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1.1 Deglobalization: History Has Not Come to an End

Economics’ greatest contribution to human society is probably its advocacy of free trade. Before Adam Smith published The Wealth of Nations, most people believed that wealth accumulation is equivalent to the possession of gold, and that resource allocation is accomplished by conquering land and colonies with brute force. However, Smith revealed that wealth can be created through labor specialization and trade in free markets, which are defined as markets not controlled by rent seekers such as monarchs, aristocrats, and landlords. Despite some controversies about the results of free trade—such as the contention that there are both winners and losers in free trade, and that protection of emerging industries and innovative sectors is conducive to economic growth—most economists tend to support free trade.

Neoclassical economics, which has been the dominant school of economic thought over the past four decades, has led to government policies that promote market economies and financial liberalization around the world. This has resulted in substantial growth of global trade in both goods and services and cross-border flows of capital, technologies, and information. As technological progress has lowered the cost of transportation and information exchange, the division of labor has become increasingly specialized, and global industry chains have served as a key engine for efficiency enhancement and economic development. Francis Fukuyama, an American political scientist, argued in 1989 that humanity is at “the end of history … that is, the end point of mankind's ideological evolutionFootnote 1”, and that history has evolved towards a single final destination: Some form of liberal democracy and a market economy. Fukuyama believes that market economies would gradually form a unified community of learning and culture since “economic forces … are now encouraging the breakdown of national barriers through the creation of a single, integrated world market”.Footnote 2 In addition, Fukuyama claims that “Within the post-historical world, the chief axis of interaction between states would be economic…”Footnote 3 rather than political.

However, trade protectionism has been on the rise since the global financial crisis in 2008. Moreover, drivers of deglobalization have expanded from economic factors to non-economic ones since the outbreak of COVID-19 and the Russia-Ukraine conflict. While the pandemic had tremendous short-term impacts on supply chains, more and more signs indicate that geopolitics has again become a more fundamental factor behind global resource allocation. Considerations about national security have made it necessary to mitigate the risk of abusing industry chains as a tool for geopolitical rivalry. Therefore, history has not come to an end in the age of deglobalization.

Although COVID-19 has inflicted major impacts on global supply chains, it has also revealed international trade’s contribution to pandemic responses around the world. On the one hand, the production of certain goods in some countries may be negatively affected by pandemic-caused hurdles to imports of intermediate goods. On the other hand, the disrupted domestic supply of such goods could be substituted with imports from other countries less affected by the pandemic at the moment. Although supply chains of many companies have been substantially impacted by the pandemic at the micro level, global industry chains have remained resilient during the pandemic from a macro perspective. For example, China’s exports have played a key role in fulfilling demand in other countries. In fact, China’s share of international trade in GDP has increased since the outbreak of COVID-19.

Geopolitical rivalry has more profound and far-reaching effects on the evolution of global industry chains. Moreover, it could be difficult to distinguish between trade protectionism and geopolitical considerations, which complicates matters further. The rise of trade protectionism is partly attributable to the widening wealth gap in developed economies. In the US, left-wing politicians attribute the expanding wealth gap to inequality in income distribution aggravated by liberalism, arguing that globalization benefits only a few wealthy people. In contrast, right-wing politicians emphasize external factors, claiming that Americans have been losing jobs due to illegal immigrants from Mexico and China’s unfair trade practices. The common ground, nevertheless, between left- and right-wing US politicians is geopolitical considerations. Since President Donald Trump stepped up trade frictions, a bipartisan consensus began to emerge between Democrats and Republicans on the need to mitigate the US’s dependence on supplies from China and restrict the export of critical technologies to China.

History doesn't repeat itself, but it often rhymes. The first wave of deglobalization came in the wake of the First World War and the Spanish flu pandemic. The rise of nationalism and trade frictions in the 1920s and 1930s eventually escalated into fascism and the Second World War. Similarly, the current wave of deglobalization has been fueled by the COVID-19 pandemic and the Russia-Ukraine conflict. In this sense, international trade and economic cooperation are conducive to not only enhancing efficiency but also world peace, since a possible alternative to market trading is resource acquisition with brute force. For a long time, economists have treated national security and market analysis as completely separate subjects. However, ongoing changes have made it necessary for economists to reexamine interactions among factor endowment, economic integration, and geopolitics.

