- China's vow to achieve technological self-reliance and establish major breakthroughs by 2035 could mean large parts of the digital economy remain protected from foreign competition.
- The just-concluded fifth plenum downplayed hard targets for economic growth. This is positive and healthy.
- Still, a tough choice now looms--the more self-reliant China becomes, the slower it will grow. The tolerance for slower growth may well be tested in the years ahead.
China has just confirmed a goal that promises to be a global game-changer. The country stated its aim to become technologically self-reliant and achieve major breakthroughs in core technologies by 2035. This strategy had been signaled in advance but has just appeared in a communique of the fifth plenary meeting of the Chinese Communist Party's central committee. This ensures the goal will be at the heart of the five-year plan for 2021-2025 to be issued next March.
Hard economic growth targets were strikingly absent during the plenum, which concluded late last week. Instead, the communique reiterated what has become a common refrain in recent years, the need to emphasize quality over quantity. This is welcome. It suggests less emphasis on growth driven by excessively high capital accumulation, which brought with it a lot of debt, overcapacity, and damaging pollution. It also suggests greater tolerance for variation in the growth rate, especially when it is slower than expected or desired. Certainly, the policy restraint shown in 2020 is suggestive of such tolerance.
S&P Global Ratings believes China's technology goals--along with an earlier commitment to become carbon neutral by 2060--will be felt globally. If China succeeds in pursuing these strategies, the global economy will undergo a fundamental realignment, starting now. Trends in China's economy that were already underway will accelerate and the effects will reverberate beyond the border. Some industries will face a large and prolonged demand shock as China keeps rebalancing from investment to consumption, from fossil fuels to renewables. Some industries will confront a supply shock as Chinese companies enter and exit, moving further into technology and more out of basic manufacturing.
Dual Circulation As Risk Mitigation
The "dual circulation" policy came up in the communique, and in a context that confirmed, in our view, that this policy is China's strategic response to growing geopolitical risks. Since the phrase was uttered by President Xi Jinping earlier this year, it has become a hot topic. We are learning, gradually, what it means, helped by official policy documents and lengthy editorial comments in the state media. 
Its essence appears to be a two-part economy. The first and most important--domestic circulation--is centered on domestic supply meeting most of the needs of China's expanding and increasingly sophisticated domestic demand. The second--external circulation--is related to that part of China's economy that plugs into the global system. This ranges from international supply chains to exports to foreign firms meeting the needs of consumers in China. Officials stress that both cycles can reinforce each other.
At face value, dual circulation appears to offer little new compared to earlier reform goals, including rebalancing to domestic demand and beefing up China's own capacity for innovation. It also sounds reasonable--are not all economies a mix of purely domestic activity and linkages with the outside world?
However, this new concept arrives amid what the communique describes as the "new contradictions and challenges brought about by the complex international environment." The communique adds that "uncertainty about instability has increased." In this context, dual circulation could be considered a strategy to reduce the economy's vulnerability to external shocks. These are not the traditional shocks, such as an unanticipated policy change by the Federal Reserve or a recession in the U.S. or Europe. Instead, the focus is turning to new types of shocks related to chokepoints in global technology or shocks tinged by geopolitics.
The question is whether the domestic part of dual circulation will be an open loop or instead a largely closed loop with carefully designed wiring with the global economy.
Technology Independence Is Another Policy For The Times
If dual circulation retains some mystery, then China has been more forthright on its aim to achieve technology independence or self-reliance. The communique noted that "technological independence and self-reliance should be the strategic support of the country's development." We should not be surprised by its mention at the plenum because President Xi has emphasized the importance of self-reliance repeatedly, most recently during his tour of Guangdong province but also at a symposium with scientists.
The emphasis on self-reliance builds on the themes of the "Made in China 2025" effort. This plan aimed to increase substantially the market share of domestic firms in China in a range of core technology-rich industries. However, when Made in China first emerged in 2015, the risks of a trade and technology war seemed low and it sounded more like a plan to leapfrog China's development. Now, similar to dual circulation, self-reliance sounds like it has more of a risk mitigation angle. If China does not need foreign technology, then it will be insulated from abrupt changes in the supply of hard-to-substitute inputs.
