China’s latest five-year plan promises to shift the economy from its dependence on exports toward domestic consumption as an engine of growth. The key to achieving this will be for the nation to enhance the ability of its economy to innovate. Yet China’s record on this score is mixed. Understanding why that is, and how to fix it, is important to estimating the likelihood China will succeed in its ambitious goals.

The first step is to appreciate the different kinds of innovation going on right now. When most people hear that word, they think of “inventing things,” and on this score China is making progress toward becoming a more innovative economy instead of merely mass-producing goods that are designed elsewhere. China’s spending on research and development has risen to 1.5 percent of GDP in 2008, from 1.25 percent in 2004, all the more impressive when you consider that GDP itself increased dramatically during that period. While China is unlikely to meet the goal of 2 percent set for 2010 in the last five-year plan, it still accounts for 12 percent of global R&D spending.

Significantly, this R&D spending is shifting from government-controlled research institutes to large- and medium-sized enterprises, which now account for 60 percent of total R&D spending. Despite frequent complaints about lax intellectual-property protections, foreign-invested companies account for fully 7 percent of this spending, spread among nearly 1,500 R&D centers established by multinational companies.