Perspectives - Is China about to leapfrog the West?

Some years ago I read a book by a Western author about China. The hypothesis was that China would fail to move up the value chain to be a major economic power because it has a centrally planned, non-democratic system. The book was popular at the time and no doubt influenced a lot of opinion on China’s future development.

The basic thesis was that Chinese entrepreneurs would not reinvest in China, in intellectual property, because of the lack of legal protections. The West was a safer place for investment with its ‘rule of law’. Chinese wealth would leak out to the West or at least be hoarded in non-productive assets. Economic development would stall.

With the benefit of hindsight you can say it was partially right. There has obviously been a degree of leakage of Chinese wealth into Western capital markets. The bulk of savings have not gone to invest in Chinese companies, they went into an exceptional property bubble. However, China has developed technologically to an exceptional degree.

Many would argue the basis of this development has been on the back of ‘stealing’ the intellectual property of Western companies. Again, this is partially true, a lot of IP has, no doubt, been stolen. However, all new technology develops on the back of past advances. Unfortunately for the West, in many key areas, China is now leapfrogging Western companies.

To some degree sanctions have encouraged domestic investment, particularly in semiconductors. A more important feature is the nature of the Chinese economic model. China tends to identify key industries and encourages banks to fund those industries, creating a large number of competing regional players. This leads to aggressive competition in both innovation and pricing, until a field is eventually thinned out. This is not dissimilar to Japan’s earlier growth model.

Compared to the West, where key industries are now dominated by a small number of players, competition in China, and Asia generally, is intense. This may be what is driving such rapid growth and innovation. The huge margins and cash flows of the Western monopolists can be used to buy or drive out competitors, however the sheer dominance of the Western tech monopolists may ultimately be their downfall. Combined with their cosy relationships with the US government, they may be becoming complacent. At least that is what economic theory would suggest.

Some argue that this leads to considerable bad debts, and burdens the Chinese banking sector. This is true, but unlike Western banks, Chinese banks are not subject to the same oversight regime as Western ones. If they choose to ignore bad debts for a period, the state will allow them to do so. As long as they align with state policy.

There continues to be a huge amount of naive and ignorant commentary around China and its economic development model. Much of this comes from the assumption that the Western model must be better as it is capitalist. The evidence would suggest this is not at all true, China is less regulated and has much more competition than most Western economies. Obviously, from a Western point of view we value our freedoms, regulation, welfare and our democratic system. We must, however, also recognise that a desire for these values have moved us far from the free-market capitalist model and that may mean in future we will fall behind economically.

From a market point of view, the perspective is somewhat marred by the risk of retaliation by the US in particular. The tariff and sanctions policy is designed to hinder China’s development in key industries, although it may be having the opposite effect. The worry for Western investors in emerging Chinese winners is that they become uninvestible because of government intervention, such as happened with Russia. This limits the scale of the positions that can be taken.

David Jane

Premier Miton Macro Thematic Multi Asset Team