MGI China Effect_Executive summary_October_2015.pdf

EXECUTIVE SUMMARYOCTOBER 2015THE CHINA EFFECT ON GLOBAL INNOVATIONCopyright McKinsey&Company 2015In the 25years since its founding,the McKinsey Global Institute(MGI)has sought to develop a deeper understanding of the evolving global economy.As the business and economics research arm of McKinsey&Company,MGI aims to provide leaders in commercial,public,and social sectors with the facts and insights on which to base management and policy decisions.MGI research combines the disciplines of economics and management,employing the analytical tools of economics with the insights of business leaders.Our“micro-to-macro”methodology examines microeconomic industry trends to better understand the broad macroeconomic forces affecting business strategy and public policy.MGIs in-depth reports have covered more than 20 countries and 30 industries.Current research focuses on six themes:productivity and growth,natural resources,labor markets,the evolution of global financial markets,the economic impact of technology and innovation,and urbanization.Recent reports have assessed global flows;the economies of Brazil,Japan,Mexico,and Nigeria;Chinas digital transformation;Indias path from poverty to empowerment;affordable housing;and the effects of global debt.MGI is led by three McKinsey&Company directors:Richard Dobbs,James Manyika,and Jonathan Woetzel.Michael Chui,Susan Lund,and Jaana Remes serve as MGI partners.Project teams are led by the MGI partners and a group of senior fellows,and include consultants from McKinsey offices around the world.MGI teams draw on McKinsey partners and experts.Leading economists,including Nobel laureates,serve as MGI advisers.The partners of McKinsey&Company fund MGIs research;it is not commissioned by any business,government,or other institution.For further information about MGI and to download reports,please visit IN CHINA The McKinsey Greater China Office serves clients across a broad range of industry and functional areas.Since the first office in the region was established in Hong Kong 30years ago,McKinsey has completed more than 2,500 client engagements across more than 15 industries.We advise clients on strategy and a wide range of issues.In addition to providing strategic advice,we work closely with clients to redesign their organizations for higher performance,improve their operations,market their products more effectively,integrate acquisitions,improve risk management,reduce costs,streamline supply chains,and get better value out of their IT investments.For more information about McKinsey Greater China,please visit .Jonathan Woetzel|ShanghaiYougang Chen|Hong KongJames Manyika|San FranciscoErik Roth|ShanghaiJeongmin Seong|ShanghaiJason Lee|HoustonOCTOBER 2015THE CHINA EFFECT ON GLOBAL INNOVATIONIN BRIEF CHINA CAN BECOME A GLOBAL INNOVATION LEADERChina has the potential to evolve from an innovation spongeabsorbing and adapting global technologies and knowledgeto an innovation leader.Chinese companies are performing well in some types of innovation,by filling consumer needs with better products and services and wielding the power of Chinas manufacturing ecosystem to make innovations in production processes.China has yet to take the lead in more challenging forms of innovation,such as scientific discovery and engineering,but Chinese companies are using a distinctly Chinese way to nimbly accelerate experimentation and learning on a large scale.China faces an innovation imperative.As two sources of growthlabor force expansion and heavy capital investmentfade,innovation(broadly defined)will need to contribute up to half of GDP growth by 2025,or$3trillion to$5trillion in value per year.We identify opportunities to create value of$1trillion to$2.2trillion per year in 2025 through innovations to expand and raise the productivity of the service sector and further improve manufacturing efficiency through digitization.Performance varies across the four“archetypes”of innovation.We gauge innovation impact by examining 30 industries in four innovation archetypes.China performs well in customer-focused and efficiency-driven archetypes,but is catching up in engineering-and science-based archetypes.Chinas large and dynamic market gives it an edge in customer-focused innovation.Chinese innovators use Chinas massive consumer market(more than 100million mainstream consumer households today)to commercialize new ideas quickly.Chinese consumers enable innovation by accepting early iterations of products and services and providing feedback for rapid refinement.Chinas manufacturing ecosystem enables efficiency-driven innovation.China has the worlds most extensive manufacturing ecosystem,with more than five times the supplier base of Japan,150million manufacturing workers,and modern infrastructure.Accelerated learning is essential for engineering-based innovation.Purchasing by government-owned enterprises,facilitation of technology transfers,and introduction of market discipline