By Eric Vandenbroeck and co-workers
By now, the systemic
problems that bedevil China’s economy are obvious. The country is suffering from
slowing economic growth, stagnating productivity, a malfunctioning property
sector, the misallocation and inefficient use of capital, debt-capacity
constraints, and weak household income and consumer demand. But it is less
clear how Beijing should fix these problems. Many economists outside of China,
as well as some inside the country, believe that it must recalibrate its
development model by making it far more market-oriented and driven by consumer
spending. Chinese leader Xi Jinping’s Chinese Communist Party (CCP), however,
cannot accept the political and institutional changes that such a recalibration
would require.
So Xi has chosen a different path: a growth
strategy centered on industrial policy, aimed at boosting what he and the CCP
call “new productive forces.” In Marx’s thinking, this phrase describes the
process whereby major changes in technology clash with the existing economic
order, enabling communists to overthrow it. For Xi, these new forces are the
sectors now at the vanguard of scientific and technological development, such
as clean energy, electric vehicles, and batteries—in which China already
leads—as well as industrial machinery, semiconductors and computing, artificial
intelligence and robotics, the life sciences industries, and biotechnology and
pharmaceuticals. Xi’s ambition is for China to achieve self-sufficiency in all
these sectors. Xi believes that by focusing on industrial policy and
innovation, he can rescue China’s beleaguered economy, seize geopolitical
opportunities to lead the twenty-first century’s new industrial revolution and
end the United States’ dominance in the international system.
However, this
strategy is unlikely to work as Xi intends. China is without a doubt the
world’s leading manufacturing nation. Beijing has proved that it can set
successful industrial policies in some areas and encourage the rise of powerful
companies. But it cannot create a true climate of economic innovation so long
as its rigid politics and governance and exclusionary approach to
institution-building remain in place. An innovation-based industrial strategy
may not be transformative if the government is unable to address basic systemic
weaknesses such as youth unemployment, frailties in China’s banking and
financial systems, and weak consumer demand. It is unlikely that China can
succeed at encouraging the kind of broad innovation and disruptive change on which
its economic growth strategy depends, especially in its current lower-growth
environment.
Course Correction
Xi hopes that an
innovation-focused industrial strategy can heal the embarrassment of China’s
failure to modernize in the nineteenth and early twentieth centuries. According
to the CCP’s interpretation of history, Chinese leaders did not adequately
respond to industrialization and imperialist intrusions by—for example—Britain,
France, and Russia, yielding the so-called century of humiliation, during which
foreign powers carved up the nation. He is determined not to flub what he sees
as a similar moment.
Many elements of Xi’s
new economic strategy remain unclear—for example, how it will be
financed and whether financially strapped local governments can provide the
funding. But what is clear is that the government intends to place an even
greater emphasis on industrial policy to make China the undisputed top provider
of tech-forward products such as IT hardware, industrial machinery,
pharmaceuticals and biotech products, clean energy technologies, and electric
vehicles, as well as a global leader in communications networks and nuclear,
space, and life-sciences research. These industries already accounted for
nearly eight percent of China’s GDP in 2014 and 13 percent in 2022. Chinese
officials aim to get that proportion of GDP up to 17 percent by 2025.
This approach is not
new. It can best be understood as the latest initiative in a long line of
industrial-policy strategies that China has pursued since the beginning of the
twenty-first century. Yet however Xi characterizes it, it is also purely and
simply industrial policy in a country that already accounts for a third of
global manufacturing. The policy’s price tag is likely to be eye-popping.
According to recent studies by the OECD and the Kiel Institute for the World
Economy, industrial firms in China receive substantially greater subsidies and
other forms of state aid compared to their peers elsewhere. In 2021, the
economist Barry Naughton described China’s investments in innovation from 2000
as “the greatest single commitment of government resources to an industrial
policy objective in history.”
The CCP hopes that
placing China at the vanguard of technological and scientific progress will not
only cement its aspirations to lead the global economic and political systems
but provide new growth momentum and prosperity at home. This outcome is unlikely,
however, and not just because the cost of fulfilling the strategy may be
prohibitive. Some government outlays will undoubtedly go toward boosting
successful enterprises, but China’s top-down style of governance, its statist
economic philosophy, and its preponderance of corruption mean that a great deal
of the investment is likely to end up in waste and loss. In the case of
initiatives for which failure is deemed to be a political embarrassment,
officials will likely fail to account for losses properly.
