‘Two sessions’ 2021: how China can fine-tune its dual circulation strategy to boost economic growth

Beijing has yet to address the policy distortions that have led to a decade-long growth slowdown, amplified now by US decoupling measures
It needs to find a balance in allocating public investment and between accessing technological expertise from abroad and developing capacities at home

Yukon Huang

Published: 3:30am, 4 Mar 2021

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China’s National People’s Congress meetings starting this week will formally endorse the 14th five-year plan. Progress during this period is likely to determine whether China will realise its longer-term ambitions for 2035 of becoming a prosperous nation and major innovative power.

Right now, China appears well on its way to achieving these goals because it has handled the pandemic much better than other major economies. Beijing’s draconian measures have facilitated a sharp industrial recovery and surge in exports.

China’s 2020 trade surplus increased by a quarter over the previous year and foreign reserves have hit a near-five-year high. For the whole of 2020, GDP grew 2.3 per cent, much better than the 4 per cent to 10 per cent declines for the US and euro-zone economies.

The reality, however, is much more challenging. Beijing has not yet addressed the policy distortions that have led to a decade-long growth slowdown, amplified now by US decoupling measures. The leadership has put forward a dual circulation strategy that suggests greater reliance on domestic demand if the external environment continues to be hostile.

The dual circulation concept would be more operationally useful if the domestic focus was devoted to reversing the sharp decline in the productivity of investment and the external focus was on finding the right balance between accessing technologies from abroad and developing them at home.

The link between investment and growth is captured in an indicator that economists refer to as the incremental capital-output ratio, which measures how many units of investment are needed to generate a unit of gross domestic product. Since 2005, that number has nearly doubled from 3.3 to over 6, a near halving in the productivity of investment.

The problem is not with private industrial investment, for which productivity has remained high, but with public investment largely for infrastructure carried out by central and local authorities. The issue, however, is not so much the amount being invested or that infrastructure is inherently wasteful but where the state has been investing.

For decades, public investment has been increasingly channelled to the interior provinces, especially in the far west. Returns on investment there are much lower than in the central and coastal provinces. This regional focus is being driven by both equity and strategic concerns.

Given the government’s high-level commitment to eliminating poverty, priority has been accorded to regions like Xinjiang, Tibet and Inner Mongolia. These are isolated areas with large concentrations of disadvantaged ethnic minorities, politically sensitive borders and a greater likelihood for social unrest.

They have been served with ambitious but low-return infrastructure projects, exemplified by four-lane highways with sparse traffic, a railway line traversing the Himalayas into Tibet, and communication systems across deserts and mountains serving isolated communities. The net impact is a reduction in GDP growth rates of perhaps a full percentage point annually.

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China’s new railway makes circular network with Qinghai, Tibet and Xinjiang lines

Another aspect of dual circulation relates to Beijing efforts to rely less on foreign technology and expertise and more on strengthening domestic capacity for innovation. China has been extremely successful at absorbing foreign expertise. But its future growth prospects now depend on whether it can become more self-sufficient technologically despite, or perhaps because of, the US decoupling measures.

The irony is that while security hardliners fear China becoming an innovative superpower, many observers believe that it will have difficulty in this regard. The argument points to flaws in China’s state control over resources and information flows, weak protection of intellectual property rights, and a learning environment generally depicted as stifling creativity.

This pessimism is overdone. China has made major progress in strengthening its human capital base and capacity for research and development, but what really sets the country apart is the combination of its huge market and exceptionally competitive pressures driving innovation.

The huge market means Chinese firms can achieve economies of scale at home before having to venture abroad, and that global firms cannot avoid investing heavily in China, for fear of losing their main avenue of growth. Competition arises both externally – from trade and foreign investment – and internally, from fierce cross-provincial rivalry between firms.

Finally, China is also blessed with inherently curious consumers who are willing to embrace new approaches, explaining why China is so far ahead of its Western counterparts in providing digital banking services and becoming a major player in apps, with offerings like TikTok.

Yet, China has not yet been able to produce its own globally competitive car and is struggling to produce second-generation semiconductors. This illustrates the limits of “leapfrogging” up the innovative ladder even with strong state support.

The future for Chinese firms that rely on imported semiconductors and other hi-tech components depends on the country’s success in manufacturing these products domestically. Experts suggest that it would take at least a decade for China to narrow the gap enough to achieve an acceptable degree of independence.

There are equally thorny problems to be resolved in dealing with tech transfer issues and the sanctions against Huawei Technologies Co. in particular. The provision of globally sensitive services such as 5G may need an international regulatory agency to mitigate risks, similar to the role of the nuclear Non-Proliferation Treaty. The alternative of having Huawei partner with a European company like Nokia to mitigate security concerns is far better for everyone than preventing it from operating at all.

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Chinese engineers from Huawei, China Mobile build world’s highest 5G base station on Mount Everest

The likelihood of China becoming a major innovative power will also depend on how its regulators deal with the increasing power of its internet giants. Their prominence has raised concerns about financial risks stemming from their control of data, as evidenced in recent actions to rein in Ant Group. But these regulatory interventions need to be handled carefully to avoid dampening innovative initiatives.

In sum, Beijing needs to find the right balance in allocating its public investments and between accessing technological expertise from abroad and developing capacities at home. How well it does will determine whether GDP growth rates will be closer to a reassuring 6 per cent or a disappointing 3 per cent at the end of this five-year plan.

Yukon Huang is a senior fellow at the Carnegie Endowment for International Peace