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III RESEARCH PAPER

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China’s Drive Toward Innovation Alan Wm. Wolff1 Dewey Ballantine LLP October , 200 On the road into Suzhou, a large rooftop sign proclaimed “Development is an Immutable Truth” in English under massive Chinese characters. The mes- sage was from Deng Xiao Ping, and although it has been translated in various other ways over time, the message is unmistakable: There is one acceptable path for China and that is economic development. This sentiment might not seem remarkable in any country seeking to industrialize. But in China, it carried special force. 1Author: Alan Wm. Wolff, Managing Partner, Dewey Ballantine LLP, Washington D.C. office, was a member of The National Academies’ Board on Science, Technology, and Economic Policy (STEP Board) from 1997-2004. The Council of the National Academy of Sciences and the Governing Board of the National Research Council then designated Mr. Wolff as a lifetime “National Associate” of the National Academies. From April 2005 to the present Mr. Wolff is serving as a member of the Com- mittee on Comparative Innovation Policy: Best Practice in National Technology Programs. This article draws on a presentation made to the “Conference on Regional and National Innovation,” co-hosted by the U.S. National Academy of Sciences and the Flemish Government, in Leuven, Flanders, Belgium, on September 21, 2006. The author gratefully acknowledges the splendid research capabilities of the Dewey Ballantine LLP International Trade Group whose research efforts are overseen by partner Thomas R. Howell, its lead research experts Rachel Howe and Maki Hishikawa, and the devoted assistance of Gabriel Key and Maxine Walker. I also benefited from confirmation of my conclusions gained through exposure to discussions with many experts on the subject of Chinese innovation at the Levin Institute in July 2006, when this project was already well formed. The views expressed here are of a legal practitioner, former government negotiator, and an advisor to major companies engaged in trade and not those of a formal scholar, which accounts for the perspectives, insights, and undoubted shortcomings, but also its perspective. The views are solely those of the author, and not necessarily those of his firm, its clients, or the National Academies. 127

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12 INNOVATIVE FLANDERS Deng’s message has been refined over time by his successors but never diluted. In 1999, Jiang Zemin stressed the importance to China of innovation: 2 In today’s world, the core of each country’s competitie strength is intellectual innoation, technological innoation and high-tech industrialization. The current leader, Hu Jintao, continued this emphasis, incorporating innova- tion as the guiding direction for national policy. [We should gie] priority to independent innoation in S&T [Science and Tech- nology] work, take efforts to enhance S&T innoation capability, increase core competitieness and [strie to make] S&T innoation with Chinese character- istics a reality. We must aim to be at the forefront of the world’s S&T deelopment, speed up the building of [a] national innoation system,…strengthen the coordination of eco- nomic policies and S&T policies, [and] create a policy enironment beneficial to technological innoation, high-tech deelopment and industrialization.3 In the Chinese system of governance, statements like these shape national and local policies. There is a singularity of purpose in China rarely found in Western governments even when comparable sentiments are on occasion expressed.4 2Jiang Zemin, General Secretary of the Communist Party of China Central Committee, keynote speech, National Technological Innovation Conference, August 23, 1999. 3Hu Jintao, General-Secretary of the CPC Central Committee, November 27, 2005, as quoted at . 4Cf. TOKYO (XFN-ASIA)—Prime Minister Shinzo Abe has said he will make goernment leaner and foster innoation to pilot the economy through the threats posed by a shrinking and aging population. In his first policy speech to Parliament since taking office this week, Abe said technological adances were ital to ensure sustained economic growth. . . . “It is possible to bring about economic growth een if the population shrinks. Through innoation and open-minded policies, I promise to infuse itality into the Japanese economy,” said Abe. Japanese PM aims for leaner government, innovation 09.29.2006, 02:39 AM, Forbes Magazine Web site. Cf. also the following White House announcement: America’s economy leads the world because our system of priate enterprise rewards innoation. Entrepreneurs, scientists, and skilled workers create and apply the technologies that are changing our world. President Bush beliees that goern- ment must work to help create a new generation of American innoation and an atmosphere where innoation thries. On April 2, 200, President Bush announced a series of specific measures to inspire a new generation of American innoation—policies to encourage clean and reliable energy, assure better deliery of health care, and expand access to high-speed Internet in eery part of America. By giing our workers the best technology and the best training, we will make sure that the American economy remains the most flexible, adanced, and productie in the world. White House Web site, . And for the European Union: “Ten priority actions to achiee a broad-based innoation strategy for the European Union. The aim of the Communication is to present ‘a broad based innoation strategy for Europe that translates inestments in knowledge into innoatie products and serices’. The Com-

