Meeting the China Challenge: Responding to China’s Managed Economy

Introduction

China’s rise has been long predicted and is often accompanied by a corresponding prediction of American decline. Ascendency and decline are relative terms, but managing China’s ascent is the fundamental challenge for American foreign policy in this century. Military tensions are dangerous but the greatest test is economic, and will come from China’s industrial policy and its effect on the global economy and American security.

The question for the United States and the world is under what conditions will China exercise its new power? China is now the second-largest economy in the world and continues to grow. A China that observes global norms, including those for business and competition, would be a welcome addition to the international community. This is not, however, the China of today.

Chinese policies are shaped by a degree of pragmatism, by a commitment to preserving party rule and defending Chinese sovereignty, and by underlying expectations of a return to global predominance. The theme of reclaiming China’s rightful place appears frequently in public statements by senior officials, often accompanied by revanchism and strongly nationalist expressions.

Reclaiming this leadership role does not mean the kind of global conquest envisioned by twentieth-century dictators, nor is it the law-based system pursued by the United States, but a world shaped by China’s preferences (and China’s preferences are those of its ruling communist party). A crucial element of China’s strategy is overtaking the United States, as it has overtaken other nations. As part of this, China has a well-financed strategy to create domestic industries intended to displace foreign suppliers, dominate standards-making, and reshape global norms.

China’s nationalism has reinforced a self-confidence and assertion that stems from decades of economic success and from an assumption of the inevitability of China’s rise. Beijing wants to rearrange global rules and institutions to better serve China’s interests. China endorses the rule of law, but with Chinese characteristics, which means that the Party is the ultimate arbiter of any decision. For the United States and other nations, the problem for security and foreign policy is how best to engage with China’s leaders to reshape China’s policies.

A New Kind of Contest

The goal is not to devise ways to block China’s growth or impose some kind of Kennan-esque containment. China and the West are too deeply integrated economically for this to work. We CSIS | VII are in a contest with China, but it is a new kind of contest, given the interconnectivity of our economies. When China opened its economy after Mao, it was not accompanied by a parallel political opening. China is in the liberal world order but not of it. The issue is how to change China’s nationalist industrial policies to end their disruptive effect on other economies.

This is not a military conflict, but the question of how China interacts with the world has serious implications for American security and for the prospects of an international system based on the rule of law and democratic norms. American laws, policies, and regulations that were adequate in the past, whether for trade, export controls, or foreign investment, must be reconsidered to manage the challenge America faces from China’s managed economy.

The international community first needs to redefine the terms by which a managed economy takes full advantage of trade agreements for itself while denying them to foreign competitors. China is a member of the World Trade Organization (WTO), but is lax in observing the requirements for treating foreign companies, arguing that as a developing economy, China should be granted some latitude in meeting its obligations. This may have made sense a decade ago, but it is no longer acceptable, but there is no reason for the Chinese to change absent external pressure.

We should note, and many Chinese would agree, that a China with policies more in accord with international practice would better serve its own economic interest, improving productivity and reducing inefficient investments. China’s rulers are not convinced that they should abandon a strategy that has, until recently, worked well and provoked little complaint. A more confident and assertive China will not change course without external pressure, and this external pressure will not materialize without U.S. leadership. Even a comprehensive, U.S.-led response to China’s economic policies will face difficulties and it will take years to see change. The alternative, however, is significant harm to Western economies, a point upon which more and more Western governments agree.

Reshaping China’s policy requires U.S. leadership, simply because of America’s size and wealth and the still powerful expectation in other countries that America will maintain international institutions and norms. No other nation is ready to deal with China. The European Union might be able to pick up this burden, but it faces internal conflicts, including from a few member states that have been influenced by Chinese money. Germany, which plays a leading role in the EU, is hampered in taking up a global role by its own political vicissitudes and by trade concerns. No other G-7 or G-20 country has the wherewithal to counter China. Absent U.S. leadership there may not be an effective response to China’s economic encroachments. The choices for other Western nations is to wait for the United States to develop coherent policies, consider their own responses, or reach an accommodation with China. Leading nations are now using a mix of all three. This is not in the U.S. interest.

