# Perfecting China, Inc.: China's Unambitious 13th Five-Year Plan

Date June 23, 2016 Scott KENNEDY (Deputy Director, Freeman Chair in China Studies, and Director, Project on Chinese Business and Political Economy, Center for Strategic and International Studies (CSIS)) TAKAGI Seiji (Director-General for International Affairs, Global ICT Strategy Bureau, Ministry of Internal Affairs and Communications)

## Summary

### Introduction

Scott KENNEDY

We conducted this project on China's 13th five-year plan, considering that it would be an excellent window into how China makes economy policy and the direction of its economic policy. We believe that based on gaining a clearer picture of those two elements, we would become able to say something about the implications for companies around the world, multinational companies, and governments responding to what the Chinese are doing.

I will talk about the "why" of the plan—why they needed it; the "what" of the plan—the contents of the plan and what is good and not good in it; and "how" they drafted the plan—a crazy process, and, lastly, what the implications are for businesses and countries around the world.

A telling video came out in October 2015, put out by the Shanghai Media Group, a media group hired by the Central Communist Party Propaganda Department to promote understanding about the five-year plan. It is the high point of public engagement on the plan and is frankly much more interesting than the actual plan. It came out five months before the plan was passed, which was during the night of March 17, 2016. There are 148 pages of long-winded, terse, hard-to-read, boring text. Every sentence has no subject. Who was the audience for the video, considering nothing else has come out since? It was by, of, and for the Chinese officials primarily.

### The "why" of the plan

What did China need to do to come up with a grand economic policy plan? The most important point with regard to "why" is how inefficient China's economy is. Growth can be attained by throwing more people at a problem or more money, or the quality of the people and the efficiency of the money and what is used can be improved. The latter is preferred and that is measured by total factor productivity (TFP). Looking at economic growth from 1971 to very recently and divided up into the five-year plans, China's growth is pretty high over the total timespan, but the TFP changes over time. Simplified, over the last 25 years, the proportion of Chinese growth that comes from TFP or improvements in human capital and technology is on the decline. If China continues on its current trend, it will soon have a growth structure that looks like the Cultural Revolution.

There is extreme inefficiency, particularly in the use of capital. In 2008, it took roughly two units of renminbi to generate one unit of growth. By 2015, it took nine units of renminbi to generate the same amount of growth, in real renminbi terms. In real terms, this is not the type of growth trajectory that it should have. To get to that, my colleague Chris Johnson and I think two kinds of rebalances are needed.

The first is an economic rebalance: moving away from investment in infrastructure and heavy industry toward services, and greater promotion of a social safety net toward a rebalanced economy away from the old growth focus.

In addition to that, China needs a rebalance of the relationship between state and market. It needs less government intervention and a greater role for market forces to determine the allocation of capital, because markets typically do a better job of that and then do an even better job of it the closer it reaches the technology frontier. Also, when financial markets become more complicated and a country is more integrated with the rest of the world, the chances of government failure increase and successful government intervention decrease.

When we looked at the five-year plan and its draft process, we considered whether it had both types of rebalances in it. It is lacking in this regard.

### The "what" of the plan

China wants to rebalance the economy. The plan has five themes. The first is technological innovation—it wants to move from assembly and manufacturing to design of high-technology goods, moving up the value added chain. Over one-fourth of the document focuses on how to improve innovation. The second is integrating China. In some ways, China is similar to dealing with Europe. There are 31 different provincial-level bodies, thus it is hard to have one policy implemented and difficult to trade and invest across provinces. Improving that integration is another big theme of this plan, as is green development. China talks a lot about improving the environment in this plan, in many different areas: use of land, water, and air.

Looking at the five-year plans over time going back to the first one, they include economic targets, quantitative targets, goals to reach on the economy, social policy, the environment, etc. The number of targets devoted to the environment had been increasing substantially over the last several plans. In the current 13th five-year plan that was just adopted, 16 of the 33 targets are related to the environment and resources. They comprise almost half of the targets, whereas formerly there were none, and every one of those 16 targets is mandatory. Targets are divided into predictive ones that would like to be met and mandatory ones that must be met. Job performance is based on meeting those targets. This is a pretty significant shift from what was done in the past. This is consistent with China wanting to rebalance its economy.