are accelerating learning needed for engineering-based innovation in such industries as communications equipment,wind power,and high-speed rail.Chinese companies are trying to catch up in science-based innovation using novel approaches.The government push to raise R&D spending,train scientists,and file for patents has yet to give China a lead in science-based innovation.Today,Chinese companies in science-based industries are developing their own approaches to catch uptaking advantage of Chinas lower cost and large pool of researchers to industrialize and accelerate experimentation and discovery.In the next ten years the“China effect”on innovation will be felt around the world as more companies use China as a location for low-cost and rapid innovation.The overall China effect could be disruptive,bringing large-scale yet nimble innovation to serve unmet needs in emerging markets and produce new varieties of goods and services for advanced economies.Around the world consumers could benefit from better goods at lower prices.1 Innovation measured as contribution from multifactor productivity growth.2%=Chinese companies share of global revenue pool.Accelerating the China effect to make innovation cheaper,faster,and more globalAccelerating the China effect to make innovation cheaper,faster,and more globalSupport innovation clusters Improve lifestyle factors to attract top talentReward innovatorsReform capital-raising processes and strengthen intellectual property protectionRaise the bar for quality As purchaser,be a demanding customerEnable innovators Remove barriers and encourage competitionBuild a Chinese talent poolRecruit and develop talent in novel waysDiscover new sources of insights Find ideas through open innovation processes Operate at China speed Rapid,nimble innovation processesMake bigger bets Invest more in China-based innovationGovernmentCompanies ChinasadvantagesCurrent performanceFutureopportunityExtensive manufacturing ecosystem(suppliers,labor,infrastructure)Next-generation manufacturing($450B$780B by 2025)Massive domestic market for rapid commercializationInternet-enabled innovation in service sector($550B$1.4T by 2025)Government creates local demand,enables learning Opportunities in targeted industries,including nuclear power,medical equipmentDrug discovery,genomicsRapidly increasing,low-cost R&D capacityStrong Solar panels(51%)Construction machinery(19%)Rapidly improving Household appliances(36%)Internet software(15%)Mixed High-speed rail(41%)Commercial aviation(1%)Opportunities Branded pharmaceuticals(1%)Semiconductor design(3%)FutureopportunityCurrent performance2Chinasadvantages SCIENCE BASED EFFICIENCY DRIVEN FOCUSED CUSTOMERENGINEERING BASEDChina has opportunities in 4“archetypes”of innovationChina has opportunities in 4“archetypes”of innovationChina can become a global innovation leaderChina can become a global innovation leaderChina faces an innovation imperativeChina faces an innovation imperativeThe labor force is no longer growingAging is expected to reduce the working-age population by 16%by 2050Return on fixed asset investment is decliningIt takes 60%more capital to generate a unit of GDP than it did from 1990 to 2010Two traditional sources of growth are fading.Productivity share of GDP growthProductivity share of GDP growth1990200020102014201520252000201030%48%40%$3T$5T by 2025Up to 50%.so to sustain 5.56.5%growth rates through 2025,innovation would need to contribute up to 50%of GDP growth1viiiMcKinsey Global Institute AlamyEXECUTIVE SUMMARYHow innovative is the Chinese economy?By some common measures of innovation,China has already become a global innovation leader.Each year it spends more than$200billion on research(second only to the United States)and turns out close to 30,000 PhDs in science and engineering.It leads the world in patent applications(more than 820,000 in 2013).However,when it comes to the actual impact of innovationas measured by the success of companies in commercializing new ideas and competing in global marketsthe picture is mixed.China has become a strong innovator in some industries,largely by serving domestic demand.In the more challenging types of innovation,such as creating new drugs and designing new commercial airliners,China is still not globally competitive.In this research we have examined the state of innovation across major sectors of the Chinese economyidentifying factors that drive successful innovation in different types of industries and the policies that can advance innovation.We find that China has some unique strengths in innovation,including the largest base of consumers of any country,which enables rapid commercialization of new ideas.It also has the worlds most extensive manufacturing ecosystem,enabling continuous innovations in production processes that reduce costs and improve quality.And,thanks to investments over the past three decades,China has created capacity for research with a growing number of universities and research institutions,as well as an