For Official Use

Organisation de Coopration et de Dveloppement conomiques Organisation for Economic Co-operation and Development

DSTI/STP/TIP(2011)15

30-Nov-2011 ___________________________________________________________________________________________ _____________ English - Or. English

DIRECTORATE FOR SCIENCE, TECHNOLOGY AND INDUSTRY

COMMITTEE FOR SCIENTIFIC AND TECHNOLOGICAL POLICY

DSTI/STP/TIP(2011)15 For Official Use

Working Party on Innovation and Technology Policy

TIP THEMATIC WORKSHOP ON FINANCING R&D AND INNOVATION IN THE CURRENT MACROECONOMIC CONTEXT: ISSUES PAPER

7 December 2011, OECD Conference Centre, Paris

Delegates will find attached the Issues Paper for the TIP Thematic Workshop on Financing R&D and Innovation in the Current Macroeconomic Context to be held at the OECD Headquarters on 7 December starting at 9:00. Delegates may wish to note that a second paper on "Entrepreneurial Financing of R&D and Innovation" prepared for the TIP project on "Financing, Transferring and Commercialising Knowledge", which complements this background paper, will be made available under reference code DSTI/STP/TIP(2011)14.

N.B. This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area.

Contacts: Caroline Paunov, Email: Caroline.Paunov@oecd.org, Tel: + 33 1 45 24 90 40; Dominique Guellec, Email: Dominique.Guellec@oecd.org, Tel: + 33 1 45 24 94 39
JT03312490

English - Or. English

Document complet disponible sur OLIS dans son format d'origine Complete document available on OLIS in its original format

DSTI/STP/TIP(2011)15

INNOVATION IN THE CURRENT BUSINESS CYCLE

Summary 1. This background document to the TIP Thematic Workshop on Financing R&D and Innovation in the Current Macroeconomic Context draws an initial picture of the impacts of the current business cycle on innovation. The discussion is organized around eight key questions; below is a summary of the preliminary answers the document provides: Question 1: What to expect for innovation as a result of the crises? Innovation might both thrive and suffer during downturns in reaction to the decrease in demand, the lack of liquidities in the financial system, increased uncertainties and the tightening of public budgets. A lot of the evidence on past recessions points to negative impacts on innovation activities. Question 2: What has happened to innovation? Innovation activities decreased during the global financial crisis; this is the case for firm-level indicators as well as aggregate statistics on private-sector R&D, patenting and trademark registrations. However, there is some evidence pointing to an increase in innovations aimed at enhancing efficiency. Question 3: Did the global downturn lead to creative destruction? Substantial firm exit has not been accompanied at the same time by entry. The result has been a persistent increase in unemployment levels and, in consequence, a break-down of the creative destruction process as new innovative businesses have not entered markets (yet). Question 4: What has happened to innovation financing? Innovators had a harder time in accessing external financing independently of whether they sought access to banking credit or venture capital during the global financial crisis. While the situation improved subsequently problems resurfaced in the second half of 2011. Question 5: What about the role of low demand and substantial uncertainties? The declines in consumer demand and uncertainties as to the recovery were probably substantial factors behind firms weak innovation performance. Question 6: Will there be impacts on the global distribution of leadership in innovation? The strong growth performance of some emerging economies compared to developed countries has given them the opportunity to catch-up in terms of innovation continuing a trend that pre-dates the crisis. Question 7: Is there a risk of long-term effects on innovation-based growth? With sluggish growth and substantial uncertainties potential long-term consequences become increasingly likely. While there is no evidence as yet on harmful disruptions to innovation investments or loss in leadership, potential losses in skills that are essential for innovation already constitute a risk. Question 8: What about innovation policy at present? While strong innovation performance contributes to raising growth prospects high levels of public spending in its support might be a challenge for tight public budgets. Innovation policies at present need to i) foster positive long-term trends in innovation performance, and ii) avoid possible long-term damages to innovation systems caused by the crises themselves. 2

