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December 2, 2021 | A Step Ahead
U.S. vs. China: Can Investment Today Tell Us About Growth Tomorrow?

Olga Bitel, Partner

Global Equity Strategist

Hugo Scott-Gall, Partner

Portfolio Manager,
Co-Director of Research,
Global Equity Team

Have a question for Hugo and Olga to explore on a future walk?

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If today’s reinvestment rate is a good proxy of future investment opportunities and innovation driven growth, how do the United States and China compare on that measure? Hugo and Olga delve into the specifics of public and private sector investment and debate the direction of travel for both economies.

Hugo Scott-Gall: So we finished our last walk with a cliffhanger—we talked a lot about our investability framework, which was great but philosophical and conceptual. We’re now going to take it for a drive and see how it performs. When we compare the world’s two biggest economies, the U.S. versus China, we spend a lot of time talking about reinvestment rates. The reinvestment rate is a pretty good lead indicator of innovation-driven economic growth.

So let’s start comparing the U.S. and China, and let’s begin with the reinvestment rate across the whole economy, both public and private. How should we frame the reinvestment rate? And then what do we think about the current levels?

Olga Bitel: I suppose one way to think about reinvestment rate holistically is through the concept of research and development, or R&D for short. In 2020, the U.S. National Science Board published a useful update on the state of U.S. spending on R&D and put it into an international context, so I’ll use this report as the basis for our discussion today.

Discovery, invention, and innovation are the principal components of the reinvestment rate.

To start, R&D encompasses three types of activities: basic research, applied research, and experimental development. According to the OECD, basic research is undertaken at the level of fundamental science without a specific application in mind. Applied research is directed toward a specific, practical objective, while experimental development focuses on producing new or improving existing products and processes. So, think of discovery, invention, and innovation as the principal components of the reinvestment rate.

Between 2000 and 2017, U.S. R&D activities grew at a compound annual rate of 4.2%, while the comparable figure for China is 19.3%. What this means in practice is that by the end of 2017—the last year for which detailed data are available—China’s overall R&D expenditure at $500 billion PPP nearly matched U.S. outlays of $550 billion.

Hugo: I like the idea of using R&D as the proxy for the reinvestment rate. If you were to construct a “reinvestment rate index,” how would you determine who is going up and going down? Should we even think about R&D spend relative to anything else, for example relative to the size of the economy? Or is it more of an absolute dollar spend? You don’t invent the internet relative to the economy, you just invent the internet.

I’m thinking the index would just be the absolute dollar spend and then the rate of change. You’ve already talked about the levels of R&D spending in China and the U.S., so let’s discuss the rate of change component. Is the U.S. private sector as innovative as ever, or is corporate spend all about the buybacks now?

Olga: On its face, U.S. companies do not appear to have slowed their spending on innovation. This varies widely by industry, but overall, R&D fluctuates between 3% and 4% of revenue.

If we were to look at it on a relative basis, the U.S. spends about 3% on R&D relative to GDP. It ebbed and flowed over time but has generally fluctuated between 2% and 3% since the early 1960s. What has changed dramatically is its composition. Specifically, government-funded R&D, primarily basic research, had declined from 1.8% of GDP in 1963 to 0.65% by 2018.

By far, whether in the U.S. or China, the largest amount is spent on improvement, or the D part of R&D. Invention, or applied research, makes up a further 20% of R&D in the U.S. and 10% in China. Finally, basic research or scientific discovery is primarily undertaken with government funding and accounts for 17% of all R&D spend in the U.S. and only 6% in China.

The challenge with leaving virtually all R&D activities to the corporates is that they will likely spend less than they should in aggregate.

The challenge with leaving virtually all R&D activities to the corporates is that they will likely spend less than they should in aggregate. That’s not only because basic and applied research tends to be highly uncertain and may not bear fruit for many years. Since no one company can capture the full benefits of a scientific breakthrough, corporates in aggregate underinvest in this activity. At the same time, fundamental science is crucial as it paves the way for future applications and product development.

As other countries, not least China, increase their R&D expenditures, they are increasingly competing in high-value-added products and services, eroding U.S. competitive advantages in these areas over time.

So, you are quite right, Hugo. It’s not only the overall R&D spending that matters. Arguably, what matters even more is the composition of this spending and the relative growth of each type of investment.

Hugo: Okay, so the reinvestment rate has some predictive value, which leads me to two questions. First, the reduction in the U.S. investment rate is concerning. Does it portend U.S. stagnation ahead? And similarly, does China’s rate guarantee some future success, or is it too difficult to tell?

Olga: Yes, the direction and composition of investment spending in the U.S. is concerning. And not only in an absolute sense, but especially relative to the broader competition. For example, the European entrepreneurial ecosystem is showing signs of life. I was surprised to learn recently that in 2021, Europe not only produced 72 unicorns but was the fastest-growing region for venture capital funding globally.

Back to China, The Economist, in its August 21 edition, ran a story on a breakthrough development of an affordable prosthetic hand that sends and receives signals from the brain, just like a natural hand, and costs $500. This invention is not just about a small group at Shanghai Jiao Tong University. Think of all the materials scientists, neurologists, and all kinds of other professionals who must have contributed to this.

Consistent focus on basic research provides the foundation for much innovation down the road, with the caveat that innovators may not be in the same country as the discoverers.

More broadly, albeit anecdotally, China’s R&D facilities of all sorts are now plentiful and well-staffed enough to provide compensation packages that match global rates, reducing the “China premium” that was quite common even a decade ago.

To be sure, money is not the only variable in predicting the successful, innovation-led growth of a company or a country. Consistent focus on basic research provides the foundation for much innovation down the road, with the caveat that innovators may not be in the same country as the discoverers. Broader infrastructure and education, an available talent pool, and an entrepreneurial ecosystem all need to be nurtured. And then there is the question of how to incentivize and speed up inventions and innovations. But examining the evidence available so far, it is difficult to escape the conclusion that China is on the right path.

Hugo: Fair enough. These other things you mentioned, especially the entrepreneurial ecosystem, which was so crucial in the U.S. Do you think China will be able to nurture its own? Is there enough trust in China for the private sector to work its magic in the way that it did in the U.S.? I think we need to continue this the next time.

Olga Bitel, Partner

Global Equity Strategist

Hugo Scott-Gall, Partner

Portfolio Manager,
Co-Director of Research,
Global Equity Team

Have a question for Hugo and Olga to explore on a future walk?

Send us your suggestions at astepahead@williamblair.com

SUBSCRIBE TO A STEP AHEAD

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