However, the decline in foreign application proportions has dissimilar causes in different stages. In the early stage when China’s Patent Law was enacted, the huge market and the abundant cheap labor resources in China attracted foreign enterprises to invest in China. In order to protect their benefits in the Chinese market, the number of patent applications they applied for began to increase dramatically. At the end of 2001, China entered the WTO and the level of intellectual property protection was enhanced to meet the minimum level required by TRIPS. This had two major consequences. First, foreign inventors were more willing to introduce high-quality technology in China to gain competitive advantages in the market. In such cases, with patentable conditions given, their grant ratio TOWARD AN INNOVATIVE NATION

2 3 6 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 80 70

Patent Granting Ratio

60 50 40 30 20

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Year Domestic

Overseas

FIGURE 8.17 The domestic and overseas granting ratio for patents for invention in China

would increase. Second, in the case of Chinese research and development personnel, the imitation cost and the litigation exposures from foreign patent owners increased dramatically, forcing them to take control over the core technology. This resulted in a significant increase in applications for the invention patents filed by Chinese research and development personnel. Therefore, the proportion of foreign applications assumed a downward trend. Summing up the above analysis, we know that the technology innovation capability of foreign applicants for the invention patents is obviously higher; however, the technical quality of their patent application in China is easily influenced by the political, economic, and market forces in China. China’s Patent Law has also divided inventions into duty inventions and non-duty inventions. Duty inventions comprise patent creations completed by the research and development personnel by executing the tasks designated by their work unit or by using the resources of their work unit. Both the rights of the patent application and the patent rights belong to this unit; other inventions not included in duty invention are classified as non-duty inventions and their patent application rights belong to the individual. Figure 8.19 shows the percentage of the duty inventions in the total number of patent applications and grants in China. Throughout the period considered, the percentage of 30 YEARS OF CHINA’S REFORM STUDIES SERIES

ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

237

50 45 40

Proportion

35 30 25 20 15 10

2006

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2002

2001

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1987

5

Year Proportion of Duty Inventions Applied for

Proportion of Duty Inventions Granted

FIGURE 8.18 Proportion of duty inventions in the total amount of applied for and granted

duty invention is no more than 50% and the non-duty invention by individuals constitutes the core of patent applications and grants in China. However, after 1994, the percentage of duty invention continued to increase and it reached approximately 45% by 2006, indicating that Chinese research and development personnel were increasingly reliant on research funds and resources provided by their units. It can be further noted that there was no great discrepancy between the proportion of the duty invention applications and the duty invention grants, which indicates that there are no significant systematic differences between the duty and the non-duty invention granting processes. China’s Patent Law further divided the units of duty invention into colleges and university, scientific research units, industrial and mining enterprises, and government departments and organizations. Figure 8.19 provides the percentage of each type of unit in the total amount of applications. Regarding this structure, industrial and mining enterprises have constituted the bulk of the applications and grants of duty inventions in China, especially since 1995, with the structural adjustment made to the science and technology management system by the Chinese government. Many government departments and organizations have become enterprises, and the percentage of industrial and mining industries exceeded 80%. If we review the percentage of each type of unit in the TOWARD AN INNOVATIVE NATION

2 3 8 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS) 100 90 80

Percentage

70 60 50 40 30 20

2006

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Year Industrial and Mining Enterprises Colleges and Universities

Government Departments and Organizations Scientific Research Units

FIGURE 8.19 Application processing of the duty patents in China

total amount of grants, the figure derived will be almost identical to Figure 8.19. This seems to indicate that there are no great differences among the research units in terms of innovation capability. Nevertheless, this is not true. If the application and grant composition of each unit is reviewed on the basis of their patents for invention, utility model, and design, it can be seen that the percentage of scientific research unit grants is declining, while the percentage of industrial and mining enterprises is increasing. Meanwhile, the percentage of universities, colleges, and scientific research institutes in the number of patents granted for invention is far higher than their percentage in the number applied for. In other words, the average technological research and development capability of scientific research institutes, universities, and colleges is stronger. According to the above-mentioned analysis, we can see that since the enactment and implementation of the first Patent Law in China, the number of patent applications and grants has increased rapidly. Among all patent types, the utility model patent has accounted for the highest percentage of patents, indicating that research and development activities in China are currently in the stage of technology introduction and assimilation; however, with China’s entry into the WTO and the enhancement of the level of intellectual property protection, both the number and percentage of patents for 30 YEARS OF CHINA’S REFORM STUDIES SERIES

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239

invention are increasing gradually. If we look at domestic patent application in terms of patent ownership, then individual non-duty patents are in the leading position; however, the percentage of duty patents has been increasing in recent years. The industrial and mining enterprises are the most important agents in patent applications. Finally, as compared with Chinese research and development personnel, the average innovation capacity of foreign patent applicants in China is much stronger, and their patent applications have focused on the patents for invention that serve a critical function.

