Shahid Yusuf

Chief Economist, Growth Dialogue, GWU

Following an unprecedented three decade long period of double digit GDP growth that has pushed per capita GDP to over $8,800[1], China has begun transitioning towards an East Asian middle income norm[2]. Since 2012, growth has slowed: between 2015 and 2017 it averaged 6.8 percent per annum. With the Chinese government now assigning greater importance to the quality of growth[3], a gradual easing of the pace at which the economy expands is likely to continue. However, barring a sudden and sharp deceleration of economic activity, China is well on its way to achieving the targeted doubling of GDP between 2010 and 2020 and fairly soon thereafter, entering the ranks of high income countries. Only thirteen economies have managed this feat since 1960[4]. China is likely to be among the small handful of upper middle income countries that will cross the threshold a few years hence.

China’s economic ascent that commenced in the second half of the 1970s[5] and accelerated in the early 1980s, has been scrutinized in detail[6]. The reforms that were key to the survival of the Party-state have been thoroughly documented. Many arose as a result of local initiative[7]. They were tested on a limited scale – “crossing the river by feeling the stones “– before being implemented countrywide. What is of greater interest at this juncture are the developments since the Financial Crisis of 2008-2009 as well as the implications for China and the rest of the world of Xi Jinping’s ambition, his policies and proclivities.

By the turn of the century, China’s growth strategy based on massive investment in industrial capacity, technology absorption and exports of manufactures was demonstrating its worth. China’s accession to the WTO in 2001 and the ending of the Multi Fiber Agreement in 2005 further boosted export led growth[8]. It gained impetus from foreign investment that enabled China to rapidly narrow technology gaps[9]. At the start of the reform era, China’s exports consisted largely of petroleum, raw materials and food products. Fifteen years later light manufactures comprised the majority of exports and since then, China has moved up the ladder with medium and high tech manufactures such as computers and broadcasting equipment dominating the export mix (Figure 1).

Figure 1: China Export Composition 2016

Source: https://atlas.media.mit.edu/en/profile/country/chn/

As the share of exports in GDP and in global trade increased, questions were raised as to the longer term viability of this export led growth strategy. In 2004, Premier Wen Jiabao  began calling for restraint on investment and a rebalancing of demand towards consumption[10]. Little was done to change course beyond the periodic use of credit restrictions to dampen market exuberance. In March 2007, when addressing the National People’s Congress, Premier Wen again warned that China’s growth was unstable, unbalanced, uncoordinated, and unsustainable[11]. At that time, gross investment as a share of China’s GDP amounted to 41.5 percent. Nearly two years later in November 2008, China reacted to the threat posed by the Financial Crisis and the ensuing global recession by launching a RMB 4 trillion stimulus program (approximately 12.5 percent of GDP in 2008)[12] that raised investment to almost 48 percent of GDP in 2010. Although the largely credit financed[13] spending on infrastructure, real estate and manufacturing capacity enabled China to maintain double digit growth rates during 2009-2011, the return on investment was declining steeply and by 2012[14], it was clear that a rebalancing of the economy was overdue. China needed to lessen its reliance on investment and exports as the primary sources of growth[15].

The Financial Crisis and the lingering recession in advanced economies also prompted much rethinking in China as to the merits of a market based system dominated by a lightly regulated private sector. The Crisis convinced many among the Chinese establishment that the Western model of development was seriously flawed. This disenchantment strengthened the belief that China needed to pursue its own variant of market socialism with a renewed emphasis on the embodying of “Chinese characteristics”.[16]

In November 2012, the 18^th Central Committee of the Communist Party elected Xi Jinping to serve as the Party General Secretary and to head the CPC Central Military Commission. It gave him the authority to begin reshaping China’s development strategy, authority that now President Xi has used to project China’s influence overseas making full use of the financial clout acquired through export surpluses that have fed a vast war chest of foreign exchange reserves.

The balance of this paper briefly examines several key facets of China’s development over the past five years and discusses some of their implications. Starting with a section on political structure and dynamics (1); subsequent sections deal with macroeconomic trends, structural change, urbanization and innovation (2); the role of the private sector and how this is buttressed by legal institutions that support a market economy (3); China’s external trade and the internationalization of the RMB (4); China’s increasing prominence on the international stage, overseas foreign direct investment (including through BRI), the ongoing effort to accumulate soft power and to project its military capabilities (5); and some of the challenges that China is facing particularly those arising from environmental pollution and climate change (6). It goes without saying that one could easily write a book or several books on each of these topics and in fact many have been written in addition to numerous articles. The purpose here is to provide a sense of how the economy is evolving, how China is engaging with  the rest of the world as its economic footprint expands and it acquires superpower status, and how the government is coming to coping with a variety of challenges, political, structural, and environmental.

[1] Per capita GDP at the end of 2017. https://www.ceicdata.com/en/indicator/china/gdp-per-capita A decomposition of the sources of China’s growth using official and alternative estimates of GDP growth and alternative deflators and factor weights can be found in Wu (2014) https://www.conference-board.org/pdf_free/workingpapers/EPWP1401.pdf

[2] Yusuf (2017) https://onlinelibrary.wiley.com/doi/abs/10.1111/apel.12190 This seems to be a ‘normal’ growth rate for an upper middle income country and by no means a trap.

[3] This is the stated objective, whether it will be pursued were growth to slow significantly, remains to be seen.

[4] Agenor, Canuto and Jelenic (2012) http://siteresources.worldbank.org/EXTPREMNET/Resources/EP98.pdf

[5] Hua Guofeng took the first steps after succeeding Mao. The Third Plenum of the 11^th Party Congress guardedly endorsed reforms that permitted local officials sensitive to the brewing grass roots discontent to experiment with what eventually became the household responsibility system, and also led to the creation of special economic zones followed by other measures affecting SOEs and taxation. Buckley (2013) https://sinosphere.blogs.nytimes.com/2013/11/09/portrait-of-deng-as-reformer-in-1978-plenum-ignores-history/?utm_source=twitterfeed&utm_medium=twitter

[6] Morrison (2018) provides a compact overview. https://fas.org/sgp/crs/row/RL33534.pdf; as does Arthur Kroeber (2016). China’s Economy: What everyone needs to know. Oxford University Press. New York. China’s Forty years of Reform and Development are surveyed by contributors to the volume edited by Ross Garnaut and Ligang Song (2018). https://press.anu.edu.au/node/4267/download. The period from 1978 through 1993 is searchingly examined by Barry Naughton (1995). Growing Out of the Plan. Cambridge University Press. Cambridge UK. A detailed blow by blow account can be found in L Brandt and T.G. Rawski eds. (2008). China’s Great Economic Transformation. Cambridge University Press Cambridge. UK. On issues of current interest, see Jennifer Rudolph and Michael Szonyi eds. (2018) The China Questions. Harvard University Press, Cambridge Mass.

