Chinese Economic Policy since the Global Financial Crisis: The New State Activism

1. Chinese Economic Policy since the Global Financial Crisis:The New State Activism Barry Naughton University of California, San Diego Rio de Janeiro

2. Since the Global Financial Crisis… • The financial crisis was a major turning point in Chinese economic policy. • Government has become much more actively engaged in shaping the trajectory of economic development. • Two simple points: • This change is new and significant. • It represents an enormous gamble, with costs and benefits that are not yet known.

3. 1. Background: The Big Picture • By the turn of the 21st century, China had accomplished two remarkable things. • No. 1, it had established the fundamental framework of a market economy, including • A substantial role for private business • A solid foundation for public finances • Agreement on a framework for international exchanges, through W.T.O. accession. • Rudiments of a domestic legal and regulatory framework.

4. Diverse Ownership Structure

5. Launch new tax system and SOE reform

6. No. 2: High Input, High Growth • An institutional framework that was highly tailored to support investment and growth. • Highest physical capital investment rate in the world; • Very rapid labor force growth. • Highest sustained growth rate ever achieved by any economy. • High cost: Consumption/GDP low; energy and materials usage high; pollution serious; income distribution bad & deteriorating. • Not sustainable: Labor force growth and structural transformation must slow down; as incomes and wages rise, will China face “middle income trap”?

7. 2.Hu-Wen Administration (2003-13) Sought to Modify Economic Strategy Reform Fatigue: High unemployment after mass lay-offs; health system collapsed; anxiety about impending WTO membership. Sought a “people-oriented” policy (以人为本), and a “harmonious society (和谐社会). What was the content of these new policies to be? How radical a departure from the 1990s? Examine three key policy areas to find out:

8. A. Rebuild Welfare Institutions Cautious and incremental effort to rebuild social service institutions and reduce the large urban-rural gap. Moderate but unambiguously positive effects: • Agricultural taxes reduced, then abolished. • To accommodate the reduction in local revenues the national fiscal system became much more redistributive. • Pilot program to promote universal free elementary education created and gradually expanded. • Pilot rudimentary rural cooperative health insurance scheme created and gradually expanded. These initial programs were highly consistent with, and complementary to, a well-functioning market economy.

9. A more fundamental re-thinking? The 11th Five Year Plan, to cover 2006-2010, came out at the end of 2005. The Plan was the product of a surprisingly wide process of consultation and brain-storming, more of a vision statement than a traditional five-year plan. Innovative elements included an emphasis on environmental improvement and sustainability. Most important was an emphasis on investment in human resources. This reflected both a backward-looking critique of China’s physical capital investment-driven growth model, as well as a forward-looking awareness of the need to shift to a more sophisticated development strategy as China approached middle-income status. The plan was very general, so it was left unclear what measures government would take to implement the plan; there was an ambiguity here is between social policy (adapted to these changes) and social engineering (driving the changes).

10. B. Stabilize State Ownership State Asset Supervision and Administration Commission (SASAC) created to exercise authority over the large central-run firms. A reform step in that SASAC is an “ownership agency,” independent of the government administrative apparatus, with control limited to defined set of subordinate companies But SASAC was also a step toward decelerating ownership reform. Core mandate to “maintain and increase of the value of public assets.” End of managerial buy-outs for large firms, and new commitment to maintain a significant state sector. SASAC never succeeded in articulating clear limits to public ownership, failed effort in 2007. Too many sectors included, and list never publicly released. Ambiguity between further reforms of state firms through improved corporate governance, versus protecting and rebuilding the size of the state sector.

11. C. Technology / Industrial Policy: Medium - Long Term S&T Development Program (2006-2020) • Introduces “indigenous innovation.” Argues: “Experience shows us that we cannot buy true core technologies in the key fields that affect the lifeblood of the national economy and national security.” • Lays out 16 Engineering “Megaprojects.” These are “to be completed within certain time frames through core technology breakthroughs and resource integration in order to achieve national goals; they are the priority of priorities in China's S&T development.” Including: • very-large-scale integrated circuit manufacturing technologies • nuclear power stations with large-scale advanced pressurized water reactors; • prevention and treatment of AIDS, viral hepatitis, and infectious diseases; • large civilian aircraft; etc. • Instruments such as taxation relief; procurement preference; and subsidized credit. • Ambiguity: Nationalist, centralized and top-down, but incremental.

12. An Ambiguous Shift in Direction By the middle of the decade, the Hu-Wen Administration had engineered a coherent shift in overall economic development policy. The 1990s emphasis on building market institutions and reforming the economy had been replaced with a new emphasis on rebuilding social institutions and investing in human resources and technology. The shift away from economic reform was not large and it did not undo any of the major achievements of earlier reforms. Moreover, it was concentrated in areas where market failures are known to be severe: health care, insurance, education, and investment in new technology. The new development strategy had many positive aspects. The emphasis on human capital investment was a positive alternative to over-investment in physical capital. The shift to sectors with a higher skill content was a natural step in China’s rapid development, and consistent with evolution to a more diverse and sophisticated labor force, that would also create a more diverse and sophisticated domestic consumer market. More government steerage and intervention in the economy was compatible with a modest course correction, and a positive synthesis between a market economy and government intervention.

