Podcast: How China Influences U.S. Innovation and Technological Capabilities, With Barry Naughton

January 24, 2022

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Concerns about China’s rapid rise in recent decades have affected U.S. policies on technology, innovation, and industrial competitiveness. Rob and Jackie discussed the history of Chinese industrial policy and its implications for America and its allies with Barry Naughton, the So Kwanlok Chair of Chinese International Affairs at UC San Diego and author of The Rise of China’s Industrial Policy, 1978 to 2020.





Rob Atkinson: Welcome to Innovation Files. I’m Rob Atkinson, founder and president of the Information Technology and Innovation Foundation. We’re a D.C. based think tank that works on technology policy.

Jackie Whisman: And I’m Jackie Whisman. I handle outreach at ITIF, which I’m proud to say is the world’s top ranked think tank for science and technology policy.

Rob Atkinson: And this podcast is about the kinds of issues we cover at ITIF, from the broad economics of innovation to specific policy and regulatory questions about new technology. And given that China is the huge influence on technological innovation and US technology capabilities, we’re talking today about China.

Jackie Whisman: Our guest is Barry Naughton. He’s the So Kwanlok Chair of Chinese International Affairs at UC San Diego. He’s one of the world’s most highly respected economists working on China. He’s an authority on the Chinese economy, with an emphasis on issues relating to industry, trade, finance, and China’s transition to a market economy. His most recent book, The Rise of China’s Industrial Policy, 1978 to 2020 is what we’re talking about today. Welcome.

Barry Naughton: Thank you very much. It’s a pleasure to be here.

Rob Atkinson: I’ve really been focused on China for, I don’t know, maybe 10, 12 years, kind of starting when I was co-chair of the US China innovation experts group with the Obama administration. I have to say, Barry, I’ve relied on your work over those years and not just your latest book, but other books, articles. So really, really found them super helpful and would really encourage our readers, anybody who want to go deeper into this, pick up Barry’s new book. Really, really fascinating book. And while it has academic rigor, it’s really fun to read. It’s not a slog, so that can help.

Jackie Whisman: It’s available as a free download. So we’ll link to it in our show notes.

Rob Atkinson: You’re not supposed to say that. You’re supposed to buy the book.

Barry Naughton: That’s all right.

Rob Atkinson: Buy Barry’s book.

Barry Naughton: You can download it, just make sure you cite it.

Rob Atkinson: Exactly. Anyways, as I said, I thought your book is really insightful. I learned a lot. One of the points that you really made quite clear was that there have been two phases of Chinese economic and tech policy, sort of pre-2006 to 2008 and post. Can you explain that for our listeners? What does that really mean? What does it imply?

Barry Naughton: I mean, China, from the outside, it always looks as if the Chinese government is planning everything and programming everything, and it’s easy to see a continuity in the last 40 years of Chinese policy. But the reality is when you go back before about 15, 20 years ago, the efforts of China to really implement a government steered technology and industrial policy really came to nothing. I mean, they were unrealistic targets. They didn’t have resources to put behind it. And so they have really almost no role in the Chinese economic miracle. When you really look deep into the Chinese economic miracle, what you see is big changes in economic structure, but changes that are driven by unequal pace of liberalization, things like export garments gets liberalized and we see big growth in that sector. So it’s really marketization becomes industrial policy.

 And then around 2006, as they face the fact that the Chinese economic miracle is sort of running out of steam because they don’t have these huge reserves of labor anymore, they really start to get serious about industrial policy. They start to issue targets and refine the targets. They start to put money behind it through many different channels. So it’s really only in that decade plus that they’re really doing a kind of big push industrial policy of the kind that I think by today, of course, people clearly associate with China.

Rob Atkinson: I think you say this in the book, but if you characterize China pre-06, it was really an industrial recruitment or industrial attraction strategy. It was opening up China to the world as a production base. Deng Xiaoping doing that in, what, ‘81 or whatever that was in Guangzhou and other places. And that was a highly successful strategy. But then, as you know, they felt like they needed to do something more.

