The dismal decade (Part 7: Seven forces shaping 2030 #4)
Phuah Eng Chye (27 July 2024)
Force #4 – Global imbalances and anorexic economies
China’s industrial domination and its threat to West
For decades, the hyper-globalised partnership of “China produces and US consumes” drove economic growth but this culminated in massive global imbalances. Michael Pettis points out “manufacturing comprises roughly 16 percent of global GDP…the manufacturing share of China’s GDP is 28 percent, among the highest in the world, whereas for the United States it is 11 percent, among the lowest for any major economy. The opposite is true for consumption. While consumption accounts for 75 percent of global GDP, it accounts for 80 percent of the United States’ GDP and only 53 percent of China’s GDP. To put it another way, while China comprises less than 18 percent of global GDP, it accounts for over 31 percent of global manufacturing and less than 13 percent of global consumption. The United States, which accounts for 24 percent of global GDP, accounts for less than 17 percent of global manufacturing and nearly 27 percent of global consumption”.
Max Zenglein and Francois Chimits notes “in 2023, China accounted for US$5.9 trillion in global trade, representing a staggering 20% of the world total, and US$5.5 trillion in foreign direct investment (FDI), about 10% of global investment stock”. “China’s initial integration was centered on exports of manufactured goods, imports of commodities, and inflow of foreign direct investment…Around 2016, the integration of China’s real economy began to level off as trade tensions with liberal market economies began to erode foreign trade and investment as Beijing’s development blueprints in its Made in China 2025 strategy and the Belt and Road Initiative (BRI) increasingly came across to Western policymakers as its bid for global domination”. “Under Xi, China’s economic policy agenda has shifted from catch-up development to boosting its security and techno-industrial position in the world. Having already greatly expanded its global economic power, China’s leadership is seeking its own development path forward and is no longer interested in pursuing the hallmarks of the classic globalization based on market interdependencies and division of global factors of production. Central to this is Beijing’s desire for a closely state-controlled economy that aims to increase foreign economic and technological dependencies on China. Beijing’s vision as a global economic superpower is based on a much more limited form of global integration than the form of globalization that preceded and permitted its own rise: China’s path forward rests on different foundations than those that propelled the global expansion of the US. China’s economic policies are now prompting responses from the US and other countries and, together with growing geopolitical tensions, driving global bifurcation and the formation of economic blocs. The increasing politicization of economic ties is beginning to impact the level of integration across various domains, including supply chains, financial systems, knowledge-sharing networks, and people flows. The outcome of this adjustment will likely alter the structure of the global economy and flow of production factors that have emerged over the past three decades”.
Max Zenglein and Francois Chimits argues “the CCP’s longstanding pursuit of self-reliance and economic resilience contrasts with the unfettered global integration pursued by liberal market economies until about 10 years ago. While China greatly benefited from the period when liberal capitalism was at its peak between 1990 and 2010, Xi’s China has no intention of following that model. Following China’s accession to the WTO in 2001, the US share of global industrial manufacturing declined to around 16.2% by 2022, while China posted record current account surpluses year after year. In contrast to the US, China has emerged as a manufacturing superpower, accounting for around 30% of global manufacturing. In Xi’s economic theory, manufacturing is regarded as the lifeblood of the country’s economy that should be increased and improved as the country moves up the value chain. Under his leadership, China has launched an ambitious effort to achieve technological self-reliance and establish itself as a global leader in emerging industries. China’s position as the world’s most dominant manufacturing power is central to its quest for more global economic power, maintaining a wide and deep industrial base as a strategic advantage. At a time when governments in G7 countries are growing increasingly concerned about their supply chain dependencies, China is well ahead in its already disproportionately large position in controlling the resources that determine such dependencies. Whether in green tech or digitalization, China’s manufacturing sector is deeply embedded in today’s technological transition. Given its size and growing sophistication, China’s market shares in advanced technologies are set to expand, and so is its capacity to influence global technology standard-setting. However, advanced economies are moving to impede China’s access to high technology, which will hinder the future development of its manufacturing value-add. Playing into Beijing’s hands is a growing perception worldwide of the relative decline of liberal market economies and the converse appeal of China’s dirigiste political and economic system. But this will also mean that China needs to deliver tangible economic benefits for its trading partners. The Belt and Road Initiative (BRI) remains a central element of China’s investment driven strategy, focusing on infrastructure development abroad. These efforts are complemented by additional development initiatives, such as the Global Development Initiative (GDI) in 2021, the Global Security Initiative (GSI) in 2022, and the Global Civilization Initiative (GCI) in 2023. Much of this strategy hinges on deepening economic engagement in nonadvanced economies, expanding China’s leadership role in the Global South, and offering an alternative growth model to follow. A report published in May 2024 from the Institute of Party History and Literature of the Central Committee of the Chinese Communist Party underlines this: The great success of Chinese modernization has challenged the superiority and arrogance of Western countries, and greatly boosted the international status, voice and influence of developing countries. Beijing seeks to frame its own modernization as mutually beneficial for all developing countries. For many countries, China represents a credible partner with the ability to deliver quickly, technological means, and financial resources to boost their own economic development. Central to China’s ability to expand its economic engagement with the Global South is its dominance in manufacturing, which complements its investments. In many areas, Chinese companies can either replace or at least provide an alternative in a wide scope of areas, ranging from 5G telecommunication networks and digital platforms to high-speed railway and energy solutions. It has facilitated rapid trade expansion as the world’s largest buyer of major commodities. Chinese investments in Latin America or Africa in turn help Beijing secure access to critical materials necessary to support its industrial dominance. China is the largest trading partner for 140 countries in 2023. But expanding trade with China is often unbalanced and accompanied by a trade deficit. Currently, only around 20 countries, primarily commodity exporters, have trade surpluses against China. A key reason is China’s structural overcapacity in manufacturing which has slowed the transition of offshoring value-add to other emerging economies. This has resulted in growing dependencies on made in China goods in regions like Africa, Latin America, and Southeast Asia”.
