Innovations and Investment:Two Sides of the Same Coin

7 july 2010

The Role of the State and Business in Modernization

Vladimir Yevtushenkov is Chairman of the Committee on Scientific-Technological Innovations and High Technologies under the Russian Chamber of Commerce and Industry.

Resume: The obsession with grand scale projects is as damaging to the idea of innovative economic zones as the trend towards small-budget minimalism. For example, the projects to set up Science Towns provide for all kinds of measures – from improving the public transport infrastructure to developing pedestrian walkways in neighborhoods. Just one thing is missing: a program to build effective cooperation between research centers and private business companies.

The problem of innovations and economic modernization remains a subject of heated debate in the public realm, as well as scholarly and policy circles in Russia. Initially a scholastic plan, it eventually became the major priority of the country’s economic policy for the foreseeable future. The crisis that gripped the world made the problem of economic modernization especially acute in Russia as it pushed it to the sidelines in the group of countries aspiring to be among the world leaders.

Russia’s petrodollars, a decade-long premise for all socio-economic development projections, have proven to be a far too shaky foundation for taking a confident look in the future. The need for innovations which tentatively emerged in the industrial production has become ubiquitous in all sectors of the Russian economy.

Yet the very first attempts to readjust the industrial policy and make it an eager recipient of newest technologies ran into a hopelessly obsolete production system, practically insensitive to innovations. The problem of finding constructive solutions to radically modernize the economy presented itself in full magnitude, as the very possibility of Russia’s joining the club of highly developed states was challenged.

THE PATH TO AN INNOVATIVE INFRASTRUCTURE

The realization of a liaison between innovations and modernization enables determining a set of priorities in the country’s economic development for years to come, both with regard to the system of state governance and business. Furthermore, pooling the country’s production forces for attaining global objectives would make it the first ever reason for Russia to renounce the old practice of setting private interests against public ones.

In supporting technological innovations, we should strictly adhere to the principle under which selection of such projects is the prerogative of private business, except for cases when it receives direct state orders to launch innovations in the fields outlined by the government as priority ones. Modern international experience shows that governmental support of innovations by devising “priority guidelines” in technological development is ineffective. The needs of the market are the main source of innovation priorities, and business knows these needs far better than the state.

Hence the creation of an innovative infrastructure comes to the forefront of the economic policy. This implies devising institutional mechanisms to translate innovative ideas and R&D into business projects and their proper funding. The key measures to create an innovative infrastructure are:

  • Developing an infrastructure for cooperation between research institutions and businesses. The present-day agencies, such as innovative technology centers and technology parks, are ineffective because working under direct order of business has not become a routine practice with them (as a result, research institutions often offer stale budget-funded developments to business, which are not what it really wants). Budget funding and taxation of research centers should be arranged so as to put science-business relations on a contractual basis;
  • Setting up venture capital funds to diversify the risks of innovation projects. Diversification is possible if a venture capital fund has considerable resources, large enough to finance many projects. In the present conditions, it would be expedient to set up a Russian fund of venture investments, with a capital of at least $400 to 500 million and the government’s stake of up to 50 percent. This pilot venture fund, if successful, would set an example for new venture capital funds created with private investors’ money;
  • Developing financial institutions. In the 1990s, the “new economy” sector in the member states of the Organization for Economic Cooperation and Development grew rapidly because pro-innovative companies of this sector had direct access to financial markets ready to extend loans. In Russia, the companies focusing on innovative projects are practically deprived of this opportunity due to the poor development of financial markets, where banks have little interest in giving long-term loans. Measures to reform the financial sector should necessarily agree with the objective of developing innovative business as a priority.

Business is a proactive participant in the innovative restructuring due to the very nature of innovations. In a nutshell, this is what one would like to buy: for one’s good, comfort, security, or simply for beauty, convenience and novelty.

The definition looks simplistic only at first glance. It is perfectly obvious that everybody has his own idea of novelty. For example, a perpetual motion machine would be an ideal innovation, but we realize that it cannot be built. Yet there is a steady demand for an economical, environmentally friendly, reliable, and effective engine and there is an army of specialists and inventors working on it. It is the market that decides which novelty is an innovation when it begins to buy it – preferably, in large amounts.

Yet it would be erroneous not to regard as an innovation whatever we cannot see with our eyes or feel with our hands, but which contributes to making new goods: materials, technologies, software, utility lines, and organizational, management and teaching techniques. Of course, the degree of novelty can only be determined at the expert level, but knowledge has long become an integral part of commodity production in the modern world.