Barry Naughton: And in a way, I mean, one of the really funny things about China at this crucial turning point about 2005, ‘06, ‘07 is for all of our research, we cannot find that there was any kind of deep, fundamental decision, “Oh no, we’re going to do it different now.” It was just this incremental process where partly for political reasons, partly for economic reasons, partly for technological reasons, gradually they start relying more and more on direct government intervention and, of course, direct party intervention.

 At first it’s almost like a compromise between the... There’s a group of market reformers who want to go faster. And even in China, there’s still a group of old-fashioned conservatives who actually wanted to roll back reform. And this strategy was sort of in the middle. It was, “Well, we’re not going to roll back market reforms, but we’ll guide the economy more. We’ll put more money into more of the high tech sectors.” So it gradually shifts onto a different trajectory. And then that trajectory then just, of course, becomes stronger and stronger. It feeds on itself and pushes on itself and becomes the overwhelming complex of policies that we see today.

Jackie Whisman: And what do you think was the overarching goal they saw in all of this?

Barry Naughton: I think especially initially the overriding goal was simply to make a smooth transition from a kind of labor-intensive growth to a much more innovation and technology driven growth path. I mean, that’s, I think, what got them started. Of course, if you’re thinking about China and the Chinese Communist Party, it’s always thinking about security too. So I think growth was the prime driver, but just a half a step behind it is the idea China needs to be more secure. It needs to be a stronger power. It’s got to watch out for conflict with the unnamed other, who is, of course, always the United States.

Rob Atkinson: One thing that always... I mean, puzzles may be too strong a word, but when I go to China, when I’ve met with Chinese officials either there or here, one thing that I think is clear to me is they don’t really have that overarching domestic productivity strategy. Their ag sector, there’s a lot of low-hanging fruit there, for example. I remember going once into a little shop in a hotel and there was somebody to take my sandwich and then they handed it to a person who put it into a bag. And then there was a third person to take money. I know part of that’s just, they have a lot of workers, but the Chinese officials I’ve talked to, they see the way to gain productivity is going up the value chain rather than in addition maybe broad-based productivity and retail and logistics and finance and all that. Do you have thoughts on that?

Barry Naughton: Yeah, absolutely. I mean, I think one of the difficulties for those of us who track China is there’s always something new to follow. And so the temptation to sort of be continuously distracted by all the new policies is kind of overwhelming. And we often forget to stop and say, “Well, wait a minute. Certain things didn’t happen that we were talking about a decade ago.” And one of the things that didn’t happen was China never rebalanced. I mean, when China was so imbalanced in its external account, so that it had an enormous trade surplus 2006, ‘07, ‘08, it also had a very high investment rate. And then with the global financial crisis, it pushed its investment rate way up. So, many of us were saying, “Well, it’s going to rebalance to a more consumer driven strategy.” You’ve heard that for 10 years. You still hear it today. But it’s never happened. It’s still this government driven investment-led strategy.

Now, why did I go on that long digression when you asked me about a broader concept of innovation and productivity? It’s because I think the two go together and are almost the same thing. In other words, they had an opportunity to say, “Well, now we’re going to allow consumers a much greater voice.” And that means there’s going to be innovation across the board. Yeah. More high tech stuff but also more products, more services, things that appeal more to this now middle class, sort of half middle class economy. And of course, income growth has been so fast. There’s still been plenty of that. But as a strategy, it really is the road not taken. And I think it’s a big disappointment. I think it’s important that we call it out and say, “Hey, China never rebalanced. It became even more government-led. And the role of the consumer has never been fully brought into play.”

Jackie Whisman: What’s been the role of President Xi in all of this?

Barry Naughton: He’s such a strong driver of everything. I mean, because his ideas are so complex and, frankly, contradictory, but also that he has a vision of the role of the Communist Party that is almost unbelievably backward looking. I mean, he believes in a party that is composed of a politically active elite. He wants the difference between party members and ordinary citizens to be greater, not less, because they’re supposed to be a vanguard. They’re supposed to be more responsible, right? I mean, of all the things that have happened in China in the last 30 years, this, to me, is the most unexpected because this was sort of the lesson that we learned from the catastrophe of the Cultural Revolution. It was that this kind of hyper-politicized approach leads to disaster.