Max Zenglein and Francois Chimits point out “amid dwindling mutual trust and deepening rivalry between the US and China, governments are increasingly prioritizing the fortification of their economies, attempting to improve national security and economic resilience rather than seeking global integration driven by mutual benefit and market maximization. The expanding state interventions foster greater fragmentation in the global economy, as countries prioritize self-reliance and bilateral or regional partnerships over multilateral cooperation. China’s assertion and calibration of its place in the global economy aims to deepen ties with countries that share its geopolitical objectives, particularly Russia, along with a large group of potential allies in Southeast Asia, the Middle East, Africa, and Latin America. The recalibration of the global economy, driven by geopolitical considerations, is a catalyst for an unstable new order for the foreseeable future. While interdependence remains a fundamental feature of the global economy, established patterns of business activities and institutional arrangements underpinning global economic integration are beginning to unravel. China’s hedged integration and guerrilla strategy will catalyze the fragmentation of the foundations of global economic order”. In this regard, “growing geopolitical tensions, supply chain and inflation shocks, and Russia’s invasion of the Ukraine have resulted in a stronger focus on economic security. Governments are prioritizing strategies to insulate their economies from external shocks”. In addition, “multilateral organizations that formed the institutional foundation of the current world economic order, like the WTO, the IMF, and the World Bank, are increasingly dysfunctional amid rivalry among its major members. China is beginning to contest leadership of institutions and global governance developed and once led by the US. In addition to being a technology provider, the US consumer market underwrote an epoch of globalization that lifted more than a billion people from poverty in 25 years. The relative openness of the American economy in turn fed its excellence in education and innovation systems. That openness is now at risk. If the trend persists, China will have a strategic advantage in projecting economic power due to its already hedged integration. Strengthening its relatively closed economy requires fewer adjustments requiring less costly trade-offs compared to the US and its allies. China’s economic structure and limited global integration already account for the inefficiencies and costs of boosting economic security. Reducing the US’ high level of integration and openness could induce a painful transition, potentially elevating China’s economic power in a less integrated global economy. For China to maintain its economic development, it would need to structurally rebalance its economy to raise domestic consumption, which would ameliorate global economic imbalances. Instead, China’s focus on manufacturing and self-sufficiency indicates it is relegating this goal. As countries try to adjust to new realities with national priorities, increasing scrutiny and restrictions on cross-border trade and investment, industrial policies, and an emphasis on the primacy of national security mean the likelihood of much milder global economic growth, and fewer outflows of capital and technology that drive development in poorer countries”.
Qinglian He notes “France’s Minister of the Economy, Finance and Industrial and Digital Sovereignty Bruno Le Maire recently declared that the era of happy globalisation is over and that it is giving way to the era of a globalisation of rivalries…Happy globalisation is founded on the international division of labour under the principle of comparative costs – the US provides the world with a financial system for economic services, as well as high-tech products and education; the Group of Seven leverages its industrial strength and produces technology-intensive goods; while China takes advantage of its once cheap land prices and labour costs to produce labour-intensive goods and provide the world with affordable clothing, furniture and home appliances (the old three). However, just as Western countries are enjoying the abundance of cheap Chinese goods and improving their own living standards, they are also beginning to experience industrial hollowing out and structural unemployment”. “Globalisation is happy only because China was once the world’s largest supplier of labour-intensive goods; the era of a globalisation of rivalries only began because China has now become a manufacturing superpower”.
William H. Overholt’s perspective is that developing countries usually “receive special forbearance to encourage their development…For instance, the US and Europe complained about but took minimal action against Japan, South Korea, Taiwan and Singapore during the early and middle levels of their development… But success brings huge scale that begins to distort global markets and create intolerable damage. That threshold occurred in the 1980s for Japan and later for South Korea, Taiwan and Singapore. Japan’s subsidized and protected cars and consumer electronics threatened to destroy all competitors through unfair competition. The US and EU reacted strongly with tariffs, quotas and other measures. After a difficult decade, Japan (mostly) accepted the rules of fair competition. Since then, Toyota has often been the world’s biggest car company, but Americans and Europeans welcome Toyotas because Toyota’s victories are achieved by building better cars, not by theft and subsidies”. However, “when CATL and Huawei threaten to destroy all European competitors because they have access to all world markets while the Europeans are constrained in China, the damaged parties react. Chinese spokesmen often characterize these reactions as attempts to keep China down. No, they are demands that China accept the responsibilities of success. In the view of an exceptional range of neighbors, as well as their friends and allies in the US and EU, China has evolved from a victim to a predator – because policies that were acceptable or tolerable when China was weak cause serious damage to neighbors and global markets now that China has become a great power. China, a country nearing the World Bank’s high income status, now demands all the special privileges of a weak, impoverished country while simultaneously asserting itself as a powerful global leader that will reshape the world into a community of common interest as interpreted by China. This contradiction is unsustainable”. He thinks that “if China refocuses on its domestic social challenges, it will have a solid foundation for global economic and geopolitical competition. If China accepts responsibility for international stability, its fishing boats will be as acceptable globally as France’s. CATL and Huawei could enjoy accepted global pre-eminence, as Toyota does”.
William Alan Reinsch points out China’s playbook is to provide “massive subsidies[1] to create comparative advantage and then using that advantage to drive competitors out of the market. We have seen this before in steel, aluminium, wind turbines, and solar panels, and will see it in the future in mainframe aircraft. Europe is already facing it with electric vehicles”. “One of the dilemmas of a nonmarket economy is that when capital is allocated by the state rather than the market, overinvestment in favored industries is inevitable…Unfortunately, figuring out what to do about it is difficult…Doing nothing, however, is also dangerous, as it will leave our companies ultimately exposed to the forthcoming onslaught of cheap Chinese chips (products) competing in third markets…the United States has tried to address the problem through trade tools – antidumping and countervailing duties on dumped or subsidized imports. Those can work, but they apply only to the U.S. market. They do not help U.S. companies competing with China in third markets, which will be the main battleground of the future. Multilateralizing that approach will also be difficult. When other countries produce the item and are also encountering Chinese subsidized competition, they can be persuaded to consider a common approach. However, (chip) production is limited to a small number of countries. Asking Brazil, for example, to raise duties on chip imports when it has few if any injured producers is an exercise in futility”.
So far, China has resisted Western entreaties to rebalance its economy in favour of consumption. Camille Boullenois, Agatha Kratz and Daniel H. Rosen explain “China’s National People’s Congress (NPC) concluded in March 2024 with an explicit focus on industrial policy favoring high-technology industries, and very little fiscal support for household consumption. This policy mix will compound the growing imbalance between domestic supply and demand. Systemic bias toward supporting producers rather than households or consumers allows Chinese firms to ramp up production despite low margins, without the fear of bankruptcy that constrains firms in market economies. So far, policymakers in Brussels and other advanced economies have mostly fretted over excess capacity in clean technology sectors, including electric vehicles, solar modules, and wind turbines, which have already seen supply-demand imbalances in China for years. However, indications of rapid production expansion across many more sectors have emerged since 2021, as Beijing sought to boost growth with supply-side policies during and after the pandemic. The situation underscores a systemic problem, not confined to specific sectors, which will set China on course for a trade confrontation with the rest of the world”.
A Financial Times op-ed[2] sums up the dilemma well. “The US and EU can’t embrace national-security infant industry arguments, seize key value chains to narrow inequality, and break the fiscal and monetary rules, while also using the IMF and World Bank – and the economics profession – to preach free-market best practice to EM ex-China. And China can’t expect others not to copy what it does. As the FT concludes, The shift to a new economic paradigm has begun. Where it will end if very much up for grabs…the US alone can no longer carry the world on its shoulders. The Triffin Paradox looms over the global role of the dollar – and any would-be successor; and the US will not be the net importer for everyone, the net provider of financial assets to all savers, nor the world policeman for all who require it. Indeed, the latter three stand in fundamental contradiction to each other”.
