by Arthur Kroeber
For those who are not too sure what a “Third Plenum” means, or its significance, it is a marker in a sequence of seven annual meetings of China’s ruling Communist Party between Party congresses. The National Congress itself is held every five years in the months of October or November, as the highest body within the Party. Since 1982, all key decisions on economic reforms have been announced at the third annual plenum or plenary session of each Party Congress.
If this sounds dry, bear in mind that the third plenum of the 11th Party Central Committee meeting in 1978 – before the sequence of seven was formalized – marked the outset of economic reforms that some have compared to the European Enlightenment or Industrial Revolution. The Third Plenum of the 20th Party Congress did not disappoint, although the timing was delayed from the expected October or November 2023, possibly because it was viewed internally as a landmark event. Its “final resolution” released on July 21 after the four-day session from July 15-18 unveiled the most complete expression of what has been called “Xiconomics” – the personal vision of President and General Party Secretary Xi Jinping. While the impact of the Third Plenum will be felt on China and Hong Kong for years to come, acclaimed China analyst Arthur Kroeber here takes a crack at unpacking its immediate impact on business, in conversation with AmCham HK e-Magazine editor Edith Terry.
Chen Yun, Deng Xiaoping’s conservative vice-premier in the 1980s, thought the socialist economy should be like a bird in a cage, free to move around, but within limits. After the Third Plenum has a new balance been struck?
They haven’t killed the bird, but they’ve made the cage smaller. There’s no question that the regulatory state is very prominent. You can see this both in what they’ve done over the last several years to constrain Internet platforms, but also the policy in the property sector. This latter is obviously causing a lot of sluggishness in the economy as a whole and has contributed to a very disappointing recovery from the Covid-19 era. Despite that, they are determined to keep a tight grip and not let the property sector inflate the way it has in the past.
If you read the Third Plenum document and the various other pronouncements that have come out over the summer, they reiterate the general policy line that the job that China has right now economically is to shift from the old model of growth to a new model of growth, which is essentially driven by high-tech manufacturing. And the corollary is that it is the job of the state and the government to guide that transition and to encourage capital to support the so-called “new productive forces”.
The notion of state guidance as the linchpin of economic management is now very deeply entrenched. This is quite different to how China operated from the early 1980s until about seven or eight years ago, where there was a lot more latitude for private companies and local governments to experiment and do their thing.
This is much more tightly controlled. Within that framework, the authorities are very happy for private companies to operate freely. But the framework is very rigid. It is more constraining than in the past, and there seems to be no indication it will change, even if the cost of that is an even longer period of sub-par economic growth.
How do you feel about the overall direction of China’s regulatory regime?
Most observers would agree that the property building that we saw at its peak in 2021 was too high and was beyond the needs of the country. Policies to restrain overbuilding in the property sector were appropriate. Also, China has a very strong comparative advantage in manufacturing. They’ve got a lot of technology talent, and they should have policies to promote technological development and improvement.
The problem is not so much in the objectives as in the methods and the execution. Because it seems clear that they went after the property sector in a way that was more draconian than was necessary. Some contraction was desirable, but the kind of collapse that we’ve seen is excessive, and that’s because the tools that they have are very blunt. That’s essentially an execution problem.
The bigger issue is they have committed themselves to a concept of state guidance, which leaves a much smaller role for private initiative than in the past and probably over the long run is going to erode the innovative capacity of the economy, because, essentially, they’ve made it too expensive for people to take risks.
Why do you say concept of state guidance restricts innovation?
A simple example of this is when President Xi Jinping asked why there aren’t as many unicorn firms in China as there used to be, at a conference in May.[1] And everyone in the venture capital (VC) industry said, ‘Well, it’s obvious. You had this massive crackdown on the most successful protégés of the venture capital industry, the Internet platforms, and made it very clear that if you took a lot of risks with your capital, you were not going to be permitted to earn large rewards that were commensurate with those risks. You basically killed venture capital coming into China, and now you’re surprised that there are fewer unicorns.’
They have all kinds of state plans for promoting what they call “patient capital”, but if you talk to people in the VC industry, it’s very clear they think that state capital, even if it is labeled as venture capital, is very risk averse. It has very short timelines and very low tolerance for loss.
One of the reasons that state capital has a very low tolerance for loss is that if you are someone sitting on a pile of state money, and you make an investment that goes bad, the next thing that happens is that the corruption investigators will show up at your door and say, what went wrong with this investment? And if you look at the number of anti-corruption investigations in the financial industry, they are going up very steeply.