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12 RESEARCH PAPER These pronouncements of China’s top leaders have been accompanied by an amazing array of detailed policy measures at all levels of government. China is already well into a process of industrializing. What Beijing has decided to do is “. . . to move China from an imitation to an innovative stage of production . . . from ‘made in China’ to ‘made by China.’”5 Innovation is seen by China’s leadership as essential for China to continue its economic growth, maintain political stability, support advanced military capabili- ties, and retain China’s global trade and geo-political power. In short, for China, innovation was to be a policy of unrivaled importance. The prominence given to innovation as state policy and the resources devoted to it make it unwise to dis- count the likelihood of success despite the many obstacles still to be overcome. Moreover, it should not be forgotten that throughout most of recorded history Chinese science and technology was superior to that of another nation and even that of all other nations combined.6 China has not forgotten. Foresight is rarely granted to us. A world view in 1950 would have been unlikely to have anticipated Japan’s achievements in manufacturing and inter- national trade during the next 40 years nor the successful creation of a European common market, and its joint endeavors like the Airbus. ARCHITECTURE OF THE CHINESE INNOVATION POLICY SYSTEM This is a fascinating time in Chinese development. With respect to inno- vation policies and their implementation, there is much emerging. China has released policies encouraging science and technology development in the past, 7 munication proposes a ten-point programme for immediate action to make the business enironment more innoation-friendly.” MEMO/0/2, Brussels, September 1, 200. The action plan memo is available on the Europa Web site, . 5Kathleen Walsh, Testimony before the U.S.–China Economic & Security Review Commission, April 21, 2005. 6For example, China was familiar with cast iron and coal firing in the fifth century B.C., and was probably smelting ore with coke by the thirteenth century A.D. Europe, by contrast, did not cast molten iron before the fourteenth century A.D., and smelting with coke did not come into common usage until the last years of the eighteenth century. Paper was invented in China and the technology was transferred to Europe via the Islamic countries. The Chinese were producing gunpowder in the ninth century A.D. and firearms in the eleventh century, long before Europe. Printing presses with movable type were being used in China in the ninth century A.D. when Europe was still in the Dark Ages and over five hundred years before Johann Gutenburg “invented” the printing press in Germany. Chinese scientific concepts known to have diffused to the West include quantitative cartography, magnetic science, and the double-acting principle of rotary and longitudinal motion. See Joseph Needham, Science and Ciilization in China (five volumes), Cambridge: Cambridge University Press, 1954-1986; Fernand Braudel, Capitalism and Material Life 100-100, London: Harper Colophon Books, 1973. 7China began issuing science and technology specific programs in earnest in the 1980s. Significant previous efforts include the Key Technologies Research and Development Program (1982), the 863

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10 INNOVATIVE FLANDERS but China’s new Innovation Policy is different, both in depth, because it involves long-term technology planning beyond single-ministry technology development programs, and in breadth, because its execution is broadly dispersed among a half-dozen ministries at the central-government level, as well as at the provincial and local levels, and is strengthened by powerful and ongoing policy tools, such as government procurement, that give the broad policy initiative teeth.8 The basic documents for China’s Innovation Policy include China’s Medium and Long Term Program on Science and Technology Development (2006-2020), the unfolding of the 11th Five-year Plan (2006-2010) and in all probability the new National IPR strategy. Even when underlying documents are not yet pub- lished or fully elaborated, the tenor of the strategy can be identified in the state- ments of central government and provincial officials. The overarching document to China’s innovation planning and strategy is the Medium and Long Term S&T Program. To achieve the objectives of the plan, a variety of policy tools are being used to promote, favor and reward indigenous innovative technologies. An overall goal is to increase R&D spending to 2.5 per- cent of GDP by 2010, a doubling over the current rate. The 2010 target is compa- rable to the current rate of spending by the United States, is 0.6 percent less than Japan’s and 0.6 percent more than the European Union’s. The expected doubling in China’s spending will be accompanied by the implementation of key state proj- ects “. . . launched to generate important strategic products. . . .”9 Their breadth and scale are huge. In the United States, comparisons might reasonably be found in American investments during the period 1945-1991 in telecommunications, space exploration, communication, aeronautics, and energy. The Medium and Long Term plan identifies 16 key state projects covering a number of priority sectors, and represents an enormously ambitious series of undertakings: • Core electronic components; • High-end general chips; • Basic software; • The technology for manufacturing extremely large integrated circuits; Program (1986), the Torch Program (1988), the Spark Program (1986), and the 973 Program (1998). China added strategic emphasis in the 1990s with incentives, offered specifically through the Tenth Five-Year Plan for Science and Technology (2001-2005). 8Many of the 99 regulations supporting the State Council’s innovation policy (the long-term science and technology plan) will be drafted by NDRC (approximately 29), many others by MOST (approxi- mately 17), some by MOF (approximately 21) and the Ministry of Education (approximately 9), and the remainder by miscellaneous other government agencies, including MII and MOFCOM. 9State Council of the People’s Republic of China, Outline of the National Medium-and Long-Term Program on Scientific and Technological Deelopment, (200-2020), February 9, 2006, Provisional Translation from Chinese on file, original available at: .

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11 RESEARCH PAPER • New-generation broadband wireless mobile telecommunications; • High-end numerically controlled machine tools and basic manufacturing technology; • Development of large oil and gas fields; • Large nuclear power plants with advanced pressurized water reactor high- temperature gas-cooled reactors; • Control and treatment of pollution in water bodies; • Nurturing of new, genetically modified biological species; • Development of important new drugs; • Control and treatment of major contagious diseases such as AIDS and viral hepatitis; • Large aircraft; • High-resolution earth observing system; • Manned space flights; and • Lunar exploration projects.10 The central government has committed to releasing 99 policies elaborating goals of the Long-Term S&T Plan by the end of 2007 and has already released several of these documents. A sampling indicates the breadth of their coverage:11 10Ibid. 11Guo Ban Han [200] No. 0 (A Letter in Reply from the General Office of the State Council on Approving the Formulation of the Rules for Implementation of the Several Supporting Policies for Implementation of the Outline of the National Medium and Long-term Plan for Development of Science and Technology), Gazette of the State Council, Issue No. 17 Serial No. 1196, June 20, 2006. Available at (provisional translation on file). So far, 5 of the expected 99 documents to be issued in support of the Long-Term S&T Plan are known to be published. The full set of 99 is expected to be published by the end of 2007. The titles and subject areas for the five published are listed below: 1. Guidelines for Priority Areas of High-tech Industrialization and Deelopment, June 200, most recent and is sixth on the State Council’s list of those 99; underscores the importance of focusing on industries with independent innovation. 2. Proisional Regulations on the Management of State Projects of High-tech Industry Deelop- ment, February 2, 200. This document provides general guidance on the organizational structure and management operations of national high-tech projects. 3. Notice of the General Office of the State Council on Distributing Guiding Opinions on Build- ing State Engineering Laboratories, July 1, 200. This document provides that a core group of new national engineering laboratories will be established, in part to reduce dependence on foreign technology. 4. Measures pertaining to the Selection of Postgraduate Students Sent abroad by the State for Public Duties 200, undated. This document states that outstanding postgraduate students sent abroad will be identified and honored. 5. Seeral Opinions of the Ministry of Commerce, National Deelopment and Reform Commission [et al.] on Encouraging Technology Introduction and Innoation and Promoting Reform of Foreign Trade, July 1, 200. This document identifies nine industries in which foreign technology acquisition will be particularly encouraged.

