By Zhuoran Li

The United States Innovation and Competition Act, labelled by observers as a return of industrial policy, discussed extensively how China's industrial policy hampers American competitiveness. However, this argument overlooks that China's total factor productivity growth, an important indicator of innovation and efficiency improvement, has been declining since 2008, when China first launched its industrial policy, to almost zero. China's "grand steerage" to foster innovation through massive top-down investment has only caused economic distortion and inefficiency. Innovation cannot be simply achieved through billion-dollar investments. In China, many structural deficiencies, such as labor movement restrictions, distorts  China's innovation drive. Liberalizing Chinese labor mobility and accelerating urbanization of China's largest cities can not only improve technological development, but also boost consumption and lower inequalities. However, the Household Registration System (hukou), the migration management policy currently in place, hinders urbanization and continues to hold back China's economic potential.

The Chinese Communist Party (CCP) introduced the hukou system in 1958 to manage labor in the planned economy. The government divided the population into urban and rural residential categories and granted them separate hukou registrations. With this policy, the government eliminated labor turnover and population migration, as the system tied hukou status to employment—urban hukou holders  to work units and rural hukou holders  to the farmland. Thus, the government could squeeze out rural wealth to fund urban industrialization through price-scissors: the government procures food from farms cheaply and sells it to the urban population at a much higher price. 

Since the Deng era, China has gradually lifted the restrictions on population movement to address excess rural labor. This relaxation created large waves of rural migrant workers who left their land to take jobs in cities. Population movement has contributed to a significant part of economic growth in China. It fuelled employment in urban manufacturing firms, formed manufacturing clusters, and supplied labor for making exports. As a result of the massive migration, China experienced rapid urbanization. The urbanization rate jumped from 18% in 1978 to over 60% in 2020. 

However, rapid urbanization has created new challenges. Rural migrant workers live as second-class citizens in cities. They live in poorly managed areas, cannot access urban social benefits, and face discrimination from local urbanites. Furthermore, China's urbanization has been slowing down since 2014, and two-third of migrants are moving within the same province rather than to first-tier cities. In addition to hukou restrictions, Chinese local governments adopted a land-based local fiscal policy and sponsored the infrastructure boom. These factors have caused Chinese cities to add more land than population through the administrative redistricting process. This has also led to  sprawling, a phenomenon that lowers urban population density in small cities and thus lowers urban economic productivity.

Facing these problems, the Chinese government further loosened the hukou system. The New Urbanization Plan (NUP) launched in 2015 granted urban hukou to 100 million rural migrants. In April 2021, the Chinese government abolished all hukou restrictions for cities with less than three million residents. Unfortunately, the government continues to reject hukou reform in first-tier cities. The NUP discourages the growth of mega-cities and prefers the formation of city clusters: a bundle of neighboring small urban centers. Beijing even started to practice "reducing-size development," which aimed to limit the population of Beijing to twenty-three million and to reduce population density from 1,400 per square kilometer to 1,200 per square kilometer. Since 2017, Beijing has been "evacuating" migrant workers by cracking down cheap underground residences, restricting individual vendors, and moving manufacturing and service businesses out of Beijing. The ambitious Xiong'an project, which Xi envisioned to move manufacturing and service sectors from Beijing to Xiong'an, also accelerated the evacuation process. Given Beijing's special role as the national capital, Xi's ambition to develop Xiong'an, and the patron-client relationship between Xi Jinping and the Beijing Party Secretary Cai Qi, one can infer that Beijing's development plan reflects the spirit of the NUP, which restrains the growth of large cities.The strategy aims to improve livability of megacities by reducing congestion. However, it has a negative impact on economic efficiency.  

Eliminating the hukou system will release China's economic potential by encouraging migration to large cities. Abolishing hukou will break all barriers restraining population migration, such as housing, education, and social welfare accessibility. This urban migration process will increase China's domestic consumption and innovation. Boosting innovation and domestic consumption have been vital policy goals of the Chinese government. The 19th Party Congress 5th Plenum report highlights that China's key goal before 2035 is to achieve "significant breakthroughs in key technologies." Xi Jinping highlighted breakthroughs in "bottlenecks technologies" as a vital target of the dual circulation strategy (DCS), which emphasizes  domestic consumption-led economic growth rather than export-oriented or investment-led growth. Xi pinpointed China's tremendous market as a key engine for China's future economic growth. Vice Premier Liu He, Xi Jinping's chief economic advisor, also cited "increasing internal demands" as the "strategic base point" of the DCS. Removing barriers against migration will help further induce domestic-driven growth, in line with the DCS.

