Domestic Innovation and Government Procurement Policies

New developments indicate China is moving to delink its innovation and government procurement policies.

By US-China Business Council Staff

Indigenous innovation, a policy concept that the PRC government developed to boost the creation and commercialization of home-grown ideas and technology, is an integral component of PRC technology and economic development policies. Top PRC leaders view it as one way to bring industrial transformation and economic benefits to China. First announced in 2006, the PRC government has subsequently incorporated the concept into a range of policies and regulations, including those related to intellectual property (IP), standards, taxation, and government procurement. In late 2009 and early 2010, several key PRC regulators released a series of measures designed to create a product catalogue that would grant preferences to indigenous innovation products during the government procurement process.

Though many countries share China’s goals of promoting innovation and economic development, indigenous innovation programs that encourage discriminatory practices are problematic for foreign companies and inconsistent with international best practices. The PRC government has seemed responsive to such concerns from the business community and foreign governments. PRC President Hu Jintao announced during his January 2011 trip to the United States that innovation policies would not be linked to government procurement, and PRC officials pledged to eliminate the use of indigenous innovation product catalogues at all levels of government procurement at the May 2011 Strategic and Economic Dialogue (S&ED). Regulatory developments in June and August have shown that China is working to meet these commitments. More work must be done to fully realize both pledges, however.

Policy development

Several PRC government agencies are responsible for developing and implementing indigenous innovation policies.

•     The State Council Leading Group on Science, Technology, and Education is comprised of representatives of major ministries and government offices, such as the Ministry of Finance (MOF), National Development and Reform Commission (NDRC), Ministry of Science and Technology (MOST), Ministry of Industry and Information Technology (MIIT), Ministry of Commerce, and the Chinese Academy of Social Sciences, among others. Led by Premier Wen Jiabao, this group is responsible for assessing and approving major policies and strategies on science and technology (S&T) and coordinates relevant departments and localities to implement key tasks and projects.
•     MOST is responsible for leading the reform of China’s S&T system and formulating S&T strategies, policies, laws, and regulations. Responsible for China’s overall innovation strategy, MOST and its provincial and local branches authorize indigenous innovation products and develop related product catalogues.
•     NDRC is the PRC government’s chief ministry-level macroeconomic planning body. NDRC sets China’s long-term national economic development agenda, from which ministries devise and implement their own policies. Importantly, S&T and innovation are outgrowths of these long-term economic development policies.
•     MOF oversees government procurement and sets the basic criteria for products the government buys. Procurement is a core component of the strategy to boost domestic production of high-tech and innovative products. Government purchases guarantee a funding stream to the companies that make these products, which may be untested in the marketplace. MOF also oversees the State Administration of Taxation, which is responsible for creating preferential tax programs that foster research and development (R&D).
•     MIIT is responsible for the regulation of electronics and information product manufacturing. It also crafts and implements China’s industrial policies, of which innovation is an essential component.

 Policy implementation

At the center of China’s indigenous innovation drive is the Medium- and Long-Term National Plan for Science and Technology Development (2006-20) and a follow-up document on its supporting policies. The State Council released both of these policy plans in 2006. The plan and its supporting policies formally introduced the concept of indigenous innovation into China’s national industrial policy and laid out goals to

•     Develop a system to evaluate and qualify indigenous innovation products;
•     Establish a system to use government funds to buy indigenous innovation products; and
•     Give preferential treatment in the government procurement process to indigenous innovation products.

In addition, indigenous innovation has received an increasingly prominent place as a part of broader Chinese development strategies. It was a component in China’s 11th Five-Year Plan (FYP, 2006-10), and it received prominent mentions in China’s most recent draft 12th FYP (2011-15). That draft included “supporting technological progress and innovation”—through “strengthening indigenous innovation capacity”—as one of the guiding ideologies for the coming five-year period.

What qualifies as an indigenous innovation product?