. Conclusion In February 2006, the Chinese government approved the “Outline of the National Plan for Medium to Long-term Scientific and Technological Development (2006–2020),” elevating independent innovation to a national strategic mission and regarding it as the central link for adjusting economic structure, transforming growth patterns, and improving a country’s competence. After entering the twenty-first century, the new science and technology revolution is still growing and developing at a fantastic speed, represented by IT, new materials, and new energy, and has provided valuable opportunities and serious adjustments for China to realize economic growth and to build a society with moderate prosperity. Facing rapid technological progress, in order to seize the initiative in the face of severe international competition, it is critical for China to enhance its independent innovation capability, to assume control over core technologies in several key domains to own independently developed and owned intellectual property, and to develop a number of enterprises with international competence. According to the target set by the outline, by 2020, China should have considerable independent innovation capabilities and should have become an innovative country, building the foundation to become a world science and technology powerhouse by the mid-twentyfirst century. As seen through some key indicators, by then, the percentage of research and development input of the entire society will increase to over 2.5%; the scientific and technological progress contribution rates will reach over 60%; the foreign technology dependence will reduce to no more than 30%; and the amount of annual grants of invention patents by Chinese people and the number of international scientific papers cited will rank amongst the top five in the world. Based on our analysis mentioned above, the research and development activities in China have progressed rapidly since the reforms, in terms of input and output. The instensity of China’s research and development, the number of scientific and technological papers, international ranking, the number of patents, and the percentage of patents for invention have all increased dramatically. Meanwhile, there are great changes in the agent behavior in scientific and technological activities in China. One of the most TOWARD AN INNOVATIVE NATION

2 4 0 ANALYSIS OF THE PERFORMANCE OF CHINA’S NATIONAL INNOVATION SYSTEM (NIS)

outstanding points is that enterprises have become the major force of research and development input and output. This indicates that after many years of market reform, science and technology has integrated more with the national economy. Science and technology has become the key avenue for boosting China’s economic growth. However, we may clearly notice that there still exist some outstanding shortcomings in China’s National Innovation System. Insufficient investment is one of them. In 2006, the research and development intensity of China, namely the percentage of research and development expenditure in GDP, was only 1.62%, and there was still a wide gap between the target of 2.5% set by the outline. It lags far behind the developed countries such as the United States as well. Although the number of scientific and technological papers in China has catapulted forward in the world rankings, few of these papers are cited. Therefore, overall quality needs to be improved. Although the number of patent applications and grants in China has increased dramatically, these were mainly patents for utility models and designs. The number of patents for invention, which are the core of technological development, is still significantly insufficient.

30 YEARS OF CHINA’S REFORM STUDIES SERIES

C

APTE

9

R

H

Epilogue Since the reforms and opening up in 1978, the Chinese economy has undergone rapid growth, becoming a “miracle economy,” and has drawn world-wide attention. However, according to many economic studies, the economic growth in China over the past 30 years was mainly due to large-scale factor accumulation with miniscule contribution from technological progress. The total factor productivity of China has even assumed a downward trend in recent years. Considering China’s incredibly high savings ratio, the limits to higher education, environmental damage, and the recent rapid increase in labor wages, the sustainability of China’s growth is questionable. Some people warn that China’s “miracle” has become an unsustainable “myth” and that without a solid innovation foundation, it is on the road to failure. Is this the case? The answer lies in whether or not China has a substantive innovation foundation. After the foundation of the People’s Republic of China (PRC), a highly centralized science and technology management system was established in China. Research institutes were responsible for the research and development of technology; factories were responsible for new technology implementation; schools were responsible for training talent; and the government departments such as the Bureau of Industry were responsible for factor coordination. The major advantage of the original system was its ability to “concentrate efforts on addressing significant issues.” Some specific strategic targets, such as a successful satellite launch and the explosion of an atomic bomb, were achieved accordingly. However, conventional innovation activities under the original system encountered serious problems related to information and stimulus. Micro subjects lacked decision autonomy, making them unable to take advantage of economic information. Under the past financial system with “unified revenue and expenditure,” micro-subjects were not sensitive to costs and yields, as their actual income was irrelevant to the operational performance. Therefore, both the enterprises and research institutes lacked the correct incentives to actively research and develop, and were unlikely to introduce or promote

