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Scenarios for China’s dual circulation strategy

Scenarios for China’s dual circulation strategy •

by Dr. Junhua Zhang

In May 2020, President Xi Jinping unveiled the dual circulation strategy (DCS). The plan aims to create a new development pattern, with a large domestic circulation as the mainstay and interaction between domestic and international trade as a complement. The DCS has been enshrined into China’s 14th Five-Year Plan (2021-2025). But, according to official statements, it could go far beyond this time frame and become a guiding economic strategy for the next 15 years.

The dual circulation strategy

Chinese leaders often remain intentionally vague when conceptualizing a strategy, like with the Belt and Road Initiative first proposed in 2015. Many details are deliberately blurred to give more room for adjustment during implementation.

The main pillar of the DCS is domestic circulation, which consists of two aspects. The first step is to increase the population’s purchasing power – in other words, to boost domestic demand. The authorities want to rebalance economic growth by raising household income so that Chinese people can buy more local goods. But this policy is not new. Ever since 2008, the Chinese Communist Party (CCP) has been hoping to reduce dependence on exports and investment by increasing the share of consumption in gross domestic product (GDP).

The second aspect of domestic circulation concerns the supply side. China, with the help of foreign companies from industrial nations, has built the most complete manufacturing supply chain in the world, and for nearly a decade or so it has enjoyed the status of the largest manufacturer. Yet tensions with the United States and other Western countries have exposed a heavy dependence on American high-tech products, like semiconductors. China’s largest chipmaker, SMIC, lags two generations behind its Taiwanese rival TSMC, and most of its chips’ designs come from the U.S.

According to China’s own assessment, the vast majority of Chinese companies are only in the third echelon in terms of manufacturing quality and sophistication compared to the U.S. (first echelon), Japan and Germany (second echelon). The Xi administration advocates breaking this “old order” by radically improving Chinese technology and manufacturing.

The CCP believes China came late to the three past industrial revolutions, but that it is now entering the fourth almost on par with the West – and that it could possibly lead. To this end, Chinese leadership is actively promoting so-called new infrastructure: 5G networks, artificial intelligence (AI), blockchain and the Internet of Things.

The race to self-reliance

It is one thing to set ambitious goals, but to achieve them is another. The Chinese authorities have decided to invest massively in pursuing technological innovation, with self-reliance as the ultimate goal. Vice Premier Liu He believes the ability to make fundamental technological progress will be a matter of survival for the country. He was recently entrusted by President Xi with the task of advancing China’s third-generation semiconductor production.

With regard to the international circulation aspect of the DCS, Mr. Xi stresses that China will continue to promote trade with other countries and regions. And Beijing intends to attract more foreign investment in high-end manufacturing to strengthen its supply chain and discourage Western companies from moving out. At present, foreign-invested enterprises (see box) account for less than 3 percent of all businesses in the country, but provide nearly half of China’s exports and a fifth of the country’s tax revenues. They also employ about 13 percent of the urban population. Many multinational corporations have partnered with Beijing to establish research and development centers and “localize” components for their products. All this has created a favorable environment to spur China’s own technological innovation and productivity.

Foreign-invested enterprise

A foreign-invested enterprise is a legal structure which companies use to participate in a foreign economy. The term usually relates to companies in Asian countries, especially China. There, foreign-invested enterprises take many forms, including equity joint ventures, cooperative joint ventures, wholly-owned foreign enterprises, and foreign-invested companies limited by shares.

Source: Investopedia

Interest groups resisting change

The hope to harness consumption as an economic engine has been around for a long time, but so far change has been slow. This is because progress requires fundamental reforms in various areas that would affect the interests of many government agencies and state-owned enterprises.

For example, the existing registration system (in Chinese, Hukou) has caused an apartheid-like divide between urban and rural citizens that greatly hampers consumption. But to fully abolish it is no easy task. In the short to medium term, this may be partially achieved in third and fourth-tier cities, but definitely not in first and second-tier cities, because the local governments are not willing to do so.

Another area needing reform is the social security system, including healthcare. The Chinese’s high savings rate (44.9 percent ) can only be reduced if people do not have to rely mainly on their own resources in case of illness or misfortune. As for the tax system, with the poor paying more taxes and the rich paying less, China will not be able to change the situation rapidly. Finally, housing policy and real estate prices are major obstacles to urban consumption, and farmers are unable to use their land commercially. Meanwhile, many local governments rely heavily on land sales and high property prices for revenue. In such circumstances, it is highly unlikely that reforms will go smoothly.

