According to the National Bureau of Statistics of China, Chinese GDP in the first quarter of 2020 declined by 6.8 percent from a year ago as the country battled coronavirus through large-scale shutdowns and quarantines to limit human interactions. This is the first time China has reported a negative growth rate in the first quarter since 1992 – the first year China started to report quarterly GDP data. Manufacture production and fixed investment fell 10.2 percent and 16.1 percent respectively in the first quarter from a year ago. In services sectors, wholesale and retail sales fell 17.8 percent, while online sales of physical goods rose 5.9 percent because people bought more online during the lockdowns. The hardest hit is in the hotel and restaurant sector with a 35.3 percent decline. The consumer price index (CPI) increased by 4.9 percent in the first quarter.

The growth forecast for China and the world economy varies. The IMF projects an average five percent growth rate in the next two years (1.2 percent in 2020 and 9.2 percent in 2021), compared to a -3 percent growth globally in 2020.¹ The World Bank is more optimistic, projecting a 5.9 percent, 5.8 percent, and 5.7 percent rate respectively in 2020, 2021, and 2022 for China but a 2.5 percent growth rate for the whole world in 2020.² Given the importance of China as a manufacturing center in the world and its continued growth momentum, most estimates predict a faster growth in China than in the rest of the world in the near future.

Nevertheless, this pandemic has already posed a tremendous challenge to China and will continue to be so over a long time. Three key factors stand out. First, China faces different challenges in the short run as compared with the long run but is more comfortable with handing the immediate crisis than more difficult but needed structural changes. Second, China’s economy will be hurt by potential decoupling from the global markets. And third, China’s experience of pandemic control does not suggest that China’s system at this point is a viable alternative to the Western democracies and market systems.

The recovery in the second quarter of 2020 will continue to face strong headwind. In the first quarter, production has always been a bit slower during the Chinese New Year holiday, so the effects of the lockdowns on production were muted relative to the effects on demand. In addition, despite the cancellation of some orders, many firms still had some previous orders to fulfill during the first quarter of 2020. The effect of the lack of new orders, especially international orders, will become more obvious starting from the second quarter, except for medical products. Therefore, the downturn in the economy during the rest of 2020 will likely continue. However, China has successfully joined global value chains in many industries and the rest of the world is highly dependent on China’s supply of parts and components, as well as many assembled final products. So, it is unlikely for the rest of the world to decouple with China immediately. In the short term, the Chinese economy will continue to supply the world as a global factory and will likely to do better than the rest of the world.

In the long term, however, China will face more uncertainties depending on the severity of the COVID-19 pandemic. If the rest of the world enters a severe recession, this will hurt the Chinese economy which depends heavily on international markets. Even worse, if the rest of the world forms an alliance against China, attempting to decouple from China by diversifying their global value chains, this will be painful for the Chinese economy. Decoupling is very unlikely if only one country like the U.S. takes actions by erecting trade barriers or withdrawing investment from China because such an attempt will eventually fail if all of the companies in other countries, such as Germany, Japan, and Korea, can take advantage of the cheaper labor in China and compete against American firms globally. However, if major Western economies can jointly take collective actions against China, this will hurt China even if such actions are somewhat against economic principles and the trend of globalization. Even though every country will suffer in the short run, policy makers in the western countries may be able to justify such a decoupling from a dynamic perspective for long run gains at the cost of some short run losses to social welfare. The Chinese government should prepare for the worst scenario and handle this global crisis properly to avoid this.

Unless an effective vaccine is found, the COVID-19 will likely stay for a while. Countries may have to prepare to work around this virus. For China in particular as the most populous country, employment is a national priority. With the sharp declining demand domestically and internationally, it is no longer practical to maintain the previously set GDP growth goals. To ensure an economic recovery and avoid mass unemployment, however, a decent economic growth rate is still needed. To achieve these goals, a set of comprehensive and coherent policies should be in place.

In the short run, a country cannot resume all jobs immediately while the risk of contagion still exists. More effective policy to help those hit hard by the pandemic is probably fiscal stimulus such as direct money transfers to citizens or wage subsidies to firms. At the same time, proper measures should be taken to ensure safety when reopening the economy and extreme caution should be used to prevent systematic risks that may arise during the time with slow growth. This is especially important to China where people and policy makers have become accustomed to fast growth for decades. These risks include but are not limited to financial risks, public, corporate or individual debt crises, inflation, and political uncertainty. In the short run, the Keynesian type of counter-cycle policies can help to address this crisis.

However, these kinds of against-wind policies will not be a proper choice in the long run. Instead, China should continue to push forward structural changes and institutional reforms. Continued efforts should be made to deepen economic and political reform, which has lagged since Xi Jinping took power. On employment, China needs to pay special attention to rural migrant workers who usually travel long distances from home for work, and were hit the hardest during the pandemic. A certain set of safety nets should be established to protect their jobs and health. Otherwise, this public health crisis can turn easily into a widespread social and economic crisis. Given the close ties of the Chinese economy with the world market, China should embrace candid and open-minded policies to rebuild the trust of the rest of the world. A large part of such trust has been lost in the recent several years, and especially so during this pandemic of COVID-19. The constitutional change to a lifetime presidency, increasing reliance on state-owned enterprises, tighter control of the government under Xi Jinping, and widespread nationalism are the true enemies of China.