1.2 Spatial Economy: The World is Not Flat

The “pin factory” is a well-known example of division of labor described in the first chapter of The Wealth of Nations. “A workman … could scarce(ly), perhaps, with his utmost industry, make one pin in a day”Footnote 4 However, things would change if “the important business of making a pin is … divided into about eighteen distinct operations”.Footnote 5 In fact, the division of labor would significantly enhance efficiency and raise the factory’s output to thousands of pins per worker per day. Starting from consumer goods and followed by an increasing number of intermediate goods, global industry chains came into existence through the expansion of specialization of labor and free trade from a single country to the international community. The spatial structure of an industry chain reflects not only costs incurred due to geographical distances, but also differences in factor endowment, technological progress, and institutional environment. The division of labor in global industry chains brings not only benefits but also implicit risks of instability. A key issue in the development of an industry chain is how to balance the efficiency and security of its spatial structure.

Traditional trade theories stress the effect of factor endowment from a spatial perspective, arguing that a country would gain cost advantages if it enjoys a large endowment of factors that are required in the production of its export goods. Therefore, countries with abundant labor supply would manufacture and export more labor-intensive products, while those with ample capital would manufacture and export more capital-intensive products. International trade is driven by the mutually complementary interactions between these two types of countries. Neoclassical economics, which has been the dominant economic school of thought over the past four decades, went further to assume that corporate entities’ choice of production sites is based on costs of production and transportation. Therefore, capital would flow from developed economies, which offer low returns on capital, to high-return developing economies. This would result in a “catch-up effect”, i.e., growth of low-income economies would outpace that of high-income ones, and international differences in labor and capital returns would diminish. Neoclassical economists believe this will eventually lead to the convergence of economic development in different countries.

Indeed, four decades of globalization have made geographical distance less important. A company or a person now faces competition not just from a single region or country, but from the whole world. In other words, the global market has become a homogeneous playing field. Thomas L. Friedman, an American political commentator and author, describes the “flattening of the world” in his book The World is Flat published in 2005. Friedman states that spatial distance no longer matters and that the formation of a “global village” is the prevailing trend. In a flat world, global networks and interactions would lead to harmonious coexistence, the spatial distance between countries would no longer be regarded as a big issue, and government control on national economy and society would subside.

Nevertheless, the assertion that location differences no longer matter is clearly inconsistent with reality. It is important to note that only a few economies, mainly East Asian ones, successfully caught up with developed economies. Meanwhile, the trade between developed countries often outweighs their trade with low-income countries. One reason for this phenomenon is economies of scale, which require companies to increase the output of a single type of product as much as possible. However, raising the output of one type of product means a decline in the production of other goods due to limited resources. As such, there is a conflict between economies of scale and consumers’ preference for variety. This problem can be mitigated through more extensive and more sophisticated division of labor and trade. Even for two countries with the same factor endowments, it is still possible to enhance efficiency through specialized division of labor and international trade. This explains the large amounts of trade among developed economies.

Another factor that interacts with economies of scale is the cost of transportation to cover spatial distances, which pushes producers to move closer to consumers and restricts the concentration of production. However, the concentration of economic activities leads to economies of scale and may benefit businesses if economies of scale outweigh transportation costs. Taking into account both transportation costs and economies of scale, it is most advantageous to develop industrial clusters in markets with abundant demand. In the early stages of China’s reform and opening-up, the development of the country’s manufacturing industries benefited from cheap labor. Although China’s labor costs increased along with economic development and income growth, the country’s status in global industry chains continued to improve thanks to its enormous market with abundant final demand.

