Supporting Innovation: Unquenchable Flames

Abstract

Innovation is the source of economic growth on a per capita basis and an essential way to improve standards of living. Thus, developing innovation capabilities is fundamental for modern economies. The innovation system of a country includes market-based cooperation and interaction between enterprises, universities and government, as well as innovation-related framework conditions such as infrastructure, policy framework, and macroeconomic environment. In this way, a complete ecosystem nurtures innovation.

China has been establishing an innovation system that conforms to its national conditions. The country’s innovation system shows notable competitive advantages given its enormous domestic market system and world-leading physical infrastructure. China has also established innovation-related systems and policies, including those for anti-trust and IP protection. It is able to provide a macroeconomic environment that encourages overall innovation. For example, it has established a modern enterprise system, and continues to strengthen the provision of financial support for technological innovation. Facing changing situations at home and abroad, China continually upgrades its approach to integrating into the global innovation framework, and the country is shifting from a latecomer in traditional segments to a frontrunner in new fields.

Regional innovation centers are also an important part of China’s national innovation system. They are essential for implementing national innovation policies. Regional innovation centers in different areas have their respective advantages, and we expect them to improve further, with Silicon Valley and Germany providing valuable models.

We should not neglect the government’s role in coordinating and supporting technological innovation. In China, the government emphasizes its role in promoting innovation, especially during key periods and for core industries. It can make targeted use of market resources and policy measures when supporting corporate R&D, and improve the efficiency of its financial support to innovations in the private sector. We also believe that it is important for the government to make reasoned decisions, to increase the flexibility of R&D management system, and ultimately, to make full use of the new system for mobilizing resources.

The government also plays a vital role in financing innovation. While innovation needs external financial support, the financial industry does not always spontaneously invest in it. We attribute this to the constraint from financial cycles, a high risk of failure, and an innovation paradox. The government could correct such failures to enable the financial system to better support innovations, including allocating appropriate financial resources to different types of innovations. For example, the private equity market has limited financial resources, but it is better positioned to support smaller firms, which have a stronger desire to promote “radical innovation”. The stock market could create a divesting channel for venture capital to make the private equity market more active. Large firms tend to rely on “incremental innovation”, which could be supported by banks that naturally prefer stable cash flows and ample collateral.

Currently, China is catching up with advanced economies, and we expect the country to become a global frontrunner in technology in the long term. A number of domestic industries (e.g., semiconductors) are facing vertical risks. In such sectors, the “catching up” innovation financing model in which large banks offer ample credit resources to big companies may need to play an important role. As such, China should improve the “leading” innovation financing model where medium-and-small firms rely on capital markets to raise money to fund innovation. Thus, the financing models for both radical and incremental innovations are key to China.

7.1 Promoting Innovation is a Fundamental National Task

Innovation is a major source of a country's economic growth and is essential for sustainable development. With the rapid development of computer and information technology in the 1980s, the mobility of knowledge has increased, and people’s understanding of innovation has shifted from a linear model in its early stage (from basic scientific research to R&D investment, and then to innovation achievements) to a non-linear systemic and ecosystem-based model. Innovation is highly reliant on the interaction among enterprises, universities, the government, and other entities in terms of knowledge, human capital, and funds. ¹ Such interaction, in turn, depends on a country’s market system, ² social infrastructure (including education, scientific research, and social security system), and macroeconomic policy environment³ (including finance, fiscal, and trade policies). These together constitute a “national system of innovation”⁴ in a broad sense (Fig. 7.1).

Fig. 7.1

Schematic diagram of national system of innovation. Source CICC Global Institute

At the core of the national system of innovation stand the market system and the enterprises, universities, and government within the system. Since the 1990s, the Organization for Economic Cooperation and Development (OECD) has been analyzing and evaluating the effectiveness of the national system of innovation in various countries, focusing on the flow and diffusion of knowledge, and emphasizing four kinds of interactions between the three types of innovation entities (namely enterprises, universities, and research institutions established by the government): Cooperation in innovation between enterprises; cooperation in innovation between enterprises, universities, and governments; the diffusion of knowledge; and the flow of innovative human capital among the three entities.

Policies and institutions that promote the flow of innovation resources outside the market constitute the ecosystem for innovation. International organizations such as the OECD and the EU call it the “framework conditions of innovation”⁵. We divide the framework conditions into three major categories—infrastructure, institutional system, and macroeconomic environment—as shown in Fig. 7.2.

Fig. 7.2

Source CICC Global Institute

Framework conditions for innovation.

Infrastructure is the enabling environment that guarantees and promotes the orderly flow of factors of production and the regular operation of the market. It includes physical infrastructure, social infrastructure, and financial infrastructure. The institutional system is the direct means for the government to manage the market, maintain order, and guide technological and industrial development. It comprises legal and regulatory systems and conventional economic policies, and can minimize the transaction costs among all parties.⁶ The macroeconomic environment includes fiscal policy, tax policy, and monetary policy, among others.

Infrastructure facilitates the flow of factors of production, the institutional system ensures that production factors can function normally, and the macroeconomic environment ensures that innovation activities are carried out in a stable and predictable business and economic environment. These framework conditions serve as public goods, and the responsibility of the government is to create public goods that can promote the flow of factors required for innovation, playing the role of the “visible hand”.

The establishment of a sound national system of innovation requires coordination and cooperation between the market system and public policies to improve the effectiveness of innovation in three ways, namely R&D investment, the demand channel, and the flow of knowledge.

The first move is to optimize R&D investment in both quantity and quality. In terms of quantity, R&D investment should be at the most effective level, being sufficient and reasonable.

In terms of quality, R&D investment should be well-structured, i.e., the distribution of R&D input in basic research and application development should be optimal.

The second is to expand or create demand for innovative products. Successful innovative firms such as Apple create demand for their new products, and the government can create demand for innovation. For example, the government’s goals of reaching peak carbon emissions and achieving carbon neutrality and the related policies have driven demand for environmentally friendly technology products and services. Market size is also crucial to innovation as market capacity determines innovator costs and returns.

Third, the government could promote interaction and flow of knowledge among different innovation entities, as well as improving the social rate of return of innovation.

Both the market and the government are indispensable in the national innovation system, complementing one another. The government can correct market failures of innovation activities, making its role in innovation far more significant than in conventional economic activities. This is mainly because of the following two points.

Innovation has positive externalities. It is the process of generating knowledge. Once knowledge is generated, the cost of innovation is then fixed, regardless of how many people learn to use the knowledge. Market mechanisms often lead to an insufficient supply of incentives for innovation activities with positive externalities.

The results of innovation are also highly uncertain. Such uncertainty is more difficult to predict than risk events and is impossible to eliminate or reduce through insurance. Due to the high level of uncertainty, the market mechanism featuring perfect competition usually leads to insufficient innovation.

Coordinating the roles of the market and the government is the key to improving the national system of innovation, and it is usually difficult to strike a balance between the two. The first challenge is to measure the benefits of innovation. The knowledge produced by innovation is almost freely transmitted. The more an innovation activity relies on basic R&D, the greater its externality would be, and the transmission of knowledge cannot be traced or measured. More importantly, it is difficult to measure the inputs and results under different policy assumptions as such assumptions can deviate from the reality. This makes it difficult to evaluate different policy combinations empirically. However, we still seek to conduct policy analysis to provide suggestions for China to improve its innovation system.

7.2 The Practicalities of Establishing a National Innovation System

Since the introduction of the reform and opening-up policy more than four decades ago, China has gradually established a market system and modern enterprise system, as well as world-leading hardware infrastructure, laying a solid foundation for a national system of innovation. Especially since China joined the WTO in 2001, the domestic market has witnessed unprecedented expansion, and a number of world-leading companies have emerged, marking China’s great progress in developing its innovation system.

In 2005, the Ministry of Science and Technology of China commissioned the OECD to conduct research on innovation policy. Renowned Chinese and foreign scholars in technology innovation policies spent three years in completing the report OECD Reviews of Innovation Policy: China.⁷ The report states that China should learn from the successful experience of OECD countries, including adjusting the role of the government, improving the framework conditions for innovation, enhancing human capital in science and technology, improving the collection of science and technology innovation policies, maintaining strong support for public R&D, and strengthening industry-university-institute cooperation. Looking back at the past decade, we note that the Chinese government adopted some of the suggestions made in the OECD report. China also explored a pathway to developing its innovation system that conforms to its national conditions, something that went beyond the parameters of the report.

