Unnoticed by many, China has been rapidly transforming itself from the world’s factory floor into its R&D hub.

A spate of recent announcements by multinationals highlights a dramatic turnaround in the way China is perceived. To name a handful: Germany’s Siemens, an engineering corporation, in December 2015 announced plans for a new innovation centre to develop new digitalisation solutions for both the Chinese and international markets; Sweden’s Ericsson, a software and communications infrastructure company, entered an agreement with China Mobile Research Institute, the research division of the world’s largest mobile operator, to collaborate on 5G R&D, the next major phase of mobile telecommunications standards; and US-based Ford Motors announced a plan to invest $1.8bn in China over a five-year period, to improve the connectivity and semi-autonomous features of its cars, significantly building up its R&D capabilities in China, especially at its Nanjing Research and Engineering Centre.

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Shifting patterns

Driving the remarkable shift of R&D functions from the West to China – and India – is the need to be close to a high-growth market, to manufacturing sites, and to suppliers, as well as the search for lower development costs, according to the 2015 Global Innovation 1000 study by Strategy&, PricewaterhouseCoopers' (PwC's) strategy consulting business.

Drawn by these factors, foreign companies increased their spending on R&D in China by 79%, or $44bn, in 2015. That brought total 2015 R&D spend by domestic and foreign companies in China to $55bn, according to Strategy&.

Furthermore, according to greenfield investment monitor fDi Markets, China attracted 88 greenfield R&D projects worth $5.5bn from foreign companies between 2010 and 2014 – making it the world leader in terms of capital expenditure. The US attracted 91 projects, but their aggregate value was less than half of those based in China.

Figures from China’s Department of Foreign Investment Administration show that FDI in R&D and design in the country was up 52% in the first half of 2015 compared with 2014, while FDI in scientific research services rose 114%. The trend spans industries, from transportation to aviation, IT, life sciences, manufacturing and other sectors.

Barry Jaruzelski, a principal with PwC US who co-authored the Global Innovation 1000 study, points to the growing ascendancy of Chinese companies in its rankings, as well as the rising numbers of US, European and Japanese companies bringing R&D funds to China. “Imported R&D rose 79% in eight years,” he says. “If you are doing development, you may focus on China but you are also serving the world.”

Incentivising investment

Still, many corporate honchos viewing China from their external headquarters share a misconception about the level of innovation in the country, according to Steven Veldhoen, who heads PwC’s China innovation practice. In a study he co-authored, less than one-third of CEOs outside of the country believed there was a Chinese competitor as innovative as their firm – while two-thirds of their R&D managers working and living in China held the opposite view.

“It is the difference between 'living China' – and experiencing its ultra-competitive and innovative context every day of the week – versus simply observing it from the outside,” says Mr Veldhoen.

He points out that the Chinese government recognises the importance of innovation and actively stimulates it, both by encouraging corporate R&D and by funding research itself. “There is also a good flow of venture capital and private equity, and the mindset of the young in China is very entrepreneurial,” he says.

In October 2015, China announced an additional set of tax incentives to promote corporate R&D by foreign companies. National priorities include upgrading the quality of FDI; implementing 'smart manufacturing' projects; promoting cloud computing, big data, 'car networking' and integration of the internet with industry; and 'smart transportation'.

Satisfied customers

The history of Siemens in China – which dates back to 1872 – illustrates how the value chain has shifted. Starting with manufacturing, then adding more knowledge-intensive activities, its Chinese operations began to work on country-specific adaptations for some products, then moved to the development of less complex products for a global market, according to Norbert Gaus, head of research for digitalisation and automation and platform development at Siemens' headquarters in Munich.

About 10 years ago, Siemens began to build up its research capability in China, and now has research activities in Beijing, Shanghai, Wuxi and Nanjing. Its new innovation centres will be in Suzhou and Jiangsu province. Mr Gaus declined to disclose the cost of the new investment, which will focus on digitalisation and automation, but said it will add 300 researchers, bringing the total in China to about 700.

Ford opened its Nanjing research centre in 2007, as one of eight product development centres worldwide. The centre “has played a key role in the product development process” for the Ford Escort and Ford Taurus in China “while continuing to support Ford’s global vehicle development programmes”, according to a Ford spokesperson.

With nearly 5000 employees in Beijing, Shanghai, Guangzhou, Nanjing, Chengdu and Shenzhen actively engaged in R&D and global product development of the entire Ericsson portfolio, China has become the largest R&D base of Ericsson outside Sweden, according to a company spokesperson. The country is also Ericsson’s second largest market.

A note of caution

Despite the attractions of China as an R&D hub, it also faces a major drawback: the threat of intellectual property (IP) theft is almost legendary. The US-China Business Council reports that half of its members surveyed are holding back on R&D in China for this reason. Mr Gaus says Siemens has been burnt as well. “We started to take an increasingly strong position on the valuation of our IP, and we have successfully sued product pirates in China,” he says.

But Mr Gaus, together with the other experts interviewed for this feature, agree that the Chinese government now recognises the importance of a trustworthy IP regime, and has toughened the laws on IP protection. The cause has been helped by the growing number of global Chinese corporations anxious to protect their own patents and copyright.

Mr Gaus has some advice for companies contemplating R&D in China. “You have to be in it for the long term. That’s the biggest mistake a company can make,” he says, adding that it takes time to build a strong R&D team. Competition for the top engineering and scientific talent is intense, and hires have to be smart people who also understand product life cycles and how products work in diverse markets. Companies located outside the most desirable cities or regions face an extra hurdle in attracting talent.

In addition, Mr Gaus warns: “Cost should not be the decisive factor.” In fact, a 2013 report by KPMG concluded that while construction, plant and property costs were still relatively low in China, especially outside of the coastal regions, the salaries of middle or upper R&D managers may be the same or higher than in the US or Europe, because of still limited supply and high demand from both foreign and domestic companies.

For the moment, the US retains its position as the top global location for innovation, according to the Strategy& study, and remains a favoured destination for R&D by foreign multinationals. It ranks fifth on the World Intellectual Property Organization’s 'Global Innovation Index 2015' of 141 countries, behind Switzerland, the UK, Sweden and the Netherlands. However, China has moved up to 29th place and patent applications filed there amounted to one-third of the world total in 2014.

The secret is getting out.