The Growth Dialogue's Policy Briefs

POLICY NOTES

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Publications Seminars and symposia are helping raise the GD’s profile and making it known to the international community of scholars and policymakers. Presentations and publications by the managing director of the GD and the chief economist at seminars and international conferences are helping publicize the GD’s role. This effort is being further boosted through the issuing of a steady stream of short policy notes and papers by GD staff, presenters to events hosted by the GD and members of GD’s advisory group. The GD is also gaining some additional mileage and publicity through links with the websites of prominent academics such as Michael Spence. GD has issued policy notes and the intention is to maintain a steady tempo and in the process, enlarge the number of contributors while increasing the salience of the GD website.

CONTENTS

The Euro-Zone: Slow Growth, High Debt and Pressures on Banks and Official Financial Institutions JAMES A. HANSON l SEPTEMBER 2011l No. 1 ……………………….……………… China’s Medium-Term Growth Prospects BARRY NAUGHTON l NOVEMBER 2011l No. 2 ………………………………………. The Changing Geography of Innovation, the Current Crisis, and Implications for Economic Growth SHAHID YUSUF l JANUARY 2012 l No. 3 ……………………………………………. What Do We Know about Green Growth and its Policy Ramifications? DANNY LEIPZIGER l FEBURARY 2012 l No. 4 ……………………………………….. China’s 12th Plan: Big Challenges, Vast Opportunities SHAHID YUSUF l JANUARY 2012 l No. 5 ……………………………………………. The Changing Geography of Innovation: The Rise of the BIC- Challenges and Opportunities CARL DAHLMAN l MARCH 2012 l No. 6 …………………………………………….. The Competition between Western Capitalism and State Capitalism as Drivers of Economic Growth DANNY LEIPZIGER l MARCH 2012 l No. 7 …………………………………………... The Changing Landscape of Innovation after the Economic Crisis: Notes from the Paris Symposium SHAHID YUSUF l APRIL 2012 l No. 8 ………………………………………………..

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*Former Senior Financial Advisor, World Bank. Send comments to [email protected], copied to [email protected]

The Euro-Zone: Slow Growth, High Debt and Pressures on Banks and Offi cial Financial Institutions

OverviewThe risk of continued slow growth and even a double dip recession is high in the Euro-zone. The slow growth refl ects continued although often incomplete austerity programs to ease sovereign debt problems; the lack of fundamental structural reforms in these programs; and the market’s recognition of these half-hearted att empts. Lack of fi scal space, exacerbated by the recent fi nancial crisis as well as the increased cost of borrowing, limits the possibility of fi scal stimulus, and euro membership removes either the exchange rate or monetary as policy instruments. The patt ern of slow growth is not unusual for highly indebted countries (Re-inhart and Rogoff , 2010), although it is made worse by euro member-ship. Given the pessimistic outlook, the private sector is unlikely invest much, thereby contributing to the slow growth and intransigently high debt-to-GDP ratios.

Financial-sector issues in the Euro-zone interact with these prob-lems. Banks remain weak in many cases, as refl ected in equity markets and recently noted by the IMF. In the future banks may face capital problems from increasingly weak loans and losses from partial defaults on sovereign debt; there are already signs of liquidity issues. In response, banks are limiting their lending, which contributes to the slow growth and raises new concerns and the risk of bailouts.

These developments mean that the European Central Bank (ECB) and the national central banks are likely to face pressures to provide support to weak banks and buy sov-ereign debt over the next 12 months. The ECB’s role as lender of last resort has been stretched to the limit. Faced with continued political resistance to debt write-downs, however, pres-sures will persist and present chal-

James A. Hanson*

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lenges both to the ECB as well as to the Euro-zone itself.

Growth, Fiscal and Sovereign Debt ProblemsEuro-zone countries face a signifi -cant risk of continued slow growth or even a double-dip recession. In many countries, GDP growth has slowed or even declined during the last year; even Germany appears to have slowed down in the most recent data. Only Germany, like the United States, has roughly returned to its 2007 GDP. Fiscal stimulus is impos-sible for many countries given their lack of fi scal space, which refl ects both the 2008–09 fi nancial crisis and structural fi scal defi cits, particularly during slow growth periods. Some countries have become overvalued under the fi xed euro exchange rate and lost export shares even within the Euro-zone. Other countries have proposed or started fi scal austerity measures to reduce the problems associated with fi nancing their high debt-to-GDP ratios and fi scal defi cits. However, concerns have been raised that austerity programs without sig-nifi cant structural reforms will lead to still slower GDP and employment growth and less tax revenue, and as a result the programs may not af-fect the fi scal defi cit or debt-to-GDP ratios much.

Limited progress on the auster-ity programs has occurred in some cases. Regarding Italy, for example,

European leaders have expressed concern over the slow progress of a signifi cant austerity program in the Italian parliament. Portugal, which received a support program from the European Union (EU) and the International Monetary Fund (IMF) in 2010, is proposing new fi scal aus-terity measures.

The Greek program has been the most important concern. The 2010 support program from the EU and the IMF has proved insuffi cient. At end-July 2011, a preliminary agree-ment was reached on a second Greek bailout, to be finalized and then presented for national parliaments’ approval. The preliminary-agreed bailout involved a) the IMF; b) the EU; c) the European Financial Stabil-ity Facility (EFSF), which pending parliamentary approval will have the authority to provide loans to Euro-zone banks and/or buy sovereign debt directly or in the market); and d) a reduction of Greece’s obliga-tions to holders of its debt, similar to the Brady Plan but without its guarantees.

Various complications have aris-en since July, however. Some coun-tries (for example, Finland, the Neth-erlands, and Austria) have inquired about collateral for their contribution and Greece is seeking 90 percent participation in the debt relief part of the plan. Such a level of participation would mean losses to the German government-owned “bad banks” for

September 2011 Policy Brief No. 1 3

two German weak banks that had held substantial Greek debt. Greece is also showing reluctance to sell shares of publicly owned enterprises in its depressed stock market and its fi scal performance continues to be worse than projected in program negotiations. On September 2, 2011, offi cials negotiating the fi nal package left Greece for 10 days. More gener-ally, concerns continue to exist that Greece will be unable to carry out the terms of the new program; that the program would be too small; and, based on this experience, that any future bailouts of larger countries would require a much larger EFSF and more funds in general, which would certainly face major resistance in the current political environment in many Euro-zone countries.

Debt and Banking Sector IssuesThe countries’ austerity programs are motivated by the problems in rolling over the high levels of sover-eign debt and fi nancing large fi scal deficits. The fiscal deficit, not the primary deficit, is important, be-cause the primary defi cit adjusts for interest payments, in eff ect assuming a rollover can be made. The critical fi scal issue, particularly in a period leading up to a possible crisis when interest rates are much higher than nominal growth and rollovers are diffi cult, is fi nancing the fi scal defi cit including interest payments.

A further major debt issue in the Euro-zone is that national treasuries sell bonds denominated in euros, a currency they do not issue. Like non-U.S. countries selling dollar-denom-inated bonds, Euro-zone countries cannot guarantee that they will have suffi cient liquidity to pay interest and maturing bonds, without debt rollovers or Euro-zone support. Unexpected domestic infl ation, rec-ommended by some, does not help reduce a Euro-zone country’s debt burden, because the debt is fi xed in euros. The overindebted countries ei-ther need to a) roll over outstanding bonds in the markets; or, b) if market and bank demand for the bonds is lacking, receive support from offi cial Euro-zone fi nancial institutions; or c) default. Default would cause major problems throughout the Euro-zone because of the importance of multicountry banks, not to mention the holdings of these national debts by the ECB and the national central banks.

European banks of course suf-fered during the 2008–09 fi nancial crisis and received government support; some were closed. The sur-viving banks have been rebuilding capital and, not surprisingly given the slow recovery, limiting lending. The slowdown in lending, in turn, has limited growth. In this environ-ment, banks had incentives to hold government debt because of its zero risk weight in calculating required


ratios of capital to risk. Weighted assets meant less capital had to be accumulated.

Currently, capital issues have nonetheless reemerged in some banks and liquidity seems to be an increasing issue. The IMF recently raised the issue of low capital in Euro-zone banks. Recent stress tests by the EBA did suggest that less than 10 percent of the sampled banks, fi ve of which were in Spain and two in Greece, would fall below the mini-mum capital adequacy in the event of a shock. All major banks were calculated to exceed the minimum capital under stresses posed in the test, although some were close to the minimum. However, the tests may have understated the exposure to a sovereign default, particularly default by the home countries of smaller banks. The International Ac-counting Standards Board has raised that issue recently by calling into question some banks’ provisions for losses on debts of governments, not just in Greece. This issue is particu-larly relevant given the precedent for requiring sovereign debt holders to accept losses in the second Greek bailout.

Liquidity is also an issue because large European banks tend to de-pend more on short-term and inter-bank funding than large U.S. banks. Various estimates (for example, from Morgan Stanley and the European Banking Authority (EBA) Stress Test)

suggest that nearly half of their cur-rent funding would need to be rolled over in the next 12 months. Although interbank markets do exist, banks tend to shun loans to banks that ap-pear weak and cannot be counted on for funding. Moreover, U.S. money market funds have recently reduced their exposure to European banks. Hence, funding for banks and, cor-respondingly, bank lending may be slowed further, curtailing GDP growth. Banks’ ability to finance increased purchases of government debt may even be limited. These liquidity issues suggest that there may be need for funding support from Euro-zone fi nancial institutions and, for failing banks, takeovers with government funding.

Funding from Offi cial Financial InstitutionsIn general, central banks’ funding to banks is often titled lender of last resort support, although it often does not meet Bagehot’s classic policy (1873) for lenders of last resort: lend at a penalty rate to solvent but illiquid banks that have adequate collateral. Nor does central bank funding meet the implicit policy for insolvent banks of prompt injection of capital or closure, with a deposit insurance payoff , if it exists, and liquidation by bank resolution facilities if nec-essary. Judging whether a bank is solvent or not depends on the quality of accounting and involves issues re-


garding the time horizon over which and the asset prices at which a bank is judged solvent. In practice, lenders of last resort have often charged non-penalty rates, eased their collateral requirements, and have been used to avoid prompt bank closures.

There are also some general problems with the existence of a centralized lender of last resort. It may encourage banks to minimize their liquid asset holdings and rely on market finance, particularly if lender of last resort rates are low and collateral requirements are weak—a moral hazard created by the existence of a lender of last resort. Finally, in open economies, lender of last resort loans may fuel a run on the currency, as occurred in the East Asia crisis of 1997. Such problems of the lenders of last resort, and lack of prompt intervention for and resolu-tion of weak banks, have proved costly and contributed substantially to debt buildups in both developing and industrial countries.

In the EU initially, the lender of last resort function was decentralized and based on national central banks, deposit insurance, and treasuries in a refl ection of the EU’s national fi scal responsibility rules. The ECB focused on monetary policy. Inte-gration of the impact of the national lenders of last resort on Euro-zone monetary policy was addressed and coordination developed on informa-tion and liquidity issues across the

national central banks. (Schinasi and Teixeira, 2006, discuss these develop-ments and issues.). Not surprisingly, however, decentralization still faces information and coordination issues, especially with banks’ expansion across the EU. This expansion also raises the issue of which national bank/deposit insurance/treasury should act as the lender of last resort and recapitalize a bank with subsid-iaries across the EU.

In the 2008 crisis, the ECB went beyond its monetary policy focus by off ering major support as lender of last resort, although this support was still much less than the U.S Federal Reserve’s support of $1.2 trillion (maximum) outstanding in Decem-ber 2008. Interestingly, the Federal Reserve (Fed) played a major role in support for European banks. Almost half of the Fed’s top 30 borrowers were European banks, including the Royal Bank of Scotland, UBS, Bel-gium’s Dexia SA, Societe Generale, Rabobank, and Germany’s Hypo Real Estate Holding AG and Com-merzbank (see various Bloomberg presentations). The European banks’ U.S. subsidiaries were often, but not always, the borrowers—some bor-rowing banks had a minor presence in the United States. Another factor in European banks’ borrowing was the Fed’s substantial easing of its lending rates and collateral quality requirements. Thus, the demand for funds probably refl ected both


a demand for dollars and the Fed’s easier terms compared to the ECB’s.

In 2010–11, the ECB has contin-ued a version of its lender of last resort support. The ECB made loans to banks based on collateral of debt from Ireland, Greece, and, to a lesser extent, Portugal, Spain, and Italy. This collateral was accepted even though the Greek debt in particular had dropped substantially below AAA ratings, exposing the ECB to risk in the event of a default. These ECB’s loans were often, but not al-ways, to banks from the same coun-try as the collateral. In some cases large banks from other countries, notably France and Germany, con-tinued to hold debt from other gov-ernments despite the fall in its price, to avoid a sale that would show a loss. Other lender of last resort funds came from the national central banks in the southern tier of the Euro-zone, which in eff ect have been extend-ing credit by running up payments defi cits with the northern-tier central banks (The Economist, 2011).

Recently, demands by banks for support have been growing and actions are being taken to support weak banks rather than close them, as is often the case with lender of last resort facilities. Since the July preliminary agreement on Greece, requests for ECB lender of last re-sort support have grown. One bank recently borrowed some $500 million from an ECB facility that had not been used in the past six months. The

ECB has also authorized national central banks to lend to domestic banks when they run out of “EDB eligible capital.” In Greece, the worst-hit country in the sovereign debt crisis, deposits have fallen sub-stantially. Recently, Proton, a small, failing bank, received a €100 million transfer from the government, was intervened by the central bank, and was recapitalized by the four largest Greek banks to help avoid a run on the Greek banking system. One of these four banks received €3 billion support from the central bank and merged with another, with new capital funds for the merged bank of €500 million from Qatar. The fourth largest bank received €2 billion from the Greek central bank.

Also, the ECB recently renewed its policy shift from a purely lender of last resort role to buying debt of European governments. In May ECB reopened its Securities Market Program (SMP), which had begun in May 2010 and had largely been used for Greek, Irish, and Portuguese debt. The SMP recently purchased over €30 billion of Spanish and Ital-ian debt in an att empt to limit the rise in their interest rates owing to contagion from potential loss on Greek debt under the preliminary agreement on the second Greek bailout. The ECB purchases were in the secondary market—the ECB is prohibited from primary market purchases—and small relative to these countries’ outstanding debt.


