Can a country outsource innovation? And do multinationals need to spread their research and development across international borders? China may provide an answer to both these questions.
The country needs to move up the technological ladder as its economy gets richer and changes from being driven by low-cost manufactured exports. It needs ideas and entrepreneurs to do that.
At the same time, commercial R&D in high-tech industries is becoming an increasingly global undertaking, with still unfolding economic and security implications. Whereas China accounts for barely 2% of the capital spending by U.S. and U.S.-affiliated companies outside the U.S., in the computer and electronics industries the figure is more than 10%.
In the mid-1980s, China identified information technology as well as biotechnology, space technology, laser technology, automation technology, energy and advanced materials as key areas of expertise it needed to modernize its economy. To get it, the government ended a 30-year-long Maoist ideology-imposed break in sending science and engineering students to the U.S. on state scholarships.
At the same time, the science ministry set up a program to commercialize discoveries made by government research institutes and universities at home.
The program didn't work.
State-owned enterprises remained industrial deadbeats. Private companies relied on a network of overseas Chinese links, mainly in Hong Kong, Taiwan and Singapore, for capital, technology, product design, quality control, manufacturing equipment and raw materials or components.
So China switched gears in the mid-1990s, learning from the way industrializing Japan and South Korea invested heavily in their domestic universities to modernize their economies.
China has more than quadrupled its number of university students since 1998, to 16 million. It now annually churns out 352,000 engineers with at least a bachelor's degree. The comparable number for the U.S. is 137,000.
China still sends its best students abroad for advanced studies. One-quarter of foreign Ph.D. candidates in the U.S. are Chinese. But, like India, China is increasingly luring back those in its academic diaspora, often after a few years of working experience abroad. Beijing says 170,000 Chinese who studied abroad have returned--30,000 of them last year.
This hasn't yet resulted in a stream of world-beating innovations on a commercially significant scale. Chinese companies still come up with clever but imitative products. Their R&D capabilities lag those of Taiwan and South Korea.
One sign of the lack of an innovative cutting edge: In 2004, China was ninth in the country ranking for published scientific papers, but only 124th in the average number of citations per paper.
China also has a widely acknowledged problem with academic "borrowing," up to the point of plagiarism. Emulating the well-regarded work of earlier scholars is a tradition of Chinese academics. It makes many Chinese corporations effective at reverse engineering, but it does not make for much in the way of breakthrough research.
But the country's R&D is getting a keener edge. China has just passed Germany to stand fifth in international new-patent rankings. Last year China spent more than Japan on R&D for the first time, according to the Organization for Economic Co-operation and Development. Only the U.S. spends more. In the last decade, R&D has more than doubled as a share of China's gross domestic product.
Some 250 to 300 multinationals--including most of the world's leading computer and telecom companies--have set up R&D centers in China. Among them are Microsoft (nasdaq: MSFT - news - people ), Nokia (nyse: NOK - news - people ), General Electric (nyse: GE - news - people ), Unilever and Alcatel-Lucent (nyse: ALU - news - people ).
Google (nasdaq: GOOG - news - people ), IBM (nyse: IBM - news - people ), Motorola (nyse: MOT - news - people ) and Intel (nasdaq: INTC - news - people ) will conduct their own research and fund projects at China's leading universities. Those centers support both those companies' worldwide operations and their fast-growing local businesses.
Scientists in China cost less than a third of their counterparts in the West, and China offers tax breaks, construction loans and other incentives to attract Western information technology companies' R&D dollars. But Alcatel, the communications multinational that owns Bell Labs and spends $3.6 billion a year on R&D, says its researchers in Shanghai are generating patents faster than the rest of the company.
The benefit for China is not only a transfer of technology but also that a young generation of its scientists is being trained in the soft skills of managing complex research projects, working with university researchers and collaborating with other companies that have niches of expertise.
Next challenge: Can Beijing augment that by replicating the reverse migration of the scientific diaspora of South Korea and Taiwan? The trick in those countries was to assure that the returnees would be free to exercise both their academic and personal freedoms, including the freedom to get rich.
The opportunity to be an entrepreneur would be a big draw in China, as it lets successful Chinese avoid the glass ceiling of working in multinational corporations. But an emerging entrepreneurial middle class poses a long-term threat to the political authority of the ruling Communist Party.
China needs that entrepreneurial class if it is to foster innovation. Unlike South Korea or Japan, it lacks conglomerates with the size and culture to take R&D chances, such as Samsung and Sony (nyse: SNE - news - people ). In China, the large companies are mostly state-owned and run by risk-averse bureaucrats.
To encourage its entrepreneurs, it also needs to accelerate financial reforms and protections for intellectual property rights. Its current financial system provides scant support to private entrepreneurs, and intellectual property theft, despite increased policing, remains rampant. Strong intellectual property rights in China won't be far behind, once the country has its own IP to protect.
China has also learned a lesson from the U.S.: pour government money into defense R&D, both for its own sake and as an economic catalyst. China "is investing more heavily in the hard science areas that underpin modern defense and commercial activities, whereas the U.S. is investing more heavily in the medical, psychological and social problem science areas that underpin improvement of individual health and comfort," a recent report by the U.S.'s Office of Naval Research notes.
For all the progress it is making in R&D, especially against other developing economies, China still lags developed nations in the quality of its research overall. It is only now establishing the R&D foundation that the U.S., Japan and Europe built years ago, but globalization will help it quicken the process.
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