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China’s Need for Innovative, Market-Based Economic Growth

Hu Jintao

SOURCE: AP/Shannon Stapleton

Chinese scholars in Beijing claim Hu Jintao, pictured above, is planning a big innovation policy push for this fall that will focus not on channeling more R&D funds toward state-owned enterprises, but rather on the systemic barriers to a more competitive innovation environment.

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This is the second in a six-part series highlighting the research and recommendations of a recent Center for American Progress report, “China’s Real Leadership Question.” The report explains the major players and factors in China’s upcoming political transition and describes the numerous challenges the country faces during the transition and well into the future.

As China prepares for its upcoming political transition, the country’s new leaders will be asked to handle an economic downturn in which Chinese growth could hit lows not seen since the 1989 Tiananmen Square crisis. After a decade of nearly unprecedented growth, including exceeding IMF expectations for growth for 10 straight years, China’s economy is starting to slow down, with analysts suggesting the growth rate for this year may only be 7.5 percent.  If that proves correct, it will be China’s lowest growth rate in more than 20 years.

To be sure, a slowing Chinese economy is not necessarily a bad thing. In recent years, China’s high growth rates have been fueled by unsustainable investments in infrastructure and real estate, and if the country can shift away from that model toward something more sustainable, that will be a positive development. Problem is, that shift will not be easy to achieve. And for a Chinese Communist Party that has staked its legitimacy on keeping the economy booming, any slowdown brings new political challenges. That is particularly true at this point in time because in addition to managing growth rates, Chinese leaders must also figure out how to deal with a growing middle class that is starting to demand a higher quality of life and a larger chunk of the benefits of China’s economic prowess.

This column intends to explain the following:

  • The model by which the Chinese economy has enjoyed such long economic growth
  • Why the current model is no longer sufficient to maintain that growth
  • The manner in which China can and should promote more innovation and domestic consumption of its goods
  • The difficulties the country will face in trying to upend its current growth model, especially in taking power away from local government authorities, specifically in the energy sector

With China’s new political leaders set to ascend in the near future, they will have to recognize the need for change in their economic plans to keep the economy growing at its robust rate. They will also have to prepare to make some difficult political choices.

Rebalancing the economy to meet the demands of China’s rising middle class

For the past three decades, Chinese economic growth has depended primarily on exports and state-funded fixed asset investments in infrastructure and real estate. That model is now running out of steam. Domestic wages are rising, which is eroding China’s cost advantages as a low-value-added manufacturer. Fixed-asset investments are consuming too much energy, polluting the environment (which triggers destabilizing mass protests), and concentrating wealth among the leaders of state-owned enterprises and their buddies in the local government who dole out these big infrastructure contracts, sometimes in exchange for lucrative kickbacks.

To keep the country growing and to keep their citizens happy enough to support the regime instead of protesting against it, Chinese leaders must shift the country toward a new growth model that will depend less on exports and fixed asset investments and more on domestic consumption and higher-end technology innovation. Consumption and innovation are connected and both benefit China’s growing middle class.

If Chinese companies can move up the value chain from lower-end to higher-end manufacturing, they can pay their employees more, which will expand job and wage opportunities for average Chinese citizens. Once Chinese citizens have better jobs and higher wages, they can then buy more, allowing Chinese companies to sell more of their goods domestically instead of depending primarily on export markets, which can be unpredictable. Higher wages for Chinese workers would also address one of the biggest complaints about the current system—that wealth is too concentrated in the hands of a well-connected few at the expense of ordinary Chinese.

Technological innovation is particularly important in this quest. Thus far China has primarily served as a manufacturer for western designs. If they can shift not only toward higher-end goods but also from western to indigenous Chinese designs, then Chinese firms will get a larger share of those profits. Today western firms hold the intellectual property rights for most of the higher-technology goods China produces. That means western firms get a large cut of the profits for every unit sold. If China can keep more of those profits at home, that would provide new revenue streams for the Chinese economy.

But moving toward a modern, higher-tech, consumer-driven economy will require the type of independent regulatory governance and judicial structure that it is very hard for an authoritarian regime to provide. One of the biggest stumbling blocks is providing a good domestic environment for technology innovation. Investments in innovation will not deliver good returns without a good legal system to protect intellectual property rights. The United States has such a system, which is why U.S. technology entrepreneurs and venture capitalists are willing to risk so much on new ideas.