7.2.1 Framework Conditions for China’s Innovation System

The enormous domestic market is a major advantage of China’s innovation system. From the perspective of the national system of innovation, China’s market system shows a notable competitive advantage thanks to large market capacity and extensive coverage.⁸ In the twenty-first century, the ubiquitous internet technology and the advancement of infrastructure construction nationwide have accelerated the process of market integration. So far, China has become the world's largest market, with total retail sales of consumer goods surpassing that in the US. The enormous market implies substantial demand for innovative products and high potential profits from innovation, which in turn provides a powerful incentive for innovation activities (for details, please refer to Chap. 2 of this report).

A unified labor market promotes the flow of human capital and facilitates the diffusion effect of knowledge and technology. A large-scale unified market has taken shape in China, mainly driven by changes in the number of employees in the industry amid the reform of the household registration (hukou) system and reform of SOEs in recent years. In particular, the reform of the hukou system played the biggest part in improving the efficiency of labor allocation in China.⁹ According to the China Torch Statistical Yearbook, from 2010 to 2020, the transaction value of China’s technology market increased by 11 times, accounting for 1.6% of total GDP.

China has world-leading physical infrastructure, and is improving its social infrastructure for technological innovation. China leads the world in terms of transportation and information and communication technology (ICT) infrastructure, which helps reduce transaction costs and increases the profitability of enterprise innovation. For example, high-speed rail (HSR) in China accounts for more than 60% of the world’s total operating mileage, and is the world’s fastest.¹⁰ In 2020, the penetration rate of mobile phones in China reached 113 units per 100 people, and mobile internet coverage was almost universal.¹¹ Backed by leading ICT infrastructure, the Chinese government is at the forefront of digital governance, and plays an important role in supporting innovation in the digital economy era.

In addition, China has completed the development of social infrastructure, including education, scientific research, and social security, providing necessary public goods for the development of science and technology. For example, the Chinese government accounts for a large share of R&D expenditure in China. In 2020, China’s total R&D expenditure reached Rmb2.2trn, ranked No.2 after the US; and the government contributed 20% of China’s total R&D spending, mainly to fund government-affiliated scientific research institutes and universities.

Antitrust and intellectual property (IP) protection systems are taking shape in China. The government’s governance and regulatory policies for technological innovation mainly focus on these two aspects. As for antitrust policies, we believe that three factors deserve attention. First, technological innovators will maintain some monopoly power for a period, and the corresponding monopoly profit is a necessary reward for them. Second, it is difficult for monopolistic enterprises to develop advantages that are large enough to avoid competition or to limit the entry of competitors. Finally, large companies and small players can also be partners rather than just competitors. It is technological innovation that typically empowers small businesses to challenge the leadership of large companies, thus facilitating cooperation between the two.

China’s IP system originated from the “863 Program”.¹² After nearly 30 years of development, IP rights covered by the scientific research under the program have expanded to ownership, right to use, right to transfer and right to benefit. The ownership of IP rights has also gradually shifted from government departments to institutions and researchers, thereby providing stronger economic incentives for scientific research institutions and individuals.¹³ Looking ahead, China should ensure IP is protected to strike a balance between the incentive of knowledge production and the diffusion of knowledge. The patent system is a tool suitable for realizing this goal, under which innovators disclose technical secrets in exchange for a number of years of protection.

China has developed a favorable macroeconomic environment for technological innovation. First of all, the Chinese government attaches great importance to the stability and consistency of macroeconomic policies. In the past 20 years, China has maintained a stable domestic economy, providing a favorable environment for innovation, even during financial crises in the US, Europe, and emerging markets. At the same time, China’s nominal interest rate has dropped from double-digit levels to a level close to that in developed countries and has remained low since 1995, increasing investment returns for innovation activities. Moreover, China’s average CPI inflation has been relatively moderate, at about 3% in the past 20 years. This not only provides rewarding market prices to innovative products, but also avoids rapid depreciation of current assets or high nominal interest rates that are detrimental to technological innovation.

In addition, a relatively high tolerance for asset bubbles usually benefits technological innovation. Human development has been driven by rounds of technological changes, each accompanied by bubbles created by financial capital and production capital.¹⁴ The social rate of return is higher than the internal rate of return to innovators because new technologies have positive externalities. Even after the bubble bursts, the socio-economic benchmark level under the new equilibrium will still be higher than that of the previous round.¹⁵ Many studies in developed countries have shown that emerging, R&D-intensive companies are more reliant on equity financing. They tend to issue new shares to raise funds during the bubble to accumulate resources for innovation.¹⁶ However, regulators should be aware that the bubble has to be triggered by technological innovation rather than speculative activities, and the scale of the bubble or the damage after it bursts should be manageable.

China has also established a modern enterprise system,¹⁷ including cultivating a number of competitive enterprises and building an environment conducive to the growth of innovative enterprises. Enterprises are the biggest driving force of innovation.¹⁸ Most R&D investment comes from enterprises, and their decisions could determine the outcomes of innovation. Due to the relatively friendly conditions for establishing companies in China, the number of newly registered companies has grown rapidly in recent years. At the same time, local governments, industrial parks, venture capital funds, and small- and medium-sized banks cooperate in leveraging-related market mechanisms. This has helped form a set of mechanisms for discovering, cultivating, and supporting technological innovation enterprises with great potential.

China has been strengthening the provision of financial support for technological innovation. With the release of the National Medium- and Long-Term Program for Science and Technology Development (2006–2020) in 2006, the central government introduced a series of policy measures and called for the development of a system under which the financial sector supports innovation. Since 2006, the ChiNext board and STAR market have been launched. The ChiNext board was introduced in 2009, and the total market cap of listed companies hit nearly Rmb1.1trn by the end of 2022. The top seven industries by market cap are closely related to technology, and they accounted for over 80% of the total market cap, highlighting the technological attributes of the ChiNext board.¹⁹ The STAR market was launched in June 2019, featuring the adoption of the registration-based IPO system, which streamlines the listing process and lowers the threshold for the listing of technological companies.

Another major achievement is the development of the venture capital (VC) industry. From 2008 to 2018, annual investment by China’s venture capital funds rose from less than US$5bn to nearly US$35bn, accounting for 13% of the global total. The amount of money raised by China’s VC funds accounted for 21% of the global total, second only to the US.²⁰ Investment and financing activities in the IT industry have witnessed the fastest growth, with the financing amount once exceeding more than 50% of China’s total, before stabilizing at about 40%.²¹

Facing trade-offs between opening up and facilitating indigenous innovation, China upgrades continues to upgrade its approach to integrate into the global innovation framework. In the past 40 years, the innovation activities of Chinese enterprises have mainly focused on learning advanced foreign technologies, and multinational companies have played an important role in diffusing knowledge and technologies. At the same time, a growing number of foreign investors are investing in domestic startups and listed companies.

In practice, China has adhered to the opening-up policy over the years and fulfilled its commitments to the WTO, integrating itself into the global trade value chain and innovation system. First, China has relaxed restrictions on foreign investment substantially since 2010. Even in 2020, when global foreign direct investment (FDI) fell by 35% amid the COVID-19 pandemic, China’s use of foreign capital bucked the overall trend to increase by 6.2%.²² Second, China is playing an increasingly important role in the global value chain. From 2008 to 2020, China’s share of global exports rose from around 8.8% to 14.7%, and its share of global imports trended up from 6.9% to 11.5%. In terms of R&D, multinational companies have established more than 2,400 R&D centers²³ in China, covering a wide range of industries.

Faced with sentiment of deglobalization, China introduced a new economic development pattern that is focused on the domestic economy and features positive interplay between domestic and international economic flows. Given the sudden changes in the international situation in the past five years, China may seek to strike a balance between opening up and accelerating indigenous innovation and domestic substitution, posing new challenges to the development of the innovation system in the country.²⁴

Meanwhile, China is shifting from latecomer in traditional segments to “frontrunner” in new fields. The Chinese government is deeply aware that the new round of changes in basic technologies, such as information, energy, and life science may reshape the global industrial structure.²⁵ Policies have been issued to promote technological innovation in seven strategic emerging industries, namely energy conservation and environmental protection, new generation information technology, biology, high-end equipment manufacturing, new energy, new materials, and new energy vehicles.²⁶ According to the National Development and Reform Commission (NDRC), over 2015–2019, the average annual growth rate of industrial output of enterprises above a designated size in these strategic emerging industries was 10.4%, while that of the overall industrial sector was merely 6.1%.²⁷ Backed by such established exposure to new fields, China has been striving to catch up with developed countries and to even become a frontrunner in the new fields and move to high-value-added sectors in the global value chain.