Finally, what are the implications of this pandemic for the so-called “China model,” which features a heavy hand from government? China took swift actions to lock down cities and quickly controlled the spread of the virus, which contrasts sharply to what happened in the rest of the world, especially the Western world with market economies and democratic political regimes. Many people hail the success of the China approach and some claim its overall superiority over Western systems. This is unfortunately a misperception and may have serious consequences.

The control of contagious disease is a classic example of an “externality” in economics and is often used to explain “market failures.” Because the benefit of contagious disease control to an individual is far smaller than the benefit to the whole society, an individual tends to take less than optimal caution and measures to control its spread. In this case, government can help by forcing people to take vaccines, wear masks, or even tolerate locked downed cities. China’s regime with a strong central government and previous experience with the SARS is well-suited to address these kinds of crises. The same logic works for other types of market failures, including but not limited to public good provision and other types of activities with externalities such as high-speed trains. It is not surprising to see China’s success in these areas and indeed the Western world should learn from China to redesign policies to ensure quicker and more effective responses to these market failures or crises.

However, we cannot simply generalize it to all other areas where market and individual decisions should take control. Many decisions in society involve trade-offs, and no regime is perfect in all aspects. China’s regime does have advantages in some areas over Western democracies, but the inadequate response to this pandemic in the Western countries alone is certainly not sufficient to justify its overall inferiority to China’s regime.³ Such an awareness can help China to deepen the reforms and handle international conflicts. For instance, although the more centralized regime of China does give some advantages to Chinese firms when competing against companies in the Western world, this is not sustainable as shown by the current trade war between the U.S. and China. To fully integrate into the world economy, China will have to embrace more market reforms and institutional changes to ease the tension with the Western market economies, rather than commanding even more control over the economy and society as the current regime under Xi Jinping is doing. China’s economic miracle over the last several decades did not occur because there was more and more control from the government, but rather because of less and less control over time.

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Overall, the trend of changes under Xi seems troubling both domestically and internationally. At home, Xi is now president for life after a constitutional change approved by the Communist Party. On the economy, the government has intentionally and unintentionally been pursuing policies that strengthened the state-owned sectors. In the following, I will discuss primarily the following two issues: (1) state versus market in the Chinese economy under Xi with a special focus on China’s industrial policies; and (2) the ongoing trade war between the U.S. and China.

State versus Market in the Economy under Xi and China’s Industrial Policies

Over the last several decades, the relative role of state-owned sectors has been declining. Based on the data from the National Bureau of Statistics of China, Lardy (2014) shows that the share of state-owned sectors in industrial output dropped from 78 percent in 1978 to only 26 percent in 2011.  He also shows that, between 1995 and 2014, the export share of state-owned companies dropped from 67 percent to 11 percent. However, many critical and strategic sectors such as banking, infrastructure, and some upstream sectors are still largely controlled by state-owned companies. Some people attribute China’s economic success to the strong role of government in managing the economy, and name this path of economic development the “China model.” Because the state-owned sectors are the major participants implementing the government’s strategies, many economists and policymakers in China begin to emphasize the importance of state-owned sectors in national development and international expansion. The emphasis on state-owned enterprises in China is not a surprise given what was stated in the above-mentionedDecisions of 2013, but it raises a renewed concern of the retreat of private sectors, which have been the true engine of the economic growth in China over the last several decades.

Although Xi probably has no intention to reverse the course of China’s market reforms, he doesn’t seem to emphasize the importance of continued economic reforms and the development of private sectors, not to say political reforms. Due to the close relationship between government and state-owned sectors, a natural consequence is a system favoring state-controlled firms. In recent years, the “advancement of state-owned sectors and the retreat of private sectors” (guo jin min tui) are particularly worrisome. The retreat of private sectors may not be the intention of the government, but rather a side effect of the over-emphasis on the importance of state-owned sectors. This problem can be driven by a few factors. One of them is the 2008 world financial crisis. Against this backdrop, countries including China implemented the against-wind macroeconomic policies through rescue plans, quantitative easing, stimulus programs, etc. In China, state-owned companies have played an important role in implementing the stimulus policies while private sectors were reluctant to invest. In addition, to switch from the original development strategy built on low wages and labor-intensive industries, the Chinese government has been trying to redirect resources toward more high-tech sectors. Due to externalities, the lack of resources, and less favorable economic prospects since the 2008 financial crisis, private firms – except a small number of large ones – have little incentive to invest in high technologies. State-owned companies naturally become “better” candidates in fulfilling the goal of climbing the technology ladder and industrial upgrading. Accordingly, state-owned companies backed by the government also receive preferential treatment in the areas such as financing. On the contrary, private sectors find it increasingly difficult to compete against state-owned companies to secure loans, especially those with good terms. As documented by Lardy (2019), 57 percent of loans went to private firms and 35 percent to state-controlled firms in 2013 when Xi just assumed office. By 2016, state-controlled firms received 83 percent of loans, compared with 11 percent for private firms. This is also shown by Harrison et al. (2019): currently state-owned firms receive more subsidies and lower interest rates than formerly state-owned firms, which in turn, are favored relative to always-private firms. This happened despite the fact that the profitability of private-sector firms is more than double that of state-controlled companies. Much of this lending came from state-owned banks. The induced inefficiency can be huge. This is why many entrepreneurs and economists in China called for “competitive neutrality” to make sure that private and state-owned sectors receive similar treatment and are on a level playing field. Finally, some market-oriented reforms have unintended consequences. For example, the sudden crackdown of shadow banking seems to be a move in the right direction, but could block the only access of small private firms to credit, and indirectly provide state-owned sectors even more favorable conditions relative to private sectors in the credit market.

