The events of 2015 have shown that China is passing through a challenging transition: the labor-force expansion and surging investment that propelled three decades of growth are now weakening. This is a natural stage in the country’s economic development. Yet it raises questions such as how drastically the expansion of GDP will slow down and whether the country can tap new sources of growth.

New research by the McKinsey Global Institute (MGI) suggests that to realize consensus growth forecasts—5.5 to 6.5 percent a year—during the coming decade, China must generate two to three percentage points of annual GDP growth through innovation, broadly defined. If it does, innovation could contribute much of the $3 trillion to $5 trillion a year to GDP by 2025. China will have evolved from an “innovation sponge,” absorbing and adapting existing technology and knowledge from around the world, into a global innovation leader.

Our analysis suggests that this transformation is possible, though far from inevitable. To date, when we have evaluated how well Chinese companies commercialize new ideas and use them to raise market share and profits and to compete around the world, the picture has been decidedly mixed. China has become a strong innovator in areas such as consumer electronics and construction equipment. Yet in others—creating new drugs or designing automobile engines, for example—the country still isn’t globally competitive. That’s true even though every year it spends more than $200 billion on research (second only to the United States), turns out close to 30,000 PhDs in science and engineering, and leads the world in patent applications (more than 820,000 in 2013).

When we look ahead, though, we see broad swaths of opportunity. Our analysis suggests that by 2025, such new innovation opportunities could contribute $1.0 trillion to $2.2 trillion a year to the Chinese economy—or equivalent to up to 24 percent of total GDP growth.

To achieve this goal, China must continue to transform the manufacturing sector, particularly through digitization, and the service sector, through rising connectivity and Internet enablement. Additional productivity gains would come from progress in science- and engineering-based innovation and improvements in the operations of companies as they adopt modern business methods.

To develop a clearer view of this potential, we identified four innovation archetypes: customer focused, efficiency driven, engineering based, and science based. We then compared the actual global revenues of individual industries with what we would expect them to generate given China’s share of global GDP (12 percent in 2013). As the exhibit shows, Chinese companies that rely on customer-focused and efficiency-driven innovation—in industries such as household appliances, Internet software and services, solar panels, and construction machinery—perform relatively well.

However, Chinese companies are not yet global leaders in any of the science-based industries (such as branded pharmaceuticals) that we analyzed. In engineering-based industries, the results are inconsistent: China excels in high-speed trains but gets less than its GDP-based share from auto manufacturing. In this article, we’ll describe the state of play and the outlook in these four categories, starting with the two outperformers.

1. Customer-focused innovation: The Chinese commercialization machine

China benefits from the sheer size of its consumer market, which helps companies to commercialize new ideas quickly and on a large scale; even a relatively small market like online gaming is bigger than the auto industry in Turkey or Thailand.

Chinese companies have learned how to read the requirements of their rapidly urbanizing country and to scale up new products and services quickly to meet them. Manufacturers of appliances and other household goods dominated the first wave of customer-focused innovators in China. Their innovations were “good enough” products such as refrigerators and TV sets. But these offerings no longer suffice to gain a growing share of consumers.

Companies like smartphone manufacturer Xiaomi are responding with cheaper and better products designed to offer hardware features as good as those from global brands but priced for the Chinese market. Like other customer-focused innovators in China, Xiaomi also uses the massive consumer market as a collaborator, rapidly refining its offerings through online feedback. Internet service providers are another hotbed of customer-focused innovation.

Alibaba, Baidu, and Tencent have become global leaders in online services, largely thanks to their success in the enormous Chinese market. Customer-focused innovation could reshape large swaths of China’s service sector, where productivity lags behind that of its counterparts in developed economies.

The government already is pushing to modernize traditional businesses through its Internet Plus initiative, announced in early 2015. Innovations are needed to expand access to services (for example, remotely monitoring the health of rural patients), to improve the quality of offerings (greater choice and customization in financial and educational products), and to optimize operations (crowd-sourced logistics). Chinese companies will also have opportunities to use their skills in customer-focused innovation to take a lead in selling to other emerging markets.

2. Efficiency-driven innovation: The ecosystem advantage

In manufacturing, China’s extensive ecosystem has provided an unmatched environment for efficiency-driven innovation. The country has the world’s largest and most highly concentrated supplier base, a massive manufacturing workforce, and a modern logistics infrastructure. These advantages give Chinese manufacturers a lead in some important knowledge-based manufacturing categories, such as electrical equipment, construction equipment, and solar panels.

Today, Chinese companies improve their efficiency with a variety of cutting-edge approaches, including agile manufacturing, modular design, and flexible automation. The apparel manufacturer Everstar, for example, uses automated equipment and online design and e-commerce systems that help consumers to customize designs for clothing and receive finished goods within 72 hours.

China is also pioneering the use of open manufacturing platforms. The challenges are mounting, however. As wages rise, the country becomes less competitive for the most labor-intensive work. At the same time, a worldwide transition is under way toward a new kind of manufacturing, sometimes called Industry 4.0: a much more intense digital linkage of manufacturing components, processes, and logistics. As a result, Chinese companies will face pressure to improve their performance in utilizing assets, matching supply with demand, and controlling quality.

