Why China still needs industrial policy as a "talisman of victory"

Will China's budget constraints worsen the impact of a Trump-led trade war?

Our briefing on critical economic and financial developments in China as of Tuesday, 3 December, 2024:

• China should continue to implement industrial policy as a “talisman for achieving victory” that runs in accordance with modern trade theory, according to a leading Chinese economist at a top state-owned bank.

• Beijing has just unveiled “counter-cyclical” cuts to export rebates traditionally designed to prop up the Chinese economy during periods of weakness, in a bid to either alleviate budgetary pressure on the Chinese government, or ease trade tensions with other major economies.

Why China still needs industrial policy as a "talisman of victory"

Xu Gao (徐高), chief economist at the investment banking vehicle of Bank of China (BOC), believes China needs to maintain its use of industrial policy to tide the economy over as it faces mounting headwinds to growth.

"The government not only needs to use industrial policy to spur industrial development, it also has ample room to do so," Xu said in a recently published speech that he delivered at Peking University on 22 September.

Xu argues that without industrial policy, China would be unable to overcome the advantages of scale achieved by other countries with a first mover advantage in established market sectors.

"Once an industry is developed at scale, this forms an extremely strong advantage against latecomers. "Looked at from this perspective, the state should play a highly active role in driving domestic industry to seize the initiative and form advantages of scale.

"New trade theory provides the theoretical foundation for government intervention in industrial development, and is for this reason also referred to as strategic trade theory."

In the realm of empirical outcomes, Xu points to the tremendous success of China's electric vehicle (EV) sector, thanks to the support provided by industrial policy.

"Since the start of 2020, China's vehicle exports have seen explosive growth," Xu said. "In 2023 China's vehicle exports surpassed Japan for the first time to become the world's leader."

"Over the past three years, China's share of the passenger EV market has surged from under 5% to around 45% at present."

Xu contends this development would have been impossible without the support of China's industrial policy.

"The success of our EVs required the government to provide targeted support to the EV sector over the past decade," he said.

"From the initial industry plans, to production, consumption and infrastructure - government policy always had a role to play."

Xu argues that it is only the effectiveness of China's industrial policy that has incurred hostile responses from the US and other developed nations - as opposed to its dubious moral character.

According to Xu, this assertion is warranted by their adoption of similar retaliatory measures in response.

"From the perspective of other countries, our successful experience has already created a 'threat,' and some nations are now adopting our measures.

"For example, in April of this year, the European Union (EU) released a report running to more than 700 pages, outlining China's support policies with regard to EVs, such as vehicle purchase subsidies, encouragement to manufacture EVs and special funds.

"These policies are viewed by the EU as a form of 'market distortion,' yet also as the 'talisman of victory' for the development of China's EV sector."

Will China worsen the impact of a Trump-led trade war because of budget constraints?

A leading Chinese economist says the negative impact of Donald Trump's proposed tariffs could be further exacerbated by "counter-cyclical" cuts to export tax rebates by Beijing, partially intended to offset the impacts of deficit-driven fiscal stimulus.

On 15 November, China's Ministry of Finance and State Administration of Taxation jointly announced the cancellation or reduction of export tax rebates on a slew of goods.

These included the removal of rebates for 59 export categories, including aluminium, copper, and chemically modified animal fats, and the reduction of the rebate rate for 209 goods, including refined oil, photovoltaic devices, batteries, and certain non-metallic mineral products, from 13% to 9%.

The rebates are intended to prevent the reduplication of taxes on export goods, such as value-added taxes, already paid during the process of manufacture and circulation.

Rebate cuts could worsen China's economic weakness

Zhang Yu (张瑜), a researcher from Renmin University's International Monetary Research Institute, points out that the rebate cuts are deeply "counter-cyclical" from an economic perspective.

They arrive just as the Chinese economy’s growth is struggling, with a property sector that has yet to recuperate, faltering efforts to boost domestic demand, and near-imminent worsening of trade relations with the US, as Trump waits in the wings to assume presidential office.

"In the past, whenever the economy came under considerable pressure, the export rebate was a customary means for stabilising foreign trade and growth," Zhang wrote in an online opinion piece.

She pointed in particular to the 2008 financial crisis, foreign trade slumps in 2014 and 2016, the start of Sino-US trade disputes in 2018, and the Covid pandemic which kicked off in 2020, as periods when Beijing opted to raise rebates to alleviate pressure on exports.

Cutting the rebates could have a negative impact on exports by increasing the prices for Chinese-made goods.

Is China cutting rebates to balance its budget?

The imperative of balancing the budget and averting an excessive debt burden could be part of the motivation for China's top policymakers to reduce export rebates.

China is expected to step up fiscal stimulus, with domestic economists calling for 10 trillion yuan in spending, and Beijing already scheduling the issuance of one trillion yuan in ultra-long-term treasuries in 2024.

This will put considerable pressure on the budget of the Chinese government.

According to Zhang, export rebates currently equal over 10% of China's tax revenues. For the period from January to October of 2024, China's total tax revenues were 15.1 trillion, while export rebates amounted to 1.7 trillion.

She nonetheless points out, however, that the current round of adjustments are unlikely to have a major impact on China’s fiscal revenues.

Zhang's research indicates that the rebate reduction will likely increase fiscal revenues by just 84.9 billion yuan.

Preventing "involuted competition" and trade tensions

Zhang instead speculates that Beijing has other motivations for reducing export rebates, in addition to alleviating the debt burden of fiscal stimulus.

Chief amongst them are:

“Involuted" competition in Chinese industry

In July, China's Politburo called for "strengthening industry discipline, and preventing adverse, involuted (内卷式) competition.” It also called for strengthening market mechanisms for ensuring the Schumpterian rise of strong businesses, and the obsolescence and closure of weak firms.

Zhang points in particular to the photovoltaic sector as an example of adverse competition which has "increased volumes by reducing values."

For the period from January to October this year, China’s exports of photovoltaic goods affected by the latest rebate adjustment totalled USD$28.65 billion, for a decline of 34.1% compared to the same period last year.

Alleviating trade tensions with the West

A considerable number of the goods affected by the latest rebate adjustment involve the clean energy sector,, including aluminium, copper, photovoltaic products and batteries.

Zhang believes this could help to alleviate trade tensions with other major economies, and serve as a bargaining chip in negotiations, following the launch of anti-dumping investigations and tariffs against China by the US, EU and Canada since 2023.