The professor and former World Bank economist says China’s industrial policy essential to fuel innovation, avoid Japan-like depression

Justin Lin Yifu, Professor of Economics at Peking University and former Chief Economist at the World Bank, is renowned for his "new structural economics" theory. This approach advocates for developing countries to actively shape and optimize their industrial foundations, a perspective that has reportedly influenced Beijing's economic strategies over the past decade. Lin has projected that China will "surpass the US, as measured by market exchange rate, around 2030" and overcome the middle-income trap "within two or three years." He served as a counsellor for China's State Council from 2013 to 2023.

In this latest installment of the Open Questions series, Lin expands on his economic forecasts, provides an analysis of the documents released following the highly anticipated third plenum, and explores the dynamic between governmental bodies and market forces. For previous interviews in the Open Questions series, please refer to the provided link.

Q: A topic of particular interest in China is the trajectory of market-oriented reform. While the full text of the decision document from the recent third plenum referenced the market's "decisive role" in resource allocation, this phrase was absent from the initial summary. This omission sparked some apprehension regarding a potential diminishment of the market's role. How do you interpret this situation?

A: The designation of the market as playing a "decisive role" in resource allocation is already a strong statement. It would be challenging to find terminology that could further emphasize the market's significance beyond this characterization.

Market failure is a well-established phenomenon in economic development theory and practice. Recognizing this, the third plenum proposes to optimize governmental roles and ensure effective regulatory frameworks to address and mitigate such market inefficiencies.

The manifestation of market failure varies significantly across industrial sectors and developmental stages. Consequently, for the government to enhance its efficacy, it must adopt a flexible approach, tailoring interventions to specific contexts and circumstances.

This nuanced perspective should not be misconstrued as a diminution of the market's significance. Rather, it represents a more refined articulation and enhancement of governmental functions. The ultimate objective remains to facilitate the market's decisive role in resource allocation.

The third plenum's decision also advocates for the relaxation of certain restrictions. However, it simultaneously emphasizes the government's responsibility to "strive to better maintain order" in instances of market failure or monopolistic tendencies. This dual approach underscores the complex interplay between market forces and governmental oversight in fostering optimal economic outcomes.

From the perspective of new structural economics, the relationship between effective governance and efficient markets is symbiotic and mutually reinforcing. An effective government serves as a prerequisite for an efficient market, while simultaneously, an efficient market remains the ultimate objective of effective governance.

The necessity of effective government as a precondition for market efficiency stems from the inevitability of market failures and potential monopolistic tendencies. Without appropriate management or intervention in these instances, market efficiency would be compromised. However, it's crucial to note that the purpose of governmental action is not to supplant market mechanisms, but rather to enhance market efficiency.

Market failures are not self-correcting phenomena; they persist in the absence of governmental intervention. Conversely, excessive governmental involvement that surpasses the requirements of an efficient market may impede the market's capacity to play a decisive role in resource allocation. Thus, policymakers face the delicate task of striking an optimal balance.

In response to the evolving economic landscape at China's current developmental stage, a decision to refine market operations has been formulated. This necessitates a flexible approach to government policies. Where appropriate, restrictions should be further relaxed to enable enterprises to capitalize on developmental opportunities. Simultaneously, the government must retain the capability to maintain order in the face of monopolistic practices or systemic risks.

This nuanced approach acknowledges the dynamic nature of economic development and the need for adaptive policy responses. It reflects a sophisticated understanding of the complementary roles of markets and governments in fostering sustainable economic growth, recognizing that the optimal balance may shift as an economy progresses through various stages of development.

You are considered a vocal advocate of industrial policy. Based on the decision document from the third plenum, it appears Beijing will continue allocating resources to favoured sectors. While China has achieved success in specific sectors like electric vehicles (EVs), people are also concerned about misallocation or waste, excessive investment or overcapacity. What do you think?

Economic development requires continuous technological innovation and industrial upgrading, which in turn require research and development. In the process of innovation, there will inevitably be many market failures. As the product of research is a public good that does not yield high profits, enterprises may not be willing to invest if the government does not support them. And if the government does not provide patent protection to new inventions, firms will not be willing to develop new technologies either, as it can be easy for others to copy.

For developing countries, we must continue to climb up the industrial ladder, from industries with low productivity to those with high productivity. Of course, if you want to succeed in the process, there is a very basic principle: it must be based on comparative advantage.

If you violate the comparative advantage principle, you may fail as a pioneer and bear all the costs. But the failure can warn latecomers against jumping in.

