Understanding Innovation in China

By Josh Lerner

Posted on April 6, 2016


Share

One of the most dramatic changes in the global innovation landscape has been the rise of China as a hub for patenting and innovative activity more generally. China has in recent years ranked among the top nations globally in terms of the level and growth of R&D expenditure and patent application and grants, as Figure 1 illustrates. The table depicts the total number of awards made annually by the major national and regional patent offices, whether these were awarded to domestic applicants or foreign ones. China today has more patents filed than in any other nation, and Chinese companies are among the most active patentees.

 

At the same time, intellectual property protection in China is weak. For instance, in the U.S. Chamber of Commerce’s 2015 Global IP Index, China ranked as 12.4 on a 30-point scale, well below of median of the 31 nations considered1, a finding that echoes earlier ratings of intellectual property systems by academics. Similarly, the office of the United States Trade Representative has repeatedly placed China on its "priority watch list" for intellectual property rights violations, along with other nations.

 
Image: Lerner_graph_1.PNG

Figure 1
Source: World Intellectual Property Indicators, World Intellectual Property Organization, 2014

 

The seeming contrast of the first two paragraphs pose a variety of interesting questions. Without good intellectual property protection, what incentives do firms have to invest in R&D and innovate? Where does China’s innovation take place—in the state-owned firms or in the private sector? These questions are left largely unanswered by prior studies focusing on cross-country evidence.

 

Making the growth of patenting in China particularly puzzling is that the influential literature on law, finance, and economic growth establishes that effective legal and financial institutions more generally lead to better economic outcomes. But an influential critique by Allen, Qian, and Qian2 points out that China’s experience represents a puzzle. On the one hand, China ranks below the majority of countries studied in the “law and finance” literature: not only does the typical nation have better creditor and shareholder protection than China, but its legal systems, corporate governance, accounting standards, and quality of government are significantly less developed3. While state-owned enterprises (SOEs) have seen relatively slow growth, as the literature would predict given the country’s weak legal and financial institutions, private sector firms have nonetheless achieved staggering growth. Allen and co-authors posit that alternative mechanisms, such as those based on reputation and relationships, supported the performance of the private sector. The evidence presented above suggests that there is also a “China puzzle” in the R&D and innovation arenas.

 

In “Intellectual Property Rights Protection, Ownership, and Innovation: Evidence from China,” Lily Fang, Chaopeng Wu, and I examine the importance of institutions in China’s development by focusing on innovation. Specifically, we examine how different levels of intellectual property rights (IPR) within China affected the investment in and outcomes of innovative activities. Many papers on the relationships among IPR protection, innovation, and growth are based on cross-country evidence, which is subject to concerns about unobservable variables. By focusing within China, we limit the impact of much of this heterogeneity: The IPR laws are the same across all provinces in the country, though local enforcement levels differ. This allows us to test whether IPR protection matters for firms’ incentive to invest in R&D and to innovate.

 

By comparing the role IPRs play in the innovative activities of the state versus the private sector, our paper makes a unique contribution to the political economy question of whether control rights can substitute for legal institutions. As is well-known, state-owned enterprises (SOEs), which are directly controlled and run by various administrative levels of the government, are an important part of China’s economy. China’s court system is also controlled by the state and has been shown to be biased towards SOEs. If the legal institutions involved in IPR protection are not well developed, one hypothesis is that SOEs in China have stronger incentives to innovate than do private sector firms because their intellectual property is less likely to be expropriated given their protected status and the biased judicial system. In other words, state ownership and control act as a substitute for IPR protection. Anecdotally at least, this hypothesis holds appeal, as some of China’s most innovative firms, such as Huawei and Lenovo, have strong links to the government, though they are not (or are no longer) directly owned by the state. (Alternatively, these firms may have fewer incentives to innovate, because they can expropriate others’ intellectual property with impunity.)

 

In sum, our paper examines the interplay between IPR protection, firm ownership (state-owned versus private), and innovation in China. Our specific empirical questions are:

  1. Where does China’s R&D and innovation take place: in SOEs or in private sector enterprises?
     
  2. Are IPRs important within China; that is, are they positively related to R&D and innovation in China?
     
  3. What is the interaction effect between IPRs and state ownership on R&D and innovation? Are IPRs more important for private firms’ incentives to innovate?
     

Our empirical findings are as follows. First, since 2006, private firms in China invested more in R&D and innovated more than SOEs. These patterns are depicted in Figure 2 below, which shows the ratio of the stock of R&D expenditures (i.e., the discounted amount of prior R&D spending) to assets for public- and privately owned firms.

 
Image: Lerner_graph_2.PNG

Figure 2

 

Second, we find that within China, IPR protection matters: Firms located in provinces with stronger IPR protection invest more in R&D and innovate more than firms located in provinces with weak IPR protection. Thus, contrary to the puzzling cross-country evidence, we find a positive relation between IPR and innovation within China. The result is shown in Figure 3, which contrasts the patents (normalized by assets again) in province with high and low IPRs. Here we distinguish the provinces by the “win rates” in reported patent litigation; results are similar when we use the frequency of news stories about the importance of IPRs in the official provincial news organ to distinguish between provinces. This finding establishes the importance of effective institutions within China.

