Industrial policy and Chinese development

The rapid growth and transformation of the Chinese economy since 1978, when policymakers began a programme of economic reforms, has been extraordinary. Up until the last few years, GDP growth averaged around 10% per year, lifting hundreds of millions out of poverty. This represents the largest episode of poverty reduction in human history. China, as the largest manufacturing nation, has become the ‘workshop of the world’.

With a population of 1.4 billion, and an economy relatively open to international trade, these changes have and will continue to have an enormous impact on the rest of the rest of the world. For this reason, we should take a great interest in China’s continuing evolution.

Donald Trump, both on the campaign trail and since becoming US President, has placed great emphasis on getting some sort of ‘better deal’ between the US and Chinese economies. His administration has criticised China for taking advantage of the US on trade and the use of technology. But should China’s rise be a worry in these respects? Or is the US being hypocritical? In fact today’s rich countries all intervened in the economy and used forms of trade, industrial and technology policy to promote their growth and enable periods of ‘catch up’ with those at the frontier. China has been no exception.

The imperative of industrialisation

The historical record shows that for a country to develop and raise living standards for its population, it needs to industrialise. If it is rich in natural resources such as oil, it may be able to accumulate wealth for some time without doing so, but this process has definite limits. In such countries, wealth and income are often very unequally distributed, with much of the benefit flowing to those at the very top of society amid a lack of broad-based economic and social development and poverty reduction.

By contrast, the process of industrialisation has the potential to raise economy-wide productivity, employment and wages. Firms in the manufacturing are often subject to increasing returns to scale, so productivity can grow with output as production processes become increasingly specialised and improved with an increasing division of labour (Adam Smith’s pin factory being the most famous example of this).

Of course, parts of the services sector are also subject to increasing returns, and in many cases their growth in output and productivity is interdependent with that of manufacturing.

Those countries that have been the most successful in experiencing sustained and widespread poverty reduction and improvements in living standards have gone through periods of ‘catch-up’ with the most advanced nations. They have all employed forms of industrial policy.

Japan, South Korea, Taiwan and Singapore are some of the best-known examples, but Indonesia, Malaysia and Thailand have also had some success with industrial policy, although they have grown less quickly.

Catch-up and industrial policy

China, as already mentioned, is the most dramatic example of economic transformation in history, by virtue of its size and the speed of change it has experienced. Depending on how its GDP is measured, it is now either the largest or second largest economy in the world, after the US. But in terms of GDP per head, it remains a middle-income country. Tens of millions of its population remain poor, particularly in rural areas, and it has a high degree of inequality.

Despite all this, China has so far made great strides in catching-up economically with the richest countries. To do so, its government has employed an industrial policy as part of its reform programme in order to promote particular ‘strategic’ sectors, in that they create large positive spillovers or externalities for the rest of the economy.

China’s industrial policy is a variant on the East Asian developmental state model, which has proved so successful for some of its neighbours. The term model is perhaps slightly misleading, in that it has been employed differently in each country, but the overall aim has been to encourage rapid growth in economic sectors with the greatest potential for technological progress and improvements in productivity.

Outcomes in terms of the rate of growth have also varied between countries, but China is widely regarded as being a great success to date, despite areas of waste and inefficiency.

Some theories of industrial policy in ‘late developers’ describe it as state intervention to accelerate technology acquisition and the accumulation of capabilities. The emphasis is on policies which encourage the emergence and growth of firms and sectors which have the potential for rapid productivity growth.

Since such economies are much poorer than the most advanced nations, their industries will be a long way from the technological frontier. Their priority in this accumulation of capabilities in order to facilitate catch-up is for firms to learn to adapt and use already existing technologies, rather than develop new ones.

Due to the scale and sophistication of firms in more advanced countries, this will involve a period of protection to enable learning-by-doing to take place. The aim should be to achieve international competitiveness and the ability both to serve the domestic market where appropriate, but also to export onto the world market, with the opportunity to achieve a much greater scale of production and sales.

The Chinese experience

So how has industrial policy worked in China? According to Chris Bramall in his book Chinese Economic Development, growth was at first driven more by domestic factors, in agriculture and light industry in rural areas, as reform focused on the gradual liberalization of prices and the encouragement of private enterprise.

Domestic industries were initially protected by high tariffs. Increasing openness to trade and Foreign Direct Investment came later, in the 1990s. Tariffs were lowered after China joined the World Trade Organisation in 2001. The country was subsequently able to benefit from the rise of global supply chains made possible by the development of containerisation and Information Technology.

The government set up Export Processing Zones (EPZs) and provided financial incentives for foreign investment, as well as good quality infrastructure. Energy prices for industry were managed to reduce the volatility of input costs. China’s well-educated workforce and the potential of its vast domestic market were also part of the story.

These factors put the state in a strong bargaining position vis-à-vis foreign investors. There was a lax enforcement of Intellectual Property Rights, but investors could not ignore the size of China’s market, so they invested anyway.

Overall, there was an emphasis on acquiring foreign knowledge via technology licensing, copying and reverse engineering. State enforcement of joint ventures and linkages with foreign investors enabled domestic firms to do this. In this way, and following its successful East Asian neighbours, industrial policy encouraged emulation and production for export. Only more recently has it started to focus on indigenous innovation.

Industrial policy and state ownership

State-owned enterprises (SOEs) have also played a significant role in China’s industrial policy. Cambridge University’s Peter Nolan has written extensively about the government’s support for and reform of SOEs.