The combination of the factors discussed above (i.e., economies of scale, diversity in consumption, transportation costs, and other distance-related costs) means that the spatial distribution of industry chains is imbalanced and that the world is not flat. We need to reexamine and recognize the importance of location. We should take into account not only economic factors (e.g., transportation costs), but also noneconomic factors (e.g., politics, society, history, and culture) from broader geographical and spatial perspectives. In addition, we should understand that business clustering shows distinct regional characteristics and disparities as it is affected by a multitude of variables such as transportation costs, economies of scale, politics, social policies, as well as path dependence. This means spatial adjustments of industry chains (i.e., reshoring, nearshoring, and friend-shoring) incur costs, including the cost of equipment relocation, the sunk cost of long-term fixed investment, as well as implicit negative externalities due to reliance on infrastructure and public services. For the aggregate economy, adjustments to industry chain usually mean lower efficiency and higher costs.

Can structural adjustments make industry chains more resilient and secure? From a micro perspective, reducing the spatial coverage and intermediate links of an industry chain can help make it more stable. From a macro perspective, however, reshoring, nearshoring, and friend-shoring are not necessarily contributors to industry chain resilience. Reshoring and nearshoring run the risk of putting all eggs in one basket, while friend-shoring might also be risky since relations between countries are unstable as well. Instead, industry chain resilience at the macro level depends on spatial diversification of supply sources, including diversification across different geographical, political, and cultural environments. The underlying reason is that risk diversification at the macro level is not diversification of sources of supply for a single type of product, but diversification of aggregate supply for the whole economy—no country is likely to produce all the goods that it consumes on its own. Compared with the age of globalization, a decline in efficiency (an increase in costs) is an inevitable consequence of adjustments to industry chains driven by geopolitics and other noneconomic factors. However, can such adjustments make industry chains more secure? The answer is uncertain, but an analogy might help: An increase in defense budgets in all countries would not necessarily improve national security for any of them.

Land is another variable that may substantially affect industry chain development going forward, although its specific effects remain unclear. More precisely, such effects stem from the role of land in climate change responses and green transition. Land provides the space for final absorption of carbon dioxide (e.g., through forest carbon sinks and carbon sequestration), as well as for production of renewable energy (e.g., solar, wind and hydro energy). The use of land (e.g., construction of reservoirs) may help people cope with floods and droughts caused by extreme weather. In addition, land is also involved in the transformation of traditional fossil energy production and related infrastructure. There are economies of scale in the manufacturing of renewable energy equipment, and the shift from fossil fuel to renewable energy may improve energy security for China. However, extensive land occupation in renewable energy utilization leads to diseconomies of scale, while climate change responses may entail substantial changes in land uses and landscapes.

For large countries, land supply does not seem to be a problem. However, it is important to note that land has special features as a factor of production. Land cannot be moved across space or transformed intertemporally, while general productive capital can transform current consumption into future consumption. In addition, land is a natural monopoly. The use of land is often associated with rent seeking, corruption, and diseconomies of scale, which distort resource allocation. For example, housing prices have skyrocketed in a few large cities even though the supply of land by mother nature is by no means in shortage. In the age of industrial economy, the role of land has declined, and neoclassical economists view land as a part of productive capital. In the new era of climate change responses, land has again become an increasingly independent factor of production. As different uses of land are pitted against each other, it remains to be seen how the new role of land affects industry chains. However, our preliminary judgement is that the growing importance of land will drive up costs due to its diseconomies of scale.

1.3 Non-Neutrality of Technology: Balancing Efficiency, Equity, and Security

Technological progress and scientific & technological innovation hold the key to success in endeavors for coping with impacts from geopolitics and climate change (green transition) on industry chains and ensuring both efficiency and security. From a spatial perspective, there are two seemingly opposing forces in scientific & technological innovations: Agglomeration and dispersion. Agglomeration manifests itself in the growth of regional centers, while dispersion is embodied in the rise of global industry chains. Economic activities in large cities show effects of agglomeration: The concentration of factors of production leads to economies of scale and scope. In particular, interpersonal interactions facilitate the emergence and spread of new ideas and technologies. On the other hand, technology shortens distance and supports spatial distribution in specialized division of labor. The rise of global industry chains results from technological progress and, in turn, fosters innovation.