Opening Up Here But Not There
At the same time, Chinese officials are keen to dispel the notion that self-reliance means China will turn inward. Dual circulation, after all, includes an external side and these two cycles will "mutually reinforce" each other. The communique noted that opening up will happen "in wider areas and deeper levels."
Concrete policies follow these commitments. The number of free trade zones will rise to 18 from 12 in the months ahead. Negative lists, which detail which industries foreign firms are prohibited from entering, have been trimmed, especially quickly for financial activities, including securities trading, asset management, and insurance. Other industries have also opened, including infrastructure construction and autos.
Important parts of China's economy, those set to grow fastest in the next decade, look set to remain closed, however. In 1922, Vladimir Lenin said that the Party must control the "commanding heights" of a socialist economy. In China's case, state-owned enterprises (SOEs) have fulfilled this role.  The agency responsible for overseeing China's SOEs (SASAC) has identified these commanding heights. In a pre-digital 2006, SASAC identified seven strategic industries where the state would retain full control: defense, petroleum, power, telecommunications, civil aviation, coal, and waterways.  SASAC also identified five pillar industries, including information technology. In most cases, especially in strategic sectors, SOEs have had a dominant position.
A Firmer State Footprint In The Digital Economy
As China's economy pivots to a digital economy, the commanding heights and who occupies them are changing. Technology is now expected to provide a strategic support to the economy; hence it seems likely that the industry itself will become strategic. This will mean more state involvement, not less. SOEs will play a dominant role in some areas of technology, especially capital-intensive industries such as semiconductor fabrication. The plenum's communique once again stressed the need to "give full play to the decisive role of the market in the allocation of resources," but this will run up against the strategic imperative to achieve tech independence.
China's dominant private sector national champions look set to play a key role in achieving the goals of the new five-year plan. The Director of SASAC has suggested that these firms will help SOEs extend their digital footprints.  We have already seen a closer relationship between these firms through mixed-ownership reforms, with Alibaba Group Holding Ltd. and Tencent Holdings Ltd. taking large stakes in SOEs such as China Unicom Ltd.
One other important tool to secure these commanding heights will be the cybersecurity law of 2017 which tends to disadvantage foreign firms in some key parts of the technology industry, including in public sector procurement. The Digital Trade Estimates Project suggest that China's digital trade is the most restricted among 64 of the largest economies in the world. 
So, while opening will continue, it will likely be in industries with low supply chain risks, a strong presence of competitive domestic firms, a limited digital footprint, or a relatively mature market structure. In other words, opening will happen where it is deemed safe to do so and examples include the financial sector (except, perhaps, for leading edge fintech) and consumer durables (from autos to luxury goods). We would expect substantial growth opportunities for foreign companies in these industries. However, where one or more of these conditions is not met, market access for foreign firms is set to remain difficult, if not impossible. Large parts of the digital economy may not meet these conditions.
There is no contradiction between self-reliance and opening-up in the context of dual circulation. All of these policies can co-exist but one needs to be clear-eyed about what will open up and how.
The More Self-Reliant China Becomes, The Slower It Will Grow
The price of greater self-reliance will, almost surely, be slower economic growth. One school of thought believes that that by forcing China's economy to produce all the technology it needs, innovation and productivity growth will accelerate. This is an odd view--it suggests that China, by engaging with the global economy--was leaving money on the table. If only China has decided to do everything itself earlier, the country now would be far richer!
In fact, decades of research and our own analysis suggest that openness fosters higher productivity and growth. These results hold globally but also for China. This works through many channels including technology and knowledge spillovers, network effects from diverse and sophisticated supply chains, and the pressure of external competition. (See "The Great Game And An Inescapable Slowdown," published on RatingsDirect on Aug. 29, 2019).
