Size matters

Major countries' advantages in economies of scale can be further strengthened by opening-up

From the perspective of global industrial chain development, China is facing both new opportunities and challenges in economies of scale, the innovation economy and economic opening-up.

Innovation is closely linked to opening-up. Over the past few decades, the global innovation framework could be summarized as a "G2" model — developed countries, such as the United States, lead global technological innovation, and innovation outputs are rapidly commercialized in China as it has a huge talent base and an enormous market. The entire world has benefited from such cooperation between China and the US and enjoyed new technologies at low costs.

However, such a model has encountered new challenges, including the latest geopolitical competition. First, situated at the downstream of the global value chain, China is facing technological bottlenecks posed by the supply bans from the US, especially in hi-tech areas. Second, there has been a tendency to decentralize China from global supply chains. In 2000, the world's three major production centers were Germany, the US and Japan, but China rose to become the largest production center for finished goods in 2019. Moreover, since the COVID-19 pandemic outbreak, China's status has not been undermined, but rather strengthened. Fears of overreliance on China for finished products have prompted developed countries, the US in particular, to speed up the decentralization process of production.

Against this backdrop, to achieve higher-standard opening-up and promote innovation-driven economic development, the following measures could be considered.

First, China should continue to open up, especially remaining committed to opening up to the developed world. Opening-up and economic cooperation will eventually bring about win-win outcomes, although geopolitical competition has increased economic costs for international cooperation. Looking ahead, as the two largest economies in the world, China and the US still have the basis for cooperation in areas such as the green transition and public health that matter to the human community with a shared future.

Second, China should make full use of its "new advantages" in economies of scale. The diversified demand of consumers helps to achieve economies of scale by asking for specialization of labor and market exchange of goods and services. This idea first appeared in The Wealth of Nations by Adam Smith — the term "invisible hand "illustrates the division of labor and exchange of goods and services in a free market. This constitutes the foundation for China to fully exert its advantages in economies of scale as a major country in the years to come.

In addition to the more specialized division of labor, a major country can better share the costs of public services among its people. A simple example is that youths in many small-sized economies need to fulfill compulsory military service, but such a problem does not exist in China, because its large population can share the costs of national defense.

The advantage in economies of scale used to be underappreciated, because in the era of globalization small-sized economies can also enjoy economies of scale by participating in the global division of labor. For instance, benefitting from globalization, the Taiwan region of China has a semiconductor industry which accounts for roughly 20 percent of its GDP, which is inconceivable for a closed economy. However, such a development model is facing new challenges as the US demands to relocate part of the advanced semiconductor production capacity from the Taiwan region of China to the US. In the future, it remains to be seen whether small-sized economies can still enjoy economies of scale by participating in global division of labor. Conversely, in the international competition environment, major countries' advantages in economies of scale will be further strengthened by opening-up.

Third, China needs to build a favorable market ecosystem to foster innovation-driven economy and knowledge-based economy, further enhancing its scale effect as a major country. Innovation is to a certain extent a public good, offering more benefits with a larger-scale economy and population. In this sense, major countries are naturally endowed with innovation incentives.

According to the report to the 20th National Congress of the Communist Party of China, Chinese path to modernization is the modernization of a huge population. On one hand, achieving modernization with more than 1.4 billion people is a challenging task. Once China accomplishes the task, the economic aggregate will be gigantic, profoundly changing the global economic, social and political landscapes. On the other hand, a large population also translates into great development potential, innovation capacity and advantages in opening-up. A production center is usually located at a place with the largest population and consumer demand, cashing in on proximity to the large market — the saved cost exceeds transportation cost. Therefore, the economies of scale brought by a large population are critical to the division of labor in the global industrial chain.

With regard to innovation factors, more than 200 million Chinese people have received higher education, followed by India and the US (both less than 100 million). The talent base constitutes an advantage for China to advance innovations. Another advantage lies in the thriving digital economy. The history of human society development shows that the non-rival feature of production factors — from land, productive capital, to science and technology, and data — has become more and more evident. Therefore, from the perspective of innovation economy, the digital economy can magnify economies of scale to the greatest extent.

To promote innovation, the key is to combine economies of scale with a market economy, thus creating a favorable market ecosystem.

First, the digital economy should play a bigger role. The digital economy is a double-edged sword in achieving economies of scale. On the one hand, data are non-rival with the benefits of economies of scale and economies of scope. On the other hand, digital technologies could be exploited by the government to tighten up controls over the economy, especially when geopolitical factors are becoming more and more important nowadays. If so, economic globalization could turn into economic fragmentation. Therefore, the development of the digital economy calls for not only antimonopoly and anti-unfair competition endeavors, but also a better-regulated digital governance system that rises to the challenge of how to fully utilize economies of scale in opening-up and international cooperation. The US, Europe and China each has their own distinctive supervision model, and the entire world is exploring new solutions.

Second, a new development model is needed for the housing sector. The scale effect of land is the least significant. China's housing sector should avoid the old path and strive to build a new development model. On the supply side, the government should increase the supply of government-subsidized housing and promote both housing purchase and renting; on the demand side, the government should correct the distortions in resource allocation caused by over-marketization of the housing sector and impose a property tax.

Last, since finance plays a crucial role in promoting economies of scale and a market economy, it is necessary to constantly improve the financial structure, with a special focus on the banking behaviors under government guarantee. Government guarantee here refers to general guarantee schemes represented by the deposit insurance scheme and lender of last resort setup. To improve the financial structure, a strict separation of financial and commercial activities should be required to prevent the government's guarantee for banks from extending to the real economy, in order to avoid unfair competition. As for the financial industry, separated financial operations can restrain the government's guarantee for banks from getting into the capital market, so as to enhance the role of capital market in facilitating technological innovation.

The author is chief economist of China International Capital Corporation Limited, and dean of CICC Global Institute. The author contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily.