China and the US, who innovates better?

In recent years, China and the US have been competing on many fronts. Before this century, competition between powers was centred around resources and markets, but since the beginning of the 21st century, focus has shifted to technology and innovation, with the more innovative side being more likely to claim the final victory.

There are two perspectives from which to view the China-US innovation competition. On one hand, since the 2008 global financial crisis, some Western academics seem to have lost confidence in their own ability to innovate. On the other hand, some Chinese academics readily conclude that China is less innovative than the West. It seems that for both parties, the grass is always greener on the other side.

In his 2016 book The Rise and Fall of American Growth, Robert Gordon of Northwestern University notes that sluggish innovation is the main reason for the slow growth of the American economy in recent years. So far, there have been three stages in the Industrial Revolution, each punctuated by a period of slow innovation. Gordon holds that this is one such period, and it may last for decades. Today's computers and peripherals have changed little from 15 or 20 years ago, and the same can be said for retail business models, university education, and air travel, hotel, vehicle rental, and healthcare services. Many of today's so-called new enterprises and new products appeared on the scene before 2006, with only the smartphone appearing after 2007.

Among the expected upcoming new inventions, improvements to small robots are not revolutionary, 3D printing technology is not for mass production but more suited for small batch processing, and big data and artificial intelligence are mainly used in marketing and sales, with no revolutionary or innovative uses as yet. Driverless vehicles may be a bigger game-changer, but they are still far from being commercially viable. Gordon believes that the impact of the IT revolution on economic development simply does not compare with the revolutionary innovations that emerged between 1870 and 1970. Gordon argues that the slowdown is likely to be permanent as technological progress is facing a set of headwinds such as rising inequality, stagnating education, and an ageing population.

Why is innovation so sluggish? Why is it unable to drive economic growth as rapidly as before? Is it getting harder to find revolutionary innovations? In The Innovation Illusion (2016), Swedish economist Fredrik Erixon and entrepreneur Bjorn Weigel point out that Western capitalism, far from fostering innovation described by economist Joseph Schumpeter as "creative destruction", has turned grey. And as the bodies of innovation age, Western society has become a "capitalist society without capitalists".

The causes of this aged, tired capitalism are an expanding middle class and a longer life expectancy. With ageing and higher retirement savings come increasing size of retirement pensions, elderly funds, and sovereign wealth funds. According to estimates by the Organisation for Economic Co‑operation and Development (OECD), in 2013, insurance companies, pension funds, and investment funds managed US$93 trillion in assets, five times the American GDP that year.

As sovereign and pension funds keep expanding their investment portfolios, these institutional investors become the main owners of companies. In 1950, only 6.1% of all issued equity was owned by institutional investors, but by 2009, that figure was over 50%. Conversely, in the 1960s, individual investors owned 84% of all issued public stock; that percentage was down to just 40% in 2013.

As a result of institutional investors buying a high volume of shares, many big companies have become "public-owned". Before it was bought over by the Bank of America, about 50% of Merrill Lynch's shares were held by institutions such as sovereign funds, mutual funds, and retirement funds, with the other half held by individual investors. Just 0.07% was held by the largest individual shareholder. In 2019, about 82% of General Electric shares were held by 1,859 institutional investors, the largest of which is the Vanguard Group. This group is the world's largest issuer of mutual funds and second-largest issuer of exchange-traded funds (ETFs). It owns 7% of stocks on the Standard & Poor's 500 Index and serves 20 million investors around the world. Vanguard is owned by its funds, and the funds are owned by their respective shareholders.

The shift to more "public-owned" companies prompts changes to the incentive system. As shares are spread out, ownership of 10% or even 5% of shares is often enough to have a controlling stake. Major shareholders can free-ride on smaller shareholders and use other people's money to do as they wish, while smaller shareholders are concerned only with the most basic issues, such as the rise or fall of share prices and whether they get dividends, without questioning larger matters such as the operations of the company. Institutional investors feel this is simply asset investment, a means of diversifying their assets, and therefore do not want to get involved in board management. But with shares spread too thinly, shareholders' ownership rights are not well protected as they have little control over the management.

