Role of Institutional Quality in Determining the R&D Investment of Chinese Firms

• Published date: 01 July 2014
• Date: 01 July 2014
• DOI: http://doi.org/10.1111/j.1749-124X.2014.12075.x
• Author: Yixiao Zhou

60 China & World Economy / 60–82, Vol. 22, No. 4, 2014

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Role of Institutional Quality in Determining

the R&D Investment of Chinese Firms

Yixiao Zhou*

Abstract

This study adds to the understanding of China’s innovation prospects by examining how

variations in institutional quality within China impact on the R&D efforts of firms located in

different provincial regions. In the process of identifying the effect of institutional quality, the

roles of other factors such as ownership types and market structures are revealed, which

provides interesting insight into firms’ R&D behavior. The key findings suggest that

institutional quality positively affects the decision of firms to engage in R&D activities. Once

firms start to engage in R&D, the subsequent expansion of firm-level R&D intensity depends

on factors such as market structure. Therefore, strengthening domestic institutional quality

is the first critical step towards the goal of building a knowledge-intensive economy in

China. Efforts to nurture market development are also important for achieving this goal.

Key words: innovation, institutional quality, R&D investment, the Chinese economy

JEL codes: D21, L20, O31

I. Introduction

Since the late 1970s, China has undergone a significant economic transformation and grown

into a manufacturing powerhouse with the per capita income reaching the middle income

level. However, new challenges, such as global imbalances, demographic shifts,

environmental degradation, rising income inequality and weakening of the external markets,

have forced China to alter the way it industrializes by adopting a new model for growth

centering on a strategy of relying more on innovation (McKay and Song, 2010).

In tandem with the transition towards an innovative economy, the enhancement of

*Yixiao Zhou, PhD candidate, Crawford School of Public Policy, the Australian National University,

Australia. Email: yixiao.zhou@anu.edu.au. The author thanks Jane Golley, Peter Drysdale and Ligang

Song for their invaluable comments on a draft of the present paper. The financial support from the Rio

Tinto-ANU China Partnership for my graduate work at the Australian National University is gratefully

acknowledged.

61

R&D Investment of Chinese Firms

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

institutional quality is increasingly relevant for China’s growth performance as China relies

more on innovation for growth. There has long been debate about how China has grown so

rapidly despite its relatively low institutional quality (Huang, 2008). On the one hand, much

of the economic growth literature views institutional quality as a fundamental determinant

of economic growth, and perceives factors such as physical and human capital accumulation

and technological progress as part of growth itself (Acemoglu et al., 2001; Acemoglu and

Johnson, 2005). On the other hand, China’s growth performance over the past three decades

seems to be contrary to what the theory predicts. However, as the results of the present

study show, the institutional changes have played an important role in enhancing firms’

incentives to innovate in China. Thus, institutional quality will become even more important

as China continues to catch up and move towards the world technology frontier.

Accordingly, the government’s policies are becoming more focused on innovation

and institutional quality. In the conclusions reached from the Third Plenary Meeting of the

18th Congress of the Chinese Communist Party held in Beijing in November 2013, it is

emphasized that the government needs to improve the incentive structures for technological

innovation, to strengthen the use and protection of intellectual property, to deepen the

reforms of the management and operational system of intellectual property rights and to

remove the barriers to the transfer and diffusion of scientific and technological achievements

so that business enterprises will play a dominant role in technological innovation.

Against such a background of China’s growth dynamics, the present paper is focused

on one question: How will institutional quality impact on China’s innovation performance?

To answer this question, the present study will examine how variations in institutional

quality within China impact on the R&D efforts of firms located in different provincial

regions. This analysis will reveal how institutional quality affects China’s innovation

prospects and, therefore, China’s growth potential.

The structure of the paper is as follows. Section II considers the aggregate pattern of

R&D activities in China to set the stage for the firm-level analyses. Section III discusses the

determinants of firm-level R&D intensity. In Section IV, the method of data construction in

the econometric analysis will be explained, followed by discussion on the econometric

specifications and difficulties in the estimation procedure. The baseline results and

robustness checks are presented in Section V, and Section VI concludes.

II. Aggregate Pattern of R&D Activities in China

China’s national R&D expenditure has experienced continuous and accelerating growth

over the past two decades (Figure 1). While China’s annual GDP growth rate has been