Hence the first conclusion: a successful strategy of innovative development, capable of giving a competitive edge to domestic manufacturers, boosting the GDP and raising the standard of living, should be based on defining the investment component of innovative activity.

R&D results and technological or organizational ideas cannot be called innovations if they have not been implemented in production. This applies to scientists’ discoveries, patents for inventions, or projects that cannot be implemented for lack of necessary market conditions. The main indicator of the market’s readiness to accept innovations is the desire of business to invest in these projects. In case of Russia’s inertia economy based on primary products, this readiness heavily depends on the government policy to support innovations with investments, which suggests creating incentives for innovative activity.

It follows from the above definition that the constant demand for novelties is the crucial characteristic of the innovative economy. It is the demand that sets reference points and incentives for innovative activity. From this point of view, the shift of innovative production to the corporate level is a sign of the time. Business, as an economic actor, has one unquestionable quality – it is closer to the market as it actually lives for its sake. Therefore, business is the mainspring of the market economy development that is embodied in innovations.

Despite the government’s efforts to create institutional conditions to stimulate innovative activities (tax incentives, technology development zones, technology parks, special foundations, etc) we see little innovative enthusiasm except for slogans and calls. In other words, innovations do not look increasingly appealing to business, and not just because of inertia thinking or limited planning perspective.

Innovations have not yet become a factor of production development (growth) as a result of an active investment policy in Russia. For a number of reasons, reducing production costs as the key factor to remain competitive has not become the primary concern of the Russian management. Consider the following figures: in 2009, Germany’s largest car-makers increased their liquidity reserves by almost twofold, as if the crisis or plunging profits had not affected them at all. Almost all these reserves – more than 50 billion euros – have been saved with the sole purpose of investing in the newest technologies and equipment to outperform rivals on the global market.

THE STATE AND INNOVATIONS

What is happening in Russia? The natural (and not so natural) monopolies simply hiked their tariffs, increasing the non-manufacturing costs, which frustrates any efforts to bring forward and implement innovative projects. This drive to lower one’s production costs by no means can expand to the field of innovations, not with the complete uncertainty of the business environment.

Hence the second conclusion: due to the above circumstances, the government policy of direct investment support of innovations should become the critical factor to compensate for – and ultimately remove – the shortcomings of the existing environment of innovative activity.

Admittedly, Russia has never formulated the principles of this policy since the start of economic reforms, while the few measures aimed at supporting innovations have proven ineffective. There are several reasons behind this situation:

  • The government policy to support innovations has long been associated with the financial support of mostly state research institutions. The criteria for funding did not match the necessity to encourage research centers to seek innovative partnership with private business;
  • In determining the priorities in the policy to support innovations, the government focused on “strategically significant vectors” of technological development, planning to amass budget resources there. Such an approach actually made the government a substitute for market mechanisms, both in selecting innovative projects that qualified for financial support and the sources of funding. The meager financial resources allocated for a few separate projects could not yield national scale results in principle;
  • As the government attempted to directly fund innovative projects, it did not pay enough attention to stimulating private business to boost investments in innovations. Due to the persistent uncertainly of the economic environment, and a lack of the mechanisms of large-scale venture capital funding of the innovative sector, Russia has few chances to launch a stable self-sufficient innovative process with incentives emerging in the business sector. This means the government’s efforts to “nudge” innovative projects are unavailing: innovative activity tends to degenerate once the government scales down its support;
  •  A lack of dialogue between government bodies and business people led to many different interpretations of the basic issues of state support of innovations. As a result, the attempts to produce a legal basis for the principles underlying government support ran into the problem of obscure legal formulations, and were largely declarative.

At the same time, Russia has made obvious progress – both in terms of the government’s attention to innovations, and its efforts to bridge the gap between science and business and help transform the intellectual achievements of domestic researchers and designers into a competitive product by world standards. This makes groundwork for fruitful cooperation between the government and business in determining the promising policy guidelines to support innovations. The Government Commission on High Technologies and Innovations chaired by the Prime Minister confirmed the allocation of 1.1 trillion rubles for research, innovative projects and federal targeted programs in 2010, and announced a benchmark fourfold increase in the funding of government procurements of innovative products.

A logical question arises: What funds should and can the government tap to support the innovative sector of the national economy? This issue is particularly topical today, as the work on the key tax policy guidelines and the next budget has entered an active phase.

