Industrial policy refers to a government agenda to shape industry structure by promoting certain industries or sectors. Although casual observation suggests that industrial policy can boost sectoral growth, researchers and policymakers have not yet mastered predicting or evaluating the efficacy of different types of government interventions, nor how to measure the overall short-run and long-run welfare effects (Juhasz et al. 2023, Millot and Rawdanowicz 2024). In this column, we focus on one particular example of industrial policy: the shipbuilding sector.

The history of shipbuilding is as tumultuous as the seas themselves. Shipbuilding has always held an allure for governments, in its real and perceived interactions with industrialisation, maritime trade, and military strength (Stopford 2009). Figure 1 shows the succession of countries as the world’s dominant shipbuilding nation. The UK held the lion’s shareof the industry for the better part of the 19th and 20th centuries, fending off competition from other Western European economies (mainly Germany and Scandinavia) at times. After WWII, it is swiftly overtaken by Japan, which prevails as aworld leader until the 1980s, when South Korea dominates the global market.

In the 2000s, China entered the shipbuilding scene. In 2002, former Premier Zhu inspected the China State Shipbuilding Corporation (CSSC), one of the two largest shipbuilding conglomerates in China, and pointed out that “China hopes to become the world’s largest shipbuilding country (in terms of output) by 2015.” Within a few years, China overtook Japan and South Korea to become the world’s leading ship producer in terms of output. Figure 2, PanelA shows the rise in China’s global market share of shipbuilding by plotting China’s total shipbuilding output as a share ofglobal output. China’s national and local governments provided numerous subsidies for shipbuilding, which we classify into three groups. First, below-market-rate land prices along the coastal regions, in combination with simplified licensing procedures, acted as ‘entry subsidies’ that incentivised the creation of new shipyards. As shown in Panel B of Figure 2, between 2006 and 2008, the annual construction of new shipyards in China exceeded 30 new shipyards per year; in comparison, during the same time period, Japan and South Korea averaged only about one new shipyard per year each.

Second, regional governments set up dedicated banks to provide shipyards with ‘investment subsidies’ in the form offavourable financing, including low-interest long-term loans (a common industrial policy tool, as illustrated also by theprogrammes in Japan and South Korea) and preferential tax policies. China’s rise in total capital invested in shipyards is illustrated in Panel C of Figure 2. Third, China’s government also employed ‘production subsidies’ of various forms, such assubsidised material inputs, export credits, and buyer financing. The government-buttressed domestic steel industryprovided cheap steel, which is an important input for shipbuilding. Export credits and buyer financing by government-directed banks made the new and unfamiliar Chinese shipyards more attractive to global buyers.

The combination of these policies was followed by a sharp expansion in China’s shipbuilding production, market share, and capital accumulation. China’s market share grew from 14% in 2003 to 53% by 2009, while Japan shrunk from 32% to 10% and South Korea from 42% to 32%. Then came the Great Recession of 2008-09, which drove the global shipping industry to a historic bust. The large number of new Chinese shipyards exacerbated low capacity utilisation and contributed to plummeting global ship prices. The effectiveness of China’s industrial policy was questioned. In response to the crisis and in an effort to promote industry consolidation, the government unveiled the "2009 Plan on Adjusting and Revitalizing the Shipbuilding Industry" that resulted in an immediate moratorium on entry and subsequently shifted support towards only selected firms in an issued ‘whitelist’.

Kalouptsidi (2018) and Barwick et al. (2024) study the impact of China’s 21st century shipbuilding programme on industry evolution and global welfare. To our knowledge, this work is the first attempt at evaluating quantitatively industrial policy in shipbuilding globally and among the first papers employing the structural industrial organisation methodology to understand the welfare implications and effective design of industrial policy more generally.

We build a model that is flexible enough to capture rich dynamic features of a global market for ships. On the demand side, a large number of shipowners across the world decide whether to buy new vessels. Their willingness-to-pay for new ships depends on present and expected future market conditions, notably on world trade and the current fleet level.

