The events of 2015 have shown that China is passing through a challenging transition: the labor-force expansion and surging investment that propelled three decades of growth are now weakening. This is a natural stage in the country’s economic development. Yet it raises questions such as how drastically the expansion of GDP will slow down and whether the country can tap new sources of growth.
New research by the McKinsey Global Institute (MGI) suggests that to realize consensus growth forecasts—5.5 to 6.5 percent a year—during the coming decade, China must generate two to three percentage points of annual GDP growth through innovation, broadly defined. If it does, innovation could contribute much of the $3 trillion to $5 trillion a year to GDP by 2025.
China will have evolved from an “innovation sponge,” absorbing and adapting existing technology and knowledge from around the world, into a global innovation leader. Our analysis suggests that this transformation is possible, though far from inevitable.
To date, when we have evaluated how well Chinese companies commercialize new ideas and use them to raise market share and profits and to compete around the world, the picture has been decidedly mixed. China has become a strong innovator in areas such as consumer electronics and construction equipment.
Yet in others—creating new drugs or designing automobile engines, for example—the country still isn’t globally competitive. That’s true even though every year it spends more than $200 billion on research (second only to the United States), turns out close to 30,000 PhDs in science and engineering, and leads the world in patent applications (more than 820,000 in 2013).
When we look ahead, though, we see broad swaths of opportunity. Our analysis suggests that by 2025, such new innovation opportunities could contribute $1.0 trillion to $2.2 trillion a year to the Chinese economy—or equivalent to up to 24 percent of total GDP growth.
To achieve this goal, China must continue to transform the manufacturing sector, particularly through digitization, and the service sector, through rising connectivity and Internet enablement. Additional productivity gains would come from progress in science- and engineering-based innovation and improvements in the operations of companies as they adopt modern business methods.
To develop a clearer view of this potential, we identified four innovation archetypes: customer focused, efficiency driven, engineering based, and science based. We then compared the actual global revenues of individual industries with what we would expect them to generate given China’s share of global GDP (12 percent in 2013).
Chinese companies that rely on customer-focused and efficiency-driven innovation—in industries such as household appliances, Internet software and services, solar panels, and construction machinery—perform relatively well.
However, Chinese companies are not yet global leaders in any of the science-based industries (such as branded pharmaceuticals) that we analyzed.
In engineering-based industries, the results are inconsistent: China excels in high-speed trains but gets less than its GDP-based share from auto manufacturing.
The following is a summary of the outlook for innovation in these four categories, starting with the two outperformers.
1. Customer-focused innovation: The Chinese commercialization machine
China benefits from the sheer size of its consumer market, which helps companies to commercialize new ideas quickly and on a large scale; even a relatively small market like online gaming is bigger than the auto industry in Turkey or Thailand. Chinese companies have learned how to read the requirements of their rapidly urbanizing country and to scale up new products and services quickly to meet them.
Manufacturers of appliances and other household goods dominated the first wave of customer-focused innovators in China. Their innovations were “good enough” products such as refrigerators and TV sets. But these offerings no longer suffice to gain a growing share of consumers.
Companies like smartphone manufacturer Xiaomi are responding with cheaper and better products designed to offer hardware features as good as those from global brands but priced for the Chinese market. Like other customer-focused innovators in China, Xiaomi also uses the massive consumer market as a collaborator, rapidly refining its offerings through online feedback.
Internet service providers are another hotbed of customer-focused innovation. Alibaba, Baidu, and Tencent have become global leaders in online services, largely thanks to their success in the enormous Chinese market.
Innovations are needed to expand access to services (for example, remotely monitoring the health of rural patients), to improve the quality of offerings (greater choice and customization in financial and educational products), and to optimize operations (crowd-sourced logistics).
2. Efficiency-driven innovation: The ecosystem advantage
In manufacturing, China’s extensive ecosystem has provided an unmatched environment for efficiency-driven innovation. The country has the world’s largest and most highly concentrated supplier base, a massive manufacturing workforce, and a modern logistics infrastructure. These advantages give Chinese manufacturers a lead in some important knowledge-based manufacturing categories, such as electrical equipment, construction equipment, and solar panels.
The challenges are mounting, however. As wages rise, the country becomes less competitive for the most labor-intensive work. At the same time, a worldwide transition is under way toward a new kind of manufacturing, sometimes called Industry 4.0: a much more intense digital linkage of manufacturing components, processes, and logistics.
As a result, Chinese companies will face pressure to improve their performance in utilizing assets, matching supply with demand, and controlling quality.
Entrepreneurs are poised to play a bigger role. In Shenzhen, a rich ecosystem of component suppliers, design services, business incubators, and outsourced assembly capacity has helped start-ups prototype products and scale up global manufacturing businesses quickly.
3. Engineering-based innovation in ‘learning industries’
China has had mixed success with engineering-based innovation. The best performers are found in Chinese markets where motivated domestic industries are nurtured by national and local governments that create local demand, push for innovation, and facilitate the transfer of knowledge from foreign players. China has used this formula successfully in high-speed rail (Chinese companies have a 41 percent share of the global railroad-equipment revenues, according to McKinsey estimates), wind power, and telecommunications equipment.
Learning and innovation have been slower to come in automotive manufacturing. To date, most domestic Chinese carmakers have relied on platforms from their global partners or on designs from outside firms to bring products to market quickly. Thanks to exploding domestic demand and strong profit streams from joint ventures, they have felt little pressure to innovate.
In other industries, such as medical equipment, the private sector will drive innovation. Mindray, United Imaging Healthcare, and other smaller new Chinese players will continue to make inroads in market categories (for instance, CT scanners and MRI machines) that foreign suppliers now dominate.
4. Science-based innovation: Novel Chinese approaches
A massive government push to raise R&D spending, train more scientists, and file more patents has yet to give China a lead in science-based innovation. The slow progress has a number of explanations—not least that this type of work takes a long time to pay off and requires an effective regulator to protect intellectual property.
Huge investments by government and the private sector to shepherd projects from the lab to commercial deployment are needed, as well. What’s more, despite the large number of Chinese students trained in scientific and technical fields, companies struggle to find capable talent.
Chinese innovators are adopting novel approaches—for instance, using the country’s massive market size and huge pool of low-cost researchers to industrialize and speed up experimentation and data collection. One such innovator, BeiGene, gained ground in the biotech industry by developing drugs to treat cancers and other diseases. The company has accelerated the drug-discovery process by deploying a large-scale drug-testing team, testing compounds on human tissue (such as cancerous tumor samples) during the preclinical phase to get early indications of issues that might arise in human testing, and capitalizing on access to China’s large pool of patients.
The extent and speed of China’s advances in innovation will have significant implications for the country’s growth and competitiveness and for the types of jobs, products, and services available to the Chinese people. They will also have powerful consequences for multinationals (competing at home and abroad with Chinese companies), some of which are now using China as an R&D base for global innovation.
Fortunately, that isn’t a zero-sum game: a more innovative China ought to be good for a global economy that seeks new sources of growth.
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I'm a senior partner in McKinsey's Shanghai office and Director of the McKinsey Global Institute (MGI) in Asia. I also co-lead the Urban China Initiative (UCI), a thinktank devoted to transforming China's urban future. Visit the UCI websitehere. Read my latest work as co-author of No Ordinary Disruption (Public Affairs, May 2015), which examines how long-term shifts in the global economy challenge long-held assumptions.
This article is based on the new McKinsey Global Institute report, “The China effect on global innovation”, available for download here.