Is China’s industrial policy boosting tech - or hurting productivity?

China's state-led industrial policy, while fostering globally competitive firms like BYD, has failed to deliver significant productivity gains, a key goal of President Xi Jinping. Despite record investment in strategic sectors, overall productivity growth has slowed, particularly in manufacturing, with some estimates suggesting outright declines. Evidence suggests that subsidies often favor politically connected or less productive firms, distorting incentives and hindering broader economic efficiency, as exemplified by the heavily subsidized shipbuilding sector.

Analysis

China's extensive industrial policy, intended to drive innovation and productivity as per President Xi Jinping's objectives, has yielded mixed results. While fostering globally recognized firms like BYD, the strategy has notably failed to achieve its primary goal of a substantial increase in total factor productivity. Data from Capital Economics and IMF estimates indicate a significant slowdown, with overall productivity growth declining from 3.7% in the 2000s to 1.9% in the 2010s, and some models even suggesting a contraction. Manufacturing productivity, a core focus, has reportedly stalled since 2012. The policy's deployment of subsidies, tax breaks, and cheap loans into strategic sectors like electric vehicles and artificial intelligence has faced criticism; for instance, the EV sector, despite deep subsidies throughout the 2010s, saw most firms fail to achieve profitability, and licenses in Shanghai once cost more than the subsidized price of top-selling EVs. This highlights concerns that subsidies often benefit politically connected or less productive firms, distorting market incentives and potentially lowering overall productivity, as evidenced by studies reviewed by the National Bureau of Economic Research. The shipbuilding industry serves as a stark example, receiving ¥550 billion in subsidies over eight years, a sum estimated to be five times greater than the sector's projected profits for this century, despite China now building half the world's ships. Conversely, the success of firms like DeepSeek in AI, which thrived with minimal state support, suggests that China's innovation potential may be better realized with less direct government intervention. Capital Economics posits that China's early pivot to prioritizing innovation, driven more by strategic concerns than economic conditions, coupled with increased state intervention, has weakened overall business dynamism.

Key Decisions for Investors

• Investors should critically assess companies heavily reliant on Chinese state subsidies, scrutinizing their underlying profitability and innovation quality beyond state support, given the evidence of misallocated capital and distorted incentives.
• Consider diversifying exposure within China towards firms demonstrating organic growth and innovation with limited state intervention, as exemplified by entities like DeepSeek, rather than solely focusing on state-backed champions.
• Closely monitor China's total factor productivity metrics and manufacturing productivity data, as sustained weakness could indicate systemic issues with the current state-led growth model, impacting long-term investment returns.
• Be cautious of sectors identified as 'strategic' or 'pillar' industries receiving extensive subsidies, like shipbuilding or certain segments of the EV market, due to potential high fiscal costs, international backlash, and the risk that subsidies may not translate into sustainable profitability or genuine competitive advantage.