Thinking clearly about China's economic statecraft

  • Spring 2009

William Norris is a Ph.D. candidate in political science at MIT and a member of the Center's Security Studies Program.

By William Norris
May 1, 2009

One of the most important phenomena characterizing the international environment today is the rise of China. At $3.4 trillion, China's economy is the third largest in the world (having recently surpassed Germany) and continues to grow rapidly. Moreover, China seems intent to use its economic clout to help achieve its strategic objectives.1 Indeed, as China pursues a "peaceful rise" grand strategy, economic power seems to provide a more and more attractive alternative lever of power than military force. Current indications seem to suggest that this economically-oriented "peaceful rise" strategy is producing favorable results and greatly strengthening China's ties to other countries in the region and beyond.

How should strategists think about the exercise of economic power? Despite its importance, much of the discussion surrounding China's economic statecraft is often limited by a lack of an analytical framework to inform policy decision making. In this piece, I provide a typology that captures the range of ways that trade and investment can affect a country's security. Conceptually, it is important to distinguish between the pattern of trade or investment and the security externalities that result from that particular economic interaction. By being more precise about the specific security externalities arising from a particular pattern of economic interaction, debates over issues like Chinese overseas investment can more clearly discuss appropriate policy responses. Second, I introduce an often overlooked, but critical aspect of economic statecraft—namely the role of commercial actors. In today's modern global economy, firms—rather than states themselves—are responsible for conducting the investment and trade activities that comprise "inter-state" economic activity. As a result, an effective lens for thinking about economic statecraft must incorporate this principal-agent dynamic. Finally, I sketch a brief illustration of how this theory can be applied to questions of Chinese foreign investment.



This section introduces a typology that captures the full range of ways by which economic interaction can carry security consequences. There are six types of security externalities which fall into two broad categories: those acting through primarily economic channels and those externalities with directly military effects. Thus economic interaction may produce a direct effect on a state's military capabilities or security externalities may be indirect, acting on the state's security position through the channel of the target state's economy.2 Both channels ultimately carry strategic consequences.

A Typology of Security Externalities

A Typology of Security Externalities

On the top main branch of the typology are those externalities that affect a state's security by way of primarily economic channels. For this family of externalities, the security ramifications are often the second-order consequences of the economic interaction (as opposed to the military effects branch of the typology in which the economic interaction directly contributes or detracts from military capabilities). The economic branch is subdivided into two groups: 1.) the types of externalities that affect the overall health of the target state's economy as an end in itself and 2.) those security externalities in which the economic interaction plays an instrumental role as a means to a strategic end. In this first group, "Corrosion" is one category of externalities that weaken the target state's economy and "Bolstering" is another category of externalities that strengthen the target state's economy. Economic interaction can also be used instrumentally via "Coercive Leverage" which capitalizes on economic dependence to force targeted states to comply with the more powerful state's wishes3; and via "Interest Transformation" which is the externality generated by economic integration. The objective of "Interest Transformation" is not only to force the targeted state (let's call it "State A") to behave in a manner that is conducive to the sending state (let's call it "State B")'s interests, but rather toredefine State A's interests, goals and objectives in such a way that State A then actually wants the same thing as State B.

The four categories of security externalities discussed above carry implications for a state's security by way of the economy. Each of these share a common causal root in that the ultimate security effect stemmed from what were primarily economic conditions. Unlike these first four categories, the categories of externalities discussed below derive their ultimate security consequences from what are primarily militaryconditions. On the branch of the typology labeled military channel, there are those security externalities that weaken the target state's military capabilities (this process is referred to as "Hollowing Out"—for example, weakening a state's military-industrial complex) and those that enhance the target state's relative military capabilities (this process is called "Strategic Transfer"—for example, transferring dual-use technologies or securing a supply of saltpeter). The typology is a useful way to organize thinking about the relationship between economics and security. This typology enables us to be specific about what particular security-related consequences of economic interaction we are worried about. In addition, by framing the topic of economic statecraft as an issue of externalities, we can be analytically tidy in distinguishing between the underlying economic patterns of commercial behavior and the security consequences stemming from these patterns.



