Does China’s research and development funding reach the right firms?

From imitation to innovation: Where is all that Chinese R&D going? 

EGC Research Summary, March 2022

Chinese investments in research and development (R&D) have burgeoned since the turn of the century, increasing more than tenfold in absolute terms since 2000 and reaching a high of 2.4 percent of GDP in 2020. As the world’s second biggest spender on R&D after the United States, China is certainly a force to be reckoned with on the global innovation landscape. Its fresh push toward innovation-led growth and stated ambition of becoming a technological innovation powerhouse by 2050 have prompted questions: is China on course to attain its goals, and will greater investments in R&D — as promised by Premier Li Keqiang — get it there?

In a study forthcoming in Econometrica, Yale economist Fabrizio Zilibotti and coauthors Michael König, Zheng Michael Song, and Kjetil Storesletten tackle this question through the lens of misallocation.

Results at a glance

• Despite the extensive labor and capital market distortions emphasized in the literature on Chinese economic development, R&D investments have been an important driver of China’s productivity growth.
• Nevertheless, alleviating distortions in the Chinese economy would boost the productivity of innovation, by creating the conditions for the “right firms” to invest in R&D.
• Hence, reducing misallocation not only promises significant static efficiency gains (gains when the economy is in equilibrium), but also dynamic gains (gains as the economy adjusts toward equilibrium), because it spurs the firms with a natural comparative advantage in innovation to undertake R&D.
• The targeting of innovation-based policy matters. Heavy expenditure on R&D — for instance through government subsidies — cannot guarantee high growth and could backfire, if it incentivizes unproductive firms to innovate and pass up the more suitable innovation strategy of imitating.

The authors’ analysis suggests that R&D investments were an important determinant of productivity growth in the 2007-2012, despite the headwinds imposed by widespread policy-induced labor and capital market distortions (for instance, restrictions on labor mobility through the hukou system, and heavy intervention in capital allocation through administrative credit plans).

China vs. Taiwan

The Taiwanese and Chinese economies bear strong similarities in their export-orientedness and manufacturing sector importance. “One question we’re interested in is, what would happen if China had access to the same technology as Taiwanese firms?” Zilibotti said. The authors corroborate the validity of their theoretical model by testing it on a dataset of Taiwanese firms, and then compare results across their Chinese and Taiwanese samples. While estimated parameters for the authors’ Taiwanese sample are qualitatively similar to that of their Chinese sample, the quantitative differences turn out to be striking: innovation and technology diffusion are more rapid in Taiwan than in China.

Counterfactual policy experiments and their implications

To study the implications of misallocation, the authors conduct counterfactual analysis, meaning they consider hypothetical ‘realities’ where certain aspects of the economy are tweaked. In one counterfactual, they investigate the effect of a reduction in misallocation. Reducing misallocation generates dynamic efficiency gains, by triggering an adjustment towards a new equilibrium with higher growth. Growth accelerates and the distribution of firm productivity becomes more dispersed. This suggests that reducing misallocation, for instance, by toning down state support to politically-linked firms or easing credit constraints, could enhance the productivity of innovation and boost growth considerably.

In another counterfactual, the authors find that non-targeted R&D subsidies — subsidies that are accessible to all firms rather than specifically targeted at just a subset of firms — speed up productivity growth at moderate levels, but can backfire if excessively generous. In other words, R&D subsidies can be too much of a good thing: when R&D subsidies are dished out indiscriminately, the “wrong firms” innovate even if they would have been better off imitating, inhibiting TFP growth. 

“An important policy implication is that throwing money at firms to conduct R&D is not enough guarantee productivity growth," Zilibotti said. "Above all, the resources must induce the 'right firms' to innovate. To this aim, market-oriented financial development – venture capital, grass-root entrepreneurship, investor protection, etc. – have historically proven a very powerful medium to promote innovation-led growth. It is at best unclear whether a top-down approach with a strong role of the government can be a good substitute for that.”

Research Summary by Valerie Chuang