The government can intervene in the economy in many ways. Besides regulations, monetary and fiscal policies used in typical market economies, a government can lay a heavy hand on the economy through other means such as state-owned or sponsored enterprises, industrial policies, and government procurement. Industrial policy is the major channel through which the Chinese government implements its development strategies, which culminates with the recent Made in China 2025 Initiative. MIC2025 first appears in the 2015 Report on the Work of the Government and again in the reports of 2016 through 2018. The Report (2015) states, “We will implement the ‘Made in China 2025’ strategy; seek innovation-driven development; apply smart technologies; strengthen foundations; pursue green development; and redouble our efforts to upgrade China from a manufacturer of quantity to one of quality.” The Report (2016) states, “We launched the ‘Made in China 2025’ initiative to upgrade manufacturing, set up government funds to encourage investment in emerging industries, and to develop small and medium-sized enterprises, and establish more national innovation demonstration zones.” The Report (2017) states, “We developed and launched a plan for completing major science and technology programs by 2030…. We will intensify efforts to implement the ‘Made in China 2025’ initiative… we will adopt a variety of supportive measures for technological upgrading and re-energize traditional industries.” The Report (2018) states, “Implementation of the ‘Made in China 2025’ initiative has brought progress in major projects like the building of robust industrial foundations, smart manufacturing, and green manufacturing, and has accelerated the development of advanced manufacturing.” As an ambitious plan to upgrade the Chinese economy by climbing the technology ladder, the “Made in China 2025” initiative lays out the strong state-directed industrial policies.

Industrial policies have been used by most of the countries in the world at certain stages of development. We have seen more failures than successes.  These policies often create tension among countries in the era of globalization, especially when a country is large, because firms in different countries and sectors may no longer be on a level playing field. Depending on how domestic firms acquire their technologies, the protection of intellectual property rights also becomes a concern of many western companies that are strongly against forced technology transfers and infringement of intellectual property rights. This is why MIC2025 has attracted so much attention and is one of the major reasons behind the 2018 U.S.-China trade war. This is probably why a similar statement on MIC2025 disappears from the 2019 Report on the Work of the Government to avoid further escalation of such disputes. The Chinese government seems flexible enough to accommodate the requests and concerns from other nations. However, this by no means implies that China has abandoned its MIC2025 Initiative. It is unrealistic to stop the practice of industrial policies in China (or any other major economy), so the best we could do is probably to develop an approach for open discussions. To ensure effective negotiations, countries should at least have a mutual understanding of information sharing and fairness.

I end this section with a discussion of the so-called “China model” or “Socialism with Chinese Characteristics” with strong government involvement. This strategy has its advantage in certain countries at particular states of economic development. Besides addressing market failures such as public goods and externalities, the government can help gather limited resources and make concerted nationwide efforts to target specific development goals so that a developing country can catch up with advanced countries more quickly. The more centralized system and state-owned companies have played important roles in the economic development in China, especially in certain areas like infrastructure. Tighter regulations and the gradual opening of financial markets help to contain risks and avoid large-scale financial crises. China’s economic success has offered valuable insight to both developing and developed countries around the world. However, placing too much confidence in government- and state-owned sectors is dangerous. As stated in my original essay five years ago, this ignores the basic fact that China’s economic miracle has been driven by market reforms rather than government control. It is important to realize that the so-called the market economy with Chinese characteristics is a transition period from a destined-to-fail socialist regime to a more efficient market regime.  Its outstanding performance during the last several decades in China should not be over-emphasized. On the contrary, China’s success demonstrates how severely the economic capacity of China was depressed under the socialist policy before the reform.  The Chinese economy took off and prospered when the government gradually released its control. The past success can be a poor guide for the future. To ensure continued economic prosperity, China needs deeper market reforms, not a reversal of this policy with a stronger hand of government on the economy.

Trade War between the U.S. and China

Global free trade is a natural extension of a free market economy within a country. The benefits from trade are now well understood. China’s economic size (GDP) has grown 10 times larger from about $1.4 trillion since its 2001 entry into the World Trade Organization to about $14 trillion in 2019 (predicted). When China grows into a global power, its domestic policies have important international implications. The “China model” featured with state capitalism can clash with western market economies. In state capitalism, the government owns and provides preferential treatment to businesses in critical sectors in the name of industrial policies. Although many countries in the west also implement certain industrial policies – such as the support to high-tech or green technologies – their polices are relatively more transparent than in developing countries like China. The combination of state capitalism and the lack of transparency in China, as well as the influence of interest groups through lobbying in many western economies, pose tremendous challenges when the international community seeks to promote an open, competitive and fair system through multilateral talks under the WTO framework. Large countries like the U.S. may abandon multilateral trade talks and initiate a trade war. I believe that this is a fundamental reason behind the trade wars initiated unilaterally by the Trump administration.

