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Bike share bicycles are piled thoughtlessly in Beijing at the height of the bike sharing craze in 2017. Image by Mira Liu available at Wikimedia Commons under CC license

07:44 am | 13. November 2019

Piling Into the Lead

China is now at the top of the tables when it comes to investment in research and development. But problems like bureaucracy and short-term thinking continue to hold innovation back.

By Chen Jibing

The second decade of the new millennium has been a momentous one for China in terms of spending on technology development. The numbers indicate dizzying growth, whether in terms of overall spending, per capita spending or ratio of GDP.

According to data from China’s National Bureau of Statistics, the country’s spending on research and development reached 706.3 billion yuan, or more than 100 billion US dollars, in 2010, which many saw as a historic milestone. The next year, investment in R&D grew again by more than 50 percent, reaching 868.7 billion yuan, more than 150 billion US dollars. This put Chinese spending on R&D above that of Japan, long in the number-two position (though it was still dwarfed by the United States, which spent 400 billion dollars in 2011).

Key Points

* In 2013, China spent more than 2% of GDP on R&D, meaning China has achieved its "technology takeoff." Since then, China’s R&D input has maintained a high rate of growth and might already have surpassed Europe in 2018.

* But Chinese innovation through R&D investment still faces fundamental problems. It is focused on the short term, with lack of basic scientific research. The problem of fraud, particularly with state-funded projects, is widespread. 

* Despite assumption of high government input, Chinese companies are the engine driving R&D expansion. 

* Chinese capital is keen to invest in research and innovation in the West, focusing on fields like telecoms, AI and biotech.

* R&D investment is just the first step in becoming an innovation giant. Ultimately, it is people, not capital, that defines a nation's innovative capacity.

By the time R&D spending topped one trillion yuan in 2009, it had nearly doubled in just three years since 2009. China’s R&D expenditure ratio – the proportion of GDP dedicated to research and development – had nearly doubled already in the decade from 2000 to 2010 (from 1 percent to 1.97 percent). Even through the global financial crisis in 2008 and 2009, as the US and other countries slashed R&D budgets to face the economic slowdown, China’s R&D input maintained a high rate of growth.

When the Battelle Memorial Institute, a non-profit science and technology development organization, released a study in December 2013 saying China’s R&D would surpass that of Europe by 2018, and exceed the US by 2022, this prediction garnered a lot of attention. The institute’s prediction for Europe has already come to pass.

Today, R&D expenditure in China’s more developed coastal provinces and citiessuch as Jiangsu, Shanghai and Tianjin – has already surpassed that of countries like Italy and Spain, not only in absolute value terms but also in terms of R&D spending per capita. In 2017, for example, corporate R&D input in Shanghai reached more than 10 billion US dollars, while corporate R&D input in Italy stood at 6.5 billion dollars.

We can be reasonably certain that China’s R&D ratio will reach 2.5 percent by 2020, the goal set in the country’s 13th Five-Year Plan (2015-2020). At present, the average in developed countries is 2.8 percent, and the global average is 1.8 percent. Some people believe, in fact, that actual expenditure on R&D by Chinese companies may already have surpassed 2.5 percent as early as 2014.

According to a report from the World Intellectual Property Organization (WIPO), the proportion of China’s R&D expenditures in the world rose from 5 percent in 2002 to 13 percent in 2010, putting it in the number two position globally.

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China's total domestic spending on R&D in millions of USD. 

Consider that in 1993, just after the acceleration of economic reforms that followed Deng Xiaoping’s “southern tour,” Chinese R&D expenditures accounted for just 2.2 percent of the global total. For decades, the United States, still in the number one position, has maintained a global ratio of around 35 percent.

Based  on the  experiences of OECD countries in innovation development, it generally takes a very long time for a country’s R&D ratio to reach 1 percent. From that point, it experiences rapid growth until it stabilizes at around 2 percent. The stage between the 1 and 2 percent marks is what analysts call the “technology takeoff” period.

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China's domestic spending on R&D as a percentage of GDP. 

“Technology Takeoff”

If we look at this “technology takeoff” in various countries, we find the process happening over the decade between 1950 and 1960 in the United States. In Germany, the process took 11 years, from 1951 to 1962. In Japan, it happened over a much longer period of 19 years, from 1959 to 1978. South Korea’s “technology takeoff” occurred over the shortest period thus far, from 1983 to 1988.

