China's going full speed ahead on technology innovation. Will it work?

The recent meeting between representatives of the US and China in Alaska clearly showed the extent to which the two countries have adopted opposing stances on ideology, politics and security concerns. President Biden confirmed at his first press conference that his administration intends to prevent China from surpassing the US to become the most powerful country in the world. In other words, the technological competition that has emerged between China and the US in particular, but which Europe and Japan are also paying attention to, will challenge Chinese initiatives in this century.

Contrary to the expectations of some observers, these international headwinds have not cowed China into a more submissive stance, but rather have amplified the Chinese leadership's ambitions to become self-reliant in terms of core frontier technologies.

The Covid-19 pandemic added another challenge for economic development, hitting Chinese supply chain industries and setting back economic growth targets in 2020. However, the lockdown that gripped society also provided ample demand for new digital services, such as the industrial internet and online retail shopping, together with public services, such as pandemic surveillance and telemedicine, which have ultimately enhanced the trends towards creating a digital economy and innovation in advanced information and communications industries in China. Adopting the dual circulation strategy, the leadership intends to utilise this emerging domestic market for advanced technology in conjunction with international markets.

The draft 14th Five-Year Plan (FYP) was finally endorsed at the National People's Congress in March. The FYP, which has been in the making over the last few years, has highlighted precisely the attention paid to the promotion of indigenous innovation, with an annual growth rate of R&D expenditure of at least 7% and a strong support for strategic sectors and frontier areas. The plan also calls for raising the share of basic research within total R&D spending total to 8%, reflecting the leadership's ambitions to participate in pushing forward the frontiers of science and technology, rather than simply adapting breakthroughs developed elsewhere.

For strategic and frontier sectors including artificial intelligence and semiconductors, the core initiatives outlined in the FYP stretches beyond the traditional targets of industrial policy to mobilise a variety of economic actors with new instruments of innovation policy (i.e. a "new type" of whole-of-nation approach). These industries are considered strategic because they remain essential for China's participation in the global supply chains.

For example, China imported more than US$350 billion semiconductor products in 2020, making semiconductors China's largest import item in recent years. Moreover, the development of the digital economy relies extensively on access to semiconductors, such as those needed for the building of data infrastructure including 5G, data storage centre, etc. While this "new type" of whole-of-nation approach appears to be a government-led and mission-oriented effort, the 14th FYP and recent policies also aim to use market-based incentives to leverage non-state resources into the preferred areas.

For example, the key elements of such innovation policy instruments for supporting catch-up for the semiconductor and software industries were outlined in a recent government guideline issued in July 2020. For specially targeted enterprises in these industries, the government provides special finance and taxation incentives. For instance, enterprises or projects for the production of integrated circuits of less than 28 nanometers with an operating period of more than 15 years will be exempt from corporate income tax from the first to the tenth year; while those for integrated circuits of less than 65 nanometers are exempted from corporate income tax for the first to fifth years.

Similar tax incentives were offered for Integrated Circuit (IC) design and software firms. Financial incentives include full use of national and local government investment funds to support the development of the integrated circuit industry and software industry, together with efforts to encourage private capital to raise funds through multiple channels, including bank loans and corporate bonds. One such measure is the creation of the China Integrated Circuit Industry Investment Fund, also known as the 'Big Fund', which rolled out its second phase of funding for the next five years with a budget to the tune of 204.15 billion RMB (US$28.9 billion), even if few successful ventures have resulted from the first phase.

At the same time, policies for research and development have sought to coordinate major projects in the format of whole-nation innovation platforms in fields such as advanced storage, advanced computing, advanced manufacturing, high-end packaging and testing, key equipment materials, and new-generation semiconductor technology. The State Council also emphasised the implementation of standards of software quality, information security, and software development management.

Another element in China's innovation policies that has become ever more essential over the decade has been the need to attract and develop talented employees. For example, to promote the semiconductor industry, the government will encourage the development of education - strengthening the construction of integrated circuit and software majors in colleges and universities, encouraging qualified colleges and universities to extend cooperation with integrated circuit companies, and reward high-end talents who have made outstanding contributions in the field of integrated circuits and software.

