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Digital Dragon or Analog Tiger?

The recent agreement between the U.S. and China to avoid a trade war (for now) removes the immediate threat of tit-for-tat tariffs. President Trump’s desire to strike a deal that both avoids pain for U.S. farmers, and ensures continued Chinese support for a potential summit with North Korea, likely pushed the U.S. negotiators to walk back from their threats of large tariffs and sanctions on ZTE.

While an immediate trade war has been averted, U.S.-China competition, particularly in advanced technologies, is just heating up. In what has been dubbed a technological cold war, both countries are using restrictions on market access, cross-border investment, and even foreign researchers to protect and promote domestic innovation.

While Chinese innovation is nothing new, their stated intentions to move up the value chain and erode the technological superiority of the West are now increasing viewed in the U.S. as a strategic and economic threat. But is Chinese innovation progressing so rapidly that it warrants the onset of such tensions?

Anecdotes abound over the ubiquity of mobile payments and facial recognition technology, but how does China compare to other countries on measurable metrics of innovation and technological advancement?

Is China’s domestic progress matched overseas?

Using data on patents, research & development (R&D), and intellectual property rights (IPR), it’s evident that some Chinese firms are making progress, but as a whole China is still far behind the technological leaders of the U.S., Japan, Germany, and to an extent even Korea and Taiwan. One way of measuring innovation at the country level is IPR licensing fees.

Last year, the U.S. technology sector generated $127 billion in royalty fees, while paying out $44 billion, Japan earned $41 billion while paying out $21 billion, in comparison China earned just $4 billion, while paying $28 billion. On average, U.S. firms earned nearly three dollars of IPR royalties for every dollar they paid. Chinese firms earned only sixteen cents for every dollar they paid – a ratio one-eighteenth as good as the U.S.

The IPR data bucks two commonly held beliefs; first, contrary to the view of China as a massive thief of intellectual property, it actually pays a significant amount in IPR licensing fees, second only to the U.S. Second, China’s earnings from intellectual property show that despite headlines about rapid innovation, it is still far from being a technological leader.

China has bought more intellectual property than it sold

National sources, Haver, Aberdeen standard Investments

Is Chinese “innovation” really ground-breaking?

What about Chinese patents and R&D figures? It’s often cited as clear evidence of China’s technological progress that they leads the world in patent applications and are second only to the U.S. in R&D. However, the numbers only tells one side of the story. China is churning out new patents, but they are of questionable quality -- government incentives to boost patent numbers have resulted in an explosion of patent applications for small design changes or functional alterations. A better way to judge these patents is by looking at how they fare abroad.

Chinese patents filed abroad are more likely to capture innovative advancements; the more likely a Chinese invention is truly innovative the more incentive the inventor would have to file abroad, specifically in the U.S., EU, and Japan where they could generate significant royalties. In 2016, while Chinese residents were granted 1.75 million patents domestically, Chinese nationals were only granted 20,348 patents abroad.

Using cross country comparisons of patents known as triadic patents (flied jointly in the U.S., EU, and Japan) which represent the gold standard particularly for tech and IT patents, China is progressing but still significantly lags the U.S., Japan, and Germany and only recently surpassed Korea. In 2015, China was granted 2889 such patents compared to 4457 for German and over 17,000 for the U.S. Thus, in addition to IPR royalties, patent numbers show the same story – China is making progress but still far from the tech leaders.

R&D spending shows a similar story. China is now second only to the U.S. in terms of total spending, and growth in R&D spending tops the world. But, when looking at spending efficiency, China is among the least efficient in terms of bang for the buck. China spent approximately $11.5 million per overseas patent compared to $2.5 million in the U.S. and $600,000 in Japan. While R&D is rising rapidly, a focus on the absolute number masks the inefficiency with which it is spent.

China is innovating, the trends in research and patents clearly bear that out; but looking beyond the anecdotes it’s also clear that China is still in catch-up mode. Instead of fear mongering, the West would be wise to recognize that competition is a good thing.

China is now second only to the U.S. in terms of total spending, and growth in R&D spending tops the world.

After all, a country generally acquires new technologies through three paths: domestic innovation, overseas acquisition, or theft. If China is intent to move up the value-chain, doing it through domestic innovation or purchases of existing technology are better outcomes than theft.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.

ID: US-250518-65835-1