China—Its Importance in the Markets and the Global Economies Today and Tomorrow

Greece is not our issue

I would recommend getting a copy of John Mauldin’s and Worth Wray’s e-book on China, A Great Leap Forward? In the meantime, in almost every short video we have posted on our site, in addition to some thoughts on the topic of the day, I have suggested one needs to pay attention to China. As an expectation for our Perspectives piece, “What to Expect in 2015 (and beyond),” we suggested that growth in China would be significantly lower than the seven percent plus targets being set. The implications of this were significant in terms of others’ trade balances, the prices of commodities, starting with oil, possible elements of unrest, and the possibility of diversions geopolitically as the population experienced this slowdown in growth. We expected that the government would weather this slowdown, having many tools at its disposal. As I have said before, trading in the Chinese markets themselves should be left to the professionals. I will keep saying that every chance I get.

In A Great Leap Forward? in general, a stronger case was being made that the debt picture could lead to disruptions and might put the country on a very slow growth path for a long time to come. China’s recent actions, i.e., rate lowering and an attempted bailout of provincial debt, would indicate the growth rate might be even slower than we thought. Is China on the path to its own QE? What is interesting, though, thus far, the currency has tracked the US dollar. China appears to be holding to several of its strategic goals: The yuan as a reserve currency; reduction of the cost of corruption on efficiency and political stability and strength; via the Silk Road initiatives, creation of a significant transportation infrastructure increasing its links and lowering its costs to and for its neighbors on trade with China; increasing internal consumption versus trade (still problematic); and, the topic covered in the chapter below from A Great Leap Forward?continued value-add technological development as a part of the transition to serving its own populace while competing on elements other than price with its goods and services. None of the above will be smooth paths for China. The bumps will have significant impact on the rest of the world as the transitions occur. Overall, growth rates will drop, somewhat consistent with, but still higher than what we can expect in the “developed” world over the next decade.

China’s creation of successful intellectual property development systems has major implications for the technology centers elsewhere in the world. As one looks at technology investing, capital will try to find its way into the Chinese system. And with the capital may come capabilities that move the country more quickly from Invention to Innovation and Implementation. Chinese capital will seek to acquire technology where it can. The capital markets will have to Pay Attention to what is happening economically and financially in China. Just understand, in the background, Moore’s Law, which knows no boundaries, will continue to find applications in a big testing ground.

In the meantime, maybe the chapter below from A Great Leap Forward? will provide a perspective on what to watch for as Moore’s Law finds a new set of users:

 

Chapter 5
Invention, Innovation, & Implementation
in the People’s Republic of China

Our next chapter comes from a true Wall Street legend.

Jack Rivkin is currently the chief investment officer at Altegris Investments in La Jolla, California; but he’s had a long and varied career with over 46 years of experience in public and private equity, alternative strategies, and cross-asset investment research. He holds several board positions with a wide variety of companies worldwide, including Idealab, Dale Carnegie, and Operative, and has worked closely with the United Nations Environment Program on climate change issues. He is also on the board of the World Policy Institute.

Mr. Rivkin is a respected thought leader worldwide and has held senior roles in the investment industry, including chief investment officer and head of private asset management at Neuberger Berman, and director of global research and head of the Worldwide Equities Division of Lehman Brothers Inc. Following his time at Lehman Brothers, he was a vice chairman and director of global research at Smith Barney (ultimately a subsidiary of Citigroup), and an executive vice president with Citigroup Investments, making direct investments and leading an investment team.

Jack is the principal subject in a series of Harvard Business School cases describing his experience as director of research and head of equities at Lehman Brothers, where he raised the firm’s Institutional Investor standings from worst to first in only three years. In that instance, “legend” may be an understatement.

While Jack has a keen understanding of the debt, demographic, and other structural problems dragging on the global economy today and threatening to destabilize markets without warning, I (John) am always struck by his unwavering optimism in the miracles of capitalism and the onward march of human progress. On that note, Jack is also the co-author of Risk & Reward: Venture Capital and the Making of America’s Great Industries (1987). 

In the following report on “Invention, Innovation, & Implementation in the People’s Republic of China,” Jack calls attention to the recent explosion in Chinese patent filings and argues that Beijing is making huge strides in encouraging the development of intellectual property. Over the course of the next 30 years, he argues, China is likely to follow a path to technological transformation similar to that of the United States over the past century. But he explains that China “is not turning its intellectual property into innovations, and ultimately businesses, at the pace of the developed world.” 