expanding pool of talent.We also have identified obstacles to innovation,such as slow regulatory processes and weak intellectual property protections.Our conclusion is that China has the potential to build on its strengths in innovation and become a global leadercreating a“China effect”on innovation around the world.This conclusion is based on Chinas momentum in consumer-facing industries and manufacturing,and its growing capacity for innovation in industries where it is not yet globally competitive.Not only can China serve as the locus of innovation for a growing number of companies that want to penetrate China and other fast-growing emerging markets,but the Chinese approach to innovation also can spread,helping companies everywhere turn ideas into products and services more quickly and for less cost.Completing the journey from innovation spongeabsorbing and adapting existing technology and knowledge from around the worldto global innovation leader is not just a way to signal Chinas progress as an economy and society.The boost to productivity that innovation provides is critically important for sustaining Chinas growth.We also identify specific innovation opportunities in manufacturing and service industries that can contribute$1.0trillion to$2.2trillion in value by 2025,or equivalent to as much as 24percent of total GDP growth.$1.02.2TValue of specific innovation opportunities in manufacturing and services2McKinsey Global InstituteExecutive summaryCHINAS INNOVATION IMPERATIVE As the events of 2015 have illustrated,China is in the midst of a very challenging transition to a slower-growing,more consumption-driven economy.For 30years,from 1985 to 2015,Chinas GDP rose by 9.4percent per year on average.However,two forces that helped to drive this growtha constant flow of new workers into the labor force and massive investments in housing,infrastructure,and industrial capacityare receding.Because of aging,Chinas labor force will soon peakperhaps as soon as 2016and begin a long decline that could reduce its size by 16percent by 2050.And macroeconomic returns on fixed asset investments have fallen:it now takes 60percent more capital to produce one unit of GDP in China than it did,on average,from 1990 to 2010.1 Investment is also constrained by Chinas debt,which,at 282percent of GDP,exceeds debt-to-GDP ratios in the United States and Germany.Without labor force expansion and investment to propel growth,China must rely more heavily on innovation that can improve productivity.We use multifactor productivitygrowth that does not come from factors of production such as labor and capital investmentas a proxy for the macroeconomic impact of innovation broadly defined(including productivity gain from catch-up).The contribution to GDP of multifactor productivity has been falling in China,from nearly half of yearly GDP growth in the 1990 to 2000 decade to 30percent in the past fiveyears.To reach the growth target of 5.5 to 6.5percent per year(the current consensus view from five leading economic institutions),multifactor productivity growth will need to contribute 35 to 50percent of GDP growth,or two to three percentage points per year of GDP(ExhibitE1).2 Improving innovation performance would have additional benefitshelping Chinas transition to a more balanced,consumption-driven economy by expanding the service sector and providing more high value-added jobs.Rising productivity is also critical for creation of the well-paying jobs that can raise living standards and employ a growing urban population.1 This is based on the incremental capital-output ratio(ICOR),which averaged 3.4 from 1990 to 2010 and stood at 5.4 in 2010 to 2014.2 Consensus is based on projections from The Economist Intelligence Unit,IHS Global Insight,the International Monetary Fund,the Oxford Economics Forecast,and the World Bank.It now takes 60 percent more capital to produce oneunit of GDP in China than it did,on average,from1990 to 2010.3McKinsey Global InstituteThe China effect on global innovationExhibit E1SOURCE:McKinsey Global Institute analysisMultifactor productivity share of GDP growth(%)Real GDP growth%1 Calculated as total GDP growth minus three factors of production(energy,labor,and capital),multifactor productivity broadly measures the impact of innovation on the economy.2 Baseline GDP estimate developed by regressing more than 100 variables from historical trends,assuming no major economic shocks.Key variables include demographic change,unemployment rate,interest rate,factor cost changes,depreciation,inflation,and urbanization rate.NOTE:Numbers may not sum due to rounding.3.24.23.73.52.31.10.92.31.81.04.05.04.22.40.51.0Fixed capital2.03.0Multifactorproductivity12015E2025E25.56.5Employment10.519902000Energy supply0.12010148.00.32000100.210.41980909.3355043484030Residual(innovation/multifactor productivity)Factors of productionInnovation(broadly defined)can contribute 2 to 3 percentage points of GDP growth in China by 2025,accounting for 35 to 50 percent of