Since China was the first country to recover from the pandemic, it is not consumption, but investment, exports and real estate that drove GDP growth in 2020. This year, countries like India and Vietnam were so severely affected that some of the production based there temporarily returned to China. Because of this backflow, all levels of Chinese government relied on flourishing exports, failing to implement measures to increase domestic consumption.

Since former President Trump’s trade conflict with China, sensitive technologies have been a major concern. The U.S. is trying to stop technology spillover. Other countries and regions, like the European Union, have also taken steps to prevent China from acquiring cutting-edge technologies. Beijing reckons that about 40 percent of the technology that China urgently needs today could theoretically be obtained from EU countries, hence its attempts to get along with Europe despite its “wolf warrior diplomacy” tactics.

Meanwhile, the fight against Covid-19 has exposed the world’s dependence on the Chinese supply chain for medical equipment and other essential items. As a result, many Western countries have decided to bring supply chains closer to home, at least for certain products. The lack of political trust between the West and China has also accelerated decoupling, particularly with sensitive technologies.

President Xi Jinping’s decision to achieve technological self-reliance was influenced by all these factors. And, unlike his predecessors, he has opted for a rushed timeline. By 2035, China should “achieve major breakthroughs in key core technologies and enter the forefront of innovative countries.” He is clearly keen to see his “Chinese dream” become a reality while he is still alive or in office. The 2018 constitutional changes have already paved the way for him to stay in power for life.

For the sake of innovation, China has a high tolerance for risk. The Chinese government will not spare administrative and financial resources if it means successfully developing more advanced chips. It is ready to invest $1.4 trillion in developing new infrastructure and advanced technologies by 2025. This determined – even desperate – approach stems from Beijing’s conviction that there will be no ideological compromise with the West.

Among China’s political elite, the hope to overtake and replace foreign companies in the country through technological spillover still exists. That is why China will continue to selectively open its market to foreign companies, particularly those with high-end technology, and improve the business environment in the next 15 years. At the same time, Beijing has reinforced the importance of political correctness for foreign companies, with a new anti-sanctions law and data security law soon to be approved.

But even if the Chinese side caters to foreign companies to obtain technology, in practice many enterprises have already learned from the past. For example, the first period of China’s high-speed rail development saw much forced technology transfer.

Scenarios

What are the chances of success for President Xi’s dual circulation strategy? And how realistic is his strategic goal of achieving self-reliance through a technological quantum leap in the next 15 years?

China has the largest number of science, technology, engineering and mathematics (STEM) graduates and the largest number of engineers in the world. It has ranked first in the number of patent applications for more than a decade. It is also ahead, at least for now, in the application of AI.

But Chinese STEM graduates lag behind the West in terms of innovation. The country faces a brain drain among top science and engineering talent, with 80 percent of PhDs studying in the U.S. choosing to stay there instead of returning to their home country. China’s research environment is not particularly friendly, for political and institutional reasons. This explains why the overall conversion rate of Chinese patents is less than 10 percent, far lower than 50 percent in the U.S.

More than an innovation gamble, Mr. Xi’s ambitious plan is a carefully crafted long-term challenge to the West. Whereas Western democracies struggle to adopt long-term strategies because of regular elections, the Chinese leader set his goal for 2035 with the stroke of a pen.

In the Party-led approach, Mr. Xi sees the opportunity to pool resources, using different industrial policies and taking advantage of “socialist dictatorship” to achieve technological breakthroughs. The Chinese leader is more convinced than his predecessors that his nonmarket or “hybrid” approach is the right one, and that under his leadership China will be able to maximize its benefits. In short, there is no plan B for Xi Jinping when it comes to technological self-reliance.

China will encounter enormous difficulties in implementing this strategy. But the delay in increasing consumption seems less critical than the delay in technological innovation. It is the technological breakthroughs that matter most. And here, chances of overtaking the U.S. are roughly 50 percent. If Western countries and companies make crucial mistakes (like leaking key technologies), then these chances of success may increase to 60-70 percent. But all this assumes that the CCP does not make, in the words of Xi Jinping, a “disruptive mistake” between now and 2035.

Dr. Junhua Zhang is a senior associate at the European Institute for Asian Studies. He has been a Professor of Political Science at the School of International and Public Affairs of the Shanghai Jiao Tong University and Zhejiang University for ten years.

Source: GIS Reports

The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.

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