McKinsey: Chinese future economic growth depends on innovation

The Chinese economy is slowing down from a mammoth 9.4% annual increase over the past three decades. In order to remain a key player in the competitive landscape with Industry 4.0 in sight, China needs to, according to a new report, evolve from an innovative ‘sponge’ to an innovative leader. The study finds that China's two strongest areas with potential for innovation are the service sector and next-generation manufacturing.

In a new report from McKinsey Global Institute, titled ‘The China Effect on Global Innovation’, the management consulting firm considers how improving productivity through innovation can shore up the country’s GDP growth over the coming decade.

Economic grow sustainability
Two factors have driven Chinese growth in recent years: a constant flow of new workers into the labour force and massive investments in housing, infrastructure, and industrial capacity. These forces however, are receding. China’s labour force may well peek in 2016 but a long period of decline may follow due to ageing, which could see the labour force reduced by 16% by 2050. The investment streams too are falling rapidly, it now takes 60% more capital to produce one unit of GDP in China than it did, on average, from 1990 to 2010, while investment is also constrained by China’s debt, which, at 282% of GDP, exceeds debt-to-GDP ratios in the US and Germany.

On the back of its major growth factors, the Chinese economy grew at an average annual rate of 9.4% between 1985 and 2015. The changing demographics, as well as investor sentiment, will, according to the research from McKinsey’s Global Institute in collaboration with McKinsey China, see annual GDP growth fall significantly over the coming decade. A substantial decline may be halted however, if a trend in the share that productivity brings to GDP is halted from its steady drop over the past three decades, from 48% to 30%. Boosting productivity as a share of GDP growth to between 35% and 50%, would see the Chinese economy grow between 5.5% and 6.5% between 2015 and 2025 – adding between $3 trillion and $5 trillion a year to GDP by 2025.

Innovating productivity strengths
One of the aims of the consultancy’s research is to identify the effect that innovation has on the Chinese economy’s GDP growth, as well as identifying ways in which China’s strength in innovation may be leveraged to boost productivity. According to the analysis, specific innovation opportunities in manufacturing and service industries can contribute $1.0 trillion to $2.2 trillion in value by 2025, or equivalent to as much as 24% percent of total GDP growth.  China has established strengths in 15 innovation metrics out of 31 considered by the research, which are spread over four categories.

In the broader customer-focused innovation category, the country has a very strong household appliances innovation proposition, and a relatively strong internet and software, as well as internet retail, proposition. In terms of efficiency-driven innovation, its top performing sector is solar panels – which is expected to continue to boom on the back of meeting COP21 targets. The country also performs well in the area of generic pharmaceuticals. Key manufacturing sectors, such as steel, textiles, construction machinery, electrical equipment and chemicals too do relatively well in the category – the least innovation capacity in the category is found in semiconductor foundry and back-end engineering, as well as paper and forestry.

The two categories in which the Chinese economy fares the poorest are engineering-based innovation and science based innovation. In the former, the economy does well in rail-road equipment, wind turbines and communications equipment. While in the latter category, the economy produces only the lowest level of innovation.

Innovation value
The analysis highlights innovation within its two strength areas, service-sector innovation and next-generation manufacturing, have the potential to significantly boost the country’s productivity addition to GDP. Continued improvement in the former could add between $550 billion and $1.4 trillion to GDP, while in the latter an additional value of $450 billion to $780 billion could be derived. The combined effect creates the $1 trillion to $2.2 trillion in additional benefit to the economy. Additional benefits may be derived from breakthroughs and other innovation categories – although given the significant unknowns, the consultancy declined to quantify the potential effect.

Service-sector innovation
Service-sector innovation is backed by a number of key factors, the research finding that the country’s 1.3 billion consumers uniquely positions it to excel at customer-focused innovation. This large and dynamic consumer market gives innovators a huge supply of problems to solve and needs to fill, as well as a means of commercialising new ideas rapidly. Another advantage: Chinese consumers are willing participants in market testing and commercialisation—happy to accept new products that are not completely refined and eager to share feedback to make them better. This makes China a hotbed of innovation for an expanding universe of Internet services and products ranging from air conditioners to smartphones.

According to the authors, a number of structural barriers inhibit service-sector performance by limiting competition and by business models that limit productivity. China could, the consultancy adds, expand the service sector by improving access to services, and improve quality and efficiency by using technology and best practices.

Next-generation manufacturing
To capitalise on China’s strengths within manufacturing, the consultancy considers a number of key factors. Its current position, the report finds, is based on it being the premier global manufacturing location and increasingly becoming a world leader in efficiency-driven innovation, in large part because of the vast ecosystem of suppliers, workers, service companies, and logistics providers that has arisen around China’s manufacturing industry. This ecosystem has transformed China into a global manufacturing hub, making it possible for both Chinese and foreign companies to put virtually any kind of product into production rapidly and affordably.

To remain a top contender within the field and to meet productivity targets, the report suggests: “China embraces new technologies, adopts structural measures to aid manufacturing, and addresses cost challenges, we believe that Chinese factories can remain highly competitive in global manufacturing. While Industry 4.0, other innovations, and changes in factor costs have the potential to alter the competitive landscape, we also think that some of these trends can favour China.”