Many countries have been ambivalent about pushing back on China’s nationalistic economic policies. This reflects the reasonable concerns of their exporters, who fear retribution from China in terms of market access or sales, and there is a considerable record of retaliatory acts the Chinese have used to punish nations that displease them, from canceling purchases from Norway over a Nobel Prize award to restricting tourism to Korea in response to THAAD (Terminal High Altitude Area Defense) deployments. China is not afraid to use its economic VIII | Meeting the China Challenge power and some nations do not believe the United States will support them against such retribution. China is a huge market that countries are reluctant to risk, and while there is growing concern in Europe and Japan about unfair competition from the Chinese state, so far this has mainly resulted in a tension between fear of Chinese retaliation versus a desire for continued market access. This tension and the ambivalence it creates hamper any Western response.

This ambivalence is changing, however. In the United States, there is consensus about the need to take action against China’s industrial policy, using export controls, trade measures, and restrictions on foreign investment. One of the conclusions shared by the essays in this collection is that a purely defensive, nationalist strategy will only slow China’s progress on its current nationalist path, not change it, and there is no consensus on how to rebuild the sinews of American economic power, including the research complex that supports American military strength and economic growth.

Steady pressure can persuade China to accommodate Western concerns, but America must plan on managing complex, interrelated negotiations on trade, finance, and security over a period of years. Any administration would find this to be challenging to design and implement. The United States and its allies still have a strong hand to play, since China’s economy, despite its size, needs access to Western markets and technology. A good first step, one where the United States might be able to persuade Europe and Japan to join us, is jointly to lay a marker on more equitable treatment of foreign and Chinese companies. These essays by CSIS scholars lay out the elements of a comprehensive strategy. Effective pressure for change in Beijing requires a comprehensive response that uses a blend of diplomatic actions, regulatory measures, and domestic investment in public goods. The United States, in using its domestic policy tools and working with its allies, can lay out a path for change for China and use a blend of carrots and sticks to send China along this path.

Scott Kennedy’s essay on the “monumental” challenge of China’s industrial policy and the need for a strategic response from the United States and others lays out in detail the nature of industrial policy under Xi Jinping, noting that these policies have grown in scale and sophistication, as Chinese officials and companies have learned to “game” global economic regimes. They seek to redefine globalization to better serve China’s policy goals and could potentially result in an “entirely uneven playing field.” Kennedy’s assessment is that so far, this industrial policy has worked well enough. Like Stephanie Segal, he argues that China needs to alter these policies, but that the chances of China doing so of its own accord are low. Setting the theme for this collection of essays, he calls this a critical turning point for the United States if we are to avoid damage to national security and economic strength.

Stephanie Segal’s essay “Economic Policies to Meet the China Challenge” highlights both the economic problems China faces that may hamper its continued growth and the investments the United States needs to make to maintain technological leadership. The drivers of China’s economic expansion—an ample supply of cheap labor and massive, state-directed investment— have “largely run their course,” and it is not clear that China is willing to make the reforms needed for continued growth. This is only partial consolation for the United States, where years of underinvest in infrastructure, STEM education, and R&D are beginning to catch up. Segal CSIS | IX makes a compelling argument that one of the best ways the United States can respond to the China challenge is to invest in itself.

Matthew Goodman’s essay “Going on the Offensive” shows how the United States “can still powerfully shape thinking and policy in other countries when it uses smart economic statecraft.” Goodman argues that agreements on trade and investment are a proven counter to the “magnetic pull of China’s growing economic might.” The elements of economic statecraft require a compelling narrative, leveraging U.S. advantages, and working closely with allies and partners to create a persuasive alternative to China’s initiatives and economic clout. Bilaterally, with China, the United States should combine a “judicious use of trade remedies” with a positive agenda to seek improvements in market access and broader economic reform in China.