And yet here we are again. Now, I’m not saying that Xi Jinping is going to take us back into a Cultural Revolution, but that there are certain aspects of that that he completely believes in. And so in the same way, if you imagine that vision on a kind of party personal level or just transpose it to a national development strategy level, you see exactly what you see in China today, which is everything for the team. The team has to strengthen the nation. The way to strengthen the nation is high technology. I mean, they say innovation, but what they mean is high tech with, of course, the distinction that Rob just brought up a few minutes ago. So Xi is a big driver. Absolutely.

Rob Atkinson: You see that when, I can’t remember how long ago, a year or so or two years ago, where they mandated that most medium and large sized companies now have to have a representative of the party in there. It was funny, one time when the strategic and economic dialogue was going on, and so I was over there as part of my role as this Obama taskforce on China. And so the members and a bunch of USG folks, we went on this tour, and we ended up visiting a very large state-owned enterprise. It was in Beijing, and we’re in the lobby, and we’re waiting to meet with the number two, the deputy CEO. And I’m in the lobby and I’m watching and they have this little display thing of the company’s history going back. It was formed, I think, in 1913, or I don’t know what it was, but what was really interesting is the very first placard was Marx, then it was Lenin, then it was Stalin, then it was Mao, and then it was the country. And I thought, “Wow, that’s really interesting that it’s just so right out there in front.”

Barry Naughton: Of course, it’s inside a state-owned enterprise where not that many people necessarily venture, right? I mean, you’re an honored guest, but I’ll bet they don’t get too many foreigners.

Rob Atkinson: Yeah.

Barry Naughton: This is something I’ve been thinking about quite a bit lately, because translation is a big issue, right? I mean, you say things in Chinese, you have to say them in English. They have a whole strategy for not saying the same thing in Chinese as in English. Now, I mean, it’s most obvious in the sense that when Xi Jinping leaves the country, in English, he’s President Xi, and when he returns to the country, in Chinese, he’s General Secretary Xi. Because within the country, everybody understands that the party rules. But in terms of dealings with foreigners, he has to be the president because that’s a kind of protocol-based thing. And there are other things like this too. There’s a line in the most recent party congress that says, “The Communist Party leads everything: north, south, east, west, students, businessmen, workers, farmers,” et cetera. And the English translation says, “The Communist Party exercises overall guidance over all important issues.” So it’s not quite the same thing.

Rob Atkinson: So, Barry, this is fascinating. I want to jump down a little more in specific levels. One of the things that you wrote about in there, which was really interesting, because we followed this a little bit, but you had a lot of detail on it, this new policy tool they call Industrial Guidance Funds. What are they? How do they work? How big are they? What’s going on there?

Barry Naughton: Yeah. In conception, I think this is if you’re going to follow this kind of government guided policy, this is a very smart thing to do. I mean, it’s essentially a kind of clone of a venture capital fund with the key difference being that almost all the main actors are state-owned entities. But just as in a venture capital fund, you separate between a strategic partner and a limited partner. The strategic partner is the one responsible for making the actual investment decisions. The limited partners provide capital and come together twice a year or quarterly to discuss the investment strategy.

So you’ve got much stronger incentives for the investor, much more specialization in who’s making the decision. So it’s a good idea. But of course, this being China, what we see is lots and lots of money pours into these. Oversight, it’s not horrible. It’s better than some of the alternatives, but it’s still not a truly market driven thing. Or rather, it’s market driven but it’s always buffered by politics and by other types of goals. But they’re definitely big players. They’ve raised hundreds of billions of dollars that have then been passed on into investments in the crucial high tech sectors. I think among these people are most likely to be familiar with the semiconductor fund, which has done two big rounds, all of which are fully invested at this point. Yeah.

Rob Atkinson: I met with the guy who runs that once and he talked a good line. He said, “Well, this is a purely private sector driven initiative. We’re just an investment fund.” And I can’t remember whether I said it or not, but I certainly knew it, which was, “Aha, and you mean that your fund on Monday was staffed up by 25 people from MIIT,” Ministry of Information Technology and Industry, or whatever it’s called. They just moved from MIIT over to his fund from Friday to Monday, and it was funded by the state tobacco state-owned enterprise. It was like, they have a good facade of being private, because they know it’s a WTO issue. But as you point out in the book, there’s a lot of government money there.

