Ask leading senior executives in the United States, Western Europe or Japan how they intend to cope with the challenges of China and India, and you'll get a familiar response: "We shall move higher in the value-added chain." China might be the "world's factory" and India the "world's back office", but the conventional wisdom reassuringly says, "Cheap manufacturing may migrate to China and cheap services to India-but innovation will remain in America."

The conventional wisdom is a myth. Emerging multinationals in China and India are no longer satisfied with imitating. Instead, they seek to convert cost advantages to more sustainable competitive advantages-often through innovation.

Competition for Innovation

Prosperity is based on productivity, which is rooted in innovation. Often, innovation is measured by input indicators, such as research and development (which reflect the willingness to invest but do not guarantee the ability to excel). Output indicators, such as patents, also measure innovation.

Throughout the 1950s and 1960s, the United States set the standards for prosperity, productivity and innovation. America enjoyed superior leadership in science and technology, R & D and the emerging sector of information and communication technology (ICT) goods and services. After World War II, the economies of Europe's leading nations and Japan were too devastated to pose a competitive threat to U.S. multinationals, which were barely exposed to international competition. Since the late 1970s and 1980s, the innovative capacities of OECD countries have converged substantially.

Like the UK, Germany and France in the postwar era, China and India are now accelerating catch-up efforts and seeking to move higher in the value-added chain. Take, for instance, recent developments in ICT.

In the early 1990s, China's economy was still known primarily for simple, low-tech manufactured goods, such as textiles, shoes and plastics. Now the Chinese economy is moving to produce more complex, high-tech ICT goods. After almost a decade of explosive growth in the electronics sector, China overtook the United States as the world's biggest supplier of ICT goods in December 2005. According to the OECD, China's ICT exports-including laptop computers, mobile phones and digital cameras-increased by more than 46 percent to $180 billion in 2004, for the first time surpassing U.S. exports of $149 billion. Between 1996 and 2004, the value of America's combined exports and imports of ICT goods grew more than 50 percent, from $230 billion to $375 billion. Over the same time period, the value of China's ICT trade soared from $35 billion to $329 billion-almost 1,000 percent.

For decades, India sought its place in the sun as a tourist destination yet received fewer tourists than Singapore. Meanwhile, the government ignored the entrepreneurial firms-driven IT sector. That has changed. By year-end 2005, India had 44 percent of the global market for IT and business process outsourcing (BPO) offshoring. By early 2006, India's IT sector amounted to $36.3 billion, and the number is expected to rise to more than $56 billion in 2007. IT services accounted for almost half the total, BPO for a fifth. Almost 80 percent of all IT services and software revenues are exported. The revenues of each Indian IT leader-Infosys, Wipro, Tata and Cognizant-exceed $1 billion, and they dominate almost half of IT and 4-5 percent of BPO services. Increasingly, these Indian leaders are seen as cost-efficient alternatives to the IBMs and Accentures of the world in areas such as application outsourcing and development.

Innovation Catch-Up

When faced with these realities, conventional wisdom points to the fact that, despite the gains made by China and India, the list of the top ten innovator countries has changed relatively slowly, as measured by the United States Patent and Trade Office (USPTO). A small number of geographic locations tend to dominate the process of global innovation in specific sectors and technological areas. In the 1980s these locations included the United States and Canada, the leading European nations and, of the Asian nations, only Japan. Toward the late 1990s, Taiwan and South Korea made the list. Meanwhile the relative share of large EU countries, such as France, Germany and the United Kingdom, has decreased. Since the introduction of reforms, first in China and later in India, the nations steadily improved their rankings until 2004-in 2005, China was 26^th (18^th in 2004) and India 27^th (19^th in the previous year).

Moreover, the advanced nations dominate the worldwide patent competition. In 2005, the top four innovator countries-the United States (51.9 percent), Japan (21.1 percent), Germany (6.3 percent) and the United Kingdom (2.2 percent)-accounted for more than 81 percent of patents. China and India remain far behind the top ten innovator countries in absolute terms. In 2005, almost 75,000 patents were filed in the United States, more than 30,000 in Japan and some 9,000 in Germany. In China and India, the corresponding figures were 402 and 384-that is, each about 0.5 percent of the U.S. volume (See Figure 1).

