Modern central banking in the modernization drive

Shortly after being reappointed as the governor of China’s central bank, Yi Gang gave a speech in Beijing with the rather dull title of “Building a Modern Central Banking System to Contribute to Chinese Modernization.” As is obligatory with the speeches of most Chinese officials, it opens and concludes with references to the important decisions of the Communist Party and the major slogans of the moment.

The key term in the title of the speech is one of these coinages from Xi Jinping: the more precise translation would be Chinese-style modernization (中国式现代化), as it refers not simply to the modernization of China but modernization done China’s way. It’s one of the umbrella terms for his overarching project of achieving national greatness.

The bulk of the speech consists of Yi summarizing the central bank’s major policy priorities and justifying how it has pursued them. The temptation for foreign readers is to skip over the political sloganeering at the beginning and end and focus on the technical content in the middle.

Indeed, this was the approach that Yi himself took when he gave a more elaborate version of the same presentation, in English and with charts and references to the economics literature, to an audience in the US. Yi favorably compared the gradualist methods of the People’s Bank of China, which moves interest rates rarely and in small intervals, to the dramatic recent swings in Federal Reserve policy (see the writeup in The Economist for more on this angle).

Yi Gang on April 14, 2023

But abstracting Yi’s speech from the Chinese political context in this way risks blinding us to the some of the significance of what he says. How Yi positions the central bank’s technical policy priorities relative to the overarching goals of the Communist Party leadership is a very important part of his speech. What I think he is doing is nothing less than trying to ensure that modern central banking and financial regulation can be implemented in the Chinese political context.

To maintain political buy-in from the leadership for his preferred policies, Yi needs to convince them that these policies do in fact serve the overarching political goals set by Xi. He starts off his speech by citing the official mandates of the People’s Bank of China, as written in Chinese law. Based on the text of the law, he asserts that

Preserving currency stability and financial stability are the two central tasks of the PBOC. On this point, everyone has increasingly reached a consensus in recent years. By properly accomplishing these two tasks, we can promote full employment and economic growth, which better serves Chinese-style modernization.

That is pretty direct and clear: the traditional goals of the PBOC and the consensus of technical experts are not in conflict with the current political agenda, but actually support it. Yi further elaborates that the concept of currency stability includes stability of consumer prices and stability of the exchange rate, both of which are not only beneficial to the population at large but help the nation achieve long-term goals:

Stable consumer prices and exchange rates serve to safeguard the pocketbooks of consumers, so that the money in their hands won’t depreciate. Fundamentally, this is a people-centered effort to safeguard the interests of the broadest possible majority of the people. …

Price stability and the basic stability of the renminbi exchange rate at an adaptive and equilibrium level provide strong support for us to realize the strategic goal of Chinese-style modernization. 

At the end of the speech, Yi acknowledges that the new agenda laid out by Xi at the Party Congress and other high-level meetings requires at the Party Congress “means new requirements” for the work of central bankers. But fundamentally what he is saying in this speech is that these new requirements can be met by the same old policies. The key ones he highlights in the speech are: a less controlled and more market-determined exchange rate, strict regulation oriented towards preventing financial risk, and a conservative monetary policy biased against dramatic moves.

This emphasis on stability and continuity is probably why Yi’s speech got little attention in the press. He did not propose anything new, and largely emphasized recent accomplishments. But that is the point he wants to make: these policies have been successful in making China stronger, so they should continue. You don’t have to agree that his argument is correct on the merits to understand that he wishes to preserve the PBOC’s autonomy and policy preferences in an era of heightened politicization and grand campaigns.

It’s not hard to imagine how some of Xi Jinping’s priorities could potentially have big implication for macroeconomic policies. He has a vision of a whole-of-society effort to refashion China’s industrial base to make it less vulnerable to external shocks. His “dual circulation” concept calls for reducing China’s economic dependence on the rest of the world while increasing the rest of the world’s economic dependence on China.

To pursue these ideals, some officials could perhaps argue for an aggressively undervalued exchange rate, that keeps exports competitive and deters domestic spending on imports, or a much looser monetary policy, to ensure industrial upgrading has plenty of resources. That stuff hasn’t happened, perhaps because Xi favors strict supervision and control in finance as in other areas. But it’s still an open question how existing macroeconomic policies will adapt to the political requirements of Xi’s so-called “new era.”

Beijing Q&A on growth and security

 In Beijing earlier this month, I bumped into some former colleagues from the foreign press corps, and was invited to come talk to the Foreign Correspondents’ Club of China. As a former officer of the FCCC, I could not turn down such an invitation. Below is a transcript of that session on May 3; it was all Q&A, pretty lively, and we covered a lot of ground. I’ve cut out a few bits where my answers were short or unilluminating, and smoothed out the speech for easier reading.

· · ·

Q: Andrew, maybe we start with this. I saw you wrote a piece the other day about the Politburo on the state of the economy last week and which I also found very interesting. So what are the other key takeaways from this meeting? The signals seem to be more mixed, not really upbeat, enthusiastic but more sober as far as I understand.

A: I think there are a few key messages from the Politburo meeting.

The first was basically to deliver a positive assessment of the economy: they said very clearly that the economy is performing better than expected. I guess it depends whose expectations that is relative to, and I think they mean their own expectations as of late last year. If we think back a bit, remember that a lot of people worried that there would be multiple waves of Covid outbreaks and that the economy wouldn’t really get going until Q2. And in fact Covid wrapped up pretty quickly and things started to get back to normal just before Chinese New Year. So overall, the first quarter was better than expected for that reason.

The corollary to the better than expected outcome is that they don’t need to necessarily juice the economy a lot more. The economic policies that they’ve taken over the past year have been pretty extensive, but I think a lot of them didn’t really have a chance to work cause of the disruption from Covid lockdowns. There’s a cumulative effect of various things they’ve done in terms of loosening property market policies, cutting interest rates, expanding credit growth. Basically all of that stuff is hitting the economy now as a delayed impact over several months. I think their assessment is that this stuff is working, it’s feeding its way through into the economy, and we don’t necessarily need to pump it up a lot more since growth has already accelerated.

And then another key message was really to reassure people that the disruptions of the last couple of years will not return. So you’ve seen in the rhetoric very clearly over the last few months this repeated mention of support for the private sector, even specifically support for the internet platform companies that were the target of severe regulatory action in 2021. That’s a pretty clear shift in the signaling on this particular issue.

There is a longer term question that everybody acknowledges, and I think it’s interesting that the Politburo also acknowledged it in the communique. Yes, we’re having this bounce back in consumption. Everybody can see that, it’s a natural process. Obviously people have been prevented from consuming as normal for quite some time. So we should expect that they come back and do some of the things that they’ve been wanting to do for a long time. But is that really enough to drive sustainable growth for the economy over more than the very short term?

Q: What we’ve seen over the past few weeks is more like an overshooting of consumption as people want to travel again. Over the next few weeks, we might see a moderation, and see that this was more or less revenge spending and then things will normalize. I’m thinking of unemployment rates among the youth, and I’m thinking of lagging household income growth. And then at the same time we’ve seen private investments are still pretty low. So that this ends up like an L-shaped recovery, which will then moderate very fast during the second half of the year probably.

A: Yeah, that’s one view. My view is a little bit different, and is maybe a little more optimistic than that. I don’t think consumption is overshooting right now. If we look at different indicators of consumer spending, they’re still below where they should be based on the pre-pandemic trends. Right? If we just assume that those growth rates had continued, then household spending should be up here, and instead it’s still about here.

So, I don’t think that consumption is overshooting. I think it’s in the process of getting back to trend. And there’s still more room for consumption to continue to improve in coming months. In the very short term, there is this kind of snapback dynamic. There’s probably a lot of pent-up demand in the first quarter, and maybe some of that comes off a bit in April. But early indications are that the travel for the May Day holiday was also pretty good. So maybe things pick up again in May. I’m not the expert on this kind of micro forecasting of what the Chinese economy is doing week by week. But my basic view is that the rebound in consumption has started and it still has some way to run rather than already being exhausted.

