Meaningful advances are emerging in fields ranging from genomics to mobile apps—and what’s happening beneath the surface may be even more significant.

June 2013 | by Gordon Orr and Erik Roth

Back in 2011, when we began work on a McKinsey Quarterly article called “A CEO’s guide to innovation in China,”1 much of the debate was about whether the country was more likely to become innovative or to remain a fast follower of foreign leaders. Even then, that seemed like yesterday’s question. Companies in China were innovating; we were seeing that every day in areas such as renewable energy, consumer electronics, instant messaging, and mobile gaming, both at domestic players and at multinationals with significant research and product-development presences.

Nothing that has happened since has changed our view. Indeed, our sense today is that the pace of innovation is quickening and that a new spirit of innovation is spreading across sectors into universities and even into key departments of the Chinese government. In a recent series of interviews with executives at Chinese companies, we detected evidence of real innovation leadership and the potential for more to come. John Oyler, CEO of the three-year-old Chinese biotech company BeiGene, for instance, underscored the attitude—“anything is possible, we can make it happen, there is no challenge we cannot conquer, we will surprise the world”—that he’s now seeing among Chinese scientists at his company.

In fact, a wide range of companies have begun mounting challenges in sectors traditionally the preserve of US, European, Japanese, or South Korean businesses. Beijing Genomics Institute (BGI), for example, the world’s biggest genetic-sequencing company, now claims to account for roughly 50 percent of global capacity and probably sequences more genetic material than Harvard University and the Massachusetts Institute of Technology combined, while developing some of the world’s most advanced biologic-computing models. In information and communications technology, Huawei attracted attention at this year’s Consumer Electronics Show, in Las Vegas, with innovative new smartphone platforms built on chips and software designed in-house. Another smartphone player, Xiaomi, founded in 2010 and often compared to Apple for its marketing strategy and loyal following, is on track to sell more than 15 million phones this year. Midea surprised its industry recently by announcing a highly efficient 1-hertz variable-speed air-conditioning compressor ahead of foreign competitors. And, a voice-based communications and gaming service, has captured growing attention with its mass online karaoke.

In our previous article, we suggested that tomorrow’s winners in China would focus on infusing their innovation efforts with a more sophisticated understanding of Chinese customers, retaining local talent, instilling a culture of risk taking, and promoting internal collaboration. This list remains crucial, but it is incomplete. In this article, based on recent interviews and our work with dozens of Chinese companies, we want to highlight three more recent developments that are likely to shape the innovation environment during the years ahead: the growing role of Chinese universities in the local innovation ecosystem; the gathering local interest in, and concern about, intellectual-property (IP) protection; and the emergence of a new generation of talent. If we are right that these forces are accelerating China’s realization of its innovation potential, then embracing them is mission critical—for Chinese companies and multinationals alike.

1. Seek Chinese universities as innovation partners
The prevailing view of Chinese universities is that they are highly effective at turning out large numbers of reasonably well-qualified specialists whose strengths are in the application of existing practices to predefined problems and whose future may lie in shanzhai (“copycat”) innovation. But that picture is changing rapidly, with the best universities starting to recruit the world’s top faculty talent for priority disciplines and creating an environment where breakthroughs can happen. When Fudan University wanted to develop a wastewater-treatment science program, for example, it hired one of the world’s top thinkers on the topic, who was teaching and conducting research in Singapore at the time. Globally recognized scientific journals are also increasingly filled with publications from leading Chinese researchers: Nature, for example, published 303 papers by Chinese scientists in 2012, up from 46 in 2006.

As Chinese universities raise their game, they are becoming increasingly interesting innovation partners for a wide range of domestic and global companies. To some extent, this is nothing new: Intel, for example, has long collaborated with these universities to sponsor research projects, PhD theses, and technical forums related to technology that’s close to the company’s business. What seems to be changing is the growing use of Chinese universities as a form of “outsourced R&D,” to borrow a phrase from an executive we interviewed recently.