On the supply side, shipyards located in China, Japan, and South Korea (which account for 90% of world production) decide how many ships to produce, by comparing the market price of a ship and its production costs. In addition, shipyards decide whether to enter by comparing their lifetime expected profitability to entry costs, which include the costs to set up a new firm (such as the cost of land acquisition, shipyard construction, and any initial capital investments) and the implicit cost of obtaining regulatory permits. They exit if expected profitability from remaining in the industry falls below a given threshold, capturing the shipyard’s ‘scrap’ value (that is, the proceeds from liquidating the business, as well as any option values of the firm). Firms also invest to expand future production capacities. For estimation, we employ a rich dataset consisting of firm-level quarterly ship production between 1998 and 2014, firm-level investment, entry andexit, and new ship market prices by ship type (containerships, tankers, and dry bulk carriers, which together account for 90% of global sales).

Our estimates suggest that China provided $23 billion in production subsidies between 2006 and 2013. This finding is driven by the cost function obtained from this analysis, which exhibits a significant drop for Chinese producers equal to about 13-20% of the cost per ship. Simply put, Chinese shipbuilding firms were ‘over’-producing after 2006 compared to our prediction of output without subsidies. Altogether, China provided $91 billion in subsidies along all three margins – production, entry, and investment – between 2006 and 2013. Notably, entry subsidies were 69% of total subsidies, while production subsidies were 25%, and investment subsidies accounted for the remaining 6%. These estimates reflect the fact that shipbuilding firms ‘over-entered’ (recall the astonishing entry rates during the boom years of 2006-2008) and ‘over-invested’ (recall the striking increase in investment during the bust), as shown earlier in Figure 2.

Our structural model suggests that China’s industrial policy in support of shipbuilding boosted China’s domestic investment in shipbuilding by 140%, and more than doubled the entry rate. It also depressed exit. Overall, industrial policy raised China’s world market share in shipbuilding by more than 40%.

In terms of policy design, a counter-cyclical policy would outperform the pro-cyclical policy that was adopted by a large margin: strikingly, subsidising firms in production and investment during the boom leads to a gross rate of return of only 38% (a net return of -62%), whereas subsidising firms during the downturn leads to a much higher gross return of 70% (a net return of -30%). Moreover, if an ‘optimal whitelist’ is formed – that is, the most productive firms are chosen for subsidies – the gross rate of return would climb to 71%.

Our results highlight why industrial policies have worked better for some countries. In East Asian countries where industrial policy was often considered successful, the policy support was often conditioned on firm performance. In contrast, in Latin America where industrial policies often aimed at import-substitution, no mechanisms existed to weed out non-performing beneficiaries (Rodrik 2009). In China’s modern-day industrial policy in the shipbuilding industry, the policy’s return was low in earlier years when output expansion was primarily fuelled by the entry of inefficient firms but increased over time as the government relied on ‘performance-based’ criteria via its whitelist. Such targeted industrial policy design can be substantially more successful than open-ended policies that benefit all firms.

In terms of the rationale – why China subsidised shipbuilding – the standard arguments for industrial policy do not seem to apply especially well in our setting. The shipbuilding industry is fragmented globally, market power is limited, and markups are slim. Thus, there are no ‘rents on the table’ that, when shifted from foreign to domestic firms, outweigh the cost of subsidies. We find little evidence of learning-by-doing, perhaps because the production technology for the ship types that China expanded the most, such as bulk ships, was already mature. Spillovers to other domestic sectors are limited; in addition, more than 80% of ships produced in China are exported, which limits the fraction of subsidy benefits that is captured domestically. A scenario whereby Chinese output growth forces competitors to exit does not seem first-order either: by 2023, no substantial foreign exit occurred.

