Central planning and China’s productivity challenge

By James Pethokoukis

China is aiming to become a tech powerhouse, especially in advanced sectors such as AI, aerospace, robotics, and chips. And that means more and more government R&D funding. Back in March 2021, Premier Li Keqiang announced Beijing’s objective to increase investment by 7 percent annually between 2021 and 2025. But “Innovation versus imitation: Where all that Chinese R&D is going” by Michael König, Zheng (Michael) Song, Kjetil Storesletten, and Fabrizio Zilibotti questions whether more is always better.

The authors note that many Chinese firms “respond to R&D subsidies by relabelling non-R&D expenditures as R&D expenses.” And innovation is about more than just R&D. “Economic reforms improving investor protection and the independence of the judiciary system are preconditions for nurturing the type of grassroots innovation culture which flourished earlier on in some Western nations.” But there is a deeper issue with top-down planning, and it gets at an inherent problem with national industrial strategies:

Another reason for R&D expenditures to be potentially inefficient is misallocation. The investments could be carried out by the wrong firms and in an ineffective way. China’s economic policy biases resource allocation in favour of state-owned firms and private firms that are connected to the state (e.g. Song et al. 2011, Hsieh and Song 2015, and Bai et al. 2020). . . . Altogether, our analysis indicates that already in 2007–12 R&D was an important determinant of aggregate productivity growth in China, despite large distortions attenuating its benefits. The result is robust to introducing international knowledge spillover in the theory. In a counterfactual policy experiment, we find that a moderate increase of R&D subsidies across the board could enhance TFP growth, although an overly generous subsidy policy would backfire and reduce growth by hindering technology diffusion. Reducing misallocation (e.g. state support to politically linked firms) would also have a powerful (and potentially less expensive) growth-enhancing effect.

Chinese President Xi Jinping poses for his annual new year address on the eve of 2022 on Dec 31, 2021 in Beijing. Via REUTERS

The researchers also take a look at Taiwan, which has a far more open and market-oriented economy than China and find that “R&D investments are more productive in Taiwan than in mainland China.” They also offer this caveat: “Most important, we focus on the period 2007–12, when growth is still relatively strong for the Chinese economy. More recently, there are signs of productivity slowdown.” (China’s productivity problem is something I’ve been writing about.)

One other thing: The bit about Chinese companies relabeling “non-R&D expenditures as R&D expenses” brings to mind a WSJ story from earlier this week: “Two Chinese Startups Tried to Catch Up to Makers of Advanced Computer Chips—and Failed,” this part in particular:

Beijing in around 2014 began unveiling industry-support plans that included a $22 billion central-government kitty for chip investments, known as the Big Fund. Local governments set up similar funds. In 2019, the state established a second national semiconductor fund of about $30 billion. Soon, chip money was sloshing across China. Tens of thousands of Chinese companies registered their businesses as related to semiconductors, including some whose main activities involved restaurants and cement-making, according to the Tianyancha database. China did improve at some aspects of chip making, including designing chips. But some companies went belly up because they didn’t have sufficient expertise or capital, industry experts say.

China is vast, and the central planners are far away.

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