How can China trigger more innovation?
How can China trigger more innovation?
Leveraging the virtuous cycle of consumer demand and innovation
In my answer below, I discuss what I think are the key elements to China’s innovation success in the coming years:
Continued development of the economy (more resources are available to invest in R&D)
Leveraging the virtuous cycle of consumer demand and innovation
Avoiding rent-seeking type behavior
Improving quality of life to retain talent
These elements are not unique to China but broadly applicable to most large developing countries around the world.
I recently took a trip to Shenzhen’s famous electronics bazaar (Huaqiangbei 華強北). It was an eye-opening experience and I was quite impressed by the amount of innovation and hustle that was taking place right in front of me. To me, this is one type of Chinese innovation that you can see happening in real-time. I describe this experience below in detail.
(1) Continued development of the economy
Part of the innovation game is simply having enough spare resources in the economy to focus on long-term activities like innovation – as opposed to short-term activities like making sure there is enough food on the table.
Like people, economies tend to work their way up their own Maslow’s hierarchy of needs. First, they need to focus on basic and pressing needs like providing food, shelter and defense so that their citizens don’t starve to death and society does not crumble. Then, they move onto intermediate and medium-term needs like providing jobs, consumer goods, a good education etc. Only when they have largely taken care of these can they start freeing up resources to work on long-term pursuits like “bleeding edge” innovation.
We can see this throughout various facets of the Chinese economy as it has grown. As Chinese companies scale, they are able to devote more of their budgets to research and development. As tax receipts grow, State budgets have more room to budget basic R&D spending, or divert funds to invest in more and better research universities and institutions. As the economy becomes more productive, you need fewer workers to produce the same amount of goods and services, which means spare resources for some to spend their time thinking creatively instead of being needed on the factory floor.
For China, we can see this very clearly in the gradual increase in R&D spending as a percentage of the GDP [1] over time as its economy has become more developed:
Two generations ago, most Chinese people worked on a farm. One generation ago, their kids started working blue-collar factory jobs in and around the cities. Today, most new jobs being created are service jobs in the cities, including increasing numbers in innovation-type businesses. This is the typical path of economic progress.
China never lacked the energy or ability to innovate. It’s just that at the lower stages of development, it’s more efficient for that energy and creativity to be used on “catch-up” type innovation instead of what we think of in the developed world as true “bleeding edge” innovation. Now an upper middle income country, China is entering the stage where “bleeding edge” innovation starts to matter more in terms of driving it into the next tier (“high income” level).
(2) The virtuous cycle of consumer demand and innovation
As long as you have a well-functioning capitalist-driven economy, consumer demand will attract entrepreneurs interested in making money. These entrepreneurs will find or develop products that can satisfy this demand and the successful ones will end up building profitable businesses that create new jobs that are usually higher quality than existing jobs. These new high-quality jobs then drive even more consumer demand, completing one full revolution of this virtuous cycle. With each full revolution, the wheel spins even faster.
The U.S. is the best example today of this virtuous cycle in effect. Because it is the world’s largest unified consumer market, it gets a disproportionate share of attention from entrepreneurs. New consumer products and services scale here much more quickly than in the Eurozone, where consumer marketing must be done on a country-by-country basis due to greater language and cultural differences.
Because of its size and scale, China is one of the few countries that has the potential to match the United States in terms of aggregate consumer demand. However, to date Chinese policymakers have not really cared all that much about the consumer economy, focusing policies more to support export-oriented businesses that cater to foreign demand or centralizing the country’s resources into urbanization and infrastructure build-out. In fact, for much of past two decades, Chinese policymakers used a policy of “financial repression” that acted like a regressive tax on consumption [2] to fund more capital-intensive activities.
But this now appears to be changing. The Renminbi has been appreciating against most world currencies since the mid-2000s. The “financial repression” tax was lifted in stages starting around 2012. This was akin to reducing taxes on the household sector – the beating heart of consumer spending – which is having a positive effect on consumer demand. Further, the recent drop in commodity prices (especially oil) has provided a further boost for consumers. As a result, retail demand and consumer spending have held up despite a relatively weak overall economy (i.e. the industrial economy in China and generally in the rest of the world).
I think we are only at the beginning of a middle class Chinese consumption boom. Because of its sheer size, it will dwarf the first Chinese consumption boom [3] which was largely driven by the top 1% of households in China. It is this source of consumer demand that will be the key driver of innovation in the coming years. If successful, China’s development path will veer away from the export-driven paths Japan and South Korea took, and start to look a lot more like the United States itself.
(3) Avoiding rent-seeking type behavior
Rent-seeking behavior is the type of economic activity that leads to mere transfers of wealth without enlarging the pie for everyone. Rent-seeking behavior is often rooted in corruption but is ultimately driven by the the type of incentives and opportunities that a country’s economic system produces.
Rent-seeking behavior can destroy a country’s innovation capabilities. If ambitious entrepreneurs find that it is easier to enrich themselves by engaging in corrupt or otherwise non-pie-enlarging activity, you can be sure that they will do so. By doing so, they quickly turn from noble entrepreneurs into greedy oligarchs that look to extract perpetual rents on society. They become incentivized to want society to remain relatively stagnant so that their profit-making businesses are not disrupted. They often use their economic power to influence politics and continue to skew the system in their favor, often by stifling the next generation of entrepreneurs.