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12 INNOVATIVE FLANDERS • Accelerating Creation of Independent, ‘Well-known’ Chinese Brands; • Supporting Technology Innovation of Small and Medium-sized Enterprises; • Issuance of Corporate Bonds for Qualified High-Tech Enterprises; • Regulation on Management of Start-up Investment Funds and Debt Financing Ability of Start-ups; • Suggestions on Establishing and Improving Regional Intellectual Property; • Standardizing Foreign Acquisition of Key Chinese Enterprises in the Equipment Manufacturing Industry; • Building Research-Orientated Universities; • Promoting the Development of State Supported High and New Tech- nology Industry Development Zones; • Establishing Guidelines and Funding for Venture Capital Investment; • Creating Tax Policies Supporting the Development of Start-ups; and • Establishing “Green Channels” for High-level Talents Who Have Studied Abroad to Return to China. The breadth and depth of this undertaking are massive by any measure and are designed to equal results achieved by further evolved market economies that had a head start of decades and, in some cases, more than a century. This requires China to acquire a financial, educational, and legal infrastructure quickly to support an economy whose growth is based on innovation. WHY INNOVATE? The motivation for this grand effort was described in National Development and Reform Commission Minister Ma Kai’s recent remarks:12 . . . [W]e will promote deelopment by relying on enhancing independent inno- ation capability, take it as a national strategy and shift economic growth from relying on the input of capital and material factors to relying on scientific and technological adancements and human resources. This is a solution put forward to address the bottlenecks of science and technology and human resources China encounters in economic and social deelopment. China’s economic growth largely relies on material inputs and its competitive edge is to a great extent based on cheap labor, cheap water and land resources and expensive environ- mental pollution. Such a competitive edge will be weakened . . . with the rising price of raw materials and the enhancement of environmental protection. Therefore, we should enhance [our] independent innovation capability . . . and increase the contribution of science and technology advancement[s] to [our] economic growth. . . . 12Ma Kai, Minister, National Development and Reform Commission, The 11th Five-Year Plan, March 19, 2006, available at .

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1 RESEARCH PAPER In fact, a primary emphasis of the 11th Five-Year Plan period is to “give more strategic importance to developing education,” creating a large number of “highly talented people [to build] . . . a strong nation with abundant human resources.” INNOVATION POLICIES Intellectual Property In the course of being developed is also the National Intellectual Property Rights strategy. Lu Wei, deputy director general of the Technical Economic Department, Development Research Center of the State Council, described the policy in the following terms:13 To adapt the Strategy to China’s deelopment situation, there are three fields that we shall pay attention to: First, [we shall] abide by international principles and meet the lowest protec- tion standards of the WTO, and offer reasonable protection. Second, [we shall] not only encourage self innoation, but also encourage absorption, consumption, and innoation of introduced technologies and pay attention to IPR protection of technological transactions and technological licenses. Third, [we shall] strengthen the antimonopoly [actiities] related to IPR and prohibit multinationals from shutting domestic enterprises out of the market using IPR. This statement is of interest at various levels. It is considered important by China’s policymakers that China protect intellectual property, because most IP is foreign, and there will be no opportunity to attract and absorb foreign technolo- gies without the protection of intellectual property. However, there is also a strong sense that excessive dependence on foreign technology is harmful to China. Therefore, adherence to “the lowest protection standards of the WTO [World Trade Organization” allows China to honor the letter of its WTO commitments while protecting and preserving China’s domestic markets for domestically pro- duced “innovation” goods. The schizophrenia over the need for and reaction against the influx of for- eign technology is also evident in discussion of potential for use of China’s new antimonopoly law (discussed further below) to impede competition from foreign companies with strong patent portfolios for the benefit of domestic competitors. 13Wang Changyong, “IPR Sails Against Current Stream,” Caijing Magazine, October 17, 2005. Available at .

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1 INNOVATIVE FLANDERS Standards Policy A tool China intends to use to promote indigenous innovation (and restrain foreign competition) is standards setting. The recently promulgated Shanghai Municipal Government Intellectual Property Strategy demonstrates how stan- dards setting can be used to foster innovation. The Shanghai Strategy states: 14 [We shall] actiely promote the formulation and implementation of technical standards with self-owned intellectual property rights and translate that tech- nological adantage into a marketplace adantage to maximize the benefits of intellectual property rights. This sentiment is carried one step further in the National Medium and Long Term Program on Scientific and Technological Development.15 [We shall] actiely take part in the formulation of international standards, and drie the transferring of domestic technological standards to international standards. . . . The recent and highly contested case of the WAPI wireless standard is an example of this policy in practice. With WAPI, China sought to impose an indigenous, not internationally recognized standard for wireless networking within China. Although China was entirely within its rights to impose this standard for domes- tic consumption, the plan would have required each foreign supplier of wireless computers to share its proprietary technology with a Chinese partner company. In turn, the Chinese partner would supply an essential encryption algorithm, without which the product would have been denied access to the Chinese market. After receiving strong representations from Colin Powell and other U.S. cabinet secretaries, the plan was put on hold indefinitely. That was not the end of WAPI, however, as China has attempted to have its WAPI domestic standard recognized and accepted at WIPO (the World Intellectual Property Organization). As yet, little progress as been made by China toward attaining that objective. 16 14Shanghai Municipal Government, Notice of the Shanghai Municipal Goernment Regarding Dis- tributing the Outline of Shanghai’s Intellectual Property Strategy (200-2010), September 14, 2004. Provisional translation on file; original available at . Shandong province has issued a similar policy statement. See People’s Goernment of Shandong Proince, Outline of Shandong’s Intellectual Property Strategy, July 14, 2005. Provisional translation on file; original available at . 15State Council of the People’s Republic of China, Outline of the National Medium-and Long-Term Program on Scientific and Technological Deelopment (200-2020), February 9, 2006. Provisional Translation from Chinese on file; original available at . 16Yang lei, ed., “Chinese WAPI Delegation Quits Prague Meeting,” Xinhua, June 8, 2006. Available at .

