Market vs. Government in Managing the Chinese Economy: Domestic and International Challenges Under Xi Jinping

This essay is a reflection of what I wrote five years ago on the Decisions of the 11th Party Congress’ 3rd Plenum of China’s Communist Party in 2013 (Liu, 2014). In the original essay, I pointed out that the dominant role played by state ownership stated in the Decisions somewhat contradicts the decisive role of the market in the same Decisions. My concern at that time was on the direction of change regarding the roles of market versus government in the economy. This seems to be an appropriate time to evaluate what has happened during the past five years under President Xi Jinping and what to expect in the future.

Overall, the trend of changes under Xi seems troubling both domestically and internationally. At home, Xi is now president for life after a constitutional change approved by the Communist Party. On the economy, the government has intentionally and unintentionally been pursuing policies that strengthened the state-owned sectors. In the following, I will discuss primarily the following two issues: (1) state versus market in the Chinese economy under Xi with a special focus on China’s industrial policies; and (2) the ongoing trade war between the U.S. and China.

State versus Market in the Economy under Xi and China’s Industrial Policies

Over the last several decades, the relative role of state-owned sectors has been declining. Based on the data from the National Bureau of Statistics of China, Lardy (2014) shows that the share of state-owned sectors in industrial output dropped from 78 percent in 1978 to only 26 percent in 2011.  He also shows that, between 1995 and 2014, the export share of state-owned companies dropped from 67 percent to 11 percent. However, many critical and strategic sectors such as banking, infrastructure, and some upstream sectors are still largely controlled by state-owned companies. Some people attribute China’s economic success to the strong role of government in managing the economy, and name this path of economic development the “China model.” Because the state-owned sectors are the major participants implementing the government’s strategies, many economists and policymakers in China begin to emphasize the importance of state-owned sectors in national development and international expansion. The emphasis on state-owned enterprises in China is not a surprise given what was stated in the above-mentionedDecisions of 2013, but it raises a renewed concern of the retreat of private sectors, which have been the true engine of the economic growth in China over the last several decades.

Although Xi probably has no intention to reverse the course of China’s market reforms, he doesn’t seem to emphasize the importance of continued economic reforms and the development of private sectors, not to say political reforms. Due to the close relationship between government and state-owned sectors, a natural consequence is a system favoring state-controlled firms. In recent years, the “advancement of state-owned sectors and the retreat of private sectors” (guo jin min tui) are particularly worrisome. The retreat of private sectors may not be the intention of the government, but rather a side effect of the over-emphasis on the importance of state-owned sectors. This problem can be driven by a few factors. One of them is the 2008 world financial crisis. Against this backdrop, countries including China implemented the against-wind macroeconomic policies through rescue plans, quantitative easing, stimulus programs, etc. In China, state-owned companies have played an important role in implementing the stimulus policies while private sectors were reluctant to invest. In addition, to switch from the original development strategy built on low wages and labor-intensive industries, the Chinese government has been trying to redirect resources toward more high-tech sectors. Due to externalities, the lack of resources, and less favorable economic prospects since the 2008 financial crisis, private firms – except a small number of large ones – have little incentive to invest in high technologies. State-owned companies naturally become “better” candidates in fulfilling the goal of climbing the technology ladder and industrial upgrading. Accordingly, state-owned companies backed by the government also receive preferential treatment in the areas such as financing. On the contrary, private sectors find it increasingly difficult to compete against state-owned companies to secure loans, especially those with good terms. As documented by Lardy (2019), 57 percent of loans went to private firms and 35 percent to state-controlled firms in 2013 when Xi just assumed office. By 2016, state-controlled firms received 83 percent of loans, compared with 11 percent for private firms. This is also shown by Harrison et al. (2019): currently state-owned firms receive more subsidies and lower interest rates than formerly state-owned firms, which in turn, are favored relative to always-private firms. This happened despite the fact that the profitability of private-sector firms is more than double that of state-controlled companies. Much of this lending came from state-owned banks. The induced inefficiency can be huge. This is why many entrepreneurs and economists in China called for “competitive neutrality” to make sure that private and state-owned sectors receive similar treatment and are on a level playing field. Finally, some market-oriented reforms have unintended consequences. For example, the sudden crackdown of shadow banking seems to be a move in the right direction, but could block the only access of small private firms to credit, and indirectly provide state-owned sectors even more favorable conditions relative to private sectors in the credit market.