Over the past 30 years, China and the US have played pivotal roles in global industry chain development and scientific & technological innovation, which can be summarized as a “G-2 model”: The US has leveraged its superior strength in invention and innovation to lead the development of critical technologies, while China has taken advantage of its enormous market and production scale to rapidly expand technology commercialization and reduce costs. This has enhanced the global supply capacity and benefited consumers around the world. In addition, China has managed to shorten its distance to technological frontiers by participating in international competition and learning in both upstream and downstream sectors of industry chains. Meanwhile, profits from the Chinese market have helped US companies strengthen their innovation capabilities and maintain their leading status. Other countries also improved their economic efficiency through participation in the division of labor along industry chains. Some small economies have focused on a few niche areas to become major producers of certain products around the world.

However, the G-2 model for innovation is confronted with challenges as international technological cooperation and competition face increasingly strong impacts from geopolitics. The US government makes increasing use of its executive power to implement industrial policies. For example, the US Department of Commerce issued an “Entity List”Footnote 6 to restrict imports and/or exports. Moreover, the US government recently imposed new restrictions on exports of advanced semiconductors and related equipment, which are unprecedentedly extensive and stringent. Thus, the external environment for China’s technological hardware sectors, especially semiconductors, has changed fundamentally. Under these new geopolitical circumstances, indigenous innovation is increasingly important.

An important feature of knowledge is its non-rivalrous nature, which means the use of knowledge by one individual does not affect the use by others. Therefore, scientific & technological innovation has positive externalities and characteristics of a public good. As a result, the private sector’s investment in innovation is often insufficient. In addition, the innovation process (from initial input to final delivery) can often be lengthy, non-linear, and highly uncertain. While private institutions lack the patience and the ability to take the risk of failure, the public sector may make up for the private sector’s inadequacies in the two aspects discussed above. Specifically, the government may play two roles: (1) Direct participation in innovation such as investing in R&D and education; and (2) using policy issuance and mechanism designs to create a market environment that provides incentives for innovation by private institutions.

Technology is generally believed to be neutral, i.e., neither good nor evil in itself. However, some technologies in certain key areas may be linked with political orientations as geopolitical competition intensifies. The non-neutrality of technology could also manifest itself in other areas such as social equity. Technological progress can change cost differences that result from factor endowments. When rapidly falling costs of robots make it possible for them to replace human workers, manufacturing industries may return to developed countries. Thus, developed and developing countries may manufacture the same type of product, with developed countries leveraging their abundant capital and developing countries taking advantage of their ample labor supply. Thus, the necessity of international trade would decline. While replacing human workers with machines could improve resilience in supply for developed countries, it could leave some workers at a greater disadvantage and aggravate income distribution problems among workers.

The non-neutrality of technology should also be properly handled in the development of the digital economy as some digital technologies have inherent value orientations. For example, the inventor of Bitcoin said in an email in 2008 that “(Bitcoin) is very attractive to the libertarian viewpoint…”.Footnote 7 The underlying reason is that Bitcoin has the potential to become a currency that is free from government intervention and does not require authentication by a centralized and “trusted third party”,Footnote 8 while encryption represents bottom-up decision-making by a multitude of individuals and computers. In contrast, artificial intelligence may help strengthen centralization as it enhances the efficiency of centralized machines that make decisions in a top-down manner. In Web 3.0, developers and users can not only interact with platforms, but also participate in platform development and governance. Compared with the modern market economy, Web 3.0 bears a closer resemblance to a community that owns means of production, distribution, and exchange.

While it remains to be seen which type of technology will dominate in the future, initial signs clearly indicate the importance of digital governance. Among major economies, the US adopts a more liberal approach to digital governance, the EU places greater emphasis on regulation, while China’s methodologies are somewhere in between. As digitization has accelerated markedly since the COVID-19 outbreak, digital regulation has strengthened in various countries. Digital technologies are a double-edged sword. On the one hand, they facilitate further division of labor and development of global industry chains, which creates economies of scale. On the other hand, they enhance governments’ abilities to control and regulate economic and social activities. As the importance of geopolitics grows and national security or data sovereignty become increasingly significant issues, digital regulation and governance could exacerbate the fragmentation of the global economy. Thus, the concept of “country” could be strengthened rather than weakened in the digital era, in our view.