In addition, there is an emphasis on continuing to expand ties globally. The Belt and Road Initiative is a big part of the plan as well as other international economic initiatives. Improving the investment environment in China is also a part of the plan. All of those point toward an economic rebalancing. But that is still only half of what we think China needs to do to have a sustainable long-term economic growth trajectory.

### Incomplete rebalancing

In 2013, the Communist Party had its famous 3rd Plenary Session and issued a famous decision on economic reform stating that it should make the market decisive in determining and allocating resources. Everyone's hopes were raised. But the same feelings don't exist today. There is no parallel commitment to changing the relationship between state and market in the 13th five-year plan. In fact, it is quite the opposite.

China has identified six strategic emerging industries to promote, including a long list of specific technologies to gain leadership in and replace imports with Chinese technologies. Adding up all of the technologies in these industries and other priority areas, there are around 250 priority technologies in which China wants to gain dominance. It has announced that it will spend trillions of renminbi from the government budget and investment funds to achieve that dominance. It will spend more on these technologies in the next five years than it did in the last 30 years. That is government-directed spending. There are political organizations that do this under President Xi Jinping, who has a fascination with leading small groups, party-, and government-based organizations that coordinate across ministries and leave power in a small group of people's hands. There is such a group on semiconductors, for example, that has decided where China should invest, which firms it should try to acquire abroad, etc. This looks like continuing government intervention.

Also, there is the term "indigenous innovation." The Chinese invented this term in 2006 to identify the specific type of innovation they wanted: technologies in which the intellectual property is held by Chinese companies, preferably state-owned or loyal companies such as Huawei Technologies Co. Ltd. Policies were begun to achieve that goal. However, when Xi and Premier Li Keqiang came into power, they stopped using that word, as they knew the word generated foreign antagonism. For example, there were government procurement strategies that stated they could only buy Chinese technologies. Yet, the phrase reappears in the most recent five-year plan, mentioned more than in the previous plan written by former President Hu Jintao and former Premier Wen Jiabao. Indigenous innovation is as dominant today as it was 10 years ago in government speeches and reports. They use their language very carefully, so this is another small sign.

Just as important are the terms used in talking about regulatory reform: state-owned enterprises (SOEs), the fiscal system, the financial system, and competition policy. Every single one of those areas is discussed in this plan, but only in terms of need for incremental change, with wordings such as "eventually," "possibly," "conditionally," and "depending on." There is no consensus in China about what to do about SOEs. I asked one of the people that participated in the drafting of the plan in an interview about when we would know if SOE reform was successful in China, and he replied that when the number of SOEs in the Fortune 500 has doubled, then we will know that it has been successful. That shows you what its priority is: not making them more efficient but making them larger and more dominant regardless of the cost.

The way China talks about openness has changed. This latest plan is divided into five themes, with openness as the shortest at only seven pages long and only one page is about improving the market environment in China for foreign businesses. The other six pages are about making the global economy more open to Chinese trade and investment and increasing Chinese influence in international economic and securities organizations. The world opening to China is what it means by openness.

The broader political environment in China does not convince me that the government is committed to reducing government intervention in society. The treatment of journalists, lawyers, shareholders, non-profit organizations, foreign non-government organizations (NGOs), and others shows that this is not a spring of liberalization in China. It's quite the opposite. It is committed to control, across the board. There is no rebalancing away from the state and toward the market in this plan.

### The "how" of the plan

There are two interesting things about the way this plan was drafted. They can be summed by the famous Leninist saying "democratic centralism." It was a very collaborative process with thousands of people participating at every level of government, doing research, putting forward ideas, and arguing about all of the big issues: SOE reform, the growth rate, the role of government in general, etc. Experts from foreign companies, research institutes, and international organizations all contributed to the conversation.

But once the Chinese top leadership decided what they were going to do, the serious discussion ended. It stopped in October 2015 when the video I mentioned earlier came out, when Xi spoke at the 5th Plenary Session of the 18th Party Congress where they announced the summary of the five-year plan proposal. This was the first time ever that the head of the Communist Party gave that summary. Every other time, it was the premier who did it. So, this is Xi's plan, not Li's plan. From October 2015, they continually revised the plan to fit what Xi wanted. The earliest draft was finished in August 2015. Then Xi wanted his five themes put in it. In January 2016, China's economy went in a tailspin, and an addition of a new chapter was inserted during Chinese New Year on supply-side reform, an idea which had not come up in the previous two years and which was not in the proposal in October 2015, but an idea that one of Xi's economic advisors came up with. All of this was put in when everyone was supposed to be on holiday visiting their families. There were over 20 drafts of the plan. Eight of them were written from February 2016 and on, over a four-week period.