The government can intervene in the economy in many ways. Besides regulations, monetary and fiscal policies used in typical market economies, a government can lay a heavy hand on the economy through other means such as state-owned or sponsored enterprises, industrial policies, and government procurement. Industrial policy is the major channel through which the Chinese government implements its development strategies, which culminates with the recent Made in China 2025 Initiative. MIC2025 first appears in the 2015 Report on the Work of the Government and again in the reports of 2016 through 2018. The Report (2015) states, “We will implement the ‘Made in China 2025’ strategy; seek innovation-driven development; apply smart technologies; strengthen foundations; pursue green development; and redouble our efforts to upgrade China from a manufacturer of quantity to one of quality.” The Report (2016) states, “We launched the ‘Made in China 2025’ initiative to upgrade manufacturing, set up government funds to encourage investment in emerging industries, and to develop small and medium-sized enterprises, and establish more national innovation demonstration zones.” The Report (2017) states, “We developed and launched a plan for completing major science and technology programs by 2030…. We will intensify efforts to implement the ‘Made in China 2025’ initiative… we will adopt a variety of supportive measures for technological upgrading and re-energize traditional industries.” The Report (2018) states, “Implementation of the ‘Made in China 2025’ initiative has brought progress in major projects like the building of robust industrial foundations, smart manufacturing, and green manufacturing, and has accelerated the development of advanced manufacturing.” As an ambitious plan to upgrade the Chinese economy by climbing the technology ladder, the “Made in China 2025” initiative lays out the strong state-directed industrial policies.

Industrial policies have been used by most of the countries in the world at certain stages of development. We have seen more failures than successes.  These policies often create tension among countries in the era of globalization, especially when a country is large, because firms in different countries and sectors may no longer be on a level playing field. Depending on how domestic firms acquire their technologies, the protection of intellectual property rights also becomes a concern of many western companies that are strongly against forced technology transfers and infringement of intellectual property rights. This is why MIC2025 has attracted so much attention and is one of the major reasons behind the 2018 U.S.-China trade war. This is probably why a similar statement on MIC2025 disappears from the 2019 Report on the Work of the Government to avoid further escalation of such disputes. The Chinese government seems flexible enough to accommodate the requests and concerns from other nations. However, this by no means implies that China has abandoned its MIC2025 Initiative. It is unrealistic to stop the practice of industrial policies in China (or any other major economy), so the best we could do is probably to develop an approach for open discussions. To ensure effective negotiations, countries should at least have a mutual understanding of information sharing and fairness.

I end this section with a discussion of the so-called “China model” or “Socialism with Chinese Characteristics” with strong government involvement. This strategy has its advantage in certain countries at particular states of economic development. Besides addressing market failures such as public goods and externalities, the government can help gather limited resources and make concerted nationwide efforts to target specific development goals so that a developing country can catch up with advanced countries more quickly. The more centralized system and state-owned companies have played important roles in the economic development in China, especially in certain areas like infrastructure. Tighter regulations and the gradual opening of financial markets help to contain risks and avoid large-scale financial crises. China’s economic success has offered valuable insight to both developing and developed countries around the world. However, placing too much confidence in government- and state-owned sectors is dangerous. As stated in my original essay five years ago, this ignores the basic fact that China’s economic miracle has been driven by market reforms rather than government control. It is important to realize that the so-called the market economy with Chinese characteristics is a transition period from a destined-to-fail socialist regime to a more efficient market regime.  Its outstanding performance during the last several decades in China should not be over-emphasized. On the contrary, China’s success demonstrates how severely the economic capacity of China was depressed under the socialist policy before the reform.  The Chinese economy took off and prospered when the government gradually released its control. The past success can be a poor guide for the future. To ensure continued economic prosperity, China needs deeper market reforms, not a reversal of this policy with a stronger hand of government on the economy.

Trade War between the U.S. and China

Global free trade is a natural extension of a free market economy within a country. The benefits from trade are now well understood. China’s economic size (GDP) has grown 10 times larger from about $1.4 trillion since its 2001 entry into the World Trade Organization to about $14 trillion in 2019 (predicted). When China grows into a global power, its domestic policies have important international implications. The “China model” featured with state capitalism can clash with western market economies. In state capitalism, the government owns and provides preferential treatment to businesses in critical sectors in the name of industrial policies. Although many countries in the west also implement certain industrial policies – such as the support to high-tech or green technologies – their polices are relatively more transparent than in developing countries like China. The combination of state capitalism and the lack of transparency in China, as well as the influence of interest groups through lobbying in many western economies, pose tremendous challenges when the international community seeks to promote an open, competitive and fair system through multilateral talks under the WTO framework. Large countries like the U.S. may abandon multilateral trade talks and initiate a trade war. I believe that this is a fundamental reason behind the trade wars initiated unilaterally by the Trump administration.