Barry Naughton: What they end up doing, of course, is not surprising. They tend to separate it into two classes of investment. And in one you’ve got a target rate of return of 20%, and in the other you’ve got a target rate of return of essentially zero. Try not to lose your money because these are... But you need to support these because they’re strategic for the nation. Yeah.

And even then, I mean, I think a really important thing to watch will be now that these have been in operation for a couple of years, some of them, of course, should be failing. And an interesting question will be how many fail? What do they do? Do they legitimately let them go bust and take a loss, or do they try to sort of keep them afloat forever in order to avoid acknowledging the loss of money?

Jackie Whisman: Another term we hear is civil military fusion.

Barry Naughton: I mean, again, it’s one of these things that come initially from the Chinese looking at the United States. And they go, “Oh, wow. In our system, we have these narrowly defined military industrial firms. And then we’ve got capabilities in the civilian economy, but we can’t tap them. Look at the United States. They’re so smart. They’ve got Boeing, they’ve got Lockheed that combine these things.” And so it’s really initially an attempt to emulate that model.

 But of course, again, it’s China. So once they start down a road, they always go further than you expect. So it becomes a conscious effort to, first of all, emphasize to private firms that they have a responsibility in the Chinese system, they have to participate in this. And second, to sort of tap into, through various mechanisms, really a whole range of mechanisms, to tap into the expertise in artificial intelligence and new materials and other things that are developing in the non-state sector and the private sector, and to make sure that those are accessible by military and defense industry related projects.

Rob Atkinson: So, Barry, one of, to me, the key things that I think people in the US, particularly, I think, a lot of the trade policy establishment people or the conventional economists, they don’t quite understand about China, they look at this and they just see inefficiency. And of course, from a sort of capital allocation efficiency argument, yeah, enormous amount of inefficiency. I don’t think anybody questions that.

But what they’re missing, though, is the notion that certain industries are strategic in the world we now live in. And the Chinese recognize that. And they’re willing to suffer inefficiencies to gain competitive advantage in strategic industries like semiconductors and quantum and the like. And we still seem to be having this viewpoint of, “Potato chips, computer chips, what’s the difference?” which was a Michael Boskin quote supposedly back in the first Bush administration. I mean, my impression is China sees that they have really two parts of their economy. They have a strategic part and they have a nonstrategic part. The strategic part they manage and this nonstrategic part they’re willing to sort of let it go by how markets work. Is that too simple?

Barry Naughton: No, I think that’s a good characterization. I mean, I think the other thing is that there’s a parallel conception that I think often overlaps, and that is they really believe in, shall we say, strategic competition and bigger is better. So there is this belief that really filters through so many different players in the economy that they need to build up a few large-scale international competitors so that they can have heft. And of course, obviously you see this with some of the big state-owned enterprises, but I think you also see it with attitude toward Huawei and Alibaba and Tencent, that there’s a strong belief, in other words, in national champions.

Now, of course the national champions are going to, in many cases, overlap with the strategic technological sectors. But I think in terms of the big problem for trade policy is that both these things are going on, right? And I think that they have basically decided that they’ve developed a range of tools that will allow them to participate in the world trading system with all these tools in place to promote their national champions. And that’s where I sort of come back to how you started this question with, what is it that standard trade people don’t get? I think they don’t quite understand the magnitude of the subsidization tools and the strategic willingness to support national champions that motivates Chinese policy in trade and technology areas.

Rob Atkinson: Yeah. I mean, too many, I think, of the folks who’ve grown up and built their careers in US trade policy fundamentally have a Ricardian perspective of comparative advantage and will do very well in aerospace and biotech, and somebody else might do well in chemicals or something else, and that that’s kind of market-based. And your point about that is critical. I thought you made a really interesting point about scale. If you look at CRRC, for example, they’re a state-owned high-speed rail company. My colleague Nigel Cory wrote a really nice report on that. I mean, they actually had two big state-owned rail companies and it wasn’t good enough for them. And so they merged them into one big one.