The ECB also undertook steriliza-tion of the SMP’s monetary impact. Nonetheless, these ECB purchases brought criticism, notably from the Bundesbank and the president of Germany. Thomas Mayer, economist for Deutsche Bank, and others have commented that such purchases have gott en the ECB into govern-ment fi nancing, contrary to the intent of the Maastricht treaty.

More fundamentally, the Euro-zone countries and banks face the risk of sovereign default, if there is a lack of purchases of the euro-denominated bonds, as noted above. The EFSF was expected to ease this problem by replacing the ECB as a buyer of Euro-zone debt, but it is still awaiting fi nalization of the second Greek bailout. In any case, the EFSF is likely to be too small and cumbersome to intervene eff ectively in bond markets, particularly given the political obstacles to another sovereign bailout.

ConclusionsThese and other developments sug-gest that the ECB’s lender of last resort function, its overall role, and bank resolution in the Euro-zone will face major demands and challenges over the next few months. European banks, which have relied more on market-based, short-term fund-ing than U.S. banks, are expected to require substantial rollovers of their funding in the next 12 months. However, U.S. money market funds

are selling off European banks’ debt, not buying. And the Fed, which is al-ready examining the European bank subsidiaries’ access to funds, may not wish to play a large lender of last resort role to European banks again.

The ECB is already supplying increasing liquidity to EU banks, as noted, as are national central banks in the countries with the weakest sovereign debt. More generally, some European banks could use more capital. And banks’ provisions for losses on sovereign debt, not just in Greece, are often low, according to the International Accounting Stan-dards Board.

In this context, and given the po-litical opposition to further bailouts in the Euro-zone, the Zone’s lenders of last resort are likely to be called upon increasingly. They would face risks of supporting insolvent banks because of information problems, which would affect their capital, as well as questions of who should support multicountry banks. There is also a question of whether such activities can be done on a large scale when fully sterilized, since sterilization will tighten credit in the already-slowing northern Euro-zone tier. In this context, full sterilization to avoid monetary expansion from the support to banks and infl ation would be premature.

The ECB’s role in supporting government bonds, although thus far small, is likely to face challenges, politically and economically, if na-

tional crises develop beyond Greece and bailouts continue to face major political opposition in the EU. As a result, the ECB is likely to limit its purchases of government bonds in the near future. This policy may con-tribute to higher rates on countries’ sovereign debts and, along with their slowing economies, increase fi scal problems. And, in the event the second Greek bailout falls through and/or other crises occur, the ECB seems unlikely to be ready to in-crease promptly and substantially its support. The role of the ESFS faces similar and more difficult issues. Addressing these problems is com-plicated by the more general issues of fundamental political diff erences over bailouts and macroeconomic policy within the Euro-zone. These differences limit the Euro-zone’s

ability to respond promptly to crises and raise deeper questions of its very unity and its single currency.

ReferencesEconomist, The. 2011. “How Much

Financial Risk Has the ECB Taken On as a Result of the Euro Debt Crisis?” June 9.

Reinhart, Carmen, and Kenneth Rog-off . 2010. “Growth in the Time of Debt.” American Economic Review (May): 573–578.

Schinasi, Garry, and Pedro Gustavo Teixeira. 2006. “The Lender of Last Resort in the European Single Financial Market.” IMF Working Paper WP/06/127. IMF, Washing-ton DC.

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The views expressed in Policy Briefs are those of the authors and do not necessarily reflect those of the Growth Dialogue or George Washington University

*Professor of Chinese Economy and Sokwanlok Chair of Chinese International Affairs, University of California at San Diego. Send comments to [email protected], copied to [email protected].

China’s Medium-Term Growth Prospects

China is in the news every day, either because of its remarkable growth record, or because of immediate concerns about a growth slowdown and the resilience of its financial system. If we look beyond the head-lines, and consider China’s medium-term prospects, we need to begin by considering China’s position with regard to its long-run transformation. The main ideas of this Note can be summarized in three points:

• China is at a turning point that will gradually lead it onto a slower growth path.

• Until quite recently, China had been extraordinarily well positioned to make it smoothly through that turning point.

• Today, due to policy drift and slow response to economic changes, China is in a much less favorable position to make the transition.

Overall, China’s long-run position is still quite positive, and we should expect that the country will make a successful struc-tural transformation over the medium term. However, we should also expect some very rocky patches, generating economic turbu-lence and demanding changes in policy, and greater responsiveness and flexibility. With effective policy making, China should emerge as a successful upper middle-income

economic power, but this will not happen without some significant policy adaptation.

The current turning point is in the first instance demographic. The age cohorts entering the labor force from now on are getting smaller, while the age cohort retiring from active labor is beginning a period of rapid growth. At virtually the same historic moment, rural-urban migration has passed its peak, and nearly all the young people in accessible areas have already left the farm. Over the past 20 years, rapid labor force growth in the modern sectors contributed almost two percentage points to annual growth: this contribution will drop to zero in the next 20 years. This type of struc-tural transformation is experienced by every middle-income country. But in China, for essentially accidental reasons—the way that the delayed impact of strict birth control policies coincided with the peak of rural-urban migration—these changes are highly concentrated in the next 5 to 20 years.

The end of China’s “surplus labor” is already leading to rapid growth of wages for unskilled workers, and this in turn creates new challenges for China’s competitiveness. Rising wages create inflationary pressures which, given China’s nearly-fixed exchange rate, are exacerbated by rising global com-modity prices. Macroeconomic policy needs

Barry Naughton*

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to adjust to these new conditions. Successful development means creating comparative advantage in a new range of higher skilled sectors, while moving as smoothly as possible out of unskilled, labor-intensive sectors such as garments and toys. Worries about this transition have lead some in China to fret about a possible “middle income trap.” How effectively will China navigate through this turning point?

Until very recently, China was extraor-dinarily well positioned to make this transi-tion. Even a short list of six factors makes this clear. First, rapid expansion of higher edu-cation has greatly expanded China’s skilled manpower base (annual college and junior college graduates increased from less than a million in 2000 to over 5 million by 2008). Second, China’s participation in a broad range of global production chains exposes it to advanced manufacturing techniques and presents opportunities for upgrading beyond the unskilled assembly jobs in which it is currently specialized. Third, China has recently been rising in global research and development networks to become a site for cost-effective research, both basic and applied. Fourth, China’s huge domestic market gives it additional flexibility. Fifth, successful 1990s economic reforms have had a tremendous positive, lagged effect on China’s growth through the first decade of the 2000s. Finally, China’s planners were early to understand the challenges of the turning point, and as early as the 11th Five Year Plan (2005-2010) laid out a program to shift China’s economic development strat-egy towards a less resource-intensive, more knowledge-based, and consumer-friendly growth path.

However, in the last several years, much of this good positioning has been lost. Let me illustrate this point with an anecdote from the coal fields. In 2005 and 2006, the coal-rich province of Shanxi began a pro-

gram of mine consolidation that involved a substantial measure of privatization. Subsur-face coal reserves were sold for an average of around 3 yuan/ton, such that private min-ers typically invested around 1-200 million yuan in a mine. In turn, this legitimized the position of private mine-owners, some of whom had been mining locally since the 1980s, and attracted a new class of investors (often from the hyper-capitalist merchants of Wenzhou). However, during 2007 a succes-sion of mine disasters and scandals caused the firing of two provincial governors and a dramatic shift in strategy. A new program of renationalization of mines was launched at the end of December 2007 in Linfen County in Shanxi, and by April 2009 a fully opera-tional program of renationalization was in place province-wide. Private miners were compensated for their reserves, at about 1.5 to 2 times their original purchase price. However, the price of coal had increased much more than this since 2005, and miners were not compensated at all for the invest-ments they had made in their mines in the interim. On balance, there was a significant element of expropriation in the renational-ization. In 2010, the government announced that re-nationalization would be expanded to other coal-rich provinces, including Henan and Inner Mongolia. Of course, a single an-ecdote cannot stand in for China’s diversity and complexity. However, it can stand as a convenient marker of a broader policy turn, in which I flag four key elements:

1. The end of privatization, and the ap-pearance of episodes of what is argu-ably expropriation. There are examples of this outside the coal sector, and a lively discussion in Chinese media of guojin mintui (the state advancing at the private sector’s expense) has emerged. We certainly do not yet see a shrinking private sector or an increase in the

November 2011 Policy Brief No. 2 3

government’s ownership share of, say, industry. But China’s private business-men and businesswomen unambiguous-ly face less secure property rights and an increasingly politicized environment. Their investment decisions increasingly must factor in political risk.

2. The economic stimulus policy of 2009 had many positive effects, but also led to a transfer of resources to the state sector, perhaps inevitably. The effect on the financial system has been profound.

3. The policy agenda in place in the early 2000s that envisaged strengthening independent regulatory institutions while opening up more of the economy to fair competition has now clearly stalled out. Sectors from steel to the Internet find that conditions for fair competition have not improved, and both foreign and domestic private firms face increased challenges.

4. The Chinese government has launched a big push in “strategic emerging industries,” made up of 35 industrial sectors that correspond to the cutting-edge sectors every (developed) country wants to foster. This is a risky gamble on frontier industries, on leap-frogging into uncharted territory, rather than on catching up by imitating established patterns. It also represents a turning away from cooperation with multi-national corporations and inevitably leads multinationals to guard their core technologies more carefully than ever.

Put together, these policy choices have contributed to the failure of the “rebal-ancing” initiatives laid out back in 2005. With the government trying to maintain rapid growth, the economy has become even more dependent on investment, which has reached unprecedented highs. Exports have again become an important driver of

growth in 2011. The cumulative impact of these policy choices can be characterized as follows:

• Rapid growth of infrastructure, but with low utilization.

• Rapid growth of housing, but with low occupancy rates.

• Heavy investment in hi-tech industries, but with as-yet low efficiency.

• Rapid growth in university education, but with many underemployed college graduates.

All these changes are incremental; there is no inevitable cliff to fall off. Economy-wide, rapid absorption of international experience, improved education and skills, and externalities to improve infrastructure all boost productivity. Nevertheless, Chinese government policy is gradually facilitating the accumulation of underutilized resources, and this is likely to begin slowing the pace of productivity growth that has heretofore been outstanding. This trend, as it takes hold, will eventually make the transition to a lower growth rate more difficult to manage.

In a broader sense, the recent policy shift is simply not in the right direction. China needs to increase production and consumption of middle-income goods and services; it needs to tap into native Chinese entrepreneurship in the creation of new products suited to China’s large and rap-idly diversifying domestic market. It needs more flexibility, more room for initiative, and fewer boundaries on creative behavior. However, policy seems currently to be mov-ing in the opposite direction.

What will happen? For the next year, not much is likely to change. The country is wrapped up in the political transition occurring at every level of the system, from national leaders down to the county level. Given the current policy settings, China’s main problems are not going to disappear:

inflation is not going to go away, absent a broader decline in the global economy. However, neither will Chinese demand col-lapse. Technocrats are focused on problems in the financial system, so they are unlikely to let things unravel by taking their eyes off the ball. The current policy dilemmas will still face the new leadership when it assumes power in October 2012. A year later—say, by

October 2013—they will have had a chance to assess the situation, and to acknowledge that current policies simply cannot get China where it needs to go. At that point, significant policy changes are likely, and the implications for China’s growth trajec-tory as well as global growth prospects will be clearer.

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The views expressed in Policy Briefs are those of the authors and do not necessarily reflect those of the Growth Dialogue or George Washington University.

*Chief Economist, the Growth Dialogue. Send comments to [email protected] with a copy to [email protected]

The Changing Geography of Innovation, the Current Crisis, and Implications for Economic Growth

Long-term growth in middle-income coun-tries will be sustained by gains in productiv-ity arising from technological convergence, structural change, improved efficiency, and innovation. As countries move closer to the technology frontier, more of the increases in productivity will need to be sourced from innovations of all kinds—product, process, design, organizational, and others. Most in-novations will be incremental, interspersed with the occasional radical breakthrough. A few countries, such as the Republic of Korea and Finland, have effectively managed in-teractions among government, universities, and business entities and have developed the capabilities to generate a stream of in-novations. However, most industrializing countries are struggling to arrive at the optimal mix of government policies, institu-tions, human and research and development (R&D) capital, and corporate cultures.

Some researchers, among them Tyler Cowen, Robert Gordon, and Benjamin Jones, question the likelihood that future gains from innovation will match those real-ized in the twentieth century. They believe that the low-hanging fruit from structural transformation and axial technologies has already been harvested. They also note that the flow of significant innovations from the

Internet is becoming sparser and might not necessarily enhance productivity (for exam-ple, productivity growth in the United States since 2004 has declined to 1.65 percent per year compared to 3.2 percent during the preceding eight years). Finally, they observe that growth-enhancing innovations from biotechnology have been slow to materialize, and that the potential of green technologies remains uncertain.

The majority opinion is more positive and envisions that innovation in the future will likely be substantially buoyed by the globalization of R&D and the increased volume of resources devoted to research. This process is being supported by the expanding pools of scientific, engineering, and math skills, especially in China, India, and a few other emerging economies. These economies have enlarged their tertiary-level programs in science and technology and are steadily ramping up both their public and private R&D. For example, Huawei of China was the leading applicant for patents from the World Intellectual Property Organization (WIPO) in 2008, and many other Chinese, Indian, and Brazilian firms are redoubling their efforts to generate patents and trans-late them into profitable innovations. In addition, multinational corporations are

Shahid Yusuf*

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January 20122 Policy Brief No. 3

diversifying their R&D operations and trans-ferring more of their research activities to emerging economies in order to capitalize on the elastic supply of skills and on expand-ing market opportunities.

The economic crisis of 2008–09 and its lingering aftermath appear to have rein-forced a trend increase in the contribution of emerging countries to innovation activities worldwide. Growth has slowed markedly in developed countries, dampening investment in R&D whereas thus far R&D has proven more resilient in a few of the middle-income economies. If such trends persist, these latter countries could benefit from an accelerated convergence towards more slowly evolving frontier technologies.