To make things worse, in the international sphere, Xi has abandoned the policies under previous leadership since Deng Xiaoping by keeping a low profile and focusing on domestic economic reform and development. Instead, Xi seems to be more interested in advocating the “China model” for other developing countries to emulate as an alternative to western market capitalism. Xi has spelled out openly his ambitious plans to exert a greater influence on the rest of the world through strategies like “One Belt One Road” and MIC2025 initiatives. Although these initiatives are considered strategic plans for the future in China, the goals are more or less incompatible with other statements, e.g., the claimed developing country status that makes China qualified for preferential treatment under various international agreements, such as the WTO. As a result, China has paid the price: the 2018 trade and economic war between the U.S. and China, among other international disputes and conflicts. As Reuters reported (Miles, 2019), the U.S. is drafting WTO reform to halt handouts for big and rich states that claim to be developing nations, including China, India, etc. Special and Differential treatment (S&D) under the WTO entitles developing countries to longer time periods for implementing commitments, measures to increase trading opportunities, provisions requiring all WTO members to safeguard the trade interests of developing countries, support to help developing countries build the capacity to carry out WTO work, handle disputes, and implement technical standards, and provisions related to least-developed country (LDC) members. The WTO currently allows countries to self-designate as developing countries. The U.S. draft reform posted on the WTO website said current and future trade negotiations should withhold such special treatment from countries classified as “high income” by the World Bank, OECD members or acceding members, G20 nations and any state accounting for 0.5 percent or more of world trade.

The U.S.-China trade war has gone far beyond trade into many other areas including investment and technology. In 2018, the U.S. Congress passed the Foreign Investment Risk Review Modernization Act (FIRRMA), expanding the authority of the Committee on Foreign Investment in the United States (CFIUS) to include mandatory filings. FIRRMA is a legal hurdle to stop foreign firms from investing in the U.S. and acquiring American businesses in key sectors: filing fees,approval process, and expanded scope of coverage. In addition to the FIRRMA legislation, the Export Controls Act of 2018 was also passed to mitigate technology transfer activity from the U.S. to China. The U.S. had proposed sanctions against the Chinese state-owned company ZTE, but defused after agreement, and then placed sanctions against other Chinese firms including Huawei. Recent accusations of forced technology transfers, discriminatory licensing of American firms in exchange for market access in China, unfair ruling of IP disputes, government-facilitated acquisition overseas, cyber-attacks, stealing of technology and trade secrets (e.g., the investigations of the scholars in the 1000 Talents Program and even proposed restrictions on the exchanges of students and scholars), and violations of Iran sanctions by Chinese companies such as ZTE and Huawei. Under the pressure, China has agreed to revise IPR rules and step up IP protection and grant more market access. ¹

In the following part of this essay, I will focus on the 2018-2019 trade war between the U.S. and China. We know that China has been running a huge trade surplus with the U.S. The main concerns of the U.S. are China’s exchange rate manipulation, industrial subsidies, and slow delivery of WTO commitments in the areas of market access, government procurement, and subsidy notifications. I don’t think the Trump administration has any intention to change the U.S.’s open trade policy. Tariffs are just a means for the U.S. to demand a level playing field from other countries including China, India and allies such as the EU, Japan, and Canada, although different countries may have different interpretations of fairness in trade. The U.S., of course, could bring the case to the WTO as has been done numerous times in the form of anti-dumping or countervailing charges. But the process can be long, especially given the lack of transparency in China’s economic policies. As the U.S. claimed, China hasn’t made much progress on delivering subsidy notifications to the WTO. Without sufficient information and a formal channel to obtain the required information, it is hard to resolve the conflicts through appropriate channels recommended by the WTO. Together with the pressure to get reelected, this is probably why the Trump administration sets aside the WTO and approaches China directly through bilateral trade wars and talks. Note that, in this essay, I focus on issues that require international cooperation, keeping in mind that the U.S. domestic policies are also responsible for its large trade deficit.²

Given the obvious costs of the trade war, the right solution is still multilateral (WTO) or bilateral negotiations. After many rounds of high-level talks, several threats and setbacks, the U.S.-China trade negotiations have been going through a scary roller coaster ride. Although the two parties agreed at the G20 meeting in late June 2019 to sit down again to negotiate, the prospect is still unclear. Just recently, Donald Trump announced a new round of tariffs on imports from China that would go into effect September 1, 2019. Although this leaves a short window for the two parties to try to work out their differences, it is a tough task. Progress could be made if China starts to buy more American products, strengthens IPR protection, speeds up financial market liberalization, grants more market access to American firms, and refrains from manipulating currency, and the U.S. removes tariffs on Chinese products over time. Resolving some other issues such as transparency on subsidies, information-censoring, and the modification of China’s laws, however, may require drastic economic and even political reforms, which the Chinese government is reluctant to do, at least in the short run. Despite the differences in opinions, the intertwined economic interests make the trade war too costly for both countries to afford. But the process to achieve free trade can be a long one.