1.4 Economies of Scale: China’s New Advantage

As discussed above, the development of international trade and global industry chains is given a boost from the combination of consumer diversity (which requires a large enough population size) and economies of scale on the production side. How are we to understand the role of economies of scale and its effect on industry chains under deglobalization trends? Economies of scale are defined as increasing returns to scale. Simply put, this means outputs are more than doubled when inputs double. The increase in production scale raises production efficiency and lowers the unit cost of products. On the one hand, the division of labor and equipment enhances labor productivity. On the other hand, a sizeable market means there is sufficient demand to help dilute fixed costs and attract investors and entrepreneurs.

By participating in global market competition, China has benefited from economies of scale in global markets and recorded strong economic growth over the past 30 years. As for smaller economies, they may in fact gain more from participation in global division of labor and cooperation. In the era of globalization, the total size of international markets for an individual company can be much larger than that of its home market. Therefore, a small economy can benefit from economies of scale by focusing on and expanding a certain industry. For example, semiconductor output accounts for around 15% of GDP in China’s Taiwan region. It is inconceivable that a closed economy, without globalization, would devote one-third of its resources to a single industry instead of developing different industries. In the era of globalization and free trade after the Second World War, many small economies benefited from global economies of scale and grew rapidly into wealthy economies.

A higher degree of economic integration means a country’s economic growth is less affected by its geographical size. This may explain why mainstream macroeconomic analysis in the past few decades did not pay much attention to the size of countries defined in traditional political terms. In the deglobalization era, free trade and other economic factors become less important, while noneconomic factors such as politics, culture, and history have become more significant. Thus, there is a decline in potential economies of scale that a country can enjoy by participating in division of labor along global industry chains. While this is detrimental to all countries, small economies may suffer more losses. Deglobalization has reinforced the geopolitical concept of “country”, and the economy and population size of a country have become more important than before.

In the age of knowledge economy, countries with large populations have abundant human capital and can support substantial investment in R&D. With more human resources for innovation, these countries can make faster technological progress. Moreover, technological progress has a strong spillover effect, which means all industries can adopt a new technology as soon as it is born. Large countries can take greater advantage of the effect as their enormous markets mean they would have greater potential to achieve increasing returns to scale. Another advantage for large countries is that they have more people to share the costs of public goods. Low per capita costs mean that everyone has access to better public services, including infrastructure, public health, and education. In addition, large countries are better able to protect themselves and hence are more secure, while small countries may have to spend more resources on national defense, which crowds out expenditures on other public services. Moreover, different regions in a large country may help each other (e.g., via fiscal transfer payments) and are better able to cope with shocks from natural disasters or other calamities.

Deglobalization not only elevates the importance of geopolitics and national security, but also exacerbates frictions among different countries in international markets. Therefore, countries need to further leverage the original economies of scale in their domestic markets to participate in international competition. Abundant demand in large domestic markets help large countries gain an upper hand in international industrial competition. Serving global markets, in turn, expands these countries’ original economies of scale. Moreover, tighter integration among different parts of industry chains in large countries may help these countries dominate more industry chains. Compared with small economies, large countries’ ability to influence global industry chains and the economic landscape may actually increase in the era of deglobalization.

The Report to the 20th CPC National Congress states that: “We will leverage the strengths of China’s enormous market, attract global resources and production factors with our strong domestic economy, and amplify the interplay between domestic and international markets and resources.”Footnote 9 China is the world’s second largest economy and one of the most populous countries in the world, and its labor force is as large as that of India, the US, and Indonesia combined. Therefore, it has the potential to take advantage of economies of scale, which will likely become a new growth engine for its economy going forward. However, large countries are not necessarily able to achieve economies of scale. To ensure economies of scale, competition in market economy and a consumption-led development model are essential. The Soviet Union failed to take advantage of its large population as the country’s planned economy was unable to match production with consumption and lacked market competition to facilitate division of labor and trade. As a result, the former Soviet Union fell behind in its competition against the US.

