Navigating China's Economic Model: A Path to Competitiveness
In 1994, the Communist Party of China made a significant decision that transformed the country’s fiscal federalism. Prior to this, provincial governments held the majority of taxing and spending powers. After the reform, these lower-level governments were required to remit a larger share of tax revenue to Beijing while still maintaining their spending responsibilities.
Around the same time, as China's manufacturing sector experienced a remarkable boom, average households began transitioning into the middle class. However, due to financial repression and unpredictable markets, they needed a safe place to invest their savings. In 1998, China legalized the buying and selling of residential property, creating a perfect match: local governments needed revenue, and households needed assets.
Real estate firms quickly emerged as intermediaries, selling government land. As Mike Bird argues in his book, 'The Land Trap: A New History of the World’s Oldest Asset,' these decisions fueled China’s real estate boom. After 2008, cheap credit further inflated the bubble, which finally burst in 2021–2022.
These events reveal a deeper truth about China’s economic model. While external observers often assume that everything in China is meticulously planned, the reality is a mix of intended and unintended consequences. The decision to monetize land in the 1990s and double down on it in the 2010s was not solely a top-down directive from the CCP elite in Beijing. Instead, it was a complex interplay of various factors.
As commentators increasingly point out, the core issue is China’s political economy model. This model involves financial repression—low deposit rates and wages—and channels this differential to manufacturing industries through incentives, subsidies, and loans. The goal is to prioritize export-led growth while keeping the average household relatively poorer. This model is not static; once an industry reaches saturation, subsidies are redirected to another sector, keeping the cycle in motion.
When China’s real estate bubble burst a few years ago, the central and provincial governments redirected investments towards sectors such as high-speed rail, electric vehicles, solar, battery, pharmaceuticals, and other priorities outlined in the Made in China 2025 plan. By 2020, real estate accounted for an estimated RMB 6-7 trillion in investments, while the industry itself received around RMB 1 trillion. By 2023, the share of investments in these new sectors had risen to about RMB 5 trillion, with the real estate sector receiving less than a trillion.
The scale of China’s industrial policy is staggering, and it is actively leading to deindustrialization in the Global North. The developing world is in an even more precarious position. Given the scale of Chinese manufacturing capacity and industrial policy, the export-led growth model is no longer viable for many countries.
China itself has not escaped the downsides of this investment-heavy economic model. The country is stuck in a profound deflationary cycle, and the problem of involution or 'neijuan' across sectors has become dire. The Politburo and government have had to take a stand against overcapacity, price wars, and a race to the bottom. From solar to electric vehicles to batteries, one sector after another is experiencing involution, marked by growth in revenue and volumes but minimal increases in firm-level profits.
The auto sector, especially electric vehicles, highlights the real political economy problem in China. Through 2025, auto subsidies are estimated to account for 3% of total central government fiscal revenue and equivalent to 7% of aggregate auto sales. The irony is that these subsidies are likely incentivizing involutionary competition among automakers and falling sales prices across the sector.
It is tempting to blame Chinese policymakers for unleashing domestic deflation and making manufacturing uncompetitive for the rest of the world. However, China is now too large a share of the global economy for such simplistic narratives. Chinese policymakers, from CCP Standing Committee members to township officials, cannot envision a world with an alternate developmental model. They fear the risk of mass political chaos if an alternative model fails or takes too long to materialize.
This leaves the rest of the world with a difficult policy choice: either do nothing or raise protective barriers against Chinese imports and embrace some inflation until supply chains reorient. However, there is another option. Assuming the Chinese model is unlikely to change in the foreseeable future, countries should start anticipating which sectors the government subsidies and bank loans are likely to be redirected towards. This is the first step.
The next step is selecting which of these sectors your economy might have the capacity to become competitive in, five years later. For those selected sectors, the government should incentivize R&D, production incentives, and cheap credit, given existing fiscal constraints. Trade protectionism should be used strategically to ensure that necessary capital goods and inputs can be imported at competitive prices.
The second half of the 20th century saw most countries trying to emulate the US, including industrial policy veterans like South Korea and Japan. It is increasingly clear that the first half of this century will require countries to become more like China if they want to meet their citizens' aspirations.
