Free to Create: China’s Quest for an Innovative Economy

 

BY PAUL CHEN

This piece appeared in our 2015 print journal. You can order your copy here

Seven-hundred million Chinese have grown out of poverty since the Chinese Communist Party (CCP) launched economic reform programs in 1979. Harvard’s Tony Saich summarizes the reform efforts as introducing economic liberalization while retaining political control, a governance model that the CCP calls the “socialist market economy.”1

Subsequently, economic success has boosted citizens’ confidence in the CCP’s supremacy as China’s ruling party.

However, China’s growth model of heavy investments, cheap labor, and advantageous foreign exchange rates has resulted in manufacturing overcapacity, a polluted environment, and an insatiable demand for resources. China’s 2014 GDP growth of 7.4 percent, its lowest level in twenty-four years, failed to meet the government’s growth target. Since economic performance has become the citizens’ primary barometer of success for the Chinese government, lower than expected GDP growth may prove politically destabilizing for the CCP.

Unsurprisingly, the economic slowdown may have inspired China’s new leaders to consider alternative economic models.

China’s top economic manager Premier Li Keqiang has indicated that innovation should be a driving force of the country’s economic upgrade. Similarly, China’s President Xi Jinping highlighted the potential of scientific innovation to stimulate development. Having successfully converted China into the world’s leading manufacturer, the CCP now aims to transform China into a creative economy.

This essay analyzes existing best practices for advancing China’s innovation economy. This piece explores Silicon Valley as an innovation zone and examines its application in the Chinese political context. Urbanization warrants a detailed analysis given the CCP’s strategy of deepening urbanization to facilitate China’s transition to a consumption and innovation economy, but is beyond the scope of this piece.

Silicon Valley is a “leading center of innovation,” with innovation industries representing thirty-three percent of the region’s GDP, a statistic that exceeds those of other American innovation regions.

However, recreating Silicon Valley elsewhere has proven to be challenging.

Creating a Silicon Valley-like region in China will be especially difficult given China’s “socialist market economy,” which selects elements of capitalism that suit China’s authoritarian system. Thus, fostering an innovation economy in China may threaten to destabilize the nation’s tightly controlled political culture.

Part I: Overview of Silicon Valley

Silicon Valley originated in Northern California in the 1930s, when Stanford engineering professor Fred Terman began encouraging his students to start their own companies.2

Since then, organizations such as Hewlett & Packard, Fairchild Semiconductor, Apple, Xerox, Palo Alto Research Laboratories, and Stanford University have transformed the region into the global hub of technological innovation.3

There are several representative features of Silicon Valley.

Foremost, the region’s talented and mobile work force provides the necessary human capital for sustained innovation. Innovators from around the world flock to Silicon Valley, lending diverse perspectives that foster new discoveries. This rich human resource base has allowed Silicon Valley to advance Professor Terman’s original vision by deepening the symbiotic relationship between academia and the private sector. Stanford and UC Berkeley affiliates have not only started ventures, but have formed networks of companies, students, faculty, and venture capitalists, allowing the latest technologies to seamlessly flow between industry and universities.4

Stanford also permits its faculty to consult for companies, join boards, and take sabbaticals in business.

In return, companies sponsor studies and startup competitions that advance university research.

A high-risk tolerance pervades Silicon Valley. Entrepreneurs take significant risks to “create new technologies, new products, new markets, and sometimes entire new industries.”5

Investors understand that ventures to create new technologies will likely fail.6

But the payoffs of the few outsized winners such as Apple, Oracle, or Google are enormous.

Over time, investors and entrepreneurs have witnessed a significant number of successes to embrace this high-risk, high-reward culture. However, this unique culture also has a downside.

Silicon Valley can create tech bubbles, which serial entrepreneur Steve Blank defines as “the rapid inflation in the valuation of […] technology companies that exceeds their fundamental value by a large margin.” The crash of the 2000 dot-com bubble wiped out $7 trillion of stock value, followed by a recession.

Unemployment climbed from 3.9 percent in October 2000 to 6.3 percent in June 2003.

Yet just a decade later, pundits are talking about another potential tech bubble. Thoughtful investors including Jeremy Grantham stated that “a fully-fledged bubble” is in place as the stock market continues to rise steadily in spite of constrained OECD economic growth, sluggish corporate earnings, and continuing Middle Eastern instability.

Finally, intellectual property (IP) protection, which serves Silicon Valley firms, is an important feature of the American legal system that can promote “innovative discoveries.” U.S. Deputy Under Secretary of Commerce for Intellectual Property, Michelle Lee, highlighted that the law needs to protect patents so that entrepreneurs and investors can recoup their enormous investments from betting on risky ideas.