The debate on overcapacity
The US-led battle cry on overcapacity is the latest addition to the list of anti-China themes such as decoupling, friendshoring and derisking. Noah Smith notes overcapacity manifests as “a seemingly huge flood of cheap Chinese goods glutting world markets and threatening other countries’ manufacturing industries”. Chen Jing reports since April 2024, “overcapacity has become the new bone of contention between China, Europe and the US. During their respective visits to China in April, both US Treasury Secretary Janet Yellen and German Chancellor Olaf Scholz expressed concerns over China’s overcapacity. At the same time, the European Union (EU) is carrying out anti-subsidy investigations into various Chinese new energy companies, while the US began Section 301 investigations into the acts, policies and practices of China targeting the maritime, logistics and shipbuilding industries for dominance. In just a month, the overcapacity controversy spread from new energy products like electric vehicles (EVs), solar panels and lithium batteries to traditional materials like steel and aluminium”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen defines overcapacity as a form of structural (rather than temporary or cyclical) under-utilisation of factory production capacity; when companies “maintain or grow their unused capacity without worrying about making a profit (or a loss)” and “when it is sustained through government intervention”. “Over-capacity is back in China” and “now affects the industrial sector as a whole”. “In early 2023, aggregate capacity utilization dropped below 75% for the first time since the worst point of China’s last overcapacity cycle in 2016”. High profile examples include silicon wafers where capacity utilization rates dropped from 78% in 2019 to 57% in 2022 while production of lithium-ion batteries reached 1.9 times the volume of domestically installed batteries in 2022. Other sectors with declining or low-capacity utilisation include machinery, food, textiles, chemicals, and pharmaceuticals as well as the property-related sectors.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen argues “the under-utilization of production capacity in China is concerning in its own right for foreign policymakers and businesses. It incentivizes firms to lower their prices in search of a market for their excess capacity. In the past, this has led to global over-supply, price declines, weak profitability, bankruptcies, and job losses…Chinese companies, across a wide range of sectors, now produce far more than domestic consumption can absorb. This domestic surplus can produce low factory utilization rates. But it can also find its way into foreign markets, creating a growing trade surplus and, at times, global redundancies that threaten industrial ecosystems in other countries. Those imbalances are not new, but they have reached unprecedented levels since the pandemic. In 2020, as COVID hit the global economy, China launched a stimulus program to boost industrial companies, with little support for household consumption. Beijing rolled out substantial tax credits, production subsidies, and interest rate cuts to keep struggling companies afloat and workers employed. When economic growth continued to disappoint in 2023, Beijing’s policy support kept the emphasis on producers, as their bias against welfarism kept policymakers from stimulating consumption. China’s growing support for its companies resulted in rapidly growing production capacity across many industrial sectors. From 2016 to 2020, investment and production capacity growth was concentrated in strategic sectors linked to the Made in China 2025 strategy, such as advanced electronics, particularly chips, and clean technology sectors. In other areas of the economy, the focus was instead on reducing capacity in the supply-side structural reform campaign from 2015 to 2019. However, this changed in 2020, with renewed growth across all manufacturing sectors, including non-strategic ones like steel products, household refrigerators, fertilizers, microcomputers, and machine tools. This capacity build-up was supply-driven, and most often not matched by equivalent domestic demand. With little support from the government, household consumption labored under strict zero-COVID restrictions and failed to pick up enough in 2023 to deliver a consumption-led recovery. The property market downturn played a role, dampening demand for a wide range of goods, from machinery to plastics and furniture. As a result, consumption did not grow nearly as fast as industrial production and investment…One last difference is how much support central and local governments have given failing enterprises with little consideration of profit and efficiency. In addition to generous credit and tax support measures, struggling companies were granted credit forbearances during COVID to help them face liquidity crunches and operational disruptions. Government support and prevention of market exit boosted the number of loss-making companies. In a crowded environment, with loose budget constraints, firms lowered prices and accepted razor-thin margins to retain market share. Perversely, it also pushed them to build additional capacity in hopes of offsetting lower margins with higher volumes, and because they knew from prior episodes that if authorities ultimately forced a market consolidation, survival would be determined based on scale, not financial health”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen points out “because China’s previous cycles of policy-driven capacity expansion severely affected global markets – especially in steel and aluminium, but also in promising sunrise industries like solar panels – advanced economies are watching with intense concern and evaluating response options. In 2023, the number of EVs exported from China was already 7 times greater than in 2019 and 1.7 times greater year-on-year. China’s exports of solar cells in 2023 were five times larger than in 2018, and 40% above 2022 levels. These surges are potentially devastating to market-constrained producers in advanced economies. The growing mismatch between fast-paced capacity expansion and slow-growing domestic demand in China will have trade impacts beyond green technology sectors too. China’s share of global trade expanded by 1.5 percentage points in 2020, arguably in the context of global supply chain disruptions that put China at a global advantage. But, importantly, that share did not come down as COVID-19 restrictions retreated everywhere. In select sectors, Chinese firms have been gaining significant global export shares in the past four years. In the electronic machinery sector, for example, China’s share of global exports grew more than 5 percentage points between 2019 and 2022 in 18 of 46 HS-4 product categories. In 2016-2019, that was the case for only 7 out of 46 categories. In lower-technology sectors such as textiles and furniture, China has also been re-gaining market shares it had lost in previous years due to diversification of production and relocation to lower-cost destinations. Export gains are not the only spillover channel for China’s rapidly growing production capacity. In sectors where China used to be a net importer, such as the petrochemical sector, the combination of domestic production capacity increase and weak demand in China resulted in sometimes drastic declines in Chinese imports, affecting firms in Europe and the United States”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen note “low prices are not the only factor behind Chinese firms’ ability to export their growing capacity abroad. Competitiveness is another one. By lowering firms’ costs, allowing them to scale up, and increasing their ability to improve products as they learned by doing, state support made some Chinese companies fiercely competitive in global markets. The electric vehicle sector is a case in point. The top Chinese exporters of EVs, BYD and SAIC, are not the most affected by overcapacity – they are close to working at full capacity. Still, these carmakers were able to leverage the supportive environment of the past four years to become more efficient and more technologically competitive than their rivals. Facing low profit margins in China today, and intense competition, they are uniquely equipped and motivated to capture growth and profits outside of China. The effects of this new wave of policy-driven capacity expansion in China are not yet all visible. In certain industries, the timeline from investment to production can stretch over years, meaning that funds allocated in 2021-2022 might only begin to materialize into market-ready products or services several years later, with a delayed impact on Chinese and global markets”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen argue “although overcapacity created strong deflationary pressure within China, it has not yet impacted global prices to the same extent. In fact, China’s export prices were up in most sectors in 2023 compared to 2021, and the prices of imports from China rose more quickly than the prices of imports from other extra-EU countries in 2021-2022, before decelerating in 2023. This is because many Chinese firms are still using overseas markets to make up for lower prices, margins, or even losses on the China market. But this China-world price discrepancy also means that Chinese firms could lower their export prices further in the future to gain market access, weed out competitors, or make up for new tariff barriers in the EU or the US”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen note “in the last two quarters of 2023, China’s capacity utilization rates have picked up, reaching 75.9% – a level similar to 2018-2019. However, China’s capacity expansion in manufacturing sectors will likely stay elevated in the long run, creating episodes of overcapacity and further effects on global trade. In previous overcapacity cycles, cheap Chinese exports contributed to rising trade tensions and a series of anti-dumping investigations, such as the EU investigations on Chinese steel in 2016. Overcapacity also hurt Chinese companies’ profits and came with unsustainable debt growth. Reducing overcapacity thus became a priority for the Chinese government in 2016. This time around, the Chinese government is also expressing awareness of the issue. The Government Work Report in March 2024, for example, mentioned strengthening investment guidance for key sectors to prevent overcapacity, poor quality, and redundant development. However, the solutions adopted will likely center on retiring obsolete capacity and letting the most uncompetitive companies shut down while continuing to support capacity expansion, innovation, and exports in others…This policy mix is part of a broader economic strategy that emphasizes manufacturing and exports as key growth drivers. Beijing has made clear in recent years that it wants to prevent China from de-industrializing, including in low-tech industries that would otherwise naturally migrate to lower labor-cost countries. Since the 14th Five-Year Plan in 2021, Beijing has vowed to stabilize the share of the manufacturing sector in GDP – a reversal of a decade-long trend…Beijing is also desperately looking to rebalance the economy away from the infrastructure and property sectors and toward new growth drivers. Yet in the absence of a clear strategy to prop up consumption, this means supporting the manufacturing industry – particularly in emerging sectors such as renewable energy and electric vehicles – as a core engine of growth”.