The upshot of these developments is the increasing likelihood of a geographic redistribution in the locus of innovation as-sociated most strongly with the rise of China. Undoubtedly, a changing landscape of in-novation will demand wide-ranging policy actions by advanced and middle-income countries alike.

Prognostication is always risky, but with-out some effort at anticipating the likely direction of change, it is difficult to define strategies and to prepare the groundwork for policy. Below are some preliminary thoughts on how the landscape of innova-tion might evolve and the implications.

• Slow growth and fiscal constraints are likely to reduce public R&D spending in the advanced countries. However, modest reductions need not significant-ly affect innovation and productivity growth in the short and medium run. In fact, high-income countries could retain their comparative advantage in discov-ering and exploiting general-purpose technologies, and a rationalization of R&D spending combined with more stringent evaluation of research projects

could raise the efficiency of public R&D and the quality of innovation.

• It is likely that the vast increase in China’s spending on research and the sharp gains it has registered in patent-ing and the publication of scientific arti-cles will catapult it into the ranks of the world’s most innovative economies. It is much less apparent from their recent performance and policies that countries such as the Russian Federation, South Africa, India, Malaysia, and Brazil will quickly follow suit—although they have the potential. Under this scenario, innovation might be increasingly con-centrated in North America, Northern Europe, and Northeast Asia.

• The globalization of R&D, with multi-national corporations taking the lead, is being paralleled by a globalization of the learning economy. Demand for tertiary education is surging in middle-income countries while it is likely to shrink in high-income countries be-cause of the diminishing cohort size of potential college applicants. Therefore, universities in high-income countries are trying not only to enroll more stu-dents from overseas but also enter into collaborative arrangements with uni-versities in middle-income countries. To this end, universities are setting up satellite campuses in middle-income countries so as to extract the maximum gains from institutional brand names, in-house talent, and tacit knowledge. China, Singapore, and the United Arab Emirates have attracted the most atten-tion and traditional knowledge hubs in the advanced countries may soon be joined by knowledge hubs in East Asia.

• If new knowledge hubs do take root—in Beijing, Shanghai, Hong Kong SAR China, and Singapore, for example—this would contribute to the greater

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circulation of knowledge workers, reinforce the redistribution of R&D, and further integrate the national in-novation systems of countries pursu-ing innovation-led growth strategies. Countries that are slow to reform and upgrade their education systems to take advantage of the globalizing pro-cess risk being left behind—and this includes some of the advanced coun-tries that have allowed the quality of education to slip.

• The dominance of services in high-income countries and the rapidly increasing share of the service sector in middle-income countries could fundamentally alter the composition and even the tempo of innovation. Traditionally, research, technological change, and innovation have been most vigorous in manufacturing and especially in the high-tech industrial segments. However, looking ahead, services might take the lead in innova-tion with formal R&D playing a much diminished role. Moreover, the pro-ductivity gains from such innovation might be smaller than past gains that have accrued from product and process innovation (in manufacturing).

• Furthermore, the character of innova-tion might be transformed if those middle-income countries richly en-dowed with labor become the drivers of innovation. Capital-intensive and labor-saving process innovation suited for advanced countries and products sought by higher-income buyers might lose ground to innovations tailored to the factor endowments and markets of economies where per capita incomes are lower, employment generation is a burning concern, and the need to nar-row income gaps is urgent. How such a change in the character of innovation

might affect productivity and growth remains to be determined, but it is quite possible that a dollar of R&D anywhere will produce less growth in the future.

• Many governments see green tech-nologies as the drivers of innovation. Rapidly urbanizing countries with deep pockets—such as China—are pinning their hopes on advances in transport, renewable energy technologies, and information technology, among oth-ers. However, given trends in (green) patenting and the costs of scaling up promising green technologies, it is far from obvious that a greening of innova-tion will be rapid or that it will deliver the sort of growth that followed the in-troduction of electricity and the internal combustion engine. If the payoff from “greening” falls well short of current expectations, then much R&D spending will have been in vain and there may be the drought of innovation that Cowen fears may occur.

• Lastly, a global innovation landscape with a few peaks and many deep val-leys and a global learning economy with hubs concentrated in a handful of the most innovative countries could result in widening international dis-parities in growth rates and in incomes. These disparities likely would lead to other imbalances (and associated pres-sures) and would threaten trade and capital flows. The risk is that a highly uneven globalization of innovation would strongly impinge upon the role of government and perhaps encourage dirigisme or protectionism. Avoiding such an outcome should be one of the highest priorities for policy makers. A change in the landscape of innovation should be advantageous for the major-ity and not just for the early movers and a few large resource rich countries.

How this landscape unfolds will depend on the actions of individual countries and on a form of globalization that maximizes spillovers and encourages sharing. At the country level much depends on the inter-action among elements of the ‘quadruple helix’ that determines the dynamics of innovation—the government, the business community, universities, and the financial sector. The quality and effectiveness of the

government’s innovation policy will be the trigger in most countries, but absent the constructive contribution of the other three elements of the helix, progress will be slow. If, however, enough countries can make headway with national innovation policies, then there is a real possibility that they will capture the benefits of innovation for further economic growth.

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*Professor of International Business and International Affairs at George Washington University and Managing Director of the Growth Dialogue. Send comments to [email protected] with a copy to [email protected].

What Do We Know about Green Growth and its Policy Ramifications?

The concept of “green growth” is currently much discussed and many observers are ask-ing whether this is simply a new sobriquet for sustainable development. A recent Mexico City Conference organized by the World Bank, UNEP, and the OECD brought together academics and policy makers with an interest in green growth (http://www.greengrowth-knowledge.org/Pages/Events.aspx). The conferees agreed that there are numerous definitions for the widely shared imperative of generating economic growth. However, they also concluded that growth must not come at the cost of permanently damaging the earth’s natural resource endowments. Each agency has its own definition of green growth, but a workable consensus probably can be built on the desire to go beyond mere output measures, such as GDP, and toward a broader measure of growth based on human and environmental welfare.

The green growth issue can be usefully framed within neoclassical growth theory, which helps emphasize analytic factors. For example, Hallegatte et al. (2011) illustrate the various dimensions of greenness by examin-ing the three basic factors that influence the production possibility frontier (that is, a coun-try’s maximum output): (i) labor, (ii) physi-cal and natural capital, and (iii) technology. Neoclassical growth theory is predicated on the idea that output is a product of these three sets of variables. Various intangibles and

unexplained influences are usually imbedded in the technology variable.

Labor. Green elements could increase the efficiency of individual labor inputs into the so-called “production function.” Efficiency-enhancing factors could include, for example, climate mitigation actions, which can reduce destruction of physical capital caused by climate-related disasters; water-conserving measures, which enhance agricultural out-put; and better air quality, which improves the health of the workforce. These are strong examples of how greening or better manage-ment of the earth’s environmental assets can increase the quantity and quality of factors of production and thereby output.

Physical and Natural Capital. More ef-ficient use of the existing stock of physical and natural capital could bring output closer to the production frontier. Such efficiencies could include more appropriate pricing of factor in-puts, and technical improvements in the use of the stock of inputs, such as smarter energy use.

Technology. Finally, through innovation and new technologies, the production possi-bility frontier can actually be expanded. Many such technologies are green innovations. Simple examples include recycling technolo-gies or the development of solar panels, which allow us to produce more with less and hence expand the production frontier.

At the core of the green growth conver-sation are two key issues: (i) time horizons

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within which to examine alternative eco-nomic outcomes, and (ii) the extent to which growth tradeoffs exist between greener and browner policy choices. Of course the two issues are related. They can be condensed and radically simplified into policy choices of “grow now and correct the environment later” or “balance the requirements of growth and environmental preservation.” Even the latter choice, however, does not obviate the need for decisions that involve tradeoffs between the goals when their mutual fulfillment conflicts.

A major dilemma, however, is that unlike other international issues, the global negative externalities of unbridled growth are very dangerous. Individual economic actors or countries cannot be allowed to make com-pletely independent policy choices about the mix of growth and environmental damage or about the timeframe for action. The need for international coordination is daunting since it involves welfare discussions across gen-erations, across countries, and across income groups. Lest we be discouraged, however, some progress has been made on the agreed growth agenda, relying on self-interest, moral imperatives, and the realities of science.

Some analysts have stressed the dif-ficulties of both imperfect information and of what are called principal-agent problems. In the former category we can place the fact that housing prices rarely incorporate energy efficiency. In the latter we can place the real-ity that landlords have no incentive to invest in energy efficiency while renting to energy users who don’t pay for electricity. Other analysts stress the importance of proper pric-ing, pointing to profligate carbon-generating activities that are encouraged because the externalities remain untaxed. Still others use behavioral economics to explain how green growth decisions can be influenced by social norms, rules, or other cognitive means other than strict cost-benefit calcula-tions. Behavioral analysts thus may suggest going beyond incentive pricing policies and

advocate for ones that rely on fundamental behavioral change.

There are formidable large-scale con-straints to green growth. However, one can find positive developments in the decision making of economic entities that need to generate strong but green growth. Their actions could influence the green-brown debate. One useful political unit to focus on is an individual city. Cities will provide the bulk of new economic growth over coming decades. They attract new entrants to the workforce and provide the dynamism and scale needed for economic activity. Further-more, cities’ political constituencies may be closer to the green-brown debate, which could allow some of the difficult tradeoffs to be more practically managed.

Hence we face the need to consider ways of further greening city-led economic growth. Greening should not be seen in some sort of vague pastoral sense but rather as a set of practical issues, such as designing effective waste disposal, enacting energy-efficient housing standards, putting in place zoning that encourages lower carbon-intensive trans-port systems, and choosing locations and technologies for industrial activity that are less damaging to the air. Managers of cities are confronting these issues on a daily basis, and are searching for practical solutions that are affordable and politically implementable. Of course, these decisions cannot be totally divorced from national policies that set the price of fossil fuels or national pollution standards, but cities offer a more manageable political unit for the green growth debate.

In reality, there has been considerable innovation in managing the green agenda in cities. Solutions have included projects as simple as bike paths and automobile traffic restrictions, to urban redevelopment projects, to adoption of Leadership in Energy and Environmental Design (LEEDS) standards in housing, to recycling programs for water, and to master plans for energy and for air quality

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improvement. Cities as diverse as Mexico City, Curitiba, Vancouver, Bogota, Brisbane, and Oklahoma City have succeeded in inno-vating without sacrificing economic growth.

Why should the issue of green growth concern the Growth Dialogue project? First, the Dialogue aims to help design policies that lead to sustainable and equitable economic growth; and a growth path that doesn’t suf-ficiently consider the preservation of the natural resource base will be neither sustain-able nor equitable. Obviously, lower output and higher costs from resource constraints will harm future income and welfare levels. Furthermore, the costs may well be dispro-portionately borne by the poorer segments of society in terms of declining health, degrada-tion of the land, and worse living conditions.

One may legitimately ask whether this is the right time to address green growth concerns. The global economy has recently suffered the most severe and synchronous economic downturn in 70 years. The press-ing national objective of restoring economic growth in many countries might naturally lead to a diminution of interest in green growth solutions, but that would be wrong. The argument that green growth will gener-ate employment is plausible and attractive although not overwhelmingly persuasive. The more convincing argument is that there are many efficiency gains associated with green growth. These gains are immediately accessible in both the short and long run. Smart grids, improved housing efficiency standards, better waste collection and man-agement, and improved mass transit are all investments that pay for themselves. They also generate longer-run benefits that make future tradeoffs more palatable.

A good reason to focus on cities is that it highlights the crucial role of government. By setting the agenda, designing the proper mix of support and incentives, and in co-ordinating and planning, government is a major contributor to green growth success.

The relationship between government and cities is particularly effective because cities are juridical units that face fewer constraints than do countries. One sees this clearly in the role of government in zoning, carbon charges, housing standards, and the like. As a result, much of the experimentation and many of the tangible green growth successes are oc-curring at subnational levels.

That said, however, some countries, particularly in northern Europe, have regis-tered impressive strides on the green growth agenda. Do these countries have radically different social discount rates between eco-nomic outcomes today and tomorrow, and a greater willingness to invest in a sustainable future? If this is the case, then we should ex-pect countries in East Asia to begin to invest much more heavily in green technologies, even if their adoption may entail a short-term economic cost. After all, these countries have historically saved much more than Western countries, reflecting their national inter-temporal tradeoffs. If, however, the decision to deal more aggressively with the green growth agenda reflects other factors, such as a successful process of information and socialization, then political support for the agenda will need much more bolstering to become widely accepted at the national level.

It is noteworthy that in the Republic of Korea, green growth was sold to the public as a way to develop global competencies that would foster future exports. Thus, the Korean government undertook its Green Growth Stimulus Package of 2008–10 with the dual purpose of boosting aggregate demand and strategically positioning itself in this grow-ing technological niche, while its domestic reform agenda has moved much more slowly. In China, by contrast, where energy intensity is high and where carbon emissions now ex-ceed those of the United States, a major policy shift has occurred that at least in the carbon arena is leading to reduced emissions in the name of economic self-interest. Of course

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there are myriad other areas where China has yet to come to grips with the longer-term economic costs of its high-growth strategy.

In federal and politically complicated countries like the United States (which is the second largest air polluter), action at the state level is more likely than at the national level. We see this dynamic at work in the adoption of renewable development standards in 20 states that incentivize the use of wind and solar power. These are positive develop-ments; however, they are not necessarily the investments with the highest payoff. Much more can be done in energy conservation and housing standards, and transport policies offer another arena for high returns to green investment and green policies. This work inevitably will involve cities.

A final point should be made on the need to change behaviors. This is obviously the long-term approach to altering demand for costly options in energy and resource use. Social marketing has been successful in many contexts. Yet there are at least two reasons why a reliance on behavioral change may be problematic. First, such change may take a generation, even if adopted, and the sci-ence tells us we can’t wait 30 years to change patterns of resource use. Second, there are many forces, including vested interests, that influence price setting and thus artificially inflate demand for brown options. For this reason, many countries have opted for gov-ernment policy changes that reset demand. These decisions can also play a major role in stimulating new technologies that fulfill our earlier requirement of expanding the production frontier and fostering economic growth. We have already seen the benefits of some of these investments in that they have helped place green innovators in competitive leadership positions.