And I think the prospects for the second half of the year are actually a little bit better. One reason is that in this initial phase of reopening from Covid, you’re seeing what I would call trickle-down consumption.

You have the high-income households, the people who were able to wait out the lockdowns working on their laptops from home, whose salaries were not cut, who didn’t lose their jobs. They have household savings, and they have the same income that they had before Covid, or even higher, and just haven’t been able to consume as normal. They have come out in force in the initial stages. And as they spend more on recreation, services, travel, all that stuff, they support employment in service sectors and create more jobs. Then you’ll see some of those gains trickle down to lower parts of the household income distribution.

So I think in the first half of the year you have this initial boom of spending from the upper half of the distribution. We’re already seeing signs that the the job market is improving, unemployment is coming down. Business surveys show that companies are hiring more and worth paying higher wages. This stuff takes effect with a little bit of a lag, and I think it will show up more obviously in the second half of the year.

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Q: One interesting thing that was in the readout from the Politburo meeting, and you also mentioned it during your first answer, that there’s a commitment that they’re not going to repeat the mistakes of the past, like on internet platforms and private business and so on. How can we be really sure that this is not going to happen? I mean, we’ve just seen very loud commitments to foreign investment and they want foreign companies to come in. At the same time they’re raiding the offices of foreign companies. And so there’s always, in my view at least, a gap between the official rhetoric and then what’s going to happen on the ground and in the provinces and cities.

A: Yeah, that’s obviously a very fair point. I think generally there’s an issue with authoritarian regimes making promises about what actions they will take in the future. Because by the nature of the regime, their actions are not bound by any external constraint. So it’s hard for them to credibly commit to not doing certain things. They may feel like not doing them now, but if they feel like doing them later, there’s nothing to stop them basically.

I guess my view on this is a little bit cynical. There’s a school of thought out there that that the new administration led by the new Premier is trying to bring back a quote unquote pragmatic, quote unquote business-friendly, style of policy making. I think that’s true in kind of a short-term tactical sense. I don’t think it’s true in a long-term strategic sense.

The the top guy has been pretty clear that he wants to reorient the way the Chinese bureaucracy functions away from the all-out pursuit of economic growth and towards the pursuit of a different set of goals. And I think the style of policy making that people now conventionally describe as pragmatic and business-friendly was really an artifact of that previous policy orientation — where every government official at every level knew that they had to do anything they could to support economic growth. And that’s not the regime that we’re currently in.

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Q: Can the youth unemployment problem be solved in coming years? Or is it some kind of structural problem? There’s more and more young people coming to the job work market from the universities every year.

A: I think high youth unemployment right now is a cyclical problem, not a structural problem. I think it’s a result of basically everything that happened during Covid with all the lockdowns that destroyed a lot of service sector employment, which is precisely the kind of jobs that young people tend to take at the very early stage of their career.

Right now I think that youth unemployment is just kind of a more volatile indicator of overall unemployment. It’s higher than total unemployment. But as total unemployment comes down, I think youth unemployment should also come down. That’s based on the argument that I just made, that the improved consumer spending on services is going to create jobs, or restore jobs that were destroyed over the last three years, since there is some recent improvement there.

I think there is a structural mismatch in the Chinese labor market. I’m not sure if high youth unemployment is exactly the right diagnosis for it. Basically you’ve had a huge expansion of university education over the last couple of decades. So right now the system is producing a lot of people who, because they have university degrees, want to be white collar employees. And that is the whole point of having a university degree: that you can be a white-collar salaried employee and work with your mind and not with your hands. But in fact, a lot of the jobs that the economy is creating are more blue-collar jobs where you do work with your hands and not with your mind.

So I think there is a kind of a structural mismatch. I’m not sure there’s a mismatch in terms of the number of people, but there is a mismatch in terms of people’s expectations about what kind of jobs that they’re entitled to as a result of their own efforts, and then what kind of jobs the economy is actually offering.

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Q: Can I just go back to what you were saying about the overall policy direction and to ask you what do you think foreign investors ought to think about common prosperity, what it means for them? You can also tell us what you think it means.

A: One interpretation of the rhetoric on common prosperity is that the government wishes to have a more explicitly left-wing, socialist, social democratic, call it what you will, type of policy and be more aggressive in redistributing incomes. Some people are worried about that because they see a lot of China’s success as having come from pursuing relatively more liberal, free-market policies rather than these kinds of measures that we’d associate with European social welfare states.

I don’t think that’s what common prosperity actually is. So if people are worried that there is going to be new government program to expand the welfare state and redistribute income, they can rest assured that, at least in my view, that’s not going to happen.

I think the common prosperity rhetoric is more political signaling from the top. It’s more a kind of political campaign to signal the administration’s adherence to socialist values.

It is, strangely enough, not really connected to specific policy discussions. In fact, if you read the debates about common prosperity domestically, there’s a lot of people who are saying, well, we have this goal of common prosperity, that means we should implement measures like, better unemployment insurance, or a better pension system. And yet there doesn’t seem to be any actual interest in or movement toward doing these things.

So I don’t think the common prosperity rhetoric is a sign of a so-called leftist tilt in Chinese policymaking. The actual substance of it is a bit harder to interpret, I think, for outsiders. But again it is, in my view, more of a political campaign that’s oriented around symbolic gestures rather than substantive changes in economic policy.

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Q: What’s going on in the property market?

A: Property, always a super interesting question for China. I think the surprise in the first couple months of this year is that property market sentiment was actually pretty decent. Sales were up quite a lot, and prices are rising in most of the cities. Again, I think there’s this pent-up demand issue where a lot of stuff snaps back immediately after the reopening. Maybe it doesn’t last quite as long, and property sales have tailed off a bit from where they were in January and February. But they’re still running decently above last year’s level.

So it does seem that in fact property is going to be a growth contributor for China this year, which is not something that a lot of people necessarily expected last year when we went through the biggest property market correction in modern Chinese history.

The outlook past this year I think is a little more equivocal. It’s our view and the view I think of pretty much everyone that the fundamental demand for housing in China is probably at or past its peak. It’s probably not a growth sector for the economy in the future. So it’s going to be stable or declining as a share of the economy, which means it’s going to be be subtracting from growth rather than adding to it, on average, in the future.

This year sales are likely to be okay. Construction is not that great. But if sales have a good year, and property developers’ financial situation improves, they’ll leave it more cashed up. So you can maybe have decent construction into next year as well.

But again, I think these are short-term cyclical dynamics. If you look at the government’s signaling on property policy, it’s pretty consistent. Of course they realize that last year was kind of a mess, and they want to get out of that mess, and get the market back to more normal levels of activity.

But they’ve been engaged in an effort over the last several years to actively try to wean the economy of its reliance on real estate, and to bring down levels of leverage of property developers and generally shift the balance of the sector away from private-sector profit maximization and towards more fulfilling a public-service role where there’s more construction of social housing, rental housing and other stuff that’s not as purely profitable as the private luxury market stuff. So I think the direction of travel for the property sector is pretty clear by now.

Q: What can China do in terms of finding new growth sectors for the economy to replace property and real estate? And then the second question is what could China do to prepare its economy for the possibility of conflict over Taiwan?

A: These are both great questions. And in fact, they’re the same question, at least I think from the perspective of the government. So what I thought was the most interesting about the both the Politburo meeting that we just had, and also a lot of the other rhetoric that’s been coming out of the government, is that after the Party Congress, the leadership seems intent on reorienting government priorities towards this geopolitical competition with the US.

And the overriding economic priority is to build up the economy so that it can survive, prosper and prevail in that competition. Of course that means increasing scientific and technological self-reliance, which they have talked about ad nauseum for several years now. And we’re also now seeing this language about building a modernized industrial system, and this seems to have some security connotations.

What I think is going on is that the government essentially wants to drive growth by investing in a whole-of-society effort to reshape the Chinese economy for this geopolitical competition with the US. They think that not only is this a national security priority, but it is also something that can be a growth driver for the economy.

The first of those is something that we’ve known already over the last couple years. And what I think is interesting is that they gave this indication that they see this refashioning of China’s industrial base not just as a security issue, but also as the core of their economic policy.