Camille Boullenois, Agatha Kratz and Daniel H. Rosen conclude “the systemic nature of China’s trade surplus and market distortions, not confined to specific sectors, may also motivate larger actions. Strong measures such as revoking the Permanent Normal Trade Relations status or introducing a new tariff column for China are already on the radar of US politicians during an election year. But China’s growing manufacturing surplus is not only a problem for the US and the EU. In fact, China’s trade surplus with G7 countries grew by a third between 2019 and 2023 while it more than tripled with developing economies, setting a daunting barrier as they try to nurture their own industrial sectors. The spillovers of China’s domestic imbalances are already compelling a response from a broader set of countries, including Brazil, India, Mexico, and South Africa. If China’s imbalances continue, this emerging market pushback will also likely intensify”.
Noah Smith offers several theories that plausibly explain why “Chinese cars, chips, steel, solar panels, machinery, and other goods are flooding world markets”. First, industrial expansion is being used replace real estate – “since Xi Jinping doesn’t seem to believe that consumption and service industries make a country strong” – to stimulate economic growth and keep employment steady. Second, related to this, while China’s consumption has slowed down, government subsidies and other factors has kept production going. “In part, China’s overcapacity is achieved by firms selling at or below cost – enabled by policy decisions that unfairly depress capital, labor, and energy costs…the government continues to support companies such as Zhido and others, encouraging unprofitable carmakers to keep producing as officials try to boost economic growth, preserve jobs and expand China’s role in the global electric-vehicle business”. A more benign explanation is that swings in consumption in China’s large domestic market may be so rapid and volatile that it can “result in swings in imports and exports that look huge from an international perspective but are actually small compared to the domestic market. For example, Chinese domestic vehicle sales have decreased recently…coupled with roughly flat production, has resulted in a gigantic percentage increase in auto exports, even though those exports are still only one-sixth of domestic consumption: Similar patterns manifest in steel and some other industries. In fact, China exports far fewer cars as a percent of total production than countries like Japan or Germany. But because China is just so huge, what look like small swings to China are huge, disruptive swings for other countries around the world”. Third, some Chinese policymakers believe China has a comparative advantage in manufacturing “and that fundamental economic factors dictate that China should do more of it, and other countries should do correspondingly less”.
Fourth is the hypothesis the Chinese government subsidises industries to intentionally force the deindustrialisation of its geopolitical rivals. Noah Smith notes “gaining a commanding share of global manufacturing might even allow China to displace the US and its allies as the world’s dominant power – something the country’s leaders have repeatedly said they want to do – without a fight”. If the West is “bereft of manufacturing industries”, China would gain a military advantage and create a window to “accomplish its military objectives (e.g. conquering Taiwan), and establishing itself as the global hegemon”. Fifth, President Xi Jinping and Chinese policy elites believe there are hinge points to human history “where emerging technologies can topple an existing economic order…The British Empire and the United States rose to global hegemony because each pioneered a global techno-economic revolution. Now the past repeats. Humanity again finds itself on the precipice of scientific upheaval”. “Xi argued that historical experience shows that [these] technological revolutions profoundly change the global development pattern. Some states seize this rare opportunity. Others do not. Those who recognize the revolution before them and actively take advantage of it rapidly increase their economic strength, scientific and technological strength, and defense capabilities, thereby quickly enhancing their composite national strength. Sixth is the theory that “China’s subsidy-driven manufacturing boom represents the beginning of war production…building up civilian industries like steel and computer chips that are easily converted to military use could be a way of preparing for this conversion…any country at war is vulnerable to having its supply lines cut, so building up domestic manufacturing of critical components like chips is a way to insulate a country against sanctions and blockades…This…suggests that the export boom might be incidental – an accidental side effect of China’s creation of the greatest military production machine the world has ever known”.
Martin Chorzempa notes “China’s most recent macroeconomic data reinforce the arguments of those accusing China of macro-level overcapacity. In June 2024, China recorded its largest ever trade surplus, at $99 billion. At the same time, monthly imports fell from a year earlier, and year-to-date imports were only up 2 percent. Falling export prices overall but also for EVs, semiconductors, batteries, and solar panels mean that even that record surplus understates the increased quantity of goods reaching world markets. China can legitimately argue that it has improved its balances, producing trade and current account surpluses that are smaller as a share of its economy than in the past, but its critics can also legitimately say China should be held to a higher standard. China’s smaller surpluses as a share of its GDP today translate into a larger impact on trading partners, because of its larger share (20 percent) of world manufacturing exports as of 2020, double its share in the mid-2000s”.