Until now, federal target programs have been the only instrument of government support of business strategies. Poor implementation of a majority of these programs in 2009 forced the government to significantly reduce their number and suspend several of them. The approved and partially implemented target programs need one trillion rubles of investments, and another 500 billion rubles are required to implement the presidential and government “innovative modernization” initiatives.

Privatization is often used as a money-raising instrument. However, due to a downturn in this field, the Ministry for Economic Development and Trade doubts it will provide for necessary replenishment of the budget items intended for funding federal target programs. Apparently, the government will not do without mobilizing the resources of business.

A popular assumption is that business can only be motivated with budget money, but this is not so. In innovative business, other mechanisms play a far larger role. Russia does have these mechanisms, but their operation has been tentative so far.

Motivating investments in innovations is a far more complex and larger task than budget injections in this or that branch of the economy. It requires support of new forms of private-state partnership, such as the establishment of functional clusters. Their objective is simple: to consolidate functionally-related companies, not the companies operating in various branches of the economy within a given region. The crucial integrating function belongs to investments.

It is the clusters buoyed by investments that can create favorable conditions for interaction between different branches of industry, as a juncture of various branches of knowledge and production. Clusters can provide for the accelerated commissioning of developments in mass production, disseminate innovative approaches, ideas, and solutions for new tasks, and the competent and professional management of all these processes.

Clusters are groups of associated, closely interacting companies, whose joint investments help develop and launch innovations that give a competitive edge on the market. A successful development of clusters requires:

  •  establishing economic and scientific/technological ties between companies;
  •  combining cooperation between companies with competition that stimulates continuous search for innovations, with a view to increasing effectiveness and strengthening competitive advantages;
  • generating a considerable and steady demand for products of a large number of companies operating in the same sector of the economy or associated sectors, which are brought together by similar technological processes, or in the sectors united by vertical economic ties;
  • “attracting” financial, consulting, research/educational, and logistics services necessary for the companies operating within clusters.

A close look at the above conditions provides for two important conclusions, which have long become essential for the world practice of industrial policy.

First, it is impossible to enforce clusters with administrative levers, without taking into account the real prospects for their economic activities. The fact that several companies of a given branch use or go by the same technologies does not imply that they will form a viable cluster – they need to develop cooperation and include a sector of services in it. None of these targets can be met through administrative decisions, without objective market prerequisites. Furthermore, excessive administrative measures of regulation may create additional obstacles to innovative clusters, become a straightjacket for business, not the breeding ground.

Second, the key factor to secure an atmosphere of confidence and a large and steady demand is the inclusion of large companies in clusters. In innovative clusters, large companies play a dual role: as investors attracting banks and subcontractors to implement their projects, and generators of demand for the services of innovative companies of small and medium business, by providing orders and markets for their intellectual developments. Conversely, the clusters comprising only small and medium innovative companies do not have many chances to develop dynamically in a transition economy, above all, because they have no access to large investments and are unable to generate a steady demand for products of associated branches.

The administrative system of clusters is practically free from corruption – too many parties are interested in the common results of activity, and the sharing of preferences is too transparent, being encumbered by high risks (developers, manufacturers and sellers do not know in advance if they will be able to reach their goals). Contractual relations between all the participants in innovative processes are an effective instrument to mobilize investments and divide functions: a scientist or developer of an innovation can often cope with their tasks well, but they may have a poor knowledge of market laws. No wonder commercialization of research results is a topical issue: inventing something or creating a product prototype does not yet make it an innovation. When it appears on the market and is in demand, the goal is as good as reached.

Government investment in such functional clusters would help resolve another important task, namely involving regional authorities in shaping and implementing the innovative policy. Admittedly, there is a large gap between the setting the objectives of the innovative policy at the federal level and introducing it into the regional governance system. The Russian Ministry for Economic Development and Trade is expected to come up with a program to support clusters, under which regional authorities will stimulate the production of innovative products with subsidies. Of course, there is a danger of lapsing into administrative frenzy and enforcing a formal participation in the cluster for the sake of drawing extra budget funds. Yet thanks to partnership with business, it is easier to neutralize this threat than ignore the opportunity to mobilize small and medium businesses in regions.

It is important to avoid the errors made during the establishment of special economic zones, technology parks and the so-called Science Towns that were supposed to form business incubators geared for innovations. In a majority of cases, we deal with the extremes – the attempts to set up small budget centers of innovative development whose beggarly working conditions scare off potential investors, or the ambitious projects to create “innovative infrastructure” which in actual fact have nothing to do with the development of innovative activity.

