China’s economic policy of Dual Circulation

This essay is an updated and abridged version of a commentary published by the East Asian Institute.

China’s 14th Five-Year Plan, approved last March, proposes “Dual Circulation” as a solution for lacklustre external demand and geopolitical tensions.

The concept of Dual Circulation, first proposed by Xi Jinping in May 2020, remains somewhat vague, which is not unusual for new Chinese policy concepts. It implies greater reliance on domestic supply chains, domestic demand, and “indigenous innovation” as a means to create growth and employment, in contrast to the “international circulation” of overseas demand which has been a focus since the mid-1980s.

Foreign trade and investment are becoming less important for China. China’s share of trade in goods to GDP has come down from almost 50% in 2008 to a little over 30% now. This is not much different from that of the EU-27 and Japan (Figure 1), but still about 10 percentage points higher than the United States.

China’s current account surplus has also come down sharply, from 9% of GDP in 2007 to less than 1% in 2019—though it bounced back in 2020, as China was quick to resume production and exports after getting COVID-19 under control. In the past decade, China has also expanded its domestic supply chains, while divesting from the more labour-intensive production it specialised in before. Both led to less reliance on trade.

Finally, China’s economy is increasingly dependent on services and less on manufacturing, which tends to lower the share of trade to GDP; the relative price of services also tends to increase as countries become richer. On the demand side, China has been trying for more than a decade to rebalance demand, external versus internal and investment versus consumption.

Moreover, richer households tend to save more. While income inequality in China has stopped rising, it remains as high as in the United States. On the other hand, wealth inequality, driven largely by housing ownership and housing prices, has been rising since the late 1990s.

Unlike more advanced countries, the government redistributes little because social welfare spending is still low as a share of GDP and the tax system relies predominantly on indirect taxes, in particular VAT. While the latter is efficient in raising revenues, it is not an equalising tax.

Finally, urbanisation—a key driver of domestic demand—has continued apace. Currently, 64% of the population live in urban areas.

However, only 45% of the population has urban hukou, or household registration. Those without it have fewer opportunities in the labour and housing markets. Their families have less access to social services and social security.

In response, China is doubling down on its efforts to promote “indigenous innovation.” Moreover, the emphasis seems to have shifted from more applied innovation to fundamental research, so as to become less dependent on foundational technologies from abroad.

China is well under way to becoming a technological powerhouse. The country now spends some 2.3% of GDP on R&D, and although it just missed the 2.5% target of the 13th FYP, its spending adds up to the second largest absolute amount globally, after the United States.

Though quality issues remain, the number of patents and academic papers originating from China is rising fast. China’s talent pool is deep. Some eight million students graduate every year, and more than half are STEM majors. In some areas of technology, such as fintech, e-commerce, 5G, solar and wind energy, power transmission and electronic vehicles, Chinese companies are already cutting edge. However, even those companies depend on foundational technologies from elsewhere, notably the United States, as the sanctions on Huawei and others make clear.

This list of priority industries in the 14th Plan pretty much looks like the industries in the Made in China 2025. Dragonomics, a consultancy, calculated that the financial support for these sectors not only attract government support, much of which through “government guided funds”, but also get leveraged many times over through the capital market and banks.

Most funding for R&D in China comes from the non-state sector, not from government budgets. More than 80% is done in industry, not in government organisations such as universities and research institutes. This balance is likely to shift somewhat as China’s emphasis is shifting to more fundamental science, not just applied R&D. One sector is of particular interest: Integrated Circuits (“chips”), the prime battleground in the US-China tech war. It has been the focus of attention for a long time in China’s technology policies and IT was featured already in the “863” technology plan of 1986.

Despite the billions of dollars spent, China has not been able to catch up with the leading producers in this area. Its most sophisticated chips are still a generation behind the cutting edge. However, this time may be different. Necessity is, after all, the mother of invention.

In 2020, the Chinese government allocated some RMB200 billion to the industry. This will be leveraged many times over by local governments and private capital. It is in the nature of innovation that much of that money will not deliver results. But some of it will. Once China has found alternatives to the Qualcomms and Intels of the world, it will not be coming back.

The 14th FYP mentions the need for international cooperation in science and technology, and such cooperation would clearly benefit China and the rest of the world. Nevertheless, China’s plans for indigenous technology development are likely to be controversial internationally. Perhaps unnecessarily so: China is one of the few countries that brings together its plans in this arena in one place, but countries around the world have their own technology policies, and a growing number have been pursuing industrial policies in light of disappointing economic performance since the global financial crisis.

The challenge for China and other countries is to keep the instruments with which they pursue such policies compatible with an open, market-based international economic system.

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