Uday Khanapurkar, Research Intern, Institute of Chinese Studies

China and the USA, the world’s two largest economies, are currently embroiled in an acrimonious two-front geo-economic tussle. On the trade front, a 10 per cent tariff on 200 billion USD of Chinese exports to the USA came into effect on September 24, 2018; with President Trump threatening further duties on 267 billion USD should the Chinese retaliate. On the financial front, the USA enacted a law in August, 2018, aimed at strengthening the Committee on Foreign Investment in the United States (CFIUS) in order that it may undertake more meticulous scrutiny of Chinese investments in the US and prevent undesirable technology transfers. Combined, these contestations in the economic domain put China under significant pressure.

To be sure, China is at a precarious stage in its economic development. Rising wages and an aging population entail that low-quality manufacturing and assembly cannot generate more growth. Investment spending experiences decreasing returns to scale. As the productive capacity of capital and labour, the two prime factors of production, erodes, the Chinese economy must rely on innovation to sustain growth and escape the fabled ‘middle income trap.’ According to a McKinsey study, multifactor productivity – a measure of innovation – in China needs to grow from the current level of 30 per cent of GDP growth to between 35 to 50 percent in order to sustain growth rates of 6.5 per cent per annum. Trump’s protectionist moves in the realms of trade and finance jeopardise the attainment of this benchmark.

The aforementioned study identifies four archetypes of innovation in China that contribute to multifactor productivity. The first two, customer-driven innovation and efficiency-driven innovation, capitalise on China’s large consumer base and supplier base respectively. The former is benefited from the vast feedback mechanism China’s large consumer population supports and the latter is enabled by infrastructure networks and supply chain management. The ongoing trade war could prove to be an impediment to both in the short run. Contractions in the levels of demand faced by Chinese companies could deprive the economy of the scale required to innovate in these two areas.

While much of the commentary on the trade war alludes to the resilience of the Chinese economy by highlighting the reduced share of foreign trade in China’s GDP, its transition to a consumer-demand based economy is hardly complete. At 47.3 per cent, China’s gross domestic savings rate in 2017 was far higher than the world average at 24 per cent. To conflate a reducing dependence on foreign trade with the absence of one is erroneous. Others argue that dependence on trade with the US in particular is not large enough to matter. The effect of tariffs, however, will not be restricted to trade with the US since the disruption of supply chains will arguably engender contractions in other markets as well; trade disruptions will rock the entire boat. Hunting for alternative buyers and sellers in the third market also comes with significant costs in the short run. China’s investors are exhibiting cognisance of the impending hazards; the Shanghai Composite Index is headed for an annual loss of 17 per cent and has ceded its position as the world’s second largest stock market to Japan’s. While this is likely an overreaction since China excels in the first two types of innovation, trade disruptions will certainly cause some uneasiness.

Trump’s strengthening of CFIUS promises to complicate China’s pursuit of the third and fourth archetypes of innovation, namely engineering-based innovation and science-based innovation. Attaining competitiveness in cutting edge technologies such as semiconductors, robotics and high-end machinery is central to Xi Jinping’s flagship ‘Made in China 2025’ programme. One of China’s preferred methods in this pursuit has been to invest heavily in the West’s leading companies and absorb technical know-how. Access to foreign technology has enabled China to imitate and internalise technology quicker than would be possible indigenously. The reformed CFIUS is slated to upset this modus operandi by erecting strict barriers to Chinese investments in the high-tech sectors citing national security risks. The Committee also seeks to cooperate with investment regulators in Europe to curb dubious technology acquisitions; the advanced economies of Germany, France and UK have already put stricter procedures in place and are likely to cooperate with the USA.

Advocates of China’s resilience contend that its performance in high-tech innovation has improved remarkably and in some instances already surpasses that of the US. The implication is that China’s progress in this area will not be hindered by lack of access to foreign technology. However, this is unlikely to be the case in the short run since indigenous innovation is a time-consuming affair that generates returns long after investments are incurred, if at all. Being deprived of swiftly absorbable foreign technology could hamper China’s ability to attain the high-tech targets it has set for the Communist Party of China (CPC) centenary in 2021.

China is also faced with fewer economic policy options to spur growth than has previously been the case. Given that China is currently grappling with mountainous public debt levels, the government is unlikely to resort extensively to monetary stimulus, as it did post the 2008 financial crisis. This would only serve to exacerbate structural inefficiencies. The trade war is also upsetting China’s reform agenda, with the administration fearing that opening up the economy in the current political climate could be construed as China caving to pressure from the US.

Contestations in the economic domain effectively compel China to rely more on boosting domestic demand and indigenous innovation for growth in the short run. China’s troubles stem from the fact that both of these elements take longer to be cultivated. While China’s economy is unlikely to be irrevocably crippled, the ongoing disruptions certainly place it under a great deal of duress. With China forced to make haste in affecting the transition to an advanced, consumer-demand based economy within key timeframes, the scope for error is ostensibly magnified.