To foster market competition under the trend of deglobalization, China needs to mitigate fragmentation of domestic markets and tackle new challenges posed by the shift to non-tradable sectors and the development of the digital economy. In domestic markets, measures to ensure fair access to public services and narrow the income distribution gap can help boost consumer demand and enlarge domestic consumer markets. In non-tradable sectors, it is important to note that land is a major factor that distorts resource allocation and widens the income gap due to its inherent diseconomies of scale and strong ability to capture benefits of development from other sectors. Over the past two decades, expansion of exports and the real estate sector have been important features of China’s economic development. While both exports and real estate can boost short-term demand, their effects on efficiency are quite different. Export sectors compete in global markets and help enhance efficiency, but real estate undermines efficiency of the whole economy due to its natural connections to monopoly and rent-seeking behaviors.

Challenges posed by the development of digital economy include balancing economies of scale with anti-monopoly actions, privacy protection, cross-border digital governance cooperation, and other issues in relations of production. Monopoly prevention calls for measures to foster external economies of scale, cluster effects, and upstream–downstream connections rather than unlimited encouragement for scale expansion of a company. In fact, large production scale is no longer a must for efficiency enhancement since companies can now achieve this with automation and numerical control technologies, which may also help them meet diverse consumer demand more swiftly. Thus, the development of the digital economy has exhibited signs of a decline in internal economies of scale and an increase in external economies of scale. Policies for digital industries face challenges in two areas: (1) Privacy protection and the fight against unfair competition; and (2) prevention of the integration between financial and non-financial businesses in platform companies. As the financial business is license-based and receives credit guarantees from the government, the integration between financial and non-financial businesses may solidify platform companies’ monopoly and distort resource allocation.

1.5 Return of Industrial Policy: New Wine in an Old Bottle

The International Monetary Fund (IMF) published in 2019 a working paper titled The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy, which talks about governments’ renewed emphasis on industrial policy. Why was industrial policy referred to as “the policy that shall not be named”? Over the past four decades, economic policies followed guidelines elaborated in the Washington Consensus, which emphasized trade liberalization, privatization, and deregulation (i.e., “big market, small government”). Against such a backdrop, industrial policy became highly controversial and was even “tainted with bad reputation”.Footnote 10 In the past two years, however, governments’ roles in social and economic activities have expanded substantially due to responses to COVID-19. In addition, governments of various countries have issued an increasing number of special policies targeting certain industries amid the rise of protectionism and geopolitical forces. The return of industrial policy has become a consensus and is bound to have a major impact on the development of the global industry chain.

In market economies, industrial policy can guide resource allocation at different levels. Historically, various countries adopted a wide variety of industrial policies, some of which were successful, while others failed. After the Second World War, the world saw a decline in trade protectionism, notably the removal or reduction of tariffs and non-tariff barriers. However, Japan and South Korea adopted an alternative form of protectionism—restrictions on foreign direct investment (FDI). Meanwhile, European countries and Japan attached importance to state-owned enterprises (SOE) for some time. In fact, the governments of France and Japan formulated development programs similar to China’s Five-Year Plans (FYP). Some European countries provided support for the development of small- and medium-sized enterprises (SME) via public banks, while Latin American countries adopted import substitution policies in the 1970s. The US government provided strong support for R&D, and its national defense budget was a major source of R&D spending. particularly during the Cold War. In view of outcomes over the following decades, such government support for R&D was arguably the strongest industrial policy in the world.

How are we to understand industrial policy’s functions under new circumstances? Three dimensions merit attention: (1) Protectionism to bolster domestic employment and income: From the perspective of developed countries, a popular view is that globalization has eroded employment in high-income industries such as manufacturing. In the past, the main solution adopted for this issue was to remedy it with social policies such as improvements to education, training, and social security. Nowadays, greater attention is being paid to policies targeting specific industries to change their competitive landscapes. (2) Policies addressing externalities and market failures: Policies in two areas warrant special attention: Government investment and supportive measures to foster scientific & technological innovation, and policies to facilitate carbon emissions reduction and green transition. (3) Geopolitical rivalry: Technological competition is a key aspect of this issue. The three dimensions discussed above are entangled with each other. For example, geopolitics is often connected with protectionism. Therefore, industrial policies exhibit a distinct external orientation and have direct or indirect links with international trade and investment.