One insight we gain from the U.S.-Japan trade negotiation in 1980s is that it can take a long time for two economic powers to settle trade disputes. China has learned the lesson from Japan and will likely refuse to make drastic changes such as currency appreciation, so this can make the U.S.-China negotiation even more prolonged. Therefore, both the U.S. and China should be patient throughout this process. In recent years, we have seen an increasing divide between the U.S. and China on the timing for a resolution to address these issues. At an international symposium to commemorate the 40^thAnniversary of Normalization of U.S.-China Diplomatic Relations at the Carter Center in Atlanta in early 2019, I raised the concern about the possible escalation of the U.S.-China trade war and suggested a gradual approach for the bilateral negotiation.  Mr. Craig Allen (President of the U.S.-China Business Council) pointed out that the time for U.S.-China trade talk is running out. He said that China prefers to follow a gradual approach and needs another 10 or 20 years to implement deeper reform and open policies, while the U.S. has lost patience saying that China has delayed fulfilling its commitments at the entry of the WTO for a long time and these should have been done yesterday. Facing this stalemate, the two countries were dragged into a trade war in 2018.

Initially, as stated in a draft framework for negotiation by the U.S. Delegation (2018), the U.S. demands “China immediately remove market-distorting subsidies and other types of government support that can contribute to the creation or maintenance of excess capacity in the industries targeted by the Made in China 2025 industrial plan.” The U.S. demands that China eliminate specified policies and practices with respect to technology transfer within a few months and must concede to the U.S.’s enforcement mechanisms without retaliation. In addition, China must abandon its state-led economic development model, which would be politically difficult to swallow in China because a large part of the economic success of China is based on this type of policy. Indeed, accepting U.S. demands likely would require not just a policy paradigm shift, but also a regime change, which is impossible to accomplish in the short run. The U.S. cannot expect that China will scrap its economic model overnight. With the intertwined interests and complicated relations, we have to be patient with U.S.-China negotiations. On the other hand, if the U.S. condones China’s state capitalism, this would legitimize a system that puts U.S. firms at a permanent disadvantage. To be realistic, the U.S. needs to continue to press China to speed up its economic reforms through bilateral and multilateral talks, but at the same time have patience to work things out with China, probably following the approach of the U.S.-Japan negotiations in 1980s.

China should take U.S. demands seriously and make meaningful changes as quickly as possible. To address its large trade imbalance, China should adopt a more market-determined exchange rate policy, continue with structural reform by transforming an investment- and export-driven economy to a domestic consumption-driven economy, and contain the risk from excessive borrowing and underperforming state-owned sectors.

It is important to understand China before pressing the government for a deeper reform and drastic changes. The last part of this essay will address this issue in a broader context, not just the trade war. China has been following a gradual approach in its economic reform and opening. It has proved to be very successful during the past several decades, not only helping China to reap the benefits from having an increasingly market-oriented system, but also avoiding the sudden shocks from drastic reforms. Despite being authoritarian politically, China has managed to transfer powers peacefully and maintain a very stable economic and political environment. But whether China should continue with this approach is controversial. The potential dividend from this approach has largely been redeemed. To revive the economy, China now needs a new approach that encourages innovation in a competitive economic and political environment, without relying heavily on cheap excess labor and distortive government policies. This new development model requires deeper institutional reforms. Although most people believe China should eventually embrace a fuller market economy, the timing is hard to judge. A drastic reform will create a series of new problems and hence may face opposition in both business and political circles. For example, as mentioned earlier, a drastic change in regulation in the credit markets by prohibiting shadow banking seems to be a sign of progress in China, but it can do more harm to small private businesses if other accompanying policies are not in place.

