Innovative China Innovative China New Drivers of Growth World Bank Group Development Research Center of the State Council, the People’s Republic of China Washington, DC © 2019 International Bank for Reconstruction and Development / The World Bank and the Development Research Center of the State Council, P. R. China 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 2 3 4 22 21 20 19 This work is a product of the staff of The World Bank and the Development Research Center of the State Council, P. R. China. Note that neither The World Bank nor the Development Research Center of the State Council, P. R. China necessarily owns each component of the content included in the work. The World Bank and the Development Research Center of the State Council, P. R. China therefore do not warrant that the use of the content contained in the work will not infringe on the rights of third parties. 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ISBN (paper): 978-1-4648-1335-1 ISBN (electronic): 978-1-4648-1420-4 DOI: 10.1596/978-1-4648-1335-1 Cover design: Critical Stages, LLC Library of Congress Cataloging-in-Publication Data has been applied for. Contents Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxxi Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 China’s Rapid Growth and Evolving Economy . . . . . . . . . . . . . . . . . . . . . . . . 3 An economy already transforming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 A rapidly changing and more uncertain global environment . . . . . . . . . . . . . . . . . . . . . . . . . .8 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 2 The Need for New Drivers of Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Investment’s diminishing contribution to growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Labor’s diminishing contribution to growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 3 The Productivity Challenge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Promoting new drivers of growth through the “3+6+7” reform agenda . . . . . . . . . . . . . . . .21 The three D’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Six strategic choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Seven critical reform areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 The impact of reforms on future growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 INNOVATIVE CHINA v vi CONTENTS 4 Reshaping Industrial Policies and Supporting Market Competition . . . 29 Industrial policies to support market competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Promoting greater competition in the services sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36 Promoting entrepreneurship and improving the business climate . . . . . . . . . . . . . . . . . . . . .38 Ensuring fair competition and reforming state-owned enterprises . . . . . . . . . . . . . . . . . . . .42 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 5 Promoting Innovation and the Digital Economy . . . . . . . . . . . . . . . . . . . . . 49 China’s rapidly increasing innovation capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49 Promoting the diffusion of innovation and technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54 Improving research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56 Improving intellectual property policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57 Improving the management of innovation policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59 Supporting innovation driven by digital diffusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60 Promoting data trade and data flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63 ICT telecommunications infrastructure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71 6 Building Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Technology’s impact on China’s labor market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76 Building universal foundational skills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79 Creating a world-class higher education system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .80 Teaching creative thinking and problem solving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85 Using technology to teach creativity and problem solving . . . . . . . . . . . . . . . . . . . . . . . . . . .86 Strengthening technical and vocational education and training . . . . . . . . . . . . . . . . . . . . . .87 Promoting lifelong learning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89 China’s new education sector strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .91 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .92 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93 7 Allocating Resources Efficiently . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 China’s financial sector developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .95 Financing small and medium enterprises and entrepreneurs . . . . . . . . . . . . . . . . . . . . . . . . .97 Facilitating free flows of labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .104 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .109 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 8 Leveraging Regional Development and Integration . . . . . . . . . . . . . . . . 113 Reducing spatial frictions in factor markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Nurturing and connecting economic clusters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120 9 Promoting International Competitiveness and Economic Globalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 China’s integration into the global economy and rising competitiveness . . . . . . . . . . . . . . .124 Major challenges and opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129 Policy recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137 CONTENTS vii 10 Governing the Next Transformation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Toward a new state-market relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .140 Strengthening regulatory governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Aligning the government’s incentives with the needs of the new economy . . . . . . . . . . . . . 143 Reforming intergovernmental relations and tightening fiscal discipline . . . . . . . . . . . . . . .144 Improving public sector transparency and accountability . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 Boxes 4.1 Industrial excess capacity in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 4.2 Impact of the Mass Entrepreneurship Program in Guangdong Province . . . . . . . . . .39 5.1 Digital health . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62 5.2 OECD recommendations for protecting data privacy . . . . . . . . . . . . . . . . . . . . . . . .64 6.1 A modern tertiary education governance framework. . . . . . . . . . . . . . . . . . . . . . . . .83 6.2 Lessons from recent World Bank TVET projects in China . . . . . . . . . . . . . . . . . . . .88 6.3 Adult learning in the United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 7.1 An integrated system delivers better social insurance services . . . . . . . . . . . . . . . . .106 Figures 1.1 Composition of GDP growth in China, 1992–2018 . . . . . . . . . . . . . . . . . . . . . . . . .4 1.2 Contribution of fixed-asset investment to growth in China, 2005–18 . . . . . . . . . . .5 1.3 Share of industry in GDP in China, by sector, 1978–2017 . . . . . . . . . . . . . . . . . . . .6 1.4 Share of services in GDP in China, 2016. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 1.5 Share of labor income and gross savings in GDP in China, 1992–2017 . . . . . . . . . .7 1.6 Number of Internet users in China, 2007–18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 1.7 Value and share of online retail sales in China, 2008–18 . . . . . . . . . . . . . . . . . . . . .9 1.8 Growth in the global trade of goods, 2001–19 . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 2.1 Sources of growth in China, 1978–2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.2 Sectoral gross capital formation as a share of GDP in China, 1990–2016 . . . . . . .12 2.3 GDP growth and the incremental capital-output ratio (ICOR) in China, 1995–2018. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.4 Capital-output ratio in China, by economic sector, 1990–2015 . . . . . . . . . . . . . . .13 2.5 Estimated composition of debt accumulation in China, 2012–16 . . . . . . . . . . . . . .13 2.6 Real gross capital formation in China, 2001–18 . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.7 Public and private sector capital stock per worker in China and other countries, 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.8 Projected labor force in China, by age, 2010–30 . . . . . . . . . . . . . . . . . . . . . . . . . .15 2.9 Population of China, by gender and age group, 1971–2041 . . . . . . . . . . . . . . . . . .16 3.1 Aggregate growth of total factor productivity (TFP) in China, 1978–2017 . . . . . .20 3.2 Growth of total factor productivity (TFP) in industry in China before and after the global financial crisis, 1998–2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 3.3 Contribution of labor productivity to growth in China, by sector, 2003–17 . . . . .21 3.4 The three D’s: reducing distortions, accelerating diffusion, and fostering discovery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 3.5 Total factor productivity (TFP) relative to the global technology frontier, 2014 . . .23 3.6 Share of income and consumption in GDP in selected countries, 2016 . . . . . . . . . .24 3.7 Projected gross national income (GNI) per capita in China, 2011–46 . . . . . . . . . .26 B4.1.1 Industrial capacity utilization rates in China, 2013–19 . . . . . . . . . . . . . . . . . . . . .32 4.1 Annual number of insolvency cases in selected countries, 2017 . . . . . . . . . . . . . . .35 viii CONTENTS 4.2 Inputs into productive sectors in selected countries, 2011 . . . . . . . . . . . . . . . . . . . .36 4.3 Services Trade Restrictiveness Index in selected countries, 2017. . . . . . . . . . . . . . .37 4.4 Number of new enterprises registered annually in China, 2013–18 . . . . . . . . . . . .38 4.5 Doing Business’s distance to frontier and the rankings for China and comparators, 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 4.6 Entrepreneurs’ perceptions of fair competition in the market in China, 2017. . . . .43 5.1 National innovation system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50 5.2 Ranking on the global innovation index of select countries, 2007–18 . . . . . . . . . .50 5.3 R&D spending in selected countries, 1996–2014 . . . . . . . . . . . . . . . . . . . . . . . . . .51 5.4 Number of domestic and international patents, 1990–2016 . . . . . . . . . . . . . . . . . .52 5.5 Managerial capabilities of Chinese firms and their competitors . . . . . . . . . . . . . . .54 5.6 Digital adoption index in China and comparator countries, 2017 . . . . . . . . . . . . .60 5.7 Disaggregating the digital diffusion lag between China and OECD countries . . . .61 5.8 Broadband adoption in selected countries, by speed, first quarter of 2017 . . . . . . .69 6.1 Educational attainment of the labor force in China and comparator countries, 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76 6.2 Employment shares in China, by wage and skill distribution, 2000–15 . . . . . . . . .78 6.3 Evolution of the skill content of Chinese jobs, 2000–15 . . . . . . . . . . . . . . . . . . . . .78 6.4 Number of postsecondary students and tertiary institutions in China, 1985–2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81 6.5 Government spending on tertiary education in selected countries . . . . . . . . . . . . .81 6.6 Cross-country public spending in education, 2015 . . . . . . . . . . . . . . . . . . . . . . . . .91 7.1 Financial sector share of GDP in selected countries . . . . . . . . . . . . . . . . . . . . . . . .96 7.2 Share of the net credit growth of SOEs and non-SOEs, 2011–16 . . . . . . . . . . . . . .96 7.3 Access to credit in China and comparator regions, by size of firm, 2012 . . . . . . . .98 7.4 SME capital markets in selected countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 7.5 Resident and hukou population as a share of total population in China, 2011–20. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .105 7.6 Average job tenure in selected countries and within China . . . . . . . . . . . . . . . . . .108 8.1 Trade within and between provinces in the Yangtze River Economic Belt of China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 9.1 China’s share of global exports of goods, 1993–2017 . . . . . . . . . . . . . . . . . . . . . .124 9.2 Global network of intermediate trade (minimum-spanning-tree method), 1995 and 2016. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125 9.3 China’s foreign direct investment and outward direct investment, 2005–18 . . . . .125 9.4 “Fitness analysis” of the diversity and complexity of China’s exports . . . . . . . . .126 9.5 Revealed comparative advantage in gross exports and value-added exports in China, 2000–14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 9.6 Domestic value added (DVA) in exports in selected economies, 2000–14. . . . . . .128 9.7 Exports of processed products as a share of total goods exported from China, 1994–2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128 9.8 Quality of export manufacturing in major economies, 1980–2014 . . . . . . . . . . . 131 9.9 Logistics Performance Index (2018) and logistics costs (2016) in selected countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132 9.10 Stock of foreign direct investment and outward direct investment in selected countries, 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133 9.11 Foreign direct investment (FDI) restrictiveness index, 2018 . . . . . . . . . . . . . . . . .134 10.1 Reforms and GDP growth in China, 1978–2014 . . . . . . . . . . . . . . . . . . . . . . . . .140 CONTENTS ix Tables 3.1 Projected growth of GDP and labor productivity in China under three scenarios, 2001–50 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 5.1 Mechanisms to facilitate technology diffusion . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 5.2 Digital trade policy framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .63 5.3 ICT infrastructure indicators in selected countries . . . . . . . . . . . . . . . . . . . . . . . . .68 Foreword Four decades ago, Deng Xiaoping initiated this challenge. To this end, the Development the reform and opening-up of China’s econ- Research Center (DRC) of the State Coun- omy with his famous speech, “Emancipate cil, the Ministry of Finance (MOF), and the the mind, seek truth from fact, and unite as World Bank Group (WBG) initiated a joint one to face the future.” Since then, China has research program on the new drivers of witnessed one of the most remarkable periods growth in China’s economic transition era. of sustained growth anywhere in the world, Researchers from the DRC and the WBG lifting 850 million Chinese people out of pov- worked together for more than two years erty. China achieved this growth by investing to analyze China’s main development chal- in its infrastructure and people, expanding lenges and to propose a new set of policy and the role of markets, and welcoming foreign institutional reforms. Joint teams were estab- trade and investments. Reforms were often lished to work on economic growth and pro- gradual, pragmatic, and experimental, taking ductivity, innovation and technology, human advantage of local pilots before expanding capital development and the labor market, new policies to other regions. Through such entrepreneurship and competition, indus- reforms, China transformed itself from a pre- trial upgrading, regional integration and dominantly rural, agricultural economy to an development, global integration and interna- industrialized global manufacturing hub and tional competitiveness, and governance and the second-largest economy in the world. institutions. China is now at a crossroads in its devel- The teams have held a series of work- opment. Rapid industrialization, urbaniza- shops over the past two years, with partici- tion, and efficiency gains resulting from four pation by DRC and WBG experts, as well decades of reform and opening-up are no as domestic and international researchers. longer sufficient to sustain past growth rates. Domestic and international study tours were Declining returns to public investment, a rap- conducted, surveys and focus group discus- idly aging population, and a less favorable sions with enterprises were carried out, and international environment add to the urgency numerous background papers and case stud- of finding new drivers of economic develop- ies were commissioned. Lessons were drawn ment. China’s leadership is fully aware of from China’s own experiences, as well as INNOVATIVE CHINA xi xii FOREWORD international ones. The focus was on devel- This report, Innovative China: New Driv- oping pragmatic policy recommendations ers of Growth, is the fruit of extensive debate that could be implemented within China’s and discussion with the objective of reach- specific institutional context. ing a consensus. The value of a joint study A key conclusion from this report is that was precisely to foster mutual understanding boosting productivity will be key to China’s and a better appreciation of China’s institu- future growth prospects and innovation, and tional realities. The joint study process also that market competition will need to drive informed DRC’s internal advice to the gov- productivity-led growth. This effort, in turn, ernment and fed into the preparation of the will require addressing three “D’s”: reducing WBG’s new strategy for China. Distortions in the allocation of resources; We hope the report will help guide China’s accelerating Diffusion of existing advanced policy makers on the appropriate growth technologies and innovations to take advan- strategy going forward. We also believe that tage of China’s large remaining potential for it can provide useful insights to other coun- catch-up growth; and fostering Discovery of tries looking to promote innovation and new technologies, products, and processes to boost productivity in their economies. The push out China’s own production possibility success of China’s growth strategy, and the frontier. To promote the three D’s, the report policies adopted to achieve it, matter for the identifies six major policy choices and recom- international community. We hope that the mends structural and policy reforms in seven this report will serve as an evidence-based key areas. Together they form the proposed contribution to an ongoing debate of consid- “3+6+7” reform agenda. erable global significance. Ma Jiantang Victoria Kwakwa Party Secretary and Vice President East Asia and Pacific (Minister in charge) Regional Vice President Development Research Center of the World Bank Group State Council, P. R. China Acknowledgments Innovative China is a joint report by China’s DRC; Former Vice Minister Yaobin Shi and Development Research Center of the State Vice Minister Jiayi Zhou of MOF; and EAP Council (DRC), China’s Ministry of Finance Regional Vice President Victoria Kwakwa, (MOF), and the World Bank and Interna- World Bank China Country Director Martin tional Finance Corporation (IFC) of the World Raiser, and IFC China Country Manager Bank Group (WBG). A high-level joint steer- Randall Riopelle (all of the WBG). Former ing committee provided the oversight for the World Bank China Country Director Bert report. Members of the Steering Committee Hofman and former IFC Chief Economist were former Minister Jie Xiao, former Minis- Ted Haoquan Chu were former executive ter Jiwei Lou, Minister Kun Liu, former Vice heads. The main technical coordinators for Minister Yaobin Shi, and Vice Minister Jiayi DRC were Mingjie Ma, Wei Lyu, Changwen Zhou (all of the MOF for the Government of Zhao, and Jun Ma. For the World Bank, the China), former President Wei Li, Party Secre- Task Team Leader was Hoon Sahib Soh. tary and Vice President (Minister in charge) Joint DRC and WBG teams were respon- Jiantang Ma, Vice President Junkuo Zhang, sible for preparing the main report’s eight and Vice President Guoqiang Long (all of themes. A series of joint workshops discussed DRC); and former President Jim Yong Kim, the analytical findings and policy recommen- Chief Executive Officer Kristalina Geor- dations, with participation from international gieva, IFC Chief Executive Officer Philippe experts. The teams consulted relevant gov- H. Le Houerou, East Asia and Pacific (EAP) ernment agencies, including the Ministry of Regional Vice President Victoria Kwakwa, Foreign Affairs (MFA), Ministry of Finance and East Asia and Pacific (EAP) Vice Presi- (MOF), the National Development and dent Ceyla Pazarbasioglu (all of the WBG). Reform Commission (NDRC), the Ministry The chief directors for the report were of Science and Technology (MOST), Minis- Party Secretary and Vice President (Minister try of Education (MOE), Ministry of Indus- in charge) Jiantang Ma of DRC, Minister Kun try and Information Technology (MIIT), Liu of MOF, former President Jim Yong Kim Ministry of Human Resources and Social of the WBG, and IFC Chief Executive Officer Security (MHRSS), Ministry of Commerce Philippe H. Le Houerou. The executive heads (MOC), People’s Bank of China (PBOC), the of the report were Vice President Junkuo State-Owned Assets Supervision and Admin- Zhang and Vice President Guoqiang Long of istration Commission of the State Council INNOVATIVE CHINA xiii xiv ACKNOWLEDGMENTS (SASAC), the National Bureau of Statistics Stefan Beisswenger, Xavier Cirera, Marcio (NBS), the State Intellectual Property Office Cruz, and Gregor Schueler (WBG) on tech- (SIPO), and several nongovernmental orga- nology adoption; Ari van Assche and Jo van nizations, including the Organisation for Biesebroeck (WBG) on importing and pro- Economic Co-operation and Development ductivity; Mingzuo Sun, L. Colin Xu, and (OECD), World Intellectual Property Orga- Xiaobo Zhang (WBG) on regional patents nization (WIPO), and McKinsey Global and growth; Danqing Zhu (WBG) on STI Institute. A study tour of Singapore and the indicators; Justin Hill, Ruimin Pei, Juan Rog- Republic of Korea were conducted to learn ers, and Hua Shen (WBG) on the innovation about policies to support productivity and policy mix; Dan Prud’homme and Zhang innovation. Extensive consultations with Taolue (WBG) on intellectual property rights; private sector representatives included focus and Qursum Qasim and Lin Shi (WBG) on group discussions and a new survey of entre- firm-level case studies. Yu Shang provided preneurs carried out for the report. A new excellent administrative support. enterprise survey was also carried out for the The team on human capital development report. and the labor market was composed of Seng The report was prepared by a joint team Gong, Lihui Liu, Bingzi Zhang, Dandan comprising Mingjie Ma, Changsheng Chen, Dong, Weijing Wang, Ruoyun Hua, Fei Teng, Yongzhi Hou, Changwen Zhao, Wei Lyu, Ting Shao, Lu Yu, and Yu Zhouof of DRC, Qi Zhang, Jun Ma, Shiji Gao, Sen Gong, and Omar Arias, Elena Glinskaya, Mahesh- and Peilin Liu of DRC, and Hoon Sahib Soh, wor Shrestha, Ning Fu, and Dewen Wang of Lin (Amanda) Yang and Jian Chan (consul- the WBG. Critical contributions were pro- tant) of the World Bank, under the guidance vided by Yong Guo and Fei Shi (Tsinghua of the executive heads of the report. Eight University) and John Giles (WBG) on anal- joint DRC-WBG teams worked on specific ysis of the returns to college and turnover; research themes. Albert Park (HKUST) and Yang Du (Chi- The team on growth and productivity was nese Academy of Social Sciences) on analy- composed of Changsheng Chen, Guangpu sis of the task content of Chinese jobs; Jin Yang, Jianwu He, Wei Xu, and Chengjian Li Song (Chinese Academy of Social Science) on of DRC; and John Litwack, Elitza Mileva, background research on returns to college; and Luan Zhao of the WBG. Critical con- and Samer Al-Samarrai on education spend- tributions were provided by Loren Brandt, ing inputs (WBG). Xichen Li (consultant) Luhang Wang, and Yifan Zhang (all con- provided excellent research assistance. Help- sultants) on firm-level productivity analysis; ful comments were provided by Harry Patri- Richard Herd (consultant) on sectoral capital nos, Philip B. O’Keefe, John Giles, Dandan stock analysis; and Min Zhao (WBG) on sub- Chen, Josefina Posadas, Amer Hasan, and national government policy. Huitian Bai and Yang Huang (WBG). Peng Zhou provided excellent research assis- The team on entrepreneurship and com- tance. Lin Yang provided excellent adminis- petition was composed of Jun Ma, Yongwei trative support. Zhang, Dongming Yuan, Shuping Ma, Xiao- The team on innovation and digital econ- bai Ma, Chenghui Zhang, and Hongming omy was composed of Wei Lyu, Mingjie Ma, Zhu of DRC, and Chunlin Zhang and Jus- Jietang Tian, Jianjun Dai, and Hongru Xiong tin Hill of the WBG. Critical contributions of DRC; and Denis Medvedev and Marcin were provided by Jianfeng Wu (University of Piatkowski of the WBG. Critical contribu- International Business and Economics) on tions were provided by Ge Wang and Baoming the entrepreneurship survey and the associ- Chen (Chinese Academy of Science and Tech- ated discussion; Mariana Iootty De Paiva nology for Development); Shahid Yusuf and Dias (WBG) on entrepreneurial support, Philipp Boeing (consultants) each separately market competition, and state-owned enter- on innovation policy; Banning Garrett (con- prise reforms; Shanthi Divakaran (WBG) on sultant), Victor Mulas, and Anastasia Neday- the venture capital industry; Sylvia Solf and voda (WBG) on disruptive technologies; Andres Federico Martinez (WBG) on the ACKNOWLEDGMENTS xv business climate; Ana María Avileés, Jeff Joanna Mclean Masic of the WBG. Other Chelsky, Sergio Schmukler, and Radu Tatucu authors who provided key inputs to the chap- (WGB) on the financial sector; and W. Ber- ters include Barjor E. Mehta, Binyam Reja, nard Drum on the case study of U.S. Rust Wanli Fang, Hua Tan, Ted Chu, and Rana Belt cities. The team is grateful for inputs Karadsheh (all WBG). Critical contributions from Qursum Qasim, Nan Jiang, Facundo came from Uwe Deichmann on the spatial Abraham, Jennifer Chien, Lin Huang, Juan distribution of economic activity; Prof. Ver- Jose Cortina, and Seidu Dauda (all WBG), non Henderson, Prof. Siqi Zhang, and Prof. and from Patrick McGinnis, Qiong Zhang, Qinghua Zheng on the misallocation analyt- Jing Zhao, Yi Yan, Yaxin Yan, Anqing Shi, ics; Kevin Chen and Xiaobo Zhang (Interna- Lin Ma, Yifan Wei, Xinze Yao, and Anne tional Food Policy Research Institute, Beijing) Ong Lopez (all WBG consultants). The sur- on the Yangtze River Economic Belt analyt- vey of entrepreneurs in the five cities was ics; Yao Zhao on the regional case studies; conducted by a team at Beijing Horizonkey Ziming Liu on transport analytics; and Qil- Information and Data Co., Ltd., led by Hui iang Mao, Guohua Zhang, Yanming Jin, and Zhang. In the financial market section, com- Tiezhi Liu on infrastructure analytics. The ments and suggestions were received from authors would like to acknowledge Xiao Wu Daofu Chen, Xingchen Zheng, Gang Wang, for operational support. Junsheng Zhu, and Yang Wang (all DRC), The team on global integration and inter- and from John Litwack, Rozani Osman, national competitiveness was composed of Qi Ran Tao, and Luan Zhao (WBG). Nan Zhou Zhang, Jinpin Zhao, Gang Lyu, Yuze Luo, (WBG) provided valuable statistical support. and Fangyu Zong of DRC, and Daria Taglioni Jian Chen (consultant) and Changyi Shao (IFC) and Jakob Engel of the WBG. The team (WBG) supported the dialogue with counter- acknowledges contributions from Kunfu Zhu parts and relevant stakeholders. Administra- and Jianwu He on global value chain (GVC) tive support was provided by Qiujing Yang. analysis; Timothy Sturgeon and Eric Thun on The team on industrial upgrading was the case studies of China’s automobile and composed of Changwen Zhao, Jianlong information and communication technology Yang, Zhaoyuan Xu, Wei Wang, Tao Liu, hardware sectors; Smita Kuriakose, Joanna and Yunhua Zhang of DRC, and Mary Hall- Lewis, Jeremy Tamanini, and Shahid Yusuf ward-Driemeier and Gaurav Nayyar of the on the case studies of China’s solar, wind, and WBG. Critical inputs were provided by Sebas- energy sectors; Claire Hollweg on trade vul- tian Saez and Ruchita Manghnani (WBG) nerability analysis; Maryla Maliszewska and and Erik Van der Marel (consultant) on the Fan Zhai on computable general equilibrium services sector and the digital policies; Mad- analysis; Jose Ramon Perea, Nadia Rocha, hur Gautam, Paavo Eliste, and Jianwen Liu Matthew Stephenson, Gonzalo Varela, (WBG) on the agriculture sector; Jun Zhao Alvaro Espitia, and Laura Gomez-Mera on (consultant) on rural surplus labor analy- foreign direct investment (FDI) economic sis; Chao Peng (Research Center for Rural analysis; Ramprakash Sethuramasubbu on Economy, Ministry of Agriculture and Rural FDI legal regulatory analysis; Chunlin Zhang Affairs) and Chen Zhang (Renmin University on Belt and Road Initiative analysis; Mauri- of China) on agriculture analysis; Prof. Binkai cio Monteiro Vieira and Yiren Fund (WBG) Chen (Central University of Finance and Eco- on environmental and social safeguards; Ber- nomics) on the upgrading of the manufactur- nard Aritua (WBG) on trade logistics; Nicola ing sector; Jiechang Xia, Yi Liu, and Hongfu Spatafora (International Monetary Fund) and Ni (Chinese Academy of Social Science) on José Romero (consultant) on manufactur- services sector analysis and statistical sup- ing export quality; and Masud Cader and port; and Sugandha Huria and Wei Meng. Kirstin Roster (International Finance Corpo- The team on regional integration and ration, IFC), as well as Yi Yao and Edward development was composed of Yongzhi Hou, M. Logan (consultants), on the analysis of Peilin Liu, Yunzhong Liu, Zhiyan Sun, and export complexity. Administrative support Jianwu He of DRC, and Somik Lall and from Cynthia Abidin-Saurman, Jian Chen, xvi ACKNOWLEDGMENTS and Yu Shang is gratefully acknowledged. Associate Dean of the School of Economics The team also thanks Kippy Ye (IFC consul- and Management, Tsinghua University; Wil- tant) for his invaluable support in coordinat- liam Maloney, EFI Chief Economist of the ing industry and policy maker interviews in World Bank; Marianne Fay, former Sustain- Beijing, Shanghai, Guangzhou, and Shenzhen able Development (SD) Chief Economist of in March–April 2017. the World Bank; and Roberta Gatti, Human The team on governance and institutions Development (HD) Chief Economist of the was composed of Shiji Gao, Zuojun Li, Jiwen World Bank. Chang, Xiaowei Xuan, and Haiqin Wang Overall coordination for the technical of DRC, and Jurgen Blum and Min Zhao work was provided by Mingjie Ma, Wei of the WBG. Other authors who provided Lyu, Changwen Zhao, and Jun Ma of DRC, key inputs to the chapters include Yun Wei and Hoon Sahib Soh and Jian Chen (consul- (Beijing Urban-Rural Innovation Develop- tant) for the World Bank. Support for coor- ment Ph.D. Association), Xijun Zhao (Chi- dination and management of the work was nese Academy of Sciences), Shunkui Huang provided by Hongru Xiong and Minghui (Shenzhen Dapeng New District Manage- Wang of DRC, and Lin Yang and Yu Shang ment Committee), David Bulman, Mary of the WBG. Luan Zhao (WBG) provided Gallagher, Andrea Renda, Peter Farup Lade- overall analytical support in updating esti- gaard, and Roy Bahl (WBG). Critical con- mates and figures. Harold Luis Bedoya and tributions were provided by Xun Yan and Zoubida Allaoua, World Bank country pro- Qiong Zhang. gram coordinator (CPC) and former CPC On the digital economy, critical contribu- for China, respectively, provided valuable tions were provided by Deepak K. Mishra advice for the report. Tianshu Chen (WBG) and Bradley Robert Larson (digital diffusion provided interpretation support for the and adoption), Natasha Beschorner (digital project. Zhihong Hao (WBG) managed the economy and the telecommunications sector); World Bank’s budget for the report. Kath- Randeep Sudan (digital economy), Prasanna ryn Ann Funk and Yingnan Jia provided Lal Das (digital data policy on digital econ- coordination support in the Washington, omy), and Erik Van der Marel (digital trade DC, headquarters of the World Bank. Patri- policies). cia Katayama and Susan Graham managed Peer reviewers of the report were Chong- the publication of the English version of the En Bai, professor of economics and Executive report. Executive Summary The need for new drivers exports is improving rapidly, and its manu- of growth facturing “fitness,” a measure of manufac- turing capability, is at par with that of high- After nearly four decades of rapid growth, income economies. Furthermore, services China has entered a new normal of slower have taken over manufacturing as the largest growth. China’s economy is growing at some share of GDP and are now the largest con- 6–7 percent a year, which remains high by the tributor to GDP growth. Meanwhile, domes- standards of most middle-income economies, tic consumption, rather than investment, is and per capita gross domestic product (GDP) the main driver of demand, thanks to a grow- stands at nearly US$10,000, about one-fourth ing middle class and rising urbanization. of the average for Organisation for Economic China’s innovation capabilities are Co-operation and Development (OECD) growing rapidly, reducing the gap with countries. China has considerable room for leading OECD countries. China’s ranking on further catch-up growth. The experience of indexes such as the global innovation index other countries suggests that the recent slow- has risen steadily and is now the highest down was to be expected at China’s current among developing countries. The number level of income. Only a few economies have of domestic patents filed for inventions has maintained growth rates around 7 percent for increased to an annual 1.56 million (2018), another decade after reaching China’s current the highest in the world, although the per capita income level. quality of patents remains uneven. China’s China’s next transformation is well under spending on research and development way, and a “new economy” is emerging. (R&D) has risen significantly, reaching 2.18 China maintains a strong manufacturing base percent of GDP in 2018, compared with the and is the leading global exporter of manu- OECD average of 2.4 percent. China’s total factured goods and one of the central hubs spending on R&D accounts for around 20 of the global value chain. Its export products percent of the world’s total, second only to are becoming increasingly more sophisti- the United States. China is among the global cated, and the share of domestic, value-added leaders in technologies such as e-commerce, exports has been rising steadily in the past artificial intelligence, fintech, high-speed decade, as domestic supply chains have deep- trains, renewable energy, and electric cars. ened. The quality of China’s manufacturing Companies such as Alibaba, Didi Chuxing, INNOVATIVE CHINA xvii xviii EXECUTIVE SUMMARY Huawei, and Tencent are operating at the made a negligible contribution to productiv- global technology frontier. ity growth both before and after the global China’s growing human capital is support- financial crisis. By contrast, the reallocation ing its innovation capabilities. China runs of resources is typically the main source of one of the world’s largest education systems, productivity growth in high-income econo- with more than 7 million students graduating mies. China is not alone in the productivity from its universities (in 2017), of whom more slowdown; the decline in TFP growth fol- than 40 percent are in science, technology, lowing the global financial crisis has been engineering, and mathematics. China is sec- widespread across developed and developing ond only to the United States in the number countries alike. of journal publications, and their quality—as China’s old drivers of growth are running measured by the number of citations—con- out of steam. In the past decades, China ben- tinues to improve. China’s leading universi- efited from a rapid structural transformation ties are climbing up the global rankings and from agriculture to manufacturing and ser- are producing a growing volume of high- vices, high levels of investments, demographic quality research. The country is turning into dividends, and rapid rural-urban migration. a research base for global technology com- China can no longer rely on those old driv- panies, such as IBM and Microsoft. China’s ers of growth. High investment rates have emergence as an increasingly important inno- increased China’s capital stock, and public vator is expanding the global stock of knowl- sector capital stock per worker has reached edge and technologies that can benefit all OECD levels. Therefore, additional capital countries. Despite this progress, China ranks investments are likely to add less to growth, 44th on the World Bank’s human capital and the challenge now is to address sectoral index (2018), indicating significant potential bottlenecks to the effective use of existing for improvement. Less than 20 percent (2017) infrastructure assets. The allocation of credit of China’s labor force has completed tertiary appears to have become less efficient since the education, compared with 30–40 percent in global financial crisis, because an increasing OECD countries, and the share of research- share of commercial credit has gone to infra- ers in the labor force is still well below that of structure and real estate, which has had a OECD countries. declining impact on growth. High investment rates also have resulted in the rapid accumu- lation of debt, raising financial vulnerabili- China’s productivity challenge ties in the economy. Demographic dividends China’s productivity growth has been slow- are reversing, as China’s labor force is set to ing since the global financial crisis and has decline in the coming years and also to age remained relatively low, despite signs of mod- considerably. Employment contributed 2.9 est recovery in recent years. Since the crisis, percentage points to GDP growth in the two China’s growth in total factor productiv- decades following 1978, almost a third of ity (TFP), a broad measure of how produc- total GDP growth, but that contribution fell tively an economy uses capital and labor, to 0.3 percentage point in the past 10 years has declined. This decline matters because and is expected to be negative in the years China’s TFP is currently only about half the ahead. The reallocation of labor from agri- level of OECD countries, which means that culture to industry has been a major driving significant potential remains for TFP to be force of China’s economic growth, but rural a major driver of future growth. Firm-level surplus labor has declined considerably and data suggest that productivity growth has will continue to decline. been slowing due to declining contributions China’s authorities are fully aware of from the entry of new firms and from within- the need to develop new sources of growth. firm productivity increases. The reallocation Innovation and productivity are recognized of resources to more productive firms, includ- as important sources of growth in the 5th ing through the exit of less competitive firms, Plenum of the Central Committee of the 18th EXECUTIVE SUMMARY xix Party Congress, the 13th Five-Year Plan, FIGURE ES.1 The 3 D’s Framework—Reducing Distortions, and the Secretary General’s report to the accelerating Diffusion, fostering Discovery 19th Party Congress. The authorities believe Capital that markets should play a decisive role in allocating resources and that the govern- ment’s role should be to support the markets. China places a high priority on strengthening domestic capacity for innovation, science and Fostering technology, and R&D, and on promoting the “D”iscovery transformation and upgrading of its manu- facturing industry, particularly by deepening the application of Internet-related technolo- gies and developing smart manufacturing. Accelerating “D”i usion A strategic reform agenda for promoting an innovative and productive China Reducing China will need to promote new drivers of “D”istortions growth to address its major challenges to productivity. Sustained growth in the long run will depend on continuous productivity China’s Global growth. This report proposes the “3+6+7” China production production frontier frrontier Labor reform agenda for addressing China’s pro- ductivity challenges and achieving long-term Governance and institutional reforms promote all 3 D’s sustained growth: • China’s future growth will come from The second D, accelerating the diffusion 3 D’s: removing distortions, accelerating of advanced technologies and innovations, diffusion, and fostering discovery. will help China to extend its current produc- • China’s authorities are facing 6 strategic tion frontier to the global frontier. Acceler- choices in furthering productivity and ating diffusion would allow China to take innovation. advantage of its large remaining potential for • China’s authorities will need to address catch-up growth by promoting technology 7 critical areas of structural and institu- diffusion, upgrading the capacity of its work- tional reforms. ers to adopt and use new technologies, and facilitating access to global technologies and innovations. The three D’s The third and last D, fostering the discov- China can pursue more innovative and ery of new innovation and technology, will productivity-led growth by addressing the help China to create new innovations and to three D’s: removing distortions, accelerat- push out the global technology frontier. Fos- ing diffusion, and fostering discovery (figure tering discovery will become more critical as ES.1). The first D, reducing distortions in the China becomes richer and edges closer to the allocation of resources, has been a key driver global technology frontier. of growth in the past, and continuing reforms Governance and institutional reforms would allow China to reach its current maxi- underpin the promotion of all three D’s. mum potential production frontier. The first As the economy grows and becomes more D requires land, labor, and financial resources complex, the market will assume a greater to be allocated competitively and efficiently to importance, and the state will acquire a more their most productive uses in the economy. market-supportive role in promoting market xx EXECUTIVE SUMMARY competition and strengthening the business policies can undermine market competition climate. when markets are protected, and favored firms benefit from targeted support, contrib- Six strategic choices uting to persistent overcapacity. The con- sensus in developed countries is that, to be China’s policy makers face several strategic effective, industrial policies need to focus on choices that will promote the three D’s and market failures and to be market conform- determine the country’s future growth per- ing and enhancing. Industrial policies that formance. This report identifies six strategic leverage and promote market competition priorities. are particularly important for China, given its large state presence. Striking the right balance between the three drivers of growth Adjusting the balance between the China’s recent policies have emphasized the state and markets third D, fostering discovery and new tech- The strategic choice is for the state to be nologies. Investments in new technologies less market interventionist and more market can have a large payoff for the country and supportive and augmenting. In China, state- contribute to pushing out the global technol- owned enterprises (SOEs) are at the core of ogy frontier. New technology fields are also the coexistence between the state and the less crowded than more established ones, pro- market. SOEs will retain an important role viding new opportunities to take a leading in China’s economy, but ensuring fair com- position. At the same time, China remains, petition between SOEs and non-SOEs would on average, quite distant from the global expose firms to competitive pressure and technology frontier and thus has substantial encourage markets to select the most produc- remaining potential for catch-up growth. tive enterprises, regardless of their ownership China could double its GDP simply by catch- structure. ing up to OECD countries in its TFP. To take advantage of catch-up growth, China needs to pay sufficient attention to the first and sec- Attaining mutually beneficial ond D’s: reducing distortions in the allocation international trade and investment of productive resources and promoting the relations with global partners diffusion and adoption of existing technolo- Global trade tensions have brought uncer- gies, production processes, and management tainty and downside risks to the global practices. The first and second D’s are likely economy. A major risk is the potential weak- to produce significant payoffs for China’s ening of the rules governing global trade immediate future and will remain the main and investment and the unraveling of global drivers of growth for some time to come. value chains. As the world’s largest trader and second-largest economy, China can play an important role in working with global Reshaping industrial policies partners to achieve a common understand- Since its early years of reforms and open- ing of mutually beneficial global economic ing up, China has used industrial policies relations. China has stated its opposition to to accelerate its catching up to high-income protectionism and advocates an open and economies. Those policies often were mod- inclusive global economic system and inter- eled on examples from other economies, national partnerships and collaborations. such as Japan and the Republic of Korea, It has taken steps to open up its economy although the outcomes in China, as else- further, such as the recent introduction of where, have been mixed. China is now at the foreign investment negative list, which a more advanced stage of development and is the list of sectors in which foreign direct needs to consider a new approach to indus- investment (FDI) is restricted or prohibited. trial policies. Within China, industrial With China’s rise as a global economic and EXECUTIVE SUMMARY xxi trading power, its contribution to the multi- Seven areas of structural and lateral rules for global governance will be institutional reforms critical. Addressing China’s key strategic challenges to promoting the three D’s requires a range Balancing supply-side reforms with of structural, governance, and institutional demand-side reforms reforms. The proposed reform agenda is China will need to rely less on investments organized into seven major areas. and more on consumption for growth, while maintaining robust overall aggregate Reshaping industrial policies and demand. Historically, domestic household supporting market competition consumption has played a relatively small role in driving China’s growth, reflecting its China could reduce “vertical” industrial high savings rate. But China’s consumption policies that target specific sectors and firms, share in the economy is already growing, and and instead transition to more “horizontal” the government can accelerate this growth by policies that improve factor markets and encouraging lower household saving through the broader business environment and reforms, such as reinforcing the social safety promote market competition. The remaining net, pension system, and health insurance and targeted industrial policies, to be efficient introducing more progressive income taxes to and effective, need to be focused on market lower the burden on labor. Reforms of the failures, such as information asymmetry household registration (hukou) system would and externalities. This focus would require further enhance aggregate demand by further using industrial policy more selectively by integrating migrants, now some 15 percent of targeting only a few “strategic” industries. the urban population, into the urban system. In such industries, support would be made available to all firms rather than to just a few firms. China could further strengthen Preparing for the future impact of the discipline of local governments’ support technological changes for industries—for example, by clearly Policy makers need to start preparing China’s regulating the limits of local government workers today for the future impact of tech- support and incorporating performance nology on the workplace. The impact of new criteria and sunset clauses for discontinuing technology on jobs, income, and income support. A more active market-led corporate distribution may be gradual as technologies bankruptcy regime would promote the are developed and diffused, but preparing timely discontinuation of government for the future workplace needs to start now. support and facilitate the exit of nonviable New technologies and innovations can result firms. Finally, China could systematically in new employment opportunities, but many expand government-industry dialogue and current jobs may be displaced or require new the monitoring and evaluation of industrial skills due to automation and artificial intel- policies to make policy support more ligence. Technological change has a skills transparent and accountable. bias, favoring workers with more skills and Opening more sectors to private and education, which could lead to rising income foreign investment would promote greater inequality. Moreover, recent technological competition. The government’s recent innovations could lead to a “winner takes all” introduction of a negative list for private outcome, which further exacerbates inequal- and foreign investment is a welcome move ity. Medium-skill routine jobs, many in man- in this direction. Increasing competition ufacturing, are at particular risk of automa- is particularly beneficial for the services tion. Finally, the share of labor in a broad sector, where China’s market restrictions range of economies has declined in recent are greater than those of OECD countries. decades, part of which can be explained by Further opening the services sector to private technological change. and foreign investments also would facilitate xxii EXECUTIVE SUMMARY the “servicification” of manufacturing (the policies by increasing the capacity of the integration of services and manufacturing), competition regulatory agency, the State which is currently lower than in higher- Administration for Market Regulation income countries, and thereby strengthen (SAMR), established in 2018, and providing China’s manufacturing competitiveness. it with more independent authority. Reducing market restrictions will be critical to the government’s “Mass Entre- Promoting innovation and the digital preneurship” Initiative, launched in 2015. economy The enterprise survey carried out for this report indicated that reducing regulations China has built a large and extensive and improving the local business climate national innovation system, but the system would support entrepreneurship more than could be improved further in several ways. providing support for firms through govern- China’s top-down approach to promoting ment subsidies or financing. China could innovation could be complemented with carry out comprehensive reforms to improve a more bottom-up, market-oriented, and the business climate and the local innova- decentralized approach by expanding R&D tion and entrepreneurship ecosystems. It tax credits and other innovation support could develop and publish subnational busi- programs that are open to all industries. This ness climate indicators to support efforts would help to ensure that the country does to assess and compare local entrepreneur- not miss out on innovations outside the areas ship ecosystems. A high-level oversight of policy focus or misidentify the industries body could coordinate the business climate and technologies of the future. More public reforms and institutionalize regular pri- R&D support could be reoriented to basic vate sector consultations. China also could “blue sky” research to complement private consider establishing a National Center of R&D and to help address China’s relatively Excellence for Entrepreneurship Promotion low share of R&D devoted to basic research. Policy, dedicated to analyzing, developing, China also could expand its global innovation and disseminating entrepreneurship promo- partnerships and R&D collaborations to tion policies. ensure that the government’s promotion of SOE reforms would complement the “indigenous” innovation does not result in improvement of the business climate and the technologies that are only relevant in China. promotion of market competition by help- Strengthening the national innovation ing to ensure fair competition—long advo- system requires not only promoting the cated in China. China could introduce a discovery of new innovations (the third formal state ownership policy for SOEs that D) but also supporting the dissemination would articulate the purpose of state owner- and adoption of existing innovations and ship and focus the SOEs in strategic sectors. technologies (the second D). Given the The government could prioritize corporate importance of management capacity for governance reforms of commercial SOEs the adoption and diffusion of technology, and further expose them to market competi- the government could expand technology- tion. Corporate governance reforms and the oriented management extension “mixed-ownership” reforms initiative, which programs. The programs could provide increases nonstate equity in SOEs, are mutu- benchmarking assessments of a firm’s ally reinforcing and would promote improved managerial performance, given that firms performance of the SOEs. often overestimate their capabilities, and Competitive neutrality would be supported therefore do not invest to improve their by full implementation of the government’s managerial capacity. Such programs could be “fair competition review,” launched in 2016. complemented by demand-based instruments, This would help to ensure that competition such as matching grants and innovation policy is provided a “fundamental position” vouchers, to promote the collaboration of in economic policy making. China also could small and medium enterprises (SMEs) and improve the enforcement of competition knowledge providers. Recently, high-income EXECUTIVE SUMMARY xxiii countries have used shared technology prioritized digital innovations and aims libraries and collaboration platforms to become a global leader in key emerging to facilitate technology exchanges and digital technologies, such as artificial innovative networking. intelligence. But China still has significant The government recognizes the importance potential to promote the diffusion of existing of protecting intellectual property (IP) rights digital technologies, as its rate of digital for promoting innovation. To strengthen IP adoption lags that of OECD countries, rights, China could increase the damages and although it is higher than that of many other fines for IP infringements; address judicial upper-middle-income countries. To promote “local protectionism” (unfair handling of digital innovations, China could facilitate court and administrative enforcement cases the trade and flow of data by making digital to protect local firms) by moving more court policies more open and less restrictive, cases to out-of-area jurisdictions, including including with regard to the requirements to the specialized IP courts; centrally for data localization and cybersecurity. monitor and limit unfair court rulings and More open data policies could facilitate expand the publication of court cases; and cross-border traffic of innovation and data, strengthen the capacity of the courts and which is now a key aspect of global trade. relevant administrative agencies and improve China also could engage more actively in interagency coordination to handle the global cooperation and seek a global solution significant increase in the number of patents. regarding data policies and standards, for China’s promotion of patents has been example, by working with other countries to quite successful, as China is now the world’s develop World Trade Organization (WTO) largest producer of patents. Rather than rules governing data in commerce. focusing on the quantity of patents, China Telecommunications infrastructure pro- can now focus on improving the uneven vides the infrastructure for digital services. quality of its patents by making eligibility for China has made good progress in expanding government financial support of patenting access to telecommunications services, and more stringent and dependent on the quality now it could focus on improving the quality of patents. It also could shift the focus of services, such as improving access to faster of government financial incentives from broadband. Quality improvements could be reducing the costs of patenting to promoting achieved through greater market competi- services that make patents commercially tion. In this regard, China could accelerate valuable, such as services related to patent and expand pilots of market liberalization, evaluation and due diligence, marketing and for instance, in the pilot free trade zones. feasibility studies, and proofs of concept. This China also could reorient the regulatory focus could be part of an overall reorientation framework for the telecommunications sector of patent promotion policies to broader toward a greater emphasis on the quality of aspects of investments in innovation. China is services and public accountability for perfor- currently drafting a new patent law. The draft mance—for example, by expanding the mon- patent law proposes welcoming provisions itoring and evaluation of sector performance that extend the protection for design, and publicly disclosing data on operational increase the damages for infringement, and performance. China also could consider address indirect infringement. Some of the enhancing the independence of regulatory provisions may need further consultation authorities, including by further separating and piloting before full adoption, including the government’s regulatory functions from the proposed expansion of the power of local its ownership interests and policy making. administrative IP enforcement authorities. T he govern ment also could consider Building human capital extending the stronger treatment of patent infringement to trade secrets. The quality of China’s human capital, not the Digital technology is critical to China's quantity, will increasingly be the cornerstone developing innovation capacity. China has of its economy. To sustain productivity and xxiv EXECUTIVE SUMMARY innovation-driven growth, China will need Third, China could prepare a comprehen- to shift investments increasingly from physi- sive strategy and policy framework for the cal capital to human capital. To achieve this, balanced and sustainable development of a China could develop a new education sector multitiered tertiary education system. China strategy that is focused on developing a work- will need to continue promoting the top tier force for an innovative China that is prepared of world-class universities, but balanced for the future workplace. The future work- development would ensure that all tiers of place will be shaped increasingly by technol- the system are resourced adequately and ogy and will demand nonroutine, cognitive, developed. Key reform priorities would include and interactive social skills. Jobs requiring amending the Higher Education Law (1998) routine skills will be taken over increas- to align it with a modern tertiary education ingly by technology. To prepare for this new system; streng thening the autonomy, future, China’s new education strategy could accountability, and quality assurance oversight highlight the following five major priorities. of universities; and developing new regulations First, China could address the remain- to manage the expansion and healthy ing regional and socioeconomic disparities development of private higher education in educational attainment to build the uni- providers and the new applied universities. versal foundational skills of all its students. Fourth, China could carry out curriculum This effort is critical because China needs to and pedagogical reforms to emphasize maximize the productivity of each worker as the promotion of creativity and cognitive the size of its workforce declines. It needs to and socioemotional skills. These reforms support disadvantaged individuals who fail wo u l d i n c lu d e e x p e r i m e n t i n g w i t h to acquire critical foundational skills through collaborative classroom approaches that are the basic education system. To achieve this, multidisciplinary and problem and project China would need to close the investment based and that emphasize teamwork and disparities in education and learning for early cooperative learning. Tertiary education childhood and compulsory primary educa- can avoid requiring students to specialize tion, especially for rural areas, migrants, and too early, which can undermine a broader “left-behind” children. More than half of perspective that is helpful for more creative China’s future labor force is being educated and cognitive thinking. Also, students could in rural areas and small towns and counties, be provided more freedom to devise individual which significantly lag urban areas in educa- learning goals and educational paths. In this tional performance. China also could focus regard, China could harness its burgeoning on providing adequate nutrition and health edtech industry and the associated digital to disadvantaged children to help ensure their technologies to reorient teaching that would full cognitive development and well-being. enable more collaborative, personalized, and Second, China could consider gradually project-oriented learning. eliminating tuition fees for upper-secondary And fifth, China could strengthen its tech- education, in accordance with the govern- nical and vocational education and training ment’s fiscal capacity, for both the vocational (TVET) system and develop a comprehensive, and academic streams to help universalize lifelong learning system. Increasingly, the upper-secondary education and reduce dis- acquisition of skills is a continuum through- parities in the education system. Whether out one’s life that requires a combination of China can significantly increase the average general and technical skills. China could pro- level of educational attainment will depend on mote a more flexible lifelong training system younger cohorts staying longer in school, par- that fully integrates the technical and aca- ticularly in upper-secondary schools, where demic streams to facilitate transitions between enrollment rates decline sharply. Reducing them. It could improve the market rele- the cost of tuition and fees for upper-second- vance of training through closer education– ary education would encourage the poor and industry collaboration and strengthen the disadvantaged to remain in school. the incentives for workplace learning and EXECUTIVE SUMMARY xxv on-the-job training, such as through “train- help to improve the impact and coverage of ing contracts.” In the future, workers are credit guarantees for SMEs. expected to experience more frequent Venture capital and the fintech indus- changes of jobs and careers, increasing the try are a growing source of financing in importance of lifelong learning. China could China, including for SMEs. China is now the expand modular and task-based training that second-largest venture capital market, after is more suitable for a future workplace char- the United States, and the largest fintech acterized by multiple job and career changes. market in the world. With the rapid growth It also could reorient training to fit the needs of venture capital financing, promoting the of a more services-based economy. quality of fund management will be a prior- These reforms will likely require addi- ity. In particular, government guidance funds tional financing. China has more than dou- (government investment funds) that target bled its public education spending over the start-ups will need to be market oriented last 15 years, but its current public spend- and commercially managed and focused on ing on education, at 4.1 percent of GDP addressing market failures to avoid crowding (2018), is relatively low for its income level out private financing. Capital markets as an and lower than the average of 5.2 percent exit path for venture firms are more impor- for OECD countries (2015). Increased edu- tant in China than in other countries, so cation spending would need to be comple- ensuring that initial public offerings are not mented by a more transparent monitor- unnecessarily administratively delayed would ing system to evaluate the efficiency and support the growth of venture firms. impact of the spending, complemented by With regard to the fintech industry, the public access to data on the education sec- major challenge will be to scale up regula- tor and school performance to strengthen tory and supervisory oversight of the indus- public transparency and accountability for try while still encouraging innovation. Rules performance. regarding disclosure and transparency, sales and marketing, safety of funds, dispute reso- lution, and data protection and privacy could Allocating resources efficiently be expanded. Regulatory authorities could Improving the allocative efficiency of finance consider a more structured and managed approach to innovation, such as “regula- Efficient allocation of financial and human tory sandboxes.” Strengthening enforcement resources is central to the first of the three capacity, expanding financial education, and D’s. More than one in five firms in China improving coordination among the vari- rates access to finance as the most significant ous financial regulatory authorities (People’s business constraint, according to the World Bank of China, China Banking Regulatory Bank’s enterprise survey. Private firms are and Insurance Commission, and China Secu- almost twice as likely to have been turned rities Regulatory Commission) will be critical, down for a loan than state-owned enterprises. given that fintech can have new and innova- SMEs, in particular, face challenges in tive features that cut across different markets. accessing financing in China. China could Maintaining sustained growth requires promote SME lending by improving market China to not only improve the allocative conditions to reduce SMEs’ credit risks, by efficiency of finance, but also to address the strengthening and expanding the financial significant debt accumulated in the economy. infrastructure, and by expanding the use The rapid expansion of China’s financial sys- of public and private sector data on SMEs, tem to support its high investment rates has while adopting appropriate measures to resulted in significant debt accumulation, rais- protect data. China could expand dedicated ing financial vulnerabilities. Alongside debt SME lines of credit and the securitization of accumulation, the expansion of shadow credit SME loans to pool SME risks. Consolidating has increased the complexity of the financial and scaling up the guarantee industry could sector and made bank balance sheets less xxvi EXECUTIVE SUMMARY transparent. The government has taken recent Targeted active labor market policies could steps to limit shadow credit, but challenges be expanded for older workers as well as for remain in deleveraging an economy that is female workers and workers displaced by experiencing decelerating growth. technological changes or transitioning out of overcapacity industries. Expanding child and elderly care services could help to keep female Improving the allocative efficiency of labor workers employed longer. With its working population expected to age and decline, China will need to access the Leveraging regional development and underutilized labor in agriculture, increase integration female labor participation, and extend the working lives of its labor force. A key priority China has been highly successful in leverag- is to continue reforms of the hukou system, ing spatial transformation for its development China’s household registration system, to over the past 40 years. Rapid urbanization promote labor mobility. While important supported increased density and proximity. strides are being made on hukou reforms, more There is still room to increase the pace and actions are needed to meet the government’s efficiency of urbanization, with China still ambitious plan to settle 100 million people about 8 percentage points less urbanized than in cities, including by further liberalizing is typical for its level of income. Reducing hukou restrictions in the largest cities, which spatial frictions in factor markets—in par- currently favor highly qualified migrants. ticular, the rural-urban migration of labor— Consolidating the currently fragmented will be central to enhancing the pace and effi- pension and social security system would ciency of urbanization. Effective national and enhance labor mobility and the allocative effi- regional markets for trading land quotas and ciency of labor by improving the portability reducing unnecessarily restrictive land poli- of social insurance entitlements and benefits cies are reforms to consider for enhancing the when workers move across jobs and regions. efficiency of the allocation and use of land. China could develop a comprehensive pen- China’s regional planning and develop- sion strategy that provides a road map for ment have been a key national priority since transitioning to a system based on pooled the start of the reforms and opening up. Four pension funds, and that includes a financing regional strategies—Western Region Devel- strategy for legacy costs. The national strat- opment, Northeast Region Revitalization, egy also could prioritize the expansion of Rise of the Central Region, and Leading coverage to the poor. The Chinese authorities Development in the Coastal Region—aim to have indicated plans to pool pension funds optimize spatial development, cultivate new at the national level by following a partial- growth poles, and foster territorial coopera- pooling approach. Similar reforms could tion. Regionally coordinated development be considered for the other social insurance would be supported by reforms of the gov- programs. These reforms could be comple- ernment performance appraisal system to mented by reforms to strengthen the long- incentivize coordination and collaboration, term sustainability of the pension system whereas the system traditionally has empha- by gradually increasing the retirement age, sized competition and local economic devel- establishing pension indexation, and improv- opment. These reforms could be comple- ing the pension benefit adjustment mecha- mented by reforms of the intergovernmental nisms. The total social insurance contribu- fiscal and taxation relationship to incentivize tion rate in China, over 40 percent, is very cooperation and collaboration further. high, and lowering it would help to promote Laggard regions often face multiple depri- domestic consumption. vations of relevance to prospective investors, A priority for China’s aging society is to including human capital, institutional incentivize firms to employ older workers. quality, and infrastructure. Therefore, Policy options include promoting more flex- coordinated policy responses, strong skills ible working arrangements and strengthen- in planning and execution across a broad ing lifelong learning and training systems. range of local government functions, and EXECUTIVE SUMMARY xxvii active collaboration among subnational China could pursue “deep” preferential (provincial and local) and national agencies trade agreements to stimulate trade and FDI are critical. The rapid development of flows and further integrate with global value Shenzhen, which established a business chains. Trade and investment agreements climate that encouraged entrepreneurship with developed countries would require a and promoted inward migration, offers common understanding of mutually ben- valuable lessons for other regions. Finally, eficial trade and investment relations. China the Belt and Road Initiative (BRI), China's could further liberalize the imports of inter- ambitious effort to improve regional mediate goods and services inputs to its pro- economic integration and connectivity on duction. China could provide leadership in a transcontinental scale, could provide formulating international rules on FDI and new development opportunities for towns cross-border mergers and acquisitions that a and cities in the western region. However, broad cross section of developed and devel- there is a need to ensure that economies of oping economies could support. It could scale and specialization are reaped and that continue to engage in actively strengthening complementary investments and policies are global economic governance, such as to sup- implemented in a coordinated manner. port implementation of the WTO’s Trade Infrastructure investment has been an Facilitation Agreement, and in promoting important part of regional development global goods, including to address climate initiatives in China. But given the significant change. China has stated that it supports improvements in the country’s infrastructure, reforms of the WTO that reflect the needs of going forward the priority is not simply both developing and developed countries. to invest more in infrastructure but also China has benefited substantially from to find smarter ways to plan, utilize, and integration with the global economy through manage infrastructure investments. For FDI, which has turned the country into a example, the priority for the energy sector global hub for manufacturing exports and would be sectoral reforms to ensure that provided access to new technologies and the investments in power generation—in management methods. FDI will remain particular, renewable energy—can be used important for China to catch up to high- and transmitted efficiently. Similarly, given income countries. China recently introduced the rapid expansion of transport connectivity, a national foreign investment negative the priority for the transport sector appears to list to liberalize its foreign investment be reforms to address inefficiencies in logistics regime f u r ther. It could continue to chains through more holistic and multimodal reduce the number of restricted industries networks and improved links between on the negative list. China’s significant transport networks and selected industries. improvements of its business environment, as assessed by the World Bank’s Doing Business indicators, benefit foreign as well as domestic Promoting international investors. China could further promote FDI competitiveness and economic by ensuring a level playing field between globalization foreign and domestic investors and providing China’s integration into the global economy a transparent and predictable policy and has been a major driver of its growth and regulatory environment. development. China has become the world’s The new Foreign Investment Law (FIL), largest trader of manufactured goods and a which will come into effect on January 1, major destination for foreign investments. 