This transformation is a long-term process, and while the current trend will likely lead to an enormous rise in Chinese productivity over the longer term, it’s not enough to save the People’s Republic from its shorter-term debt troubles or its high-stakes efforts to rebalance the economy over the next few years. That said, concrete steps taken today toward higher productivity growth may offer a way out of Japanese-style stagnation in the years to come.

Jack Rivkin
Invention, Innovation, & Implementation
in the People’s Republic of China
 

The date of China’s entry into the modern global economy might truly be identified with the creation of the China Patent Law in 1984. The next year the Law became a part of the Paris Convention for the Protection of Industrial Property, originally created in 1883, during the Second Industrial Revolution, and still in existence.

Much like many other emerging countries at the earliest times in their industrial and technological development, including the United States (US), respect for Intellectual Property (IP) was initially minimal, particularly for use within domestic borders. The US, for example, did an effective job of using IP developed in Europe during the early days of the First Industrial Revolution in the 1700’s. The textile industry benefited from skilled workers and merchants breaking the laws and immigrating [sic] to the continent with specific information. Some of the early families in the northeast, whose names are still familiar today, used machine designs memorized from observation in England to start major businesses. It wasn’t until the Second Industrial Revolution, beginning in the 1870s [sic], when many countries had developed their own intellectual property to protect, that patent laws and the legal enforcement of same became a part of the competitive industrial landscape. 

China, which has its own multi-century history of invention, followed the same path that many developing nations have when it began its move from an internally focused rural nation to a country in contact with the rest of the world. With cheap labor costs and an undervalued currency, China developed a labor-cost-driven export economy as it began building infrastructure, moving labor from the farms to the cities, and taking advantage of the pace of technological development in the rest of the world. Its internal development, satisfying the largest population base in the world, has not kept pace with its external growth. China is certainly aware of this, and in its more recent five-year plans has attempted to shift the economic mix. This has become more important as wage growth has diminished the Chinese labor advantage while other countries with low-cost labor have developed infrastructure and logistics to serve the global markets. The impact of the Great Global Recession has affected the path of China’s growth, while at the same time the populace has experienced the early benefits of an improved standard of living. And, through the presence of modern technology, the citizens are more aware of how much better life could be.

It is not that China has been unaware of its requirements to build a sustainable society. The pace and outcome have been affected by the success of its export efforts to take advantage of global demand. That has created major imbalances within the economy, particularly with the slowdown in external demand from the Great Recession.

China has already taken the first step toward determining its own future and shifting the internal balance of activity. The leaders have embraced what Alan Kay (of PARC fame) posited, ‘The best way to predict the future is to invent it.’

In 2006 the State Council published the 14-year National Medium- and Long-Term Plan for Science and Technology Development geared toward turning China into an “innovative nation.” Several key “frontier” fields were selected for specific science and technology development. 

Biological Sector:
Animal and Plant species design;
Pharmaceuticals;
Genetics and Protein engineering; 
Industrial biotechnology

Information Industry:
General applicability of computerization
 

Materials:
Intelligent materials and structure;
High-temperature superconducting;
Efficient energy and materials technology
 

Advanced Manufacturing:
Breakthroughs in extreme manufacturing;
Robotics;
Replacement cycles of products and facilities
 

Energy Research:
Economical, efficient and clean use of energy;
Exploration of new energy resources;
Alternative energy
 

Oceanic:
Exploration;
Monitoring of maritime environment;
Deep-sea operations;
Exploitation of gas-water mix
 

Space:
Laser technology;
other (not fully disclosed)
 

Key industries were also singled out for specific emphasis: 

Energy Water Mining Transport

Environment

Agriculture

Manufacturing

Communication

Information

Population Control

Health

Urbanization

Public Security 

In the Plan the Government indicated it would take on the primary funding responsibility for 1) basic research and 2) popularizing science and technology as educational fields. 

In addition, the Plan indicated that incentives would be put in place to create an emphasis on development of Intellectual Property. 