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The launch of Long March 3B Rocket from China's Xichang Satellite Center in 1997. China's space program has made major strides over the past two decades. Public domain image from AAxanderr available at Wikimedia Commons

But regardless of how compressed or extended this period of “technology takeoff” is, the process is generally followed by a clear increase in innovative activities that then expand across society, resulting in the widespread creation and development of innovative  companies and industries. We see innovative products from these countries acquiring international prestige and demand only after they successfully went through the process of “technology takeoff.”

China’s R&D ratio remained below 1 percent for a long time. For some time in the early reform and opening period, the ratio was actually below .5 percent. It was not until 2000 that it reached 1 percent, and from that point it continued to rise until it reached 2.08 percent in 2013. So we see that China took 13 years to achieve its “technology takeoff.”

This is an important milestone for China.

But if we compare China to developed countries, we can note that its “technology takeoff” has two distinct characteristics. First of all, if we look at China’s per capita GDP, it is still a developing country. And yet, China’s R&D spending is much higher than we can find in countries at the same income level comparable to R&D expenditure in developed countries.

China’s R&D spending is much higher than we can find in countries at the same income level – comparable to R&D expenditure in developed countries.

 

Second, while China’s total R&D spending remains lower than that of developed countries, its input in certain cutting-edge areas – such as renewable energy, bioscience, and new materials – has reached or even surpassed spending in some developed countries. By contrast, R&D spending in a number of  developed countries still focuses on traditional areas, such as the automotive industry.

Government Largesse

One important factor that has propelled China’s growth in R&D input since the late 1990s is growing investment from all levels of government.

On the one hand, after the late 1990s, tax reforms in the Zhu Rongji era, which directed more tax income to the central government, substantially increased the central government’s fiscal income. Meanwhile, the rapid development of the property sector allowed local governments to increase their income through land sales. There is a popular belief in China that the government generally is flush with funds. While this may not be true everywhere, it is certainly true that the central government and various regional governments are investing in a wide range of research projects, both directly and indirectly, and most of these were begun after 2000.

On the other hand, as economist Steven Cheung (张五常) has pointed out in his book The Economic System of China, fierce competition among local governments has long been an important factor in China’s economic development during the reform and opening period. Once they have attained a certain level of economic development, local governments shift their focus to technological progress in pursuit of greater economic competitiveness. They establish a seemingly countless number of so-called “high and new technology development zones,” and they provide deep benefits to companies that settle in these zones and pursue technological development.

Two of the most prominent examples of this pattern of local stimulus and growth are western China’s Guizhou province and the city of Chengdu, in Sichuan province. Over a period of just a few years, Guizhou, once China’s poorest province, became a hotspot for companies in cloud computing. Once sleepy Chengdu, meanwhile, has become China’s “software capital,” and recently overtook Shenzhen as the country’s “best performing” city in the latest annual survey from the Milken Institute.

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Tiered fields have long been the image of rural Guizhou province. But Guizhou is now getting a reputation as a leading data center. Image by Cyril Massenet available at Flickr.com under Creative Commons license.

Corporate Spending

But the dramatic increase in corporate investment in R&D, which is closely related to structural reform in China over the past two decades, is another critical factor.

Before 2000, the export processing sector, with low levels of technology and added value, was the pillar of China’s economy. Low profit margins meant there were limited resources to invest in R&D. Since the mid-1990s, however, China’s economy has gradually upgraded. In particular, China has grasped the opportunity of the internet information industry, where a lot of internet technology companies have risen and prospered.

Most of the Chinese companies on the list of the world’s top 500 that are not monopoly state-owned enterprises in key sectors like energy and infrastructure are IT companies, including the likes of BAT and Huawei. The rise of these giant new companies has pushed the rapid growth of corporate R&D spending in technology. The most obvious example is Huawei, which now ranks fifth in the world in terms of R&D spending and at the top in terms of registered patents.

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Eight of the world's top 20 tech firms by market capitalization are now Chinese. The rest are from the US. SOURCE: Kleiner Perkins Internet Trends Report 2018, Forbes, Company Reports.