When the pioneers succeed, everyone will know that this new industry is in line with our comparative advantage and will then follow, which leads to competition. In this stage, the pioneers can only earn average profits, which are the same level as those of the latecomers.

So regardless of success or failure, the industrial pioneers will create useful information for society. However, the cost and benefit are asymmetric. If the government does not provide compensation for the information externality created by first movers, no one will be willing to become one, and the industry will no longer be upgraded.

The new industry may also need a lot of things that entrepreneurs cannot or are reluctant to provide, such as workers capable of using the new technology, because the firms may find the workers they have invested huge amounts of money in to train can be easily attracted away by latecomers and competitors with slightly higher wages. Other examples include infrastructure, financial and legal institutions.

But the resources that the government can leverage are limited, so it should allocate limited resources to those industries with comparative advantages. Such action is industrial policy.

Even though industrial policy has been deemed as wrong for a long time, we have not seen any developed country that can maintain its leading position in the world without industrial policy. If the government does not support basic research, technological innovations will stagnate. This is essentially industrial policy, even though they do not acknowledge it.

The basic research for various technologies and industries the United States is leading the world in were all supported by the US government in the early stage. Mariana Mazzucato, an Italian economist, called the US government an “entrepreneurial state”.

But unfortunately, developing countries have been told they cannot use industrial policies for anything more than supporting basic research. Most have been brainwashed.

Since World War II, there are few developing economies that have been able to catch up with developed countries, as most have fallen into the poverty trap or middle-income trap – except for a few East Asian economies and Israel, which have used active industrial policies to support the development of their comparative advantages.

Intellectuals in developing countries have the responsibility to summarise our own experiences … We should not simply wait for developed countries to tell us what we can or cannot do

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As a professional economist, I support industrial policy not out of preference, but based on empirical evidence and economic theory. The principle I adhere to is that for economic development, any economy must allow the market to play its role, provide sufficient incentives for entrepreneurs, and leverage government intervention to overcome market failures that entrepreneurs cannot address independently. Industrial policy is one tool in this toolkit, and I'm encouraged to see a growing consensus around this perspective.

Intellectuals in developing countries have a responsibility to synthesize our own experiences and propose novel theories. We shouldn't passively wait for developed nations to dictate what is permissible. Instead, we should pursue strategies we deem effective based on our unique contexts and experiences.

Admittedly, many industrial policies ultimately fail. However, as scholars, our response shouldn't be to entirely oppose industrial policy due to these failures. This would be akin to rejecting entrepreneurship because most startups fail. Rather, our focus should be on studying successful industrial policies to increase the probability of success and minimize failures in future policy formulations.

Regarding China's economic trajectory, I project that China will become the world's largest economy around 2030, and I reject the notion that China will follow Japan's path into economic stagnation. This projection is based on several key factors:

In the 1980s, Japan's GDP reached 65-70% of the US's, similar to China's current position at 60-70%. The US's attitude towards Japan then mirrors its current stance towards China – resistant to being surpassed and prone to suppression tactics.

However, China's situation differs significantly from Japan's. The Plaza Accord of 1985 forced Japan to appreciate its currency drastically, severely impacting its export competitiveness. The US also imposed restrictions on Japanese auto exports and mandated technology transfers in the semiconductor industry, citing national security concerns.

These factors contributed to Japan's 30-year economic stagnation, with its per capita GDP falling from 130% of the US's in the 1980s to less than half today, and its total GDP shrinking to less than 20% of the US's.

China, however, has several advantages that make it unlikely to follow Japan's trajectory. These include a larger domestic market, more diversified industrial base, and a more strategic approach to managing international economic pressures. Furthermore, China has learned from Japan's experience and is actively working to avoid similar pitfalls.

In conclusion, while historical parallels can be instructive, they shouldn't be over-emphasized. China's economic future will be shaped by its unique circumstances, policy choices, and global economic conditions, which differ significantly from those faced by Japan in the late 20th century.

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From an economic perspective, China retains significant latecomer advantages in industrial upgrading. Its per capita GDP, when adjusted for purchasing power parity, is approximately one-quarter of the U.S. figure, and only about one-sixth when calculated using market exchange rates. This gap indicates substantial room for catch-up growth.

Moreover, the fourth industrial revolution has created a more level playing field in emerging sectors such as AI and big data, where China can compete with developed economies from a similar starting point. China possesses four key advantages in these new industries:

1. A large pool of skilled workers, crucial for these technology-intensive fields.
2. A vast domestic market, allowing for rapid scaling and cost reduction through economies of scale, enhancing global competitiveness.
3. A robust manufacturing ecosystem, particularly beneficial for hardware-dependent innovations.
4. A hybrid model combining an efficient market with effective government intervention, including the strategic use of industrial policy.