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1 RESEARCH PAPER Government Procurement Another policy instrument used by China to seek to foster innovation is gov- ernment procurement. Government procurement has long been a tool to provide preference and protection to developing industries. The WTO’s Government Procurement Agreement is designed to ensure that member governments utilize open, transparent, competitive, unbiased, merit-based, and technologically neutral procurement procedures. In 2001 China committed to initiate negotiations for membership in the GPA “as soon as possible,”17 and at the April 2006 U.S.–China Joint Commission on Commerce and Trade (JCCT) meeting stated: “Negotiations on China’s entry to the GPA will be launched no later than the end of December 2007.”18 However, recent Chinese policy documents indicate that China intends for its state institutions to go against the basic tenets of the GPA: We shall . . . introduce an open, fair and square competition mechanism to em- body preferential policies for goernment procurement. . . . Finance departments at proincial leel shall work with the science and technology departments at the same leel to establish implementation plans for deeloping indigenous innoation goernment procurement policies for their proinces.19 Due to the prominent role China’s centralized governmental structure plays in China’s economy, the use of a discriminatory government purchasing policy at the central, provincial, and local levels can provide a significant amount of protection to foster indigenous innovation and may have a very powerful negative effect on trade. The State Council has decreed: The goernment shall set a priority procurement policy on important high-tech equipment and products deeloped by domestic enterprises with independent intellectual property. [We shall] proide policy support to enterprises purchas- 17Working Party on the Accession of China, Report of the Working Party on the Accession of China WT/MN(01)/3, November 10, 2001. 18Transcript, Press Conference with U.S. Commerce Secretary Carlos Gutierrez, U.S. Secretary of Agriculture Mike Johanns, U.S. Trade Representative Bob Portman, Chinese Vice Premier Wu Yi at the Annual Meeting of the U.S.–China Joint Commission on Commerce and Trade, The Department of Commerce, Washington, D.C., April 11, 2006. Available at . See also Inside US-China Trade, Industry Worried China Backing out of Commitment to Join GPA, September 27, 2006. 19Chinese Ministry of Finance, Opinions of the Ministry of Finance on Implementing Goern- ment Procurement Policies That Encourage Indigenous Innoation, Cai Ku [2006] No. 47, June 13, 2006. Provisional Translation from Chinese on file; original available at .

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10 INNOVATIVE FLANDERS Direct Funding Direct government financial support is also an important part of Chinese gov- ernment innovation policy as it is for all countries seeking to promote innovation. Thus, for the most part, China is not out of step with its competitors in seeking to promote indigenous technological development through government funding. One example from the current Chinese experience consists of the measures to promote the development of a domestic equipment manufacturing industry, mea- sures which include:39 Preferential taxation;40 • Incentives for purchase of Chinese-made machinery;41 • • VAT rebates on imported parts and materials; Allocation of special funds for technologically advanced products; 42 and • • Relief of enterprises’ “social responsibilities.” While the phrase “relief of enterprises of social responsibilities” has not been defined, American automobile producers (and former executives of former steel manufacturing companies) can testify that if this means “legacy costs,” that is, health and pension costs of retired workers, among other “social responsibili- ties,” relief of these costs can mean the difference between profitability, stunning losses, and in the extreme, but all too well known cases, bankruptcy. 43 By far the highest profile recent instance of government funding is the announced agreement by two municipalities to attract semiconductor fabrication facilities through 100 percent funding of capital costs of a private company. The beneficiary is SMIC (the Shanghai Manufacturing International Corporation), a major semiconductor foundry. SMIC has announced that it will receive the benefit of construction of two new chip fabrication facilities, from Chengdu and Wuhan 39State Council, Seeral Opinions on the Reitalization of the Equipment Manufacturing Industry, published on June 28, 2006. 40The Ministry of Commerce (MOFCOM), NDRC, and relevant state organs are to implement specific preferential tax policies, provide exemptions from tariffs, and provide value-added tax rebates with respect to the importation of key parts and raw materials used to develop key equipment and projects. 41Companies are encouraged to purchase their “initial” equipment from domestic manufacturers. Purchasers, equipment makers, and insurance companies are to work together to share risks and profits arising out of such purchases. Insurance companies will be guided to provide insurance coverage to the companies making domestic purchases. 42Increasing financial support to key technological equipment manufacturers. The government will allocate special funds annually for the creation of key programs and technologically advanced projects. 43Relieve enterprises’ societal responsibilities. National and local governments are to provide funds and support to relieve enterprises of their “societal responsibilities.” The state-owned Assets Supervi- sion and Administration Commission of the State Council are to facilitate this process and reduce social burdens on enterprises. China State Council Issues Opinions on Equipment Manufacturing Industry, Dewey Ballantine LLP, available upon request.