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Despite their absolute superiority, the leading innovator nations have fallen behind in the relative growth rates (measured as compound annual growth rate, CAGR). From 1977 to 2004, the patent growth rates of the United States, Germany and France were about 2-3 percent, whereas Japan's was twice that, 6.4 percent. Meanwhile, the growth rates of the tiger economies (South Korea, Taiwan, Singapore and Hong Kong) have been two to four times faster than in Japan. Despite the vast size of the nation, China's performance (25.6 percent) was almost as strong as that of South Korea (26.1 percent) and nine to ten times faster than that of the United States and the leading EU nations. India's growth rate has been quite impressive as well (12.5 percent).[1]

Furthermore, recent growth rates conceal a rapid decrease among the leaders and a rapid increase among the challengers. Between 2000 and 2005, the growth rates of all top four innovator countries were negative (-0.5 to -2.5 percent). The tiger economies showed healthy rates of 2 to 8 percent-but China and India were in a class of their own-with 22.5 and 19.6 percent respectively.

Let's take a closer view at the emerging innovation strengths in these two respective nations.

Innovation in China and India

Of almost thirty organizations among first-named assignees in China, some two-thirds represent an array of electronics industries, including semiconductors, contract manufacturing, computer hardware, software and IT services. Other major industries include petrochemicals, pharmaceuticals, hand tools and power tools.

Private-sector companies drive innovative activities, but academic organizations play a significant supporting role. During the past half a decade, of the thirty first-named assignees, 26 were companies. The top four patent players were Hon Hai, Microsoft, China Petrochemical and China Petroleum and Chemical Corp. Academic organizations-including Tsinghua University, Changchun Institute of Applied Chemistry (Chinese Academy of Sciences of China) and China Academy of Telecommunications Technology-are among leading innovators.

Finally, one cannot ignore the role of the multinationals. Of the total, U.S. (Microsoft, ibm, Great Neck Saw Manufacturers, Intel), Chinese (China Petrochemical, China Petroleum, Huawei, Semiconductor Manufacturing) and Taiwanese (Hon Hai, Winbond Electronics, Foxconn, Inventec) organizations owned 38, 34 and 19 percent of the patents, respectively. The rest belonged to Hong Kong and Japan. Measured by the locations of headquarters, the growth rates of foreign multinationals were significantly higher than those of indigenous producers.

In India, from 2001 to 2005, 43 percent of the 37 companies among first-named assignees were in pharmaceuticals or related industries (health care, medical). Some 22 percent were in electronics and another 22 percent in computers. The remaining companies sold petrochemicals and consumer products.

A greater share of innovation in India derives from the private sector. The top four innovators were ibm, Texas Instruments, ge and Ranbaxy. However, there were three major public-sector players, including Council of Scientific and Industrial Research, Department of Science and Technology and the National Institute of Immunology (NII).

As in China, multinationals have played an important role. Half of these innovators were based in the United States and some 40 percent in India. The rest came from Switzerland and the UK. Measured by the location of headquarters, the growth rate of foreign multinationals has been 50 percent faster than that of indigenous producers (30.5 and 19.7 percent respectively).

In both countries, as in the United States (with places like Silicon Valley), innovation output trends demonstrate substantial regional specialization. Between 1985 and 2005, the top four patent regions in China-Guangdong, Zhejiang, Taiwan and Beijing-accounted for 34 percent of all domestic applications, while the top eight regions accounted for almost 55 percent. In 2001 and 2002, only two regions in India-Delhi and Maharashtra-accounted for some 56 percent and the top eight regions 92 percent of the total (See Figure 2 and Figure 3).

Multinational Enterprises, Local Employees

In many industries, innovation is migrating from high-income nations to emerging economies. In the past few years, multinationals and indigenous producers have been particularly busy building R & D hubs, and developing brands and designs, in China and India. As the notion that innovation will remain in America has proved untenable, IT has been relaxed. Here's the new version: "Well, China and India may dominate as suppliers, but their foreign multinationals are the true winners."