To make things worse, in the international sphere, Xi has abandoned the policies under previous leadership since Deng Xiaoping by keeping a low profile and focusing on domestic economic reform and development. Instead, Xi seems to be more interested in advocating the “China model” for other developing countries to emulate as an alternative to western market capitalism. Xi has spelled out openly his ambitious plans to exert a greater influence on the rest of the world through strategies like “One Belt One Road” and MIC2025 initiatives. Although these initiatives are considered strategic plans for the future in China, the goals are more or less incompatible with other statements, e.g., the claimed developing country status that makes China qualified for preferential treatment under various international agreements, such as the WTO. As a result, China has paid the price: the 2018 trade and economic war between the U.S. and China, among other international disputes and conflicts. As Reuters reported (Miles, 2019), the U.S. is drafting WTO reform to halt handouts for big and rich states that claim to be developing nations, including China, India, etc. Special and Differential treatment (S&D) under the WTO entitles developing countries to longer time periods for implementing commitments, measures to increase trading opportunities, provisions requiring all WTO members to safeguard the trade interests of developing countries, support to help developing countries build the capacity to carry out WTO work, handle disputes, and implement technical standards, and provisions related to least-developed country (LDC) members. The WTO currently allows countries to self-designate as developing countries. The U.S. draft reform posted on the WTO website said current and future trade negotiations should withhold such special treatment from countries classified as “high income” by the World Bank, OECD members or acceding members, G20 nations and any state accounting for 0.5 percent or more of world trade.

The U.S.-China trade war has gone far beyond trade into many other areas including investment and technology. In 2018, the U.S. Congress passed the Foreign Investment Risk Review Modernization Act (FIRRMA), expanding the authority of the Committee on Foreign Investment in the United States (CFIUS) to include mandatory filings. FIRRMA is a legal hurdle to stop foreign firms from investing in the U.S. and acquiring American businesses in key sectors: filing fees,approval process, and expanded scope of coverage. In addition to the FIRRMA legislation, the Export Controls Act of 2018 was also passed to mitigate technology transfer activity from the U.S. to China. The U.S. had proposed sanctions against the Chinese state-owned company ZTE, but defused after agreement, and then placed sanctions against other Chinese firms including Huawei. Recent accusations of forced technology transfers, discriminatory licensing of American firms in exchange for market access in China, unfair ruling of IP disputes, government-facilitated acquisition overseas, cyber-attacks, stealing of technology and trade secrets (e.g., the investigations of the scholars in the 1000 Talents Program and even proposed restrictions on the exchanges of students and scholars), and violations of Iran sanctions by Chinese companies such as ZTE and Huawei. Under the pressure, China has agreed to revise IPR rules and step up IP protection and grant more market access. ¹

In the following part of this essay, I will focus on the 2018-2019 trade war between the U.S. and China. We know that China has been running a huge trade surplus with the U.S. The main concerns of the U.S. are China’s exchange rate manipulation, industrial subsidies, and slow delivery of WTO commitments in the areas of market access, government procurement, and subsidy notifications. I don’t think the Trump administration has any intention to change the U.S.’s open trade policy. Tariffs are just a means for the U.S. to demand a level playing field from other countries including China, India and allies such as the EU, Japan, and Canada, although different countries may have different interpretations of fairness in trade. The U.S., of course, could bring the case to the WTO as has been done numerous times in the form of anti-dumping or countervailing charges. But the process can be long, especially given the lack of transparency in China’s economic policies. As the U.S. claimed, China hasn’t made much progress on delivering subsidy notifications to the WTO. Without sufficient information and a formal channel to obtain the required information, it is hard to resolve the conflicts through appropriate channels recommended by the WTO. Together with the pressure to get reelected, this is probably why the Trump administration sets aside the WTO and approaches China directly through bilateral trade wars and talks. Note that, in this essay, I focus on issues that require international cooperation, keeping in mind that the U.S. domestic policies are also responsible for its large trade deficit.²

Given the obvious costs of the trade war, the right solution is still multilateral (WTO) or bilateral negotiations. After many rounds of high-level talks, several threats and setbacks, the U.S.-China trade negotiations have been going through a scary roller coaster ride. Although the two parties agreed at the G20 meeting in late June 2019 to sit down again to negotiate, the prospect is still unclear. Just recently, Donald Trump announced a new round of tariffs on imports from China that would go into effect September 1, 2019. Although this leaves a short window for the two parties to try to work out their differences, it is a tough task. Progress could be made if China starts to buy more American products, strengthens IPR protection, speeds up financial market liberalization, grants more market access to American firms, and refrains from manipulating currency, and the U.S. removes tariffs on Chinese products over time. Resolving some other issues such as transparency on subsidies, information-censoring, and the modification of China’s laws, however, may require drastic economic and even political reforms, which the Chinese government is reluctant to do, at least in the short run. Despite the differences in opinions, the intertwined economic interests make the trade war too costly for both countries to afford. But the process to achieve free trade can be a long one.

One insight we gain from the U.S.-Japan trade negotiation in 1980s is that it can take a long time for two economic powers to settle trade disputes. China has learned the lesson from Japan and will likely refuse to make drastic changes such as currency appreciation, so this can make the U.S.-China negotiation even more prolonged. Therefore, both the U.S. and China should be patient throughout this process. In recent years, we have seen an increasing divide between the U.S. and China on the timing for a resolution to address these issues. At an international symposium to commemorate the 40^thAnniversary of Normalization of U.S.-China Diplomatic Relations at the Carter Center in Atlanta in early 2019, I raised the concern about the possible escalation of the U.S.-China trade war and suggested a gradual approach for the bilateral negotiation.  Mr. Craig Allen (President of the U.S.-China Business Council) pointed out that the time for U.S.-China trade talk is running out. He said that China prefers to follow a gradual approach and needs another 10 or 20 years to implement deeper reform and open policies, while the U.S. has lost patience saying that China has delayed fulfilling its commitments at the entry of the WTO for a long time and these should have been done yesterday. Facing this stalemate, the two countries were dragged into a trade war in 2018.