7.2.2 Regional Centers Are Main Components of a National Innovation System

Regional innovation centers are an important part of the national innovation system and are essential for implementing national innovation policies as they are central to development of innovation capabilities. This is because innovation activities are concentrated in a few countries and regions, due to geographic constraints on knowledge spillover, as well as a virtuous cycle between innovation activities and the concentrations of factors of innovation. In addition, different regional innovation centers compete and collaborate with each other, together promoting the formation and development of a national innovation system.

China has emphasized the development of regional innovation centers. It has built a three-layered system: The first layer consists of international science and technological innovation centers in Beijing, Shanghai and the Guangdong-Hong Kong-Macao Greater Bay Area (GBA). The second consists of national science and technological innovation centers in the Huairou district of Beijing, the Zhangjiang district of Shanghai, and Anhui, Hefei, among others). The third layer consists of regional science and technological innovation centers, including 21 innovation demonstration zones and 169 new national high-tech zones (Fig. 7.3).

Fig. 7.3

Source State Council, CICC Global Institute

China has built a three-layered innovation system. Note The above chart uses 2021 data.

Regional innovation centers in China have played an essential role in propelling the construction of the country’s national innovation system. Companies in high-tech zones represented around 50% of total R&D investment at companies in China in 2019, accounting for 12% of GDP. In addition, per capita labor productivity in these companies was triple the national average, while their energy consumption per value added was one-third of the national average.²⁸

Inspired by the methodology applied by the European Innovation Scoreboard (EIS),²⁹ we use a five-dimension metric (i.e., research, applications, intermediary agencies, policies, and environment) to measure the development of China’s regional innovation centers (Fig. 7.4).

Fig. 7.4

Source Autio (1998), CICC Global Institute

A five-dimension metric to measure development of regional innovation centers.

Research: Universities, research institutions, public laboratories, and other organizations dedicated to creating and spreading new knowledge, skills, and technologies play pivotal roles in developing regional innovation centers. We use the number of colleges and universities, the number of research projects, and other indicators to evaluate the capabilities of regional innovation centers.³⁰

Applications: A well-built industry chain system not only propels the industrialization and commercialization of innovative products and services, but also plays a crucial role in stimulating innovation. We use the share of companies conducting R&D and the number of high-tech companies, as well as other indicators, to evaluate the applications of innovative products and services in a regional innovation center.³¹

Intermediary agencies: Financial intermediaries and other agencies provide financing, shared risk, and other services to facilitate innovation activities and propel the application of innovative products and services. We use the number of financial institutions, the value of private equity (PE) and venture capital (VC) investment in the past five years, and other indicators to evaluate intermediary agencies.³²

Policies: Policies to stimulate innovation vary across regions as different regional innovation centers have different historical backgrounds, natural resources, and industrial structures. We use the number of policies pertaining to innovation, the number of national innovation company incubators, and other indicators to evaluate policies in regional innovation centers.³³

Environment: The inherent cultural traditions, behavior patterns, and attitudes towards innovation and technological progress greatly affect the development of regional innovation centers. We use the business environment index, the price to income ratio (PIR), and other indicators to evaluate the environment of regional innovation centers.³⁴

The five dimensions are not mutually exclusive for building regional innovation centers. For example, universities and companies can cooperate to propel innovation under the R&D contracting model. Companies can also gain knowledge and improve know-how through learning-by-doing, thereby further encouraging innovation.

Based on the five-dimension metric, we conclude the following from our analysis of available data in 49 cities.³⁵

Advanced regional innovation centers are concentrated geographically; the innovation indexes of Beijing, Shenzhen, and Shanghai exceed those in other cities. Our metric shows advanced regional innovation centers are concentrated in the Yangtze River Delta region, the middle and upper reaches of the Yangtze River, and the GBA. Most cities in these regions have high innovation indexes. The indexes of Beijing, Shenzhen, and Shanghai average around 3.5, while those in many provincial capitals are between 1.5 and 2.5.

Regional innovation centers have respective advantages. Different regional innovation centers have different comparative advantages, as shown by our metric (Fig. 7.5). Beijing has higher research and intermediary agency indexes than Shenzhen. However, its application and environment indexes are lower. The innovation indexes of Hefei and other emerging innovation centers are lower than those of Beijing, Shanghai, and Shenzhen. However, they have gained competitive advantages by leveraging research and policy tailwinds.

Fig. 7.5

Source CICC Global Institute

Competitive advantages of four regional innovation centers in 2019. Note: Based on the five-dimension metric system.

Jinhua and other manufacturing-oriented innovation cities have lower intermediary agency, policy and environment indexes. However, their application indexes are notably higher, pushing up their overall innovation indexes.

The research indexes are relatively low in many regions, while only a few regional innovation centers have gained advantages in research. Research is one of the main driving forces for innovation, and it is crucial to the development of regional innovation centers. According to our metric, only Beijing, Nanjing, Xi'an, Wuhan, and several cities that are supported by renowned colleges and universities have a relatively solid foundation for research. Innovation capability remains relatively weak in many tier-2 and tier-3 cities.

Networks of Regional Innovation Centers

Cities in the GBA complement each other in innovation activities. The GBA is one of the most innovatively active regions in China. A development situation where cities are complementary to each other’s innovation activities has formed there, with Shenzhen and Guangzhou³⁶ taking the lead in regional innovation activities, and Zhuhai, Zhongshan, and Huizhou with their respective advantages. Generally, cities in the GBA have notable advantages in applications and environment, but their research and intermediary agency indexes are low. They typically gain advantages from localized manufacturing via industrial transfer, and support the regional innovation network (Fig. 7.6).

Fig. 7.6

Source CICC Global Institute

Cities in the GBA area complement each other in innovation activities. Note Based on the five-dimension metrics system; we use data for 2019.

The G60 Science and Technology Innovation Valley of Yangtze River Delta to see balanced development of multiple innovation centers. The G60 valley originated in the Songjiang district of Shanghai, and now consists of nine cities in four provincial-level administrative regions, i.e., Shanghai, Jiangsu, Zhejiang, and Anhui. The valley is a multi-layered regional innovation network, with Shanghai leading in regional innovation activities; Hefei, Hangzhou, and Suzhou advancing side by side; and another five cities strengthening their respective capabilities. The innovation indexes of cities in the valley diverge notably, with the innovation index of Xuancheng lower than the indexes of many cities that we monitor. We believe that the cities in the G60 valley will see balanced development of multiple innovation centers, and that the valley will play an exemplary role in propelling innovation in neighboring regions (Fig. 7.7).

Fig. 7.7

Source CICC Global Institute

G60 valley to see balanced development of multiple innovation centers. Note Based on the five-dimension metrics system; we use data for 2019.

Regional innovation centers in China currently confront a number of challenges. First, the guidelines for the development of regional innovation centers could be further clarified. For example, functions and orientations of different regional innovation centers are sometimes overlapping, and the development goals might be unclear. Also, the development of regional innovation centers could be further improved.

Second, divergence in the output efficiency of innovation investments should be resolved. In 2019, technological innovation input and output efficiency (as measured by science and technology expenses and the number of patents at local government agencies) continued to improve in the top 5% of the 100 most advanced cities as measured by GDP in China, while efficiency fell in the top 5–30% of these cities. In 2018 and 2019, the number of patents declined in the remaining cities.

Third, an effective coordination mechanism should be established. Factors of innovation and resources represent the main engine for regional economic growth, in our view. Local government agencies are willing to attract as many innovation resources as possible in order to boost local economic growth. However, from a perspective of the entire country, cross-regional homogeneous competition for innovation resources and repeated investment and construction may, to some degree, impede the completion of a country's innovation targets.

7.2.3 International Experience from Silicon Valley and Germany

National innovation policies and regional resources are crucial to regional innovation centers. Meanwhile, regional innovation centers can facilitate sustainable development of each region and propel innovation in a country.