[7] For example the household responsibility system that transformed agriculture was a grass roots phenomenon that was not officially endorsed until 1981 once it had proven its worth. Deng took time to wean himself from his attachment to collectivized agriculture. See Warren Sun and Frederick C. Teiwes (2016). Paradoxes of Post-Mao Rural Reform. Routledge. New York.

[8] China’s exports grew from $0.51 trillion in 2001 to $4.3 trillion in 2014. Yuan (2015) https://www.wto.org/english/thewto_e/acc_e/Session2YuanYuanPostAccessionLookingback14yearafter.pdf

[9] See Michael Enright. Developing China: the Remarkable Impact of Foreign Direct Investment.

New York: Routledge, 2017. Van Reenen and Yueh (2012) estimate that between the mid 1990s and the mid 2000s, China’s annual GDP growth gained up to 1 percent from the technology transferred by FDI. https://www.economics.ox.ac.uk/materials/papers/5634/paper592.pdf; The contribution of FDI to China’s growth is contested by Gungby, Jin and Reed (2017) who do a meta-analysis of 37 studies and a total of 280 estimates. They maintain that publication bias and sample characteristics tend to bias results. https://www.sciencedirect.com/science/article/pii/S0305750X16304831

[10] Naughton (2005) http://media.hoover.org/sites/default/files/documents/clm11_bn.pdf; Lardy (2007)  http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.487.9944&rep=rep1&type=pdf.

[11] http://www.chinadaily.com.cn/business/2007-03/16/content_829815.htm

[12] Naughton (2009) deconstructs the program identifying the relatively modest share financed by the Central government and what became the responsibility of local authorities, which turned to banks and shadow banks to find the needed resources. http://media.hoover.org/sites/default/files/documents/CLM28BN.pdf

[13] The Central Government undertook to finance only about a third of the program. The rest came from banks and local government budgets. Local authorities were quick to seek approval for a long wish list of projects and to initiate implementation. Naughton (2009) http://media.hoover.org/sites/default/files/documents/CLM28BN.pdf

[14] Chen and Ratnovski (2017) show that the impact of credit expansion was waning rapidly during 2010-2015. https://blogs.imf.org/2017/12/12/propping-up-the-chinese-economy-credit-versus-fiscal-stimulus/

[15] Daokui Li (2015) https://www.brookings.edu/on-the-record/the-big-picture-debating-chinas-rebalancing/

[16] Fan, Morck and Yeung (2011) attempt to understand what this implies in practice – although the Chinese model continues to evolve – even as market capitalism confronts its own challenges in the face of rising inequality and an upsurge of populism. https://papers.ssrn.com/Sol3/papers.cfm?abstract_id=1972735

Shahid Yusuf

Chief Economist, Growth Dialogue, GWU

China shares a land border with fourteen countries and (contested) maritime boundaries with six others. Its past relations with three of its neighbors – Russia, Japan and Vietnam – have been at times contentious. During the Cold War decades, Chinese leaders were acutely conscious of encirclement by hostile neighbors. It was the fear of an invasion that motivated the development of a Third Front (1964-71). This vast and secretive program resulted in the transfer of industrial activities to the interior of the country so as to make these regions self-sufficient and enhance their survivability in the event of war[1].  Breaking out of this encirclement and making China’s influence felt globally, has been an objective of China’s leaders at least since the early 1990s in line with China’s improving economic fortunes, the tightening of its relations with trading partners, China’s participation in international organizations, the scale of its FDI, and the influence exerted by its burgeoning overseas diaspora[2].

Starting in 1992[3], Jiang Zemin began discussing the need for Chinese companies to “go out”, deepen their penetration of foreign markets and take advantage of investment opportunities beyond China’s borders[4]. However, capital shortages constrained overseas investment during the 1990s. But by the end of the decade with China’s exports on an ascending arc and FDI pouring in, Jiang signaled China’s readiness to build overseas assets at major conferences and Politburo meetings. Accession to the WTO (in 2001), bilateral investment treaties (BIT) that induced Chinese investment[5], an increase in China’s overseas development assistance, a more visible Chinese presence in international fora, and active participation in international bodies was part and parcel of this effort to raise China’s profile and to become a global player now that its export prowess was an established fact. In the aftermath of the Financial Crisis, companies in developed and developing countries saw their valuations plunge and suffered from a shortage of funding. They offered ripe targets for Chinese firms eager to spread their wings abroad. Although global FDI declined in 2008, Chinese firms invested almost $60 billion overseas double their spending in 2007. As of 2017, China’s stock of overseas investments amounted to $1.87 trillion by early 2018[6]. In this context[7], the internationalization of the Renminbi deserves special attention because it straddles the going global and domestic financial reform objectives.

There are several reasons why China wants to elevate the status of its currency. First, if the renminbi becomes a reserve currency, a widely used medium of exchange and one in which a large volume of trade is denominated – particularly the major commodities – it would enhance China’s status among the community of nations making it commensurate with its economic heft. Second, it would reduce China’s reliance on the US dollar to settle trades and on the US financial system that mediates a host of banking transactions. Third, the demand for yuan denominated assets would lower the cost of borrowing by Chinese entities by tens of basis points, an advantage enjoyed by the US government and American corporations. Fourth, internationalization is appealing to reformers[8] because it could expedite domestic policy action on a number of fronts.