Q: A related question is do you feel also that the economy is changing more into a war economy? Especially if you look at what’s happening at the countryside, more stress on producing, let’s say rice and less on producing tea, et cetera.

A: I don’t think I would describe it as a war economy. But what we do see is a generalized focus on national security, what they call the holistic national security concept which encompasses many different areas including food security, which is obviously a very close interest of Xi’s, energy security, technological security, and so on and so forth.

I think it’s a general effort to harden the economy against external shocks. I wouldn’t go so far as to say it’s an effort to put the economy on a war footing. I don’t see evidence of that. But it is based on the recognition that China is operating in what they view as a more uncertain, more hostile world. It’s their responsibility to protect the economy from external forces.

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Q: China has a 17% value added tax. So if you reduce the value added tax, would that help increase consumption?

A: I’m going to kind of dodge the question and say I don’t think they’re going to do that. The reason is that China actually has very few reliable sources of tax revenue. Their tax structure is quite unusual. It’s heavily reliant on the VAT, the corporate income tax and then various transaction taxes including taxes on property and other stuff like that.

If you look at the government revenue structures of the US and European countries, they get a lot of revenue from the individual income tax, and that’s basically what they use to fund welfare states. China has made a political decision of long standing that they’re not going to have substantial direct taxation of household incomes.

And so that creates some constraints for them in terms of what they can do with government revenue. They’ve already cut corporate taxes substantially over the last several years. I can’t remember the figures off the top of my head, but the taxation of companies as a share of GDP has gone down substantially since 2016.

And they have, as you know, a lot of future obligations. They’ve got this burden of the aging population to deal with. They’ve got this massive local government debt problem, which the central government is probably going to have to use its own financial resources to solve.

Basically in the future they need more tax revenue, not less. So I think it’s pretty unlikely that they would substantially cut the VAT because it’s their best source of tax revenue.

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Q: Just a short question on the GDP growth target. Do you think they’re ever going to get rid of it?

A: I think this is an interesting question. One of the things that Xi Jinping did at the Party Congress in 2017 was to signal a shift away from the focus on GDP growth as the be-all and end-all of China’s political objectives. And so it’s kind of interesting that, in that context, they still retain a GDP growth target. Even though the political messaging around the target and the administrative structure around it is quite different.

People have different theories about this. One of the theories is just that there’s a lot of inertia in the Chinese system and actually a lot of different departments in the Chinese government need the GDP target as a kind of a reference. They need to have some kind of number to base their plans for the coming year on. If they don’t have a GDP target then what number are they going to use? You need some kind of anchor for just the internal forecasting and budgeting work of the government. Since you have to have some target, since there has to be some kind of internal reference, you might as well keep it.

There’s also been for been for many years, as you know, a view that having the GDP target was distorting, that it created incentives for local governments in particular to act in destructive ways. I actually remember many times when I was on the other side of the microphone and calling up various economists to ask them for quotes, and they would always say, oh, you know, China has to get rid the GDP target and transition to a market-based economy and blah, blah, blah.

I think actually the GDP targets serve as a useful discipline on the government. They are to some extent a remnant of the previous regime in which government policy was oriented around the pursuit of economic growth, and the need to ensure economic growth acted as kind of a disciplining mechanism on government decisions. So if they knew that doing X would have a large negative impact on economic growth, that was a good reason for not doing X. And then if you don’t have a GDP growth target and you don’t have the necessity to drive growth so much, then you might go ahead and do X anyway, and that wouldn’t be good.

So I think in the Chinese political system, the GDP growth targets do serve a useful function in terms of putting some guardrails around the government’s intervention in the economy. My view, maybe it’s a bit against consensus, is that keeping them for the moment is actually not a bad thing.

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Q: If I understand right, you said earlier that the government in China wants to drive the growth by investing in preparing the society and economy for political competition with United States, self-reliance on food, energy, science, technology, et cetera. If suddenly they are putting a whole lot of energy and resources into making themselves self-reliant rather than focusing on making money and getting foreign factories in, isn’t it going to be more costs than profit? It’s going to be a huge gamble right now. So the question is does the Chinese focus on increasing self-reliance and economic security impose a cost on the economy, relative to a more open trajectory?

A: The standard economist’s answer to this would be absolutely yes. The reason that you have this globally distributed division of labor in the semiconductor industry and many other sectors is that you have a high degree of specialization in different functions across different geographies. By arranging things in this way, everyone can do what they’re best at, and then the overall profitability and efficiency of the system is maximized.

So what China is doing in terms of trying to replicate domestically capabilities which already exist outside of China is in a sense duplicative investment. Is it really going to benefit the economy to invest in doing these things which don’t really push the frontier of human knowledge forward, but just kind of repeat and duplicate what already exists? Probably that is a lower productivity trajectory for Chinese investment.

But as you know, the reason that they are doing this is that they see even greater risks that they would be denied access to these critical inputs, to critical materials and the ability to build up their technological base. So it is worth spending some money to avert that risk in the future. I think that’s ultimately a political judgment rather than an economic judgment. The reasons why they are doing that are pretty clear. And they are not imaginary, these are real issues for them.

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Q: I was wondering could you say something about the impact of de-risking from China, which we are hearing about all the time, not just in tech but in many sectors. I think last year, a quarter of European companies said they were considering shifting their investments, but considering and doing as of course, a different thing. As far as you can tell, is it happening on a big scale, does it have an impact on the overall economy?

A: This is a tricky one. The data on this stuff are hard to read to be honest. The IMF had a study in the most recent World Economic Outlook report which looked at FDI data and found some evidence that there was a shift at the margin away from China as a destination for investment. That’s probably the best look at the underlying realities that I’m aware of right now.

I would say, based on my conversations with foreign businesses and what I’ve seen here that there is a general shift away from using China as a global export base and more towards being in China to serve the Chinese market.

Multinationals have always had multiple strategies relative to China. Obviously China is the world’s second-largest economy, it’s not going away. If you want to be a globally successful producer of consumer or producer goods you need to have a presence in the Chinese market. So for many companies that hasn’t changed, nor can it change in a reasonable way.

But there’s been another aspect of that, which is using China as a manufacturing base to supply markets outside of China. The trade war with the US, various supply chain disruptions, the general perception of higher geopolitical risk due to the bad state of US-China relations, I think all of that all can change people’s thinking on this.

There’s a shift at the margin here. None of this stuff happens very rapidly. Factories take a long time to build. So this is a multi-year process process. And I don’t think you’re going to see dramatic exits from China. But I do think there has been a real shift in people’s understanding of the balance of risks relative to China that’s going to affect their presence here.

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Q: You mentioned that you’ve been noticing that national security has been driving the leadership. Is there a coherent model that the government has in mind of a a national security focused economic strategy?

A: Hmm, I’m going to say no. But there’s a grand Chinese tradition of figuring things out as you go along, right? Crossing the river by feeling the stones. So I think they know the direction that they would like to go in. And so they will try to figure things out as they head in that direction.

Again going back to the Politburo meeting last week and the readout from that, one of the interesting things is that they they highlighted the success of China’s electric vehicle industry. What is now getting global notice is the EV exports surge, particularly into Europe. And also you’re seeing the domestic EV brands really take over the domestic market and the legacy foreign automakers are quite worried about their prospects here. So I think it’s reasonable that China sees that as a success for industrial policy. They moved ahead with investing in a a new economic sector, and attained a leadership position that they can now leverage to support the overall economy.

I’m not sure that the EV industry is a model that’s easily replicable. Generational transitions in the single most important durable consumer good don’t come along very often. So there’s not necessarily another consumer product that’s comparable to cars that’s going to go through a comparable technological transition out there.

Also, and I think this goes back to the question about de-risking, one of the reasons you’ve seen the success of the EV industry and particularly of EV exports is that China was chosen as a global manufacturing base by global producers, most notably Tesla but also some of the other European brands. So the EV exports from China are not all Chinese brands, there are foreign brands in there. And that reflects decisions about supply chains that were made many years in advance because it takes a long time to build factories and put together the whole industrial chain.