To sum up, we are well aware of the need to rely increasingly on urban-led economic

growth because of agglomeration economies and the reality that the movement of people to cities and their environs is inexorable. If this is the future, then the dual agendas of greening and fostering economic growth should increasingly coincide. Considerable progress has been made in the greening of growth, but the success depends decisively on planning, strong regulation, and private-public partnerships. As in other arenas, these conditions imply a strong, competent, and far-sighted government. Some major carbon-emitting nations are curtailing environmental damage out of self-interest; similarly, cities will by necessity be challenged to deal quickly with environmental issues. How well they manage the green growth challenge will have profound implications for cities and their inhabitants, but also for the climate change agenda more broadly.

BibliographyDahlman, Carl J. 2011. The World Under Pres-

sure: How China and India Are Influencing the Global Economy and Environment. Palo Alto: Stanford University Press.

Ekins, Paul. 2012. “Measuring Well-Being and Performance: Purpose, Measures and Policy.” Presentation at the World Bank, OECD, UNEP, and IGGI Conference on Green Growth, Mexico City, January 12–13.

Hallegatte, Stéphane, Geoffrey Heal, Mari-anne Fay, and David Treguer. 2011. “From Growth to Green Growth: A Framework.” Policy Research Working Paper 5872. World Bank, Washington, DC.

Stavins, Robert. 2012. “Green Growth and Technological Change: What We Know—and Don’t Know—About What Drives Improvements in Energy Efficiency.” Presentation at the World Bank, OECD, UNEP, and IGGI Conference on Green Growth, Mexico City, January 12–13.

*Chief Economist, The Growth Dialogue, George Washington University School of Business. Send com-ments to [email protected], copied to [email protected].

China’s 12th Plan: Big Challenges, Vast Opportunities

China’s 12th Five Year Plan (FYP) is off to a strong start with growth in 2011 of 9.2 percent,1 a solid 2 percent in excess of plan targets, but in line with recent trends. Growth was sustained by extraordinary levels of investment in housing, real estate, and infrastructure, amounting to almost 30 percent of GDP, and by investment also in industrial capacity for a total of 49 percent of GDP, the highest figure ever recorded for any country (Japan invested 35.5 per-cent of GDP at its peak in 1970). Consumer spending also rose, albeit not as strongly as expected by planners, and at 34 percent of GDP (in 2010) remains unusually low (it was 60 percent in Japan in 1970). China’s com-modity trade surplus shrank significantly (from $315 billion in 2007 to $210 billion in 2011). For the year 2011 as a whole, the country’s estimated current account balance was 2.9 percent of GDP, which meant that the tradable sector generated less growth than in the recent past.

This growth performance was under-pinned both by increased fiscal spending (equal to 13 percent of GDP) and by a mas-sive increase in credit. Credit rose from 121 percent of GDP in 2008 Q4 to 147 percent

1. However, growth slowed during the course of the year from 9.7 percent in the first quarter of 2011 to 8.9 percent in the final quarter.

of GDP in 2011 Q2, far in excess of other countries in China’s per capita GDP bracket. Credit financed the building of almost two billion square meters of floor space (half the world’s total for the year); the expansion of China’s transport and energy networks; and household purchases of homes, automobiles, and consumer durables. Looking ahead, credit could be tighter so as to contain the risk of housing bubbles and related financial crises, but no so tight as to precipitate a crisis. There will also be continuing effort to pro-mote structural change that weans growth away from an excessive reliance on fixed investment and exports and increases the contribution of domestic consumer demand.

To bolster China’s growth as the contri-bution of investment declines, the 12th FYP also envisages gains in productivity stem-ming increasingly from innovation. The goal is to stimulate innovation by incentives for R&D and the deepening of research capital in seven pillar activities: biotechnology, new energy, high-end equipment manufacturing, energy conservation and environmental protection, clean-energy vehicles, new ma-terials, and next-generation information. China expects to spend RMB 4 trillion on these industries so as to raise their share of GDP from 5 percent in 2010 to 8 percent in 2015, the final year of the 12th FYP.

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Relative to other BRICS2 and neighbors in the East Asia Region, China’s economic future appears more assured. Few expect its growth rate to dip below 7 percent per year over the 12th FYP period or even during the course of the decade.3 Recent estimates by Arvind Subramanian (2011) show China pulling ahead of the United States as mea-sured by nominal GDP by 2020 at the latest. In fact, the 7 percent target is not just an economic but also a political benchmark. It is viewed as the minimum rate needed to achieve a steady improvement in welfare countrywide, absorb new entrants to the labor force, and maintain unemployment at politically tolerable levels.

Three years ago, few raised doubts about China’s economic prospects, but the financial crisis and its lingering aftermath have drastically changed trends in global growth and trade. A weakening of demand for exports in the second half of 2011—coupled with rising wages—has dampened manufacturing activities in China’s key coastal provinces, which for the first time in almost three decades have seen their growth fall short of the national average. Inflationary pressures (the CPI rose by ap-proximately 5 percent in 2011) and fewer jobs than anticipated for university gradu-ates have deepened uneasiness regarding the country’s economic future. Strategy and policies are being reappraised in the light of dramatically altered external circum-stances and a sharpening of the challenges confronting the Chinese economy. The 12th FYP provides an opportunity to begin ad-dressing four of the most urgent challenges.

Structure of Demand For too long, China’s growth has been pegged to the fortunes of export-depen-

2. Brazil, China, India, Russia, and South Africa.3. Justin Lin (2011) projects a growth rate for China over the next two decades averaging 8 per cent per annum.

dent manufacturing industries. China has emerged as the world’s leading exporter and as long as foreign demand was expand-ing rapidly, the economy hummed along. However, now that Chinese producers are encountering resistance in their principal overseas markets, there is an urgent need to partially substitute domestic for foreign demand. Furthermore, investment in infra-structure and real estate needs to be scaled back as it is sometimes wasteful, subject to decreasing returns, and is imperiling the banking sector by storing nonperforming loans. Rising incremental capital output ratios (ICORs) and declining returns un-derscore these problems, similar to Japan’s experience in the 1970s. By a rough esti-mate, expenditure switching amounting to as much as 15 percent of GDP is desirable from investment and net exports to domestic consumption. This process should raise the share of consumption in GDP to about 50 percent,4 and it implies very slow or nega-tive growth of investment and of exports over the next decade.

To implement such a process, China may need to substantially modify its policies in four areas. First, a faster appreciation of the renminbi would be required to augment household spending power. Second, the repression of deposit rates and preferential access of state-owned enterprises (SOEs) to low-cost financing would need to be curtailed. Third, the excess profits and the high investment rates of large and favored SOEs would have to be scaled back through reforms that exposed them to competition and required a distribution of profits to shareholders and, in significant amounts, to the State-owned Assets Supervision and Administration Commission (SASAC). Fourth, China would need to reconsider

4. For consumption’s share to reach even 40 percent by 2020, consumption spending would need to increase by 10 percent per year with GDP growing by 8 percent. Consumption spending rose by 8.9 percent in 2011.


and significantly moderate its investment in infrastructure, which in some areas is well in excess of likely demand over the medium run.5 These policies are likely to face stiff opposition, as they would be im-mensely painful for the export sector, the construction industry, banks, and large, highly profitable SOEs.6 Moreover, even if policy makers successfully cut back invest-ment spending and export dependence, consumer spending might not rise fast enough to fill the gap in demand because the dislocation, the adjustment lags, and localized unemployment would magnify household uncertainties. If the additional domestic demand materializes with a lag, then growth could slow sharply and even fall below 7 percent to the 5 percent levels that are now the norm in South East Asia.

The preferred solution is to introduce all these policies gradually so as to protect demand and the growth rate. The downside of this politically safe approach is that delay will compound the waste of resources on “bridges to nowhere,” preserve redundant production capacity, and further entrench those interest groups seeking to prolong the status quo. Unsettled global economic conditions could also expose China to even greater pressures from its Western trading partners, who are already chafing over trade deficits.

Inequality and the Middle Class Since the late 1990s, income inequality has been on the increase, mainly because of a widening gap between rural and urban incomes (the Gini coefficient stood at 47 percent in 2010). The appearance of free-spending, wealthy urban elites is exacerbat-ing the trend with worrisome social and po-

5. Infrastructure investment could be a source of re-source misallocation that could affect future gains from total factor productivity. See Pettis (2012), Flyvbjerg (2009), and Jones (2009).6. See also Lardy (2012).

litical implications in a country accustomed to an egalitarian distribution of income and modest lifestyles. Declining employment in manufacturing and technological changes (evident in other advanced countries) are likely to limit the growth in demand for unskilled and semiskilled labor and threaten the growth of China’s urban middle class. If entry into the middle class slows while the numbers of the super rich continue to grow,7, inequality will widen and the in-crease in household consumption will fall below expectations. Diminishing employ-ment in manufacturing is probably un-avoidable and might even be accelerated by slowing exports. China will need to embrace a more progressive tax and transfer system if income inequality is to be contained or even reversed. Among the well-known steps for ameliorating inequality that could be more vigorously implemented during the 12th FYP, three policy areas stand out: (i) fiscal reform, (ii) government social programs, and (iii) benefits for migrant workers.

Fiscal reform. An overhaul of the fiscal system is overdue—the last major tax reform was in 1994—and such reforms are best done comprehensively. Such an overhaul would not only need to comprehensively address tax equity, effort, and buoyancy, but also intergovernmental transfers and the allocation of taxing and spending responsi-bilities across lower levels of government so as to weed out numerous distortions.

Government social programs. Fiscal reform would complement a second policy strand that pertains to the government’s health, education, and social security pro-grams. These have all been the focus of intense effort spanning several plan peri-ods. However, China remains at a distance from efficient and affordable outcomes that

7. China counted 1.11 million millionaire households in 2011, compared to 5.22 million in the United States and 1.53 million in Japan.


factor in the experience of other countries. Effective leverage of technological advances, especially in information technology, could help close the gap.

Benefits for migrant workers. In the context of ameliorating inequality, a third policy strand is the treatment of 128 million urban migrants without an urban hukou (or residence permit). These workers lack access to the social and welfare services available to urban residents. Extending hukou benefits has long been resisted because of the costs it would impose on municipalities and because urban planners fear that it would increase the flow of migrants.

These three policy strands are inter-linked and the 12th FYP provides an oppor-tunity to decisively tackle a critical set of issues and rein in income inequality.

Urbanization One half of the Chinese population is now classified as urban and there can be no doubt that cities will be absorbing millions more in the coming decades. With urban areas accounting for up to 80 percent of all global greenhouse gas emissions, the design of cit-ies and the greening of urbanization take on a superadded importance. China passed the United States as the largest emitter of carbon in 2009 and urban pollution takes a heavy toll on the populace, with China sacrificing as much as 6 percent of GDP annually.8 Furthermore, inattention to urban plan-ning, zoning, and land-use regulations has led to sprawling, low-density development that eats into valuable arable land adjacent to cities. Sprawl has been exacerbated by heavy reliance on land leasing to mobilize municipal revenues (40 percent nationwide on average). With so much urbanization still in the offing, environmental imperatives, energy security, and growth economics argue for a greening of urbanization with

8. See World Bank (2007).

a focus on design (to encourage compact-ness and mixed use of urban facilities) and energy efficiency standards for buildings, equipment, and transport. Some of the tech-nologies already are at hand, while others can be developed.

The bottlenecks to be eased have little to do with technology or knowledge. Rather, they are created by the interests of major industries and politically powerful groups. For example, municipal governments derive revenues from land leasing, the community of developers is reluctant to shoulder the additional costs of urban greening, and the auto industry is highly committed to sprawl-ing urbanization that generates demand for cars. Overall, there is strong resistance to tough new standards, innovative urban design, and the development of multimodal public transport.

Green growth is assigned a prominent role in the 12th FYP. Clearly there is rising awareness in China that future growth and urban welfare hinges on implementing costly and far-reaching policies, but top-down imposition of reforms is becoming steadily more difficult. Much will depend upon the strength of dispersed initiatives, as in most advanced countries.

Becoming Innovative The 12th FYP puts much store on enhanc-ing national innovation capabilities so as to sustain growth and achieve technological parity with leading industrialized countries. Typically the emphasis is on raising numeri-cal indicators in activities such as:

• spending on R&D (1.76 percent of GDP in 2011)

• patenting by Chinese residents • publishing in major refereed journals • encouraging firms to introduce new

products • creating world class universities


• increasing Chinese representation in the Forbes 500 and other listings of top corporations

• setting domestic standards to induce localization

• using government procurement to pro-vide a market for innovative products.

With regard to published papers and patents, China has made spectacular prog-ress in less than a decade and is one of the highest-ranked countries. It has also climbed in the innovation rankings constructed by the European Institute of Business Admin-istration (INSEAD), the World Economic Forum (WEF), and the World Bank. How-ever, the challenge for China lies in improv-ing the quality of patents and papers and introducing breakthrough (or disruptive) innovations, which, for example, make a substantial impact on GDP growth or urban greening.

The payoff from a further increase in R&D spending during the 12th FYP (to 2.2 percent of GDP) is uncertain. By all accounts it could be fairly modest, partly because it takes time for the innovation system to mature and make the best use of resources. Payoff also depends in part on the global strategies and organizational capabilities of corporations. Looking beyond the 12th FYP, innovativeness will strongly buttress total factor productivity, possibly by as much as one percent per year. Hence, a lot hangs on China’s use of top-down policies to nurture innovation capabilities, complemented by decentralized efforts to create an open learn-ing and networked environment.

Other ChallengesThe discussion above presents a subset of the internal and external challenges China will face during implementation of the 12th FYP, but arguably they are among the most important. Another challenge is managing

macroeconomic policies and the indebted-ness of local governments so as to minimize the risk of shocks. Yet another is managing China’s external relations as its footprint expands and it becomes an even more active player on the global stage. Energy and food security concerns will also be important; and with global warming, conserving and efficiently using water will become a higher priority.

