Opportunities for Future Development

While the PRC clearly faces challenges in the face of a rapidly globalizing economy, there exist some potential opportunities that, when appropriately leveraged, can be used to offset the existing disadvantages. In this section, we draw on our analytical framework developed in Section 2 to show how the PRC can create and intensify its innovative capacity and hence re-adjust its strategic directions.

Essentially, we envision the way forward for small and medium enterprises is for them to position themselves in the top-right hyperquadrant of Figure 2. In particular, by pursuing what we call a globalized fast follower innovation mode-which emphasizes an upgrading of both product and process technologies, coupled with an export orientation-the PRC's government can foster an environment that allows its SMEs to be competitive in the global economy.

Given the PRC's existing economic policymaking structure-premised heavily on the former Soviet Union's model of establishing functionally specialized organizations, whose activities and interactions would be managed by a central government body and not between each other (Lo 1997; Maruyama 1990)-any successful transition must take into account the appropriate scope of government involvement. Since the central government has hitherto been the primary manager of both the internal activities of these functionally specialized organizations, as well as the transfer of resources between them and between the government and each of these organizations, disconnecting future development from the existing government infrastructure would be tantamount to reinventing the wheel.

What this suggests is that reform of the SME sector is best undertaken in the context of the existing NIS. Indeed, the central issue in the PRC’s NIS today is not so much the establishment of actors. The necessary actors are, by and large, mostly in place. More important are the changes in organizational boundaries surrounding the activities that occur within the NIS, as well as the incentives that exist for actors to undertake these activities and to perform well. Clearly, this needs to be undertaken concomitantly with an effort to enhance linkages between actors. ¹⁵

We view measures that enhance the linkages between actors as crucial for the continued strengthening of the PRC's NIS. The network cluster strategy is particularly suited to the PRC's development strategy at this point, since the collective nature of the cluster may help resolve the problem of the "missing middle." The PRC has a surfeit of small enterprises that cannot grow because of informational and other market failures associated with its economic history of communism, and its current status as a transition economy.

The primary weakness of the existing cluster infrastructure in the PRC is that there is little or no integration that would afford the network economies that a directed cluster strategy would afford. With low levels of technological spillovers, limited local entrepreneurship, and little involvement of the government as intermediary agents, existing clusters are not viable as a medium and long-run strategy for upgrading the SME sector. One needs to be careful in the form of government intervention, however: Experience shows that forcing clusters to develop in a particular manner-other than being in potential violation of WTO rules-often leads to multiple inefficiencies, and undermines the competitiveness of the cluster as a whole. Intervention, therefore, should be limited to intermediation, as opposed to direct involvement.

The measures that we consider include providing a positive regulatory environment where private businesses can operate efficiently; fostering inter-firm cooperation through policies such as tax incentives and benchmarking; addressing the asymmetric information problem through advisory services and the training of human resources, coupled with micro-level financial reform; and promoting domestic and international technology transfer via an institutional infrastructure that supports such transfers. ¹⁶

Regulatory environment for private business

Firms in the PRC often suffer from a regulatory framework that imposes high costs in terms of both time and money in their relationships with government authorities. In the short run, nationwide reform may not be realistic. However, at the local level-such as within a network cluster-the government is beginning to provide a fair degree of latitude insofar as local governments' ability to institute local policies are concerned. This enhances ownership and hence has the potential to redirect local authorities' incentives away from neglect and toward commitment. The danger here, of course, is that providing such flexibility also engenders the danger of greater bureaucratic red tape and (possibly) corruption, which is inimical to growth (Djankov, La Porta, Lopez-de Silanes & Shleifer 2001).

A balance must clearly be reached in terms of practical measures that would provide a positive environment for private business establishment and operation. These measures include the establishment of long-term consultation mechanisms between the local business community and local government, the removal of unnecessary red-tape and rectifying bureaucratic procedures to promote efficiency, the introduction of agencies that assist in business formation at the local level, and the provision of better training of local civil servants, coupled with meritocratic recruitment policies. The experiences from advanced industrial countries suggest that such an inclusive approach at the local level can potentially reap beneficial outcomes (Organization for Economic Co-operation and Development 1996, 1997). With the success of the local level in place, the same strategy may then be feasibly attempted at the state/province level. The PRC has already demonstrated some success in this regard in its Special Economic Zones. The natural next step is to allow the diffusion of these zones into the macroeconomy in general, using as a model the regulatory environment of Hong Kong.