The success of
China’s new policy will depend on proper audits to identify failing initiatives
before they become entrenched and efficiently allocate resources to the most
commercially viable enterprises. But proper audits and assessments are
tremendously difficult to do in China, given the government’s lack of
transparency on funding and financing. Take the solar and wind industries:
although the direct cash flows to leading firms can be measured, the indirect
subsidies and assistance that flow through the supply chain cannot. Local
governments are normally the agents of most industrial policy spending, but in
China, these are generally in too poor financial shape to take on additional
spending burdens.
Estimates by the
Center for Strategic and International Studies suggest that industrial policy
subsidies amounted to about 1.7 percent of GDP in 2019—a huge percentage
compared with other countries, including the United States, where the
equivalent figure was 0.4 percent. And that number is bound to have increased
since then, especially as China has stepped up industrial support in the wake
of export controls and restrictions that the United States and other countries
have placed on China, especially those regarding semiconductor chips.
Maintaining these high levels of support for industry will become one of
China’s biggest headaches, especially given faltering national revenues and a
host of other growing expenses, such those brought about by a housing bust, an
aging society, and rising spending on the military and on internal security.
False Advertising
The most fundamental
challenge, however, is that the CCP persistently conflates industrial policy
with innovation, which are not the same thing. Industrial policy is a vertical
strategy that positions the state at the apex of the economy, leading the development,
financing, and funding for designated industries and sectors with a view to
creating national champions. Fostering innovation, by contrast, is a more
horizontal concept in which government initiatives are explicitly designed to
create stronger and more inclusive institutions and conditions that encourage
more development and creativity across a swath of sectors, including those
often considered traditional, such as retail, wholesaling, transportation, and
distribution. When a government seeks to boost innovation, it typically focuses
on regulatory policies, encouraging competition, education and skill formation,
infrastructure investments, and tax and labor policies. The government is
mostly an enabler and facilitator, whereas with a more formally defined
industrial policy the government takes on a more specific leading role
indistinguishable from its role in promoting trade and exports.
But China’s track
record on innovation is mixed. In 2023, the World Intellectual Property
Organization’s Global Innovation Index—which ranks 132 countries by
innovativeness based on 80 indicators—situated China in 12th place. This
position looks impressive for a country with China’s income per head; China is
the only middle-income country ranked among the survey’s top 30 most innovative
nations. China’s overall score, however, conceals an important distinction. The
index’s indicators are divided between so-called innovation inputs, which
capture the aspects of an economy that enable creativity and innovation, and
innovation outputs, the end results of innovation. Inputs include things like
the quality of an economy’s regulatory, legal, and business institutions;
educational attainment; research and development; communications and energy
infrastructure, and measures of business and market sophistication. Outputs
comprise knowledge creation, intellectual property, patents, labor
productivity, software spending, intellectual property, high-tech exports,
trademarks, brand value, and online creativity.
In the World
Intellectual Property Organization’s 2023 survey, China ranks eighth in terms
of innovation outputs but 25th in terms of inputs—a noteworthy difference,
because over the long run, strength in inputs ultimately determines an
economy’s strength in outputs. That distinction reveals that China’s
manufacturing prowess and ability to absorb and exploit knowledge and
technology is world-class. But the broad range of institutional factors that
ultimately help nurture creativity and initiative across society are not in the
same league.
Consider, also,
China’s prowess in one often-cited measure of innovation capacity, patent
registration. Globally, China now accounts for almost half of global patents.
Yet the overwhelming majority of Chinese registered patents are of the
lower-value utility type—for example, the creation of particular products or
processes—as opposed to the more science- and innovation-oriented design type
in which Germany, Japan, and the United States excel, which safeguard unique
design characteristics that could be applied to an infinite range of future
products. Less than ten percent of Chinese patents are filed and granted
abroad, suggesting that a lot of effort goes into patent registration
domestically that is not recognized or valued abroad. In a 2024 study, Yuen Yuen Ang and other authors examined 4.6 million patents
filed between 1990 and 2014 in 333 mainland Chinese cities. They discovered a
high level of gaming of top-down patent targets. China’s patent registrations
can often be attributed to wasteful subsidies and duplicative and low-value
patents.
Systems Failure
Xi’s new “productive
forces”-focused industrial policy will also fail to address the systemic
weaknesses that have put China’s economy in danger. Because it will encourage
overproduction and expansion in industries with relatively low labor input, it
will be unlikely to reverse the tide of jobs flowing out of other forms of
manufacturing and construction into lower-paid, lower-skill sectors such as
delivery, ride-hailing, and selling products on online platforms.