Resistance to internationalization comes from the NDRC and the MOF who worry that it would raise interest rates and the cost of borrowing by the government. It could also make China more vulnerable to speculative attacks and the outflow of hot money that precipitated the East Asian Crisis of 1997-98. SOEs are opposed because their borrowing costs could rise; and banks worry that their margins would narrow, which would eat into their profits. There are other hurdles in the way as well. Before the renminbi can become a full-fledged reserve currency, China would need to eliminate interest and capital controls, enhance the liquidity of its financial markets and enlarge the volume of high quality government debt so as to attract investors and to permit holders of RMB denominated assets to freely move in and out of China[9]. Moreover, foreigners would be more willing to invest in Chinese assets if there was greater confidence in protections afforded by the legal system in China – protections that circumscribed the scope for arbitrary actions by the government to seize assets or to prevent their transfer abroad. As matters stand, strict capital controls are in force, although various schemes allow foreigners to invest in Chinese instruments[10]. There is a legal infrastructure but the rules are not binding on the Party. Recent arrests of some of China’s richest businessmen and extrajudicial kidnappings of individuals residing in Hong Kong and elsewhere, are not calculated to build confidence. 

These hurdles notwithstanding, China succeeded in October 2016 to persuade the IMF to include the RMB in the SDR’s (Special Drawing Rights) basket of currencies with an initial share of 10.9 percent. The grounds for including China were: that it is the world’s largest exporter (9 percent of trade) with the highest degree of interconnectedness; it is the second largest economy (13 percent of global GDP); and its currency is widely used for settling trade payments and in currency exchange trade.

Thirty seven countries hold the RMB in their reserves (2017) with China’s allies such as Venezuela, Russia and Zimbabwe among the more prominent. China has also entered into swap arrangements with 34 central banks so as to facilitate trading in the currency[11]. In addition, the RMB is likely to become the third currency benchmark for Brent and West Texas crude oil. However, its use in trade and transactions is growing slowly. As of end 2017, its share of international and domestic payments was 1.61. and the share of cross border payments was 1 percent. According to SWIFT data, the RMB ranked fifth in global usage for the settling of transactions.

Recent actions by the US on the trade front and with respect to international treaties, could erode the primacy of the dollar and possibly enlarge the role of the RMB over time but China’s autocratic system will remain a severe hindrance. China might also be reluctant  to ease capital controls in the near future for fear that the huge overhang of credit could result in a resumption of a capital outflow of the kind that caused a mini-crisis in 2015-2016[12]. Over the medium term, the RMB like the Euro is more likely to emerge as a regional currency than a global one[13]. It is not inconceivable that a trade war could administer a shock that dislodges the dollar much as the Second World War toppled Sterling, the leading reserve currency during the first half of the twentieth century. As Eichengreen, Mehl and Chitu (2017, p.5-6)[14] observe, a reserve currency with a long established reputation for transparency predictability and liquidity benefit from status inertia. “That currency will remain locked in unless a significant shock causes agents to abandon established practice and coordinate a shift from one equilibrium to another”.

[1] The transfer of industry from the East and North east was costly and the small scale dispersed production of metals, machinery and other products was highly inefficient. Naughton (1988)  https://www.cambridge.org/core/journals/china-quarterly/article/third-front-defence-industrialization-in-the-chinese-interior/16DF6F4BDC5398BB2C6FFAEF39AD6230

[2] Chinese entrepreneurs, researchers, and workers are active worldwide. There are 1.5 million Chinese enrolled in foreign universities (2017) and more Chinese traveled overseas than from countries such as Japan and the United States. https://www.scmp.com/business/china-business/article/2130421/chinas-tourist-numbers-rise-year-after-record-45b-trips-2017;  https://www.telegraph.co.uk/travel/comment/rise-of-the-chinese-tourist/

[3] Prior to 1992, the stock of China’s overseas investment was just $1.2 billion. By 2010, the net stock amounted to $317 billion. Shambaugh (2013, p.177) op.cit.

[4] Shambaugh (2013, pp.174-175), op.cit.

[5] When Chinese leaders travel abroad their entourage includes a number of business leaders on the lookout for products to buy and for investment opportunities.

[6] Developed and emerging economies are the focus of China’s OFDI as is apparent from the China Going Global Investment Index for 2017. EIU (2017) http://pages.eiu.com/rs/753-RIQ-438/images/ODI_in_China_2017_English.pdf; Europe was the largest recipient.  https://www.bbvaresearch.com/wp-content/uploads/2018/02/201802_ChinaWatch_China-Outward-Investment_EDI.pdf;  http://www.aei.org/china-global-investment-tracker/

[7] Starting in 1994, China’s devaluation of the RMB and the maintaining of an undervalued exchange rate greatly contributed to export competitiveness.

[8] Now that Zhou Xiaochuan is no longer the Governor of the PBoC, reformers of the financial system may have lost a key ally.

[9] Barry Eichengreen, Arnaud Mehl and Livia Chitu (2017, p.4) write, “The country with the deepest and most liquid financial markets, will be attractive as a place for investors from other countries top hold their foreign balances, since investors value the ability to buy and sell without moving prices”. How Global Currencies Work: Past Present and Future. Princeton University Press. Princeton NJ.

[10] Prasad (2016) https://www.brookings.edu/wp-content/uploads/2016/07/USCESRCTestimony27Apr16.pdf Investors must register with the PBoC and must be in for the long haul. Hot money is not welcome.

[11] Active trading is limited mainly to Asian markets with Hong Kong in the forefront.

[12] Since the beginning of 2018, the RMB has depreciated by about 6 percent against the dollar as the trade war rhetoric has escalated and new tariff barriers have been put in place by both the US and China. How Chinese exchange rate and monetary policy will evolve is unclear especially if the trade war heats up and leads to other developments that raise US interest rates. https://www.ft.com/content/dbbafe0a-7db2-11e8-bc55-50daf11b720d; Setser (2018)  https://www.cfr.org/blog/chinas-currency-back-play; Subacchi (2018)  https://www.project-syndicate.org/commentary/china-renminbi-and-the-dollar-by-paola-subacchi-2018-07

[13] Eichengreen and Lombardi (2015) http://www.nber.org/papers/w21716;  In part, it will depend on US policy and its willingness to defend the primacy of the dollar. Cohen (2017) https://www.chathamhouse.org/sites/default/files/publications/research/2017-03-20-renminbi-internationalization-statecraft-cohen.pdf

[14] Eichengreen et al (2017) op.cit.