No one in the system has an incentive to really take risks. Everyone has an incentive just to go with the flow and do what the government says. And even if the overall objectives of the government make a lot of sense in terms of where China needs to go economically over the next 10 or 20 years, the way that they’re going about it is not just an execution problem, it’s a conceptual problem.
They believe that there is much, much less room for private initiative to lead the way than before. The state leads the way, and the private sector essentially executes on the vision that the state lays out. And I and a lot of other economists have some skepticism about just how successful that’s going to be in the long run.
Clearly, there are areas where it will be successful, because if you want to build a semiconductor industry and various other things, you basically need a lot of capital. It’s not going to be a disaster, necessarily, but it probably is not going to generate as much dynamism or as much productivity growth as the government hopes, because there’s too much emphasis being put on the leadership of the state, and not enough emphasis on the ability of the private sector to lead the way with new ideas.
The Third Plenum emphasized the importance of high-quality development and new productive forces. Does this mean that tech is back in favor?
It certainly does not mean that tech is back in favor, if by tech you mean the kind of tech firms that were riding high five years ago. Alibaba (BABA.US) and Tencent (0700.HK), essentially the Internet platforms, that whole universe has been significantly constricted. It’s been made very clear that there are certain kinds of business models that people were looking at, particularly in fintech, that will not be permitted. The outsized profits that that some of these companies derived, arguably, from quasi-monopolistic positions will be much less tolerated. The consumer Internet is going to be allowed to continue, but in a much more constricted way.
If by tech you mean, high tech manufacturing, that is front and center. And there are a couple reasons for that.
One of the reasons is that within the Party people have always had a view that technological progress means building things. Physical technology is really the key, and the sort of consumer-oriented software technology that Alibaba and Tencent did was not really, in the view of state planners, a driver of economic progress. The emphasis is very much on promoting technological manufacturing and using technology to improve the productivity of all manufacturing, even traditional stuff. That’s what they call new productive forces.
What is the difference between industrial policy and “new productive forces”?
Number one, there’s industrial policy, which says we’re going to identify 20 sectors, semiconductors, green energy, electric vehicles, new materials and these kinds of things, and these sectors are going to be the priority investment sectors. And if you look at the flows of bank lending, and if you look at the patterns of equity raising in the stock market, it is very, very clear that if you are on the strategic emerging industries list, if you’re operating in one of those sectors, you are getting most of the new capital that is being raised in China today, whether it’s via bank lending or via equity raises. There’s a very successful effort to redirect capital flows towards these priority, technology-intensive industrial sectors that have been identified by the government.
Then you have the idea of “new productive forces”, which is harder to understand. There have been a lot of vague statements. People in and out of government have jumped in and tried to define it. It’s become a slogan that everyone interprets according to what they want it to mean. But as far as we can tell, what Xi thinks it means is the ability to use technology to improve the way production works throughout the economy. It does not refer to this sector or that sector. It refers to the approach of trying to use technology and deploy technology to make everything work better.
President Xi Jinping has tied it very specifically to total factor productivity, which is the economist’s “X” factor. Once you’ve accounted for labor inputs and capital inputs, whatever growth you get beyond those things is the result of total factor productivity, or TFP. And most measurements suggest that TFP growth in China has been very low for the last decade. The government is saying, ‘Well, how do we improve total productivity? It’s by investing in these technological sectors and then making sure that that the technology that gets produced is used effectively throughout the economy.’
Industrial policy and the new productive forces are the two main pillars of their economic strategy, and together, you could say that they constitute “high-quality development”. Investment in property and infrastructure are not considered high-quality development, they are seen as low-quality development. High-quality development is economic progress that is generated by technological investments and technological forces. That is, very clearly, the strategy. There was no backtracking on it at all in the Third Plenum decision, so I think it is crystal clear that they’re going to continue on the same track. And everything else economically is a sideshow to this.
What are they talking about in terms of specific industries?
It’s straightforward. There’s a list of strategic emerging industries. There were originally seven, now there are eight categories. These categories are broken down into about 20-odd sub-sectors, which continue to be the focus of investment. If you’re looking at a sector-by-sector analysis, it’s anything related to green energy, semiconductors and advanced information technology. And that takes you to realms like quantum computing and artificial intelligence. Biotechnology, aerospace, all these things are fine.