The emphasis on
industrial policy also fails to address the serious damage that Xi’s repressive
governance has wrought on the private sector. Superficially, Xi’s government
has lately adopted more encouraging rhetoric toward private enterprise. But
Beijing has not made real adjustments to the political and regulatory
environment that constrains private enterprise, especially the
national-security and anti-espionage regulations that conflate the collection,
use, and transfer of information that is essential for due diligence with
misconduct and criminality.
In accord with Xi’s
famous dictum that “government, military, civilian, and academic; east, west,
south, north, and center, the party leads everything,” the Chinese government
still affords top priority to state-owned firms and metes out arbitrary punishments
to businesspeople who fall afoul of its wishes. That political inclination also
means that Xi’s industrial policy ignores the need to boost consumption in
China. While CCP leaders pay lip service to the need to boost consumer demand,
they do not actually hold policies to drive consumption in high esteem, because
their ideology rejects “Western” consumerism.
Finally, the new policy
risks simply externalizing the consequences of its economic and industrial
policies in the form of higher exports, lower prices, and, for countries such
as the United States, bigger trade deficits. It impossible to envisage how
China, whose manufacturing sector now represents 29 percent of GDP and a third
of global manufacturing, could further subsidize and boost manufacturing
without incurring bigger imbalances and debt at home and imposing larger trade
deficits on the rest of the world. By externalizing the Chinese economy’s
demand weaknesses, Beijing will likely trigger more and more retaliatory
policies from other countries, and these could also damage the Chinese economy.
In May, the Biden
administration announced a range of new and additional tariffs on Chinese products
such as steel, aluminum, semiconductors, lithium batteries, solar cells, some
medical products, and ship-to-shore cranes, while tariffs on electric vehicles
have been raised to 100 percent. The EU, for its part, has launched an
investigation into China’s alleged distortion of the market for electric
vehicles, as well as inquiries into railway engines and wind turbines. The
European Commission’s concerns about China’s market-distorting practices could
lead to retroactive countervailing tariffs. Even some countries in the global
South, which China regards as a bedrock of support, have lately pushed back
against what they regard as intrusive trade practices.
No Shortcuts
Although China will
undoubtedly make some headway with its new industrial-policy goals, its hope to
lead the world in innovation cannot be easily reconciled with its unswerving
belief in the effectiveness of government direction, its distaste for free market
competition, its weak legal and regulatory institutions, and the rent-seeking
and corruption that characterizes its economy. Japan offers a worthwhile point
of reference. Writing about Japan’s industrial, corporate, and trade
policies George Packard the country’s “strategy will result in
spectacular advances and growing supremacy in a variety of fields such as
industrial ceramics, lasers, semiconductors, biotechnology, solar energy,
robotics, superconductors and possibly in space exploration. These advances, in
turn, will be largely used in consumer products and will lead to increasing
exports, rising ‘techno-nationalism,’ and deepening fears among Americans that
we can no longer compete.”
One might be forgiven
in thinking that this passage was written recently about China. Predictions
that Japan would achieve worldwide industrial supremacy never came true. As a
result of deep-seated systemic flaws in Japan’s economy and misguided policies,
by 1990, leading Japanese companies such as Sony, Hitachi, Toyota, Honda,
Matsushita, and Sumitomo succumbed to the bursting of Japan’s asset bubble,
precipitating a relative macroeconomic decline that lasted for almost three
decades. The causes and consequences of the economic shock in Japan were
compounded by important institutional weaknesses, including the government’s
resistance to reform the role of financial institutions, rigid corporate
governance, archaic labor-market practices such as lifetime employment, and
nepotism between firms and the public sector. Many of these factors are also
present in China today. And although China does not lack laws, it does not—and
cannot—develop an economy governed by the rule of law.
The example of Japan
shows how two things can be true at the same time. An economy boasting
world-class companies and striking achievements in innovation can also be an
economy in which systemic imbalances, asset bubbles, political contradictions,
and institutional rigidities run too deep for the most impressive companies to
drive sustainable nationwide growth. Great firms and a strong top-down
industrial policy do not protect an economy against bad macroeconomic outcomes.
Technological islands of excellence are no substitute for good macroeconomic
governance and well-institutionalized technology ecosystems that diffuse
benefits throughout the economy—neither of which the Chinese system seems
likely to produce any time soon.
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