Shahid Yusuf

Chief Economist, Growth Dialogue, GWU

The rebuilding of China’s Science and Technology (S&T) capacity (after its decapitalization during the Cultural Revolution) commenced in the mid 1980s. The current hands-on ST&I policy dates back to the mid 2000s when Premier Wen Jiabao launched the Medium and Long Term Plan (MLP) “re-conceptualized the broader innovation policy framework”, “introduced the theme of indigenous innovation”, created a Leadership Small Group to guide and coordinate technology development and made it clear that it would be “implemented with key point projects and key point tasks”. A Science and Technology Progress law passed in 2007 lowered the obstacles to the commercialization of technology by universities much like the Bayh Dole Act did in the United States.

The MLP proposed four broad objectives: to allocate 2.5 percent of GDP to R&D by 2020; to source 60 percent of growth from productivity; to base 70 percent of production on technologies that are homegrown; and to raise the share of strategic and emerging industries to 15 percent of GDP (Ling and Naughton 2016, Pp. 2144-2145)[1]. Backstopping the MLP was a parallel program to raise the quality of STEM skills acquired by students in primary and secondary schools, which was elaborated by the National Plan for Medium and Long-term Education Reform and Development 2010-2020[2].

 The 13^th FYP reaffirms the commitments enunciated in the MLP to increase spending on R&D and to drive growth by raising productivity. The technology development strategy is wide ranging and informed by the “Made in China 2025” (MIC) Program (issued in mid 2015), green development and the “Internet Plus” program. The latter seeks to integrate Big Data, the Internet of Things (IoT) and mobile telecommunications more tightly with e-commerce and manufacturing so that China can benefit from the potential of ‘industry 4.0’ and accommodate the inward shift in the supply of factory labor and rising wages through an increase in productivity (Ernst 2016)[3]. In principle, the 2025 Program supports development guided by market forces. It is less focused on advancing the technologies of seven strategic industries and instead highlights the role of ten priority sectors: advanced IT; aerospace and aeronautical equipment; high speed rail; automated machinery and robotics; new materials; agricultural equipment; electric vehicles and others using new energy technologies; maritime equipment; biopharma and medical products; and new sources of electric power. Nevertheless, the emphasis on the localization of technology and production of high tech items remains on the agenda with the majority of industrial robots, renewable energy equipment to be manufactured domestically and an increasing percentage of items such as mobile phone microprocessors[4]. The industrial and technology policies that have been adopted in order to realize the objectives of the 2025 Plan include localization targets, government R&D funding, technology standards, procurement and import guidance[5].

At the epicenter of the R&D endeavor are a number of China’s leading universities – Peking, Nanjing, Tsinghua, UST of China, Zhejiang, and Fudan – and CAS. Moreover, in addition to Beijing, Tianjin and Shanghai, other cities are emerging as research hotspots hosting major laboratories, satellite campuses of leading universities, and research institutes, Shenzhen, Chengdu, Xian, and Hangzhou at the forefront (O’Meara 2015)[6]. Chinese researchers are engaged in cutting edge research on nuclear energy (fast reactors), stem cells, genomics[7], protein and green chemistry, optoelectronics, supercomputing, ballistic and anti-satellite weaponry, AI, and others. Furthermore, China has been closing technology gaps in a wide range of industries through joint ventures, licensing, learning from MNCs that have invested in China, technology sharing arrangements, local sourcing requirements, technology transfer via participation in GVCs, acquisition of foreign companies with IP[8], the establishing of sentinel research centers in European and American technological hotspots, joint R&D and industrial espionage. In the process, Chinese firms have developed outstanding manufacturing capabilities and can adapt and improve foreign production technologies and scale up production at short notice[9]. A study by Shen, Wang and Whalley (2016)[10] of technology gaps between China and the U.S. that estimated (with a CES production function) China’s hypothetical output per worker using U.S. technology, found that the gap had narrowed from 7.79 in 1979 to 3.86 in 2008. Other research also suggests that China’s tech industry still lags behind that of the U.S however, between 2012 and 2017 it advanced from a 15 percent level to a 42 percent level; has nurtured 164[11] unicorns many with the help of a thriving VC industry (85 percent as large as America’s); and China’s expenditure on R&D is catching up fast[12].

Creating a productive innovation system is a slow process. In China, top down policy directives demanding increased research effort orchestrated by MOST[13], are reinforced by inter provincial competition between rival provincial and metropolitan innovation systems nested within the national system. The net result is a great improvement in measurable quantitative indicators dear to planners – such as expenditure on R&D, supply of venture capital, patents, published scientific papers - but with research that feeds true innovation and results in breakthrough products, proceeding more slowly[14]. For example, China’s State Intellectual Proerty Office reports that the number of invention patents per 10,000 population rose from 6.5 in 2015 to 9.8 in 2017 and should easily reach the target of 12 per 10,000 by 2020. By 2017, China’s contribution to scientific publications tracked by the SCI was 2^nd only to the United States and the quality appears to be improving as measured by citations. Moreover, the targeted science and technology progress contribution rate for 2020 – 60 percent – also appears to be within reach. Between 2015 and 2017, the STCPR increased by 2.2 percentage points to reach 57.5 percent.

To accelerate the pace of STI development during the 13^th FYP, Chinese authorities have voiced commitment to market principles and to greater openness in pursuit of innovation[15]. The plan has also underscored the role of the private sector and of property rights including intellectual property[16]. But this is not necessarily supported by policies that are enlarging the role of the public sector, oversight by the Party and weakening the independence of the judiciary.

All this is positive. But China has more work to do in order to make its business, social and academic environments conducive to innovation. A society open to new ideas, that vigorously debates them, is hospitable to diversity, and is well informed about developments worldwide, is more likely to be innovative. A large, competitive private sector subject to churning of firms that enjoy ease of entry and exit, is also advantageous. So too, is a regulatory system that manages with a light touch, and a not too overbearing and privileged state sector. 

