Pledge to reduce overcapacity in traditional industries, eliminate many 'zombie enterprises' and deleverage won't be enough

Production overcapacity is something that regularly occurs in all regions of the world due to natural economic cycles. However, the current oversupply, which can be observed in many of China's traditional industries such as steel, cement, glass and petroleum processing, points to more structural issues as the Chinese economy undergoes a major shift.

As there is not much hope of short-term recovery, Keynesian demand-side spending, which can help to overcome a short-term decline in demand, would certainly be less effective than the supply-side policies decided by the Chinese government.

China has pledged three "cuts" as key moves of the reforms: reducing overcapacity in traditional industries, eliminating a large number of so-called zombie enterprises and deleveraging.

Yet cleaning up underperforming industries and reducing costs through the creation of synergies will certainly not be enough. China must also upgrade its growth model in order to make it sustainable in the long run.

For companies, supply-side reforms represent an opportunity for a radical overhaul and innovation breakthroughs. And demand for new innovations is growing at a fast pace, in China just as in any other country. They must seize this possibility instead of passively waiting for the government's actions.

But as the planned measures to cut production capacity will inevitably lead to negative micro and macroeconomic effects in the short term, it is vital to also support them in their development.

Hence, besides the "three cuts" defined in the supply-side policies, there should also be "three add-ons": the development of an innovation-friendly business environment, the enhancement of China's total-factor productivity, and the creation of China's own ecosystem for innovation through attracting more diversified and professional talent and fostering cooperation.

Developing an innovation-friendly business environment requires less intervention and government control, and stronger legal support for innovative companies; for example, intellectual property protection.

In practice, this also means decreasing tax burdens and other costs, such as legal expenditure for enterprises, which can in turn spend the saved amounts on research and development. In addition, as Chinese financial markets are still immature, the government must make sure to adequately fill the gaps in innovation financing.

Another important issue in China is the generally high market entry barriers for small players. Unlike larger competitors, smaller businesses face much higher pressure and are thus willing to take risks that lead to much more disruptive business models and allow the exploration of completely new markets - as opposed to incremental innovations.

It is true that companies are at the heart of economic development, but the Chinese government must make sure to not only listen to large players, but also maintain a positive attitude toward innovative business models when crafting policies.

China's total-factor productivity has been constantly lower than that of South Korea and Japan over the past 20 years. It could be significantly enhanced by improving China's innovation capabilities through targeted investments from the state, which should go to key industries and to fields that would best boost China's national competitiveness in the long term.

Education and training is one of them. It has been frequently stated that China still lacks an education system oriented toward practical technical applications in specific fields and must also improve re-employment training.

As an example, Germany's Expert Commission for Research and Innovation stated in its latest report the German dual system of on-the-job training functions as the basis for companies' innovation activities.

Modernizing the educational system, and transforming Chinese companies and their management as well as organizational structures from inside out, will be a lengthy process. Actually, many researchers today are not efficient enough to generate the desired breakthroughs, even with massive investment support from the state.

It is therefore equally important for China to reinforce the attractiveness of its ecosystem by taking in a more diversified workforce, based on innovative talents and professionals from all over the globe, and by fostering the cooperation between existing players.

In the United States, the founders of many great innovative companies are not American natives; rather, the government has managed to create a talent system to bring them in.

The new planned policies to increase the practical use of green cards by giving permanent residents the same entitlements as local citizens - for example, when it comes to buying homes, school enrollment and social security coverage - are certainly a step into the right direction.

It is equally vital, though, to then bring together all these newcomers - be it new ventures or foreign workers - with the traditional players. This is especially valid for China in order to make use of the country's existing assets.

In today's disruptive environment, traditional management models and business models have become less effective. In a world where transaction costs tend toward zero, size does not necessarily matter anymore. Instead, companies must be able to adapt to changing environments, make more-targeted, less-capital-intensive investments and build meaningful alliances.

This does not mean that traditional companies - private or state-owned - are excluded from the innovation movement. Corporates actually have a great deal more potential than they are often aware of. But it often can only be fully released through cooperation with smaller players that have a more disruptive product or service offering.

Governments can certainly foster this type of cooperation by supporting the startups adequately, connecting them through the right platforms and providing incentives to traditional businesses to work with them.

It is obvious, however, that many of these measures also require financial means. So Chinese leaders must consider allowing moderate expansion of the fiscal deficit and taking active measures to stimulate aggregate demand in targeted areas.

In this respect, the fact that the Chinese government has already made innovation a national priority is reassuring. It is important, however, to pursue the innovation efforts within the context of supply-side reform and target all measures to company needs.

Moreover, companies - small or large - must be given the freedom to explore new opportunities and new ways of working - as otherwise they will only be able to produce incremental innovations but no truly disruptive products and services.

In today's volatile, uncertain, complex and ambiguous environment, no single company, institution or state can actually predict where technology and progress are headed. Thus, the abilities of government planning with regard to the innovations of tomorrow are also limited.

So, the success of supply-side reforms will require joint efforts by enterprises and governmental bodies. With regard to economic development, China traditionally benefits from two important advantages: solid administrative structures and the entrepreneurial spirit of its people. Here lies the opportunity for the government to create the right framework that will transform this incredible energy into breakthrough innovations.

The author is global CEO of Roland Berger Strategy Consultants. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 03/25/2016 page9)