I think, given the current geopolitical situation in the world, that it’s hard to envisage multinational companies deciding to make China the global export base for whatever their next big product is. Maybe that decision was understandable five or six years ago. I think it would be a lot harder to make that kind of decision now.

So the particular model that China followed in EVs, which was heavily domestically focused but also relied on this global manufacturing base, I think will be harder to do again in the future.

Q: I was quite struck when you characterized the potential growth drivers in China around self-reliance and national security. You go back a couple years to the five-year plan, there was really a strong theme about investments in basic research, science and technology. And obviously that can work pretty well with the way that you characterized the potential growth drivers in China.

Another way of characterizing that is a movement up the value chain into higher value manufacturing, higher value jobs. There was, at that time, almost a sense that policy makers saw this industrial change as a bit of a silver bullet for some of the economic woes: Invest more in high value industry to transform China from low value manufacturing to high value manufacturing, high paying jobs.

Now, I think you’ve sort of touched on the fact that there isn’t a coherent model yet, or there’s a variety of models. There’s the EV model and the chip model and the aircraft manufacturing model. They’re all pretty different. I guess I was wondering, what do you think China’s prospects are for moving up the value chain longer term, noting the challenges you’ve laid out?

A: So is moving up the value chain a focus of policymakers? Absolutely. But I think one thing that’s implied by the more intense focus on national security that we see now relative to even a few years ago is that it’s not just about moving up the value chain. It’s about keeping the entirety of the value chain within China, or at least, under effective control by China.

So I think there’s a slightly different conception here. Yes, China wants to occupy the high end so that they can compete effectively at a global level with the advanced economies. But also, I don’t think that they’re as relaxed maybe as they would’ve been in a previous generation about seeing some of that low end stuff go away. Maybe they’re going to feel that there’s a more of a need to keep those kind of basic components within China security and controllability purposes.

Moving up the value chain, this kind of rhetoric, is based on the theory of globalization, where you have have this geographic specialization at different points in the supply chain. So as one country moves to the high end of the supply chain, another country can come in and occupy you the medium and lower ends. And then you have high levels of global trade to make the whole thing work.

If, as both US and Chinese leaders have seemed to signal recently, we are moving into an era where countries don’t take globalization for granted, they don’t take high levels of trade for granted and they see a higher necessity of controlling for risks and uncertainty, then it implies a kind of a different orientation towards the position in the value chain. And not necessarily to vacate positions in the value chain as they move up.

The political economy of financial discipline

China’s most consequential economic policy of the last several years, aside of course from the Covid lockdowns, was its turn to increased financial discipline. In the decade after the 2008 global crisis, the financial sector had exploded in size, but in 2017 that growth came to, if not quite a halt, then a very obvious inflection point. As the chart below shows, the size of China’s financial sector relative to GDP has been roughly stable since then (the spikes in 2020 and 2022 were due to sharp slowdowns in the growth of the denominator rather than accelerations in the growth of the numerator).

The new direction was signaled at the end of 2016, and then really got going after Xi Jinping made the Politburo attend a study session on financial risk in early 2017. At the meeting he declared that “financial security is an important component of national security,” launching a campaign against financial risk in a way that made it a top political priority rather than a matter of mere technical management. Since then, the government has been remarkably consistent in holding to a tough, conservative stance on monetary policy and financial regulation.

Although no Chinese official would express it this way, essentially what happened in 2017 is that China started doing what the IMF and similar worthies had been telling it to do: control debt, close regulatory loopholes, impose hard budget constraints. This was a pretty unexpected move for Xi, who up until that point had focused his attention more on foreign policy, security issues, propaganda and ideology. It was also a pretty unexpected success for the technocratic types who had been warning about the dangers of rising debt for several years, to little effect.

This episode in Chinese economic policymaking is still not well understood. Why did the people usually identified in the Western press as “market reformers” focus their energy and political capital on this issue of financial discipline? And how were they so successful at getting their agenda adopted at the highest levels? Maybe one day when the principals write their memoirs we will know the real story.

But until then, I have some theories–or, at least, speculations. Even in a top-down system like Xi-era China, major policy decisions usually need buy-in from a range of interest groups. My speculation is that there are two major interest groups that aligned in support of this new agenda of financial discipline.

Let’s call the first group the “reform faction.” These people are indeed concerned that the surge in debt after 2008 has raised the risk of a financial crisis in China. But they also see the easy availability of credit as encouraging the worst features of the Chinese economy: the continued large role of state-owned enterprises, and the corrupt and unhealthy relationship between property developers and local governments. Imposing more financial discipline on these actors will thus help push the economy in the direction of higher productivity and a larger private sector.

Let’s call the second group the “control faction.” Their diagnosis of China’s problems is almost the opposite of the reform faction’s. Rather than seeing easy credit as enabling the dominance of inefficient state enterprises, they see it as enabling the aggressive expansion of corrupt and unaccountable private-sector companies. The huge concentrations of private wealth created by booms in property and the internet undermine China’s governance and challenge the authority of the Party. Imposing more financial discipline on these actors will reduce social and economic polarization and allow for healthier growth.

The ideals of these two factions are almost diametrically opposed. However, both can agree that the lax post-2008 policies caused a lot of problems, and that tighter central control of the financial system will help address these problems. The consensus policy is to impose financial discipline on both the private sector and the state sector, not just one or the other. For me, this model helps account for some of the internal contradictions of the financial crackdown–how it married a seemingly technocratic agenda with a socialist political campaign–as well as for its surprising toughness.

An unholy alliance between the reform faction and the control faction does not sound like an inherently stable configuration. Indeed, the indications are that the balance of interest groups is now shifting. All the top officials who implemented the financial crackdown are headed for retirement due to age. Recent corruption probes have implicated senior officials at the central bank and financial institutions. And the government has just announced a wide-ranging restructuring of the entire financial-regulatory apparatus.

Even if my model is wrong (as it quite likely is), the political economy around financial regulation in China has clearly shifted. Whatever was the actual balance of personalities, interests and agendas that supported the turn to financial discipline in Xi’s second term, it will be different for his third term.


China’s government has never been particularly shy about supporting its manufacturing sector, a key engine of growth for decades. Since 2021, though, it has become even more vocal about the importance of manufacturing, officially adopting in its plans the view that manufacturing is a special sector of the economy deserving of special treatment. That view may well be correct, and I have some sympathy for the argument. But the metric the government has chosen to measure its success is likely to prove a disappointment.

A good recent example of the new style of rhetoric around manufacturing is an article published in a recent issue of Seeking Truth, the Communist Party’s theoretical journal, by Jin Zhuanglong, head of the Ministry of Industry and Information Technology (MIIT). It does not break new ground but expresses the current line of thinking quite clearly; here are a few choice passages:

Industrialization is the precondition and foundation of modernization. … For a large country like ours, it will be difficult to achieve the goal of becoming a modernized superpower without a strong and large industrial sector. …

Industry is the main engine of economic growth, and plays a key role in stabilizing the overall macroeconomy. Industry is the main battlefield of technological innovation, it is the sector with the liveliest innovation activities, the most abundant achievements of innovation, the most concentrated applications of innovation, and the strongest innovation spillover effects. According to statistics, industry in the United States accounts for less than 20% of GDP, but 70% of innovation activities rely directly or indirectly on the industrial sector. …

We must hold fast to the real economy, especially the manufacturing sector, consolidate the advantages of a complete industrial system, keep the proportion of the manufacturing sector in GDP basically stable, and avoid the “virtualization” of the economy.

There are a lot of fairly abstract goals outlined in Jin’s article: many things that must be “improved” or “strengthened” in the common parlance of Chinese officialdom. The main one that can be actually measured is the manufacturing share of GDP; the goal of keeping that ratio “basically stable” was written into the 14th five-year plan.

That mandate is why, in the MIIT’s annual work conference in January, Jin proudly reported on the rise in the manufacturing sector’s share of GDP in 2022, to 28%. Such a shift in China’s economic structure is indeed a notable event, reversing a multi-year decline in the relative (not absolute) size of the manufacturing sector, which was over 30% of GDP as recently as 2014. But most of the change happened in 2021, when there was a simultaneous boom in both export manufacturing and in domestic demand, driven by property.