Even “good” entrepreneurs have the tendency to get lazy once they’ve made it. In the past, they may have created a wonderful business that creates lots of jobs, provided a good or service that benefited society and had a huge positive impact on society. But after that initial success, it may be easier for them to simply use their market dominance as a way to extract more and more profits, instead of actually innovating. Remember that the incentives of shareholders and society are not always aligned and there is a role for the government (through a regulator) to play in making sure everyone is playing fair (of course, it is often extremely difficult to draw the line between good and bad regulation).
This is the type of behavior that China needs to avoid in order to trigger more innovation. No economy can completely stamp out corruption but the more you can control it, the higher its economic potential will be. The more we hear about people making money in technology, design or robotics in China vs. protected monopoly businesses or those that depend highly on political patronage, the better China is doing in this respect.
(4) Improving quality of life to retain talented entrepreneurs
For many years, talented Chinese have headed overseas, attracted by better educational opportunities, economic opportunities and better quality of life than was available in China.
Over the last two decades, China has solved some of these issues and many talented individuals have either returned from overseas or are more likely to stay to pursue economic opportunities that are available at home.
However, the one area that has not improved significantly is quality of life. Certainly in some areas it has gotten better but in other ways it has gotten worse (e.g. pollution). It is very common for Chinese entrepreneurs – once they have made an initial batch of money – to try to re-locate their families overseas where the air is cleaner and the educational system easier on their kids. If you live in places like Downtown Manhattan, Vancouver or Orange County, you know what I am talking about.
If China wants to compete with Silicon Valley, it will need to bring its quality of life standards up to par with the rest of the world. Talent is global and quality of life is very important for entrepreneurs.
Witnessing on-the-ground innovation in Shenzhen
Two weekends ago, I visited Shenzhen’s famous electronics bazaar (Huaqiangbei 華強北). It is a massive district featuring dozens of large commercial buildings that each contain hundreds or even thousands of small shops that specialize in every imaginable consumer electronics or related good. The typical stall is around 50 square feet and staffed by 3-4 employees:
As I walked around, I marveled at the amount of entrepreneurial hustle and activity that surrounded me. There were stores that specialized in everything from branded smartphones (occupying the more expensive ground retail space at street level) to telescopes to weed accessories. Delivery people whizzed back and forth at street level delivering goods (usually on carts or via bicycle) into the buildings or picking up goods for online delivery (many of these stores/stalls also sold their goods on Taobao as well):
The variety of goods was amazing. I visited one small store that specialized solely on providing designer USB cables with some interesting twist. For example, instead of your normal plastic sheathing, the cables used colorful designer threads (see picture below at left). Another product they offered was a single USB cable that had every standard plug (e.g. Lightning, micro-USB etc) on the other end. In addition, I noticed that retail/consumer packaging is getting more sophisticated as you can see with the picture on the right – it even has a little hologram / QR code at the bottom left to ensure authenticity:
I’ve never heard of this brand “Joyroom” and I have no idea whether it will become a successful brand in the future. Moreover, many of the products being hawked at other stalls were clearly counterfeit (with the store owners making zero attempt to try to dupe the customer into thinking they were authentic) and many of those stores will likely fail in the coming years. But I am also sure that some of these brands and some of these store owners will succeed and by doing so, they are doing their small part to drive innovation.
Outside one of the buildings at street-level there was a standalone glass building that piqued my interest because there was a large crowd inside. The store was like a next-generation Lego store where instead of plastic blocks, you could put together metallic parts and combine it with some software to create a variety of robot cars, printers and other hardware devices. I later discovered that this was one of many companies in Shenzhen’s burgeoning Maker Movement community which encourages people to tinker with designs and exercise their creativity. The Maker Movement is a natural offshoot of shanzhai (山寨) culture which had its roots in illegal counterfeiting but has since evolved into something that is very legitimate. The company was selling these kits to children starting in early elementary school, and this very much felt like the “future” to me in the same way PCs felt like the future to my parents’ generation during the 1980s in America.
Ultimately, I ended up buying this cute little plastic thing that holds an iPhone (or in this case, a Xiaomi Yi wide-angle camera) in its “mouth” – kind of like a more flexible tripod. We use it to hold the phone when the kids Facetime with their grandparents. The kids named it “Joey”. It cost a cool ¥15 (about $2.30) at the Shenzhen electronics bazaar after negotiating it down from ¥20. With better negotiating skills, maybe I could have gotten it down to ¥12!
The Shenzhen electronics bazaar is pure unadulterated capitalism at work and the type of place that will drive innovation for China in the years to come.
Notes
[1] Source: World Bank
[2] This was largely accomplished by using its tight control over the banking system to keep interest rates very low (often below inflation) on household banking deposits and then lending at low rates to capital-intensive businesses which were disproportionately state-owned enterprises.
[3] The first Chinese consumption boom was largely driven by the top 5% of households, as we could see across many luxury-oriented categories of goods.
This was originally published on Quora in March 2016.