Notes - China's Road to High Tech Supremacy

June 19, 2025

Arthur Kroeber is the founder of Gavekal Dragonomics, a research consultancy focused on China, and the author of "China’s Economy: What Everyone Needs to Know". The interviewer highly recommends Kroeber's book as "the most valuable and useful resource" he has found on how China works.
The fundamental question regarding China's economic rise is not merely if it becomes as wealthy or economically large as America, but how it achieves this wealth.
A common criticism is that China seeks to get rich by relying on a massive manufacturing export machine, which depends on global buying power and creates an enormous trade surplus. Critics label this model as unfair, unsustainable, and unstable for global economic participation.
The concern is whether China operates under the same rules, allowing others to participate in its market, or if it makes it impossible for other countries to maintain their own production structures, relying solely on ever-growing trade surpluses.
From a pure welfare perspective, China becoming as rich as America would be beneficial. However, this prospect is seen as having "difficult and destabilizing political consequences" due to the significant differences between China's political system and those of the US and other major industrialized nations.
Regarding trade surpluses, it's not definitively clear that they are solely enabled by government involvement in industry. Accounting identities suggest that high savings combined with insufficient domestic investment will naturally lead to a trade surplus.
On paper, China's trade surplus implies that Chinese taxpayers and savers are subsidizing foreign importers, essentially giving foreign economies "a good deal". While some, particularly manufacturers outside China, are upset, it is not "obviously insidious".
A core issue is the "systemic political difference" between the US and China. The US identifies itself as the leader of democracies, a self-identity largely shaped by its victories against fascism and communism in World War II and the Cold War. This history fostered a belief in a world converging towards democratic, market-based systems.
China challenges this narrative as a "successful authoritarian system" that remains communist. US elites have never fully accepted the legitimacy of the Chinese political system, which complicates resolving issues.
Economically, the way China has organized its economy is viewed as a problem. While the rest of the world financially benefits from China's willingness to subsidize low-cost production, leading to cheap goods and improved global welfare, this has had negative political consequences for the US over the last 20 years.
It is crucial for large countries to maintain a diversified production structure and social cohesion. The loss of manufacturing capacity and related employment can cause significant social disruption. The US's "purely financialized economy" in the early 2000s, partly due to its economic arrangement with China, was detrimental to its "social compact".
A legitimate challenge exists in integrating China's growing power, wealth, and industrial might into the global economy in a way that is tolerable for societies worldwide. This is acknowledged as a "legitimately difficult problem".
Many current problems attributed to China are argued to stem from US domestic policy, serving as a scapegoat to deflect from necessary internal decisions on income redistribution and macroeconomic policy.
However, China's substantial share of the global economy (20% and growing) and manufacturing (one-third) necessitates an agreed-upon set of rules for its interaction with the world, ensuring benefits beyond just financial terms. Such an agreement currently does not exist.
The interviewer suggests that the US may have learned a "bad example" from past great power conflicts, assuming that opposing political systems must inevitably collapse. While this was true for Hitler and the Soviet Union (described as "evil regimes"), China is not considered to be in the "same tier as Stalin or Hitler," implying that collapse is not the only viable end state for competition.
The interviewer poses that if a democratic country like Australia were to dominate global production and achieve US-level economic size, similar concerns about trade dislocation might arise, but likely without the adversarial attitude seen towards China.
Low value-added manufacturing, where labor cost is a major factor, moved to China, but if not China, other countries like Vietnam or Bangladesh would have taken that role. For high-tech manufacturing (e.g., advanced semiconductor wafers), labor cost is negligible; the key is a country's production capability.
Arthur Kroeber explicitly states that a "Cold War" is "absolutely not" the correct framework for the conflict with China.
Empirically, Cold War trade and investment with the Soviet Union were minimal (never exceeding 1% of US trade), whereas China at its peak accounted for 17% of US trade (similar to Japan in the late 1980s/early 1990s), a figure that remains substantial even with indirect trade. US corporate investment in China exceeds $600 billion, generating sales far greater than US exports to China. The economic integration between the US and China is "extraordinary" and historically unprecedented, operating at a "completely different order of magnitude" than during the Cold War.
If a "Cold War" approach were taken, it would imply reducing these trade and investment flows to near zero, which would be "a very difficult problem".
The conflict with China will not end with China "going away or turning into something completely different". China is "too big," "too successful," and its economic model is fundamentally successful despite its problems.
China is "deeply integrated with the entire global economy," which benefits China and most other countries, giving "everyone... a stake in China continuing to succeed".
Even if the Chinese Communist Party (CCP) were to disappear, any successful successor government would "almost certainly share many of the characteristics" of the CCP. This includes a strong determination for China to be an independent geopolitical actor with a powerful military for self-defense. Such a government would also remain committed, like all Chinese governments since the mid-19th century, to maximizing technological progress and domestic production for core technology needs.