2020, is an opportunity to provide a clear China has stated that it is committed to and unambiguous legal and regulatory building a “community of shared destiny” framework by specifying and streamlining and promoting an open global economy. associated regulations, administrative Continued reforms to open up its economy reviews, and licensing procedures to protect will be critical for realizing China’s aspiration the rights and interests of foreign investors to become a more productive and innovative in China. In this regard, China plans to economy. issue a series of laws and regulations to xxviii EXECUTIVE SUMMARY smooth the implementation of the FIL. The approach. It could consolidate and streamline formulation of these laws and regulations the pre-investment administrative rules, would benefit from extensive consultations regulations, and approval procedures with both foreign and domestic investors. c o n c e r n i n g O D I , a n d i m p r ov e t h e China could expand regular communication coordination of ODI-related authorities. and consultations with foreign firms to help China could expand and improve the quality identify investors’ concerns and minimize of extension services for enterprises engaging misunderstanding of government policies in ODI to support risk monitoring of overseas and regulations. markets and improve firms’ understanding Foreign investors have raised concerns that of environmental and social safeguards, they are compelled to transfer technology international rules, and the laws of the host to gain market access, but China has stated countries. that it has never introduced such policies or The BRI provides an opportunity for practices. It is in China’s interests to provide China to improve its investment in soft the legal and institutional framework to infrastructure to complement its investment prevent “forced” technology transfers and in hard infrastructure, including the adoption to encourage the introduction of foreign of international standards and rules on technologies in China. The government trade, foreign investment, and environmental could introduce a transparent monitoring, standards. China could introduce a more veri f ic at ion , a nd g rieva nce -ha nd l i ng multilateral approach to BRI through the mechanism for technology transfers. The new introduction of institutional mechanisms to FIL explicitly prohibits “forced” technology coordinate investments, financing, relevant transfers through administrative measures. policies and regulations, and platforms for Specific associated laws, regulations, and dispute resolution and risk management. guidance are needed to implement and BRI investments should aim to be more enforce the law. These laws and regulations transparent and environmentally, socially, could aim to ensure fair and equitable and fiscally sustainable. treatment of foreign investors, including by specifying an investor dispute settlement Governing the next transformation mechanism and ensuring coordination and complementarity between the dispute Unlocking the new drivers of growth will prevention (grievance management) and require governance reforms to strike a more dispute settlement provisions. balanced coexistence between the state and China could expand programs to strengthen market. As China’s economy becomes more the linkages between domestic and foreign complex and innovation driven, the market enterprises to enhance technology and will need to play a more decisive role and the managerial spillovers and global collaboration. state to play a more market-supportive role. Programs that could be expanded include The role of the state will need to evolve to targeted extension services to upgrade local focus on providing stable market expecta- suppliers and supplier databases, platforms, tions and the rule of law. Priority reforms to and matchmaking services to link foreign support this transition include the following. and local firms. Such programs would benefit First, China can carry out regulatory from close participation of foreign investors governance reforms to provide clear, fair, and in program design and implementation to predictable regulations. China could further ensure that they reflect the needs of the streamline policies and regulations affecting foreign enterprises. China also could continue businesses to lessen the administrative burden to expand programs to attract top global on enterprises and reduce the opportunities managerial talent and help China to access for discretionary application and enforcement global technologies and connect with the of regulations. It could strengthen vertical global economy. reporting lines of local enforcement agencies, China could further improve its outward as was done for environmental protection direct investment (ODI) management bureaus, to reduce local government system by adopting a more market-oriented discretion. The central government could EXECUTIVE SUMMARY xxix enhance horizontal coordination among responsibilities to lower levels. Reforms enforcement agencies to achieve more are needed to reduce counterproductive consistent enforcement within a decentralized interjurisdictional competition for private model. China could make data on regulatory investments, including by transitioning from a compliance more widely available to the derivation-based to a needs-based tax transfer public and improve public communication system, which would reduce the incentives of regulatory and licensing interpretations to intervene in markets to support local and decisions to strengthen transparency enterprises. and accountability. Finally, China could The hardening of subnational govern- systematically carry out evidence-based ments’ budget constraints is needed to regulatory impact assessments, incorporating complement the intergovernmental fiscal them in its policy making. reforms. The priority is to strictly and fully Second, China can further reform its civil implement and enforce the 2014 amendments service management system to strengthen to the budget law that aimed to strengthen incentives to support markets and long-run fiscal discipline of local governments. A productivity growth. Local governments in reform road map could include the adoption China exercise considerable discretion over of capital budgeting, more comprehensive and implementing policies, enforcing regulations, transparent financial reporting, and stronger and supporting local enterprises. China has management of contingent liability risks sought to adjust local incentives by reforming associated with public-private partnerships its civil ser vice (cad re) ma nagement (PPPs) and other off-budget vehicles. The system to make promotion criteria more government could develop a comprehensive comprehensive and less narrowly focused PPP policy and regulatory framework, on short-term growth. To further reforms, drawing lessons learned from the series of China could lengthen cadres’ terms of office regulations issued in recent years. Finally, to align incentives better with long-run China could adopt a comprehensive and productivity growth and adopt a “lifetime transparent government financial reporting achievements” approach to performance system to provide the information necessary evaluation by evaluating the long-term for monitoring and evaluating the financial impact of reforms. China could strengthen sustainability and performance of subnational the public accountability of local leaders to governments and assessing progress on the help reduce local discretion. Reducing the fiscal reforms and their impact. rigidity of staffing rules and reviewing the Fourth, China could improve the coverage, competitiveness of public service salaries quality, and public accessibility of government- could ensure that the civil service attracts related data. China has the potential to be well-qualified staff. This effort could be a global leader and to set new international complemented by an assessment of the standards in data collection and dissemina- capacity constraints across all levels of tion. Improved data and greater access to data government to identify the major bottlenecks on government-related operations and basic in staffing, resources, and skills. economic information would help to improve T h i rd , C h i n a c ou ld re s h ap e a nd public sector performance by enhancing the modernize its intergovernmental relations transparency and accountability of gov- and strengthen fiscal discipline. Reshaping ernment operations. China could provide C h i n a’s i nter gover n ment a l relat ion s consolidated budget data and fuller pub- requires a comprehensive and politically lic access to household budget survey data, challenging package of complementary industrial enterprise survey and census data, reforms. Expenditure responsibilities across and improve labor market and education different levels of government need to be assessment data. Data can be gathered from reviewed, adjusted, clarified, and specified a variety of new sources, with appropriate more consistently, addressing issues such arrangements for privacy protection. The as concurrent expenditure responsibilities government could consider developing an and substantial discretion by higher levels access-to-information policy for the public of government to assign expenditure sector. Abbreviations AML Anti-Monopoly Law BIT Bilateral Investment Treaty BRI Belt and Road Initiative CBIRC China Banking and Insurance Regulatory Commission CCRC Credit Reference Center of PBOC CFIUS Committee on Foreign Investment in the United States CPC Communist Party of China CSRC China Securities Regulatory Commission DARPA Defense Advanced Research Projects Agency DVA domestic value added ECD early child development EU European Union FAR floor area ratio FDI foreign direct investment FIL Foreign Investment Law GCI global competitiveness index GDP gross domestic product GNI gross national income GVC global value chain ICOR incremental capital-output ratio ICT information and communication technology IFC International Finance Corporation INSEAD Institut Europeen d’Administration des Affaires IP intellectual property IPO initial public offering IT information technology ITU International Telecommunication Union LGFV local government financing vehicle LPI Logistics Performance Index MIIT Ministry of Industry and Information Technology MIS management information system INNOVATIVE CHINA xxxi xxxii ABBRE VIATIONS NDRC National Development and Reform Commission NEEQ National Equities Exchange and Quotations NIS national innovation system ODI outward direct investment OECD Organisation for Economic Co-operation and Development P2P peer to peer (lending) PBOC People’s Bank of China PCT Patent Cooperation Treaty PIACC Program for the International Assessment of Adult Competencies PISA Program for International Student Assessment PPP public-private partnerships R&D research and development RCA revealed comparative advantage SAMR State Administration for Market Regulation SIPO State Intellectual Property Office SME small and medium enterprise SOE state-owned enterprise STEM science, technology, engineering, and mathematics STRI Services Trade Restrictiveness Index TF Trade Facilities Agreement TFP total factor productivity TVET technical and vocational education and training UN United Nations WBG World Bank Group WIOD World Input-Output Database WIPO World Intellectual Property Organization WTO World Trade Organization Introduction After nearly four decades of rapid growth, centennial of the founding of the People’s China’s economy is transitioning to a “new Republic of China. China’s policy makers are normal” of slower but more balanced well aware that the country needs new driv- and sustainable growth. Its old drivers of ers of growth to achieve its two centenary growth—a growing labor force, the expan- goals. China’s leaders have emphasized that sion of manufacturing, migration from rural productivity and innovation will be central areas to cities, the accumulation of capital in the country’s next phase of growth. They (thanks to high savings), expanding exports, also have emphasized the market’s decisive and opening to foreign investments—are role in resource allocation, as well as the waning or having less impact. China’s demo- government’s important role in the economy. graphic dividends are reversing, and invest- This guidance has been reflected in numer- ment growth—supported by the large domes- ous policy documents and plans, including tic economic stimulus that China mobilized the decisions of the 3rd and 5th Plenums of after the global fi nancial crisis—is having a the 18th Central Committee of the CPC, the declining impact on growth and has resulted 13th Five-Year Plan, and the report of Gen- in a rapid buildup of debt. The slowdown in eral Secretary Xi Jinping to the 19th National global trade after the global fi nancial crisis, China’s already large share in global markets, Congress of the CPC. and rising global trade tensions are constrain- Innovative Chin a: New Drivers of ing exports as a driver of growth. Growth proposes a reform agenda to support China has two “centenary goals”: (1) to policy makers in their efforts to achieve become a moderately prosperous society in a modern and innovative China. Chinese an all-around manner by 2021, the centen- premier Li Keqiang and former World Bank nial of the founding of the Communist Party Group president Jim Yong Kim agreed to of China (CPC); and (2) to become a great study the new drivers of growth, and the modern socialist country that is prosperous, result, Innovative China, is the product of strong, democratic, culturally advanced, more than two years of cooperation between harmonious, and beautiful by 2049, the the Development Research Center of the 1 2 INNOVATIVE CHINA State Council, the Ministry of Finance, and • Removing distortions to strengthen market the World Bank Group. competition and enhance the efficient Innovative China analyzes productivity allocation of resources in the economy and innovation in China’s economy, takes • Accelerating diffusion of advanced technol- stock of China’s policy initiatives to promote ogies and management practices in China’s productivity and innovation, and identifies economy, taking advantage of the large the key challenges that China faces on its remaining potential for catch-up growth journey to more productivity and innovation- • Fostering discovery and nurturing China’s driven growth. It recommends structural, innovative capacity as China approaches governance, and institutional reforms to pro- Organisation for Economic Co-operation mote new drivers of growth, drawn from a and Development (OECD) levels of income review of China’s past growth and productiv- in the decades ahead and contributes ity and its achievements in structural trans- to extending the global innovation and formation, entrepreneurship, innovation, and technology frontier. technological upgrading. It also compares China’s key policies and reforms with inter- The first three chapters of Innovative national practices, including international China analyze China’s economic growth and domestic case studies in areas of interest and productivity. The remaining seven to policy makers. cover the major reform areas: industrial The main conclusion is that promot- policies and market competition, innovation ing productivity is the key to China’s future and technology, human capital and labor, growth and its ability to become a high- efficient allocation of resources, regional income country. China can achieve higher development and integration, international productivity through a comprehensive pro- competitiveness and economic globalization, gram of reforms to address the “three D’s”: and governance and institutions. 1 China’s Rapid Growth and Evolving Economy China sustained an annual growth rate of The reforms associated with China’s World gross domestic product (GDP) that averaged Trade Organization (WTO) accession in 2001 nearly 10 percent for more than three decades accelerated reforms and productivity growth. (figure 1.1), spurred by reforms that unlocked China is now the world’s largest exporting China’s huge growth potential and created country. It presents a striking example of how conditions for the country to catch up rapidly opening an economy and integrating in global with higher-income economies. The economy value chains can boost productivity, competi- underwent significant structural changes as tiveness, and the adaptation of modern tech- the labor share of agriculture declined 44 nologies. China is increasingly important to percentage points between 1978 and 2017, global value chains. Its export products have according to China’s National Bureau of become more sophisticated, with the share of high-technology manufactures in China’s Statistics, and people moved to cities to fi nd exports growing from next to nothing in more productive employment in the industry 1980 to around 30 percent in 2017. and services sectors. A high and rising sav- Various international assessments indi- ings rate fi nanced the investments in infra- cate that China has been gradually improv- structure and production facilities needed for ing its national innovation capacity, ranking rapid growth and urbanization. it highest among low- and middle-income At the outset of reform in 1978, state countries. But China is still well behind lead- and collective fi rms accounted for all of the ing Organisation for Economic Co-operation workforce and investments in the economy. and Development (OECD) countries in inno- Since then, the state’s share has declined to vation capacity. China’s spending on research less than 20 percent of the workforce and less and development (R&D) rose to 2.18 percent than 30 percent of GDP, as market-oriented of GDP in 2018, up from 1.4 percent in 2007 reforms have allowed the private sector to and near the OECD average. Its spending on expand rapidly.1 Even so, state-owned enter- R&D accounts for around 20 percent of the prises continue to play an important role in world total, second only to the United States. various areas of the economy. Its number of patents granted annually for 3 4 INNOVATIVE CHINA FIGURE 1.1 Composition of GDP growth in China, 1992–2018 20 15 10 Percent 5 0 –5 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Final consumption Net exports Gross capital formation GDP growth Source: Calculations based on National Bureau of Statistics data. inventions increased from 68,000 in 2007 quality of academic papers, as measured by to 420,000 in 2017, the highest in the world, the number of citations. Although overall although their quality varies, according to public spending on education has been China’s State Intellectual Property Office. increasing rapidly, constituting 4.1 percent Seventy-six percent of R&D spending is by of GDP in 2018, China still lags behind the industries, facilitating commercial applica- OECD average of 5.2 percent (2015). tions. China is also a hotbed for venture capi- China’s growth has been slowing to the tal in search of the next technology, raising new normal, but this is not entirely unex- approximately US$110 billion in the decade, pected. History and economics suggest surpassed only by the United States. that slowdowns generally occur at about China’s human capital capabilities are China’s current level of income per capita. the foundation of its growing innovation Some countries remain for extended peri- capabilities, but it has some way to go to match ods in a “middle-income” trap, and only the OECD countries. Less than 20 percent a select few—such as Israel, Japan, and the (2017) of China’s labor force has completed Republic of Korea—have maintained growth tertiary education, much less than the 30 to rates around 7 percent for another decade 40 percent in OECD countries. China has, on after reaching China’s current income level. average, 2 researchers per 1,000 employed, China’s growth is highly exceptional, as most well below the European Union, which countries revert to their mean growth after 10 has 10. But capacity is improving rapidly. to 15 years of rapid growth. China’s leading universities are climbing the global rankings and producing a growing An economy already volume of high-quality research. Each year, 7 million university students graduate, 1.5 transforming million of them in science and engineering, China still has much room to grow to catch and 30,000 new PhDs in technical disciplines up with the high-income economies. Its per have turned the country into a research base capita GDP stands at nearly US$10,000, for technology companies such as IBM and about a fourth of the average for OECD Microsoft. China is second only to the United countries. In many ways, China’s next States in the number of publications and the transformation is well under way, and a new CHINA’S RAPID GROW TH AND EVOLVING ECONOMY 5 economy is emerging rapidly. Chinese firms 2001 all helped to catalyze its development have developed outstanding manufacturing into the “world’s factory,” with multinational capabilities, and the value added in high-tech corporations, drawn to its low-cost labor manufacturing is now second only to that of and extensive transportation infrastructure, the United States. China is leading or closing seeking to set up subsidiaries as export the technology gap in e-commerce, fintech, platforms. Economies that continued to grow high-speed trains, renewable energy, and rapidly beyond China’s current income per electric cars. McKinsey ranks China among capita—such as Germany, Japan, Korea, and the top three investors in fintech, virtual Singapore—sustained a manufacturing base reality, autonomous vehicles, robotics, and for much longer than economies that faltered. big data. Alibaba, Didi Chuxing, Huawei, and But although China remains a dominant Tencent are already operating at the global global manufacturer, the contribution of its technology frontier. China’s digital services manufacturing investment to growth has economy has done particularly well. With its been falling, along with other key investment large-scale, high penetration of mobile phones sectors of the economy (figure 1.2). Also, and Internet use, China is a major source of manufacturing wages in China have been innovation and productivity in digital services. growing at double digits, much faster than in China is a dominant global manufacturer, other economies. with a strong and broad manufacturing base Even as China has continued to expand its offering ample scope for product and process share of global manufacturing value added, innovations to drive future productivity gains. its industrial structure has been evolving, China’s share of global manufacturing value and the share of manufacturing in GDP added increased from 7 percent in 2000 to has declined from 46 percent in 1994 to 41 nearly 27 percent in 2015, the largest increase percent in 2018 (figure 1.3). The share of among all countries. China’s abundant labor services in GDP has been rapidly growing, supply, deep economic reforms in the 1980s while the share of agriculture has been and 1990s, and accession to the WTO in declining steeply. Services recently overtook FIGURE 1.2 Contribution of fixed-asset investment to growth in China, 2005–18 35 30 25 Percentage points 20 15 10 5 0 –5 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Mining Infrastructure Total Manufacturing Services Source: Calculations based on National Bureau of Statistics data. 6 INNOVATIVE CHINA FIGURE 1.3 Share of industry in GDP in China, by sector, 1978–2018 services sector remains relatively small for its income per capita (figure 1.4), reflecting 60 the continued dominance of export-led manufacturing. Investment in manufacturing is now dominated by private firms (78 Share of GDP (2015 constant prices) 50 percent of total investments, compared with 40 8 percent for state firms), but investment in services by private firms (37 percent) is less 30 than investment by state firms (44 percent). Therefore, significant potential remains for 20 expanding private services. Services “embodied” in manufactured 10 goods are an increasingly impor tant determinant of manufacturing competitiveness 0 and are critical for a wide range of economic activities in downstream manufacturing. 19 8 19 0 19 2 19 4 19 6 19 8 19 0 19 2 19 4 19 6 20 8 20 0 20 2 20 4 20 6 20 8 20 0 20 2 20 4 20 6 18 7 8 8 8 8 8 9 9 9 9 9 0 0 0 0 0 1 1 1 1 19 Primary industry Secondary industry Tertiary industry These services are inputs (design, marketing, and distribution costs included in the value of Source: Calculations based on National Bureau of Statistics data. a good) to trade and enablers (logistics services or e-commerce platforms) of trade. They are important determinants of productivity industry as the largest sector of the economy, (Arnold et al. 2011, 2015; Barone et al. 2011) and services are now the country’s largest and essential drivers of global value chains employer. Value-added services in China have (Low and Pasadilla 2016; Sàez et al. 2014). been growing rapidly, at 11 percent in 2002– The role of services as inputs to manufacturing 13, outpacing the growth in comparator can be assessed from the perspective of countries, which ranged from 0.73 percent in forward and backward linkages, either for Japan to 9 percent in India. However, China’s final domestic use or for export. China’s share of value-added services as inputs to manufacturing is relatively small. FIGURE 1.4 Share of services in GDP in China, 2016 Based on the OECD’s trade in value-added data, the share of value-added inputs from 100 services as part of China’s total manufacturing backward linkages is only 26 percent. This is 90 lower than that of Korea (27.5 percent) and India (33.0 percent), and much lower than 80 countries with a larger manufacturing base, such as Japan (35.8 percent) and Germany 70 (41.2 percent). This suggests that services Percent 60 linkages are relatively weak in China’s manufacturing sector. Similarly, the share of 50 value-added inputs from services in China’s manufacturing exports, at 25 percent, is lower 40 than in most other comparator countries. Links between manufacturing and modern 30 services—such as R&D, and computer- 100 1,000 10,000 100,000 1,000,000 related services—are relatively weak in China. Log of 2016 income per capita The share of R&D and business services Selected countries China inputs in manufacturing for both domestic Upper-middle-income countries High-income economies consumption and exports is around 11–12 percent. Although the share has been rising, Source: Calculations based on World Development Indicators data. it is far lower than in many other countries, CHINA’S RAPID GROW TH AND EVOLVING ECONOMY 7 both high-income and low- and middle- are outsourcing specific production steps, income economies, whose share is 15 to 30 such as land preparation and harvesting, percent. The share of computer and related to professional service providers. The services inputs to Chinese manufacturing, emergence of agricultural service providers at around 1.5 percent of total value-added can provide competitive labor-substituting inputs from services, is lower than the 3 to 5 professional mechanization services. These percent in most peer countries. services help China overcome constraints A corollary to China’s rapid industrializa- faced by traditional smallholder agriculture, tion has been the decline in the share of pri- accelerate productivity growth through mary agriculture in GDP, from about 31 to greater efficiency, and generate future releases 33 percent in the early 1980s to 7 percent in of agricultural labor to other sectors of the 2018. However, this is a relative trend, and economy. agriculture has continued to grow consis- Along with the sectoral transformation tently, at an average annual rate of more than of the economy, a gradual transition from 4 percent since 2004, which is an impres- an investment-driven economy toward a sive rate by global standards for agricultural consumption-driven one has also been taking growth. China is now the world’s largest place in recent years. The final consumption agricultural producer, with more than 23 expenditure share of GDP has been volatile percent of global production, higher than and declining since the beginning of the the total of all high-income countries and all reforms and opening up, falling below 50 other country groups. percent in the aftermath of the 2008 global The share of agriculture is expected to financial crisis. But since 2014, consumption continue to decline, but agriculture still has has outpaced investment to become the potential to contribute to overall growth biggest driver of growth, contributing on through industrialization and “servicifica- average 57 percent to overall growth. The tion” of the sector. This would help expand final consumption expenditure share of GDP the agroprocessing and food services (trade, gradually rose to 53.6 percent in 2017. This restaurants, prepared foods) segments of shift has been supported by a rising share the postharvest agricultural value chains. of labor income, reversing a two-decade China’s agricultural production structure negative trend, as well as a falling savings rate has slowly started to shift, but the country’s (figure 1.5). value added in agroprocessing is only 14 percent of the agriculture sector’s total value added, much lower than for high-income FIGURE 1.5 Share of labor income and gross countries (90 percent for the United States, savings in GDP in China, 1992–2017 132 percent for Germany) and some low- and middle-income countries (25 percent for the 60 Russian Federation, 29 percent for Brazil). Therefore, China has significant potential 55 to grow by expanding industries associated with agriculture. 50 Beyond agroprocessing, the “servicifica- % of GDP tion” of agriculture also creates new growth 45 opportunities. The growth of agricultural 40 services, particularly machinery leasing, has accelerated sharply since about 2006–07, 35 driven in part by government subsidies to promote mechanization. With an increasingly 30 “industrialized” structure (capital intensive 1992 1997 2002 2007 2012 2017 and mechanized), the use of data-intensive Compensation of labor Gross savings digital technologies and practices will become increasingly important. Farmers Source: Calculations based on World Development Indicators data. 8 INNOVATIVE CHINA A rapidly changing and more 2017). Many of these unicorns are com - uncertain global environment panies that use digital technology to create new innovation in e-commerce, mobile trans- As China’s economy transforms, it faces portation, finance, and education. Digital new global challenges and opportunities, technologies are central to China’s plans for shaped by two megatrends: rapid technology industrial upgrading to improve the produc- advancements and rising protectionist tivity and domestic value added of the coun- sentiments. Technology-induced disruptions try’s industry supply chains. China has been of i ndust ries and t he workplace a re aware of the importance of deepening the accelerating, becoming more frequent and application of Internet-related technologies unpredictable. Many technologists argue that in manufacturing and of developing smart we are at the beginning of a new acceleration manufacturing (MIIT 2015). The Internet+ in technological change, propelled by digital strategy, introduced in 2015, foresees the technologies that enable new products and application of Internet technology to each services. In the United States, it took 39 years sector of the economy, as in Internet+finance, for landline telephones to reach 40 percent Internet+health, and Internet+logistics.3 penetration and another 15 years for them China now has the highest number of to become ubiquitous. Smartphones, by Internet users and the largest (and one of the contrast, reached 40 percent penetration in fastest-growing) e-commerce markets in the just 10 years. world. The number of Internet users in China The adoption of digital technologies in reached 829 million in 2018, and the annual manufacturing, known as Industry 4.0 or the volume of e-commerce trade grew 30-fold Fourth Industrial Revolution, is expected to from 2004 to 2018 (Ministry of Commerce reshape manufacturing. Cloud computing, big data analytics, and the Internet of Things 2019), reaching RMB 31.6 trillion (figure are driving the expansion of the digital 1.6). China started from less than 1 services economy and the modernization of percent of the global value of e-commerce business operations and services. 2 Digital transactions a decade ago to reach more than platforms such as e-commerce can reduce 40 percent, exceeding France, Germany, the cost of entering new markets, thus Japan, the United Kingdom, and the United promoting entrepreneurship and competition. States combined (Woetzel et al. 2017). Entrepreneurial start-ups, as agents of E-commerce helps to drive growth by enlarg- disruption propelled by the technology- ing the market reach of enterprises and led economic transformation, leverage helping them to manage their operations technologies to develop new business models efficiently. and, in some instances, entirely new business Online retail sales have grown particularly categories. Traditional companies, spurred rapidly, more than 70 times from 2008 to on by the new competition, have come under 2018, to RMB 9 trillion (figure 1.7). In 2008, pressure to adapt their business models or only 1 percent of retail sales of consumer create new products and services. Hotel goods were purchased online in China. In businesses need to adapt to Airbnb, taxi 2018, this share reached 24 percent, making companies need to cope with Didi Chuxing it the highest in the world. However, online and Uber, and banks need to react to fintech. retail sales vary across regions. More than China is already considered a global leader 45 percent of online retail sales of consumer in industries enabled by digital technologies, goods were conducted in Beijing, followed by such as e-commerce and fintech, as well as nearly 40 percent in Shanghai, compared with emerging fields like artificial intelligence. less than 2 percent in nine inland provinces. Among the 252 nonlisted start-ups in the China also faces a more challenging global world, with a valuation of US$1 billion and environment, with the slowdown in global above (commonly referred to as unicorns), 98 trade and rising protectionism. China’s are from China, surpassed only by the United exports have soared in dollar terms, by 14 States, with 106 (PricewaterhouseCoopers percent annually in the past two decades, CHINA’S RAPID GROW TH AND EVOLVING ECONOMY 9 and the country has become a dominant FIGURE 1.6 Number of Internet users in China, 2007–18 exporting nation on the world stage. Its integration into the global value chain was 1,000 60 marked by huge waves of foreign direct investment, focused on manufacturing for 800 50 export and, increasingly, for its enormous and rapidly growing domestic market. 40 600 The global financial crisis slowed global Percent Millions trade, which contracted by 12.8 percent in 30 2009, and removed exports as a major of 400 20 source of growth for China. The volume of world merchandise trade grew by just 2.4 200 10 percent a year from 2009 to 2018, which is less than half of the average rate of expan- 0 0 sion during 2000– 08 (figure 1.8). World 07 08 09 10 11 12 13 14 15 16 17 18 20 20 20 20 20 20 20 20 20 20 20 20 merchandise trade continued to experience Internet users Internet penetration rate (right axis) relatively weak growth into 2019. This weak growth reflects, in part, a slowing demand Sources: Calculations based on China Internet Network Information Center, National Bureau for capital goods amid elevated trade policy of Statistics data; CIECC Research Institute 2016. uncertainty, according to the latest edition of the World Bank’s Global Economic Pros- FIGURE 1.7 Value and share of online retail sales in China, 2008–18 pects (June 2019). There has been some debate about whether 10 25 the slowdown in global trade reflected a 9 cyclical fluctuation and slow recovery from the global financial crisis or a structural shift 8 20 away from global value chains. Arguments 7 for the “end of globalization” have rested on RMB (trillions) 6 15 Percentage various explanations, including rising eco- 5 nomic nationalism and protectionism, new 4 10 manufacturing technologies that reduce the 3 importance of labor costs and enable close- to-market production (“reshoring”), rising 2 5 labor costs in exporting countries (particu- 1 larly China), and increased domestic produc- 0 0 tion of intermediate goods in exporting coun- 08 09 10 11 12 13 14 15 16 17 18 20 20 20 20 20 20 20 20 20 20 20 tries (again, particularly China). Online retail sales China faces external concerns about Ratio of online retail sales to total retail sales of consumer goods its “unfair” industrial and trade policies (right axis) and demands for reciprocity in foreign Sources: Calculations based on China Internet Network Information Center, National Bureau investments. For the past four decades, China of Statistics data; CIECC Research Institute 2016. and its major trade partners have embraced globalization. China has gradually opened up its economy and integrated into the global differences regarding the role of the state in economy. Today, however, tensions between the economy. China and other major trading nations Such tensions can undermine support are building regarding China’s trade and for the global trading system and constrain investment policies, intellectual property China’s ability to leverage global trade and rights, and overseas investments in critical investments to promote its growth and infrastructure and technologies. A common development. In response, China’s leadership underlying concern has been fundamental has stated its commitment to supporting 10 INNOVATIVE CHINA FIGURE 1.8 Growth in the global trade of goods, 2001–19 20 15 10 5 Percent 0 –5 –10 –15 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019a Source: Calculations based on CPB World Trade Monitor data. a. The 2019 data are for Jan.–April only. globalization, an open global economy, and Benefit Manufacturing Firms? Evidence from a global “Community with a Shared Future the Czech Republic.” Journal of International for Mankind.” It has announced plans to Economics 85 (1): 136–46. open its domestic markets further to foreign Barone, J. Michael, and P. Karen Winterich. 2011. “Warm Glow or Cold, Hard Cash? investments and to lower tariffs, and it has Social Identity Effects on Consumer Choice for launched important major initiatives, such Donation versus Discount Promotions.” Jour- as the Belt and Road Initiative, to promote nal of Marketing Research 48 (5): 855–68. connectivity. CIECC (China International Engineering Con- sulting Corporation) Research Institute. 2016. Notes Felton, Michael. 2008. “Consumption Spreads Faster Today [Chart].” New York Times , 1. World Bank estimates based on National February 10. Bureau of Statistics data. Low, Patrick, and O. Gloria Pasadilla, eds. 2. Cloud computing services use a network of 2016. Services in Global Value Chains: remote servers to store and process data over Manufacturing-Related Services. Singapore: the Internet. The Internet of Things is the send- World Scientific. ing and receiving of data through the many MIIT (Ministry of Industry and Information digital devices connected through the Internet. Technology). 2015. “Notice of the State Coun- Big data analytics reveal patterns, trends, and cil on Printing and Distributing ‘Made in associations in large sets of data. China 2025.’ ” May 19, MIIT, Beijing. 3. See “Premier Li on Internet Plus Tradi- Ministry of Commerce. 2019. “E-Commerce in tional Industries,” State Council of the China 2018.” A report released at the 2019 People’s Republic of China Premier News, China E-Commerce Convention in May. October 5. http://english.gov.cn /premier Sàez, Emmanuel, Stefanie Stantcheva, and /news/2016/10/05/content_281475459076998 Thomas Piketty. 2014. “Optimal Taxation of .htm. Top Labor Incomes: A Tale of Three Elastici- ties.” American Economic Journal: Economic Policy 6 (1): 230–71. References Woetzel, J., et al. 2017. “China’s Digital Econ- Arnold, Jens M., Beata S. Javorcik, and Aaditya omy: A Leading Global Force.” McKinsey Mattoo. 2011. “Does Services Liberalization Global Institute, Discussion Paper, August. 2 The Need for New Drivers of Growth China’s past growth benefited from capital as China’s demographic dividends have deepening, labor force expansion, and produc- reversed, and the working-age population has tivity improvements. Decomposing China’s started to decline. In short, China’s previous economic growth shows that all of these fac- drivers of growth are losing their impetus. tors played an important role over the past four decades. Almost half of China’s gross Investment’s diminishing domestic product (GDP) growth since 1978 was from capital deepening, about a third contribution to growth was from productivity, measured by total fac- China made use of its exceptionally high tor productivity (TFP), and the rest was from savings rate to mobilize massive resources for an expanding labor force and investments investments. The country’s rapid accumulation in human capital (figure 2.1). The structural of basic economic infrastructure is the envy of reforms, initially driven by accession to the many developing countries. In response to the World Trade Organization (WTO) in 2001, global financial crisis, China implemented a allowed the country to maintain relatively large public sector stimulus program, which high TFP growth, but the contribution of focused on investments in infrastructure and TFP has declined sharply since the global real estate. China’s investments now face the fi nancial crisis, from 3.2 percentage points challenge of diminishing returns, as measured in the years before the crisis to just 1.1 per- by the increase in the country’s incremental centage points afterward. Other researchers capital-output ratio (ICOR) (figure 2.3). estimate lower or even negative TFP growth Much of the increase in the economywide since the global financial crisis.1 ICOR, which represents a declining impact of As a result of the lower contribution investments on growth, can be explained by of TFP, growth has had to rely to a much higher ICORs in infrastructure and real estate, greater extent on investments in physical cap- reflecting significant investments in those ital (figure 2.2). High investment rates have areas (figure 2.4). In contrast to infrastructure greatly increased China’s capital stock, but and housing, the returns to capital in the additional capital investments are likely to business sector deteriorated only marginally add less to growth in the future. The contri- after the crisis, which indicates that improving bution from labor also has declined sharply, the allocation of capital could enhance 11 12 INNOVATIVE CHINA FIGURE 2.1 Sources of growth in China, 1978–2017 FIGURE 2.3 GDP growth and the incremental capital-output ratio (ICOR) in China, 1995–2018 12 16 14 Contributions to the average annual 10 12 change in real GDP (%) 8 10 6 8 4 6 4 2 2 0 0 1978–2017 1978–87 1988–97 1998–2007 2008–17 95 97 99 01 03 05 07 09 11 13 15 17 Employment Human capital per worker 19 19 19 20 20 20 20 20 20 20 20 20 Physical capital per worker Total factor productivity GDP growth (%) Incremental capital-output ratio Source: Calculations based on National Bureau of Statistics data. Source: Calculations based on National Bureau of Statistics data. Note: TFP = total factor productivity. Private enterprises may have been more FIGURE 2.2 Sectoral gross capital formation as a share of GDP in pessimistic about market prospects due to the China, 1990–2016 moderation of China’s growth, while state- owned enterprises (SOEs) may have increased investments in infrastructure to implement 50 the government’s postcrisis stimulus. SOEs Share of gross capital formation (current prices) % 45 have received disproportionately larger 40 shares of credit, with roughly nine-tenths of bonds outstanding issued by state firms. 2 35 Finally, private firms may already have taken 30 advantage of most of the liberalization of 25 market entry that the state has authorized, 20 and boosting private investments further may require addressing the remaining barriers to 15 market entry. 10 The investment-oriented stimulus also 5 contributed to the rapid growth of commercial credit to the nonfinancial sector, reaching 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 almost 251 percent of GDP by the end of Business Housing Infrastructure Government 2018. The most rapid growth of debt between 2012 and 2015 was for SOEs, and the fastest- Source: Herd 2017. growing component of SOE debt during this period was for local government financing productivity and efficiency. With basic public vehicles (LGFVs) involved in subnational infrastructure now largely in place, the overall public investment (figure 2.5). By 2015, returns to public investment for economic infrastructure, construction, and housing growth can be expected to decline. accounted for more than half of new debt Rising investments since the global in the nonfinancial sector. This very rapid financial crisis have been driven by rising expansion in credit to the nonfinancial sector public investment rates, whereas the growth could have hindered China’s productivity of private investment has been declining. growth in two important ways. First, as This decline could be due to several factors. suggested in the decomposition of the ICOR, THE NEED FOR NEW DRIVERS OF GROWTH 13 FIGURE 2.4 Capital-output ratio in China, by economic sector, 1990–2015 3.5 3.0 2.5 2.0 Ratio 1.5 1.0 0.5 0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 90 91 92 93 94 95 96 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 19 19 19 19 19 19 19 Business Housing Infrastructure Government Source: Herd 2017. the flow of credit to sectors with higher FIGURE 2.5 Estimated composition of debt accumulation in China, ICORs indicates an inherent inefficiency 2012–16 in the allocation of credit that directly affects productivity. Second, the growing 300 burden of nonfinancial sector debt will itself slow growth in the medium term, when it 250 inevitably will need to be deleveraged.3 Given 38.8 44.4 such risks, the Government of China has 200 35.7 33.1 44.5 prioritized containing the growth of credit 29.7 41.7 40.2 % of GDP and deleveraging the economy. 150 37.2 34.4 Investment growth in China has weak- 66.8 63.9 ened significantly in recent years, growing at 65.4 100 62.4 57.7 less than half its 2001–10 average pace. Real 47.8 52.8 investment expanded 18 percent a year in the 42.0 42.9 50 42.0 decade before 2011, compared with just 5 41.6 48.2 49.7 percent in 2017 (figure 2.6). The slowdown 30.9 36.2 0 in investment has occurred in the context 2012 2013 2014 2015 2016 of slowing economic growth and rebalanc- Local government financing vehicles General government ing toward household consumption. Recent State-owned enterprises Households efforts to reduce excess industrial capacity Private enterprises and to limit financial risks have also contrib- uted to lower investment. In addition, new Sources: Calculations based on Bank for International Settlements, People’s Bank of China, Wind Information Co., Ltd., and CEIC data. economy sectors such as software and infor- Note: LGFV = local government financing vehicle. SOE = state-owned enterprise. mation technology as well as consumer ser- vices are generally less capital intensive and percent for upper-middle-income countries. therefore require less investment. China’s gross capital formation—at 44.8 Despite the recent slowdown, the growth percent of GDP in 2018—remains one of rate and level of investment are still high by the highest in the world. By comparison, the international standards. In 2013–17, capital average investment rate in the Organisation formation in China increased 6.9 percent for Economic Co-operation and Development a year, compared with an average of 4.9 (OECD) is about 22 percent of GDP. 14 INNOVATIVE CHINA FIGURE 2.6 Real gross capital formation in China, 2001–18 growth. By contrast, the nonpublic capital stock of China is only around half that of the 30 OECD, suggesting that capital deepening in the nongovernment sector can still contribute significantly to growth and labor productivity 25 in the coming decades. In this regard, declining private investment rates are an added concern. 20 2001–10 average All of this points to the importance of setting priorities and being selective in future Percent 15 infrastructure investments. The critical question is what kind of capital—in which 2011–18 average industry and in which economic activity—is 10 most productive for China's future growth? Growth can still come from new capital 5 investments if it is in areas that are still lagging, because there are significant differences 0 in the performance of various kinds of 2001 2003 2005 2007 2009 2011 2013 2015 2017 infrastructure. China is internationally competitive in transport infrastructure, but Source: Calculations based on National Bureau of Statistics data. it still lags in power and in information and communication infrastructure in remote Although the aggregate impact of invest- areas. To make capital investment more ment on grow th is declining, capital productive, China needs to improve its accumulation can still contribute to future policies and ensure that the market plays a growth, particularly for the business sector, decisive role in the economy. which has not seen a big decline in returns to capital. China’s public sector capital stock Labor’s diminishing contribution per worker has already reached OECD levels (figure 2.7). For this reason, more to growth public infrastructure may not address the China’s demographic dividends are reversing. most critical bottlenecks for China’s future While employment contributed almost a third FIGURE 2.7 Public and private sector capital stock per worker in China and other countries, 2014 a. Public capital stock per worker b. Private capital stock per worker 150 250 100 200 150 100 Log of thousands of 2011 US$ Log of thousands of 2011 US$ 50 China 50 China 50 100 150 50 100 150 Log of 2014 GDP per capita (PPP, thousands of 2011 US$) Log of 2014 GDP per capita (PPP, thousands of 2011 US$) Sources: Calculations based on Penn World Tables 9.0 and International Monetary Fund data. Note: China’s public (panel a) and private (panel b) capital stock per worker at historical levels of income per capita (red line) are compared with 2013 levels in other countries (2011 international US$, thousands, purchasing power parity [PPP], log scale). Organisation for Economic Co- operation (OECD) and Development countries are in purple. THE NEED FOR NEW DRIVERS OF GROWTH 15 to GDP growth (2.9 percentage points) in the 5 percent of the labor force. The increases two decades following 1978, its contribution would come almost entirely from people age has fallen to 0.3 percentage point in the past 50 and above (figure 2.8). The shrinking and 10 years. According to United Nations (UN) aging labor force raises the importance of estimates, total population growth in the improving labor productivity by investing past five years was only 0.5 percent a year, in human capital and ensuring that the while the growth rate of the working-age economy can use workers fully throughout population (ages 15–64) began to decline in their working lives. 2016. Raising the retirement age can add consid- In line with the population decline, China’s erably to the active labor force. In China, the labor force will also decline in the coming standard old-age dependency ratio, defined years and age considerably. The labor force as the ratio of the population age 65 and is projected to shrink by 47 million, from 793 older per 100 persons ages 15–64, was 13.3 million in 2010 to 746 million in 2030. UN in 2015, in line with the average for upper- projections show the labor force declining middle-income countries. The UN projects 1 percent a year in the 2030 s, thus that the ratio will rise to 32 in 2035. But if contributing negatively to GDP growth. The the ratio is adjusted to reflect China’s cur- average age is projected to increase from 38.9 rent retirement age—60 for men and 55 for years to 43.3 years. As a result of the aging women—the ratio would already have been of the population, the share of people age 28 in 2015 and would be expected to reach 60 and above in the labor force is projected 59 in 2035. This illustrates the significant to increase from 6.6 percent in 2010 to 13.8 impact of China’s early retirement age on percent in 2030. Hence, it will be increasingly the structure of its labor force and thus the important to keep elderly workers in the labor reduced contribution of labor to the econ- force. If by 2030 China were to achieve the omy. In addition, the retirement age is lower same labor force participation per age cohort for females than for males, resulting in a as in Japan today, an additional 38 million faster decline in the female workforce than in workers would join the labor force—almost the male (figure 2.9). These estimates ignore FIGURE 2.8 Projected labor force in China, by age, 2010–30 120 100 Population (thousands) 80 60 40 20 0 15–19 20–24 25–29 30–35 36–39 40–44 45–49 50–54 55–59 60–64 65+ Age (years) 2010 2030 ILO projection 2030 Japan’s projection Source: Calculations based on ILOSTAT data. Note: ILO = International Labour Organization. 16 INNOVATIVE CHINA FIGURE 2.9 Population of China, by gender and age group, 1971–2041 a. Men b. Women 800 800 700 700 600 600 Population (millions) Population (millions) 500 500 400 400 300 300 200 200 100 100 0 0 1971 1981 1991 2001 2011 2021 2031 2041 1971 1981 1991 2001 2011 2021 2031 2041 Ages 0–14 Ages 15–59 Ages 60+ Ages 0–14 Ages 15–54 Ages 55+ Source: Calculations based on United Nations Population Division data. the fact that women in blue-collar jobs today three. Under scenario one, based on the often retire at 52, resulting in an even larger current technological trajectory, very little gender gap in the retirement age and greater rural labor surplus remains, and the economic underutilization of the female labor force. contribution of labor through its reallocation The sectoral reallocation of labor from from agriculture is expected to be fairly agriculture to industry has been a major negligible. The much larger estimated driving force of China’s economic growth. rural surplus labor under scenario three As with the declining labor force, the con- indicates that technological advancement can tribution from sectoral labor reallocation is significantly raise the potential for sectoral also likely to be more limited in the future. reallocations of agricultural labor. Rural surplus labor was projected up to Under all three scenarios, rural surplus 2030, using official statistics, based on three labor is projected to decline continuously. It scenarios: the business-as-usual baseline sce- is projected to disappear by 2023 under sce- nario of the current technological trajectory, nario one. Hence, the small remaining labor a second scenario reflecting a medium tech- surplus is projected to disappear completely nological trajectory with moderately faster within four years. With faster technological labor productivity growth, and a third sce- trajectories, rural surplus labor is projected nario representing the fastest technological to remain up to 2030, ranging from 24 mil- trajectory and thus the fastest labor produc- lion in scenario two to 48 million in scenario tivity growth. Higher levels of technology three. and labor productivity in agriculture would These estimates of rural surplus labor are imply greater rural surplus labor, which in based on official aggregate statistics, which turn would indicate greater potential for indicate that a large share of labor remains labor reallocation to other sectors of the in agriculture—almost 43 percent, according economy. to rural hukou status in 2016. But household The estimated labor surplus ranged from data indicate that rural households devote, approximately 165 million to 230 million on average, only about one-third of their time in the early 2000s but has since declined to farming.4 If the estimated rural labor sup- steadily. The rural labor surplus in 2018 is ply is adjusted according to the actual time estimated to range from 20 million under spent farming, no rural surplus labor would scenario one to 95 million under scenario remain in 2018 under all three scenarios. THE NEED FOR NEW DRIVERS OF GROWTH 17 Notes Efficiency in China,” IMF Working Paper 07/09, International Monetary Fund, Wash- 1. This report’s estimates of TFP growth are ington, DC. similar to results from Bosworth and Collins Feenstra, R. C., R. Inklaar, and M. P. Timmer. (2008) and Perkins and Rawski (2008) and 2015. “The Next Generation of the Penn are somewhat higher than results from Chow World Table.” American Economic Review and Lin (2002), Feenstra, Inklar, and Tim- 105 (10): 3150–82; data available at http:// mer (2015), Wei, Xie, and Zhang (2017), Woo www.ggdc.net/pwt"www.ggdc.net/pwt. (1997), Wu (2011), Wu (2017), and Young Haltiwanger, J., R. Kulick, and C. Syverson. (2003). The more recent papers (Wei, Xie, and 2018. “Misallocation Measures: The Distor- Zhang 2017; Wu 2017) found that aggregate tion That Ate the Residual,” NBER Working TFP actually declined after the global finan- Paper 24199, National Bureau of Economic cial crisis. Although this report’s estimates of Research. recent TFP growth are higher, the overall trend Herd, R. 2017. “Estimating Capital Forma- and hence the associated qualitative interpreta- tion and Capital Stock by Economic Sector tion are similar to the other estimates. in China.” Background paper for this report, 2. Data are from the Wind Information Co., Ltd. World Bank, Washington, DC. The exact shares were 90 percent in 2015 and Hofman, B., and J. Wu. 2009. “Explaining 86 percent in 2016. China’s Development and Reforms: Commis- 3. See, for example, Reinhart, Reinhart, and sion on Growth and Development,” Working Rogoff (2012). Paper 50, World Bank, Washington, DC. 4. See the Research Center for the Rural Econ- Hsieh, C.-T., and Z. Song. 2015. “Grasp the omy’s nationally representative panel surveys Large, Let Go of the Small: The Transfor- from 2003 to 2013. mation of the State Sector in China,” NBER Working Paper 21006, National Bureau of Economic Research. Bibliography Lardy, Nicholas R. 2014. Markets over Mao: The Aghion, P., and P. Howitt. 1992. “A Model Rise of Private Business in China. Washing- of Growth through Creative Destruction,” ton, DC: Peterson Institute for International Econometrica (60) 323–51. Economics. Bai, C.-E., C.-T. Hsieh, and Z. M. Song. 2016. ———. 2016. “State Firms: A Growing Drag “The Long Shadow of a Fiscal Expansion”, on China’s Economic Growth?” Background Brookings Papers on Economic Activity, Fall paper for this report, World Bank, Washing- 2016, pp. 129-181. ton, DC. Barro, R. J., and X. Sala-i-Martin. 2004. Eco- Perkins, D., and T. Rawski. 2008. “Forecast- nomic Growth. Cambridge, MA: MIT Press. ing China’s Economic Growth to 2025,” In Bosworth, B., and S. M. Collins. 2008. “Account- China’s Great Economic Transformation, ing for Growth: Comparing China and India.” edited by L. Brandt and T. Rawski. Cam- Journal of Economic Perspectives 22 (1): bridge: Cambridge University Press. 45–66. Reinhart, C. M., V. Reinhart, and K. S. Rogoff. Cecchetti, S. G., M. S. Mohanty, and F. Zampolli. 2012. “Public Debt Overhangs: Advanced 2011. “The Real Effects of Debt,” BIS Work- Economy Episodes since 1800.” Journal of ing Paper No. 352, Bank for International Economic Perspectives 26 (3): 69–86. Settlements. Research Center for the Rural Economy’s nation- Checherita, C., and P. Rother. 2010. “The Impact ally representative panel surveys from 2003 to of High and Growing Government Debt on 2013. Economic Growth: An Empirical Investigation Seck, A. 2012. “International Technology Diffu- for the Euro Area,” ECB Working Paper 1237, sion and Economic Growth: Explaining the European Central Bank. Spillover Benefits to Developing Countries,” Chow, G., and A. Lin. 2002. “Accounting for Structural Change and Economic Dynamics, Economic Growth in Taiwan and Mainland (23) 437– 51. China: A Comparative Analysis.” Journal of Timmer, M. P., G. J. de Vries, and K. de Vries. Comparative Economics 30 (3): 507–30. 2015. “Patterns of Structural Change in Devel- Dollar, D., and S.-J. Wei. 2007. “Das (Wasted) oping countries.” In Routledge Handbook of Kapital: Firm Ownership and Investment Industry and Development, J. Weiss and M. 18 INNOVATIVE CHINA Tribe, eds., pp. 65-83. Data available http:// Debate Revisited with a Newly Constructed www.rug.nl/ggdc/productivity/10-sector/. Data Set.” RIETI Discussion Paper 11-E-003, Wei, Shang-Jin, X. Xie, and X. Zhang. 2017. Research Institute of Economy, Trade, and “From ‘Made in China’ to ‘Innovated in Industry, Tokyo. China’: Necessity, Prospects, and Challenges.” ———. 2017. “China’s Institutional Impediment Journal of Economic Perspectives 31 (1): to Productivity Growth: An Industry-Origin 49–70. Growth Accounting Approach.” Unpublished Woo, W. T. 1997. “Chinese Economic Growth: paper. Sources and Prospects.” Working paper, Young, A. 2003. “Gold into Base Metals: Pro- Department of Economics, University of Cali- ductivity Growth in the People’s Republic of fornia, Davis. China during the Reform Period.” Journal of Wu, H. X. 2011. “Accounting for China’s Growth Political Economy 111 (1): 1220–61. in 1952–2008: China's Growth Performance 3 The Productivity Challenge The recent slowdown of China’s economic Enterprise data indicate that average man- growth results in large part from declining ufacturing TFP growth in China essentially productivity growth. Macroeconomic esti- halved after the global fi nancial crisis. This mates of total factor productivity (TFP)—a decline can be attributed almost entirely to measure of economic efficiency and inno- the falling contribution of firm entries. Before vation, including technological innova- the global fi nancial crisis, new fi rm entries tion—experienced a significant slowdown were the largest contributor to productivity in growth, from about 3.51 percent in the growth. After 2007, the contribution of firm 10 years before the global fi nancial crisis to entries to TFP growth was lower by nearly a 1.55 percent in 2008–17. Nascent signs of full percentage point, matching the estimated improvement have emerged in recent years, decline in overall average TFP growth. The but TFP growth remains significantly lower rate of entry of new industrial firms1 had than its precrisis levels (figure 3.1). increased to more than 12 percent annually The estimated slowdown in TFP growth in 2004 but subsequently declined by 3.5 to based on macroeconomic data is consistent 4 percent by 2013. This contributed to the with estimates based on industrial manufac- declining impact of new entries on overall turing enterprise data (figure 3.2). Enterprise TFP growth. The lower rate of entry could TFP growth can be decomposed into the entry have been due to a combination of factors, of new firms, exit of firms, improvements including overcapacity in certain sectors and among incumbents (within-firm TFP growth), entry barriers in others. Industries suffering and reallocations of resources to more pro- from overcapacity would discourage new ductive firms. The entry of new firms would entries due to low profit margins. High entry contribute positively if they are more produc- barriers to otherwise profitable industries tive than incumbents. The exit of poorly per- would prevent new entries. forming firms also would raise productivity, There is evidence that the rate of firm as would reallocating resources among exist- entry increased after 2013, perhaps reflecting ing firms toward more productive firms. Lib- the government’s “Mass Entrepreneurship” eralizing markets can expand the potential Initiative, and this could have contributed to contribution through each of these channels. improved enterprise TFP growth. The TFP 19 20 INNOVATIVE CHINA FIGURE 3.1 Aggregate growth of total factor productivity (TFP) in the most recent years (figure 3.1). The recent China, 1978–2017 incipient recovery of TFP growth coincides with a decline in investment rates and 10 government reforms to reduce the growth of credit, address overcapacity in industries, and 8 tighten local government budget constraints. Government promotion of innovation and 6 new technologies may also be starting to have an impact. More recent data and analysis are 4 % growth needed to assess the underlying drivers of recent improvements in TFP growth. 2 Given the declining contribution of firm 0 entry since the global financial crisis, the higher productivity of incumbent firms –2 has become the main contributor to TFP growth in China. Both before and since the –4 global financial crisis, there have been few or 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 no gains in TFP growth from firm exits or Total factor productivity growth reallocation of productive resources among Total factor productivity growth (alternative estimate) firms. This indicates that poorly performing firms are not exiting sufficiently to contribute Source: Calculations based on National Bureau of Statistics data and authors’ calculations. to overall TFP growth, and more productive Note: TFP growth is based on a production function that includes separate estimates of human capital. TFP growth (alternative estimate) does not include separate estimates of firms are not receiving sufficient productive human capital. resources (labor, capital, and intermediate inputs). Chapter 2 provides evidence of rising FIGURE 3.2 Growth of total factor productivity (TFP) in industry in inefficiency in the allocation of resources to China before and after the global financial crisis, 1998–2013 infrastructure and housing, as evidenced by rising incremental capital-output ratios. The 2.5 minimal contribution of resource allocation may be due to a variety of reasons, including 2.00 “zombie” firms that should exit the market, 2.0 Contribution to annual TFP growth (%) but instead remain to capture resources and 1.63 productive small and medium enterprises 1.5 1.22 1.28 that are having difficulty accessing financial 1.11 and other resources. 0.95 1.0 0.78 Consistent with the recent slowdown of TFP growth, China’s labor productivity 0.52 0.5 0.37 grow th has also been declining. T he 0.04 0.04 slowdown in labor productivity growth has 0 been due to lower contributions from both –0.10 –0.05 the services and industry sectors (figure 3.3). –0.15 –0.16 The declining contribution of services has –0.5 1998–2013 1998–2007 2007–13 been due to a large decline in productivity Overall Between Within Entry Exit growth within the sector, from an average of 9.3 percent a year in 2006–10 to 3.6 percent Sources: Brandt, Wang, and Zhang 2017, based on National Bureau of Statistics enterprise in 2011–15. Industry’s contribution has survey data. declined because the reallocation of labor has increasingly been to services rather than analysis of the enterprise data in this report to industry. Given that the labor productivity extends only up to 2013, based on data of services is lower than that of industry, availability, 2 but macroeconomic estimates China’s aggregate labor productivity growth of TFP growth show a modest recovery in has slowed. THE PRODUCTIVITY CHALLENGE 21 FIGURE 3.3 Contribution of labor productivity to cyclical factors. Finally, the beneficial effects growth in China, by sector, 2003–17 of widespread structural reforms in emerging economies during the 1990s and early 12 2000s may have petered out, and the global financial crisis may have postponed new 10 reforms (World Bank 2018). 