There is a lot of difficulty in implementing the plan because one of the core elements is not only increasing the supply of advanced technologies and innovating but also reducing capacity in those areas where China has grown too much, having too much supply to meet demand. Because of the financial circumstances in the beginning of the year, China pushed a lot of money into the economy that was supposed to be used for productive purposes but was used for propping up SOEs and supporting useless companies. The process is less about rebalancing state and market and more about consolidating Jinping's political position.

### Implications

If China follows the approach in this plan, what we will see is an economy where they try to rebalance the relationship between state and market. This leads to a lot of growth but also a lot of volatility. I think China will grow relatively fast, but it will be up-and-down, uneven growth. If it succeeds in many of the areas it invests in, it will become an inefficient technology power.

What does that mean for everyone else? It will put a lot of pressure on multinational companies that do business with China. Some of them will be able to benefit from all of the money that China is putting toward technologies, where these companies have something that the Chinese want. One example would be Cummins Inc., which makes large engines. It has technology, which the Chinese will never have, to make large earthmoving equipment used in mines and construction. China will continue to expand infrastructure, so Cummins will benefit from that tremendously, having good relationships with SOEs.

There are others who are targets of investment and acquisitions for China that will be in an increasingly difficult position. For companies in information and communications technology (ICT) and semiconductors, their days are numbered. China is going to spend a lot to acquire these technologies.

What does that mean for business models? Global business models could be put under a lot of stress. Acer Inc.'s founder came up with the idea of the smile curve. The idea was that Acer, at the time, spent too much time assembling other people's technologies and that if it wanted to be successful, it needed to design and brand technologies and that would yield more value added per unit. That's the story of Taiwan as well. It's also the story China wants to replicate. In an efficient economy, there is a smile curve. But if a lot of money is wasted on research and development (R&D) and investment and branding is not done well, the smile becomes a frown. China could then end up getting a lot of market share, but that won't make it into a more efficient economy and will put all of the adjustment costs not on China but on everyone else.

Economies and companies without the loose budget constraints of China are in for a wild ride. As an example, China's huge steel industry had the power to drop global steel prices significantly, causing troubles between itself and the United States. It could do the same for semiconductors and other technologies if it applies the same type of governance and investment approach.

### Q&A

Q1. Xi Jinping and Li Keqiang are not very eager for SOE reform. You mentioned that despite that policy, the economy will grow fast though with some ups and downs. Do you envision any sort of scenario of collapse? Second, you say that with Xi in power, China will continue this approach, but if someone else takes his position, can China move in another direction?

Scott KENNEDY
Optimists about China think the country is reforming or that China is doing a very good job of continuing market intervention. The pessimists are worried about the gravity of debt bringing the country down. They believe investment has slowed because of growing debt. China now has debt of about 250%-300% to the gross domestic debt (GDP). People can vote with their money, taking it out of China, which can cause a crisis. Reinsertion of capital controls can stop this, however. Real estate or investment losses could damage the financial system. I think collapse is unlikely. I think China is just making a lot of mistakes, and that will cost it in terms of growth, but it will not lead toward collapse. This can be avoided.

How could things possibly change in China? There might be a new leader, but that is far in the future. Some people think Xi has a secret plan to first consolidate his position, and then, with political control and no opponents, go for liberal reform, though it doesn't look like that's what he is doing to me. It appears that he is not receiving liberal advice from his advisors. Through a crisis, it might change, but I don't see a crisis coming. Foreign pressure would require the United States to reorganize itself, and I am not holding out a lot of hope for the chances of the United States coming up with a strategic approach to China, passing the Trans-Pacific Partnership (TPP) and other things that would create leverage against China.

The only possibility for change I can see is if the rest of China doesn't pay attention to Xi, that is, if local governments and businesses in China do business according to what they think makes sense and only superficially follow the plan. Under Xi, it is harder for people to only genuflect toward Beijing's preferences, so I am not putting a lot of hope on that. As well, Xi will have a lot to say about who any new leader would be.

