Have Chinese innovators (and banks) finally grown-up?

Aoife Hanley, Wan-Hsin Liu, Andrea Vaona, 24 March 2011

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There is a wind of change in China. Chinese policymakers have become more ambitious. They are now aspiring for innovation leadership status (OECD 2008; World Bank Report 2009). For this to happen, Chinese firms and universities are encouraged to work harder at developing their own R&D capability and to wean themselves off imported technologies. However, opinion is mixed about whether these ambitions for China’s research capability, i.e. spending 2% of GDP on R&D, compared to a European average of 1.7% in 2010, and making China fourth in the world in absolute terms, can be realised due to shortcomings in the banking system. According to research by Deutsche Bank (2004), 60% of the banking system was in state hands. The question is whether Chinese banks today are equal to the task of funding innovation.

Since 2001, when China first entered the WTO, it systematically commenced an overhaul of its financial system, a move then welcomed as one of the most important steps taken in the transition to a Western-style free market. The radical overhaul of banking, staggered between 2001 and 2006 was also seen as a necessary step if China was to achieve its research capability ambitions. More recently, doubts have been raised about the adequacy of China’s banking function. In 2009, a World Bank report cited “lack of capital” as a major problem for aspiring innovators.

Our recent report (Hanley et al. 2011), on Chinese research capability and bank finance investigates how well the revamped Chinese financial system is dealing with the innovation capital constraints highlighted in the World Bank 2009 report. For the first time in an analysis of this kind, we include both a measure of financial depth as well as a measure of foreign direct investment (FDI), recognising that new technologies can be both spearheaded by foreign firm presence (through spillovers) as well as financed by Chinese banks. We apply a regional methodology because although bank lending can technically transcend regions, the bulk of lending is carried out within each of the Chinese provinces. This suggests extensive barriers to capital mobility across Chinese regions as Boyreau-Debray and Wei (2005) have indicated. We apply a regional panel dataset compiled from different issues of China’s statistical yearbooks for 30 provinces for the years 2000 to 2008, estimating the effects of FDI, banking depth and other control variables such as regional wealth on the production of new knowledge in China. New knowledge is measured as the number/quality of patents produced. We start by estimating one-way error component models to align our analysis with Cheung and Lin’s (2004) benchmark study. The latter reported that FDI represented a significant driver of China’s innovation growth. One novelty of our analysis is the application of two-way error component models which help to deal with unobserved heterogeneity at both the regional- and time-level.

What becomes clear when looking at innovation patterns in China in the context of how this innovation is financed is that Chinese banks, in spite of reforms, appear to favour targeting finance at the least developed regions. Figure 1 shows how the largely underdeveloped Eastern parts of China have been major recipients of credit, much of which is channelled through the State owned commercial banks. The pattern of patenting (Figure 2) appears, at least superficially, not to map very well to the credit patterns in Figure 1. The highlighted Eastern parts where much innovative activity takes place is strongly influenced by FDI locational factors (foreign firms favour the more highly developed Eastern parts of China). Our regressions attempt to disentangle this dualism of FDI and funding.

Figure 1. Credit to GDP ratio by Chinese province (2007)

Figure 2. 

In contrast to the earlier, pre-financial reform study by Cheung and Lin reporting a strong showing of FDI in driving Chinese patenting, we find that the net effect of FDI on regional innovation is small and insignificant. When focusing on the within-estimators, effects of FDI disappear completely. On this basis, it is misleading to overemphasise the role of FDI in spurring Chinese innovation which although undisputedly important, tells only one part of a far more nuanced story. The financial capability of Chinese banks matters a lot. Interestingly, the returns to Chinese patenting activity from credit is most pronounced in China’s Coastal and Central regions (see our paper Hanley et al. 2011) but the relatively underdeveloped Western provinces do not benefit significantly. This relative inability of Western regions to capitalise on credits is likely due to firms and individuals in these regions lacking the expertise and means to translate funds into innovation growth.

Innovation growth in China is highly uneven, although capitalisation of this growth by banks may help to smooth some differences e.g. note how the less developed Central Provinces exhibit comparable credit elasticities to the more developed Coastal provinces.

Finally, there is the issue of how well the unique Chinese banking system with its mixture of private and state-owned banks performs in capitalising innovation. In short, quite well. Both private as well as state-owned banks are helpful to innovation but interestingly, it is better for innovation that either banking type dominates (see negative interaction term), possibly a result of scale economies in information gathering and lending for private and state-owned banks respectively. This finding suggests that China is not a ”textbook case” for innovation development, in that the State-owned commercial banks do a relatively good job in fostering innovation. The finding needs to be looked at in context. Chinese economic policies have been actively promoting indigenous innovation since the new millennium. The most promising innovators in regions strongly supported by State-owned commercial banks lending, are seen to face fewer financing difficulties in carrying out costly innovation activities. What we cannot rule out from our regressions is that  “crowding out” of other firms is taking place. Crowding out would take place if the policy-driven prioritisation of innovative borrowers over other firms – some of whom are crucial for commercialising patents – impeded overall economic growth.

We also find a markedly lower response of innovations in smaller Chinese enterprises to increases in credit volumes, although it is a stylised fact that large firms, at least in Western economies, undertake the bulk of new knowledge creation.

Regardless of how we measure credit intensity (using several measures of regional financial depth) and regardless of which econometric model is applied, all financial depth measures are associated with higher regional patenting intensities. Accordingly, policymakers should not dismiss the role played by China’s banks in supporting China’s goal towards world innovation leadership. Although FDI may formerly have been a mainspring of technological advancement in China, in contrast to the earlier study by Cheung and Lin (2004), our recent findings suggest that the role of FDI in spurring innovation is losing ground to domestic financing channelled within a stronger and ever-improving financial system.

References

Boyreau-Debray, G and S Wei (2005), “Pitfalls of a State-dominated Financial System: The Case of China”, NBER Working Paper 11214.

Cheung K and P Lin (2004), “Spillover Effects of FDI on Innovation in China: Evidence from the Provincial Data”, China Economic Review, 15(1):25-44

Hansakul, S (2004), “China’s Financial Sector: Institutional Framework and Major Challenges”, Deutsche Bank Research, China Special Issue.

Hanley, A, W Liu, and A Vaona (2011), “Financial Development and Innovation in China: Evidence from the Provincial Data”, Kiel Working Paper, 1/2011

OECD (2008), “OECD Reviews of Innovation Policy”, OECD.

Zhang, C, D Zeng, W Mako, and J Seward (2009), “Promoting Enterprise-Led Innovation in China”, World Bank.

Topics: Productivity and Innovation
Tags: China, foreign direct investment, innovation

Lecturer, University of Kiel
Wan-Hsin Liu
Researcher, Kiel Institute for the World Economy
Andrea Vaona
Lecturer, University of Verona; Researcher, Kiel Institute for the World Economy

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