Silicon Valley is an example of how to build a regional innovation center. Its success could be mainly attributed to the large amount of defense expenditure by the US government during the Cold War period, company strategies, and cooperation between universities and companies.³⁷

Silicon Valley’s success in innovation is a result of policy support and local advantages. First, R&D contracts signed with the US federal government boosted the growth of start-up firms in Silicon Valley. The value of these R&D contracts exceeded the value of contracts from business customers,³⁸ and companies undertaking national R&D projects typically received follow-up product orders that gave them opportunities to enter new industries.³⁹ Second, the rise of high-end electronics manufacturing attracted companies in other regions, raising the concentration of high-tech companies in the region. Third, government agencies generated policies favorable to the VC industry. US Congress approved the Small Business Investment Act and established the Small Business Administration (SBA) in 1958, allowing the VC industry to grow notably in the 1960s. Over the long term, Silicon Valley has accounted for 40% of VC investment in the US.⁴⁰

Long-term growth engines for Silicon Valley include innovation and entrepreneurship friendly environment enabled by human capital, universities, companies. Lenient immigration policies have made Silicon Valley attractive to innovation talent, and helped cultivate a unique innovation culture. This culture has notably improved the efficiency of technological innovation, and was a key competitive advantage for Silicon Valley. Support from universities and alumni associations for innovation and entrepreneurship projects has created a favorable environment for innovation. Leading firms have also been pivotal in cultivating an innovation and entrepreneurship friendly culture.

Silicon Valley continues to eliminate adverse impacts of concentrations of innovation resources. The concentrations of factors of innovation can lead to elevated housing prices, traffic congestion, and other social issues. To solve such problems, cities in Silicon Valley have passed laws to regulate rental prices, thereby avoiding a real estate bubble. At the same time, transport departments have helped alleviate traffic congestion by reducing constraints on infrastructure development across administrative boundaries.

Another example of promoting technological innovation is Germany, which strikes a good balance between cross-regional competition and collaboration. In 1995, the German federal government launched the first national initiative to generate biotechnology clusters, i.e., the BioRegio contest (BRC). Under the BRC program, the federal government chooses several BioRegio to participate. After these regions have formed their own development plans for local biological innovation, an independent review committee selects four winners. The federal government then provides them with funding and policy support, which help increase the R&D capacity of local companies and the industrialization of biotechnology.

The BRC program conducted under the cluster-based model has a clear division of labor that ensures fair and objective results. Second, participants develop their own BioRegio program, which coordinates the government's innovation strategy with the goals of regional development. Such programs promote healthy competition and innovative cooperation among regions. As a result, the BRC program has greatly improved the division of labor and collaboration between the federal government and the regions, and has played an important role in encouraging innovation.

Germany has notably improved its biotechnology capabilities through the BRC program. The federal government investment in the winning regions has contributed to regional development and an increase in the number of practitioners.⁴¹ Implementing the program has also stimulated the biotechnology industry, with R&D-based clusters emerging, and the number of biotechnology patents in Germany increasing rapidly.⁴² Germany continues to support leading biotech firms to sustain the program's achievements and the country’s competitive advantage in biotechnologies.

The success of the BRC program demonstrates that the cluster-based model contributes to implementation of a national innovation strategy. Following its success, Germany continues to roll out new cluster-based programs. For example, it proposed the InnoRegio program to address the unbalanced development in eastern and western regions of the country, and the Go-Cluster program to support the transformation of German innovation clusters into international clusters of excellence.⁴³

In summary, Germany has built a comprehensive regional innovation center system. The country has conducted multiple innovation programs under a cluster-based model, striking a balance between the federal government and each region, and improving the division of labor, coordination, and cooperation between regions. Follow-up programs have continued to implement the existing innovation strategies amid new trends and innovation needs.

7.3 Government as a Coordinator and Supporter of Technological Innovation

Since China adopted the reform and opening-up policy more than 40 years ago, the country has established a set of innovation systems that conform to its national conditions. However, as China enters a new era of economic development, the Outline of the 14th Five-Year Plan for National Economic and Social Development and Long-Range Objectives (referred to as the Outline hereinafter) for 2035 has put forward new goals for China’s development in the next 15 years. To achieve the goal of increasing per capita GDP to the level of moderately developed countries by 2035, China’s economic growth will rely more on innovation in the context of a decline in working-age population and falling saving rate.

The Outline puts forward the task of “strengthening original and leading scientific research”, and requires that “basic research accounts for more than 8% of total R&D expenditures” (versus 6% in 2020) and “industrial output of strategic emerging industries accounts for more than 17% of total GDP”. These goals suggest that China will gradually shift its innovation model from “incremental innovation” to “radical innovation”. However, innovation activities in China are still dominated by incremental innovation driven by the commercialization of new technologies, while basic research-based radical innovation activities remain insufficient. The innovation task in the new era poses new requirements for China’s innovation system in terms of both quality and quantity. To fulfill these requirements and correct market failures in R&D, the government’s role in coordinating and supporting technological innovation could not be neglected.

7.3.1 The Government Should Play a Major Role in R&D

7.3.1.1 A “Visible Hand” to Correct Market Failures

We do not think the public sector's role in R&D should be neglected, although the private sector is now a major source of funding in major economies. Due to the existence of market failures, we believe that the government must play a role as a "visible hand" to boost innovation. The government has various policy options to achieve this.

The first option is to increase the share of government funding in R&D investment. China’s long-term development goals require further increases in R&D intensity and basic R&D investment. Increasing government investment in basic research is a direct solution to China’s insufficient investment in basic R&D caused by market failures. Compared to the US, China’s fiscal R&D expenditures remain low. To achieve long-term development goals, the Chinese government might want to consider increasing the proportion of government funding in R&D investment, especially in basic R&D.

The second is to encourage the private sector to increase R&D investment in radical innovation. In China, the total annual tax credit for R&D expenses of industrial enterprises provided by the government over 2013–2019 climbed from Rmb33.4bn to Rmb140bn, corresponding to an average annual increase of 27%, and its share in total R&D expenses rose to 10% from 4%.⁴⁴ An OECD study on effective tax rate for R&D found that the tax rate in China was 11.7% in 2020 versus 20.1% in the US.⁴⁵ However, the tax and credit incentives provided by the government for innovative enterprises are not only related to the R&D intensity of the enterprises, but also to their sales revenues and profit. Thus, preferential policies mainly cover incremental innovation related to market development, rather than the basic research vital for radical innovation. The government shall provide additional tax and credit incentives to enterprises focusing on radical innovation, in our view.

The third option is to cultivate long-term investors for innovative activities. Long-term investors in developed economies are usually charitable or pension funds. However, for historical reasons, most pension funds in China still adopt a pay-as-you-go model. With the gradual exit of this model, the balance in individual accounts should gradually increase. This lays a foundation for increasing the number of long-term investors in China’s innovation system. The government can also introduce policies to encourage the development of commercial endowment insurance and commercial medical insurance, and encourage qualified enterprises to purchase commercial insurance for their employees. Building China’s "third distribution" system, which includes charitable donations, and expanding the scale of endowment and charity funds, should help accumulate funds for long-term investment.

The government could also help establish an innovative intermediary service system to bridge enterprises and universities and thus match technological supply and demand. Such a service system might include, for example, technological transfer offices at research institutions and universities, technology transaction markets, and productivity facilitation centers. In recent years, the Chinese government has launched projects such as the national manufacturing innovation centers, industrial innovation centers, and technology innovation centers. We believe that the government should increase capital and human resource inputs to such bases and centers, driving institutions to play an intermediary role in coordinating cooperation among industries, universities, and research institutes. We believe that this would promote cooperation in innovation activities. Measures could also be taken to reform the education system and transform demographic dividend for talent dividend.

7.3.1.2 Key Periods and Core Industries Need More Government Intervention

The public and private sectors' roles in R&D normally change in the process of national development. First, a country's R&D models vary between different stages of development. They are closely related with a country's stage of development, resource endowment, and policy targets. As short-term focuses differ, policies and R&D models should also be different.⁴⁶ To be specific:

For countries experiencing import substitution, such as Germany in the nineteenth century and the US in the nineteenth century and early 2000s, the focus of R&D is technological and product localization, and thus policies should encourage the import and digestion of technology. Government-led R&D, as well as R&D cooperation among companies, universities, and research institutes, are the major R&D models.

For countries that are catching up with advanced economies (such as Germany and Japan after World War II), the focus of R&D is upgrading products and raising international competitiveness. Independent R&D by a company, as well as R&D cooperation among companies, universities, and research institutes, are the major R&D models.

