Of course, China’s sheer size and its contribution to global growth mean it continues to be an outsize component of global prosperity. According to the International Monetary Fund, China accounts for 30 percent of world output growth—more than that of the United States and India combined. That perpetuates the idea that China is powerfully vulnerable to decoupling.

How will the combination of a U.S. tech policy “divorce” (well underway before the virus) and the post-Covid reality of deconstructed supply chains shape Chinese reliance on the external sector?

U.S. efforts to reduce reliance on Chinese high technology and limit China’s access to key inputs (with emphasis on semiconductors, telecommunications, artificial intelligence [AI], and aviation equipment) are almost certainly now regarded as inevitable by Beijing. The Covid-19 crisis has added medical products to that list.

Even before Covid-19, for state planning purposes, decoupling was a fact of economic life for Chinese policymakers—one requiring coping strategies that needed to be fully operational over the five years of Xi’s second term. They are focused not on stopping it, but on:

1. Slowing acceptance of critical decoupling by U.S. allies (notably Huawei switching equipment);
2. Diversifying sourcing (preferring EU, South Korean, and Japanese products to their U.S. equivalents);
3. Developing a menu of options for selective retaliation against the United States;
4. And—most important—developing indigenous alternatives across the range of affected sectors in a quest for greater self-reliance. China may no longer be talking about its China 2025 program, but it has certainly not abandoned its objectives of being self- sufficient and a market leader in ten or more critical areas.

What will these policies look like and how will they shape global supply chains? 

They may take several forms:

1. No lurch to autarky: Chastened by the speed of Covid-induced alternative sourcing by other countries in sectors as diverse as auto parts and drug components, the most extreme reaction would be to reduce vulnerabilities by moving to a near North Korean “juche” model of self-reliance. That approach runs contrary to Chinese foreign policy goals of expanding soft power by fostering economic dependence. It also carries unacceptable risks to many vested domestic interests in state-owned enterprises (SOEs), disrupting input reliance and exposing too many vulnerabilities—starting with energy. A rapid about-face on China’s approach to globalization that includes most critical sectors is a near impossibility. A “critical sectors” list) has existed since the ‘90s for purposes both of restricting foreign investment and reducing import reliance. Where once it looked as though there would be opportunities for collaboration with foreign business in these sectors, the list of restrictions now is likely to be expanded. A move to complete import substitution is unachievable in the near term and exposes the Party and government to too many risks.
2. Accelerated independence and double down industrial policies supporting keystone technologies: China’s strength in AI, telecom switching/5G, and features of semiconductors has led some to the mistaken view that China’s tech dominance is ubiquitous. That is wrong. As a recent CSIS study describes, Chinese tech strength is uneven. The Xi government regards the previous Hu/Wen regime as having failed to achieve “indigenous innovation” for foundational technologies. Government procurement preferences, subsidies, and infant industry border protection have failed to meet previous plan goals. Xi intends to redress that in the current Five Year Plan. Expect it to be an even more prominent feature in the next Five Year Plan, which will be considered at the party plenum at the end of this year. The artifact of Covid-19 disinvestment and accelerating U.S. tech pressure is likely to be 1) accelerated timelines for highest priority programs that can produce outsized economic gains quickly (AI, manufacturing technologies, e-commerce) and 2) more direct government support across key industries.
3. Possible re-emphasis on SMEs as a source of growth. Pre-Covid-19 Xi policies have been criticized as giving preferences to SOEs and larger firms and undercapitalizing small- and medium-sized enterprises (SMEs), which are the source of 60 percent of all job creation in the United States. While a broad re-examination of China’s growth strategy is not in the cards now, it is possible that undercapitalized SMEs could benefit in the shift to sustain growth and play a larger role in the external sector. While evidence for such a policy shift is mostly anecdotal, it is important to consider in post-Covid-19 modeling. Much will depend on whether the policy banks and other key lending institutions can be persuaded—or compelled—to redirect their attention to those critical businesses and job creators. In a planned economy, a change in a situation does not mean a change in the fundamentals of the plan. Much about the current plan will continue to guide policy. Expect the knife’s edge of China’s exports to be led by 1) E-commerce platforms (Alibaba, Tencent) and 2) security systems (facial recognition, “smart city” CCTV products.)

What about the role of FDI inside China?

As noted above, that space was contracting before Covid-19 in favor of stronger preferences for domestic champions, despite the show of some new protections for foreign investors. It is unclear how much further China will continue to open its financial and banking services sectors, which have been prominent features of recent reforms, both in terms of improved management, close collaboration with international markets and more efficient allocation of resources.

As the Committee on the Foreign Investment in the United States (CFIUS) and the Foreign Investment Risk Review Modernization Act (FIRRMA) procedures expand and continue to target Chinese firms, reciprocal policies and unpublished guidance will continue to squeeze U.S. companies, reducing options and margins. U.S. and other foreign firms will be watching the signaling from the end-year plenum meetings to understand what is possible in this shrinking space. The past five years have been challenging; the next may be more so.