In China, however, the Chinese Communist Party worries independent courts would turn against it, so the party keeps the courts on a short leash. There is no judicial independence in China. If party cadres do not like the way a judge rules in a case, they can have that judge fired. That gives party leaders sway over every court decision and opens up the possibility that they will use that sway to protect favored companies. And that means investors cannot trust Chinese courts to enforce intellectual property rights laws in a fair and impartial manner.

That was all fine and good as long as most intellectual property cases were being filed by foreign companies against Chinese defendants. In that situation, weak IP enforcement was just another form of protectionism. The American Semiconductor case is a recent example of that traditional dynamic. American Semiconductor Corp., or AMSC, has clear evidence that Sinovel, the Chinese wind turbine manufacturer, stole AMSC engineering secrets and used them to produce a Chinese product based on AMSC designs. American Semiconductor responded by filing suit against Sinovel in the Chinese court system. In the West AMSC’s suit would be an open-and-shut case, but Sinovel has strong party and government backers, so Chinese judges keep throwing the case out of court.

Chinese leaders may not mind giving foreigners a hard time, but now they want Chinese companies to come up with their own engineering secrets. If ownership rights are hard to enforce, however, few Chinese companies will have an incentive to do so. That is particularly the case for private-sector companies who would have to invest their own funds or take out large loans to develop new technologies. And those are exactly the types of companies China needs to encourage if it wants to move up the technology value chain.

This past May current Party Secretary Hu Jintao convened a Politburo meeting to address this problem. At that meeting party leaders talked about the need to build a more supportive environment for innovation and announced a new goal: making China one of the world’s most innovative countries by 2020. Chinese scholars—interviewed for our main report—in Beijing claim Hu Jintao is planning a big innovation policy push for this fall that will focus not on channeling more R&D funds toward state-owned enterprises (which has not worked that well so far), but rather on the systemic barriers to a more competitive innovation environment, including intellectual property enforcement.

No matter what the party comes up with, however, we can bet that it will not include judicial independence. As long as the party insists on maintaining control over the courts, China’s intellectual property regime will favor whoever has the best political connections, not the best innovators, and that will deter some of China’s best and brightest technology prospects from taking a gamble on new ideas.

Reducing government support for state-owned industries

Shifting the economy toward a new growth model will also require reducing government support for the state sector, and that is not easy to do. For the past 10 years, the Beijing leadership directed by Party Secretary Hu Jintao and Premier Wen Jiabao has had to focus more on social stability and less on economic reform. When economic problems emerged they threw money at those problems instead of making difficult political adjustments. This culminated in China’s 2008 stimulus package, which doled out RMB 4 trillion ($586 billion) over two years to keep the economy running throughout the global financial crisis.

More than 80 percent ($468 billion) of those stimulus funds were earmarked specifically for infrastructure and construction projects. Beijing issued treasury bonds to finance some projects and ordered state banks to support the rest by providing long-term, low-interest loans to the companies involved. Local government cadres were thrilled because they got to decide which projects to build and which companies to award the contracts to. Overall, the stimulus program put China’s local government officials in charge of huge amounts of pork, and pork can buy a lot of friends in China. Most of the stimulus projects were contracted out to state-owned enterprises with connections to China’s local governments and state banks. All across China, elite groups of government officials, bankers, and well-connected state-owned enterprises were passing around huge amounts of money, and they could not have been happier.

Now Chinese leaders need to redirect that spending from local governments and state-owned enterprises to private-sector innovation by allowing banks to choose projects based on profitability rather than political connections. China must shift from letting its government officials pick winning companies based on those same connections to letting the market pick the winners based on who has the best technology. That is the only way China can climb up the value chain to become a major global innovator. It will not be easy, however. Local officials and the heads of local state-owned enterprises (often one and the same) strongly resist any reforms that redistribute wealth at their expense, and those are very powerful interest groups in China.

In China’s political system, the leaders in Beijing—who today can claim neither democratic legitimacy nor Mao-era ideological legitimacy—need support from the lower levels to make big policy decisions. The Politburo (the top 25 party leaders) and the larger Chinese Communist Party Central Committee include not only national leaders based in Beijing but also powerful provincial officials. Just like congressional representatives here in the United States, China’s provincial officials bring their own interests to the table when they participate in economic decision making in Beijing. And key policy decisions are always made via consensus, so Beijing has to take those regional interests into account. Top national party leaders such as Hu Jintao today and Xi Jinping in the future cannot ram reform plans down the throats of their subordinates—they have to get their support.