DSTI/STP/TIP(2011)15 Introduction 2. The collapse of Lehman Brothers in September 2008 led to a major global economic crisis that was unprecedented in its magnitude in at least half a century. World GDP retracted as did industrial production, trade collapsed even more substantially and unemployment increased in many of the worlds major economies. A moderate short-lived recovery took off by the end of 2009 which continued with some notable exceptions in 2010 and the first half of 2011. Market speculations over the sustainability of sovereign debt and the challenges involved in negotiating fiscal consolidation lowered expectations for a fully-fledged quick recovery of the world economy. Because of the substantial impacts on the worlds major economies output, on global financial institutions (which hold a central role as intermediaries for businesses and their innovation investments) and on public finances (which provide key support to innovation systems) the current business cycle downturn cannot be disregarded when it comes to innovation. Innovation performance is certainly mainly the result of underlying structural rather than business cycle factors. The exceptional nature of the current macroeconomic context, however, renders the impacts of the business cycle much more important for innovation. 3. Overall the global financial crisis has led to a sharp decrease in innovation investments. The evidence also suggests that the process of creative destruction whereby more innovative businesses enter and the least innovative exit has broken down with the onset of the global financial crisis. Notably, persistent high rates of unemployment point to a substantial waste in resource deployments. The global financial crisis rendered business access to banking credit more difficult and available venture capital financing decreased substantially. There are early signs to suggest the 2010 recovery process of innovation was but short-lived specifically but not only for Europe. The intensity and prolonged nature of the downturn raises serious concerns over potential long-term scars on innovation systems: the substantial increase in long-term unemployment rates threatens to reduce available skilled human capital even after the downturn. The 2010 recovery in private R&D for the worlds leading businesses suggests, however, that their R&D processes were not fundamentally damaged after the slowdown of 2009. Moreover, both crises have affected developed countries much more strongly than some of the emerging economies; this seems to have facilitated pre-crisis trends in catching-up in terms of their innovation performance. Finally, public policies are not powerless and should, in particular, aim at reducing potential threats for long-term innovation-based growth. This has to also involve addressing long-term unemployment rates. With constraints on public finances answers will not be easy and probably require smart ways of making more out of less and relying on partnerships with the private sector to design innovation-based recovery processes. 4. This background document to the TIP Thematic Workshop on Financing R&D and Innovation in the Current Macroeconomic Context draws a first picture of the impacts of the global financial and public debt crises on innovation. It builds on the 2009 study Policy Responses to the Economic Crisis: Investing in Innovation for Long-Term Growth (OECD, 2009). The discussion is organized around eight key questions where preliminary answers are provided based on what we know from past crises and the available statistical evidence. The OECD and the TIP in particular can play a substantial role in identifying policy priorities for STI policy in this evolving context. The Workshop will provide an opportunity for corresponding discussions to inform the forthcoming Science, Technology and Industry Outlooks chapter on innovation in the current business cycle.

DSTI/STP/TIP(2011)15 Question 1: What to expect for innovation as a result of the crises? 5. What does not kill you makes you stronger. Nietzsche is credited for a popular quote which, if applied to the current context, reflects a somewhat less pessimistic outlook. In fact, Joseph Schumpeter has famously argued that a process of creative destruction while painful is precisely what fosters innovations and progress as the old and familiar has to be left behind for the new and better. From that perspective the downturn might have offered opportunities for innovators and innovation systems. Before turning to what to expect for innovation below, Box 1 briefly discusses the three dimensions of the global financial and sovereign debt crises that are most essential for innovation.
Box 1: The global financial and sovereign debt crises: Effects of relevance to innovation Three aspects of the present context warrant caution over simplified confidence in merely marginal impacts of the current downturn on innovation: First, innovative businesses in many developed economies have been confronted with lower demand for their products and substantial uncertainties over future trends in consumption. The shock of the global financial was unprecedented in its magnitude in at least half a century and even beats some negative records established by the Great Depression (Almunia et al., 2009, Reinhart and Rogoff, 2009). Innovators were not exempted from the downturn: high-tech companies saw their revenues decrease substantially also due to the fact that the demand for higher quality innovative products trends to decrease during recessions (Lien, 2010, Piva and Rossi-Lamastra, 2011). Subsequently to the global financial crisis most developed economies have known but a short-lived and often incomplete recovery. By the end of 2011 substantial uncertainties over quick recovery prospects had risen in response to increased concerns over sovereign debt and limited opportunities for consumption to recover quickly due to deleveraging. The historic evidence also points to a slow recovery process (Reinhart and Rogoff, 2009). Second, public support for innovation faces potential challenges as fiscal consolidation has become a top priority. High levels of sovereign debt and markets speculations over potential sovereign default restrain the scope for public policy interventions. Fiscal consolidation has not only been at the forefront of policy discussions in Europe but also in the United States and Japan. Moreover, population ageing will likely over the medium-run add further pressure on pension and health budgets and challenge governments possibilities for prioritising investments in long-term growth, including factors in support of innovation such as education, innovation projects and infrastructure. Third, fragilities in the banking sector pose a threat to innovative businesses opportunities to receive external finances. The 2008-2009 global financial crisis exposed substantial vulnerabilities in the global financial system (Reinhart, 2011). The stability of the banking sector in Europe and beyond remains fragile with markets speculating over sovereign default risks (IMF, 2011a,b). The quick expansion of investment credit in China for 2009-2010 has also led some to question the quality of some of the financed projects adding to other challenges of the Chinese banking system (IMF, 2011a).

