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Private sector requires incentives to lead R&D

China Daily

So why are Chinese enterprises reluctant to concentrate on research and development (R&D)?

Entrepreneurs from the private sector are keen to give the answer: In the first place, R&D requires huge amounts of investment on which there may be no returns if the project fails. It is difficult to recoup funding even if it turns out to be a success.

Newly developed products are widely copied shortly after they enter the market. The pirated products are extremely cheap, which simply elbows out competition.

Private entrepreneurs are also concerned about the uncertainty and volatility of the market. They say the best course of action is to urgently make money while economic conditions are favourable.

State-owned enterprise (SOE) managers tend to be short-sighted when it comes to R&D, though their considerations are different.

Top SOE executives are appointed by the government, with their tenure generally spanning five years, which is a shorter period than the cycle needed for developing a new and important product.

Promotion is their key motivation. This requires a good performance, particularly in the short term.

Suppose the development of a new product takes 10 years. Most SOE managers are not expected to survive as incumbent executives to see success over such a long span. To make matters worse, all opportunities for promotion would have slipped away by the time R&D yielded fruit.

No matter how important the new product is to the enterprise and the country, it is secondary in terms of the indicators in superiors' annual evaluation of executive performance.

Because of this, incentives need to be introduced. But this would be difficult as R&D needs such a huge input of capital while it remains uncertain whether investments will pay off or not.

There are other big question marks. Would the new technology or product be accepted by the market? Would it be copied upon release, robbing the developer of the ability to price this new product or technology?

The loss of the ability to price the new product means sales income would fall far short of expectations.

In the event of investment in R&D failing to bring in profits, enthusiasm for R&D would be dampened.

Some have suggested the government preside over R&D work in order to make up for the lack of both enthusiasm and capital input on the part of the private sector.

The issue of government involvement in stimulating interest in R&D is also important as there are commercial aspects to the development of large-scale State-sponsored projects such as the manned spacecraft.

In the first place, the success or failure of an R&D project has nothing to do with the interests of government personnel that are overseeing the project. So where does their initiative come from?

Second, government officials generally lack experience in business and commerce. As a result, they are no smarter than private entrepreneurs when the selection of programmes, management of R&D and application of research outcomes is concerned.

Third, the government is unable to make accurate judgments on an R&D project's commercial potential, seeing as it does not possess enough market information, unlike private entrepreneurs that are deeply involved with the market.

Enthusiasm for R&D would be encouraged if a new model were introduced under which the government looks after matters of capital and private firms bid for R&D projects. But it will remain difficult for the government to steer clear of incentive, market experience and information possession.

In the final analysis, it is obvious that only private enterprises should play the leading role in R&D. Therefore the remaining question is: What is their incentive?

The answer lies in upgrading the current set-up so that it effectively protects intellectual property rights (IPR).

Only if piracy and copying activities are effectively controlled will the developer be fully capable of pricing his newly-developed product, which means a relatively high price and a larger margin for profits.

This, in turn, would help guarantee returns for investors that back risky R&D projects.

Only profits will persuade enterprises to continue to pursue R&D.

Douglas North, 1993 Nobel Laureate in Economics, discovered in his study of Western European economic history that effective IPR protection helped increase returns on R&D investment and stimulated systematic, commercial-orientated and sustainable R&D activities over the long term.

He pointed out the quintessence of Industrial Revolution was not merely a matter of technology. It involved an interaction between technology and economic infrastructure, or, in other words, the decisive role played by the set-up in the course of technology translating into productivity.

Applying this thinking to an analysis of China's situation, we can see that protecting private enterprises' IPR has double significance. First, IPR protection helps increase returns on R&D investment. Second, it helps reduce uncertainty about the future of the market and, in turn, leads private enterprises away from merely pursuing short-term interests, making them strengthen core competitiveness in the long run.

IPR protection is equally important to SOEs.

But this is not enough. The selection and engagement of SOE executives ought to be dictated by market forces. Currently, government-appointed SOE heads are not concerned so much about evaluation of their performance by the market as by assessments made by their superiors. The government's non-commercial tendencies determine that SOEs' enthusiasm for R&D is weaker than that of the private sector.

It is necessary to continue to reduce the proportion of State-owned economic entities in the economy.

The government's role is non-market by nature. The selection of R&D projects, which are commercial in essence, management of the projects and application of new technology is none of the government's business, except for major non-commercial R&D programmes such as space exploration.

The government should, instead, concentrate on introducing up-to-date set-ups, while particularly emphasizing IPR protection.

The author Xu Xiaonian is a professor at the Sino-European Business College.

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