Innovation gauntlet laid down to facilitate economic transformation

Both President Xi and Premier Li have highlighted the importance of innovation in driving China's future growth, in addition to their call to reduce the bureaucratic costs of doing business in the country.

So why did China fail to make significant progress in innovative growth? To understand this, we need to appreciate how the nation managed to achieve its growth record so far, as well as the origins of its current problems, as discussed earlier in this section. The key is to see the continuity of China's ‘trial-and-error' social-reform philosophy and strategy in its evolving growth model.

The trial-and-error approach, initiated by the late leader Deng Xiaoping, is similar to the scientific methodology where the basic assumption is that policy-makers and society may not know beforehand the best social reform approach and that they need to discover it through experimentation.

Since it is difficult to carry out low-cost controlled social experiments, it is inevitable that the new social institutions and practices tried are likely to bring both the benefits from successful experiments and the costs from failed experiments. So to achieve innovation in both the physical and social dimensions, it is impossible to avoid failures if one wants to innovate through the trial-and-error approach.

The real capacity for innovation through trial and error includes both the benefits of the trial of the new and uncertain - potentially good things, on the one hand - but also the necessity to absorb any losses from failed experiments.

The economics for generating and allocating the upside gains of innovation is covered by the theory of private property rights and market competition.

Internet technology dramatically reduces the information and transaction costs, crucial for more transparent and larger-scale market competition. The economics of allocating and absorbing downside losses from innovation is covered by the theory of sunk costs and the social and legal framework for bankruptcy. Companies are born and die locally through a social and legal process specific to the location, but have to grow nationally and globally through global market competition. Local governments, courts and regulators are key players here.

Over the past 35 years, China captured huge upside gains from the social and institutional innovation of creating and enabling markets and private companies, leveraging on ‘good competition' among cities, companies and individuals. But this also generated significant downside losses in the form of laid-off workers from state-owned enterprises (SOEs), overcapacity, pollution and corruption caused by ‘bad competition'.

When profits are diverted from SOEs to private companies, it is entirely normal to see at the same time the overcapacity in SOEs. When people leave small, remote towns and villages to megacities for better jobs, it is normal to see at the same time ghost towns and local debt crises as a result of the reallocation of human capital. When local governments are obsessed more with creating GDP and profits than with policing pollution and corruption, it is normal to see pollution and corruption increase faster than GDP and profits.

However, if the incentives of local governments are changed to inclusive, sustainable and innovative growth, the results can change. The diverging phenomenon we observe in China cannot simply be taken as a sign of economic and social collapse. Instead, one needs to uncover the true driving force of China's evolving growth model.

Competition quality

The quality of competition in China has also improved steadily over the past 35 years, particularly when the internet gained wide penetration. The Chinese ways of dealing with bankruptcy and tort are also evolving, with the establishment of deposit insurance and the term transformation of local debt. Moreover, low-income housing for laid-off or unemployed workers, stricter environmental standards and regulation and anti-corruption measures, as highlighted at the National People's Congress, are all necessary components of an emerging socioeconomic infrastructure for dealing with the downside losses of an innovative economy where ‘trial' and particularly ‘error' are the rule, rather than the exception.

One of the critical reforms for upgrading China's trial-and-error innovative growth strategy is related to China's capital market reform, where the current initial public offering system based on government approval will be replaced by a registration-based system.

This reform, proposed for 2015, is intended to shift China's financial system from a bank-dominated one towards a more balanced system where both stocks and bonds could have a much larger share.

Joint-stock companies with publicly traded shares are probably the most important invention for facilitating risk-taking and innovation because this allows for the voluntary absorption of limited losses by an unlimited number of shareholders when companies fail in their attempt to develop new products. It is no accident that the US economy, with its equity-dominated financial sector, is probably the most innovative large economy in the world. Its market capitalisation-to-GDP ratio is about 120%, compared with about 40% for China.

Another critical reform for supporting innovative growth is to develop regular and sound bankruptcy procedures for private companies, SOEs and local governments. Unfortunately, this is not yet on the government's agenda for 2015. Lack of timely and sound bankruptcy procedures could create big problems for a slowing economy because a large amount of credit and production input could be tied up in many unprofitable projects.

China needs to draw lessons from its dealing with triangular debts among SOEs in the 1990s, when it successfully did the work of bankruptcy without bankruptcy law by putting the bad debts into state-owned bad asset management companies and then listing the good banks on the stock markets.

The debt restructuring dramatically improved the efficiency in the allocation of the stock of credit and laid the foundation for 20 years of solid growth.

China needs to do this again for some local government debt. It would be better to have a permanent institutional infrastructure for bankruptcy because, in an innovative economy, failure is the rule, rather than the exception - and, as the Chinese saying goes, ‘failure is the mother of success'.