Many people assume that it is the government in China that plays the leading role in the expansion of R&D in the country.

In recent years, in order to build China as an “innovative country,” the government certainly has increased funding for R&D devoted to technological development. In early 2015, for example, the State Council announced the establishment of a 40 billion yuan fund to guide the nation’s entrepreneurship and investment in emerging industries, supporting mainly innovative companies in the startup phase. Aside from national funding, local governments across the country established various investment funds and sponsored technology innovation through low or no-interest loans, investment with share participation, awards, subsidies and other forms of support.

But while government participation remains important, enterprises are the true leaders in technology R&D input today. Some estimates have corporate R&D input accounting for around 70 percent of China’s total. According to data from China’s National Bureau of Statistics, funding for China’s technology development in 2012 reached 1.02 trillion, surpassing one trillion yuan for the first time in history. Of that total, 22.3 percent,  or about 228.5 billion yuan, came from the central government.

While government participation remains important, enterprises are the true leaders in technology R&D input today.

 

A 2016 research report by Strategy&, a PricewaterhouseCoopers consultancy, showed China leading the world in corporate R&D spending growth. In the present economic environment, however, the growth picture can change rapidly. A subsequent study in 2017 showed corporate R&D spending in China declining for the first time, only to rebound in 2018 with double-digit growth of 34 percent. In 2017, nine of the top ten Chinese companies in terms of R&D spending were private companies.

The most recent report showed 130 Chinese companies listed among the top 1,000 “innovative” companies globally, measured by R&D spending. The consultancy noted that its list of innovators “reflects the continued dramatic rise of China-based companies.” In particular, the report noted that while China in 2007 accounted for just 3 percent of high-leverage innovators, those capable of consistently launching strong-performing new products and services, this number had risen to 17 percent in 2017.

In 2015, Huawei was listed for the first time as one of the  world’s top ten corporations in terms of R&D spending, coming in at number nine (with 9.48 billion US dollars in spending) just behind the Swiss healthcare company Novartis, and just ahead of Johnson & Johnson.

Investment bank Credit Suisse has pointed to corporate R&D spending as the primary driver behind innovation development in China. Among the great variety of industries that have emerged in China over the past two decades, the internet and telecommunications equipment industries have made significant progress, with massive  input of R&D funds. The leading companies in these two industries regularly spend 10 percent or more of their sales income in R&D. In the US alone, Huawei, now one of the world’s leading telecommunications equipment firms, has six R&D centers in the United States alone.

The telecoms equipment firm ZTE, another company sanctioned last year by the US, reports that it now spends around 10 percent of its income in R&D every year.

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ZTE, a leading Chinese tech company, has faced pressure from the US government, which has alleged the company poses a threat to the security of US communications networks. Image by Kārlis Dambrāns available at Flickr.com under CC license.

Credit Suisse has predicted that China will, with continued input into R&D and the support of a massive domestic market, become the global leader in cutting-edge technology fields such as biotechnology, big data, AI, the Internet of Things, and new energy vehicles. 

Of course, we cannot talk about state versus corporate support for R&D in China without addressing the stickier question of the state funding behind many of the Chinese enterprises whose spending boosts the corporate side of statistics on R&D input. Much of corporate spending on R&D in China is spending by state-owned enterprises, and this spending, whether it is applied inside China or overseas, is more or less related to the Chinese government.

China Bound

Beyond the numbers on R&D spending, however, innovation is an extremely complex issue. Over the past decade, as domestic labor costs have risen, China’s manufacturing industry has lost much of its attractiveness for foreign capital. But China has been increasingly successful in attracting higher-value foreign technology investment projects, and it is fast becoming a global center for technological development.

Research by fDi Markets, a service from the Financial Times, has shown that China has caught up with the U.S. in attracting foreign R&D funds. Since 2010, China has attracted more funds, both in number and in scale, than the U.S. in greenfield R&D investments from foreign countries, ranking the first in the world. Three industries in particular – pharmaceuticals, commercial machinery and equipment, and consumer electronics – have attracted the most foreign R&D investment, and the US remains the most active in investing in R&D in China.

An important factor driving the rapid pace of R&D investment growth among Chinese companies over the past 20 years has been strong financial support, the most important source of which has been a robust global venture capital network.

