China's Creative Block.

THE OUTING OF Chinese computer scientist Chen Jin for faking a chip breakthrough is a sign that Beijing may be pushing its best and brightest too hard to come up with world-beating innovations. The Chen scandal also reminds us that China has a long way to go before it can transform itself from manufacturing powerhouse to innovation nation. I Indeed, the world's most ascendant economy remains hobbled in one key respect: An immature and overburdened financial system more often than not is used to keep struggling, old-line industries afloat or help cowboy capitalists keep speculative dreams alive. The only reasonable conclusion is that capital does not get correctly allocated to true innovators.

Certainly, China is putting in place some of the necessary building blocks to help foster technological and scientific progress. College enrollments are way up, increasing the supply of highly trained labor. And research and development spending in China has grown at an unprecedented rate, due in part to billions poured in by foreign-owned companies.

Yet attempting to compress 100 years of economic advancement into 20 is a tall order. Innovation is a lot harder than it looks. Even major industrialized countries such as Japan, Germany, and France have a hard time sustaining cutting-edge technology. Despite all the talk of American kids falling behind in science, one crucial ingredient allows the U.S. to continue leading the world in innovation: well-functioning capital markets.

You cannot say that about China. A new McKinsey Global Institute report says China's wholly and partially stateowned companies, those infamously underproductive leviathans of yesteryear, still absorb most of the available capital funding. And a new International Monetary Fund paper says "it remains unclear the extent to which currently reported data reflect the true credit risk in loan portfolios."

The Chinese, of course, don't want to talk about that, just as they were loath to admit that Chen's chip wasn't what it seemed. When accounting firm Ernst & Young in May released a report that China's nonperforming loans had nearly doubled since 2002, to $911 billion, China's central bank quickly expressed its disapproval. E&Y subsequently retracted the report. But whether or not the bad loan number was on the money, the takeaway is clear: Scientists wielding bogus breakthroughs is just one of the hurdles Beijing faces as it plots its next leap up the economic ladder.

PHOTO (COLOR): RIGHT STUFF A class in computer science at Beijing University

~~~~~~~~

By Michael Mandel