Abstract: In this paper, the author argues that to adjust China’s development strategy, China should reduce its dependence on export, strike a proper balance between supply chain efficiency and security, strengthen independent R&D and improve the structure of foreign assets and liabilities. On the outlook of China’s economic growth, the author analyzes the negative and positive factors and suggests that China adopt more expansionary and proactive macro policies to maintain a 6% growth rate.
In 2020, the Chinese government put forward the proposal to foster a new development paradigm with domestic circulation as the main body and domestic and international markets reinforcing each other, known as the “dual circulation” strategy. The concept of “dual circulation” has received a great deal of attention from home and abroad. Since there are some misinterpretations of the concept, I would like to take this opportunity to share with Japanese friends my views on “dual circulation”. In the latter half of my speech, I will talk a little bit about my opinions on China’s growth outlook.
I. The background, development, and problems of China’s export-oriented development strategy
In late 1970s and early 1980s, China embarked on a journey to pursue “four modernizations”. During this period, besides institutional reforms, China did two things worth mentioning. First, China introduced advanced technologies and equipment from foreign countries, especially through importing complete sets of large-scale equipment. Japan also provided much support in this regard. Second, China expanded foreign trade and improved resource allocation by leveraging its comparative advantage.
To purchase advanced equipment and develop foreign trade, foreign exchange is needed, but China was extremely short of it at that time. In 1978, China had a foreign exchange reserve of less than $200 million. In 1979, China’s GDP reached $178.2 billion, accounting for 1.8% of the world’s total; China’s exports totaled $13.7 billion, representing 7.7 % of China’s GDP. Throughout the 1980s, China registered trade deficits except for two years.
Luckily, China’s shift away from an inward-looking development strategy that stressed self-reliance and economic independence coincided with a favorable international environment. For example, original equipment manufacturing was flourishing in Asian countries. This type of processing trade provided an opportunity for China to circumvent its shortage of foreign exchange and engage in foreign trade by harnessing its advantage of labor resources. While developing processing trade, China also aggressively attracted foreign direct investment (FDI). Processing trade brought trade surplus, thus creating foreign exchange. So did FDI. With over a decade of efforts, by maintaining twin surpluses in trade and capital accounts, China overcame the shortage of foreign exchange. In 2014, its foreign exchange reserves stood at nearly $4 trillion.
China’s strategy of “great international circulation”, when first coined by Mr. Wang Jian in the late 1980s, referred to the model of “l(fā)arge-scale imports and exports” and “putting the two ends of production process (the supply of raw materials and the marketing of products) on the world market”. It was an export-oriented strategy characterized by processing trade and FDI. The proposal and implementation of the strategy have made great contributions to China’s high-speed development.
In 1979, China’s GDP ranked 11th in the world, with a share of only 1.79% in the world economy. Its export volume represented an even paltrier share of world exports. But 20 years later, in 2009, China became the world’s largest exporter, and in 2013, the world’s largest trading nation. China’s share of imports and exports in world trade rose from 3% in 1995 to 12.4% in 2018. In 2010, China became the world’s second largest economy. As of August 2020, China’s foreign exchange reserves stood at $3.16 trillion, higher than any other countries.
Although China’s export-oriented strategy has succeeded, such success has brought about a series of problems. I think there are mainly four problems: first, limited capacity of the international market; second, decreased ability of China’s industrial system to withstand external shocks; third, lack of motivation to innovate independently; fourth, cross-border and inter-temporal resource mismatch.
II. The capacity of the international market
With 40 years of effort, the share of China’s export of important products in world export has risen. In fact, ten years ago, Mr. Kwan Chi Hung from the Nomura Institute of Capital Markets Research already made such observation. For example, in 2018, China’s export share of office and telecommunications equipment, electronic data processing and office equipment, and telecommunications equipment in the world’s total reached 31.61%, 36.25% and 42.29%, respectively. China’s strong competitiveness has driven many foreign companies in the same sectors out of business, the photovoltaic industry is a case in point. China’s expansion of export has provoked trade protectionism among Western countries, leading to worsening trade conditions for China.
In fact, China had realized these problems before 2005. In 2006, China’s export-to-GDP ratio peaked at 35.21%. Afterwards, the Chinese government started to adjust its export policy and the ratio went on a sustained downtrend, dropping to 17.4% in 2019. Likewise, China’s trade-to-GDP ratio peaked at 64% in 2006, and started to decline since then. Other indicators also showed a similar pattern.
III. Decreased ability of the industrial system to withstand external shocks
Participating in the global division of labor entails striking a balance between efficiency and security. Here, security has three dimensions: first, the possibility of future development. In international trade theory and development economics, the discussions on “infant industry protection” and “how to avoid being locked in the low end of the international division of labor” are in essence related to security issues. Second, economic security, such as food and energy security. For example, in the past, many scholars thought that food security was not a problem, but now probably no one holds such view. Third, national security. Undoubtedly, without a strong industrial system, national security could not be guaranteed. In short, given its unique situation, China has to attach great importance to economic security when it is actively participating in the global division of labor.
China participates in the global division of labor through general trade and processing trade. The first approach is similar to that adopted by Japan and South Korea, known as the Flying Geese Paradigm. In this model, countries start by promoting the export of labor-intensive products like textiles, then steels, heavy chemical products and capital-intensive products, and finally technology- and knowledge-intensive products like communications and semiconductors. As their comparative advantages change, labor-intensive and some of the capital-intensive industries are transferred overseas, while some of the capital-intensive industries as well as technology- and knowledge-intensive industries remain in the domestic market. Those domestically retained industries gradually replace imports. For example, the automobile industry in China gradually raised the rate of localization and finally achieved import substitution.