In this respect, the situation in China is not unlike that to be found in Silicon Valley, where quality ventures can find the means to secure substantial levels of funding. China’s most successful internet and technology companies to date have all relied on strong support from overseas venture capital to support their rapid development. These include the major internet portal sites in their infancy, such as Sina and Netease, the so-called “BAT” three – Baidu, Alibaba and Tencent) – as well as many newcomers such as electronics company Xiaomi and the e-commerce platform Pinduoduo. All of these, and many others, have relied on strong support from oversea venture capital to propel their breakneck development.

The situation in China is not unlike that to be found in Silicon Valley, where quality ventures can find the means to secure substantial levels of funding.

 

Since around 2012, China has also attracted more venture capital than both Europe and Japan, becoming the number-two destination for venture capital after the United States.

Through 2018, China was reported also to be second only to the US for so-called unicorns, privately held startup companies valued at over one billion US dollars, and the latest numbers last month showed China edging into the lead in 2019, with 206 unicorns.

In another sign of the growing maturity of funding for innovation, successful tech companies in China have begun to establish their own funds to raise capital and advance their development strategies. In June 2019, the Chinese AI company iFlytek, an information technology company that has been under scrutiny in the US, revealed that it is raising a fund of 300 to 350 million US dollars to invest in AI startups.

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A place to now see Chinese investors? Buck's of Woodside, a restaurant in Woodside, California, gained fame in the 1990s a place where tech entrepreneurs and venture capitalists would meet. Image by Intel Free Press available at Wikimedia Commons under CC license

In recent years, major overseas investment banks such as Morgan Stanley and Goldman Sachs have lended heavily to some of China’s most innovative tech unicorns, hoping to cash in on profitable future IPOs. .In recent years, Wall Street banks like Morgan Stanley and Goldman Sachs are lending heavily to China’s most popular technology unicorns, hoping they will bring more lucrative IPO consignment. For example, three Chinese Unihorns, namely ByteDance (owner of Toutiao and Tiktok), Beike Zhaofang (贝壳找房), and Guazi.com (瓜子二手车), a platform for direct sale of second-hand cars, received in total 3 billion US dollars in loans from Wall Street banks during the first half of this year. Loans of this kind were rare for China in the past.

Going Out

A more recent trend in financing for innovation has been the outflow of Chinese capital to the West, particularly to the US. This trend, which has involved investment in research and innovation labs as well as technology startups, was rare before to 2010, and it has prompted some level of concern.

Prior to the US-China trade war, it became routine for Chinese investors to visit Silicon Valley during Chinese holidays like the Spring Festival. The Chinese seemed keen to find opportunities, and startups in the US soon learned that the gatherings they organized could offer a chance to raise funds.

Analysis from DIUx, a research unit under the US Department of Defense, has indicated that Chinese investors invested roughly 3-4 billion US dollars in early-stage U.S. companies in 2015. Between 2015 and 2017, China accounted for around 15 percent of all capital invested in US companies, according to DIUx, second only to Europe. Even in 2018, despite of the US-China trade war, as reported by Forbes, China to U.S. venture investments climbed to a record of 3 billion dollars.

Many of these investments, according to the Rhodium Group, focused on telecommunications, AI and biotech. But as the Foreign Investment Risk Review Modernization Act took effect in August 2018, authorizing the US government to inspect and ban foreign investments in sensitive technological fields (even for minority investments), such investments came under much greater scrutiny – and Chinese investment has noticeably declined as a result. While the act did not directly target China, the consensus view was that the objective was to deal with security fears that came with China’s more active posture globally.

The growing concern over Chinese investment stems to a large degree from the perception that much of this investment comes from the Chinese state, and lack of transparency certainly fuels this concern. Concrete numbers are difficult to come by, but estimates in 2018 from Rhodium suggested that 21 percent of Chinese investments in the United States between 2000 and 2017 were made with state capital, sourced through funds ultimately controlled by the state. That rate rose to 41 percent in 2018.

As the trade war between China and the US has raised barriers for Chinese investors, they have increasingly turned toward technology innovation projects and small and medium-sized startups in other developed countries, notably Japan. In 2018 alone, as China’s ministry of Commerce stated, Chinese investors merged or invested in 59 Japanese companies, reaching a historical record in the past 5 years.

