China faces challenges from generative AI amidst the fragmentation game

China's strategic initiatives for AI development

In May 2017, Google's AlphaGo astounded China when it defeated Ke Jie, the renowned Chinese Go champion and the world’s number one in ranking, with its artificial intelligence (AI) capability in a 3-0 victory. This triumph not only demonstrated the power of AI, but also somehow marked the point China embarked on a more aggressive pursuit of AI technology.

In July 2017, China unveiled its "Next Generation Artificial Intelligence Development Plan," followed by the "Three-year Plan for Next Generation AI Development (2018-2020)" in December. These strategic initiatives aimed to propel China to the forefront of AI innovation and were further complemented by the New Infrastructure Initiative introduced in May 2020.

China leveraged its mobile-plus-internet economy, fuelled by vast amounts of data, to empower AI algorithms in understanding consumer preferences. Internet giants like Baidu, Alibaba, Tencent and JD.COM successfully utilised AI to identify market trends, deliver personalised products and services, and even anticipate customer needs before they arise.

The challenge of generative AI

China has made significant strides in AI applications, but generative AI demands a new level of sophistication and computing power. Over the past two decades, Chinese companies thrilled on applying relatively mature technology to disrupt and transform how merchandise trading, retailing, payment, entertainment and social media are conducted, first starting by copying the business models from overseas and eventually coming up with business innovations that turned out to lead the global trend instead. Nonetheless, the achievement has been mainly about business model innovation and expanding AI applications to more and more aspects of people’s lives. In this process, the vast pool of data available in China has added to the speed and extent of development and made Chinese internet companies corporate giants with dominant domestic positions and global reach.

While China excelled in certain AI domains, particularly visual recognition and AI-enhanced big data analysis, it now faces a new challenge in the form of generative AI, similar to AlphaGo's breakthrough. Generative AI models, such as OpenAI's ChatGPT, have proven capable of generating coherent and contextually relevant content, expanding the boundaries of AI capabilities. This development has sent shockwaves across China, prompting a scramble to catch up.

In search of technology innovation and computing power

The Chinese authorities have reportedly been urging Chinese internet companies to come up with more generative AI solutions and applications and the latter are fully aware of the urgency to prepare for the disruption that generative AI presents. However, the new challenges posed by generative AI are the advancement of the underlying technology innovation and the massive demand for computing power, and less about business model innovation and new applications of mature technology. According to the Artificial Intelligence Index Report 2023 by Stanford University, China has come close to the US in AI conference citations (China: 22.02%; US: 23.86%) and depository citations (China: 20.98%; US:29.22%), but China (at 8.04%) is still a long way away from the US (at 54.02%) in terms of citations in the field of large language and multimodal models, which are fundamental to generative AI such as ChatGPT. 

The challenge of computing power faced by China is even more daunting as computing power requires a large number of advanced microchips, which China is incapable of designing and manufacturing. Moreover, the US ban on exporting high-end semiconductors as well as the relevant equipment and technology to China since October last year has further exacerbated the situation, limiting the country's access to the necessary hardware for rapid AI development, in particular generative AI.

Implications for China's economy and investors' perspectives

China aims to foster a virtuous circle of economic growth through technology innovation, technology application, business model innovation, productivity enhancement, economic growth, and further investment in technology. In a globalised world, this circle could be sustained even if certain critical technologies were lacking. However, in the fragmentation game that increasingly dominates the world’s order, falling behind in technology innovation could disrupt the virtuous circle and result in declining productivity, ultimately hindering economic development.

Investors take this risk into account when considering investments in China, along with factors like the slower-than-expected economic recovery and various constraints. These constraints include a highly leveraged economy, particularly among local governments and the property sector, which somewhat restricts the Chinese authorities' ability to implement stimulus measures without potentially causing future financial turmoil.

The extent of the impact on productivity in the Chinese internet sector, manufacturing sector and the broader economy, as well as how it will unfold, remains uncertain. Some investors positioning themselves for these changes are looking at companies capable of developing generative AI applications, manufacturing AI-related hardware, or producing AI-relevant microchips, semiconductor materials or equipment. Some Chinese companies actively sought after by investors include Baidu, 360 Security, Lenovo, Shanghai Boasight Software, Iflytek, Unisplendour, ZTE and Foxconn Industrial Internet, which are listed on the mainland and Hong Kong stock exchanges.^[i]

While major Chinese internet and technology companies are aware of the need to adapt their business models to potential disruptions, their generative AI products and new applications have yet to demonstrate promising prospects and significant impacts on their revenues.

Baidu has shown some progress with its early focus on AI and the launch of ERNIE, an AI model capable of search, dialogue and content generation. Xiaomi continues to pursue an AI and Internet of Things development path, utilising deep learning to connect mobile and IoT devices. Tencent has developed its own AI models, including HunYuan and WeLM, facilitating text generation, dialogue, translation and gaming. Alibaba has created the Multi-Modality to Multi-Modality Multitask Mega-transformer (M6) model, while JD.COM has come up with pre-trained language models for natural language understanding and generation. Bytedance contributes a multilingual machine translation model, and NetEase offers the YuYan language model.

These efforts are commendable but yet to have meaningful impact on their business models and much more needs to be done. Some of these stocks which trade at reasonable valuations based on their existing businesses may present interesting investment opportunities, but investors should take into consideration that high growth could be something of the past for these companies.

As technology innovation and productivity growth hold the key to success, companies that advance in intelligent manufacturing which employs generative AI may be the next “new-new thing” to watch in China in the coming years. Investors can potentially benefit from following developments in this area.

Concluding remarks

China's drive towards a virtuous circle of economic growth, fuelled by technology innovation and productivity enhancement, is of utmost importance. Investors evaluating China should acknowledge the challenges posed by generative AI, while also recognising potential investment prospects in companies poised to leverage these transformative changes.

[i] Saxo has not conducted independent research on these companies and is not recommending any of these stocks. They are for inspiration only.