And I compare and contrast that to where antitrust is going in the US right now, where it’s almost the opposite. It’s saying, “We’ve got too many big companies. We should be trying to break them up.” And our position on those issues is there’s nothing wrong. In fact, it’s good for antitrust authorities to be looking at anti-competitive conduct. Companies shouldn’t be allowed to manipulate their market share or market positions or anti-competitive. But I do think that a lot of the antitrust folks today are missing the importance of scale in this big, giant global economy, and that the Chinese fundamentally understand that they have to have scale if they want to dominate.

Barry Naughton: Now, I think we’ve been agreeing on so many things here. Let me just introduce a complication to that.

Rob Atkinson: Sure.

Barry Naughton: Because one of the interesting things we... Because the way you laid it out is certainly true in terms of state firms, right? No question. And there was a definite turning point. The railroad construction companies are a perfect example of this. They had them split in order to produce competition. And then they changed their mind and said, “No, we want scale,” and they remerged them. So, that’s a really important change in Chinese policy that people need to probably be more aware of.

We have seen something funny this summer, right? Which is that for the internet giants, the Chinese government has been willing to rein them in and impose some restrictions on anti-competitive behavior of various kinds, including specific abuses, but also by limiting the way that big internet firms like Alibaba and Tencent can use their data. They now have much stronger restrictions on how they can cross use data across different business sectors. And it’s been tough on these companies. They’ve lost a lot of their stock market value. And Xi Jinping has essentially said, “I don’t care. This is the way it is. We have data security,” which means for him very much a national defense thing, that data is protected within the country. But also within the country, only the government has access to all the data, and Alibaba and Tencent no longer do.

So, I mean, it’s funny because I think some people look at this and they say, “Well, in this area, China is actually ahead as a regulatory standard setter.” I don’t think it’s quite that simple because these decisions are still too politicized to be just simply labeled regulation. They’re a part of a complex maneuver between the state and private businesses. But we could say that there are a few things in there at least that they’ve been willing to do that so far we haven’t been able to generate the political consensus to do in the United States, right? Everybody’s unhappy with Facebook, but nobody can seem to begin to agree on what it is we need to do to make that better.

Rob Atkinson: Yeah. No, I mean, we could talk for a long time, but we have to close, so I won’t. But I will say just this one thing, I think, is there are a lot of people who looked at that immediately and sort of used it to advance their agenda in the US, “Oh, we need to [crosstalk 00:25:51].”

Barry Naughton: Sure.

Rob Atkinson: And I always looked at it a little bit like... I looked at it exactly like you did. Very complex what they’re doing there. Some of it to me, like particularly with Jack Ma, was a shot across the bow, “Hey, Jack. Look, don’t get too much power here. Don’t get your head too big, because we’re still in charge.”

Barry Naughton: Right.

Rob Atkinson: So I think there’s a lot of different things going on there, but the one thing that they haven’t done is trying to break the companies up. They’re regulating them, which is, you can argue, good or bad, but I still see them... I mean, they want to see those digital champions out in the belt and road countries and gaining market share there, I think.

Barry Naughton: I think for sure that’s right. I mean, I think there is a view out there in the markets that it’s way too Pollyannaish about what Chinese regulators have been doing this year. Because what they’re not seeing is that along with the enhanced regulation, there’s also this willingness on the part of Chinese government to use new sets of instruments that they know to be costly and not very effective. And so it actually also represents a worrying, if you’re China, shift away from an assumption that market conforming instruments are best. Now they’re just kind of saying, “Ah, whatever works we’re going to do it. And what the long-term costs are, too bad. Let the chips fall where they may.”

Rob Atkinson: It does seem like in the last year they’ve gone in a new direction. Barry, unfortunately we have to close. I mean, maybe we can have you back another time. This is such a really interesting discussion. So, thank you so much.

Barry Naughton: I’d love to. My pleasure.

Jackie Whisman: And that’s it for this week. If you liked it, please be sure to rate us and subscribe. Feel free to email show ideas or questions to [email protected]. You can find the show notes and sign up for our weekly email newsletter on our website itif.org, and follow us on Twitter, Facebook and LinkedIn @ITIFdc.

Rob Atkinson: We have more episodes and great guests lined up. New episodes drop every other Monday. So we hope you’ll continue to tune in.

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Podcast: How China Influences U.S. Innovation and Technological Capabilities, With Barry Naughton