8 Promoting new drivers of growth Percentage points through the “3+6+7” reform 6 agenda 4 China will need to promote new drivers of growth to address its major productivity 2 challenges. Sustained growth in the long run will depend on continuous productivity 0 growth. This report proposes the “3+6+7” 2003–07 2008–12 2013–17 reform agenda to address China’s produc- Agriculture Industry Services tivity challenges and achieve long-term sus- tained growth: Source: Calculations based on World Development Indicators data. • “3” refers to the three D’s that are the keys to promoting productivity-driven growth: The slowdown in labor productivity removing distortions, accelerating diffu- growth may indicate that China is beginning sion, and fostering discovery. to enter the next stages of its economic • “6” refers to the six strategic choices for development. Typically, countries grow richer promoting the three D’s. by accumulating physical and human capital • “7” refers to the seven critical areas of and experiencing structural transformation of structural and institutional reform. their economies, as reflected in agriculture’s declining share of the economy and industry’s rising share. As economies develop further, The three D’s growth decelerates due to diminishing To promote continuous productivity growth returns to capital accumulation and declining and cultivate new drivers of growth, China gains from structural transformation of the could pursue policies to deepen the structural economy. and institutional reforms that promote the The recent slowdown in the growth of three D’s: removing distortions, accelerating China’s labor productivity and TFP has diffusion, and fostering discovery (figure 3.4). coincided with a decline in productivity The first D, reducing distortions in the allo- growth across many other countries. An cation of resources, has been a key driver of aging workforce, slower growth of human growth in the past, and continuing reforms capital, weakening momentum of global would allow China to reach its maximum trade integration, and the waning effect of the potential production frontier. The first D information and communication technology requires reforms of financial, labor, and land (ICT) boom are among the possible longer- markets to ensure that resources are allocated term structural causes. Excessive investments competitively and efficiently to their most before the global financial crisis also could productive uses in the economy. have contributed to the subsequent decline in The second D —accelerating diffusion productivity growth, as economies adjusted of more advanced existing technologies, to the overcapacity by reducing outputs and products, and management techniques— investments and deleveraging. Therefore, the will help China extend its current produc- slowdown could be viewed as a combination tion frontier to the global frontier. By tak- of long-term structural and shorter-term ing advantage of China’s large remaining 22 INNOVATIVE CHINA FIGURE 3.4 The three D’s: reducing distortions, accelerating As the economy approaches the global diffusion, and fostering discovery production frontier, the state will need to assume a more market-supportive role, Capital to promote market competition, and to strengthen the business climate. Market participants will need to have a stable and predictable market and fair competition. China is now pursuing all three drivers Fostering “D”iscovery of growth simultaneously. The three D’s are interrelated and interconnected. The returns (in productivity gains) to existing technolo- gies and new discoveries will be higher if pro- ductive resources can flow to a more produc- Accelerating tive use in the economy. The country could “D”i usion save resources by addressing existing inef- ficiencies in resource allocation more force- fully, which would benefit both diffusion and discovery. Policies and institutional reforms Reducing “D”istortions that promote market competition and a state that is more supportive of markets would support all three D’s. Greater market com- China’s Global petition would allow more competitive firms China production production to access resources and encourage firms to frontier frrontier Labor invest in innovation and research and devel- Governance and institutional reforms promote all 3 D’s opment (R&D). When the state focuses on promoting market competition, a conducive business environment and level playing field, potential for catching up to the global pro- firms have the confidence to invest long term duction frontier, the second D would have in truly innovative R&D. a significant payoff for China in the imme- diate future. Accelerating diffusion requires Six strategic choices innovation and science and technology poli- cies that promote the diffusion of technol- Striking the right balance between the ogy; an upgraded education and training three drivers of growth system that prepares workers to adopt and China’s recent policies have focused on the use new technologies; and an economy that third D, fostering discovery and new technol- is more open and integrated with the rest of ogies. Investments in new technologies can the world to facilitate access to global tech- have a large payoff for the country and con- nologies and innovations. tribute to pushing out the global technology The third and last D, fostering discovery frontier. New technology fields are also less of new innovation and technology, will help crowded than more established ones, pro- China to extend the global production fron- viding new opportunities to take a leading tier. The third D will become more critical position. At the same time, China remains, as China becomes richer and edges closer to on average, quite distant from the global the global frontier. It requires a more open, technology frontier and thus has substantial bottom-up, and collaborative national inno- remaining potential for catch-up growth (fig- vation system based on modern world-class ure 3.5). China could double its GDP simply universities, stronger intellectual property by catching up to Organisation for Economic rights, and a greater emphasis on basic “blue Co-operation and Development (OECD) sky” research. countries in its TFP. To take advantage of Governance and institutional reforms catch-up growth, China needs to pay suf- underpin the promotion of all three D’s. ficient attention to the first and second D’s, THE PRODUCTIVITY CHALLENGE 23 FIGURE 3.5 Total factor productivity (TFP) enhancing. Industrial policies that leverage relative to the global technology frontier, 2014 and promote market competition are particu- larly important for China, given its unique 2.0 context and large state presence. 2014 TFP relative to the United States 1.5 1.0 Adjusting the balance between the state and markets (log scale) The strategic choice is for the state to be 0.5 less market interventionist and more market China supportive and market augmenting. In China, state-owned enterprises (SOEs) are at the core of the coexistence between the state and the 0 market. SOEs will retain an important role in 0 50 100 150 China’s economy. Fair competition between Log of 2014 GDP per capita (PPP, thousands of 2011 US$) SOEs and non-SOEs ensures that the markets will select the most productive enterprises, Source: Calculations based on Penn World Tables 9.0 data. regardless of their ownership structure. Note: Red line is China’s TFP relative to the United States at similar levels of income per capita. PPP = purchasing power parity. Reaching a consensus with global partners on mutually beneficial reducing distortions in the allocation of pro- international trade and investment ductive resources and promoting the diffu- relations sion and adoption of existing technologies, production processes, and management prac- Global trade tensions have brought uncer- tices. The first and second D’s are likely to tainty and downside risks to the world produce significant payoffs for China’s imme- economy. A major risk for the world econ- diate future and remain the main drivers of omy is the potential weakening of the rules growth for some time to come. governing global trade and investment and the unraveling of global value chains. As the world’s largest trader and second-largest Ensuring that industrial policies economy, China can play an important role support market competition rather in working with global partners to achieve than supplanting it a common understanding on mutually ben- Since the early years of reform and opening- eficial global economic relations. China has up, China has used industrial policies to stated its opposition to protectionism and accelerate its catching up to the high-income advocates an open and inclusive global eco- economies. Those policies were often mod- nomic system and global partnership and col- eled on examples from other economies, laboration. It has taken steps to open up its such as Japan and the Republic of Korea, economy further, such as the recent introduc- although their outcomes in China, as else- tion of the national foreign investment nega- where, have been mixed. China is now at a tive list, which is the list of industries that more advanced stage of development, and a restrict or prohibit foreign direct investment new approach to industrial policies needs to (FDI). With China’s rise as a global economic be considered. Within China, industrial poli- and trading power, its contribution to the cies can undermine market competition when multilateral rules for global governance will markets are protected, and favored firms be critical. China could provide leadership in benefit from targeted support, contributing formulating international rules on FDI and to persistent overcapacity. The consensus in cross-border mergers and acquisitions that a high-income countries is that industrial poli- broad cross section of both high-income and cies, to be effective, need to focus on mar- low- and middle-income economies could ket failures and be market conforming and support. 24 INNOVATIVE CHINA Balancing supply-side reforms with to automation and artificial intelligence. demand-side reforms Historical experience suggests that employ- ment can expand with technology-induced China will need to rely less on investments productivity gains, but not necessarily in the and more on consumption for growth, while industries experiencing the technological maintaining robust aggregate demand. His- changes. Medium-skill routine jobs, many in torically, domestic household consumption manufacturing, seem to be at particular risk has played a relatively small role in driving of automation. Technological change also has China’s growth, reflecting its high savings a skills bias, favoring those with more skills rate (figure 3.6). But China’s share of con- and education, which could lead to rising sumption in the economy is already grow- income inequality. Moreover, recent techno- ing, and the government can accelerate this logical innovations tend to lead to a “winner growth by encouraging a lower household takes all” outcome, which further contributes savings rate through policies that would rein- to inequality. Finally, the share of labor in a force the social safety net, the pension system, broad range of economies has declined in and health insurance. Reforms of the house- recent decades, part of which can be explained hold registration (hukou) system would fur- by technological change. The impact of new ther enhance demand by bringing migrants, technology on jobs, income, and income dis- now some 15 percent of the urban popula- tribution can be gradual as technologies are tion, into the urban system. developed and adopted, but preparing for the future workplace needs to start now. Starting to prepare now for the future impact of technological changes Seven critical reform areas Policy makers need to start preparing China’s Addressing China’s key strategic challenges workers today for the impact of technology to promoting the three D’s requires a range on the future workplace. New technologies of structural, governance, and institutional and innovations can result in new employ- reforms. This report organizes the proposed ment opportunities, but many current jobs reform agenda into seven areas: may be displaced or require new skills, due • Reshaping industrial polices and support- ing market competition (chapter 4) FIGURE 3.6 Share of income and consumption in • Promoting innovation and the digital econ- GDP in selected countries, 2016 omy (chapter 5) • Building human capital (chapter 6) 80 • Allocating resources efficiently (chapter 7) • Leveraging regional development and inte- gration (chapter 8) 60 • Promoting international competitiveness Share of GDP (%) and economic globalization (chapter 9) 40 • Governing the next transformation (chap- ter 10). 20 Although the reform areas contribute to all three D’s, they differ in their impact on 0 them. Many reforms reduce distortion in China United Japan Korea, Rep. the economy by strengthening market com- States petition and improving factor allocation. Disposable income Household consumption Labor compensation Reforming innovation policies and build- ing human capital would benefit both the diffusion of existing innovations and the Sources: World Development Indicators and National Bureau of Statistics. discovery of new ones. Regional and global THE PRODUCTIVITY CHALLENGE 25 integration also would benefit diffusion of productivity) significantly improves. Scenario existing innovations, while greater market 2 represents “moderate reforms” and assumes competition and the promotion of entrepre- no significant changes in the quality of neurship would strengthen China’s capacity China’s institutions, policies, and other for generating new innovations. competitiveness factors (that is, no changes in the country’s relative long-term productivity). The impact of reforms on future Scenario 3 is a “limited reforms” scenario, in which a high level of accumulated debt growth further slows growth. It captures the risk of Reforms to promote the three D’s are expected a substantial and long-lasting slowdown in to have a significant impact on China’s future growth stemming from China’s debt overhang growth. For this report, China’s growth and assumes that the negative impact of a high prospects were estimated using a long-term debt burden on growth can be considerable, growth-forecasting model, based on the con- even in the absence of a financial crisis, ditional convergence literature. 3 No single consistent with empirical evidence. model can capture a country’s full spectrum The comprehensive reforms scenario of growth opportunities and challenges or the assumes that China will improve its GCI interactions between them, but the projec- score to the average of countries ranked in tions here provide a coherent and transparent the top 10 in the quality (not quantity) of its illustration of China’s plausible future growth infrastructure; tertiary education enrollment trajectories. The forecasting model assumes rate; domestic and foreign competition that a country’s long-run (steady-state) pro- (goods market efficiency); and pace of ductivity depends on the quality of its poli- technology adoption, including the use of cies, institutions, and other specific factors. ICTs. As expected for an upper-middle- The model therefore approximates the impact income country, China also has significant of policy and institutional reforms proposed opportunities for further improving its in this report. The World Economic Forum’s ranking in business sophistication and global competitiveness index (GCI) is used as innovation. Scenario 1 assumes that China a measure of the quality of institutions and will successfully implement reforms to close policies. the remaining gaps in the GCI with the top The GCI, a comprehensive set of indica- 10 performers by 2030. tors capturing the determinants of growth Under scenario 1, China’s GDP growth and competitiveness that have emerged from with comprehensive reforms is projected the literature, is strongly and positively cor- to slow from an average of 7.2 percent in related with the level and growth of produc- tivity (World Economic Forum 2014). The TABLE 3.1 Projected growth of GDP and labor productivity in 2017–18 Global Competitiveness Report China under three scenarios, 2001–50 ranks China as the 27th-most competi- Percent tive country in the world (World Economic Scenario 2001–10 2011–20 2021–30 2031–40 2041–50 Forum 2017). The growth-forecasting model Working-age population 0.5 0.1 −0.1 −0.4 −0.9 assumes that, once a country has reached its 1. Comprehensive reforms steady-state productivity, its labor produc- GDP growth 10.6 7.2 5.1 4.1 3.0 tivity will grow at the rate of technological Labor productivity 10.0 7.1 5.4 5.0 3.8 progress at the global technology frontier. If a country is below its steady-state labor pro- 2. Moderate reforms ductivity, its productivity will grow faster GDP growth 5.1 2.9 2.2 than technological progress until it “catches Labor productivity 5.4 3.9 3.0 up” to its long-run level. 3. Limited reforms The long-term projections are based GDP growth 4.0 1.7 2.3 on three scenarios (table 3.1). Scenario Labor productivity 4.3 2.7 3.0 1 represents “comprehensive reforms,” Sources: Calculations based on National Bureau of Statistics data and United Nations Popu- in which China’s GC I (and long-run lation Division 2017. 26 INNOVATIVE CHINA FIGURE 3.7 Projected gross national income (GNI) per capita in could potentially be as high as US$41,000 China, 2011–46 with comprehensive reforms or as low as US$27,000 with limited reforms. 60 Notes 50 1. The National Bureau of Statistics data used GNI per capita (thousands of US$) are for industrial firms with sales greater than 40 RMB 20 million. 2. The National Bureau of Statistics industrial enterprise survey data are currently available 30 to researchers only up to 2013. 3. Barro and Sala-i-Martin (2004) provide an 20 extensive overview of the theoretical and empirical literature on growth convergence. 4. The World Bank’s high-income threshold for 10 fiscal 2018 is set at US$12,236 GNI per capita. GNI measures the value added produced by a 0 country’s citizens plus the income of the coun- 2011 2016 2021 2026 2031 2036 2041 2046 try’s nationals earned abroad. The projections Limited reforms Moderate reforms Comprehensive reforms assume that the threshold will grow at the rate of long-term inflation of the special drawing Sources: Hubbard and Sharma 2016; calculations based on United Nations and World Devel- rights basket. opment Indicators data. Note: GNI per capita uses the Atlas method. Bibliography Adler, G., R. Duval, D. Furceri, S. K. Çelik, K. 2011–20 to an average of 5.1 percent in Koloskova, and M. Poplawski-Ribeiro. 2017. 2021–30 and 4.1 percent in 2031–40. By con- “Gone with the Headwinds: Global Productiv- trast, GDP growth would be 2.9 percent in ity” IMF Staff Discussion Note SDN/17/04, 2031–40 with moderate reforms under sce- International Monetary Fund, Washing- nario 2, and it would decline further to 1.7 ton, DC. percent with only limited reforms under sce- Au-Yeung, W., M. Kouparitsas, N. Luu, and nario 3. Similar differences can be expected D. Sharma. 2013. “Long-Term International for labor productivity growth. GDP Projections,” Australian Treasury Work- High-income levels are within China’s ing Paper 2013-02. Ball, L. 2014. “Long-Term Damage from the reach in the not-too-distant future in all three Great Recession in OECD countries,” Euro- scenarios. Based on the projections, China pean Journal of Economics and Economic is expected to attain high income status Policies: Intervention. Edward Elgar, 11(2) around 2023 under both the comprehensive 149–60. and moderate reform scenarios (figure 3.7).4 Barro, R. J., and X. Sala-i-Martin. 2004. Eco- China’s gross national income (GNI) per cap- nomic Growth. Cambridge, MA: MIT Press. ita, US$8,690 in 2017, is projected to double Brandt, L., K. Storesletten, and G. Kambourov. by around 2030 under both the compre- 2016. “Firm Entry and Regional Growth Dis- hensive reforms scenario and the moderate parities: The Effect of SOEs in China.” 2016 reforms scenario. Meeting Papers 182, Society for Economic A significant income gap opens up over Dynamics. Brandt, L., J. Van Biesebroeck, and Y. Zhang. the long term in the three scenarios. By 2050, 2012. “Creative Accounting or Creative under the scenario with moderate reforms, Destruction.” Journal of Development Eco- income per capita could be about 25 percent nomics 97(2) 339–51. greater than under the scenario with limited Brandt, L., L. Wang, and Y. Zhang. 2017. “Pro- reforms, and it could be an additional 25 ductivity in Chinese Industry: 1998–2013.” percent higher with comprehensive reforms. Background paper for this report, World Bank, This means that by 2050, GNI per capita Washington, DC. THE PRODUCTIVITY CHALLENGE 27 Cai, Y., and Y. Fu. 2017. “The Technical and United Nations Population Division. 2017. 2017 Structural Effects of TFP Growth: Measure- Revision of World Population Prospects. New ment and Decomposition Based on China’s York: United Nations. Macro and Sector Data.” Economic Research World Bank. 2018. Global Economic Prospects: Journal 52 (1), 72–88. Broad-Based Upturn, But for How Long? Conference Board. 2018.“Global Productivity on Washington, DC: World Bank. Upward Trajectory.” Conference Board (press World Economic Forum. 2014. 2014–15 Global release), March 26. https://www.conference Competitiveness Report. Geneva: World Eco- -board.org/press/pressdetail.cfm?pressid=7372. nomic Forum. Foda, K. 2016. “The Productivity Slump: A ———. 2017. 2017–18 Global Competitiveness Summary of the Evidence, Global Economy Report. Geneva: World Economic Forum. and Development at Brookings.” Retrieved Wu, H. X. 2011 “Accounting for China’s Growth from https://www.brookings.edu/wp-content in 1952–2008: China’s Growth Performance /uploads/2016/08/productivity-evidence.pdf. Debate Revisited with a Newly Constructed Hsieh, C.-T., and P. J. Klenow. 2009. “Misallo- Data Set,” RIETI Discussion Paper 11-E-003. cation and Manufacturing TFP in China and ———. 2017. “China’s Institutional Impediment India” Quarterly Journal of Economics, Vol. to Productivity Growth: An Industry-Origin CXXIV, Issue 4. Growth Accounting Approach.” Informal. Hubbard, P., and D. Sharma. 2016. “Understand- Young, A. 1995. “The Tyranny of Numbers: Con- ing and Applying Long-Term GDP Projec- fronting the Statistical Realities of the East tions.” East Asia Bureau of Economic Research Asian Growth Experience.” Quarterly Journal Working Paper No 119. of Economics (110) 641–80. National Bureau of Statistics. Enterprise survey ———. 2003. “Gold into Base Metals: Productiv- data. ity Growth in the People’s Republic of China Tian, X., and X. Yu. 2012. “The Enigmas of TFP during the Reform Period.” Journal of Political in China: A Meta-Analysis.” China Economic Economy 111(1) 1220–261. Review 23 (2) 396–14. 4 Reshaping Industrial Policies and Supporting Market Competition Industrial upgrading was an important driver economy offers significant potential to boost of growth in China in past decades. During productivity by improving manufacturing this period, China experienced a significant processes as well as enhancing the agri- structural transformation. The share of agri- culture and services sectors. Although the culture sector value added in gross domestic share of agriculture can be expected to product (GDP) declined from 27.7 percent continue to decline, the industrialization in 1978 to 7.2 percent in 2018. In the same and servicification of agriculture can be an period, the share of industry declined from important source of productivity growth in 47.7 percent to 40.7 percent, and the share the future by expanding agricultural value of services rose from 24.6 percent to 52.2 chains to agroprocessing and food services. percent. China also experienced industrial To promote industrialization, many coun- upgrading within sectors. The share of low- tries have used industrial policies through- technology manufacturing to total manufac- out their history. Market failures, coordina- turing declined from 29.4 percent in 1999 tion externalities, technology spillovers, and to 24.6 percent in 2017, and the share of dynamic productivity gains have been the medium-technology manufacturing industry main justifications for targeted industrial rose correspondingly. policies. However, researchers have expressed China still has a high potential for doubts about the effectiveness of industrial industrial upgrading. Industry competitive- policies. To implement targeted industrial ness can be enhanced through greater policies effectively, policy makers need to be “servicification” of manufacturing and able to identify the market or government the application of new technologies. The failures that have held back an industry from government sees considerable scope for developing. Often, this identification requires China to leverage product quality as a new some judgment on the degree of hard evi- driver of manufacturing growth. For services, dence required to justify supporting a specific “modern” services are increasingly traded industry. internationally, facilitating scale economies Even if justified, targeted industrial sup - and technology diffusion and creating port does not guarantee success. For indus- new opportunities for growth. The digital tries to become internationally competitive, 29 30 INNOVATIVE CHINA policy makers need to identify the country’s industrial policies are in place, incentives and comparative advantages correctly and to the political economy can make it difficult to develop and implement a credible support adjust or abandon them. plan effectively. Doing so is becoming Governments in other high-income coun- increasingly difficult in light of the rapidly tries have supported specific technologies and changing landscape of technology and industries, particularly by targeting research globalization, heightening the risks of betting and development (R&D). In the United States, on the wrong industry or technology. For government agencies such as the Defense example, new labor-saving technologies in Department’s Defense Advanced Research a more integrated global environment can Projects Agency (DARPA) and the National rapidly weaken the competitiveness of a Institutes of Health provided critical financ- country’s labor-intensive industry. ing for key technologies that contributed to East Asian economies that succeeded in the growth of the biotechnology industry, the becoming high income, such as Japan and Internet, and the Apple iPhone.1 The Euro- the Republic of Korea, used targeted indus- pean Commission’s Industry Policy Strat- trial policies widely and actively, at least in egy emphasizes horizontal policies, such as the early stages of their development. They improving the information and communica- combined greater integration with the inter- tion technology (ICT) infrastructure, intellec- national economy and heavy government tual property rights, and upgrading of work- involvement in nurturing industries and com- force skills. These policies are complemented panies. However, there is skepticism about by support for key enabling technologies the effectiveness of selective interventions and industries—such as the space, defense, to promote specific industrial sectors, and automotive, and steel industries—including many observers note the widespread failure through various funds, such as the European of interventionist industrial policies across Structural and Investment Funds (five funds other countries and regions. Some observers worth more than €450 billion) and Horizon attribute the successful development of East 2020 (€77 billion for 2014–20). Some Euro- Asian countries more to good fundamental pean Union (EU) countries also have national macroeconomic policies, competent govern- industry promotion strategies, most notably ments with good capacity, and high invest- Germany’s Industry 4.0, that promote manu- ment rates in physical and human capital and facturing upgrading by increasing the digiti- less to targeted industrial policies. zation and interconnection of products, value East Asian economies also modified chains, and business models. their policies as they became larger and Promoting industrial development has more complex and transitioned to a more been a major priority for China, with an k nowledge- and tech nolog y-intensive emphasis on promoting science, technology, economy. T hey reali zed that heavily and innovation. The outline of the National interventionist industrial policies had to Medium- and Long-Term Science and Tech- be modified at later stages of development. nology Development Plan (2006 –2020) This approach typically involved reducing provides a blueprint for strengthening the “vertical” industrial policies that target country’s scientific, technological, and inno- specific sectors and firms and instead vation capabilities. It emphasizes the promo- transitioning to more “horizontal” policies tion of indigenous or independent innovation, that improve factor markets and the broader through the absorption and “re-innovation” business environment. Some observers credit of foreign technology and the nurturing of the the success of East Asian countries more to national innovation system to produce original horizontal learning strategies and less to innovation. Manufacturing 2025 outlines an sector targeting (Cirera and Maloney 2017). ambitious plan for “techno-industrial” poli- This evolution of industrial policies indicates cies to promote a multitude of advanced indus- that it is important for countries to know tries and technologies, such as information when to phase out previously successful technology, new energy, and new materials for industrial policies. The challenge is that once China to modernize its industries and become RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 31 a leading manufacturing power. The plan heavy industry sectors in China (box 4.1). calls for market-oriented and government- Without competitive pressure, firms have led development that gives markets a decisive little incentive to invest in innovation and role in allocating resources, creates a stable technological upgrades or to differentiate environment for business, and actively trans- themselves from their competitors. Industries forms government functions. such as the automobile and wind turbine sectors could benefit from more open Industrial policies to support competition. This chapter proposes reforms specific to market competition industrial policies. The main proposals are China is evolving as its economy grows to (a) focus and streamline industrial poli- beyond middle income and increasingly cies; (b) improve government-industry dia- approaches the global technology frontier. logue and the monitoring and evaluation of Industrial policies can continue to play an industrial policies; (c) instill greater discipline important role as China becomes a high- in local governments’ support for industries; income country, but the policies will need to and (d) ensure timely exits of nonviable firms. evolve to deal with expanded and more com- Industrial policies, however, need to be con- plex markets and increasing technological sidered in the context of the broader set of uncertainty and unpredictability. complementary reforms. To analyze industrial policies in China, case The broader reform agenda encompasses a studies were conducted of automobiles, mobile wide array of reforms: reforms of innovation phones, semiconductors, and renewable promotion that target support for specific energy (solar and wind), with a focus on technologies; reforms of the services sector policies to promote technology and innovation to remove barriers to entry; reforms to (Sturgeon and Thun 2018; Kuriakose et improve the business climate by shifting al. 2017). These industries benefited from the policy focus from vertical to horizontal significant growth of domestic demand and interventions; reforms to promote market targeted state support over the years, and they competition and anti monopoly policy to embody the global technology and innovation ensure fair competition; and reforms of upgrading long sought by the government. foreign direct investment (FDI) policy to Each industry differs in the type of technology address the requirements for joint ventures used and market structure, but cross-cutting and technology transfer policies. These themes emerged from the analysis. reforms are discussed throughout the report, The key message is that industrial policies, but at the core is the need to promote market to be effective, have to be less distortionary competition. State-owned enterprise (SOE) and support and complement market reforms are particularly critical for China, competition. Industrial policies are less given the importance of SOEs in its economy. effective when they undermine open and fair market competition. They can lead to too little Focusing and streamlining industrial competition when markets are protected and policies favored firms benefit from targeted support and can lead to “too much” competition when Industrial policies need to be selective, support for industries and firms produces focused, and streamlined. In China, the cen- persistent overcapacity. By constraining tral authorities formulate policies, but local market mechanisms, both outcomes hinder governments implement them, since much efforts to promote technology and transition of government spending is local. Local offi- to innovation-led growth. cials are, in theory, agents of the central gov- With too little competition, firms can ernment, making them highly responsive to enjoy profits by capturing the rents from central policies and objectives, and they try protected markets, which can contribute to demonstrate that they are actively imple- to overinvestment and excess industrial menting central policies. But they also enjoy capacity, as experienced by some of the some degree of autonomy and discretion, so 32 INNOVATIVE CHINA BOX 4.1 Industrial excess capacity in China China has experienced chronic excess capacity in which included reducing 150 million tons of crude its industry sector. Industrial capacity utilization steel capacity and 800 million tons of coal capacity rates in China have been consistently below 80 per- over 2016–20. Measures included setting targets for cent since the global financial crisis (figure B4.1.1). capacity reduction of central state-owned enterprises Although excess capacity usually occurs during an (SOEs), strengthening environmental and energy effi- economic downturn due to weak demand, the per- ciency standards, suspending production in mining sistence of excess capacity in China cannot be fully and raw materials sectors during peak heating sea- explained by demand-side factors. Rather, overin- sons, limiting financial supply to overcapacity sec- vestment appears to be the fundamental problem tors, and restructuring or liquidating inefficient enter- that led to excess capacity in China, which was exac- prises. Strong government actions during 2016–17 erbated by a massive fiscal stimulus carried out in appears to have had a significant impact on curbing response to the global financial crisis. Excess capac- excess capacity. As a result, industrial capacity utiliza- ity affected the heavy industries, such as ferrous and tion rates recovered, rising to 78 percent in 2017, the nonferrous metals, chemicals, and transport equip- highest rate since 2013. These actions, together with ment manufacturing. The government understands ongoing efforts to restrict industrial production in that it needs to deal with excess capacity to enhance polluted sectors, helped to lift prices and contributed the efficiency of the industry sector and to improve to the growth of corporate profits in China in 2017. the quality of economic growth. However, challenges remain to reduce excessive In 2015, China’s authorities introduced a compre- capacity further. While the focus has been on eliminat- hensive program aimed at reducing excess capacity, ing existing capacity, some firms have been building new capacity. Policies have so far focused mainly on reducing the capacity of large SOEs through admin- FIGURE B4.1.1 Industrial capacity utilization rates in China, 2013–19 istrative measures, but such measures are less binding on private producers. Finally, reducing excess capacity 79 requires winding down inefficient enterprises through 78 bankruptcy and closure and resolving the correspond- 77 ing increase in bad debts, as well as removing market- distorting policies, such as subsidies that promote the 76 emergence of new capacity. However, the number of 75 bankruptcies tends to be comparatively low in China. Percent 74 With too much competition, an industry suffers 73 from persistent overcapacity, and firms compete on low price and low quality. The resulting lower prof- 72 itability reduces incentives to innovate by eroding 71 payoffs to new technology and reducing the amount 70 of resources available to invest in R&D. If the sec- tors are exporting, persistent overcapacity can also 3 13 14 14 15 15 16 16 17 17 18 18 19 01 20 20 20 20 20 20 20 20 20 20 20 20 2 ar. p. ar. p. ar. p. ar. p. ar. p. ar. p. ar. lead to international trade disputes and accusations of Se Se Se Se Se Se M M M M M M M Source: National Bureau of Statistics. “dumping,” as with photovoltaics. policy implementation can be uncoordinated W hat are some general criteria for and have consequences unintended by central streamlining industrial policies? The typical authorities. Streamlining and focusing arguments are to focus on market failures industrial policies would reduce unintended and externalities—which would generally and uncoordinated local responses and favor promoting innovation and technologies facilitate central government monitoring and that are new and have significant potential management of local policy implementation. for information and technology spillovers— It would also help make policy interventions rather than to focus on specific industries or more coherent, transparent, and predictable. firms. For industrial policies that focus on RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 33 particular industries, the government could be improve the transparency and inclusivity of more disciplined and selective in identifying the dialogue as well as facilitate the collection the targeted industries to support. It could and dissemination of information. ensure that the support is not concentrated on a few firms in any sector, emphasize new Instilling greater discipline in local firm entry, encourage younger enterprises, governments’ industral policies and and phase out support for noncompetitive ensuring that all types of businesses firms in a timely manner by ensuring that can enjoy equal support the support has clear sunset clauses and performance criteria (see also Aghion et al. Reform of industrial policies requires 2012). These clauses and criteria would help addressing the role of local governments to ensure that the benefits of policy support and central-local dynamics. To carry out are justified by the costs of the support. industrial policies, local governments have Even where industries have been promoted provided support to local firms through successfully in technological upgrading, the financial subsidies, tax deductions, subsidized costs may have been too large and spending interest, and public venture capital. They too inefficient. Rigorous evaluations of have provided land at a discount and helped industrial policies are needed that compare local firms deal with permits and approvals. benefits with the costs of providing support, They also have established high-technology including all direct and indirect support development zones, science parks, and, more provided to specific industries and firms. recently, technology incubators (Breznitz and Murphree 2011; Heilmann, Shih, and Hofem 2013; Zhou 2008). It is generally Improving government-industry acknowledged that competition among local dialogue and monitoring and governments and their experimentation evaluation of industrial policies and initiatives have contributed to the An institutional framework that improves country’s rapid growth, complementing and the f low of govern ment-indust r y compensating for the underdeveloped private information in an inclusive and transparent sector in the earlier stages of development. way is important to identify key market But with the expansion of the private sector constraints and failures and to monitor and the need to transition to more innovation- the impact of industrial policies. This intensive growth, local governments need to public-private d ialog ue is i mpor ta nt evolve along with industrial policies. because the private sector is likely to have Efforts to reform local government better access to policy-relevant market incentives and behaviors need to preserve information, and therefore a wide range of the positive elements of local initiatives while private sector actors helps to make the process tempering the excesses. Local government effective. Such dialogues were considered a support for local industries has at times key factor in the success of industrial policies resulted in excessive entries of new firms in Japan and Korea. The dialogues can and inadequate exits of failing firms due to be used to seek out new investment ideas, continued support and protection provided achieve coordination among different state by local governments. This situation has agencies, and push for necessary regulatory contributed to persistent overcapacity changes. and oversupply in various industries. This An institutionalized process for government- excessive supply has also been accompanied industry dialogue has to ensure that the risks by local protectionism and the fragmentation of corruption and state capture by industries of industries, at times hindering the formation are adequately managed. Public transparency of national markets, standards, and new of information and regular evaluation of technologies, and resulting in considerable the effectiveness and efficiency of industrial waste. Market fragmentation also has led policies can be helpful in this regard. New to rent dissipation and suboptimal scale, types of ICT and web-based platforms can reducing the resources for R&D and the 34 INNOVATIVE CHINA incentives to innovate because local firms are on EU restrictions regarding support for protected from competition. local enterprises. The new regulations The incentives of local governments con- should address the need to discourage tribute to market fragmentation. China has local protectionism, such as for electric a centralized cadre management system, vehicles, which dampens competition and through which individual positions and fragments the national market, and hinders careers of government officials are managed. national standardization and diffusion The cadre management system has tradition- of technology. To facilitate enforcement, ally evaluated the performance of local offi- industrial policy needs to be transparent and cials based largely on local economic growth. relevant information made publicly available. Thus, local officials have had strong incen- Performance criteria and clear sunset clauses tives to promote local economic growth, would help ensure that those industries which has led at times to local protection- and firms that are unable to improve their ism and reluctance to allow local firms to competitiveness lose access to support. fail, hindering market adjustment to indus- Government guidance funds have become trial oversupply. In response, the government an important source of local government sup- has broadened the performance evaluation port for local enterprises. Professionally man- criteria of local officials beyond the growth aging and operating the funds in a market- of local GDP, in an effort to reflect “high- oriented way would help to ensure that the quality” growth.2 With the expansion of the funds support market competition and criteria, the challenge is to ensure that local innovation. At an estimated RMB 5.3 trillion officials do not continue to perceive targets (early 2017), the funds dwarf government for local growth as being the most important. appropriations for science and technology The disparities between local revenues and for nationwide spending on R&D and expenditures create further incentives (Divakaran and others 2017). With the for local governments to hold onto local sizable mobilization of funds, the challenge enterprises. Subnational governments are is to ensure an adequate number of good typically responsible for about 85 percent investment opportunities. With regard to of public expenditures, but central transfer high-technology investments, the scarcity of payments account for less than 50 percent engineering and managerial skills may be a of local expenditures. Most of the remaining more binding constraint than financing. gap is financed by other local revenues, such as local shared tax and debt finance (China Ensuring the timely exit of nonviable Ministry of Finance). For the major taxes firms shared between the central and local govern- ments (value-added tax and corporate and China has a comparatively low rate of firm personal income taxes), the portion allotted exits (figure 4.1). Ensuring that noncompeti- to local governments is based on the location tive firms exit markets is necessary for market- of tax collection (derivation-based revenue supportive industrial policies to work. A more sharing). This incentivizes local governments active market-led bankruptcy and corporate to promote local enterprises. Reforms of the restructuring regime is needed that would dis- tax rules could help address the disparities in tinguish viable and nonviable companies and local budgetary revenue and expenditures, address them accordingly, by reorganizing accelerate reforms of intergovernmental fiscal the former and liquidating the latter, includ- relations, and also encourage local govern- ing zombie firms. Lenders and firms need to ments to compete based on the provision of recognize a firm’s insolvent state early. The quality public services, rather than by sup- regulatory and supervisory framework needs porting local enterprises. to ensure timely recognition, since banks are On the expenditure side, limits to the type often reluctant to resolve overindebted bor- and extent of support that local governments rowers and to dispose of distressed loans. can provide to local enterprises could be Otherwise, the banks’ capacity to provide specified more clearly and concretely—and fresh loans to the economy remains locked in could be better regulated, perhaps modeled nonviable, loss-making firms at the expense RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 35 FIGURE 4.1 Annual number of insolvency cases debtors and creditors negotiate settlements, in selected countries, 2017 local gover n ments cou ld promu lgate nonbi nd i ng g u ideli nes t hat d raw on 25 23,591 international examples, such as the London Approach popular in the United Kingdom in the 1970s and 1980s and, more recently, the 20 International Association of Restructuring, 16,502 Insolvency, and Bankruptcy Professionals 15 (I NSOL) Principles for Multi-Creditor Thousands Workouts (International Federation of Insolvency Professionals 2000). For out- 10 8,371 8,447 of-court workouts, some countries have prepackaged reorganizations, “prepacks,” to 5,665 grant an accelerated channel for reorganiza- 5 tion and to prevent very few creditors from withholding support in an attempt to extract 0 exorbitant terms. United United China Romania Japan States Kingdom The China Banking Regulatory Commis- sion issued notices in 2016 and 2017 (the Source: Online official statistics for each country, available as of Creditor Committee Guidelines) that require November 2017. lenders of a distressed borrower to form credi- tor committees.4 The guidelines regulate the of new, more vibrant ones. Once banks rec- operation of such committees and the types of ognize problem loans, they need to distin- enterprises to restructure. They also recom- guish viable and nonviable debtors, based on mend intercreditor agreements to document financial strength and prospects. A standard terms agreed on as part of a workout. But methodology, such as that used by European they fall short of encouraging restructurings. countries after the global financial crisis, pro- Multicreditor workouts seem compara- vides a good basis for such assessments. But tively rare, for various reasons. The Creditor qualitative judgments are also important. Committee Guidelines appear to be purely China’s Enterprise Insolvency Law largely voluntary, and creditors may have incentives adheres to international good practices, to dispose of their distressed loans rapidly, but it has several drawbacks. Procedures which would be quicker than engaging in are quite costly. Creditors are excluded lengthy restructurings. The guidelines do from participating in making important not seem to be accompanied by legal or decisions during insolvency proceedings. regulatory incentives for banks to engage in And the law does not contemplate priority workouts, and they do not seem to encourage for fresh financing, cross-border provisions, workouts to happen organically within a or prepackaged (hybrid) restructurings. Nor predictable general framework. Instead, they does the law have specific provisions for the are considered on a case-by-case basis. A insolvency of corporate groups. The number general framework could be introduced for of cases for insolvency and for business restructuring distressed loans, with interbank restructuring and reorganization is relatively agreements that bind dissenting creditors small in China, and a majority of bankruptcy in the workout. Such a framework could proceedings end in liquidation (85 percent of be accompanied by temporary tax breaks resolved insolvency cases).3 The insolvencies and other provisions to encourage banks to are often initiated as a last resort, when engage in such restructurings, as provided in the companies are already in an untenable Korea, the Philippines, and Turkey. financial state, and it is too late to consider When informal or hybrid proceedings restructuring. fail, debtors and creditors have recourse to One way to promote the restructuring a formal, court-driven reorganization, the of viable firms is to take fuller advantage type of proceeding envisaged under China’s of informal workout procedures. To help Enterprise Insolvency Law. When a firm 36 INNOVATIVE CHINA is fundamentally nonviable, the objective China’s economy has been increasing recently, should be to convert the assets of the firm reaching 52.2 percent in 2018, a large part to cash as quickly as possible through a of this rise has been due to the growth of collective proceeding (rather than individual financial services and real estate. There is debt enforcement). Countries with systems still potential for further development of the that do this effectively have several common services sector, particularly higher value- features. First, the test for when a company added services—such as R&D, ICT-related can be put into such a procedure is clearly services, and consumer services—which will laid out, most often based on the firm’s cash be increasingly demanded by a growing and flow. Second, creditors are given a large say more consumption-driven economy. in who administers the process and how they Internationally, the integration of ser- do so, which helps to maximize value since vices with manufacturing and agriculture is their economic interests are at stake. Third, increasingly viewed as a key contributor to the court can reverse transactions that are economic growth and development. High- on noncommercial terms (such as asset sales income countries tend to use more inputs to related parties at less than market value) from the services sector, which can help to or that unfairly favor one creditor. Ensuring promote greater specialization within indus- speedy access to a court, promoting a culture try sectors by outsourcing services and focus- of restructuring in the business and legal ing on core competencies. communities, and expanding the number In China, the contribution of service of regulated restructuring professionals and inputs to productive sectors is low relative to specialized courts would also support market- that in other countries (figure 4.2). The con- led bankruptcies and corporate restructuring. tribution of traditional services, such as dis- tribution and transport, to manufacturing is relatively higher than more modern services. Promoting greater competition Taking further advantage of some of the more in the services sector modern services—such as R&D, business, A more vibrant and competitive services sector and digital services—could help to upgrade can contribute significantly to productivity China’s manufacturing even further. These growth. Although the share of services in modern services have a high impact on eco- nomic development because they have a high value-added and are easily tradable, such as FIGURE 4.2 Inputs into productive sectors in selected countries, 2011 through the Internet, which considerably reduces trade costs. In particular, new digital 100 technologies—such as the Internet of Things, 90 cloud computing, and Big Data—are driv- ing new innovations in China’s services sec- 80 tor. China now has the largest e-commerce 70 market in the world, providing new oppor- 60 tunities for suppliers and consumers to con- Percent 50 nect to markets. But although digital services 40 have been growing in China, unlocking their 30 potential requires strengthening their link- ages with manufacturing. 20 Reducing restrictions in the services sector 10 would help to promote greater competition 0 and growth of services. The globalization China Korea, United Germany Japan Mexico India Brazil Rep. States of services also enables China to tap into Services Manufacturing Primary production services as a source of growth. The Services Trade Restrictiveness Index (STRI) of the Source: Calculations based on Organisation for Economic Co-operation and Development Organisation for Economic Co-operation and (OECD) Trade in Value Added (TiVA) data. Development (OECD) indicates that market RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 37 restrictions on the services sector in China services to majority foreign ownership are are in line with those in some of the other welcome, but more could be done. Reform major upper-middle-income countries— measures would need to be designed such as Brazil, India, Indonesia, the Russian according to the type of market restrictions Federation, and Turkey—but are more affecting each subsector, because the types restrictive than those in OECD countries of restrictions vary significantly across the (figure 4.3). The difference with OECD services sector. Market restrictions can countries is mostly due to higher restrictions target either firm entry or firm operations. on foreign entry. Other types of restrictions S T R I i nd ic ate s t hat i n C h i na ent r y are aligned more closely with those in OECD barriers seem to matter more for business, countries, although a gap remains between telecom munications, and IC T-related China and the better-performing countries. services, while operations barriers appear to FDI restrictions affecting firm entry in be more important for transport and logistics China are mainly those that limit foreign services. equity holdings, followed by screening and Reducing restrictive barriers in services approval restrictions. OECD’s product wou ld need to be complemented by market regulation indicators for China are regulatory governance reforms to sustain the also relatively high for barriers to trade and impact of the reforms and address regulatory investment, barriers to entrepreneurship, and uncertainty identified by both foreign and the degree of state control. domestic investors as critical for doing China could open more services to pri- business in China. An improved regulatory vate investment, to expand opportunities governance framework would allow for for competitive and innovative private continuous revisions and systematic fine- companies. Opening up the services sector tuning of regulations after the initial reforms. further, by reducing market barriers to Chapter 10 discusses regulatory governance FDI, would promote a more attractive reforms overall. Regulations for the services domestic environment for investment. Recent sector would need to account for fundamental announcements of the opening of financial market failures specific to each subsector, FIGURE 4.3 Services Trade Restrictiveness Index in selected countries, 2017 0.6 0.5 0.4 0.3 0.2 0.1 0 es n ey e il y m an p. ico a a da ce ca ia an az di in ag io es Re do at fri an rk p na ex Ch In at Br rm er Ja n St Tu hA ng Fr a, Ca er M do av Ge re d d Ki ut In ite CD Fe Ko d So Un ite ian OE Un ss Ru Restrictions on foreign entry Regulatory transparency Restrictions on movement of people Other discriminatory measures Barriers to competition Source: Organisation for Economic Co-operation and Development (OECD) Services Trade Restrictiveness Index. Note: Higher scores indicate that services trade is more restrictive. 38 INNOVATIVE CHINA such as asymmetric information in finance, FIGURE 4.4 Number of new enterprises natural monopolies in network industries, registered annually in China, 2013–18 such as telecommunications and digital platforms, and public good characteristics 8 in education and health services. Strong and 6.7 7 effective institutions and regulatory bodies 6.1 New enterprises (millions) would be required to address such market 6 5.5 failures. 5 4.4 4 3.7 Promoting entrepreneurship and 3 2.5 improving the business climate 2 Entrepreneurship has been a key driver of 1 China’s economic growth since the 1980s. 0 New firms have been a source of improved 2013 2014 2015 2016 2017 2018 products and services and competitive pres- sure on incumbents, thus contributing to Source: State Administration for Industry and Commerce. higher productivity. The first major wave of entrepreneurial activity occurred in the 1980s, when reform in agriculture led to the enterprises accelerated to 19.3 percent, from emergence of township and village enter- 9.5 percent in 2008–13. In 2016, 15,100 prises, created by entrepreneurial farmers enterprises were registering daily, up from in the legal form of collective ownership. 2,376 in 2013. The number of “market par- The second major wave crested after the late ticipants,” including all enterprises as well 1990s, when domestic private enterprises as business individuals (getihu) and farmers emerged, fundamentally reshaping the struc- associations, increased 44 percent between ture of the Chinese economy. 2013 and 2016 (State Administration of The third, and current, major wave is Industry and Commerce 2017). being propelled by the Mass Entrepre- With the surge in business creation, more neurship Initiative, launched in 2015 (box systematic collection and analysis of relevant 4.2). The initiative aims to remove insti- data would allow the government to assess tutional barriers to mobilizing and real- the impact of the initiative on new firm izing the entrepreneurial spirit of the Chi- entries as well as exits and the contribution nese people. A wide range of national and to economic growth. For example, part of subnational policies has been put in place the increase in the registration of private to promote entrepreneurship, notably in enterprises may stem from a change in the supporting targeted groups of the popula- registration category of private businesses, tion (such as university graduates, staff of from informal getihus to private enterprises R&D institutions, and migrant workers); (box 4.2). If confirmed, the surge in promoting venture capital, microlending, business registration may be overestimating guarantees, and leasing; providing support the creation of new private enterprises, infrastructure such as incubators, cowork- particularly those with potential for further ing spaces, and accelerators; supporting growth and expansion. Addressing such entrepreneurial training and advocating questions would allow policy makers to an entrepreneurial culture; providing tax understand which policy measures worked exemptions to micro and small enterprises; and to what extent. helping these enterprises access government Roughly 50 0 entrepreneurs in five procurement; and implementing business Chinese cities surveyed for this report regulatory reforms. indicated that the most effective elements The Mass Entrepreneurship Initiative has of the Mass Entrepreneurship Initiative are seen a surge in business creation. In 2014–16, those that improve the overall local business the average annual growth in the number of environment and promote competition RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 39 BOX 4.2 Impact of the Mass Entrepreneurship Program in Guangdong Province This report carried out a preliminary assessment have decided to register as firms rather than as getihu, of firm entry and exit in Guangdong Province using a result of business registry reforms that lowered reg- the business registry. There has been significant istration costs. This could explain some of the accel- growth in the establishment of new firms over time, eration in the number of new firms in labor-intensive primarily in the private sector and in services. This services such as wholesale and retail trade and the growth could reflect various elements of the Mass secular decline in average firm size in the sector. Entrepreneurship Initiative, particularly reforms of After initially rising, exit rates for firms recently the business registry, which have lowered the costs declined sharply. But falling exit rates could also of setting up new firms. reflect reforms of the business registry that may have There has been a marked reduction in the size of increased the cost of exit. A rising number and per- new start-ups, particularly in services. Data on the centage of firms with zero sales (“zombie” firms) also establishment of getihu (small, individual-run enter- indicate that the cost of exit may have been a fac- prises in the informal sector) show a pronounced tor. The extent to which declining exit rates reflect a increase in their absolute number through 2017, but real decline could have implications for productivity then a leveling off. As a result, their share of new if resources are tied up in less productive firms that establishments (firms plus getihu) fell after 2017. One require government and bank support to remain in possible explanation is that new business owners may operation. Source: Brandt and Zhang 2017. and talent migration, rather than direct in its region, and again in 2019 for making government subsidies or financing. In the greatest improvement in its “distance to China, enterprises in provinces with faster frontier” score between 2002 and 2015. As diffusion of technology benefited from a result of these reform efforts, China is now fundamental reforms of the enabling business ranked 46th globally. But Doing Business environment, a good education system, indicators also show that administrative and effective governance. By contrast, the and regulatory burdens remain high—and level, composition, and source of R&D that reforms to deal with permits, get credit investments had quite modest effects on (secured transactions), pay taxes, and resolve enterprise technology adoption. Provinces insolvency could all improve the business getting basic policies right also do well in climate (figure 4.5). exploiting the benefits of technology. Case China could consider carrying out com- studies of old industrial regions in the United prehensive reforms to improve the business States, carried out for this report, concluded climate. Reform programs would need to that an enabling environment was more define clear objectives related to the long- important for economic revival than subsidies term strategic vision of the country. Suc- or tax incentives to companies. Also, strong cessful governments generally follow a lon- public-private partnerships were important ger-term agenda that aims to increase the for designing, financing, and implementing competitiveness of the economy. Adopting a regional revitalization programs, including more comprehensive approach increases the programs to develop entrepreneurship chances of success and impact, given that and to provide higher education, research, reforms in different areas tend to be comple- and vocational training, backed by public mentary. Colombia, India, Mexico, Russia, investments. and the United Kingdom all incorporated China improved its business climate business regulation reforms into a broader as measured by the World Bank’s Doing competitiveness agenda. Clear, evidence- Business indicators. 