However, China seems to be departing in practice, from this approach. It’s Doing Business ranking was 78^th in 2018 showing only a modest improvement over the past two years[17]. As noted earlier, the government is giving greater prominence to SOEs and tightening its oversight of businesses by Party Committees. MNCs are being challenged[18] and there is greater wariness with regard to foreign ideas spread via the Internet. The activities of foreign NGOs are being curtailed. The Great Firewall is becoming harder to scale thanks to the rigorous policing by  an army of censors[19]. The research environment is becoming less open and the scope for collaboration is being narrowed by a regulation passed in March 2018. Foreign scientists and foreign invested research establishments must obtain permission from the government before they can transfer any data abroad or to other foreign parties in China[20]. And even as China steps up its Belt and Road Initiative (BRI) and woos foreign investment, its relationships with some of its neighbors and trading partners are becoming unusually tense.

Research on the drivers of productivity points to the contribution of managerial competence whether of private or public enterprises. This factor goes a long way to explaining why some firms are more innovative, efficient and close to the technology frontier relative to others in the same industry. Bloom, Sadun and van Reenen (2016)[21] report that a good 30 percent of the differences in TFP among countries can be explained by variations in the quality of management. Managerial shortcomings some arising from inexperience, in combination with the constraints imposed by the business environment, hamper performance of Chinese firms in particular SOEs. Unless corrected, both will dampen China’s potential for realizing productivity gains through innovation.  The role of management will take on a greater importance as the share of services increases and manufacturing firms as well as pure services providers must tackle innovation not through conventional R&D but through organizational changes, HR policies and the accumulation of intangible capital.  In this context, management technology transfer from foreign MNCs could become more consequential than gaining access to product and process technologies as the management scores of MNCs are higher in almost every country. Looking ahead, FDI in China’s services industries could enhance productivity more than investment in manufacturing.     

Innovation capability is not an end in itself but a means of raising productivity. Such capability develops over time as the quality of the talent pool improves[22], there are increasing numbers of experienced research managers and project leaders, technological absorption reaches a point where many if not most industries are at or close to the frontier, and the institutional environment matures and becomes supportive of openness to bold new ideas some drawing on a multiplicity of disciplines. The timescale for such development can be shortened through investment in research capital but East Asian experience would suggest that the process can still take decades. A Big Push can accelerate the deepening of manufacturing capabilities and movement towards the technological frontier as China and several East Asian economies have learnt to their advantage however, making the leap into innovativeness takes longer and spending on R&D that exceeds the absorptive capacity of the system only leads to waste[23].

[1] https://econpapers.repec.org/article/eeerespol/v_3a45_3ay_3a2016_3ai_3a10_3ap_3a2138-2152.htm

[2] CSIS (2016) http://chinapower.csis.org/education-in-china/  

[3] Ernst (2106) discusses the objectives of the MIC and its reliance on the German model.  http://www.eastwestcenter.org/system/tdf/private/iegwpoo6.pdf?file=1&type=node&id=35555. On the technological potential of industry 4.0 see Klaus Schwab. The Fourth Industrial Revolution. Crown Books 2017; BCG (2015) https://www.bcgperspectives.com/content/articles/engineered_products_project_business_industry_40_future_productivity_growth_manufacturing_industries/ 

[4] Wubbeke et al (2016) also refer to the takeover of foreign firms with IP as a part and parcel of strategy to make China more technologically independent. https://www.merics.org/fileadmin/user_upload/downloads/China_Flash/161121_Handout_IndustrialInternet_Web.pdf Recent tensions with the US and rising protectionist sentiments worldwide have reinforced the government’s intention to indigenize core technologies.

[5] See Koleski et al (2018) https://www.uscc.gov/sites/default/files/Research/China%27s%20Technonationalism.pdf

[6] http://www.nature.com/nature/journal/v528/n7582_supp_ni/full/528S179a.html

[7] The Chinese firm BGI is one of the leading lights in genome sequencing.

[8] For example, the meteoric rise of China’s wind turbine firms such as Goldwind is the result of technology transfer from foreign companies such as Vestas, Siemens and Gamesa, licensing of technology from firms such as Jacobs Energie, the takeover of Vensys, government support through R&D, financing and procurement. See Joanna Lewis (2013). Green Innovation in China. New York, Columbia University Press. Ch.5. China’s emergence as the leading producer of solar panels and modules commenced in the early 2000s following import of production equipment and technical collaboration with foreign firms and universities. Government programs promoting the installation of solar arrays and subsidies for producers permitted scaling up and incremental improvements. Gallagher and Zhang (2013) http://fletcher.tufts.edu/CIERP/~/media/Fletcher/Microsites/CIERP/Publications/2013/Climate%20Technology%20and%20Development%20Case%20-%20Kelly%20Sims%20Gallagher.pdf; Kelly S. Gallagher (2014). The Globalization of Clean Energy: Lessons from China. Cambridge Mass. MIT Press. 

[9] In their hurry to commercialize and bring a “good enough” product to market, Chinese firms too often cut corners and neglect quality. This has been brought home by scandals and recalls affecting food products, pharmaceuticals and others. See: Jeremy R. Haft, (2015). Unmade in China. Polity Press. Cambridge, UK; Paul Midler, (2009). Poorly Made in China. John Wiley. New York.

[10] http://www.nber.org/papers/w21657

[11] https://www.scmp.com/business/companies/article/2139684/heart-chinas-techno-nationalism-hit-list-200-unicorns

[12] Economist (2018, p.61) https://www.economist.com/graphic-detail/2018/02/16/chinas-tech-industry-is-catching-up-with-silicon-valley. In 2017, R&D absorbed 2.2 percent of China’s GDP.

[13] The restructuring of ministries announced by the People’s Congress in 2018, have concentrated more decision-making power in the Ministry of Science and Technology. https://www.nature.com/articles/d41586-018-03246-w

[14] This may change as China’s research in fields such as AI and genomics gathers momentum.