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11 RESEARCH PAPER (and Hubei) local government agencies. This amounts to a grant equivalent to billions of U.S. dollars. SMIC is to receive an operating contract and the plants are dedicated for the sole use of SMIC. According to press reports, SMIC will also receive a “management fee” and will have the option to buy the plants in the future. Current profits from operations would be retained by SMIC. This goes beyond most examples of innovation funding as far as I know and is one of the most extreme cases.44 High-tech Incubation Parks Information on company-specific benefits is not usually publicly available to this extent, especially in the case of state-owned enterprises. A more common, historic, and well-documented form of support for private enterprise is the use of industrial incubation parks, which in China are built on a scale not seen anywhere else on the planet. The parks are the showcases and a chief element of pride of Chinese government innovation planners. As Ministry of Science and Technology official Xu Lupin said, “China considers science parks to be central to its efforts to build capacity for innovation. . . .”45 Thirty more parks are planned to be established by 2010. By 2004, parks had accounted for 38,565 participating companies, US$ 226.4 billion of production, and US$19.7 billion investment in infrastructure.46 44The business model includes an option to buy fabs in 3-5 years “at original price.” “[w]e have 100% of the authority to operate and to manage the fab, and to fully use that capacity.” [“Semiconductor Manufacturing International Q1 2006 Earnings Conference Call,” April 27, 2006.] “[t]he profit from this operation belongs to us, and we will pay whatever we need to the fab owners. So this is the method. Almost like we rent the fab, almost like that. It’s basically outsourcing a model.”[“Semiconductor Manufacturing International Q1 2006 Earnings Conference Call,” April 27, 2006.] Wuhan Xinxin Semiconductor Manufacturing Corp. SMIC announced at the end of June that it is participating in a multi-billion dollar fab investment being made by the Hubei provincial and Wuhan city governments. “Chinese Government Builds 300mm Fab,” Semiconductor Fabtech, June 28, 2006; “Chinese Province Pays to Get 300-mm Wafer Fab,” EE Times, June 28, 2006; “Chip Giant Quickens Steps of Expansion,” TMCNET, June 28, 2006. For the time being, the entity is fully government-owned and financed by an investment company associated with the Hubei Provincial Government, Wuhan City Government, and the Wuhan East Lake New Technology Development Zone. SMIC describes its participation as a management contract under which SMIC “will not invest any money to construct or equip the wafer manufacturing facili- ties but will manage the operations, including the wafer loadings, of the facilities.”[Semiconductor Manufacturing International Corp. Form 20-F for Period Ending December 1, 200, p. 23.] SMIC reportedly signed an MOU in conjunction with this contract in March 2006. [“SMIC Gets $3B Nod from Chain’s Wuhan Government,” Electronic News, May 22, 2006.] The SMIC example may well not be out of the ordinary in China where State-owned enterprises account for a substantial portion of the economy. 45Wu Ching, China to Build 30 new science and technology parks, SciDev.net, April 19, 2006, available at . 46Dr. Yong Shang, Vice Minister Science and Technology China, Speech, “Innovation: New National Strategy of China,” as presented at Levin Institute Conference, “Industrial Innovation in China,” July 2006.

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12 INNOVATIVE FLANDERS A good example is the Tianjin Binhai New Area, which claims investments from 69 companies of the top Global 500 and 42 R&D centers. On May 26, 2006, the State Council declared the project of “national importance.” The pur- pose of the Binhai Hi-Tech Industry Park is to import S&T personnel, R&D institutions and “knowledgeable enterprises,” and provide them with support services for patent applications, investments, finance, and corporate regulation. The stated goal is to have the Binhai New Area become the “medicine port” for East Asia.47 As is often the case in China, different areas are in sharp competition with each other to incubate new industries and foster innovation. This has been the case with Shanghai and Beijing for some time, with major bids being made by Wuhan and Chengdu and numerous others. Shanghai Zhangjiang Hi-Tech Park aspires to become both China’s Silicon and Pharmaceutical Valleys. China’s “Pharmaceutical Valley,” occupying 16 square kilo- meters is “to form a perfect Hi-tech innovation chain,” having attracted $10.6 bil- lion in foreign capital, including facilities of 42 foreign companies including Roche, GlaxoSmithKline, and Medtronic. It has established 31 R&D institutes, and has provided a hospital for clinical trials.48 Shanghai Zhangjiang Hi-Tech Park, in its desire to become “China’s Silicon Valley,” states that it has attracted 70 fabless49 companies, 3 foundries, 2 photo- mask producers, 12 packaging and test companies, 34 equipment vendors, and numerous systems application companies. A common thread throughout the various initiatives is the Chinese planners’ emphasis on absorption of foreign investment. It is, as the Ministry of Commerce stated in 2004— “an important part of China’s fundamental principle of opening up to the outside world, and an important component of Deng Xiaoping Theory. [It] is one of the great practices of building up socialist economy with Chinese characteristics.50 The inward flow of foreign direct investment, not only to attract manufacturing for its many benefits, but for technology transfer, is vital. Particular emphasis is given to attracting foreign R&D facilities. Fifteen Korean companies have R&D 47Professor Li Jianjun, Director General, Tianjin Science and Technology Commission, “The Devel- opment and Opening of Tianjin Binhai: New Area & China’s Biotechnical Innovations” as presented at Levin Institute Conference, “Industrial Innovation in China,” July 2006. 48Shanghai Zhangjian Hi-Tec Park: China’s Silicon Valley and Pharmaceutical Valley at and . 49Fabless semiconductor producers are design houses that have their products “fabbed,” that is produced, by a company having a fabrication facility. 50Ministry of Commerce, June 14, 2004, available at .