For leading countries, such as the US after World War II and Germany after reunification in 1990, the focus of R&D is on frontier technologies, and cross-country R&D cooperation is needed. In addition to the company-dominated R&D model, government dominance and public subsidies are important R&D models.

Second, the government plays an important role when there are key obstacles to technological development. When a country just starts to catch up with advanced economies or the key obstacles in technological innovation emerge, domestic companies lack enough resources to make breakthroughs, and the government needs to help them overcome these difficulties. When Japan was localizing its semiconductor industry in the 1960s to the 1980s, the country relied on industrial policies to protect the industry when it was in its infancy from being beaten by imports from the US.⁴⁷ In 1990, Japan and Germany both faced key obstacles to technological advancement. The governments then reformed R&D systems and started to provide financial support for R&D on clean energy and information technologies.

Third, the government plays a vital role in the forefront of innovations. When technologies and economies are highly developed, innovations would usually enter into uncharted territory, posing strong challenges to R&D. During this time, the boost of technologies to innovations has peaked, and innovations rely more on breakthroughs in basic sciences.⁴⁸ Meanwhile, R&D and innovations in uncharted territory are time-consuming and face large uncertainties. Close academic cooperation and opinion exchange through publications (e.g., dissertations) are needed, which has a large knowledge spillover effect that results in market failure. Under these circumstances, the government's role is very important. The US created a number of frontier technology programs after World War II, underscoring the government's role in R&D in uncharted territory.

7.3.1.3 The Policy Options in Favor of R&D

Characteristics of R&D vary among industries, and the government should offer policy support to each industry based on their actual needs. In our view, R&D projects in each industry can be divided according to the time needed and technological complexity.

In terms of the time required, if R&D of a technology is time-consuming and costly, countries that have developed this technology are more likely to maintain their monopoly positions, and other countries would face great difficulties in catching up.⁴⁹ In terms of technological complexity, the more complicated a technology is, the more cross-disciplinary expertise its R&D would require, and thus related industries need to spend more time to gain the expertise. In other words, countries that lag in this technology face great difficulties in catching up.

For industries that are relatively less complicated and have a shorter R&D cycle, leading countries could only succeed in restricting others in the short run. The problem for lagging countries is how to mobilize capital and human resources to support the costly and time-consuming R&D of frontier technologies. In this context, we believe the government should encourage the private sector to invest in R&D; support cooperation among companies, universities, and institutes; and increase R&D spending on the industries mentioned above.

However, for technologically complicated industries with a long R&D cycle, companies themselves are not capable enough to make R&D breakthroughs in the short term, and hence governments need to play a major role. For example, the Japanese government played an important role in helping its semiconductor sector catch up with foreign competitors in the 1960s and 1970s. The German government also helped its chemical sector catch up in the nineteenth century. We believe the R&D policy options for these industries with complicated technologies include:

The government needs to increase R&D spending; promote R&D cooperation among companies, universities, and public research institutes; and mobilize each party to make breakthroughs. In our view, R&D of crucial industrial technologies, especially of general-purpose technologies, requires the government to function as a coordinator. We think the government should spend more on R&D; encourage eligible companies to make breakthroughs; and define the public sector and the corporate sector's roles, liabilities, and interests regarding joint R&D and independent R&D. For instance, Japan established a sizable integrated circuit (IC) institute to support its semiconductor industry,⁵⁰ which we believe is a typical case of the government's participation in R&D of crucial technologies. In our view, the Chinese government needs to play a role to promote R&D cooperation in key areas such as IC equipment, aircraft engines, and high-end precision instruments.

The government also needs to cultivate innovative talent and help universities and research institutes boost R&D capabilities. To realize this goal, we think the government should cultivate local scientists, engineers, and technicians, and attract foreign talent at the same time. For instance, the rise of Germany’s machinery and chemical industries relied on a large number of workers from the UK,⁵¹ including German students who studied in the UK. In addition, the prosperity of the German chemical industry, to a large extent, is attributable to the extensive cooperation between domestic universities and large companies such as BASF and Bayer.⁵² We believe this underscores the importance of R&D cooperation between companies and universities or research institutes.

7.3.1.4 The Government Could Enhance the Efficiency of Financial Support for R&D in the Private Sector

If the government's financial support for R&D prompts the private sector to increase R&D spending, we believe this would be more beneficial than simply increasing public spending on R&D. Empirical studies suggest that the government’s financial support for R&D would stimulate corporate spending on R&D. Nevertheless, the effect of any support tends to vary, depending on four criteria.

Business size: For smaller firms, the government's financial support for R&D is helpful, and can have a greater effect than supporting larger companies.⁵³

Development stage: Startups typically lack resources, and the government's financial support for their R&D can help produce better outcomes. In contrast, financial support for mature companies is unlikely to generate desirable effects.⁵⁴

R&D intensity: The higher R&D intensity a company has, the stronger its technological strength, and the better results of the government's financial support. However, when a company’s R&D intensity reaches a sufficient level, the marginal effect of financial support diminishes.⁵⁵

Type of ownership: Multiple empirical studies show the Chinese government’s financial support cannot significantly boost R&D spending and efficiency of SOEs, but the effect on other types of firms is highly positive.⁵⁶

In addition, policy tools can also affect the results of financial support for R&D. Tax allowances are a popular tool used by governments to encourage companies to increase spending on R&D. This is particularly the case for high-tech firms, smaller companies, and firms that have not invested greatly in R&D. However, unlike direct subsidies, tax allowances prompt companies to pursue R&D projects that may generate lucrative profits in the short term rather than focusing on long-term basic research. Moreover, if a company's taxes are minimal pre-allowance, the impact of any additional tax allowances would be relatively low.⁵⁷

Credit policies are also used as complementary policy tools for R&D. Compared to direct financial support, supportive credit policies can reduce moral hazard as loans need to be repaid. Studies show that supportive credit policies such as subsidized loans can promote corporate R&D, while direct subsidies cannot produce the same results. The effect of subsidized loans in regions with poor financial conditions tends to be much greater than in other areas.⁵⁸

The scale of the government's R&D financial support, selection of qualified parties qualified for the support, stability of the support, and how government funds are utilized can also affect the result of the financial support.⁵⁹ Studies show that R&D financial support does not produce good results if the scale is too large or too small. Offering moderate financial support to many companies may be more beneficial than providing strong funding support to a few companies. Enabling companies to receive gradual, predictable, and reliable R&D funding support is better than offering funding support ad hoc, as indicated by empirical studies on technological innovation in energy.

In addition, competitive R&D subsidy policies can help companies enhance innovation efficiency. Against the background of accelerating “radical innovation”, China’s innovation system has shortcomings. The most prominent issues include a lack of impetus for basic scientific research and innovation, support from the education system to develop human resources capable of innovation, and the government’s need to improve its innovation governance capability.

7.3.2 Improving Innovation Governance Capability: Scientific Decision-Making and Flexible Management

Given the strategies introduced in this new era, the Chinese government has an urgent need to improve its innovation governance capability. A primary task is to make the decision-making process more “scientific”. A basic principle of technological innovation and industrial development is that enterprises of different types and scale and in different segments play specific roles, forming an industrial system featuring market-based operations, with the market economy and enterprises as the core actors within the system.

However, some policies introduced at local levels are not based in science. For example, the industrial planning and policies adopted in different regions are highly similar, resulting in overcapacity or even abandoned projects. Supportive policies tend to favor large or renowned companies, while SMEs contributing to technological innovation can only access limited resources, which does not bode well for the improvement of the regional innovation system. Moreover, due to insufficient understanding of the complexity of industries and their feature as a system, supportive government policies for industries often fail to deliver desired results.

Another mission is to increase the flexibility of R&D management system. China’s R&D management system features regulatory planning and administrative interventions. Some of the departments involved might not fully recognize the diversity of human capital, lack of consensus, and uncertainty in scientific research. This undermines China’s ability to achieve a flexible management structure or to adopt a scientific and reasonable method of resource allocation. These problems may dampen the motivation of talented individuals, especially young people, and are detrimental to a research culture that features free thinking and the pursuit of excellence.

Given the new tasks in the new era, we suggest that the government strengthen its innovation governance capability and introduce more policies based on scientific decision-making. Some solutions might include the following.

Mission-oriented approach. Local governments determine their technological innovation missions in accordance with the central government’s strategic deployment and regional development plans, and formulate policies accordingly after clarifying the major tasks.