Success will depend on how well China can exploit the scale of today’s manufacturing ecosystems and clusters to extend their benefits beyond individual factories through digitally linked networks. Some efforts are under way to mobilize rapid, flexible manufacturing.

In Guangdong province, for example, manufacturers have set up joint platforms to share the benefits of R&D and operations among companies in the same clusters. Elsewhere, companies are looking at ways to mass-customize products by combining flexible manufacturing with the aggregation of a huge Internet consumer base.

New manufacturing gains may also emerge from the aggressive use of robots, which could make China’s huge pool of semiskilled factory workers more effective. Entrepreneurs are poised to play a bigger role. In Shenzhen, a rich ecosystem of component suppliers, design services, business incubators, and outsourced assembly capacity has helped start-ups prototype products and scale up global manufacturing businesses quickly.

3. Engineering-based innovation in ‘learning industries’

China has had mixed success with engineering-based innovation. The best performers are found in Chinese markets where motivated domestic industries are nurtured by national and local governments that create local demand, push for innovation, and facilitate the transfer of knowledge from foreign players.

China has used this formula successfully in high-speed rail (Chinese companies have a 41 percent share of the global railroad-equipment revenues, according to McKinsey estimates), wind power, and telecommunications equipment. In 2008, the Ministry of Railways launched a major program to develop a new generation of high-speed trains—a top-down, nationwide effort that has been China’s equivalent of the Apollo space program in scale and complexity. We estimate that the country has accounted for 86 percent of global growth in this market since then.

Using technology transfers from overseas partners as a knowledge base, Chinese companies tailor their offerings to local requirements, such as terrain and temperature conditions, through incremental innovation. Learning and innovation have been slower to come in automotive manufacturing. To date, most domestic Chinese carmakers have relied on platforms from their global partners or on designs from outside firms to bring products to market quickly. Thanks to exploding domestic demand and strong profit streams from joint ventures, they have felt little pressure to innovate. Deregulation, a rapid increase in China’s base of engineering talent, and continued high levels of government investment promise to make engineering-based companies more motivated and effective innovators in the future.

In some sectors, such as nuclear power, explicit state support will continue to be critical. China has an ambitious government plan to build nuclear plants resulting in a total installed capacity of 58 gigawatts by 2020, which can support its goal of obtaining 20 percent of its energy from non–fossil fuel sources by 2030.

In other industries, such as medical equipment, the private sector will drive innovation. Mindray, United Imaging Healthcare, and other smaller new Chinese players will continue to make inroads in market categories (for instance, CT scanners and MRI machines) that foreign suppliers now dominate. Government programs to subsidize purchases of Chinese-made equipment by the country’s hospitals are providing a boost even as a new generation of medical entrepreneurs draws from global knowledge and partnerships.

4. Science-based innovation: Novel Chinese approaches

A massive government push to raise R&D spending, train more scientists, and file more patents has yet to give China a lead in science-based innovation. The slow progress has a number of explanations—not least that this type of work takes a long time to pay off and requires an effective regulator to protect intellectual property. Huge investments by government and the private sector to shepherd projects from the lab to commercial deployment are needed, as well.

What’s more, despite the large number of Chinese students trained in scientific and technical fields, companies struggle to find capable talent. The government is addressing some of these obstacles. For example, recently launched reforms to the drug-review process could reduce the time to get a new drug to patients by two or more years. Efforts such as the Thousand Talents program bring overseas Chinese to the country to launch their own companies and work in scientific organizations and universities.

Even as these reforms play out, Chinese innovators are adopting novel approaches—for instance, using the country’s massive market size and huge pool of low-cost researchers to industrialize and speed up experimentation and data collection.

One such innovator, BeiGene, gained ground in the biotech industry by developing drugs to treat cancers and other diseases. The company has accelerated the drug-discovery process by deploying a large-scale drug-testing team, testing compounds on human tissue (such as cancerous tumor samples) during the preclinical phase to get early indications of issues that might arise in human testing, and capitalizing on access to China’s large pool of patients.

In genomics research, another company, BGI, is deploying massive scale (2,000 PhDs and more than 200 gene-sequencing machines) to power its way through biotech problems. The extent and speed of China’s advances in innovation will have significant implications for the country’s growth and competitiveness and for the types of jobs, products, and services available to the Chinese people. They will also have powerful consequences for multinationals (competing at home and abroad with Chinese companies), some of which are now using China as an R&D base for global innovation. Fortunately, that isn’t a zero-sum game: a more innovative China ought to be good for a global economy that seeks new sources of growth.

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About the authors

Erik Roth is a director in McKinsey’s Shanghai office; Jeongmin Seong is a senior fellow of the McKinsey Global Institute; and Jonathan Woetzel is a director in the Shanghai office, as well as a director of the McKinsey Global Institute.

The authors wish to thank McKinsey’s Jason Lee for his contributions to this article.