Scott Miller’s essay “Trade Enforcement: Where Bark Meets Bite” begins by noting that the WTO’s Dispute Settlement Understanding (DSU) may not be adequate to deal with the growing tensions in the U.S.-China relationship. Miller looks at available trade remedies, including the use of Section 301, restrictions on investment (discussed at length in John Schaus’s piece), and, less favorably, unilateral tariffs. Miller notes that China is not Japan, nor is this the trade environment of the 1980s, limiting the value of tools like Section 301. His conclusion is that the United States is better off using the existing WTO dispute settlement system and coordinated actions with like-minded partners to help change China’s behavior, rather than unilateral measures where the United States selectively applies its own international obligations.

Andrew Hunter’s “A U.S. Investment Strategy for Defense” lays out the success of U.S. investment in technology as a key contributor to national security and describes how a revised strategy remains relevant today, if it is tailored to fit the changing nature of global R&D and innovation. Hunter identifies the elements of a defense investment strategy to compete with China: a more flexible and resilient supply chain, partnerships with other nations, recalibrating federal R&D investment to complement the surge in private-sector spending on research, and investing in people to develop technical talent, which he identifies as perhaps the key element of a new R&D strategy.

Samm Sacks writes on how China’s leadership is in the midst of building perhaps the most extensive governance system for cyberspace and information and communications technology (ICT) of any country around the world. A blend of national strategies, laws, regulations, and standards make up China’s vision of becoming a “cyber superpower” by building a robust ICT governance system. While China is not closed to U.S. firms, the costs required to operate in China are increasing, particularly in high-tech sectors, and companies are reassessing the tradeoffs required to be in the market. Calibrating the right response must begin with an accurate view of this complex system. U.S. and Chinese technology development, supply chains, and commercial markets are tightly intertwined in such a way that a sweeping approach will hurt U.S. economic prosperity and our ability to maintain our edge in technology innovation, and Sacks concludes that without a targeted approach, U.S. businesses are likely to become collateral damage in a trade war between the United States and China that benefits neither side.

John Schaus’s essay “Ensuring CFIUS remains a robust protector of National Security” details how Chinese investment has become a central focus for the work of the Committee on Foreign X | Meeting the China Challenge Investment in the United States (CFIUS), how it could be improved, and reviews a number of legislative proposals to strengthen the committee and, perhaps, broaden its scope. CFIUS is an essential tool for dealing with national security risk form Chinese economic activities, and Schaus makes four recommendations: to preserve CFIUS’s sole focus on national security and not add new concerns like employment or food security; to provide CFIUS with the flexibility to respond to evolving security and technology challenges; to enhance CFIUS’s alignment with export control mechanisms; and to ensure that CFIUS is adequately resourced, including funding to ensure monitoring and evaluation of the mitigation agreements that CFIUS often requires before approving a transaction.

There are common themes in each of the essays on the need for investment in infrastructure, research, and STEM education; on the essential requirement for cooperation with allies and partners in using the existing international rules and processes to our advantage, for strengthening that international system. A U.S. effort to get China to follow global norms on technology, trade, and investment is long overdue, but it will not work without moving ahead domestically in growth and innovation.

If there is a temptation to dismiss these recommendations as the usual mainstream internationalist ideas, note that the authors have extensive experience in these areas—more experience, in fact, than many in Washington. It is this experience, usually associated with successful outcomes for the United States, that guides our thinking in identifying a pragmatic set of policies that are more likely to work in changing China’s behavior than policies that are either supine or provoke confrontation for its own sake. Best practices derived from previous U.S. engagements with China provide a useful guide on how to respond to the complexity and sophistication of the China challenge.

A key difference between the two countries may determine the outcome. China’s leaders are willing to invest in research and infrastructure, particularly transportation to win competitive advantage. America’s leaders have not matched them. Strengthening innovation and growth is necessary to retain sufficient influence to compel changes in Chinese behavior. If the Chinese calculate that the United States is in political and economic decline, they may choose to simply outwait any effort to induce change.