ConclusionThe world economy has been subjected to a great deal of tension in the past three years and the problems that arose following the financial crisis of 2008–09 are not behind us. In fact, a return to earlier trend rates of growth may lie some distance in the future. Thus, as the 12th FYP period unfolds, China will need to come to grips with some knotty domestic issues. It must also cope with and help calm, as well as restore, a turbulent international environment.

Web SitesInformation on China’s 12th Plan can be found at the following Websites:

http://www.apcoworldwide.com/content/pdfs/chinas_12th_five-year_plan.pdf

http://www.uscc.gov/researchpapers/ 2011/12th-FiveYearPlan_062811.pdf

h t t p : / / c b i . t y p e p a d . c o m / c h i n a _ d i -rect/2011/05/chinas-twelfth-five-new-plan-the-full-english-version.html

http://www.nzte.govt.nz/features-commen-tary/In-Brief/Documents/China’s%20%20Five-Year%20Plan%202011-2015.pdf

Further ReadingFlyvbjerg, Bent. 2009. “Survival of the Fit-

test: Why the Worst Infrastructure Gets Built—and What We Can Do About It.” Oxford Review of Economic Policy 25(3): 344–367.

Jones, Charles I. 2011. “Misallocation, Economic Growth, and Input-Output Economics.” Paper presented at the 10th World Congress of the Econometric So-ciety, Shanghai, China.

Lardy, Nicholas R. 2012. Sustaining China’s Economic Growth After the Global Financial Crisis. Washington DC. Peterson Institute of International Economics.

Lin, Justin Yifu. 2011. “China and the Global Economy. “Paper presents at the Hong Kong University of Science and Technol-ogy. March 23rd.

Pettis, Michael. 2012. “Building Debt in Chi-na.” EconoMonitor, January 23rd. http://www.economonitor.com/blog/2012/01/building-debt-in-china/.

Subramanian, Arvind. 2011. Eclipse: Living in the Shadow of China’s Economic Dominance. Washington, DC: Peterson Institute of International Economics.

World Bank. 2007. Cost of Pollution in China: Economic Estimates of Physical Damage. Washington, DC: World Bank.

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*Henry R. Luce Professor of International Relations and Information Technology at Georgetown University. Send comments to [email protected], copied to [email protected].

The Changing Geography of Innovation: The Rise of the BICs—Challenges and Opportunities

The last two decades have seen a change in the geography of innovation toward de-veloping countries in three areas.1 First, on the input side, there has been a significant increase in the share of total world research and development (R&D) expenditures by developing countries. There has also been an increase in the share of students in higher education, as well as of the number researchers. Second, developing countries have increased their share of intermediate outputs in the form of scientific publications and the number of patents. Third, on the output side, the growth of GDP in develop-ing countries has been greater than that of developed countries, largely because it is easier to grow by using technology that al-ready exists (technological catch-up) than by pushing the world technological frontier for-ward. At the same time, and accelerated by the financial and economic crisis of 2008–09, there has been a significant shift in the share of total world economic activity accounted for by developing countries, which also has implications for the direction of innovation, as will be argued below.

1. Although not geographic, another important shift has been that of the relative importance of the main agents of innovation. The shift has been from government to the productive sector, and to the university.

Much of this changing geography of innovation and growth is the result of the emergence of the BICs—Brazil, India, and China.2, 3 This policy note focuses on the changing geography of innovation in these three countries, particularly China, and pro-vides a quick overview of innovation efforts and performance. As China is already well on its way to becoming a major global player in innovation, this note will summarize some of the lessons from the county’s success, as well as its challenges. This note then will more broadly summarize the challenges and opportunities for advanced countries as well as for other developing countries. Finally, it will describe some challenges and opportunities for the global system.

ChinaChina’s authoritarian government has fo-cused on science and technology since the 1960s. Science and technology was one of the four modernizations proclaimed by Cho

2. The Republic of Korea has also become a major player on the global innovation stage in inputs, outputs, and growth over the last two decades, but is not considered here. Korea is already ranked as a developed country and this note focuses on developing countries.3. Russia has lost relative share in world totals on all the above indicators in the last two decades. However, in recent years it has been recovering some lost ground as it focuses on strengthening its innovation system.

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En Lai in 1963. In addition, after Deng, most Chinese leaders have been engineers rather than lawyers or social scientists as in most Western countries, and they have focused on science and technology.

China already has the largest number of researchers in the world; is the second largest spender on R&D in the world in purchasing power parity (PPP) terms (after the United States, and having surpassed Japan in 2010); and is the second-largest producer of scien-tific publications. In 2011 it also registered the largest number of patents by domestic residents in the world. In China the produc-tive sector already accounts for more than 65 percent of R&D, which is close to the aver-age for advanced countries. In 1995 China’s spending on R&D was just 0.5 percent of GDP. Currently it is 1.6 percent of GDP, but China aims to be spending 2 percent of GDP on R&D by 2020, which is the average for EU countries, and 2.5 percent of GDP by 2025, the average for the United States.

Some of China’s major innovation ac-complishments include its own green revo-lution, space technology, and the nuclear bomb. Some of the country’s state-owned enterprises are demonstrating growing technological capability; they include the China Ocean Shipping Company (COSCO); the State Construction and Engineering Company, China National Petroleum, China Offshore Oil, China Communications Con-struction, China Railways Construction Co., Sinochem, Sinosteel, Shanghai Baosteel, the China International Trust and Investment Corporation (CITIC); and Beijing Enterprise Holdings (diversified conglomerates). Pri-vate firms are evolving too; they include Shanghai Automotive Industries, Huawei and ZTE (makers of telecommunications equipment), Lenovo (which bought IBM’s personal computer division), Haier (electri-cal appliances), Goldwind (windmills), and Suntech Power (the world’s largest producer of solar panels).

At the most macro level, a gross measure of a country’s innovation performance is the annual rate of economic growth. In the stylized economist’s framework, growth is the result of increases in capital and labor as well as technology. China’s growth per-formance has been extraordinary, averag-ing 9 to 10 percent per year for the last 30 years. This is due in part to high rates of investment and the growth of labor and education. Another large driver of growth has been due improvements in productivity and other technical changes, which are the result of successful technological catch-up and innovation with the developed world.

BrazilBrazil started focusing on innovation during the military period from the mid-1960s to the late 1970s. Spending on R&D reached one percent of GDP in the 1970s, the bulk of it by the government. Most researchers work for the government. The government has been trying to increase spending on R&D for several decades now but has not man-aged much of an increase. It also has failed to get the private sector to spend more on R&D, which remains at barely half a percent of GDP. However, Brazil has increased its share of scientific publications from less than one percent of the world’s total to almost three percent in 2008.

Some of Brazil’s main innovation ac-complishments include the development and implementation of methanol-based alcohol as an alternative fuel; multiple agri-cultural innovations lead by EMBRAPA (the public research development and extension services) that have increased productivity in agriculture; deep-water exploration by Petrobras (the state-owned oil company); wells; and the development of an inter-nationally competitive aircraft producer (Embraer—once a state-owned company but now private). Brazil also has many in-novative and internationally competitive

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private companies, including Gerdau (basic metals); Votorantin, Suzano, and Klabin (cel-lulose and paper products); JBS-Bribol and Marfig (crop and natural animal produc-tion); Camargo Correia, Duratex (construc-tion); Weg (electrical equipment); Magnesita (nonmetallic minerals); Brazil Foods and Minerva (food products); Natura (cosmet-ics); and Metalfrio and Romi (manufacture of machinery and equipment).

Brazil’s growth performance during the early part of the military period was high. However, growth stagnated with the global oil price increases of the early 1970s (this was the motivation for the development alterna-tive fuel program) and the country became highly indebted and also suffered macro in-stability in the 1980s. Its performance during the 1980s was poor. It was not until the early 2000s that Brazil resumed growing. This was the result of successful macro stabilization but also of the high demand for commodity exports from China. The rate of investment has been low, which has prevented Brazil from incorporated technological advances as fast as China. As a result, the contribution of productivity growth and innovation has been low, except in agriculture.

IndiaIndia had a very autarkic policy toward research after independence from Britain. It set up a large network of government labs to develop the technologies the country needed. This infrastructure was focused pri-marily on the needs of government, particu-larly the large number of state enterprises. It was only after India’s trade liberalization starting in 1991, when the private sector started to face international competition, that the government research infrastructure started to respond to the needs of the private sector. India has been spending about three quarters of a percent on of GDP on R&D for a long time. However, more than 80 percent

of this spending has been by the public sec-tor. The government has been trying to get the private sector to spend more on R&D. Between 2003 and 2007 it managed to get the private sector to increase its share from 18 percent to 28 percent. This increased spending was in part the result of attracting investment from transnational corporations (TNCs), but increased R&D by some domes-tic firms was also significant. The country’s investment in R&D has now increased to almost 0.9 percent of GDP.

Some of India’s innovation accomplish-ments in the state sector include the Green Revolution (an international cooperative R&D program) and space technology (though more limited than China). Strong, innovative private sector companies have also flourished, including Infosys, HCL, WIPRO, Tata Consulting Services, Patni Computer Systems, Hexaware Technolo-gies, i-Gate Global Solutions, NIIT, and Birlasoft (information technology); Ranb-axy, Dr. Reddy’s Laboratories, Sun Pharma-ceuticals, Biocon, and Piramal Healthcare (pharmaceuticals); Tata (a conglomerate with products including iron and steel, autos, telecoms, IT services, and chemicals); Mahindra and Mahindra (autos); Larsen and Toubro (engineering and construc-tion); Bharat Forge (forging and auto com-ponents); Videocon (a conglomerate with products including electronic picture tubes, mobile phones, and telecommunications); and Suzlon (windmills).

India’s overall growth performance was a low 2–4 percent per year until it be-gan to open up to the trade with the world after 1991, when growth increased to 5–6 percent. India’s rate of investment was also low at around 20 percent until the early 2000s. After 2003, India started to grow at over 8 percent. This was in part due to the dynamic growth of its information-enabled service industries (which though small, had


strong multiplier effects), and of knowledge services more generally. In addition to faster growth, investment increased from around 20 percent through the early 2000s to over 35 percent in the second half of the 2000s. With greater liberalization came higher investment and greater tapping of global knowledge, all of which helped to improve productivity across the economy.

SimilaritiesThe BICs have some interesting similarities. Early on they focused on large, mission-oriented projects. All included nuclear, aerospace, and space. China and India developed their own nuclear weapons. All three have developed aerospace and space technology. Brazil has developed one of the four largest airplane producers in the world. China is now developing its airplane indus-try—somewhat later than Brazil, but faster. China also has a very strong space program and is one of only three countries (besides the United States and Russia) to have launched a man into space. All three BICs have significantly improved agricultural productivity. All three have also developed their automotive industries. India initially developed its own domestic auto industry and then went for joint ventures. Brazil has relied on foreign multinationals. China has developed its own industry and also has relied on multinationals. India and Chi-nese domestic firms are already exporting domestically developed automobiles, and China has very ambitious export plans. All three countries have concerns about income inequality. Brazil has the highest inequality. It has developed an integrated program for reducing inequality, including measures addressing children’s education, health, and food, which is having some success. Inequality is increasing rapidly in China and India. The governments of all three countries are now developing programs to support

product, process, and service innovations that address the needs of the low-income population (“inclusive innovation” as it is called in India).

DifferencesA major difference between China, India, and Brazil is that the first two are very la-bor rich but natural resource poor on a per capita basis. Brazil is very rich in natural resources and not as populous as the first two. In the 1950s all three countries began import substitution strategies. China and India were much more autarkic than Bra-zil, which was more open to foreign direct investment. Brazil developed a broad-based industrial sector and increased the share of manufactures in its exports. However, in the last 10 years the majority of its exports have been natural resources and commodities as a result of the large import demand from China. Surprisingly, China, the communist country, was the first to go for a traditional strategy of export of manufactured goods, supported by foreign direct investment. This strategy started in the late 1970s when China began to open up to the world and es-tablished its first export processing zones. It quickly built on its export strategy and even-tually joined the WTO in 2001. It has become the world’s largest merchandize exporter, mostly manufactured products. India has not been much of an exporter until recently. It opened up to trade in the early 1990s, and its strength is in information-enabled service exports rather than manufactured products.

What can they learn from China?Given China’s tremendous success, what can the other two countries learn from its experience? China’s innovation strategy can be described as following three strands. The first and most successful strand to date has been to be fast learner. China has been the most effective at tapping into global knowl-


edge. This has included formal mechanisms as well as informal ones. The main formal ones have been trade, foreign direct invest-ment, technology licensing, and foreign study. The informal ones have been attract-ing back expatriated Chinese citizens and copying and reverse engineering. China’s use of reverse engineering is not just larger in absolute terms, but also relative to the size of its economy.

China has been able to incorporate a lot of new technology into its economy because it has had a very high ratio of investment to GDP. This ratio has averaged over 40 percent over the last two decades and has increased to nearly 50 percent in the last five years. To be able to absorb and effectively use this technology China also has made massive investments in tertiary education. By 2010 it had more than 30 million students enrolled in higher education institutions, compared to 19 million in the United States, and only 14 million in India. An important element of China’s strategy has been that it has become well integrated into global value chains con-trolled primarily by foreign firms. Thanks to its investments in education, particularly higher education, Chinese firms have been able to move up these value chains from simple labor-intensive activities to those requiring greater technological capability.

The second part of China’s strategy has been an explicit plan announced in 2006 (the Medium and Long Term Science and Tech-nology Plan) to go from catch-up or imita-tion to its own frontier innovation. Starting in 2006 China began to significantly increase its R&D. By 2010 it was the second-largest spender in R&D in the world, second only to the United States.

China has also leveraged its large do-mestic market to improve its innovation capacity in several ways. First, its large market has given domestic firms opportuni-ties to develop their capabilities and to reap

economies of scale. Second, its large market has been a very strong magnet for TNCs. They have not been able to resist participat-ing in China’s booming market, even if they know that their technology will be pirated.

