China’s Quixotic Quest to Innovate

By now, the systemic problems that bedevil China’s economy are obvious. The country is suffering from slowing economic growth, stagnating productivity, a malfunctioning property sector, the misallocation and inefficient use of capital, debt-capacity constraints, and weak household income and consumer demand. But it is less clear how Beijing should fix these problems. Many economists outside China, as well as some inside the country, believe that it must recalibrate its development model by making it far more market-oriented and driven by consumer spending. Chinese leader Xi Jinping’s Chinese Communist Party (CCP), however, cannot accept the political and institutional changes that such a recalibration would require.

So Xi has chosen a different path: a growth strategy centered on industrial policy, aimed at boosting what he and the CCP call “new productive forces.” In Marx’s thinking, this phrase describes the process whereby major changes in technology clash with the existing economic order, enabling communists to overthrow it. For Xi, these new forces are the sectors now at the vanguard of scientific and technological development, such as clean energy, electric vehicles, and batteries—in which China already leads—as well as industrial machinery, semiconductors and computing, artificial intelligence and robotics, the life sciences industries, and biotechnology and pharmaceuticals. Xi’s ambition is for China to achieve self-sufficiency in all these sectors. Xi believes that by focusing on industrial policy and innovation, he can rescue China’s beleaguered economy, seize geopolitical opportunities to lead the twenty-first century’s new industrial revolution, and end the United States’ dominance in the international system.

But this strategy is unlikely to work as Xi intends. China is without a doubt the world’s leading manufacturing nation. Beijing has proved that it can set successful industrial policy in some areas and encourage the rise of powerful companies. But it cannot create a true climate of economic innovation so long as its rigid politics and governance and exclusionary approach to institution building remain in place. In fact, an innovation-based industrial strategy may not be transformative if the government is unable to address basic systemic weaknesses such as youth unemployment, frailties in China’s banking and financial systems, and weak consumer demand. It is unlikely that China can succeed at encouraging the kind of broad innovation and disruptive change on which its economic growth strategy depends, especially in its current lower-growth environment.

COURSE CORRECTION

Xi hopes that an innovation-focused industrial strategy can heal the embarrassment of China’s failure to modernize in the nineteenth and early twentieth centuries. According to the CCP’s interpretation of history, Chinese leaders did not adequately respond to industrialization and imperialist intrusions by—for example—Britain, France, and Russia, yielding the so-called century of humiliation, during which foreign powers carved up the nation. He is determined not to flub what he sees as a similar moment.

Many elements of Xi’s new economic strategy remain unclear—for example, how it will be financed and whether financially strapped local governments can provide the funding. But what is clear is that the government intends to place an even greater emphasis on industrial policy to make China the undisputed top provider of tech-forward products such as IT hardware, industrial machinery, pharmaceuticals and biotech products, clean energy technologies, and electric vehicles, as well as a global leader in communications networks and nuclear, space, and life sciences research. These industries already accounted for nearly eight percent of China’s GDP in 2014 and 13 percent in 2022. Chinese officials aim to get that proportion of GDP up to 17 percent by 2025.

This approach is not new. It can best be understood as the latest initiative in a long line of industrial policy strategies that China has pursued since the beginning of the twenty-first century. Yet however Xi characterizes it, it is also purely and simply industrial policy in a country that already accounts for a third of global manufacturing. The policy’s price tag is likely to be eye-popping. According to recent studies by the Organization for Economic Cooperation and Development and the Kiel Institute for the World Economy, industrial firms in China receive substantially greater subsidies and other forms of state aid compared with their peers elsewhere. In 2021, the economist Barry Naughton described China’s investments in innovation from 2000 as “the greatest single commitment of government resources to an industrial policy objective in history.”

Maintaining high levels of support for industry will become one of China’s biggest headaches.

The CCP’s hope is that placing China at the vanguard of technological and scientific progress will not only cement its aspirations to lead the global economic and political systems but provide new growth momentum and prosperity at home. This outcome is unlikely, however, and not just because the cost of fulfilling the strategy may be prohibitive. Some government outlays will undoubtedly go toward boosting successful enterprises, but China’s top-down style of governance, its statist economic philosophy, and its preponderance of corruption mean that a great deal of the investment is likely to end up in waste and loss. In the case of initiatives for which failure is deemed to be a political embarrassment, officials will likely fail to account for losses properly.