Ultimately, the principal-agent problem becomes the main issue in corporate governance. Before the 2008 global financial crisis, chief executive officers (CEOs) of large corporations had more power than the heads of state-owned enterprises in China. Their salaries kept climbing as they continued giving themselves pay raises. Amid the crisis, the Lehman Brothers and Enron scandals broke. And even as companies were bleeding money, retrenching staff, and requiring taxpayers' help to avoid bankruptcy, one CEO spent US$1 million on a luxury renovation for his office, while other senior managers from that company went on a luxury retreat and awarded themselves huge year-end bonuses. The scandal sparked public outrage when it was exposed by the media. Congress proposed a bill for a 90% tax on bonuses, and then-US president Barack Obama harshly criticised the irresponsible, shameless behaviour of these executives. However, some of these senior managers pointed to the potential for serious social consequences of a company collapse, using this rationale to hold the government and taxpayers ransom, channelling benefits to individuals while losses were born by the community.

After the global financial crisis, the government strengthened the regulation of companies. Due to the lack of information and regulatory capabilities, the government could only set up various systems, which generated a series of complex, erratic rules. In 1955, there were anywhere from four to seven key performance indicators for an average executive. Today, there are about 25 to 40. Further, with rules becoming increasingly complex, many companies now have a chief compliance office to ensure that companies follow rules, policies, and procedures.

Government policy is directed at maintaining market stability and guarding against the impact of innovation. It aims to prevent innovation products from having a major disruptive impact on the market, such as the financial derivatives that led to the financial crisis. As a result, companies conceiving revolutionary innovations will encounter high compliance costs. Government regulatory agencies have even created "regulatory sandboxes" to set the pace of innovation and its market impact through regulation. However, sandboxes are used for training pet cats, and strong regulation will make entrepreneurs lose their thirst for innovation.

Institutional investors such as retirement and pension funds must be accountable to other investors. They fear that retirement and pension funds would shrink again in the event of another financial crisis, leading them to ramp up regulation of companies. One way this is achieved is to limit companies' cash flow, prohibiting companies from investing with their own funds and ensuring that external organisations will watch over these investment decisions. As a result, the ratio of retained earnings to net income for US companies has dropped from 50-60% in the 1960s to less than 10% today.

In addition, institutional investors want to spread out the risks and want predictable investment returns. They do not encourage competition between companies, because they also hold shares in these competing companies. Senior management is aware that the needs of institutional investors are in line with elderly retirees, and they are becoming more risk-averse. Erixon and Weigel found that current senior management of US companies are strongly on the defensive. They are more concerned about the potential risks than they are about the potential benefits of their decisions. Actively involved in fund management, they often act more like banks. An OECD report said that in the 1970s to 1980s, the US business sector borrowing had a value of about 15-20% of produced assets, but in 2007, the business sector lent money to the rest of economy, with a value of about 5% of produced assets. Companies often bought back shares and acquired competitors, but they invested less in research and development.

Erixon and Weigel hold that the power of an innovative economy is not inventing, but competing and adapting, driving workers, investors, companies, and the government to be more effective. In recent years, Western companies have changed in three ways that get in the way of innovation. First, because companies lack their own funds, they grow more dependent on the financial market. In addition, bureaucratic rent-seeking behaviour takes the place of entrepreneurship. Further, government regulations are complex and erratic. "Greying" Western countries lack breakthrough innovations mainly because Schumpeter-type entrepreneurs have been replaced by asset managers and money managers, and those running Western capitalism today are not really entrepreneurial capitalists.

Those who share the views of these academics are still in the minority. The mainstream view is more positive about the innovative capabilities of the West. However, in recent years, China has been expanding on a large scale in research and development, and has implemented industry policies to guide innovation. The rapid growth of Baidu, Alibaba, Tencent, Huawei, Xiaomi, and other technology companies, as well as innovations in 5G technology, e-commerce, mobile payments, and other related products, are all adding to the sense of crisis in the West, and they are more wary of the challenge from China, leading to stronger policy reactions.