The property boom deflated in dramatic fashion in 2022, with historic declines in construction indicators. And while exports started off strong, by the end of the year they were declining, as China’s major export markets scaled back their spending on goods favored during the pandemic (furniture, electronics). The increase in the manufacturing share for the year as a whole was small, and higher-frequency data show it had actually begun declining by the end of the year.

China’s economic growth is universally expected to accelerate in 2023 thanks to the lifting of Covid restrictions, but a repeat of the 2021 manufacturing boom looks quite unlikely. Real-estate construction could pick up some, and with it demand for manufactured goods like steel, cement, and machinery, but a return to the boom years is not in the cards. While consumer spending in the US is solid, spending patterns are shifting to be less favorable to China (more services, fewer goods). A similar shift is likely to unfold domestically, with consumers splurging on the services, like travel, they have not been able to fully enjoy for three years.

It looks quite probable that manufacturing will lag rather than lead overall economic growth in 2023, resulting in a lower share of GDP. That may be why, at the latest MIIT work conference, stability in the manufacturing share was not mentioned as a specific goal for 2023, which it was for 2022 and 2021. There’s no point in emphasizing goals that are unrealistic.

Looking beyond the peculiar circumstances of 2023, I think it’s more likely than not that de-industrialization, meaning the decline of the manufacturing share of GDP, will resume. Rather than being an indication of the hollowing-out of the Chinese economy, as policymakers seem to fear, such continued structural change would probably be a fairly normal and neutral development.

The success of manufacturing in raising incomes in China naturally leads to some relative decline: as households’ incomes rise they tend to spend more on services, while at the same time Baumol’s cost disease raises the relative prices of services over time. Neither of those trends threatens the international competitiveness of Chinese manufacturing.

The manufacturing share of GDP stayed unusually high in China for decades in part because of typically socialist economic distortions: repressing consumer spending to channel investment into industrial capacity. Trying to maintain such distortions to prevent natural structural change could be quite costly in what is now a much larger, more marketized and globally integrated economy.

To really prop up the manufacturing share in an economy of China’s size would probably require extending the housing boom even further, or consistently undervaluing the currency, neither of which sounds like a great idea. My best guess is that China’s government won’t be able to stop a renewed decline in its manufacturing share of GDP, and, despite its rhetoric, won’t seriously try to.

The polarization of global R&D spending

How has China’s rise as a science, research and technology powerhouse reshaped how research gets done across the world? One admittedly simplistic way to track this is to look at a single widely available statistic: R&D spending. (It’s worth keeping in mind that R&D spending is not precisely “science”–it does include spending on research projects by academic institutions, but most of it is actually corporate expenditures.) The story those numbers tell is less alarming for the US than you might assume from a lot of reporting, but the shift in the global distribution of research does create new issues.

While the OECD is the usual go-to source for cross-country data on R&D spending, I am not sympathetic with all of the technical choices they make. In particular, they present all their figures in terms of purchasing power parity, which in China’s case means R&D spending is converted to US dollars at an exchange rate of around 4, instead of 6-7. While the OECD charts show China’s total R&D spending overtaking that of the EU and closing in on the US, that’s mostly an artifact of this particular methodological choice.

Using purchasing power parity certainly sounds all proper and economist-y but it’s not automatically appropriate for every purpose. The PPP exchange rates were developed to compare the living standards of ordinary people across countries by laboriously comparing prices for a basket of the goods and services they consume; since a lot of these are not traded across borders their prices can vary widely. It’s not clear this is the right choice for comparing R&D expenditures, which are going to be mainly on salaries of highly skilled staff and specialized equipment. To me it seems more likely that there is in fact a global market for top researchers and their gear, and that therefore market exchange rates are appropriate.

To come up with more accurate charts, I made my own cross-country comparison of R&D spending. The procedure is simple: take the R&D share of GDP reported for a country in the World Bank’s World Development Indicators database, multiply that by its annual GDP, and convert to US dollars at market exchange rates. Since the R&D share of GDP doesn’t change a lot from year to year, in cases where it hasn’t been updated yet I use the previous year’s share times the current year’s actual GDP.

I ended up with 56 major economies where the World Bank has more than scattershot data on R&D spending, with data up to 2021. That’s not a complete sample of the world of course, but if a country can’t report its R&D spending to international organizations consistently then it probably isn’t capable of doing a lot of R&D spending anyway. Aggregating the countries into large regions generates the following result in terms of absolute values:

The rise of China is indeed pretty dramatic. In particular it has overtaken the combined R&D spending of developed countries in its own region of Asia (Australia, New Zealand, Japan, South Korea, Taiwan, Singapore), which has been somewhat stagnant for the past decade. R&D spending elsewhere in the world has continued to grow at a decent clip though. So it’s also useful to look at the relative shares:

To me this chart is even more interesting. Back in 1995, when data for most countries becomes available, global R&D spending was roughly equally distributed across three groups of developed economies, those in North America, Europe and Asia-Pacific. China’s rise has come mainly at the expense of Europe and developed Asia, whose R&D spending has not grown as rapidly in dollar terms. The US has done better and has actually kept a high share of global R&D spending, with its share rising not falling in the last several years. Other developing countries (admittedly not as well represented in this sample) have attained a marginally higher share of global R&D over the past decade, but nothing like China.

Based on recent trends, it seems that global R&D spending is becoming less evenly distributed across the world, and is increasingly concentrated in the two hubs of the US and China. That does line up with anecdotal impressions: the US and China are home to the two main clusters of large internet companies, and are also the two leading locations for artificial-intelligence research.

These two hubs are, obviously, not talking to each as much as they used to. There has been only minimal travel in and out of China for the past three years, and the recent political climate in the US has made collaboration with Chinese researchers much more fraught. If ties between the US and China stay troubled, then this more polarized distribution of global R&D spending might turn out to be a less efficient allocation of resources.

Those research dollars will do the most good for technological progress in the world as a whole if they are spent in complementary ways. If instead the two hubs are pursuing conflicting or duplicative agendas, then the same global sum of R&D spending could produce fewer results. This is speculative, of course, as in general it’s hard to know how inputs of R&D spending translate into the output of actual productivity gains. But it is clearly the case that the main global locations for R&D spending are different than they were two or three decades ago, and that the relationships among those locations are more complex.

China’s housing crisis is an institutional crisis

There’s a tendency among economic and financial analysts to treat all housing crises as essentially the same. Housing is a long-lived asset purchased with leverage, therefore it’s not surprising to see a common pattern of a buildup of leverage leading to higher prices leading to excess construction, which at some gets out of hand and then is followed by collapsing prices, construction and leverage. Yet the details of housing markets do matter, and vary quite a lot between countries. As with Tolstoy’s line about unhappy families, every housing crisis is a bit different and exposes a different set of institutional flaws.

The housing crisis that China is now experiencing centers on its peculiar institutions for selling housing before it is built. Housing sales are plunging, not precisely because households can’t get mortgages or fear falling prices, but because they no longer trust that developers will actually complete and deliver housing bought in advance. There is good reason for that, as some of the nation’s largest developers have become so financially stressed that they have stopped construction on projects, including those that have already been paid for. Households that own units in the affected projects have tried to draw attention to their plight with online protests and threats to stop paying their mortgages.

It is a bit complicated to explain how this extraordinary sequence of events happened, but I have not yet seen a better explanation of the issues in English than in this piece from Caixin, which is worth quoting at length:

Although developers in many countries are allowed to sell homes before they finish building them, the practice in China is special in two ways.

First, homebuyers have to pay in full when they decide to buy. Usually, they produce a downpayment for a mortgage and the bank covers the rest. But in other countries like the UK, buyers of presale homes only need to come up with a deposit to reserve a property. They don’t need to pay off a mortgage until their homes are delivered. This full-payment requirement has helped developers raise cash quickly.