Eliminating hukou restrictions will enable the Chinese economy to benefit from urban agglomeration effects. Urban agglomeration leads to productivity gains because the concentrated business sectors share supply chains, human capital, and economies of scale. Industrial specialization and competition lead to an increase in labor productivity and innovation. In the United States, innovation centers are often located among the best post-secondary education institutes because research centers can cooperate with universities and hire their top graduates. The world-famous Silicon Valley is adjacent to UC Berkeley and Stanford University. Boston, the home of Boston Dynamic and many other innovative firms, is next to Harvard and MIT. The biotech corridor in Maryland benefits from its proximity to Johns Hopkins University and the National Institute of Health. In order to take advantage of its urban agglomeration, China should increase the concentration of highly educated young people in first-tier cities, where China's best universities are located, to boost innovation. 

The hukou system is a significant obstacle to innovation because it prevents the concentration of young talents. The barriers to getting local hukou in Beijing and other first-tier cities drive many young talents away. To obtain Beijing hukou, one must meet the rigorous requirements on age limit, education requirement, minimum years of social security contribution. Furthermore, he/she must find a job that can sponsor Beijing hukou.  Moreover, other local governments are accelerating their own innovation projects, such as industrial parks, to retain talents in their localities, because local officials must fulfill the innovation target in the cadre responsibility evaluation in order to compete for promotion. However, such efforts divert young talent away from first-tier cities and create inefficiencies. For example, Xi'an, a midwest city known for tourism, is aiming to become the new Silicon Valley of China. Xi'an is not alone; over thirty Chinese cities established innovation hubs for robotics, causing waste and overcapacity problems. Governments of smaller cities actively try to invite young, high-educated talents to settle and work in their localities with prize money and other incentives. Wuhan provides affordable houses for college graduates. Zhengzhou gives every PhD student a 100,000 RMB ($15,000) mortgage subsidy to encourage settlement. This trend accelerates the flow of human capital away from first-tier cities and prevents the concentration of talents. Every 1 percent human capital mismatch has a statistically significant 0.52 percent decrease in technological innovation, as measured by R&D input efficiency. Thus, by eliminating the hukou system, China could minimize distortions, promote urban agglomeration, and foster more innovation. 

Elimination of the hukou system will improve social welfare, which can contribute to rising domestic consumption. The hukou divide prevents rural migrant workers from accessing urban social welfare programs. A 2019 research indicates that only 22% of the 286 million rural migrant workers in Chinese cities enjoy urban social welfare coverage. Chinese poor households have unusually high savings rates because of the lack of direct government transfers. Without social welfare support, they must save for emergencies. Among them, rural migrant workers have even higher saving rates because of their lack of economic prospects and second-class citizen living status in cities. Rural migrant workers with families left behind and rural migrant workers without social insurance coverage are major precautionary savers and consume significantly less. The hukou reform will provide rural migrant workers with social welfare protections. These reforms will reduce their precautionary saving rates and raise their  consumption levels. Hukou reform faces significant resistance. Critics claim that abolishing hukou will dampen livability in first-tier cities by causing environmental problems, overcrowding, overburdened local social services, and sparking conflicts between locals and newcomers. However, hukou reform will allow China to follow the steps of the East Asian "dragons" and transform itself into an innovation-driven, consumption-led high-income economy. South Korea serves as a case study on how China's economy could rapidly grow by abandoning the hukou system. South Korea developed an innovation-oriented economy through its large middle class. The rapid urbanization process constructed the large middle class and eliminated the urban-rural wage gap by 1994. The size of the Chinese middle class increased from less than 2% of the total population in 2000 to 11% in 2010, but it was still small relative to other countries at a similar per capita income level. Compared to Korea in 1986, when its per capita income was parity to China's in 2010, the size of the Chinese middle class was only a quarter of Korea's middle class in terms of population share. Abolishing the hukou system would further accelerate the urbanization process, enlarge the middle class, and boost domestic consumption. The agglomeration effect will also spark an eruption of exciting research and development. This reform will liberate China's growth potential and propel China to converge with the East Asian high-income countries.

Zhuoran Li is a second-year M.A. candidate at Johns Hopkins School of Advanced International Studies (SAIS), concentrating in International Relations with a minor in China Studies. His research interests include Chinese politics and economy, East Asian comparative studies, and East Asian national security. Z's articles are featured in the Diplomat and the National Interest. Z can be reached at zhuoran0322@gmail.com.