Japan's economic stagnation can be partially attributed to its abandonment of industrial policy following U.S. pressure after the Plaza Accords. This shift limited Japan's ability to incubate new industries, resulting in a lack of world-leading innovations post-1980s. China, by contrast, maintains its commitment to industrial policy, which should support continued economic development and innovation.

Regarding private sector sentiment, it's important to note that while concerns exist, many of China's best-performing enterprises in cutting-edge sectors like electric vehicles, solar panels, and lithium batteries are private firms. Their success in both domestic and international markets suggests a level of confidence and competitiveness that belies broad generalizations about private sector sentiment.

The third plenum's emphasis on better protection for private firms, including legislation and opportunities to lead national research projects, is a positive step. However, the simultaneous pledge to strengthen the state sector creates a complex landscape. To further boost private sector confidence, policymakers should focus on:

1. Ensuring consistent and transparent implementation of protective legislation.
2. Creating a level playing field between state-owned and private enterprises.
3. Continuing to open up sectors traditionally dominated by state-owned enterprises.
4. Enhancing intellectual property protection to encourage innovation.
5. Streamlining regulatory processes to reduce bureaucratic burdens on private firms.

By balancing support for both state and private sectors while addressing structural challenges, China can maintain its economic dynamism and continue its trajectory towards becoming the world's largest economy.

So when we say that private enterprises have no confidence, it may depend on the sector. They may be in traditional industries. They may rely on exports. These companies are not willing to invest now, but what is the reason behind this?

The international market has not yet recovered. Before 2008, the world economic growth rate was about 4.5 per cent annually, and the growth rate of global trade more than double that figure. After 2008, the world’s economic growth rate declined to a little over 3 per cent, down one-third, and the trade growth rate was less than the economic growth rate.

China, as the world’s largest exporter, was the most affected by this. More than 95 per cent of China’s export sectors come from private enterprises. When the country’s annual export growth dropped from more than 15 per cent to only about 5 per cent, a lot of excess capacity had to emerge.

So it is true that many private firms have no confidence in investment, because they are affected by these external factors.

Many attribute the lack of confidence of private enterprises to the expansion of the state sector. It is true that the proportion of state-owned enterprises (SOEs) in the overall economy has been rising since 2008. But was the increase a result of squeezing out private firms? Or was it because the private sector was not performing, and SOEs had no choice but to shoulder some countercyclical intervention to stabilise economic growth and employment?

In recent years, all the major public infrastructure projects such as highways, high-speed railways and 5G communications were done by SOEs. These SOEs increased investment, so their proportion in the economy went up.

But has this squeezed out or actually helped private enterprises? In fact, it was more of the latter. Because when SOEs make investments, they create jobs, leading to an increase in residents’ income and thus consumption. And consumer products are all produced by private firms.

When SOEs invest in big infrastructure projects, the steel, cement and equipment are also mostly produced by private companies, thus these investments create new markets for them.

China’s SOEs are concentrated in sectors related to defence infrastructure, or natural monopolies such as power and telecommunications. These are essential for maintaining economic security and development, so of course they must be made “bigger and stronger”.

And if they become bigger and stronger, it can reduce the transaction costs of private firms. For example, China’s infrastructure is the best among developing countries, and that is why companies like Meituan, Pinduoduo and JD.com can grow so fast in China.

So when we talk about making SOEs bigger and stronger, we need to look at which industries. They are not competing with private firms, but strengthening themselves in sectors to serve private businesses or safeguard national security, which is ultimately conducive to the development of the private sector.

Building a “unified national market” has been brought up as a key target. While such a concept can be found in government documents from as far back as the 1990s, it has received more attention in recent years. How will such a market help China’s economy? What are some obstacles to this, and how can they be overcome?

China is a large economy, and internal circulation is a key advantage. If the national market is fragmented rather than unified, there will be no such advantage. Reform and opening up is a gradual, dual-track process. At the beginning, the government retained many interventions in the economy.

It continued to subsidise several capital-intensive heavy industries, violating comparative advantage to maintain stability. It also liberalised investment for private and foreign firms in some labour-intensive processing industries in line with comparative advantage, actively helping them address market failures such as poor infrastructure by building industrial estates where the business environment could be improved immediately. These labour-intensive sectors were thus able to develop rapidly. This is a major reason why China could maintain stability and achieve rapid development at the same time.