Second, until recently, Chinese developers had been allowed to use the bulk of their presale revenue for whatever they wanted. Although China has laws and regulations requiring developers to set aside enough money to finish construction on their housing projects, local governments and banks had allowed them to sidestep some of the rules, including the requirement that presale funds must be deposited into government-supervised escrow accounts. Instead, a vast amount of presale funds ended up in developers’ own accounts.

It didn’t really matter that developers hadn’t socked away as much money in escrow as they were supposed to. They were still able to finish their projects because they could always get their hands on more money, either through loans from banks and trust companies and issuing bonds, or by starting new projects. New homes were usually easy to sell. But when this changed, and it became harder to get financing and sell new homes, the business model fell apart.

The two issues here are that 1) China’s system for financing the construction of new housing put an unusual amount of risk onto households, 2) the legal safeguards in place to protect households from those risks were in practice routinely ignored. A recent post by Ren Zeping, a celebrity economist who used to work for China Evergrande, the giant developer whose troubles precipitated the current crisis, explains more of the background to both issues. Why does China have such a peculiar system?

The simple story is that the advance sale of commercial housing originated from Hong Kong, as a way for developers to put on leverage. In the mainland, the 1998 housing reform borrowed from Hong Kong’s experience and introduced the presales system due to the shortage of commercial housing and the shortage of funds at developers. In fact, a presales system currently exists in many countries around the world.

But here is the important point! Developed countries generally have very strict regulatory safeguards. Developers can start selling only after the project has been approved by the government, and buyers do not, as in China, pay the full amount of the purchase price at once with a bank loan after paying a deposit, but pay in installments according to the developer’s construction progress before delivery is completed. Therefore, the presales system requires strict supervision of funds with installment payments and penalties for default as safeguards.

The first cause of the current loss of faith in China’s housing institutions is thus that those institutions were poorly designed at the outset. In the early stages of the creation of a commercial housing market, when the priority was financing new construction to replace the dilapidated Maoist-era housing stock, it probably made sense to prioritize the interests of developers over those of urban households. That initial decision, however, created a path dependency, so that developers were permitted to keep transferring risk to households long after there was a reasonable justification for it.

The second cause, as the Caixin article clearly demonstrates, is the failure to enforce the rules that actually existed. When homebuyers paid in full for a housing unit that they would not take possession of for years, their interests were supposed to be protected by requirements to use those funds to actually complete the project. It was an open secret in the industry that these requirements were not enforced. Caixin quotes an executive at a property developer saying they could actually do whatever they wanted with 90% of the presales revenue they received.

Ren Zeping describes a couple of ways in which developers could get access to the funds. The property developer and the contractor could collude, with the contractor requesting more money for construction than was actually needed, and then sending the excess to the developer (which could then use it to start more projects). Or the developer could convince the local government and the bank that are supervising the funds to approve the release of money from the account, for instance by exaggerating the actual progress on construction.

There are undoubtedly many other such dodges and schemes. But the general point is that the institutions that were supposed to be protecting the interests of Chinese households in the housing market did not, and instead were corrupted by developers. It’s no wonder people are protesting. The authorities who were tasked ensuring developers met their obligations to households failed to do so until it was far too late (local governments have reportedly tightened supervision of presales funds over the past year). The current housing crisis is thus not simply a failure of technical regulation, but also a failure of ethics and the rule of law. Proposals for institutional fixes will have to reckon with this demonstrated difficulty in ensuring even-handed enforcement of rules around real estate, an area where corporate and local government interests are so strong.

The strange case of China’s self-employment statistics

It is a well-known habit of Chinese government officials to pepper their public remarks with statistics. Very occasionally, this habit leads to the disclosure of some new information. At a press conference early this year, a deputy director of the State Administration for Market Regulation (SAMR), which among other responsibilities handles the legal registration of businesses, waxed enthusiastic about the rapid growth in small businesses–specifically getihu, meaning individual businesses or sole proprietorships. In the process, he dropped some big numbers:

The Party Central Committee and the State Council attach great importance to the development of individual businesses. By the end of 2021, the number of registered individual businesses nationwide had reached 103 million, accounting for two-thirds of the total number of market entities. Passing 100 million is a historic breakthrough. Among them, 90% are concentrated in the service industry, mainly in wholesale and retail, accommodation and catering and residential services.

According to a survey, the average number of people employed by individual businesses is 2.68 people. Based on this survey, it is estimated that individual businesses nationwide provide employment for 276 million people in our country. This is very impressive.

The last two figures cited by Pu Chun are indeed very impressive: 276 million people is 37% of the nationwide employed population, an extraordinary figure. Employment by sole proprietorships, which basically means self-employment, is the most internationally comparable way of measuring informal employment. It is, for instance, the measure adopted in a recent World Bank report, The Long Shadow of Informality, which collates and compares worldwide data on the informal economy. If the SAMR figures are correct, they would indicate that self-employment and thus informal employment in China are much more prevalent than previously thought.

Prior to SAMR’s announcement, the government had not published a figure for the number of people employed by sole proprietorships for the past two years. The last published estimate by the National Bureau of Statistics was that sole proprietorships employed 177 million people as of 2019, equivalent to 23.4% of the employed population. As SAMR reported 83 million registered getihu that year, those figures imply that sole proprietorships employ an average of 2.14 people each. The most accurate estimate is probably from the 2018 economic census, a massive effort to enumerate all businesses in China conducted every five years, which counted 149 million people employed by getihu, or 21.2% of the workforce; the census figure of 63 million getihu works out to an average of 2.37 people each.

The SAMR survey cited by Pu Chun, about which no other information was disclosed, therefore implies that either roughly 100 million people moved from formal employment to self-employment in two years; or that all previous estimates of self-employment had somehow missed around 100 million people and that SAMR, an agency with no previous experience in collating employment statistics, had gotten it right. Neither of these possibilities is very likely.

SAMR itself holds the administrative records for business registrations, so there is no reason to doubt its count of the number of sole proprietorships. But its survey showing average employment of 2.68 people, 25% more than the historical data, is hard to believe. Given the recent increase in gig workers such as delivery drivers, many of whom are independent contractors registered as sole proprietorships, it’s more likely that the average number of employees per getihu is falling not rising. China’s 103 million sole proprietorships do probably employ well over 200 million people, but the 276 million figure is implausible.

What is somewhat mysterious is why SAMR officials would wish to exaggerate the extent of self-employment in China in this way. A high degree of self-employment is usually considered a sign of a less developed economy; to quote the World Bank report, “countries with larger informal sectors have lower per capita incomes, greater poverty, less developed financial sectors, and weaker growth in output, investment, and productivity.” The World Bank uses the economic census figure of 21.2% of China’s workforce being self-employed; that puts China right along the trend line of a cross-country comparison (see the chart below reproduced from the report). If instead 37% of China’s workforce is self-employed, as SAMR effectively claims, then China would actually be an international outlier with an unusually high level of informality for its level of income. Having a very high level of self-employment doesn’t actually make China look better in a global context.

The best explanation is domestic political incentives. Over the past several years, Premier Li Keqiang has waged a campaign to improve the environment for small businesses, and he never misses a chance to talk about how important they are to the Chinese economy. Li has also implemented several measures that have lowered the costs and simplified the procedure for registering businesses. Their most dramatic effect has been in new registrations of getihu, which have surged to 9-10 million per year from 5-6 million previously (see my previous post, What’s behind China’s boom in company formation?).

Since SAMR, as the agency in charge of business registrations, can take credit for this increase, it has some incentive to claim that its efforts are benefiting the economy by creating jobs. As the National Bureau of Statistics has, for whatever reason, stopped publishing the standard data on self-employment, SAMR has an open field to put its own numbers out there. The size of self-employment has thus become a figure by which SAMR can advertise its administrative accomplishments rather than an objective tool for analyzing the structure of the labor market.