Given the unique factors that fostered Silicon Valley’s growth, China faces several political challenges in creating a similar innovation zone as a means to sustain economic growth.

Part II: Political Implications of Creating Innovation Zones

The model that sparked China’s tremendous growth may now be precipitating its decline. In a report to the Chinese government, top thinkers explained that technological development in advanced economies coupled with an open world economy empowered China to move its rich supply of labor from agriculture to manufacturing.

China’s specialization subsequently satisfied the advanced economies’ demand.

However, numerous factors now point to increasing instability in this model. Growth rates for Chinese exports have decreased due to weakened demand, especially from Europe.

Meanwhile, manufacturing has polluted China’s environment, illustrated by the fact that seven of the world’s most polluted cities are in China.

The economic costs of this pollution range from $100 billion to $300 billion.

As unprecedented investments fueled the manufacturing economy, China’s investment inefficiency measured by Incremental Capital Output Ratios (ICORs) has risen rapidly since the 1990s, exceeding the international average.7

Finally, income inequality rose as China’s Gini coefficient increased from 0.3 in 1978 to 0.45 in 2007.8

Faced with these challenges, China is reconsidering its model.

Chinese leaders have advocated for innovation policies to prompt sustainable growth.

However, as argued by Lee Kuan Yew, China’s transition from an investment-driven industrial economy to a dynamic knowledge economy has many obstacles to overcome.9

Mr. Lee highlighted governance as China’s biggest challenge during this transition. Chinese companies and the government have invested significant capital to boost innovation. But the results have been less than impressive.

In 2014, China ranked 25th in the global innovation index, lagging behind smaller countries such as New Zealand.

As China experiments with various policy initiatives, fostering a Silicon Valley-like region could destabilize China’s tightly managed political system.

Immobility of Workforce

The inability of Chinese entrepreneurs to move freely inhibits their capacity to innovate. Tension exists between the benefits of a mobile workforce on business and the need to control population flow, as achieved by the Hukou system. Hukou divides the population into agricultural and non-agricultural categories according to birthplace.

This system enables the government to control population flow to maintain political stability, but at a hefty price to citizens.

260 million migrant workers have moved to cities, but their rural registrations limit their ability to buy homes, benefit from the healthcare system, and send their children to school.

This system is especially limiting to entrepreneurs. Today, Beijing is the entrepreneurial capital of China, but due to Hukou, non-Beijing entrepreneurs face restrictions on accessing public services.

Additionally, university graduates in Beijing, among the best in China, are forced to leave if they lack Beijing Hukous. Ultimately, these restrictions impose barriers for entrepreneurs to cross-pollinate ideas. Reproducing the efficient web of human capital in Silicon Valley would disrupt the Hukou system and China’s political goal of maintaining social order. However, fluid population movement alone is not sufficient to engender innovation.

Constraint of (IP) Violation on Innovation

China’s inadequate IP protection dis-incentivizes domestic innovation. In 2008, the State Intellectual Property Office of China claimed that implementing IP protection is critical to spur innovation within China.10 IP violation not only hurts foreign firms, but also Chinese companies. Trademark infringement damaged Chinese domestic consumer goods firms since their investments in marketing their brands were counterfeited by competitors.11 Expectedly, Chinese companies increasingly demand knowledge protection. In 2009, the People’s Supreme Court of China disclosed 30,626 civil lawsuits on IP violations. As China moves toward an innovative economy, Chinese firms will need stronger protection of their knowledge. Encouragingly, China is creating specialized courts in Beijing, Shanghai and Guangzhou for IP cases.

Meanwhile, the need for IP protection to foster homegrown innovation could conflict with China’s industrial policy. The Chinese government aims to enhance “original innovation through co-innovation and re-innovation based on the assimilation of imported technologies.”12 The U.S. Chamber of Commerce has a more alarming interpretation of this policy as an unprecedented “blueprint for technology theft.”13 Thus, China’s industrial policies could be seen as neutralizing forces to its own push for stronger IP protection.

Economic Volatility as Political Risk

China lacks the economic and political stability to support the “high-risk, high reward” culture of Silicon Valley. High-tech booms could eventually bust due to unchecked investors’ euphoria for tech stocks. Crises like the 2000 Bubble could increase economic volatility in China, which could lead to political instability, as the CCP’s legitimacy depends on its delivery of continued economic prosperity. As the CCP intends to rule China indefinitely, potential citizen dissatisfaction from economic slowdowns is politically problematic.