One Chinese packaged-goods company conducts food-science research almost entirely through the labs of a local university. Pei-Yuan Peng, vice president and head of LG Electronics’s Shanghai-based R&D center, recently described for us the range of joint-research efforts his company undertakes with leading Chinese university labs and the role that Chinese professors play in helping LG recruit the best and brightest Chinese researchers and engineers. Meanwhile, in the life-sciences sector, BeiGene’s Oyler describes Chinese universities and research institutions as underappreciated treasure troves of innovation pockets. Oyler’s team actively collaborates with scientists at the National Institute of Biological Science located across the street from BeiGene’s headquarters and full of creative, passionate world-class scientists. Last year, the institute (headed by Xiaodong Wang, a member of the US Academy of Sciences) discovered the hepatitis B virus receptor–a huge advance against one of the most common chronic diseases in Asia. Researchers from the two organizations trade ideas in both formal and informal meetings.2
There are risks for multinationals, to be sure. Many Chinese universities have strong ties to the government, whose prioritization of domestic innovation may discourage close and open work on advanced topics. As LG’s Peng points out, though, those ties also mean that Chinese professors often pick up valuable information from government officials about changes in policy direction and market rules. Multinationals that make Chinese universities part of their innovation ecosystem are likely to gain earlier access to these insights, too.

2. Make intellectual-property protection a core part of innovation culture
The government has become noticeably more active in its support of intellectual-property protection. Gao Feng, deputy director of the Ministry of Public Security’s economic-crime investigation department, has been describing, with surprising openness, the weaknesses of the current IP system and vowing continued improvements. 3 The Chinese government ministry charged with prosecuting intellectual-property violations recently announced that it handled 2,347 cases in 2012, up almost 40 percent from 2011, and over those two years resolved $2 billion in violations.4 And in Jiangsu Province, the local government in Suzhou is building a 500,000-square-meter facility next to its innovation park. The idea is to bring together IP-related agencies and leading technology companies to elevate IP issues in importance, while improving the processing and quality of patent approval and protection. Efforts such as these, while localized, reflect a growing appreciation for the importance of IP protection.

Nonetheless, intellectual-property theft—including the reverse-engineering, copying, and sale of components and finished products—remains a concern, particularly for multinationals. Many continue to report deliberate cybersecurity breaches by Chinese hackers trying to steal valuable secrets over corporate computer networks and across national borders. Interestingly, savvy Chinese companies are already working hard to protect themselves. One priority: creating physical barriers to piracy. We’ve seen companies forbidding the use on their campus grounds of PCs, mobile devices, and other electronics not issued by the company. Precautions might extend to not allowing laptops or smartphones to enter or leave the campus, for fear that they might carry sensitive material, and restricting the most sensitive engineering activities to buildings where wireless access is blocked, computers are tied down to desks, and there is no access to external networks.

Other practices include compartmentalizing knowledge so that only a few individuals have a complete understanding of complex core systems. It is increasingly common to require camera-enabled devices to be stored under lock and key before entering R&D facilities. Many companies have also banned the use of devices, such as portable hard drives and USB thumb drives, that could be used to transfer media electronically. Haier, for its part, has begun monitoring employee activity on technology platforms, including e-mail and Web browsing.

Haier’s experience suggests it is possible to create strong structural safeguards without compromising a company’s innovation culture. Culture, in fact, can be a crucial element of internal IP-protection efforts. Increasingly over the last year or so, we’ve seen companies trying to make intellectual property part of internal codes of conduct and ethics efforts, sometimes demanding an annual review and a formal sign-off process by employees. For multinationals, the opportunity is particularly large: employees who feel they are deeply valued as part of a broader global entity, as opposed to a fungible resource needed to help “crack China,” are less likely to sell company secrets.

In an understandable effort to minimize IP leakage, many multinationals inadvertently isolate the Chinese team from the rest of the company. But as one Chinese executive said to us, “If you want Chinese employees to be loyal, then ask yourself how loyal you are to your employees. There must be a mutual feeling of respect to gain their trust.”

3. Tap into a younger generation of Chinese talent
It’s commonly said of China that innovation capacity (measured in terms of patent volumes and the construction of R&D facilities, for example) outstrips capability—in particular, the quality of China’s talent pool. Young Chinese graduates, especially, come under the microscope: educated in large numbers, raised in relative affluence, and more attracted to safe career tracks in the government or state-owned enterprises than to entrepreneurial ones, according to surveys.5
We don’t dispute any of these surveys, but they don’t quite square with our experience meeting young Chinese entrepreneurs such as 28-year-old Guosheng Qi, a Tsinghua University graduate and the founder and CEO of Gridsum, a cloud-based Web-analytics company. Gridsum’s customers range from Baidu to multinationals such as Coca-Cola, and last year it beat out companies from around the world to be named as one of Microsoft’s most innovative new software partners.