 
Image: Lerner_graph_3.PNG

Figure 3

 

Finally, we find that IPR protection affects the innovation gap between private firms and SOEs: In provinces with higher IPR protection standards, private sector firms lead SOEs in R&D investments and innovation by a wider margin than in provinces with lower IPR protection standards. This result shows that not only do institutions (in our specific case, IPR protection) matter in China, but also that they matter particularly to private sector firms: Building better institutions apparently plays an increasingly important role in fostering the growth and development of private sector firms.

 

One concern for studies of the relation between IPR protection and innovation is endogeneity, or reverse causality: IPR protection standards may be high because local firms are more innovative and thus have higher demands for IPR protection, rather than the other way round. We address this issue in three ways:

 
  • We use SOE privatizations as an identification instrument. SOE privatizations are typically part of broad economic reforms and are not primarily motivated by innovation. Our key conclusions are robust in this setting: Firms increase innovation after privatizations, and the increase is larger for firms in provinces with high standards of IPR protection.
     
  • We use a difference-in-difference approach by comparing the outcomes of failed versus successful SOE privatizations (the outcome in these efforts is largely due to factors exogenous to innovation, such as union issues and shifting government policies, etc.), and find that the change occurs only in successful privatizations.
     
  • We use provinces’ exposure to Christian thought in the early 1900s (which, as we discuss below, is related to citizens’ concept of property rights but unrelated to current innovation patterns) as an instrument for IPR protection, and our results are robust in this instrumental variables (IV) regression.
     

We also show that these pattern hold not just when we look at patents, but also when we examine other measures of patent importance (e.g., citation in other documents, the geographic scope of patent filings, and proxies for the breadth of the patent awards).

 

While these findings shed some light on the nature of innovation in China, there are many open questions that deserve further research. Among the most critical of these are:

 
  • Given the apparent weakness of formal intellectual property systems in China, why have we seen so much emphasis on patenting by Chinese firms? To what extent does this reflect purely economic considerations, or is the surge of filing rather a response to policy imperatives? Are there substantial benefits that Chinese firms enjoy from being awarded large numbers of “weak patents”?4
     
  • One widely discussed idea among the historians of technological change is the importance of incremental process innovations. In particular, authors like de Solla Price and Rosenberg5 have argued that much of the surge of American innovation in the nineteenth and twentieth centuries came not from de novo discoveries in universities and research laboratories, but rather from incremental discovery as part of the production process, which cumulatively led to major innovations. Is this type of aggregation of process innovations being seen emerging in China as well?
     
  • While in its initial decades, the Chinese venture capital industry struggled, in the past five or six years, it has enjoyed spectacular returns. Much of this success has been driven by firms who have taken American entrepreneurial models ad transferred them into a Chinese setting, such as Didi Kuaidi, the “Uber of China.” Yet in other cases, the firms seem to have introduce innovations that are genuinely novel, such as the new payment systems introduced by Alibaba. Understanding the nature and evolution of venture-backed innovation in China seems like an important research topic, given the evidence6 that this sector has been a disproportionate contributor to American innovation.
     

In summary, our findings have important policy implications. So far, China has been able to sustain impressive economic and innovative growth despite weak institutions. As China moves beyond being the “factory of the world,” its ability to innovate and capitalize on intellectual capital is critical to its further development. For example, in the country’s current, 12th Five-Year Plan, which lays out China’s development goals, innovation and R&D play a central role. As argued by Joel Mokyr7 and many others, the systematic application of technological developments laid the foundation for the evolution of the U.S. from a colonial backwater to a pre-eminent world power. As China develops and increasingly depends on innovation and the private sector to drive its growth, our results suggest that the strengthening of those institutions that protect intellectual property will become increasingly critical.

 

 

____________________

 

1 http://www.theglobalipcenter.com/GIPCindex/.

2 Allen, F., Qian, J., Qian, M., 2005, Law, finance, and economic growth in China, Journal of Financial Economics 77, 57-116.

3 Ibid.

4 The “weak patent” terminology is from Joseph Farrell and Carl Shapiro, “How Strong Are Weak Patents?,” American Economic Review, 98 (2008), 1347–1369.

5 Derek J. de Solla Price, Little Science, Big Science, New York, Columbia University Press, 1963; Nathan Rosenberg, The Economics of Technological Change: Selected Readings, New York, Penguin, 1971.

6 See, for instance, Samuel S. Kortum and Josh Lerner, “Assessing the Contribution of Venture Capital to Innovation,” RAND Journal of Economics, 31 (2000), 674-692.

7 Mokyr, J., 1990, The Lever of Riches: Technological Creativity and Economic Progress, New York, Oxford University Press.

 

** **

 

Understanding Innovation in China” is published on TAP by permission from its author, Professor Josh Lerner.

 

This paper is based on “Intellectual Property Rights Protection, Ownership, and Innovation: Evidence from China,” which is joint work with Josh Lerner, Lily Fang (INSEAD and MIT Sloan School of Management) and Chaopeng Wu (Xia Men University). We thank Harvard Business School’s Division of Research and the Toulouse Network on Information Technology for research support. The authors have advised innovative Chinese companies and investors in those companies. All errors and omissions are our own.

 

Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, and head of the Entrepreneurial Management unit. Much of his research focuses on venture capital and private equity organizations. (This research is collected in three books, The Venture Capital Cycle, The Money of Invention, and Boulevard of Broken Dreams.) He also examines policies on innovation and how they impact firm strategies. (That research is discussed in the books Innovation and Its Discontents, The Comingled Code, and the Architecture of Innovation.)

 


Share