A successful strategy requires ways to bring national resources to bear on public problems. America has innate advantages, with a strong scientific base, leading technology companies, and an innovative culture that others find difficult to match. Where we lag is spending on public investments. In the last 15 years, the United States has spent at least $850 billion in Afghanistan. In contrast, China has invested billions of dollars in science and technology in the same period. We consume, whereas China saves and will spend to attain its strategic goal of displacing the United States. Strengthening and revitalizing American technological innovation will require a willingness to invest in growth. Hunter and Segal make especially clear that policies to increase investment research and STEM education are crucial.

For “mature” economies, innovation is the best path for growth, as people find better ways to use existing resources to produce goods and services. If we use traditional metrics—such as the number of patents issued, published research, the percent of national income spent on basic research, the number of graduates with science degrees—the innovation trend-lines for the CSIS | XI United States are flat or in decline. More complex measures would look at income and productivity growth, and data for the United States shows declines in both areas. This suggests that the nation is coasting on the public investments of the Cold War. Changing this will be crucial in determining America’s ability to influence China.

Nor can a response to China recreate a Cold War-style bifurcation between America and China (if only because our allies are unwilling to support this). Our economies are integrated to a degree that was inconceivable for the United States and Soviet Union. This is not a bipolar world when it comes to technology and trade. The interrelations between the U.S. and Chinese economies are complicated (and both are also intertwined with Europe, Israel, and other Asian nations). China still takes more than it gives when it comes to innovation, but its ample capital and supplies of talent can make it an attractive partner for foreign companies.

These essays make clear that the optimal strategy in the current political environment has three elements. The United States should make targeted investments in infrastructure, research and new technology, perhaps linked to defense goals to make spending more palatable to Congress. It should combine these investments with an increased use of regulatory tools, to manage risk from American exports and Chinese investment and acquisition. Finally, it should develop a multilateral and cooperative strategy of engagement with China accompanied by concerted pressure on China to change its behavior. This is a minimalist strategy, but politically achievable.

What this means for Congress and the administration is steady application of existing policy and regulatory tools, including a modernization of CFIUS to close loopholes currently exploited by China and a reenergizing of export controls. The United States will need careful diplomacy to gain allied support and to persuade China to change.

As much as anything, this is a competition over governance. This is not an endorsement of the Chinese model of governance or another iteration of the dictators-more-efficient-thandemocracy argument. As essays by Kennedy and Segal make clear, China is not efficient. There is still widespread corruption and wastefulness. China faces immense problems, but the United States cannot expect to maintain its power vis-à-vis China unless it can resolve its own political disputes over the role of government and the need for public investment.

We do not need to mirror China’s state-directed industrial policies to protect our economy, but neither a laissez-faire approach better suited to the nineteenth century nor the directive and intrusive economic policies often found in Europe are adequate to the economic and technological requirements of this century. Finding a new middle ground between state and market that maximizes America’s strengths may be difficult, given the political constraints we face, but is essential for continued American power and, we believe, for a safer and more prosperous world.

The goal is not to punish China, but to build an equitable partnership. China has its own problems and we have time to strengthen our own economy and the framework of international agreements we want China to observe. The United States will always be one of the most important nations in the world, simply because of the size of its population and territory and its inherited wealth, but this does not mean it will necessarily set the international agenda or XII | Meeting the China Challenge the rules for state behavior. The alternatives are either a world of disorder or a world that operates in the arbitrary way that China’s Communist Party rules China. Neither is desirable, but these outcomes cannot be ruled out unless we change course. The root of the word governance is “to steer” and the fighting over the rudder has left America steering an erratic course in a challenging race.

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Matthew P. Goodman is a senior adviser for Asia and holds the William E. Simon Chair in Political Economy at CSIS.
Andrew P. Hunter is a senior fellow and director of the Defense-Industrial Initiatives Group at CSIS.
Scott Kennedy is deputy director of the Freeman Chair in China Studies at CSIS.
James Andrew Lewis is a senior vice president at CSIS.
Scott Miller is a senior adviser with the Abshire-Inamori Leadership Academy at CSIS.
Samm Sacks is a senior fellow with the Technology Policy Program at CSIS.
John Schaus is a fellow with the International Security Program at CSIS.
Stephanie Segal is a senior fellow and deputy director of the Simon Chair in Political Economy at CSIS.