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Imitator turned innovator: Technological change in China

Recent newsflow about China has been dominated by the Communist Party’s five-yearly plenum. But we believe the real story of interest for investors is the radical shift from imitation to innovation within the country’s economy. As China’s technology sector expands rapidly, we assess its transformative impact on the nation’s economy.

Change is afoot in the global technology sector. Shenzhen is vying to become the next Silicon Valley – not in the immediate future, but perhaps in the next 15 years. And imitation by the world’s biggest factory is no longer the sincerest form of flattery. China is determined to be at the forefront of the next wave of technological innovation.

Today, the government is fuelling growth in the technology sector. Funding for research is ramping up, thanks to the economy’s $11tn annual GDP, which is growing by over $650bn per year. By 2020, China will spend 2.5% of its GDP on R&D – that’s a 70% rise in absolute terms since 20151, and in line with the developed world. Furthermore, a nationwide policy introduced earlier this year allows all local governments to add R&D expenses into their GDP2. This should spur governments to compete on this measure, boosting the country’s aggregate investment in R&D. Importantly, the effort is not limited to official channels. Support from the private sector is also driving technological innovation. China is fast becoming a hot destination for venture capitalists, already attracting more start-up capital than Europe3.

China’s global share of high-value added exports continues to grow. Indeed, much has changed since I first visited the country as an investor in 1991. At the time, the only listed tech companies in the Chinese markets had names like Shanghai Number 2 Pencil Corporation and Shanghai Electric Vacuum Tube.

Figure 1: China’s global share of high-value-added exports has surged

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Source: WTO, Morgan Stanley Research as at June 2016

The country is also set to usurp the US in 2019 as the largest user of the International Patent Office. Last year, Chinese patent applications surged 45%, which is a statistic that many may disregard given the plethora of useless patents worldwide. Today, article citations are considered a more accurate gauge of patent quality. In the five years to 2007, China lagged its major peers in top 1% cited articles (those most cited by scientists). Between 2008 and 2013, it ranked second to the US – and the gap between the pair is narrowing.

Another key driver of technological innovation is education. China is creating a deep pool of talent. Its number of STEM (science, technology, engineering and mathematics) graduates has quadrupled since 2000, and there is a disproportionate domestic emphasis on publishing articles in core scientific sectors, including computer science, mathematics, materials science and engineering4. Conversely, its interest in psychology and social sciences disciplines is disproportionately low compared to its global peers. But that’s a problem for later.

Figure 2: Number of Chinese students taking science and engineering as their first degree

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Source: Science and Engineering Indicators 2016, National Science Foundation as at October 2016

Given the private sector’s focus, a steady supply of STEM graduates, and ready cash flow from exports, corporate R&D spending has ballooned. It has already surpassed Europe, and by 2020, at $700bn, it is projected to exceed the US. As China scampered to catch up commercially, the bulk of spending was committed to development. Presently, it ranks lowest among its global peers in basic research. But that will undoubtedly change. For example, it has reported good progress in quantum computing.

Shenzhen: China’s ‘Silicon Valley’
Silicon Valley still dominates the global technology sector, but Asia has begun to mount a challenge. And the implications of this challenge will be far-reaching not just for investment, but geopolitics and world culture too.

Investment has poured into Shenzhen since the local government introduced tax incentives for high-value-added manufacturing. The city’s status as a special economic zone (SEZ) has helped Shenzhen attract businesses in its early development. As well as tax breaks, plenty of cheap land for high-tech companies, the mobility of cheap labour and good terms of trade effectively drove the development of the city into a manufacturing hub. The city now boasts well-developed transport and electricity networks and one of the world’s fastest growing ports. It is also home to some of the nation’s biggest tech companies, including Tencent, ZTE, SF Express, Huawei, BYD and DJI. However, while Shenzhen has taken active steps to become China’s ‘Silicon Valley’, not all provincial governments have been as far-sighted.

Ecommerce: where China leads the world
In e-commerce, China leads the world in scale (see the Alibaba case study). But unless you can read Mandarin, it is hard to appreciate the complexity and innovation inherent in Chinese technology giants. E-commerce companies, such as Alibaba and Tencent (through its WeChat messaging service), have built strong, expanding businesses with an ability to capture the preferences of millions of consumers – and adapt quickly.

In China, mobile internet platforms, payment systems, lending and insurance are evolving at light speed. The latest leap is facial recognition technology: Alibaba’s Ant Financial has just rolled out its ‘Smile to Pay’ system, and a colleague trying to pay cash for a snack in a local street market recently was told: “No cash, only Alipay!”

 

Role reversal
Decades ago, China was a mere imitator of Western products, but there are now instances of a role reversal. Innovative Chinese business models are being replicated in the US. For example, LimeBike, a California-based start-up, has adopted the dockless bike-sharing model first rolled out by China’s Ofo and Beijing Mobike Technology for US consumers.

Other Asian companies have also moved well beyond pilfering intellectual property, becoming world class competitors in semiconductor foundry (TSMC), electronic screens (the latest iPhones have Samsung OLED screens), and IT services in India. Furthermore, Huawei knocked Apple off the top spot in regard to Chinese consumers’ buying intentions: a recent study found less than a quarter intend to buy an iPhone, while 31.4% plan to purchase a Huawei smartphone5.

A new era
Today, technology companies represent 26% of the emerging markets benchmark index, and 99% of the market capitalisation of technology is listed in Asia. In China, where Shenzhen leads the way in high-valued-added goods, the rest of the country would do well to follow. That requires huge investments in robotics, artificial intelligence and electronic manufacturing. The government is rising to the challenge: funds dedicated to research and development are growing at a rate of 30% each year.

We’re not living in the world of Blade Runner (the original was set in 2019), but the pace of change is accelerating. In the ‘New China’ of innovative technology, it is now possible to tip the author of an online comment with the click of a button, flash a smile to pay for coffee, bike rental or street food.

Chinese tech giants, such as Alibaba and Tencent, also maintain their social license to operate with relative ease. And no wonder: Alibaba captures data from hundreds of millions of users on a daily basis. In its home city of Hangzhou, it uses intelligent cameras to identify cars on the road. This is ostensibly a traffic management system, but in reality, since it also identifies pedestrians, it can also be seen as an Orwellian surveillance system in operation. Here lies a clue about the true price being paid for technological advancement: ‘Smile to Pay’ may turn into a grimace. And perhaps not only in China.

  1. 1“2016 Global R&D Funding Forecast,” published by IRI and R&D Magazine as at October 2016
  2. 2“Innovation is on steroids in China. Shenzhen is leading the Middle Kingdom’s innovation quest,” published by 13D Research as at 10 2017
  3. 3“EY Global Venture Capital Trends 2015”, published by EY as at 10 2016
  4. 4“Science and Engineering Indicators 2016”, published by National Science Foundation as at 10 2016
  5. 5“Apple beaten by Huawei in China smartphone survey”, published by Financial Times on 10 2017

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