56704 Public Financial Support for Commercial Innovation in ECA Countries Itzhak Goldberg, Manuel Trajtenberg, Adam Jaffe, the centrality of innovation and knowledge creation in the Thomas Muller, Julie Sunderland, and Enrique Blanco growth process and, on the other hand, the understanding Armas that these are economic factors that may be shaped and influenced by properly designed economic policies. Key Messages1 Commercial innovation and R&D are key For the purpose of this Knowledge Brief, innovation can be factors driving self-sustained, long-term defined as the development and commercialization of new economic growth. These factors are unproven technologies and untested processes and products, generated from within the economic system, and absorption as the application of existing technologies, responding to economic incentives. processes, and products. The ability of an economy to research and develop new technologies increases its ability Translating research into economically to understand and apply existing technologies. Vice versa, productive commercial applications is a the absorption of cutting-edge technology inspires new critical missing link in Europe and Central ideas and innovations. Asia (ECA) countries. Typically, the bulk of R&D spending in However, the adoption of existing technology via trade, ECA, as much as two-thirds of the 0.9 Foreign Direct Investment (FDI) or licensing is not percent of GDP, is financed by governments guaranteed or cost free. Firms and countries need to invest whereas only about one-third is financed by in developing absorptive` or national learning` capacity, the private sector. which in turn is a function of spending on research and development (R&D); domestic R&D has a role in The utilization of instruments such as developing a firm`s ability to identify, assimilate, and matching grants and venture capital--with exploit knowledge from the environment, that is, enhance as much private sector participation in risk the absorptive capacity of the economy. sharing and selection as possible--will be needed in ECA countries to ensure Innovation in ECA transparency and commercial viability and mitigate the risks of government failure. Scarcity of capital and the high cost of labor in ECA countries, relative to their Asian competitors, limit cost- Growth and Innovation versus Technology based competitiveness. The crisis exposed the limits of Absorption growth fueled by external financing or natural resource exports. Revitalizing growth requires new strategies to raise Key factors driving self-sustained, long-term economic competitiveness: export-led sectoral diversification; growth are innovation and technology absorption; these investments in skills and infrastructure; and innovation and factors are generated from within the economic system, absorption of technologies from the world. responding to economic incentives. This conceptual framework molds our analysis: on the one hand, the view of The ECA region has a fairly high human capital stock and well-developed research institutions, with an average of 1 nearly 2,000 R&D researchers per million; Russia has the This Knowledge Brief is based on a Knowledge Economy Study that is part of an ongoing Regional Working Paper Series sponsored by the Chief Economist`s highest ratio of researchers to its population--more than Office in Europe and Central Asia Region of the World Bank. 3,400 per one million people. In Figure 1, the gross ECA Knowledge Brief domestic expenditures on R&D (as a percentage of GDP) of investments in R&D in their respective countries. The some of the major ECA countries are compared with other European Union`s (EU) Lisbon Strategy has prompted the developed nations. The average R&D-to-GDP ratio in ECA new member states and other ECA countries to consider is 0.9 percent. Of the 28 ECA countries, only 6 countries implementing financial instruments to promote innovation, have a ratio of 1 percent or more. especially venture capital schemes. However, this is being done with little consideration for the necessary institutional However, in most ECA countries, R&D is typically isolated requisites or appropriateness of the instruments. In a from industry and effective structural reform would require number of countries in the former Soviet Union (for bridging this gap between industry and research. To example, Russia, Ukraine, Kazakhstan) and its satellites and effectively integrate their R&D activities in line with private in the former Yugoslavia (Serbia, Croatia), the legacy of sector innovative efforts, two crucial problems of research and human capital also provides an incentive to institutional design must be addressed: (i) aligning the R&D revive their research capacity. But absorptive capacity activities performed in institutes and academia to the remains an issue in all ECA countries. Some of the technological demands of existing business enterprises, and countries are likely to have higher productivity returns from (ii) facilitating two-way flows of information and investments in building absorptive capacity than in knowledge at the public-private interface. commercial innovation. Spending in ECA on applied research that has higher commercial potential is low when compared with the Should Governments Support Innovation? world`s most developed countries. There is also a mismatch between the research being undertaken and private sector In a new book2 on entrepreneurship and venture