Apple’s iPod transformed the music business and served as the foundation for the hugely successful iPhone and iPad. While CEO Steve Jobs and his colleagues led the overall design, bulk of the work on the iPod was done in India and China. Apple outsourced the brains of the iPod (a microprocessor) to Portal Player, a Silicon Valley based semiconductor company. Portal Player’s engineers in Hyderabad, India and Silicon Valley worked around-the-clock to design the chip. The chip itself was manufactured in Taiwan. The final assembly of the iPod took place in China.

Since 2007, GlaxoSmithKline, the U.K. based pharmaceutical company, has invested over US$100 million to build a major neuroscience research center in Shanghai, China. The center is responsible for virtually all of the company’s research on neurodegenerative diseases. As the head of the company’s R&D operations has noted, for GSK, China is not just about outsourcing and cheap labor. It’s also about shifting the needle from made-in-China to discovered-in-China.

As these examples illustrate, even though China and India remain two of the poorest – thus, lowest cost – countries in the world, they are also rapidly emerging as two of the world’s most powerful innovation hubs. The explanation lies in both supply-side and demand-side characteristics.

On the supply side, the very large populations and the strong higher education systems in both countries have created a situation whereby they produce more science and engineering every year than any other country – over one million per year in China and over half a million per year in India. The impact of scale shows up not just at the bachelor’s level but also at the level of specialists with master’s and PhD degrees. As a senior executive in Goodyear’s China operations noted to us, "The US will probably graduate 3 PhDs this year in tyre technologies. In China, we know of at least 50." A senior executive at GE’s John F. Welch Technology Centre in Bangalore made a similar observation to us in an entirely different domain, "It’s virtually impossible to find expertise in computational fluid dynamics in the U.S. In India, we can find dozens of specialists in this field." Given these realities, it is hardly surprising that, according to data from the U.S. Patent and Trademark Office, over the last five years, China and India have been the two fastest-growing countries-of-origin for patents granted by the USPTO.

The demand-side forces are playing out differently but with a similarly large impact. As history keeps reminding us, necessity is the mother of innovation. Japan’s extremely high population density and thus very high real estate costs were the factors that induced Toyota to invent an entirely new approach to manufacturing including concepts such as total quality management and just-in-time inventory systems. Similarly, the adversity that China and India face is that, even though they are very large and rapidly growing markets, they have very low per capita incomes – one-tenth of the U.S. in the case of China and one-thirtieth of the U.S. in the case of India.

A direct result of this demand-side characteristic is that a growing number of domestic as well as multinational companies in each country are becoming pioneers at the art and science of frugal innovation i.e., creating ultra-low-cost products and services for the low-to-middle income market in each country. As illustrated by Tata Nano and ultra-low-cost wireless telecom services in India, frugal innovation goes well beyond de-featuring and leveraging lower labor costs. Starting with a deep understanding of what the low-to-middle customer needs and is willing to pay for, it requires the company to redesign all aspects of the business model. The resulting innovations can have massive spillovers for a company’s operations worldwide – in emerging as well as developed markets. GE’s extremely low cost and portable ECG machine provides an excellent example. The MAC 400 was developed in India, upgraded to MAC 800 in China, and is now being sold globally including in the United States.

The implications for multinational companies are clear. If you wish to remain a global leader in your industry, you must leverage China and India not just for low-cost manufacturing or services but also for cutting edge innovation. For governments everywhere, the implications also are clear. Invest in education and research. Innovation and higher productivity are the only sustainable routes to long-term wealth creation.