China’s defence on over-capacity is incoherent but this is due to the complexity of issues. Global Times labelled US allegations of forced technology transfer and intellectual property theft along with overcapacity as a means of justifying imposing high tariffs on Chinese goods and argue “these are fragile lies that can easily be exposed”. It also accuses the US of “suppressing advanced industries of other countries under the banner of overcapacity and using fair competition as an excuse to promote protectionism are blatant bullying”. It claims “Chinese technology is advanced and does not need to compel American companies to engage in forced technology transfer, nor is there intellectual property theft“. It argues “any product that the US lacks competitiveness in and is important to the US can be arbitrarily labeled as overcapacity…the so-called overcapacity of some Chinese products is the result of the US’ policy of trade protectionism and market distortion behavior. If the US opens its market, the overall supply and demand of these products in the international market will be more balanced, and the demand for new energy products in the US will also be met”.
Chen Jing notes “Chinese officials initially emphasised that the (new energy) sector developed rapidly through its advantages like technological innovation, a comprehensive supply chain, and effective market competition, instead of government subsidies…a Chinese Ministry of Commerce spokesperson went on to say that from a global perspective, the new energy sector is facing a capacity shortage rather than overcapacity”. “According to the China Metallurgical Information and Standardisation Institute, there were 112 anti-dumping or anti-subsidy government circulars issued in various countries around the world against Chinese steel products in 2023, 20 more than in 2022. Other than the developed economies in Europe and the US, developing countries like Brazil, Mexico, Chile, and others have also started pushing back against Chinese goods”. Yet, “China only exports about 5% of its overall steel output, which is far lower than the export ratios of Japan or Korea, so…the allegations against Chinese overcapacity are unfair”. “China accounts for around half of global steel production. Even if it only exports 5% of what it manufactures, this is enough to impact the global market”.
Chen Jing points out the central economic work conference in 2023 admitted “the issue of overcapacity in certain industries was mooted for the first time in five years, and it was labelled one of the challenges that China needs to overcome for its economy to recover. The Chinese State Council Government Work Report…reiterated this view, urging more precise oversight to foster coordinated development and investment in the country’s key industries to prevent overcapacity and low-quality duplications. Putting aside trade risks, overcapacity would also cause the prices of goods in China to decline and local companies to face higher debt risks, potentially impacting jobs and incomes”. Various schemes have been rolled out to encourage upgrading of industrial equipment and nationwide trade-in of consumer goods including automobiles, household electrical appliances, and kitchen or bathroom fixtures to boost consumption and reduce surpluses. Global Times report China’s Ministry of Industry and Information Technology (MIIT) had “issued draft rules for the country’s lithium-ion battery industry, aiming to guide companies to reduce projects that aim solely to expand production and instead focus on technological innovation…In an apparent bid to guide companies to bolster research and development (R&D), the draft rules require lithium-ion companies to spend at least 3 percent of the revenue from their main business on R&D and technological upgrades. They also set specific standards of energy density for various types of lithium-ion batteries”. Hence, the Chinese government understand SOEs, private firms and financiers have gone overboard in expanding capacity and needed to be reined in.
Martin Chorzempa explains “overcapacity is related but not identical to typical trade concepts of dumping or macroeconomic concepts of balances. If excess capacity is dumped on foreign markets at prices below cost or fair value, or if unfairly subsidized foreign competition harms domestic producers, then World Trade Organization (WTO) rules allow countries to impose antidumping or countervailing duties to stop harm to their domestic industry. China has faced many of these allegations – even before former president Donald Trump’s trade war, 7 percent or $100 billion in China’s exports to G20 economies faced antidumping or related trade restrictions. Many industries, like semiconductors, experience cycles of demand and supply in which sometimes there are shortages and other times there are gluts. Much of the problem lies not necessarily with nefarious plans to bankrupt foreign producers but with poorly coordinated industrial policy in which local governments subsidize producers in industries favored by Beijing, leading to subsidized competition that produces nonmarket distortions, preventing local firms from failing and in the process driving down global prices. China is not wrong when it says that its solar panels, batteries, and EVs are not just cheap, subsidized products but are highly competitive and innovative. In addition, precipitous price declines because of overcapacity is only one side of the tradeoff. While a bane for foreign producers, low prices can be a boon for buyers of these goods. If prices are low because of Chinese subsidies, then Chinese public money will have subsidized the global green transition. The landscape is uneven, however: While Chinese producers benefiting from local government subsidies sell below cost in the solar sector, China’s leading EV producer BYD in fact charges more and makes solid profits from sales in Europe, not a typical dumping case. Past examples of steel overcapacity seem to fit and were met with antidumping measures, but these map less easily to EVs. The Biden administration has legitimate concerns about the US and the world being completely dependent on Chinese green technology and is willing to pay a large cost through tariffs and subsidies to develop its own offerings. Tariffs and subsidies alone, however, will not replicate Beijing’s formidable green energy sector, so resilience benefits from reliance on non-Chinese production will come at a significant cost”.
Han Feizi defends China’s approach. “China stomped on its tech monopolies and now manages to deliver similar if not superior products and services – able to make inroads into international markets (e.g. TikTok, Shein, Temu, Huawei, Xiaomi) – at always much lower prices. The Western business press, confusing incentives with outcomes, lazily relies on stock markets to determine value creation…What China has done in industry after industry is to flatten the supply curve by subsidizing hordes of producers. This spurs innovation, increases output and crushes margins. Value is not being destroyed; it’s accruing to consumers as lower prices, higher quality and/or more innovative products and services. If you are looking for returns in the financial statements of China’s subsidized companies, you are doing it wrong. If China’s subsidized industries are generating massive profits, policymakers should be investigated for corruption”. For example, China’s EV subsidies has triggered “a Cambrian explosion of market entrants flooding China’s market with over 250 EV models. Unbridled competition, blistering innovation and price wars have blinged out China’s EVs with performance/features and lowered prices on all cars (both EV and ICE) by $10,000 to $40,000. Assuming average savings of $20,000 per car, Chinese consumers will pocket ~$500 billion of additional consumer surplus in 2024. What multiple should we put on that? 10x? 15x? 20x? Yes, China’s EV industry is barely scraping a profit. So what? For a measly $231 billion in subsidies, China has created $5 to $10 trillion in value for its consumers. The combined market cap of the world’s 20 largest car companies is less than $2 trillion”. “The more significant outcomes of industrial policy are externalities…To name just a few, switching to EVs weens China from oil imports, lowers particulates and CO2 emissions, provides jobs for swarms of new STEM graduates and creates ultra-competitive companies to compete in international markets. Externalities from the stunning collapse of solar panel prices may be even more transformative. Previously uneconomic engineering solutions may become possible from mass desalinization to synthetic fertilizer, plastics and jet fuel to indoor urban agriculture. China could significantly lower the cost of energy for the Global South with massive geopolitical implications”.
Gao Shanwen[3], Chief Economist at SDIC Securities, explains the Chinese government views overcapacity as “an unavoidable phase in the development of emerging industries…emerging industries must endure a painful but inevitable phase of overcapacity and subsequent capacity reduction. Only after this phase can the industry mature, stabilize, and enable companies to achieve profitability and provide sustainable dividends to shareholders…industries such as railroads, automobiles, telecommunications, and computers have faced similar overcapacity issues, demonstrating the universality of this phenomenon”.