They are likely to be quite successful in some of them and maybe less successful in others. But I think what they’re talking about is less this sector and that sector. The concept of new productive forces is an effort to get away from the mentality of individual sectors that are going to drive growth. It is an effort to say we need to be using technology everywhere in a smarter way, and we need to be maximally innovative. If you look at a lot of the rhetoric around new productive forces, they’re talking about breakthroughs and revolutionary new things. And it’s all very general and vague.
I think it’s a call to arms to have a broader and less silo-ed view of the way that technology can promote economic growth. I have some skepticism, given the way that China works. With the government’s view that the state makes all the key directional decisions, and the private sector just executes on them, the state-led system is going to be much more risk-averse than a private-led system. It’s harder for me to see how you get spillovers from the semiconductor or the electric vehicle (EV) industry into the rest of the economy.
You get those spillovers if private companies basically face few or no restrictions on their ability to come up with new stuff, a lot of which will be delivering services to consumers using new technology. But if you say from the start, Alibaba and Tencent are not really helping economic growth, and we want to constrain them, then you are making it harder, in my opinion, for technology to diffuse through the whole economy.
And it’s really diffusion that you want. That’s what drives long-run economic growth. Most studies of technology and innovation suggest that the big economic impacts do not come from the invention of a new technology, but from the way that technology gets used and deployed by all kinds of other actors. The state-led model makes that harder.[2]
To be fair, there’s a cogent theory behind industrial policy led growth. The view is that you invest in technologies, and they get used in various ways throughout the economy, and that is what drives economic growth in the long run. As the technologies diffuse, you get new employment opportunities, new income opportunities, and so consumption, household incomes and consumption rise in the wake of all of these. But I’m not certain that it will play out exactly that way in China, because the government is essentially trying to set up a system where there are a lot of obstacles to the diffusion of technology and not enough incentives for private actors to maximize the deployment of technology.
Where does China’s export economy come out post-Third Plenum?
The export economy, frankly, is looking fine. Direct exports to the US have gone down. But once you account for indirect exports, through trade diversion, or other mechanisms, it’s not clear that the underlying exports to the US have gone down that much. And if you look at China’s overall share of global exports, and particularly of global manufactured exports, it continues to be very high.
China has about a 20% share of global manufactured exports, and that seems to be certainly not falling, and maybe rising a little bit. They’re very competitive. Chinese companies love to export because they can charge higher prices outside China than they can inside China. Their profit margins are much stronger from export sales.
This is now feeding into the whole debate about excess capacity, because Europe and various other places are saying, ‘Hey, wait, can we really keep absorbing all these Chinese imports?’ My guess is that people will, because there aren’t very many good alternatives. China is very competitive across a very wide spectrum of export industries. They’re competing not just on price, but increasingly on quality. A lot of the so-called protectionism that you see now is basically just an effort to encourage Chinese companies to invest more locally.
You can see this in Europe, where Chinese companies invested a lot in battery plants, and they’re beginning to invest in EV assembly plants. They’re doing the same in Brazil, and in Turkey.[3] Increasingly, what’s going to happen is that Chinese companies, as they internationalize, will not only export, but will also invest in local production facilities around the world.
In a lot of these sectors, they’ll do quite well and maintain high market share, so that part of the economy basically is doing fine. I don’t think that it will be severely constrained by protectionism, except potentially in the United States, where I think there is strong political motivation. Most other places, though, will ultimately make their peace with it.
What are the sources of funding for the Chinese economy?
One of them is export earnings. But behind that lies the fact that you have a very large economy. It’s now about an $18 trillion economy with a 40% national saving rate. There’s a lot of funding that is available from the domestic economy because of the very high saving rate.
At the end of the day, despite these fiscal problems, will China be able to finance its technological ambitions? The answer is basically yes, because they have a very high domestic saving rate, and they have very strong foreign exchange and flows from the export sector. You put those two things together, and they will do fine. There will be a lot of political tension, as we’ve seen already, about the rising Chinese export machine and the rest of the world. That’s friction, but it’s not a real obstacle.
How do you see the future of de-coupling from China?
The point I want to make there is that we have now a lot of evidence that, number one, supply chains are very, very sticky, and even if you move final production out of China, so much of your supply chain is in China that you haven’t really reduced your exposure to China. The “China plus one” strategy was that you reduce your reliance on China and make more investment somewhere else.
