Abstract: With changes in the development stage, environment and conditions for the Chinese economy, China will need an innovation-friendly financial system that can better serve its “dual circulation” strategy. An innovation-friendly financial system should be able to help the country seize the opportunity brought by the new round of industrial revolution, resolve three imbalances in economic structure and stimulate the vitality of micro-entities.
Since the beginning of this year, Chinese President Xi Jinping has on many occasions discussed how to understand and grasp the major trends both at home and abroad in a scientific way and to balance between development and security, and proposed the new development pattern based on “dual circulation” with domestic and international markets reinforcing each other and with domestic market as the main body.
In my opinion, the core of the new development pattern is the “dual circulation” strategy, and in some cases, the two phrases—“new development pattern” and “dual circulation” are interchangeable. The “dual circulation” strategy is likely to be a major strategy leading China’s future economic and social development for a long period of time, or at least during the 14th Five Year Plan period.
I. Innovation is of paramount importance to the “dual circulation” strategy
While the “dual circulation” strategy is new, the economic thinking underpinning it is not. For instance, the supply-side structural reform put forward at the Central Economic Work Conference in 2015 was aimed at resolving significant structural imbalance that had obstructed economic circulation; the Central Economic Work Conference in 2018 proposed to deepen the supply-side structural reform and “consolidate the gains made in the five priority tasks, strengthen the dynamism of micro entities, upgrade supply chains and ensure unimpeded flows in the economy” so as to facilitate smooth industrial, market and socio-economic circulations.
Therefore, ensuing smooth “circulation” is a consistent thought underpinning China’s economic policy. In other words, the “dual circulation” strategy represents a strong continuity with the guiding principle of the Chinese government in making economic development strategies in recent years.
What kind of financial system does the “dual circulation” strategy need? The first step to answering this question should be to understand what problems the “dual circulation” strategy aims to address. President Xi has pointed out that the “dual circulation” strategy, or accelerating the formation of the new development pattern, was put forward based on the changes in China’s development stage, environment, and conditions. I would like to talk about what problems the “dual circulation” strategy aims to solve from these three aspects.
First, the change in development stage, which refers to the high-quality development phase and should not be simply regarded as a new era or new period.
According to President Xi’s report to the 19th CPC National Congress, China’s economy had “shifted” from the phase of high-speed development to one of high-quality development. But a series of meetings in the first half of this year, such as Politburo meetings and Politburo Standing Committee meetings, said China had already “entered” the phase of high-quality development. The minor change of wording from “shift” to “enter” in describing China’s economic development stage reflects the importance and urgency in promoting high-quality development.
The major contradiction in the high-quality development phase is one between people’s increasing demand for a better life and imbalanced and inadequate development manifested by underdeveloped innovation capacity, weak agriculture, large urban-rural development and income gaps, weak links in ensuring people’s livelihood, daunting ecology protection tasks, and deficiencies in social governance etc.
While all of these problems are important, I want to put the emphasis on underdeveloped innovation capacity. The fundamental solution to this problem is adhering to the new development concepts, especially placing science and technology innovation at a more important position so as to upgrade the quality, efficiency and impetus of China’s economic development.
Second, the change in development environment. At the symposium with socio-economic experts on August 24, President Xi said that the world is undergoing tremendous changes unseen in a century with rising protectionism and unilateralism, anemic world economy, and increasing non-economic disruptions in global supply chains.
For China, there could be more new pressure during the process of global supply chain reshuffle. So how should China maintain a sound balance between supply chain relocation and industrial upgrade? Besides, the addition of some of China’s high-tech enterprises to the US Entity List and the restrictions on their access to core technologies have all brought shocks to the stable development of China’s economy and society.
Therefore, the relationship between development and security must be balanced, and the only solution to ensuring security is to accelerate science and technology innovation.
Third, the change in development conditions. After 40 years of reform and opening-up, China’s resource endowment and factor conditions have gone through tremendous changes. For instance, the decrease in working population, rise in wage level, and stricter environmental requirements have all weakened its conventional competitive advantages.
What are the new advantages? In 2018, we conducted a joint research with the World Bank on the new drivers of growth during economic transformation and put forward one major task and three drivers of growth. The major task is to improve total factor productivity. Of the three drivers of growth, the first driver is original innovation that can continuously expand technological frontiers, the second driver is the commercialization and industrialization of technology, and the third driver is addressing the misallocation of resources through the deepening of reform. Hence, science and technological innovation is the key to reshaping competitive advantages under changing development conditions.