5 China was recognized based frameworks for prioritization are criti- in Doing Business 2013 as the top improver cal to translating the long-term vision into a 40 INNOVATIVE CHINA FIGURE 4.5 Doing Business’s distance to frontier and the rankings for China and comparators, 2019 a. Distance to frontier b. Rank (Scale: score 0 center, 100 outer edge) (Scale: Rank 190 center, 1 outer edge) Starting a Starting a business Dealing with business Dealing with Resolving construction Resolving construction insolvency 100 permits insolvency 1 permits Enforcing Getting Enforcing Getting 0 electricity electricity contracts contracts 190 Trading Trading across Registering across Registering borders property borders property Paying taxes Getting Paying taxes Getting credit credit Protecting Protecting minority minority investors investors China High-income OECD BRICS (excluding China) Source: World Bank Doing Business database. Note: BRICS = Brazil, Russia, India, China, and South Africa. reform program with specific objectives and reforms, innovation, and other policy activities. matters affecting the private sector. The Successful countries establish reform council included ministers and heads of structures, with various degrees of institu- government research agencies, private sector tionalization. Effective structures involve representatives, academics, and members of releva nt publ ic agencies a nd private civil society, such as labor representatives. representatives and create clear mechanisms Its responsibilities include identifying reform to ensure coordination and information priorities, preparing an implementation flows among all parties. Many countries road map, and helping to coordinate establish high-level oversight committees or implementation. public-private councils that prioritize the Consultations with private firms have reform agenda and maintain the momentum been used widely to identify reform priorities. of reforms. Technical working groups then Korea, Russia, and the United Kingdom have lead implementation at the agency level, with used a bottom-up approach involving private representatives from all key agencies as well sector stakeholders. Korea established the as knowledgeable members of the private Public-Private Regulatory Reform Task Force sector. Of the seven countries analyzed for to strengthen the interaction between the this report that carried out comprehensive Presidential Council on Competitiveness and business climate reforms, all established the private sector and to accelerate reforms. high-level oversight mechanisms, technical The task force identifies burdensome working groups, and a coordinating unit. 6 regulations through consultations with Some created new institutions and public- businesses and formulates concrete reform private bodies to anchor the agenda for proposals in collaboration with relevant business environment reform, usually government entities. It also monitors monthly within a broader mandate to promote progress on the issues raised by businesses competitiveness. In 2008, Korea established and identifies bottlenecks in implementation. the Presidential Council on Competitiveness In the United Kingdom, the Business to advise the government on regulatory Reference Board systematically consults RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 41 with the private sector. This public-private workdays to 8.5. The government plans to mechanism involves triannual meetings with introduce this reform in five cities—Dalian, 97 business organizations representing more Ningbo, Qingdao, Shenzhen, and Xiamen— than 750,000 members. It seeks a frank to be followed by a national rollout. Measures dialogue on regulation and enforcement to reduce the time required for government issues with sector business associations. approval of construction projects from In addition, the United Kingdom uses the the current average level of more than 200 Business Perceptions Survey as a key source workdays to 120 workdays will be piloted of data on business views regarding the U.K. in 15 cities, including Beijing, Shanghai, and regulatory environment. In 2011, the U.K. Tianjin, as well as in Zhejiang Province.7 government also launched the Red Tape In February 2019, a state council executive Challenge, an effort to review the country’s meeting, chaired by Premier Li Keqiang, stock of more than 21,000 active statutory announced that China’s central government rules and regulations. Using a public website, would eliminate, or delegate to lower- the government gathered the views of the level authorities, more items that require business community and the public from government approval and also implement April 2011 to April 2013, reaching its goal of nationwide the reform of the construction- identifying 3,000 pieces of regulation to be project-reviewing system. scrapped or improved (World Bank 2012). China could introduce subnational business Given the significant increase in new climate indicators, made publicly available to firm entries in China, business climate induce competition among local governments reforms can now focus on improving the for attracting enterprises. These indicators quality and efficiency of local innovation could be developed from a range of sources, and entrepreneurship ecosystems to support including the Doing Business database. By the new firms. The ecosystem would cover combining the Doing Business approach seven dimensions: the policy and regulatory with a strong local engagement strategy, environment; the cultural environment; subnational assessments could increase access to finance; access to R&D and skills; ownership of the reform agenda at all levels availability and quality of supporting services; of government. Subnational Doing Business access to markets for inputs and outputs; and assessments in Mexico strongly encouraged large established companies as connectors local regulatory reforms. During the six in the ecosystem network. Taking lessons subnational Doing Business benchmarking from the revival of old industrial cities in the rounds in Mexico, the number of reforming United States, local governments could focus states increased considerably. The subnational on investing in education and training and assessments encouraged competition for on partnering with private stakeholders and reform and inspired peer-to-peer learning. civic organizations in designing, financing, China could also consider setting up and implementing programs to promote the a new National Center of Excellence for local economy. Also, government support for Entrepreneurship Promotion Policy. This local entrepreneurship could be subjected to could be either a new agency or an existing more rigorous monitoring and evaluation. agency tasked with the new role and respon- China has identified improving its business sibilities. The center’s main objective would climate as a high priority. Premier Li Keqiang be to analyze and develop entrepreneurship has called for efforts to remove barriers to promotion policies and disseminate relevant market access, to lower transaction costs, knowledge and experience. It would focus and for local governments to explore ways on the “how to” of policy design and deliv- to create a healthy business environment for ery, including providing best-practice advice fair competition. In 2018, the State Council and knowledge, identifying good examples, announced that the time required to start learning from failed approaches, disseminat- a business in municipalities, subprovincial ing best practices, and developing knowledge cities, and provincial capitals would be networks and monitoring and evaluation reduced from an average of more than 20 frameworks. The proposed center would 42 INNOVATIVE CHINA not be a government department or office inconceivable without its SOE reform that holds the power to issue or implement efforts. The reforms in the 1980s and 1990s policies. Instead, it would help local policy fundamentally transformed the SOE sector, makers design and deliver best-practice poli- allowing it to contribute to economic growth cies, drawing on national and international and develop in line with its role in the national research and findings. economy. The radical market-oriented reform The center would develop national learn- and restructuring in the late 1990s were ing networks that diffuse local and inter- followed by a decade of improving SOE national knowledge. It would link training financial performance, which narrowed and mentoring with best-practice “linkage the gap with non-SOEs. The average return organizations,” such as incubators. It would on equity of industrial SOEs rose from 2.0 support cities to develop customized policy percent in 1998 to 14.4 percent in 2006 and packages tailored to local contexts. It would 15.7 percent in 2007. The gap with non- facilitate competition between subnational SOEs narrowed from 5.4 percentage points in governments to improve the business environ- 1998 to 2.7 percentage points in 2006 before ment. The center could also support second- falling back to 4.4 percentage points in 2007. tier cities in developing a “buddy system” As early as 1993, a Communist Party of with more advanced cities in the country China (CPC) decision to establish a socialist a n d w i t h m a r k e t l e a d e r s g l o b a l l y, market economy affirmed that the state must facilitating learning networks in China and create the conditions to allow enterprises of internationally. For second-tier cities, the all ownership types to compete equally and center would facilitate the transfer of best for the government to treat them on equal practices to initiate integration with more terms (CPC 1993). A 2013 CPC decision on advanced regions. For example, Shenyang deepening reforms reiterated the position by is looking to Germany’s Industry 4.0 for requiring the state to ensure that enterprises best practices. Sharing best practices and of all ownership types use factors of produc- potentially bringing in international service tion on equal terms and participate in mar- providers to partner with local service ket competition in an open, fair, and equal providers and boost standards would support manner (CPC 2013). Greater competition, further market development. including reforms of SOEs, is now vital for China’s search for new drivers of growth. Ensuring fair competition After departing from the traditional Soviet model, in which state ownership dominated and reforming state-owned the urban sector, China has chosen to move enterprises to a “basic economic system,” character- China recognizes that different types of ized by the coexistence of multiple types of businesses need to enjoy equal government ownership, including public and private, support, regardless of ownership or scale, and domestic and foreign. Policy makers and that foreign-funded enterprises, private can work toward clarifying the boundaries enterprises, and state-owned enterprises between competition and industrial policies (SOEs) must all enjoy a level playing field. to ensure that industrial policies support There were 167,000 nonfinancial SOEs market competition. in China in 2015, with RMB 37.8 trillion Continuing reform in the direction set by (US$5.6 trillion) in state-owned equity the 2013 CPC decision and the 19th National capital, equivalent to 52 percent of GDP Congress can generate new momentum for that year. From 2008 to 2015, the number China’s economic growth (CPC 2013). The of nonfinancial SOEs increased 52 percent, key is to ensure that SOE reforms enable and their state owner’s equity increased 180 enterprises of multiple types of ownership percent. In this context, SOE reforms have to coexist and compete in the market. This been critical, and China’s unprecedented requires that the SOE reforms not only development success would have been improve the performance of SOEs but also RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 43 FIGURE 4.6 Entrepreneurs’ perceptions of fair competition in the market in China, 2017 60 40 % of responses 20 0 Strongly agree Agree Neither agree Disagree Strongly disagree nor disagree Competition with large enterprises is equal No entry barrier for small enterprises Competition with state-owned enterprises is equal Government favors large enterprises Source: World Bank survey of entrepreneurs in five Chinese cities. Note: SOE = state-owned enterprise. ensure that competition between SOEs and This articulation could be conveyed by non-SOEs is on equal terms. introducing a formal and explicit state- In a survey of entrepreneurs in five cities ownership policy for SOEs, in line with the conducted for this report, approximately recommendations of a government study 41 percent of respondents d isag reed (DRC 2014). Establishing a stand-alone that competition between small private state-ownership policy to codify national enterprises and SOEs is on an equal basis strategy in one formal document of the State in their city (figure 4.6). There were also Council would introduce strategic clarity to concerns regarding market entry for smaller the role and management of SOEs, including firms, where many entrepreneurs (39 percent) the overarching objectives for managing state disagreed with the statement that small capital in business enterprises. domestic private enterprises face no barriers It is crucial for the state-ownership policy to entry into most sectors. The majority of to articulate different objectives for different entrepreneurs (75 percent) indicated that types of SOEs, depending on the degree of government favors large domestic enterprises their commercial orientation. China has over young entrepreneurial businesses. categorized SOEs into commerical SOEs and Overall, entrepreneurs in the five cities said public-interest SOEs. The former is further that they do not feel that they operate in an divided into two subcategories: SOEs whose environment of equal competition or equal main business is in competitive industries treatment. or fields (commercial-competitive SOEs), and those that undertake special projects in industries or fields that are crucial to Articulating a policy regarding state ownership China’s national security and national econ- omy (commercial-strategic SOEs). Accelerating China’s SOE reforms and The priority for the commercial-competitive ensuring fair competition first require clearly SOEs is to strengthen their commercial articulating the purpose of state ownership. orientation and expose them to market 44 INNOVATIVE CHINA competition by introducing three reforms. The proposed state-ownership policy The first is to ensure managerial autonomy by could define how Chinese citizens—the ulti- reducing government interference that goes mate owners of state capital—benefit from beyond its shareholder role, by deepening the operations of SOEs. The main channels the reform of the state capital management for Chinese citizens to directly receive finan- system.8 The second is to strengthen corporate cial benefits from SOEs include the transfer governance by expanding the “mixed- of SOE dividends to the public finance budget ownership” reforms, to further increase to fund social expenditures, and the trans- nonstate equity in SOEs. This would convert fer of some state ownership stakes in SOEs the SOEs into state-participated enterprises to social security funds to strengthen their with a more balanced equity structure, financial position.9 in which no single shareholder holds an ownership stake large enough to enable Implementing competition policy more single-shareholder dominance. The third is to effectively ensure that commercial-competitive SOEs are fully exposed to market competition. Competition policy in China is embodied Due to their contribution to the pub- in the 2008 Anti-Monopoly Law (AML). lic good, commercial-strategic and public- Strengthening this law’s enforcement would benefit SOEs would need to be treated dif- help to level the playing field and ensure ferently from commercial- competitive that different types of businesses receive SOEs. These two types of SOEs should be equal treatment, regardless of ownership or reasonably compensated for the costs of scale. International experience indicates that providing public goods and undertaking competition policy requires regular reviews noncommercial strategic projects, to ensure and updating. After almost a decade of their financial sustainability and to allow for implementation, this would be a good time an accurate assessment of their performance. to assess the law’s track record and make The proposed state ownership policy necessary amendments. To gather feedback, could selectively identify sectors in which the national government could consult with commercial-strategic and public-benefit lower governments and the private sector. SOEs would not have a significant presence, The enforcement of China’s AML had as part of an overall process of determining been the responsibility of the Anti-Monopoly the strategic allocation of state capital. The Commission of the State Council, established desirable allocation of state capital across in 2008. The commission’s most visible economic activities has been an objective of contributions have included the drafting of China’s SOE reform since the mid-1990s. various policy documents, including guidelines Across the world, selectivity is also a com- for the definition of relevant markets under the mon practice in allocating state capital to AML. Under the commission, three agencies economic activities (OECD 2015). China had shared responsibility for enforcing the could consider several options for accelerat- law: the National Development and Reform ing reform in this area; for example, it could Commission (NDRC), the Ministry of transform commercial-competitive SOEs Commerce, and the State Administration of from wholly state-owned to state-controlled Industry and Commerce. or state-participated enterprises through In line with the global trend to unify “mixed ownership” reforms; it could with- en forc e m ent re sp on sibi l it ie s , C h i n a draw capital from some nonstrategic, non- announced plans to establish a stand- public-interest SOEs, especially those finan- alone independent regulatory agency for cially distressed and nonviable; and it could competition. The 13th National People’s improve the allocative efficiency of finan- Congress, held in March 2018, decided cial resources channeled to those SOEs by to consolidate the A M L enforcement further reforming the financial sector and responsibilities of the three agencies into the strengthening the commercial orientation of newly established State Administration for financial institutions. Market Regulation (SAMR), which would RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 45 also act as the Office of the Anti-Monopoly Full i mplementation of the fai r Commission of the State Council. competition review will go a long way toward This latest reform would help to address implementing the government’s 2013 decision the long-standing fragmentation of AML to give competition policy a “fundamental enforcement caused by the division of position” in economic policy making. Seen responsibilities among the three previous as a first step, the review will need to be authorities and increase the independence of extended, when conditions are ready, to cover the AML enforcement function from other not only the “flow” but also the “stock” government functions, such as industrial, of competition policy—that is, the laws, trade, and FDI policies. Nonetheless, AML regulations, documents, and policies enacted enforcement remains only part of the scope before the reform. This is important because of work of SAMR, which has a lower status the implementation plan will not stop the than a ministry in the Chinese government enactment of new anticompetitive regulatory system. In order to give competition policy a and policy measures as long as they are based more fundamental role, it will be crucial for on relevant laws, regulations, and rules set by the government to ensure the authority of the the State Council. It may also be necessary to AML enforcement unit of SAMR to enable elaborate and develop further the 18 criteria it to deal effectively with inevitable conflicts to ensure fuller coverage of anticompetitive between competition policy and other government actions. The goal could be a government policies, including industrial national “fair competition standard” to policy. It will also be critical to ensure that define in specific and enforceable terms SAMR is well staffed and resourced and exactly what government actions can be to expand the disclosure of enforcement regarded as aligned with the principle of guidelines and other information to enhance fair competition among all enterprises. The credibility and predictability. In many standard should be applicable to domestic countries, competition authorities have a market competition and be aligned with semi-independent or independent status to China’s role in and commitments to the help them enforce competition laws and global economy. regulations. As a major step in strengthening the role Making mixed-ownership reforms of competition policy, the State Council effective launched a “fair competition review” in 2016 (State Council 2016), and five ministries, Mixed ownership is a key component of led by NDRC, enacted an implementation China’s SOE reform strategy, as put in plan. The fair competition review is intended place by the CPC and the State Council in to ensure that no directive, instructive 2015. Bringing nonstate equity capital into document, or ministerial policy measure is SOEs is intended to improve their corporate enacted, and that no draft law, regulation, or gover na nce a nd performa nce. Ch i na State Council policy measure is submitted to United Network Communications Group the State Council for enactment when it has Co. (Unicom Group), one of the six SOEs the effect of excluding or restricting market picked by the NDRC in 2016 for a pilot in competition. The review is to be conducted mixed ownership, completed the reform by the policy-making and -drafting body that transactions in 2017, shortly before the 19th proposes the legal, regulatory, or policy rules. CPC National Congress, in which almost The State Council has codified 18 criteria RMB 78 billion (US$11.7 billion) of shares, under three broad categories for the fair representing a 35 percent stake in the group’s competition review: market entry and exit; Shanghai-listed subsidiary, were sold to more free flow of products and production factors; than a dozen investors, including technology and regulatory and policy measures that have giants Alibaba Group Holding Ltd. and an impact on either the cost of production Tencent Holdings Ltd.10 Unicom Group and operation or the behavior of producers will remain the biggest shareholder, with 37 and market participants. percent, but it will give up the majority stake. 46 INNOVATIVE CHINA China Eastern Air Holding, China Nuclear establishing policy or standard operational Engineering and Construction Group, China procedures, and even intervening directly State Shipbuilding, China Southern Power in operational matters. But this can lead to Grid, and Harbin Electric are the five other interference in management matters, with companies initially selected for the pilot suboptimal results. mixed-ownership program. Three, build professional boards of In their equity structure, most SOEs are directors. The board’s composition and no longer wholly state-owned enterprises. functioning have a sizable impact on A review of 2013 firm-level data for 16,499 the governance of the company, on its state-owned and -controlled industrial operational and financial performance, and enterprises (accounting for 89 percent of thus on its ability to maximize returns to the assets of state-owned and -controlled state capital. Boards following good practices industrial enterprises) showed that only 38.3 require members who act in the interest percent of their sales revenue was produced by of the company, who face no conflicts of wholly state-owned enterprises. In contrast, interest, and who have the competence and 55.2 percent was accounted for by “state- experience, including in the private sector, to controlled enterprises,” mostly domestic lead the company. limited-liability companies and joint stock Four, professionalize SOE management. companies that are not wholly state owned. Good practices increasingly call for empow- This situation is a result of reforms since the ering the board to appoint and, subject to 1990s that encouraged such diversification clear terms, remove the chief executive offi- through initial public offerings, employee cer when necessary. In countries with highly shareholding programs, and the sale of addi- developed SOE frameworks, boards may also tional shares to nonstate investors. But some be empowered to oversee executive pay. Some of these efforts have not been fully realized countries require setting executive remunera- because some enterprises still have a domi- tion within the confines of broader public nant state majority shareholder. sector pay policy, but the policy should allow Improving corporate governance is the key for flexibility and not limit the ability of the to making mixed ownership effective. It is SOE to hire competitively. particularly critical that shareholder institu- Five, adhere to high standards of trans- tions have well-defined mandates and carry parency, disclosure, and financial discipline. out their ownership responsibilities with the Transparency and disclosure are vital to requisite autonomy and in a professional holding shareholder institutions and SOE manner with high levels of transparency and managers accountable for their performance. accountability. International best practices Good practice requires annual financial for SOE corporate governance point to five statements prepared in accordance with key priorities for the state as owner. accounting standards and other requirements One, clearly define the mandate of key stakeholders, to define accountability and for listed companies, and audited by the provide the basis for determining objectives statutory auditor (if required) and an and targets. This would provide conceptual independent external audit firm. Dividend clarity for the roles and responsibilities of policies can strengthen financial discipline the board, management, and employees, and and improve capital allocation. help with decision-making and measuring performance. Notes Two, have the state, as owner, focus on 1. According to Mazzucato (2015), the Internet the exercise of core ownership rights without was initially funded by DARPA, the global infringing on the day-to-day management of positioning system was funded by the U.S. SOEs. While shareholder rights are usually Navy, touchscreen display was funded by the defined in laws, more important is how such Central Intelligence Agency, and the voice- rights are exercised in practice. As owner activated personal assistant Siri was funded and shareholder, the state may feel justified by DARPA. RESHAPING INDUSTRIAL POLICIES AND SUPPORTING MARKET COMPETITION 47 2. Chapter 10 of this report discusses the reform Cirera, Xavier, and William F. Maloney. 2017. agenda for the cadre management system. The Innovation Paradox: Developing-Country 3. Financial Times, 2017. Capabilities and the Unrealized Promise of 4. China Banking Regulatory Commission, Technological Catch-Up. Washington, DC: “Notice on the Banking Sector Financial World Bank. Institutions—Notice of the Work of the CPC (Communist Party of China). 1993. “Deci- Creditors’ Committee —1196 of 2016,” sions on Some Issues of Establishing a Social- July 6, 2016; China Banking Regulatory ist Market Economic System.” Retrieved Commission,“Notice Regarding Furthering from http://cpc.people.com.cn /GB/64162 Work on Banking Financial Institutions /134902/8092314.html. Creditor Committees,” May 10, 2017. ———. 2013. “Decisions on Some Important 5. Doing Business indicators measure the Issues of Comprehensively Deepening Reform.” “ease of doing business,” covering rules and Retrieved from http://news.xinhuanet.com regulatory processes relating to 10 stages of /politics/2013-11/15/c_118164235.htm. a firm’s life cycle, from starting a business Divakaran, Shanthi, Patrick McGinnis, Jing through to operations and insolvency. 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Working Paper No. 23368, National Bureau of Economic Research. 5 Promoting Innovation and the Digital Economy Broadly conceived, a national innovation sys- system entails placing greater emphasis on tem (NIS) covers the supply of innovation gen- the second D, accelerating diffusion, so that erated by research and development (R&D) the country’s R&D policies and institutions institutions and enterprises, the demand for could be reoriented to increase the emphasis innovation by enterprises, and the accumula- on promoting the diffusion of technology tion and allocation of resources that enable and innovation. both the supply of and demand for innovation (figure 5.1). This chapter focuses on policies China’s rapidly increasing and institutions relevant to the supply of inno- vation, but such policies are only one of many innovation capacity components of the NIS that have strong com- China has built a large and extensive NIS plementarities and synergy. Therefore, under- to supply the innovation and technologies standing the policy priorities for China’s NIS required for productivity growth. Evalua- necessitates taking a holistic approach that tions of China’s innovation capacity differ considers the findings in this chapter together across various international assessments, but with those in other chapters that cover indus- they all indicate that gaps remain between trial policies and market competition, the China and high-income countries. The global business climate, the financing of innovation, innovation index—developed by the World trade and foreign direct investment (FDI) Intellectual Property Organization (WIPO), regimes, and investments in human capital. INSEAD, and Cornell University—is the China is already well advanced in building most positive, indicating that China’s inno- an NIS capable of supplying the innovation vation capacity has been improving steadily. and technologies needed for productivity- China is moving up in cross-country rank- led growth. The challenge now is to refine ings, from 29 in 2011 to 17 in 2018, and it an already large, existing system. Currently, is the highest-ranking middle-income coun- the country’s innovation system focuses on try and the fi rst middle-income country to promoting the third D, fostering discover- join the 20 most innovative countries (Cor- ies of new innovations and technologies. To nell University, INSEAD, and WIPO 2016). complement the third D, refining the current China’s improvements stand out among 49 50 INNOVATIVE CHINA FIGURE 5.1 National innovation system Government oversight, resolution of market and systemic failures, and coordination SUPPLY ACCUMULATION / ALLOCATION DEMAND Universities / think tanks / Physical capital The rm technology extension centers Human capital Human capital Incentives to accumulate Support for rm capability upgrading Knowledge – Macroeconomic context NIS INSTITUTIONS – Productivity / quality extension – Competitive structure services Barriers to all accumulation – Trade regime and international – Process / best practice dissemination Credit networks – Advanced consulting services Entry/exit barriers Business/regulatory climate Firm capabilities Domestic science and technology Rule of law – Core competencies (management) system Barriers to knowledge accumulation – Production systems International innovation system – Technological absorption and Rigidities (labor, etc.) production Seed/venture capital Innovation externalities Wider factors that may also need attention from NIS Factors that usually set the attention of NIS Source: Cicera and Maloney 2017. Note: NIS = national innovation system. comparable countries, which have experi- assessment by the World Economic Forum enced few improvements or a decline in their has improved little over the years. In 2016/17, ranking (figure 5.2). China also has improved China ranked 28 out of 144 countries on its innovation quality and now is ranked 17 overall competitiveness and 74 on techno- in the relevant indicator. logical readiness, compared with 27 and 78, In contrast to improvements in the respectively, in 2010/11. According to the global innovation index, China’s innovation information and communication technology FIGURE 5.2 Ranking on the global innovation index of select countries, 2007–18 0 10 20 Cross-country ranking 30 40 50 60 70 80 90 2007 2008–09 2009–10 2011 2012 2013 2014 2015 2016 2017 2018 United States Germany Japan Korea, Rep. India China South Africa Brazil Russian Federation Source: Global innovation index by WIPO, INSEAD, Cornell University. PROMOTING INNOVATION AND THE DIGITAL ECONOMY 51 (ICT) development index for 2016, China FIGURE 5.3 R&D spending in selected countries, 1996–2014 was ranked 81, behind the República Boli- variana de Venezuela and Bosnia and Her- a. Share of R&D spending zegovina, although this was an improvement 5.0 over its ranking of 84 in 2015 (ITU 2016). 4.5 The Bloomberg index of innovative econo- 4.0 mies ranks China 20, between Canada and 3.5 Poland. China scores high on patent density 3.0 Percent (7) and high technology density (9) and is in 2.5 the middle of the range on R&D intensity 2.0 (15) and manufacturing value added (19); 1.5 however, it is near the bottom (43) on tertiary 1.0 efficiency, productivity, and researcher con- centration (Jamrisko and Lu 2017). 0.5 R&D investments and number of pat- 0 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 ents have risen rapidly in recent years. China GDP per capita (US dollars) spent 2.18 percent of gross domestic product Japan Korea, Rep. United States China Germany (GDP) on R&D in 2018, compared with the Organisation for Economic Co-operation b. Amount of R&D spending and Development (OECD) average of 2.4 per- 600 cent (figure 5.3). In 2013, China’s aggregate 500 spending on R&D became the second high- Current US dollars (billions) est in the world, after the United States, and 400 accounted for around 20 percent of global spending on R&D. R&D expenditures as 300 a share of GDP are multiples above what is 200 common for a country at China’s level of development. Unlike in other middle-income 100 countries, where the public sector is respon- sible for a large share of R&D expenditures, 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 in China R&D spending by enterprises accounts for three-fourths of total spending. China United States Japan Germany France United Kingdom India Korea, Rep. In line with higher spending on R&D, China’s domestic patenting has increased Source: For panel a, calculations based on Organisation for Economic Co-operation and dramatically over the last half decade (fig- Development (OECD) data. For panel b, calculations based on National Science Board 2018. ure 5.4, panel a). It has the world’s larg- Note: R&D = research and development. est number of domestic patents, with more than 1.7 million domestic patents granted in outputs, China is now second only to that of 2016. In 2016, China filed the world’s third- the United States.2 highest number of applications under the China’s enterprise sector accounts for Patent Cooperation Treaty (PCT),1 with ZTE approximately three-fourths of total R&D the most frequent, and Huawei the second- spending, above the OECD average of two- most frequent PCT filers in the world (fig- thirds and also that of most middle-income ure 5.4, panel b). Due to such companies, countries. Enterprise sector spending includes China became the third-largest applicant for R&D outlays of state-owned enterprises international patents in 2016 and is likely to (SOEs), which in 2015 amounted to about overtake second-place Japan soon. China is one-third of the total, down from 55 per- also second only to the United States in the cent in 2005 (Molnar 2017). ICT producers number of scientific publications. The quality accounted for about one-third of total R&D of China's research papers is also improving. spending in China, followed by automobiles According to Nature Index’s weighted frac- and transport and ICT services. The contri- tional count of the quality of global research bution of Chinese ICT to global innovation is 52 INNOVATIVE CHINA FIGURE 5.4 Number of domestic and international patents, may be investing relatively little in R&D. The 1990–2016 average R&D intensity (defined as the ratio of R&D investment to total revenue) of all a. Domestic patents granted Chinese companies (among companies with 2,000 at least € 24 million in annual R&D spend- ing) was only 2.8 percent, less than half of average spending in the United States (6.2 1,500 percent), indicating a sizable gap between many Chinese companies and their global Thousands 1,000 counterparts, regarding investments in inno- vation and technology. However, among the world’s 2,500 most-R&D-intensive compa- 500 nies, R&D spending by Chinese companies grew 18.8 percent in 2017, compared with 7.2 percent in the United States and a 3 per- 0 cent decline in Japan, suggesting that Chinese companies are catching up rapidly (European 90 92 94 96 98 00 02 04 06 08 10 12 14 16 19 19 19 19 19 20 20 20 20 20 20 20 20 20 Inventions Utility models Designs Commission 2017). Multinationals have played a signifi- b. International applications cant role in China’s international patent- ing, reflecting the increasing globalization United States of R&D. Multinational enterprises based Japan in China helped to drive the rapid growth in U.S. patents through imported innova- China tion platforms, including management, net- Germany works, and corporate structures that pro- vide the necessary complementary factors Korea, Rep. within multinational corporations (Brans- France tetter 2012). This pattern is distinct from the pattern seen in the Republic of Korea, United Kingdom where the vast majority of international pat- ents are registered by indigenous enterprises. 0 10,000 20,000 30,000 40,000 50,000 60,000 The foreign share of domestic invention pat- PCT patent applications ents in China—patents granted by the State 2016 2015 Intellectual Property Office (SIPO)—is siz- able but declining, from 44 percent in 2001 Sources: For panel a, State Intellectual Property Office (SIPO) data; for panel b, World Intel- lectual Property Organization (WIPO) data. to 25 percent in 2016. Given the significant Note: Panel b refers to applications under the Patent Cooperation Treaty. share of domestic innovation carried out by foreign firms, it will be important to enhance growing; Huawei is the third-largest corporate local knowledge, product, and entrepreneur- R&D spender in the global ICT industry (and ial spillovers. Countries like Korea that have the only Chinese company on the list of the traditionally been less dependent on FDI, as world’s largest R&D companies). well as countries like Singapore that have had The top five Chinese companies accounted much higher levels of FDI, have taken steps for almost 30 percent of total R&D spend- to enhance the capacity of indigenous firms ing in China, a higher proportion than to absorb technology spillovers, providing among the top five companies in the United important lessons for China.3 States and the European Union (EU), where China’s patents still lag those of frontier they represented less than 20 percent of total countries on a variety of measurements of spending. This indicates that, in China, enter- quality, such as patent citations, retention prise research is more concentrated in the rates, patent commercialization (as measured largest firms, and the majority of enterprises by patent out-licensing), and average number PROMOTING INNOVATION AND THE DIGITAL ECONOMY 53 of claims. A key aspect of quality is China’s higher quality and greater commercial viabil- reliance on “utility” patents, which are less ity. The government has recognized the need costly, easier, and faster to obtain but have to adjust incentives for patenting. It could a shorter duration of protection than inven- shift the focus of government financial incen- tion patents. Although other countries also tives from reducing the costs of patenting to offer utility patents, the vast majority of promoting services that make patents com- the world’s utility patents are filed in China mercially valuable, such as services related to (WIPO 2018). Utility patents granted in patent evaluation and due diligence, market- China have skyrocketed in recent years (fig- ing and feasibility studies, and proofs of con- ure 5.4, panel a), accounting for 43 percent of cept. This focus could be part of an overall the stock of patent applications in 2016. reorientation of patent promotion policies to Utility models are useful instruments broader aspects of investments in innovation. supporting latecomers’ catch-up process. Improving the managerial capacity of Chi- Because of their relatively low eligibility nese firms will also be critical for enhancing requirements, they have provided learning the quality of patents, innovation, and tech- opportunities to latecomer firms in East Asia. nological upgrading. Such capacity is vital in But precisely for the same reason, they may harnessing higher technological capabilities, not be as useful in China today as they were through process and product innovation, at earlier stages of development, as they tend R&D, and patenting, and ultimately firm to have less technological intellectual value. competitiveness and productivity. Some even Utility patents, as well as design patents, have argue that, in East Asia’s newly industrialized relatively low retention rates, indicating that economies, the organizational and manage- they often do not hold sufficient economic rial capacity of firms to acquire, learn, and value to justify paying the retention fees. apply technology has been more important For utility patents granted in 2013, 61 per- than conventional R&D, and that at least 30 cent were abandoned within five years, as the percent of the differences in total factor pro- patent holders stopped paying the retention ductivity (TFP) among countries stems from fees.4 The equivalent share was even higher variations in management quality. Despite for design patents (91 percent). China’s impressive growth of industrial pro- The huge increase in the number of pat- duction, the quality of management at firms ents may reflect policy incentives. More pat- is far behind the frontier (figure 5.5, panel ents reflect greater investment in R&D and a).5 Chinese managers may be quite good at possibly improved protection of intellectual running short-run assembly lines but com- property rights. But government policies to pare relatively poorly in just-in-time man- encourage patenting also have played a sig- agement, long-run strategic planning, and nificant role in increasing the number of pat- human resources management, all critical for ents. Different layers of the government have innovation. set ambitious patenting targets and rolled out China’s top firms, which would be intellectual property (IP)–conditioned state expected to contribute the most to innova- financial incentives. However, due to insuffi- tion, appear to have managerial qualities that cient quality-related requirements for patents, lag those of U.S. firms, more than for firms in these programs may have contributed to the the bottom or middle of the firm distribution rising quantity of patents at the expense of (figure 5.5, panel b). While Chinese firms are quality, particularly for utility patents. Many among the biggest in the world, none made patents may not be economically, technologi- the list of Thomson Reuter’s Top 100 Global cally, or commercially viable. Innovators, which was led by U.S. and Japa- Having largely achieved the original objec- nese firms. tive of increasing the quantity of patents, the In recognition of the need to strengthen government could now shift its focus to pro- the innovation capacity of firms, China has moting the quality of patents by reorienting extensive innovation support policies that support to broader aspects of investment in span the gamut of economic objectives (pro- innovation that would produce patents of ductivity, diversification, human capital, 54 INNOVATIVE CHINA FIGURE 5.5 Managerial capabilities of Chinese firms and their competitors a. Average management score for manufacturing b. Average management score and Kernel density United States 3.308 Japan 3.23 0.8 Germany 3.21 Canada 3.142 United Kingdom 3.033 0.6 France 3.015 Kernel density Australia 2.997 Mexico 2.899 0.4 Singapore 2.861 Greece 2.72 China 2.712 0.2 Turkey 2.706 Brazil 2.684 India 2.611 0 Ethiopia 2.221 1 2 3 4 5 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 Firm average management score Average management scores for manufacturing United States China Brazil India Poland Source: Cirera and Maloney 2017. entrepreneurship, and inclusion) and sci- as well. Finally, most policies are targeted at ence, technology, and innovation objectives younger firms (start-ups and seed and pre- (research excellence, technology transfer, seed entities) and micro and small firms. and R&D and non-R&D innovation) that Although these policies may help to address are commonly seen in other countries. The the sharp decline in the contribution of new policies employ a wide range of instru- entrants to firm-level productivity growth ments to support innovation, such as fiscal in China, more analysis is needed to assess incentives, grants, loan guarantees, vouch- whether they are easing the constraints on ers, equity, public procurement, technology high-productivity entrants. extension services, incubators, accelera- tors, competitive grants and prizes, science Promoting the diffusion of and technology parks, collaboration, and networks. innovation and technology It is critical to ensure that innovation As a developing country, China has much policy instruments are aligned with firms’ to gain from catch-up growth by promoting needs. In China, supply-side policies are the diffusion and adoption of existing inno- emphasized more than demand-side poli- vations and technologies. It will need to pre- cies, and instruments aiding applied research pare for growing technological disruptions outnumber those supporting basic research. through a combination of policies promoting These instruments tend to favor financial technology transfer, science-industry collabo- mechanisms over regulatory, advisory, and ration, and R&D-based and non-R&D-based collaborative support. This indicates that innovation, and upgrading of the skills and the main market failure that the authori- managerial capacity of firms to innovate and ties seek to address is funding and access to absorb technology. The majority of poten- finance. However, evidence on managerial tial productivity gains, even in developed capabilities of Chinese firms suggests that countries (55 percent), appear to result from other critical nonfinancial gaps are present adopting best practices and technologies PROMOTING INNOVATION AND THE DIGITAL ECONOMY 55 TABLE 5.1 Mechanisms to facilitate technology diffusion Diffusion mechanism Operational mode (primary) Example Dedicated field services Diagnostics, guidance, and mentoring Manufacturing Extension Partnership (United States) Technology-oriented business services Advice linked with finance; capacity Industrial Research Assistance Program development (Canada); I-Corps (United States) Applied technology centers Contract research, collaborative applied Fraunhofer Institutes (Germany); Manufacturing research, prototyping, and standards USA (United States); Kohsetshushi Public Technology Centers (Japan) Targeted R&D centers Advanced research on emerging technologies Campus for Research Excellence and intertwined with commercialization missions Technological Enterprise (Singapore) Knowledge exchange and demand-based Technology community networking; Knowledge Transfer Networks (United instruments knowledge transfer incentives Kingdom); Innovation Vouchers (multiple countries) Open-technology mechanisms Shared technology library; virtual networking BioBricks/Registry of Standard Biological Parts (United States) Source: Shapira and Youtie 2017. Note: R&D = research and development. rather than developing new ones (Manyika et technical assistance to facilitate the digiti- al. 2015). Mechanisms to support the diffu- zation of SMEs, sometimes by partnering sion of new and existing technologies range SMEs with large ICT companies. Similarly, from broad management extension services vouchers can incentivize the collaboration to more sophisticated R&D institutions, and of SMEs and knowledge providers in devel- more recently, technology information and oping and adopting Industry 4.0 processes. collaboration platforms (table 5.1). Grants have financed the collaboration of Manufacturing extension activities have SMEs with local consultants or universi- been widely adopted. The broader manage- ties to support the technological needs ment and field extension services tend to of SMEs. follow a model similar to traditional agri- For more specialized technologies, OECD cultural extension services and to emphasize countries have used technology and R&D supporting small and medium enterprises centers. Some technology centers, such as (SMEs) to absorb existing technologies. In those in Catalonia, Spain, arose from public- Germany, Mittelstand-Digital helps SMEs to private partnerships (PPPs) to solve techno- understand the advantages of digital applica- logical problems and develop solutions for tions and to take concrete steps toward Indus- specific sectors or clusters. The centers tend try 4.0. It does so primarily through “SME to be very specialized in specific technologies 4.0 competence centers” that demonstrate and are managed as a network, as with the how digitization, innovative networking, and Fraunhofer Institutes in Germany—a net- Industry 4.0 can be used in business prac- work of 60 private nonprofit research insti- tices. In Japan, Kohsetshushi Public Technol- tutes that undertake contract research for the ogy Centers provide free advisory services to government and for business organizations SMEs as well as access to laboratories on a (Shapira and Youtie 2017). But the capabili- cost-sharing basis (Ezell and Atkinson 2011). ties of the Fraunhofer Institutes are insepa- The United States supports technology dif- rable from the strength of Germany’s engi- fusion through the Manufacturing Exten- neering sector. Without strong capabilities in sion Partnership, a network of local centers the private sector, implementing these models in all U.S. states at 400 locations and with a may be difficult in other contexts. staff of 1,600 funded from federal, state, and Today, France, Germany, Japan, and industry sources. the United States are leading the efforts to Technology extension programs can be deploy existing and new policy instruments narrowly focused on specific technologies, to facilitate the adoption and diffusion of such as specific digital technologies. Many advanced technologies, although Brazil countries have used matching grants and and China are also making deep inroads 56 INNOVATIVE CHINA (Staufen AG 2015). The first steps in these Improving research and efforts are to set up a central secretariat development or platform that orchestrates all efforts around Industry 4.0, to conduct foresight Moving from top-down to more studies, and to create national plans involv- bottom-up and open innovation ing multistakeholder working groups. Ger- many and the United States provide leading Because new technologies expand and mature examples of creating integrated approaches faster than before, the pace of technology to deploying policy instruments (BMBF adoption has accelerated globally, such that 2017; GTAI 2018). The United States, for predicting technology trends is increasingly example, launched the Advanced Manufac- challenging. Consider former market lead- turing Partnership 2.0 (AMP 2.0) in 2011, a ers, such as Kodak and Nokia, which missed “national effort bringing together industry, the digital and smartphone revolutions and universities, and the federal government” lost most of their market shares. The same (White House 2011). Made up of 19 indus- applies to governments, which run an ever- tries, academia, and labor representatives, larger risk of misidentifying industries and the AMP Steering Committee published technologies of the future, especially in a report in 2014 titled “Accelerating U.S. countries like China that are moving closer Advanced Manufacturing,” which provides to the global technology frontier. The disrup- policy recommendations on skill building, tive and unpredictable nature of technology research, and technology adoption (AMP development implies that governments can no Steering Committee 2014). Overseeing the longer take all of the risk or internalize the implementation of these recommendations is process of generating innovation by directing the Advanced Manufacturing National Pro- top-down technological change. gram Office, as part of the National Insti- To manage risks better, China’s top-down tute for Science and Technology, with its approach to promoting innovation could be manufacturing.gov platform. It coordinates complemented with a more market-oriented, multistakeholder PPP initiatives. private-sector, bottom-up approach. China Given the importance of management could derive lessons learned from the EU’s capacity for technology adoption and dif- “smart specialization” concept. Smart spe- fusion, strengthening managerial capacity cialization is about prioritizing public sup- needs to be at the core of SME extension port for innovation in economic activities programs. The government of China could that may not yet be fully “visible” but that consider introducing a package of measures have the largest developmental potential and management extension programs, titled based on an economy’s current comparative perhaps the Mass Initiative for World-Class advantages. Smart specialization is under- Enterprises. This initiative would highlight pinned by an entrepreneurial discovery pro- the importance of high-quality management cess, which helps to identify, select, modify, for productivity through awareness and best- and eliminate (as necessary) innovation pol- practice campaigns. It could provide detailed icy priorities—smart specializations—to sup- benchmarking information for firms to port promising new industries and economic assess their managerial performance against activities and to ensure that they reach a criti- local and international peers. It could sup- cal mass of development. Bottom-up innova- port training and advisory services on man- tion policy could be invigorated by expanded agement upgrading against these bench- R&D tax credits and stronger innovation marks. It could provide specialized support support programs open to all industries. in designing, building, and using brands, and in developing and integrating servicification Strengthening basic research and technology use. And it could promote business services that SMEs can outsource, As China shifts from catch-up growth to particularly in lagging regions, so that SMEs the forefront of innovation, it could increase can focus on their core capabilities. the relatively low share of R&D devoted to PROMOTING INNOVATION AND THE DIGITAL ECONOMY 57 basic research. Reorienting public R&D era, open and collaborative research and more to basic and “blue sky” research would innovation, through both domestic and complement private R&D. China could also international collaborations, is the surest strengthen research project management way to invigorate China’s innovation capac- and reform its research funding system so ity. Indeed, an open and globally integrated that funding is allocated more competitively, innovation system is critical to strengthening and is less dependent on personal networks, domestic innovation capacity and avoiding to ensure equal access. Research evalua- technologies that are only relevant in China. tion should be bolstered, including through Chinese scientists are engaged in collabor- greater use of peer reviews. ative research in more than 94 countries. The The multiplicity of national and local agen- close to 100,000 doctoral degree scientists of cies responsible for financing and overseeing Chinese origin in science, technology, engi- science and technology programs engenders neering, and mathematics in the United States coordination problems and leads to con- facilitate research collaboration. China has siderable duplication and waste of research programs to encourage returnees in the sci- funding. For example, biotech research has ence, technology, and innovation community no less than nine ministerial-level agen- to play a catalytic role in transforming China’s cies sharing responsibilities under the State research environment. Such programs could Council Leading Group. Better coordination be reviewed to identify and address the mechanisms could help reduce the fragmen- obstacles to working with returnees more tation and duplication of research, but this efficiently and to enhance the environment will take time, and some waste is inevitable for attracting researchers from abroad. without streamlining programs and oversight The relatively underdeveloped R&D capac- agencies. ity of Chinese enterprises could be addressed To support basic research and innovation, by paying greater attention to university- a major priority is to move to a more bot- research linkages and research and innova- tom-up system and to nurture the underlying tion networks, modeled on successful pro- learning and creative culture that supports grams in high-income countries. China could basic research. Grassroots initiatives and the establish a network of incubators centered freedom for young researchers to pursue fresh on existing science and technology parks, research ideas are hampered not only by the with links to business and professional net- bureaucratic structure but also by research works, to build ecosystems to incubate new hierarchies that concentrate decision-making technologies and connect market leaders with authority and resources in the hands of senior start-ups. Having already reaped huge ben- researchers and their bureaucratic allies. And efits from expanding its international R&D evaluating research is linked primarily to the cooperation, China should consider being quantity of publications and patents, induc- even more active in global research initiatives, ing—even compelling—researchers to focus such as the Human Frontier Science Program. on publication and downstream contract Its involvement in the Human Genome Proj- work for firms. Recognizing such challenges, ect has already resulted in Chinese enterprises the Chinese Academy of Social Sciences and and academics collaborating with the world’s other agencies are attempting to revamp the leading geneticists, moving the country to approach to evaluating researchers in order to prominence in the global genomics research make it more qualitative and more focused on community. outcomes. Improving intellectual property Promoting research collaboration policies A key challenge is to ensure that promoting China’s intellectual property laws and regula- “indigenous” innovation does not under- tions have improved over the years and have mine China’s ability to benefit from open made significant progress in adopting inter- and collaborative innovation. In the modern national standards. In the past, part of the 58 INNOVATIVE CHINA motivation for these reforms was to comply raising the degree of punishment and com- with international IP treaties and respond pensation. A major deterrent to the effec- to foreign concerns. More recent reforms of tiveness of judicial IP enforcement is the low IP law are motivated by the need to provide amount of actual damages awarded in IP a stronger appropriability environment for cases, which can be attributed to the fact that domestic Chinese firms that now have greater judges tend to rely on statutory damages 6 technological capabilities for innovation. rather than the full damages afforded by the This orientation aligns with the government’s law. Understanding and addressing the rea- interest in encouraging domestic enterprises sons that judges behave this way could help to invest in innovation and R&D. A major to improve IP enforcement. priority for improving the IP legal framework The government has made progress in is to strengthen appropriability further by strengthening IP enforcement through the increasing damages for IP infringement and launch of specialized IP courts in recent to clarify or remove ambiguous provisions years. Stronger enforcement now entails an on relevant laws that can limit appropriabil- array of adjustments to IP court procedures, ity, such as those for licensing IP from state- such as strengthening specialized enforce- funded research. ment units, applying more significant fines Despite the significant progress in estab- and sanctions for noncompliance, improving lishing a modern IP rights system, China rec- acquisition and admissibility of evidence, and ognizes that more could be done to strengthen encouraging judges to impose higher dam- the protection of intellectual property in the ages on those who infringe intellectual prop- country. According to a 2016 countrywide erty rights. Better coordination of admin- representative survey of patent holders by istrative IP enforcement among the relevant SIPO, 70 percent of respondents said that bodies and among civil, administrative, and patent protection in China needs to be rein- criminal procedures in IP cases would also be forced. A further 59 percent said that their beneficial. patents could be easily circumvented. Such Judicial “local protectionism” (unfair han- concerns with China’s IP protection could dling of court and administrative enforce- discourage investment in innovation and ment cases to protect local firms) undermines R&D, and thereby reduce knowledge, prod- the perceived fairness of IP court enforce- uct, and entrepreneurial spillovers and ulti- ment. In China, plaintiffs have a better mately economic growth. Foreign firms still chance of winning IP disputes in their local indicate difficulties in protecting and enforc- area jurisdictions (China IP Index Report ing intellectual property rights in China, 2016; Judicial Big Data Research Institute which may discourage them from developing 2017). In general, local protectionism can frontier technology in the country or transfer- lead to discrepancies in the outcomes of ring such technology to China-based entities. trials of IP cases, potentially undermining Strengthening the IP regime and enforcing trust in the system. Reform measures are intellectual property rights are particularly needed to deter local protection further, pos- important for start-ups and SMEs, which sibly by moving more court cases to out-of- have fewer resources and limited experience area jurisdictions, and additional central to deal with intellectual property theft. initiatives are needed to monitor and limit Generally, judicial IP enforcement has unfair court rulings as well as to expand IP become more efficient and effective, although courts across the provinces or nationwide. IP litigation cases can still be lengthy. Dam- Over the past decades, China has gradu- ages awarded for IP infringement help ensure ally established a complex and relatively that judicial IP enforcement is effective. unique government system for administer- China’s newly revised trademark law has ing IP rights. In addition to the standard punitive damages that increase the conse- enforcement agencies used in other coun- quences for trademark infringement, and the tries, such as the judiciary and customs, patent law is being revised by significantly local government administrative agencies PROMOTING INNOVATION AND THE DIGITAL ECONOMY 59 also enforce IP rights in China. It can be financial resources. Greater use of techni- challenging to coordinate across such a large cal specialists from outside the court sys- and complex system and to ensure consistent tem could address some of the capacity con- IP enforcement for all regions. IP adminis- straints. More resources could be invested in tration officials have been facing a signifi- nongovernment arbitration and mediation cant challenge as the number of IP disputes for IP cases, given that the majority of IP law- handled by local IP enforcement authorities suits in China are being addressed through has risen rapidly in recent years. mediation, if not withdrawn. Procedures Despite such challenges, China’s govern- could be adopted to encourage greater use of ment institutions for administering IP rights these mechanisms. have generally become better managed. As Technology start-ups are particularly vul- part of the institutional reforms announced nerable to IP theft, given their lack of capac- by the State Council in March 2018, the ity to protect their rights and the centrality of State Administration for Market Regulation IP in their business models. The government (SAMR) was established, patent and trade- could consider targeted measures to improve mark management was incorporated into IP support for technology start-ups. State- the SIPO, which was renamed the China backed consulting and financial assistance National Intellectual Property Administra- programs for IP management exist for such tion (CNIPA), and CNIPA was incorporated firms, but the quality of their consulting ser- into SAMR. This merger and consolidation vices needs to be improved. could help to improve overall administrative enforcement and coordination across decen- Improving the management of tralized management. Decentralized management can result in innovation policies a lack of coordination among the many cen- Innovation policies would benefit from tral, provincial, and local government bodies streamlining and consolidation. Since 2001, governing IP rights, challenging the state’s China has issued more than 170 innovation ability to administer IP rights effectively support policies at the central level alone, and and efficiently. The government has sought many more have no doubt been issued at the to address these challenges. For example, it local level. Policies are formulated and imple- is strengthening law enforcement coopera- mented by at least 24 ministries and agencies. tion mechanisms in the Beijing-Tianjin-Hebei The large number of policies and institutions region, the Yangtze River economic belt, means that innovation policies suffer from and other regions, to improve the handling institutional fragmentation, duplication, and of cross-regional cases. However, further a lack of focus and prioritization. To stream- reforms are needed. The state could improve line and consolidate innovation policies, the the coordination of IP administration and government could carry out a public expen- enforcement among relevant state bodies and diture review of innovation policies and pro- enhance oversight of subnational IP policy grams. The review would help to identify making and strategizing. To handle the large institutions, policies, and support instru- number of patents, the state could expand the ments that could be upgraded, expanded, size and quality of China’s IP administration or—if they are no longer effective—dis- infrastructure, in terms of staffing and mana- carded. China also could strengthen its moni- gerial and administrative systems. However, toring and evaluation framework to assess there is an ongoing debate about the extent systematically the efficiency and effectiveness to which the power of local patent admin- of innovation policy and adjust policy priori- istrative enforcement authorities should be ties and public spending accordingly. expanded. Recognizing the need to improve the Given the significant increase in the num- coordination of innovation policies and pro- ber of IP cases, the courts, including spe- grams, in July 2018 the government estab- cialized IP courts, also need more staff and lished the national Science and Technology 60 INNOVATIVE CHINA Leading Group, led by Premier Li Keqiang. of grant reviews conducted by professionals This leading group could consider several with the requisite expertise and reduce the possible priorities. It could aim to enhance share reviewed by government administra- the administrative efficiency and streamline tors. Finally, it could expand rigorous impact the funding architecture of innovation sup- evaluation of innovation support programs port programs to reduce fragmentation and to inform public policy and enhance project any unnecessary bureaucracy, and to make performance. the programs more user friendly for enter- prises to access. It could expand the share Supporting innovation driven by digital diffusion FIGURE 5.6 Digital adoption index in China and comparator countries, 2017 Global innovation is increasingly driven by digital technology. Digital technology is already an important foundation for China’s a. China’s digital adoption compared with innovation capabilities and a key driver of upper-middle-income country average 1.0 China’s future growth. The government has prioritized the promotion of digital innova- 0.8 tion and aims for the country to become a global leader in key emerging digital technol- 0.6 ogies, such as artificial intelligence. There are indications that China is well on its way to Index score 0.4 building the necessary capabilities and envi- ronment to promote the digital economy. But much like the overall innovation system, sig- 0.2 nificant potential remains to take advantage of catch-up growth by promoting the diffu- 0 Digital Business People Government sion of existing global digital technologies Adoption Index subindex subindex subindex and innovations. China Upper-middle-income country average OECD average China’s digital adoption rate is higher than the average for upper-middle-income b. China’s digital adoption compared with OECD countries countries, but many individual upper-middle- 1.0 income countries have higher adoption rates, Korea, Rep. Germany according to the World Bank’s digital adop- 0.8 Japan tion index7 (figure 5.6, panels a and b). China’s United States digital adoption rate is also lower than the OECD average, and is, in fact, lower than the 0.6 rates of all OECD countries estimated. There China = 0.59 Index score is a large gap between China and OECD countries in the extent of digital adoption 0.4 among businesses and individuals, according y = –0.48 + 0.12x to indicators such as lower shares of business t = 22.89 websites and lower Internet access. By con- 0.2 R2 = 0.75 trast, digital adoption in China’s government Lower- Upper- sector is almost on par with the OECD aver- Low middle middle High income income income income age and significantly higher than the upper- 0 middle-income-country average. The assess- 1,005 3,995 12,235 ment of the government sector reflects the GNI per capita extent of digital adoption in core government China OECD countries administrative systems and the use of digital identification and online public services. Source: Calculations based on the World Bank digital adoption index. Note: GNI = gross national income. UMIC = upper-middle-income countries. OECD = Among enterprises in China, the use of Organisation for Economic Co-operation and Development. traditional digital technologies has become PROMOTING INNOVATION AND THE DIGITAL ECONOMY 61 nearly universal. In 2016, the latest year for The diffusion gap in digital technologies which data are available, 99 percent of enter- between China and OECD countries can prises used computers, and 96 percent used be disaggregated into three components: the Internet. But more modern digital tech- the gap within China, between the lagging nologies, such as websites and e-commerce, and technologically frontier provinces (“x” were still being deployed across the economy. in figure 5.7); the gap between China’s fron- For example, only 45 percent of enterprises tier provinces and OECD average countries used online sales, 46 percent used online pro- (“y” in figure 5.7); and the gap between the curement, and 39 percent used Internet mar- OECD average countries and the OECD keting (CNNIC 2017). frontier countries, such as Japan, Northern The adoption rate of more modern digi- European countries, and the United States tal technologies among Chinese enterprises (“z” in figure 5.7). The technology diffusion remains significantly lower than that of gap exists in all three components. The dif- OECD enterprises. Compared with China, fusion gap between China and the OECD where 49 percent of enterprises have their countries dominates for the most mod- own website, on average more than three ern digital technologies. Diffusion within out of four businesses in OECD countries China becomes more important for rela- have a website. Even enterprises operating tively less modern and more widely available in the most advanced Chinese provinces are technologies. still several years behind their global peers, Within China, the difference in the rate on average, in the use of more modern digi- of adoption between various generations of tal technologies. For example, the percent- technologies is considerable. For example, in age of enterprises with a website is highest Heilongjiang Province, 76 percent of enter- in Shanghai, at 62 percent, but this is still prises use the Internet for marketing, but lower than in 26 of the 33 OECD countries.8 only 2.5 percent use it for purchasing goods China’s digital adoption rate is closer to that online. And the diffusion of digital technolo- of the poorer OECD countries—such as Lat- gies appears to be diverging, with enterprises via, Mexico, Portugal, and Turkey—and far in poorer provinces adopting technologies behind OECD leaders, such as Finland and at a much slower pace than their counter- Switzerland. parts in richer provinces. Regression analysis FIGURE 5.7 Disaggregating the digital diffusion lag between China and OECD countries 100 OECD frontier (2014) 80 z Share of enterprises using digital technologies (%) OECD average (2014) China interior (2015) 60 y Diffusion gap 40 x: Within China x + y: Between China’s interior and the OECD average x + y + z: Between China’s interior and the OECD frontier 20 China frontier (2015) x 0 E-sales E-purchases E-commerce Websites Marketing and Information Internet Computers promotion management through the systems Internet Source: Estimates based on data from the China Statistical Yearbook of Tertiary Industry (various issues). Note: OECD = Organisation for Economic Co-operation and Development. 62 INNOVATIVE CHINA indicates that provinces that provide a more retail trade, and government and related sec- supportive business environment—in the tors, such as health care, education, and util- form of strong property rights and a more ities. These industries have had to adopt dig- open and diversified local economy—tend ital technologies in response to consumers’ to be associated with higher levels of digi- embrace of digitized services, as reflected in tal technology adoption. By contrast, direct the expansion of online sales, smart grids interventions to encourage technology adop- and smart meters for public utilities, digital tion, as measured by R&D spending and health (box 5.1), and online education (see patent filings, appear to have much smaller chapter 6). impacts on increasing the adoption of digital Capital-intensive industries—such as man- technology.9 ufacturing, oil and gas, and chemicals and There are also large variations in the pharmaceuticals—are the next tier of indus- degree of digital adoption across industries tries to have been digitized. Supply chain (McKinsey Global Institute 2017). As in and customer management have been largely other countries, the most digitized sectors digitized, but investments in digitization, the in China are ICT, media, and finance. In stock of digital assets, and the level of auto- ICT, China’s Internet companies are rap- mation remain relatively low compared with idly increasing their investments in digital high-income countries. Similar to other econ- infrastructure. Chinese semiconductor com- omies, the sectors that lag farthest behind are panies have been automating and digitizing fragmented and localized industries, such as facilities to serve global customers. The next real estate, agriculture, local services, and set of relatively highly digitized industries construction. But even in lagging sectors, dig- includes entertainment and recreation, the ital solutions are penetrating the industries, BOX 5.1 Digital health Digital technology is transforming the face of health Artificial intelligence (AI) is particularly promis- care in China, improving the diagnosis, treatment, ing for digital health, and nine priority application and management of patients; the operation of health areas have been identified: virtual assistants, disease care providers and insurance agencies; and the sup- screening, medical imaging, patient record analytics, ply and use of pharmaceuticals and medical technol- hospital management, intelligent medical devices, ogy devices. Digital health provides health workers drug development, health management, and genome and patients with tools to engage more fully with the sequencing analysis. By August 2017, 83 enterprises care process and to improve care management and in China were applying AI in the health care sector, decision-making, supporting new forms of interac- mainly in medical imaging, patient record analytics, tions such as remote physician consultations. These and virtual assistants. new forms of interactions could help to mitigate the China has a comparative advantage in developing overuse of large hospitals and the underuse of smaller AI for the health sector given its vast amount of medi- facilities. cal data and generally less restrictive data privacy The digital health care revolution in China is regulations, compared with Europe and the United facilitated by the government’s commitment to inte- States. But most hospital data are unstructured raw grating technology in health sector development. The data not ready for use in AI systems, and it is unclear 13th Five-Year Plan formulated an action plan for a whether hospitals would be willing to share their healthy China, identifying smarter health care as a data. The health sector could benefit from more AI major priority. To promote digital health, China has talent, since only around 5,000 AI specialists work been making progress in establishing the necessary in the sector. Finally, AI laws and regulations, ethical digital infrastructure, including digital health records norms and policy systems, and AI security assessment and care management systems, and in ensuring the and control capabilities will eventually be needed to interoperability of digital health tools across facilities establish policy and ethical norms in the industry. and services. PROMOTING INNOVATION AND THE DIGITAL ECONOMY 63 such as by start-ups offering digital solutions needed on the management and governance and platforms for restaurants and for residen- of data, which entail rules, processes, and tial property sales and rentals. organizations for the use and maintenance of data.10 As nontraditional sources of data become Promoting data trade and the norm, and data are put to entirely novel data flow uses in the digital economy, questions arise A fundamental consensus has emerged today about who owns what data, who can do that data flows produce significant economic what with them, and what protections are value and can lead to flows of technology, afforded to whom. Some policies on data capital, and talent, including across national flows can be legitimate and necessary to pro- borders. Therefore, restricting data flows can tect the privacy of the individual or to ensure constrain the benefits for a country’s eco- national security. But policies can unneces- nomic development. Digital trade is affected sarily restrict the free flow of data, and alter- by a wide range of policies, including those native policies may be available that are less on digital services and investments, move- restrictive but still allow the government to ment of data, and e-commerce. A digital achieve its policy objectives. trade policy framework can be organized More open data policies tend to be asso- into four clusters: fiscal restrictions and mar- ciated with greater data traffic. Restrictions ket access, establishment restrictions, data on data can be measured in terms of data restrictions, and trading restrictions (table policies, intermediary liability, and access to 5.2) (Ferracana and van der Marel 2017). content. Preliminary analysis indicates that Each policy can be assessed based on whether China has a relatively restrictive data policy it is excessively burdensome (trade distortive) environment and a comparatively low level for digital trade and discriminatory against of data traffic per capita, measured using digital, online, and foreign providers. The Cisco’s estimates of domestic Internet Proto- framework indicates that the overall digital col traffic per capita. The United States has trade policy environment encompasses a wide among the least restrictive data policies and range of complementary and interrelated fac- the highest data traffic per capita. Some of tors, including competition policy, intellec- the factors that contribute to China’s rela- tual property rights, and fiscal policies. tively restrictive data policy environment Data policy is a central component of a include its policies on data protection and country’s digital trade policy environment. data localization, the lack of a “safe harbor” Data are at the heart of the digital economy data transfer regime, and the nationwide and the Fourth Industrial Revolution. They “Great Firewall” system.11 Restrictive data provide the basis for the development of policies can inhibit cross-border innovation new digital products and services and the and the ability of foreign and domestic Chi- refinement of existing ones. Data are often nese companies to operate global platforms described as infrastructure for the digital and perform cutting-edge, globally integrated economy. There is a growing recognition that R&D in China. The free flow of data can data as an infrastructure asset is as impor- also support the realization of China’s Inter- tant as more traditional infrastructure, such net+ and National Big Data strategies. as transport and public utilities. To address Data policy is an incompletely developed data as an infrastructure asset, policies are and still-evolving policy area, both in China TABLE 5.2 Digital trade policy framework Fiscal restrictions and market access Establishment restrictions Data restrictions Trading restrictions • Tariffs and trade defense • Foreign investment • Data policies • Quantitative trade restrictions • Taxation and subsidies • Intellectual property rights • Intermediary liability • Standards • Public procurement • Competition policy • Content access • Online sales and transactions • Business mobility 64 INNOVATIVE CHINA and globally. In a cross-country survey, more cut off from international trade opportuni- than 60 percent of respondents reported ties, because many trade transactions now having difficulty understanding legal issues involve cross-border data transfers that related to data protection and privacy. With require adherence to minimum legal require- data policies still being developed across the ments for data protection. At least 35 coun- world, significant opportunities remain to tries are drafting data protection laws to reconsider and adjust the balance between address this gap. domestic legal and regulatory requirements In 2013, the OECD Council adopted and the needs of the domestic and interna- revised Recommendations Concerning tional business communities. Major areas of Guidelines Governing the Protection of Pri- data policy concern personal data protection, vacy and Trans-Border Flows of Personal data localization requirements, and cyber- Data. This revision updates and modernizes security. There is a need to balance efforts to the original 1980 release of the guidelines, in protect personal data privacy and ensure data light of changing technologies, markets, and security in key sectors, such as banking and user behavior and the growing importance of health services, with solutions that facilitate digital identities. The new guidelines identify and therefore lower the cost of data transfers seven governing principles for protecting per- under all reasonable circumstances. As the sonal data. They also emphasize the need for volume of cross-border data flows contin- greater efforts to address the global dimen- ues to increase, so can the compliance costs sion of privacy through improved interopera- associated with data location and data flow bility. Several new concepts were introduced, restrictions. including national privacy strategies, privacy management programs, and data security breach notification. Personal data protection In 2016, the EU published the new General A key element of the data infrastructure is per- Data Protection Regulation to come into force sonal data protection. More than 108 coun- in 2018. It incorporates some of the world’s tries have data protection laws (UNCTAD most stringent data regulations.12 The cur- 2018). In the nearly 30 percent of countries rent EU data regime is based on a 1995 direc- with no laws in place, personal data receive tive. The new regulation exceeds the current poor levels of protection, reducing trust provisions in many ways. It greatly enhances and confidence in a wide range of commer- individual rights—such as the right to rectify, cial activities. These countries risk being object to, and erase personal data, and the BOX 5.2 OECD recommendations for protecting data privacy The OECD, in its Recommendations Concerning 4. Security. Collected data should be kept secure Guidelines Governing the Protection of Privacy and from any potential abuses. Trans-Border Flows of Personal Data (2013), identi- 5. Disclosure. Data subjects should be informed fies seven governing principles for the protection of about who is collecting their data. personal data: 6. Access. Data subjects should be allowed to access their data and make corrections to any inaccurate 1. Notice. Data subjects should be given notice when data. their data are being collected. 