capital, needs. Typically, the bulk of R&D spending in ECA--as Josh Lerner of the Harvard Business School writes: When much as two-thirds of the 0.9 percent of GDP--is financed we look at the regions of the world that are, or are emerging by governments; only about one-third is financed by the as, the great hubs of entrepreneurial activity-- places such private sector. By contrast, in countries with high rates of as Silicon Valley, Singapore, Tel Aviv, Bangalore, and R&D expenditure, such as Japan, the United States, Guangdong and Zhejiang provinces--the stamp of the Sweden, Finland, Ireland, and Germany, the share of public sector is unmistakable. ... While the public sector is industry-related R&D spending ranges from 65 percent to important in stimulating these activities, I will note that far 70 percent, whereas government spending amounts to only more often than not, public programs have been failures. 20 to 30 percent. Many of these failures could have been avoided, however, if leaders had taken some relatively simple steps in designing Figure 1: R&D intensity (Gross Domestic R&D expenditure as a and implementing their efforts. percentage of GDP), 2006 or latest available year Any public intervention must be weighed against the actual and potential costs of intervention. This includes the well- known problems of capture and corruption. Market failures may justify government intervention to stimulate absorptive capacity in the private sector. However, policy design needs to account for potential risks of government failures, such as capture of policy makers by large companies and other vested interests and misaligned incentives of government officials who risk high penalties if their policies fail but expect little extra compensation if they succeed in risky policies. The government plays a special role in promoting start ups because of the high risk that deters the entry of new ventures and their high failure rate once such ventures are established. It is the role of the government to encourage new ventures as a way to generate new activities and support sustainable job creation. This role derives from the Source: OECD Science, Technology and Industry: Scoreboard 2007 2 Josh Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost In recent years, policy makers in the ECA region have Entrepreneurship and Venture Capital Have Failed--and What to Do About It, Princeton Press, 2009. increasingly directed their attention towards enhancing ECA Knowledge Brief asymmetry of risk between the government and the start up: Mature stage and exit: international and local the failure of a startup is a total loss for the private investor equity funds and strategic investors. but from the point of view of society, the intellectual property (IP) assets that a failed startup created and the One of the major problems of the innovation system is in skills imparted to its former employees can be used to start the sequencing of support for early stage vis-à-vis support a new enterprise utilizing those assets. Therefore, for for growth stage` innovation, mainly VC. Effective governments, the subsidization of failed startups, rather than sequencing should aim at building a significant deal flow of being a total loss, contributes to innovation and developing early stage projects before supporting VC. The success of future startups. In particular, it is important that the growth stage of the commercialization cycle depends on governments support new ventures which are based on IP a deal flow` of attractive companies coming out of the because it is support precisely for those firms which, by early stage. For example, in Israel, the VC boom in the definition, are introducing new technologies and new 1990s would not have been possible without the projects products and which are developing new markets. which had been supported by matching grants for 20 years by the Office of the Chief Scientist Program. How Can Governments Support Innovation? Governments can support innovation and technology The more traditional approach to R&D support for firms has absorption in three major ways: been through tax incentives or subsidized loans. However, since the 1980s, there has been an increasing awareness Regulatory interventions: to improve the policy among OECD countries of the benefits of matching grants environment for innovation and technology in encouraging firms to share and manage risk. A number of absorption via easier entry and exit, mobility, historically successful grant programs, such as Australia`s removal of barriers to FDI and non-tariff-barriers R&D Start Program and the U.S. SBIR Program, have an and an intellectual property rights (IPR) regime implicit matching component in that firms are expected to conducive to international R&D cooperation and support a portion of the research budget. Figure 2 shows an the global openness of science. estimated breakdown of actual funding sources for early Financial instruments: to subsidize R&D and stage technological development (ESTD) in the United business development in start ups, enterprises and States. spinoffs (matching grants, loans, tax holidays, etc.). Institutional instruments: incubators, technology Figure 2: Funding For Early Stage Technological parks, technology transfer offices, etc. Development in the United States Government interventions need to be carefully designed to promote private risk-taking instead of rent seeking and to stimulate markets for private risk capital, so as