A new element of China’s innovation strategy is massive investments in alter-native energy technologies. This includes investments in nuclear energy, hydropower, wind, and solar, as well as investments in carbon capture and sequestration. China is making the largest investments in the world to develop these technologies. Moreover, the large needs of the Chinese market in this area is also attracting foreign companies to develop and scale up these technologies in China, because the Chinese government offers very attractive terms to set up and operate businesses with these new technologies in China. China’s focus on green technologies is not just an element of developing alternative energy but also of strategic energy security. It is very likely that with these massive investments China will soon be the world’s technology leader in these areas.

China’s challengesChina has many economic challenges. These include an asset bubble; a reduction in import demand from developed countries that are still suffering anemic growth in the aftermath of the 2008–09; the consequent need for China to restructure its economy towards domestic demand; risks of a protec-tionist backlash from the rest of the world; and rapidly rising inequality. In addition, China’s rapid growth makes intensive use of environmental resources and technology, which has lead to rising costs of air and water and increased pollution.

A major challenge for China is how to main its high rate of growth. In the short term this is more difficult in light of the fall in global demand for its exports. In the medium


to long term different challenges emerge. China will catch up with the technological frontier; the contribution of labor growth will decrease as population growth slows as a result of the one child policy; and the depen-dency burden of the graying population will increase. China is counting on innovation to help it maintain a high rate of growth.

On the innovation side there are three main challenges. First, China must able to reap returns commensurate with its increased investment into output into the R&D. The rapid raise in technical and sci-entific publications suggests that it will. However, there has been concern about significant fraud and cheating in research and scientific publications and that many patents are of little value. The argument is that this activity has proliferated because promotions and salary increases in universi-ties and research labs have been reoriented to be based on publications and patenting.

Second there is concern that continued violations of international intellectual prop-erty laws could increase frictions with the international suppliers of technology and bring about retaliatory trade actions through the Trade Related Aspects of Intellectual Property Rights (TRIPs) mechanism of the WTO. In spite of China’s very large invest-ments in R&D, it is not likely that its own innovations will give it the 2–3 percentage points of growth it is seeking through this means. China will continue to rely heavily on technology that it gets from the rest of the world, making it important not to an-tagonize the suppliers of that technology.

Finally, there is increasing speculation that China’s authoritarian regime may constrain innovation, particularly radical innovation, despite the country’s rapidly increasing investments in R&D. So far none of the eight Nobel prizes in science awarded to persons of Chinese origin have been to a scientist working in mainland China. It also

appears that although China has an aggres-sive program to recruit top scientists and engineers of Chinese origin and has been successful in the past, in the last five years it has been having more trouble recruiting the talent it is seeking.

Implications for advanced economiesThere are opportunities and challenges for developed economies from the changing geography of innovation. The first opportu-nity is for TNCs from developed countries to do more R&D in the BICs, as they have a growing stock of qualified scientists and engineers with much lower salaries than in advanced countries. The second is for firms from advanced countries to innovate prod-ucts and services that address the needs of the growing populations of these countries. Not only are their populations still grow-ing, but so is their income, so they are very attractive markets. The third opportunity is for governments of advanced countries to do more science, technology, and innovation cooperative agreements that tackle issues of mutual interest, reflecting the growing capa-bility in the public innovation infrastructure in emerging countries.

The first challenge is that there will be more competition from BICs firms as they continue to develop their capabilities. Gen-eral Electric, for example, has announced that it has to develop innovations for mar-kets in China and India because domestic firms there are producing those innova-tions. In addition, these lower-cost products and services developed for the emerging markets are beginning to be exported to developed-country markets and disrupting TNCs’ home-country competitiveness. The second challenge is for the governments of developed countries. As TNCs from their countries pursue opportunities in emerging countries, they may act less in the interest of


the home countries. This may be clearest in the cases where TNCs locate more of their corporate functions, including research, in China. The externalities from this research spill out to the Chinese economy, not to TNCs’ home countries.

Implications for other developing countriesThere are also opportunities and challenges for other developing countries. For example, BICs may provide innovations that are rel-evant for developing countries’ low-income populations, such as the Nano car and the $35 Aakash tablet computer. In addition, the competition from other developing countries is leading developed-country TNCs to in-novate products and services that respond to the needs of lower-income countries. For example, GE’s $1,000 portable electrocardio-gram developed for the Indian market and the $15,000 personal computer–based ul-trasound developed for the Chinese market are now being exported to other developing countries and even back to the United States. A second opportunity that goes beyond technology is that the growth of the BICs markets will create demand for exports of goods and services.

The principal challenge is that the increasing technological capability and in-novation in the emerging countries will lead to greater competition across a wider range of goods and services. A second challenge is that although the diversification of technolo-gies and the greater speed of technological development are very positive, there is also a downside. Taking advantage of the increased diversity and rate of technologi-cal change also means that countries have to increase their capability to acquire and make effective use of those new technolo-gies. This requires upgrading of education and technology support infrastructure. The poorest developing countries will likely

have the most difficulty taking advantage of rapid change and run the risk of being left farther behind.

Global challenges and opportunitiesThere are several challenges to the global system. The first is the risk of the increased competition from emerging economies. China in particular could lead to a protec-tionist reaction from advanced countries as well as other developing countries. This risk is heightened because of the very slow recovery, continued economic fragility, and high unemployment in the United States and the European Union. A second challenge is the risk of increased frictions over research and intellectual property. This is related to the composition of R&D spending. In the United States and developed countries, a higher proportion of their R&D spending is on basic research, which is largely a public good. In developing countries, including China, only a very small proportion of R&D is spent on basic research. Thus there is a growing concern that emerging countries with very successful catch-up strategies, such as China, are free riding on the basic research financed by developed countries. It is not clear how this will be worked out. Will it lead to a reduction in spending on basic research in advanced countries, particularly as their governments are facing severe fiscal constraints? Or will emerging countries feel increased pressure to do more basic research and put more effort into protecting the intel-lectual property of advanced countries? A third challenge is the continuing increase in inequality within most countries as well as across countries. This is an issue of internal and international political stability. It is also a humanitarian issue as many of the poor-est countries have very limited capability to take advantage of the rapid advances of technology and are being left further behind.

Many of them are also vulnerable to climate change, which is largely the result of the successful industrialization of the advanced countries and now the emerging countries.

The opportunities are to rise to these challenges and to develop better global systems to deal with them. Defusing the risk of growing trade frictions depends on actions from both trade deficit and trade surplus countries. Trade deficit countries need to increase their savings, successfully address their fiscal problems, and reestab-lish sound growth. Trade surplus countries like China (and Germany and Japan) need to develop their domestic markets rather than to continue to rely so heavily on an export-oriented development model. Addressing the issue of free riding requires more invest-ment in basic research by large countries that rely mostly on the basic research of oth-ers, and more enforcement of international property rights. Addressing the problems of growing internal and international in-equality requires more and better domestic and international redistributive policies, as well as more efforts to develop innovations that serve the needs of poorer populations,

including addressing the global challenge of climate change.

Given the increasing innovation capa-bility of the emerging countries, there are important opportunities to develop coop-erative programs to address major global public goods issues. These include climate change, global pandemics, agricultural in-novation to combat food shortages, innova-tions to deal with water shortages (including desalination technologies), and many other innovations to help ensure environmental sustainability. There are already good prec-edents for international public good actions that have involved international cooperation and appropriate innovations. These include the Green Revolution, the African Program to Eliminate River Blindness, and, most recently, the Global Health Challenges ini-tiated by the Gates Foundation. Thus there are many opportunities to work out better outcomes. What is required is greater aware-ness of the interdependence of the world on the actions of the main countries, and greater leadership to make the first signifi-cant moves toward solutions.

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*Professor of International Business and International Affairs at George Washington University and Manag-ing Director of the Growth Dialogue. Send comments to [email protected] with a copy to [email protected]..

The Competition between Western Capitalism and State Capitalism as Drivers of Economic Growth

State capitalism is capturing a great deal of attention. There is particular focus on East Asian economies, in which state plays a dominant role, and which are seen to be outperforming Western economies. Many commentators are extolling the virtues of Asian capitalism and predicting the demise of alternatives. Of course, the strong points of East Asian development have long been recognized, beginning with the high sav-ings rates, hyperinvestment in education and infrastructure, and a strong planning role for the state. There are also examples of state capitalism in other parts of the world that are less laudable. Nevertheless, a surprising number of the world’s largest corporations are now state owned. Does this portend the demise of the West? Frankly, it may be premature to dismiss the future of Western capitalist economies, despite their current travails.

It is important to note that the agents of state capitalism differ greatly. There are sovereign wealth funds (SWFs) whose goals are to preserve living standards of the population for future generations. Some are based on exploitable resource revenue (as in Norway) or revenues derived from state-led government corporations (as in Singapore). Other state capitalists include state-led

corporations in the Russian Federation or China that have strategic market objectives and are able to use the powers of the state to advance their commercial interests. These state-owned enterprises (SOEs) are not only large but of increasing global significance. Still other variants involve private corpora-tions that retain government support to ad-vance national goals, such as the “chaebol” of the Republic of Korea, or more recently the promotion of national champions in France. One conclusion is clear, however: although government-firm interactions are unique to country circumstances, the nature of that interaction will help define the future of capitalist economies.

Correctly, many are highlighting the failures of western capitalism in light of the financial crisis, its origins in under-regula-tion, and its aftermath in public bailouts that rewarded excessive risk-taking. Indeed, one of the major differences between state-led and market-led capitalism is the way risk-taking is managed. Importantly, whereas the statist model has government on both sides of the risk-return ledger, the market model has the asymmetric characteristic of the private sector reaping the gains of successful risk-taking and the government covering major risk-taking losses. Can this

Danny Leipziger*

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be reformed or is the alternative model of strong state control the only alternative? This lies at the core of the debate between state-led and state-regulated capitalism.

I pose three questions: (i) who bears business risks and who reaps the return; (ii) how do societies decide on the balance between consumption today and tomorrow; and (iii) how should governments and firms handle the tradeoffs between national inter-est, private gain, and global commitments? State capitalists seem rather clear in their views on these issues, whereas market-led societies seem confused and conflicted. It is my view that resolution of these questions is indispensable for the Western capitalist model to continue to be successful.

How can the Western market model be changed so that the asymmetric risk-return balance is redressed? The quintessential ex-ample of this market failure is the financial sector, where government foots the bills for poor decisions but profits are pocketed by the risk-takers. Remedies may need to include a re-introduction of a Glass-Steagall separation of commercial and investment banking functions in the United States. De-positors in Citibank should not be financing highly leveraged hedge funds; the fact that depositors don’t flee is based both on poor information and government insurance. The much-debated Volcker Rule is one such step. Furthermore, rather than impos-ing global taxes on financial transactions that will neither thwart bad behavior nor fund the costs of future bailouts, Western governments should rethink their role in risk bearing. A prime example of misguided principle was the government bailouts that were easily and quickly repaid. Distress financing should reward the government (and the public) and in the United States as well as Europe financial bailouts have been underpriced. Governments in the state-led

system would be benefiting from the “up-side;” not so in the West!

Some Western democracies are turning to SWF creation to advance the national interest. What would have happened had the U.S. government put shares of General Motors and Citibank in trust for future gen-erations? What would happen if firms using space technology had agreed to pay with shares given to a “ National Futures Fund?” The illusion of separation between govern-ment and private firms would be shattered, but it would better reflect the extent to which the government bears risks and gets too little return for these investments. Moreover, at least in the United States, the housing fiasco involving quasi-government corporations has cast a pall on any further government involvement in future public-private invest-ments. This is a grave error. The government should back infrastructure investments through a national infrastructure bank, and these are risks worth taking for the genera-tion of future economic growth. The needed “rethink” of government’s role should be pragmatic rather than ideological. That is a valuable lesson from Asian economies.

How can the Western market model be altered so that investing for the future is given greater weight in comparison to short-term profits and current consumption? Is this an alien objective that can only be pursued by government or can it be linked to long-run corporate and household strate-gies? In the first case, I believe the problem can be dealt with but only if we see sub-stantial reforms in the weak role played by corporate governance in most corporations. Share price maximization is the goal of most CEOs. Altered incentives would be a useful first step, such as deferred compensation packages according to some national norm, combined with tax reforms that favor invest-ment of earnings over dividends. It should


be possible to mimic the strategic objectives of Asian state capitalism, which drives large and powerful SOEs in China with corporate boards that are more far-sighted in the man-agement of their advanced technologies, for example. This would require national cor-porate governance boards that are strategic, independent, and empowered.

Another avenue worth pursuing to plan more effectively for the future is to enlarge the role of bipartisan or independent com-missions to decide on investment levels, pension benefits, and sustainable budgets. These can be effective in guiding household decision making. Europe has done better than the United States in resisting some short-term political pressures, as have other non-state-led capitalists such as Australia, Canada, and New Zealand. Some national decisions require guidance, and if govern-ments are too politicized to act in the long-term interest, then other institutions may be needed. Clearly in the case of health care, pensions, and other long-term decisions, demographics dominate and government has to play a major role in guiding decisions via smart incentives.

How can the Western market model be amended to restore a sense of national purpose in a world without borders, while neither sacrificing principles of open trade, nor encouraging narrowly nationalistic policies? This is at the core of Dani Rodrik’s “impossible trilemma” argument, wherein he holds that governments cannot be fully democratic, further national goals, and also adhere to difficult international commit-ments (Rodrick 2011). Is it reasonable for a fiscally strapped nation like the United States to lose all tax revenue from major corporations that park profits offshore? Can a nation like the United States that competes with China allow its advanced technologies to be shared by corporations seeking short-

term profits, especially if some technologies were publicly financed in the first place? A strong argument can be put forward that if nations are able to successfully pursue some national economic goals, only then will they be able to exercise strong global leadership. Since the state-led capitalist model is quite clearly pursuing national aims, it behooves the market-driven capitalists to come to grips with these kinds of difficult political issues. Without resolution, they damage chances that the non-state-led model will prevail.

It has been argued that state capitalism has a corporate vision and that all aspects of state policy are brought to bear to ensure success. The weaker variant in the non-state model is coordination of policies and dia-logue. The latter option is seen at work in Korea, where SOEs are now the exception, but where policy coordination works to op-timize the export-based production model. The latter approach is also seen in Germany, where business, labor, and government work together to ensure competitiveness of industry. In the United States, the lack of planning and coordination is seen in an im-migration policy at odds with higher educa-tion policy, incentives that favor yesterday’s industries rather than tomorrow’s, and a singular lack of dialogue among economic agents. Some Western democracies need therefore to learn best practices from one another in order to compete.

