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5 reasons China could become an innovation leader

Eng Teck Tan and Glenn Freeman  |  29 May 2018Text size  Decrease  Increase  |  
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China is ideally positioned to throw off its traditional association with original equipment manufacturing and become the Silicon Valley of the east, writes Eng Teck Tan for Nikko Asset Management.

While China’s first phase of innovation was concentrated in manufacturing, logistics and supply chain management, its more recent advancements have been concentrated in technology and healthcare. We believe this next wave will broaden to biotechnology, artificial intelligence, security and robotics, with its move up the value chain taking place in 10-30 years – at a break-neck speed compared to the 60-70 years it took the US. Disruption will be the name of the game as future breakthroughs focus on improving efficiencies and throughput in existing industries.

From our analysis of leading innovative hubs such as California, where Silicon Valley is widely regarded as the crucible of creative technology developments, and Massachusetts – known for cutting-edge drug discovery – we distilled five important factors needed to successfully cultivate innovation.

1. Large domestic market

The world’s most populous nation is more traditionally known for producing cheap copies of existing products that line hypermarket shelves of around the world. However, we argue that with its natural advantage of a vast talent pool, financing and market access, China has most of the ingredients needed for success. The key factor is its large domestic market, which affords companies the cash cow to fund overseas expansion.

Japan and the US have proven this concept with their sizeable domestic reach. In the case of Korea and Taiwan, while many of their enterprises are extremely creative, they lack a large enough domestic market to incubate and grow into massive multinational companies.

Entering foreign markets requires financial muscle – to cushion the blows from incumbents – and a fat cash cow at home to milk while enduring losses as brand recognition is built over time. For example, Taiwan smartphone maker HTC’s global expansion has been sub-par, mainly because its home market is too small to afford it the cash-burn needed when going overseas to establish a name. Most mid-sized Korean firms have also had middling success, except for the large chaebols such as Samsung and Hyundai.

Conversely, China is at the forefront, with its huge and deep market of 330 million middle-class Chinese eager to embrace new ideas and technologies. Although termed an emerging market, its diverse consumer base provides a huge test bed for both mass and niche products, which is a needed to breed innovation.

China also has the advantage of leapfrogging technology, as seen when the country moved directly to using mobile phones and skipped pagers. This phenomenon enables it to decisively adopt new technologies with no legacy issues. Hence the speed of adoption is rapid with 731 million Chinese having access to the internet at 53 per cent penetration and 95 per cent of internet users accessing mobile internet.

2. Government support

Although many of the US companies disrupting industries today are private enterprises, in our view, most major technological advancements since World War II were initially driven by the government.

The ubiquitous internet and global positioning system (GPS) were both publicly-funded, with the latter developed as a US military technology for space-based radio-navigation system. These inventions were then further developed for other commercial applications at substantial cost efficiencies.

Government support has enabled Chinese company Huawei to develop into the world's third-largest smartphone maker. Another lesser-known company, Hangzhou Hikvision, manufactures surveillance cameras that are now top-sellers in Europe and the US. Its growth came on the back of support from the government, which was keen to equip all train stations with video cameras following a 2014 terrorist attack in Yunnan. The Shenzhen-listed company, which is ultimately 42 per cent owned by the Chinese government, reported latest first half 2017 net profits of RMB 3.3 billion.

3. Good ideas are a necessary ingredient

China has reached a critical mass in research and development (R&D) spending, with clusters quickly forming around existing and future hubs. The country now tops worldwide filings for patents, trademarks and designs, with new applications exceeding the combined total of the US, Japan, Korea and the European Patent Office in 2016. This perhaps foreshadows the rise of a new technology superpower.

Extending outside the usual capital and financial cities of Beijing and Shanghai, six Chinese cities alone filed more patents per 10,000 residents than Silicon Valley in 2015.

4. Skilled staff and management

The Chinese government’s courtship of returning talent has borne some fruit, with many “hai guis” returning to start or head Chinese companies and lending their expertise to contribute to the fourth factor necessary for innovation success. In the case of drone maker Dajiang Innovative Technology, known as DJI, founder Frank Wang Tao returned to Shenzhen in 2006 from building prototypes of flight controllers out of his dorm room at the Hong Kong University of Science and Technology. DJI drones now comprise a market share of 80 to 85 per cent in consumer drones.

5. Easy access to funding

One of the key features contributing to the US market’s success is its developed capital market where start-ups can easily raise funds.

In the 1990s and 2000s, China relied heavily on foreign direct investment to fuel its growth. Now the situation has all but reversed, with funds from China flowing overseas as newly affluent locals hunt for overseas opportunities. Foreign private equity players are now eager to fund good ideas, overcoming their notorious reluctance to invest in Chinese startups.

China attracted US$31 billion in venture capital in 2016 – 25 per cent of the global figure – with companies drawn by benefits such as tax breaks. Provincial governments also have schemes to attract capital, with Hubei province alone having a US$81 billion fund for investments.

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Eng Teck Tan is senior portfolio manager, Asian equity, with Nikko Asset Management.

Glenn Freeman is senior editor, Morningstar Australia.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

Eng Teck Tan is senior portfolio manager, Asian equity, with Nikko Asset Management. Glenn Freeman is senior editor, Morningstar Australia.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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