13. 3. The U.S. financial crisis changed everything. It shattered a 30-year-old presumption that the US model was the best & that China would move steadily in this general direction. It elicited a very strong stimulus response in China, which was successful in insulating China from the worst of the crisis. We would consider this a strongly Keynesian response to crisis (to be wound down after the crisis is past). The Chinese leadership concluded that this was evidence of broader strength, and for the first time argued that their current system of strong government and market economy is superior to a U.S.-style system (no need to scale it back). China’s current successes and problems all trace back to the choices made in late 2008-early 2009. First among these is a surge of liquidity.

14. Crisis caused the acceleration and reformulation of the development strategy shift already underway. Increasingly common rationales included: • We have to pump money into the economy to avoid crisis anyway, so we can do the things we’ve always wanted to do. • The advanced countries will pump money into their economies to support their strategic industries of the future, so we have to do the same, or we will be left behind. • The ability to shape the macroeconomic trajectory is a strength of our system, so we should use it pro-actively. The emphasis on re-balancing was played down; the emphasis on direct government intervention to restructure the economy was increased.

16. Rapid expansion and acceleration of local projects and national programs Planned infrastructure investment of 4 trillion RMB (US $586 Billion) was announced quickly, but the overall response was much bigger, more complex. Tens of thousands of local infrastructure projects were launched; but so were hundreds of large-scale central government projects. Example: “16 Mega-Projects” to be rolled out gradually over 15 years 2005-2020. In early 2009, decided to begin all 16 by year-end. Agreed to give Chongqing aid and policy breaks worth 800 B. RMB through 2020 to support “Chongqing Model”

17. Shanghai-Hangzhou line, October 13, 2010. (Just Opened for passengers.) China’s high speed rail is an example of a project under development for a long time, that was suddenly accelerated in the wake of the global financial crisis.

18. Stimulus Policy was Successful, and success was interpreted broadly. We learned from the crisis the need to “fully bring to bear the superiority of the socialist system in effective decision-making, a powerful organization and concentrated power to accomplish big things.” “充分发挥我国社会主义制度决策高 效、组织有力、集中力量办大事的优势。” • Wen Jiabao, Government Work Report, March 2010, reporting on the official lessons learned from the crisis.

19. 4A. Expansion of Social Policies Health: Within the last three years, China has rolled out two new health insurance plans that complement the existing urban formal sector insurance. Together these cover more than 90% of the population by the end of 2010. The level of individual coverage is modest, but the total outlays of $60 billion projected for 2011 is substantial. Only 1% of GDP, but up from almost nothing a few years ago. Government has taken over direct management of most clinics, as well as procurement of a list of 307 categories of drugs, and enforced an average price reduction of 40%. This was the major source of clinic revenue that government is now replacing.

20. Expansion of Social Policies (cont.) Housing: Major move into provision of public housing. For sale at subsidized prices, and creation of public housing rental sector. Plans: 2010: 5.9 m. M2 2011: 10.0 m. M2 Ambitious plans—calling for about 15-20% of all 2011 construction to be public housing—probably will not be fulfilled. Similar trends apparent in education, social welfare and pension spending.

21. 4B. State Ownership • A lively discussion has emerged in China about “the state advancing at the expense of the private sector” (国进民退). State firms bulked up on credit and expanded their business lines. • Central SASAC has substantially more employees now (about 12 million) than it did when it was created in 2002 (8.6 million). • As important as the quantitative dimension is the newly vindicated ideological position of state firms, who can lead technologically. For 2011, SASAC’s primary task is grow central state firms into “globally competitive national champions.”

22. 4C. Technology / Industrial Policy “Indigenous Innovation”: Policy was always vague with multiple strands. New in 2009-10 was: “the degree of intensity and simultaneous use of multiple tools” (Scott Kennedy), used with overlapping, and unpredictable impact. • Technical Standards • Used strategically to privilege local technology and increase bargaining power over royalty payments. • Full roll-out of TD-SCDMA (indigenous 3G telecom standard) is green lighted at beginning of 2009.

23. Overlapping Policies of Indigenous Innovation (Cont.) • Patent rules that require disclosure of technologies used in vital national standards. • Required disclosure of sensitive technology for information security. • Procurement preference for products with “indigenous technology” content; combined with an indigenous innovation product list. • Collusion among government agencies with the objective of protecting local producers. • Rapid increase in subsidies to individual firms and to R&D process in general.

24. “Emerging Strategic Industries” 7 Designated Sectors, with 35 sub-sectors or projects: • Clean energy (solar and wind) • Electric vehicles • New materials, esp. nanotech, composites and rare earth. • Precision Machinery, including Aeronautics and high-speed rail. • Biotech industries, esp. transgenic plant breeding • Advanced telecommunications networking • Environmental protection equipment These sectors account for only 2% of China’s GDP today, but planners call for growth to 8% by 2015 now written in to 12 FYP. Is this realistic?