6. The global financial and sovereign debt crises as described in Table 1 have had four types of effects on the private sector: i) a reduction in the demand for products, ii) a reduction in liquidities in the financial system, iii) an increase in uncertainties as to future developments as well as iv) impacts on innovation policy. These can via several mechanisms, as described in column 2, have impacts on innovation performance and investments. Column 3 shows implications for innovation can both be positive and negative. While few exceptions (Nickell et al., 2001, Francois and Lloyd-Ellis, 2008), the procyclicality of R&D and innovation has been observed over various business cycles and for a variety of countries (e.g. Griliches, 1990, Broda and Weinstein, 2010, Barlevy, 2002, 2007, Comin and Gertler, 2006, Fatas, 2000, Francois and Lloyd-Ellis, 2009, Rafferty, 2003, Walde and Woitec, 2004).

DSTI/STP/TIP(2011)15
Table 1: Potential expected effect of various aspects of the global financial and public debt crises on R&D, innovation and entrepreneurship Direct effects Reduced demand for goods and services Mechanism how innovation is affected as a result Demand Effects - Ambiguous impact on innovations as the downturn likely reduces the demand for innovative goods as these are often more expensive and/or durable goods whose purchase can be more easily postponed but downturns possibly also increase demand for certain innovative products specifically those offering lower prices and/or responding better to altered demand during recessions Competition Effects - Competition might increase as gaining other firms market shares is the only way to maintain sales levels Impact on innovation including examples and evidence from past downturns Innovation: Negative for certain product innovation but positive for process innovations as well as product innovations aimed at reducing costs/prices (e.g. low-cost airlines grew out of the recession in the early 1990s) Entrepreneurship/ Firm Dynamics: Fewer market opportunities exist for young innovative firms except for those with business model aimed at responding to demand for lower priced goods. High-potential entrepreneurs react more to the presence of good business opportunities (than marginal entrepreneurs who are more likely to respond to labour market conditions). They will affect innovation performance (Koellinger and Thurik, 2011). Innovation: Impact on innovation depends link between product market competition and innovation, trade-off between rents from less competition and incentives for innovation to escape competition (Schumpeter, 1942; Nickell,1996; Aghion et al., 2005a) Entrepreneurship/ Firm Dynamics: Competition leads to creative destruction processes and the failure of incumbent less innovative firms. It can facilitate opportunities for entrepreneurship improving aggregate innovation performance (Hall, 1991, Mortensen and Pissarides, 1994, Caballero and Hammour, 1994, 1996 and Gomes, Greenwood and Rebelo, 2001). Evidence in support: Bailey et al., 2001, Foster et al., 1998. Disney, Microsoft, Hewlett-Packard, Oracle and Cisco were created during downturns. However, young firms with substantial innovation capacities in the future might be forced to exit during recessions before they have fully developed their potential, crushing possible set-up costs spent in building up firms innovation systems (Ouyang, 2011). Innovation: Negative for innovation activities if external financing is not available, specifically small and young firms might lower investments as they face greater risks of being forced to exit and face stronger financing constraints Entrepreneurship/ Firm Dynamics: Exit of innovative businesses can result if external financing constraints exist (Barlevy, 2002). Evidence for such effects during recessions includes Sawnson and Tybout, 1988, Eslava et al., 2010, Baden-Fuller, 1989, Nishimura et al., 2005, Hallward-Driemeier and Rijkers, 2011. However, layoffs and lower wage and/or force firm exit reduce opportunity costs of entrepreneurship, increase individuals willingness to take on greater risks and increase the availability of qualified labour during downturns (Koellinger, 2008, Audretsch, 1991, 1995)

Cash Flow Effects - Firms cash flows are possibly reduced, fewer internal resources are available to cover operational expenses

DSTI/STP/TIP(2011)15
Direct effects Mechanism how innovation is affected as a result Inter-temporal Resource Allocation Effects Firms opportunity costs of investing in innovation at the expense of spending on the production of output are lower with low demand (Caballero and Hammour, 1996, Cooper and Haltiwanger, 1993, Aghion and Saint Paul, 1998), Private payoffs for innovations are higher when demand is at its peak (Barlevy, 2007) Reduction in loans due to deleveraging affects all types of investments, notably of SMEs (as they rely more on financing from loans than large firms). Market failure in credit markets might be worse as lower cash flows mean firms have less collateral (Bernanke and Gertler, 1995). Investors have fewer resources to allocate across investment projects Uncertainties might reduce the number of risky investments by investors, banks and firms, specifically as sunk costs of such investments provide incentives to postpone them (Pindyck, 1991) Impact on innovation: examples and evidence from past downturns Innovation: Firms invest more in innovation and less on production during the downturn to reap higher payoffs in the future i.e. at the peak of the recovery - but keep innovations for the future. The time lag between investment and private payoffs to innovation will ultimately determine whether the recession should have positive or negative effects on innovation. Entrepreneurship/ Firm Dynamics: Entrepreneurs might postpone entry with innovations as to when markets recover and demand is higher Innovation: Lack of financing negatively affects innovation during downturns (Aghion et al., 2005b, 2008; Krozner et al.,2007; Dell'Ariccia et al., 2008). Evidence on variation in the volume of venture financing with the business cycle (Gompers and Lerner, 1998, 1999, Kaplan and Schoar, 2005). Entrepreneurship /Firm Dynamics: Reduces innovative start-ups entry (Lerner, 2011). Evidence on negative firm dynamics due to insufficient entry Caballero and Hammour, 1994, Parker, 2009, Bailey et al., 1992 Innovation: Firms might be less willing to face uncertainties and risks associated with introducing new products and/or processes since the latter might compromise survival if demand evolves unexpectedly (Fernandes and Paunov, 2011). Entrepreneurship/ Firm Dynamics: Limited firm entry can also be caused by uncertainties. Entrepreneurs will wait prefer to wait for greater certainty as to the recovery of demand as well as financial markets. Innovation as well as Entrepreneurship / Firm Dynamics: To the extent that business innovation and R&D are positively linked to public R&D and support, they will vary in the same direction.

