In 2013, the proportion of value-added from the tertiary industry in GDP exceeded the secondary industry for the first time. The change indicates that China is making progress in maintaining steady growth while optimizing economic structure, promoting industrial transformation through innovation-driven development, and improving the quality of economic growth. It also shows that after 30 years of steady growth, China has entered a critical stage of economic restructuring.

The fact that for two consecutive years China's annual economic growth was below 8 percent shows that China's economy has slowed. According to economic rules and experience from other countries, after experiencing such a shift in economic growth, a developing economy will face the challenge of optimizing and upgrading its industrial structure. It is the only way out, a long uphill battle; it is a challenge, but more of an opportunity. If China manages to optimize and upgrade its industrial structure, gathers new momentum for a steady economic growth and gains a new competitive edge, it will escape the middle-income trap and develop into a high-income country.

Theoretically speaking, optimizing and upgrading the industrial structure indicate the process of production factors such as capital, labor, land and technology flow from the production sectors or links of industrial chains with low value-added, poor efficiency and high consumption, such as industries of overcapacity and high pollution, to those with high value-added, high efficiency and low consumption, such as advanced manufacturing industry and high-end producer services. In a market economy, the flow and reorganization of production factors among different sectors and links of production rely on market competition and price mechanism. Simply put, production factors flow toward where higher and more sustained economic returns are generated.

But that is not the case in the real world. Market mechanism is less smooth and efficient than we expect in guiding the flow of factors, which fail to go where they are best needed. For example, the process of commercialization in the strategic emerging industries remains slow; while some traditional industries face the problem of extreme overcapacity. In the final analysis, such dilemma is caused by both technological factors, such as incomplete information, patent barriers, imperfect competition, and institutional factors, including market access barriers, market segmentation and distortion of factor prices. Under such circumstances, the government should play a bigger role in allowing the free flow of production factors during structural transformation and upgrading. Premier Li Keqiang said in this year’s Report on the Work of the Government that factors of production should flow in with more active effects, and out in a more proactive and orderly manner. So the key lies in deepening the reform and letting the market play a decisive role in resource allocation; meanwhile, the government should play an active role.

Enhancing Increment and Upgrading China's Industry

To let factors of production flow in where they are best needed, it should both enhance the increment and optimize the inventory.

There are two aspects for enhancing the increment: First, the country should upgrade its manufacturing industry, making it information-based, intelligent, environmentally friendly, and service-oriented. In particular, it should accelerate commercialization of new technologies or domains such as new generation mobile communication devices, intelligent manufacturing, 3D printing, smart power grids, industrial robots, new materials and new energy vehicles, in order to guide market demand and strategic investment, form new high-end industrial chains by setting up innovative platforms and creating the right environment for entrepreneurship; it should help emerging industries overcome bottlenecks and embrace high-speed growth with incremental returns. In fact, it is the way out for China to meet the challenges of increasing factor costs and decreasing demographic dividends, and from resource and environment, and to upgrade the industry and take a leading position in global competition.

Second, there is much room for developing producer services. From a global perspective, developing high-end producer services becomes a new strategic pillar for the developed economies to deal with the international financial crisis and boost economic growth. Last year, the value-added of tertiary sector accounted for 46.1 percent of the GDP, surpassing the secondary sector for the first time. It signals that after entering the transitional period before late stage industrialization, China's economy is now facing new situations in upgrading its industrial structure. However, as for the internal structure of the tertiary sector, life services are still in dominance and producer services lag behind, which means a huge potential in the latter yet to be tapped. Therefore, it must seize the opportunity in this round of new technological revolution to boost high-end producer services, such as cultural and creative industry, financial services, R&D and design, software development, big data, cloud computing, system integration, information service, e-commerce, modern logistics, background service, energy-saving service, ecological restoration and vocational education, to create, extend and integrate industrial chains, and speed up the development of producer services.

Transforming and Upgrading Traditional Industry through IT Application and Innovative Management

To optimize inventory, the key is to make full use of current information and technologies, integrate IT application and industrialization, and accelerate the transformation and upgrading of traditional industries so that they will embrace new vigor and vitality.

In recent years, labor-intensive industries with traditional advantages in China are at an important crossroads with great challenges ahead, such as the increasing cost of energy, raw materials and factors of production like labor and land, a sluggish external market, and alternative competition with surrounding countries. But, we must be clearly aware that traditional industries are not necessarily sunset industries, and can be invigorated through sustained innovation. In this respect, developed economies can offer us both good examples and painful lessons. The long-lasting boom in the equipment manufacturing industry in Germany gives credit to the sustained internal innovation. In contrast, traditional electronic giants, such as Nokia, Sony, and Sharp, have found it hard to press ahead in recent years and lagged far behind the late-comers like Apple and Samsung due to weakening innovation capability.