Gao Shanwen argue it is misleading to perceive “overcapacity in China is a result of the country’s industrial policies and government subsidies…In the late 1990s, following rapid expansion throughout the 1980s, China’s textile industry experienced severe overcapacity. Market mechanisms for natural selection and exit were not functioning smoothly, forcing the government to implement large-scale administrative measures to reduce excess capacity, known as the spindle reduction campaign. Since the 21st century, China’s textile industry has not faced severe overcapacity again and has become relatively stable and globally competitive with limited growth. In 2016, China launched the policy to cut overcapacity, reduce excess inventory, deleverage, lower costs, and strengthen areas of weakness…in industries like steel, cement, and coal. Between 2017 and 2019, despite limited overall economic growth, the prices and profitability of these industries significantly recovered. These examples indicate that the Chinese government does not favor overcapacity but is compelled to resort to strong administrative measures to reduce it due to inefficient market competition and exit mechanisms. Other sectors, such as home appliances and baijiu (Chinese liquor), have also experienced significant overcapacity and transitioned to market-driven clearance, which cannot be attributed to government subsidies”.
Gao Shanwen note “the role of local government incentives in exacerbating overcapacity remains contentious. From a micro perspective, the issue is clear: local governments swarming to provide cheap land, credit support, and various subsidies to relevant enterprises naturally leads to more new capacity and worsening overcapacity. From a macro perspective, however, the situation is more complex. In an open economy, the increased competitiveness to an industry, driven by local government subsidies, would result in more exports, leading to stronger pressure for RMB appreciation. Currency appreciation would counteract the effects of government subsidies, discriminating against industries that did not receive subsidies and weakening their competitiveness. Thus, competitive advantages in some industries develop simultaneously with disadvantages in others”. In addition, “China is a massive economy, and its enormous export competition has created strong political opposition from affected U.S. groups. Meanwhile, beneficiaries of China’s rise, such as Wall Street, multinational corporations, and ordinary consumers, are either too dispersed or politically marginalized to counterbalance this opposition. This dynamic is an important backdrop to the U.S.-China trade disputes”.
To address overcapacity disputes, Gao Shanwen recommends “first, strategically, China should unwaveringly shift towards expanding domestic demand, with a particular focus on increasing domestic consumption to drive economic growth. Second, efforts should be made to maintain stable aggregate demand, smooth out economic fluctuations, maintain exchange rate flexibility, and ensure international coordination and communication of macroeconomic policies. Third, when emerging industries achieve competitive advantages, China should promptly phase out related supportive industrial policies. This includes guiding the internationalization of industry supply chains, production, and sales systems to enhance resilience against trade frictions and promoting the timely market-based elimination of inefficient capacity. Finally, China should strive to uphold a rules-based international trade system centered around the WTO, continue to advocate for and promote free trade, maintain restraint and rationality, and address trade disputes through agreed-upon dispute resolution mechanisms”.
The source of China’s overcapacity thus stems from excessive competition and industry disruption rather than protection. In a crowded field, players compete for survival and emphasise on scale, speed and target market share rather than profits. Everyone can see an industry fall-out is looming, that there isn’t enough room for so many players. As long as provincial governments, financiers and investors are willing to back their players, the overcapacity problem will persist. The fallout is something China’s government (as well as Western governments) should anticipate and prepare to manage. In the car industry, the initial victims of intense competition and industry disruption are the marginal legacy foreign manufacturers which have either exit China or shut down their Western EV operations because they are unable to compete on prices and value and they are under pressure to generate returns to shareholders.
Although the West complains a lot about “overcapacity”, David P Goldman explains “the remarkable thing is that China’s exports to developed markets haven’t moved much, while exports to the Global South doubled in the past four years”. “Tariff avoidance through the extension of Chinese supply chains to the developing world, that is, explains about half of China’s export growth to the Global South. The other half comes from industries that China has come to dominate during the past several years: electric vehicles, solar panels, digital infrastructure, transportation infrastructure and electronic equipment”. He notes the Global South “has virtually unlimited demand for $10,000 electric vehicles, cheap solar panels and broadband infrastructure”. In addition, “China’s exports to the Global South have built productive capacity in low-income countries that support higher exports to the United States and other developed markets. China, in other words, is building infrastructure and manufacturing, not simply flooding the Global South with cheap consumer goods”. “China has fostered an unprecedented wave of entrepreneurship in the developing world, by building mobile broadband networks throughout the Global South. A notionally communist party, that is, has become the most effective propagator of capitalism on record. This conclusion is richly supported by data on broadband usage, business formation, and economic growth. All the available evidence indicates that China’s remarkable export performance is driven by manufacturing productivity due to investment in robotics and AI applications”.
David P Goldman points out China has overcome sanctions and export controls to continue its techno-industrial advance. Huawei has built 3.8 million 5G base stations (as compared with 100,000 in US) using older-generation chips manufactured in China and recently launched a 5G smartphone with an advanced 5G chip produced in China. “The US policy community can’t admit that it was collectively, catastrophically wrong, and is groping for an explanation of Chinese success”.
David P Goldman also rules out a weak currency as a reason for China’s export success. “China’s real effective exchange rate (its exchange rate adjusted for inflation) has risen rather than fallen, according to the Bank for International Settlements, from an index level of 50 in 1994 to a level of 90 today. It fell during the past two years but not nearly as much as the Japanese yen. Moreover, Japan’s exports stagnated despite the sharp fall in its inflation-adjusted exchange rate, while China’s leapt. That’s an appropriate comparison because China and Japan compete directly in the world’s largest industry, namely automotive. China exported 5.22 million passenger cars in 2023, a 57% jump from the previous year, while Japan – previously the world’s largest auto exporter – sold only 4.22 million, a 16% increase”. “Drastic reductions in EV prices stem not from currency fluctuations but from enormous economies of scale in vehicle production. China last year installed more industrial robots than the rest of the world combined”.
Overall, the debate on overcapacity and subsidies are frankly superfluous. The US campaign against China has been broad covering issues ranging from trade unfairness, human rights, ideological differences and even China’s territorial disputes. Hence, the problem isn’t overcapacity per se but reflects growing US anxiety about China’s challenge to its hegemony and an intensification of the economic war. Western complacency has allowed China a head start to entrench itself. China has gained dominance in global manufacturing and this is a magnet for global dissatisfaction and retaliatory actions. Hence, criticisms on overcapacity and subsidies can be seen as part of an ongoing battle to break China’s global industrial dominance. However, it is evident China does not intend to repeat Japan’s mistake of retreating under geopolitical pressure as this will inevitably result in losses. It will also be an uphill task for challengers because the Chinese government’s approach is to subsidise disruption rather than preserve legacy businesses and Chinese MNCs pursue market share rather than profits. With both sides doubling down, “overcapacity” will turn into a “survival-of-the-fittest” contest.