[15] http://www.apcoworldwide.com/docs/default-source/default-document-library/Thought-Leadership/13-five-year-plan-think-piece.pdf?sfvrsn=2

[16] http://www.chinabusinessreview.com/13th-five-year-plan-stresses-economic-restructuring/ 

[17] World Bank (2016) http://www.doingbusiness.org/~/media/GIAWB/Doing%20Business/Documents/Annual-Reports/English/DB16-Full-Report.pdf;  http://www.doingbusiness.org/rankings

[18] http://www.cnbc.com/2015/02/10/us-businesses-in-china-we-feel-less-welcome-here.html

[19] Discourse on the Internet is regulated and channeled by the “Tencent Army” of paid government commentators and by Party netizens. Overt censorship is combined with measures that make it harder and costlier to access some types of information thereby discouraging many, and by the flooding cyberspace with information that the government wants citizens to read and to believe. See Rongbin Han (2018). Contesting Cyberspace in China. Columbia University Press. New York. Margaret E. Roberts (2018). Censored: Distractions and Diversions inside China’s Great Firewall. Princeton University Press. Princeton NJ.

[20] “China curbs transfer of scientific data by foreign businesses”. FT June 6^th 2018. https://www.ft.com/content/69a44c36-689a-11e8-8cf3-0c230fa67aec

[21] http://www.nber.org/papers/w22327

[22] China is attempting to lure Chinese scientists working overseas as well as foreign researchers with the offer of grants and the opportunity to serve as lead investigators in well-equipped labs. Normile (2018) http://science.sciencemag.org/content/360/6393/1053

[23] As China much like the advanced economies, becomes more services centric, the role for conventional R&D by S&E personnel will diminish and more innovation will come from places other than research laboratories.

Shahid Yusuf

Chief Economist, Growth Dialogue, GWU

Enlarging the role of the RMB is only one strand of China’s globalization strategy, overseas foreign direct investment (OFDI, see above) now spearheaded by the Belt and Road Initiative (BRI) is another. OFDI has four objectives: to secure supplies of energy and raw materials as the economy’s’ dependence on external sources increases; to increase China’s export penetration and create new market opportunities for Chinese firms; to acquire foreign technological expertise, IP and intangible capital by taking over firms in advanced countries; and to enhance China’s connectivity with countries near and far so as bring these into China’s sphere of influence, economic and political. The bulk of China’s OFDI has been channeled into Europe, followed by Asia and North America. BRI and the actions of the Trump Administration could lead to a reallocation favoring Asia (Figure 8).

Until 2014, the PBoC took the lead in acquiring foreign assets (e.g. 80 percent in 2011), mostly low yielding securities such as US T-bills and in the process, it constrained the appreciation of the RMB. By 2016, the share of foreign assets held by private investors and firms had risen to 38 percent. However, the rush to acquire overseas assets, to move funds overseas and to become too big to fail has resulted in a sacrifice of quality in the pursuit of quantity. As a consequence, the return on investment by firms and individuals had declined from 15 percent in 2014 to as little as 0.4 percent on average. This compares with the 4 percent return claimed by the PBoC on its foreign reserves (in 2016) and the 6.8 percent return averaged by US overseas investors (Tang and Beddor 2017; Huang and Tang 2017)[1]. There is a risk that investment associated with BRI while it could further spur Chinese overseas investment, will also generate low returns given the nature of the projects that BRI is likely to target.

Although the strategy underpinning BRI has not been clearly articulated, most commentators are of the view that the Chinese authorities view BRI as a means of achieving three primary objectives. It can facilitate export penetration and give rise to demand for capital equipment and construction materials thereby utilizing excess capacity in Chinese industry not to mention the excess capacity in the construction sector. Such demand plus any additions resulting from increased activity in neighboring countries, can support China’s growth. BRI will tighten China’s economic and political ties with nations along the transport corridors radiating out of China. In other words, BRI can contribute to China’s development and further its international clout. And BRI is a branding exercise contributes to Xi Jinping’s political standing in China[2]. The Economist (July 28^th, 2018, p.7) notes that “BRI is bound up with the growing cult around Mr. Xi. State media call it the “path of Xi Jinping”. It has become shorthand for China’s overseas aid, state-led investment abroad, and for Mr. Xi’s ‘great power diplomacy with Chinese characteristics’”.

China looks for gold down the Silken Corridors

By all accounts, BRI is an enormously ambitious undertaking that encompasses both a “Silk Road” connecting China to Europe via the South China Sea and the Indian Ocean; the Silk belt that envisages six corridors: one snaking through Pakistan to the Arabian; others that lead through Central Asia to Iran; through Mongolia and Russia to Europe; to Turkey; through Indo China all the way to Singapore; plus a Eurasian Landbridge that cuts through Kazakhstan and beyond to 34 destinations in Europe; and satellite and telecommunications networks built by Chinese companies will create a Spatial Information Corridor that will enable participating countries to expand and share broadcasting, communications and imaging services[3]. BRI will be a costly endeavor. It could absorb well in excess of $4 trillion - more than 30 times the amount disbursed by the Marshal Plan that in 2016 dollars amounted to $130 billion. Forty countries have signed on to the BRI and a total of 65 countries are included in the Initiative. The stakes for China are high. The outlay on physical infrastructure will provide a boost to the Chinese economy and employ an army of Chinese construction workers. The successful establishing of economic beachheads by Chinese companies in countries spanned by BRI, could support trade over the long run. Greater connectivity would increase China’s economic sway over Asian countries and even European ones. In effect, if BRI lives up to Xi Jinping’s expectations, China would become the axis of the Eurasian economy – “would bestride the [Eurasian] world like a colossus”[4].

