Industrial Policy – Lessons from China

Industrial policy has been a reform instrument in China since the late 1980s, playing a decisive role in China’s development from an imperative planned economy to a “market economy with Chinese characteristics.” So, it is not surprising that industry has become one of the most important pillars of the Chinese economy over the years. Now, it contributes about 40 percent to GDP, 28 percent to employment, and more than 40 percent to the gross value added of the Chinese economy. For Chinese policymakers, industrial policy is not only a reform instrument of the past, but the means to become an international leader in innovation and technology in the future.

In the previous blog post from our series “The Future of European and German Industrial Policy,” we presented the industrial policy approach of the US with a special emphasis on its role in fostering innovation. Now, we continue with the Chinese industrial policy, its history, and how its undergoing reform is shaping a new Chinese economy.

Historical development

China has experienced a unique development in recent history: from a relatively poor country in the late 1970s to the second-largest economy in the world. Between 1978 and 2017, China’s GDP grew by a factor of 225 from 367.9 billion RMB to 82.7 trillion RMB. Today, China is the “factory of the world” in terms of industrial production and a serious new competitor for developed industrial countries. This has been, to a large extent, the result of active and targeted industrial policymaking.

This active approach started in the late 1980s when the 7th Five-Year Plan (1986-1990) named industrial policy as an official reform instrument. China’s reform politicians influenced by the “East Asian economic miracle” saw the necessity of building a new industrial model that would allow China to follow a “catching-up” process vis-à-vis the industrialized countries as was the case of South Korea and especially Japan in the 1960s and 1970s. In the following decades, a series of economic reforms would allow China to build an industrial model that attracted manufacturing of foreign firms and would lead to rapid economic growth.

From the “factory of the world” to an innovation leader

The process of economic reform that started in the 1980s had an important effect on the development of the Chinese innovation landscape as fostering domestic technologies, and independent innovations became more relevant for Chinese politics. As early as the 1980s, a number of programs ranging from financial support for R&D and cooperation between business and science up to the creation of autonomous research institutions were initiated by Chinese policymakers.

Most importantly, in recent years, it became a central goal of Chinese economic policy to end China’s role as “factory of the world” and move up into the lucrative segments of global value chains becoming the “research laboratory of the world”. The emphasis of Chinese policymaking has evolved to be placed even more strongly on an industrial innovation policy than in the past, resulting in national strategies like Made in China 2025 (MIC2025) that aim to bring more dynamism to China’s economic development by promoting innovations.

Chinese strategies and measures

Fostering innovation is a core objective of the current Chinese economic order. The state has a fundamental in supporting public and private institutions in the technology sector. To this end, the central government issues economic and political guidelines that are implemented by local governments with a certain degree of leeway. Moreover, the Chinese innovation model contains both centralized and decentralized elements and is characterized by a complex interplay between central and local government, private companies, and research institutions. Similar to the USA, the state plays a prominent role as regulator and consumer.

It also guarantees protection for domestic companies against foreign competition so that they can develop internationally competitive innovation activities. These strategies and the conscious protection of domestic companies play an important role in the creation of innovations made in China.

Strengths and weaknesses

China’s recent development of innovation and technology has shown that the Chinese government is able and has the political will not only to formulate long-term strategies but also to implement them. These include industrial policy strategies such as MIC2025, which set targets over a period of more than 30 years on how certain industries and technologies should develop and where the acquisition of foreign technology may be necessary. The Chinese government also has the financial means to do so. Both strategies play an important role in the development of new infrastructure, which is necessary for the implementation of innovations.

The roles of the state as regulator, financier, and consumer are also strengthened by combining long-term governance with sufficient financial resources. In this way, the Chinese government can promote innovative technologies in a targeted manner and encourage companies to push these more strongly. In addition, market size combined with highly competitive pressure is an important factor in the development of the Chinese innovation model. It can have a positive impact on the market introduction, adaptation, and distribution of technology since economies of scale can be achieved more quickly. Thus, the incentive to bring innovations quickly to market maturity and become concrete application in practice can be higher than in small economies.

However, the strengths of the Chinese innovation model go in part hand in hand with China’s autocratic political system. This exhibits significant weaknesses. These weaknesses include, for instance, the education system, which in large parts is still not designed to promote independent creativity and critical questioning as well as restrictions on the free flow of information – both essential factors for an innovative economy. This makes it more difficult to reduce China’s dependence on foreign technologies. In addition, there are ethical questions that have so far played a much smaller role in the Chinese research and innovation landscape than in the EU and Germany (e.g., genetic research).

An additional systematic weakness of the Chinese economy has been the misallocation of resources, which unavoidably affects the innovation initiatives of the Chinese government.  Furthermore, China’s industrial policy programs to promote technology and innovation can also cause discrimination and distortion of national and international competition. On the one hand, the question arises as to whether state support always reaches the most innovative domestic companies or whether it is rather the politically best-networked, i.e., often state-owned companies.

Discrimination against foreign companies often emerges as a by-product of the protection of national firms. Foreign companies and governments are less and less willing to accept such distortions of competition. They are increasingly taking action to defend themselves. The most extreme example of these actions is currently the trade conflict between the USA and China, which could cause considerable damage to China. The most important goal of the Chinese government – to make China a leading location for technology and innovation by 2049 – is being severely disrupted by this issue.

The future challenge of Chinese industrial policy

China’s innovative capacity will be crucial for its future competitiveness, especially as it is in direct competition with other industrialized countries.  Nevertheless, China is still highly dependent on foreign technology, particularly in the high-tech sector.

Although, as stated above, the Chinese government is already in the process of changing this, the next step is for China to develop into a world-leading location for innovation and technology, especially in key sectors such as aviation, robotics, environmental protection, transport, and medicine. For this to work, Chinese policymakers are challenged to develop further mechanisms and strategies that foster domestic innovations but, most importantly, that allow China to cooperate and compete on a level playing field with and in foreign markets.