How should we deal with China’s industrial policy?

China is supporting its local industry with the help of huge subsidies and an industrial policy targeting 21^st century high-tech applications. The reaction of the US and Europe has been a barrage of policy measures to prevent Chinese companies from gaining market share. Yet, if you ask me, only one thing really works…

As part of its Whole Nation Strategy (the successor of Made in China 2025) China provides massive subsidies to domestic companies like BYD (electric cars), CATL (batteries), or SMIC (semiconductors). It is difficult to measure how much exactly is provided in subsidies, grants, below market rate lines of credit and other policy measures but the most common estimate puts China’s government support of local industry at roughly three times the volume of what we see in Europe, and Asia.

Estimated government support for businesses as share of GDP

Source: DiPippo et al. (2022)

Whenever China decides in one of its five-year plans to support a specific industry, the impact is felt around the globe. The chart below shows an analysis of the impact of Chinese industrial policy on US businesses in the targeted industries. On average, in the four years after China starts supporting a specific industry with a five-year plan, employment in the same industry in the US drops by 10-15%, investments drop by c. 10%, and bankruptcies in the industry rise by about 2%.

Impact of China targeting specific industries on US competitors

Source: Cen et al. (2024).

The West has reacted to this unfair competition by Chinese firms in a variety of ways:

• Tariffs: Under President Donald Trump and Joe Biden, the US have introduced significant tariffs on Chinese goods imported to the US. The EU has done similar things or is investigating potential tariffs albeit to a lesser extent. The problem is just that tariffs can be circumvented by exporting goods to third parties like Mexico that are part of a free trade zone with the US and then exporting these goods with minimal changes as ‘Made in Mexico’ to the US without incurring any tariffs. This is exactly what China has done to circumvent US tariffs. And where tariffs cannot be circumvented, all they did was raise prices for end consumers and reduce economic activity.

• Trade restrictions: Under President Joe Biden, the sale of high-tech components to manufacture semiconductors has been restricted. Yet, thanks to some simple tricks, it took China only 11 months to get the technology that they were supposed to be blocked from for ten years.

• Industrial policy: The Inflation Reduction Act in the US, just like the EU Green Deal are industrial policies enacted in the West to support local businesses in their efforts to develop capabilities in the technologies needed for the energy transition. This is fighting with fire because it essentially levels the playing field by providing similar support to Western businesses that Chinese businesses get from their government.

In my view, enacting industrial policies of our own is the only reasonable way forward to deal with Chinese competition. Tariffs and trade barriers don’t work as the links above show.

Yet, many business leaders demand protectionist measures from their government to secure jobs at home and oppose government industrial policy as socialism and ‘the government picking winners’.

Yet, the study on the impact of Chinese industrial policy on US businesses cited above shows one thing very clearly: While on average, US businesses suffer from Chinese competition, a subset of companies thrive and manage to defend their market share. These are companies that react flexibly and nimbly to the rising competition. They either move into niches or upstream and downstream applications that complement Chinese products, or they change manufacturing processes (including offshoring) to compete with Chinese manufacturers on price and quality.

And if you ask me, this is what we should do. Instead of closing our markets to protect us from the evil Chinese, we should keep our markets open to foster competition but level the playing field by providing industrial policies that support local businesses just the way the Chinese support their companies. Markets work best when businesses are allowed to compete with each other and the best businesses with the best products can win. Tariffs and trade barriers undermine competition and allow inefficient businesses to survive unnecessarily. So let’s help our most agile businesses who are best able to innovate to compete with China. I am sure we are able to outcompete Chinese businesses if we give our businesses the same level of support China does theirs. But if our businesses are too stupid, lazy or incompetent to innovate and compete with foreign competitors, I think we should let these companies decline. There is no universal right to life in the business world.

Case in point: The traditional car industry (in particular the German car manufacturers). For many years they were embracing government targets to stop selling internal combustion engine cars by 2035. Now, cost pressures are rising, and consumers are buying fewer electric cars because of their costs. Meanwhile, Chinese manufacturers are producing good quality electric cars at cheaper prices and gain market share.

So, what do the car manufacturers do? They want to invest less in the development of electric cars and continue to produce internal combustion engine cars for longer. Plus, they ask for import tariffs on Chinese electric cars, so they don’t lose market share to them.

As someone who owns a Chinese-built electric car, I can tell you that the reason why Chinese electric cars are gaining market share is because they are better than anything the Germans have on offer. German car manufacturers are about three to five years behind the Chinese or Tesla. Other car manufacturers like Ford, Stellantis, or GM are even further behind.

For years, established car manufacturers have laughed at electric car makers and missed a global revolution. They have laughed at Chinese car makers and missed the fact that these upstarts have caught up and in some areas overtaken on build quality and technology. Meanwhile, established car makers were happy to sell their cars to China without China imposing any tariffs.

Now the same legacy car makers push their governments to protect them from technologically superior competitors. And instead of investing more into electric car technology to close the technology gap, they want to sell more internal combustion engine cars to keep cash coming in and keep their shareholders happy.

Why are politicians and business leaders not praising free markets in this case? Ah, because these business leaders realise that they have run car manufacturers into the ground by not investing enough in the future. And now they want the government to stop the change that is coming. I can tell you one thing. If you want to know how this ends, look at the fate of other uncompetitive businesses that have received government protection to prevent their decline. Names such as US Steel, Bethlehem Steel, GM, British Leyland, Rover, etc. come to mind.