Reduced liquidity of the financial system

Uncertainties affecting demand and finance

Public budgetary situation

Policy makers do not address challenges posed by innovation given other priorities and/or lower public resources or alternatively focus specifically on innovation Recovery packages vs. fiscal discipline affect public expenditure as it relates to innovation

DSTI/STP/TIP(2011)15

Question 2: What has happened to innovation? 7. The available evidence on firms shows innovation activities declined. Among 4,238 European firms a larger share decreased their innovation spending at the onset of the global financial crisis compared to the pre-crisis period (26.7% relative to previous 10.8%). However, more than half of the interviewed firms maintained their levels of innovation spending (Archibugi and Filippetti, 2011). Furthermore, evidence from the World Bank Financial Crisis Survey for 2008-2009 on firms across six countries Bulgaria, Latvia, Lithuania, Hungary, Romania and Turkey shows that R&D investments were procyclical during the global financial crisis (Mnnasoo and Merikll, 2011). Also, among more than 1,500 Latin America firms one in four stopped innovation investment projects in response to the global financial crisis (Paunov, 2012). The same pattern is true for the worlds top R&D investors; their R&D spending decreased by 1.9% in 2009. It recovered in 2010 increasing by 4% to 456 billion (EC, 2011). 8. Aggregate innovation performance indicators similarly reject the hypothesis that the downturn fostered innovation. Patenting activity if PCT filings are considered decreased compared to 2007: Figure 1 and Table 2 show worldwide trends and trends for a selection of countries: the decline was specifically pronounced for some of the major contributors including the United States, Canada and Germany. For some countries as e.g. the United States 2010 marked a further decrease relative to 2009 whereas for others including Germany there was a recovery although 2007 levels were not attained. China and South Korea, by contrast, continued to increase filings substantially in 2010. Preliminary statistics for 2011 indicate a substantial recovery with, however, some notable exceptions including the United States and the United Kingdom. The global financial crisis also led to persistent below-trend trademark registrations (Figure 2). Similarly businesses R&D spending declined in 2009 compared to 2008 for some of the major economies (Figure 3).
Figure 1: Trends in the number of PCT patent filings for selected countries (2007 = 100)
150.0 USA Germany Total 125.0 Japan Korea

100.0

75.0

50.0 2004 2005 2006 2007 2008 2009 2010 2011*

Source: WIPO Statistics Database

DSTI/STP/TIP(2011)15
Table 2: Trends in the number of PCT patent filings for selected countries (2007 = 100)
2004 United States Japan Germany China Republic of Korea France United Kingdom Switzerland Sweden Netherlands Canada Italy Others Total 80.3 73.1 85.4 31.3 50.2 79.0 90.9 75.8 78.0 96.6 73.0 74.1 77.6 76.7 2005 86.8 89.6 89.7 45.9 66.3 87.5 92.0 85.9 78.9 101.5 80.4 79.7 87.1 85.5 2006 94.9 97.4 93.9 72.3 84.2 95.4 92.0 94.5 91.3 102.7 89.4 91.6 92.3 93.6 2007 100 100 100 100 100 100 100 100 100 100 100 100 100 100 2008 95.6 103.7 105.8 112.2 111.8 107.8 98.6 99.1 113.2 98.4 103.4 97.9 107.3 102.1 2009 84.4 107.4 94.3 144.8 113.7 110.3 91.0 95.8 97.6 100.7 87.8 90.0 100.7 97.2 2010 83.2 115.9 98.6 225.4 136.9 110.4 88.3 97.3 90.6 91.7 93.7 90.2 106.0 102.7 2011* 86.8 137.0 101.1 330.1 144.1 123.5 87.7 112.1 101.3 75.4 108.7 99.9 107.8 113.1

Note: 2011 data are obtained on using linear projections for August-December 2011 Source: WIPO Statistics Database,

Figure 2: US gross domestic product and trademark applications at the USPTO, 1999-2011 Comparing cycles, by type of trademarks, percentage deviation from the long-term trend
%

Goods trademarks Finance, insurance and real estate trademarks

Services trademarks US gross domestic product (right-hand scale)