BRI is a gamble and the stakes are high. Infrastructure projects e.g. energy (43%), transport (29%) and water (21%) can generate attractive economic returns if they crowd in productive private investment in other directly productive activities and/or enhance the productivity of existing activities[5]. Whether they do depends upon a host of country specific macroeconomic and institutional factors. Infrastructure projects spanning several countries can be far more difficult to negotiate, design, and implement because of myriad governance and regulatory issues. Not infrequently, the return on investment can be disappointing, which is why private investors have generally shied away[6]. If BRI financed projects do not lead to a rapid payoff in terms of growth, they could quickly become a worrisome liabilities for countries along the Belt. The risks highlighted by the Hurley, Morris and Portelance (2018) [7]and also by the IMF (2018), are that some countries could become burdened by debt and struggle to service the loans received from China and returns guaranteed to its energy and telecommunications companies that have invested in these countries[8]. Pakistan, Sri Lanka, Laos, Tajikistan, Kyrgyzstan, Maldives, Mongolia, Bangladesh, and Djibouti might all become excessively debt encumbered. The newly elected Malaysian government (May 2018) is already moving to shed some transport and gas pipeline projects including the high speed rail link between Kuala Lumpur  and Singapore and the East Coast rail link, fearing that these will become a burden on the exchequer and create debt servicing problems down the road[9]. The recently installed government of Imran Khan in Pakistan is also taking another look at some of the projects that have been completed and others in the pipeline[10].

China’s neighbors along the Belt and Road already fearful of deindustrialization, worry that the purpose of the infrastructure and connectivity is to facilitate the export of Chinese products and services (steel, rolling stock, vehicles, power generating equipment, solar panels, wind turbines, telecom equipment, construction equipment, cement etc.). BRI could exacerbate the resource curse in countries such as Kazakhstan, Turkmenistan and Afghanistan. They could be rendered more resource dependent and their tradable sectors would remain stunted. Others such as Pakistan and Bangladesh could find it difficult to break out of the light manufacturing trap in the face of unrelenting competition from Chinese products.

There are other concerns arising from opacity of tendering practices, the disproportionate role of Chinese firms and suppliers in Chinese funded projects[11], guarantees extended to Chinese Independent Power Producers (IPPs) and the reliance of contractors on Chinese workers[12]. Needless to say, with BRI and its far flung investments in Europe, the US, Africa and Latin America, China is embarked on a vast spending spree to acquire within a decade the economic and political influence that the resurgent Middle Kingdom believes it can rightfully claim.

A global giant builds military muscle

A third strand that is intertwined with the desire to secure supplies of raw materials and to advance (lend greater credence to) China’s claim that it is now an emergent global power, is the creation of a military industrial complex supplying advanced hardware to bring China on par with its rivals in East Asia and across the Pacific[13]. This rapid buildup of military capabilities[14] that include both defensive and offensive weapon systems comparable to those of the US and its allies[15] is proceeding hand in hand with: China’s assertion of its territorial water rights over much of the South China Sea[16]; the militarization of several artificial islands[17] that have been dredged into existence with the help of the world’s largest dredging fleet that has scooped up sand from the ocean floor[18]; a more threatening posture with respect to Taiwan backed by the building of amphibious landing platforms and flights by H-6K bombers around the island; the increasing frequency of long distance training flights by the PLA Air force[19]; the more visible presence of Chinese naval vessels in the Indian Ocean and beyond[20]; and a more aggressive pressing of its claim over the islands in the Senkaku/Diaoyu Chain, which has heightened tensions with Japan.

Both the BRI and China’s strengthening of its military capabilities are making its influence felt in the region and beyond. This is of concern to the US that senses the erosion of its capacity to militarily maintain the upper hand in the Pacific and honor its treaties[21]. It is a concern also for Japan, the Republic of Korea, Southeast Asian countries, and India that are being compelled to come to terms with China’s economic dominance, its military potential and its growing international political influence[22].

Were China to maintain or even somewhat increase the 2 percent share of GDP it spends on its military (well below the 3+ percent that the US spends and lower also than spending by Russia and Korea.)[23], there can be little doubt that it will build a formidable war machine able to decisively challenge the US and its allies[24]. In particular, the newly constituted Rocket Force (PLARF) is strengthening China’s nuclear and non-nuclear missile capabilities (e.g. with the deployment of solid fueled and mobile DF 26, DF31AG and DF41 missiles[25]. The PLARF is also acquiring anti-ship and anti-aircraft weaponry that will make it hazardous for US carrier fleets and AEW aircraft to operate in close proximity to China thereby neutralizing their current threat potential[26]. Mark Stokes (2014, p.243) writes that “Chinese analysts view disruption of US ability to project conventional power as legitimate force modernization requirement….Increasingly accurate and lethal ballistic and land based cruise missiles[can] suppress air defenses and air operations…More advanced conventional air assets, integrated with persistent surveillance, a single air and space picture, and survivable communications architecture, could give China greater confidence (2014) in enforcing a broader range of territorial claims around its periphery”.[27]

What sort of power balance  - if any - prevails in the Region remains to be seen. Given the surfacing of isolationist tendencies in the US and the declining credibility of US defense assurances, there is the possibility that Japan and Korea may be compelled to develop their own nuclear arsenal as a counter to China and North Korea[28]. A threatening China could also induce Southeast Asian nations to redouble their outlay on their militaries. The list of imponderables is long. It includes ineptitude and miscalculation on the part of political leaders; dysfunctional techno nationalism; an arms race harnessing AI and automation for military purposes; and a greater readiness to use damaging cyberattacks[29]. Whether the rising power could precipitate a showdown with the ruling power – the so-called Thucydides Trap[30] – is a concern albeit perhaps a distant one. All that one can say at this stage is that China continues to gain in economic strength and the odds appear to be tilting militarily in China’s favor with erratic signals from Washington strengthening China’s hand vis-à-vis other nations in the Asian region.

[1] https://foreignpolicy.com/2017/10/17/its-no-accident-that-chinas-tycoons-are-bad-investors/;  https://piie.com/blogs/china-economic-watch/why-china-curbing-outbound-direct-investment

[2] BRI has been incorporated into China’s constitution via an amendment.

[3] China is contracting with countries along the Belt and Road to build and launch communications and weather monitoring satellites.

[4] Cassius referring to Julius Caesar. Act I, Scene II. On China’s use of rail and other transport links to further its diplomatic goals, see Will Doig (2018). High Speed Empire. Columbia University Press. New York.