Our analyses point to two alternative potential rationales. As China became the world’s biggest exporter and a close second largest importer during our sample period, transport cost reductions from increased shipbuilding and reduced shipping costs can lead to substantial increases in its trade volume. Our estimates suggest that China’s industrial policy expanded the global shipping fleet, reduced freight rate, and raised China’s annual trade volume by 5% ($144 billion) between 2006 and 2013. This increase in trade was large relative to the size of the subsidies (which averaged $11.3 billion annually between 2006 and 2013). Of course, ‘more trade’ does not translate directly into economic well-being, but the relative magnitudes are suggestive.

How do small caps solve their image problem? In an era of MAG 7 ‘mega cap’ tech dominance, global small caps have struggled to maintain their visibility, with endless headlines focused on macro-level major themes – like artificial intelligence (AI) – capturing investors’ attention and leading to ever-higher multiples for a heavily hyped shortlist of names.

In this environment, small cap stocks have struggled, in terms of performance, relative to large caps. But these kinds of market cycles are nothing new. While this latest cycle of large-cap outperformance has endured, there have been many more periods where small cap stocks have outshone their larger peers, led by consistently higher earnings growth (Exhibit 1).

For the past few years, mega-cap tech stocks have carried the stock market on their shoulders, but 2024 has seen some cracks finally appear in the profile for these stocks, where even strong growth has not been enough to satisfy the rapacious expectations of the market. This has left investors starting to look elsewhere for value.

As we move further past the peak of the interest rate cycle, and central banks continue to cut rates in pursuit of a ‘soft landing’ scenario, we see potential for investors to continue recalibrating their portfolios towards areas of the market that have historically tended to benefit the most from lower interest rates – small cap stocks.

Outside of macro trends, the key to small cap outperformance is the capacity they have to grow their earnings in a way that large cap stocks will struggle to consistently match. It is hard for a company like Apple to deliver significant growth on US$400 billion of annual sales, given its existing penetration. It is much easier for a small business to grow its sales by expanding into new markets, acquiring new clients, or broadening its product range.

There is also a case for investors to use small caps as a diversifier, given the clear structural differences that differentiate the small cap sector from their large cap peers. Small caps tend to operate more in industrials or materials than technology and are generally more focused on local markets. This means that an allocation to small caps leaves investors exposed to different structural drivers, such as de-globalisation (ie. the rebuilding of domestic production lines, rather than outsourcing to places like China).

But that does not mean that these sectors are not also participating in global mega trends, supplying the parts, products or raw materials that fast-evolving technology needs to sustain its growth. There are plenty of small cap stocks tapping into the huge long-term structural capex cycle for major technology firms, rather than relying on the variables of consumer demand.

The ‘evergreen’ argument for allocating to small caps is the persistent tailwind of merger and acquisition (M&A) activity. While the split can differ between regions, the vast majority of all M&A includes involves the acquisition of small cap businesses by a larger rival (Exhibit 2). Big companies buying small ones – often at a real premium to the prevailing price.

Ultimately small caps remain unloved and out of favour, but we see a lot of pent-up demand, with investors still lacking a bit of confidence in the economy – more so in Europe and the UK than in the US.

Smaller companies in the UK have had a tough time over the past few years, with uncertainty around Brexit compounded by rising interest rates costs and higher corporation tax rates. We see 2024 as a transformative period, and UK small caps are arguably no longer the ugly duckling. Growth in the economy is stirring, inflation is under control and we have a new government with a clear mandate for growth. Balance sheets are strong and we see lots of smaller companies with a net cash position (45% as at 30 September 2024).

Anecdotally, we are also seeing M&A interest picking up, primarily driven by overseas and private equity investors. But alongside that we are seeing a lot of buyback interest, as companies start to recognise their own value, rather than being just ripe targets for buyouts from their larger peers.

Europe might have the perception of being sclerotic, arguably even boring, but that overlooks that European small caps arguably have the most latent potential at a regional level. Europe is home to many fantastic companies that are exposed to any structural growth theme you can name. Companies with products or materials that are in consistent demand, or with scarce assets or a particular expertise that means they get paid whatever happens in the market.

