China's Heavyweight R&D Spending

(See also: Book Review: Where are the great Asian Brands?)

Although previously China has publicly indicated its ambition to invest heavily in research and development, the amount to actually be devoted to the sector is staggering, and is expected to be distributed mostly by fiscal or government subsidy – actual cash payment.

Sean Darby, Asia strategist for Nomura international (HK) Ltd., estimated the amount of spending over the next five years in a report this week at 5 trillion yuan (US$758.4 billion), an even bigger amount than the mammoth – and successful – 4 trillion yuan stimulus package announced by the central government in 2008 as an attempt to minimize the impact of the global financial crisis.

Hugh Peyman, the managing director of Research-Works, the leading independent equities research firm based in China, told Asia Sentinel that "It will be larger than people think. We are 60 percent of the way through a 25-year program to get R&D up to 2 percent of GDP, yet 75 percent of the spending lies ahead in the last decade to 2020."

US President Barack Obama spoke of a so-called "Sputnik moment" during his 2011 State of the Union address, alluding to the scientific achievement by the Russians in 1957 to put the first satellite into space. Obama told the Congress that "after investing in better research and education, we didn't just surpass the Soviets; we unleashed a wave of innovation that created new industries and millions of new jobs."

Nonetheless, it is questionable whether the Sputnik moment will generate the investment Obama wants. The United States is constrained by a massive budget deficit and a newly-minted Republican majority in the House of Representatives that is deeply averse to government spending. Obama said he would send a budget to Congress that includes funding for biomedical research, information technology, and especially clean energy technology. Although that statement was met with applause, any idea that the Republicans will put forward the funding is farfetched.

By contrast corporate USA, sitting on fattened balance sheets, has the funds to continue innovation and there is no denying the powerhouses like Silicon Valley. But at the same time, educational quality in the US continues to slip. Educators were shocked in December when students in Shanghai trounced the OECD averages in reading, mathematics and science. American students scored below the OECD average of 496 overall, with Finland, South Korea, Belgium, Estonia, Iceland, France, and the Slovak Republic, among others outperforming them. US students scored higher than those in just five countries in the survey: Greece, Israel, Turkey, Chile, and Mexico. These children, particularly in mathematics and science, are the natural resources on which innovation is built.

That isn't to say Chinese research and development is going to beat the world, and much depends on how the money is is spent. .

"To me, the willingness of Chinese companies to spend on R&D is the key to the future," research analyst Johnny Wong told Asia Sentinel.. "I have traditionally been a skeptic. After visiting some of the 'high-tech' companies, I think the follow up question should be how efficiently and productively the 'R&D' money will be spent. It is surprising how low tech some of these companies are. But I do agree that there seems to be good quality companies out there, like Huawei."

Nonetheless, in a 107-page report issued last February and written by Peyman and a team of researchers, Peyman wrote that "The most overlooked investment case for China is its growing R&D strength. Skeptics may quip it is R&C (R& copying) but this ignores the facts. Huawei, a private Chinese company, registered the most patents globally in 2008 and ranked second only to Panasonic in 2009. China has had a successful space walk and increasing numbers of world firsts."

China's forthcoming 12th Five Year Plan, to be released in March, is expected to define seven strategic industries for development, including energy efficiency and high-end manufacturing, Darby wrote. No official announcement has been released till now regarding the exact investment amount.

"What investors appear to have overlooked is that the authorities are willing to support these initiatives through a massive boost in R&D, high-end equipment expenditure and preferential investment allocation," Darby wrote. "From press releases and other public announcements, it would appear the authorities are likely to use the access to R&D and high-end scientific equipment as a way of encouraging industrial leaders. Indeed, it seems that the market has missed the fact that China is targeting a certain level of R&D to GDP or sales and this is driving a second ‘industrialization'. The mooted figures for this ‘upgrading' are not small, either.

The funds, Darby wrote, will not all be through cash disbursements but achieved through tax credits, privileged import tariff reductions and presumably easier credit and trade finance terms. The other sectors are to include environmental protection, next generation IT, bio-technology, new energy, new material, and clean-energy vehicles.

While in American and European Union companies the ratio of total research and development spending is as high as 5 percent, the R&D to GDP ratio in China is around 1.5 percent now while in the next five years, it is expected to rise to 2-2.5 percent. China, Darby wrote, "is experiencing a revolution, from OEM (original equipment manufacturing) to independent R&D and manufacturing. There is also an interesting slogan, changing "Made in China" to "Made from China."

Already, according to Peyman, China has 1,160 research institutes in place, producing 2 million engineering and science graduates, four times as many as in 2000 and five times the number the US is producing.

In the meantime, he wrote, "What is interesting is to project forward to 2015 or even 2012. Chinese spending is likely to expand still rapidly while OECD R&D budgets will be lucky to avoid being cut."

The Americans, of course, constantly object that China is not playing fair. "There is nothing wrong with seeking to spur innovation and technology," wrote Frank Vargo, the US National Association of Manufacturers vice president for international economic affairs in the NAM"s blog, ShopFloor.

"Just about every major country, including the United States, pursues that objective. But the United States and other countries follow the global rules they have adopted and seek to promote development within those rules. China's policies, however, bend and break the rules. Its policies come at the specific expense of foreign companies and competitors, essentially forcing the transfer of foreign technology to China."

There appears to be some truth to the complaints. Chinese subsidies, both local and national, have been so generous that OECD companies have relocated to China to take advantage of them, leaving behind empty factories and jobless workers. Local content requirements in what the Chinese consider pillar industries have forced overseas companies to deliver proprietary technology to Chinese partners. Wind turbine companies complain that such local content requirements have wiped out their original Chinese lead, for instance.

However, Peyman wrote: "China is no longer stuck in the Research and Copying, phase, as every other emerging leader went through, including the United States. Now China has real R&D and the products and processes that flow from it, something that has not yet registered with the popular mind, despite the mounting evidence.

The speed at which the transformation is taking place explains why it is being ignored. There wasn't even a government policy on R&D before 2006. Just five years later, China has built the world's largest high-speed rail system. The Haier Group, China's largest home appliance manufacturer, which was founded only 27 years ago, has become one of the world's leading white goods manufacturers and introduced the world's first WiFi television. Haier now has obtained 6,189 patented technology certificates and 589 software intellectual property rights. Its products are sold in more than 100 countries.

"What has surprised us as we researched into R&D is to find how broad-based it is," Peyman wrote. "A few high-profile national projects, like the Sputnik, do not guarantee an economy's sustainable future. More prosaic spending like Lining's 2 percent of sales spent on R&D, compared with Adidas and Puma's under 1 percent, may."

In addition, although most of the R&D funding was by China's state-owned industries, today 71 percent of spending is by private and state-owned enterprises – the same as the OECD's – 19 percent by government and 9 percent by universities. Some 75 percent of the R&D by enterprises is by local companies.