Leaving aside the entrepreneurial world, we’d also highlight a powerful corporate cross-current that senior leaders, especially at multinationals, should heed. As one Western executive at a Chinese company told us, the simultaneous growth in the number of young graduates and new companies is having an important impact on corporate cultures and individual mind-sets. His logic is that regardless of the attitudes young people bring to the first day on the job, those just entering the professional workforce following their undergraduate or graduate studies are highly malleable to new ways of working. Echoing this viewpoint, Tao-Sang Tong, president of Tencent’s Social Network Group, says his company prefers pulling talent directly from college, “before they are exposed to less innovative Chinese company cultures.”

Further, more Chinese graduates now move into the private sector than into any other source of employment. And many of today’s fast-growing companies are more likely to breed innovative habits than were the large-scale “first employers” of the 1980s or 1990s, a substantial number of which were state-owned enterprises or had only recently been privatized. In short, as the number of students entering and graduating from Chinese universities skyrockets (from 1.6 million new students in 1999 to 7.5 million in 2012, and from about 1 million graduating students to 6.7 million for the same years), the Chinese talent landscape is evolving in tandem.6
Yet many multinationals we know seem focused primarily on landing experienced Chinese hires who can help them quickly localize operations. They’re less interested in cultivating the next generation of talent and aren’t looking to it for the fresh ideas needed to sustain and grow their businesses. Indeed, only about 17 percent of respondents to a recent McKinsey survey of high-tech companies (including multinationals) operating in China described their development efforts there as leading edge.

Contrast all that with the approach of companies such as Lenovo, which, according to chief technology officer (CTO) George He, hires roughly 70 percent of its fresh talent straight from Chinese universities. Multinationals should certainly embrace the young-talent pool. But more than that, they are unlikely to overcome their established habits until they shift innovation decision-making authority to China. Companies can move in this direction by creating autonomous “ring fenced” Chinese R&D budgets and by permanently relocating the CTO or other innovation-related senior-executive roles to China.

Microsoft is an interesting example of a multinational raising its game with young talent in China. Ya-Qin Zhang, corporate vice president and chairman of Microsoft’s Asia-Pacific Research and Development Group, oversees the company’s Asia-Pacific R&D headquarters in Beijing. He proudly showed us around the new Azure accelerator, which is intended to help start-ups make use of the Azure cloud-computing platform when they set up their companies. Business teams submit proposals to a contest and are selected to join the accelerator, where they are assigned an executive sponsor and receive training from Microsoft engineers. The incubator represents more than a cloud-computing play; it’s also part of a long-term effort by Microsoft to boost its visibility among rising engineering talent. This effort appears to be paying off. Ya-Qin Zhang commented during our tour that the engineers Microsoft can recruit in China are now on par with those hired at its corporate headquarters, in Redmond, Washington—a big change from the prevailing reality ten years ago.

The Chinese model for innovation, and the kinds of breakthroughs Chinese organizations achieve, are likely to be quite different from those of Western ones. There is a greater willingness in China to go directly from development (usually based on already-known or highly anticipated customer orders) to manufacturing and shipping products. Circumventing the traditional “create, test, refine, develop, produce, market, sell” innovation process of many Western companies breeds speed, in the form of shorter time frames to launch and scale new businesses. That will be difficult for many multinationals to match. We constantly hear from these companies’ innovation and product managers about their struggles, through seemingly endless sets of steps and approvals, to make “China for China” innovation a reality instead of merely corporate rhetoric.

The Chinese approach also has its limitations; we’ve all seen evidence of quality breakdowns, excess waste in the development process, and unpredictability in production, all of which open the door for multinationals. Those that are not only inspired by the latest surge of Chinese energy but also mindful of the latest trends in universities, IP, and talent will be among the winners, turning out cutting-edge products of the kind we now still associate with the United States, Europe, Japan, and South Korea.

About the authors
Gordon Orr is a director in McKinsey’s Shanghai office, where Erik Roth is a principal.