70 60 50 40 30 20 10 0 -10 -20 -30

8.75 7.50 6.25 5.00 3.75 2.50 1.25 0.00 -1.25 -2.50 -3.75

Source: OECD (2011a)

DSTI/STP/TIP(2011)15
Figure 3: Trends in business enterprise expenditure on R&D for a selection of countries (2007 = 100)
115
110 105 100 Canada Finland

France
Germany

95 90
85 80 75

Israel
Italy Japan

70 2004 2005 2006 2007 2008 2009 2010

United Kingdom

Note: The following data points are provisional: Canada - 2010, Germany - 2009, Israel- 2009, 2010, Italy - 2009, 2010, UK 2010. The following statistics are national projections or estimates: France, 2009 Finland -2010. Note that data for Israel across all years exclude the defence sectors spending. Source: OECD MSTI Database 2011-1

9. However, innovations aimed at improving efficiency have possibly increased in response: Among respondents to a survey of about 1,500 Latin American the number of firms that introduced process innovations from 2008 to 2009 increased (Paunov, 2012). This might indicate that firms sought efficiency improvements in their production processes to face the economic crisis. Also, some respondents to a survey of 532 senior executives by McKinsey said that while the global financial crisis led to reductions in R&D it also allowed for efficiency improvements in the way R&D was conducted: This included improving the accountability for performance and spending, increasing collaboration with outside R&D groups and the streamlining of core R&D processes (McKinsey, 2010). Question 3: Did the global downturn lead to creative destruction? 10. Creative destruction - a process whereby economic downturns force incumbent less innovative firms to exit and allow entry of more innovative firms can play a powerful role in improving overall innovation performance (see also Table 1). In consequence, it matters substantially for growth (Aghion and Howitt, 1992). The available evidence suggests the creative destruction process has broken down with the onset of the crisis. Figures 4 and 5 provide information on enterprise creation and bankruptcies from official business registries for a selection of countries. There is a clear decrease in the rate of enterprise creation that tends to be most pronounced in the first half of 2009. The downward trend differs somewhat across countries with larger declines for Australia, France, Denmark, Spain and Norway than for Finland, Germany, Italy and the United Kingdom. Only few countries manage to return to levels attained in the precrisis period: the U.S. rate of enterprise creation continues to be below the 2006 rate and there is an apparent absence of recovery in firm creation for Denmark and Spain. At the same time bankruptcies also increased substantially in some of the countries with weak firm entry, the United States and Denmark stand out as clear examples.

DSTI/STP/TIP(2011)15
Figure 4: Enterprise creation (2006 = 100)
130 120
110

100 90 80 70 60 50
Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010

Australia Finland France Germany Italy Denmark

Figure 5: Number of bankruptcies (2006 = 100)

350.0

Australia
300.0

350.0

Canada

France
300.0

Netherlands Norway United Kingdom

Japan
250.0

Denmark Finland
250.0

USA

200.0

200.0

150.0

150.0

100.0

100.0

50.0 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010

50.0

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010

Source: OECD (2011b)

11. High exit, but low entry results in a substantial increase in unused resources, notably of labour, this represents a costly downside to recessions. The global financial crisis led to a rise in unemployment rates with no or only moderate returns to pre-crisis unemployment levels. Ireland, Spain, Greece and Hungary have had unemployment rates in the double-digits since mid-2009. While the increase has been more moderate for other countries unemployment rates have often remained at pre-crisis levels; this is for instance the case for Canada, the United Kingdom and the United States. Korea, Norway and particularly Germany are notable exceptions. Figure 6 shows that for Spain, the United Kingdom and the United States the unemployment rate of workers with tertiary education also increased.

10

DSTI/STP/TIP(2011)15
Figure 6: Annual unemployment rate for workers with tertiary education for selected countries
14.0 12.0 10.0

Spain United Kingdom United States

8.0 6.0

4.0 2.0 0.0 2005 2006 2007 2008 2009 2010 2011*

Note: Data for 2011 are based on information for the first half of 2011 only. Source: ILO Department of Statistics, November 2011

Question 4: What has happened to innovation financing? 12. A lack of available external resources to finance innovation activities especially when cash flows are reduced is one of the major explanations for pro-cyclical innovation investment patterns (Table 1). It is well known that the specificities of innovation investments render obtaining external financing more challenging (Hall and Lerner, 2009, for a comprehensive overview). Interestingly, Lerner (2011) suggests the efficiency of venture capital investments could be improved if the reverse was true since these investments appear to be deployed much less effectively during boom periods. 13. With regards to venture capital markets, Figure 7 shows a sharp decline in the numbers of venture capital deals for the United States as the global financial crisis set in. A comparable trend was observed in Europe. Funding for new entrepreneurial endeavours from other sources during the credit crunch has proven to be nearly impossible as a consequence of the financial markets collapsing with pension funds, (university) endowments and wealthy individual investors reluctant to fund ventures. Moreover, increasingly risk-adverse investors were reluctant to commit to new obligations (Lerner, 2011). While by last quarter of 2009 a recovery process set in the market has not returned to its 2008 performance. The pattern applies similarly across different industries.
Figure 7: Venture capital investments in the United States across by sectors: Number of deals (Quarterly, 2006 3 quarter of 2011)
1,400 1,200
rd