The success of China’s new policy will depend on proper audits in order to identify failing initiatives before they become entrenched and efficiently allocate resources to the most commercially viable enterprises. But proper audits and assessments are tremendously difficult to do in China, given the government’s lack of transparency on funding and financing. Take the solar and wind industries: although the direct cash flows to leading firms can be measured, the indirect subsidies and assistance that flow through the supply chain cannot. Local governments are normally the agents of most industrial policy spending, but in China, these are generally in too poor financial shape to take on additional spending burdens.

Estimates by the Center for Strategic and International Studies suggest that industrial policy subsidies amounted to about 1.7 percent of GDP in 2019—a huge percentage compared with other countries, including the United States, where the equivalent figure was 0.4 percent. And that number is bound to have increased since then, especially as China has stepped up industrial support in the wake of export controls and restrictions that the United States and other countries have placed on China, especially those regarding semiconductor chips. Maintaining these high levels of support for industry will become one of China’s biggest headaches, especially given faltering national revenues and a host of other growing expenses, such as those brought about by a housing bust, an aging society, and rising spending on the military and on internal security.

FALSE ADVERTISING

The most fundamental challenge, however, is that the CCP persistently conflates industrial policy with innovation, which are not the same thing. Industrial policy is a vertical strategy that positions the state at the apex of the economy, leading the development, financing, and funding for designated industries and sectors with a view toward creating national champions. Fostering innovation, by contrast, is a more horizontal concept in which government initiatives are explicitly designed to create stronger and more inclusive institutions and conditions that encourage more development and creativity across a swath of sectors, including those often considered traditional, such as retail, wholesaling, transportation, and distribution. When a government seeks to boost innovation, it typically focuses on regulatory policies, encouraging competition, education and skill formation, infrastructure investments, and tax and labor policies. The government is mostly an enabler and facilitator, whereas with a more formally defined industrial policy the government takes on a more specific leading role indistinguishable from its role in promoting trade and exports.

But China’s track record on innovation is mixed. In 2023, the World Intellectual Property Organization’s Global Innovation Index—which ranks 132 countries by innovativeness based on 80 indicators—situated China in 12th place. This position looks impressive for a country with China’s income per head; China is the only middle-income country ranked among the survey’s top 30 most innovative nations. China’s overall score, however, conceals an important distinction. The index’s indicators are divided between so-called innovation inputs, which capture the aspects of an economy that enable creativity and innovation, and innovation outputs, the end results of innovation. Inputs include things like the quality of an economy’s regulatory, legal, and business institutions; educational attainment; research and development; communications and energy infrastructure, and measures of business and market sophistication. Outputs comprise knowledge creation, intellectual property, patents, labor productivity, software spending, intellectual property, high-tech exports, trademarks, brand value, and online creativity.

In the World Intellectual Property Organization’s 2023 survey, China ranks eighth in terms of innovation outputs but 25th in terms of inputs—a noteworthy difference, because over the long run, strength in inputs ultimately determines an economy’s strength in outputs. That distinction reveals that China’s manufacturing prowess and ability to absorb and exploit knowledge and technology is world-class. But the broad variety of institutional factors that ultimately help nurture creativity and initiative across society are not in the same league. 

Consider, also, China’s prowess in one often cited measure of innovation capacity, patent registration. Globally, China now accounts for almost half of global patents. Yet the overwhelming majority of Chinese registered patents are of the lower-value utility type—for example, the creation of particular products or processes—as opposed to the more science- and innovation-oriented design type in which Germany, Japan, and the United States excel, which safeguard unique design characteristics that could be applied to an infinite array of future products. Less than ten percent of Chinese patents are filed and granted abroad, suggesting that a lot of effort goes into patent registration domestically that is not recognized or valued abroad. In a 2024 study, Yuen Yuen Ang and other authors examined 4.6 million patents filed between 1990 and 2014 in 333 mainland Chinese cities. They discovered a high level of gaming of top-down patent targets. China’s patent registrations can often be attributed to wasteful subsidies and duplicative and low-value patents.

SYSTEMS FAILURE

Xi’s new “productive forces”-focused industrial policy will also fail to address the systemic weaknesses that have put China’s economy in danger. Because it will encourage overproduction and expansion in industries with relatively low labor input, it will be unlikely to reverse the tide of jobs flowing out of other forms of manufacturing and construction into lower-paid, lower-skill sectors such as delivery, ride-hailing, and selling products on online platforms.