Forward-looking research. When formulating technological innovation policies, related departments need to conduct extensive research first, and introduce and implement policies after gaining a good understanding of market trends, corporate needs, and how the policies work and take effect.

Leveraging market resources, with the market serving as a tool to improve policy efficiency.

The market provides abundant information, which is conducive to the formulation and implementation of government policies. The market also provides a variety of resources, and the government can use the resources at hand to leverage more market resources so as to achieve innovation-related goals and tasks.

7.3.3 Promoting Innovation Through the New System for Mobilizing Resources Nationwide

The system for mobilizing resources nationwide, known by the abbreviation SMRN, refers to an innovation policy model which establishes a special organization to mobilize resources within a short period in order to quickly achieve a strategic goal.⁶⁰ From the perspective of institutional economics, transaction costs are the core factor affecting economic entities. The SMRN greatly reduces internal costs through a state-led approach, and the government coordinates the implementation of market institutions to reduce uncertainty. The problem of insufficient innovation incentives caused by market failures can also be corrected.

When the People's Republic of China was established, in order to develop its industrial sector against the background of the blockade by Western countries, China introduced a nationwide system of “concentrating resources to accomplish major undertakings” in the industrial sector.

Market-oriented Western economies such as the US and EU established similar institutions when they had to channel a large amount of resources to complete major goals. For example, institutions such as the War Production Board (WPB), the Manhattan Engineer District, and the Defense Advanced Research Projects Agency (DARPA) existed in the US since the middle of the twentieth century. During the technology innovation boom in the 1980s, the US established departments such as the Small Business Administration (SBA), the Department of Energy (DOE), and the Department of Transportation (DOT) to implement projects aimed at supporting SMEs, such as Small Business Innovation Research (SBIR), Small Business Technology Transfer (STTR) and Small Business Investment Company (SBIC) programs.

The new SMRN emphasizes the application of the system to innovative tasks in the field of environmental protection and social reform, as well as the resulting change in the relationship between the government and the market. The concept of “mission-oriented” innovation proposed by Italian academic Mazzucato⁶¹ clarifies that the role of government as not only intervening when there are explicit market failures, but also to co-create and shape markets. For example, the Chinese government led the development of a green economy and introduced the goals of reaching peak carbon emissions and achieving carbon neutrality, which triggered the need for technological innovation, and further led to the launch of voluntary emissions reduction projects similar to Alipay’s Ant Forest.⁶² These moves to guide market participants to invest in innovation and achieve established strategic missions are features of the new SMRN (Fig. 7.8).

Fig. 7.8

Source Mazzucato (2017), CICC Global Institute

Comparison between versions of the SMRN.

The green economy helps fuel SMRN. Compared with the SMRN that supported high-tech industries in the 1970s and 1980s, a similar model is needed to drive a disruptive green revolution. In the US, President Joe Biden's US$1.2trn Infrastructure Investment and Jobs Act provides investment in electric vehicles, clean energy, broadband, and power grids exceeding US$120bn. Green transition is also at the core of the EU’s economic recovery plan issued at the end of 2020. The EU introduced the Next Generation EU recovery instrument with total investment of EUR1.8trn, with 37% of the funds to be invested in green transition and innovation in related fields.⁶³ YI Gang, the former governor of the People’s Bank of China (PBoC), predicted that China’s low-carbon economic strategy would drive investments in the tens of billions of renminbi in related fields between 2021 and 2050.⁶⁴

7.3.4 National Innovation Systems: The US Experience

Well-coordinated and orderly organizational structure at the federal level are distinguishable features of the US innovation system. The US federal government has three layers of administrative departments to formulate policies and organize innovation networks.

The first layer comprises organizations and institutions under the White House. By setting up institutions including the Office of Science and Technology Policy (OSTP), the National Science and Technology Committee (NSTC), and the President's Council of Advisors on Science and Technology (PCAST), the White House integrates the three functions of administration, decision-making and coordination, and professional consultation. This allows the US to establish a top-level governance mechanism for technological innovation.

The second layer comprises relevant administrative departments, with each department having an independent financial budget to support R&D activities in their respective fields. The Department of Defense, the Department of Health and Human Services, and the Department of Energy accounted for the largest share of the total budget over the years, which shows that the US attaches great importance to the military, medicine, and energy technology industries.

The third layer includes the special research institutions under the administrative departments, which are responsible for allocating the R&D budgets of the corresponding departments to various institutions across the country, with part of the fixed budget allocated to research centers and entities under the institutions to undertake research projects directly. Such a mechanism ensures that the country’s R&D funds are mainly allocated by professionals.

At the same time, non-market based policies enable the visible hand to play a key role. By adopting the so-called “non-market based” policies, the government does not selectively fund certain industries or institutions based on market mechanisms. Besides taking the form of top-down, command-based planning, such policies could also be adopted under the model of developmental network state, giving a boost to technological innovation.⁶⁵

The US federal government’s R&D subsidy and consortium policies are typical non-market based policies. The R&D subsidy policy is implemented via a variety of technology programs. For example, government departments also review the application submitted by market institutions, and offer support to high-quality ones. In addition to sector-specific support, the federal government also supports cross-sectoral technology programs.

The US government also influences development of technological innovation through non-market based investment and trade policies and antitrust policies, among others. The US strictly reviews the acquisition of US companies by foreign entities on the grounds of national security. Meanwhile, the Department of Commerce oversees the export of US technologies, and selectively reviews and supervises export activities to certain countries. Antitrust policies have an important impact on the landscape of the US technology industry. For example, the tightening antitrust measures over 1940–1980 resulted in relatively loose intellectual property rights protection, which in turn promoted the growth of emerging enterprises in the early stage.

In addition to non-market based measures, the US government implemented a series of market-based policies to encourage innovation. The so-called market-based mechanism refers to policies that cover all market entities and do not hinder the operation of the market mechanism. As long as related conditions are met, all innovative entities would receive policy support.

In terms of R&D policies, in addition to launching selective technology programs, the federal government introduced universal R&D tax credits in 1981, followed by various states from then on. So far, more than 30 states have adopted this policy.⁶⁶ The policy has been widely applied in OECD countries and has been proven effective in increasing corporates’ R&D investment (for details, please refer to Chap. 1).

The US has established a sound intellectual property system. Strengthening the protection of patent rights makes it easier for new companies with only a few patents to enter the market with technological strength. It also promotes the vertical division of labor among technology companies, especially in the field of biomedicine. ⁶⁷ The US has also introduced a number of laws to ensure the smooth progress of technology transfer, thereby protecting the due rights of R&D personnel and promoting enthusiasm for innovation.

In the field of finance, the US government launched a special policy. Specifically, it introduced a special venture capital license under the SBA, so as to promote the development of the venture capital industry in the US. In addition, the US adopts a looser stance on immigration policy, which enables the country to attract a large number of foreign students and scholars to visit or study in the US. This provides an important talent supply mechanism for innovation activities in the US.⁶⁸

7.4 Financing innovation—Capital Markets Are Not The Only Player

Financial support is the backbone of technological innovation. As mentioned previously, financial support is a framework condition for promoting innovation. Statistics also show that finance and innovations are positively correlated (Fig. 7.9). How might we interpret any causal relationship? Does finance lead to innovation (or vice versa), or are finance and innovation both triggered by other factors? What is the most effective way to finance innovation? This section discusses the relationship between finance and innovation, how different financial structures support innovation, and government’s role in financing innovation.

Fig. 7.9

Finance and innovation are positively correlated. Note The financial market development index is a financial industry index that the CICC Global Institute compiled based on credit, market capitalization, and venture capital deals in each country that the Global Innovation Index (GII) covers; the GII measures global ranking based on scientific knowledge output and innovation output (including intangible assets, creative goods and services, and online creativity). Source Global Innovation Index 2020, CICC Global Institute

7.4.1 The Financial Industry Does not Spontaneously Invest in or Promote Innovation

As mentioned in the previous section, innovation has positive externalities, and results of innovation are highly uncertain. We believe this explains why the financial industry neither spontaneously invests in innovation (although it can support innovation) nor spontaneously promotes innovation (though innovation requires financial support).

The financial industry does not spontaneously invest in innovation. Financial firms and industrial companies both seek to maximize profit. They lack a strong desire to support innovation if other activities prove more profitable, in our opinion. A large number of economic activities are highly profitable, and their existence is necessary; thus, it is reasonable for the financial industry to support these activities.