However, because of the interventions, market operation was not smooth. To subsidise capital-intensive industries, the government intervened in factor prices, including the prices of mineral resources and interest rates.

But China’s gradual dual-track reform was very efficient. Industries with comparative advantages have developed rapidly, accumulating massive capital, and the old capital-intensive industries have gradually come in line with comparative advantage, no longer needing protections or subsidies. This was why the third plenum in 2013 proposed to let the market play a decisive role in resource allocation, because we no longer needed the government to artificially intervene in prices.

This is just one of the conditions for a unified national market. The formation of a unified national market also depends on the quality of infrastructure. If your infrastructure is not good, you will only have regional markets, not a national market.

Of course, China’s infrastructure has been getting better in recent years. So whether it is market price liberalisation or infrastructure, the conditions for a unified national market have gradually improved, but new situations have also emerged.

For example, data has become a new element. To make sure data can flow according to market demand, we must clarify who owns the data and can use the data. There must be regulations.

So to establish a unified national market, China must continuously improve the policy environment according to the new situation.

More than 300 reform tasks were brought up in the third plenum resolution document. Could you name some of the most important ones for breaking through the biggest barriers facing China’s economy, and could you elaborate on them?

First of all, fiscal and tax reform. Now, everyone is very concerned about local government debts. Why do local governments have those debts? Because our local governments were not allowed to have a deficit on their budget.

After the international financial crisis in 2008, China undertook a lot of infrastructure projects to stabilise employment and economic growth. Within that 4 trillion yuan (US$551 billion) stimulus package, the central government only provided 1.2 trillion yuan, and the remaining 2.8 trillion yuan had to come from local governments.

But as they could not have a deficit, they set up local investment platforms and borrowed money from banks to build these projects. As the money was underwritten with local government credit, it inevitably became hidden debt. Even if they are not shown in the budget, the liability belongs to the local governments.

One problem here is that these infrastructure projects are long-term projects, but the money they borrowed is short-term debt, so there is a mismatch.

The US’s economic containment of China will certainly create difficulties for China, but it also creates difficulties for itself

So, how to solve this problem? First, the local government debt problem in China is not as bad as it looks. One big difference between local government debt in China and in other countries is that foreign debt is real debt, because most of the money borrowed is used to boost consumption or relieve unemployment. Most of the debt of Chinese local governments, however, was used for infrastructure investment, which means there are assets underlying the debts, so the net debt is much smaller than nominal.

Second, many developing countries borrow money in foreign currencies, and China’s local government debts are yuan-denominated. Usually debts in a country’s own currency are not likely to lead to a crisis, as the country can print more money.

So we don’t have to worry too much about China’s debt problem, but it does not mean there is no need to solve it. And the solution is just like what the documents of the third plenum say – that is, let local governments’ fiscal revenues match their responsibilities.

And if the central government should issue a policy that needs infrastructure, the money should come from the central government’s pocket.

I think the third plenum shows China’s fiscal reform is heading in the right direction. More specific details will follow, maybe at the Politburo meeting, the annual central economic work conference or the 15th Five-Year Plan.

Another noteworthy reform task is the hukou, or household registration system. The process of economic development is accompanied by urbanisation, where rural populations enter cities.

But with our old hukou system, when rural people moved to the cities, they could work or buy property but they could not enjoy the same public services – healthcare, education for children – as urban residents. And now such restrictions are gone.

So this is also a very important institutional reform, which is another key element to the establishment of a national unified market as we mentioned earlier.

China’s national unified market is already quite perfect in terms of the flow of products and commodities. The main obstacle is the factor market, including the labour market. So hukou reform is key to further deepening the market economic system.

As technology containment from the US tightens and threats of higher tariffs increase, what should the Chinese government and enterprises do to maintain economic growth or the growth of their businesses? If the US imposes 60 per cent tariffs on all Chinese goods, or additional tariffs, how should China respond?

Troops for the enemy, earth for floods: there will always be a way out. China should continue leveraging its advantages to develop its own economy well, open up its economy and let China’s development become something other countries can rely on.

The US’s economic containment of China will certainly create difficulties for China, but it also creates difficulties for itself.

Why is inflation so high in the US? Because it is cheaper to import directly from China. Now instead of China, it imports at higher cost from Mexico and Southeast Asia, even though many intermediate goods still come from China. So even if China’s exports to the US have decreased, our shipments to Mexico, Vietnam, Cambodia, Indonesia and Malaysia have increased. So the overall impact [of US tariffs] on the US is greater than their impact on China.

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