Hailed by some as a blueprint for economic success, China's industrial policy really risks negative spillovers and impeding economic growth, writes Guangwei Li (ShanghaiTech University).

Author: Guangwei Li, ShanghaiTech University

China’s industrial policy has drawn global attention, sparking different reactions from developed and developing nations. Developed countries tend to perceive China’s industrial policies as a threat to their firms’ competitive positions, leading them to respond with their own industrial policies. Many developing countries view China’s policy as a blueprint for economic success, inspiring them to adopt similar policies in the hope of achieving rapid economic growth.

From both perspectives, though, there’s a consistent underlying assumption — acceptance of the significant role of industrial policy in China’s economic success.

The history of Chinese industrial policies, however, offers valuable insights. Initially, Chinese industry operated under a state-centred, ‘pure’ Soviet-style planned economy, where industrial policies in the usual sense did not exist. Instead, economic directives were authoritative commands. It was only during the reform and opening-up era of the late 1970s and 1980s that industrial policies emerged as essential tools for economic management. During this time, China drew inspiration from Japan’s remarkable post-war economic achievements. It considered Tokyo’s proactive intervention through industrial policies the key factor behind the much-acclaimed ‘Japanese miracle’.

The influence of the Soviet-style planned economy and Japanese industrial policies on China have been profound. China began with an economic management system marked by absolute government control. Beijing made decisions about the production, pricing, and the distribution of goods within and across industries, effectively sidelining market mechanisms. In this context, as China chose a new development path, it possessed the ‘advantage of backwardness’.

Any industrial policy implemented during this period, even if it appeared heavy-handed from a ‘pure’ market economy standpoint, could be seen as a step towards economic liberalisation. In an era when the Chinese economy faced severe shortages of capital, technology, and skilled managers, the continuous regulation of the flow of inputs across sectors did not significantly hinder growth.

While China focused on catching up with developed nations, Japan’s industrial policies served as valuable guides. China could refine its policies by adapting successful Japanese industrial policies and discarding ineffective ones.

Then the trajectory of Chinese industrial policy underwent a significant transformation in 2006 with the introduction of the Outline of National Medium- and Long-term Program for Science and Technology Development. This was the first official endorsement of domestic innovation, reflecting China’s ambition to propel its firms towards achieving cutting-edge technological capabilities.

The outline itself was not an industrial policy, but a national strategy that guided subsequent industrial policies for innovation-driven development and technological self-sufficiency, including, later, the Made in China 2025 initiative.

Promoting innovation-driven growth became an imperative for China. While the readily attainable benefits of microeconomic liberalisation were realised between the 1980s and early 2000s, China now grapples with challenges such as an ageing population, a declining workforce, diminishing returns on investment and decreasing productivity. Faced with these obstacles, it has no choice but to shift its economic focus towards innovation-driven growth. That said, industrial policy might not be the most effective approach to achieving the transformation that is now desired.

There is a growing gap between the Chinese government’s industrial policy ambitions and its capacity to realise them. As the technological objectives of China’s industrial policy have expanded, so has the challenge of precisely targeting directions and measuring outcomes. This complexity has also widened the scope for opportunistic behaviour by firms and local governments.

A 2023 study on quantity-based subsidies under heterogenous innovations developed a Schumpeterian growth model analysing the direct relationship between China’s industrial policy and its impact on economic growth. The study focused the trade-off among innovating firms between radical and incremental innovations when faced with industrial policies. The study separated the aggregate impact of government subsidies into quantity and quality channels.

Utilising Chinese firm-level data from the early 2010s, the analysis revealed that the negative effects of the quality channel dominate the positive effects of the quantity channel. During this period, innovation subsidies based on quantity reduced the total factor productivity (TFP) growth rate and welfare by 0.19 percentage points and 3.31 per cent, respectively. This evidence suggests that China’s innovation-driven industrial policy may sometimes actually impede economic growth.

Other empirical evidence corroborates the reported negative impacts of industrial policy on TFP growth. An investigation into the relationship between government subsidies and TFP for Chinese listed firms suggests there is limited evidence that the Chinese government ‘picks winners’. The predicted productivity of firms is, rather, negatively correlated with the subsidies they receive from government. Subsidies also appeared to have a negative impact on firms’ ex-post productivity growth between 2007 and 2018.

A related study in 2020 for the National Bureau of Economic Research Working Paper Series examined the impact of the Made in China 2025 policy initiative on subsidies received, research and development expenditure, patenting, productivity and profitability of Chinese listed firms. The study found that while more innovation-promoting subsidies seemed to flow to listed firms targeted by the policy and these firms subsequently exhibited an increase in research and development intensity, there was little statistical evidence of improvement in productivity, patenting and profitability.

While research has raised doubts about the efficacy of China’s innovation-focused industrial policies, the influence of these policies on other economies in the region is ambiguous. Some researchers have demonstrated that industrial policies targeting upstream industries with strong spillover effects can benefit downstream industries. This suggests that, theoretically, Chinese industrial policy could aid foreign industries that are downstream of China’s targeted industries within the same supply-chain network.

This conjecture is complicated by findings that indicate that government subsidies in China have a positive direct effect on the productivity of subsidised firms but exert a negative indirect effect on non-subsidised firms operating within the same cluster. The negative indirect effect tends to dominate, revealing the uncomfortable reality of industrial policy — that benefits for one industry or firm might come at the expense of another. These negative spillovers might even extend across borders.

Guangwei Li is Assistant Professor at the School of Entrepreneurship and Management, ShanghaiTech University.

This article appears in the most recent edition of East Asia Forum Quarterly, ‘Industrial policy 2.0’, Vol 15, No 4.

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