Stimulating inter-firm cooperation

Firms in the PRC that are currently organized as clusters often do not engage in much inter-firm cooperation. When the cluster hosts a number of competitive firms-and possibly even world-class manufacturers-the opportunity exists for these firms to play the role of demonstrators of best practice, which may be profitably imitated by the other firms in the cluster. Why, then, is such behavior uncommon in the PRC's industrial clusters? There are two main reasons. First, the uncompetitive environment under the centrally-planned economy, where every firm produces according to quota, has bred an attitude of complacency. Second-and related to the first-being sheltered from internal competition, these firms have no additional incentive to upgrade their manufacturing processes toward attaining best practice, or are simply ignorant of their underlying problems. As such, creating an awareness of the necessity for substantial improvements is a crucial precondition for intensified inter-firm cooperation.

Of course, such changes will not come easily. Firms that have acted independently in the past will not easily switch to a mode of close cooperation; this is not only because of an absence of trust, but also since engaging in cooperation may involve high fixed as well as transactions costs, especially at the outset. However, if government policy can highlight the advantages of cooperation within the network cluster, perhaps by offering tax incentives to do so, the discounted value of engaging in cooperative behavior may then exceed their persistence with the status quo. Alternatively, policymakers can adopt benchmarking with firms elsewhere (or with a world-class firm within the network cluster, if one exists), which may then clarify for firms just how far behind they are from the industry leaders. ¹⁷

Information, advisory, and training

As mentioned earlier, informational asymmetries are currently a significant inhibitor of SME growth in the PRC, especially with respect to the financial constraints that they face. One advantage of the network cluster approach is that information may be more easily shared, due to physical proximity. Moreover, the economies of scale that accompany organization as a network cluster may make it feasible for financial institutions to establish long-term relationships with the network cluster, as opposed to individual SMEs. As far as policymakers are concerned, the government can play a role in the dissemination of information by establishing dissemination standards. Moreover, the unique position of the state as a central actor also means that it may have more up-to-date information on technology, market structures, and regulatory mechanisms.

At present, the PRC's NIS has both venture investment funds as well as a general investment fund to support high-technology firms. However, these do not offer much by way of support for SMEs, in part because of informational asymmetries, and in part because of the relatively immature financial sector. Policymakers can help the development of the financial sector by encouraging collaboration between different classes of financial organizations, especially within a network cluster context, and hence promote the evolution of innovative financial schemes that are targeted toward the needs of SMEs, such as leasing, factoring, venture capital, e-finance, and securitization of SME debt.

A related problem that existing clusters in the PRC face is the poor match that occurs between the supply of and the demand for trained personnel. Often, the demand for qualified workers outstrips supply, in part because the labor market fails to operate adequately as a signaling device for training institutions. More specifically, while most graduates in the PRC do find jobs, it is unclear whether their respective training institutions are equipping graduates with the skills that are the most critical (and needed) for the job at hand, or whether market conditions for skilled labor in the PRC's overheated economy are so tight that firms are willing to accept applicants that possess qualifications that are only remotely relevant to the job. This is a form of market failure that can potentially be addressed within a network cluster setup. Since research and training institutes are located within the network cluster, they are closer to the ground in terms of understanding the network cluster's specific human resource needs. In addition, the government can also act as intermediary agents that organize clearinghouses that facilitate the exchange of human resource needs between firms and training institutions, and aid in the matching process of skills training to firm needs. This would facilitate the placement of the PRC's growing numbers of foreign-educated university graduates. Moreover, such intermediaries can also provide subsidies for the training of highly specialized human resources that may be needed in a network cluster-positions such as high-skill manufacturing personnel and quality assessment workers that are currently under-supplied by the domestic labor market.

R&D and domestic technology transfer

Finding support for R&D is usually a challenge in developing countries, and the PRC is no different. Moreover, the mere creation of an infrastructure for the promotion of R&D activities does not necessarily imply that such an infrastructure will be put to use. Undoubtedly, SMEs do benefit from easy access to cutting-edge research, since they may not be able to afford such functions on their own. However, the mere availability of such research is only a necessary but insufficient condition for their use, if there does not exist a channel between research institutions’ R&D output and the use of this R&D as an input in the production processes of firms. In this regard, communication is key. By providing a forum where such dialog can take place, policymakers can encourage firms and institutions to talk to one another, and cooperative partnerships may arise with a greater understanding of each other's specific aims and requirements. In addition, such a forum may also provide an avenue for airing misunderstandings and addressing conflicts that arise in the process of cooperative activity. Such fora also play an important role in promoting the utilization of research results, through conferences and meetings that announce new findings, or in helping in the process of technology matching.

