THE end of cheap China is at hand. Blue-collar labor costs in Guangdong and other coastal hubs have been rising at double-digit rates for a decade. Workers in the hinterland, too, are demanding—and receiving—huge pay increases. China is no longer a place where manufacturers can go to find ultra-cheap hands. Other countries, such as Vietnam, are much cheaper. What will this mean for China and the world?

Contrary to conventional wisdom, it will not mean that companies close their Chinese factories and stampede to somewhere poorer. China is still a terrific place to make things. Labor may be cheaper elsewhere, but it is only one cost among several. Unlike its lower-paying rivals, China has reasonable infrastructure, sophisticated supply chains and the advantage of scale. When demand surges for a particular product, the biggest firms in China can add thousands of extra workers to a production line in a matter of hours.

So China is not about to hollow out. But if it is to keep growing fast, it must become more innovative. At present Chinese innovation is a mixed bag. There are some outstanding private firms. Frugal engineers at private companies such as Mindray, which makes medical devices, and Huawei, a telecoms giant, are devising technologies that are cheaper and sometimes better than their rich-world equivalents. Manufacturers operating near China’s coast, whether home-grown or foreign, are adept at “process innovation”—incrementally improving the way they make things. And China’s internet start-ups, such as Tencent (a social-networking service) and Alibaba (an e-commerce company), have had a genius for copying Western business models and adapting them to the Chinese market.

But innovation is about more than this. One way of defining it would be as fresh thinking that creates value people will pay for. By that measure, China is no world-beater. Though its sweat produces many of the world’s goods, it is designers in Scandinavia and marketers in California who create and capture most of the value from those products.

China’s leaders know this, and are pouring billions of dollars into research and development. The current five-year plan calls for “indigenous innovation”, which the government thinks it can foster by subsidizing “strategic” industries and strong-arming foreign firms to transfer intellectual property to budding national champions. That system of state capitalism worked when the aim was to copy and to adapt other people’s ideas in the cheapest way possible. But can new ideas truly be created by fiat? Elsewhere governments have tended to run into two problems: the state is not a good innovator, and it gets in the way of others who are. Is China really so different?

Although the Chinese government invests a fortune in research and development, too much of this cash is wasted, according to the OECD. Most of it goes into development; not enough into research. It is far too difficult for new Chinese ideas to move from the laboratory to the marketplace. And the pockets of research excellence that exist—for example, in genomics—tend to be disconnected and politicized fiefs. Meanwhile, the state’s efforts to pick technology winners have been patchy. Telecoms has been a success, but electric cars have not, and subsidizing clean-energy manufacturers has had mixed results. As for trying to set up regional internet clusters, China seems committed, but so far Silicon Valley has proved far too complex and delicate a system for a bureaucrat to copy.

Let me in to the dragon’s den

If the argument that the Chinese state is uniquely innovative is at best unproven, the obstacles in front of a small private-sector innovator are clear. The most obvious is piracy. China’s intellectual-property laws are not bad on paper, but are enforced patchily and partially. Another problem is the way so many industries have been consolidated in the hands of favored firms. Antitrust and competition laws are not applied vigorously to well-connected champions. State-directed banks take the Chinese people’s savings and lend them at microscopic interest rates to national champions. This starves clever but unconnected firms of capital, and cheats savers, too.

Nobody expects the Chinese government to let the reins go completely, but it needs a less top-down approach that gives its citizens more space to experiment. It must let private investors risk money on ideas they think might work, and bear the consequences of failure. An obvious place to start would be to let firms build on what they already do well, such as process innovation. But the next Chinese breakthrough may actually come in an unexpected field. China was once a dazzling innovator: think of printing, paper, gunpowder and the compass. If its rulers loosen their grip a little, it could be so again.