Is the Dragon finally flapping its wings?

As the boom in artificial intelligence (AI) accelerated throughout 2024, it was routinely assumed the US’s technology titans would maintain their exclusive foothold at the forefront of innovation. This cosy notion was blown out of the water just days into 2025.

The launch of DeepSeek, an AI-powered chatbot developed in China, wiped billions of dollars from the collective value of the “Magnificent Seven” tech stocks. President Donald Trump spoke of a “wake-up call” for American companies – if not for Western businesses as a whole.

The fact that China had suddenly unveiled a would-be rival to the likes of ChatGPT was not the sole reason why markets were so rattled. It quickly became apparent that DeepSeek was at least as good as its US peers – if not better – and had been developed at much lower cost.

As a result, investors are now confronted by a familiar question: has China finally caught up with the West in the race to deliver breakthrough technological advances? Might it even have assumed the lead?

The idea that China has achieved parity in tech – or even pre-eminence – has gained prominence on several occasions during the past quarter-century or so. It has invariably turned out to be illusory.

For example, research published in 2011 examined an explosion in Chinese patenting between 1999 and 2006. It discovered the rapid rise was almost entirely due to a handful of notably large, mainly export-oriented, highly R&D-intensive organisations.

“Most companies are likely to focus on incremental process innovation rather than ‘new to the world’ innovation,” the study concluded. “The Dragon may be flapping its wings, but it is not flying just yet.”

Is the picture different this time? It may well be, because the most interesting pockets of genuine innovation in China today are increasingly found among the country’s smaller businesses.

Beijing re-embraces tech

China’s reputation as a “fast follower” has been more than merited over the years. The prevailing business model has been to replicate rather than revolutionise – to gently improve rather than shatter the mould.

This reflects Western perceptions that Chinese business culture is less rooted in free thinking and more mired in hard work and grit. For as long as this outlook prevails, the logic goes, innovation will play second fiddle to imitation.

Yet the boundaries are becoming more and more blurred. The hype surrounding AI has perhaps tilted more towards the East of late – and not just because of DeepSeek’s spectacular emergence.

It is barely five years since President Xi Jinping oversaw a regulatory crackdown on China’s private sector and its tech companies in particular. Profits plunged. Some businesses went bust. Infamously, Alibaba founder Jack Ma all but vanished from public view.

That period in China’s economic history looks to be well and truly over. Numerous pro-growth stimulus measures have been introduced during the past six months, while a February meeting between Xi and leading entrepreneurs appeared to signal Ma’s return to the fold.

The message to the private sector now seems unequivocal: “Go forth and grow.” This should be music to the ears of China’s smaller companies.

After all, wherever you look in the world, small and medium-sized organisations tend to be inherently more innovative than their larger counterparts. In tandem, they are also more likely to deliver growth over time.

A significant challenge for investors, of course, is to identify these opportunities. Specialist investment teams with extensive local knowledge are often best placed to unearth the hidden gems.

Towards genuine transformation?

Precision Tsugami is a good example. Best known as a manufacturer of lathes, grinders and other precision tools, it recently announced several orders related to AI and robotics.

These fields currently account for just a fraction of overall business. Yet the potential for growth is considerable, especially in light of the company’s capacity to scale up operations.

Another of our holdings that we expect to benefit from Beijing’s renewed enthusiasm for tech is Kingdee. A producer of ERP (enterprise resource planning) software, it is expanding its offering to meet the needs of businesses all along the market-capitalisation spectrum.

An important point here is that China now recognises its innovation efforts should not be centred only on online marketplaces or video games. Rather, they should encompass areas that are key to its geoeconomic and geopolitical rivalry with the US.

To that end, crucially, China has sheer numbers on its side. For instance, it is easier to test and maximise the power of big data and AI if you have a population of more than 1.4 billion – and if, like multifaceted services provider Ping An, you have over 230 million retail customers and in excess of 600 million online users.

There is a nascent school of thought that the Chinese government’s conspicuous shift back towards tech – and towards the private sector more generally – will prove transformative. This is certainly an opinion held by some highly experienced and respected China strategists.

Needless to say, no-one can be sure how things will pan out – not least in an environment of tariff tantrums. But Chinese companies are essentially being told that capitalism is fine, that tech marks the way ahead, that they should be adventurous and that they will not be penalised for succeeding.

It could be argued that something comparable last occurred when Deng Xiaoping instituted the sweeping economic reforms that opened China to the world in the late 1970s and the 1980s. And when that happened, as you may recall, the Dragon flapped its wings pretty vigorously.

Gabriel Sacks is investment manager, Aberdeen Asia Focus.