At the end of 2006, MOF, MOST, and NDRC jointly released Trial Administrative Measures on the Accreditation of National Indigenous Innovation Products, which defined the kinds of products eligible to receive indigenous innovation status. In these measures, a qualified product was to

•     Be produced by an enterprise that had full ownership of IP in China via its own technological innovation activities; or the Chinese enterprise, work unit, or citizen had, by legal means, obtained the China IP rights or usage rights;
•     Have a trademark that was owned by a Chinese company and was registered in China;
•     Embody a high degree of creativity and innovation—for example, a product that used core technologies or improved product functions by applying new technologies; and
•     Offer a high degree of reliability with certification from the China National Certification Administration or its provincial branches.

Though the three agencies invalidated these measures in August 2011, the measures helped indicate how the government viewed indigenous innovation products. Accredited products eventually were to be listed in product catalogues that governments at various levels were to use to guide their procurement decisions.

Based on such guidance, some provincial and municipal governments have since developed product catalogues, which include lists of products accredited as indigenous innovation. Very few products made by foreign companies were included in these provincial lists. For example, based on the US-China Business Council’s (USCBC) review of the 523 products listed in Shanghai’s 2009 catalogue of indigenous innovation products for government procurement (now invalidated), only two were made by foreign-invested enterprises (FIEs) and both of these were from Chinese-foreign joint ventures with majority Chinese ownership. Reviews of Nanjing and Beijing catalogues showed similar trends.

Moreover, some of these catalogues either explicitly or implicitly restrict domestically made products from other provinces. For example, Wuhan’s catalogue is largely comprised of local products from Wuhan and surrounding Hubei Province, though the catalogue does not explicitly limit eligibility to local products.

Main advantage: Preference in government procurement

The primary benefit conferred upon products that receive indigenous innovation recognition has been preference in government procurement. China’s vast government bureaucracy at the central and local levels presents substantial commercial opportunities across a wide range of industry sectors.

In addition to granting priority in government procurement, China’s 2006 Selected Supporting Policies for the Medium and Long-Term National Plan for Science and Technology Development favor indigenous innovation products in price-based bidding. Article 23 of the plan states that during the price-based bidding process, if the price of an indigenous innovation product is higher than others, the company making the product may reduce the price in its bid; if the price is not higher than other products, the government agency must procure the indigenous product. In addition, several articles of the 2007 Evaluation Measures on Indigenous Innovation Products for Government Procurement, which were invalidated in June 2011, awarded indigenous innovation products special treatment:

•     Article 13 provided that indigenous innovation products be given preference at a margin of 5-10 percent if price was the sole determining factor.
•     Article 14 stated that indigenous innovation products would enjoy an additional 4 to 8 percent boost in their technical and price evaluations if comprehensive evaluation methods were used. These comprehensive methods weighed technical merit and other technology-related factors with the product price to create an overall score, which was used to select the most competitive products.
•     Article 24 called for establishing a government system for initial purchasing and ordering that would encourage the commercialization of products with indigenous innovation accreditation. The government would purchase the first set of innovative products created by domestic enterprises, universities, and research institutes if the products were thought to have future wide-market potential.

Recent policies

Since 2009, a series of PRC government agencies released various documents that relate to indigenous innovation, raising questions and concerns from FIEs and prompting a response from US and other foreign industries.

Notices on central-level indigenous innovation catalogue

MOF, MOST, and NDRC released in November 2009 application procedures and a notice that outlined provincial responsibilities for a proposed central-level indigenous innovation catalogue. Four of the six areas identified for inclusion in the indigenous innovation catalogue were information technology-related: computers, communication, office equipment, and software. The remaining areas were related to new-energy equipment and energy-efficient products. Foreign company concerns center on Section IV of the application procedures, which reiterates conditions, including patent and trademark ownership requirements, that would likely exclude foreign companies’ products from qualifying.

In April 2010, MOF, MOST, and NDRC released a revised draft notice that addressed some foreign-company concerns about the November notice. The Draft Notice Regarding the Launch of the National Indigenous Innovation Product Accreditation Work for 2010 detailed requirements that products must satisfy to be eligible for national indigenous innovation product accreditation. The scope of the policy covered the same six product areas outlined in the November notice but made positive changes to the November proposal:

•     Intellectual property and licensing  The April notice appeared to relax requirements governing IP ownership in China to allow indigenous innovation accreditation for products with foreign IP that had been licensed for use in China.
•     Trademark registration  The notice modified requirements for trademark registration and no longer required trademarks and brands to be registered first in China. Instead, applicants must have had exclusive rights to the product’s trademark, or have had the right to use the trademark, in China.
•     Technology requirements  To qualify for inclusion in the product list, a product must have possessed technologies that were proven effective in conserving energy, reducing pollution, and raising energy efficiency, or had “substantially” improved on an original product’s structure, quality, material, craftsmanship, or performance.

