Innovation is central to the long-term economic development of a country. In order for innovation to arise, a socio-economic, financial and institutional enabling environment is fundamental. Innovation however does not arise by itself: it requires actors capable of driving innovation and adopting innovation.
A leader, a follower, and a competitor
When assessing the current situation, it is important look both at the static picture and at the dynamic development. The current global picture of innovation then depicts the United States leading the way, the European Union following with difficulty, and China chasing them both.
The US is in fact still a global leader: with GDP per capita over $55,000, labour productivity per person around $119,000, and over 1,500 patents filed per 1 million inhabitants in 2014, the US maintains a strong advantage. The EU follows quite closely and still performs better than China. However, it has stopped catching up with the US since the late 80s, losing ground since the 2008 crisis. China still lags behind both the US and the EU, however catching up at an incredibly high pace. Since 1990, GDP p.c. has grown fourteen-fold in China. In the last decade, China has experienced sustained growth in labour productivity peaking at 10% and 12% in 2006 and 2010, whereas the American and European growth rates were mainly below 2%. And from virtually no patents filed in 1990, China has almost caught up with the EU.
The US has always been leading the way, while the EU has transitioned from being an engaged “catcher-up” to a limping follower. On the other hand, starting from a low point, China has been chasing the EU and the US, and is now turning into a real global competitor.
An Innovation-Friendly Environment
High-quality human capital, efficient infrastructures, developed financial sector, and reliable institutions are necessary elements to build an innovation-friendly environment. In almost all these areas, the pattern of a leader, a limping follower and a competitor can be detected.
Human capital is arguably the most important determinant of long-term economic success of a country. The US and the EU score similarly well, while China lags behind. In terms of public expenditure on education, the US leads with 5.2% of GDP in 2014, the EU follows with 4.9%, while China spent only around 3.6%. Furthermore, among the world top 100 universities for engineering and technology, 24 are American, 25 are EU-based, and only 6 are Chinese.
Efficient and integrated infrastructures reduce costs and widen the markets for inputs and outputs of production. The World Economic Forum (WEF) rates the quality of American infrastructures at 5.9 out of 7, of EU ones slightly below at 5.8, and of Chinese ones at 4.7. Nevertheless, in the EU and the US, infrastructure investments rates have decreased in the 2008-2013 period, while increasing in China. Furthermore, China is investing more than Northern America and Western Europe together (8.6% of world GDP versus a combined 5%).
The importance of the financial sector (and venture capital in particular) mainly lies in its provision of funding. In terms of VC availability, China has already overtaken the EU (which is loosing ground on the US) and is closing the gap with the US. One of the reasons hampering early stage financing in the EU is the greater difficulty for VC investors to sell their shares through equity markets. European exit markets are not only smaller, but also fragmented along national lines, reducing liquidity and venture capitalists’ exit possibilities.
Institutions such as property rights, intellectual property rights, transparency, accountability, efficiency of the legal framework and investor protections all have a strong impact on how innovation-friendly the economic environment is. There is virtually no gap between the US and the EU in any of these categories, while China scores much worse. The institutional environment might actually be one of the main challenges China will have to overcome.
Driving and Absorbing Innovation
Driving innovation requires scientists and engineers, high company spending on R&D, government procurement of advanced tech products, and university-industry collaboration. The US leads in these areas, while the EU has been overtaken by China, which is quickly catching-up with the US. The EU poor performance can be explained in terms of weak industry-science links, poor commercialisation of research results, and the economic crisis. Even in terms of innovation hubs, the US leads with 9 hubs in the world Top 20, while China stops at 2 (Shenzhen 2nd, and Beijing 4th), and the EU at 1 (Einhoven, Netherlands 19th).
For innovation to be useful, it has to be adopted by firms. Comparing the availability of latest technologies, the firm-level technology absorption, and technology transfer, the US performs best, with the EU following it. China performs significantly worse, but it has largely improved. Specifically, the largest gap between China and the US is in availability of latest technologies.
A Dynamic Economy
The need of a dynamic environment is also crucial. Dynamism can be analysed looking at the easiness of starting a business, dealing with construction permits, registering property, getting credit, enforcing contracts, and trading across borders. China performs worst in all of them, while the EU closely follows the US. The EU performs best only in trading across borders, but the statistics do not distinguish between intra- and extra-EU trade.
Purchasing Power Parity
Purchasing Power Parity (PPP) is the notion that “in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services in any two countries”. Using the Big Mac Index and USD as the benchmark currency, what emerges is that the euro is undervalued by 16.6% and the Chinese Yuan is undervalued by 44.7%. Further, when compared to the euro, the Yuan is undervalued by 33.8%. This gives China a great advantage over the US and the EU in attracting investments and businesses.
The US still maintains a strong hold on the leadership in the innovation race. On contrary, the EU is relentlessly drifting away: while it was catching-up with the US until the 90s, it has since then stopped in the process and the gaps have in fact widened since 2008. Further, the EU has been surpassed by China in some areas. China has been experiencing amazing improvements and is on the way to eventually close the gap with the US. Moreover, China can still count on the advantaged of a strongly undervalued currency. However, while it is well on its way to become a real competitor of the US in the field of innovation, China still has to confront some major challenges, which mainly lie in the fields of institutions and easiness of doing business.
A Final Note: Brexit
In this article, the performance of the EU stands for the average performance of the 28 member states, weighted by their GDP. It is important to note that the result of the British referendum on EU membership will negatively affect the performance of the EU. All top EU universities are in fact British (Oxford, Cambridge, LSE, and UCL). The Oxford-Cambridge-London area is one of the most important ones in the EU in terms of innovation. London has been the main financial hub serving the entire EU, providing financial services and venture capital. And the British economy is among the most innovative and dynamic ones in the EU.