The One Bargaining Chip China Won't Surrender

(Bloomberg Opinion) -- As trade negotiations rattle on, you can bet the one area where China won't budge is industrial policy. 

The “Made in China 2025” program, a subsidy-driven blueprint to turn the country into a global powerhouse of advanced technologies, has been a point of contention since the trade war began. The Trump administration, and other foreign critics, say government handouts distort the market and throw up hurdles to access. China's sheer size – accounting for about a quarter of the world's manufacturing – means that economies of scale lower costs, which makes factories from Detroit to Dresden less competitive.

At a press conference earlier this year, China's vice minister of industry and information technology defended China's industrial policy and pledged to keep refining it. And while Beijing eventually dropped the “Made in China 2025” slogan, the program persists in all but name – and it isn't going anywhere.  

That's because industrial policies are the bedrock of China's economy, and have been for more than four decades. Its companies have grown up and gotten hooked on investment from the state, tax benefits and cheap capital as Beijing set up industrial bases across the country.

With a global push into new technologies such as artificial intelligence and robotics, subsidies have become even more crucial to competitiveness. On Tuesday, state media said that Beijing is considering a plan to build out more high-tech, specialized industrial clusters in China's provinces. The added value of high-tech manufacturing rose almost 8 percent in China in the first quarter; and investment in technology upgrades for the manufacturing sector increased 17 percent – even faster than industrial investment.

Given the fragile state of China's economy, Beijing is bound to dig in its heels still further – even to its own detriment. Decades of capital misallocation and misuse have put China Inc. in a fix. The return on assets for state and private companies is falling. Marginal returns on capital have dropped and investment isn't as effective as it used to be. Industrial-sector subsides no longer support the cash flows they once did. That makes China even more reliant on its old playbook for boosting growth.

Rather than twisting China's arm on industrial policy writ large, U.S. negotiators might be better served tying conditions to the money from abroad that China so desperately needs. The country still manages to attract huge amounts of long-term capital in the form of foreign direct investment.

There's already been some progress on this front: In March, China passed an overhaul of its foreign-investment laws that, in theory, seeks to equalize domestic companies and their rivals from abroad; protect foreign-investor rights; and ensure equal-market competition. Beijing is working on shortening its “negative list” of restricted foreign investment, and developing a catalog of industries seeking foreign cash. This is where the negotiations should happen – where foreigners want to put in capital and where China needs it.

The U.S. should also consider that the contours of China's industrial policy are changing. As Beijing tries to shore up its fiscal coffers, policy has become more targeted, shifting away from large-scale, indiscriminate handouts. Subsidies are likewise becoming more focused on strategic sectors like consumer goods and high-tech manufacturing, rather than steel and aluminum, as China prioritizes domestic consumers over foreign ones. As productivity wanes, China needs to move up the value chain.

China's other trading partners are starting to recognize the benefits of the country's approach. In France and Germany, for instance, officials are revisiting the idea of state-led industrial policies as their domestic economies struggle. Even in the U.S., fledgling industries like electric vehicles can't evolve entirely on their own without government support. It's China's scale that gets people nervous, and makes the prospect of its future competitiveness in key industries very real.

Since then, the State Council's arms have put out various research papers and policies reiterating their intention to focus on high-quality development and hi-tech manufacturing.

To contact the editor responsible for this story: Rachel Rosenthal at rrosenthal21@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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