Since the 1980s, the Chinese government has claimed to continue to pursue an open and reform policy. Even under the current administration, the 2017 Report of Work of Government states, “We will make big moves to improve the environment for foreign investors. We will revise the catalog of industries open to foreign investment, and make service industries, manufacturing, and mining more open to foreign investment. We will encourage foreign-invested firms to be listed and issue bonds in China and allow them to take part in national science and technology projects. Foreign firms will be treated the same as domestic firms when it comes to license applications, standards-setting, and government procurement, and will enjoy the same preferential policies under the Made in China 2025 initiative. Local governments can, within the scope of the powers granted them by law, adopt preferential policies to attract foreign investment. We will build 11 high-standard pilot free-trade zones, and widespread practices developed in these zones that are proven to work… China’s door is going to keep on opening wider, and China will keep working to be the most attractive destination for foreign investment.”

Concluding Thoughts

Despite the claims or promises by the Chinese government, other countries have been concerned about the actual implementation and the political constraint, even though China’s continued economic success has disappointed many people who predicted China’s collapse. China has actually done pretty well in keeping promises and carrying out the open and reform policies, but it becomes increasingly difficult to implement deeper reforms. This problem has become more evident during the past decade. In the case of the trade war, even if the U.S. and China successfully sign an agreement later this year, the implementation will certainly be a central issue for discussion. The U.S. and some other countries have accused China of not implementing promised changes that were part of its commitments for entry into the WTO. As another example, in the original essay (Liu, 2014), I mentioned particularly the Shanghai Pilot Free Trade Zone. Adopting a negative list approach, this is demonstration of the decentralization of power in areas including trade, investment, financial reforms, and regulations. It is useful to look at what has been achieved during the past five years, but it turns out not much has been done. On banking services liberalization, for example, due to many regulations and slow opening of Chinese market, the presence of foreign banks and their services are still very limited in China as compared to domestic state-owned banks. The essence of these free trade zones is minimal government intervention, which is hard to achieve in China. The implementation of the free zone polices requires deeper economic and even political reform and changes in related laws and regulations on foreign companies and joint ventures. This explains why it has not been as successful as the first round of special economic zone experiments under Deng Xiaoping in the 1980s.

As a final note, China should have already realized that it needs to make significant and meaningful changes in its policies, but it is unlikely that it will make drastic economic and political reform to satisfy all of the demands from the U.S. and other western countries. Given the size and importance of China’s economy, however, western countries cannot afford an economic decoupling with China.  Therefore, a practical approach in multilateral and bilateral negotiations is needed. This can be a long process and may become the new norm. A minimum requirement for successful negotiations is transparency in policies. For example, all nations including China and other developing countries should disclose their industrial policies and notify other WTO members regarding their subsidies as required by the WTO. This is easier to say than to do. Transparency is actually a tough issue to address in China because it will eventually involve political reforms. Instead of relying on censorship and firewalls to block citizens’ access to information, Chinese leaders should be more confident to embrace an open society. This will benefit China’s long-run growth, and also help China to integrate better with other countries in today’s globalized economy.

References

Harrison, Ann, Marshall Meyer, Peichun Wang, Linda Zhao, and Minyuan Zhao, 2019. “Can a Tiger Change Its Stripes? Reform of Chinese State-Owned Enterprises in the Penumbra of the State.” NBER Working Paper No. 25475

Lardy, Nicholas, 2014. Markets over Mao: The Rise of Private Business in China. Peterson Institute for International Economics, Washington D.C.

Lardy, Nicholas, 2019. The State Strikes Back: The End of Economic Reform in China?Peterson Institute for International Economics, Washington D.C.

Liu, Xuepeng, 2014. “Market vs. Government in Managing the Chinese Economy.” China Currents 13(2)

Source: https://www.chinacenter.net/2014/china_currents/13-2/market-vs-government-in-managing-the-chinese-economy/

Miles, Tom, 2019. “U.S. drafts WTO reform to halt handouts for big and rich states.” Source:https://www.reuters.com/article/us-usa-trade-wto/u-s-drafts-wto-reform-to-halt-handouts-for-big-and-rich-states-idU.S.KCN1Q426T

The Report on the Work of the Government of People’s Republic of China (2015)
Source:http://english.gov.cn/archive/publications/2015/03/05/content_281475066179954.htm

The Report on the Work of the Government of People’s Republic of China (2016)
Source:http://english.gov.cn/premier/news/2016/03/17/content_281475309417987.htm

The Report on the Work of the Government of People’s Republic of China (2017)
Source:http://www.xinhuanet.com/english/china/2017-03/16/c_136134017.htm

The Report on the Work of the Government of People’s Republic of China (2018)
Source:http://en.people.cn/n3/2018/0403/c90000-9445262.html

U.S. Delegation, 2018. “Balancing the Trade Relationship between the United States of American and People’s Republic of China.”

Source:https://xqdoc.imedao.com/16329fa0c8b2da913fc9058b.pdf