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1 RESEARCH PAPER centers in China, 14 of these established since 2000. Samsung and LG Electronics have three each. These concentrate on development of technology and product models for the Chinese market.51 FACTORS DRIVING AND INHIBITING INNOVATION Major Positive Factors Innovation efforts in China are a vast work in progress, conjuring up images of past grand public works efforts—more like perhaps the building of Grand Canal system52 than the Great Wall, but there are more than a few trace elements of the latter, protective element, that appear in the statements of Chinese planners and regulators. Growth There are strong innovation drivers in China at present. First among these is an impressive rate of GDP growth. While this can be something of a double- edged sword, in that resources can be scarce in a rapidly growing economy, clearly the positives far outweigh the negatives—for those who seek rewards for innovation, more are to be found in a buoyant economy. Human Resources A second innovation driver is the huge talent pool. Enormous resources are being poured into graduating engineers and scientists, and given the immense population base, this is an effort that can in sheer numbers equal the output of many of China’s foreign competitors, taken together. Market Size The large domestic market is both an incentive to indigenous Chinese pro- duction and also serves as a magnet for foreign direct investment. It is a market that a global company cannot afford to ignore. And it is from these foreign com- panies that potentially much can be learned, leapfrogging the painful earlier steps in innovation that were required of the technology donor companies. It helps to attract higher end foreign investment that the Chinese market is increasingly a 51Professor Yong-June Kim, School of Business and Dir. China Research Institute, SKK University, Seoul, Korea, “A Korean Perspective on China’s Innovation System,” as presented at Levin Institute Conference, “Industrial Innovation in China,” July 2006. 52Conceived of by the Duke of Wu in the eighth century B.C., but really culminating in the construc- tion during the SUI dynasty some 1,100 years later.

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1 INNOVATIVE FLANDERS very sophisticated one. Cell phone and computer penetration in China are very high. Increasing Protection of Intellectual Property Formal intellectual property protection, poorly developed, to non-existent, in much of China until relatively recently is making strides, particularly in Beijing and Shanghai. There have been a number of cases which have resulted in sat- isfactory outcomes for foreign and domestic IPR holders in China. While there is much progress to be made, it is clear that intellectual property protection is improving. This movement is being bolstered by the incentives for indigenous patenting which create domestic stakeholders in a functioning IPR system. Setting Priorities On top of these advantages is a government (or more accurately, a series of governments, at the central, provincial, and municipal levels) pledged to full economic mobilization to support innovation—and at the provincial and local levels in a rivalry to achieve often grand objectives. The setting of priorities may be particularly effective where their objectives are specific: [We will] significantly increase the self-sufficiency ratio to over 70 percent for integrated circuits used for information and national defense security, and to over 30 percent for integrated circuits used in communications and digital household appliances…. We should basically achiee self-sufficiency in key products supply….53 Some Indications of Progress There are a variety of concrete measures of success. China’s high-tech exports have been growing at an annual rate of more than 40 percent over the last 5 years. China is now third in the ranking of countries in R&D expendi- tures. Another crude measure of success is the number of domestic patents filed with China’s State Intellectual Property Office (SIPO): 99,278 patents in 2001, 171,619 in 2005, a 73 percent increase.54 Whether this represents true innovation will only be a matter to be assessed with hindsight—as the high-tech exports are 53“Outline of the 11th Five-Year Plan and Medium-and-Long-Term Plan for 2020 for Science and Technology Development in the Information Industry,” Ministry of Information Industry, Xin Bu Ke [2006] No. 309, August 29, 2006. Note that the text of the Outline itself is undated, but the MII Web site posting the Outline is dated August 29, 2006. 54China’s State Intellectual Property Office listings for 2001-2005, available at . Listed patents included Innovation, Utility Models, and Design.

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1 RESEARCH PAPER probably very heavily the products of foreign multinational corporations and their Chinese joint ventures. Some Negatives Other countries’ innovation planners must accord China a measure of respect for its accomplishments to date, given the very low level from which it started so very recently. But imbedded in some of the very causes of success are also issues that can and do serve to inhibit innovation. Among these are the major overhang of the vestiges of a command economy and the newness and in some instances lack of the legal and market infrastructure characteristic of a nonmarket form of economic organization. Government as a Mixed Blessing State planning is a double-edged sword. Those who make plans are not necessarily those closest to the cutting edge of innovation and may not fully understand its needs. Nonmarket factors may skew economic activity. When the cheering died down a bit, observers of the Japanese miracle began to note that Japan suffered deeply from problems of crony capitalism that saddled its bank- ing system with nonperforming loans and contributed to depressing its economic growth for over a decade. In China, some two-thirds of the economy is accounted for by state-invested companies and state-owned companies. No one has accused these companies as a group of being on the leading edge of innovation. The influence of the state can be too pervasive. Complicating the positive story of the dominance of market forces today are stories of the recent resurgence of the Communist Party’s involvement in business. What impact this will have it is too early to tell, but it is likely to reinforce a relationship-based pattern of transactions that may often run counter to the dictates of the market.55 Workforce Issues In the rest of the world, particularly in the United States, Europe, and Japan, but also in India, and others of China’s competitors, the number of China’s engi- neering graduates graduated annually is causing concern. Newspaper articles have 55. . . The Communist party is insinuating itself more deeply into business by setting up committees in many of the country’s 0m-odd priate companies. . . . Its economy may hae been opened up, rigid central planning phased out, competition unchained and shares in state companies sold off. But critical leers of control remain firmly in official hands. Do you need a bank loan, foreign exchange, a site for a new plant or access to scarce raw materials? Then, in China, you need friends in the right places. Guy de Jonquieres, “China’s Curious Marriage of Convenience,” Financial Times, July 19, 2006.