It may well be argued that pursuit of the national economic interests requires a basic understanding between business, labor, and government. Such a social com-pact is difficult to manage when wealth and income become highly skewed. Countries like Singapore have been steadfast in ensur-ing that economic redistribution occurs and have been able to combine the statist market model with sharing by government of the


benefits with the disadvantaged portion of the population. A laissez-faire approach to distributional issues is at odds with the social dialogue needed to effectively compete in the global economy where state capitalism is prevalent. First pointed to by Joseph Stiglitz (2002) in Globalization and Its Discontents, the issue of how benefits of the Western system are shared among various segments of society is at the core of the lon-gevity of that system. According to Sylvia Nasar (2011), the demise of alternatives to capitalism was based on the rapid produc-tivity gains of industrialization that ben-efited larger and larger groups in societies.

With the global economic convergence that Michael Spence (2011) and others have highlighted, the growth in the pie is slow-ing in parts of the advanced economies and the existing fruits of capitalism are becoming more skewed. This bodes badly for Western capitalism unless major reforms are undertaken. The mechanics of those reforms are not insurmountable; however, the political consensus needed to deal with redistribution within the United States or the Euro area is difficult to achieve. It may be argued that the market that Alan Greenspan extolled has spun out of control and that vested interests cannot be persuaded to divert some of their market-derived gains to reinvest in a more stable system. This is a problem of democracies, especially those flawed by the exercise of political influence where government is less able to exercise a nonpartisan role of arbiter and futurologist.

State-led capitalism has one Achilles heel, of course, in that it most often coincides with a lack of political freedoms. In this cir-cumstance, entrepreneurs are unlikely in the absence of controls to invest their creativ-ity in new businesses. It is therefore in the area of innovation that the Western model

has an edge, if it can align its incentives correctly. This means using its education advantage along with the legitimate use of risk capital to encourage entrepreneurship. With innovation can come new jobs and profit. Naturally, the returns will need to be secured, and the intellectual property system respected. State capitalists tend of-ten not to play by the same set of rules, and short-sighted Western governments have mistakenly thought that better adherence to global norms would eventually emerge. This is a mistake, as Carl Dahlman (2011) has pointed out in his new book, The World Under Pressure, since the time to manage ad-herence to global rules is earlier rather later. I have argued elsewhere that the advanced economies, the traditional custodians of the international system, are struggling and cannot provide the necessary leadership, while the newly powerful economies are not yet willing to take up the gauntlet of global responsibility. Under these circumstances, multilateralism will be under increasing stress (Leipziger 2011).

The competition between state-led capi-talism and market-dominated capitalism is reaching a decisive stage. The state capital-ists are growing faster, investing more, and following a clear strategy that is leading to a larger share of world output and income. With that increase in economic power will come other political aims of statism. Fur-thermore, as Henry Kissinger (2012) has argued, military objectives are often seen as corollaries of economic power. The Western democracies are mired in short-term dif-ficulties, distracting them from the urgent and necessary reforms to the system that would enable them to compete. It is not too late to fix the Western capitalism model, but soon it will be.


ReferencesDahlman, Carl. 2011. The World Under

Pressure. Palo Alto: Stanford University Press.

Kissinger, Henry. “The Future of U.S.-China Relations.” Foreign Affairs 91(2): 44–55.

Leipziger, Danny. 2011. “Multilateralism, The Shifting Economic Order, and De-velopment Policy.” In Global Challenges: Multilateral Solutions. Canadian Devel-

opment Report 2011. Ottawa, Ontario: North-South Institute.

Nasar, Sylvia. 2011. Grand Pursuit. New York: Simon and Schuster.

Rodrik, Dani. 2011 The Globalization Paradox. New York: W.W. Norton.

Spence, Michael. 2011. The Next Convergence. New York: Farrar, Straus & Giroux.

Stiglitz, Joseph. 2002. Globalization And Its Discontents. New York: W.W. Norton.

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*Chief Economist, The Growth Dialogue, George Washington University School of Business. Send com-ments to [email protected], copied to [email protected].

The Changing Landscape of Innovation after the Economic Crisis: Notes from the Paris Symposium

Note: This paper draws on presentations from the Paris Symposium, sponsored by the Growth Dialogue, OECD, and the World Bank Institute, January 19–20, 2012.

The past five years have witnessed a world-wide increase in science and technology (S&T) capacity. The gains are most evident in Asian countries relative to North America and Europe. Asia equaled North American outlay on research and development (R&D) in 2009, and most observers forecast that the advanced countries will continue los-ing ground.1 The biggest gainer is likely to be China, which has raised its expenditure by about 10 percent annually over the past few years and is targeting a 2.2–2.5 percent share of GDP for R&D by 2020.2 By then it expects to have surpassed the projected R&D conducted by the United States, as well as the U.S. output of scientific papers and

1. See Mervis (2012). In most OECD countries, the crisis of 2007–08 resulted in a contraction of R&D and in the supply of venture financing in 2009. Although spending on research, particularly by large multinational corporations (MNCs), recovered in 2010, smaller firms that are unable to access public resources continue to skimp on R&D and the entry of firms in high-tech sectors has not returned to precrisis levels. See Paunov (2012). 2. In 2011, China’s spending on R&D amounted to 1.76 percent of GDP.

patents. In this respect at least, the research capacity landscape is changing, and the cri-sis, by tightening government budgets and forcing Western countries to cut spending, is accelerating the process.

Middle-income Asian countries and a few in Latin America and Eastern Europe, which have experienced a slowing of growth in recent years paralleled by declining investment,3 are seeking an alternative en-gine of growth. They are targeting aggregate growth rates of 5–6 percent per year over the medium term with the help of ‘new’ indus-trial and innovation policies that could yield sustainable gains in productivity. Countries such as Malaysia, Thailand, and Vietnam, which invest 1 percent or less of GDP in re-search, are all introducing policies that will bring them closer to the OECD average of 2 percent of GDP within a decade.

The Asian and other middle-income countries have set themselves ambitious targets of total factor productivity (TFP) growth of 2.5 percent and more per year. These targets will be difficult to reach, if their own track records of the recent past

3. Cheung, Dooley, and Sushko (2012) find that the impact of investment on growth could be weakening so a revival of investment may be less effective in rais-ing growth.

Shahid Yusuf*

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(except China) and European experience are any indication.4

Western countries are also keen to sustain or increase the share of research in GDP. However, they will be hampered by budgetary constraints, demographic trends, the continuing decline of R&D-intensive manufacturing activities, and the transfer by MNCs of R&D5 to industrializing countries.

The changing S&T landscape is of con-siderable interest in its own right. However, much more important from the standpoint of sustainable growth and welfare is its implications for innovation and how in-novation affects growth rates. R&D spend-ing complemented by an increase in the quantum of S&T skills, correlates with the output of scientific papers and patents. But the impact of R&D spending and of tertiary-level skills on productivity growth depends upon a number of factors and it can be quite small. Countries that invest an additional 1 percent of GDP in research can expect to gain no more than a fraction of 1 percent in TFP growth per year—possibly as little as 0.1–0.2 percent depending on the sophisti-cation and flexibility of national innovation systems. Even this could be squeezed if fixed capital accumulation and the share of the manufacturing sector shrink further, as they have in several middle-income countries.6

The symposium identified a number of issues relevant to R&D policy, among which the following four are uppermost:

• Is it meaningful for countries to target R&D spending in order to raise growth

4. Peak TFP growth rates between 1995 and 2009 were less than 3 percent for almost all OECD countries—the Republic of Korea and Ireland being the exceptions. Even China’s TFP growth has been declining since 2001 and is currently in the range of 2.7 percent per year. See Chen, Jefferson, and Zhang (2011). 5. In most instances, MNCs are transferring testing, product development for local markets, and down-stream, applied research.6. See Comin (2004) and CBO (2005).

and do they have the policy instruments to achieve results?

• Does the composition of R&D spending count (for example, basic vs. applied; manufacturing vs. services; high tech subsectors vs. others) and can this be influenced by policy?

• How might policies enhance the poten-tial of R&D to stimulate innovation7 (by inducing the entry of new firms) and the productivity of spillovers from in-novation?

• In a world where research activities are integrated and globe spanning, does it matter for innovation and productivity gains in any one country, where research is actually conducted?

In addressing these questions, sympo-sium participants helped to flesh out some of the answers, identified the issues deserv-ing further attention, and illuminated the known unknowns.

The Absence of Scientific Criteria for Targeting R&D The symposium reaffirmed the importance of S&T policies and the central role of quality R&D activities but it also drew attention to the absence of scientific criteria for targeting R&D.8 There is no evidence that Japan’s 3.4 percent of GDP outlay on R&D is closer to the optimal for a middle-income country than the 2.7 percent invested by the United States. Much depends upon hard-to-mea-sure R&D absorptive capacity, corporate strategies, market competition, the supply of risk capital and its uptake, the domestic macroeconomic environment and the state of the global economy. In many low- and middle-income countries the absorptive ca-

7. Policy makers in developing countries are also at-tempting to make innovation more inclusive.8. In this context, see Leydesdorff and Wagner (forth-coming) who attempt to gauge the relationship between research spending and output.

April 2012 Policy Brief No. 8 3

pacity is slow to materialize. Even when top-down directives to increase research backed by incentives to patent and publish—as in China and Singapore—produce many more scientific papers,9 their consequences for growth can be negligible. Furthermore, in most countries, 60 percent or more of the applied research and development is by the private sector and companies will increase R&D only if it is in their interests to do so10—as the European countries have discovered.11 China, with its large public sector and many government-controlled state-owned enterprises (SOEs) and research entities, can raise research activity according to plan, but few countries have the policy levers to bring about a 1 percent of GDP increase in R&D over a 10-year period. Even China took a good 10 years to achieve this outcome.

R&D spending does not automatically produce innovation. Creating a steady in-novation pipeline takes time and the patient building of linked academic and corporate research that helps generate, seek,12 and transform ideas with the government serving as a sort of midwife. Most middle-income countries are struggling to create such cultures. Thus far, few (or none) have transformed their universities into world-class institutions or built corporations that peg their international competitiveness to innovation. It is difficult to name a company

9. Publication in catalogued journals by Asian research-ers has been promoted by financial and other incentives and by the surge in scientific publications from Asian countries. See Wagner (2011). 10. The top spenders on R&D are not the ones with the best financial results. See Jaruzelski, Loehr, and Holman (2011). 11. Surprisingly, given the high private and social returns to R&D computed by economists, many com-panies prefer to maintain huge cash stockpiles that deliver negligible returns rather than invest a portion in their research activities. See Wieser (2005).12. Kodama and Suzuki (2007) describe the “receiver active” approach of Japanese firms that actively look out for research that dovetails with and enhances the value of their own.

from a middle- or low-income country that is an outstanding and consistent innovator in any sphere—although Huawei of China may soon join that league.13 At best they are highly competitive, low-cost produc-ers, some with the capacity for incremental process innovation. They have mastered the art of manufacturing and integrating with global value chains primarily serving developed-country markets.

Middle-income countries are finding that they need to increase both the number of graduates with S&T skills and the quality of training imparted because it is the latter that promotes good research.14 But virtually all are failing to raise quality even as they expand enrollment. University reform and innovation in pedagogical practices are not keeping pace with expansion. Universities in aspiring innovators such as Malaysia, Vietnam, South Africa, and Brazil are sel-dom able to attract the best students into the teaching profession and into academic research. Hence the hunt is on for trained faculty from advanced countries and col-laboration with the leading Western schools. In India, for example, a third of the faculty positions are vacant with more to follow as ageing instructors retire.15 In South Africa,

13. The Boston Consulting Group assembles a list of “New Challengers” that identifies rising firms from the MICs. The 2011 report (Boston Consulting Group 2011) identifies an imposing list of firms some of which are active incremental innovators but innovation is not as yet their strong suit. 14. This extrapolates from the link found by Hanushek and Woessmann (2007) between the quality of educa-tion as measured by test scores of secondary school graduates and GDP growth. It is also intuitively plausible. 15. A report by India’s leading scientist C.N.R. Rao, a chem-ist by profession, observed that “India’s laboratories are rife with mediocrity and its universities are in decay.” Moreover, Rao remarked “In any given area of science or engineering, the number of experts is rather small in India…. I don’t think that a professor in a university in any state in India has the freedom to think properly because he is completely cowed by the atmosphere” (Bagla 2012: 157).


well over a third of the faculty is approach-ing retirement and replacing them with equally talented teachers is proving to be a challenge.

To translate good ideas into innovation requires a deepening of entrepreneurship. Entrepreneurial talent appears to be rela-tively abundant in China and India. Else-where, including in the advanced European countries, there is a perceived dearth of entrepreneurial initiative and of young lead-ing firms (“yollies”) in dynamic industries.16

Determining the Composition of R&D for InnovationWith the benefit of hindsight we know that the composition of R&D has long-run im-plications for innovation, but determining the composition is difficult. Nevertheless, foresight analysis and Delphi (software) techniques have proven helpful in Japan and the United Kingdom in identifying priorities, evolving coordinated policies, and winning commitment.17 Doing basic research in the ‘right’ and technologically most promising areas18 is clearly advanta-geous. The problem, however, is to decide how much funding to allocate for basic research and of what sort (here foresight analysis is not helpful) and how to distrib-ute the funds among universities, research institutes, and corporations. The United States devotes 18 percent of its spending to basic research. China devotes only about 6 percent of GDP, but with a per capita GDP of US$4,500, China may be spending wisely today. As it grows richer, it could rightly divert more resources into basic research but there is no fixed target to aim for.

16. See Veugelers and Cincera (2010).17. See Martin and Irvine (1989). Forecasts have in some instances morphed into national research objec-tives and what started out as a forecast became a self fulfilling prophecy.18. The most R&D intensive industries are identified by van Pottelsberghe (2008).