2 4 2 EPILOGUE

new products and technology. This resulted in the serious situation of the two isolated layers of science and technology and the economy. The Third Plenary Session of the Eleventh Central Committee of the Party corrected the ultra-leftist stance taken since the Cultural Revolution, and officially established a policy of “centering on economical construction”. The economic system reform unleashed the dynamism of many manufacturing enterprises. As a result, they actively searched for technologies to improve their economic state. The implementation of this economic system reform required the reform of the scientific and technological management system. In 1985, the “Decision on the Reform of the Science and Technology Management System” by the Central Committee of the Communist Party of China was enacted and a strategic policy making economic reconstruction reliant on science and technology and scientific and technical work oriented toward economic construction was put in place. A basic framework was established for future reform in making the science and technology management system market-oriented. Over the past 30 years, the target of the science and technology reform in China has been to promote horizontal connections between the economy and science and technology. First, the central government facilitated a strict reform of the appropriation system, greatly reducing appropriation and even ceasing appropriation for the expenditures of scientific research institutes. This forced them to seek funds in the market while realizing the industrialization of technology by hardening the budget constraints. As a supporting measure, the State allowed enterprises and scientific research institutes more decision-making autonomy, letting them take risks and share the profits of their operational decisions. The State also developed a series of laws, regulations, and rules to confirm the market value of technological achievements made by scientific research institutes, promoting the trade of technological products by forming the technological market. However, due to the characteristics of the technological products and the complexity involved in technological transactions, a single market solution for technology could not completely eliminate horizontal information barriers between technology and the economy. Therefore, the Chinese government facilitated the organizational restructuring of enterprises and scientific research institutes to combat this, by facilitating mergers between enterprises and research institutes by using administrative approaches. The approach with the most obvious effect was encouraging good asset stripping of scientific research through the Torch Program, which created a number of star enterprises in China including Lenovo and the Stone Group. China is a technologically undeveloped country. Thus, the introduction of advanced technologies from other countries seemed to be the way forward for development, with the market for technology becoming an important motivation for foreign investments. 30 YEARS OF CHINA’S REFORM STUDIES SERIES

EPILOGUE

243

Undoubtedly, the entry of huge amounts of foreign capital has greatly boosted the rapid growth of the Chinese economy; however, practices within the automobile industry indicate that market measures cannot be a substitute for core technology development. Without independent innovation capability, research and development eventually falls into the vicious circle of lagging behind, introducing foreign technology, and then lagging behind again in the face of further technological innovation abroad. To counter this, the Chinese government has started advocating independent innovation in recent years, constructing an efficient National Innovation System (NIS). The “Outline of the National Plan for Medium to Long-term Scientific and Technological Development (2006–2020)” not only established the development strategy of “independent innovation, key-point breakthrough, supporting development, and leading the future,” but also enacted policy measures for nine aspects including tax, government acquisition, finance, industry, and regions. This was for the purpose of strengthening intellectual property rights and technological standards strategies and encouraging enterprises to independently innovate, through measures such as technological introduction and assimilation to re-innovation. Only when the connotation of innovation is properly grasped can we appropriately evaluate the performance of the Chinese Innovation System over the past 30 years. According to Schumpeter (1934), new markets, methods, products, combinations, and organizations are concrete representations of innovation, while entrepreneurship is the soul driver of innovation. In this case, innovation not only includes technology innovation but also the system of innovation. Considering the transitional characteristics of the Chinese economy, the innovation of the innovation system itself may be more important than any specific technological innovation. The two isolated layers of science and technology and the economy were the major shortcoming of the original system. In early stage of the transition, overcoming the original rigid system rather than the technological constraints was of the highest importance to the Chinese economy. It not only restrained horizontal integration between science and technology and the economy but also seriously restricted entrepreneurship in China. In retrospect, NIS in China has progressed enormously over the past 30 years. If the reform of the science and technology management system itself can be deemed as innovation, then economic growth in China over the past 30 years has had a solid foundation for innovation. It would suffice to say that the current system is more advantageous in terms of technological creation, introduction, and diffusion. The improvement in economic freedom has not only changed the behavioral patterns of the existing organizations but has also triggered a large number of new entrepreneurial organizations, including the emerging township enterprises dedicated to technology and industrial structure updates as well TOWARD AN INNOVATIVE NATION

2 4 4 EPILOGUE

as the high technology (hi-tech) enterprises incubated within universities or research institutes. Today, either from the viewpoint of scientific and technological input or scientific and technological output, the enterprises have already replaced scientific research institutes and play a leading role in China’s NIS. The enterprise structure has laid a solid foundation for China’s desire to become an innovative country. The profitpursuing behavior of the enterprises enables them to rapidly react to market demand signals, such as cost reduction and quality improvement, which provides the Chinese economy with an intense demand pull effect. In addition, the State has enhanced financial support for scientific and technological research and shifted the support focus to fundamental research and strategic research domains. The scientific and technological output derived from this will generate considerable technology opportunities, providing China with a steady stream of the technological push effects and allowing it to become an innovative country. However, similar to the Chinese economy in general, China’s innovation system is still in transition. There are still many severe challenges for China on its way to becoming an innovative country. One of the most important challenges is the adjustment of the government function. The government has to consider some serious questions such as the following: • •

•

•

How to further influence the operation and strategic options of enterprises by indirect rather than direct measures? How to stabilize the incentives of civilians by ensuring property security, encourage the diffusion of technology by loosening constraints on labor flow, develop reasonable industry policies to promote technological innovation instead of being manipulated by vested benefits groups and how to use these policies for gain rather than as instruments for protecting backward and corrupt enterprises? How to enact and implement intellectual property rights and anti-monopoly policies in accordance with the ground realities in China in order to reach a reasonable balance between innovation and monopoly? How to realize a strategic transformation from encouraging technological imitation to stimulating independent innovation?