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1 INNOVATIVE FLANDERS reported that the 70,000 U.S. science and engineering graduates for 2004 pales in comparison to China’s 600,000.56 But, those numbers of graduates do not tell the whole story. A number of studies have found these comparisons to be misleading. A study by Duke Uni- versity found the United States actually produced 137,437 while China produced 351,537 graduates in the Engineering, Computer Science, and Information Tech- nology fields.57 The study largely attributes the disparity in these numbers to issues of quality. China’s state-centered and rote learning approach to education is heavy on theoretical and Marxist learning, producing “ivory tower” engineers with little problem solving and teamwork skills.58 Engineering curricula are often made more crowded with ideological courses that detract from the quality of the graduates entering the workforce. China’s educational system, Marxism included, is said to be inadequate, emphasizing depth over breadth, quantity of graduates over quality, leading to “transactional vs. dynamic engineers,” and since it does not nurture creativity, producing an insufficient number of “innova- tive” engineers.59 The Ministry of Science and Technology, and other planners are not unaware of these defects and are issuing new state guidelines and opinions to “. . . further strengthen the cultivation of talents in short supply. . . .” 60 Inadequate Protection of Intellectual Property Rights (IPRs) A key roadblock to accelerating innovation is the inadequate protection of intellectual property. This exists in part because there is relatively little history or culture of protecting intellectual property rights and there is only a recent history 56Framing the Engineering Outsourcing Debate: Placing the United States on a Leel Playing Field with China and India, Duke University Master of Engineering Management Program. Available at . 57Ibid. 58Jo Johnson and Richard McGregor, “Are India and China up to the Job?,” Financial Times, July 12, 2004. See also Guy de Jonquieres, “To Innovate, China Needs More than Standards,” Financial Times, July 12, 2004, and Guy de Jonquieres, “China and India Cannot Fill the World’s Skills Gap,” Financial Times, July 12, 2004. 59Framing the Engineering Outsourcing Debate: Placing the United States on a Leel Playing Field with China and India, Duke University Master of Engineering Managmenet Program. Available at . Cong Cao and Denis Simon, “China’s Evolving S&E Talent Pool and Its Roles in Industrial Innovation,” presentation at Levin Institute Conference, “Industrial Innovation in China,” July 25, 2006. McKinsey Global Institute, The Emerging Global Labor Market, June 2005, available at . 60Guo Ban Han [200] No. 0 (A Letter in Reply from the General Office of the State Council on Approving the Formulation of the Rules for Implementation of the Several Supporting Policies for Implementation of the Outline of the National Medium and Long-term Plan for Development of Science and Technology), Gazette of the State Council, Issue No. 17 Serial No. 1196, June 20, 2006, available at (provisional translation on file).

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17 RESEARCH PAPER of private property.61 The result is that China’s share of world patents is very low, and Chinese officials state62 that the quality of patents is also low with some 99 percent of Chinese firms owning no patents. The situation may be changing for the better. The State Intellectual Property Office (SIPO) has provided figures on shares of Chinese patents that do show at least a quantitative improvement: • 2002: foreign 73 percent, Chinese 27 percent. • 2005: foreign 54 percent, Chinese 46 percent. IPR enforcement is going to be a problem for some time to come. With the best enforcement will in the world, there is and will remain a serious shortage of IP specialists, both legal and management. There is also a basic domestic public policy question involved in accelerating IPR enforcement. Counterfeit goods are far less expensive than branded items. With a low per capita GDP and a great divide between those with disposable income and those in poverty, the balance of the goals of enhanced IPR enforcement vs. some alleviation of poverty can weigh in favor of the latter. Forced Technology Transfer Lastly, there is an element of IPR that is prevalent but on which statistics will never be available, and that is forced technology transfer. In any governmental regime, but particularly in the Chinese case, where there is a strong desire on the part of foreign firms to enter the market to sell and/or to produce, the price paid for entry can and very often is an agreement on the kind and amount of technology that will be brought into China. While not quantifiable, issues of this kind surface from time to time that indicate that the problem is extensive and important. One example is the nonpayment of royalties to Japanese manufacturers for DVD players. This is a very large market segment, and the royalties owed can be assumed to have been very large. They are involuntarily waived. There is a view in the industry that official administrative guidance was given that royalties should not be paid (and certainly there are many general pronouncements that the payment of royalties by Chinese companies should be avoided wherever possible). The practice is tolerated 61China’s Westernization Movement (Yangwu Yundong), which arose in the 1860s, encouraged study of Western systems of science and technology, and in 1896, China’s leading newspaper, Shen Bao, proposed a Western-style patent system. In 1898 China enacted a patent law and a Chinese inventor was awarded a patent for a novel form of spinning machine. However, decades of war and revolution followed, and under Mao, the government took the position that all intellectual property belonged to the state. Liwei Wang, “The Chinese Traditions Inimical to the Patent Law,” Northwestern Journal of International Law and Commerce, Fall 1993. 62Dr. Hu Zhijian, Deputy Director General, Deptartment of Policy, Regulation and Reform, Ministry of Science and Technology, “IPR Policies In China: Challenges and Directions,” presentation at Levin Institute Conference, “Industrial Innovation in China,” July 2006.