Moreover, it is those very technology-intensive sectors where self-reliance is being pursued where the most rapid productivity growth comes from. Our analysis, based on the productivity growth across industries in China since 1980, show that it has been the manufacturing of technology goods that explains most of the economy's catch-up to richer economies. Notwithstanding other reforms, service sector productivity growth has lagged far behind.
Growth To Average About 4.6% Through 2030 But Could Be Lower
Supply and not demand determines growth in the long run. China has a large domestic market, but this does not guarantee that consumers can spend their way to rapid growth. Consumers will need to see their real wages grow quickly, year after year, and that can only come from productivity growth or a rapidly rising stock of capital. The latter seems less likely if China is rebalancing away from investment and trying to control leverage.
Our current long-term projections assume two things: that China remains a high performer but its edge over the global average is eroding. These assumptions are rooted mainly in our projections for productivity growth.
We base our productivity projections on a global model that includes relative income per capita, human capital, and openness to trade. We tweak China's projection higher to account for its advantages, including its size and track record. However, we also assume that China becomes slightly more average as it becomes less open in those sectors that drive productivity. (Technically, we used a fixed effect for China at the 90th percentile of the global distribution, which is still generous.)
Combined with China's shrinking workforce, this results in overall growth averaging 4.6% between 2021 and 2030. Growth will continue to fall through 2035 for all the same reasons. We have not yet changed our long-term forecasts because we already expected a shift towards more digital self-reliance.
The usual disclaimer applies of course. This is a long-run projection and it implicitly assumes that China does not leap immediately to the technology frontier by 2035. This could happen but it would be unprecedented in modern history.
Testing The Bottom Line
We do not yet know if a slower growth rate would be deemed acceptable by the government. Some prominent Chinese economists are suggesting the economy can keep growing at between 6% and 8% a year with the right reforms.  Others see 6% as more likely, which is still 1.5 percentage points above our estimate which is based on fairly optimistic assumptions. 
While growth targets were abandoned this year and look set to be softened in the years ahead, a "bottom line" is likely. This bottom line can be defended by using policy stimulus, at least for a year or two. However, if the underlying slowdown is due to supply-side factors, including eroding productivity gains, this is not a sustainable strategy. It will show up in imbalances, whether too much debt or too much inflation. Indeed, this was the story for China's economy for much of the last decade.
While our base case of 4.6% has not changed, we do see the risks of a downside scenario edging higher. Let's explore a simple downside scenario. Instead of China ranking just in the top 10% of economies since 1950, we'll assume its ranking is in the top 25% in the next decade. This might reflect a sustained effort to achieve self-reliance, including heavy state involvement in high-productivity sectors and, initially, a less-than-stellar return on stepped-up investment. This could see China's real GDP growth fall to 3% on average between 2021 and 2030.
A sustained decline in growth, lower than the consensus expects, may indeed be the price for self-reliance. We do not yet know if the government would be willing to pay it.
 Zhong, Jingwen, "Deeply Grasp the Essence of Accelerating the Formation of a New Development Pattern," China Economic Daily, Aug. 19, 2020.
 Fan, Joseph, Randall Morck, and Bernard Yeung, "Capitalizing China," NBER Working Paper 17687, December 2011.
 State-owned Assets Supervision and Administration Commission of the State Council, "Guiding Opinion On Promoting the Adjustment of State-Owned Capital and the Reorganization of State-Owned Enterprises," 2006.
 Digital Trade Restrictiveness Index, European Center for International Political Economy, 2018.
 State-Owned Assets Supervision and Administration Commission of the State Council, "Hao Peng meets with Tencent Chairman and CEO Ma Huateng," August, 2018.
 People's Daily, "Justin Yifu Lin: by 2030, China's GDP still has the potential to grow by 8% a year," October 30 2020.
 Liu Jun, "6% should still be country's GDP growth target," China Daily, March 2020.
The Great Game And An Inescapable Slowdown, Aug. 29, 2019
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