1,000
800 600

400
200 0

Qtr 4 2006

Qtr 1 2007

Qtr 1 2008

Qtr 1 2009

Qtr 2 2009

Qtr 2 2010

Qtr 3 2010

Qtr 2 2011

Other Sectors Media and Entertainment Medical Devices, Equipment and Healthcare Services

Computer and ICT Industrial/Energy Biotechnology

Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report based on data from Thomson Reuters

11

Qtr 3 2011

Qtr 1 2006

Qtr 2 2006

Qtr 3 2006

Qtr 2 2007

Qtr 3 2007

Qrt 4 2007

Qtr 2 2008

Qtr 3 2008

Qtr 4 2008

Qtr 3 2009

Qtr 4 2009

Qtr 1 2010

Qtr 4 2010

Qtr 1 2011

DSTI/STP/TIP(2011)15 14. Banks lending activities have also changed during the global financial crisis. Evidence from the October 2011 European Central Banks (ECB) Bank Lending Survey indicates banks enterprise credit standards tightened widely with the global financial crisis. It is also worth noting the upward trend in the third quarter of 2011 (Figure 8). It will matter to understand the underlying reasons for such changes in banks lending behaviour as this plays a role when it comes to designing policies in support of the financing for innovation. Responses to the same survey indicate that one reason is banks liquidity position. The uncertainties about general economic situations, however, are also part of the explanation.
Figure 8: Changes in credit standards applied to the approval of loans or credit lines to enterprises

(net percentage of banks reporting tightening of credit standards)

70 60 50 40 30 20 10 0 -10 -20

Oct-06

Oct-07

Oct-10

Apr-08

Apr-09

Apr-10

Apr-06

Apr-07

Apr-11

Overall Loans to large enterprises Long-term loans

Loans to small and medium sized enterprises Short-term loans

Source: ECB Bank Lending Survey

15. There is no evidence yet as to the impacts of financing constraints on innovation. To the extent that similar factors affected innovation as export performance, the findings by Chor and Manova (2010) which show U.S. exports declined more substantially in sectors with greater financing needs supports the hypothesis that financing constraints have played a substantial constraining role in constraining firms activities. 16. Beyond questions of access to banking credit, strong uncertainties and volatilities in stock markets in the current business cycle pose challenges for alternative financing opportunities, as well. There is the open question as the high market valuation of high-tech companies stocks. Substantial volatilities in financial markets also relate to the recently much-debated question how financial markets activities relate to expectations about companies or investments long-term growth prospects. Question 5: What about the role of low demand and substantial uncertainties? 17. The declines in consumer demand and uncertainties as to the recovery were probably substantial factors behind weak innovation performance. Responses to the ECBs Bank Lending Survey suggest firms demand for loans from banks decreased substantially during the global financial crisis (Figure 9). Also, more than 70% of firms in each of the six Eastern European countries (Bulgaria, Hungary, Lativa, Lithuania, Romania and Turkey) interviewed for the World Banks Financial Crisis survey said the primary impact of the crisis was a drop in demand for their products (Ramalho et al., 2009). Finally, asked about major challenges a larger percentage of firms were preoccupied about factors related to product markets i.e. finding customers and competition over access to finance. Figure 10 shows responses for SMEs; the evidence on large firms is closely similar on that dimension. 12

Oct-11

Oct-08

Oct-09

Jan-07

Jan-08

Jan-09

Jan-06

Jan-10

Jan-11

Jul-06

Jul-09

Jul-10

Jul-11

Jul-07

Jul-08

DSTI/STP/TIP(2011)15
Figure 9: Changes in demand for loans and credit lines to enterprises (net percentage of banks reporting positive loan demand)
20 15 10 5 0 -5 -10 -15 -20 -25 -30 -35

Oct-06

Oct-10

Apr-06

Apr-07

Apr-10

Apr-11

Apr-08

Apr-09

Overall Loans to large enterprises Long-term loans

Loans to small and medium sized enterprises Short-term loans

Source: ECB Bank Lending Survey

Figure 10: Most pressing problem faced by SMEs in the Euro area (percentages)
30 27 24 28 25 25 23 1 2009 1 2010 17 15 15 14 14 12 10 9 15 16 13 11 9 8 5 5 8 7 7 14 13 13 14
12

20

8 9 4 1

Oct-11

Oct-07

Oct-08

Oct-09

Jan-06

Jan-07

Jan-10

Jan-11

Jan-08

Jan-09

Jul-06

Jul-07

Jul-10

Jul-11

Jul-08

Jul-09

2 2009 2 2010

3 2

0 Finding customers Competition Access to finance Costs of Availability of production or skilled staff or labour experienced managers Regulation Other Don't know