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1 INNOVATIVE FLANDERS because being in the Chinese market is profitable or is believed to be profitable in the future. Given what is at stake, the right to royalties is not surrendered by foreign companies. It is just not vigorously pressed. Another IPR-related problem exists because of the very heavy dependence on inward foreign direct investment (FDI). Because of deficiencies in IPR pro- tection, foreign investors withhold core technologies as well as the latest cutting edge technologies, thus limiting technology transfer to the more routine. Chinese planners are well aware of this problem and this spurs even greater efforts on their part to their fostering the creation of indigenous invention. 63 The Regulatory Environment and Techno-nationalism Lastly, a major inhibiting factor to innovation is a combination of negative (as seen from abroad) government promulgated measures. The Chinese govern- ment is far from monolithic, and this is not just a reference to the division of power with provincial and municipal governments. Within the Chinese govern- ment there are those who believe that the less intervention there is the better, and that the attractiveness of the market, left to some extent unfettered, is the best course for development. There are then those who believe in and practice a brand of techno-nationalism. The measures taken and threatened have been enumer- ated above, and include the whole panoply of investment controls, conditional financial support, possible administrative guidance to avoid payment of foreign royalties, threatened use of the antimonopoly law, regulatory approvals of all sorts, and the like. As this is a paper focused on government measures, other market factors, such as lack of physical infrastructure, availability of feedstocks, and constraints caused by limited opportunities for synergies with local partner companies, will be reserved for other studies. CONCLUSION It would be clearly imprudent to draw sweeping conclusions about the rate of innovation in China at present. Extrapolation of trends of current efforts do not have very much predictive quality. In the 1980s it would have been and was a mistake to just extend the curve of then current Japanese growth. Similarly, Boeing presumably misjudged the prospective competition from Airbus. Most of China’s innovation lies mainly in the future. What we do know are several factors upon which success could depend. 63Leonard Lynn, Case Western Reserve University, Hal Salzman, Urban Institute, “Collaborative Advantage and China’s Evolving Position in the Global Technology System,” as presented at Levin Institute Conference, “Industrial Innovation in China,” July 2006.

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1 RESEARCH PAPER The Gold Rush Attraction of the Chinese Market We know that foreign firms still see China as a vast and vital market, as well as a production platform for export. While companies may be guarded in transfer- ring technology, the greatest form of technology transfer is human, and there are a very large number of Chinese engineers working for foreign firms in China and those abroad who will repatriate. Stock options and other forms of economic and intangible rewards of participating in a new frontier as well as a better quality of life in some ways (a lower cost of living for one) act as magnets. U.S. immigra- tion policy actually now pushes newly awarded PhDs from American universi- ties to return home. Conditions are improving in all respects, and absent some upheaval, the polarity of the magnetism with respect to inward (into China) talent flows is unlikely to be reversed, just as it has been with respect to the movement of overseas ethnic Chinese back to Chinese Taipei in recent decades. In addition, the deficiencies in domestic Chinese training are known, and there is no reason to believe that they cannot be significantly rectified. Remaining Uncertainties There are, of course, many unknowns. A series of “ifs” exist—they always do. The move toward indigenous innovation will continue if political stability is maintained, if the instinct to techno-nationalism is checked (not manipulat- ing trade, the antimonopoly law or product standards for mercantilist reasons, for example), if the inward flood of FDI remains largely unabated because the market continues to grow and China remains a low cost-production platform and the protection of IPR continually improves, and if the rate of economic growth continues to be strong, not cut off by either political or economic factors (such as weaknesses in the banking system, or external causes—reactions to trade imbal- ances, for example). In short, if the interventionists among the planners exercise enough self-restraint and support rather than acting to resist market forces and there are a few good breaks—such as continued global trade expansion—there are very good prospects for innovation taking hold in China in a very major way. EPILOGUE China’s national innovation policy is a work in progress. Chinese officials have allowed much to take place that is healthy. Foreign firms’ participation in the economy is essential, as is external collaboration by indigenous firms. To date the results have been mixed, but mainly positive: state intervention has its costs, but has been offset by welcoming a major wave of foreign investment. The key question is: Can China have as much state-run intervention as it does at present and still create a market economy that maximizes innovation? What is sure is that whatever is true today will change rapidly and will be dif- ferent in a year, and perhaps unrecognizable in 5 years. Those of us who traveled

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10 INNOVATIVE FLANDERS to China in the 1980s and saw the empty fields of Pudong could not have foreseen that area of industrial and scientific ferment that exists today. The short survey above is partial, and for that reason cannot be predictive. There are areas not addressed at all, such as the role of universities, for the simple reason that their role was not stressed in most of the literature and discussions that went into the preparation of this piece. But the role of universities was important in the creation of Silicon Valley and Route 128, and may play a significant role in China’s high- technology development. That subject alone deserves further study. The emphasis in this review is on the role of the state. Part of that is due to the fact that the state is more dominant or at least more visible in China compared with other locations (even given the role of the U.S. Departments of Defense and Energy, and the National Institutes of Health in the United States, and various German, Japanese and French institutions and institutes). At least in its early stages, the role of the state in China is reminiscent of the historical role of the state in Japan through the Meiji Restoration. The relevance of Japan’s experience is however limited by the very different path that China has taken, welcoming foreign investors and goods for its vast home market. What is present in China is the will to succeed, and an excitement about China’s growth potential and scientific and engineering possibilities that is some- what reminiscent of the faith that the American settlers had in moving west in the mid-19th century. China is an exciting venture. It is one of the greatest human experiments of our time—like the Green Revolution, or the manned space flight program. The economic development of a vast continent and even vaster popu- lace is an enormous challenge. The Asian tigers are likely to have been just the precursor of development in Asia. While we have not seen the first dominant innovation—like a Chinese iPod, wonder drug, or Windows operating system, there is no reason to think that contributions from China like these will not be forthcoming and perhaps soon. China has assimilated contract high-end manu- facturing, it is moving into contract design. It would be a mistake to bet against China’s earning a very respectable place in the forefront of innovation. The only question is when.