Though analysts considered the revised accreditation requirements a step forward, several significant issues in China’s indigenous innovation policies remained. In particular, the notice did not address the use of product lists or their link to government procurement preferences. The proposed changes to the National Indigenous Innovation Product qualification criteria also did not answer questions about the relationship between the national product list and provincial and local product lists. Some provincial and local lists were compiled based on discriminatory accreditation criteria, including IP ownership and import substitution requirements that often differ from province to province. Finally, though the accreditation criteria no longer mention import substitution (a strategy that aims to replace imports with locally produced goods) as a policy goal, the notice did not appear to change the November notice’s application form. The form asked whether an applicant’s product can substitute for imports, a strong signal that import substitution is a goal.

Catalogue of industrial equipment products for development

To boost China’s domestic equipment manufacturing industry, MIIT, MOF, MOST, and the State Asset Supervision and Administration Commission in December 2009 released an industrial equipment product catalogue that the government wants domestic companies to develop. In addition to offering tax and financing incentives, the catalogue gives priority to domestic manufacturers of the listed equipment types in accrediting their products as national indigenous innovation products. These manufacturers can also receive preferential financing for product commercialization and be included in government-related R&D plans for S&T products. Some analysts speculated that listed equipment types might be incorporated into any future national-level catalogue for government procurement of indigenous innovation products.

Many of the equipment types listed in the catalogue are being imported or developed by FIEs in China. Though the catalogue does not explicitly exclude FIEs from receiving indigenous innovation product accreditation, its reference to indigenous innovation product catalogues and to recently released qualification criteria that effectively exclude FIEs from the forthcoming national catalogue raise concerns.

At the December 2010 US-China Joint Commission on Commerce and Trade meeting, PRC negotiators agreed to revise China’s major equipment catalogue in 2011 and publish a draft for public comment. Government officials also stated that the revised catalogue would not be used for import substitution, the provision of export subsidies, or otherwise discriminate against foreign suppliers. As CBR went to press, however, PRC officials had not yet released a draft catalogue.

Draft implementing regulations for PRC Government Procurement Law

The State Council’s Legislative Affairs Office in January 2010 released draft Implementing Regulations for the Government Procurement Law—rules that outline the scope, responsibility, conditions, format, procedures, and requirements for government procurement in China. In a positive development, the draft defines domestic products, projects, and services in a way that appears to include FIEs.

Article 10 of the draft implementing regulations defines what constitutes a domestic product under the 2002 PRC Government Procurement Law, such that a “domestic product” is one “made within China’s borders and for which domestic manufacturing costs exceed a certain percentage of the final price.” This definition should allow FIE products that pass a local content threshold, which apparently will be applied equally to Chinese-owned companies, to qualify as domestic for government procurement purposes. The draft, however, does not confirm the percentage of domestic content that is required to qualify as domestic.

Article 10 also states that government procurement for projects and services will apply to Chinese nationals, Chinese legal persons, or other Chinese organizations. Because FIEs have legal-person status under existing PRC laws, this definition indicates that projects and services provided by these FIEs should be treated as “domestic” for government procurement.

In addition, these regulations provide a threshold for the price preference to be given to domestic products and services. Many countries allow or require government entities to preferentially procure domestically produced items unless they are “unreasonably” expensive compared to a competing import. The draft regulations define “unreasonable commercial terms” to mean that the price of domestic goods, projects, or services is at least 20 percent higher than those of non-domestic competition. If a domestic offering meets this definition, it should not receive preference in procurement.

Article 9 of the implementing regulations gives preference in government procurement to energy-saving and environmental-protection products, indigenous innovation products, products made by small- and medium-sized enterprises, and products made in minority ethnic areas, such as Xinjiang. The article is significant because it states that qualifying products should either be given priority or mandatory purchase preferences, without further clarification. Foreign companies are concerned about this article, because the existing and proposed qualification criteria effectively exclude FIE participation.