During the first era of economic reforms, Deng Xiaoping bought that support by giving local government cadres more authority over the local economy. The next era of reforms will require taking some of that economic authority away. For economic rebalancing to succeed, local cadres can no longer be in charge of picking winning firms and awarding lucrative contracts for massive infrastructure projects. Instead, commercial banks will allocate capital to the projects and technologies that show the most promise, regardless of which region they are located in or who their friends are.

This would be good for China in the long term, but not so good for local government officials and state-owned enterprises in the short term, particularly if they have sunk investments into less-competitive industries and technologies that would be phased out under a more market-based system. Those officials and state-owned enterprises will fight hard to keep that from happening.

Chinese leaders have plenty of cash, so they can easily funnel resources into new industries. They are already directing funding toward strategic emerging industries such as green technology products and next-generation information technology equipment and software. Where they run into trouble, however, is in actually getting those new industries off the ground. That requires turning off the spigots of government support flowing toward the older and more inefficient industries and state-owned enterprises, a tough task when local government officials are fighting hard to keep them alive.

In green energy, for example, Chinese leaders have directed substantial resources toward wind and solar. That has paid off in clean energy manufacturing: Chinese companies are using cost innovations to manufacture cheaper versions of wind and solar technologies developed abroad, and they are exporting those products all over the world. What Chinese leaders really want, however, is to develop their own technologies and sell more of them at home, and that is not going so well. Chinese leaders are doling out funds for clean energy R&D, but they distribute them through government channels, and government officials direct the money toward old friends instead of new prospects. Resources go to the well-connected instead of to the entrepreneurial. Many private enterprises cannot get financing, and private enterprises are more likely to generate the new ideas China needs.

China’s ability to buy and install those clean energy products at home is also lagging behind, particularly in the solar industry. Chinese solar panel manufacturers export more than 90 percent of the products they produce, and those exports are currently being hit with tariffs. Chinese solar manufacturers want Beijing to increase domestic solar energy consumption so they can sell more solar panels at home and depend less on exports (thus limiting their exposure to tariffs), but the growth of solar demand in China is much slower than it could be.

That’s because China’s electricity sector is dominated by state-owned enterprises that prefer to stick with the coal infrastructure they already have instead of investing in new technologies such as solar. Solar generation is still more expensive than coal, and China’s generation companies can’t make a profit even using coal because Beijing fixes electricity prices at below-market rates to keep consumers happy.

Over the past few years, coal prices have gone up, but electricity prices stayed low, so China’s state-owned power generators have been selling electricity at a loss and getting government bailouts to balance the books. The last thing those companies want is to increase their costs and losses even further—and Beijing cannot increase electricity prices too much because that would slow down the economy and infuriate consumers.

China has a “Golden Sun” program that provides government money to build solar generation plants, which should help bring down costs, but local governments are not managing it well, and many Golden Sun projects have been plagued with fraud. For the solar generation projects that have been built, getting connected to the grid is also problematic because China’s State Grid Corporation (a state-owned enterprise) controls 88 percent of the country, and State Grid is dragging its feet on renewable energy connection.

All of these factors keep China tied to coal and lock China’s clean energy economy into the old model of depending primarily on exports instead of selling more goods at home. Overall, then, China is locked into a situation where the central government is trying to push their economy in new directions, but central-local political dynamics constrain Beijing’s ability to transform the system in a meaningful way.

To be sure, the country has made some progress. When measured by annual growth rates, China’s domestic clean energy markets are booming, and no one doubts Beijing’s determination to turn its country into a clean energy powerhouse. The problem is that things are just not moving quickly enough, particularly on domestic consumption and home-grown technology innovation—and those are the clean energy improvements that China really needs.

Overall, it seems as though every time Beijing comes up with a new idea, vested interests stand in the way. If China’s incoming party leaders cannot find new solutions to these problems, then economic growth may slow dramatically. And that has major implications, not only for the economy, but also for the Chinese political system more broadly.

To read the full report, “China’s Real Leadership Question,” click here.

Melanie Hart is a Policy Analyst for Chinese Energy and Climate Policy at the Center for American Progress. Alex Lach is an Assistant Editor at the Center.

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