7. Accountabilit y. Data subjects should have 2. Purpose. Data should be used only for the purpose a method available for holding data collec- stated and not for any other purposes. tors accountable for failing to follow the above 3. Consent. Data should not be disclosed without the principles. data subject’s consent. Source: OECD 2013. PROMOTING INNOVATION AND THE DIGITAL ECONOMY 65 rights to data portability and to avoid being currently managed through the Decision on subjected to automated profiling. It introduces Strengthening Online Information Protection tougher sanctions for violations, up to 4 per- and the National Standard of Information cent of the global turnover of violating firms. Security Technology, sometimes collectively It expands the definition of personal data to referred to as the General Data Protection include any data that can identify a person, Law. The new Cybersecurity Law (2017) has using “all means reasonably likely to be used.” significant implications for personal data pro- And it widens the territorial scope to apply tection and related cybersecurity practices. It even to organizations based overseas if their has stronger consumer data protection rights, data subjects reside in Europe. It expands imposing greater restrictions on the use and investigative powers to include data protection trading of personal data and the use of per- audits and the right to issue public warnings, sonal information for fraudulent purposes. and it makes it easier for individuals to claim The law imposes new security and data compensation. The new provisions establish protection obligations on “network opera- higher data processing and management stan- tors.” The new cybersecurity measures could dards and require public organizations and improve individual privacy in several ways, organizations processing large quantities of by prohibiting firms from collecting informa- data to appoint data protection officers. Each tion on individuals that is unrelated to busi- EU member state has an independent data ness purposes, strengthening data security protection authority that supervises, through measures, and requiring encryption tools to investigative and corrective power, the appli- protect data. China does not have a separate cation of the data protection laws. regulator or commission for data privacy, In contrast to the harmonization across similar to the United States and many East member states, which is a major goal of the Asian countries. upcoming European legislation, data protec- High-income countries such as the United tion laws in the United States are marked by States and those in Europe tend to have diversity. The United States does not have a stronger data privacy concerns, particularly comprehensive national data protection law in Europe. China has had a reputation for and instead has more than 20 sector-specific having a relatively lax data privacy regime laws, plus hundreds of variations among the and a similarly lax consumer attitude toward 50 states and territories. California alone has data privacy, and these characteristics typi- 25 state data privacy and protection laws. cally have been considered an advantage in There is no standard definition of personal the development of the digital economy. In a data across the states. The definition of sensi- 2013 cross-country survey by Boston Con- tive personal data also varies greatly across sulting Group, three-quarters of respondents states, although it typically includes personal outside of China indicated that caution is health data and financial and creditworthi- necessary when sharing personal informa- ness data. Unlike the EU, there is no dedicated tion online, compared with only half the national data protection authority, although respondents in China (Boston Consulting the Federal Trade Commission monitors the Group 2013). But public views may be chang- data protection policies and related practices ing. Concerns about online fraud could be of firms. Almost all states require notification contributing to changing consumer atti- of security breaches—a U.S. innovation now tudes about data privacy. A 2016 survey by being adopted worldwide. Most countries in the Internet Society of China found that 71 East Asia have laws protecting personal data percent of respondents said that they had suf- and requiring individual consent for data fered some form of online data fraud (China transfers.13 Internet Network Information Center 2017). Like the United States, China does not Data privacy is not simply a domestic issue have a comprehensive data protection law, for China; it also has implications for China’s but a data protection law is included in the efforts to globalize its enterprises. The Com- legislative plans of the 13th National People’s mittee on Foreign Investment in the United Congress. The data protection regime is States recently rejected China’s Ant Financial’s 66 INNOVATIVE CHINA proposed acquisition of money transfer pro- Data localization and cybersecurity vider MoneyGram due to concerns about per- sonal data security. As the exchange of digital Data localization laws and regulations refer data becomes central to the business models to requirements that data about a nation’s of all industries, differences in data privacy citizens or residents be collected, processed, and data security regimes can increasingly or stored inside the country, often before constrain China’s efforts to expand into high- being transferred internationally and usually income-country markets. only after meeting local privacy or data pro- China’s proposed “social credit system” is tection laws. The goal of such regulations is one example of its unique approach to data typically to safeguard the security of citizens’ privacy and personal data use. The proposed personal information and other important system will rate individual citizens’ “trust- data. In practice, restricting where data are worthiness” and adjust access to credit and stored and how data are transferred may not other public services based on the individual’s be the most effective approach to achieving social credit scores (State Council of China those goals. 2014). This approach is a variation of a Protecting data requires a strong inter- national digital identification system, widely national consensus on industry standards recognized as being of strategic importance and access to service providers with proven to the future of digital services. Digital identi- privacy and security capacity, regardless fication systems can be developed for specific of whether they have data infrastructure applications—for example, to manage gov- located physically in the local area. Defend- ernment health or social programs—or they ers of localization laws cite national security, can be developed as a universal multipurpose the local cultural and historical context, and system capable of supporting a wide range of economic nationalism as supportive argu- needs for legal identity. Among developing ments. Opponents see such laws as a major countries, only 3 percent have digital identi- barrier to trade and competitiveness. There is fication systems that are universal schemes, a fundamental tension between trade liberal- as is currently envisioned for China’s social ization and data localization requirements, as credit system. Because digital identifications most global businesses depend on the provi- contain personal data, a critical aspect of any sion of information services across borders. digital identification scheme is the protection Countries have increasingly imposed of personal privacy and information. Digital restrictions on the cross-border transfer of identification can raise legal and regulatory data in the form of data localization require- concerns about the type, extent, and use of ments, storage and processing requirements, personal information to be collected. and conditional flow regimes in which a firm The government is currently experiment- must fulfill burdensome requirements before ing with the social credit system, by provid- it can move data across borders (ECIPE 2017; ing licenses to private companies to develop Stone, Messent, and Flaig 2015). At least 36 the systems and algorithms for social credit jurisdictions have restricted the movement scores. Meanwhile, some web operating com- of data across borders, most of them in the panies use the data analyses to support their last five years, and most commonly through business. One of the best-known examples so requirements for data localization. far has been Tencent’s China Rapid Finance. The EU’s 1995 Data Protection Directive Another is Ant Financial’s Sesame Credit, permits the transfer of personal data only if which determines credit scores based on fac- another jurisdiction provides adequate pro- tors such as the individual’s credit history; tection, and the new General Data Protec- fulfillment of contractual obligations, such tion Regulation permits the transfer of data as whether electricity or phone bills are paid outside the EU if there are appropriate safe- on time; personal behavior and preferences, guards, such as binding corporate rules, a such as shopping habits; and interpersonal valid European Data Protection Seal for both relationships. controllers and recipients, standard data PROMOTING INNOVATION AND THE DIGITAL ECONOMY 67 protection clauses, or contractual clauses and cross-border data flows—needs to be authorized by a state data protection author- monitored carefully. The Cybersecurity Law ity. Canadian laws require personal infor- would also benefit from more detailed regu- mation held by public bodies to be stored lations to bring greater clarity and transpar- and accessed only in Canada, unless certain ency to the proposed new requirements and exceptions apply. In Korea, the Personal procedures, for example, regarding the pro- Information Protection Act requires informa- posed review regimes. To the extent possible, tion processors to inform and obtain consent requirements for adopting local technology from data subjects for transferring personal solutions unique to China should ensure information to a third party overseas. compatibility with global standards to facili- China has a variety of national and sector- tate the use of global technology solutions in specific data localization and cybersecurity China. requirements. The General Principles of Civil Law, promulgated in March 2017, defines Improving global cooperation on data the right to personal information as a basic policies civil right. To obtain personal information, any organization and individual would need With global trade increasingly involving data to obtain information in accordance with the flows, the wide range of data policies requires law and ensure the information’s security; a global solution. Government measures that should not illegally collect, use, process, or disrupt open exchanges of data can inhibit transmit personal information; and should digital trade. The Internet has become sub- not illegally trade, offer, or disclose personal ject to myriad overlapping jurisdictions and information. conflicting obligations. No single government The new Cybersecurity Law (Network can tackle the problem on its own. But inter- Security Law), which came into effect in June national Internet governance is complex, and 2017, further changed the landscape for data the institutional landscape is crowded and protection in China. It states core principles relatively fragmented. There are conflicting on the collection and use of personal infor- priorities among countries and few dedicated mation, requires data on consumers in the spaces in which different stakeholders can areas of “key information infrastructure” to interact and devise different solutions. be stored within the country, and bans the Achieving policy coherence across coun- export of “personal and important data” that tries requires close and sustained interna- could threaten national security or the public tional cooperation among all governmental interest. This means that multinational cor- and nongovernmental stakeholders to pre- porations operating “key information infra- serve the cross-border nature of the Internet. structure” need to set up data centers physi- A mixture of organizations has emerged to cally within China and that the state needs bring together the technical community, to review and authorize the exporting of businesses, governments, and civil society, any sensitive data “due to business need(s).” such as the Internet Corporation for Assigned Should any violation occur, the government Names and Numbers, Internet Engineering may impose fines on the firm and on individ- Task Force, and World Wide Web Consor- ual employees deemed to be responsible for tium (Bildt 2018). The World Trade Organi- the violation and may revoke or cancel com- zation and trade agreements have also been mercial licenses, suspend operations, or shut identified as ways to deal with fragmentation. down a firm’s website. For example, the Trans-Pacific Partnership The government believes that data stor- came close to setting new standards for vari- age and export regulations are necessary to ous trade-related aspects of digitalization, safeguard against threats such as hacking including data localization and the accessibil- and terrorism. The potential commercial ity of websites, devices, and apps. effect of these new requirements—including The EU is going in a very different direc- their impact on innovation, data markets, tion from the United States in regulating the 68 INNOVATIVE CHINA transfer and use of data, with more stringent in less profitable rural areas (TeleGeography privacy rules and limits on how much data 2017). And in 2017, it announced that it was companies can use for AI and in what fash- working with the Ministry of Finance, local ion. Europeans may opt to put data in public governments, and enterprises on a universal- “trusts” that private companies could access service pilot to promote broadband in rural with public supervision rather than just let- and remote areas (MIIT 2017). The 13th ting corporations use data for commercial Five-Year Plan includes a capital expenditure gain. China is emphasizing “cyber sover- target of US$290 billion for telecommunica- eignty,” the idea that states have the right to tions infrastructure investments in 2016–20. manage and control their own Internet with- The telecommunications market is domi- out external interference. nated by three state-owned enterprises— China Mobile, China Telecom, and China Unicom—which provide the core network ICT telecommunications infrastructure and fixed, mobile, and Inter- infrastructure net services. Other service providers include Telecommunications infrastructure is the mobile virtual network operators that offer physical backbone and key enabler of the telecom services over the incumbents’ net- digital economy. Affordable, reliable, and works and a large number of Internet and widely available high-speed Internet ser- social media applications that use the exist- vice facilitates the delivery of digital ser- ing telecom infrastructure. Foreign invest- vices and transactions across all sectors of ment in telecommunications is restricted by the economy. Recognizing the importance the share of equity. of ICT infrastructure, the Chinese govern- China has made significant investments in ment has issued several policy directives to rolling out mobile broadband for individual improve access to and the quality and afford- users and fixed broadband (optical fiber) with ability of broadband services. In 2013, the higher data transmission capabilities. As a State Council issued the Broadband China result, China’s access to broadband services Strategy (2013–20) to develop the country’s is well advanced (table 5.3). There is nearly broadband networks, establishing targets universal mobile network coverage as well for coverage, access, speeds, and subscrip- as mobile subscriptions. The percentage of tions. Also in 2013, the Ministry of Indus- the population with an active mobile broad- try and Information Technology (MIIT) band subscription, 69.1 percent, is above the issued the Notice of Implementation of the Asia-Pacific average but lower than in Bra- Broadband China Program. In June 2015, it zil, Japan, Korea, and the United States. The announced that it would set up a universal percentage of the population with a fixed service fund to deploy broadband networks broadband subscription, 22.9 percent, is also TABLE 5.3 ICT infrastructure indicators in selected countries Indicator China Brazil India Korea, Rep. Japan Asia and Pacific United States Percentage of population Fixed-line subscribers 14.7 20.4 1.9 56.1 50.6 10 37.1 Mobile subscribers 96.9 118.9 87 122.7 131.8 98.9 120.8 Fixed broadband subscribers 22.9 13 1.4 41.1 31.4 11.3 32.4 Active mobile broadband subscribers 69.1 89.5 16.8 111.5 132.3 47.4 124.9 Mobile 3G network coverage 98 96.9 79.7 99 99.9 87.6 99.9 Mobile LTE (4G) network 97 79.6 73.5 99 99 73.6 99.7 Percentage of GNI per capita Mobile prices 0.6 1.7 1.8 1.2 1 3.2 0.8 Fixed broadband prices 2.4 2.1 4.8 1.5 0.6 14.5 0.8 Mobile broadband price 1 gigabit 1.1 2.3 3.2 0.4 1.5 5.4 0.3 Source: ITU 2017. Note: Numbers greater than 100 percent may indicate multiple SIM cards. GNI = gross national income. PROMOTING INNOVATION AND THE DIGITAL ECONOMY 69 above the Asia-Pacific average but lags that in in a few provinces, such as Anhui and Jiangxi, Japan, Korea, and the United States. does penetration fall below 60 percent. China appears to have relatively competi- China could also focus on expanding tive fixed broadband and mobile prices, com- broadband access for higher bandwidths, pared with other Asia-Pacific countries and allowing faster download and upload speeds. higher-income economies.14 Even though Broadband speed is a proxy for the qual- three SOEs dominate both fixed and mobile ity of Internet service and overall network broadband, economies of scale have enabled quality and capacity, affecting e-commerce, lower prices. The government has also played financial services, and online government a strong role in lowering prices. For example, services. According to Akamai’s State of the in 2015, MIIT issued directives to the tele- Internet Report 2017, which provides global communications SOEs to lower prices by at benchmarking, Korea has the world’s fastest least 30 percent by December 2015. A fur- average download speed, at 28.6 megabits ther price reduction directive was issued in per second (Q1 2017; Akamai 2017). China 2016 without specific targets. In March 2017, ranks 74 of 100 countries surveyed in aver- the government instructed the three major age download speeds, at 7.6 megabits per telecom operators to increase speeds, reduce second, but it has among the highest rate of prices, reduce fees for Internet access and year-over-year increase in average download leased lines for SMEs and households, phase speed, at 78 percent. China compares reason- out domestic long-distance and roaming ably well for broadband adoption rates, at charges, and reduce prices for international the lower broadband speed of 4 megabits per voice calls. second (figure 5.8). In particular, China’s rate The government plans to make substantial is twice the rate for India, a similarly large investments in the next generation of net- country. But both China and India are well works, known as 5G. MIIT plans to launch behind other countries in the widespread 5G commercially by 2020, with large-scale adoption of the higher bandwidths. deployments to follow within two to three China has largely succeeded in expanding years. China already claims 97 percent cover- access to telecom services, but the massive age of the population for 4G LTE but plans expansion of Internet use continues along- to leapfrog into 5G to be among the interna- side slow broadband speed and limited Inter- tional leaders in the technology. Although 4G net business penetration. The major reform standards are supporting current Internet of question is whether the current strategies and Things deployment, 5G will become a criti- institutional arrangements are sufficient to cal infrastructure to support the hundreds of address the remaining challenges for China’s millions of machine-to-machine and Internet of Things connections. FIGURE 5.8 Broadband adoption in selected countries, by speed, first quarter of 2017 Remaining challenges and reform options 120 The main challenge for improving telecom- 100 munications access in China is to reduce significant regional disparities in broadband 80 Percent penetration. Consistent with other countries, 60 penetration is highest in larger urban cen- 40 ters and lower in more rural, remote prov- 20 inces. The mobile broadband penetration rate exceeds 90 percent in the heavily urbanized 0 China Korea, Singapore Australia India United and prosperous eastern coastal areas of Bei- Rep. States jing, Shanghai, and Tianjin, and in the prov- Above 4 Mbps Above 10 Mbps Above 15 Mbps inces of Guangdong and Zhejiang. Penetration rates are lower in other provinces, particularly Source: Adapted from Akamai 2017. in the more rural, remote provinces, but only Note: Mbps = megabits per second. 70 INNOVATIVE CHINA telecommunications infrastructure. The pol- regulatory framework for telecommunica- icy and regulatory framework is extensive, tions is quite extensive, top down, and inter- but can it put sufficient competitive pressure ventionist. Different authorities are respon- on the incumbent operations? Various policy sible for telecom and media, requiring the documents refer to the promotion of private State Council to coordinate. For example, competition. The network infrastructure is MIIT is responsible for overall regulation, essentially regionally distributed among the including licensing. The National Develop- three telecom operators. There is competition ment and Reform Commission is respon- at the services level, by virtual network oper- sible for approvals of investment projects ators and value-added service providers, such and pricing. While retail prices are market as the Internet service providers. In other determined, interconnection rates continue countries, greater private sector participation to be regulated, and there is frequent con- has promoted a more competitive market flict over interconnection. The regulatory environment and improved sector perfor- framework has undergone a series of reforms mance. Indeed, competition is a critical fac- since China’s membership in the World Trade tor in driving down prices for mobile phone Organization began, and some institutional service. Steps toward greater competition restructuring has contributed to separating could be achieved through gradual market the government’s regulatory functions from liberalization, combined with procompetitive ownership interests and policy making. The regulatory reforms. government could consider further steps to The government has been experimenting separate these functions. with market liberalization and foreign par- In other countries, major telecom market ticipation in the telecom sector. In late 2013, reforms typically involve de-monopolization it established the China (Shanghai) Pilot Free and the establishment of an autonomous Trade Zone to promote reforms and experi- regulatory authority. The general consen- ment with foreign investment in telecom- sus is that an independent regulator is best munications, as well as in e-commerce, legal positioned to resolve key conflicts, such as services, logistics, and marine insurance. In interconnections between networks. More- 2014, three more pilot free trade zones were over, establishing a regulatory authority established in Fujian, Guangdong, and Tian- before de-monopolization increases telecom jin. There are currently 12 pilot free trade investments (Wallsten 2002). But regulatory zones. A foreign-invested telecommunica- authorities vary in effectiveness. In many tions enterprise incorporated in the Shang- countries, the regulator covers both telecom hai free trade zone can have full ownership and media, a reflection of the convergence in an enterprise offering various types of of these technologies; in China, they are telecommunications-related services, includ- separate. ing Internet access and online data and trade China could consider more incremental processing. reforms to strengthen regulatory oversight These experiments in market liberaliza- of the telecom sector. In addition to taking tion could be accelerated and replicated in further action to separate regulatory func- other locations and extended to a range of tions, the regulatory framework could be other Internet services. There could also be reoriented toward greater emphasis on the an expanded role for the nontraditional ser- quality of services and public accountabil- vice providers—such as Alibaba, Baidu, and ity for performance, as in other countries. Tencent—which already provide extensive This reorientation would include reforms to “over the top” value added services on exist- ensure greater public disclosure of data on ing networks. Their participation could push operational performance. In this regard, in the sector to improve access, quality, and March 2018 MIIT announced that it would affordability. Incentive mechanisms may be establish a public list of “bad” and “untrust- needed to encourage the new providers to worthy” telecom businesses, focusing pri- accelerate rollouts in underserved regions. marily on the business practices of service Greater market competition could be providers. However, considerable scope complemented by regulatory reforms. The remains for expanding the monitoring and PROMOTING INNOVATION AND THE DIGITAL ECONOMY 71 evaluation of the telecommunications sector’s 9. The findings are based on a regression analy- performance, including at the subnational sis on determinants of provincial DAIs. The level, and for making the relevant data more quality of the business environment was widely available to increase accountability. measured by the proxy variables trademarks issued per capita, to measure strong property rights; trade to GDP ratio, to measure open- ness; and share of tertiary sector, to measure Notes higher diversified sources of growth. 1. The Patent Cooperation Treaty is an interna- 10. Open Data Institute (https://theodi.org/topic tional treaty with more than 145 contracting /data-infrastructure/). states. The treaty makes it possible to seek pat- 11. In a “safe harbor” data transfer regime, a ent protection for an invention simultaneously country grants Internet intermediates broad in many countries by filing a single “interna- or conditional immunity for third-party con- tional” patent application, instead of filing tent, provided that certain conditions are separate national or regional applications. respected. It is considered critical to the pro- 2. The Nature Index measures global high- motion of innovative services, as it provides quality research output based on absolute intermediaries with sufficient legal certainty and fractional counts of publication produc- to provide digital services. tivity at the institutional and national levels. 12. See https://www.eugdpr.org/. Weighted fractional count (WFC) accounts 13. However, acceptance of contractual obliga- for the share of authorship on each article tions typically has been interpreted as consent for transfer of personal data. and applies a weighting to adjust for the 14. Making direct comparisons of prices is dif- overrepresentation of papers in astronomy ficult, especially for mobile services, because and astrophysics. https://www.nature.com/ the terms, conditions, and quality of services articles/d41586-018-02904-3. can differ in addition to the prices. As a result, 3. In 2000, 99 percent of Singaporean patents price comparisons can differ across different were registered to nonresidents (Dodgson data sources. For example, International Tele- 2000). communications Union data (for 2017) indi- 4. “China Claims More Patents Than Any cate that mobile broadband prices are higher Country—Most Are Worthless,” Bloomberg in China than in Korea, but OECD data indi- News, September 27, 2018. cate that they are lower. In addition, the prices 5. Based on the World Management Survey and should be converted into purchasing power various industry case studies. See https://world parity to compare the real cost to users. managementsurvey.org/. 6. Statutory damages are damage awards in civil law, in which the amount awarded is stipu- Bibliography lated within the statute rather than being cal- Akamai. 2017. 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Various indus- Manufacturing.” https://obamawhitehouse try case studies. 6 Building Human Capital Human capital investment is essential for that help workers adjust to a more dynamic promoting the second and third of the three modern workplace. D’s. It facilitates the diffusion of innovation China has made considerable progress and technology (the second D) by enhanc- in strengthening its education system and ing the capability of the workforce to use, expanding education opportunities. Over the adopt, and disseminate technologies. A more past three decades, China has made primary capable workforce would help to foster new education universal and expanded access to discoveries and innovations (the third D) education at all levels. China runs one of and strengthen the research capabilities of the world’s largest education systems, with China’s universities, research institutes, and more than 270 million students enrolled at enterprises. Prioritizing human capital invest- various levels. Yet much remains to be done. ments and strengthening China’s education Gross enrollment rates across all levels are and training system will be essential for tran- now comparable to those in upper-middle- sitioning to innovation- and productivity-led income countries, but enrollments in upper- growth. Investing in each worker is particu- secondary (88.8 percent) and tertiary edu- larly urgent for China, given its shrinking cation (48.1 percent) still lag enrollments in and aging workforce. China needs to focus high-income countries in 2018. Overall, the on ensuring that no child is left behind and educational attainment of China’s labor force that each child has education opportunities lags well behind that of comparator countries at all stages of schooling, starting from early (figure 6.1). childhood education. China also needs to A record 7 million students will gradu- think ahead and consider the expected impact ate from Chinese universities in 2017, nearly of rapid technological changes on the future 10 times the figure in 1997 and more than economy and how best its education and twice the number in the United States in training system could prepare workers for 2017. When the Republic of Korea reached the future workplace. Reforms of the educa- China’s current gross domestic product tion and training system will need to be con- (GDP) per capita in 1992, its gross tertiary sidered together with complementary active enrollment was 40 percent, similar to that of labor market and social protection policies China today. Korea’s subsequent transition 75 76 INNOVATIVE CHINA FIGURE 6.1 Educational attainment of the labor force in China and comparator countries, 2015 a. Labor force with a high school education b. Labor force with a college education 120 60 100.0 51.4 53.1 100 94.0 50 46.4 47.7 86.5 87.6 90.6 79.3 80 40 36.5 64.9 65.5 Percent Percent 53.8 55.0 28.6 29.8 60 30 22.5 22.5 23.2 37.4 39.3 20 18.2 20.0 40 20 10 0 0 s de s n ey Ge bia n Co ey a Co hile ud bia OE up y d e ian Ja . Fe pan n a ud bia o u ile av 0 Ge age re y ss ed p. a 0 p Ko tate Fe tate o an Ko an in in ite rag bi CD f 2 t io tio pa CD of 2 Ru nit , Re Re rk rk Gr Ch Ch ra Ch Sa lom Sa lom ra rm rm C er OE p o Ja ra ra Tu Tu Un ave a, S ia n S iA iA a de re Gr U ss Ru Source: Li et al. 2017. Note: OECD = Organisation for Economic Co-operation and Development. to high income was supported by a grow- range of skills needed to adapt to new job ing supply of university graduates. By 2004, requirements, not just on a narrow range of two decades later, Korea’s gross enrollment vocational or occupational skills. rate had reached 90 percent. This was accom- plished with the underpinning of universal Technology’s impact on China’s access to quality basic education. Although the number of university gradu- labor market ates has increased rapidly in China, enter- Technological advances are expected to prises still identify skill shortages as a major change the world’s labor markets, includ- constraint. In a survey of entrepreneurs con- ing China’s, by automating a large share of ducted for this report, up to three-fourths of tasks performed by labor. Electronic and respondents indicated that finding workers information technologies have already auto- with technical and managerial skills was dif- mated many routines and noncognitive tasks. ficult. So China needs to close the investment Advances in big data analytics and machine gaps in basic education and learning, espe- learning could automate more cognitive cially in rural areas and among disadvan- tasks—such as driving, analyzing texts, and taged populations, and to ensure the quality recognizing faces. In the United States, over of postsecondary education. 2005–14, traditional occupations declined Different types of skills will be emphasized to about half of total employment in manu- in the future workplace, shaped by technol- facturing, while more highly skilled occupa- ogy. China’s education and training system tions grew the fastest, such as architecture, will need to prepare its workers for the future engineering, business, finance, management, workplace by equipping them with nonrou- sales, and computer and mathematical occu- tine, cognitive, and interactive social skills. pations (Oldenski 2015). Technical education and short-term training Robot density is expected to increase rap- need to be geared more toward jobs in the idly in China. Industrial robots can displace services sector, and lifetime learning will be local jobs much faster than the local economy increasingly critical for workers to keep up can create other jobs. In the United States, with changing technology. The whole post- they have reduced local employment and secondary system needs to mainstream more lowered wages in local labor markets, indi- work-based learning and focus on the full cating insufficient offsetting gains in local BUILDING HUMAN CAPITAL 77 employment (Acemoglu and Restrepo 2017). will change the types of skills demanded and It is estimated that adopting one new indus- the nature of tasks that humans perform. trial robot would displace six to seven work- A number of studies indicate that modern ers in the United States, but the impact in work will increasingly deemphasize the skills China may differ, given the vast differences needed for routine tasks, which are easier to in country context. automate, and instead require cognitive and Technology can displace workers by auto- socioemotional skills required for nonrou- mating their tasks, but it also can increase tine tasks. In high-income countries and in demand for labor by improving productiv- most low- and middle-income countries with ity and creating new jobs and tasks. The net data, the share of middle-skill jobs, intensive effect of technology on jobs will depend on in routine tasks, has been declining, and the both factors. Studies of the displacement share of high- and low-skill jobs has been effect vary widely in their estimates. Some growing—described as “job polarization” estimates suggest that up to half (47 percent) (Autor, Levy, and Murnane 2003). of U.S. jobs can eventually be displaced by In Western European countries, much of automation (Frey and Osborne 2017). World job polarization has been attributed to tech- Development Report 2016: Digital Divi- nological change, to the impact of outsourc- dends estimates that up to two-thirds of the ing, or to other competing factors (Goos, jobs in developing countries (and possibly a Manning, and Salomons 2014). Several stud- somewhat higher proportion in China) can ies confirm that polarization is due largely be automated, and potentially 57 percent to technologies that displace routine tasks of jobs in the Organisation for Economic and increase labor productivity in high-skill, Co-operation and Development (OECD) abstract tasks—and less to technological dis- countries (World Bank 2016). ruptions in low-skill occupations’ intensive However, the rate of technology adop- in nonroutine manual tasks. Industries and tion depends on many factors and does not countries that have seen faster growth of necessarily translate into actual automation. information and communication technology As automation increases, labor becomes (ICT) have increased the demand for college- cheaper, lowering the incentives for firms to educated workers and lowered the demand automate. In response, labor also can adjust for workers with middle-level skills, without and specialize in complementary tasks that necessarily displacing the low-skill and least- are difficult to automate. Studies that account educated workers (Michaels, Natraj, and for delays in technology adoption, offsetting Van Reenen 2014). In many countries, the employment gains, wage adjustments, and polarization has also translated into wage the heterogeneity of tasks within an occupa- polarization, with less-educated employees tion find a much smaller net impact of tech- experiencing smaller increases in earnings nology on jobs, often several times smaller. and more-educated employees experiencing Offsetting employment gains in other parts larger gains. This suggests that middle-skill of the economy—and the creation of new workers have difficulty acquiring the more jobs and industries enabled by technology— complex skills required in nonroutine tasks can absorb the displaced labor and signifi- and thus take on jobs in occupations below cantly reduce the net impact on employment. their education level, driving down wages. Accounting for such factors, the estimate Until recently, China was an exception to of jobs at risk of full automation in OECD the global trend of job polarization. Unlike countries falls to only 9 percent (Arntz, many other countries in the 2000s, China’s Gregory, and Zierahn 2016). In general, the share of middle-skill occupations (World difficulty of predicting future jobs and indus- Bank 2016), such as clerks, craft and related tries makes estimating the impact of technol- trade workers, and plant and machine opera- ogy on jobs extremely challenging. tors and assemblers, increased. Also in the Instead, it may be more helpful to consider 2000s, the employment share of workers in how technological advances and automation the middle ranges of wage distribution and 78 INNOVATIVE CHINA FIGURE 6.2 Employment shares in China, by wage and skill distribution, 2000–15 a. Wage distribution b. Skill distribution 20 15 15 10 % change in employment share % change in employment share 10 05 05 0 0 −05 −05 −10 −10 −15 −15 0 20 40 60 80 100 0 20 40 60 80 100 Employment share in 2005 (%) Employment share in 2000 (%) 2000–15 2000–05 2005–10 2010–15 Sources: National Bureau of Statistics census and intercensal survey data, from Du and Park 2017. education experienced the largest increase, FIGURE 6.3 Evolution of the skill content of providing further evidence that the share of Chinese jobs, 2000–15 middle-skill jobs had increased (figure 6.2; Du and Park 2017). This most likely reflects 60 Change in job skill intensity (standard deviation) the expansion of China’s manufacturing sec- tor and the associated expansion of middle- 40 skill jobs in the 2000s, as China benefited from the outsourcing of manufacturing pro- 20 duction from high-income economies. In more recent years, China has started 0 to show signs of labor market polarization. Since 2010, the share of higher-wage employ- –20 ees has increased significantly, much more than that of lower-wage employees and in –40 previous years (figure 6.2, panel a). Also, after 2010, the employment share of workers –60 with the highest and lowest education lev- 2000 2005 2010 2015 els increased the most (figure 6.2, panel b). Routine manual Routine cognitive Such indications of labor market polarization Nonroutine manual physical are also evident in the changing demand for Nonroutine manual interpersonal skills in the labor market. Since 2010, as in Nonroutine cognitive analytical Nonroutine cognitive interpersonal most high-income and middle-income econo- mies, in China work has become less manual Sources: National Bureau of Statistics census and intercensal survey and more intensive in cognitive and interper- data, from Du and Park 2017. sonal skills (figure 6.3). The share of work- ers with manual skills increased in 2010, but then declined in 2015, the largest decline skills. This change may reflect the growth of among workers of all skill levels. Nonrou- jobs in services. tine manual interpersonal skills increased the Labor market polarization is likely to most in 2015, followed by routine cognitive deepen in China with the advance and BUILDING HUMAN CAPITAL 79 adoption of technology. In particular, China’s recent years, suggesting that any reshoring is rapid adoption of industrial robots and its being canceled out by offshoring. In general, large number of manufacturing jobs could offshoring continues and appears to remain make displacement much more severe than more important than reshoring. Despite ris- in many other countries. In China, more ing labor costs, offshoring to China could than 40 percent of the country’s manufac- continue, as companies seek access to China’s turing workers are employed in firms with large and emerging domestic market. automation equipment, and some 10 percent are employed in firms with robots. By 2015, Building universal foundational China had become the world’s largest user of robots. Industrial robots, which accounted skills for 27 percent of new robots globally, are pro- Reforms to prepare students for the future jected to constitute 40 percent of global sales workplace will be necessary across the entire by 2019. But robot density—the number of education system. China needs to build the industrial robots per 10,000 workers in man- universal foundational skills of all students by ufacturing jobs—is still low in China (49) addressing the remaining disparities in edu- compared with Korea (531), Singapore (389), cational attainment. And it needs to support Japan (305), Germany (301), the United States the most vulnerable individuals who drop out (176), and the United Kingdom (71). and fail to acquire critical foundational skills Technological upgrading also can change throughout basic education. the demand for manufacturing jobs and skills For the early years and compulsory pri- by changing how manufacturing production mary education, China needs to close the is organized. It can lead to a global redistribu- investment gaps in education and learning, tion of manufacturing jobs, potentially affect- especially in rural areas and among disadvan- ing China. Over the past decades, firms in taged populations. In 2016, the gross enroll- high-income countries have been offshoring ment rate for preschool education was around their manufacturing capacity to lower-income 77.4 percent,1 but rural and migrant children countries to take advantage of lower labor have been starting their education significantly costs and to gain efficiency through expand- later than their urban peers, contributing to ing global value chains. China has been one of large differences in length of attendance. This the prime beneficiaries of this process, allow- is critical because cognitive and interpersonal ing it to become a global manufacturing base skills as well as creative thinking begin to take and contributing to the increasing share of root early in life. The 2015 Program for Inter- middle-skill jobs. But these favorable trends national Student Assessment (PISA) science could start to reverse for China. Advances results indicate that Chinese students with in technology could enable the reshoring of early child development (ECD) perform 2.5 jobs to local and regional hubs closer to final- years ahead of those with no ECD. consumer markets. China could be hit hard OECD countries already spend, on aver- given the large share of its manufacturing age, 2.3 percent of GDP on services for exports attributed to foreign-invested firms families and for children ages 0 to 6 years, and its rising labor costs. which allows many of them to provide ECD But further work is needed to assess global services for free. China’s investment in ECD reshoring. Anecdotal evidence based on firm has increased over the years, and it reached surveys is fragmented and incomplete, and the 0.4 percent of overall GDP in 2016. Seventy- results vary widely (De Backer et al. 2016). seven percent of children attended prepri- Aggregate data on the activities of U.S. multi- mary school, but only 60 percent in rural national enterprises show no signs that the areas attended, compared with nearly 100 home share of employment is increasing, but percent in urban areas (2015). 2 Large dif- they do provide some evidence that capital ferences in educational inputs, such as the investment is increasingly concentrated in the pupil-to-teacher ratio, indicate that children United States. Home employment shares of in rural areas are likely to receive a lower- European multinationals1 have been stable in quality preprimary education. 80 INNOVATIVE CHINA For compulsory basic education, poor Creating a world-class higher nutrition and health among disadvantaged education system children, including left-behind children and migrant children in elementary school, have A world-class higher education system will been linked to poor cognitive performance help China join the ranks of global innova- and lower well-being. These learning deficits tion and technology leaders. China’s higher linger from earlier stages of education, and a education system has undergone major significant number of students, particularly expansion and transformation over the from rural and migrant families, do not com- past two decades. In 1999, the government plete a full cycle of high school education. decided to expand university admissions, and Rural children also exhibit lower progression since then the number of new college students to the academic stream of senior-secondary has risen rapidly—from 1.6 million in that schools and therefore are less likely to apply year to 7.5 million in 2016 (figure 6.4). In the to tertiary institutions. In 2015, 78 percent of same period, the number of tertiary institu- junior-secondary school graduates in urban tions (universities offering four-year bache- areas entered the academic stream of senior- lor’s degrees and two- and three-year colleges secondary school, compared with only 45 offering certificates) also increased rapidly— percent in rural areas.3 from 1,071 in 1999 to 2,596 in 2016. Hence, Whether China can significantly increase the number of tertiary institutions more than the average level of educational attainment doubled, and the enrollment of college stu- will depend critically on younger cohorts dents almost quintupled. staying in school longer. As the education of China now has one of the world’s larg- the first nine years is compulsory and nearly est tertiary education systems, with 27 mil- universal, raising the level of educational lion students in its universities and colleges attainment requires moving students on to (including 16.1 million in technical or spe- upper-secondary school. Over the years, the cialized short-cycle programs), 2 million in transition rate from lower-secondary edu- graduate schools and research institutes, and cation to higher-secondary education has 5.8 million in 284 tertiary institutions for increased significantly, driven mostly by adult education. Public higher educational improved access for rural students. How- institutions, where 86.5 percent of students ever, the transition rate has been declining are enrolled, are overseen by either the central somewhat since 2014. Despite the overall ministries or the provincial ministries. All of increase in access to upper-secondary school, the institutions under the central ministries the central and western rural areas continue are full universities; the majority of the most to experience significant student dropouts, prestigious universities are overseen by the highlighting retention and equity challenges. Ministry of Education.5 The costs (tuition and fees) of an upper- As university enrollments in China con- secondary education and the opportunity tinue to increase, the number of young (ages costs of work are important barriers to 25 to 34) college graduates with tertiary attaining upper-secondary schooling, par- degrees in China is projected to rise a fur- ticularly for the poor and the underserved. ther 300 percent by 2030, compared with Furthermore, there is a significant urban- an increase of about 30 percent in Europe rural divide, with only 47 percent of rural and the United States (OECD 2015). In youth having completed upper-secondary 2013, China already accounted for 17 per- school at the age of 20 (2015).4 These are cent of all young college graduates across major challenges for the government’s goal of OECD and Group of 20 countries, the larg- universalizing secondary education. Different est share among all countries, and this share provinces and regions also demonstrate large is expected to reach 27 percent by 2030. variations in the average years of schooling of China’s contribution to the pool of scientists their labor force, highlighting regional gaps and skilled technicians will be even greater; in access to upper-secondary schooling. its share is projected to reach 37 percent by BUILDING HUMAN CAPITAL 81 2030, due to the greater share of Chinese stu- FIGURE 6.4 Number of postsecondary students and tertiary dents graduating in STEM subjects (science, institutions in China, 1985–2017 technology, engineering, and mathematics). In 2013, 40 percent of Chinese university 10 3,000 graduates completed their studies in STEM 2,500 subjects, compared with less than a third 8 in countries such as France, Germany, the Tertiary institutions Students (millions) 2,000 United Kingdom, and the United States. 6 Government spending on tertiary educa- 1,500 tion, at 0.87 percent of GDP, is comparable to 4 1,000 spending in Japan and Korea, but lower than spending in other high-enrollment countries 2 500 such as Brazil, India, the United Kingdom, and the United States (figure 6.5). Maintain- 0 0 ing adequate resources across the tertiary 19 5 19 7 19 9 19 1 19 3 19 5 19 7 20 9 20 1 20 3 20 5 20 7 20 9 20 1 20 3 20 5 17 8 8 8 9 9 9 9 9 0 0 0 0 0 1 1 1 19 system has been a struggle in the face of the Enrolled college students High school graduates rapid growth in the number of institutions. Number of tertiary institutions (right scale) For example, while enrollment has qua- drupled, the full-time faculty has increased Source: National Bureau of Statistics. only 1.7 times. As in most countries, the traditional model of state-supported higher FIGURE 6.5 Government spending on tertiary education in education in China has long since given way selected countries to a model of cost sharing by students, rais- ing concerns about affordability, access, and equity. Despite extensive efforts to improve 1.6 tertiary education opportunities worldwide, 1.4 1.36 1.36 access to and success at this level of education 1.23 tends to be highly inequitable. 1.2 China’s top universities have moved up in 1.0 0.97 0.88 0.87 0.86 the global rankings. In the QS World Uni- % of GDP 0.8 0.78 versity Rankings (2018), which is used by the global innovation index, China has six 0.6 0.55 0.50 universities among the top 100 in the world 0.4 and seven among the top 200. In the Times Higher Education World University Rankings 0.2 (2018), China has two universities among the 0 top 100 (Peking University and Tsinghua Uni- es n il m a a p. an n sia az di in tio ta Re do at p versity) and seven among the top 200. The ne Ch In kis Br Ja ra St ng a, do de Pa re d Ki In ite Fe seven among the top 200 in both rankings Ko d Un ite ian Un are the same.6 Both rankings are dominated ss Ru by U.K. and U.S. universities. According to the Academic Ranking of World Universities, Sources: For China, calculations based on 2016 government data; for other countries, calcu- lations based on World Bank Edstats data (most recent year, 2013–16). originally produced by Shanghai Jiao Tong University, the number of Chinese universi- ties in the top 300 increased from 0 in 2000 to strengthen the country’s top 100 higher to 6 in 2008 and to 18 in 2017.7 education institutions, particularly their Creating world-class universities has research capacity. In 2015, China announced been a long-standing priority for China, the Double World Class Project, to succeed which has been upgrading its top universities the earlier programs tasked with promoting through targeted programs. The “211” and the best universities to world class. A total of “985” projects were launched in the 1990s 42 universities and 95 subjects were selected 82 INNOVATIVE CHINA to receive funding from central and local gov- Over the past decades, China has carried out ernments to improve facilities and infrastruc- higher education governance reforms that ture, conduct research and development, and granted more autonomy to higher educa- attract high-level academics. tion institutions. Other East Asian countries Creating world-class research universities have also carried out reforms to grant greater is an expensive endeavor. The key is to ensure autonomy to higher education institutions, the balanced development of the entire higher starting with reforms in the 1990s by Indone- education system. China has experienced sia, Korea, Malaysia, and Thailand, followed significant regional disparities in resources by a second wave of reforms in the 2000s and enrollment within the higher education in Japan and Singapore. However, some of system: many universities supported by the the reforms to grant greater institutional Double World Class Project are in the east- autonomy have been partial and incomplete ern region, while universities in poorer areas (World Bank 2012). struggle to mobilize adequate resources and In China, the governance reforms are also quality faculty. The disparity is reflected in considered an unfinished agenda. The Higher the significant variation in spending per stu- Education Law (1998) established the legal dent, from RMB 64,850 in Beijing to RMB status of higher education institutions and 21,678 in Guizhou province in 2016.8 provided regulations regarding institutional Disparities in the tertiary education insti- autonomy for admission, programs, majors, tutions have obvious implications for overall and course instructions. The National Out- quality. Across countries, the rapid expansion line for Medium- and Long-Term Educa- of tertiary education systems has posed signif- tional Reform and Development (2010–20) icant challenges to ensuring quality across the attempted to clarify the relationship between system. In China, the massive college expan- the government and higher education insti- sion has induced many to attend college, but tutions and advocated building a “modern the returns to a college education have been school system” based on “self-governance” more moderate and flattening since the mid- for the education institutions. Direct man- 2000s, consistent with the deteriorating qual- agement of higher education institutions ity of colleges. And returns are much lower has declined except for certain national uni- in rural areas (8 percent annual returns) than versities. But regulations remain extensive, in urban areas (21 percent).9 A sizable por- and government approval is still required tion of college graduates in China are getting for many managerial decisions. In a 2010 very low returns to college education, and expert survey of East Asian countries by the those returns are not necessarily justified by World Bank, higher education institutions in the cost of a college education. Accounting China were assessed as having no autonomy for private expenditures on college education, or only partial autonomy on various indica- about 10 percent of college graduates earn a tors of higher education autonomy: setting negative net return on their investments in academic and course structure and content; college education. If public expenditures are determining salaries and hiring and dismiss- added, this share would be higher. ing faculty; owning buildings and equipment; and determining the size and composition of student enrollment (World Bank 2012). Governance reforms to modernize Chinese universities essentially have a dual China’s higher education system governance structure. The university presi- Good governance has been identified as an dent, although formally the leader and legal important determinant of high-quality uni- representative of the institution, shares the versities. University autonomy is considered authority to appoint members of the senior a key aspect of good governance, and its academic and administrative team with a importance increases as the tertiary educa- Communist Party of China (CPC) secre- tion system expands and becomes more com- tary, who in many cases is the chair of the plex (Altbach and Salmi 2011; Salmi 2009). university board. CPC secretaries also are BUILDING HUMAN CAPITAL 83 often directly involved in daily management leadership. Updating the Higher Education and administration, in some cases acting like Law would provide the legal basis for mod- a co-president. The president is selected and ernizing higher education governance. Such appointed by the government, and members laws should be updated at least every 10 years of the board are either selected or approved (the law in China dates to 1998). One model by the government. To provide the faculty to consider for the higher education strategic with a greater role in university management, plan is the California Master Plan for Higher universities in other countries have estab- Education (Altbach and Salmi 2011), which lished academic councils or faculty senates is considered a pioneer in systemwide gov- that decide on academic matters. The univer- ernance frameworks for higher education. sity president, who is also the council presi- The plan emphasizes the balanced growth dent, coordinates administrative and aca- of California’s three-tier public higher edu- demic decisions and implements the council’s cation system, while also committing to the decisions. As part of its strategy to become excellence of its top-tier research universities. a world-class university, Shanghai Jiao Tong Academic freedom is at the core of the plan, University established an academic council in and all appointments and promotions of 2008. faculty are rigorously meritocratic. Internal China could consider developing a strate- governance of the university is mainly in the gic plan for higher education to establish a hands of professors, and key administrative modern tertiary education governance frame- decisions on academic policies receive input work with governance reforms to support from academics. greater autonomy of tertiary education (box Granting greater autonomy and decision- 6.1). Tertiary education institutions could be making authority to higher education insti- provided greater organizational, financial, tutions requires increasing their institutional human resource, and academic autonomy. capacity and leadership to handle their Reforms could be piloted first in universi- increased responsibilities. Across countries, ties with adequate institutional capacity and granting this authority typically involves BOX 6.1 A modern tertiary education governance framework A modern tertiary education governance framework the authority to approve strategic plans and annual supports the autonomy of tertiary education institu- budgets and to recruit the university president tions through four main dimensions: organizational, (chief administrator). The university leader and the financial, human resource, and academic. These four leadership team (deans and so on) are selected com- dimensions were first introduced by the European petitively according to professional criteria, using University Association in its Lisbon Declaration in an external search committee. 2007 and are supported by various research pro- • Financial autonomy is the freedom to mobilize, grams on the importance of autonomy for successful manage, and use financial resources, including the universities in Europe and the United States. They are freedom to determine tuition and fees and to own also core elements of an assessment (benchmarking) and manage properties. framework of tertiary education systems developed • Human resources autonomy is the freedom to by the World Bank: recruit and dismiss faculty and set salaries unen- cumbered by civil service requirements. Human • Organizational autonomy refers to the roles, func- resource policy is based on meritocratic and com- tions, and authority of the governing board of the petitive recruitment and retention of staff. university. It is characterized by an independent • Academic autonomy is the freedom to define aca- university board with external representation and demic structure, programs, and course content. Source: Altbach and Salmi 2011. 