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Innovation not yet out of the shadow of investment

May 22, 2017
Cheng Hong

This article “Innovation not yet out of the shadow of investment”is published in Gobal Times on May 7, 2017.

 

China's economy grew by 6.9 percent in the first quarter of 2017, the fastest pace since the third quarter of 2015, but we should not be too optimistic about the current economic situation. The Chinese economy still faces headwinds and we should avoid misjudging the second quarter.


First of all, although entrepreneurs appear bullish in terms of investment confidence and market expectations, they are at something of a loss regarding the future development direction. We recently conducted a survey of nearly 200 entrepreneurs from Central China about their views regarding the transformation and upgrading of their own businesses. The firms involved ranged in value from 30 million yuan ($4.3 million) to 300 million yuan and were in both traditional and emerging industries, offering a good reflection of the current state of the Chinese economy, the real economy in particular. The interviews revealed some of the uncertainties among Chinese entrepreneurs. Most are taking a wait-and-see attitude toward innovation. While realizing the importance of research and development as well as innovation to the future development of their enterprises, most entrepreneurs are hesitant about how to incorporate innovation into their business models, and how to integrate it with production capacity and exploration of markets.


Second, the steady recovery of the Chinese economy at the current stage remains based on the continuation of the traditional investment-driven growth model. Despite the confidence that the macro data provides, there is growing concern and anxiety over potential asset bubbles. Through structural analysis of the macroeconomic data, we found that industrial structural adjustment contributed little to this round of economic recovery, which was based more on traditional large-scale fixed-assets investment and rapid increase of money supply.


Finally, the Chinese government still puts too much emphasis on growth instead of reform at the current stage. After visiting local governments in South China's Guangdong Province, East China's Jiangsu Province and Zhejiang Province, Central China's Hubei Province and other regions, we concluded that due to the political characteristics of the Chinese economy, GDP growth remains an important measure for the promotion system of local officials. Although local authorities have recognized the importance of innovation to the long-term growth quality of China's economy, they still fail to pay enough attention to supply-side structural reform and often put a lot of emphasis on short-term economic growth when it comes to practical policy choices.


However, reform is the key to solving the existing structural conflicts in the Chinese economy, which is critical to releasing long-term economic growth impetus. As long as the effective accumulation of economic innovation momentum can promote the transformation and upgrading of industries and product structures, to the benefit of balanced economic growth, it should be acceptable to give up some short-term economic interests and even sacrifice economic growth to a certain degree. Since the beginning of 2017, local authorities have started to pursue GDP growth by attracting businesses with heavy assets. In other words, the authorities invest in the provision of facilities, plants and equipment based on the requirements of the newly introduced enterprises, and will gradually recover the investment costs by collecting rent every year. The method has greatly lowered the threshold for business investment, stimulating their investment enthusiasm.


While such an approach may stimulate private investment to help stabilize economic growth, it also brings great concerns. As a provider of public services, the government has only limited intelligence about market investment, and this creates huge risks due to information asymmetry about industrial areas dominated by market forces. At the same time, enterprises can benefit greatly from the heavy asset provision by the government without bearing the corresponding investment costs, encouraging them to pursue maximization of short-term interests through scale expansion, which may lead to repetitive investment, overcapacity and lagging transformation and innovation. More importantly, attracting businesses with heavy asset investment relies mostly on local government debt financing. With local government debt growing continuously, once the heavy asset investment triggers credit risk, it may adversely affect the recovery of the overall Chinese economy.


To sum up, without reforming local governments' assessment of the promotion system, it will be hard to curb investment driven by the mindset of stabilizing growth, and the excess capacity problem caused by the 4 trillion yuan investment spree may come back again. Only by giving up the conservative growth strategy and by effective implementation of innovation-driven supply-side structural reform can the Chinese economy actually enter a new cycle of economic prosperity.