These are questions that require further consideration.

30 YEARS OF CHINA’S REFORM STUDIES SERIES

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30 YEARS OF CHINA’S REFORM STUDIES SERIES

Index A

E

L

Academic reward system, 28–29 Arrow-Debreu model, 16 Arrow’s Paradox, 81, 82 Automobile industrial policies, 174–186 Automotive industry, 151–187

Engineering Index (EI), 224, 225, 226, 227

Large and medium-sized enterprises, 53, 56, 86, 87, 88, 90, 91, 92, 105, 163, 165

C China’s miracle, 241 China’s science and technology management system, 2, 5, 6, 29, 32, 43, 52, 53, 57, 67–107, 112 Chinese Academy of Sciences (CAS), 6, 7, 8, 11, 21, 25, 26, 27, 28, 32, 50, 51, 53, 54, 87, 105, 216 Chinese Academy of Social Sciences (CASS), 71 Chinese Communist Party (CCP), 2, 23, 113 Cisco, 190, 196–201, 202, 203, 205, 206, 208 Collectively owned enterprises, 75, 76, 77, 78, 79, 80 Common big rice pot, 32, 33, 35, 36, 41, 46, 93, 213 Comparative advantage, 15, 81, 110, 132, 134, 138, 142, 143, 149 Contract system for technology, 36–38 Council for Mutual Economic Assistance (CMEA), 112 Cultural Revolution, 21, 23, 25, 26, 27, 29, 242

D Decentralization, 15, 41, 52, 89, 157, 187 Demand-pull, 71, 109

F Financial management system, 3 First Automobile Works (FAW), 153, 154, 155, 156, 171, 172, 174, 175, 181 First wave of productivity, 10–19 Fortune, 151, 500

G Great Leap Forward, 29, 30, 155

H Higher-learning institutes, 6, 8, 12, 25, 27, 43, 50, 62, 64, 71, 73, 80, 86, 104, 105, 212, 216, 217, 219, 220, 229, 230 Horizontal barriers, 1, 10–15, 69 Household contract responsibility system, 33, 41 Huawei, 94, 151, 190, 191, 196–201, 202, 203, 204, 205, 206, 208

I Independent innovation, 63–65, 92, 150, 184, 191, 203, 204, 208, 209, 239, 243, 244 Index to Scientific and Technical Proceedings (ISTP), 224, 225, 226, 227 Industrial development zones, 51, 52, 54, 63, 145–148 Industrial plans, 2 Industrial policy, 110, 112, 175, 177–180, 182, 183, 184, 185, 186, 187 Institute for Scientific Information (ISI), 224

M Market-oriented reform, 41 Military-to-civil, 14

N National Conference on science and technology, 24 National Innovation System (NIS), 1, 63, 64, 105, 114, 211–240, 243 New institutional economics, 67, 68, 95, 223

O Organizational restructuring, 84, 93, 242

P Patents, 48, 136, 139, 140, 141, 142, 146, 147, 150, 189, 190, 191, 197, 198, 201–207, 224–230, 231, 232, 233, 234, 235, 236, 238, 239, 240 Patents for invention, 139, 140, 141, 142, 233, 234, 235, 236, 238, 239, 240 Personnel system, 43, 64 Planned economy, 1, 2, 4, 12, 13, 16, 17, 68, 81, 93 Privately owned enterprises, 3, 5, 14, 51, 57, 63, 75, 76, 77, 78, 79, 80, 104 Productivity Promotion Center, 105–107 Public goods effect, 18

R Regional partition, 10–15

2 5 0 INDEX

S Science Citation Index (SCI), 224 Science-push, 71 Scissors gap, 4 Second Automobile Works (SAW), 154, 155, 170, 174, 175 Self-reliance, 9, 22, 29, 208 Soviet Union, 3, 4, 6, 8, 9, 10, 13, 14, 17, 153

Spark Program, 54, 59, 95–96, 97 Spill-over effects, 150

Trade specialization coefficient (TSC), 143

T

U

Tariff barriers, 65, 189 Torch Program, 52, 94, 96, 98, 101, 102, 103, 104, 114, 242 Total factor productivity (TFP), 241

United Nations (UN), 110

30 YEARS OF CHINA’S REFORM STUDIES SERIES