The second approach is to join the global supply chain or production network of a certain product and move up the chain towards high-tech and high value-added ends. Participating in the global value chain could improve productivity and domestic welfare but also increase the risk of the industry. Extended production chains can better utilize comparative advantages and reap the benefits of specialization. But if one of the hundreds or thousands of links on the global supply chain goes wrong, the entire production process would be paralyzed. Since this disruption might have occurred on the other side of the globe, there is nothing you can do to solve the problem. The global supply chain is basically dominated by multinationals from developed countries. In most cases, Chinese firms cannot decide whether, when, where, how and at what costs they produce, and thus get locked up in some particular links.
Focusing on a few links of the supply chain could significantly boost productivity and enable companies to quickly learn specific technologies. But external dependence of production also increases, which will undermine the integrity of China’s industrial system. When it comes to ensuring industrial security, there is a huge difference between being able to produce advanced intermediate goods (which require sophisticated technology) and being able to produce final goods.
The security of an industrial system includes three dimensions: integrity, external dependence, and resilience. We are not going to establish a self-sufficient industrial system because such a system is bound to be inefficient. Integrity is a relative concept. To make up for the loss in integrity, our industrial system must have strong resilience. When necessary, we should be able to quickly produce things not produced in the past. Overall, no matter how China participates in the global division of labor, it must properly handle the relationship among the three dimensions so as to strike a balance between efficiency and security.
In recent years, the containment and embargo moves by the U.S. have brought great challenges for China’s high-tech industry. In the long term, these policies might do more good than harm to China. Leading enterprises in China will open wider to other Chinese companies, and put more efforts into supporting domestic downstream companies by offering them more opportunities to join the production process. Even if the quality of their products is a little lower than that of their American counterparts, as long as they meet the basic standard, these downstream companies will be allowed into supply chains dominated by Chinese enterprises. In due course, China will build independent and controllable supply chains in the high-tech field.
Indeed, this is not a policy that China actively pursue. But if the U.S. continues to impose sanctions on China, we won’t have better options. China hopes to strengthen cooperation with Japan, Europe as well as developing countries to reduce the negative impacts on Chinese and global economies if the U.S. removes China from the global supply chain. The proposal of “dual circulation” requires us to better balance the relationship between efficiency and security.
IV. Strengthening independent R&D
The policy of “exchanging technology with market” should be re-examined. China will emphasize more the importance of independent R&D. R&D investment is a prerequisite for the development of the high-tech industry. In the past decade, the U.S. semiconductor industry has invested $312 billion in R&D, twice that of other countries. In 2018 alone, the U.S. invested $39 billion in R&D in the sector. The U.S. government has poured a lot of money into basic research. Traditionally, U.S. semiconductor companies would invest 17% to 20% of their revenue in R&D, while in other countries, the share only amounts to 7% to 14%. The high-tech industry has two paths to realize innovation, namely, following the existing path or independently exploring new one. Should companies continue on the existing paths and keep refining the technologies, such as producing chips at 22nm, then at 14 nm, and then 3nm? Or should they turn to explore new paths? In either case, but especially the latter, it is essential to improve education and basic research, and foster an environment that encourages free exploration. China has to deepen reforms of the educational and R&D system in order to meet the requirement of independent innovation.
V. Improving China’s foreign asset-liability structure
China’s export-oriented policy attached too much importance to earning foreign exchange through exports and attracting foreign investment. At the same time, its ability for overseas financial asset allocation is also rather weak. This has led to an undesirable asset-liability structure. Despite the $2 trillion net foreign asset, its investment income is negative, a sharp comparison with Japan. It is a rarity among developed countries to be a net creditor with a deficit in investment income.
It will be hard to maintain trade surplus with an aging population and prolonged US-China trade conflicts. Once China starts to run deficits simultaneously in the current account, trade and investment income, it can only rely on capital inflows to keep balance of international payments, which is unsustainable for most countries (with some exceptions like Australia). Once capital inflows are interrupted, the country will not only fall into a balance of payments crisis, but a mixture of crises in currency, finance and economy.
Japan has long stopped running a trade surplus, but its substantial return on overseas investment has helped offset the trade deficit and even achieved surplus in the current account. It’s good experience for China to learn from.
Ⅵ. What factors affect China’s growth prospect?
As economy grows, China's industrial structure is changing. Its tertiary industry is developing faster than other industries, which is normal, but due to the currently low labor productivity in this sector, the rising share of the tertiary industry could add to the downward pressure. Aging population is another limiting factor. A greener economy will undoubtedly improve the public welfare, but also impose certain constraints on GDP growth.
Urbanization is expected to fuel China's economic growth. As of 2020, the urbanization rate of China's permanent population has exceeded 60%, leaving considerable room for further progress compared with developed countries. Generally speaking, the increase in urbanization rate should be stable. But because China still retains the household registration system, the process of urbanization has been suppressed. It is conceivable that once migration restrictions are relaxed, there might be a step change, manifested as accelerated urbanization, before reaching a new equilibrium point. In addition, there is still room for reform of China’s economic system, which will certainly play an important role in promoting the economy.
According to Mr. Huang Qifan, development in the following five areas will create a new round of domestic demand: (1) mega-cities (with a minimum population of 20 million) and urban economic agglomeration, (2) flow of land resources between urban and rural residents, (3) reform of the household registration system, (4) same retirement age (at 60) for women and men, and (5) reform of the logistics and transportation system.
In short, in the next one or two decades, there are favorable and unfavorable factors for China’s economic growth. Although we expect a clear decline, it’s still difficult to say how much decline there will be.
Based on current situations, I believe China should adopt expansionary policies to secure a 6% GDP growth rate. China should address inflation and rising leverage, but shouldn’t give up sustaining economic growth. All in all, we should be optimistic with China’s development prospect.
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