China has also been looking beyond the US in the setup of research and innovation labs overseas. Tsinghua University, China’s leading engineering university, announced plans to open a branch institution in Tokyo and to invest around four billion yuan, or about 572 Million US dollars, to support R&D in the AI and robotics fields.

Investment and cooperation between China and Japan has benefitted from the sour turn in US-China relations. In 2019, China’s CITIC Group and the Tus Holdings under Tsinghua University announced plans with Japan’s ITOCHU Corporation to establish a joint investment fund totaling around 1.8 billion US dollars (200 billion yen) to assist Japanese startups seeking to enter the Chinese market. Also this year, China’s Zhongguancun Development Group (中关村发展集团)  announced cooperation with Japan’s Mizuho Bank to establish a fund investing in Japanese startups, with a focus on IT, new materials, biotech and new energy.

Short-Term Visions

If we lookat investment amounts alone, we can imagine China ranking first in the world in R&D investment within two or perhaps three years. Objectively speaking, this is a momentous achievement for the country when we look back over the course of that development. Today, we can say, China is no longer simply “factory to the world.

But we must recognize at the same time that astonishing figures cannot disguise the many problems facing R&D spending and innovation in China.

One of the most outstanding issues is the irrational distribution of funding in China for scientific research. The vast majority of R&D funding is devoted to technology application, which means that the ratio of investment in basic scientific research is far too low.

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Based on the data I gathered in my own research in 2011, China’s total R&D funding was around 861 billion yuan, or 123 billion US dollars. Of this total, about 4.6 percent – 39.6 billion yuan – was applied to basic scientific research. In 2012, the year, as I wrote previously, when China’s R&D input for the first time surpassed one trillion yuan, the ratio devoted to basic scientific research was just 4.9 percent. This is far lower than the 15-25 percent we see in most developed countries. In the US, the number hovers around 19 percent, or about one-fifth of total R&D spending.

As researchers around the world know only too well, basic scientific research is generally high-cost and high-risk, with low returns. Even if such research is deemed successful, it might not be translated into real productivity in commercial terms. But at the same time, basic scientific research is the cornerstone of all technological invention and progress.

If we look at total spending and spending growth in R&D in China, the numbers may impress. But it is obvious at the  same time that scientific research in China remains focused on the shorter-term, on applicable projects that have some guarantee of returns. This suggests that if we characterize China today as a major scientific and technological power, we must do so with the caveat that it is a force principally in application, not in discovery.

When Fraud Pays

A second major issue facing Chinese innovation is an intertwined set of related problems, which include an inefficient government bureaucracy, lack of fairness and protection, and poor transparency in the decision-making process for scientific research. Together, these result in considerable waste of resources, fraud and sometimes even corruption in the use of funds.

If we characterize China today as a major scientific and technological power, we must do so with the caveat that it is a force principally in application, not in discovery.

 

China has yet to achieve truly original breakthroughs in underlying technologies – let alone in basic theories. This reliance on copying and applying science and technology for application in a huge domestic market is not sufficient to make China a world-class technology power over the longer term.

At some moment in the foreseeable future, this deficit in basic scientific research capability is likely to seriously hobble China’s ability to pursue innovative application of science and technology. Once the low-lying fruit has all been harvested, the greater challenges will become apparent.

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A March 2006 cover story in China's IT Times magazine looks intro the scandal surrounding Hanxin. 

Over the past two decades, stories have trickled out, despite strong controls on press coverage, of appalling frauds involving research projects and published scientific papers. In a few cases, even award-winning national projects have been exposed as fraudulent.

One of the most infamous cases occurred in 2006, as Chen Jin, dean of the microelectronics school at Shanghai Jiaotong University, was revealed to have faked his “Hanxin No.1” microchip, which had already received state funding running to tens of millions of dollars. Chen’s research toward self-developed Chinese digital signal processing (DSP) computer chips had been reported in the state media as offering potential breakthroughs for the country. But in the end it was clear that Chen had exploited these hopes and expectations to secure state funding and make a name for himself.