And I’ve had several conversations in the last six months with consultants who basically spend all their time talking to CEOs of multinational companies. And the unanimous conclusion of all these people is the China plus one strategy has failed, because the “plus-one” locations are still very heavily connected to China.
That’s the first observation, that even if you have some apparent decoupling, once you get below the surface, the actual amount of decoupling is a lot less. In a few sectors, the US has made it very clear that they’re not going to sell high-end semiconductors to China, and they’re going to block as much as they can of the equipment to make those. Where there are very obvious choke points, yes, you can do some pretty significant decoupling, but across the broad range of economic activities it is incredibly, incredibly difficult. It’s not to say that decoupling is fake or none of it is happening. It’s just that it is really, really hard. And there are only a few sectors where full disengagement is even plausible, short of a war situation, which forces everyone to localize.
The second observation is that most countries are not interested in joining a China bloc or a United States bloc. It is not really on the cards that we’re going to have anything resembling the situation in the Cold War where you had a US group of economies and the Warsaw Pact economies that did not trade with each other. No one wants that. Everyone, basically in the world has either China or the US as their number one trade partner. For most, it’s China.
To the extent that decoupling means sort of a division of the world into blocs, I just don’t see that happening in any significant way. For the vast majority of countries, the obvious right thing for them to do is to maximize their economic relations with both US and China, and extract as much as they can from both of them. And there are going to be a few exceptions, like Iran or Russia, which are very tightly tied to China. And you can come up with a handful of countries like that that are going to be tightly linked in one or the other bloc, but it is a tiny minority of countries.
Both in terms of supply chains being sticky and in terms of countries being deeply resistant to bloc formation, I think we are going to be living in a very complicated, interdependent world where you’ve got overlapping networks, and most countries are trying to play both sides. The US and China will be competing for influence continuously among all of these countries.
Is there an alternative to China in global supply chains? Could India replace China?
China is its own thing. It’s sui generis. It has a combination of qualities, as a large country, with very high education levels, superb infrastructure, enough central cohesion to drive large scale infrastructure network projects like high-speed rail or long-range electrification, and a lot of bottom up dynamism.
And India is large, but it just fails so many of those tests. It’s not cohesive in the same way as China. It has way lower female workforce participation. In terms of its manufacturing competitiveness, it is at a severe and it seemingly permanent disadvantage, although it is improving a lot in the infrastructure part. Also China, geographically, was lucky in that it was the natural hub of pre-existing industrialization that occurred in Japan and Korea and Taiwan, and it so became a natural aggregator, just by virtue of geographical proximity.
What China has done is to embed network effects, which make its manufacturing base very, very sticky. And India is just not as well placed because it’s geographically more remote from those countries. It’s not as integrated, either physically or culturally, with the East Asian industrial sphere. There’s no way for India to break in and replicate those network effects.
So whatever India does, it’s just going to have to find a somewhat different pathway, and I don’t think there’s really an effective way to use India or anywhere else as a full-on substitute for what you can do in China. It’s a substitute for some things, and it will become more competent as time goes on. But I think China’s advantages are too embedded and too complex at this point to be fully substituted for by someone else.
Arthur R. Kroeber is the founder of Gavekal Dragonomics, a China-focused economic research firm with offices in Beijing and Hong Kong and partner in its parent firm Gavekal. Before establishing Dragonomics in 2002, he spent 15 years as a financial and economic journalist in China and South Asia. He is adjunct professor of economics at the NYU Stern School of Business and a member of the Council on Foreign Relations and the National Committee on US-China Relations. His book China’s Economy: What Everyone Needs to Know (2nd edition 2020) is published by Oxford University Press.
[1] Frank Chen, “China’s unicorns set for capital boost after dwindling flock catches Xi Jinping’s eye,” South China Morning Post, May 30, 2024, https://www.scmp.com/economy/china-economy/article/3264606/chinas-unicorns-set-capital-boost-after-dwindling-flock-catches-xi-jinpings-eye
[2] Jeffrey Ding, Technology and the Rise of Great Powers: How Diffusion Shapes Economic Competition, Princeton Studies in International History and Politics (Princeton University University Press, 2024)
[3] Sinan Tavsan, “China’s BYD to invest $1bn in Turkey for EV plant,” Nikkei Asia, July 9, 2024, https://asia.nikkei.com/Business/Automobiles/China-s-BYD-to-invest-1bn-in-Turkey-for-EV-plant