not to crowd out private investment and other funding sources. The government should also not decide ex ante which technological sectors, firms or projects to support, but respond to the demands coming from the market. Especially in ECA countries, the institutional design should aim to immunize, as much as possible, the funding allocation from interference by political actors, corruption, and other state or specific interests capture. An active innovation policy government program in support of innovation should span the entire commercialization cycle. The three different stages of the innovation cycle require different policy instruments: Early stage building of a deal flow: incubators, angel investors or matching grants, as well as spinoffs and other spillovers from multinational Source: Auerswald and Branscomb 2003. Valleys of Death and companies (MNCs). Darwinian Seas: Financing the Invention to Innovation Transition in the Growth stage: government support for private United States. Journal of Technology Transfer 28 (3­4): 227­39. venture capital (VC) via risk sharing. ECA Knowledge Brief In countries such as Finland and Israel, more formal instruments like mini-grants, matching grants and venture matching grant programs are helping to create a seedbed of capital would likely address the problem through the commercialization activities out of which the most encouragement of private R&D in companies, by providing promising innovation can be generated for follow-on incentives for collaboration through the co-funding of investment by private sector investors, such as VC firms. consortia of firms and universities/research institutes to implement innovative projects. A matching grants program works by encouraging risk sharing with firms, and it orients the selection process toward R&D programs that are most likely to generate There is also a need to adapt these instruments to the innovations that can be commercialized. Qualifying firms, conditions prevalent in many countries in ECA (with or consortia from academic institutions, will submit grant regards to state capture, corruption, and weak courts, etc.). applications for specific R&D projects that are reviewed by The utilization of instruments such as matching grants and an independent research committee. If approved, the venture capital -- with as much private sector participation applicants receive a grant from 50 percent to 70 percent of in risk sharing and selection as possible -- will be needed in the stated R&D budget for the project. Successful projects ECA countries to ensure transparency and commercial (that is, those leading to sales) will be required to repay the viability and mitigate the risks of government failure. In grant, as a royalty from revenue, up to the dollar-linked situations in which the government is actively involved in amount of the grant. The royalty scheme also orients the selection, such as early-stage grants, the selection process selection process toward picking projects mainly to achieve needs to be carefully designed to include outside expertise. sales and profitability targets3. Business support services are important complementary instruments to support financial instruments, such as grants In order to encourage private VC at the growth stage, the and venture capital, but have a weak track record on a government could mitigate private investors` risks by stand-alone basis. investing as a founding and passive Limited Partner, with a minority stake. Venture capital-backed firms played a key _______________________ 3 role in driving innovative economic activity during the Theoretically, the importance of matching stems from the fact that its effect is to reduce the marginal cost of research to the firm. A firm facing a downward sloping 1990s in the US, UK and several other markets. marginal research returns schedule will always increase total expenditure when the marginal cost falls, precluding the dollar-for-dollar crowding-out. The Path Ahead for ECA In a globalized economy, local skills and indigenous About the Authors technology are not enough to remain competitive and there Itzhak Goldberg, Former Advisor, Private and Financial is a need to actively connect to the rest of the world. Sector Development Sector, Europe and Central Asia Openness to trade and FDI, investments in skills and Region, World Bank; Manuel Trajtenberg, Professor, Tel- collaboration in the world of R&D, and strong internal Aviv University; Adam Jaffe, Professor, Brandeis competition in domestic markets, are critical for innovation University; Thomas Muller, Program Coordinator, GTZ; and technology absorption in emerging markets. Enrique Blanco Armas, Senior Economist, East Asia Pacific Encouraging innovation will first require improving the Region, World Bank; and Julie Sunderland, Consultant. investment climate for innovative firms, including reinforcing the regulatory reform agenda, removing barriers to competition and fostering skills development. Policies to encourage trade, FDI and skills, and improve the investment climate should be supplemented by policies to spur participation in the world of R&D. To address the apparent lack of collaboration between the science and business sectors mentioned above financial ECA Knowledge Brief is a regular series of notes highlighting recent analyses, good practices and lessons learned from the development work program of the World Bank`s Europe and Central Asia Region http://www.worldbank.org/eca