According to Nolan, one of the key economic developments in the age of globalization has been the emergence of giant firms, often via mergers and acquisitions, rather than organic growth. Some of them are privatised SOEs, but almost all are from advanced countries.

These firms focus on core competencies and, via a ‘cascade’ effect, have put pressure on smaller firms in their supply chains to consolidate. This has created huge structural change in the global economy.

Despite this (to use Marx’s term) ‘concentration of capital’, competition among global firms has increased hugely. This is contrary to the predictions of orthodox neoclassical theory on monopoly, oligopoly and perfect competition.

The dominant Multinational Corporations (MNCs) from advanced countries compete via innovation and account for much of global spending on Research and Development.

Thus the structure of MNCs in a globalized world economy makes it ever harder for firms in developing countries, especially in strategic industries, to catch up with those in the richest countries. Nolan argues that China is no exception to this.

Part of the Chinese government’s industrial policy has been to develop a group of large SOEs in strategic industries, which after a period of protection to enable learning processes, can ultimately become competitive with already established MNCs. Despite extensive reform, they have not yet done so. They have high sales, profits and market capitalisation, but remain protected and mainly serve the fast-growing domestic market.

While the private sector as a whole runs a substantial surplus in international trade, collectively the SOE sector runs a deficit, indicating a lack of competitiveness. Some authors have argued that ownership is not as important as exposure to competition, so that the latter is key to improving the dynamism of China’s large SOEs. The latter played less of a role in other rapidly industrialising East Asian economies, but the general strategy for infant industries that managed to ‘grow up’ and become internationally competitive did involve exposure to international competition as well as periods of protection. Firms that failed to become competitive were allowed to fail or were shut down. Thus government support was conditional on success.

Changing the model

China’s success to date has, at the macro level, relied on very high rates of investment and savings, which have been used to dramatically increase capacity in manufacturing, investment and housing as industrialisation has proceeded and fueled rapid urbanisation.

Many economists now think that much of this investment has in recent years been poorly allocated, and that continued development should involve a rising share of consumption and hence a reduced share of savings in overall output, with a lower rate of investment which must become more productive.

The Chinese government seems to realise this and much of its legitimacy is dependent on its ability to raise living standards for the majority. The Communist Party leadership has been busy centralising power and trying to reign in an unsustainable growth in local government and SOE debt. Continued economic success may therefore be more dependent on political factors and overcoming resistance from some of those holding positions of power in society who have up to now benefited hugely from China’s development path.

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4 thoughts on “Industrial policy and Chinese development

  1. Perry, I agree with you. Another excellent post by Nick from which I learned a lot. What I read into the present post is my presumption that protectionism is only useful if it is combined with a suitable industrial policy, the lack of which may be the problem with Trump’s protectionist measures. Not free trade leads to successful development but managed trade.

    As A. Thirwall writes (on p. 431 of his classic Growth and Development (6th edition):

    What is important for growth is getting the fundamentals for growth right … :

    • Industrial policies to promote particular sectors of the economy (the shift to industry)

    • Government control of financial markets to lower the cost of capital and direct credit to strategic sectors.

    • Policies to promote exports and protect domestic industry.

    Crucial to all three policies was good governance … The World Bank concedes that most of the countries deviated from free market economics, but that they got the fundamentals right (for example
    efficient resource allocation, high rates of physical and human capital formation, and so on) …”

    • Thanks once more for your comments Georg. As important as the industrial policies are the political and institutional aspects which enable or constrain the policies themselves. The distribution of power in society within and beyond the state are key in this. Policymakers in those countries, such as Japan and South Korea, which had their own ‘economic miracle’ and rapid structural transformation, were able to discipline emerging firms so that support was dependent on performance and achieving competitiveness. In cases of failure, support was often withdrawn.

      Many countries that attempted industrial policy, picking winners and protecting infants, ended up with protected firms that failed to ‘grow up’ and achieve international competitiveness as policy was captured by particular interests and prevented from working well. So perhaps few countries can be exactly like Japan, South Korea or Taiwan, but they can work out how some form of industrial policy can accelerate development in their own particular context.

      There has been plenty of criticism of the so-called ‘good governance agenda’ of the World Bank by heterodox economists, who argue that what are apparently fundamentals such as stable property rights, democracy etc tend to only be achieved, achievable and sustainable by already fairly advanced countries, with sufficient capabilities on the part of the state.

      The capitalist transformation tends to be associated with unstable and changing property rights, which Marx called primitive accumulation, when resources potentially become concentrated in the hands of an emerging capitalist class for investment in sectors with higher productivity.

      Historically, no one political system is always associated with successful development, so neither democracy nor authoritarianism are a panacea. Whether and how they work well for development seems to be a contingent phenomenon.

  2. The points you are making in your above comment are very important. One of the biggest dangers in development economics is compartmentalisation. Every country is an individual. Stereotyping is the beginning and the texture of ideology, and ideology is misrepresentation. Paying attention to details and specific circumstance is of the utmost significance in devising sensible policies. But somehow we humans feel attracted to ideal types and overly categorical dichotomies as between puristic conceptions of “free markets” and “socialism”. Every economy is a mixed economy, with elements of a spontaneous nature and elements of political intervention. As you rightly argue “the political and institutional aspects” are at least as important as specific (types of, say industrial) policies, and I would suggest that without a good grasp of concrete politics and institutions one is bound to fail to understand the character and individuality of a country, i.e. the conditions for success and failure specific to it.

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