Source: ECB Survey on the Access to Finance of SMEs

Question 6: Will there be impacts on the global distribution of leadership in innovation? 18. As described in Section 1 while the global financial crisis certainly had global repercussions in developed and developing economies alike particularly, Asian economies as well as certain other countries including Brazil continued to grow in 2009. The sovereign debt crisis had an even more pronounced differential effect on developed compared to developing economies with corresponding differences in the impacts on innovation systems. Moreover, OECD growth forecasts predict Brazil, China, India and Indonesia will have much higher growth rates than the OECD in 2011 and 2012 (OECD, 2011c). Such

13

DSTI/STP/TIP(2011)15 differential macroeconomic circumstances might facilitate further catching-up specifically of the BRICs in terms of their innovation performance. 19. Effectively, a comparison of the worlds leading R&D investors shows that the recovery pattern of 2010 R&D was highly unequal with much more substantial R&D investments for China (29.5%), South Korea (20.5%), India (20.5%) and Taiwan (17.8%) compared to more moderate increases of 6.1% and 10% for EU and U.S. companies (EC, 2011). Moreover, while the statistics below should be considered with due caution, it is interesting to observe in Figure 11 evidence that Chinas and South Koreas performance differs substantially from that of the United States that has known a substantial decrease in its share of PCT filings with the onset of the global financial crisis. The evidence on pre-crisis years shows the decline reflects a trend that predates the downturn. However, it remains to be seen whether the crisis effectively facilitated in particular Chinas positioning. Notably, Chinas specialisation in lower quality production helped reduce negative impacts of the global downturn; this might in reverse cause more substantial losses during the recovery (Berthou and Emlinger, 2010). This potential negative demand shock on Chinese goods might (due to diverse mechanisms as described in Table 1) in turn have negative effects on innovation in China.
Figure 11: Country shares in total PCT filings (%), 2000 July 2011
100% 90% 80% 70% 23.4 5.2 4.4 1.7 0.8 13.5 10.3 23.1 5.1 4.3 2.1 1.6 13.0 11.0

24.2
4.9 4.6 2.3 0.9 13.0 12.7

23.8 4.5 4.5 2.6 1.1 12.7 15.1

23.0 4.1 4.2 2.9 1.4 12.4 16.5

22.7 3.7 4.2 3.4 1.8 11.7 18.2

22.3 3.4 4.2 4.0 2.6 11.2 18.1

22.3 3.5 4.1 4.4 3.4 11.1 17.3

22.9 3.3 4.8 4.3 3.7 11.6 17.6

22.5 3.2 4.7 5.2 5.1 10.8 19.2

21.6

20.2 2.8 4.2 5.7

Others UK FRA KOR CHN

3.0 4.4 5.9

7.5 10.7 19.6

60%
50% 40% 30%

8.5
9.9

22.4

DEU JPN

20%
10% 0%

40.8

39.8

37.4

35.6

35.4

34.3

34.3

33.8

31.6

29.4

27.4

26.3

USA

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011*

Source: WIPO Statistics Database,* Note that information on 2011 contains information up to July 2011 only.

Question 7: Is there a risk of long-term effects on innovation-based growth? 20. The magnitude of costs of the global downturn will be much higher if innovation systems are more permanently affected. With sluggish growth recovery performance and substantial uncertainties potential long-term consequences (which are referred to as hysteresis effects) are increasingly likely. The fact that downturns specifically if related to financial crises can bring about long-run negative costs to the economy has been established by a variety of studies (e.g. Abiad et al., 2009, Cerra and Saxena, 2008, Calvo et al., 2006, Rafferty, 2003). Evolutionary approaches to the economics of innovation following Nelson and Winter (1982) describe the potentially substantial hysteresis effects of shocks (Metcalfe et al., 2006, Dosi et al., 2010). 21. Five factors could, if affected, cause long-run effects on innovation systems: i) negative long-run effects on human capital, ii) disruptions to investments that affect efforts of future innovations, iii) negative impacts on technological leadership, iv) changes in attitudes towards innovation projects in financial markets, and v) permanent changes to public support systems for innovation. At present it is difficult to 14

DSTI/STP/TIP(2011)15 provide a verdict about the latter two aspects since both financial markets and public innovation policy are currently subject to substantial debate; potential implications on trends in innovation should be considered when corresponding policy decisions are taken. 22. First, as to negative long-run effects on skills a central element for innovation (OECD, 2010) the global financial and current crises have led to increased unemployment rates including among the skilled involved in innovation activities (from firms that decide to downsize innovation-related activities in particular in addition to innovative businesses that are forced to exit). Longer-term innovation effects from lay-offs can arise in two ways: Skilled human capital might be reduced if capacities and up-to-date knowledge are lost as is the case for the long-term unemployed. In fast-paced high-tech sectors such as pharmaceuticals, aeronautics and IT long spells of unemployment lower exposure to technology and, in consequence, deplete available workers skills. High unemployment rates of college graduates also pose a challenge since early-career unemployment can permanently scar integration into the workforce along the entire career path. At the business level dismissals can lead to permanent scars for innovation processes if laid-off employees hold tacit knowledge which will be lost to firms as they leave. Such factors could bring about a much slower recovery in innovation performance as new employees first need to acquire such knowledge.

