China is not always synonymous with the concept of innovation

China is not always synonymous with the concept of innovation. The country is instead more commonly seen as one that piggybacks on the ideas of others, using its vast labour force to mass produce the same goods more cheaply

However, a report published on Wednesday by the McKinsey Global Institute claims innovation will need to account for as much as half of China’s economic growth if Beijing is to hit consensus growth forecasts of 5.5 to 6.5 per cent a year in the coming decade

“If we don’t see innovation on the scale that we are advocating, we would call the growth forecasts into question,” says Jonathan Woetzel, a Shanghai-based director of the institute. “[If we do], the resulting ‘China effect’ on innovation has the potential to disrupt markets and industries and could reshape global competition.” “

MGI points out that the traditional drivers of China’s economic growth are weakening. Because of its ageing population, China’s labour force could peak as early as next year and fall 16 per cent by 2050, it predicts. MGI

Moreover, with the easy yards already made, MGI says it now takes 60 per cent more capital to produce one unit of gross domestic product than it typically did between 1990 and 2010

As the first chart shows, $5.4 of capital are now needed to produce $1 of Chinese GDP, up from $3.4 between 1990 and 2010. MGI forecasts this will rise to $7.6 by the second half of the next decade, closer to current norms elsewhere in the world

Investment is also likely to be constrained by China’s rising debt load that, at 282 per cent of GDP, according to MGI, is higher than in the likes of the US and Germany

With growth in energy supply also likely to slow, MGI forecasts that GDP growth arising from an increased supply of the factors of production (labour, fixed capital and energy) will be only 3.4 per cent a year in the decade to 2025, down from 6.2 per cent between 2000 and 2010 and 5.6 per cent from 2010 to 2014

To a large extent this is built into GDP forecasts, with expected growth of about 6 per cent in the next decade well below the 10.5 per cent rate achieved between 2000 and 2010 and the 8 per cent level seen from 2010 to 2014

But multifactorial productivity growth, squeezing more output out of each unit of input — which MGI is loosely defining as innovation — would still need to account for 35 to 50 per cent of future economic growth for China to meet expectations, up from 30 per cent at present (see the second chart). GDP

Using this definition of innovation, Mr Woetzel argues that China “has not only made more progress than it is given credit for, but it has also created new approaches to innovation that are faster, cheaper and can work on a global scale”

Yet this progress has been patchy. MGI divides industries into four types of innovation. It argues China has made most progress in what it terms “efficiency-driven” innovation, sectors where improvements in production processes, product design and supply-chain management are central, lowering costs and accelerating time to market

In nine of the 12 efficiency-driven industries MGI analysed, such as solar panels, generic pharmaceuticals and steel, China’s share of global revenues is greater that its share of global GDP, at some 12 per cent as of 2013 (see the last chart)

Its success stories include Broad Construction, which assembled a 57-storey hotel in Changsha in just 19 days from prefabricated components, and Everstar, which allows consumers to customise clothing and receive the finished goods within 72 hours

The country has also made headway in “customer-focused” industries, defined as ones where innovation involves “identifying and addressing customer needs to develop new products”

Here China has an outsized share of three of MGI’s seven sectors: household appliances, internet software and services, and internet retailing

It remains weak in some sectors, such as smartphones, but this may be changing. MGI gives the example of smartphone maker Xiaomi, which has 1m “fans” who vote online for new features that then appear in weekly software updates

However, McKinsey points to significant weaknesses in two other arenas. In engineering-based industries, where companies innovate by solving engineering problems, it found Chinese companies generated 41 per cent of global railway equipment revenues and 20 per cent of those for wind power but a disproportionately small share of revenue in areas such as autos and commercial aviation

The picture is worse still for science-based industries, where innovation involves making discoveries and turning them into products. In each of the four sectors here, such as branded pharmaceuticals and biotechnology, China is a weakling

Overall, MGI says China’s service industries are only 15 to 30 per cent as productive as the average across the (mostly advanced) OECD nations. Internet-based innovations to expand services, improve quality and make service delivery more efficient could create value of $550bn to $1.4tn a year by 2015, the institute says

In manufacturing, China’s advantage of low labour costs has started to erode. However, MGI says its still relatively cheap labour and “superior ecosystem” give it “compelling” advantages in “next-generation” manufacturing, encapsulating advances such as the embedding of internet-of-things sensors in all products, advanced robotics and 3D printing

The could create value of $450bn to $780bn a year by 2025, making a total of $1tn to $2.2tn a year, although this still falls short of the $3tn to $5tn a year McKinsey calculates China will have to generate from innovation to meet consensus growth forecasts

It says Beijing can do more to help by expanding access to capital for small and medium-sized enterprises and entrepreneurs, enhancing the quality of regional innovation clusters, improving protection of intellectual property and upgrading the allocation of funding for scientific research

“China has the potential to evolve from an ‘innovation sponge’, absorbing and adapting existing technology and knowledge from around the world, into a global innovation leader,” says Mr Woetzel

“Our analysis suggests that this transformation is possible, though far from inevitable.”