Understanding the role of economics in China's foreign policy requires a broader theoretical understanding of the economic dimension of grand strategy in general. The typology introduced above provides some specificity regarding the manner by which states seek to use economic interaction to further their larger strategic goals. States conduct economic statecraft by seeking to influence the underlying patterns of economic interaction in order to generate the various types of security externalities discussed above. Influencing these underlying patterns of trade and investment are an important part of economic statecraft. To the extent that commercial actors are largely responsible for conducting international economic transactions, a modern theoretical understanding of economic statecraft ought to explicitly incorporate commercial actors.

The dynamics present in a principal-agent relationship mirror those present in the relationship between the state and commercial actors when the state seeks to exercise economic statecraft. The state (acting as the principal) desires to achieve some strategic national objective through the use of economics. However, the real-world practice of economic interaction (trade and investment) is actually conducted by commercial actors. As such, if the state seeks to manipulate the security externalities stemming from various types of economic interaction and this economic interaction is being conducted on a day-to-day basis by commercial actors, the state must face up to the challenges of working though a proxy—namely, the commercial actors. Thus, the dynamics highlighted by principal-agent theory provide a useful guide for framing the issues that arise when states seek to practice economic statecraft.

At the heart of principal-agent theory lies a very simple concept: principals have one set of goals and objectives but they must rely on agents to act on behalf of the principals to realize these goals.4 The wrinkle lies in that agents often have a different set of goals and objectives derived from the incentives that they face as self-serving actors. So the challenge becomes one of aligning the agents' incentives such that they will act in a manner that furthers the principals' goals. This is the principal-agent (P-A) problem in brief. The principal-agent issue is the core challenge that states must overcome to effectively use economics in their grand strategy.

In my research on China's economic statecraft, four factors seem to be important determinants of whether or not the state can effectively direct or control its commercial actors. The first is intrinsic compatibility of goals. How closely are the goals of the agent(s) aligned with those of the principal? If the basic objectives of the commercial actors are closely compatible with the basic goals of the state (i.e. the principal), it is much easier to get commercial actors to behave in a way that is conducive to state interests. The second factor is market structure. If a market in a particular industry or sector is highly fragmented, it is often more difficult for a state to monitor and control the commercial actors. At the same time, a highly concentrated market with a few large firms possessing significant autonomy and relative bargaining power enables these firms to more easily resist state attempts to direct their behavior. The most conducive market structure seems to be an oligopolistic one in which there are enough firms that the state can play one off the other, but not so many that the state cannot effectively monitor them. The third factor is bureaucratic capacity. The more advanced the principal's organizational capacity to monitor, enforce and regulate its agents, the more likely that the state will be able to control commercial actors. The fourth factor is unity of the principal. In situations where there are multiple, competing and conflicting principals or in situations in which the principal is internally divided among competing factions or groups, it is often more difficult to direct and control commercial actors.



The framework presented above is designed to more accurately consider the nature of the potential threats stemming from a commercial activity like Chinese investment abroad. For example, host nations like the U.S. have (rightly or wrongly) raised concerns about "Strategic Transfer" of sensitive technologies resulting from Chinese companies' acquisitions of U.S. companies as was the case with the Huawei-3Com deal.5 Fears of "Strategic Transfer" of what were perceived to be critical petroleum assets also generated political pressure that doomed CNOOC's acquisition of Unocal.6There are also more general fears of "Corrosion" as long term corporate profits would be repatriated and "Coercive Leverage" concerns about China's concentrated ownership of U.S. debt. One of the reasons that China's international investment activities generate concern is that host-nation policy makers perceive that the PRC's Communist Government plays an active and effective role in controlling and directing its commercial actors.