Initially, as stated in a draft framework for negotiation by the U.S. Delegation (2018), the U.S. demands “China immediately remove market-distorting subsidies and other types of government support that can contribute to the creation or maintenance of excess capacity in the industries targeted by the Made in China 2025 industrial plan.” The U.S. demands that China eliminate specified policies and practices with respect to technology transfer within a few months and must concede to the U.S.’s enforcement mechanisms without retaliation. In addition, China must abandon its state-led economic development model, which would be politically difficult to swallow in China because a large part of the economic success of China is based on this type of policy. Indeed, accepting U.S. demands likely would require not just a policy paradigm shift, but also a regime change, which is impossible to accomplish in the short run. The U.S. cannot expect that China will scrap its economic model overnight. With the intertwined interests and complicated relations, we have to be patient with U.S.-China negotiations. On the other hand, if the U.S. condones China’s state capitalism, this would legitimize a system that puts U.S. firms at a permanent disadvantage. To be realistic, the U.S. needs to continue to press China to speed up its economic reforms through bilateral and multilateral talks, but at the same time have patience to work things out with China, probably following the approach of the U.S.-Japan negotiations in 1980s.

China should take U.S. demands seriously and make meaningful changes as quickly as possible. To address its large trade imbalance, China should adopt a more market-determined exchange rate policy, continue with structural reform by transforming an investment- and export-driven economy to a domestic consumption-driven economy, and contain the risk from excessive borrowing and underperforming state-owned sectors.

It is important to understand China before pressing the government for a deeper reform and drastic changes. The last part of this essay will address this issue in a broader context, not just the trade war. China has been following a gradual approach in its economic reform and opening. It has proved to be very successful during the past several decades, not only helping China to reap the benefits from having an increasingly market-oriented system, but also avoiding the sudden shocks from drastic reforms. Despite being authoritarian politically, China has managed to transfer powers peacefully and maintain a very stable economic and political environment. But whether China should continue with this approach is controversial. The potential dividend from this approach has largely been redeemed. To revive the economy, China now needs a new approach that encourages innovation in a competitive economic and political environment, without relying heavily on cheap excess labor and distortive government policies. This new development model requires deeper institutional reforms. Although most people believe China should eventually embrace a fuller market economy, the timing is hard to judge. A drastic reform will create a series of new problems and hence may face opposition in both business and political circles. For example, as mentioned earlier, a drastic change in regulation in the credit markets by prohibiting shadow banking seems to be a sign of progress in China, but it can do more harm to small private businesses if other accompanying policies are not in place.

Since the 1980s, the Chinese government has claimed to continue to pursue an open and reform policy. Even under the current administration, the 2017 Report of Work of Government states, “We will make big moves to improve the environment for foreign investors. We will revise the catalog of industries open to foreign investment, and make service industries, manufacturing, and mining more open to foreign investment. We will encourage foreign-invested firms to be listed and issue bonds in China and allow them to take part in national science and technology projects. Foreign firms will be treated the same as domestic firms when it comes to license applications, standards-setting, and government procurement, and will enjoy the same preferential policies under the Made in China 2025 initiative. Local governments can, within the scope of the powers granted them by law, adopt preferential policies to attract foreign investment. We will build 11 high-standard pilot free-trade zones, and widespread practices developed in these zones that are proven to work… China’s door is going to keep on opening wider, and China will keep working to be the most attractive destination for foreign investment.”

Concluding Thoughts

Despite the claims or promises by the Chinese government, other countries have been concerned about the actual implementation and the political constraint, even though China’s continued economic success has disappointed many people who predicted China’s collapse. China has actually done pretty well in keeping promises and carrying out the open and reform policies, but it becomes increasingly difficult to implement deeper reforms. This problem has become more evident during the past decade. In the case of the trade war, even if the U.S. and China successfully sign an agreement later this year, the implementation will certainly be a central issue for discussion. The U.S. and some other countries have accused China of not implementing promised changes that were part of its commitments for entry into the WTO. As another example, in the original essay (Liu, 2014), I mentioned particularly the Shanghai Pilot Free Trade Zone. Adopting a negative list approach, this is demonstration of the decentralization of power in areas including trade, investment, financial reforms, and regulations. It is useful to look at what has been achieved during the past five years, but it turns out not much has been done. On banking services liberalization, for example, due to many regulations and slow opening of Chinese market, the presence of foreign banks and their services are still very limited in China as compared to domestic state-owned banks. The essence of these free trade zones is minimal government intervention, which is hard to achieve in China. The implementation of the free zone polices requires deeper economic and even political reform and changes in related laws and regulations on foreign companies and joint ventures. This explains why it has not been as successful as the first round of special economic zone experiments under Deng Xiaoping in the 1980s.

As a final note, China should have already realized that it needs to make significant and meaningful changes in its policies, but it is unlikely that it will make drastic economic and political reform to satisfy all of the demands from the U.S. and other western countries. Given the size and importance of China’s economy, however, western countries cannot afford an economic decoupling with China.  Therefore, a practical approach in multilateral and bilateral negotiations is needed. This can be a long process and may become the new norm. A minimum requirement for successful negotiations is transparency in policies. For example, all nations including China and other developing countries should disclose their industrial policies and notify other WTO members regarding their subsidies as required by the WTO. This is easier to say than to do. Transparency is actually a tough issue to address in China because it will eventually involve political reforms. Instead of relying on censorship and firewalls to block citizens’ access to information, Chinese leaders should be more confident to embrace an open society. This will benefit China’s long-run growth, and also help China to integrate better with other countries in today’s globalized economy.