China needs 7.2 percent GDP annual growth to meet government employment targets. If the Chinese economy dips into a recession following a bubble, job losses will be difficult for the CCP to manage economically and politically. In the final years of Premier Zhu Rongji’s tenure as China’s top economic architect (1998-2003), the policy to promote efficiency in state-owned enterprises (“SOEs”) resulted in 25.5 million unemployed workers.14 Demonstrations by laid-off workers in major cities caused social disturbances, which threatened the CCP’s priority of stability. In fact, a Chinese property bubble might be already visible. A threefold increase in money supply since 2008 has significantly contributed to the property boom. Tolerating even greater economic volatility of high-tech economies like Silicon Valley could be politically unsettling.

Constrained Intellectual Freedom

Finally, Singapore’s Lee suggested that China’s innovation development will be stifled by a culture that prohibits free exchange and competition of ideas.15 Oxford research fellow Ling argues that the historical political turmoil and the CCP’s current nation-building endeavors have led the government to prioritize political stability over granting individual freedom.16 However, restriction on freedom can limit new ideas, not only in politics, but also in scientific innovation. Research indicates that civil liberties and democratic values promote intellectual creativity.17 In The First Freedoms and America’s Culture of Innovation, Professor Narain Batra argues that the American Constitutional protection of personal freedom “has encouraged fearless speech, unrestrained thought, and endless experimentation leading to newer developments in science, technology, [and] the arts.”18 A statistical study affirms this view indicating that political freedom is positively correlated with innovation in over one hundred countries.19 Particularly, democracies are shown to be 100 times higher than their undemocratic neighbors in per capita rate of medical research authorship.20 Cornell’s Professor Stephen Sass commented that China would not likely lead in innovation until it “moves its institutional culture away from suppression of dissent and toward freedom of expression and encouragement of critical thought.”

Since intellectual freedom is not guaranteed in China, universities like Stanford that champion creativity are absent, undermining China’s ability to innovate. Stanford’s preamble on academic freedom states its “central functions of teaching, learning, research, and scholarship depend upon an atmosphere in which freedom of inquiry, thought, expression, publication, and peaceable assembly are given the fullest protection.” Professors and students initiate research organically and freely, empowering them to think creatively.

In comparison, Chinese universities are controlled by the CCP. The government interferes with faculty research and teaching topics. In 2014, Professor Xia Yeliang, an economist who publicly commented on Chinese politics, was dismissed from the prestigious Peking University for “being a poor teacher”. Despite Professor Xia’s alleged incompetence, he is now a fellow at the reputable global think tank Cato Institute and has been a visiting scholar to Stanford, UCLA, and UC Berkeley. Coincidental to the growing dissents, in 2015 the CCP issued a document aimed at affirming the ideological centrality of Marxism and the administrative supremacy of the CCP among Chinese universities. The Chinese Minister of Education further stated that textbooks promoting “western values” would be banned. China’s propensity to limit intellectual freedom has come at the price of foregone opportunities to advance innovation. For example, instead of opening up an official campus in China, Stanford operates a study center which “has no protection of academic freedom” according to Stanford‘s President. By stifling intellectual freedom, the CCP has not only reduced the risk of disruptive dissents, but also capped the imagination and creative competence of its citizens.

Conclusion

While the CCP has transformed China into the world’s richest developing economy, the transition to an advanced economy seems less certain. One way to sustain growth is to foster innovative industries, as seen in Silicon Valley. However, many of the salient features of Silicon Valley, including IP protection, a mobile workforce, economic volatility, and intellectual freedom can be politically unsettling to the Chinese government. The intellectual foundation of Silicon Valley is hard to recreate when the government controls Chinese universities. Innovations can rarely emerge when people are penalized for speaking their minds freely. A dynamic and meritocratic workforce is difficult to assemble when access to basic public services in cities is arbitrarily constrained by family origin. Creative domestic firms struggle to take root without the protection of their intellectual discovery.

Managing politics while transitioning China to an innovative economy mandates thoughtful diagnosis and meticulous policy planning. Further analysis of China’s urbanization strategy will help elucidate the ways in which building sustainable cities can address potential job losses from China’s manufacturing sector and the dismantling of SOEs as China adopts an innovative consumption-based economy. The following list of recommendations can be a starting point for further dialogue:

• Strengthen IP protection. The creation of specialized IP trial courts is an encouraging first step.

• Gradually remove discrepancies of public services among people with different Hukous to encourage workers to efficiently relocate. The government of Sichuan’s provincial capital Chengdu initiated Hukou reform in 2010. If the CCP were to introduce similar reforms elsewhere, it should monitor the budgetary condition of local governments that need to serve previously rural Hukou holders.