In contrast, housing market speculation exhibits negative externalities, with the resulting financial risk being borne by the whole country and returns being owned by individuals. As such, we believe it is unreasonable to use ample financial resources to support these activities. Studies show that housing price bubbles can significantly constrain innovation in the real economy.⁶⁹

Some innovation activities are not highly cost effective, which is another reason why financial companies lack a strong desire to invest in innovation. There are great uncertainties in technological innovation, and the probability of failure is relatively high. Also, the “innovation paradox” theory means innovation activities may not necessarily become more cost effective even if R&D proves successful. According to this theory, if innovation-driven companies do not innovate, market demand will shrink and they will lose their market positions. However, if they push ahead with innovation, their market positions may be threatened by their own innovation. This helps explain why innovation-driven companies are not as long-lived as other firms. The high probability of failure for innovation activities makes cash flow less predictable, and reduces the likelihood of being profitable. The innovation paradox shortens the expected lifecycle of innovative firms. These two factors both make innovation investment less attractive.

The financial industry is unlikely to promote innovation spontaneously. Research suggests the financial industry can guide innovation,⁷⁰ accelerate it,⁷¹ be neutral towards it,⁷² and also constrain it,⁷³ depending on the circumstances. The divergence implies that financial resources do not spontaneously promote innovation even if they are used to fund innovation. The reason is easily understood. Financial firms seek to make a profit, which might be incompatible with the target of corporate innovation. In addition, they may stop relying on promoting innovation to make money if they find innovative companies can help them earn more by improving financial indicators and taking other actions rather than by increasing R&D spending, in our opinion.

However, most studies generally hold neutral or positive views towards the impact of financial resources involved in innovation. Although a popular view argues that innovation should rely on capital markets funding instead of bank credit, leaders at tech firms such as Tesla⁷⁴ would appear to disagree with this view.

Overall, a popular view holds that supporting innovation relies on capital markets instead of bank credit. In contrast, leaders of top-tier high-tech firms are negative on the capital market's impact on innovation, and opt to embrace bank credit. To understand these two different opinions, we analyze the relationship between finance and innovation from the perspective of financial structure in the following section.

7.4.2 Financial and Innovation Structure: ‘Catching up’ Innovation Model and ‘Leading’ Financing Model

In our view, it would be unfounded to say that supporting innovation requires capital markets instead of bank credit, but rather both are needed. We do not believe banks’ potential support for innovation should be neglected. As we stated earlier, a popular view holds that supporting innovation relies on capital markets instead of bank credit. However, this view considers only financial structure, and neglects the structure of innovation. The roles of capital markets and bank credit in promoting innovation are different, and cannot be replaced by each other. When understanding their roles, we think types of innovation should be taken into consideration. In particular, large companies lack a strong desire for radical innovation, and prefer incremental innovation. In contrast, smaller companies prefer to promote radical innovation as they face lower costs when pushing it. We believe they are more willing to, and more capable of, relying on radical innovation to challenge larger companies’ dominant positions. In their early stages, mid- and small-sized firms rely heavily on the private equity market, where financial resources are limited and risks are relatively high. In contrast, banks with ample financial resources and low-risk appetite prefer mature and large companies. Thus, we can conclude that the capital market is more helpful in promoting radical innovation, while bank credit is more effective in pushing incremental innovation.

However, incremental innovation and radical innovation are not mutually exclusive; instead, these two types of innovation are closely related in many cases. In fact, incremental innovation paves the way for radical innovation, while the latter creates more opportunities for the former. They can both generate important social implications due to their dialectical relations. In our view, the importance of two innovation-financing models differs in different stages of economic development. For lagging countries that are catching up with leading ones, the main purpose of innovation is to help the former more quickly accomplish the stages of development completed by the latter. Under such circumstances, the bank-dominated innovation financing model helps mobilize resources to accelerate incremental innovation, catch up with advanced economies, and eliminate the vertical risks to domestic value chains, in our opinion. For leading economies, their leadership can be characterized by radical innovation such as ample new products and philosophy. Their capital market needs to play a more important role than bank credit in innovation funding.

Currently, China is catching up with advanced economies and may become a global technological frontrunner in the long term, in our view. Some domestic segments such as semiconductor are facing vertical risks. In these segments, the “catching up” innovation financing model in which large banks offer ample credit resources to big companies may need to play an important role, in our view. As such, China should improve the “leading” innovation financing model in which mid- and small-sized companies rely on capital markets to raise money to fund innovation. In our view, given the current environment of industrial security, it is necessary to analyze capital market and bank credit's relationships with radical and incremental innovation.

7.4.2.1 The Private Equity Market Faces Challenging Transformation

After rising annually before 2018, the number of new unicorns in China has plunged (Fig. 7.10). The number has contracted since 2018, even excluding the impact of HK IPO system reform in 2018 and the launch of the SSE STAR market in 2019. The private equity market faced transformation challenges in fundraising and investment in recent years. We believe this contributed to the decline in the number of unicorns in China.

Fig. 7.10

Source CB Insights, Wind, CICC Global Institute

Number of new unicorns after excluding the impact of new listing rules.

Private equity market's transformation in financing model amid new asset-management regulation. The total size of fundraising by Chinese VC funds is similar to the volume seen in the US (Fig. 7.11). For instance, Chinese VC funds combined raised about US$70bn in 2020, compared with US$79.8bn in the US.⁷⁵ Fundraising size in the US expanded steadily in the past decade, while the size in China lost steam after peaking in 2018.

Fig. 7.11

Source Pedata, NVCA, CICC Global Institute

Size of fundraising by Chinese VC funds was similar to the volume in the US, but growth has remained soft in recent years.

Chinese investors replaced foreign ones as the largest capital source of Chinese VC funds after 2007 (Fig. 7.12). However, the share of Chinese investors started to shrink after reaching 89% in 2017. In contrast, the share of foreign investors and their total investment in Chinese VC funds both trended upward after 2017. We believe this trend also means Chinese VC funds’ soft fundraising volume growth in 2018–2020 is mainly due to issues relating to domestic investors.

Fig. 7.12

Source Pedata, CICC Global Institute

Fundraising sources of Chinese VC funds.

From 2018 to 2020, the new asset-management rules⁷⁶ have not only effectively clamped down on improper financial actions but also pushed VC firms to change their fundraising methods and face high latent financial risks. These new rules have largely prevented managers of publicly-offered asset management products from investing in institutions that focus on investment in unlisted shares. As shown by the limited partnership structure of funds that invest in unlisted shares, their funds from financial institutions plunged since 2018 (Fig. 7.13).

Fig. 7.13

Source Pedata, CICC Global InstituteFootnote

The funds include angel, VC and PE funds; financial institutions include securities firms, trust institutions, banks, insurers, investment firms, and asset management companies.

Limited partnership (LP) structure of funds that focus on investing in unlisted firms.

Internet regulation pushed VC firms to shift the focus of their investment to the technology sector. The fundraising pressure naturally affected VC firms’ investment. Chinese VC companies hold their investment projects, on average, for only 3.3 years, compared with 8.2 years by their US counterparts⁷⁸ (Fig. 7.15). The shorter holding period indicates that Chinese VC firms are not highly tolerant of innovation failure, in our view. However, we believe tolerating short-term failure and providing an impetus to long-term innovation happen to be the most effective way to stimulate innovation.⁷⁹

We believe Chinese VC firms need to change their traditional investment style. Internet regulations are increasingly strict, with China clamping down on the monopoly of e-commerce platforms, and the country has intensified oversight of online education. Some VC firms switched to traditional consumer areas with lower risks (e.g., hand-pulled noodles and cakes). Other VC companies shifted to Chinese segments that face vertical risks such as software, biotechnology and semiconductors. In our view, these moves indicate that VC firms’ propensity to invest has not declined despite the pressure for investment style transformation. This trend also echoes our view that financial firms and even VC companies do not spontaneously invest in or promote technological innovation (Fig. 7.14).

Fig. 7.14

Source Pedata, NVCA, CICC Global Institute

Aggregate investment of Chinese VC firms has retreated.

Fig. 7.15

Source Pedata, CICC Global Institute

Average time that Chinese VC firms hold an investment project. Note The upper and lower lines indicate maximum and minimum levels; the “x” in red indicates the average level; the blue circle reflects the median.

