Low R&D Spending May Be China’s Achilles’ Heel

(Bloomberg Businessweek) -- In its bid for technological supremacy, China has one small problem: Its research and development spending, at a little more than 2% of gross domestic product, is dwarfed by that of Israel, Japan, and even the U.S. A global behemoth like Huawei Technologies Co. can still wow the world with its tens of thousands of active patents, but most Chinese com­panies don’t invest nearly enough in cutting-edge technology to compete.

That’s because excessive R&D spending can hamper Chinese businesses’ ability to go public. Unlike in the U.S., China’s stock exchanges require companies to be profitable for at least three years before making an initial public offering. R&D spending shows up on income statements as an operating expense and thus keeps young companies in the red for longer.

Starting in late July, technologically ambitious com­panies can list on a new Nasdaq-style platform: the Shanghai Stock Exchange’s Science and Technology Innovation Board, colloquially known as STAR, where profitability doesn’t matter. Among the 20 or so industrial and tech companies that have listed there so far, R&D spending averages 12.8% of their 2018 sales, more than double that of their counterparts on the more established exchanges.

STAR stocks gained 140% on the board’s first day, but the enthusiasm may not last. Chinese investors tend to like plain-vanilla consumer brands, especially after waves of corporate scandals this year taught them to fear complicated accounting. Han’s Laser Technology Industry Group Co., a supplier of smartphone parts to Apple Inc., was such a market darling that in April, it was valued at more than 30 times earnings. In July state media reported that the company, instead of building a 1 billion-yuan ($142 million) research center as it claimed, was developing a five-star hotel near a ski resort in the Swiss Alps. Han’s Laser is now being investigated for possible misuse of funds (the company says there was no misappropriation), and the stock is worth only half of its 2019 peak of about 45 yuan.

Intangibles are difficult to value everywhere, but that’s particularly true in China, where banks refuse to accept intellectual property as collateral for loans. Last year, as China’s trade war with the U.S. bit into corporate profit, listed companies wrote down more than 10% of their 1.3 trillion yuan worth of goodwill assets.

It’s laudable that Beijing is trying to bring China Inc. into new fields such as automation and 5G technology, but it has to teach its companies better governance as well. Otherwise they’ll be stuck chasing their competitors’ success—or worse, sitting on a pile of worthless assets and bad debt once the market moves on.

STAR stocks are shining now, but chances are that many of them will fade quickly. Chinese stockholders risk falling into the same trap as investors in the U.S., which still lags behind many of its economic competitors, in viewing “R&D” as code for “pet projects that will never generate value.”
 
Ren is a markets columnist for Bloomberg Opinion

To contact the editor responsible for this story: Jillian Goodman at jgoodman74@bloomberg.net, Eric Gelman

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