• Encourage the development of the civil society sector to provide public services supplementary to those provided by the government.

• Prepare workers to embrace the volatility of tech bubbles. The CCP can institute re-employment educational programs to help outplaced workers.

• Grant intellectual freedom to universities. Rather than vesting administrative authority in government officials, professors and students must be permitted to devise self-determined research agendas.

The Chinese government has chosen to decouple economic freedom from political freedom in order to manage a massive population. While it is encouraging that Chinese leaders have recognized innovation as a sustainable economic solution, they must acknowledge that without the freedom to think and speak freely, citizens lack both the aptitude and space to create. Creativity hinges upon certain conditions. When we can think independently, we can begin to unlock our deepest human potential, and thus, create.

 

Born in Sichuan, China, Paul Chen immigrated to the United States as a teenager. He recently graduated from the concurrent degree program at Stanford Graduate School of Business (2014 MBA) and Harvard Kennedy School (2015 MPA). This essay stems from his independent study advised by Stanford’s Professor Myron Scholes, Frank E. Buck Professor of Finance and Nobel laureate in Economics, and co-originator of the Black-Scholes options pricing model. 

Photo credit: Carlos ZGZ via Flickr

1  Saich, Tony. Governance and Politics of China. New York, NY: Palgrave MacMillan, 2011.

2  Chong-Moon Lee, William Miller, Marguerite Gong Hancock, Henry Rowen, The Silicon Valley Edge: A Habitat for Innovation and Entrepreneurship. Stanford, CA: Stanford University Press, 2000.

3 Ibid

4 Ibid

5 Ibid

6 Ibid

7 Lim, Edwin, Porter, Ian, Romer, Paul and Spence, Michael. “Medium and Long Term Development and Transformation of the Chinese Economy – An International Perspective.” Beijing Cairncross Economic Research Foundation. March 2011. ICORs is calculated as annual investment over annual increase in GDP.

8 Ibid

9  Graham Allison and Robert Blackwill. “Lee Kuan Yew: The Grand Master’s Insights on China, the United States, and the World.” Cambridge, MA: The MIT Press, 2013.

10  Lipu, Tian. “田力普:实施知识产权战略 提升中国创新能力” (Implement the Strategy for Intellectual Property and Improve China’s Innovative Ability). 2008 Report on Scientific Discovery. 2008.  http://english.sipo.gov.cn/laws/whitepapers/200904/t20090427_457167.html

11  Maskus, Keith. “Intellectual Property Rights and Economic Development.” Prepared for: Beyond the Treaties: A Symposium on Compliance with International Intellectual Property Law. Fredrick K. Cox International Law Center at Case Western Reserve University. February 2000.

12  Schotter, Andreas, and Teagarden, Mary. “Protecting Intellectual Property in China.” MIT Sloan Management Review. June 2014. http://sloanreview.mit.edu/article/protecting-intellectual-property-in-china/

13 Ibid

14  Zheng, Zhuyuan. China’s Economic Development, 1950-2014: Fundamental Changes and Long-term Prospects. Lanham, MD: Lexington Books, 2014.

15  Graham Allison and Robert Blackwill. “Lee Kuan Yew: The Grand Master’s Insights on China, the United States, and the World.” Cambridge, MA: The MIT Press, 2013.

16  Ling, George Fusun. China Developing: Cultural Identity of Emerging Societies. Singapore: World Scientific Publishing, 2008.

17  Cappell, Mitchell. “A More Than One-Hundred-Fold Higher per Capita Rate of Authorship of Five Democratic Nations Versus Their Relatively Undemocratic Neighboring Nations Among 6,437 Articles in 14 Medical Journals: Does Democracy and Civil Liberties Promote Intellectual Creativity and Medical Research?” Digestive Diseases and Sciences, 2009, Vol.54 (8), pp.1609-1620.

18  Batra, Narain D.. The First Freedoms and America’s Culture of Innovation: The Constitutional Foundations of the Aspirational Society. Lanham, MD: Rowman & Littlefield, 2013.

19  DiPietro, William. “Effects of Connectivity and Freedom on Innovation: An Empirical Test Using Different Data Sources.” Review of Economics and Finance. Academic Research Centre of Canada. July 2012.

20  Cappell, Mitchell. “A More Than One-Hundred-Fold Higher per Capita Rate of Authorship of Five Democratic Nations Versus Their Relatively Undemocratic Neighboring Nations Among 6,437 Articles in 14 Medical Journals: Does Democracy and Civil Liberties Promote Intellectual Creativity and Medical Research?”

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