How can the government build such fora? In industrialized countries, business associations often endogenously develop in order to fill this important role of moderators and facilitators. The PRC's history of suppressing free social association thus has a direct impact on its economic sphere. A compromise would be for Chinese policymakers to relax rules of business-related associations, in order to allow such organizations to be founded and grow in the PRC. These associations can also then form the basis for more sophisticated new institutions, such as formal and informal business network structures, cooperative R&D centers and institutes, and special interest representation.

Another approach is for the government to establish intermediary organizations that act as brokers in the formation of inter-firm networks within network clusters. Such an organization can then assist companies as they seek to link up with a range of support services. The goal of such an organization, therefore, is not so much to actively promote technology transfer per se, but rather to offer a medium by which SMEs can make clearer demands to technology suppliers, such as universities, technological institutes, and industrial development centers. This will render technology transfer more demand-driven, and hence cater to the idiosyncratic cultural aspects of the domestic Chinese market. At the same time, the organization can also create a national referral network, which will permit these suppliers of technology and know-how to be better matched with SMEs that have need for their specific technology. As such, "innovation networks" can be established that involve firms and institutions such as universities, R&D institutes, and engineering consultancies. These networks can be the basis for indigenous research capabilities, and hence wean the PRC off its dependence on foreign designs and process methods.

International technology transfer

The vast flows of foreign direct investment into the PRC have also brought some degree of international technology transfer. However, much of the international technology transfer that has occurred has been somewhat limited by concerns over intellectual property (IP) protection, as well as the constraint of (currently) relatively low levels of human capital, especially in areas such as quality management, logistical control, and worker motivation. An NIS network cluster, by addressing these two issues, is an ideal way to foster both the conscious transfer of as well as incidental spillovers from international technological know-how.

Since network clusters enhance domestic technology transfer as well as provide a greater motivation for worker training, human capital can be upgraded in order to facilitate international technology transfer. Moreover, technological knowledge can also be acquired from external sources by, for example, the use of international consultants, licensing arrangements between local and foreign companies, sending local workers abroad for training, and encouraging multinationals’ affiliate plants to engage in mentoring partnerships with their local supply chains-all of which benefit from the infrastructure and stability provided by a network cluster. One possibility is for local intermediary agencies, in considering investment projects, to adopt a two-tier system that distinguishes between local and foreign firms, perhaps by offering tax incentives to foreign firms that have demonstrably high levels of technological know-how. These foreign companies can then be matched with local industries in global supply chains, which would help drive local firms toward upgrading their own knowledge base.

Inevitably, one issue that needs to be considered in the medium to long run is that of IP rights, since this issue hampers international technology transfer, and in addition is a recurring complaint after the PRC's entry into the WTO. Currently, the PRC's IP regime remains marginal at best. While there are, arguably, strategic arguments to allowing the free (or easy) use of IP goods that exhibit the low marginal cost of production property, especially in a developing country, in the medium to longer run the PRC will need to begin to develop a more comprehensive intellectual property regime, especially if it is to encourage the indigenous development of research. ¹⁸ A step forward may be to establish network cluster-specific intellectual property offices that take enforcement more seriously, especially within the network cluster. With repeated interactions, IP violations may be more easily detected, and enforced. This can then, in future, be expanded into regional IP strategy headquarters. This decentralized approach may be more feasible than the PRC's existing centralized approach, headed by the State Intellectual Property Office (SIPO).

In summary, the dynamism of the network cluster induces local governments as well as intermediary agents to build up supporting institutions and target specific policies toward the rapidly-evolving clusters. These features distinguish network clusters from simple agglomerations of foreign investments such as those that exist in export processing zones; in the latter, agglomeration economies are usually confined to the final assembly stage, and inter-firm cooperation is almost nil. Strengthening the NIS system in the PRC in this regard is therefore an important and useful step forward.

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