Can China’s centralised reform strategy transform research and innovation?

The official resolution from the third plenum of the 20th Central Committee of the Chinese Communist Party (CCP) held from 15-18 July announced a range of reform priorities regarding high-quality development and finance, aiming to provide a stable strategy for China’s future. 

Some investors and observers had expected that the meeting would offer quick-fix solutions to the persistent crisis of the property sector, and perhaps a generous fiscal stimulus to prime consumption and the markets.

However, the leadership stuck to its guns and spent its time developing a long-term strategy for China’s transformation to an innovation-driven socialist nation, in the spirit of previous third plenum events that had signalled “epoch-making” third plenums, such as the one in 1978 that cemented Deng Xiaoping’s reform-and-opening-up strategy. 

As Xi Jinping has explained: “Economic structural reform will remain our priority in further deepening reform comprehensively. The main tasks in this regard include improving the systems and mechanisms for enabling high-quality development, fostering new growth drivers and strengths, upholding and fulfilling the commitments to the public and non-public sectors, building a unified national market, and refining the systems underpinning the market economy.”

The core group drafting the resolution, led by Xi Jinping, included Ding Xuexiang, the sixth-ranked member of the Politburo Standing Committee. Ding was also recently appointed director of the party’s Central Science and Technology Commission, which was established in March 2023 to centralise strategic decision-making for science, technology and innovation.

The fingerprints of Ding’s innovation policy priorities, as well as Xi’s wish to mobilise science and technology for high-quality economic growth, are clearly discernible in the third plenum resolution issued on 18 July.

With a view to achieving the goal of basically realising socialist modernisation by 2035, the resolution announced the pursuit of comprehensive and deepening reform measures for the coming five years. 

The resolution acknowledged progress in science and technology but highlighted weaknesses in China’s innovation system. It called for reforms in research and innovation management to enhance the efficiency and effectiveness of new quality productive forces, aiming to boost total factor productivity across industries and services.

More specifically, the resolution calls for strengthening national strategic scientific and technological capabilities, improving the national laboratory system, upgrading the high-level research universities, and supporting the leading scientific and technological enterprises. It also pledges to improve the management of science and technology plans, and strengthen the strategic planning of basic research fields, interdisciplinary frontier areas, and critical fields. 

Moreover, to strengthen organised basic research, the third plenum decided to increase the proportion of science and technology expenditures allocated to basic research. It also aims to improve the investment mechanism by combining competitive support with stable funding for diverse research topics and to encourage high-risk, high-value basic research.

This is all very well, but it begs the question of where the leadership expects to generate the necessary funding to achieve these lofty ambitions?

China has increased its expenditures on research and development (R&D) dramatically during the recent decade. According to official statistics, the ratio of R&D expenditure in the Gross National Product almost doubled from 1.71% in 2010 to 2.64% in 2023, which is an impressive feat considering that the country’s annual rate of GDP growth averaged 7%. Thus, China spent more than 3.3 trillion RMB on R&D in 2023, becoming the second-largest contributor to R&D in the world, trailing only the US. 

Moreover, fiscal R&D investments are anticipated to increase by 7% annually during the current 14^th five-year plan (2021-2025). This increase will support key national science and technology projects and boost subsidies for basic research projects at an even higher rate.

In addition to direct government R&D subsidies, China’s innovation system has come to include a wide range of financial instruments supporting R&D innovation since the 1990s. 

For example, the government offers firms the incentive of a preferential tax deduction of 150% for R&D expenditures. This incentivises firms by rewarding their investment in R&D based on their own innovation priorities and interpretation of market opportunities.

This tax incentive has no doubt helped raise the rate of business R&D, but the system is subject to a considerable extent of “re-labelling” of various non-R&D related costs by firms, probably accounting for at least one-third of the expenditure declared. 

Another way that the Chinese leadership has sought to support advanced innovation has been through the creation of the so-called industrial guidance funds.

These are designated as government-social investment funds (20-30% state budget / 70-80% social funding) aiming to support the commercialisation of innovations through investment in high-tech entrepreneurial firms, similar to what private venture capital funds do. The first guidance funds were set up in 2012.

By 2022, the Chinese central and local governments had reportedly created 2,107 guidance funds with a registered target size of around 12.84 trillion RMB (US$1.8 trillion).

However, a 2021 report shows that as of the first quarter of 2020, while 1,741 guidance funds had been set up with a registered target size of 11 trillion RMB, these funds had only raised 4.76 trillion RMB or 43% of their targeted volume. Another 2023 report from Zero2IPO stated that these funds had only raised a total of about 6.68 trillion RMB.

In contrast to the target proportions, most of the capital has been provided by the government itself, while “social” contributions primarily came from state-operated banks and state-owned enterprises like the China National Tobacco Corporation.

Many industrial guidance funds operate like “Fund of Funds”, meaning they reinvest capital into local or sectoral investment funds, some of which are managed by professional venture capital firms — a rare evidence of self-recognition by government officials that they are usually poor venture capitalists! 

In spite of the fact that guidance funds were intended to provide capital for firms at the seed-stage and startup stage, only around a quarter of capital investments by the guidance funds reach these high-tech entrepreneurs, while the rest goes to less risky investments in firms at the expansion or mature stage.

Even so, the average return on investment (ROI) for industrial guidance funds that exited in 2018 was a mere 2.01 times, while the average ROI of private equity funds was 6.48 times. 

Thus, firms receiving guidance fund investments performed better in terms of contributions to fixed assets and employment than in terms of R&D intensity and profits. Recent research has indicated that high-performance Chinese private firms prefer not to receive investments from venture capital with government ties.

In other words, the Chinese leadership has attempted to use policy instruments that depended more on market forces to supplement direct government R&D subsidies, aiming to boost dynamism in the national innovation system. However, these approaches have not been particularly effective in generating innovation and promoting new quality productive forces.

The third plenum also adhered to Xi Jinping’s argument that in order to develop new quality productive forces, it is necessary to develop advanced relations of production, arguing: ”We will work to better adapt the relations of production to the productive forces, the superstructure to the economic base, and national governance to social development so as to provide strong impetus and institutional support for Chinese modernisation.” 

Accordingly, the plenum decided that China needs to develop a high-standard socialist market economy that will provide an important guarantee for Chinese modernisation, arguing: “We must fully implement the strategy of invigorating China through science and education, the strategy of developing a quality workforce, and the innovation-driven development strategy, make coordinated efforts to promote integrated reform of institutions and mechanisms pertaining to education, science and technology, and human resources, and improve the new system for mobilising resources nationwide to make key technological breakthroughs. These efforts will help boost the overall performance of China’s innovation system.”  

Moreover, the resolution argued: “Relevant rules and policies will be improved to accelerate the formation of relations of production that are more compatible with new quality productive forces, and to channel various types of advanced production factors toward the development of new quality productive forces.”

However, earlier policy initiatives where the state sought to mobilise market forces to support innovation in China, such as the R&D tax incentives and the industrial guidance funds, suffered from re-labelling and misallocation of R&D expenditure on the one hand, and low effectiveness of investment funds due to government interference. One wonders how much difference the “deepening of reforms”, following up on driving forth the socialist economy announced by the third plenum, will make? 

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