Formal R&D has traditionally been fos-tered by the manufacturing sector. Electron-ics, pharmaceuticals, chemicals, advanced materials, and automotive industries have proven to be among the most research-intensive and innovative sectors and have achieved the highest rates of productivity growth (Roche Holdings led the field in 2010, surpassing Toyota, which had been largest spender for a number of years). But in all advanced and most middle-income countries, the share of manufacturing in GDP is a fifth or less. This trend is likely to persist, with manufacturing’s share of GDP possibly settling around 14 percent a decade from now (it was 17 percent in 2009, ranging from 12 percent in low-income to 21 percent in middle income countries). Although the multiplier effects of product and process innovations could remain sizable, its effects on TFP and on growth are likely to become progressively smaller. Some researchers worry19 that substantive product innovation is becoming less prolific because the cur-rent general-purpose technologies (GPTs) are tapped out. Incremental innovations in electronics (opto and other), nanotechnol-ogy, and pharmaceuticals are yielding less bang for buck and much-touted green tech-nologies still account for only a tiny share of total patents (a leading indicator of potential innovations).

Looking ahead, countries may have to rely more on innovations in services, de-sign, marketing, finance, and organization that are increasingly important as services come to dominate GDP in all countries. Thus far, few companies from middle- and low-income countries have demonstrated much competence in this regard, even those that have shown a capacity to reverse engi-neer complex equipment and products and

19. See Huebner (2005); Cowen (2011). Arthur (2011) notes that a lot of innovation might now be happening somewhat unseen because it is prompted and mediated by digital technologies and artificial intelligence (AI).


subsequently incorporate some incremental innovation. There is a lot of learning to be acquired before the habit of innovation catches on, markets mature, and consumers demand such innovation.

Companies in the Republic of Korea; Taiwan, China; and Singapore provide some insight into the difficulty of maintaining innovation. These three economies broke away from the middle-income pack, joined the ranks of high-income countries, and nurtured world class companies. However, the business school literature offers few case studies extolling their soft innovations—or even breakthrough product innovations. Samsung and Taiwan Semiconductor Manu-facturing Company (TSMC) come to mind immediately, but it is difficult to find other names to extend the list.20

Innovation in services is (formal) R&D intensive lite and until recently, the produc-tivity of most services has benefitted less from innovation.21 In particular, the produc-tivity of the fastest-growing services seg-ments such as government, health, educa-tion, construction, security, and hospitality has increased slowly if at all.22 The question that arises is should countries continue to emphasize R&D for the purposes of product innovation and in the hope of uncovering new GPTs? Perhaps they should recognize that the big future gains lie in services, de-sist from pushing conventional R&D, and

20. Undeniably, numerous companies from these econ-omies are operating at the technological frontier and many are responsible for incremental innovations in a number of manufacturing subsectors. A company such as Foxconn/Hon Hai dominates the contract manufac-turing business worldwide, but is not associated with a new business model or with disruptive innovations. Nor are such firms as Acer, Asus, MSI, and HTC, all successful electronics producers, creating innovation.21. The productivity gap between manufacturing and services was first highlighted by Baumol (1966). See also Nordhaus (2006) and Neilson (2008).22. Jorgenson showed that the construction and health sectors generated negative productivity growth in the United States between 1960 and 2007.

incentivize innovation in services. If so, we need to identify the policy levers (other than standard competition and trade polices) that will promote such innovation.

Fiscal Incentives and Institutional Reforms to Stimulate R&D and Encourage Patenting Stimulating R&D and encouraging patent-ing are steps down the road to an innovative economy. These activities can be promoted through fiscal incentives and institutional reforms that seek to optimize intellectual property protection. More ambitiously, governments are pursuing innovation policies23 that attempt to craft open and globalized innovation systems around a “triple helix” composed of the government, business, and academia. In this context, much emphasis is placed on the need to strengthen the individual elements and the connectedness among them. Many countries are attempting to build ‘world class uni-versities’ and to create university industry linkages. However, progress in the Russian Federation, South Africa, Brazil, Mexico, and Malaysia—the only worthy contend-ers—has been imperceptible. Venture and angel financing, also a priority, has been slow to materialize. Only China stands out from the rest. In China, a systematic effort to stimulate R&D and patenting began in the 1980s. It was underpinned by steadily increasing funding, and complemented by overseas training and a tremendous growth of manufacturing. China’s efforts appear to be producing an abundance of the precursors of innovation—patents and papers and a manufacturing sector, parts of which are approaching the technology frontier. But China is some distance from

23. These are the lineal descendants of the much-debated industrial policies of old, and are now making something of a comeback by way of functional, matrix-based industrial initiatives.


its goal. The innovation system as a whole is weakly interconnected. There remain quality issues with the scientific papers and with the patents, and corporate culture has still to embrace competition strategies hing-ing on innovation. How quickly the quality issues will be resolved and an innovation culture displaces a culture of imitation is a big unknown. Top-down S&T policies are not necessarily the most effective and the continuing dominance of SOEs does not help the cause of innovation. These behemoths do follow government signals and invest in R&D but they are frequently risk averse and not quick to innovate.24

It needs noting moreover, that China’s is a qualified openness. The social sciences and the liberal arts are less open to ideas and thinking from elsewhere than the ‘hard’ sci-ences. This could slow innovation, because it is now about more than a product. To succeed, innovation is increasingly packaged with complementary advances in design and services. China could prove us all wrong, but the jury is still out. The country is rapidly acquiring research capacity but has yet to embrace an open, internationally collabora-tive25 innovation system and to significantly affect the global landscape of innovation as distinct from R&D.

In fact, juxtaposing China’s efforts and achievements to date with the experience of advanced countries highlights a number of characteristics of innovative societies.

• They are open societies, hospitable to di-verse ideas and which encourage lateral thinking.

• They recognize that the future of sci-entific discovery and innovation lies in

24. The innovation value chain is complex and China is not alone in its struggle to master its workings. See Roper, Du, and Love (2008). 25. This too is changing. Many Chinese labs are work-ing closely with and under contract from foreign enti-ties, for example, in the area of gene sequencing. See Normile (2012)

large-scale international collaboration with the help of advanced software and “thick” networking.

• Their economic activity is dominated by internationally competitive firms large and small that depend for survival on ceaseless innovation, and the churning of firms results in desirable entry, creative destruction, and exit.

• Their private sector recognizes that busi-ness failure is the rule, not the exception; risk taking is the norm; and failure is widely tolerated.

• They have a deeply embedded entre-preneurial culture, and, as industry has become more technology intensive, the university system is seen as both a source of ideas and a breeding ground of entrepreneurs who transfer ideas to the marketplace.

• They have created a plethora of institu-tions to reward, market, and finance innovation through risk capital, for start-ups and supporting services, which enable new companies to survive the dif-ficult birthing process and infancy.

• Finally, they have succeeded in creat-ing clusters of manufacturing firms or services providers in major cities—often adjacent to research universities—with the help of regional or municipal policies, as-sisted by a chain of serendipitous events.

The Speed of Research Diffusion and Possible Benefits of More Selective R&D There is a body of research showing that the latest research findings diffuse slowly and that this privileges for several years the country or region where new ideas are being generated. But MNC-dominated research networks now straddle the world, and more academic research is being conducted by transnational teams. Thus, research findings are likely to diffuse with greater rapidity and


perhaps it matters less how much any one country spends on research. In fact, if we do believe that a globalized innovation system has emerged (and many do not26), then all countries would benefit if the activity of research is guided by the supply of research skills, enabling institutions, and state-of-the-art research infrastructure. Globalization calls for greater selectivity and specialization and a division of labor.27 Instead of every country piling into stem cell research or nano-pharmacology, it might be better for some to concentrate on agro-biotechnology or health services and let a more advantaged country devote its resources to stem cell re-search. The ongoing R&D arms races seem uneconomic, especially in the light of current fiscal circumstances.

The Urban Correlates of Innovation Last but not least, innovation has urban cor-relates and most if not all innovation occurs in specific urban locales. In other words, productive innovation systems are anchored to specific metropolitan areas or to regions, which over time (and rarely through long-range planning) have created a crucible in which innovation thrives.

Are such potentially innovative hotspots taking shape in middle- or low-income countries? China is trying, but other middle-income countries are making slow progress if any. Sao Paolo, Monterrey, Cape Town, and Kuala Lumpur are no closer to becoming innovation hotspots than they were a decade ago. The effort to build urban industrial clus-ters, frequently associated with innovation, has been ongoing for more than a decade. However, it really has not led anywhere except perhaps again in China. There is no creative cluster in a Malaysian or Brazilian

26. See Adams (2006) and Keller (2002). 27. Selectivity is vital for the smaller countries but also desirable for the larger ones such as the United States and (soon) China. See Wagner (2011).

city nor is one in the making. Sparse results after decades of trying might be traceable to weak policies, or it might be the case that clusters take time to materialize. Perhaps green sprouts are emerging and will begin to flower if policies supporting the demand for innovation, ameliorating risks, and reward-ing entrepreneurship are sustained.

There is a shift occurring in the distri-bution of R&D spending and associated outputs, mostly because of the rise of China. By maintaining and refining S&T policies, a number of middle-income countries can build the desired productivity-enhancing innovation capabilities over the longer term. However, in spite of the increased speed at which technologies are currently being assimilated, this may take longer than many expect. Even if the pace of innovation, especially in services, picks up, the growth generated might well be less than what the optimists want. Perhaps expectations are pitched too high. Certainly, historical experi-ence, global natural resource endowments, and the supply of global public goods do not suggest that the sort of growth rates being sought could be long sustained, even if achieved.

References Adams, James D., J. Roger Clemmons, and Paula

E. Stephan. 2006. “How Rapidly Does Sci-ence Leak Out?” NBER Working Paper No. 11997. National Bureau of Economic Research (NBER), Cambridge MA.

Arthur, W. Brian (2011). “The Second Economy.” McKinsey Quarterly 4 (October): 91–99.

Bagla, Pallava. 2012. “Top Indian Chemist Helps Make the Case for Science Windfall.” Science 335(6065}: 157–57.

Boston Consulting Group (BCC). 2011. “Compa-nies on the Move: Rising Stars from Rapidly Developing Economies Are Reshaping Global Industries.” BCC, Boston. Available at: http://www.bcg.com/documents/file70055.pdf.

Comin, Diego. 2004. “R&D: A Small Contribution to Productivity Growth.” NBER Working Paper No. w10625. National Bureau of Eco-nomic Research (NBER), Cambridge, MA.

Congressional Budget Office (CBO). 2005. “Background Paper: R&D and Productivity Growth.” CBO, Washington, DC.

Chen, Shiyi, Gary H. Jefferson, and Jun Zhang. 2011. “Structural Change, Productivity Growth and Industrial Transformation in China.” China Economic Review 22(1): 133–50.

Cheung, Yin-Wong, Michael P. Dooley, and Vladyslav Sushko. 2012. “Investment and Growth in Rich and Poor Countries.” NBER Working Paper No. 17788. National Bureau of Economic Research (NBER), Cambridge, MA.

Cowen, Tyler. 2011. The Great Stagnation. New York: Penguin Press.

Hanushek, Eric A., and Ludger Woessmann. 2007. “The Role of Education Quality for Eco-nomic Growth.” Policy Research Working Pa-per No. 4122. World Bank, Washington, DC.

Huebner, Jonathan. 2005. “A Possible Declining Trend for Worldwide Innovation.” Technologi-cal Forecasting and Social Change 72: 980–986.

Jaruzelski, Barry, John Loehr, and Richard Hol-man. 2011. “The Global Innovation 1000: Why Culture Is Key.” strategy+business 65 (Winter). Available at: http://www.strategy-business.com/article/11404?gko=dfbfc.

Jorgenson , Dale W., Mun Ho, and Jon Samu-els. 2010. “New Data on U.S. Productivity Growth by Industry.” Unpublished paper. August 19–20. Harvard University, Cam-bridge, MA.

Keller, Wolfgang. 2002. “Geographic Localiza-tion of International Technology Diffusion.” American Economic Review 92(1): 120–42.

Kodama, Fumio, and Jun Suzuki. 2007. “How Japanese Companies Have Used Scientific Advances to Restructure Their Businesses: The Receiver-Active National System of In-novation.” World Development 35(6): 976–990.

Leydesdorff, Loet, and Caroline Wagner. Forth-coming. “Macro-level Indicators of the Relations between Research Funding and Research Output.” Journal of Informetrics.

Martin, B., and J. Irvine. 1989. Research Foresight: Priority-Setting in Science. London: Pinter.

Mervis, Jeffrey. 2012. “Report Notes China’s Influence in Emerging Asian Science Zone.” Science 335 (6066): 274–75.

Neilson, Eric G. 2008. “Baumol’s Curse on Medi-cine.” JASN 19(6): 1049–53

Nordhaus, William. 2008. “Baumol’s Diseases: A Macroeconomic Perspective.” Contributions to Macroeconomics 8(1): 1382–1382. Berkeley Electronic Press.

Normile, Dennis. 2012. “China’s Sequenc-ing Powerhouse Comes of Age.” Science 335(6068): 516–19.

Paunov, Caroline. 2012. “The Global Crisis and Firms’ Investments in Innovation.” Research Policy 41(1): 24–35.

Roper, Stephen, Jun Du, and James H. Love. 2008. “Modelling the Innovation Value Chain.” Research Policy 37(6–7): 961–77.

Veugelers, Reinhilde, and Michele Cincera. 2010. “Europe’s Missing Yollies.” Bruegel Policy Brief 2010/06, August. Available at: http://aei.pitt.edu/14847/1/PB-RVMC_Yol-lies_27082010_01.pdf.

van Pottelsberghe, Bruno. 2008. “Europe’s R&D: Missing the Wrong Targets?” Intereconom-ics, July 2008. Available at: http://www.bruegel.org/publications/publication-detail/publication/259-europes-r-and-d-missing-the-wrong-targets/.

Wagner, Caroline S. 2011. “The Shifting Land-scape of Global Science: A Challenge for Unit-ed States Policy.” Available at: http://www.carolinewagner.org/shifting-landscape-pre-publication-version.html.

Wieser, Robert. 2005. “Research and Develop-ment Productivity and Spillovers: Empirical Evidence at the Firm Level.” Journal of Eco-nomic Surveys 19(4) 587–621.

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