Does China Need Billionaires to Spur Innovation?

It is often asserted that a high level of income inequality is necessary to induce innovation. One can point to the billionaires connected to successful companies like Intel, Microsoft, Cisco, Yahoo!, and Google whose fortunes have been made through their ownership of large shareholdings and the gains from exercising stock options. The existence of NASDAQ, as a highly liquid stock market for high-tech companies, has made these fortunes possible, but it is not clear that the creation of billionaires was necessary for the innovation process to occur. It must be remembered, moreover, that in the boom of the 1998-2000, many promoters of Internet companies made hundreds of millions of dollars by cashing in on the speculative stock market, even when the companies themselves turned out to be total failures.

China is now on the way to embracing this type of financialized business model, as the country seeks to transform into an innovation-based economy. Approximately six months ago, China launched ChiNext, the long-awaited NASDAQ-style board for high-tech start-ups. Due to the “extraordinary enthusiasm of investors” (Caijing, Nov 2, 2009), the first day of trading created 13 paper billionaires based on their declared stakes in the 28 IPO companies. The biggest winners of that day were Pu Zhongjie, CEO of Lepu, a pharmaceutical company, and Wang Zhongjun, Chairman of Huayi Brothers, a film company. Both Pu and Wang saw the value of their holdings exceed RMB3 billion. A total of 116 shareholders became instant tycoons with a combined value on paper of over RMB100 million. Yet such wealth still cannot compare to the gains of the husband-and-wife team of Li Li and Tan Li from the recent initial public offering of Hepalink Pharmaceutical. After the company sold 10 percent of its shares on the Shenzhen SME Board last month, the 80 percent pre-sale stake owned by Mr. and Mrs. Li was worth RMB42.6 billion (US$6.2 billion). Overnight, this low-profile couple became the richest people in China. Meanwhile Goldman Sachs’ original US$4.9 million investment in Hepalink in 2007 is now worth US$975 million (RMB6.7 billion).

While the new stock markets are creating enormous wealth for entrepreneurs and financiers, are they providing the financial foundations for the transformation of new ventures into innovative businesses? In the six-month experiment of ChiNext, 87 companies raised US$8.5 billion, according to the Wall Street Journal. Many of these companies have relatively long operating histories (in some cases as long as ten years) developing technology for niche markets. But, given their narrow niches, even the most outstanding companies seem to be overvalued in terms of their growth potential For example, Hepalink, which recorded the highest IPO price-earnings ratio – 73 – in the history of the Chinese stock market, relies almost exclusively on the export of heparin, a pharmaceutical ingredient for blood thinner extracted from pigs’ intestines, to three US pharmaceutical producers as the only Chinese exporter accredited by the US Food and Drug Administration. In the case of Hangwang, which raised RMB1.1 billion last month in its Shenzhen-based IPO, the company leads China’s e-reader market and has a growth potential as the technology provider to multinational companies of Chinese/Asian language handwriting recognition on touchscreen handsets. Even then, however, Hangwang’s key value generator, the e-reader, possesses little in the way of distinctive technology, and is gradually losing its price advantage to new low-cost competitors.

At the same time, for all the ultrarich people who have emerged from these IPOs, how many will continue to lead their companies to generate innovative products? Among these new tycoons, Li Li of Hepalink stands out as a technological innovator for perfecting the process of extracting heparin. Yet even in his case, it is difficult to see why his contributions to innovation warrant his ranking as the richest person in China. It is the highly speculative stock market rather than the value of his contributions to technological innovation that has accorded him this lofty position.

The danger now exists that the Chinese will adopt the ideology, widespread in the United States, that only the promise of enormous riches can spur smart people to provide their skills and efforts to the innovation process. In an advanced economy such as the United States, the creation of high-tech billionaires is the result of the emergence of successful companies in a highly financialized economy rather than a necessary inducement for entrepreneurs and managers to supply their skills and efforts to build these successful companies (see the research of the European Commission project on Finance, Innovation and Growth: ChiNext may be creating instant billionaires but will it support continued investment in innovation, which is an uncertain, collective, and cumulative process?

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 23, June 2010.

Promoting Innovation at the Expense of Indigenous Firms?

On April 9th, the Chinese Ministry of Science and Technology (MoST) website announced a new draft plan for accrediting “indigenous innovation products”, covering a range of high-tech sectors including computers, telecom equipment, automatic office equipment, software, new energy, and energy efficiency devices. These accredited products will enjoy priorities in Chinese government procurements. After being excluded in the initial accreditation plan issued in 2009, foreign companies had been complaining ever since. This time, however, there are two significant changes in favor of multinationals: the accredited products must possess “intellectual property rights” and a “registered trademark” in China rather than the previous accreditation criteria of “indigenous intellectual property” and “indigenous brand”.

The draft plan is complementary to the State Council 2010 Circular No. 9 issued on April 6th, which aimed at encouraging R&D investment of multinationals in China through series of favorable polices including cheap land, tax holidays, and financial liberalization. MoST’s latest accreditation plan is, however, a major setback for many Chinese indigenous companies in the growing government procurement market for high-tech products, estimated to be over one billion dollars per year. Since multinationals are more competent in the market of technology-sophisticated products, the 2009 accreditation plan intended to expand the market share of local firms by giving them privileged access to government procurement contracts. So far, it is not clear whether multinational corporations have directly influenced this year’s draft plan, or whether MoST is pursuing a deliberate strategy that de-emphasizes indigenous innovation for the sake of leveraging access by multinationals to the Chinese market in exchange for technology.

What is clear is that the Chinese state is inclined to abandon government procurement as a policy tool to promote indigenous innovation. That having been said, the Chinese government has spent billions buying underdeveloped products from local firms such as CPU, office software, etc, which still remain commercially uncompetitive and technologically backward. There were even worse scenarios in which large local PC vendors acted as middlemen between the Taiwanese OEMs and the Chinese government, with their huge profits from the procurement market only resulting in diminished productive capabilities. Nevertheless, procurement money can be of great importance for financing innovative firms; prime examples are Huawei and ZTE in the Chinese telecommunication industry. Procurement money provides possibilities for firms to endure the high fixed costs of technological catch-up until they can succeed in generating the high quality products at low unit costs that define innovative success. But such possibilities may be about to disappear.

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 22, May 2010.