China has continued to follow this plan. In 2010, the State Intellectual Property Office (SIPO) published the National Patent Development Strategy for 2011 to 2020 (NPDS). This is a scary read, made even scarier, as it appears that China is on plan. China set very high targets for patent filings expecting to end 2015 with over 2 million filings. With trademarks counted they are already there. Without trademarks, in 2013, basic patents and design patents totaled over 1.5 Million. The US, in second place, had filed a little over 600,000. China’s other goal is to have 60% of its GDP driven from technology in services and manufacturing by 2020. At the current rate total R&D expenditures of $420 Billion on a PPP basis will approach that of the US by 2020 vs. about $300 Billion this year.

Ascending Dragon chart

Source: nature.com

Some other highlights from the NPDS: 

The plan establishes an annual budget for Patent services of around US$16 Billion. A recent FY budget request for the US Patent Office is $2.7 Billion. This is not a totally fair comparison as part of the Chinese funding is for lawyers and other professionals to support the filing process outside of SIPO. The plan also proposed setting up ten model cities focused on utilizing the patent system and incentives to create a vigorous intellectual property market. Incentives were put in place for individuals, corporations, and educational institutions to turn ideas into patents.

China also indicated it would seek to acquire intellectual property from others. A couple of direct quotes from the NPDS are worth noting: 

A large number of core patents will be acquired in some key fields of emerging industries and some key technological fields in traditional industries..:’ ‘…encourage enterprises to acquire patent rights through innovation on the basis of digesting and absorbing imported patented technology…’ 

… support and foster exports of patented technologies and increase the proportion of exported patent-intensive commodities…strengthen guidance of patent policies for enterprises in the process of overseas mergers and acquisitions.’ 

In addition, implied in the budgets for patent services was a vigorous enforcement of patent rights. Chinese companies have brought charges against major western world companies in Chinese courts and in European courts with some success. Chinese companies have also faced significant infringement charges as well. Internally, patent enforcements against non-Chinese companies represent about 15% of all attempted enforcement actions. The other 85% are actually Chinese companies against Chinese companies. Now that China has Intellectual Property Rights to defend, it is turning out to be one of the more aggressive enforcers of those rights. The number of patents in force today with their origin in the US and Japan are 2 ½ times and 1 ½ times, respectively, of China which has about 900,000 patent grants in force—sufficient enough to defend. 

The pattern of growth in filings is staggering.

Trend in patent applications chart

Trend in trademark applications chart

Trend in industrial design applications chart

Source: World Intellectural Property Organization

One can argue about the quality of the Chinese patents—not dissimilar from arguments by the US against Japan and Korea in earlier days. However, since 2009, China has had a first-to-file system, consistent with the rest of the developed world. In addition, a recent amendment requires absolute novelty of invention. This eliminates a party seeking patent protection in China for an invention first disclosed outside of China. The US and China patent offices have also extended a reciprocal agreement that “an applicant receiving a written opinion or an international preliminary examination report from either SIPO or the USPTO (US Patent and Trademark Office) that at least one claim in a Patent Cooperation Treaty filing has novelty, inventive steps, and industrial applicability, may request that the other office fast-track or expedite examination of corresponding claims…” This begins to get very technical, but in Intellectual Property claims, it is very technical. 

What is the message from these facts and observations? 

Clearly, China is serious about creating the Intellectual Property to drive Innovation and Implementation. They are executing toward their goals. Let’s start with the assumption that China has the same ratio as the US of high IQ individuals in its population. At this time the US is probably educating a larger percentage of its own high IQ population than China is — although we seem to be helping China educate a number of their smarter people. It does mean that they will have, if they don’t already, 4 ½ times the number of educated, smart people creating intellectual property. They should have, potentially, 4 ½ times the number of people who can translate those ideas or inventions into an innovation — a good or service that can potentially create value. And, ultimately, 4 ½ times the number of people who can actually turn an innovation into an implementation — turning potential value into real value. 

Beijing admits that it is not turning its IP into innovations, and ultimately businesses, at the pace of the developed world. Admitting the weakness is a step toward implementing the solutions. 

China is not without its successes:

Alibaba:
Effectively E-Bay, Pay Pal and a bit of Amazon, accounting for at least
60% of all parcels delivered in China, and 80% of on-line sales.
The Alibaba Group R&D Institute has been filing patents since 2008.
 