84 INNOVATIVE CHINA establishing and empowering the govern- countries such as Japan and Korea, and very ing boards. Modern governing boards are few institutions publish their evaluation or responsible for providing strategic vision, accreditation results. selecting the university president (chief exec- Publishing evaluation results and collect- utive), approving strategic plans and annual ing and disseminating performance data are budgets, and establishing a system of risk key aspects of a higher education quality management and the parameters of financial assurance system. Making such institutional autonomy. In East Asia, the trend has been to performance and outcome data available to establish modern governing boards or univer- the public enhances the transparency and sity councils and to strengthen their author- accountability of tertiary systems and helps ity. China has not moved in this direction, students and parents make informed choices. as its institutional arrangements reflect the Systematically gathering information about country’s unique governance and institutions. indicators of educational quality can help On their own, autonomy and a stron- policy makers and universities evaluate prog- ger governing board are unlikely to achieve ress and develop strategic plans. The system- higher education’s potential without a well- atic monitoring of graduates’ transition into functioning accountability and quality assur- the workforce is essential to evaluate the ance mechanism. Strengthening an account- relevance of tertiary education offerings to ability and quality assurance mechanism labor market needs. Such information would would also allow the government to reduce help tertiary institutions assess their own direct control over how universities should performance accurately and respond to the be run. With greater autonomy, universities changing demand for skills. Finally, annual would have to be accountable for their use of publication of university rankings is common public resources, the alignment of their opera- in many OECD countries and is becoming tions with public policy goals, and their over- increasingly common in Eastern and Central all performance in educating students. China Europe and Latin America. recognizes the importance of ensuring the New issues are emerging in China’s higher performance and quality of tertiary educa- education system. China plans to turn about tion institutions. China’s National Outline for 600 general universities into “universities of Medium- and Long-Term Educational Reform applied learning,” more commonly called and Development (2010–20) stated, “Rais- polytechnic universities or institutes of tech- ing quality is at the heart of higher education nology in other countries. Such institutions development, and it is a basic requirement of typically specialize in engineering, technol- building a strong nation of higher education.” ogy, and applied sciences and emphasize Establishing an independent quality assur- teaching rather than research. Also, with a ance agency would help to ensure the quality new Private Education Law (2017), China standards of higher education institutions. will formally introduce for-profit universities, Compliance with such standards would play recognizing the expanding and thriving pri- a significant role in determining the accredi- vate education sector that caters to millions tation status of an institution. Accredita- of Chinese youth from lower- and middle- tion also could be a prerequisite to qualify income families. Both applied and for-profit for public and private funds, maintain legal universities will require clear and compre- institutional status, attract students, and hensive regulatory frameworks and quality recruit a qualified faculty. In most countries assurance mechanisms. Such frameworks are in East Asia, including high-income coun- particularly critical for for-profit universities, tries such as Japan and Korea, the qual- which, in other countries, have at times per- ity assurance agencies are independent. In formed poorly in an inadequately regulated China, this agency is a semiautonomous environment.10 In this regard, ensuring pub- agency under the Ministry of Education. In lic access to information on school perfor- addition, fewer than a quarter of tertiary mance, and linking performance standards institutions are evaluated or accredited, and finance mechanisms to job market per- compared with three-quarters and above for formance, could be helpful. BUILDING HUMAN CAPITAL 85 Teaching creative thinking and higher education tends to be very narrow and problem solving focused. Reforming this approach, by allow- ing students greater freedom to select or alter The future workplace will have greater their educational path, could expose students demand for cognitive and interpersonal skills, to a broader education and provide them and pedagogy and curricula will need to be with the foundational knowledge and skills reoriented to provide those skills. Recogniz- to think creatively and enter any profession. ing the need for reforms, countries such as Universities are taking a more pragmatic Finland, Korea, and Singapore are moving to approach to striking a balance between nar- more balanced curricula, with greater atten- row professional skills and broader foun- tion to developing socioemotional and other dational skills. Universities in Australia, higher-order skills. Singapore is shifting Europe, and the United States are increasingly from an education model emphasizing aca- promoting more multidisciplinary courses demic performance to a “positive education” and majors. Such multidisciplinary courses approach downplaying academic grades and have become increasingly popular in univer- focusing on specific skills that assist students sities in high-income countries for equipping in strengthening their relationships, build graduates to learn and think across a broad positive emotions, enhance personal resil- range of fields while also developing in-depth ience, promote mindfulness, and encourage a academic skills. Multidisciplinary courses healthy lifestyle. Korea’s revised national cur- often follow a problem-centered approach riculum aims to nurture “creative and integra- and use case studies to solve complex prob- tive” learners by promoting socioemotional lems. Many emerging research fields tend to competencies, knowledge-information pro- be multidisciplinary. cessing skills, creative thinking skills, com- In China, education incentives are driven munication skills, and civic competency—for strongly by university entrance exams, which example, by integrating liberal arts and natu- can impact incentives for creative and broader ral science tracks in high schools. Finland’s learning.11 Such exams are common in East new national core curriculum introduced Asian countries, including Japan and Korea, collaborative classroom practices that are where students have historically scored high multidisciplinary and problem and project on international assessments, such as the based, with students expected to participate OECD’s PISA test. The school exam system in the planning of schoolwork. Students are has been criticized for creating strong incen- expected to take a more active role in Fin- tives for students and teachers to focus on land’s core curriculum, devising their own testing skills, rather than on problem solv- individual learning goals, while teachers pro- ing, curiosity, or creativity. A common view vide an enabling learning environment and is that, compared with other leading systems, support them in their individual study plans. East Asian education systems often inhibit In China, the higher education system creativity and emphasize rote memorization. emphasizes professional and specialized However, the OECD’s assessment of the cre- skills that are more directly applicable to ative problem-solving component of the 2012 the job market, and this emphasis may be PISA test found that East Asian students, hindering the development of a broader per- including students from China, outperformed spective that can be helpful for creative and students from other countries. In addition, cognitive thinking. Universities focus on there is evidence that exam-driven systems specialized skills directly relevant to the job develop persistence (“grit”), goal orientation, market in response to demands by students self-control, and willpower that can help stu- and their families. China’s tertiary educa- dents in their careers and lives (Baumeister, tion system also requires students to spe- Vohs, and Tice 2007; Choi 2014; Duckworth cialize very early. Unlike in systems in many et al. 2007). The success of East Asian emi- Western countries, students already select a grants in Silicon Valley, where China and major when they apply to college, and almost Japan are among the top five source countries from the moment they step onto campus, for immigrant entrepreneurs, also suggests 86 INNOVATIVE CHINA that growing up in an exam-driven system provide emphatic responses—and even may not inhibit creativity. take the national college entrance exam However, exam-driven systems also can (Gaokao). Such systems can then be used inhibit intrinsic motivation, stifle creativity, to provide support for individualized and have significant psychological and social learning and for teaching children with costs. For example, the stress levels of Korean autism-spectrum disorders. students are quite high by international stan- 2. Educational applications of Internet- and dards and are linked to high adolescent sui- sensor-enabled technologies help track cide rates. In Korea, the system also has led learner information and student achieve- to high financial costs for families in the form ment. Besides tracking attendance, smart of private tutoring expenditures; such costs identification cards could determine how risk exacerbating social inequality. Exam- learners move through the school dur- driven systems also can engender a relatively ing the day and with whom they inter- narrow, homogeneous set of aspirations and act—and how these actions affect student metrics. learning and achievement. For instance, facial recognition software may be used to generate feedback on student engagement, Using technology to teach which could help teachers to improve their creativity and problem solving pedagogic strategies and understand areas China’s burgeoning educational technol- where students are struggling or could ogy industry and the associated new digital benefit from more challenges. technologies can potentially be harnessed 3. Adaptive learning software, based on to reorient teaching and learning. In China, advances in data analytics, can personal- the rate of adopting new digital technologies ize instruction and measure student learn- in education is accelerating. The number of ing through interactive and real-time met- monthly users of online education platforms rics that adjust to students’ level of subject is now 170 million for children’s education, mastery. It allows teachers to gain insight 95 million for foreign language learning, into the trajectory of individual learners. and 45 million for professional education Myriad adaptive learning platforms exist, (China Internet Watch 2017). Technology- including Yuanfudao (offering a test data aided instruction has the potential to improve pool uniquely adapted to China’s testing learning when it aids teachers and gives stu- system and online courses inspired by the dents an individual learning experience. The Khan Academy), TutorGroup (connecting following six are among the most promising anytime from anywhere to synchronous technologies: tutoring with a live tutor), and Kidaptive (cloud-based adaptive learning that cre- 1. Artificial intelligence (AI) in education ates learner profiles and actionable feed- aims to improve teaching and learning by back for parents and teachers). enhancing students’ metacognition, foster- 4. Maker Education, or learning through ing collaborative learning, spreading effec- making, is a workshop environment, tive pedagogies, and relieving teachers of similar to Makerspaces, using technolo- tedious tasks. By augmenting personalized gies to promote hands-on learning and learning, it could provide students with creation. Typical activities include paint- insights that promote self-directed learn- ing, cooking, three-dimensional printing, ing and allow teachers to identify patterns and robotics. Teachers are expected to to improve their pedagogies. AI also can facilitate students’ self-directed hands-on help to broaden learning assessment sys- learning. These environments are said to tems by including socioemotional skills foster socioemotional skills like persis- through game-based learning assessments. tence, resilience, and collaboration as well In China, AI systems are being developed as higher-order skills like problem solving that can engage in conversations and and creativity. China is investing heavily BUILDING HUMAN CAPITAL 87 in Maker Education spaces, and, since learning outcomes. China would benefit their first appearance in 2010, they have from embracing the promise of new technol- spread throughout China. The China-U.S. ogies in education, using a gradual approach Youth Maker Competition has been spon- of testing and experimentation that deter- sored over the last few years by the Minis- mines the most effective approaches. This try of Education, in partnership with Intel effort could be complemented by regulations and Tsinghua University. to safeguard the privacy and security issues 5. Start-ups like DFRobot and Senfu are devel- arising from the use of these technologies in oping applications of robotics education for education. young and adolescent children. The appli- cations include kits for students to assemble Strengthening technical and a simple robot as well as more open-ended interactive hardware and a multidisci- vocational education and plinary curriculum and associated teacher training training in robotics. The hands-on contact Technical and vocational education and with modern technology encourages critical training (TVET) is an important source of and computational skills early on. Robot- skilled labor for the economy. Secondary and ics competitions, which are increasingly tertiary vocational-track students account common, offer children opportunities to for about 40 percent of all students.12 The apply their skills in solution-oriented government has a policy goal of reaching projects. an enrollment ratio for vocational to aca- 6. Virtual reality, enabling firsthand simu- demic programs of 50:50. China’s target lated experiences for learning, is used in ratio is similar to that of Europe. The share schools to teach abstract concepts in sci- of students on the vocational track is deter- ence (such as observing blood circulation), mined by many factors and is not necessar- geography, and history in more engag- ily proportional to a country’s income status. ing ways, transporting students to class- But, on average, only 29 percent of upper- rooms in other places or simulating a visit secondary students in OECD countries are to distant, unreachable locations. It also enrolled in the vocational track. For upper- nurtures socioemotional skills like empa- middle-income countries and middle-income thy through immersive experiences that countries, the ratios are 34 percent and 21 reward greater collaboration. New start- percent, respectively.13 So, China’s 40 percent ups in China are developing ways to com- share of students in vocational programs is bine virtual reality with adaptive learning comparatively high. to customize instruction for each student China’s high share of students in voca- and increase student engagement. tional programs reflects lower costs. Since 2011, the central government has prioritized Despite the hype, the potential of new investments in vocational education, and educational technologies has yet to material- mobilized additional subnational invest- ize fully. Many big investments have failed ments. Vocational education has thus become to deliver clear learning gains. The new tech- more affordable for students from rural or nologies work best when they complement disadvantaged backgrounds. More than 90 teachers rather than seek to replace them. percent of vocational school students enrolled Technology-enabled instruction to improve at the secondary level receive tuition waivers pedagogy and allow students to learn at their in addition to other financial assistance. At own pace have so far achieved better results. the tertiary level, scholarships are provided Using technology to give students a dynamic to 30 percent of all students and financial learning experience seems to improve learn- assistance to 25 percent. At the secondary ing. Hardware-focused interventions that level, the financial resources for vocational provide computers at home or at school have programs are on par with those for academic not necessarily had a significant impact on programs, but vocational programs only 88 INNOVATIVE CHINA receive 18 percent of all tertiary funding—far and international organizations (box 6.2). below the share of vocational students. But the practical relevance of vocational The State Council issued an action plan training still needs to be improved. TVET in 2014 to create a modern, demand-driven needs to acquire greater market relevance TVET system. To provide more market- through closer private sector involvement. oriented vocational training, it targets 80 Public-private partnerships to foster enter- percent of large and medium enterprises to prise participation in curricular design, deliv- enter official cooperation agreements with ery, and practical training opportunities have vocational schools and colleges. Provincial been used in other countries, such as the and local governments have more freedom Meister schools in Korea and the apprentice to adjust the training course offered by voca- system in Germany. There are also signifi- tional colleges to meet the requirements of cant disparities in the quality of facilities and local companies. To complement government staff across schools, with only 35 percent of vocational colleges, the government promotes teachers having industry experience.15 TVET expanding private vocational colleges. It also governance and management are fragmented calls for treating higher vocational training across public agencies; quality is uneven the same as university studies, allowing for across schools; courses need to adapt to a easier transfers between the two streams.14 more service-oriented economy; and TVET Many challenges remain in building a funding needs to be driven more by outputs modern TVET system in China. The gov- than by inputs. ernment has rolled out initiatives to enhance A key policy priority is to integrate techni- school-industry collaboration, the market cal and academic streams more fully. Voca- relevancy of TVET curricula, and improved tional programs with an excessive technical pedagogy. As a result, there are certainly focus do not provide an ideal learning envi- examples of successful vocational schools, in ronment for young learners to acquire core some cases schools that have benefited from competencies for long-term career develop- cooperation with international companies ment. Global evidence indicates that youth BOX 6.2 Lessons from recent World Bank TVET projects in China In the past decade, the World Bank has implemented • Ensure government buy-in. Systematic provin- several provincial TVET projects and accumulated cial reforms help to achieve objectives and to sus- experience in the reforms of TVET. Since 2007, the tain results in the long run. School reforms need Bank’s key investments in the education sector have to be accompanied by structural and institutional been skill development projects in targeted provinces, reforms to avoid setbacks in reform. ranging from the more developed Guangdong Prov- • Customize a teacher training plan. To enhance the ince to the less developed western provinces such as effectiveness of instructor training, schools should Gansu, Xinjiang, and Yunnan. The projects show- develop a customized training plan, based on the cased these good practices on building modern TVET instructor’s professional development, and that schools and improving systems through piloting and accurately reflects needs, skill demands, and good institutionalizing reforms: training practices. • Promote modular, competency-based training for • Strengthen school-industry links. Training success lifelong learning. Modular courses promote flex- is tied to how closely the programs are linked to the ible entry to and exit from training over a worker’s real demands of the labor market, which requires career and are inherently demand driven. They pro- employers to be involved in teaching and learning mote student-centered pedagogy and competency- at the school level. Industry-led skill councils can based evaluation instruments to assess students’ guide curriculum development based on specific learning outcomes and teachers’ effectiveness. skills demanded, and school-led “school-industry • Build pathways for further study. Opening path- committees” can steer broad-based school reforms ways to tertiary studies can increase the demand of curricula, pedagogy, and assessment. for secondary technical and vocational education. BUILDING HUMAN CAPITAL 89 employment rates are higher for individuals competencies that reflect changing labor with TVET education than for those with market demand. Examples of countries with academic education at the initial point of national training authorities include Austra- transition from education to work. That lia, Brazil, New Zealand, the Philippines, advantage decreases with age, however, as the South Africa, and the United Kingdom. narrow technical skills that initially helped A national qualifications framework for in obtaining work become outdated and the technical and vocational schools could also absence of more general competencies for be considered. China has a quality assurance adapting and lifelong learning becomes a con- and accreditation system, but it needs to be straint (Hanushek, Woessmann, and Zhang updated to ensure relevant and reliable stan- 2011). Therefore, the technical and academic dards for quality improvement. Occupations streams should be viewed not as separate and the associated competencies have been programs but as part of an integrated sys- changing rapidly, and curriculum and stan- tem, to allow students in the technical stream dards require inputs from industry to stay greater access to a broader education. Stu- relevant. In addition to outdated standards, dents should be allowed to shift more easily the following impediments make it difficult between streams and should receive credit for for training to stay relevant: teachers typi- skills acquired in either stream. cally lack industry connection and therefore Pathways for skills acquisition need to be are not equipped with the most up-to-date diversified. While options for post-TVET edu- technical knowledge; pedagogy tends to cation have increased in recent years, some be teacher-oriented rather than student- programs lack opportunities for graduates centered, making students less likely to to continue to study in higher education. It is engage actively during training; and facili- possible for qualified graduates of secondary ties tend to be outdated, constraining student vocational schools to be admitted to tertiary acquisition of hands-on experience. vocational programs, but such programs TVET needs to move toward preparing are generally considered less prestigious workers increasingly for employment out- than regular universities. Considering that side the manufacturing sector, such as in the a large majority of TVET students are from services sector and self-employment. This rural, migrant, and blue-collar families, hav- process begins with reforms of course offer- ing more post-TVET options would provide ings, which only recently started incorporat- more opportunities for social mobility. As ing the entrepreneurship and core business more universities are turned into universities skills training that is directly relevant for of applied learning, pathways can be explored self-employment, the management of small for vocational students to enter them. enterprises, and services. The required skills The government can coordinate managing encompass costing, pricing, preparing finan- the TVET sector. Currently, both the Minis- cial statements, keeping business records, try of Education and the Ministry of Human project management, marketing, sales, and Resources and Social Security and their preparing business plans, among others. local departments are involved in overseeing Promising programs in Korea and other coun- TVET. Reforms will require improving coor- tries are introducing entrepreneurship, work dination between the two ministries. Other readiness skills, and experiential applied line ministries are also involved in delivering teaching methodologies in secondary schools sector-specific training. The government and are developing new TVET curricula with could pursue greater coordination among a focus on skills for self-employment. agencies for T VET—perhaps by estab- lishing a new skills development author- ity—to tighten the links between schools Promoting lifelong learning and enterprises, to facilitate the provision With rapid technological development, of work-based training, especially by small job transitions throughout working lives and medium enterprises, and to update will become the norm. The labor market is the qualifications framework for technical expected to become more dynamic, with and vocational schools, with standards and more frequent job transitions, requiring 90 INNOVATIVE CHINA workers to learn new skills throughout their independent apex training authorities, such as lifetimes. A system of lifelong learning can Singapore’s Institute for Technical Education, prepare workers—notably adult workers— that have strong partnerships with employers for the expected impact of changes in tech- and other stakeholders. nology in the labor market. Adult workers China has been increasing its investments need to learn job-related skills quickly, which in adult and labor force training programs, means higher demand for modular competen- with an emphasis on clear links to employer cies-based training. These training providers demands. The higher education system has will need to be more responsive to the diverse institutions for adult education, including age and experience profiles of workers expe- universities offering education via radio and riencing job transitions. television; schools of higher education for Building a demand-driven system for life- professional staff, workers, and agricultural long adult learning will require establish- workers; colleges for management cadres; ing the institutional conditions for a well- pedagogical colleges; independent correspon- regulated market of private and public provid- dence colleges; and evening schools or cor- ers that deliver training services with the close respondence courses provided by institutions involvement of employers. Successful systems of higher education. Similar to formal higher require a high degree of coordination and education, adult continuing education also partnership between government agencies expanded after 1999, but the expansion was and the private sector, as well as provide busi- mainly in evening schools and correspondence nesses a strong voice in determining training courses of higher education institutions. policy. The government provides oversight by Workplace learning and on-the-job train- monitoring data on program quality, encour- ing are important sources of skills forma- aging autonomy and accountability, and tion, and an integral part of lifelong learning. ensuring efficiency and results-orientation Work-based training, while a government- in government financing. Building demand- mandated requirement, is uneven across side buy-in from employers is a key challenge. enterprises, and small and medium enter- The United Kingdom and some other Euro- prises, in particular, face disincentives and pean countries provide useful insights for set- capacity constraints in training their employ- ting up sector employer councils (box 6.3), ees. If labor turnover is high, employers while East Asian countries have established have less incentive to train their workers. To BOX 6.3 Adult learning in the United Kingdom The United Kingdom has a Skills Strategy, overseen of the adult learning system assess the performance of by the Skills Alliance, a ministerial-led group made the system and make necessary adjustments. up of stakeholders in the sector, including representa- Semiautonomous, nongovernmental bodies often tives of employers, the Skills for Business Network, provide information and career advice to workers—in and the National Employment Panel. Training is particular, the unemployed and low skilled. Jobcen- organized and funded by learning skills councils at tre Plus identifies the skill needs of job seekers who the national, regional, and local levels, in partnership have been unemployed and inactive for six months (its with regional skills partnerships and colleges, train- functions have since been absorbed into the govern- ing providers, and other key stakeholders. Providers ment). Learndirect offers personalized advice, infor- include publicly funded bodies, nonprofit agencies, mation, and guidance tailored to the needs of adult and private providers. clients with lower-level skills. Learning ambassadors The planning involves taking stock of the existing are local volunteers who, having themselves under- learning environment, drawing on different sources gone training, identify and work with people in simi- of labor market intelligence, and consulting with key lar situations. A new government website, Universal partners, including employers and training provid- Jobmatch, allows job seekers to search for employ- ers. Implementation involves regional learning skills ment and employers to upload and manage their own councils that secure training by open bidding. Audits vacancies and search for prospective employees. BUILDING HUMAN CAPITAL 91 counter such perceptions, the government FIGURE 6.6 Cross-country public spending in could provide incentives for workplace learn- education, 2015 ing and on-the-job training. One option is to promote “training contracts” by establish- 8 ing a legal framework to incentivize firms and workers to invest in training. Worker- 6 retention rules could be embedded in such % of GDP training contracts, depending on the nature 4 China of the investment; the worker either has to pay back the cost of training or has to stay 2 in the job for a certain period in return for 0 benefiting from employer training. 6 7 8 9 10 11 12 Log of GDP per capita (PPP) China’s new education sector All countries OECD countries strategy Sources: Calculations based on World Development Indicators for China would benefit from having a new edu- the most recent year available; China’s education expenditure data cation sector strategy to develop the work- are from the Ministry of Finance. Note: PPP = purchasing power parity. OECD = Organisation for force for an innovative China. To implement Economic Co-operation and Development. Made in China 2025, China will need a new Education 2035 Strategy to meet the labor market’s changing demands. By 2035, China and socioemotional skills, such as empathy will be the leading contributor to the world’s and teamwork. talent pool. But the quality of China’s human Two, the new strategy would outline a plan capital, not the quantity, will need to be the to increase public investments in education cornerstone of the knowledge economy. How and address spending and quality disparities might Education 2035 differ from China’s across the education system. Countries gen- current education sector strategy, the National erally increase their education expenditures Outline for Medium- and Long-Term Educa- as they develop, and China has more than tional Reform and Development (2010–20)? doubled its public education spending over One, the new strategy would provide an the last 15 years. However, its current public in-depth road map for modernizing tertiary spending on education, at 4.1 percent of GDP education. The strategy would provide a (2018), is lower than predicted by its GDP per comprehensive and coherent plan and policy capita and lower than most OECD countries framework for the balanced and sustainable (figure 6.6). development of a multitiered tertiary edu- Increased education spending will be cation system that would aim for quality, needed to finance the following major equity, and efficiency. World-class universi- reforms: closing the gaps in quality ECD, ties would continue to be promoted, but their undertaking curricula and pedagogical development would be integrated with the reforms in basic education, universalizing rest of the higher education system to ensure upper-secondary education, strengthening the balanced development of all tiers of the TVET and establishing a comprehensive life- system. Key measures could include amend- long adult training system, and addressing ment of the Higher Education Law (1998) socioeconomic disparities across the educa- to bring it in line with a modern tertiary tion system. Universalizing upper-secondary education system; reforms to strengthen the education could be achieved by reducing or autonomy, accountability, and quality assur- eliminating tuition fees for both the voca- ance of universities; new regulations to pro- tional and academic streams in a fiscally sus- mote the expansion and healthy development tainable manner. This effort would extend of private higher education providers and the compulsory education to the upper-secondary new applied universities; and curricular and level and help China to catch up with the pedagogical reforms to promote higher-order secondary school enrollment rates of high- skills, such as critical thinking and creativity, income countries. Increasing investments 92 INNOVATIVE CHINA provides an opportunity to address the sig- 4. U NICEF report based on the 2015 1% nificant disparities across regions and tiers National Population Sample Survey con- of the education system. All of these reforms ducted by the National Bureau of Statistics will require more spending on education. (https://www.unicef.cn/en/reports/population -status-children-china-2015). Three, the new education strategy could 5. China Statistical Yearbook various years and outline a strategy and a new policy and Ministry of Education website (http://www regulatory framework for a more market- .moe.gov.cn /jyb_ zzjg /moe _ 347/201508 driven TVET and lifelong learning. This /t20150824_202647.html). approach could build on ongoing initiatives 6. Fudan University, Nanjing University, Peking to strengthen school-industry collabora- University, Shanghai Jiao Tong University, tion, the market relevance of postsecond- Tsinghua University, University of Science ary vocational education and training, and and Technology of China, and Zhejiang pedagogical improvements to make training University. more modular and better geared to a service- 7. These rankings have been criticized for sim- oriented economy. The governance and man- plifying the measurement of the complex and multifaceted qualities of these institutions, agement of TVET and higher education could putting too much focus on research and not be more integrated across public agencies, enough on student learning outcomes, teach- enabling a smoother transition by students ing, the relevance of education, and other between tertiary TVET tracks and university aspects of universities. careers. In addition, public funding could be 8. China Education Finance Statistical Year- made output rather than input driven. book, 2017. Four, increased education spending would 9. Analysis of the returns to college education need to be complemented by a more transpar- was carried out by World Bank staff, based ent monitoring system to ensure the efficiency on Chinese Household Income Project survey and impact of the spending, with greater pub- data. lic access to information on the education 10. For-profit schools and universities have had sector and school performance data. China challenges even in high-income economies, including the poor quality of instruction could address the gaps in internationally com- and the labor market performance of gradu- parable data on learning outcomes and key ates, high accumulation of student debt, and input information at the provincial level. In various forms of consumer abuse. The fail- recent years, the government has developed its ures of large for-profit institutions, such as own national assessment to monitor learning Corinthian Colleges in the United States and results at the national and subnational levels. Universidad del Mar in Chile, illustrate the Making this information publicly available potential for predatory practices among for- would help to ensure more accountability at profit providers in an insufficiently or inad- the local level and could serve as a medium- equately regulated environment. term solution before all provinces join inter- 11. Discussion of college entrance examina- national learning assessments, such as PISA. tion systems is drawn from King and Rogers (2014). 12. At the upper-secondary-school stage, where Notes students are selected into academic and TVET tracks of study, 16.0 million students 1. See http://www.moe.edu.cn/srcsite/A03/s180 are on the vocational track, accounting for /moe_633/201607/t20160706_270976.html. 40 percent of students at the upper-secondary 2. See http://theory.people.com.cn /n1/2017 level. At the tertiary level, the number stu- /0323/c40531-29162998.html. dents enrolled in short-cycle courses, most of 3. Calculation based on Ministry of Educa- which are vocational programs, reached 10.8 tion data. The database is accessible at million in 2016, accounting for 40 percent of http://www.moe.gov.cn/s78/A03/moe_560 all undergraduate students as well. /jytjsj_2015/. The ratio is calculated using the 13. World Bank Edstats data. The data points number of junior secondary school graduates quoted are from 2014, which are the latest divided by the number of entrants in regular available information. senior secondary schools in urban and rural 14. 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Washington, DC: World sions and Future Urbanisation Challenges” In Bank. L. Song, R. Garnaut, and C. Fang (eds), Deep- ———. 2017. Growing Smarter: Education ening Reform for China’s Long-Term Growth Quality and Economic Growth in East Asia and Development (pp. 379–406). Australian and the Pacific. Washington, DC: The World National University Press. Bank. Mercator Institute for China Studies (MERICS). Yi, H. M., G. R. Li, L. Y. Li, L. X. Zhang, J. J. 2015. China Monitor 24, October 2. Xu, E. Kardanova, H. Shi, J. Chu, and P. Loy- Michaels, G., A. Natraj, and J. Van Reenen. alka. 2018. “Assessing the Quality of Upper- 2014. “Has ICT Polarized Skill Demand? Evi- Secondary Vocational Education and Training: dence from Eleven Countries over Twenty-Five Evidence from China.” Comparative Educa- Years.” Review of Economics and Statistics 96 tion Review, vol. 62, no. 2. (1): 60–77. Zhou, Chengchao, Sean Sylvia, Linxiu Zhang, National Bureau of Statistics. Various years. Renfu Luo, Hongmei Yi, Chengfang Liu, China Statistical Yearbook of the Tertiary Yaojiang Shi, Prashant Loyalka, James Chu, Industry. Beijing: China Statistics Press. Alexis Medina, and Scott Rozelle. 2015. OECD (Organisation of Economic Co-oper- “China’s Left-Behind Children: Impact of ation and Development). 2015. “How Is Parental Migration on Health, Nutrition, the Global Talent Pool Changing (2013, and Educational Outcomes.” Health Affairs 2030)?” Education Indicators in Focus, 34(11): 1964–971. No. 31, OECD Publishing, Paris, https://doi .org/10.1787/5js33lf9jk41-en. 7 Allocating Resources E ciently China’s financial sector of China account for another 13.7 percent of developments banking assets; and other banks, including regional banks, now hold nearly half of bank- China’s fi nancial system has mobilized sig- ing assets. During 2010–16, the rate of asset nificant resources to support investment-led growth of smaller banks was twice that of the growth. Its financial sector has expanded five big banks, with substantial off-balance- rapidly, giving the country some of the sheet exposure and shadow credit. world’s largest banks and stock and bond The rapid expansion of China’s fi nancial markets. As a result of this rapid increase, system has taken place alongside significant some in China have questioned whether the accumulation of debt in the economy, rais- fi nancial sector has gotten “too big,” result- ing financial vulnerabilities. China’s authori- ing in an imbalance between the financial ties recognize the need to address the total and real sectors. China’s financial sector has stock of debt—state-owned enterprise (SOE), indeed grown quite large, particularly when private, general government, and house- considering the country’s level of develop- hold—which increased to 251.3 percent of ment (figure 7.1). This has also raised con- gross domestic product (GDP) at the end of cerns about whether the financial sector is 2018. The rapid growth and risk exposure of adequately serving the real sector. However, many smaller regional banks may make them the critical issue is to ensure that the financial especially vulnerable to tightened fi nancial sector efficiently allocates financial resources conditions and hardened budget constraints. for the most productive uses in the economy. Local governments can influence the credit China’s financial system remains domi- allocation of regional banks, which can nated largely by the banking industry. The hinder market-driven fi nancial intermedia- five largest commercial banks in China tion. Reforms to reduce the financial vulner- accounted for the majority of assets before abilities of regional banks and improve their the global fi nancial crisis, but their share of credit allocation would need to minimize dis- total bank assets had declined to only 36.8 ruptions to financial markets. percent at the end of 2017. The development The expansion of innovative financial and policy banks and the Postal Saving Bank products has increased the complexity of 95 96 INNOVATIVE CHINA FIGURE 7.1 Financial sector share of GDP in selected countries have accounted for a large share of increased leverage in recent years, as their debt climbed 9 from 73 percent of GDP in 2012 to 103 per- cent in 2016. Public-benefit SOEs (local gov- 8 ernment financing vehicles) accounted for the 7 majority of the increase in debt (and bonds) Finance share of GDP (%) 6 as a share of GDP.1 Since 2016, authorities 5 have worked to contain leverage in the SOE sector and to channel more credit to the pri- 4 vate sector. 3 Because China’s financial system remains 2 dominated largely by the banking industry, 1 it is important to promote greater competi- tion in the banking sector and to diversify 0 0 10,000 20,000 30,000 40,000 50,000 the financial system by expanding nonbank financial institutions. To promote greater Per capita GDP (current US$) competition, the government has announced Korea, Rep. United States Japan China Germany its intention to open up the financial sector further to foreign investments. Complemen- Sources: Calculations based on KLEMS, World Development Indicators, and Bank of Korea data. tary reforms could include strengthening the corporate governance of commercial banks, the management of state-owned capital in the financial sector and made bank balance banks, and the overall supervision and regu- sheets less transparent. Nonbank financial lation of the banking sector. intermediaries—including trusts, security China’s capital markets have grown rap- companies, subsidiaries of fund companies, idly in recent decades, indicating a signifi- and asset management companies—are cant expansion in the nonfinancial sector’s channeling resources from depositors and use of equity and corporate bond markets investors looking for higher yields to bor- since the early 2000s. The combined market rowers having difficulty accessing formal capitalization of these two markets increased credit. The government recently emphasized the need to address accumulated financial FIGURE 7.2 Share of the net credit growth of risks by deleveraging the economy, includ- SOEs and non-SOEs, 2011–16 ing measures to tighten shadow credit and the creation of the Financial Stability and 100 Development Committee of the State Coun- cil to enhance policy coordination and harmonization. 80 Since the global financial crisis, financial allocative efficiency may have deteriorated. 60 Percent A rising share of new commercial credit has gone to infrastructure and real estate, 40 including mortgage loans and construc- tion. These sectors now account for roughly 20 half of China’s outstanding debt, and their returns on capital have been declining (see 0 discussions in chapter 2). The increase in 2011 2012 2013 2014 2015 2016 credit-financed investment in infrastructure State-owned enterprises has been matched by a sharp increase in the Private enterprises share of commercial credit to state-owned enterprises and a sharp decline in the share of Source: Calculations based on People’s Bank of China’s Almanac of credit to the private sector (figure 7.2). SOEs China’s Finance and Banking data. A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 97 to 158.1 percent of GDP at the end of 2017, capital markets. For example, at the start of surpassing India and Mexico and compa- 2017, more than 600 firms were queuing for rable to Germany, although still significantly approval, with wait times longer than two smaller than Japan, the United Kingdom, years (Reuters 2017). However, the average and the United States. The amount raised in wait time had declined sharply, to less than equity markets (16.9 percent of GDP) was 10 months as of May 2018. the highest among a sample of both high- income and low- and middle-income nations Financing small and medium during 2010–16, and the amount raised in bond markets (6.2 percent of GDP) was the enterprises and entrepreneurs third highest after the United States and the Small and medium enterprises (SMEs) in United Kingdom. 2 Foreign investors have a China account for more than 90 percent of limited presence in China’s financial markets, firms, employ more than 80 percent of total and Chinese firms raise most of their capital urban workers, and contribute more than 60 domestically. percent of GDP—but fewer than 30 percent Capital market development in China was of them have access to credit.3 Large corpora- accompanied by an increasing number of tions have relatively easier access to financ- issuing firms in the equity and bond markets. ing through both banks and capital markets. The average number of firms issuing equity Low access to and high costs of financing each year in China increased more than for SMEs are a major bottleneck. Accord- three times, from 161 in 2000–07 to 659 in ing to World Bank Enterprise Surveys, more 2010–16. The number of issuers in Chinese than one in five firms in China rate access to bond markets increased 24-fold, from 45 to finance as their most significant business con- 1,100. Very large corporations and SOEs straint (2012). Fewer than a quarter of small account for the bulk of transactions in capital firms that need a loan actually have access to markets. SOEs accounted for 22 percent and bank credit, compared with approximately 51 percent of the firms active in the equity half of medium firms and two-thirds of large and bond markets, respectively, and 61 per- firms (figure 7.3). Lending to SOEs, given cent and 78 percent of the amounts raised in their implicit guarantees and lower informa- each market, respectively. The major capital tion asymmetries, is considered less risky. markets are also dominated by a select num- By contrast, private firms have less access to ber of industries, including manufacturing, credit due to information asymmetries, mod- finance, transport, and energy. est collateral, shorter credit histories, and Listings in China’s capital markets are perceived higher risk exposure. As a result, limited by relatively high standards for ini- private firms are almost twice as likely as tial public offerings (IPOs). Most developed SOEs to have been turned down for a loan. capital markets have a registration-based sys- In recent years, regulatory authorities have tem, in which the market decides the scale, encouraged commercial banks and other valuation, and timing of IPOs. Instead, in financial service providers to expand lending order to protect the interests of small and to SMEs. They have implemented differenti- medium investors and ensure the quality of ated monetary and credit policies, risk com- IPO companies, China uses an approval- pensation funds, and government guarantee based system, in which the China Securities funds and tax incentives. For example, com- Regulatory Commission (CSRC) thoroughly mercial banks are allowed to issue financial evaluates firms before granting approval to bonds specifically for SME loans, increasing go public. This system is used to control the banks’ available funding for SME lending. level of IPOs and stabilize prices in capital When calculating loan-to-deposit ratios for markets, by tightening IPO approvals dur- SME business lines, the SME loans that cor- ing periods of declining prices and relaxing respond to such bonds can be deducted from them during market booms. At certain times, the numerator. At the end of 2015, 66 com- these interventions lead to long delays in IPO mercial banks nationwide had issued RMB approvals, limiting the access of new firms to 549 billion (US$83 billion) in financial bonds 98 INNOVATIVE CHINA FIGURE 7.3 Access to credit in China and comparator regions, by size of firm, 2012 100 90 86.3 Share of firms with access to credit (%) 80 71.6 72.2 70 68.2 68.3 67.3 60.4 58.7 60 54.9 49.0 50.8 50.9 50 46.7 44.3 40 38.2 36.8 29.4 30 23.4 20 10 0 China Upper-middle- High-income Developing BRICS World income economies economies East Asia and (excluding China) Pacific Small firms (5–19 employees) Medium firms (20–99 employees) Large firms (100+ employees) Source: World Bank Enterprise Surveys. Note: BRICS = Brazil, Russia, India, China, and South Africa. specifically for SME lending. The China mechanisms. It also could consider expand- Banking and Insurance Regulatory Com- ing dedicated SME lines of credit and partial mission (CBIRC) allows nonperforming loan credit guarantees, securitizing loans, and ratios for SME loans up to 2 percent higher pooling SME risks. than industrywide targets.4 CBIRC issued In recent years, the People’s Bank of Guidelines on Financial Services for Micro China (PBOC) has been developing a credit- and Small Enterprises in 2015, which speci- reporting system to reduce information fies that the growth of SME loans should asymmetries between lenders and borrowers, be no less than the average growth of all mainly through the Credit Reference Center loans, the number of SMEs receiving loans of PBOC (CCRC), a public credit registry should be no less than the previous year, and established in 2006. The CCRC collects data the approval rate of SME loan applications from more than 3,000 financial service pro- should be no less than the previous year. viders, including banks, rural credit coopera- Instead of such top-down quantitative tives, microcredit companies, insurance com- targets for lending to SMEs, a more sustain- panies, and other nonbank financial service able and effective approach requires market- providers. The CCRC distributes information oriented reforms to alter banks’ risk-return to these institutions in response to inquiries. profile for lending to SMEs. Supported by a At the end of June 2017, the CCRC covered stronger financial infrastructure, banks need 930 million individuals, including 450 mil- to develop the culture and skills to price risk lion persons with a borrowing history, and accurately among SMEs. The government 24 million legal entities, including 6.6 million could strengthen the financial infrastructure entities with a borrowing history. in several ways. It could upgrade credit regis- PBOC recognizes that the private sec- tries. It could strengthen credit information tor, including new fintech companies, could systems, including expanding the use of infor- improve China’s credit information infra- mation from nonfinancial sources for credit structure, but there had been concerns about scores. It could establish a national elec- corporate governance, independence, and tronic registry for movable collateral. It could conflicts of interest. The first credit bureau establish platforms for accounts receivables license to a private firm was issued by PBOC and strengthen out-of-court enforcement in 2018 to Baihang, located in Shenzhen. A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 99 More work is needed to clarify the licensing information technology (IT) registry system requirements for credit bureaus and to dis- is expected to launch soon. The next chal- tinguish more clearly between credit bureaus lenge for the CCRC will be to achieve a truly and credit scoring and data analytics com- integrated registration system. panies, since each type of company provides Around the world, credit guarantee supplemental data that help overcome infor- schemes have become an increasingly popu- mation asymmetries. In addition, greater lar way to promote financing to SMEs. China access to public information could benefit has a decentralized system, with a large num- financial inclusion. Government agencies— ber of provincial and municipal guarantee such as tax, commerce, and judicial authori- funds, many of them dedicated to attaining ties—hold vast amounts of valuable data on specific social goals. There were 7,340 credit both individuals and SMEs, but such infor- guarantee companies in China at the end of mation is difficult to access. A comprehen- 2015, serving 2.74 trillion guaranteed loans sive legal framework on data protection and (almost 3 percent of all bank loans). Guar- privacy for the financial sector is needed in antees are established and operated by both China to address data issues, including pub- the public sector (provincial and munici- lic access to information and the use of big pal governments) and the private sector. In data and alternative data. 2015, loans to SMEs were 84 percent of all In the past 15 years, CBIRC and PBOC guaranteed loans, but it would be useful to have encouraged commercial banks and assess whether more established and mature other financial service providers to use mov- SMEs benefited disproportionately from loan able assets—including receivables, inventory, guarantees. equipment, and title documents—as the basis Historically, China’s public sector guaran- for lending or issuing debt instruments. A tees were the prevailing form in the industry, basic legal framework and a registry system but the percentage of guarantee funds that for secured transactions were established in received government financing had fallen to the mid-2000s, spurring the development of about 19 percent in 2011 before rebound- a movable asset finance market and a collat- ing to 30 percent at the end of 2015. In eral management industry. PBOC established many countries, credit guarantees for small a modern collateral registry, the Integrated and medium enterprises tend to be a policy- Movables Financing Registration System, supported business, with private guarantee under the CCRC in 2013. The system began companies playing more of an auxiliary role. as an Internet-based filing system for security Since 2015, China has expanded efforts to interests on accounts receivables and has now build a government-supported guarantee sys- expanded to cover most movable assets. tem. Many private guarantee companies are In recent years, with the support of the still in the process of finding a sustainable International Finance Corporation, CCRC business model. Consolidating and scaling up has continued to improve its registry services the industry may help to improve profitability and to promote movable asset finance more and coverage. The regulatory and supervi- generally through complementary initiatives, sory framework may also benefit from con- including extensive training of financial sec- solidation and streamlining. tor authorities and lenders, the development State participation in the guarantee indus- of a collateral management industry, and try is typically justified as a means to pursue the creation of a digital supply chain finance policy objectives, such as creating employ- platform under CCRC. This has stimulated ment or preventing the failure of unprofitable the market and increased lender confidence, businesses, but it has undermined incentives especially to SMEs, which are 70 percent of to allocate guarantees efficiently. Local gov- the borrowers and lessees in the system. At ernments often set a cap on fees that funds the end of 2016, loans involving movable can charge for their services, which limits the assets represented about 40 percent of out- growth of funds that do not have government standing commercial loans in China, up from support. And despite agreements on paper to 12 percent in 2004. The second-generation share risks, in practice guarantee funds often 100 INNOVATIVE CHINA assume a disproportionate share of losses— ChiNext targets innovative and high-growth in some instances, full coverage of the credit start-ups and offers less strict listing require- risks—creating moral hazard and undermin- ments. The third main SME capital market ing bank incentives to assess credit quality is the National Equities Exchange and Quo- and monitor borrowing firms. tations (NEEQ), an over-the-counter market Promoting capital market financing to that provides financing options for SMEs. It SMEs has been a recurrent topic on the targets innovative start-ups with high growth government’s agenda since the early 2000s. prospects, particularly in information tech- Given that the main capital markets are not nology. It encourages the listing of small adequately serving smaller firms, China firms by offering less stringent listing require- developed secondary exchanges to sup- ments, such as no profitability requirement; a port direct financing of SMEs. The goal of rapid application process; and the possibility these markets is to offer listing and regula- to list without issuing securities. tory requirements that are less stringent SME capital markets in China have than those in the main exchanges. Currently, expanded significantly over the years, reach- there are three main SME capital markets ing a combined total market capitalization of in China, the Shenzhen Stock Exchange: US$1,280 billion (about 12 percent of GDP) ChiNext, the SME Board, and the National at the end of 2016, higher as a ratio of GDP Equities Exchange and Quotations (NEEQ). than in most other economies, including The SME Board is aimed at SMEs at a mature SME capital markets in both low- relatively mature stage of development and and middle-income as well as high-income with stable profitability, giving priority to economies (figure 7.4). However, the number high-technology companies. By contrast, of firms listed in these markets represents less FIGURE 7.4 SME capital markets in selected countries a. Market capitalization b. Listed firms Brazil Brazil Russian Federation ChiNext India Small and Medium Enterprise Board Poland Russian Federation National Equities Germany Exchange and Quotations South Africa Japan Japan Germany Malaysia South Africa National Equities Malaysia Exchange and Quotations Canada India ChiNext Korea, Rep. United Kingdom Canada Small and Medium Poland Enterprise Board Kosdaq United Kingdom 0 2 4 6 8 10 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Percent of GDP % of total SMEs Sources: Data for listed firms and market capitalization for SME Board and ChiNext are from SZSE; and for NEEQ, the data are from NEEQ and China Money Network (2016). For the rest of the SME capital markets, data are from WFE (2015). Data on total SMEs are from the World Bank MSME Country Indicators. Data on total GDP are from the World Bank. Note: NEEQ = National Equities Exchange and Quotations. SME = small and medium enterprises. A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 101 than 0.1 percent of all SMEs in China, which providers to innovate and reconsider under- is relatively low. 5 Hence, SME capital mar- served segments of the market previously kets are larger in China than in other coun- considered commercially nonviable. Fintech tries but focus on a smaller group of SMEs, companies are also working with traditional despite the fact that the three SME markets financial service providers. For example, combined have 11,555 listed firms, compared new fintech companies are providing credit- with 1,660 in the main markets (as of the end scoring services and improving creditworthi- of 2016). ness assessments and risk management sys- SME markets are oriented more to pri- tems of traditional financial service providers. vate enterprises than the main markets, with Chinese regulatory authorities have sought a smaller share of SOEs. Manufacturing to maintain a balanced policy approach to accounts for the largest share of firms in both the entrance and scaling up of fintech compa- SME capital markets and the main markets. nies. The objective of this approach has been SME markets also appeal to different indus- to encourage innovation while introducing tries than the main markets, giving greater moderate and proportionate levels of super- emphasis to IT enterprises. So SME capi- vision. This balanced approach is referenced tal markets are better suited than the main in the 2015 Guidelines on Promoting Sound markets to providing alternative financing Development of Internet Finance, which note to new, growing, and smaller private firms the need to “give ample room for innovations in alternative industries. In addition, SMEs in Internet finance,” while also highlighting listed on ChiNext and the SME Board tend the need for “ensuring the healthy develop- to be larger, and firms listed on ChiNext are ment of Internet finance so that Internet large enough to list on the main markets. The finance can better serve the real economy.” exception seems to be NEEQ, where smaller How much authorities have adhered to firms are listed. these principles has varied by provider and product. Digital payment, or third-party payment, Fintech has emerged in China with the explosive China is at the global forefront of financial growth of online e-commerce and social net- technology (fintech) and the digital finance work platforms. Third-party payment refers revolution.6 It has the world’s largest fintech to payments that a payer makes through a credit market, and its fintech has expanded nonbank payment platform. For industry rapidly to provide an alternative source of leaders Alipay (Alibaba) and Tenpay (Ten- financing for SMEs and entrepreneurs that cent), the rapid growth of payments in China have been relatively neglected by traditional was made possible by integrating payment financial institutions. About US$9 billion was functionality into existing e-commerce (Ali- invested in China’s fintech industry between baba’s Taobao and Tmall) and social media June 2015 and 2016 alone, and China is (Tencent’s QQ and WeChat) platforms with home to some of the world’s largest fintech their large user networks. Following the lending companies. In 2016, 8 of 27 fintech introduction of Alipay in 2004 and Tenpay in firms worldwide, valued at more than US$1 2005 and their mobile platforms in 2009, the billion, were in China (World Bank 2018). volume of nonbank digital payment transac- China is now the world’s biggest market tions increased rapidly to RMB 208.07 tril- for digital payments and home to diverse lion (US$29.5 trillion) in 2018, through 254 and innovative enterprises in Internet lend- e-payment providers (PBOC 2018). ing, Internet insurance, and Internet fund Despite the rapid growth, Chinese regu- management. These enterprises are lever- latory authorities initially took a “wait and aging network effects, economies of scale, see” approach to the regulation of fintech. and advanced technology, such as big data Regulations were first issued six years after analytics, to provide diversified and custom- the launch of Alipay. Fuller regulations were ized financial services. The entrance of new only issued in 2015—covering minimum fintech providers has encouraged traditional capital requirements, investor requirements, 102 INNOVATIVE CHINA caps on monthly payment activities, and cus- provided by Internet companies to their cus- tomer identification and data privacy require- tomers. An example is MYbank, a subsid- ments. Although this wait-and-see approach iary of Ant Financial, which claims to have allowed the emerging industry to innovate provided unsecured lending to 12.3 million and grow with relatively few restrictions, it small businesses and RMB 47.7 billion in also entailed risks, such as inadequate regu- new loans in 2018 (MYbank 2018). Inter- lation, monitoring, and oversight of some net banks have banking licenses but have no of the potential risks of digital payments, physical outlets or counter services. There are including fraud and money laundering. now three Internet banks in China,8 which Online peer-to-peer (P2P) lending also have been established by e-commerce and has increased rapidly in China—these are digital payment enterprises that leverage their direct person-to-person loans transacted technology, large customer base, and data to on an Internet platform by matching bor- target individuals and SMEs. rowers with potential lenders (investors). Internet bank operations have so far P2P lending takes advantage of information been constrained by regulations that restrict technology to reduce information asymme- the functionality of bank accounts opened try between debtors and creditors, thereby remotely, which are the type of accounts lowering the costs of matching. At the end offered by these banks. Remotely opened of 2016, the total outstanding loan balance accounts could eventually become fully func- of P2P lending reached RMB 816.2 billion tional if the necessary remote identification (US$122.4 billion), equivalent to 4.3 percent technology becomes available. As the tech- of the balance of household loans issued by nology develops, the authorities can address deposit-taking financial service providers, any undue regulatory restrictions on the use and the total volume of transactions reached of remote identification to access fully func- RMB 2.1 trillion (US$309.6 billion). tional accounts. Similar to digital payments, the authorities The outcome of the initial wait-and-see initially took a relatively light wait-and-see approach to regulating the fintech indus- regulatory approach toward P2P lending. But try has been a large, dynamic, and com- contrary to existing regulations, many P2P petitive industry. With a larger and more platforms started providing credit guarantees mature industry, policy makers in China and setting up pools of funds, while other have increasingly recognized the need to platforms engaged in outright fraud.7 Many manage the risks of fintech and establish a investors have lost money through fraudulent more comprehensive regulatory framework. P2P service providers in China. In response, The 2015 Guidelines on Promoting Sound the authorities issued new regulations Development of Internet Finance represent a (“interim rules”) in 2016 to clarify that P2Ps significant step in the development of a com- are information intermediaries; established prehensive regulatory framework for fintech. business rules, risk management require- They specifically encourage the development ments, and procedures to protect consumers, of existing and new types of digital financial such as information disclosure requirements; services, but emphasize that these services introduced joint and coordinated supervi- should be limited to small-value transactions. sory arrangements; and specified prohibited They clarify the regulatory mandates of dif- activities, including accepting savings (depos- ferent financial sector authorities and note its), managing pools of funds, and providing several areas where additional regulation is guarantees. required, including areas related to reserve Internet-based microlending and Inter- fund management, information security, net banks have the potential to significantly anti–money laundering, and disclosure and expand access to financing for SMEs, entre- transparency. preneurs, and individuals, but so far their Financial sector authorities could con- operations have been fairly limited. Inter- sider a “regulatory sandbox,” which pro- net-based microlending refers to small loans vides more structure than the wait-and-see A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 103 approach, while still providing the flexibility Venture capital for innovation. The regulatory sandbox is a piloting approach for introducing and testing Venture capital funding has surged in recent new technologies in a market under waived years, and China is now the second-largest or modified regulations but with clear restric- global market after the United States, with tions, such as number of customers, type or a quarter of all global venture capital invest- value of products and services, and special- ments. In 2016, almost 40 percent of venture ized monitoring and reporting requirements. capital by value was focused on early-stage The testing may continue for a certain period deals (classified as products developed but (such as 6 to 12 months), after which the not yet commercialized), up from 8 per- financial sector authorities may develop rules cent in 2010. Venture capital investments based on the experience and risks assessed.9 are most prevalent in higher-income areas; Various laws and regulations have been Beijing, Guangdong, Jiangsu, Shanghai, and issued in recent years to protect finan- Zhejiang accounted for almost 70 percent of cial consumers.10 The legal and regulatory invested venture capital from 2006 to 2016. framework now requires further adaptation But venture capital investors are increasingly to ensure that consumer protection risks in directing capital to earlier-stage companies fintech and digital finance are covered com- and to less-developed regions. Government prehensively. Fintech provides many benefits guidance funds have the potential to be an to the underserved, but consumers also face important source of venture financing. There a variety of risks, including lack of transpar- are more than 1,000 government guidance ency about product terms and conditions, funds—yuan-denominated government-led violations of data privacy, and false, mislead- funds that include venture capital and private ing promotions. equity funds. But less than 10 percent of the A comprehensive legal framework for target capital of government guidance funds data protection and privacy is needed. Rules is in venture capital funds, with the rest in regarding disclosure and transparency, sales industry funds and infrastructure funds. and marketing, the safety of funds, and dis- The rapid growth of venture capital pute resolution should be expanded to include financing and government guidance funds new fintech companies and adapted as nec- may present challenges for the quality of essary to digital finance business models. fund management. The increasing supply Supervision efforts require further strength- of capital and the ensuing competition for ening—as does coordination across PBOC, deals have pushed up valuations. Manage- CBIRC, and CSRC—because many financial ment of equity financing—early-stage equity consumer protection issues for fintech cut financing, particularly—requires appropriate across markets and products. Enforcement of managerial expertise. Given the rapid growth violations is still relatively weak. in the number of funds and the volume of Effective financial education is also financing available, the government would needed to raise the financial capabilities of want to ensure that the quality of fund man- the consumers of financial services. Accord- agement keeps pace. ing to PBOC’s 2017 Financial Consumers’ The focus of government guidance funds Capability Survey, consumers’ overall finan- for innovation should be sharpened to cial knowledge is relatively low, and a signifi- address key market failures in an environ- cant imbalance in financial knowledge exists ment with a strong supply of venture capi- between rural and urban areas and among tal. These funds need to maintain market- different regions. Consumers also have lim- oriented principles to avoid crowding out ited understanding of contracts and state- private financing. There is a well-established ments of financial products and services. international model of government inter- Digital technologies could be leveraged fur- vention in early-stage financing, based most ther to deliver financial education efficiently commonly on Israel’s experience. It appears and effectively. that many of China’s government guidance 104 INNOVATIVE CHINA funds do not necessarily adhere to this model. be most productive. Improving the spatial The international model considered best allocative efficiency of labor can ensure that practice features funds that are at least 10+2 businesses get the workers they need. Assist- years in duration (allowing sufficiently long ing people to relocate to jobs will be more investment cycles), are not required to make effective than moving jobs to people, such a positive return to government, and pro- as through government “industrial reloca- vide at least 50 percent of funding to anchor tion” programs. Major opportunities remain co-investment funds. They have incentive for a more efficient movement of labor in the structures to crowd in private investors (who economy. receive preference on returns). They are out- Hukou, China’s household registration sys- sourced to independent management teams tem, is a major determinant of labor mobil- and investment committees in which govern- ity and has important implications for the ment plays no role. They have remuneration country’s socioeconomic development and and incentives aligned with the private sector. modernization. The implication of the hukou And they are generally not sector or region system is that a proportion of the urban pop- specific by design, although funds themselves ulation—those without urban hukou —may often have a specific business model that spe- not have full access to public services in cities. cializes in regions or sectors. This leads to two definitions of urbanization For their part, venture capital funds need in China—one for urban residents, the other to have enough high-quality deals, particu- for the urban hukou population. larly those with relatively short investment The flagship report Urban China (World cycles. Therefore, before establishing early- Bank and Development Research Center of stage risk-focused government guidance the State Council 2014) recommended com- funds, it is important to assess the flow of prehensive hukou reforms centered on trans- local deals and the maturity of the ecosystem forming the household registration system to develop this flow. Government guidance from an origin-based to a residence-based funds are subject to a complex authorizing system. Since then, a series of policy changes environment, as well as regulation and super- have been made to deepen hukou reform, vision by multiple agencies, which can sub- including the issuance of a national frame- ject these funds to conflicting messages that work and guidelines for the transition to can blur their strategic objectives. Therefore, a residence-based system and a program to streamlining the governance structure and integrate 100 million migrants into cities.11 policy environment is critical. Finally, venture In particular, the 2014 State Council pol- capital–backed companies in China tend to icy initiative—Opinions on Further Promot- seek their exit in public markets rather than ing Hukou Reform—marked a new era for in private sales, whereas the latter are more reforming the hukou and managing inter- frequent in high-income countries. Therefore, nal labor mobility and migration in China. ensuring that IPOs are not delayed unneces- This policy initiative has five key aspects: sarily would support the growth of venture (1) adjusting hukou conversion policy; firms. In addition, there may be a need to (2) unifying the urban and rural hukou reg- explore reforms that aim to ensure that pri- istration system; (3) introducing a residence vate sales are a viable alternative for venture permit system; (4) establishing a national capital exits. basic population database; and (5) increas- ing the coverage of basic public services to the residential population in cities. The 2014 Facilitating free flows of labor hukou policy explicitly sets different limits With the working population expected to for hukou conversion by city size—the larger decline, China will need to access the under- the size of a city, the higher the threshold of utilized labor in agriculture, increase female hukou conversion. As a result, the hukou has labor force participation, and fully use labor essentially been liberalized in medium and throughout adult working lives. A key aspect small cities, but the threshold for large cities will be to promote labor mobility, allowing and megacities remains very high, which labor to flow to places and uses where it can discourages migration and constrains labor A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 105 FIGURE 7.5 Resident and hukou population as a share of total population in China, 2011–20 70 58.5 59.6 60.0 60 56.1 57.4 53.7 54.8 51.3 52.6 50 45.0 42.4 43.4 39.9 41.2 40 35.3 35.9 36.6 Percent 34.7 30 20 10 0 2011 2012 2013 2014 2015 2016 2017 2018 2020 Proportion of urban residential population Proportion of urban hukou population Sources: Based on National Statistical Bureau and Ministry of Public Security data. Note: The numbers for 2018 are estimates, and those for 2020 are policy targets. mobility. In 2016, the State Council issued population and urban hukou population, has the Provisional Regulation on the Residence been narrowing, although it has stabilized Permit System, detailing guidelines for imple- somewhat since 2015 (figure 7.5). In 2018, menting the transition to a residence-based the proportion of resident population and system. hukou population was 59.6 percent and 43.4 By the end of 2016, 25 provinces had percent of the total urban population, respec- introduced detailed plans to implement tively.12 The government proposed to increase the residence permit system. Government the proportion of urban hukou population by administrative data show that 28.9 million 1 percentage point in 2018. residence permits were issued by the end of While important strides are being made 2016, and the proportion of urban residents on hukou reforms, more actions are needed with a local hukou rose to 42 percent. A key to meet the government’s ambitious plan to next