The principal-agent framework suggests how we might think about determining just how easily a given commercial actor may be controlled by the Chinese government. Market concentration (the fraction of a given industry that is controlled by its top firms) provides a useful gauge for how powerful firms may be vis a vis the state. Likewise, an examination of internal Party power dynamics can provide important information regarding how splintered the state is. The degree to which China acts as a unified principal considerably determines whether the commercial firms are able to play one faction off another in an effort to maximize firm rather than national interests. Also an evaluation of the resources (expertise, human capital, financial, legal, etc.) available to the state relative to the resources available to a given firm provides important indicators as to who is directing whom. Finally, we cannot ignore the degree to which firm interests and Chinese national interests coincide.

Rather than arguing over generic, unspecified fears that can easily lead to counter-productive protectionism thinly-veiled as some form of "national economic security," debates over the relationship between economics and security should strive to be precise about exactly what threats are present and what mechanisms states have at their disposal to control their commercial actors.



1 Economics is a critical component of Beijing's "New Security Concept," "win-win cooperation," and "comprehensive national power." Economics seems likely to continue to play an important role in China's pursuit of its strategic objectives. See: Fred Bergsten et al., China: The Balance Sheet (New York: Public Affairs, 2006).

2 The strength of a nation's economy carries implications for its military power (since economic power historically has been the foundation of military power). In fact, assessments of relative power frequently rely on GDP or some other proxy of underlying economic power. See for example: Kenneth Waltz, Theory of International Politics (Reading, Mass.: Addison-Wesley Pub. Co., 1979); William C. Wohlforth, "The Perception of Power: Russia in the Pre-1914 Balance," World Politics 39, no. 3 (1987): 353-381 or see Stephen Van Evera, "Why Europe Matters, Why the Third World Doesn't: American Grand Strategy After the Cold War," Journal of Strategic Studies 13, no. 2 (1990): 1 (especially his rationale for the strategic importance and unimportance of specific geographies).

3 "Power," as I use the term here, is determined by who is dependent on whom for what. For a classic example, see Albert Hirschman's depiction of pre-World War II Nazi Germany's economic policies toward Central Europe: Albert O. Hirschman,National Power and the Structure of Foreign Trade (Berkeley and Los Angeles: University of California Press, 1945).

4 For a good introductory overview of principal-agent theory see: David E.M. Sappington, "Incentives in Principal-Agent Relationships," Journal of Economic Perspectives, Spring 1991, Vol. 5, Issue 2, pp. 45-66 and Jean-Jacques Lafont and David Martimort, The Theory of Incentives: The Principal-Agent Model Princeton, NJ: Princeton University Press 2002. For some recent applications of principal-agent theory in international relations see: Darren G. Hawkins, David A. Lake, Daniel L. Nielson, and Michael J. Tierney, eds., Delegation and Agency in International Organizations (Cambridge: Cambridge University Press, 2006); Gary J. Miller, "The Political Evolution of Principal-Agent Models," Annual Review of Political Science 8 (2005): 203-225.; and the classic: George W. Downs and David M. Rocke, "Conflict, Agency, and Gambling for Resurrection: The Principal-Agent Problem Goes to War,"American Journal of Political Science 38, no. 2 (1994): 362. In the more narrow field of security studies, see: Patrick Johnston, "The Geography of Insurgent Organization and its Consequences for Civil Wars: Evidence from Liberia and Sierra Leone,"Security Studies 17, no. 1 (2008): 107-137.; Thomas S. Sowers, "Beyond the Soldier and the State: Contemporary Operations and Variance in Principal-Agent Relationships," Armed Forces & Society 31, no. 3 (2005): 385-409.; and Peter Feaver, Armed Servants : Agency, Oversight, and Civil-Military Relations (Cambridge, Mass.: Harvard University Press, 2003).

5 Reuters, "Opposition Leads Bain to Call Off 3Com Deal," The New York Times, March 21 2008, sec. C, p. 4.; Steven R. Weisman, Michael J. de la Merced in New York, and Eric Lipton in Washington contributed reporting, "Brakes on a Foreign Deal," The New York Times, February 21 2008, sec. C, p. 1.

6 Ben White, "Chinese Drop Bid to Buy U.S. Oil Firm," The Washington Post, August 3, 2005 (January 12, 2009).