Similar embarrassment came in April 2017, as Springer, one of the world’s largest academic publishers, announced that its bimonthly peer-reviewed journal Tumor Biology had withdrawn 107 papers published in 2015 and 2016 after an investigation found that the authors had cheated the peer-review process. All of the authors involved were from China, most employed at large Chinese hospitals.

This case is just a drop in the ocean, even if we consider known cases of plagiarism, data falsification, outright fabrication and faked peer review. Instances of research-related corruption have been on the rise as R&D funding has increased. The problem is widespread and serious enough that the government has finally been forced to respond. In May 2018, the Ministry of Science and Technology was tasked to create a body to identify and deal with cases of misconduct. And in July this year, the government issued new rules for scientific publication.

Ultimately, however, the root problem is the structure of China’s current scientific research system, which is highly bureaucratic in nature – quite unlike systems in the West that place a premium instead on academic autonomy. Many researchers within academia in China complain that approval for funding for scientific research projects depends not on academic quality, originality or other standards, but upon personal connections within the Party-led system.

Killing Curiosity

A final but crucial hurdle facing innovation is overweening involvement and control by the state, which limits and disincentivizes one of the most fundamental contributors to innovation: curiosity.

The simple fact is that state-sponsored funds must receive administrative approval, and the priorities of administrators are different from those of scientific researchers and innovators. Ultimately, administrative bodies are focused on ensuring that science and technology research projects are in line with the broader development targets set by the Party-state. 

Some startup founders have made the point that while the establishment of a National Emerging Industry Venture Capital Matching Fund in January 2015 to help direct the process of industrial restructuring may help change the way the government supports innovation, a more crucial factor for entrepreneurs may be the creation of an institutional environment that better supports real innovation.

The R&D Gold Rush

Even in the realm of corporate research and development, the drive for innovation can often be compromised in China by short-term, speculative investment that is more concerned about instant gains on capital markets than about truly innovative products with longer-term viability on the market. When the focus for investors is on maximizing market expansion in the shortest period possible, this can mean overlooking key contributors to longer-term success, such as sound company management and applying R&D to ensure high-quality goods and services.

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Public share bikes from Ofo and other providers pile up in Shenzhen. Ofo has now become a cautionary tale about over-enthusiastic and ill-considered investment. Image by Chris available at Flickr.com under CC license

Such short-sighted speculation has resulted in recent years in cases like that of the video streaming company LeTV (which tried to gloss over its problems by re-branding itself as LeEco in 2016), and Ofo, the so-called pioneer of China’s bike-sharing boom, which hit serious financial trouble in 2018 after being feted for some time as a Chinese innovation to be modeled in the West. Writing about Ofo as a cautionary tale late last year, the New York Times noted that “the business model used by many of China’s tech firms — spend furiously to acquire new users, worry about profits later — is showing its limits.”

Cases like these illustrate how China’s technology R&D sector, like its inflated property sector, is prone to speculative bubbles. This state of affairs, which could prove difficult to shake, owes to the country’s relative weakness in both basic research and basic longer-term planning. Hot money is always impatient for returns, and it has little interest in basic research or other fundamental matters.

A convincing example is Apple. It does not have a big R&D expense — sometimes even half that of its leading competitor, Samsung. But Apple is a major innovator nonetheless.

In China, Xiaomi is similarly an example of a company that has not acquired many patents through R&D and has relatively small spending on R&D, but still manages to be one of the most innovative companies in China. Xiaomi’s innovative spirit lies in the fact that, as a hardware (mobile phone) manufacturer, its core competitive strength comes not from the sale of mobile phones, as in the case of Apple, but rather derives from the company’s self-sufficient “ecology” created by a whole series of linked hardware offerings. Xiaomi has, like Facebook, modeled itself as a data company, and income derived from the sale of marketing data is a major source of the company’s income.

In that sense, becoming the number one in the world in R&D input is only the first step of China’s long journey in becoming a technology and innovation giant. Indeed, capital input plays a major role in technology development and innovation activities. But in the end, what defines a company and a nation’s innovation capability in science and technology is not money, but people.

 

China Myths

Perceptions of China are often driven by frames, or myths, that hinder our understanding of the facts. Where do these myths come from? And what assumptions are we making when we employ them? 

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Piling Into the Lead

13. November 2019
Author
Chen Jibing

Chen Jibing is a media professional and expert on finance based in Shanghai.