Decoupling is deteriorating into a “beggar-thy-adversary” trade war
The West is giving notice that it will no longer tolerate China’s manufacturing dominance; a stance accompanied by narratives that China unfairly subsidises its industries, practises IP theft, and doesn’t provide a level playing field for foreign players in its market. China domination of global supply chains is blamed for the hollowing out (of manufacturing) in Western economies. However, recent escalations by US and EU[4] is meeting a strong reaction from China. This affirms the economic conflict is degenerating into a muscular “beggar-thy-adversary” trade war.
Chen Jing notes “market watchers are worried that the trade barriers arising from the debate over overcapacity might escalate into a fresh round of trade war. Jens Eskelund, president of the EU Chamber of Commerce in China, warned that as the wave of protectionism surges, China and the EU are facing a slow-motion train accident, and trade friction between both sides might escalate into a full-blown trade war”. Mary E. Lovely points out “fundamentally, US trade since the onset of the trade war has shifted away from attempts to change Chinese behavior through dialogue, defensive trade remedies, and dispute settlement to one aimed at reducing the level of bilateral economic integration”.
The US has continued with its barrage of sanctions and tariff measures. The latest appear intended to “shock-and-awe” with a headline-grabbing rise in EV tariffs from 25% to 100%. Tariffs on semiconductors, solar cells will rise from 25% to 50%; needles and syringes from zero to 50%; lithium-ion batteries, ship-to-shore cranes, graphite and other critical minerals to 25%; and face masks, rubber medical and surgical gloves, and steel and aluminium products from 7.5% to 25%.
The actual impact of the latest tariffs is thought to be minimal (estimated at $18 billion). My view is the “outrageous” tariff levels are intended to be symbolic, a call-to-arms to rally allies and hopefully to bring on board some Global South countries to join in the actions against China’s dominance of global manufacturing and to provide cover for them to follow US’s lead. Noah Smith notes recently, “the big economic news…was Biden’s very large tariffs on a number of Chinese-made goods. Those tariffs appear to have acted as a catalyst for a bunch of other countries – India, Brazil, Vietnam, Thailand, Mexico, the EU, etc. – to consider their own tariffs on China. In other words, much of the world now sees the Second China Shock as a danger to their own manufacturing industries and is acting accordingly…Most of the new trade barriers and industrial policies that we see popping up all over the world are either directly or indirectly China-related. The new tariffs are explicitly in response to China’s vast and rising trade surplus in manufactured goods”. Hence, US has sought to normalise trade actions against China’s industrial dominance (an asymmetric response to China pushing to normalise de-dollarisation against US financial dominance). On a similar note, US has also been “encouraging” other countries to follow its lead of sanctioning, blacklisting and restricting Chinese industries, firms and products.
As China’s manufacturing expansion threatens to further erode Europe’s industrial base and turn their bilateral trade surplus into a deficit, Europe[5] appears to be finally getting on board with US-instigated and India-styled protectionism. Jeff Pao notes China Chamber of Commerce complaints on EU raids on the offices of a Chinese security equipment supplier and probes into China’s procurement market for medical devices. This marked “the fifth investigation launched by the EU against Chinese firms in recent months. Prior to this, the EU has launched investigations against Chinese suppliers of solar panels, wind turbines and electric trains. It accused China of using its socialist economic system to groom its state-owned-enterprises and win green project contracts in Europe. Last October, the EU launched an anti-subsidy investigation into Chinese electric vehicles”.
Arising from coordination with the US, Jeff Pao reports “the European Union is preparing two surveys aimed at checking how China’s growing production capacity of older-generation semiconductors is affecting the bloc…The EC will ask chip-consuming firms about where they source their so-called legacy chips, which refer to 28-nanometer and older mature chips. Separately, it will ask EU chipmakers about their products and pricing, and their estimates of the same information from their competitors, including the Chinese ones. Prior to this, the EC had already said…it would carry out surveys to assess the trustworthiness of legacy chips used in everything from aerospace to automobiles to home appliances and to find evidence of market distortions”. This follows from an US Bureau of Industry and Security (BIS)’s study which said “the Chinese government had provided its chipmakers with about US$150 billion in subsidies over the past decade, which it estimated is likely to create a non-level global playing field for US and other foreign competitors”. “China’s global market share for mature chips will increase from 31% at the end of last year to 39% by 2027, according to a TrendForce analysis. According to the Ministry of Industry and Information Technology, China’s integrated circuit production rose 32.7% to 170.3 billion units in the first five months of this year from a year earlier. China’s customs data shows its exports of integrated circuits grew 10.5% to 113.9 billion units, over the period. Global semiconductor industry sales surged 19.3% to US$49.1 billion in May 2024 from a year ago, the Semiconductor Industry Association (SIA) said…Year-to-year sales were up in the Americas (43.6%), China (24.2%), and Asia Pacific/all other (13.8%), but down in Japan (-5.8%) and Europe (-9.6%)”.
S&P Global notes US[6] and EU are making inroads into China’s EV battery manufacturing dominance. Their investments into clean technology manufacturing has risen on the back of the US Inflation Reduction Act and EU’s Net Zero Industry Act. It cited an International Energy Agency (IEA) report which projects that China’s share of battery manufacturing capacity could fall from 80% in 2023 to 60% while US and EU could nearly triple their existing share of around 5% each in 2030. “In solar PV manufacturing, however, China is expected to retain the bulk of its 80%-plus market share through to 2030 despite advances in this sector by the US and India. A plant-level assessment of more than 750 facilities indicated China remained the lowest-cost producer of all clean energy technologies, with battery, wind and solar PV facilities typically 20%-30% more expensive to build in India than in China, and 70%-130% more in the US and Europe”.
The US is also starting to crack down on “connector” economies in the Global South. Nick Corbishley notes “Mexico’s government announced hundreds of temporary tariffs on imports from countries with whom it does not have a trade agreement. The tariffs have been imposed on 544 imported products, including footwear, wood, plastic, electrical material, musical instruments, furniture, and steel, and range from 5% to 50% in size. They have one clear target in mind: imports from China, Mexico’s second largest trade partner, though the word China is not mentioned once in the decree”.