It’s a pity that the it is becoming harder to understand the evolution of China’s labor market, as the changes in recent years have been dramatic. The rise in self-employment is part of a trend of polarization: there has been relatively low growth in high-paying manufacturing and service jobs and lots of growth in worse-paid labor-intensive service jobs. The key text documenting this shift is an open-access paper by Scott Rozelle and several co-authors: “Moving Beyond Lewis: Employment and Wage Trends in China’s High- and Low-Skilled Industries and the Emergence of an Era of Polarization,” much of which is also summarized in a useful CSIS briefing.

Even if the share of self-employment is not as high as SAMR claims, it has still been rising over time. Based on available data, I estimate it was about 29% in 2021, up sharply from just 17% in 2016; however, there’s a lot of uncertainty about this estimate because much of the recent surge in registered sole proprietorships could be an administrative rather than real phenomenon. Nonetheless, the trend is clearly the opposite of what one would normally expect to happen as China, already an upper-middle-income country, gets closer to high-income status.

State capacity and the income tax

State capacity is a difficult concept to make concrete: a government’s ability to do stuff is obviously important, but how to tell if it is high or low? As a useful overview over at the Broadstreet blog shows, the most common way to measure state capacity in general is to measure fiscal capacity: the government’s ability to extract revenue from the economy. This makes sense historically, as the growth over the last few centuries of governments’ ability to do things like wage wars and provide social benefits went hand-in-hand with the development of tax systems and debt markets.

For the 20th century onward, the authors suggest a more precise metric: “To measure the fiscal capacity of the modern state, we use the share of income tax revenue in total tax revenue, as the collection of the income tax calls for high administrative capacity to ensure compliance.” This is an interesting choice, as on this measure China is a real edge case. Taking a quick look at the OECD Global Revenue Statistics Database, which covers over 100 nations, here is a list of the dozen countries with the lowest share of individual income tax revenue (for China only a 2019 figure is available, the others are the average of 2015-19):

CountryIndividual income tax,
share of tax revenue
Côte d’Ivoire0.3%
Antigua and Barbuda1.8%
Costa Rica5.7%
Source: OECD Global Revenue Statistics Database

A measure of state capacity on which China underperforms Nicaragua and Mali is probably a measure that is not capturing some important dimensions of actual state capacity. To take just some of the most obvious physical manifestations of administrative and technical ability, the governments of the other countries on this list are not operating their own rovers on Mars, or managing massive numbers of infrastructure construction projects both domestically and across borders. And whatever you think of China’s zero-Covid policies, it is unquestionable that local governments are displaying extraordinary logistical capabilities in organizing the mass testing of millions of people on short notice. The common claim that these policies demonstrate “China’s strong capacity for resource mobilization” is certainly correct (whether resources are being mobilized in the best way is another question).

Why does this measure get China wrong? To some extent, the focus on income taxes overly privileges a particular set of institutions as representing capacity. The actual structure of taxation reflects more than just administrative ability: which taxes are levied is a political decision. In recent decades, China’s government has consistently made the political decision to exempt most of the lower classes from income taxes, and to tolerate plenty of tax evasion by the upper classes.

It would indeed be difficult for China to build the administrative systems to levy a more broad-based income tax, but probably not impossible. China has, for instance, successfully administered a broad-based value-added tax for more than two decades. If you were to rank countries instead by the share of value-added taxes in total taxation, then China’s share of 30.2% would put it comfortably above the OECD average of 20.3% (and the US, of course, would be at the bottom with zero, as it has consistently made the political decision not to levy a VAT).

Nonetheless, there is still some useful information in the fact that China is an outlier in terms of this particular measure of state capacity. It suggests that the nature of China’s state capacity is different from that of your common or garden-variety Western social welfare state. The Chinese government’s ability to extract and mobilize resources does not work primarily through formal fiscal channels. It is well known that off-budget instruments like local-government land sales and the operations of state-owned enterprises are extremely important in the economy.

More broadly, both the strengths and the weaknesses of the Chinese state are tied up with its peculiar institutional structure and political heritage. China is a Leninist party-state that penetrates the private sector and civil society, operates more through political directives than formal legal instruments, and regularly undertakes mobilizational campaigns to achieve society-wide transformation. The capacity of its Leninist institutions is hard to measure precisely because they often hide behind conventional state forms, but is no less real for that.

What’s behind China’s boom in company formation?

Here is an interesting empirical fact about the Chinese economy that does not easily fit into the usual narratives: under Xi Jinping, more new private-sector companies are being created every year than at any period in its modern history. This of course is exactly the kind of factoid China’s government regularly trots out to demonstrate the vitality of its private sector. In March, the People’s Daily published a front-page article extolling the fact that the number of private companies had quadrupled from 10.9 million in 2012, when Xi took office, to 44.6 million in 2021. (I don’t actually read the People’s Daily every day, but I do subscribe to Manoj Kewalramani’s invaluable Tracking People’s Daily newsletter). Company formation is one of the ways of tracking what is usually called business dynamism: how much entrepreneurial activity is happening in an economy.

The figures are even more interesting than the propagandists seemed to realize. While the official publication of company registration data has been intermittent at best, the People’s Daily article and accompanying chart allow some of the holes in that published data to be filled in. The combined data provide a picture of private-company formation in China over roughly the past two decades. Before 2012, the population of private local companies was increasing by around 1 million or less every year (this is the net increase; there is even less data available on the gross number of new company registrations). Net company formation accelerated over 2013-15, and since 2016 has been running steadily around 4 million or more per year. There’s been an even more dramatic acceleration in the formation of new sole proprietorships (getihu: not companies with a separate legal existence, but businesses run as part of a household): the net increase was over 10 million in both 2020 and 2021, up from around 3 million in 2021.

That is a pretty dramatic change in the trend. The cause is well-documented: a systematic official effort, beginning around 2014 and continuing through the present day, to lower the costs and simplify the process of forming new companies (I wrote a piece about it back in 2014). The OECD is one of the few organizations that have attempted to systematically evaluate the effects of these changes (the much-maligned Doing Business survey of the World Bank was another). Here is some commentary from its just-published 2022 Economic Survey of China, which quantifies the administrative burdens on start-ups relative to other countries:

Enterprises in China are subject to somewhat lighter burden than in the average OECD country, though higher than in Japan, Germany or Italy. In some major non-OECD economies, such as Brazil or South Africa, the burden is much higher than in China. … Only one institution needs to be contacted to start a business in China, compared with the OECD average of around four. This is the same as in the frontrunner countries of Australia, Canada, Greece, Korea, Latvia, Lithuania or New Zealand, where to set up a new firm it is also enough to contact a single institution. There is neither minimum capital requirement nor monetary costs for registering a limited liability firm in China, which is in line with the best practice in OECD countries.

Substantially reducing the barriers to company formation to close to rich-country levels is a pretty decent accomplishment. It’s not a bad legacy for Premier Li Keqiang, whose signature initiative this has been and who is finishing his last year in office. What’s curious, though, is that the enormous boom in private-company formation in recent years has not had very visible macroeconomic effects. Economic growth is not any faster: growth in labor productivity has averaged 6.6% annually in the seven years since 2015, compared to 8.4% in the prior seven years. Of course, a lot of factors have combined to slow China’s economic growth recently, so growth might have slowed even more without this boom in company formation.

But there also hasn’t been any noticeable change in the structure of national income. Since barriers to company formation have fallen, and the pace of company formation has increased, we might reasonably think that a greater share of economic activity is now taking place inside legal corporate entities rather than in the informal economy. Yet the share of corporate profits in national income (technically, gross operating surplus in the fund of flows) has remained basically unchanged around 26% since 2015. Business profits generated by households rather than companies (through sole proprietorships, getihu), have also been stable around 5% of GDP. (The chart below uses the OECD’s presentation of China’s flow of funds, which is more standardized and easier to interpret than the one published by the National Bureau of Statistics; thanks to Bert Hofman for the pointer).

In other words, although the population of private companies in China has gotten much larger, the share of economic activity generated by those companies has not. Some of the increase in private company formation could thus be because it is now easier for people to create multiple corporate legal entities, rather than because there has been a true increase in the rate of entrepreneurship.