7.4.2.2 The Stock Market: Creating Sound Exit Channels for VC Firms is Key

Although we believe the stock market is less effective than the private equity market in promoting radical innovation, it nevertheless plays an important role in the process. We believe the key is building sound exit channels for investors in the private equity market. In order for capital markets to promote radical innovation, the private equity and stock markets both need to play their roles. In the US, IPOs represent the most important exit channel for VC firms in terms of the aggregate value of the projects they exit,⁸⁰ and IPOs account for more than one half of the total value (Fig. 7.16). This share has been rising in recent years. We believe Chinese VC firms rely more on IPOs for exit (Fig. 7.17). The experience from the US shows that VC firms with a focus on semiconductor, software, and pharmaceutical industries rely heavily on IPOs for exit.

Fig. 7.16

Source Pitchbook, CICC Global Institute

Share of each exit channel for VC firms in the US (in terms of value of exit projects).

Fig. 7.17

Source Pitchbook, CICC Global Institute

Size of each exit channel for VC firms in China (in terms of value of exit projects).

As such, coordinated supports by primary and secondary stock markets help promote radical innovation. We believe the Japanese semiconductor industry’s experiences and lessons echo our view. The bank-dominated innovation financing model played an important role when Japan attempted to catch up with advanced economies. It helped Japan become one of the most prominent players in the semiconductor sector. Efforts to catch up amid incremental innovation once threatened the US semiconductor industry. However, the US now enjoys clear advantages over Japan in semiconductor design and equipment, the two semiconductor segments with the highest gross margins and least likely to be replaced. We believe this underscores the positive impact of the capital market-dominated innovation funding model on radical innovation.

7.4.2.3 The Banking System: Potential Support for Innovation Should not Be Neglected

Before China issued new asset-management rules, Chinese banks invested their money in the private equity market through multi-tiered investment instruments.⁸¹ Cooperating with trust firms was probably the most important channel, in our view, as reflected by the limited partnership (LP) structure of financial institutions that invest in private equity funds (Fig. 7.18). As banks invested in unlisted firms (and even multi-tiered higher-risk instruments), it would be inaccurate to say that banks cannot effectively support innovation due to their low-risk appetite, in our opinion.

Fig. 7.18

Source Pedata, CICC Global Institute

The LP structure of financial institutions that invest in Chinese private equity funds.

In our view, the risk appetite of commercial banks is not closely related to corporate innovation, but rather it is mainly driven by their liabilities and operating models. Commercial banks do not effectively support innovation among smaller firms with little collateral or startups with unstable cash flows, in our view. However, they do not refuse to support innovation among larger companies with ample collateral or startups with stable cash flows. For instance, we note that bank credit played an important role in both China's ultra-high voltage (UHV) and high-speed railway (HSR) industries. Incremental innovation that can help a country catch up with its leading counterparts normally requires large quantities of resources. In our view, offering ample credit resources to large companies with strong innovation capabilities could be an ideal innovation-financing model to help lagging countries catch up with leading ones.

7.4.3 The Government’s Role and Three Intervention Methods

The financial industry does not spontaneously invest in or promote innovation, regardless of whether the innovation funding model is “catching up” or “leading”. When analyzing the government's role in innovation funding, we focus on two aspects (i.e., regulatory principles and policy stance) and three means of intervention (contributing capital directly, building a series of systems, and enhancing credit) (Fig. 7.19).

Fig. 7.19

Source CICC Global Institute

The role of policies in innovation funding.

7.4.3.1 The Role of Regulatory Principle and Policy in Innovation Funding

We believe regulatory principle may have a bearing upon the impact of finance on innovation. For example, the subprime mortgage crisis in 2008 indicates that credit default swaps (CDS) are detrimental to financial stability, but innovation capabilities in the sectors that CDS covered improved substantially. The US banking system had a similar situation. After the US loosened banking regulation in states, a number of banks became more competitive than before, thereby hindering innovation. As a result, we believe that as existing banks in any given state faced new competitors, a detriment to financial stability, they subsequently became less influential, a benefit to promoting innovation.

Overall, these two cases indicate that regulatory principle should ensure a balance between financial stability and innovation motivation instead of focusing too much on financial stability. As mentioned, financial structure is also important to the relationship between finance and innovation. Financial structure represents a system arrangement that relies heavily on a country's development models, and its formation is closely related with the policy stance that the government selects amid important historical events.

7.4.3.2 Three Methods of Policy Intervention in Innovation Financing

There are three main methods for the government to intervene in innovation financing. The first is direct investment, which overcomes the constraint of fiscal money shortage. Chinese firms or government agencies became a major source of financing for Chinese VC funds. This represents an important change in funding structure of Chinese VC funds during the past decade. Firms or institutions backed by governments contributed more than half of the total fundraising volume of Chinese VC funds. Government guiding funds mainly invested in angel funds and VC funds that were in the early stages of development. As these angel funds and VC funds are more important to innovation activities than their counterparts in other stages, the government's direct investment in them can effectively support innovation.

The second method is system building, which allows moderate valuation bubbles to internalize positive externalities of technological innovations. An important reason why capital markets and banks do not spontaneously invest in or promote innovation is that the financial benefits of innovation activities are not attractive enough. Settling this issue is an important part of the efforts to build a closed innovation loop, in our view, driven by both governments and companies (Figs. 7.20 and 7.21). On the one hand, from the perspective of cash flow discounting, we believe innovative firms need to enhance their intrinsic value, which requires extending their expected lifecycle and/or improving cash flow expectations. On the other hand, in addition to formulating reasonable accounting systems, the role of monopoly in enhancing a company's intrinsic value should not be overlooked, in our view, as patents are essentially an artificially-created monopoly and help companies enhance their intrinsic value.

Fig. 7.20

Source CICC Global Institute

Two options that can enhance innovation returns.

Fig. 7.21

Source CICC Global Institute

The innovation loop driven by both governments and companies.

Enhancing companies’ intrinsic value undoubtedly helps raise expected returns. However, if the stock market is a perfect and effective market, share prices would always equal per-share intrinsic value and discounted cash flow value would be the same as one-off revenue from stock sales. In other words, there would be no excess returns. In fact, the stock market is not a perfect and effective market. Given that Graham’s analogy that the stock market is a “voting machine”,⁸² share prices being overvalued or undervalued is nothing new. When a stock has expensive valuations, investors can exit by selling the stock at a price higher than intrinsic value, thereby enhancing the returns on investment in technological innovation. In our view, creating a stock market that helps technological innovation investors exit could boost the likelihood of generating excess profit, internalize positive externalities of innovation activities, and have the capital market or banks more interested in supporting innovation. In addition, it also serves as an important mechanism to promote industrialization of R&D achievements.

The third method is credit enhancement. This method, together with direct fiscal backing, is an important way for the US government to push financial industry to support innovation. The typical options of direct fiscal funding include SBIR, STTR, and direct fiscal subsidies. However, credit enhancement is a more effective way in which the US government steers the financial industry to support innovation. Credit enhancement is widely seen in innovation projects that are funded by bank credit, capital markets or a combination of both.

First, the US government incentivizes banks to support innovation by providing credit enhancement supports to innovators. The US government has achieved this goal by establishing a state-owned federal financing bank and provide guarantees to private banks. As stated earlier, banks require borrowers to offer collateral and have ample cash flows due to their liability operation model. Although we believe it is inaccurate to say that banks cannot effectively support innovation, banks simply choose not to support innovation activities of startups or SMEs spontaneously. Therefore, offering guarantee services to startups and SMEs (e.g., credit guarantee programs, loan interest subsidies, and IP financing) is an important way through which countries push banks to issue loans to fund corporate innovation.

Second, the US government provides credit enhancement services to the capital markets’ support for innovation activities. A typical example is the SBA’s SBIC program. Initially, the SBA provided financing supports by directly purchasing the bonds issued by SBICs. After the US Congress passed the Public Law (2–213-DEC. 22) in 1971, SBA was authorized to provide guarantees for the bonds issued by SBICs. This credit enhancement practice became a mainstream way for SBA to support the SBICs' financing activities. As SBA's purchase of defaulted guaranteed loans is lower than the total amount of approved guaranteed loans (the purchase being less than 10% of the total amount over the past decade), its credit guarantee can attract much more money than direct bond purchases to support SBICs' innovation activities even if the government does not increase spending on SBIC programs.