step would be to decouple basic public settle 100 million people in cities. Local gov- services from the urban hukou, especially ernments have been piloting various “quasi- in large cities, to open access to all residents hukou” status categories as a transitional regardless of their hukou status. Hukou solution that provides partial access to urban reform would likely require reforms of the public services and welfare. The goal is to intergovernmental fiscal transfer arrange- establish a residence-based hukou system, ments between central and local governments which would not need a separate residence to share the cost of providing public services permit system. But hukou restrictions in large to migrants and to promote equality of public cities and megacities remain high. Conversion services across regions and between rural and rules in large cities and megacities depend on urban areas. In the medium term, reforms in several specific requirements, which in many social services and public finance could allow cases only allow highly qualified migrants to a nationwide common service standard, move in. irrespective of location. The portability and sustainability of pension benefits are particu- Pension and social security reforms larly important and eventually would require central administration. A nationwide pension and social security sys- In line with the progress made by the tem would enhance labor mobility. China’s hukou reforms, urbanization has been ris- broad social security system covers social ing, and the urbanization gap, measured by insurance, social assistance, and social wel- the difference between the urban resident fare. The social insurance programs include 106 INNOVATIVE CHINA pension, medical, unemployment, work- approach—that is, collecting social contri- injury, and maternity insurance. Among the butions from individual localities and real- five insurance programs, only pension insur- locating them at the national level. This is ance has achieved a provincial pooling of encouraging, and similar reforms should pension funds through either a partial pool- be considered for the other social insurance ing approach in most cases or a full pooling programs. approach in a few provinces; for the other A more sustainable pension system with social insurance programs, the social insur- an automatic balancing mechanism and ade- ance funds are pooled at the prefecture or quate pension levels could reduce precaution- county level. ary savings, boost domestic consumption, A very low level of pooling of social insur- remove fiscal pressure, and promote macro- ance funds and a fragmented social insurance economic stability. In 2014, the total social information system have constrained the por- insurance contribution rate was over 40 tability of social insurance entitlements and percent in China, among the highest in the benefits when workers move across cities or world.13 Lowering that rate would increase provinces (box 7.1). Recognizing this chal- disposable income, which in turn would pro- lenge, the 2011 Social Insurance Law called mote higher household consumption. This for pooling pension funds at the national will become increasingly important since level and other social insurance funds at China is rebalancing toward greater reliance the provincial level. In 2018, the Chinese on consumption. The contribution rates have authorities established a central fund adjust- been reduced 4 percent since 2015 as a tem- ment system by following a partial pooling porary measure in response to the economic BOX 7.1 An integrated system delivers better social insurance services A pioneer in China’s reform, Guangdong Province would integrate data management across its major has the country’s largest economy and the largest business lines—including social insurance, employ- number of both residential population and migrants. ment services, and human resources management— Guangdong is now shifting from traditional low-cost and across the 21 prefectures in Guangdong Province. manufacturing to more knowledge-intensive goods This will allow rural and urban residents in Guang- and services, resulting in a growing demand for dong to have access to social security and employ- skilled workers. However, movement across cities and ment services anywhere from local one-stop service between rural and urban areas within the province stations in the province and independent of the per- and beyond incurred significant welfare costs, as pen- son’s household registration. sion portability could not be assured, the mechanism In 2017, the provincial MIS was successfully for reimbursement of insured health services was inef- piloted at the largest prefecture municipality— ficient, and access to employment services was limited Qingyuan. With this success, Guangdong plans to because of the fragmented social security system both scale up the integrated provincial MIS to the entire across individual social insurance programs and spa- province by 2020, benefiting all of the urban and tially across and within provinces. rural residents enrolled in social insurance programs. Since 2013, the World Bank has been support- With its centralized data support, Guangdong has ing Guangdong to establish a centralized and inte- already initiated reforms to pool pension and other grated management information system (MIS) for social insurance funds fully at the provincial level. social insurance and labor programs. This project Guangdong provides an interesting model as China has helped Guangdong develop an overall architec- works to develop a national integrated social security ture design for the integrated provincial MIS, which information system. Source: “In Guangdong, China, an Integrated System Delivers Better Social Insurance Services,” World Bank News, February 14, 2018, http://www.worldbank.org/en/news/feature/2018/02/14/in-guangdong-china-an-integrated-system -delivers-better-social-insurance-services. A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 107 slowdown. If the legacy costs of the earlier, road map for transitioning from the existing more generous pension liabilities are financed system. During the transition, a strategy for separately, pension contribution rates could fully pooling pension funds at the national drop from the current 28 percent to 15–16 level is crucial. Also, it is vital to develop a percent, according to a World Bank study. financing strategy for the legacy costs that Wider reforms should be undertaken to could make the contributions sufficiently help achieve full coverage by 2020, to promote affordable to ensure broad worker coverage portability and equity, and to strengthen the and financial sustainability. long-term sustainability of the pension sys- tem. The Chinese government has developed Encouraging and supporting labor force an overall design for pension system reform, participation although the design has not been released to the public. Indications are that the authorities Firms have expressed concerns about high would consider introducing both parametric labor turnover. However, analysis for this and structural reforms. For the former, pos- flagship report concluded that the average job sible reform measures could include gradually tenure in China is comparable to Organisa- raising retirement ages and unifying them for tion of Economic Co-operation and Devel- men and women; establishing pension index- opment (OECD) countries, indicating rela- ation adjustment mechanisms; and length- tively low turnover (figure 7.6). In the SOE ening the reference period of wages used in sector, job tenures are longer and increase determining basic monthly benefits. with education, reflecting the high job secu- Several reform measures have already rity offered by the public sector. In non-SOE been undertaken. In 2017, a notional inter- (private) sectors in urban areas, job tenure is est14 for individual accounts was introduced shorter but very similar to that in Europe and for the urban worker pension scheme and the North America. Shorter job tenure is to be public sector pension scheme, suggesting that expected among employees with more highly a notional defined-contribution approach demanded skills and is not seen as a problem could eventually be adopted to the urban in the United States. Silicon Valley, for exam- worker pension scheme. Also in 2017, the ple, is noted for its high rates of employee State Council announced plans to transfer 10 turnover and its dynamic labor market.16 A percent of SOE equity into the social security reasonable turnover rate is a symptom of a funds to help address the shortfall of pen- healthy economy, as it provides an avenue for sion funds and thereby strengthen the fiscal improving the match between employers and sustainability of the funds. Transferring SOE employees. Also, the option to leave provides shares and dividends into the social security firms with appropriate incentives to compen- funds could help to lower social insurance sate their workers for their contributions, contributions. thereby making worker pay competitive. A These announcements indicate that key issue is whether firms, perceiving high reforms are generally on the right track. rates of labor turnover, hold back on invest- What is needed now is an overall strategy and ing in employee training. reform agenda to show how all of the various Despite concerns about skill shortages, reforms fit within a comprehensively designed college graduates in China cannot always reform program. Considering the country’s find jobs commensurate with their education rapid urbanization and population aging, and training, and many end up in part-time, China’s pension reform needs to follow an low-paid jobs, at least initially. Analysis for integrated framework and introduce a built-in this report indicates that college graduates actuarial balancing mechanism to establish a are increasingly ending up in jobs in middle- “clean” system,15 which would respond auto- skill occupations with lower earnings poten- matically to future demographic, social, and tial. Given enterprises’ views of a skills economic as well as technological changes. shortage, this finding may indicate low Moving toward a clean system also requires a allocative efficiency in the labor market. It 108 INNOVATIVE CHINA FIGURE 7.6 Average job tenure in selected countries and within institutions and the broader social insurance China system to fit new forms of employment and to prepare for the impacts of technology and population aging. Many recent labor law Korea, Rep. Rural China reforms in OECD countries—including Ger- Turkey many, Italy, and Spain—have moved toward New Zealand Chile more unified labor contracts and simplified Lithuania regulations that, while maintaining funda- Brazil mental worker protections, enhance firms’ Singapore Iceland flexibility in managing their human resources Denmark and reduce regulatory ambiguities and thus Estonia Russian Federation labor disputes. United States Longer life expectancy means that individ- Latvia uals can productively engage in the labor mar- Urban China, non-SOE Switzerland ket at older ages. But urban Chinese workers, United Kingdom both men and women, withdraw much ear- Hungary Canada lier from the labor market than workers in Norway other countries. Due to early retirement poli- Ireland cies, women withdraw even sooner than men. Sweden Poland The participation rate of urban women over Finland age 45 is much lower in China than in high- Austria Slovak Republic income economies, even though the partici- Czech Republic pation rate of younger women is comparable. Netherlands Although an increasing body of work has Urban China, SOE and non-SOE Luxembourg shown that participation of the elderly does Cyprus not crowd out employment of the younger Spain Greece cohort, a large degree of unsubstantiated Germany skepticism remains about policies that allow Belgium workers to phase or defer retirement. Portugal Japan China could address the shrinking labor Slovenia force by tapping the underused labor of adult France Italy women and the elderly. Policies that promote Urban China, SOE longer and more flexible working lives, as 0 2 4 6 8 10 12 14 16 well as complementary policies in areas of Average tenure in current job (years) pensions and elder care, would encourage China OECD/PIACC older workers to contribute more produc- tively to the economy. In addition, policies Sources: Calculations based on China Household Income Project 2013 data, Organisation that allow a more gradual transition from for Economic Co-operation and Development (OECD) reports; and Program for the Inter- national Assessment of Adult Competencies (PIACC) survey data. For countries where both work into retirement could reduce the bur- the OECD and PIACC estimates are available, the OECD reported measure is used. den on the workforce that currently supports them. Changes in regulations surrounding also could reflect inadequate quality in some retirement could be complemented by policies tertiary institutions, following a period of that incentivize firms to employ elderly work- rapid expansion. ers either fully or partially. Many believe that Labor laws could be reformed to enhance this policy could also delay the retirement of flexibility in human resource management their spouses since retirement decisions are while ensuring fundamental worker protec- often made jointly. Developing the child and tion, including for informal employment. elderly care market could free up time for China’s labor contract law is considered labor market participation by family mem- less restrictive than the OECD average with bers, especially adult women, who spend a regard to hiring and firing. The government considerable amount of time caring for the could consider changes to labor market children and elderly in their families. A L LO C AT I N G R E S O U R C E S E F F I C I E N T LY 109 Active labor market policies could be used database, to estimate bonds outstanding by more extensively and systematically in China private firms, LGFVs, and non-LGFV SOEs; to assist displaced workers, for example, and (c) national audit results for bank loans those in overcapacity heavy industries and outstanding issued to LGFVs for 2012, and then bank loans outstanding issued to LGFVs industries affected by labor-saving technolo- in subsequent years estimated by applying the gies. The policy instruments could be selected growth rate of bank loans outstanding of the and designed according to local conditions. WIND sample of LGFVs, and bank loans These policies can encourage the movement outstanding to LGFVs. of labor from sunset to sunrise industries and 2. China was compared to Brazil, Germany, increase reemployment and earnings pros- India, Japan, Mexico, the Russian Federation, pects for workers affected by technological the United Kingdom, and the United States. changes. 3. These estimates are from the 2018 meeting on International experience offers some SMEs, chaired by Liu He: http://www.gov.cn clues for active labor market practices. Job /guowuyuan/2018-08/20/content_5315204 search assistance and counseling—delivered .htm. 4. The CBIRC was established in April 2018 by by public or commercial agencies—can be the merger of the China Banking Regulatory cost-effective but of little use where labor Commission (CBRC) and the China Insur- demand is weak. Training programs with ance Regulatory Commission (CIRC). strong employer involvement have proven the 5. In China, SMEs are defined as firms with most effective. Wage subsidies can help to fewer than 1,000 employees, which is larger offset the short-term impacts of temporary than in most countries. Using an alternative negative shocks but are less good at increas- definition of SME might produce an even ing employment over the longer term—and lower ratio. See the World Bank micro, small, accurate targeting and design are important and medium enterprise indicators for a defini- to avoid simply displacing existing workers. tions of SMEs in different countries. 6. Partly drawn from the World Bank and With large-scale displacement and few wage PBOC, Toward Universal Financial Inclusion opportunities in the locality, support for self- in China: Models, Challenges, and Global employment, such as credit and technical Lessons, 2018. assistance, and incentives for mobility can be 7. One high-profile case was Ezubao, which the more effective interventions. authorities shut down in 2015 after it was dis- Whichever instruments are chosen, compe- covered to have operated a Ponzi scheme, sell- tition in program delivery generally improves ing fraudulent investment products to nearly efficiency and effectiveness. Options include 1 million investors and defrauding them of performance-based contracts with service more than US$7.6 billion. providers and vouchers that can be redeemed 8. WeBank (Tencent), MYbank (Alibaba/Ant Financial), and XW Bank. at different training providers. Suitable tar- 9. Such an approach has been used in Malaysia, geting, through statistical and case profiling Singapore, and the United Kingdom, among of laid-off workers, is essential for identify- others. ing what would help each worker find new 10. In 2014, China’s National People’s Congress employment. revised the Law of the PRC [People’s Repub- lic of China] on the Protection of Consumer Notes Rights and Interests. In 2015, the General Office of China’s State Council of China 1. Estimates of government debt, household issued the Guidelines on Strengthening the debt, and nonfinancial corporate debt are Protection of Rights and Interests of Financial based on data from the Bank for International Consumers. In 2016, PBOC issued the Imple- Settlements (BIS). The estimates of the com- mentation Rules on the Protection of Rights position of corporate debt by private firms, and Interests of Financial Consumers. local government financing vehicles(LGFVs), 11. Provisional Regulation on the Residence and non-LGFV SOEs were based on the Permit System by the State Council in 2016; following: (a) PBOC’s Almanac of China’s Opinions on Promoting the Development of Finance and Banking, to estimate loans out- a New-Type Urbanization; and the Program standing for private firms and SOEs; (b) Wind to Promote the Settlement of 100 Million 110 INNOVATIVE CHINA Migrants into Cities announced by the State DRC (Development Research Center of the State Council. Council). 2019. “Policy Options on Promoting 12. Data are from National Bureau of Statistics the Reform of China’s Movable-Assets-Based (2019). Financing Market.” No. 59 (in Chinese). http:// 13. State Council Office, 2019. “A Notice on en.drc.gov.cn/2019-06/04/content_37477078 the Comprehensive Proposal of Reducing .htm. Social Insurance Contribution Rates,” no. 13, The Economist. 2017. “In Fintech, China Shows April 1, 2019. the Way.” February 25. 14. In 2017, a joint regulation of the Minis- Fleisig, Heywood, Mehnaz Safavian, and Nuria try of Finance and the Ministry of Human de la Peña. 2006. Reforming Collateral Laws Resources and Social Security established an to Expand Access to Finance. Washington, administratively determined annual rate of DC: World Bank. return on individual accounts, indicating that Gozzi, J. C., and S. L. Schmukler. 2015. “Public the authorities are considering financing the Credit Guarantees and Access to Finance.” individual accounts on a pay-as-you-go basis. European Economy: Banks, Regulation, and 15. See more discussions in World Bank (2013) the Real Sector 2: 101-17. and World Bank and Development Research Harwood, Alison, and Tanya Konidaris. 2015. Center of the State Council (2014). “SME Exchanges in Emerging Market Econ- 16. Also, certain segments in China, such as omies: A Stocktaking of Development Prac- unregistered migrant workers, may exhibit a tices.” Policy Research Working Paper No. high turnover. 7160, World Bank, Washington, DC. Huang, F. 2017. “The Future of Chinese Capital Markets.” Unpublished Manuscript. Bibliography IFC (International Finance Corporation). 2012. Beck, Thorsten, Asli Demirgüç-Kunt, and María IFC Secured Transactions Advisory Project in Soledad Martínez Peria. 2011. “Bank Financ- China. Washington, DC: IFC. ing for SMEs: Evidence Across Countries and Kuntchev, Veselin, Rita Ramalho, Jorge Rodríguez- Bank Ownership Types.” Journal of Financial Meza, and Judy Yang. 2014. “What Have We Services Research 39 (1): 35-54. Learned from the Enterprise Surveys Regard- Berger, Allen, and Gregory Udell. 2006. “A More ing Access to Finance by SMEs?” Policy Complete Conceptual Framework for SME Research Working Paper No. 6670, World Finance.” Journal of Banking and Finance 30 Bank, Washington, DC. (11): 2945-66. Love, Inessa, María Soledad Martinez Peria, and Bu, Di, and Yin Liao. 2016. “The Small and Sandeep Singh. 2016. “Collateral Registries Medium Enterprises and the Credit Report- for Movable Assets: Does Their Introduction ing System in China.” Global Credit Review Spur Firms’ Access to Bank Finance?” Journal 6: 41-8. of Financial Services Research 49 (1): 1-37. Calice, Pietro. 2016. “Assessing Implementation MYBank. 2018. Annual Report. (in Chinese). of the Principles for Public Credit Guarantees https://render.mybank.cn/p/f/mybank/info.htm. for SMEs: A Global Survey.” Policy Research OECD (Organisation for Economic Co-operation Working Paper No. 7753, World Bank, Wash- and Development). 2015. New Approaches to ington, DC. SME and Entrepreneurship Financing: Broad- CFPB (Consumer Financial Protection Bureau). ening the Range of Instruments. Paris: OECD. 2017. “CFPB Explores Impact of Alternative PBOC (People’s Bank of China). 2017. “Finan- Data on Credit Access for Consumers Who cial Consumers’ Capability Survey.” http:// Are Credit Invisible.” w w w.yd 96688.com / Hd At t /at t / 2018/ 08 CGFS (Committee on the Global Financial Sys- /20180807171840851.pdf. tem) and FSB (Financial Stability Board). 2017. ———. 2018. Overall “Operation of the Pay- “FinTech Credit: Market Structure, Business ment System in 2018.” http://www.pbc.gov.cn Models and Financial Stability Implications.” /zh i f ujiesua nsi /128525/128545/1286 43 Bank for International Settlements, Financial /3787878/index.html. Stability Board, Basel. 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Washington, DC: World Bank. and People’s Bank of China. 8 Leveraging Regional Development and Integration Regional planning and development have to cluster and grow unevenly across space been a key national strategy since China’s (Duranton and Venables 2018; World Bank reform and opening up. Four regional strate- 2008). The benefits of proximity arise from gies—Western Region Development, North- the direct savings in transport and com- east Region Revitalization, Rise of the Cen- munication costs from being close together, tral Region, and Leading Development in the and economies of scale that arise as firms Coastal Region—were deployed as national and infrastructure operate at scale. Further- strategies to optimize spatial development, more, the provision of networked infrastruc- cultivate new growth poles, and foster ter- ture (such as transport and energy) is much ritorial cooperation. Since China’s 18th Ple- cheaper, per person, in dense urban areas num in 2012, three major regional strate- than in dispersed rural ones. The other driver gies have been proposed to complement the is the agglomeration economies that are gen- original four: Belt and Road Initiative (BRI), erated by close and intense economic interac- Jing-Jin-Ji Coordinated Development, and tion. These economies arise through several Yangtze River Economic Belt. These “place- different mechanisms. Thick labor markets based” strategies (initiatives) have focused enable better matching of workers to fi rms’ on developing new growth poles, increasing skill requirements. Better communication efficiency in the spatial allocation of produc- between fi rms and their customers and sup- tion factors, and enhancing regional special- pliers enables knowledge spillovers, better ization. Considering the large population in product design, and timely production. A the central and western regions, alongside larger local market enables the development natural resource abundance, the development of a larger network or more specialized sup- of growth poles in these regions is seen as an pliers. Fundamentally, larger and denser mar- opportunity to unlock untapped potential kets allow for both scale and specialization. and support new drivers of growth. Institutional and regulatory constraints These initiatives build on fundamental can create spatial inefficiencies. In principle, principles of spatial development where den- the constraints could be removed economy- sity and proximity are key ingredients, as wide, but in practice this is difficult because seen in the tendency of economic activities of the fiscal cost (for example, costs of 113 114 INNOVATIVE CHINA investments in infrastructure) and the politi- markets will be central to enhancing the pace cally challenging nature of the reforms (for and efficiency of urbanization. example, reforms to redevelop land from The second set of choices pertains to the industrial to commercial use and relax con- development of economic clusters, which straints on labor mobility across regions). include reforms to enhance linkages within Place-based strategies and associated invest- dynamic regions, such as the Yangtze River ments in growth poles, transport corridors, Economic Belt, and redeveloping regions and infrastructure also run the risk of creat- that have fallen behind. China’s investments ing stranded assets with little economic value as part of the BRI could potentially provide unless they are based on a careful assessment new development opportunities for towns of demand and address underlying market and cities in the western region, but there is and coordination failures. a need to ensure that economies of scale and China has been highly successful in lever- specialization are reaped and that a package aging spatial transformation for economic of complementary investments and policies is development over the past 40 years. Rapid implemented in a coordinated manner. urbanization has supported density and The third set of choices includes the man- proximity, with rising concentrations of agement and strategic redevelopment of people in cities and metropolitan areas. Cit- existing cities and metropolitan areas such ies with more than 1 million urban residents that the urban fabric is dense and connected. accounted for 260 million people in 2010 (20 Improving urban and metropolitan manage- percent of China’s population) based on the ment will support density; reduce congestion latest available population census, up from in transport, housing, and services; and allow 183 million in 2000 (14 percent). The urban cities to take on new economic vocations. populations of Beijing and Shanghai grew In summary, greater scale and special- almost 50 percent during this period, as did ization will be critical for China to leverage those of Chongqing and Shenzhen (47 per- regional development to support new drivers cent), while the 10 cities with 5 million to 10 of growth. These goals will require reducing million urban residents grew 41 percent. In spatial frictions in factor markets, developing terms of regions, the largest gains in popula- and expanding economic clusters, improving tion shares from 2000 to 2010 were in the urban management, and redeveloping cities Yangtze River Delta, the Pearl River Delta, in a strategic manner. and the Beijing-Tianjin region. Together, these three regions absorbed 45 percent of Reducing spatial frictions in China’s additional 91.5 million people. The spatial concentration of people has also been factor markets accompanied by rising prosperity; the com- Inefficiencies in how labor, land, and capital bined economies of Beijing, Guangzhou, are being distributed across China’s terri- Shanghai, Shenzhen, and Tianjin amounted tory are holding down China’s urbanization to US$1 trillion in 2010, twice the size of the and spatial development. Policy reforms in economies of Norway and Sweden and close each factor market would not only enhance to that of the Republic of Korea in 2010. returns to that factor but also, given comple- As China looks toward spatial develop- mentarities across factors, enhance the per- ment to support future drivers of growth, formance of other factor markets. Research three sets of policy and investment choices done for this report shows that simultane- need to be considered carefully. The first is ously reducing the costs of interprovincial the pace and magnitude of urbanization. labor migration and freeing up the spatial There is still room to quicken the pace and allocation of capital can result in welfare improve the efficiency of urbanization, with gains of more than 27 percent. Chapter 7 dis- China being about 8 percentage points less cusses inefficiencies in the flow of labor. The urbanized than other countries for its level of following paragraphs discuss the allocation income.1 Reducing spatial frictions in factor of capital and land. LE VER AGING REGIONAL DE VELOPMENT AND INTEGR ATION 115 Capital should be allocated where it is pace than the urban population (10.5 per- expected to maximize returns and contribute cent). Henderson, Lall, and Venables (2017) to growth. Research done for this report indi- show that inland cities are being allocated cates a mismatch between the regional supply more land for urban construction than they of capital and local economic activities, in the can convert, while cities in the eastern region form of the rising price of capital in eastern are converting more land for urban con- urban areas where economic expansion has struction than originally planned. Empirical been taking place. By contrast, the price of research shows that reallocating 30 percent of capital in the western and central regions rel- the land supply from low-productivity cities ative to the eastern region fell between 2007 to high-productivity cities would add between and 2014. Econometric analysis done for this 0.5 and 2.6 percent to China’s total GDP. report shows that increasing the supply of Policy reforms that constitute a national and access to capital for cities in the eastern trading market can enable high-growth cities region, where greater economic activities are to trade urban land development rights with taking place, can improve efficiency in the jurisdictions with abundant farmland and use of capital as well as contribute to greater agriculture-based economic activities. In fact, output. An important driver of the spatial land quota exchanges between jurisdictions misallocation of capital and the develop- have been piloted in Chengdu and Chongqing ment of regional clusters are the barriers that and have delivered positive outcomes. This small and medium enterprises (SMEs) face mechanism would allow for a market-based in accessing credit from state-owned com- determination of the location and intensity of mercial banks. Even though SMEs generate new development and lead to a more effective more employment than large businesses and allocation of land resources toward the high- contribute meaningfully to gross domestic est and best uses. Scaling up this practice can product (GDP), commercial banks nonethe- potentially unlock huge efficiency gains and less can favor large borrowers. In 2018, only contribute to economic growth. about 18 percent of bank loans were extended to small and micro enterprises, according to Nurturing and connecting World Bank estimates using People’s Bank of China (PBOC) statistics.2 economic clusters Food security concerns have led to national China’s leaders are putting in place strategies policies inhibiting the conversion of farmland and investments to enhance the development to urban land. The national allocation pro- of growth poles and development corridors in cess places constraints on total new urban and different parts of the country. In particular, rural land for construction. As China’s largest there is a considerable push for the develop- cities try to reorient their economic landscape ment of the western region, revitalization of to support high-end services and innovation, the northeast region, and rise of the central they will need to change their land use poli- region, adding to regional development plans cies to allow firms to benefit from economies for the Pearl River Delta, the Yangtze River of density and proximity (agglomeration econ- Delta, and the Beijing-Tianjin-Hebei (Jing- omies). At the same time, secondary cities in Jin-Ji) region. China’s leaders could consider their vicinity will need to make land available three key principles as they roll out place- for standardized manufacturing to relocate. based policies to develop clusters to acceler- There are significant spatial mismatches ate growth in specific regions. between urban growth (population and econ- omy) and urban land. Despite little growth in Reinforce agglomeration economies the urban population (0.3 percent), the north- east region witnessed sizable expansion of Firms in most sectors strongly value agglom- urban land between 2013 and 2016 (13.1 per- eration, which facilitates co-location with cent). In the eastern region, urban land areas other firms and promotes the supply of rel- also grew rapidly (8.3 percent), but at a slower evant inputs and knowledge spillovers. Firms 116 INNOVATIVE CHINA are unlikely to move by themselves to “green- spatially clustered development so that ben- field” locations, even if they are offered multi- efits from agglomeration can be reaped. Then ple advantages such as quality infrastructure firms can choose their location based on com- and institutions. More important to a firm’s mercial factors. This would be a bottom-up decision to move is the expectation that com- approach, as opposed to a more top-down, plementary firms and inputs, such as skilled centrally planned approach. labor, will move with it. This complementar- As the growth of manufacturing has ity would support scale and specialization. slowed in large cities and metropolitan areas In fact, China’s economic geography has in the east, innovative activities have begun to undergone dramatic changes over the past 40 concentrate in these cities. International expe- years to reinforce agglomeration economies, rience suggests that agglomeration in innova- with rising clustering and concentration of tive core areas leads to greater concentration people and economic activity. Market forces of innovation (McCann and Ortega-Argilés have pushed China toward concentrating 2011). Regions with large cities—dense with industry in its large metropolitan areas, with skilled people, well-endowed infrastructure, the Yangtze River Delta and Pearl River Delta and burgeoning economic activity—are more emerging as dominant industrial hubs. The innovative. The agglomeration benefits of clustering of economic activity has acceler- knowledge and research and development ated the pace of economic growth and helped (R&D) spillovers decline rapidly with dis- to reduce rural-urban inequalities by increas- tance, and dense and well-connected urban ing the incomes of rural residents (Guo et areas are the most conducive for nurturing al. 2017). Moreover, according to research innovation. China’s innovative activity is carried out for this report, the locations of highly concentrated in the coastal region’s economic activity have been changing over largest metropolitan areas. For instance, the past decade. Data at the enterprise level Guangdong contributed 19.3 percent of show a decline of manufacturing employ- the total patents granted in 2017, the larg- ment growth in the eastern region (particu- est among provinces, followed by Jiangsu larly provincial capitals) and an increase in and Zhejiang. Provinces in the central and such employment in prefecture-level cities in western regions tend to be among the least the central region. The geographic center of innovative. manufacturing firms has been moving from Shenzhen’s successful economic transfor- the east toward the center of the country mation from a provincial region of small since around 2008. towns and fishing villages in the 1980s to a China’s investments through the BRI can manufacturing center, and now a technology potentially have profound spatial impacts and innovation hub, offers valuable lessons within China, in addition to the other BRI- for other regions considering spatial and eco- connected countries. BRI investments that nomic transformation. After years of being a reduce transport costs between western manufacturing center for iPhones and other China and cross-border markets in Central electronics, Shenzhen has established a com- Asia are likely to encourage population and prehensive, high-technology, industrial value economic growth around border regions such chain, including key parts such as chips, as Urumqi (El-Hifnawy, Lall, and Lebrand memory, gyroscopes, Bluetooth, displays, 2018). This pattern is consistent with previ- and touch modules. As a result, Shenzhen ous episodes of external integration where has a strong basis for hardware innovations trade openness can induce concentrations of that can take advantage of future technology economic activity near border areas, such as trends in artificial intelligence, virtual reality, occurred along the border between Mexico drones, and the Internet of Things. Of the and the United States as a result of the North various lessons offered by Shenzhen, two key American Free Trade Agreement (Hanson insights for promoting local economies are 1998). the focus on establishing a business climate Given the changing nature of industrial that encourages entrepreneurship and the geography, policies and multisectoral invest- promotion of inward migration. First, inno- ments will be needed to support scale and vation has been led by private companies’ LE VER AGING REGIONAL DE VELOPMENT AND INTEGR ATION 117 investment in R&D. Most enterprises in government functions, and active collabora- Shenzhen have a private ownership structure, tion among subnational governments (pro- represented by some of the most dynamic and vincial and local) as well as with national line innovative private enterprises in China, such ministries. as BYD, DJI, Huawei, Tencent, and the gene- The northeast region highlights the need mapping company BGI. In Shenzhen, more for a package of coordinated actions. The than 90 percent of the R&D institutions are three northeastern provinces—Heilongjiang, located within private enterprises; more than Jilin, and Liaoning—were once the center of 90 percent of researchers are concentrated heavy industry in China. However, the region in private enterprises; more than 90 percent has been a relative laggard in economic per- of R&D funding comes from private enter- formance in recent decades, despite several prises; and more than 90 percent of patents rounds of regional revival efforts. A coordi- originate from private enterprises. Shenzhen nated and integrated approach, focused on has also established an R&D culture, report- market-oriented reforms, is needed to help edly spending US$10 billion, or 4 percent of the region get out of stagnation. The econ- GDP, on R&D, more than Singapore and omy clearly needs to diversify by promoting Hong Kong SAR, China, combined. new sectors. The northeast provinces could Second, Shenzhen has actively welcomed streamline their administrative procedures migrants. Ninety-five percent of its popu- as part of an overall effort to improve the lation are migrants who have forged the local business climate and promote market- region’s entrepreneurial spirit. Other cities, oriented reforms. The region could consider a such as Beijing and Shanghai, have certain more market-oriented approach to promoting areas with high proportions of migrants, but the local economy, by benchmarking other none has the level of migrant concentration regions where the market economy thrives. of Shenzhen. This level of concentration has For example, the government of Shenzhen is enabled Shenzhen to develop a local culture highly efficient and service oriented, focused that encourages risk taking, tolerates failure, on supporting local markets. Its policies, such and rewards talented people regardless of as online registration of firms, are designed their background. to encourage market competition, innova- tion, and entrepreneurship. Revitalizing the local economy will also require promoting Coordinate investment and policies and retaining local talent, attracting new tal- across several sectors ent, and promoting entrepreneurship. Locations that lag in development often face Infrastructure investment has been a big multiple deprivations of relevance to prospec- part of regional development initiatives so tive investors, including with regard to human far in China, and there are plans for addi- capital, institutional quality, infrastructure, tional public investment to support regional distance to ports, and presence of agglomera- development. In 1990, almost all goods were tions. These deprivations make it particularly transported either by rail or by river. The road difficult to counteract existing spatial concen- system was underdeveloped and had limited tration, and resolving just one deprivation is access to many places. By 2010, China had rarely enough to make the location attractive constructed an extensive highway system to productive firms. For example, firms can- serving the entire country. As transport costs not take advantage of transport investments if fell, and access to markets improved, regions logistics are not efficient, and the power sup- could specialize and gain from trade. In the ply is lacking. Strong information and com- longer term, transport infrastructure can munication technology infrastructure will fail help firms relocate, supporting spatial devel- to attract a high-technology sector without a opment. However, going forward, given the local pool of skilled labor and complementary large infrastructure investments so far and business services. Overcoming these barri- the resulting significant improvements in the ers to investment would require coordinated country’s infrastructure, infrastructure may policy responses, strong skills in planning no longer be as significant of a bottleneck and execution across a broad range of local as in the past. This would also mean that 118 INNOVATIVE CHINA investments in infrastructure may not need to 85 percent of all containers entering or leav- be as high as in the past. ing the ports on trucks. The lack of logistics What China needs now is not simply more hubs for multimodal transportation is one investments in infrastructure but also smart of the main reasons for the low use of rail ways to plan, utilize, and manage its infra- transportation. structure investments. For example, the pri- In addition to investment and policy ority for the energy sector should not be sim- coordination, there is room to enhance the ply more infrastructure investments but also extent to which existing economic clusters sectoral reforms to ensure that the invest- are connected so that individual towns and ments in power generation—in particular, cities can specialize, trade goods and ser- renewable energy—can be efficiently used vices within the cluster, and develop scale and transmitted. In the transport sector, for economies. Such localization and intraclus- example, expansion of the network needs ter linkages can enhance overall efficiency to be complemented by enhanced logistics and productivity. In the case of the Yang- operations, which are currently highly frag- tze River Economic Belt, empirical analysis mented and unorganized. There are 78,000 conducted for this report indicates a low road logistics companies in China that are degree of economic integration between cit- unable to optimize routes, avoid unloaded ies in the upper, middle, and lower reaches trips, employ well-trained staff, or share of the region. Much of the trade in the region information with infrastructure operators, takes place within each province as opposed logistics service providers, and logistics to between provinces, thus missing oppor- customers. The cost of logistics was RMB tunities to leverage the regional market and 11.1 trillion, or 15 percent of GDP, in 2016, interprovincial trade (figure 8.1). To benefit which is high compared with the cost in from spatial development, there is a need to other countries (NDRC and CFLP 2017). enhance trade and linkages across the Yang- There are also untapped opportunities to use tze River Economic Belt. inland water transport and railways in the The policy simulations carried out for this system. Only 1.3 percent of container traffic report indicate that a combination of infra- through China’s ports involves trains, with structure investments and spatially targeted FIGURE 8.1 Trade within and between provinces in the Yangtze River Economic Belt of China 100 90 80 70 60 Percent 50 40 30 20 10 0 n i su ui i an ai n g be ou ing x na na an ng h gh ng hu Hu izh An Hu gq n eji Jia an Jia Sic Yu Gu on Zh Sh Ch Intraprovince trade Interprovince trade Source: Calculations based on World Bank data. LE VER AGING REGIONAL DE VELOPMENT AND INTEGR ATION 119 fiscal policies can support market integra- floor area ratio (FAR) regulation is one of tion and industrial upgrading of the Yang- the most important land use regulations in tze River Economic Belt. There is significant urban China. FAR regulation takes the form opportunity for economic integration and of an upper-bound constraint on the ratio of transformation along the Yangtze River Eco- a building’s total floor area to the lot size nomic Belt to support the upgrading of indus- of the building. By law, any land parcel to tries and services within the belt, anchored be auctioned off must have a designated by the Yangtze River Delta and Shanghai, regulatory FAR level. The FAR regulation and the development of innovation hubs. is constraining the efficient development of Regional cooperation is also constrained Chinese cities, as the cities with rapid popu- by intergovernmental fiscal arrangements lation growth have lower FARs imposed on and performance assessment systems of local newly developed residential land than other government officials, which tend to encour- cities. This regulation adds to the challenges age local protectionism and market segmen- posed by low land conversion quotas in tation. Under the existing “tax assignment cities with high population growth, as dis- system” that regulates the financial and cussed earlier. In addition to raising the cost taxation relationship between the central of housing and encouraging urban sprawl and local governments, most local govern- (as land cannot be developed at scale due ment revenues are generated locally. The to conversion quotas), such regulations are supply of public services and the salaries of exacerbating congestion and environmental civil servants are closely related to local fis- degradation. cal revenues. As a result, local governments The FAR issue is one of many challenges are strongly incentivized to focus on devel- that need to be addressed to improve urban oping their local economies, including by management. A critical issue in the develop- taking protectionist measures to promote ment of high-density and high-quality urban local enterprises that provide tax revenues. environments is the reform of urban planning In addition, the government’s performance and significant improvement of urban design. assessment system has tied the promotion Cities will need to update their planning reg- of officials closely to local economic perfor- ulations to build urban amenities and public mance, and competition between local offi- services that meet the spatial needs of the cials has become, to a considerable extent, a new drivers of growth. Flexible manufactur- contest of local economic growth. In such an ing and customized production often require institutional arrangement, regions may focus small spaces at convenient, easily accessible on competition instead of cooperation and locations. Most services favor a certain popu- often tend to take a “beggar-thy-neighbor” lation density and quality of life. The expan- approach. sion of massive public transit networks in Therefore, the government could aim to Chinese cities, combined with visionary land reform its performance appraisal mechanism use plans, presents unprecedented opportuni- and the intergovernmental fiscal and taxa- ties to get the urban form right. tion relationship to provide more incentives To address the challenges and ensure for local governments to cooperate and col- an inclusive and efficient urban future, the laborate on matters such as the integration government could consider the following of traffic facilities, environmental protection, priorities: public service provision, reduction of trade barriers, and the opening of local markets to • Reform the process and procedures for support regionally coordinated development. how cities determine the type of land uses allowed and the related detailed develop- ment restrictions, such as the regulatory Engage in strategic urban management FAR limit, building height, and green area In China, limits on urban density are keeping rate. Such reforms would aim to improve agglomeration economies down and push- land use intensity and density in cities. ing housing prices up. Density-restricting In particular, local governments could 120 INNOVATIVE CHINA reform the decision-making process that Bibliography limits the FAR for new residential areas in Baum-Snow, Henderson, Brandt, et al. 2017. growing cities, and introduce efficiencies “Highways, Market Access, and Urban Growth and transparency in the process for apply- in China.” Processed. https://economics ing for changes in the FAR and in the land .smu.edu.sg/sites/economics.smu.edu.sg/files compensation fee to adjust the FAR. /economics/pdf/Seminar/2017/20170313.pdf. • Introduce zoning regulations that encour- Carlino, G., and W. Kerr. 2014. “Agglomeration age compact and mixed-use urban devel- and Innovation.” NBER working paper 20367, opment connected by high-quality pub- National Bureau of Economic Research. lic transport, where residents have easy Duranton, Gilles, and Anthony J. Venables. 2018. access to jobs, shops, schools, and other “Place-Based Policies for Development.” Policy public facilities in a walkable environ- Research Working Paper WPS8410, World Bank, Washington, DC. ment. Cities need to invest in advanced Fu, Shihe, Xiaocong Xu, and Junfu Zhang. 2018. urban planning, progressive architecture, “Land Conversion and Misallocation across urban regeneration, and people-oriented Cities in China.” Background paper for this design. report, World Bank, Washington, DC. • Develop new planning and design prin- Guo, D., U. Deichmann, and S. V. Lall. 2017. ciples and techniques, applied at multiple “The Geography of Industrial Development levels from region and city to subdistrict in China.” Background paper for this report, and local community, that can create World Bank, Washington, DC. livable high-quality urban space for the Guo, Di, Kun Jiang, Cheng-Gang Xu, and modern services economy. Xiyi Yang. 2017. “Clustering, Growth, and • Prepare the type of strategic planning of Inequality in China.” CEPR Discussion Paper no. DP12543, Center for Economic and Policy physical infrastructure and public ser- Research. https://ssrn.com/abstract=3095593. vices that can foster new types of business Hanson, Gordon. 1998. “North American Eco- opportunities, such as shared mobility nomic Integration and Industry Location.” (including cars and bikes), shared office Oxford Review of Economic Policy 14 (2): spaces, and renewable energy vehicles (for 30–44. example, planning for charging stations Henderson, J. Vernon, Somik Lall, and Anthony for electric cars). Venables. 2017. Africa’s Cities: Opening Doors • Improve real estate transparency and to the World. Washington, DC. World Bank. urban architectural design to enhance Henderson, J. D. Su, Q. Zhang, and S. Zheng. the business operating environment, raise 2017. “A Note on Migration Costs in China.” new capital, and contribute to the quality Background paper for this report, World Bank, Washington, DC. of urban life, making cities more globally Kochendorfer-Lucius, Gudrun, and Boris Ples- competitive. kovic. 2009. “Spatial Disparities and Develop- • Introduce new policies and regulations to ment Policy.” Berlin Workshop Series 2009, improve land use efficiencies by encour- World Bank, Washington, DC. aging the use of underutilized land in Lall, Somik V., and Mathilde Sylvie Maria Leb- urban centers and discouraging the over- rand. 2019. “Who Wins, Who Loses ? Under- supply of industrial land on the city’s standing the Spatially Differentiated Effects of periphery. the Belt and Road Initiative.” Policy Research working paper no. WPS 8806, World Bank, Washington, DC. http://documents.worldbank Notes .org/curated/en/292161554727963020/Who- 1. Based on a comparison of incomes and urban- Wins-Who-Loses-Understanding-the-Spatially ization with all countries globally, using World -Differentiated-Effects-of-the-Belt-and-Road Development Indicators data for 2016. -Initiative. 2. The estimate is based on micro enterprises, as L au , A la n , a nd M i n Su. 2017. “Ch i na’s opposed to medium enterprises, because PBOC E-Commerce Soft Spot: Logistics.” Retrieved defines the size (number of employees) of micro from https://www.mckinsey.com/industries enterprises similar to what other countries /high-tech/our-insights/chinas-e-commerce designate as medium enterprises. -soft. LE VER AGING REGIONAL DE VELOPMENT AND INTEGR ATION 121 Liu, Bing-lian, Jian-hua Xiao, Zhi-lun Jiao, Shao- NDRC (National Development and Reform ju Lee, and Ling Wang (eds). 2013. “Contem- Commission) and CFLP (China Federation porary Logistics in China: Transformation and of Logistics and Purchasing). 2017. “Briefing Revitalization.” Current Chinese Economic on National Logistics Operation in 2016” (in Report Series, Springer-Verlag, Heidelberg. Chinese). McCann, Philip, and Raquel Ortega-Argilés. World Bank. 2008. World Development Report 2011. “Smart Specialisation, Regional Growth 20 09: Reshaping Economic Geography. and Applications to EU Cohesion Policy.” Washington, DC: World Bank. Regional Studies 49 (8) January. Yanlin, Li. 2017. “The Study on Logistics Per- M EP (M inistry of Environmental Protec- formance Evaluation in China” (in Chinese). tion). 2017. “China Vehicle Environmen- Retrieved from http://www.transformcn.com tal Management Annual Report.” http:// / Topics/img /site22/20170925/c81f661ac8 dqhj.mep.gov.cn /jdchjg l /zhg ldt / 201706 d91b32af6522.pdf. /P020170605550637870889.pdf. 9 Promoting International Competitiveness and Economic Globalization Integration into the global economy has been integration in GVCs helps domestic enter- a major driver of China’s economic growth prises access the global supply of advanced and development. China achieved economic components, technologies, and services. As globalization through reforms to open up its China approaches the global technology economy to global trade and investments, frontier, it will increasingly need to access becoming the world’s largest trader of manu- frontier technologies. Foreign direct invest- factured goods and a major destination for ment (FDI) and outward direct investment foreign investments. China is now an essen- (ODI) in advanced manufacturing and high- tial part of the global economic landscape, end services can drive technological innova- and its production, trade, and investments tion and industrial upgrading in China. are deeply integrated in global value chains Given China’s importance to the global (GVCs). Foreign-invested enterprises helped economy, it will be increasingly looked upon China to expand its exports rapidly through to support an open global economy, pro- the processing and assembly of manufactured mote shared global prosperity, and collabo- goods. China now seeks to promote globally rate on global public goods. International competitive indigenous enterprises and move cooperation and coordination are becoming to higher-value-added parts of GVCs. more critical as rapid technological advance- Continued reforms to open its economy ment is creating closer links among nations. further will be critical for China to achieve its China’s growth was a significant contribu- aspirations to become a more innovative and tor to global growth following the global productive economy. The 3rd Plenary Session fi nancial crisis, and it remains an important of the 18th Communist Party of China (CPC) source of global economic growth. China Central Committee proposed to reform also believes that the Belt and Road Initiative and open the economy further, outlining a (BRI), an ambitious effort to improve cross- series of policy measures to support China’s country economic integration and connectiv- industrial upgrading and economic trans- ity on a transcontinental scale, will make a formation under the “new normal.” Being major contribution to the global economy. outwardly oriented with innovative domes- To achieve “win-win cooperation that pro- tic fi rms engaged in global trade and invest- motes shared development and prosperity,” ments will help to improve China’s long-term BRI will require a multilateral approach competitiveness and prosperity. China’s deep based on transparency, accountability, and 123 124 INNOVATIVE CHINA investments that are financially, environmen- by 40 years of reforms since 1978 and the tally, and socially sustainable. opening up of its economy. China has ben- China faces three major global dynamics efited greatly by integrating into the global that present both challenges and opportuni- economy and leveraging its comparative ties. First, rising global trade tensions and advantages in global trade and investments. the challenges of sustaining global growth China has become the world’s largest inter- have created a more uncertain and challeng- national trader of manufacturing goods and ing external environment for China’s open the second-largest trader in services. China’s development. Second, China’s traditional exports have soared in dollar terms—17 per- areas of labor-intensive comparative advan- cent annually in the past two decades—and tage may be weakening, while its new areas its export market shares for both gross trade of comparative advantage are still evolving. and added value have risen significantly (fig- Third, the influence of emerging economies, ure 9.1). The contribution of China’s exports including China, on the global economy is to its growth has been falling with the slow- rising, and therefore international coordina- down in global trade since the global finan- tion will require a wider consensus. China’s cial crisis of 2008, but its share of global policy choices will have a considerable impact trade has been rising. China’s share of global on global economic developments and inter- exports of goods increased from only 3.9 per- national economic and trade relations. There- cent in 2000 to 14.6 percent in 2017. fore, China and the rest of the world will need China has evolved from being a peripheral to work together to address emerging chal- actor to being one of the three major global lenges and ensure shared global prosperity. manufacturing hubs for GVCs, along with Germany and the United States (figure 9.2). China is a prime example of using GVCs to China’s integration into the improve supply-side productivity and com- global economy and rising petitiveness. To facilitate its integration into competitiveness GVCs, China has invested heavily in trans- China’s unprecedented economic growth portation, the Internet, and information and and rapid development have been driven communication technology (ICT)–related infrastructure and carried out reforms to promote foreign investment, improve trade FIGURE 9.1 China’s share of global exports of goods, 1993–2017 and investment facilitation, and strengthen the business environment. 18 Foreign investments have been critical for China’s export growth and international 16 competitiveness. Foreign-invested enterprises 14 contributed to nearly half of China’s imports and exports, one-fourth of industrial output, 12 and one-fifth of tax revenue in 2017. China 10 was the second-largest destination for FDI in Percent the world, after the United States, in 2018. 8 According to the World Investment Report 6 2017 (UNCTAD 2017), multinational firms consider China the second-most-preferred 4 destination for cross-border investment in the 2 world. China has evolved from being a net 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 importer of FDI to a net exporter in 2016 (fig- China Germany United Kingdom United States ure 9.3). Despite experiencing a sharp decline in 2017, China’s outbound investments were Sources: Calculations based on World Integrated Trade Solutions (WITS)–Comtrade database the third-largest in the world. Regional con- for 1992–2016 and International Monetary Fund Direction of Trade Statistics (DOTS) for 2017. nectivity programs, such as the BRI, have PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 125 FIGURE 9.2 Global network of intermediate trade (minimum-spanning-tree method), 1995 and 2016 a. 1995 b. 2016 Source: Calculations based on Organisation for Economic Co-operation and Development (OECD) Trade in Value Added (TiVA) data. FIGURE 9.3 China’s foreign direct investment and outward direct investment, 2005–18 UKR TUR 5 DNK NOR SWE FIN 4 IRL NLD ISR AUS RUS COL NZL TTO DZA BEL GBR 3 POL CAN ZAF MYS % of GDP SAU PAK FRA MEX KWT PHL ESP DEU SGP 2 USA JPN SVK CZE THA CHE MAR BRN HKG AUT KOR 1 ITA BRA CHL HRV IDN SVN HUN ARE ARG 0 LBY MLT 2005 2006 ROM 2007 2008 IND 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Inflows Outflows Source: State Administration of Foreign Exchange (SAFE) data. the potential to lead to further ODI oppor- export capabilities of an economy (figure tunities. Also, China remains an attractive 9.4). Economic fitness is a measure of the destination for foreign investments due to its complexity-weighted diversification of a large domestic market. Foreign enterprises country’s exports (Cristelli et al. 2017; Tac- such as BASF, BMW, Siemens, and Tesla have chella et al. 2012). An economy is more recently announced new or expanded invest- complex if more varied and useful knowl- ments in China. edge and capabilities are embedded in it China has progressed significantly on and are reflected in its exports. China’s eco- its “economic fitness,” which measures the nomic fitness far exceeds that of countries 126 INNOVATIVE CHINA FIGURE 9.4 “Fitness analysis” of the diversity and complexity of China’s exports 11.7 Fully developed countries Singapore 10.8 Korea, Rep. 9.9 Russian Federation Middle-income Brazil Malaysia trap 9.0 South Africa Log of GDP per capita China Thailand 8.1 India Vietnam 7.2 6.3 5.4 Poverty trap 4.5 –6.7 –5.8 –4.9 –4.0 –3.1 –2.2 –1.3 –0.4 0.5 1.4 2.3 Log of economic fitness Source: International Finance Corporation analysis. with a similar gross domestic product (GDP) product), also indicates that China’s manu- per capita and is now comparable to that facturing production became substantially of some high-income countries. Its fitness more complex from 1995 to 2014. 