[5] Infrastructure was not the growth driver in the East Asian tiger economies during the 1960s and 1970s. Infrastructure investment facilitated their manufacturing led growth. It was a handmaiden. The same is true for China in the 1980s and 1990s. It is only in the last decade that infrastructure and real estate have emerged as significant growth drivers. For China, infrastructure led growth over the past decade, has been costly with much misallocation of capital, and it now seems to be running out of steam.

[6] Bankable infrastructure projects tend to be scarce with private investors needing to be coaxed by guarantees co-financing and other sweeteners.

[7] https://www.cgdev.org/sites/default/files/examining-debt-implications-belt-and-road-initiative-policy-perspective.pdf;  https://www.snl.com/interactivex/article.aspx?id=44203532&Printable=1&KPLT=7

[8] For example, Chinese IPPs (independent Power Producers) in Pakistan are guaranteed in dollar terms a return of 17 percent on their equity. Husain (2017) https://www.dawn.com/news/1313992

[9] https://www.bloomberg.com/news/articles/2018-05-28/mahathir-to-scrap-malaysia-singapore-high-speed-rail-project

[10] Financial Times. Sept. 10^th 2018. “Pakistan joins backlash against terms imposed in China’s BRI deals”.

[11] Hillman (2018) https://www.csis.org/analysis/chinas-belt-and-road-initiative-five-years-later-0

[12] On these and other issues, see Yusuf (2018). http://www.saisreview.org/2018/01/09/chinas-belt-and-road-gamble-can-it-deliver/; http://growthdialogue.org/chinas-silk-road-belt-path-prosperity/

[13] https://www.uscc.gov/Hearings/chinas-military-reforms-and-modernization-implications-united-states; China’s efforts at modernizing its military shifted into higher gear after it observed the US’s military might in action during the Gulf War. The need to build capabilities was further sharpened following the face off against the US navy during the Taiwan Crisis of 1996 when the US sent two carrier groups in response to Chinese live fire exercises in the Taiwan Straits. David Shambaugh (2002). Modernizing China’s Military. University of California Press. Berkeley CA; On the defense economy, see Tai Ming Cheung (2009). Fortifying China. Cornell University Press. Ithaca NY.

[14] Char and Bitzinger (2017) https://www.cambridge.org/core/journals/china-quarterly/article/new-direction-in-the-peoples-liberation-armys-emergent-strategic-thinking-roles-and-missions/9145F7E8DBCAC4DE5F50B51C40AAB0A5

[15] https://www.uscc.gov/Press_Releases/new-report-chinas-advanced-weapons-systems

[16] At a meeting in June 2018 with US defense Secretary Jim Mattis, Xi Jinping said that China would not yield “one inch of the territory left behind by our ancestors” as defined by its Nine Dash Line that encompasses about 90 percent of the South China Sea. Financial Times, June 29^th 2018, p.2.

[17] The airstrips and other military installations have been constructed on Mischief Reef a part of the Spratly Islands, 135 miles from Palawan claimed by the Philippines, and on Woody Island also claimed by Vietnam and Taiwan. https://qz.com/863811/mischief-reef-how-a-fishermens-shelter-on-stilts-became-a-chinese-military-base-in-the-south-china-sea/

[18] Vince Beiser (2018). The World in a Grain. Penguin, Random House. New York.

[19] https://www.uscc.gov/Research/chinese-air-force’s-long-distance-training-over-water-continues-increase-and-expand

[20] https://economictimes.indiatimes.com/news/defence/14-chinese-navy-ships-spotted-in-indian-ocean-indian-navy-monitoring-locations/articleshow/61882634.cms;  https://thediplomat.com/tag/chinese-submarines-in-indian-ocean/

[21] http://www.chinafile.com/conversation/could-china-now-defeat-united-states-battle-over-south-china-sea-or-taiwan

[22] Publishers are warned to be careful about what they print on Tibet. Airlines must refer to Taiwan as a Province of China. World leaders must think twice before they meet with the Dalai Lama. Researchers need to be aware of Chinese sensitivities. And China’s trading partners must learn to toe the Chinese line or face repercussions – Korean garlic might suddenly lose its Chinese market; or Chinese tourists might suddenly head for other countries.

[23] Arriving at exact data on what China spends has proven difficult however, CSIS (2018) reviews the best guesstimates. https://chinapower.csis.org/military-spending/

[24] In PPP terms, China’s spending is much closer to that of the US. See Figure 9.

[25] Ni and Gill (2018) https://jamestown.org/program/chinas-new-missile-force-new-ambitions-new-challenges-part-1/

[26] Goldstein (2017) https://www.cambridge.org/core/journals/china-quarterly/article/uschina-naval-balance-in-the-asiapacific-an-overview/96A3A78CFDF6E4C6ED690204593A12DF; Michael Fabey (2017). Crashback: The Power Clash Between the US and China in the Pacific. Scribner. New York. 

[27] Mark Stokes (2014). China’s Evolving Space and Missile Industry. In Tai Ming Cheung (2014) ed. Forging China’s Military Might. Johns Hopkins Press. Baltimore MD.

[28] That mutually assured destruction (MAD) is a lose-lose strategy might soon be forgotten. Toon et al (2017) http://climate.envsci.rutgers.edu/pdf/ToonAsianStudies.pdf

[29] https://www.rand.org/blog/2017/03/why-its-so-hard-to-stop-a-cyberattack-and-even-harder.html

[30] Allison (2015) https://www.belfercenter.org/publication/thucydides-trap-are-us-and-china-headed-war;  http://www.eastasiaforum.org/2017/08/17/are-china-and-the-us-falling-into-the-thucydides-trap/. Drawing on the writings of classicists such as Donald Kagan and Ernst Badian, Arthur Waldron (2017) explicates the origins of the Peloponnesian War and the role of the so-called rising power, Athens in precipitating the hostilities with Sparta. Badian for one believed that Thucydides was biased and sought to minimize Athens’s culpability. https://www.straitstimes.com/opinion/there-is-no-thucydides-trap. See also the review of Allison’s volume and other books on the topic by Ian Baruma (2017)  https://www.newyorker.com/magazine/2017/06/19/are-china-and-the-united-states-headed-for-war