Why China will focus on technology but muddle through on policy at NPC meeting

Next month’s NPC meeting is unlikely to produce any dramatic changes in China’s monetary and fiscal policy or a return of massive stimulus
Instead, policymakers are expected to continue focusing on technological development and attempts to make domestic firms the core of supply chains

Andy Xie

Published: 5:30am, 23 Feb 2024

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China is likely to stick to muddling through on its macroeconomic policy at the National People’s Congress meeting next month. Cautious monetary and fiscal policy will prevail. There will not be any large-scale bailouts of the struggling property industry, shadow banking system or distressed local governments.

The real focus will remain on technology for geopolitical competition. The GDP growth rate for this year is likely to be in the middle single digits, which is good enough. Rising competitiveness will eventually bring back healthy growth and a revaluation of the yuan.

The deflating property bubble is weighing down China’s growth. Some might blame the “three red lines” on corporate leverage that burst the bubble, but the real culprit is the bubble itself. The mainland began importing the Hong Kong model in the late 1980s, ramping up land prices to boost local government finances.

The resulting bubble created a massive vested interest group that hijacked government policy and public opinion for two decades. Bubble-backed GDP growth is dangerous – its demise could reduce the size of the country’s GDP, but it would also make the economy healthier in the long run. This is where China finds itself today.

Those who reminisce about the good old days cast envious eyes at the booming stock markets in the United States, Japan and elsewhere, but these are bubbles. Britain and Japan are in recession. The US is holding up the economy with vast and expanding fiscal deficits.

These bubbles float on a bigger bubble anchored on the US dollar-yuan peg, and this big bubble is now threatened by inflation.

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Regardless of how Beijing feels about the situation, US pressure is limiting its options. It couldn’t do what it did in 2008 and print massive amounts of money to reinflate the bubble. Squandering money now has heavy consequences.

That is why, despite resuscitating the bubble multiple times in recent years, Beijing won’t throw money at it this time. Soothing words will be offered from time to time, including at the NPC meeting, but hard cash won’t come in any significant amount.

China has taken the easy path in its development. There are four pieces to China’s growth story. The government used the socialist part – state-owned enterprises and planning agencies – to develop infrastructure. The Taiwanese outsourcing model was used to develop exports, earn foreign exchange and create jobs. Foreign joint ventures were used to develop technology and the domestic economy, and the Hong Kong land model was adopted to enrich the government and elites.

These short-cut approaches left behind vulnerabilities that the US is using to slow or even reverse China’s economic progress.

The foreign direct investment (FDI) model didn’t work well for technology development. In many ways, it stunted it. Germany, Japan and South Korea did not rely on joint ventures for technological development. They used their indigenous businesses and institutions to develop their capabilities. The foreign partner in a joint venture naturally wants to protect its technology while holding onto the profit opportunity in the Chinese market.

People walk past an SAIC Volkswagen showroom in Chengdu, Sichuan province, in 2021. Volkswagen was one of the first Western companies to start doing business in China in the 1970s and now depends on the country for at least half of its annual profits. Photo: Reuters

The auto sector is the best example. While Volkswagen and Toyota turned China into an important profit centre, they protected their technology and kept their Chinese partners at arm’s length. In the meantime, South Korean companies managed to catch up with them on their own.

Falling FDI is a blessing in disguise for China. It forces the government to rely on domestic companies, as a normal large economy should. Local governments in China are competing against each other in attracting FDI by offering more and better incentives to attract foreign companies, putting local firms at a disadvantage.

The FDI model also stunted the development of local supply chains. Foreign joint-venture partners are in charge, sourcing key components from their existing supply chains, in part to protect their technology. This is one reason the Chinese economy is large but not necessarily strong, as some might argue.

The internal combustion engine is the best example. China’s auto market is the largest in the world, but the weak state of the engine supply chain is a result of the joint venture model. China’s expertise in electric vehicles is allowing it to leapfrog its competitors, but the same cannot be said for commercial jet engines.

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Even though China is the world’s largest market for semiconductors, its weak supply chain has become a vulnerability for the economy. It didn’t take advantage of this market to develop its supply chain, instead erroneously believing in the reliability of the global supply chain.

Precision components and equipment, high-performance materials and even high-end bearings are weaknesses for China. These are a result of joint-venture partners buying from their existing suppliers, denying local suppliers the opportunity to achieve scale.

No big country rises without a big struggle. China was extraordinarily lucky in the 1990s and 2000s. It made expedient choices because it could. Now it has to make hard choices, and one wrong move could spell calamity. It is overallocating capital for technological development, but that is the right decision, as some waste is justifiable.

The key is for local companies to achieve scale. Companies with scale can innovate and advance the frontier. The Chinese government appears to be relying on the domestic market and nurturing private enterprises as much as possible, similar to what Japan and South Korea have done.

Printing money to start or sustain a party is no longer on the cards. A bad stock or property market doesn’t move the policy needle like before. Anyone expecting Beijing to turn on the monetary spigot is likely to be disappointed again.

Andy Xie is an independent economist