While we have focused here on the UK and Europe, the global story is no different. US small cap stocks have shown signs of renewed momentum since mid-July 2024, initially sparked by anticipation of US Federal Reserve rate cuts, which duly followed. The argument now is if small caps might be on the cusp of an extended rotation. We see plenty of potential for additive stock selection across the global small cap space, given current prices (Exhibit 3).

The key thing to keep in mind with small caps is the fact that companies in this space often get very little research coverage, despite it being a huge universe. You can find cash-generative, profitable companies with a long track record, that are the dominant player in what are often niche – but essential – industries. And yet many investors do not know what they do.

Investors might have to work a little harder to find companies that have the potential to deliver, but identifying a quality growth company generating a high return on capital that has been overlooked by the market, or finding a catalyst for change, such as a new CEO with a clear plan to revolutionise a business, can be transformative to your investment outcome.

Ultimately, valuation matters. The price that you pay at the beginning of the life cycle of owning an asset is fundamental to determining the return that you make. And at the moment, valuations across the small cap universe arguably offer plenty to consider, both relative to history and relative to the large cap universe. We think that should be a core message for investors at this point in the cycle.

Asian stocks fell on Monday, following a record-setting day for U.S. stocks, as China’s stimulus package disappointed investor expectations.

China approved a 6 trillion yuan ($839 billion) plan during a meeting of its national legislature Friday. The long-anticipated stimulus is designed to help local governments refinance their mountains of debt in the latest push to rev up growth in the world’s second-largest economy.

“It’s not exactly the growth rocket many had hoped for. While it’s a substantial number, the stimulus is less about jump-starting economic growth and more about plugging holes in a struggling local government system,” Stephen Innes of SPI Asset Management said in a commentary.

Meanwhile, China’s inflation rate in October rose 0.3% year-on-year, according to the National Bureau of Statistics on Saturday, marking a slowdown from September’s 0.4% increase and dropping to its lowest level in four months.

The Hang Seng fell 1.4% to 20,439.99, and the Shanghai Composite picked up a bit, now gaining 0.2% to 3,461.41.

Japan’s benchmark Nikkei 225 edged less than 0.1% to 39,533.32. Australia’s S&P/ASX 200 dipped 0.4% to 8,266.20. South Korea’s Kospi fell 1.1% to 2,532.62.

U.S. futures were higher while oil prices declined.

On Friday, the S&P 500 rose 0.4% to 5,995.54, its biggest weekly gain since early November 2023 and briefly crossed above the 6,000 level for the first time. The Dow Jones Industrial Average climbed 0.6% to 43,988.99, while the Nasdaq composite added 0.1% to 19,286.78.

In the bond market, longer-term Treasury yields eased.

The yield on the 10-year Treasury slipped to 4.30% Friday from 4.33% late Thursday. But it’s still well above where it was in mid-September, when it was close to 3.60%.

Treasury yields climbed in large part because the U.S. economy has remained much more resilient than feared. The hope is that it can continue to stay solid as the Federal Reserve continues to cut interest rates in order to keep the job market humming, now that it’s helped get inflation nearly down to its 2% target.

Some of the rise in yields has also been because of President-elect Donald Trump. He talks up tariffs and other policies that economists say could drive inflation and the U.S. government’s debt higher, along with the economy’s growth.

Traders have already begun paring forecasts for how many cuts to rates the Fed will deliver next year because of that. While lower rates can boost the economy, they can also give inflation more fuel.

In other dealings Monday, U.S. benchmark crude oil lost 4 cents to $70.34 per barrel in electronic trading on the New York Mercantile Exchange.

Brent crude, the international standard, gave up 7 cents, to $73.94 per barrel.

The dollar rose to 153.47 Japanese yen from 152.62 yen. The euro edged down to $1.0720 from $1.0723.

Bitcoin rose 6.7% over the weekend and topped $81,000 (€76,000) for the first time in history during the Asian session on Monday amid optimism that a Trump Administration will benefit cryptocurrencies. Other cryptocurrencies also experienced a broad-based rally, with Ethereum up 8% and Cardano soaring more than 30%.