Q2. I noticed you didn't say the word "military" in your speech. Is it excluded from the plan?

Scott KENNEDY
There is discussion of the military in various senses. There is a chapter on civilian-military economic cooperation, for example. I didn't put a lot of emphasis on that in my talk. To some extent, it is part of their idea of how to make the economy more efficient, but it is also about military budgets and its desire to become much more influential internationally. My talk was focusing primarily on the economic trajectory, so I thought of this as something of a sideline element.

Q3. You mentioned that the Chinese leaders are making mistakes. Are they learning from these mistakes, and the right lessons?

Scott KENNEDY
Chinese economic policy has a history of two steps forward and one step back. They usually run into a wall, something goes wrong, and they learn from that and change direction. Under Xi, there is a lot less learning, for a few reasons. The first is that he centralized power, from local governments to central government and then from that to the party, largely in his own hands and his leading small groups. Therefore, he has put a lot on his plate and has limited time, limiting how strategic he can be and how broadly he can think. People outside the central circle don't have a lot of information. In addition, the anti-corruption campaign, which is also functioning as a purge, has scared everybody. No one wants to give him bad news, and they don't want to take risks. So, he doesn't hear all of the bad news. The channels of learning are not what they used to be. The chances of a mistake becoming a bigger mistake instead of being corrected are that much greater. Finally, it does not appear that he is committed to markets but instead is comfortable with extensive government intervention in the economy.

Q4. What is the reason for the inefficient Chinese way in terms of TFP? Also, the Nikkei Journal mentioned a divide in the policy line between Xi Jinping and Li Keqiang. What are the economic rationales to the two sides?

Scott KENNEDY
On the inefficiency, the largest component of growth is capital input—spending more money. China spends more money but doesn't get the right proportion back. SOEs are only one-third as efficient as private companies yet they get two-thirds of the credit. Chinese workers still only have about one-seventh of the efficiency of American workers. Most growth in China comes through capital. Interestingly, one of the solutions that people talk about, reforming SOEs, is not really a labor problem, especially compared to in the past. Capital, debt, and the inefficiency of the financial system are the problems.

Xi and Li are of similar minds, but they just don't get along. Neither is committed to the markets. Xi talks about structural reform, and Li talks more about stimulus, but they really are not inconsistent with each other. None of the major economic policies over the past several years has been implemented without Xi's approval.

Q5. You mentioned regional integration as one of the five parts of the plan. The one-child policy was terminated recently. Could there be a negative effect on the economy from that?

Scott KENNEDY
There are two things to pay attention to: reform of the household registration system and policies related to how many children families can have. This is for productivity and demographic solutions. I am not really impressed by either of the reforms. The household registration system is being liberalized very gradually. The system should have just been eliminated or scheduled for elimination in 2-3 steps. Family planning policy went from one child to two children. You are allowed to have two children, but you can't have three or four. Is there any reason for this? I believe it's because half a million people in China have had jobs regulating how many children each person has. All of the social science evidence shows across countries that once a country urbanizes and women become educated, families have a lot less children. There is no possible way China would experience a massive jump in population if it eliminates family planning altogether.

Q6. How do you see the U.S. trade policy reacting to China? Also, from a technology point of view, what are you seeing regarding Chinese technologies related to the environment? Will that be a success for it in the future?

Scott KENNEDY
In Washington, the view on China is rather somber and negative. The sense of the relationship inevitably sliding into a rivalry seems to dominate. No one in Washington is making the argument that it needs to protect the positive sides of the relationship at all costs. The business community has basically become silent. It would like the United States not to become too protectionist itself, but it doesn't want to say that too loudly in Washington. It wants the same for China, but it doesn't want to lose business there. Regardless of who becomes the next U.S. president, both candidates would lean toward putting more pressure on China. The most commonly mentioned word in the past few months in Washington has been "reciprocity." If China doesn't give to the United States, the United States won't give to China. That's the general trend, and it will take smart and courageous minds to come up with an alternative to this.

There are some technologies where the Chinese have been quite successful including solar and high-speed train technologies. Most Chinese investments in high tech have not borne a lot of fruit. The World Bank data on trade in intellectual property (IP) licensing show the Chinese annually getting a little over $1 billion in licensing fees from others, but pay over$30 billion in licensing fees.

*This summary was compiled by RIETI Editorial staff.