In short, innovation, particularly science and technological innovation, is of paramount importance from the perspective of development stage, development environment and development conditions.
II. The "dual circulation" strategy needs innovation-friendly financial system
As discussed above, science and technological innovation is the core of the “dual circulation” strategy. What kind of financial system is needed for the “dual circulation” strategy? The answer should be an innovation-friendly financial system. The next question should be what is an innovation-friendly financial system? The question should be easy to answer based on individual cases. For example, cities and regions where innovation is highly encouraged and embraced, such as Shenzhen, usually have innovation-friendly financial system. Of course, some financially developed cities and regions could lag behind in terms of innovation. Next, I want to talk about how to define an innovation-friendly financial system from three aspects.
First, an innovation-friendly financial system should be able to help the country seize the opportunities brought by the new round of technological revolution or industrial revolution. Carlota Perez put forward the concept of techno-economic paradigm, and I slightly changed the term into techno-financial paradigm to look at the relationship between innovation and technology and finance.
Different era has had different techno-economic paradigms and different techno-finance paradigms that could adapt to the techno-economic paradigm of that era. This has been the case over the past 200 years from the first to the second and third industrial revolutions as well as the new round of industrial revolution today, or the fourth industrial revolution.
How does a financial system that is geared to the “dual circulation” strategy or the new development pattern look like? We could think about this question from various angles.
For instance, we should not simply think that the commercial banking system that was formed during the rapid industrialization period can still adapt to digital economy.
Meanwhile, we have seen many organizational innovations in the era of digital economy. For example, platform economy is a major business model. In a traditional pipe business model, companies produce products with their own assets, make money by selling their products, and reinvest the earnings to grow. The business model of platform companies relies more on external resources, rather than simply using their own assets. For platform companies, they may not have the same techno-economic paradigm and techno-financial paradigm. Many small- and medium-sized enterprises and individuals on the platform can be both producer and consumer, or prosumers.
Therefore, if financiers fail to understand today’s techno-financial paradigm and still think in traditional ways of the industrialization era, they will be very likely to make mistakes. Besides, intellectual property finance has also been attached more importance in the era of digital economy.
Second, an innovation-friendly financial system under the “dual circulation” strategy should be able to help resolve three imbalances in economic structure, that is, imbalance between supply and demand in real economy, imbalance between finance and real economy and imbalance between real estate market and real economy. An innovation-friendly financial system must be able to help resolve these imbalances, at least should not aggravate the problem.
There used to be a debate over whether China’s financial system is overdeveloped or underdeveloped several years ago, which is a very important question. In academic community, there is a theory which describes the relationship between financial development and economic development as an inverse U shape, indicating that what’s good for the Wall Street might not be good for the US economy, or in other words, what’s good for financial development is not necessarily good for the entire economy.
Therefore, we need to strike a balance between finance and innovation. Otherwise, fierce competition could be triggered between the two, which can take place in four forms. First, competition over innovation factors (siphon effect); second, competition over policy (interest groups); third, competition over income distribution in the real economy (cannibalization); fourth, corporate finance mechanism, or the lack of long-term innovation.
Third, an innovation-friendly financial system should be able to motivate micro-entities. We could imagine what would happen in a world without friction. Similarly, what would happen to the financial system if enterprises are not willing to borrow money. So an innovation-friendly financial system must be able to meet micro-entities’ financing demand, rather than inhibiting their vitality.
From the perspective of leverage ratio, generally speaking, a market-based economy tends to have a lower leverage ratio than a bank-based economy. However, the leverage ratio of Germany is significantly lower than that of the US and the UK which are both market-based economies. One important reason is that German enterprises are more dynamic, perform better, and can achieve greater development by relying on internal financing and with a relatively low external financing level. In recent years, internal financing has come to play a more dominant role in many enterprises in Germany and Japan while the proportion of bank loans have been decreasing, or at least the growth of bank loans has decreased.
Therefore, an innovation-friendly financial system must be able to strengthen companies’ vitality. At present, the risks faced by the banking system largely come from enterprises. The financial system will become healthier once internal financing dominates in corporate financing structure.
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