This month, the Organization for Economic Cooperation and Development (OECD) released a report that consolidates its research on China’s innovation policies. The research was requested by China’s Ministry of Science and Technology (MOST) and is the fruit of several fact-finding operations by the OECD, an October 2006 workshop held in Chongqing, China, on the evaluation of science, technology and innovation and a September 2006 workshop held in Paris, France, on China’s National Innovation System. The report concludes that China’s economy cannot continue its explosive growth under its current model and identifies a number of policies that could support an innovation-based economy capable of sustainable, long-term growth.

The report echoes the macroeconomic conclusions of many other organizations. China’s GDP growth has been impressive, averaging roughly 10% annual growth over the past 15 years. The Chinese economy is now the fourth-largest economy in the world. Foreign direct investment (FDI) flowing into China totaled more than $60 billion in 2005. FDI in China in 2005 was valued at 30%–35% of GDP, higher than in India and Korea, and rivaling FDI in Canada and the UK. In addition, the country’s export market is increasingly moving towards high-technology products. However, more detailed data reveal some impediments to long-term innovation improvement.

While economic growth in China is impressive, the report explains that this growth is not evenly distributed throughout the country. R&D spending is highest in the eastern provinces and municipalities (see table) and weakest in the western and central provinces. Two exceptions to this pattern are the central provinces of Sichuan and Shaanxi, which inherited large R&D facilities as a legacy of the Cold War. Although R&D funding is still going to these facilities, which brings the provinces’ R&D numbers up, transforming these facilities into sources of innovation is expected to be a challenge because the provinces themselves do not offer the same support for innovation available in coastal China. And, although high-tech exports made up almost 50% of China’s total manufacturing exports in 2005, foreign firms accounted for roughly 75% of the manufacturing in the Chinese high-tech export sector in 2004. The majority of the high-tech products exported from China are made by the Chinese manufacturing facilities of multinational enterprises, and many of these high-tech products are assembled in China, while the components, equipment and technology used in these products are imported.

According to the OECD, in 2005, gross expenditure on research and development (GERD) in China, was approximately 1.4% of GDP. The report also finds that the business sector—including both domestic and foreign firms—has increased its contribution to R&D spending: companies increased their contribution to the total figure for R&D expenditure from approximately 40% in 1991 to around 70% in 2005. Foreign R&D accounted for an estimated 25%–30% of total business R&D in China. However, R&D in China tends to favor development over research. For example, about 6% of GERD went to fund basic research in 2004, while more than 70% funded experimental development, which the OECD defines as the use of “existing knowledge” for “producing new materials, products or devices,” or improving those already made. Some change to this trend is being realized by foreign firms. As of 2006, there were approximately 750 foreign R&D centers in China, one quarter of which are collaborations with universities and research institutes, and there has been a substantial increase of multinational enterprises establishing R&D centers with a heavy focus on research, which is expected to countinue. But investors, particularly for biomedical research, are specifically concerned with a lack of experienced and qualified staff candidates, which can be seen in R&D spending patterns. As an example, in 2004, China spent 20% of its GERD on instruments and equipment and just over 20% on R&D labor expenses (including training), while Japan and Norway spent approximately four and five times more, respectively, on labor expenses than on equipment and instruments.

The OECD was impressed with China’s efforts to improve innovation, specifically, the Science and Technology Strategic Plan, 2006–2020, which aims to create an innovation system that is driven by business activities. However, the report identifies an unconnected “archipelago” of government agencies responsible for improving innovation and calls for better coordination among these agencies. The report also makes a number of other specific recommendations for the improvement of China’s innovation capabilities. Although Chinese politicians are beginning to realize the importance of enforcing intellectual property legislation, there is a need for such legislation to be enforced locally. In addition, funding for innovation is not allocated to yield optimal results. For example, small- and medium-sized enterprises, which are often a source of innovation, have a higher rate of failure in China than in European countries, mainly due to a lack of funding. But the banks, which are run by the government, are more likely to give loans to large, state-owned enterprises, which have a poor record of innovation. In addition, high-risk enterprises and enterprises that do not offer quick financial returns, such as those in the biotechnology industry, are in need of venture-capital investors who can recognize and support potential success stories. The corporate culture in China has benefited from the influx of foreign management techniques, but further development and education in nontechnological skills, such as managerial techniques, is needed. Finally, the report recommends that China bring manufacturing, quality and research evaluation standards in line with international “good practices.”

The report was discussed at the OECD-MOST Conference and the High Level International Business Symposium, which were held at the end of August in Beijing. The report will be revised in light of the comments generated at the Beijing meetings and will be incorporated into the OECD’s “Review of Innovation Policy: China,” which will be published at the end of the year.