References

Harrison, Ann, Marshall Meyer, Peichun Wang, Linda Zhao, and Minyuan Zhao, 2019. “Can a Tiger Change Its Stripes? Reform of Chinese State-Owned Enterprises in the Penumbra of the State.” NBER Working Paper No. 25475

Lardy, Nicholas, 2014. Markets over Mao: The Rise of Private Business in China. Peterson Institute for International Economics, Washington D.C.

Lardy, Nicholas, 2019. The State Strikes Back: The End of Economic Reform in China?Peterson Institute for International Economics, Washington D.C.

Liu, Xuepeng, 2014. “Market vs. Government in Managing the Chinese Economy.” China Currents 13(2)

Source: https://www.chinacenter.net/2014/china_currents/13-2/market-vs-government-in-managing-the-chinese-economy/

Miles, Tom, 2019. “U.S. drafts WTO reform to halt handouts for big and rich states.” Source:https://www.reuters.com/article/us-usa-trade-wto/u-s-drafts-wto-reform-to-halt-handouts-for-big-and-rich-states-idU.S.KCN1Q426T

The Report on the Work of the Government of People’s Republic of China (2015)
Source:http://english.gov.cn/archive/publications/2015/03/05/content_281475066179954.htm

The Report on the Work of the Government of People’s Republic of China (2016)
Source:http://english.gov.cn/premier/news/2016/03/17/content_281475309417987.htm

The Report on the Work of the Government of People’s Republic of China (2017)
Source:http://www.xinhuanet.com/english/china/2017-03/16/c_136134017.htm

The Report on the Work of the Government of People’s Republic of China (2018)
Source:http://en.people.cn/n3/2018/0403/c90000-9445262.html

U.S. Delegation, 2018. “Balancing the Trade Relationship between the United States of American and People’s Republic of China.”

Source:https://xqdoc.imedao.com/16329fa0c8b2da913fc9058b.pdf

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The articles on protecting property rights and developing a healthy non-public sector are in line with China’s commitment to continued free market reform. Despite the determination of the Chinese government in implementing and deepening the market reforms, government will still play a leading role in the economy. The Decision says in Chapter II:

The basic economic system with public ownership playing a dominant role and different economic sectors developing side by side is an important pillar of the socialist system with Chinese characteristics and is the foundation of the socialist market economy. We must unswervingly consolidate and develop the public economy, persist in the dominant position of public ownership, give full play to the leading role of the state-owned sector, and continuously increase its vitality, controlling force and influence. (Emphasis added by author)

Even after several decades of market reform, the government today still has control of the commanding heights of Chinese economy, usually the upstream sectors such as resource and energy sectors.^[1] By analyzing the domestic value-added content of Chinese exports, Tang, Wang and Wang (2014) shows that state-owned enterprises (SOEs) are consistently more upstream than small and medium-sized enterprises. This finding suggests that SOEs indeed still play an important role in shaping China’s exports.^[2]

The dominant role played by state ownership stated above seems to contradict somewhat with the decisive role of the market. Such an inconsistency just reflects the mixed feelings about the role of government in China’s economy. Over the last several decades, along with the economic boom, China has developed a mixed economy with cross holding by and mutual fusion between state-owned capital, collective capital, and non-public capital. The problems of socialist policies had been well understood, and the government has gradually loosened its grip on the economy. At the same time, we also observed many issues with privatization in Russia and Eastern European countries, such as insider trading and voucher privatization,^[3] and their much less impressive economic progress. All of these, together with the 2008 world financial crisis, have spawned new critiques of privatization and free market economy, giving us an impression of the crucial role of government in the economy. They also gave rise to the so-called “China Model” or “Beijing Consensus,” with both market and government playing key roles in an intertwined way, as opposed to the neoliberal “Washington Consensus.”

On one hand, China has demonstrated the effectiveness of a gradual and determined reform that releases the vitality of the market in a controlled way to maintain fast economic growth and a stable society. China’s pragmatic use of innovation and experimentation has achieved an “equitable, peaceful high-quality growth” and “defense of national borders and interests” (Ramo, 2004).^[4] This is exemplary for many developing and transitional economies. On the other hand, however, some may be suspicious of such a type of “China Model.” To a large extent, the dominance of state capital is simply a leftover of the socialist era. The true impetus to China’s economic growth over the past decades is not government control but the introduction of market mechanisms. In other words, China’s economic success should be attributed to less, not more, government controls. But the coexistence of the still relatively high share of state assets and China’s economic success tends to give people a false sense of the importance of public ownership and an underestimation of the inefficiencies of government controls.

Since the reform of the agricultural sector in 1978, Chinese government has been retreating from the commanding heights of the economy, and private sectors have been playing a larger and larger role. Because China adopted a gradual approach to reform, unlike the shock therapy in the USSR and Eastern Europe, the change in public ownership has been gradual. Promoting this kind of mixed economy may have been a good move for China; it is debatable whether it has been the optimal choice. This point is especially important when other countries consider copying China’s approach to transform their own economies.