The emphasis on industrial policy also fails to address the serious damage that Xi’s repressive governance has wrought on the private sector. Superficially, Xi’s government has lately adopted more encouraging rhetoric toward private enterprise. But Beijing has not made real adjustments to the political and regulatory environment that constrains private enterprise, especially the national-security and anti-espionage regulations that conflate the collection, use, and transfer of information that is essential for due diligence with misconduct and criminality.

In accord with Xi’s famous dictum that “government, military, civilian, and academic; east, west, south, north, and center, the party leads everything,” the Chinese government still affords top priority to state-owned firms and metes out arbitrary punishments to businesspeople who fall afoul of its wishes. That political inclination also means that Xi’s industrial policy ignores the need to boost consumption in China. While CCP leaders pay lip service to the need to boost consumer demand, they do not actually hold policies to drive consumption in high esteem, because their ideology rejects “Western” consumerism.

Xi’s emphasis on industrial policy fails to address the damage that repressive governance has wrought on the private sector.

Finally, the new policy risks simply externalizing the consequences of its economic and industrial policies in the form of higher exports, lower prices, and, for countries such as the United States, bigger trade deficits. It is impossible to envisage how China, whose manufacturing sector now represents 29 percent of GDP and a third of global manufacturing, could further subsidize and boost manufacturing without incurring bigger imbalances and debt at home and imposing larger trade deficits on the rest of the world. By externalizing the Chinese economy’s demand weaknesses, Beijing will likely trigger more and more retaliatory policies from other countries, and these could also damage the Chinese economy.

In May, the Biden administration announced a number of new and additional tariffs on Chinese products such as steel, aluminum, semiconductors, lithium batteries, solar cells, some medical products, and ship-to-shore cranes, while tariffs on electric vehicles have been raised to 100 percent. The EU, for its part, has launched an investigation into China’s alleged distortion of the market for electric vehicles, as well as inquiries into railway engines and wind turbines. The European Commission’s concerns about China’s market-distorting practices could lead to retroactive countervailing tariffs. Even some countries in the global South, which China regards as a bedrock of support, have lately pushed back against what they regard as intrusive trade practices.

NO SHORTCUTS

Although China will undoubtedly make some headway with its new industrial-policy goals, its hope to lead the world in innovation cannot be easily reconciled with its unswerving belief in the effectiveness of government direction, its distaste for free market competition, its weak legal and regulatory institutions, and the rent-seeking and corruption that characterizes its economy. Japan offers a worthwhile point of reference. Writing about Japan’s industrial, corporate, and trade policies in Foreign Affairs in 1987, George Packard predicted that the country’s “strategy will result in spectacular advances and growing supremacy in a variety of fields such as industrial ceramics, lasers, semiconductors, biotechnology, solar energy, robotics, superconductors and possibly in space exploration. These advances, in turn, will be largely used in consumer products and will lead to increasing exports, rising ‘techno-nationalism,’ and deepening fears among Americans that we can no longer compete.”

One might be forgiven for thinking that this passage was written recently about China. Predictions that Japan would achieve worldwide industrial supremacy never came true. As a result of deep-seated systemic flaws in Japan’s economy and misguided policies, by 1990, leading Japanese companies such as Sony, Hitachi, Toyota, Honda, Matsushita, and Sumitomo succumbed to the bursting of Japan’s asset bubble, precipitating a relative macroeconomic decline that lasted for almost three decades. The causes and consequences of the economic shock in Japan were compounded by important institutional weaknesses, including the government’s resistance to reform the role of financial institutions, rigid corporate governance, archaic labor-market practices such as lifetime employment, and nepotism between firms and the public sector. Many of these factors are also present in China today. And although China does not lack laws, it does not—and cannot—develop an economy governed by the rule of law.

The example of Japan shows how two things can be true at the same time. An economy boasting world-class companies and striking achievements in innovation can also be an economy in which systemic imbalances, asset bubbles, political contradictions, and institutional rigidities run too deep for the most impressive companies to drive sustainable nationwide growth. Great firms and a strong top-down industrial policy do not protect an economy against bad macroeconomic outcomes. Technological islands of excellence are no substitute for good macroeconomic governance and well-institutionalized technology ecosystems that diffuse benefits throughout the economy—neither of which the Chinese system seems likely to produce any time soon.