At the May 2011 S&ED, PRC officials committed to revise the draft implementing regulations, particularly Article 9. This builds on previous statements that future rules would afford equal treatment to all innovation products produced in China by FIEs and Chinese-invested enterprises alike. As CBR went to press, however, no further details about the revision have emerged.

Draft administrative measures for procurement of domestic products

MOF in May 2010 released draft administrative measures for procurement designed to clarify a few key terms, particularly terms regarding domestic content, mentioned in the January 2010 implementing regulations. According to Article 6, a “domestic product” is one “made within China’s borders, where the domestic production cost ratio in the final product exceeds 50 percent.” This ratio is calculated using the product’s final production cost and the value of those production materials not sourced from China. This definition permits FIEs manufacturing in China to participate in government procurement and provides greater efficiency and transparency for companies and regulators.

Article 9, however, states that all production materials for which the source cannot be proved are assumed to be non-Chinese, raising questions about how manufacturers can and should prove the origin of their production materials. In addition, the regulations do not provide specific carve-outs or exemptions for particular sectors (such as software), as many other national government procurement programs do. This causes companies to question whether the measures allow China’s government procurement regime to be flexible enough to handle procurement of an array of product types.

Notice eliminates some key measures linking innovation to procurement

A June 2011 MOF notice voided, from July 1, three measures that linked innovation and procurement. The three measures—all passed in 2007—made up an important part of the PRC regulatory framework that promotes government procurement of indigenous innovation products. The measures include

•     The Evaluation Measures on Indigenous Innovation Products for Government Procurement, which described advantages—such as preferential prices and extra consideration in technology and quality evaluations—that accredited indigenous innovation products could enjoy in the government procurement process;
•     The Administrative Measures on Budgeting for Government Procurement of Indigenous Innovation Products, which required government entities to prioritize purchases of accredited indigenous innovation products and laid out rules and procedures for such procurement; and
•     The Administrative Measures on Government Procurement Contracts for Indigenous Innovation Products, which encouraged government entities to use state procurement contracts to promote indigenous innovation and called on such entities to provide preferential contract terms for indigenous innovation products.

In addition, MOF, MOST, and NDRC released a circular in July 2011 that invalidated 2006 trial measures on accrediting indigenous innovation products. The circular reduces the certainty that China will release a national indigenous innovation catalogue.

Circular invalidates trial measures on product accreditation

Provincial and municipal-level governments have responded to central-level policies by suspending or eliminating indigenous innovation product accreditation. In at least one case—in Shanghai—the local government formally eliminated its indigenous innovation product catalogue. In other cases, finance bureaus in Fujian, Jiangxi, Shandong, and Tianjin called on relevant agencies to suspend local rules or to follow central-level directives without the elimination of the catalogues. Other provinces, notably Jiangsu, have also indicated that they are following and studying central-level directives and their impact on local policies.

Looking forward

These steps suggest that central and local governments are beginning to implement President Hu’s January pledge to delink China’s innovation and procurement policies. More needs to be done, however, to fully implement that pledge. For example, recent USCBC research states that 22 provincial and local governments have released catalogues of indigenous innovation products, and 31 provincial and local governments have released accreditation rules that link innovation and procurement. In addition to delinking innovation and procurement in remaining catalogues and rules, the government must also revise the proposed PRC Government Procurement Law Implementing Regulations.

Furthermore, many of China’s trading partners wish to encourage China to pursue its innovation policies in a manner consistent with international best practices. Foreign companies state that China should promote and strengthen innovative capacity through a combination of strong IP rights protection and internationally accepted means, such as nondiscriminatory tax incentives and R&D support programs. These tools are used widely by the world’s most successful, innovative economies.

The US-China Business Council (USCBC), publisher of CBR, is the leading organization of US companies engaged in business with the People’s Republic of China. Founded in 1973, USCBC provides extensive China-focused information, advisory and advocacy services, and events to more than 230 US corporations operating in the United States and throughout Asia. This article is adapted from USCBC’s Issues Brief: China’s Domestic Innovation and Government Procurement Policies.