25. Commitments to Large Programs The government explicitly commits, in the 12th Five Year Plan “Suggestions” to finishing up the many projects initiated during the stimulus program of 2009. The 12th FYP also commits to increasing the degree of financial and policy commitment to the “Strategic Emerging Industries.” (It even slips in an eighth emerging industry, “oceanic industries,” which gets its own section after failing to make it into the Strategic Emerging Seven. The other major social initiatives, including about $60 billion for health care (400 B. RMB) in 2011 are built into upcoming plans. Public housing is projected to build 10 million units in 2011. Government commitment to a range of industrial policy measures is strong, and perhaps accelerating> --16 Megaprojects Total budget of projects under construction was 126% of GDP by the end of 2009; and 130% of GDP at the end of 2010. Projects begun, or accelerated, as stimulus measures now seem to have become part of long-run development plans.

26. A New Direction Taken together, these changes amount to a breath-taking gamble on the ability of the Chinese government to shift the pattern of economic development. Ideas that had been accepted by the government but were being cautiously and partially implemented are now being accelerated across the board. It is clearly the intention of the Chinese government to maintain the far higher level of government involvement with the economy that was triggered by the global financial crisis. More ambitiously, the objective is to accelerate the shift to knowledge-intensive industries; avoid a growth slow-down; and catapult China into the front ranks of the world’s economies. A new gamble.

27. Can it Work? Yes, parts of it will work. China will continue its movement towards the front ranks of world economies and the world technological frontier. However, China would have continued its catch-up under any scenario. Will these policies accelerate technological absorption? It is far from clear and will not be smooth. Chinese planners will be disappointed in the success rate of their state-sponsored research projects. How many of the 16 mega-projects will be successful in an economic sense? Will it be two or six? The answer to this question will determine the distribution of power and resources in tomorrow’s world. Planners are under-estimating the risks and the costs, but nevertheless, China has made enough investment in human resources, entrepreneurial innovation, and engineering skills, that they will be able to move ahead rapidly in some of the target sectors. But what are the costs?

28. 5. Costs and Risks • This gamble has a potentially large upside. Graduates from colleges and Universities in China have soared from only a million to over 5million in 7 years. Graduates are reasonably well trained and having a hard time find work. Can this help them? • More hard-headed evaluations are not to positive. These commitments conflict with the desire to make China’s economy more “balanced,” if balanced means with a greater role for consumer demand (quantitatively) and consumer choice (qualitatively). Prediction: We won’t see much “rebalancing” in the next two years.

29. Costs • The commitment of resources put pressure on macroeconomic balances, and reduces the government’s flexibility in dealing with inflationary pressures. Total budget of projects under construction was 130% of GDP at the end of 2010. • The Central Bank is stepping on the brake, while the government initiatives are stepping on the gas. • With multiple, inconsistent policy-levels extending over different sectors, it is hard to tell which sectgors are privileged and which are handicapped.

30. Costs (Cont.) • These types of mildly protectionist policies have benefits at the beginning and only show costs at the end. (Politically, they are the opposite of reforms, which their short-run costs and long-run benefits). • The early benefits make it easier to assemble supporters and clients. Decision-making becomes more politicized while poductivity (may) slow down. • There are substantial lag effects, in whih harmful behaviors slowly return: the soft budget constraint makes a comeback.

31. Costs (cont, again) • Crucially, the technology interventions come near technological frontier. We don’t even know which of these technologies will be technically feasible or economically profitable, much less the cost-benefit rate. • Many other countries have relied on government mobilization to coordinate efforts to borrow and assimilate foreign technologies. Industrial policy, effectively executed, can accelerate the movement to the frontier. Only rarely has government coordination effectively nurtured firms with frontier technologies. Costs will are likely to be much higher, and benefits uncertain. • Ultimately, the concern must be with the exit mechanism. Will China be able to pull the plug on underperforming projects and companies? If so, costs can be limited. If not, the Chinese economy risks being burdened for a long time by a large array of under-performing sectors.

32. Finally, the Impact of Indigenous Innovation on foreign parties Inevitably, these protectionist policies will create friction with foreign partners and technology providers On one side: Foreign businesses, particularly in high-tech sectors, find it is increasingly difficult to navigate the maze of discretionary preferential policies. They feel constrained in their ability to cooperate profitably with Chinese firms. Public complaints by, among others, GE and Siemens, indicate the depth of dissatisfaction. On the other side: A major change is taking place in patterns of resource allocation in China, particularly those that link China to foreign technology suppliers. China is already buy less technology abroad and investing much more domestically. This change will end up imposing substantial unanticipated costs on Chinese development.

33. 5. Conclusion China has embarked on a major re-orientation of development strategy in the wake of the 2008-2009 global economic crisis. The full implications of this shift will not be evident for several years. If China were to succeed in all its high technology initiatives, the result would be a profound upheaval in global relations. More likely, China will succeed in a handful of cases, and will have to manage the after-effects of mixed results and outright failure for the majority of these bold initiatives. Even on this account, however, five to ten years from now, China will have moved decisively up the global technology rankings, contributing a far higher share of sophisticated value-added. The main credit for this, though, will be the investment in human resources and the innovation in business models in the market-oriented parts of the Chinese economy.