In developed countries, notably the US, government policies for scientific & technological innovation have recently exhibited three noteworthy features: (1) In-depth government participation via increased R&D budgets and subsidies for the manufacturing of certain high-tech products. (2) Exploration of various funding models to support R&D and innovation. Industrial policies are often integrated with incentives to motivate risk-taking by private enterprises. The US government’s policies for some research areas are similar to the resource mobilization amid the space race against the Soviet Union during the Cold War. (3) Government measures to help the country benefit more from innovation and technological progress, including restrictions on the export of advanced technologies and encouragement for domestic production. For example, the US has not only restricted the export of semiconductor technologies but also provided subsidies for the reshoring of chip production back to the US. The US’s industrial policies are clearly extending from upstream R&D expenditures to specific midstream and downstream industries.

Confronted with restrictions and competition from the US, China has attached greater importance to scientific & technological innovation. According to the Report to the 20th CPC National Congress, “innovation will remain at the heart of China's modernization drive”.Footnote 11 The report stresses that China will “improve the new system for mobilizing resources nationwide”, boost its “strength in strategic science and technology”, and “deepen the structural scientific and technological reform” to create “an open and globally-competitive innovation ecosystem”.Footnote 12 As the world’s largest and second largest economies, the US and China are both expanding their industrial policies from familiar areas (innovation and R&D for the US, manufacturing for China) to less familiar realms. Meanwhile, the world’s major economies have set clear timetables for reaching peak carbon emissions and carbon neutrality. Correcting the global externality of carbon emissions not only requires scientific & technological innovation but also involves transformation of traditional industries. Measures addressing these issues may be the most important industrial policy over the next few decades. More and more signs show that industrial policies in various countries are increasingly systematic and comprehensive.

Apart from tremendous policy attention and increased investment, the key to success lies in the efficiency of policy implementation. Innovation is a special undertaking as it is highly uncertain and requires long-term investment, which calls for a close partnership between public and private sectors. Therefore, policy makers should take into account both incentives and penalties, while innovators and technological staff should be granted excess returns to some extent. For example, they can be allowed to share part of the intellectual property income from government-sponsored projects, in addition to the normal pay for their work. Meanwhile, government-sponsored technological R&D projects should have proper evaluation, tracking, reward, and penalty mechanisms, including conditional subsidies and sunset clauses.

The creation of a sound innovation ecosystem requires support from other policies so as to establish proper incentive and motivation mechanisms for innovation in the whole society. In China, policies in two interconnected areas are the most noteworthy. The first is the correction of distorted resource allocation caused by excessive marketization of the real estate sector. The key to solving this problem is establishing new real estate development models, increasing the supply of low-income housing, encouraging both rental housing and home purchases, and imposing property tax on the demand side. This would result in steady streams of revenue from land replacing proceeds from the sale of land use rights as an important source of income for local governments. The second noteworthy area is the improvement of financial structures, especially the separation of financial business from industrial sectors, and the separation of various financial sub-sectors from each other. The first separation prevents the government’s credit guarantee for commercial banks from extending to industries in the real economy, and the second prevents such guarantee from extending to capital markets. With these improvements, the financial system would better serve the real economy, and capital markets would be more conducive to innovation.

China has entered a new stage of development with five key words in its new development philosophy: “innovation, coordination, greenness, openness, and sharing”. This means the country’s economic development targets not only efficiency but also equity and security. The CICC Research Department and CICC Global Institute have collaborated to issue a whole series of in-depth reports on major topics in the new stage of development, including Digital Economy: The Next Decade, Guidebook to Carbon Neutrality in China, The Rise of China’s Innovation Economy, and Building an Olive-shaped Society (Chinese version). This new report on industry chains is the latest research project in this series, and we hope it will facilitate discussions on relevant topics. Your comments, suggestions, and criticism would be highly appreciated.

PENG Wensheng

Chief Economist

Head of Research Department

Dean of CICC Global Institute

China International Capital Corporation

Beijing, China