By contrast, a factor that might act as a counter-weight is an increase in training for those unemployed. 23. Substantial uncertainties over recovery processes suggest employment will not be quick to recover; the potential risks for long-term effects due to unemployment are, therefore, important. In a survey of 532 senior executives conducted by McKinsey some respondents worried that changes to R&D could weaken available talent for future R&D activities (McKinsey, 2010). The current downturn might also accelerate long-term trends towards more flexible employer-employee relationships. As has been widely noted information and communication technologies (ICTs) have altered work processes. More specifically, they allow segmenting production processes increasingly and this includes highly-skilled tasks which can be executed by short-term assignments. An advantage of such processes is that businesses face no labour termination costs and, therefore, might be much less hesitant to re-hire. The question whether such flexible employment relations support and/or weaken innovation processes needs to be tested. 24. Second, innovation investments that are not made in the present might likely have effects on innovation performance in the near future as with limited investments the pool of opportunities for successful innovations is reduced. Moreover, if businesses interrupt innovation investment projects then resuming such activities might require larger upfront costs. This can in turn lead to a slower recovery of innovation investments. The loss of tacit knowledge and the costs involved in establishing new arrangements for innovation can also slow down investments. At least for the worlds leading R&D innovators the substantial recovery of 2010 suggests that the shock of 2009 had not affected underlying innovation investment capacities (EC, 2011). Yet the uncertainties of 2011 might pose challenges particularly for smaller businesses. Finally, to the extent that some innovative firms exited overall innovation investments might be lower at least until entry of comparable innovative businesses takes place. The latter is as described above not the case at present. 25. Third, technological leadership would be at risk if key businesses relocated to form a cluster of activities abroad in response to prolonged low demand in local markets, difficult financing conditions and other challenges for operating their business. Such relocations might turn out to be irreversible and, therefore, have an effect beyond the downturn if businesses find returning to their previous location not

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DSTI/STP/TIP(2011)15 optimal even with a recovery. However, it would seem that a very long and severe recession only could bring about such relocation even if the increasingly global nature of innovation and ICTs might change dynamics of clusters. Question 8: What about innovation policy at present? 26. Many governments implemented stability packages in reaction to the global financial crisis and these often included substantial measures in support of innovation (OECD, 2009). Figure 12 illustrates three distinct post-2008 trends in government expenditure on R&D: For the United Kingdom and Canada spending remained at comparable levels to 2007, for Finland there was a notable increase in spending while the reverse was true for Ireland. In the present context innovation policies have to succeed in striking a balance: While strong innovation performance contributes to raising growth prospects high levels of public spending in its support can be a challenge for tight public budgets. The way forward might consist in exploring some of the following i) seeking greater efficiencies in public sectors innovation support, ii) concentrating funding in sectors of strategic relevance, and iii) exploiting co-operative arrangements in support of innovation with the private sector.
Figure 12: Trends in government intramural spending on R&D (GOVERD) for selected countries (2007 = 100)

120

Canada Finland

110

France Germany Ireland

100

90

Italy Japan

80 2004 2005 2006 2007 2008 2009 2010

United Kingdom

Note: The following data points are provisional: Ireland - 2009, 2010, Italy - 2009, 2010, UK - 2010. The following statistics are national projections or estimates: France 2009, Finland - 2010. Data for Israel across all years exclude the defence sectors spending. Data for Germany include other classes as is also the case for the 2010 data for Finland. Source: OECD MSTI Database 2011-1

27. Innovation policies at present need to focus on two objectives: the first consists in fostering positive long-term trends in innovation performance. In fact, in the United States the slowdown in new business entry predates the global financial crisis (Haltiwanger, 2011). Across the OECD a productivity slowdown also set in well before (Dupont et al., 2011). Therefore, low economic growth in the current context might partly reflect deterioration in fundamentals and point to a need for structural support policies. Similarly, low growth in some of the Southern European economies possibly also reflects wellknown weaknesses of prevalent innovation systems. At the same time the downturn has, as described above, had impacts on innovation. The second objective, therefore, has to consist in avoiding possible long-term damages to innovation systems caused by the crises themselves.

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DSTI/STP/TIP(2011)15 28. The following seem important priorities at present: Enhancing performance of public institutions in charge of innovation further Avoiding costly and inefficient disruptions of innovation processes Exploring regulatory changes in support of framework conditions for innovation Addressing demand uncertainties to unleash innovation investments Identifying effective ways for financing innovation and entrepreneurship

17

DSTI/STP/TIP(2011)15

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