In the 14th FYP, an additional ambition is to create more world-class technology leaders and innovative teams, and to cultivate an internationally competitive 'A' reserve army of young scientific and technological talents. According to the plan, China will introduce an open competition mechanism to select the best talents to lead key research projects. Finally, the 14th FYP once more recognises the need to strictly implement the intellectual property protection system and increase the punishment for violations of intellectual property rights.

Public-private cooperation constitutes a new component of innovation policies. For the case of the semiconductor sector, the government will increase support for specialised service platforms such as specialised crowd-creation spaces, technology business incubators, and university science parks that serve the integrated circuit and software industries, and enhance their specialised service capabilities. Government departments are encouraged to purchase services and transfer e-government construction, data centre construction, and data processing tasks that fall within the scope of government responsibilities and are suitable for market-oriented services, to qualified software and information technology service organisations.

For all the ambitions that the Chinese leadership has demonstrated with a series of reforms and dedicated policies aiming to beef up strategic industries to reach frontline technological innovation capabilities, there are still serious challenges in reaching these goals within a reasonable time frame. For one thing, the financial resources required are considerable, both for R&D funding and for equipment investments.

While ranking number two in total expenditure in R&D (after the US), China's R&D intensity is still lagging behind other frontier countries in the West and in Asia, such as South Korea, Japan and the US, where the ratio of R&D expenditure to GDP amounted to 4.81%, 3.26% and 2.84% in 2018 respectively, according to World Bank figures. In fact, for the 13th FYP, China did not reach its target for R&D intensity. In 2020, China spent 2.4% of GDP on R&D, which is short of the target set in the 13th FYP (i.e. 2.5% of GDP).

One concern regarding the industrial policy to support strategic sectors is that quite a few projects might involve major financial risk. For example, the capital investment for construction and operation of advanced semiconductor facilities are running in the multi-billion range; for example, a leading firm in the industry such as the Taiwanese IC company Taiwan Semiconductor Manufacturing Company (TSMC) has committed US$12 billion to building an advanced plant in Arizona. In its attempt to increase self-reliance in both chip production and the output of supply chain industries such as essential equipment manufacturers, China has already invested huge sums from central as well as local coffers. Nevertheless, very few viable Chinese producers of products like lithography equipment have materialised over the years.

Some Chinese firms in the semiconductor industry try to manage their financial conditions in different ways. In July 2020, the leading semiconductor foundry in China Semiconductor Manufacturing International Corporation (SMIC) raised over 53 billion RMB (or US$7.6 billion) from its IPO - the biggest IPO in China since 2010. In May 2020, SMIC also managed to get an investment worth US$2.2 billion from the "Big Fund". Furthermore, a Shenzhen municipal government-managed fund made an investment in a joint project with SMIC's plant in Shenzhen, valued at US$2.35 billion. The Shenzhen fund will hold a 23% stake in the project.

In spite of - or perhaps precisely because of - the generous tax and financial incentives mentioned above, local governments are tempted to rush into supporting very expensive, but questionable projects. Their attempts to identify and pick winners in potential areas of technology breakthroughs have frequently been costly. The recent abandonment of Wuhan Hongxin Semiconductor Manufacturing, where a couple of ill-qualified entrepreneurs tricked government officials and media into believing the company was capable of "frontier advanced chip manufacturing", is one such case.

Ultimately, the drive to build such strategic frontier technology industries in China is a long-term endeavour which stretches far beyond the perspectives of a five-year plan. The creation of a talent pool, well-funded and managed R&D programmes, and an ecosystem of leading firms and vibrant supply chain producers is a matter of decades. Moreover, self-reliance and the "indigenisation" of innovation is important, but China will continue to participate in international markets in order to capture economies of scale.

The adverse effects of US sanctions - such as the targeting of Huawei and other advanced Chinese producers with "Entity List" blacklisting - will act as a barrier for the rapid development envisaged by the leadership. But these sanctions are probably precisely the reasons for China's stronger motivation to persevere in joining leading nations in frontier technologies, and its efforts are likely to continue even if a new level of international cooperation should become feasible during this decade.

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