By contrast, Chinese academics generally have little doubt about the innovation capabilities of the West, but are more pessimistic about China's own innovation capabilities. A study by Professor Zhang Weiying of Peking University found that most of the 5,000 sectors categorised under the International Standard Industrial Classification of All Economic Activities were created in the past 300 years. Of these sectors and related new products, none of them are Chinese inventions. Further, according to "1001 Inventions That Changed the World" - a book edited by Jack Challoner and published in 2009 - China claims 30 of these 1001 great inventions, but all of them came before the Ming dynasty. Of the 838 major inventions that came after the 16th century, not one originated from China.

For a country with such a large population, why is China so unremarkable in invention, creation, and industrial innovation? The general view is that the Confucian concepts of hierarchy and country before self encourage centralisation and obedience, while disapproving of differences. Personal freedom is not respected, and personal rights are not protected. This combination of factors is not conducive to developing innovation talent.

Since its Reform and Opening Up, China has attracted foreign investment to learn new technologies from other countries as a means of making up for its deficiencies in innovation. However, because the law is not well-enforced, intellectual property (IP) rights violations often occur. Some government agencies even take a "market for technology" approach, opening up the Chinese market only on the condition that foreign-funded companies or joint venture companies agree to transfer their technology. As China-US competition grows more intense, IP protection and surrendering technology have become the main issues in China-US trade talks.

At the State Council executive meeting early this year, the principle of "competition neutrality" or fair play was raised. There are plans to change the rules and remove policy measures that obstruct fair competition, impede the growth of private companies, and do not treat domestic and foreign-funded enterprises equally. At a more recent meeting, the State Council also declared, for the first time, that foreign-funded companies should not be made, directly or indirectly, to surrender their technology. Further, as innovation becomes more important, there is great demand within China to ramp up IP protection. It is believed that these improvements will help spur innovation.

However, stiff challenges to creating a conducive environment for innovation remain. The 2019 Jingshan Report, headed by Professor Huang Yiping of Peking University, noted that globalisation might stop or even reverse itself, and China's economic growth might become less dependent on external markets, capital, and technology. Whether or not China's economy will achieve quality growth depends on whether its economic growth model can transit steadily from depending on production factors to being innovation-driven. However, China's current financial system, which is largely bank-based with high government intervention, can no longer support the growth of the new economy, because asset-light small scale innovative firms and private companies have become major drivers of economic innovation today, but they are not getting effective financial services.

On another note, China's local governments are usually more supportive of innovation when they enjoy more autonomy. Under a highly centralised environment, however, they choose to make conservative decisions to avoid mistakes and problems. Senior management of China's state-owned enterprises act like government officials, and they are not keen on innovation when they are under strong surveillance and supervision. In recent years, there has been a push towards mixed ownership, but with state-owned enterprises holding shares in private companies, the senior management of state-owned enterprises and the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) are behaving like institutional investors in the West, exerting tight control over companies and stifling innovation in the private sector.

Interestingly, the shareholding system is an acceptable form of "public ownership" and has been used in the reform of China's state-owned enterprises, but it has led to these enterprises behaving like large enterprises in Europe and the US, where they face the same stubborn principal-agency problem. Tight regulation means companies do not take the initiative and find it difficult to innovate, while loose regulation makes it easier for agents to exploit the principals.

Previously, innovation in the West was mostly dependent on big companies, because they had sufficient resources for research and development and were able to protect their intellectual property and make technology a barrier to competition. In the past 20 years, as IP protection laws have redefined the relevant rights, small companies in the US and even individuals are starting to own innovative technology. While big companies lack the impetus to innovate, small companies with the support of venture capital funds are becoming more innovative.

In China's case, McKinsey Global Institute found that due to population scale and consumer support for innovation services, China is now the global leader in customer-centric innovation. Furthermore, China has a large group of responsive, efficient suppliers, a sizeable and highly skilled labour force, and comprehensive logistics facilities, giving it a unique edge in efficiency-driven innovation. So, the West and China each have their own strengths in innovation.

In the end, the China-US innovation competition boils down to a competition on institutional innovation. What is clear is that whichever side has the more flexible institutions and is better at adapting to the needs of competition and innovation is more likely to emerge the victor.