The flow of funds data goes only to 2019, and so doesn’t show what happened during the two pandemic years of 2020 and 2021. By all accounts, these were horrible periods for small businesses in consumer-facing services like restaurants and tourism. They lost huge revenues during the initial lockdown of 2020, enjoyed a few months of rebound in the latter half of 2020, and then settled in for months of disappointment in 2021 as waves of intermittent Covid restrictions discouraged travel and recreation. Things have obviously gotten even worse in 2022. Data from OECD countries show that new firm creation generally fell substantially in 2020, so the fact that in China net company formation actually picked up is surprising. Of course, China’s pandemic economic trajectory in 2020 was quite different from the OECD countries. But it’s also possible that the well-documented mass closures of small business during lockdowns are not fully showing up in the company registration data: companies could stop operating without canceling their registration. (Friends who have companies in China tell me that canceling your registration is difficult and time-consuming and often not worth the bother.)

The biggest surge in registrations has not been for private companies but for sole proprietors/getihu: the pace in 2020-21 was roughly double that of 2015-16. Because sole proprietorships have inherent limitations to scale (they can’t hire more than a few people) and no limited liability, they are usually more of a vehicle for self-employment. The desire to be an entrepreneur can be a reason to choose self-employment, but in developing countries like China, self-employment is often the result of a lack of more stable job opportunities. It can also be the channel for more modern forms of unstable employment: drivers for delivery and ride-hailing services often register as sole proprietors, which makes them contractors not employees. The increase in sole proprietorships does appear to be part of a broader structural change in China’s employment patterns: an important 2020 article by Scott Rozelle and colleagues documents a sustained rise in the share of employment in informal, low-wage service sectors.

It’s certainly not a bad thing that it has become easier for Chinese people to establish companies. But the rather ambiguous economic evidence suggests that the surge in private-company formation over the last several years is not a simple story of rising business dynamism.

The consensus on centralization

Dylan Levi King has a nice essay out in Palladium on the history of decentralization in China, opening with the assertion that “the most significant reform carried out in China after 1978 was one of systematic decentralization.” It is difficult to disagree with this. As the best China scholarship of the last few decades has made clear, local initiative played a central role in the country’s growth miracle–see for instance Jean Oi’s book on local state corporatism, or Xu Chenggang’s classic article on “regionally decentralized authoritarianism”.

Decentralization was one of Deng Xiaoping’s most important policies, but King’s piece is good on its pre-1978 history. Deng justified his experiments with reference to a principle that Mao articulated in a famous 1956 speech: “Our territory is so vast, our population is so large and the conditions are so complex that it is far better to have the initiative come from both the central and the local authorities than from one source alone.” Mao distrusted bureaucrats and central planning, and in fact economic planning in China of the 1950s and 1960s was error-prone and often incompetent. Mao instead celebrated bottom-up initiative and self-reliance, which were important themes of the alternative economic model he tried to implement in the Cultural Revolution. As a result the organizational structure of China’s state-owned enterprises became significantly more decentralized than in the Soviet Union and its European satellites.

Yet while Maoist decentralization was good at tearing down rational bureaucratic structures, it was bad at actually encouraging autonomy and local initiative. Local factories and agricultural communes may have been told they had authority to make their own decisions, but in reality they lived in an oppressive environment of repeated political campaigns in which the only safe thing to do was to parrot the slogan of the moment. Mao’s China rhetorically celebrated local self-reliance while harshly punishing political deviance–an incoherent combination. As a result local initiative remained a rhetorical trope rather than a concrete reality: there was for instance hardly any local economic specialization during the 1970s. After 1978, Deng made decentralization real by officially calling a halt to the endless rounds of political purges and telling cadres instead to focus on economic development.

The reason to review all this history now, of course, is that Xi Jinping seems to be pushing to revise this pattern of decentralization and implement more effective top-down control by the central government. King’s piece points out that “local experimentation has slowed” under Xi as he has formalized the legal boundaries of local government authority. (One recent example of this trend is how the National People’s Congress recently issued an authorization for local authorities to conduct trials of a property tax, a legal nicety that was not thought necessary when such trials were first launched in 2011.) Xi is also using the Party’s Central Commission for Discipline Inspection to investigate and punish not just corrupt officials but those who fail to carry out central instructions sufficiently expeditiously.

These are extremely important changes in China’s political economy that deserve attention. But the drive to recentralize authority in Beijing did not start with Xi: the reaction to the excesses and problems of decentralization had already begun while Deng was still alive. In the roughly two decades between Deng’s retreat from active decision-making and Xi’s ascent to the top job, the top leadership consistently pursued a centralizing agenda that sought to increase the share of administrative power and financial resources controlled by the central government. This trend began around 1993, shortly after Deng’s revival of market reforms in his 1992 southern tour. According to an account by Pieter Bottelier, the idea of re-centralization crystallized at a conference held in Dalian in June 1993 with participation from World Bank and Chinese officials:

The conference marked a turning point in the national debate on two major issues: (a) the appropriate degree of economic centralization for China and (b) the management of aggregate demand in China’s semi-reformed economy. Many reports on China’s reforms since 1978 rightly emphasize the importance and benefits of economic decentralization. Few focused on the partial re-centralization of 1993/94 which followed the Dalian conference.

In the early 1990s some central government leaders began to think that China’s irregular, stop-go pattern economic performance of the 1980s – with spikes of high investment and high inflation – was due to excessive administrative decentralization. By delegating fiscal and financial powers to lower-level governments, while at the same time transferring ownership of most state-owned enterprises to those governments, Deng Xiaoping had been very successful in stimulating growth, as was his intention. But the system had also led to a loss of control by the central government over investment planning by lower level governments and local financing. …To correct this problem, a partial re-centralization of administrative controls was thought to be needed, but it was recognized that this would be politically very unpopular in the provinces.

The debates at the conference were followed by a package of fiscal reforms that reversed the sharp decline in the central government’s share of tax revenue and gave it more authority to redistribute resources around the country. The debate over fiscal decentralization in the mid-1990s tied into the increasing discussion of widening regional inequalities; influential scholars argued for more vigorous central government action to spread the benefits of prosperity more widely. That line of thinking ultimately resulted in the launch of the Great Western Development program under Jiang Zemin, which was only the first in a wide range of regional aid policies that have been successively rolled out by the central government.

Since then, the argument over centralization has moved onto different issues but the general drift often remains the same. In 2007, when I was working at The Wall Street Journal, I wrote a piece about the Hu Jintao administration’s attempts to reassert central authority over local governments, focusing mainly on regulatory issues and real estate rather than tax revenue. Re-reading that piece now, it’s striking how essentially all the talking heads I interviewed saw this as a good and necessary thing: re-centralization was endorsed as the correct technocratic move, just as it was in the 1990s.

This consistency over three different decades suggests a long-standing elite consensus on the need for the central government to re-centralize authority and manage the country in a consistent and considered fashion. Hu attempted to act on that consensus, but his attempts to claw back more authority for the central government did not get that far. The ultimate reason for this is probably that Hu was never able to consolidate his own political power and centralize authority in his person, in part because Jiang Zemin kept hanging around to prevent it. Xi, of course, has consolidated political power with extraordinary efficacy, which means that his efforts at re-centralization are likely to more effective. He has also been able to take advantage of the US-China trade war and Covid-19 pandemic to create an atmosphere of national emergency. As the economic historian Charles Kindleberger once observed, societies are more amenable to centralization of authority during times of crisis.

Nonetheless I suspect that, given the elite consensus on centralization, any other moderately competent Chinese politician would be trying to do something similar in Xi’s place (though perhaps using different methods). China’s real-estate boom has acted as a powerful centrifugal force in the economy over the years, increasing the resources under the control or influence of local governments. As a result, more than two decades after Zhu Rongji’s fiscal reforms, China remains a highly fiscally decentralized nation. It’s worth pointing out, as the chart above shows, that the central government’s share of total government revenues, once local land sales are included, is now as low as it was during the fiscal emergency of the early 1990s. Xi’s efforts to discipline property developers and stamp out housing speculation, which are currently causing great financial stress, can thus be seen as part of this long-running struggle against the fissiparous tendencies in the Chinese economy.