To improve innovation capability in traditional industries, first, it is important to integrate IT application and industrialization, speed up technological upgrading of enterprises by fully applying modern IT achievements, and to transform traditional manufacturing techniques and upgrade hardware through integrated and intelligent capital equipment. Second, it is necessary to rely on management and organizational innovation, which is the core of corporate soft power. Compared with hardware, soft power is more difficult to upgrade because it cannot be bought. Today, many domestic manufacturers that have advanced equipment and spacious modern factories, even envied by multinationals, fail to generate proportionate brand products recognized and respected in the world. The reason is obvious: it is easier to buy technologies and equipment than to cultivate management innovation.

Letting the market play role in dissolving overcapacity

Overcapacity in some industries is a prominent issue undermining the growth of China's economy and for quite a long time to come. Although there are neither exact official data of overcapacity worldwide, nor a widely recognized definition and criterion, some empirical research shows that overcapacity has long beentrouble for the world economy. At the beginning of this century, overcapacity in the steel sector worldwide was estimated at 20 percent and the auto industry close to 30 percent. Recent years have seen overcapacity spreading from these traditional sectors to emerging manufacturing sectors such as electronic information and communications. Such a situation continues to deteriorate as the recovery in main economies such as Europe, the US and Japan remain sluggish and governments worldwide have introduced excess stimulus plans for investment since the financial crisis.

With regard to overcapacity in some industries in China, mainly in resource-intensive and high-emission industries, such as steel, cement, electrolytic aluminum and plate glass sectors, the reasons are complex, including investors’ inadequate information and irrational expectations as well as local governments’ excessive regulation fueled by the worship of GDP growth and officials’ achievements, thus discouraging the market from playing its due role.

To dissolve overcapacity, we should take multiple measures in a rational way. Besides administrative means, such as removal of all implicit and explicit unreasonable preferential policies made by local governments, it should improve standards in environmental protection, energy consumption and technology, and enhance supervision during and after the events. In addition, it should bring into full play the portfolio of fiscal policies, taxation, finance, information service and intermediary agencies to dissolve overcapacity. During this process, we should strike the right balance between dissolving overcapacity and macro-control of the property market; because most of the typical industries aforementioned are closely related to the property market, which has a bearing on sensitive issues, such as the local economy, government revenue and employment.

Finally, it also requires SOE reform and developing a mixed ownership economy, making it easier for private capital to invest in the real economy.

Upgrading industrial structure through innovation

The key to solving problems is a sustained innovation capability.

Technological innovation is an enduring force and source for optimizing and upgrading the industrial structure. According to Michael Porter's theory on the competitiveness of nations, a country has to experience the transition from being production factor-driven to investment-driven, finally to innovation-driven and wealth-driven during its economic growth and formation of competitiveness. Currently, China's economy is undergoing the transformation from investment-driven to innovation-driven, in which high-level factors of production, such as knowledge, technology and human resources are a key driving force in industrial growth and competitiveness maintenance.

According to research findings by the Organization for Economic Cooperation and Development (OECD) in 2011, New Sources of Growth: Intangible Assets, intangible assets such as R&D, employee skills, software, design and marketing, are the new sources of economic growth. It also shows that OECD countries are increasing their investment in intangible assets. In particular, as a new round of technological and industrial revolution speeds up, primary factors like land and labor are less important, while knowledge, technology, and human resources are increasingly important.

To optimize and upgrade the industrial structure, the country needs to formulate and implement a new factors-driven strategy, promote the transformation from primary factor-based traditional edge to a new competitive edge based on new high-level factors.

On the one hand, the country should improve the mechanism for corporate innovation that pressures and motivates enterprises to innovate. It needs to encourage enterprises to set up research institutes with more R&D input and enhance industry-university-research cooperation. On the other hand, the government should invest more in basic research, cutting-edge technologies, technologies for public welfare as well as major generic and key technologies, improve the service platform for public science and technology and perfect the mechanism for implementing major scientific and technological projects.

Talent is a key element in technological innovation. It should build a team of talent in a balanced way. First, the country should enhance the building of top talent teams in fields like R&D, design, brand building, quality services and innovative business models. Special attention should be given to innovative and versatile talent who are qualified for modern industrial development, familiar with internal and external markets and proficient in international standards, trade rules, and management expertise. Second, the country should also make policies to highlight vocational education and professional training, to allow the flourishing of skilled industrial workers who can operate modern intelligent equipment and have great ideas.

Institutional system holds the key to technological innovation. The country should let the market play a decisive role in allocating innovation resources, value the long-term mechanism for innovation incentive, establish a unified and fair factor market; it should enhance IPR protection and application, and build a platform to cultivate and boost high-level factors of production, such as top talent, technological innovation, IPR, brand, and business model.

The year 2014 is the start of expanding reforms, and also a critical year for improving the quality and efficiency of China’s economy. We are confident in and capable of optimizing and upgrading the industrial structure in order to lay a solid foundation for sound economic growth in the future.

Authors: Shi Yaodong and Wang Xiaoming

Source: People's Daily，March 24, 2014