Innovation leadership is key to the Chinese economy.

This research, based on an impact-driven view of innovation, concludes that China does have the potential to become a global innovation leader. Although it has not yet seen the payoff, China has made the necessary investments in R&D and education to improve its performance in science- and engineering based industries. China’s success in high-speed rail and telecommunications equipment prove that, under the right circumstances, Chinese companies can be global competitors in engineering-based industries. And, even now, in science-based industries such as biopharmaceuticals, Chinese companies are harnessing the scale and speed of the home market to become more nimble and stronger innovators. With the right policies in place to support entrepreneurism, encourage market-based competition in more industries, and make China more attractive to top science talent, China can succeed in all forms of innovation. Timing will be critical: with slowing GDP growth, an aging population, and declining returns on massive fixed investments, China must find ways to raise productivity. Innovation is key to this sustainable growth path. China’s innovation imperative As we write this, China is in the midst of a challenging transition. A rapidly aging population, increasing debt, and declining returns on fixed asset investment place new burdens on the economy. Because of aging, the labor force is expected to peak this year and begin a long decline that could reduce its size by 16 percent by 2050. By 2030, China’s dependency ratio—the percentage of the population that is not in the labor force (mostly the elderly and children)—will reach 47 percent. This is far sooner, in terms of GDP per capita, than in countries such as Japan or the United States. Even as its population is aging, China’s wages are rising: average wages have risen by 11 percent a year for the past five years and are now more than 1.5 times higher than average wages in India and Vietnam. At the same time, debt-financed investment is approaching a level of diminishing returns. China’s debt-to-GDP ratio reached 282 percent of GDP in mid-2014, up from 158 percent in 2007, a ratio that is higher than that of such advanced economies as the United States and Germany. About a third of this new debt is concentrated in real estate and related industries.2 With real estate markets overbuilt, this ratio is one reason that the return on fixed-asset investment in China is declining. The incremental capital-output ratio (ICOR), which shows how much capital is needed to generate a unit of GDP, was 3.4 on average from 1990 to 2010, but it has since risen to 5.4, meaning that it takes 60 percent more capital to generate a unit of GDP. On that trajectory, by 2030, China’s ICOR could be 17 percent higher than the current ratio for the other BRIC countries (Russia, India, and Brazil) and near the current level of more advanced economies such as the United States and Korea. Given these trends, we believe that innovation is essential to China’s long-term sustainable growth. Over the past 30 years, much of China’s economic growth has come from being an “innovation sponge,” meaning it attempted to catch up with advanced economies by absorbing and adapting technology, best practices, and knowledge from overseas.3 Chinese companies did this with foreign direct investment, purchases of equipment and companies, and joint ventures. As a result, China now ranks second in the world in knowledge-intensive flows—movement of knowledge-intensive goods and services and foreign direct investment.4 Now, innovation must play a larger role across all sectors of the Chinese economy. However, as Exhibit 1 illustrates, the contribution of innovation to growth (as measured by multifactor productivity) has declined in recent years.5 From 1990 to 2010, multifactor productivity contributed between 40 and 48 percent of GDP growth. However, over the past five years, multifactor productivity has contributed just 30 percent of GDP growth, or about 2.4 percentage points of GDP growth per year, the lowest level in 35 years. To maintain GDP growth of 5.5 to 6.5 percent per year through 2025, China will need to generate 35 to 50 percent of GDP growth (two to three percentage points) from multifactor productivity. Innovation will also be critically important to generate higher-value-added and higher-paying jobs. Continued urbanization is expected to bring 100 million more residents to large Chinese cities by 2020, which will create a need for 10 million urban jobs every year, even as manufacturing employment drops. To address these challenges, China will need to accelerate the evolution from innovation sponge to innovation leader, capable of driving more breakthroughs and competing in global markets. Making this transition will require a better understanding of how China innovates today, what its core strengths are, and which policies and business practices can build on the momentum of the past three decades. Policy makers are already acting to address some of these needs. The Internet+ program, for example, is intended to use the Internet as a catalyst for grassroots innovation and innovation in business processes.