A shocking example is the Ministry for Economic Development and Trade’s program to set up business incubators: it often offers rundown buildings that used to accommodate industrial companies, consumer services and even secondary schools. Perhaps, office floors in such buildings can look attractive to firms that have grown from “shuttle trade” business or some innovative companies set up by the people with little business experience. By definition, they can have no systemic innovative effect on the economy.

The situation with Russian technology parks is as unimpressive. One might think these projects aim to create a sort of “innovative ghettos” to bring together sidelined scientists and designers, rather than modern research and design centers. The international practice in this field is markedly different. For example, Brazilian architect Paulo Mendes da Rocha, the 2006 laureate of the world’s architectural prize, is working on the technology park project for the Spanish university of Vigo. This fact conspicuously shows the significance and the level of prestige the technology park founders are hoping to attain before the leading world companies. But Russian builders of business incubators and technology parks have to think about estimating the degree of wear and accident risks of buildings they have been given as a startup for “innovative infrastructure,” not about inviting the best world specialists.

The obsession with grand scale projects is as damaging to the idea of innovative economic zones as the trend towards small-budget minimalism. For example, the projects to set up Science Towns provide for all kinds of measures – from improving the public transport infrastructure to developing pedestrian walkways in neighborhoods. Just one thing is missing: a program to build effective cooperation between research centers and private business companies.

THE LEADING ROLE OF BUSINESS

I believe it is necessary to reiterate conclusion three: only large Russian businesses can ensure the advantages in innovative zones and clusters to resolve the strategic task of creating an innovative economy. The existing experience supports the arguments in favor of this thesis.

  • Large businesses have already devised their own mechanisms to implement innovative projects: determining priorities, attracting the necessary investments and introducing R&D results in real production processes;
  • Large companies operate in many sectors of the economy, monitoring the technological ties between them and considering promising options to diversify business. This facilitates product and technology innovations, aimed at increasing the degree of raw-materials processing within vertically integrated production processes, and the competitiveness of manufactured products;
  • With clear guidelines for activity, large businesses are not interested in implementing ambitious but senseless “infrastructure projects” that are often used as sinecure for officials rather than real mechanisms to stimulate innovations. Large businesses are interested in the forms of support of investment activity that help realize the real market advantages in the innovative sector of the economy, not the projects where wishful thinking prevails over calculations.

 In view of the above facts, M&A (merger/acquisition) would be the most effective investment instrument to boost investment activity in the present condition of the Russian economy, far more effective than the enlargement of companies by creating specialized innovative business centers. For example, the IT sector, which is probably the most innovative sector of the Russian economy, has the highest M&A level.

One can hardly expect large investments in innovations until the level of consolidation of Russian business reaches a certain level. The financial-economic crisis has only increased this need. Even the U.S. Silicon Valley, which has amassed a considerable number of high-tech companies, announced that it was gearing for a merger and acquisition boom. The reason is transparent: on the one hand, large U.S. companies cannot keep pace with the development of newest products, and find it more advantageous to acquire a venture developer; on the other hand, they have enough funds to afford M&A investments.

Large business is interested in launching fruitful cooperation with innovative small and medium business companies that operate in concrete market niches. A number of promising fields in the economy (technologies for advanced processing of natural resources, pharmaceuticals, materials science, anti-virus software, food safety, identification technologies) make natural groundwork for launching productive cooperation between large business and small and medium companies. This business partnership should become an integral component in creating innovative economic clusters in the Russian economy.

The activity of the Sistema Joint-Stock Financial Corporation in the field of innovative business is an example of how a large company can perform the role of the leader in shaping innovative clusters. Today, Sistema’s corporate innovative infrastructure comprises the technology parks in Zelenograd, Dubna and Sarov; technology innovation centers (including the advanced center at the Bauman Moscow State Technology University); centers of commercialization; and a classical venture capital fund. It also includes the Sistema-Venture public company, a specialized innovative agency which coordinates the activity of technology parks and invests in the projects they are implementing.

Extensive experience in high-tech project implementation and competent analysis of the existing problems in this field has enabled Sistema to devise a comprehensive approach to making technology parks the real generators of innovations. They provide for a full cycle of project implementation: from the selection of promising ideas to their commercial realization involving venture investment mechanisms. At present, there is a successful innovative activity in micro electronics, radio engineering, satellite and medical instrument making, helicopter engineering, information technologies and compute-aided design systems. Under Sistema plans, technology parks will implement innovative projects, which Sistema can capitalize in its holdings within three to five years or more. In the Sarov innovative development zone alone, the company intends to launch 100 innovative product lines with revenues at around $100 million.