Although the Chinese government considers the dominant role of public ownership a feature of its socialist market economy “with Chinese characteristics,” it can be better understood from classic economy theories of market failures. As we know, government controls may be able to improve market outcomes in the cases of market failures. But public ownership is rarely the best option. The appropriate role of government in economics is not as a player, but as a referee that guarantees a level playing field. There is much evidence in the literature of the inefficiency of SOEs. For example, Dollar and Wei (2007) find that even after a quarter century of reforms, state-owned firms still have significantly lower returns to capital than private firms. By their calculation, if China succeeds in allocating its capital more efficiently, it could reduce its capital stock by eight percent without sacrificing economic growth.^[5]

Another serious problem associated with the state ownership in some key industries in China is “red” capitalism, a symbiosis between large businesses and high-level government officials, their delegates, or family members. This nurtures an environment for corruption and rent-seeking, discourages innovation and fair business practice, and hence is against the objective of enhancing the role of free market in the economy. Of course, this is also a political problem. Although the step-down of government from the commanding heights may not eliminate this problem, it can at least help to alleviate it. It can also help to transform the functions of the government.

I am not saying that China should privatize its state-owned sectors completely and immediately. The lesson from the shock therapy in Russia and Eastern Europe should be remembered. The importance of stability should never be underestimated, and the gradual approach adopted by China can be indeed conducive to long-term economic prosperity. My point is on the direction of change regarding the roles of market versus government in the economy. The Decision, emphasizing the decisive role of market on one hand but the dominant role of state-ownership on the other, is rather confusing. The Chinese government is obviously correct in promoting modern corporate governance for SOEs. At the same time, it is also important to point out that a stronger SOE sector does not necessarily imply a bigger SOE sector.

History can be a good guide for the future, so it is useful to review the rise and fall of the roles played by government versus market over the last 100 years. At the turn of the 20^th century, the market dominated western economies. With the Great Depression and two world wars, however, the advent of state-dominated economies was seen. The state gradually extended its sphere of influence into areas originally controlled by the market. At the extreme, the Communist states planned their economies so that government would be an omniscient entity. Many industrial countries in the West and in developing countries around the world were building “mixed economies” in which the government dominated but still allowed a functioning market system. The goal of such reforms was to provide justice, opportunity, and a good life for all. Until 1970s, this “mixed economy” remained practically uncontested and government was unceasingly enlarging. However, starting from the 1970s, government started to lose ground. Led by Margaret Thatcher in the U.K. and Ronald Reagan in the U.S., western governments were casting off power and tasks as the spotlight was shifting to “government failure” rather than “market failure.” Privatization or deregulation became the goals of governments as they rushed to sell state-owned assets to the public and took hands off the operation of businesses. After the failure of Communism in 1990s, the system disappeared in Eastern Europe and what had been the Soviet Union and had been replaced by a more market-oriented economy in China. Today all over the world, government planning has decreased, regulation has decreased, and markets have grown. Markets began the 21^st century again in a dominating position.^[6] During the 2008 world financial crisis, however, the role of governments expanded again in many countries through ambitious rescue plans, and fiscal and monetary policies.

In sum, economic development and reform remain the major focus of this report. To achieve continued economic growth and prosperity, radical reforms are still needed. The Decision recognizes the importance of finding a good balance between government and market in the economy. A revolutionary breakthrough on this issue in the Decision is the recognition of the key role played by the market in resource allocation, but the dominant role of state-owned sectors as stated in the report may cause some confusion. The planned deeper market reform is encouraging, while its true effect remains to be seen and will rely on its successful implementation. Several current economic difficulties can well prevent the government from following the rules of market. For instance, under the backdrop of a potential significant slowdown of Chinese economy after the 2008 world financial crisis, the government had already carried out stimulus plans and may step in again to avoid the collapse of its housing market. In addition, many new concerns such as environment protection and building the social security system also require the government to play a key role. Therefore, we may continue to see ups and downs of government in China in the years to come.

Liberalizing International and Domestic Trade

The Decision shows the continued commitment of China to open economic policies by further relaxing control over investment access; by providing equal treatment to both domestic and foreign investment; by providing stable, transparent, and predictable policies; by promoting the orderly opening up of finance, education, culture, healthcare, and other service sectors; and by further liberalizing general manufacturing. Although many people claim China has given up the “crossing the river by stepping on the stones” strategy and started to embrace whole heartedly the free market and open economic policy, I would still expect to see gradual changes. The reforms in the above areas may be carried out in a faster pace than before, but will not happen immediately.

A good example is the establishment of the China (Shanghai) Pilot Free Trade Zone. It is a major step that China has taken to deepen reform and open up in the face of new circumstances. Different from the special economic zones and export processing zones established in earlier years aimed mainly at promoting manufacturing, this new type of free trade zone focuses instead on financial and business services, which China has been very reluctant to open. A competitive services sector, as a typical feature of a modern economy, is crucial to sustained growth of China. If the experiment carried out in this free trade zone is successful, we would expect to see its expansion soon to the whole country.