It is a "fantasy" to believe that the problem is solely with the current regime or that they can be made to change their minds. China's approach is deeply rooted in its institutional, cultural history, and geopolitical position, ensuring that its interests will likely create friction with US interests under any government. China is expected to remain "quite successful at managing this economy".
A Chinese individual suggested to the interviewer that the "median voter in China is much more reactionary than the government," implying a democratic election might produce a "much more liberal" (in the sense of less nationalist/militaristic) regime than the current one. While polling is limited, this perception could be true, as evidenced by the "unfettered nationalist, highly militaristic thinking" present on the Chinese internet that the government largely "spends most of its time keeping in check". The government selectively "unleashes" this sentiment during disputes but mostly attempts to "tamp that down". A Chinese system fully reflective of popular views could be "very, very difficult to deal with".
Regarding a "grand bargain" where China dominates in areas like solar, electric vehicles (EVs), and batteries while the US leads in AI and semiconductors, Kroeber questions its plausibility, noting that many in China desire to dominate all technological sectors. China is "very interested in not being pigeonholed" and views strategies based on arbitrary limits on its capabilities as "not viable," just as the US would.
Arthur Kroeber suggests it would be beneficial for the US to be "much more open to direct investment by Chinese companies in manufacturing in the United States," especially in sectors like EVs, green energy, and industrial automation.
To revitalize its industrial base, the US needs to invite and compete with "the world's leading players," as China did when it industrialized by inviting foreign companies to invest and learning from them. This would be a "win-win" as Chinese companies desire access to the US market, and the US could learn from them. Such high levels of reciprocal direct investment would indicate the relationship is "not a cold war".
The current difficulty in achieving this mutual investment stems from a Washington consensus to prevent not only US technology exports to China but also Chinese companies from investing in the US.
The core reason for this consensus is "data". Modern manufacturing processes are data-generating, raising concerns about data flow and who benefits from it.
Historically, technologies were easily categorized as civilian, military, or dual-use, with only the latter requiring careful control. Today, "basically everything is dual use," meaning any technology can have military applications, making investment patterns riskier, especially concerning how data might feed another country's defense production. This is considered a "legitimate concern".
In an ideal scenario, Chinese investment in the US would be carefully regulated, similar to China's regulation of foreign direct investments (e.g., data localization rules). However, this is seen as "very difficult in the current political environment".
The "China hawk" argument that China "cheated" by benefiting from US companies' investment and technology transfer in China should logically make the reverse—Chinese investment and technology transfer into the US—"incredibly compelling".
China's past strategy to develop its auto industry (early 1990s) involved mandatory 50/50 joint ventures with foreign companies, with the goal of Chinese firms learning and eventually becoming "national champions". This strategy "failed massively" over 25 years; foreign companies thrived, but Chinese partners largely just collected dividends, with all technological and design inputs still coming from foreign partners. Chinese firms were "no closer to having globally competitive conventional car makers" by 2010-2015.
China then adopted a "leapfrogging" strategy (late 2000s/2010s) to focus on the "next stage of technological development" not yet dominated, specifically renewable energy and electric vehicles (EVs).
Comprehensive subsidies and industrial support were given to EV companies like BYD (a private company). While this effort for 10-12 years helped BYD improve its supply chain (especially batteries), BYD was "not that exciting" by 2018-2019, and Chinese consumers preferred conventional cars.
A "catalytic foreign investment" occurred in 2018 when the Chinese government allowed Tesla to build a wholly-owned Gigafactory in Shanghai, an unprecedented move for an automotive company. Tesla cars, produced from 2019, became "immensely popular" and "big status symbols".
This catalytic investment revealed that while Chinese companies had advanced EV technology (batteries, software), they were "terrible at consumer design". Tesla's success pushed BYD and others to "up their design game," leading them to hire German car designers. By 2022, Chinese companies could compete with Tesla on price and quality.
This demonstrates that China's "leapfrogging idea" was a "pretty good bet". Massive subsidies (estimated $200-300 billion for the EV industry) were invested without immediate financial return, but the government "stuck at it". The foreign investment "flipped the switch" by showing Chinese companies how to compete in the consumer market, leading to rapid improvement.
The precise necessity of the full $200-300 billion in subsidies is unclear ("half of it works, but you don't know which half"). Various types of subsidies (producer, buyer) all played a role.
What was crucial was the government's "very clear direction" and its willingness to "keep trying different things until it works" to achieve the goal of creating an EV sector and supply chain.
Despite the common view that central planning doesn't work, China's "strategic emerging industries" list (from 2010) largely comprises "pretty obvious things" like semiconductors, industrial automation, and new materials.
China acts like a "giant VC fund" willing to invest vast sums and absorb losses over extended periods, assuming a few bets will succeed and their successes will cover the failures. This is possible because China as a government can "throw a lot of money at things for a really long time and not care about what returns are".