The establishment of Sistema was a landmark event. It facilitated the emergence of innovative clusters around the innovative zones it had launched, which are expected to realize the above advantages of the agglomerative economy and positive external effects. In actual fact, Sistema is becoming the largest corporation of domestic innovative business, as it launches “the process of crystallization” of innovative clusters across the country. The enterprises incorporated in Sistema holding companies and other research and commercial organizations that operate in innovative clusters are expected to reap the benefits of this process. The government should take this experience into account in its policy to support innovative economic zones and invite large corporations having innovative and investment potential.

Investment in innovations is a challenge. This is a domain of higher risks, latent expenditures, prevalence of individual (creative) labor which defies rating, the uncertainties regarding the project implementation period. This is true, but the innovative development of the economy keeps expanding, and that means the risks pay back. We should primarily consider the development of venture investments. The U.S. accounts for some 70 percent of the world’s venture capital investments, while Russia occupies the 49th place out of 66 by the attractiveness of venture capital investments, which is not surprising. Nevertheless, Russia considers inviting Western venture capital funds to invest in the start-ups, for example, of the Internet business. Notwithstanding the low attractiveness level of the Russian innovative market, its intellectual component has a decent enough rating to expect Western capital to participate in Russian innovation projects.

Venture capital funding in the Russian economy is very week. Russia has a state venture capital company whose function is to form dedicated funds. For example, the Russian Ministry of Telecom and Mass Communications has such funds, and the Rosnano state corporation, too, funds new developments: it has already invested billions of rubles in these projects. But this is not enough: it is important to stimulate any business to invest its own or borrowed money in innovations.

Tax incentives, easy-term loans, preferential risk insurance, state support of exports are essential here. The government is already implementing some of these measures: it has allocated 60 billion rubles to support exporters of high-tech products, and another three billion rubles will be allotted to subsidize the interest rates on export loans. The government is also setting up an agency to insure foreign trade contracts, which will receive 13 billion rubles to finance its activity.

Even if these measures do not look sufficient, they are significant inasmuch as they map out the route, and moving along it will gain momentum in time. What is important is that not only the defense sector – the acknowledged locomotive of the technological development of the Russian economy – gets access to investments. There is an apprehension that these incentives might be misused, which casts a shadow on government supervisory agencies, prompting the question: Is this large body of supervisors incapable of monitoring the proper use of funds? The business community should honor its own commitments to use incentives and preferences in good faith.

One should mention the establishment of self-regulating organizations that have proven effective. Their participants voluntarily undertake commitments to meet all the requirements and directives related to work in a certain field – innovations, for example – and have this work monitored. It is practically impossible to cheat one’s colleagues, far less rivals.

It would make sense to stimulate closer interaction between businesses and research centers, while stimulating both sides of cooperation: along with the mushrooming R&D centers created by business where scientists are keen to get jobs, it is necessary to create design and engineering centers, which are not as developed yet. Federal law #217 on implementation of the results of intellectual activity has opened vistas for government-financed research and education institutions to transfer intellectual property rights to the authorized capital of commissioning organizations. But this right cannot be implemented, as there are no by-laws yet.

Hence the fourth conclusion: Russia needs institutional innovations to overhaul the system of governmental regulation of economic processes, and spell out the functions of regulators and their instruments of economic and industrial policies. These institutional changes aim to decrease the level of administrative expenses for national business and to better protect its interests on the foreign and domestic markets (above all, by protecting the rights of investors, ensuring a predictable government policy and fighting improper trade practices of foreign competitors).

The purpose and the criterion for assessing the performance of state governance bodies is their ability to offer incentives for creating effective market economy institutions. The legal and social institutions of a market economy act as important prerequisites of innovative activity: the perfection of legal institutions (above all, mechanisms to realize the patent and contract law) will make banks and other financial institutions (direct investment funds and mutual investment funds) more interested in investing in the development of markedly new products and technologies, giving up non-core subdivisions in favor of investment agencies with companies that develop and bring new products and services to the market. A reform of social institutions (labor and educational ones in the first place) will increase the proficiency and cultural level of the employees, and their ability to work in high-tech and innovative sectors of the economy.

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