Baidu:
The Google of China and more, with very specific search tools by category (including patents). The Baidu search engine was based on a US patent issued to Robin Li, one of the two Chinese nationals who founded the company after time spent in the US.
 

Huawei:
Largest telecom equipment and services company in the world. Claims 46% of its 140,000 employees are engaged in R&D. Has been involved in numerous patent disputes as plaintiff and defendant. Holds over 36,000 patents.
 

Beijing Genomics Institute:
The largest genome sequencer in the world. Has a research-for-hire model. It acquired US sequencer, Complete Genomics, over protests of US competitors, in 2013. Founded in 1999 by a PhD dropout.

Midea:
Largest HVAC company in China. With sales of $18.7 Billion,
now spending about 3% annually on R&D.
 

Foxconn via Hon Hai Precision Industries:
Largest Chinese recipient of 1,004 US patents in 2013.
Compares to #1 IBM at 6,788.

The list could go on. 

The country now has more PhD graduates than the US. And, the Chinese graduates of US universities are beginning to return home. Innovation centers are being created and supported. Corporations are being incentivized to invent, and ultimately innovate and implement. To some extent it is a numbers game. Time and technology are on China’s side. Moore’s law knows no geographic boundaries. 

At the moment, the big US advantage is Implementation. It is no longer Invention. And, in my view, “Innovation” is an overused term. Yes, the media and the general American hubris point to Innovation as American Exceptionalism. We do have a lot of innovators in the US—many more than ultimately end up with successful products and/or companies. Almost everyone, every day, is innovating—taking an idea or invention and starting at least the verbal process of translating that into the thought of a new or improved product or service that might create value. We have the equivalent of that very big roomful of monkeys sitting at typewriters (now keypads), one of which will ultimately write a work of Shakespeare. We hear about the innovations in the US that work their way into the structure of financiers and implementers who can pick and choose which innovations may produce real value on occasion. China sees that. It has organized and incentivized its “monkeys,” which number many more than what everyone else has, and is slowly—maybe not so slowly—creating the infrastructure that can take advantage of a very big local market for experimentation. It is becoming a more internally competitive market. For example, innovations in the auto industry are making their way into implementation as the local companies compete with each other. This is not dissimilar from what happened with Japan’s auto industry and the supporting providers of machinery and electronics. Japan had a big enough local market that forced competition among its double-digit number of manufacturers and led to the creation of cars that could ultimately compete very well in the global market. China is doing that in autos, electronics, cell phones, alternative energy and more. 

So, how does one participate in this new source of innovation and implementation? One can find individual companies that are capturing market share domestically in more advanced technologies. Of more interest may be understanding how the “internet of things” and technology in general work their way into the more mundane companies, e.g., Midea, serving the domestic markets. Ultimately, these companies will have made the transition to efficient, technology driven, innovation and implementation, with the potential to serve other emerging market economies and, ultimately, the western world. On a very long term basis identifying a basket of successful technology driven Chinese companies could be an implementable strategy. I think one needs expert advice on this—investment managers who are doing on the ground analysis. 

In general, though, the technological thrust in a population the size of China bodes well for continued movement toward the mix of industry, services and agriculture that exists in most other developed countries in the world. Follow the pattern of the US as it developed from an agriculturally centric economy to a services economy and expect China to do the same but at a faster pace. It will not be without its ups and downs but a well-timed investment as China works through this transition, may do very well for one’s children and grandchildren. 

This path by China will ultimately represent a similar historic shift of development with geopolitical implications. It will be similar to those in past centuries from Holland to England and England to the Americas. None of these transitions have been zero-sum games, but they have not been without volatility. China has several major transitions to work through financially, politically and commercially. In the background, though, a technological freight train (or maybe a high-speed one) is chugging down the track. To the extent China’s actions increase the competitive pace of invention, innovation and implementation globally, it will likely change significantly the overall pace of global growth and the net value of the winners versus the losers in the market place. China is taking the next step to the future beyond Alan Kay’s observation. Maybe the best way to determine the future is to invent it, but then innovate and, most importantly, implement it.

“A Great Leap Forward?” Author, John Mauldin, Editor, and Worth Wray, Editor (eBook, Kindle Edition, 2015; http://www.amazon.com/Great-Leap-Forward-Technological-Transformation-ebook/dp/B00ZAKBDBA)

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