Trade liberalization is usually achieved through various trade agreements. Besides the multilateral liberalization approach under the GATT/WTO, free trade agreements (FTA) have been on the rise, especially after the 1990s, partially because of slow progress made under the WTO in the last two decades. China also intends to speed up the construction of FTAs with neighboring countries, covering many traditional and non-traditional trade and investment related issues. FTAs may serve as an experiment for China to carry out some deeper liberalization initiatives in the areas such as investment, property rights, and services trade. In these areas, China and many other developing countries have been reluctant to open their domestic markets for fear of the fierce competition from advanced economies. Different from the multilateral approach adopted by the WTO, however, FTAs are by their very nature discriminatory because the preferential treatments apply only to member countries within the bloc, not to countries outside the bloc. This is a major exemption to the most favored nation clause of the GATT.

One pitfall of FTAs is the potential trade diversion effect when a country switches from a highly efficient non-FTA member country to a less productive FTA partner that enjoys preferential tariffs. In addition, the complex rules of origin and overlapping FTA networks, called “spaghetti bowls” by Jagdish Bhagwati, is another undesirable feature of regionalism. As a result, China should be cautious when moving away from the multilateral approach under the WTO to the bilateral approach. China has to balance well the potential benefits and costs of forming FTAs with neighboring countries.

Opening the Hinterland

The Decision also discusses how to further open up inland and border areas. China intends to promote the development of inland industry clusters by using preferential policies and promoting cooperation among regions. China will also accelerate the construction of infrastructure connections to neighboring countries and regions to build a Silk Road Economic Belt and a Maritime Silk Road, so as to form a new pattern of all-round opening. All of these policies are conducive to the economic development of the inland region.

When it comes to trade barriers, people tend to focus on international barriers and ignore domestic ones, even though domestic trade barriers can be significant. It is encouraging to see that the Decision also emphasizes developing transportation and logistics infrastructure to form a “corridor” of foreign trade that links different regions within China. Together with the market reform policy to “combat regional protection” in Article 9 of the Decision, this policy initiative intends to address the high cost of doing businesses among different regions within China. Although this issue is touched in the Decision, the economic cost of barriers within China and the potential impact of lowering such barriers may not be fully understood. Despite China’s impressive export performance in recent years, internal trade barriers remain surprisingly high but are less well understood. For example, it was reported that,

… a kilogram of cargo shipped from Shanghai to New York costs 1.50 yuan while the same weight shipped from Shanghai to Guizhou (the capital city of an inner province that is 2,000 km away) costs between 6-8 yuan. This makes the total cost of shipping from Shanghai to Guizhou four to five times as expensive as shipping to New York, which is 11,862 km away.  Transportation costs added to storage, and distribution management costs, lead to logistics costs 18 percent of GDP, that’s more than twice as much as the U.S. … Any western fashion brand from Gap to Versace, even clothing made in China, are priced 30 percent to several times more than the same product in the U.S. ^[7]

Much work has been done to examine national borders as impediments to international trade, but less attention has been paid to inter-state/provincial border effects. The internal trade barriers in China are significant and the domestic market segmentation is substantial, but these have been largely concealed by the country’s impressive export performance. These barriers not only explain why many Chinese-made products are sold in China at higher prices than in the U.S., but also help to demonstrate why China’s growth relies heavily on exports rather than domestic demand (arguably a contributing factor to global trade imbalance). A reduction in intra-China trade barriers and a less segmented national market is critical to a successful transition of an export- and investment-driven economy to a domestic consumption-driven economy.

Conclusion

To conclude, the Decision reconfirms China’s dedication to further liberalization of international and domestic trade in not only manufacturing sectors but also services sectors. Because policy making in a globalized economy becomes more complicated, the coordination of various policies remains to be a challenging task for China. It is inevitable to see some policy inconsistencies, loopholes and even setbacks during this process. For both policy makers and researchers, it is important to evaluate these policies appropriately and provide policy remedies in a timely manner.

Further Readings:

Ramo, Joshua Cooper, 2004. “The Beijing Consensus,” The Foreign Policy Centre. http://fpc.org.uk/fsblob/244.pdf

Williamson, John: What Washington Means by Policy Reform, in: Williamson, John (ed.): Latin American Readjustment: How Much has Happened, Washington: Institute for International Economics 1989.

Yergin, Daniel and Joseph Stanislaw, The Commanding Heights: The Battle for the World Economy, Published by Simon & Schuster, New York, 2002.

^[1] Upstream industries refer to sectors that process raw material into an intermediary product for the final production of finished product by the downstream industries. For instance, petroleum refineries refine crude oil into intermediary chemicals which can be used to produce plastics by other firms.

^[2] Tang, Heiwai, Fei Wang and Zhi Wang, “The Domestic Segment of Global Supply Chains in China under State Capitalism”, CESifo Working Paper No. 4797, May 2014.

^[3] Voucher privatization is a privatization method in which citizens are given or can inexpensively buy a book of vouchers that represent potential shares in any state-owned company. See

http://en.wikipedia.org/wiki/Voucher_privatization

^[4] Ramo, Joshua Cooper, 2004. “The Beijing Consensus,” The Foreign Policy Centre. http://fpc.org.uk/fsblob/244.pdf

^[5] Dollar, David, and Shang-Jin Wei, 2007. “Das (Wasted) Kapital: Firm Ownership and Investment Efficiency in China,” NBER Working Paper No. 13103. http://www.nber.org/papers/w13103

^[6] For more detailed discussion, please refer to The Commanding Heights: The Battle for the World Economy, by Daniel Yergin and Joseph Stanislaw, Published by Simon & Schuster, New York, 2002.

^[7] Li, Waiching, 2011. “Why ‘Made in China’ Costs More in China.” http://econintersect.com/wordpress/?p=11897

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