Reasons why China's industrial policy approach works, differing from traditional central planning:
- Export-driven System: Like Japan, Korea, and Taiwan, China's system heavily emphasizes exporting. Unlike closed systems, export-driven economies must constantly upgrade technology to compete globally, preventing reliance on domestic market rigging or connections. This fosters broad technological upgrading.
- Cutthroat Domestic Competition with International Participation: China's domestic market is highly competitive and involves many international companies. Unlike Japan, which protected its domestic market, China welcomed foreign companies to "spark some technological change". This creates a "crucible" for testing government ideas, allowing successes to be validated and built upon.
- Sheer Scale of Support: China's willingness and ability to support seemingly "losing bets" for prolonged periods is significant. For example, in solar energy, China deliberately built capabilities across the entire supply chain, enduring cycles of unprofitability. This contrasts with the US approach, where a single failure (Solyndra) can lead to the conclusion that industrial policy doesn't work. China's approach acknowledges that failures and government money loss are necessary to achieve the ultimate goal.
- Broader Ecosystem: Success is not just due to government directives but relies on a broader ecosystem of export-driven manufacturing, high competition, and international participation across many economic sectors.
China's economic structure differs significantly from Japan's pre-1990s system, which led to a prolonged stagnation.
- Geopolitical Independence: China is an independent geopolitical actor, unlike Japan, which relied on the US for security and was demilitarized. China faces a "very dangerous neighborhood" with 14 land neighbors, several of which have nuclear weapons, giving it "pretty significant national security needs" and existential incentives to "get things right" economically. This spur increases the likelihood that Chinese leaders will pursue policies to keep the system dynamic.
- Financial and Corporate Sector Relationship: Japan's system featured extensive cross-shareholdings between banks and industrial companies, effectively creating "one big balance sheet" tied to inflated land values. When land values collapsed, it eroded bank capital, leading to a widespread inability to lend and "debt deflation" across the entire economy.
- China, learning from Japan and Korea's crises, has "quarantined" its financial and corporate sectors. It is illegal for industrial companies to own banks (though internal financing subsidiaries for intra-group finance are allowed), and banks are prohibited from holding large shares in industrial companies. This separation makes Japan's macro problem "very, very unlikely to occur in China".
Despite this separation, China has "huge debt problems". Property developers are "very over leveraged," leading to a massive property crash in the last five years. Local governments also have large debt problems from investing in infrastructure that now yields low returns.
These debt problems have "significant negative macro consequences" but are generally "isolated and they can be dealt with sort of one by one". The industrial sector itself is "not very highly leveraged"; private companies historically relied on retained earnings for investment due to limited bank credit, keeping their leverage ratios low.
The local government land-based financing model, which enabled borrowing against future land value appreciation to finance infrastructure, was initially a "pretty smart thing to do" and worked well for about a decade. It was sponsored by the central government and China Development Bank in the early 2000s to address severe shortages of housing and infrastructure. Early estimates of land value appreciation proved to be "way too low".
After the 2008 financial crisis, a massive cash infusion into banks and state-owned enterprises led commercial banks to lend extensively to local governments for infrastructure projects with "much less robust" underwriting standards. This became "free money" for local governments, creating a "Frankenstein's monster" of excessive, uncoordinated, and often wasteful projects.
This is viewed as a "local government fiscal problem" which ultimately is a central government fiscal problem. Kroeber estimates China's consolidated government debt (central and local) as a share of GDP is probably less than the US federal government debt (US >100%, China <100%). He respectfully disagrees with estimates of local government debt alone reaching 100-150% of GDP due to potential double-counting issues and the distinction between formal and contingent debt.
Total economy-wide debt (public and private) in China is around 300% of GDP. While this is typical for highly developed economies, it is "extremely high for middle-income economies" like China, making it "way more leveraged than any other country of its level of income". This is a "significant macro leverage issue" that is "quite serious".
This high debt is an "important constraint on policy" and "important constraint on growth at the moment," contributing to China's current sluggish growth. However, Kroeber does not believe it will lead to a "financial collapse situation" because the system is contained and the debt is denominated in local currency.
Historically, Chinese debt generally financed productive assets like industrial production and infrastructure, which delivered good economic returns when the country was infrastructure-short. However, the case for this is "a lot weaker now" as the problem lies in retiring existing low-productivity, debt-financed infrastructure investments and achieving more productive returns on capital in the future.
The fundamental solution is to shift from a "supply-side strategy" to a "demand-side strategy". Stronger domestic demand would generate more profits and pricing power for companies, leading to "a little bit of inflation" and more cash flows within the economy. This would enable debt repayment by companies and local governments, and inflation would erode the real value of the debt.
This strategy is similar to how China resolved its last major debt problem in the late 1990s (gigantic bad bank debts from state-owned enterprises) through a "very, very growth friendly program that generated a lot of growth, a lot of inflation". China now needs a "revamped, updated version of that strategy" to promote domestic demand, increase profits and cash flows, and introduce more inflation, which would likely resolve the debt problem over a decade or two.