Bitcoin investors have been accumulating Bitcoin-related assets, expecting that US cryptocurrency regulations will be more favourable under a Trump administration than they are under President Joe Biden. Bitcoin surged before and after Trump's victory in the US election, with its price soaring 35% in one month and 94% year-to-date, largely attributed to the so-called "Trump trade".

The former US President has been notably pro-cryptocurrency, pledging at the Bitcoin 2024 conference to make the United States "the crypto capital of the planet" and position Bitcoin as a global superpower. Trump also vowed to dismiss Securities and Exchange Commission (SEC) Chair Gary Gensler, promising to "appoint an SEC chair who will build the future, not block the future" if re-elected.

Bitcoin has been in a range-bound movement between low-$50,000 (€47,000) to mid-$70,000 (€65,000) since March, despite favourable events including the approval of a spot Bitcoin ETF by the US Securities and Exchange Commission (SEC) in February and the Bitcoin Halving event in April. Its price soared to a new high of above $75,000 (€70,000) on election day last week, suggesting inflows picking up and leading to the breaking-through momentum.

While some analysts predict that Bitcoin could hit $100,000 (€92,000), others caution that Trump's tariff policies could reignite inflationary pressures, potentially weighing on cryptocurrency markets. Trump recently stated: "The most beautiful word in the dictionary is tariff", during an event at the Economic Club of Chicago.

Cryptocurrencies are seen as an alternative asset class, benefiting from an easing monetary environment with adequate liquidity, particularly during a rate-cutting cycle of central banks. Simply put, crypto assets tend to go up when interest rates go down; conversely, rising interest rates usually pressure these digital tokens. In a scenario where Trump imposes his pledged tariffs on other countries, we might see inflation re-elevate in the US and encourage the Federal Reserve to raise its interest rates again.

In the near term, the picture of whether the Republicans will control both the House and Senate can also impact the crypto market’s movements.

"The likely inflationary impact of the Republican promises may hit every asset class, including gold and cryptos. There is a dawning that this Red tide may mean higher interest rates for longer," Michael McCarthy, the market strategist and chief commercial officer at Moomoo, said.

Since the Paris Agreement on climate change was signed in 2015, its 195 signatories have seen financial instability resulting from the climate transition increase by approximately one third, in the context of still-increasing global emissions. In the European Union, emissions have fallen but banks have not fully internalised the costs of transitioning to net-zero. Banks continue to finance the expansion of the fossil-fuel industry. At the systemic level, this is trading a pretence of financial stability now for a more disorderly transition scenario with greater financial instability later.

Central banks are increasingly using microprudential supervisory tools to address climate-related financial risks. These tools include reviewing banks’ risk-management processes and giving warnings over shortcomings in banks’ risk models. This approach is helpful, but has so far failed to address the build-up of climate-transition-related imbalances in the financial system. This situation echoes the run-up to the 2007-2008 global financial crisis, when supervisors were busy reviewing the implementation of the latest Basel risk models by individual banks, while failing to see increased imbalances in the financial system caused by rising housing prices.

This Policy Brief proposes that central banks should take a macro approach to managing system-wide risks stemming from the climate transition. It is necessary to treat climate as an endogenous, and in many jurisdictions legally-mandated, transition, rather than an exogenous risk. The policy aim for central banks, in their macroprudential supervision capacity, should be to minimise financial instability during that transition. This Policy Brief argues that, all other things being equal, the steadiest path towards net-zero offers the greatest amount of financial stability. Current proposals to impose systemic risk buffers for climaterelated concentration risk may fail to provide such a steady reduction.

A guided transition is recommended for banks that have been reluctant to hive off profitable loans to high-emitting companies. A requirement for the financial sector to reduce financed emissions by four percentage points annually from 2025 to 2050 would deliver net-zero with the least amount of financial instability.