2 is approaching the global frontier, due to China has a relatively high level of capa- the complexity of the goods and services bility for providing “complex” goods for it produces competitively and the wide export—beyond what would be expected for range of sectors that it exports.1 A comple- its stage of development. Part of this fitness mentary analysis of economic complexity, reflects manufacturing exports by foreign- which measures the diversity of a country’s invested enterprises based in China and the exports (the number of products in a coun- large share of foreign intermediate inputs try’s export basket) and their ubiquity (the in its exports. Given that China's exporting number of countries that export a given capabilities surpass its level of development, PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 127 FIGURE 9.5 Revealed comparative advantage in gross exports and value-added exports in China, 2000–14 a. Gross exports b. Value-added exports 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.5 Index Index 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0 0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Textiles, apparel, and leather products Machinery and equipment Computer, electronic, and optical products Motor vehicles and trailers Electrical equipment Other transport equipment Source: Calculations based on World Input-Output Database (WIOD) data. it also indicates that significant potential is measured based on domestic value added in remains for the diffusion of technology and exports (value-added RCA), using the meth- manufacturing know-how within China’s odology proposed by the World Trade Orga- economy, from the exporting to the nonex- nization (WTO) and the Organisation for porting sectors. China’s expected fitness tra- Economic Co-operation and Development jectory shows that it is on a path to achieving (OECD), then the competitiveness of China’s fully developed status. It also indicates ris- high-technology exports has improved to a ing competitiveness in transport equipment, lesser degree (figure 9.5, panel b). computer manufacturing, and plastics—all In parallel with the expansion of high-tech- relatively complex industries—and additional nology exports, China has managed to retain opportunities for research and development the competitiveness of its lower-technology (R&D)–intensive exports, particularly in and more labor-intensive exports, such as ICT and robotics. textiles and garments. The share of low- China has continued to expand its high- technology exports has declined, but low- technology exports and domestic value added technology exports still account for roughly in exports. The share of high-technology one-third of exports, and their RCA remains manufactures in exports increased from relatively high, but declining (figure 9.5). nearly zero in 1980 to around 30 percent in China’s integration in GVCs has been a 2017.3 The export performance of computers, key driver of its export growth and has pro- electronics, optical equipment, and electrical vided important opportunities for accessing machinery particularly stands out. Export advanced technology. China’s level of partici- competitiveness can be measured using pation in GVCs was analyzed by estimating its revealed comparative advantage (RCA).4 domestic value added (DVA) in exports using China’s RCA of gross exports of technology- the World Input-Output Database (WIOD).5 intensive goods—such as computer and elec- The analysis indicated that China’s DVA in tronic products, electrical equipment, and exports was very low in the early 2000s but machinery equipment—have increased signifi- has been rising steadily. By contrast, the DVAs cantly (figure 9.5, panel a). However, if RCA of many major exporting countries have held 128 INNOVATIVE CHINA FIGURE 9.6 Domestic value added (DVA) in exports in selected economies, 2000–15 95 90 85 80 75 Percent 70 65 60 55 50 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Brazil China Germany India Japan Korea, Rep. Mexico Taiwan, China Russian Federation United States Source: Calculations based on World Input-Output Database (WIOD). steady or have been declining. China’s DVA and investment liberalization and its deeper is now higher than those of several major engagement in GVCs (Kee and Tang 2016). exporting economies (figure 9.6).6 During 2000–17, China’s rising DVA reflected China’s higher DVA was achieved through a shift away from the assembly and process- improvements in its base of domestic suppliers, ing trade, the share of which remains relatively which grew in response to the country’s trade high but has been declining steadily from almost 60 percent to about 30 percent (figure FIGURE 9.7 Exports of processed products as a share of total 9.7). The DVA of technology-intensive exports goods exported from China, 1994–2017 is significantly lower than the DVA of labor- intensive exports, reflecting higher shares 60 of the assembly and processing trade. For example, the DVA of exports of computers, electronic audiovisual equipment, and elec- 50 tronic instruments has been about 40 percent, significantly lower than the average DVA. Share of total exports (%) 40 China’s international competitiveness and integration with the global economy 30 were achieved through policy and institu- tional reforms. China has been reforming 20 its foreign investment regime and progres- sively expanding market access. Its acces- 10 sion to the WTO, and various regional or bilateral free trade agreements, provided the 0 necessary institutional commitment to lock 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 in and accelerate China’s domestic reforms and advance its economic globalization and Source: General Administration of Customs data. participation in the rule-based international PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 129 economic system. A major part of the reforms China has also used special economic has been the active promotion of FDI, which zones extensively to promote foreign invest- has facilitated China’s participation in global ments and pilot institutional reforms to lib- trade and integration into GVCs. As a result, eralize foreign investment regimes. China foreign-invested enterprises still account for has used various forms of special economic nearly half of China’s imports and exports zones, including free trade zones, export (2018). FDI, as well as ODI, have also been processing zones, industrial parks, and powerful channels for technological upgrad- high-technology parks. China started with ing and learning global best practices. four special economic zones in the 1980s in China’s integration into the global econ- coastal areas, and then gradually rolled out omy has resulted in significant global ben- special economic zones throughout the coun- efits. It has been the largest contributor to try. There are now more than 500 national global growth since the global financial special economic zones and many more local crisis, and it will need to continue to play a special economic zones.8 Since the initial free major role in jointly responding, with other trade zone in Shanghai in 2013, China now countries, to global crises and ensuring an has 12 free trade zones that have been used open global investment and trade system. to experiment with the adoption of inter- The government has stated that it aims to national trade and investment rules, more “promote a fair, transparent, convenient, streamlined administrative and business reg- open, and international investment envi- istration procedures, and an improved busi- ronment, through investment liberalization, ness environment. In particular, free trade investment facilitation, investment promo- zones were used to pilot pre-establishment tion, investment protection, optimizing the national treatment and the foreign invest- layout of regional opening up, and improv- ment negative list. The number of restrictive ing innovation in state-level development measures in the foreign investment nega- zones.” (International Office of the State tive list for free trade zones was gradually Council 2018.) reduced from 190 in the original version to To achieve this goal, in 2018 the govern- 45 in 2018. The piloting in the free trade ment issued for the first time a national for- zones subsequently led to the national roll- eign investment negative list, which identi- out of reforms, including the introduction fies prohibited and restricted industries for of a national foreign investment negative list foreign investment. This important reform and pre-establishment national treatment of enhances the transparency and clarity of gov- foreign investments in 2018. ernment restrictions on foreign investments and provides a mechanism to continue to reduce the number of restrictive measures. Major challenges and The negative list reduces restrictions across opportunities several important sectors, including energy, International trade tensions natural resources, infrastructure, transpor- tation, trade and logistics, professional ser- Recent downward risks to the global econ- vices, financial services, and the automotive omy, and international trade tensions, have industry. The government also announced posed significant challenges to China’s eco- plans to eventually fully open all manu- nomic prospects and potential to benefit from facturing sectors to FDI, with some sectors economic globalization. Trade tensions and requiring a transitional period. While China increased protectionist measures and senti- had committed in its WTO accession to open ments have adversely affected market and 100 services sectors, the Ministry of Com- investor confidence and amplified the uncer- merce has indicated that the country has tainty of the external environment for China’s opened 120 sectors for foreign investments.7 open development. The government has indicated that it would Europe and the United States have been open its services sectors further, including the pressuring China to open up its markets fur- telecommunications and financial sectors. ther and to liberalize its foreign investment 130 INNOVATIVE CHINA regime. The United States has conducted services. China has been converging rapidly investigations of China’s alleged unfair trade to the global quality frontier for manufac- policies and applied significantly higher tar- turing, but the gap with high-income econo- iffs on China’s imports. In recent years, more mies remains large (figure 9.8). Therefore, than 40 percent of cases reviewed by the U.S. significant potential remains for improving Committee on Foreign Investment in the the quality of its exports. Across countries, United States (CFIUS), an interagency com- faster growth in quality has been associated mittee that reviews foreign investments with with more rapid growth in output. Substan- national security implications, have involved tial differences across countries and regions Chinese companies, and CFIUS has blocked in the pace of quality upgrading suggest that Chinese acquisition of key technologies such policies have a significant impact. Both insti- as semiconductors. In the European Union tutional quality and human capital are sig- (EU), the significant increase in Chinese nificantly associated with quality upgrading. investments has raised concerns about the Evidence suggests that quality upgrading is transfer of key technologies and has led to the best encouraged through a conducive domes- introduction of an EU-wide foreign invest- tic environment, rather than through sector- ment screening mechanism. Some individual specific policies, and diversification is impor- member states are strengthening their legal tant to create new upgrading opportunities powers to investigate foreign acquisitions. (Henn, Papageorgiou, and Spatafora 2013). Some foreign investors have raised con- ICT goods have played a significant role in cerns that they are “forced” to transfer tech- China’s export success. China’s comparative nology to gain market access in China. The advantage has been the manufacturing part Government of China has indicated that it of the value chain. However, significant shares has never introduced policies or practices of the higher, value-added parts of the value that forced foreign-invested enterprises to chain that involve greater innovation are tak- transfer technology (Information Office, ing place outside of China. These parts include State Council 2018). It has stated that tech- the upstream parts of the value chain—such nology transfers have been voluntary contrac- as R&D, design, and key high-value inputs— tual transactions agreed to between foreign and the downstream parts—such as branding, and domestic enterprises to maximize their marketing, and sales—which are more con- mutual interests. sumer facing. Earlier “teardown” studies of Across a wide range of countries, it has the iPhone and similar products indicated that been shown that technology transfer require- the value added in China was negligible, con- ments—often in the form of joint ventures— sisting mainly of final assembly from imported can hinder the transfer of the latest technolo- high-value components. For the Apple iPhone, gies to host economies, as foreign firms often it was estimated that China’s domestic value supply older technologies to their joint ven- added was only US$6.54, about 1 percent of ture partners in developing countries. Hence the retail price of a US$600 iPhone 4 (Linden, the government’s announcement in 2018 to Dedrick, and Kraemer 2009). More recent loosen joint venture requirements for regular analysis indicates that the situation has been and electric vehicles is expected to encourage slow to change (Sturgeon and Thum 2017). the introduction of the latest technologies in However, domestic brands now account for China and to promote market competition. the largest share of the domestic mobile phone market, indicating that China is now captur- ing a large share of the value added of down- Export quality and value added stream activities. Given China’s already high share of global trade, it will need to shift its focus from Trade facilitation and logistics improving the quantity to improving the quality of its exports and from exports based GVCs have put a premium on reducing trade- on assembly manufacturing to more value- related costs. Trade costs resulting from poor added and innovative manufacturing and transportation, low efficiency in customs PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 131 FIGURE 9.8 Quality of export manufacturing in major economies, 1980–2014 1.1 Quality index (90th percentile = 1) 1.0 0.9 0.8 0.7 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 China Korea, Rep. 5th percentile Germany United States 95th percentile Japan Source: Calculations based on International Monetary Fund quality index. clearance, and cumbersome administrative compliance costs of trade procedures remain procedures can hinder a country’s ability to high (World Economic Forum and Global integrate into the global economy, particu- Alliance for Trade Facilitation 2016). In the larly in industries that require spare parts and World Bank’s Doing Business indicators, components to cross borders multiple times. China’s “trading across borders” indicator While integration in GVCs and improved improved significantly, from 97 in 2017 to 65 customs clearance procedures have enhanced in 2018. The World Economic Forum and the China’s trade facilitation, gaps remain rela- Global Alliance for Trade Facilitation jointly tive to international best performers. As its publish the Global Enabling Trade Report, labor costs rise, and China diversifies toward which assesses the enabling trade index higher-value manufacturing and services, of 136 countries, based on market access, inefficiencies in logistics can hinder its inter- border administration, transport and digital national competitiveness. infrastructure, transport services, and the Trade facilitation can be challenging for business operating environment. According to China, given its large size and multiple entry the latest report for 2016, China ranked 61 points by land, sea, and air. The volume and in the world, compared to 63 in 2014. China complexity of China’s trade can place a great compares significantly better than the East burden on its trade facilitation and logistics Asia average on transport infrastructure, systems. China has prioritized improving ranking 12. China is comparable to East customs clearance, through its Nationwide Asian countries in key elements of “soft” Customs Clearance Integration Regime, and infrastructure, concerning border adminis- has emphasized mutual exchange of informa- tration, operating environment, and ICT, but tion, mutual recognition of regulations, and lags in market access. mutual assistance in law enforcement in port The World Bank, working with interna- administration. tional academic institutions, produces the China’s performance in trade facilitation Logistics Performance Index (LPI), which has been improving, particularly with regard assesses a country’s performance in trade to transport infrastructure, but there remains logistics. The LPI assesses a country’s rel- significant room for improvement, and overall evant infrastructure, quality of logistics 132 INNOVATIVE CHINA FIGURE 9.9 Logistics Performance Index (2018) and logistics costs (2016) in selected countries 16 4.5 14 4.0 12 3.5 3.0 10 2.5 LPI score Percent 8 2.0 6 1.5 4 1.0 2 0.5 0 0 er s g n re da Vie and e zu zil Th nes M RB ge o ite rm re in ny Ca m Fra p. ly Au pain am ile lom a a ru a M esia ds ilip sia Ch a do a th ate Co ntin bi in nc In ali di Sin apa Ar exic Ita Re Un G apo o Pe ne Bra lan Ch dK a Ko na Ph alay In , tn gd pi str Ne d St ela ail n S a, J e ite Un Ve Logistics (% of GDP) Third-party logistics revenue (%) 2018 LPI score (right scale) Source: Calculations based on data from the Logistics Performance Index (LPI), South Africa Logistics Barometer (for logistics costs), and Arm- strong Logistics (for third-party logistics revenue). services, timeliness of shipping, tracking, and specialized logistics services will be required. tracing performance, ease of arranging com- China will also require more specialized petitively priced international shipments, and logistics services as it expands into high- efficiency of customs clearance. China has value manufacturing to allow manufacturing the most efficient customs clearance among firms to focus on their core business and to low- and middle-income regions, better than outsource logistics services. However, third- the global average and far above countries at party logistics, which are outsourced contract similar levels of development. Its LPI score is logistics, are less developed in China than in comparable to that of many OECD countries, other comparable countries (figure 9.9). although lower than the best-performing ones (figure 9.9). FDI and ODI At 15 percent of GDP, China’s logistics costs have fallen dramatically, but they remain China’s FDI and ODI still have room to significantly higher than costs in OECD coun- grow. The total stock of both FDI and ODI tries and many middle-income countries. as a share of GDP remains relatively small Individual components of logistics—such as compared with the stock in other countries transport, warehousing, and management and significantly smaller than the OECD costs—are lower in China than in high- average (figure 9.10). Although China is one income countries. The high overall logistics of the largest recipients of FDI by volume, costs appear to reflect inefficiencies in logistics FDI inflows made up less than 2 percent of chains, which concern goods when they are its GDP in 2018, relatively low compared moved and stored multiple times. Such high with FDI inflows in neighboring countries. costs could be reduced through holistic and China is a relative newcomer as an outbound multimodal networks, and focused invest- investor, and hence its stock of ODI (as a ments in logistics hubs, intelligent transport percentage of GDP) is particularly low com- systems, and better links between transport pared with that of OECD countries. China’s networks and selected industries. ODI has been increasing, and the composi- As manufacturing relocates farther inland tion of its ODI is evolving. In recent years, a in China, the gaps in domestic hinterland larger share of China’s overseas investments logistics will become more critical, and more has been directed to developed countries to PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 133 FIGURE 9.10 Stock of foreign direct investment and outward direct investment in selected countries, 2018 a. Foreign direct investment b. Outward direct investment 80 70 70 67 60 60 60 50 44 50 45 40 39 40 % of GDP % of GDP 40 40 36 36 31 30 28 29 27 30 26 22 23 22 21 21 20 20 14 10 8 7 10 0 0 Ze s m m s ou es Ge on n ain ite nd In ny sia ly a y ite ain de ly Ze a In nd sia Fe f 20 es 20 e Ru Gro ate an n in tio Ita Ita tri do do at tri a hi ti ala Un ala ne ne Sp Ch Un Sp of rm rm ian p o ra ra St St un C un ng ng do do de p Ge d d co u co Ki Ki Fe w w CD d d CD Gr Ne Ne ite ite ian OE OE Un Un ss ss Ru Source: Organisation for Economic Co-operation and Development (OECD) data. Note: Data for Brazil, the Republic of Korea, and South Africa are for 2016. access their markets and industries, and a foreign investments) (figure 9.11). But despite smaller share has been directed to developing the improvements, China still has the sixth countries and to access natural resources. most restrictive economy for FDI out of 64 China’s attractiveness as an export base OECD and non-OECD economies assessed now has greater competition. China’s labor by OECD in 2018. costs have been rising, weakening its tra- ditional source of comparative advantage. Average monthly manufacturing wages in Policy recommendations China were US$720 in 2016, considerably Global trade and investments can continue to higher than in Vietnam (US$250) and in be an important source of growth for China. Malaysia (US$594).9 FDI inflows into tradi- Facing new challenges and a new global tional industries such as textiles have been environment, China will have to continue declining, and some foreign enterprises have to improve its international competitiveness transferred their production capacities or and raise the quality and innovativeness of built new factories in neighboring countries, its exports. It will need to continue to pur- for exporting purposes. According to a 2019 sue policy and institutional reforms to open survey of U.S. companies by the American up its economy further and integrate with the Chamber of Commerce in China, only 42 global economy. These actions would provide percent regard China as one of the top three critical new drivers of growth for China’s global investment destinations, compared economy by promoting market competition, with nearly 80 percent in 2009. access to global frontier technologies, col- To attract FDI, China has been reforming laboration with globally leading firms, and its foreign investment regime and progres- integration into and upgrading within GVCs. sively expanding market access for foreign China could continue to encourage pilot investments. As a result, the OECD’s FDI programs and pioneering regions to test new regulatory restrictiveness index for China policy and institutional reforms. The result- fell from 0.627 in 1997 to 0.449 in 2006 ing successes could be replicated and dis- and to 0.25 in 2018—on a scale from 0 seminated more quickly. Special economic (open to foreign investments) to 1 (closed to zones and other platforms to open up the 134 INNOVATIVE CHINA FIGURE 9.11 Foreign direct investment (FDI) restrictiveness index, 2018 0.35 0.31 0.30 0.26 0.25 Index (0 = open, 1 = closed) 0.25 0.21 0.20 0.19 0.15 0.14 0.10 0.09 0.09 0.07 0.06 0.05 0.05 0.04 0.05 0.02 0 es m n il e sia a a ico p. n y ce ca an az in di ag io pa Re do at fri an ne ex Ch In at Br rm er Ja St hA ng Fr a, er M do av Ge re d d Ki ut In ite CD Fe Ko d So Un ite ian OE Un ss Ru Source: Organisation for Economic Co-operation and Development (OECD) FDI restrictiveness index. economy could continue to be used to experi- the global community. China can be an active ment with new administrative systems, regu- supporter of global cooperation by advanc- latory models, and international trade and ing economic globalization, safeguarding the investment rules to promote new industries multilateral system, and opposing trade and that can compete globally. China could also investment protectionism. The government explore new trade and business models, such has stated that it seeks to avoid international as e-commerce platforms. It could further trade tensions, and that there is no winner promote trade in services. in a trade war. China can continue to carry As the world’s largest merchandise trader out reforms to support the global economy and second-largest economy, China’s actions and the expansion of global trade and invest- and policy choices will inevitably have signifi- ments in the following ways. cant implications for the global economy and One, China could further liberalize global trade and investment relations. China’s imports of intermediate goods and services continued global economic integration would inputs by continuing to reduce tariffs and remain an important source of global eco- quantitative restrictions on intermediate nomic growth and contribute to the expan- parts, components, and services, to maintain sion of global trade and investments. China its manufacturing competitiveness. China could play a leading role in promoting global recently announced that it would unilaterally trade and investments, and cooperation on cut import tariffs on vehicles and auto parts, global issues, such as on climate change. In on 1,500 taxable items of other industrial particular, China could ensure that the BRI goods, and on more than 1,400 taxable items achieves “win-win cooperation that pro- of daily consumer goods. motes shared development and prosperity.” Two, China could pursue “deep” prefer- ential trade agreements to stimulate GVC- related trade and FDI flows—given that FDI Supporting the global economy is, on average, higher for countries that have China’s commitment to building a “commu- signed such agreements. China could fur- nity of shared destiny” and safeguarding an ther endeavor to expand deeper investment open global economy will be important for and trade agreements with wider coverage, PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 135 to promote market access and cross-border promote reforms of global economic gover- investments, and to reduce nontariff barriers, nance systems. China has engaged in inter- strengthen investment rights and obligations, national coordination to tackle global finan- and create a level playing field for all mar- cial risks, including through the Group of 20 ket participants. Modern trade agreements and related forums, and promoted reforms contain newer provisions on a wide array of of the international financial and monetary nontariff measures at and behind the border. systems, including implementation of Basel China’s preferential trade agreements up to III and ongoing regulatory reforms of secu- 2014 tended to have less coverage of such rities markets and shadow banking through matters, including competition policy, intel- the Financial Stability Board. China’s sup- lectual property regulations, public procure- port for the Asian Infrastructure Investment ment, investor rights, and movements of Bank and the New Development Bank pro- capital. However, its more recent free trade vides further opportunities for international agreements signed with Australia and the coordination and collaboration. Republic of Korea have included greater cov- China also could provide global leader- erage of behind-the-border issues and rules. ship on tackling global threats, such as cli- Foreign trade agreements cover a sizable share mate change, and implementing global agree- of China’s trade and investments, and hence ments, such as the WTO’s Trade Facilitation they are important channels for strengthen- Agreement (TFA). The TFA contains provi- ing international commerce. According to the sions to expedite the movement of goods Ministry of Commerce, in 2017 free trade across borders and to improve cooperation agreement partners accounted for 25 percent, on trade facilitation and customs compliance. 51 percent, and 67 percent of China’s foreign WTO estimates show that full implementa- trade in goods, services, and two-way invest- tion of the TFA could reduce trade costs by ments, respectively.10 an average of 14.3 percent and boost global Three, China could seek to advance nego- trade by up to US$1 trillion per year, with tiations on the Bilateral Investment Treaty the biggest gains in the poorest countries. (BIT) with the EU and restart BIT nego- China has stated that it supports reforms of tiations with the United States, which have the WTO that reflect the needs of both devel- stalled as a result of trade tensions. A break- oping and developed countries. through will require reaching an agreement Five, China could take more actions to on mutually beneficial investment relations. ensure that BRI provides mutually beneficial Much like the WTO accession, which helped results for all countries involved. BRI provides to drive market-opening reforms starting in an opportunity to improve relevant policy and the 2000s, BIT with the European Union and regulations that would complement the hard the United States could drive reforms toward infrastructure investments, including through further integration with the global economy the adoption of international standards and and greater market liberalization. It could rules on trade, investment, and environmen- also help to deescalate existing tensions and tal requirements. China could help to adopt build investor confidence. However, reaching a more multilateral approach to BRI by intro- an agreement with high-income countries ducing institutional mechanisms to coordi- on preferential trade or bilateral investment nate investments, financing, and relevant poli- treaties will require reforms and compro- cies and regulations; to resolve disputes and mises by all sides. Concerns raised by each manage risks; and to make BRI investments side have included FDI policies as well as more environmentally, socially, and fiscally state-owned enterprise and competition- sustainable. related policies. Four, China could continue to engage in Promoting foreign investments global cooperation and coordination on eco- nomic governance and the macroeconomy to Promoting foreign investments will remain a jointly respond to global challenges, improve key priority for China’s future growth. The global trade and investment rules, and government recently issued several policy 136 INNOVATIVE CHINA documents outlining further measures to Implementation and enforcement of regula- open up markets and promote foreign invest- tions would need to be nondiscretionary and ments.11 Now it needs to translate these predictable to help ensure a level playing field policy statements into real improvements in and fair competition between domestic and access. Promoting foreign investments, par- foreign-invested enterprises. The formulation ticularly knowledge-intensive investments, of these laws and regulations would benefit requires complementary reforms to improve from extensive consultations with both for- intellectual property rights, strengthen busi- eign and domestic investors. ness climates, and build the local human Three, China could introduce a trans- capital and R&D capabilities of firms. Those parent monitoring and grievance-handling reforms are discussed in other chapters of mechanism for technology transfers to assure this report. Priority policy and institutional foreign investors and encourage the intro- reforms specific to China’s foreign investment duction of advanced foreign technologies in regime include the following. China. The FIL explicitly prohibits “forced” One, China could continue to review technology transfers through administrative and streamline the national FDI negative measures. The government has indicated list for industries that restrict or prohibit that it would prepare specific regulations FDI. Recent policy documents have outlined and guidance for the implementation and the government’s intention to open up criti- enforcement of the law, which would need to cal sectors in advanced manufacturing and cover the enforcement of the prohibition of financial and business services to foreign “forced” technology transfers. investments. Removing those sectors from Four, China could strengthen communi- the negative list would help to lock in the cation and consultations with foreign firms reforms and address the concerns of foreign to identify investors’ concerns and minimize investors. The further opening up of the ser- their misunderstanding of government poli- vices sector would benefit manufacturing sig- cies and regulations. The government and nificantly because added value in industries related public agencies could carry out regu- is increasingly drawn from services linkages. lar and systematic dialogues with major for- Large potential remains for the “servicifica- eign investor associations, such as Japan, the tion” of manufacturing in China because the United States, and European chambers of share of services’ value-added in manufactur- commerce. It could publish all FDI-related ing remains comparatively low. regulations online in English and improve the Two, China could further improve the mechanisms for foreign investors to address transparency, consistency, and predictability trade- and investment-related grievances. In of regulations and policies for foreign inves- this regard, the government announced that tors. For the new Foreign Investment Law it will establish an interministerial central- (FIL), which will come into effect on January 1, ized system to receive and address the com- 2020, China plans to issue a series of laws plaints of foreign investors. The government and regulations to smooth its implementa- could also systematically expand opportuni- tion. This is an opportunity to strengthen ties for foreign firms to participate in regula- the regulatory framework concerning the tory consultations and standards setting. rights and interests of foreign investors by Five, China could improve its ODI man- clearly specifying and streamlining the regu- agement system and strengthen its support for lations, administrative reviews, and licensing its overseas investors. China could promote a procedures associated with the FIL. These more systematic and efficient ODI manage- laws and regulations could aim to ensure ment system by consolidating and stream- the fair and equitable treatment of foreign lining administrative rules and regulations, investors and to establish an investor dispute and by improving the coordination of ODI- settlement mechanism that would promote related authorities. China could expand and coordination and complementarity between improve the quality of extension services for the dispute prevention (grievance manage- enterprises engaging in ODI to support risk ment) and dispute settlement provisions. monitoring of overseas markets and improve PROMOTING INTERNATIONAL COMPE TITIVENESS AND ECONOMIC GLOBALIZATION 137 firms’ understanding of environmental and 3. NBS and China Statistical Yearbook on sci- social safeguards and the international rules ence and technology. and laws of host countries. 4. The RCA uses trade flows to determine Six, China could expand programs to whether a country exports more, or less, than its “expected share” of a given product, with promote linkages between foreign-invested an RCA greater than 1 signifying that the and local firms and to upgrade the capac- country has a revealed comparative advan- ity of local suppliers. Programs could iden- tage in a given product. tify multinational firms with local sourcing 5. See www.wiod.org. Although not shown, needs and match them with local firms that the analysis was also carried out using the meet required standards for quality, cost, and OECD’s Trade in Value Added (TiVA) data, delivery. Open, online supplier databases or which also showed rising DVA for China. platforms of screened local firms could be 6. Trends in DVA and comparisons of DVA developed. The programs also could pro- with other countries should be interpreted vide local firms with technical assistance with care because they can be influenced and access to finance. Successful programs by many factors, such as export composi- in other countries have benefited from close tion and degree of export diversification. By integrating further into GVCs, a country’s involvement of multinational firms in pro- share of DVA can actually decline, and this gram design and implementation. would not necessarily indicate lower export Seven, China could expand programs to performance. attract global talent. A deep pool of global 7. Wang Fuwen, Vice Minister of Commerce talent is essential if China is to gain a new and Deputy Representative of International international competitive edge. China could Trade Negotiations, delivered this keynote further streamline the working visa system speech, “Promoting the Formation of a New and reduce administrative requirements for Pattern of Comprehensive Openness,” on the entry and exit of foreign workers and pro- March 25, 2018, at the Annual Meeting of fessionals. It could improve the overall work- the China Development High-Level Forum in ing and living environment for foreigners by Beijing. expanding supportive programs and services, 8. See http://www.cadz.org.cn. 9. The wage estimate is the average for urban, such as for children’s education. nonprivate wages. The data sources are the Eight, China could reduce its logistics National Bureau of Statistics and CEIC Data costs by addressing inefficiencies in logis- for China and International Labour Organi- tics chains through more holistic and mul- zation for the other countries. timodal networks, focused investments in 10. See http://tradeinservices.mofcom.gov.cn logistics hubs and intelligent transport sys- /article/yanjiu/hangyezk/201810/70868.html. tems, and better links between transport net- 11. “Notice of the State Council on Several Mea- works and selected industries. As it expands sures to Expand Opening and Actively Use into high-value manufacturing, China also Foreign Investment” (January 12, 2017), could promote more specialized logistics “Notice of the State Council on Several services to allow manufacturing firms to Measures to Promote Foreign Investment Growth” (August 8, 2017), and “Notice of outsource logistics services and focus on the State Council on Several Measures for manufacturing. Actively and Effectively Using Foreign Capital to Promote High-quality Economic Develop- ment” (June 10, 2018). Notes 1. Given that the assessment of economic com- Bibliography plexity is based on export data, China’s assessment may also reflect its relatively American Chamber of Commerce in China large share of foreign inputs, parts, and 2017. “China’s China Business Climate Sur- components. vey Report.” https://www.amchamchina.org 2. Atlas of Economic Complexity of the Center /policy-advocacy/business-climate-survey/. for International Development at Harvard Amiti, M., and J. Konings. 2007. “Trade Liberal- University. ization, Intermediate Inputs, and Productivity: 138 INNOVATIVE CHINA Evidence from Indonesia.” American Eco- Koopman, R., Z. Wang, and S. J. Wei. 2014. nomic Review 97(5): 1611–638. “Tracing Value-Added and Double Count- Brandt, L., J. Van Biesebroeck, L. Wang, and ing in Gross Exports.” American Economic Y. Zhang. 2017. “W TO Accession and Review 104(2): 459–94. Performance of Chinese Manufacturing Linden, Greg, Jason Dedrick, and Kenneth. L. Firms.” American Economic Review 107(9): Kraemer. 2009. “Who Profits from Innovation 2784–820. in Global Value Chains? A Study of the iPod China Ministry of Commerce, General Admin- and Notebook PCs.” Industrial and Corporate istration of Customs, National Bureau of Change 19 (1): 81–116. Statistics, State Administration of Foreign Sturgeon, Tim, and Eric Thum. 2017. “Case Exchange. 2014. “Global Value Chain and Studies of China’s Automotive and ICT Hard- China’s Trade in Value Added,” Research ware Sectors.” Background paper for this paper (in Chinese). http://images.mofcom.gov report, World Bank, Washington, DC. .cn/www/201412/20141223154610238.pdf. Tacchella, A., M. Cristelli, G. Caldarelli, A. Gabri- Constantinescu, Cristina, Aaditya Mattoo, and elli, and L. Pietronero. 2012. “A New Metrics Michele Ruta. 2016. “Does the global trade for Countries’ Fitness and Products’ Complex- slowdown matter?” Journal of Policy Model- ity.” Nature: Scientific Reports 2 (723). https:// ing (Elsevier) 38(4): 711–22. www.nature.com/articles/srep00723. Cristelli, M., A. Tacchella, M. Cader, K. Roster, UNCTAD (United Nations Conference on Trade and L. Pietronero. 2017. “On the Predictability and Development). 2017. World Investment of Growth.” Policy Research Working Paper Report 2017: Investment and the Digital 8117, World Bank, Washington, DC. Economy. Geneva: UNCTAD. Espita, A., Mera L. Gomez, N. Rocha, and G. World Bank, IMF (International Monetary Varela. 2018. “China: Going Global and Gain- Fund), and WTO (World Trade Organiza- ing from It.” Background paper for this report, tion). 2018. “Reinvigorating Trade and Inclu- World Bank, Washington, DC. sive Growth.” World Bank, Washington, Henn, Christian, Chris Papageorgiou, and DC. http://documents.worldbank.org/curated Nikola Spatafora. 2013. “Export Quality in /en/874541538071614937/pdf/130272-WP Developing Countries.” IMF Working Paper -PUBLIC-Disclosed-9-30-2018.pdf. WP/13/108, International Monetary Fund, World Economic Forum, and Global Alliance Washington, DC. for Trade Facilitation. 2016. Global Enabling International Office of the China State Coun- Trade Report 2016. Geneva: World Eco- cil. 2018. “White Paper: The Facts and nomic Forum and Global Alliance for Trade China’s Position on China-US Trade Friction.” Facilitation. September. Ye, M., B. Meng, and S. J. Wei. 2015. “Measur- Kee, H. L., and H. Tang. 2016. “Domestic Value ing Smile Curves in Global Value Chains.” IDE Added in Exports: Theory and Firm Evidence Discussion Paper no. 530. from China.” American Economic Review 106(6): 1402–36. 10 Governing the Next Transformation Over the past 40 years, China has under- banks. The start of serious state-owned gone three phases of economic governance enterprise (SOE) reforms in the mid-1990s reforms: market- seeking reforms, roughly allowed commercial banks to become com- from 1978 to 1993; market-building reforms, mercial, and housing and (urban) social from 1993 to around 2003; and market- security reforms followed. Entry into the enhancing reforms, from about 2003 on (fig- World Trade Organization (WTO) in 2001 ure 10.1) (Hofman 2018). In the first phase of served as a lever for the domestic reforms market-seeking reforms, there was a genuine and ensured much greater competition in search for the right economic institutions for the goods market. The State Commission for China. Driven by politics, experiments, and Economic Reform was abolished in 1998, decentralized initiatives, China was search- and a more streamlined institution (called the ing for ways to allow more market reforms State Council Office for Economic Reform) in its system. Informed by reforms in Eastern was created, which was subsequently merged Europe under communism, China’s reforms with the State Development Planning Com- concentrated largely on microeconomics, to mission in 2003 to form the National Devel- some extent neglecting macroeconomics, as opment and Reform Commission. the highly volatile growth in the 1980s bears The third and current phase is character- witness. ized by market-enhancing or -augmenting The second phase of market-building reforms. Under the current phase, the pre- reforms saw increasing room for the market. vious expansion of markets is now being Private investment in the economy expanded complemented by a reemergence of industrial from less than 2 percent in 1992 to some 15 policies. The publication of the Medium- percent by 2003. The decisions of the 3rd Term Strategy for Science and Technology Plenum of the 14th Communist Party Con- was a major milestone to start the third gress in 1993 laid out a comprehensive plan phase, through which China prioritized the to build institutions for a market-driven strengthening of its national innovation sys- economy—including a modern tax system, tem and the development of key technolo- enterprise reforms, and a financial system gies. The promotion of industrial upgrading that separated policy banks from commercial and innovation has been a major objective 139 140 INNOVATIVE CHINA FIGURE 10.1 Reforms and GDP growth in China, 1978–2014 Market-seeking reforms Market-building reforms Market-enhancing reforms First 4 special Provisional Socialist market 16 bankruptcy economic economy Harmonious zones created law passed endorsed society 14 Stock SOE Reforms: exchange “Grab the big, let opened go of the small” 12th Five-Year Plan emphasizes 12 rebalancing and avoiding middle- income trap RMB current 10 account convertible Medium-Term Strategy for % growth Science and 8 Technology Private property in constitution Housing 6 reforms Comprehensive Central Bank 3rd Plenum of the 18th Party reform plan Law, Banking Congress: Decisive role of endorsed Law, Budget Law the market in resource 4 allocation, Strong SOEs Deng Xiaoping’s tour through Global Financial Crisis the South and Stimulus Plan 2 Deng Xiaoping’s Socialist Rectification WTO entry speech at the Commodity campaign Central Party Economy Work Conference endorsed 0 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Hofman 2018. Note: SOE = state-owned enterprise. RMB = renminbi. WTO = World Trade Organization. of the current phase, through the 5th Ple- namely, socialist modernization. In this cur- num of the 17th Party Congress (on produc- rent phase of reform, China seeks a distinct tivity and innovation), the 13th Five-Year economic governance and institutional sys- Plan, and the Manufacturing 2025 Strategy tem, with markets and the state playing com- (2015). The 3rd Plenum of the 18th Party plementary roles, state and private ownership Congress in 2014 outlined a comprehensive coexisting, and industrial policies guiding set of reforms. It emphasized that the country and competition policies regulating the mar- would maintain a “basic economic system,” ket. To manage the reforms, several central with public ownership dominant in the econ- leading commissions have been created at the omy but coexisting with private ownership, highest level of the state apparatus, notably and that the market would play a “decisive the Central Commission for Comprehen- role” in the allocation of production factors, sively Deepening Reform and the Central while the government would play its role in Commission for Comprehensively Advancing an “improved and better” way. Rule-of-Law Governance, both headed by General Secretary Xi Jinping’s report to President Xi Jinping. the 19th Party Congress in October 2017 also called for the “decisive role” of the market in the allocation of resources, an “improved Toward a new state-market and better” role for the government and for relationship public ownership, and a major emphasis on Unlocking the new drivers of growth will industrial upgrading and science, technol- require finding the right balance between the ogy, and innovation to achieve the goals of state and market and refining governance the “first phase of the New Era (2020–35),” institutions to enable the market to play a GOVERNING THE NEX T TR ANSFORMATION 141 decisive role in the economy. As economies need to invest for the long term. China’s econ- become more complex and per capita incomes omy is transitioning to the global technology rise, the role of the state typically evolves frontier, so the investment cycle will become from direct market interventions to more longer and less certain. Providing more market-supportive and market-augmenting stable market expectations and more effec- functions. In China, the central government tive incentive mechanisms will thus become seeks a balanced coexistence between the increasingly important. China compares rela- state and market, using industrial policies to tively well with Organisation for Economic promote industrial upgrading and to develop Co-operation and Development (OECD) new markets. Local governments are at the countries on many measures of government forefront of implementing these policies in capacity but falls short on evenhanded regula- support of local enterprises. tory enforcement. Information transparency, China’s decentralized governance, with which is critical for developing a knowledge local governments playing a prominent role economy, also falls relatively short. in supporting economic development, was well suited to promoting catch-up growth. Strengthening regulatory It combined high-powered career and fiscal incentives for local leaders to promote local governance growth, allowing them some discretion in China requires more efficient regulatory policy implementation. Today, however, governance, in line with its plans to liberal- these incentives threaten the transition to ize markets by further reducing entry barri- more sustainable and innovation-led growth ers and transitioning from an ex ante to an because they encourage protection for local ex post economic regulatory regime. Effi- firms (undermining creative destruction), cient governance requires improving the uneven regulatory enforcement, and overin- predictability, clarity, and fair enforcement vestment in infrastructure (threatening fiscal of regulations to support a more open and sustainability)—all at the cost of lowering competitive market and to reduce arbitrary productivity. Managing the transformation government interventions. from a market-interventionist role of the state An experimental approach to policy mak- toward a market-supporting and market- ing has been vital to China’s past growth tra- augmenting role thus requires adjusting the jectory—with many central policies provid- incentives set by the underlying governance ing only broad guidance, allowing for local institutions. It also requires rigorous cost- contextualization and innovation. As China’s benefit analysis of sectoral industrial and economy matures and the stock of regula- regulatory policies. tion grows, the downsides of this model have As countries develop and transition to become more apparent. Unclear and contra- more complex and innovation-driven econo- dictory policy signals from multiple central mies, they increasingly focus on promoting agencies have created an uncertain invest- stable market expectations and the rule of ment environment, and too much local dis- law. The Government of China made the rule cretion in enforcing regulations has enabled of law and the protection of property rights local protectionism. a priority in its reform agenda. However, at Therefore, the government could consider times, contradictory policy signals from cen- adopting a system of regulatory governance tral agencies, along with overlapping respon- based less on discretion and more on rules. sibilities and uneven enforcement of regula- The essence of a modern regulatory sys- tions, have created an uncertain investment tem consists of autonomous or semiautono- environment and an unbalanced playing field. mous regulatory bodies that are delegated China can draw lessons from high-income by specific laws to exercise their mandate economies that have transitioned to a more in a rules-based way that is fair, transpar- rule-based, predictable system of market ent, professional, responsive, accountable, regulations. Reforms would facilitate the and consistent. This would help to address country’s transition to innovation-led growth market distortions in China resulting from by providing the market certainty that firms regulatory failures caused by government 142 INNOVATIVE CHINA entities wielding too much discretionary labor law compliance, occupational safety, power through administrative decrees that and the judiciary. 3 However, China’s own are not authorized by laws. China could reca- experience indicates that this approach can librate its policy-making process by adopting lead to coordination problems with other and implementing more widely the regula- local agencies, which is a major downside. tory principles and practices recommended To achieve more consistent enforcement by international organizations and forums, within a decentralized model, the central such as the Asia-Pacific Economic Coopera- government could also enhance horizontal tion–OECD Integrated Checklist on Regula- coordination between enforcement agencies, tory Reform. perhaps using institutional solutions such as To design more effective and consistent the European Union (EU) Bureau of Euro- policies, China could integrate evidence- pean Regulators of Electronic Communica- based regulatory impact assessments with tions. Stronger consultation and coordination its experimental approach to policy making. between the central and local levels in the The State Council has long advocated cost- policy-making process would help to reduce benefit analysis, which is equivalent to regu- uneven enforcement. The central government latory impact assessment, for legislation and could set basic standards, while allowing for regulations related to the economy, but this local discretion in improving these standards, now needs to be carried out in practice.1 Used akin to the EU’s “minimum harmonization” in about 50 countries, regulatory impact rules. It also would need to strengthen the assessments could help China systematically quality of independent data on regulatory assess the effects of proposed or existing reg- compliance to enable better central monitor- ulations, especially on productivity. China ing of subnational enforcement. could also incorporate monitoring and evalu- The principle of a strong and independent ation indicators in the policy making process. disciplinary commission has already been To streamline the multiplicity of business accepted in China, and such reforms could be policies and regulations, and to reduce the broadened to encompass regulatory reform. administrative burden, the government could China could initiate reforms by first creating simplify the stock of regulations and institu- relatively independent regulatory hierarchies tionalize retrospective reviews of regulations.2 in specific sectors, such as an independent International experiences provide useful environmental regulatory system. The regula- precedents, such as the Netherlands-inspired tory environment could be improved through standard cost model to measure administra- greater separation between regulators and tive burdens or “stock-flow linkage rules,” service operators. Such separation would first as has been adopted in Germany, the United require a clear mandate empowering regula- Kingdom, and the United States. Setting up tors to conduct a regulatory overview in their regulatory oversight bodies close to the cen- sectors, which would help to insulate them ter of government could improve the quality from stakeholder interference. Such insula- and consistency of regulation. Such oversight tion is particularly important in sectors with a bodies could strengthen coordination and large share of state-owned enterprises (SOEs), help to address the inconsistent regulatory which can influence regulators’ decisions. To interpretations between central and local gov- assess the potential economic effects of regu- ernments and across ministerial departments. latory policies, the capacity of regulators will To achieve more effective and fairer also need to be strengthened. enforcement and compliance with regula- China could improve public communica- tions, China could strengthen the vertical tion of the interpretation of regulations and reporting lines of local enforcement agencies, regulatory decisions, particularly authoriza- such as environmental protection bureaus, tions and licensing decisions, and strengthen thus reducing local government discretion. the process for reviewing decisions. China This option could be considered especially was an early adopter of public consultations, for those regulatory fields that can impede through websites, regarding draft legisla- growth, such as environmental protection, tions and regulations. This effort could be GOVERNING THE NEX T TR ANSFORMATION 143 leveraged further to enhance public commu- China has sought to promote long-term nication and improve public access to public objectives by making promotion criteria information. more comprehensive by including social, China could make consultations more environmental, and innovation outcomes effective by engaging stakeholders earlier, by in the promotion criteria of local officials. making it transparent about how the consul- Such outcomes are key indicators of “high- tations are reflected in regulations, and by quality development,” as stated at the 19th encouraging greater voluntary compliance. Party Congress. Yet, current experience China could make compliance data more demonstrates the inherent limits of hierar- widely available to the public and encourage chically set targets in achieving this change. and enable research institutions, the general Local governments are asked to achieve public, and nongovernmental organizations multiple goals, with new initiatives layered to collect and disseminate such data. This on old ones. Many of the central mandates effort could include wider use of whistleblow- may be unfunded and misaligned with one ing websites (and the corresponding whistle- another; they often are vague and shifting, blower protections), use of public opinion compelling local officials to make decisions research through citizen and firm surveys, on uncertain grounds about which actions enhanced reporting to local people’s con- are encouraged and which actions are gresses on compliance, and strengthening of viewed unfavorably. Confronted with mixed the judiciary in disciplining administrative signals and competing objectives, local offi- cials have tended to focus on short-term eco- enforcement. Accelerating hukou reforms nomic goals and have less appetite for tak- could enable labor to move to the cities with ing risks and undertaking structural reforms the highest quality of life and thus fuel com- and long-term investment. In this regard, petition between cities for sound enforce- China could reduce the number of targets, ment of, say, environmental or food safety differentiate them regionally, and make the regulations. cadre evaluation system more transparent, understandable, and effective. Aligning the government’s Lengthening cadres’ tenure appropriately incentives with the needs of the can also improve the alignment of incen- new economy tives with long-run-productivity growth. The relatively short tenure of local officials incen- To transform state-market relations, China tivizes them to focus on short-term growth needs to improve the alignment of state actors’ targets, which can undermine the execution incentives with long-term, productivity- of national policies that local officials view led growth. Improved alignment requires as slowing local growth. This tendency is China to modernize its civil service (cadre) evident in the uneven progress of efforts to management system to encourage local downsize industries with overcapacity or leaders to support market competition and spikes in public investment prior to promo- long-term sustainable growth. In the past, tion periods. Policy options for extending the promotions based on short-term economic time horizon include increasing the average outcomes effectively incentivized leading length of term (for example, to the de jure cadres to promote catch-up growth. These five years) and expanding the use of “concur- incentives have, however, also encouraged rent promotions,” which are promotions that cadre behavior that is increasingly harmful as retain the current position. Future promo- China moves to productivity-led growth—in tions could be tied to the sustainability and particular, overinvestment in physical capital, long-term impact of reforms, to be assessed protection of ineffective local firms, and lack even after officials move on to new positions. of fiscal discipline. China thus faces the chal- China has partially moved in this direction, lenge of reorienting local leaders to pursue a by adopting lifelong accountability systems more diverse, balanced, and long-term set of for “grave mistakes” in 2014 and envisaging objectives. them for local debt.4 144 INNOVATIVE CHINA Reforms of local government incentives key agents of economic development. At could aim to reduce local discretion, pos- the same time, derivation-based tax sharing sibly by strengthening vertical management between the center and provinces, 5 put into in selected line ministries, departments, and place through the 1994 reforms, set power- agencies. China’s anticorruption campaign, ful incentives for subnational governments to which was initiated in 2012, may have helped compete for local economic growth and rev- to discourage the abuse of local discretion. enue collection by linking local revenues with In addition, strengthening the “downward local investments in economic development accountability” of local leaders could help to and revenue collection efforts. address information asymmetry. One option Even though the economy has expanded, is to publish firms’ survey results on the qual- modernized, and reached middle-income ity and fairness of the business environment, status, China’s expenditure assignment sys- which would be part of cadre performance tem remains much the same as it was 30 evaluations. Publishing results could help to years ago. Revenue-sharing arrangements are shift local leaders’ attention from short-term structurally similar to those put in place in growth targets to creating a level playing field the 1994 reforms, and local governments still for firms. The further bolstering of transpar- lack the authority to impose taxes. The sys- ency regulations—for information on pol- tem provides incentives for local governments lution, government budgets, and other poli- to protect their revenue base and tends to cies—could help to expose local officials to bias investment toward physical rather than greater pressures from below. human capital. It encourages competition As China’s economy continues to grow between local governments for investments and become more complex, governments at and qualified labor. all levels will need a different set of skills for Reshaping China’s intergovernmental the different functions required. An assess- relations to support productivity growth will ment of the capacity constraints across lev- require a comprehensive and politically con- els of government would identify the major tentious package of complementary reforms. bottlenecks, which may need to be addressed In the medium to long terms, China could through an expansion of staff and other move from derivation-based tax sharing to resources. Reducing the rigidity of staffing a needs-based formula to help encourage the rules and reviewing the competitiveness of shift from capital to social service expendi- public service salaries could ensure that the tures. Rather than distribute intergovern- public service attracts well-qualified staff. mental transfers to provinces according to Capacity building within the government the origin of collections (as in the current could be complemented by greater and more system), the new system would distribute rev- systematic leveraging of external resources, enues according to a transparent needs-based including greater external collaboration and formula, with the objective of closing the more flexible staffing arrangements. financing gap between the resources avail- able to different subnational governments Reforming intergovernmental and the costs of providing some basic level of services. A needs-based formula would lessen relations and tightening fiscal the incentive for subnational governments discipline to compete for tax bases.6 Such a formula China’s intergovernmental fiscal relations could encourage subnational governments to have supported rapid economic growth compete more based on the quality of pub- and infrastructure investments in the past lic services and to focus on creating a good decades. A highly decentralized expenditure business environment rather than on inter- system, with local governments responsible vening directly in markets. It also would help for about 85 percent of total public expen- remove fiscal incentives that favor economic ditures, combined with discretion over regu- development expenditures over social service latory enforcement made local governments expenditures. GOVERNING THE NEX T TR ANSFORMATION 145 The Ministry of Finance has outlined proportion of this pool, rather than as dif- the core principles for reforming intergov- ferent sharing rates for each tax. Their size ernmental fiscal relations (Kun 2018). The would be fixed by the central government. central government has already started the Unconditional grants and shared taxes could reforms to demarcate the assignment of be folded into one pool, with conditional expenditure responsibilities across central grants staying separate. This approach would and local governments, starting with spe- help to reduce unproductive interjurisdic- cific sectors, such as the health sector. It tional competition for private investment. has defined the assignment of expenditure Reforms of the central-provincial transfer responsibilities for social services in educa- system may need to be matched by reforms of tion, employment, and pension provisions. the transfers to subprovincial governments. The reforms will be extended to other social Provincial governments now have wide dis- services, such as environmental protection cretion to decide how much they will transfer and public safety, which are often larger to lower-tier local governments and how they and more complex. To ensure that revenue will make the transfers. Local governments assignment is adequately matched with are financed by these transfers and by land- expenditure responsibilities, intergovern- lease revenues. Fiscal disparities among local mental transfers would need to be increased, governments within provinces are larger than and the revenue-sharing system between cen- those between provinces, suggesting wide tral and local governments reformed—tak- variations in the quality of services. ing into account China’s unique institutional The central government could continue arrangements. The core principles outlined to maintain this approach, recognizing that by the Ministry of Finance indicate that the difference between provinces is large and the long-term resident population (not the that there is value in letting provinces decide household registration population) would be how to distribute funds to lower-tier local the basis for progressive equalization of per governments. Or it could consider whether capita social service outlays across localities. provincial governments should be directed This announcement may indicate that the to adopt a formula for distributions among government is ready to proceed with the long- third-tier governments and whether this for- standing intergovernmental fiscal reform mula should be uniform across all of China. agenda, but building momentum and accep- Such a regulation would complete the separa- tance for the reforms will be a major task. tion between where the tax revenue is raised The government will need to mitigate the risk and where the intergovernmental transfer of revenue losses, alter the distribution of rev- revenue is distributed. It would need to clar- enue across provinces, and undertake major ify how “loser” provinces would make up the complementary fiscal reforms. Designing the lost revenues and whether they would pass new system of fiscal transfers and monitoring some of the expenditure responsibilities on to its impact will therefore require a significant prefecture and county governments. research effort. The government might con- The central government should aim for sider delegating the Central Finance and Eco- revenue yields for each province to be at least nomic Commission to coordinate the design held constant at prereform levels by allow- and implementation of the system, and to ing subnational governments to impose local review the system’s success every five years taxes. Local taxing powers could encourage and make recommendations for adjusting the competition for investors and labor based on system for fiscal transfers. the comparative advantage of the city. The As one element of the reformed system, government could also be allowed to impose China could adopt a vertical sharing pool, an annual property tax, which has already including all central government taxes other been approved in principle. Such a property than those levied on international trade and tax has significant revenue potential for Chi- natural resources. Entitlements of subna- nese urban governments and could provide tional governments could be stated as a fixed incentives for better land-use decisions. In 146 INNOVATIVE CHINA the longer term, China could consider other the local government’s budget and requiring options for local revenue mobilization in line comprehensive financial reporting. But signif- with enhancing local government revenue, icant challenges remain with managing off- setting tax rates, and improving allocative budget financing, public-private partnerships efficiency. As in many OECD countries, local (PPPs), special purpose vehicles, and other off- governments could be allowed to “piggy- budget investment funds. back” on central government tax bases by What will be most critical is for the cen- selecting an additional local “urban service tral government to provide clear and con- tax” rate.7 Alternatively, the central govern- sistent signals to subnational authorities on ment could impose special rates for each city, the overriding importance of implementing avoiding the issue of dividing legislative pow- the new 2014 budget reforms, slowing down ers. China could also consider allowing sub- public investments, and ensuring the sus- national governments to raise user charges tainability of local finances. A road map for and other nontax revenues. Increased local deepening budget reform could include the taxation powers should be accompanied by adoption of capital budgeting, more compre- stronger local accountability systems. hensive and transparent financial reporting, Expenditure responsibilities across levels and careful management of contingent liabil- of government also need to be continually ity risks associated with PPPs and other off- reviewed, clarified, and adjusted. Those in budget vehicles. the higher levels of government have sub- To ensure sustainable management of pub- stantial discretion in assigning responsibili- lic investments, the central government could ties to those in the lower levels, contribut- set aggregate growth envelopes for provincial ing to the relative lack of clarity. This lack governments’ public investment spending. of clarity weakens subnational governments’ Provinces could do the same for subprovin- accountability for service delivery and can cial governments. Subnational governments entail unfunded mandates or duplicate could support these efforts with rolling out delivery efforts. In addition, China can reap three-year integrated investment financing significant efficiency gains and improve the plans that identify all proposed public invest- balance of responsibility between central ments and their sources of finance, including and local governments by reassigning some on- and off-budget sources. Hunan Province responsibilities to higher levels of govern- and Chongqing Municipality have already ment. Restructuring expenditure assign- piloted such plans. Priorities at the national ments will require tracking what level of or provincial level for public investments in government does what and with what lee- excess of what can be financed sustainably at way, whether economies of scale are being the local level would then become the explicit captured, and whether externalities and dis- financial responsibility of the higher level of tributional concerns are being handled. This government. Such investment ceilings could huge task will take serious study and time, then complement borrowing constraints but it demands a policy review that is long (quotas for government bond issuance), overdue. though they may be difficult to fully enforce. In parallel, it will be essential for China Over time, as capacity is built for local debt- to harden subnational governments’ bud- sustainability analysis, the process of set- get constraints and to draw clear boundar- ting the overall investment financing ceiling ies between the state and market at the local could be more decentralized. To encourage level. Unclear boundaries have enabled fiscal public sector capital budgeting in the longer subsidies and tax exemptions for local firms term, China could use a set of key indica- and overinvestments in infrastructure. The tors to benchmark subnational governments’ 2014 budget reform aimed to address such practices and their compliance with budget concerns and sought to contain fiscal subsi- constraints. dies and tax preferences for local enterprises China could adopt a comprehensive and by bringing all public investment–related off- transparent government financial reporting budget debt of subnational governments onto system to provide the basis for assessing the GOVERNING THE NEX T TR ANSFORMATION 147 financial sustainability and performance of initially envisaged for greater private par- subnational governments.8 This would pro- ticipation. To encourage more private par- vide greater information on public service ticipation, particularly from international units, SOEs, and the government’s financial investors, China will need to have policies interactions with them. Implementing the and regulations that ensure a level play- system will be a complex and long-term proj- ing field and enforce long-term contractual ect. It will first involve deciding which public obligations. entities—in particular, which public service The PPP model for delivering infrastruc- units and SOEs—to include and how to clas- ture is relatively complex. It often requires the sify them, distinguishing SOEs that produce local government to have in-house expertise, for the market from those that do not. Sec- with highly specialized technical, financial, ond, it will require examining whether the and legal skills. Because such expertise is entities included in the public sector can be expensive to recruit and maintain, many local justified on the grounds of economic effi- governments choose to rely on consultants to ciency or social equity. The iterative use of help with PPPs. However, both local govern- these two steps will lead to an incremental ments and the industry of PPP advisory ser- clarification and adjustment of the boundary vices are in the early stage of development in between the state and the market. China. Many lack the experience, knowledge, Reforms of local government fiscal man- and rigor required in PPP project develop- agement will need to extend to PPPs, which ment, such as value-for-money analysis, fea- increasingly are being used for infrastructure sibility studies, structuring of PPPs to ensure projects in China. At the end of 2018, the appropriate risk allocation, and the use of estimated total cost of China’s PPP pipeline legal documents to ensure long-term contrac- projects exceeded RMB 17.6 trillion (US$2.5 tual obligations. As a result, many PPP proj- trillion) (Ministry of Finance PPP Center). ects expose local governments to contingent The expansion of PPPs has raised concerns risks and challenges in ensuring performance regarding local debt, as local governments and enforcing contracts. heavily use PPPs for off-budget financing. The The World Bank’s Benchmarking PPP central government recently issued a series of Procurement Report 2017 assesses China’s regulations to close regulatory loopholes in PPP procurement practices as falling short of PPPs. It would be useful to reflect on lessons those in high-income economies, especially from past regulations and to establish a com- in preparing PPPs, managing contracts, and prehensive PPP policy and regulatory frame- terminating PPPs—areas that clearly would work that incentivizes the right behaviors. benefit from reform and capacity building PPPs have been encouraged in China to (World Bank 2016). To strengthen PPP per- promote greater private sector participation formance, China could consider establish- in the development of public infrastructure. ing a project development facility to fund It was envisaged that the private sector will up-front project preparation activities. Like introduce greater efficiency and innovation Ireland, China also could consider setting up in infrastructure development, construction, a national center of excellence staffed with operation, and maintenance. However, the PPP specialists who can support PPP projects current legal and regulatory environment cre- nationwide. As China’s PPP program evolves, ates many uncertainties that dissuade private periodic reviews of PPP projects are needed sector participation. At its core, a PPP is a to ensure that policies and practices improve long-term contractual relationship between through learning by doing. public and private partners. In China, fre- quent policy and regulatory changes and con- Improving public sector cerns about the legal protection of long-term contractual rights have tended to dissuade transparency and accountability private participation. In the past two years, China lags behind other upper-middle- SOEs have won 75 percent of financially income and OECD countries in the reliabil- closed PPP projects, dominating a market ity and transparency of economic data. Open 148 INNOVATIVE CHINA data support greater participation and shar- in addition to their 30 corresponding agencies ing of ideas, which are critical to building a at the local level. Each of the 12 departments research- and innovation-oriented culture. has regulatory and administrative responsibil- Accessibility of data typically improves with ity for one or more issues and its own codes income, and there is a wide “openness dispar- and standards. 3. For example, creation of the State Administra- ity” between high- and low-income countries. tion for Work Safety in 2001 has led to marked Based on international assessments of data improvements in work safety. openness—by Open Data Barometer and 4. The 2014 Communist Party of China (CPC) Open Knowledge International—China fares Central Committee’s Decision Concern- worse than the average for upper-middle- ing Several Major Issues in Comprehensively income countries. Advancing Governance According to Law The Government of China has been mak- moves partially in this direction by calling for ing efforts to consolidate and integrate gov- the establishment of “lifelong responsibility ernment data. It could further improve public investigation and responsibility tracing mech- access to government data, including consoli- anisms for major policy decisions.” In July dated government budget data, subject to the 2016, the Central Commission for Discipline required measures to protect individual pri- Inspection released Accountability Regulations vacy and public security. China can become that called for implementing lifelong account- ability for serious violations, regardless of a global leader by setting new international whether a cadre has moved on. These leaders standards in data collection, dissemination, are responsible for any subsequent “leadership and access to public data. It could consider failures” caused by negligence or poor work developing an access-to-information policy performance. for the public sector. 5. The derivation-based approach allocates a The government could make the latest shared national tax among provinces accord- household surveys, industrial enterprise sur- ing to collections of that tax within the geo- veys, and economic censuses more widely graphic boundaries of the respective province. available to the public, and improve labor Revenue sharing between provinces and sub- market and education assessment data. provincial governments is discretionary. Improving the quality, coverage, and avail- 6. Many formula grants include a provision to ability of such data, within and outside gov- penalize a recipient government that falls below ernment, would help increase the account- a prescribed minimum level of tax effort. 7. Piggybacking is already used in China, with ability and transparency of government the urban construction and maintenance tax policy making. It would support a culture and the education surtax, but the central gov- of evidence-based policy making and nur- ernment sets the additional rate. ture research in both the public and private 8. Since 2014, China has implemented reform sectors. to establish a government financial reporting Improved data can help provide a more system; on December 12, 2014, a “circular” complete picture of the structure of the cor- was issued by the State Council on the Approv- porate and financial sectors. Because of the ing and Forwarding the Reform Program of absence of a clear demarcation between pri- the Ministry of Finance for the accrual-basis vate and public sectors, public data alone can consolidated financial reporting system for the convey an incomplete or misleading sense of government (GuoFa 2014, No. 63). market development and dynamics. There- fore, public data can be augmented by gath- Bibliography ering new data from a variety of sources. 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