Liu Sha notes a Bloomberg report suggesting “US officials have become increasingly concerned that critical technology, infrastructure and data headed for the UAE may eventually fall into the hands of Beijing…although Gulf countries officials emphasised that they are not replacing the US as a major investment partner, the US government is still worried. In February this year, G42, an AI technology and investment company owned by Mubadala the government investment arm of Abu Dhabi, announced its divestments in China to focus on Western markets such as the US instead. G42 CEO, Xiao Peng, had earlier said that they were in a position where they had to make a choice to allay the concerns of its American business partners in order to continue accessing advanced computer chips manufactured in the US. G42 then sold its shareholdings amounting to nearly US$500 million in Chinese companies like Bytedance, JD.com and HeyGears. Those in the industry believe that G42’s decision indicates that the ADIA is paying more attention to the risks brought by increased scrutiny from the US. This is also the consideration of a substantial number of Middle Eastern investors, and a challenge arising from the current Sino-US competition”
Jin Jian Guo points out China’s role as the world’s factory is being eroded as more countries join in actions against Chinese firms, products and investments. “The Economist pointed out last year that a crescent of 14 countries and regions including India, referred to as “Altasia” (alternative Asian supply chain), could gradually replace China in the coming years and become the centre of the world’s manufacturing activities…India is the focal point of Asia’s supply chain shifts. The Indian government is aggressively pushing for its Make in India initiative, leveraging the changing China-US relationship and actively seeking foreign investments to develop its own chip manufacturing sector…Foxconn’s investment in India has also changed the location where Apple’s iPhones are assembled. Until 2019, about 99% of iPhones were made in China. But India is now chipping away at China’s dominance. Last year, around 13% of the world’s iPhones were assembled in India…The volume produced in India is even expected to double by 2025. At the end of last year, Foxconn already announced investments of over US$1.5 billion in India; in March this year, it announced a US$700 million investment for the construction of a new plant in India as part of its efforts to diversify manufacturing away from China. In February this year, the Indian government approved US$15.2 billion worth of investments in semiconductor fabrication plants, including a Tata Group proposal to build the country’s first major chipmaking facility and a packaging venture between Japan’s Renesas Electronics Corp. and the Murugappa Group’s CG Power and Industrial Solutions Ltd. Taiwan’s Powerchip Semiconductor Manufacturing Corporation has also confirmed that it will assist the Tata conglomerate in building India’s first 12-inch wafer fab”. He adds “Taiwan Semiconductor Manufacturing Company (TSMC) is building factories in the US, with the first one due to begin operations in 2025 and the second one possibly starting operations in 2027. Operations at TSMC’s Japan factory are expected to start this year…South Korea’s SK Hynix is planning to invest about US$4 billion to build an advanced packaging plant in the US, while South Korean battery maker Samsung SDI is also set to build a battery plant in the US”.
The broad range of actions to exploit China’s vulnerabilities ranging from trade and investment decoupling combined with moral suasion on Western MNCs to curtail their operations or exit China, and to withdraw capital are already having an adverse impact on China’s economic growth and financial stability. Importing countries are also putting pressure on Chinese firms to relocate their production facilities rather than to export from China. In relation to this, Chinese firms are also at a stage where it makes sense for them to expand abroad. This has resulted in Chinese FDI outflow which is adding to pressures on China’s economy.
From an asymmetric warfare viewpoint, US is signalling to allies and others to act in unison against China’s manufacturing dominance with a view to turning China’s open-door policy from a strength into a weakness. The US has probably figured that it needs to escalate trade actions against China to knock it off its comfortable position of “restraint” that allows it to enjoy the best of both worlds – foreign investments into China and manufacturing exports to the rest of the world. Hence, if China continues to exercise restraint, trade actions against China could build momentum and eventually reach a point where it seriously damages China’s access to export markets. If China retaliates against foreign trade actions, this increases the risks of strategic errors which could turn more nations against it.
China has limited strategic options in this conundrum. There really isn’t any upside for China to compromise. Placating the West will instead reveal China’s weakness and is likely to be exploited with the West demanding even more concessions. The rarely-mentioned lesson from Japan’s Lost Decades is that Japan might have been better off if it did not relinquish its technology ambitions. China is unlikely to back down on its manufacturing dominance because it does not wish to remain subordinated to Western powers. In any case, this is hardly the time for China to take its eye off the manufacturing ball. China’s techno-industrial success has whetted everyone’s appetite and they want a piece of that pie. The threat to China’s manufacturing dominance doesn’t only come from the West but also from India and several Global South countries. The pie isn’t simply isn’t going to be large enough for everyone. If China backs down, it is likely to find itself steamrolled over. In summary, China’s industry has momentum and advantage. Breaking that momentum suddenly through “voluntary restraint” can cause irreparable damage to its long-term prospects.
In any case, it should be recognised that the decoupling is cutting deeper and the conflict is moving onto a different phase. There is little point for China to persist with its passive “open” strategy and several reasons why it is timely for muscular retaliation. First, China’s needs to demonstrate it is prepared to retaliate to deter further hostile trade actions. In this context, it should be noted that while China probably is more dependent on the US, the reverse is true for the rest of US allies. As allies “copy” US trade actions, they could find themselves losing more than they bargained for.
Second, the art of war[7]advises it is timely to counter-attack when Western reindustrialisation is mid-stream towards operationalisation. Hence, China should retaliate to interrupt the West’s new production capacity that is slated to come onstream in 2025-6. The new plants in the West will then face challenges upstream trying to secure inputs while facing a price war downstream. Third, China has already built its fallback position – by rapidly increasing trade with the Global South to a size sufficient to reduce its dependence on Western markets and by domestic firms capturing foreign market share in China. China is thus positioned to openly defy Western sanctions and to retaliate as it increasingly has less to lose from loss of Western markets.
Preparations for retaliation against the West has been ongoing. Rebecca Arcesati notes “Chinese export controls came into focus in summer 2023, when the Ministry of Commerce (MOFCOM) announced new licensing requirements on the export of gallium and germanium, critical minerals in semiconductor manufacturing…While germanium is used in fiber optics and solar panels, and gallium in consumer electronics and 5G telecommunications, both are key for the aerospace and defense industries. In 2023, the Chinese government added US defense contractors Lockheed Martin and Raytheon to its Unreliable Entities List…It also deemed memory chips from US defense contractor Micron to pose a risk to its domestic critical information infrastructure. Just as Washington’s export controls seek to kneecap military modernization by curtailing China’s capabilities in semiconductors, artificial intelligence and supercomputers, Beijing could be doing the same with strategic defense minerals. China’s leaders would likely assert its latest controls are actually a measured response to the Biden administration’s muscular strategy of containing China’s technological progress”. “China also uses export controls to prevent others from building alternative supply chains that threaten its industrial and technological leadership. The EU, US and others have grown uneasy with China’s dominance in the value chains of many products needed for their low-carbon transition, such as batteries, high-performance magnets, electric vehicles (EVs), solar photovoltaic (PV) modules, and fuel cells. Losing this indispensability would erode China’s strategic and geoeconomic leverage. If G7 economies want to de-risk from China, Beijing will not let them do so easily with raw materials and technology it supplies. China enjoys a strong upstream advantage in many areas, like graphite, of which it is the world’s top producer and exporter. In October, MOFCOM announced some changes to existing dual-use licensing requirements for some types of graphite. In the past, China reportedly already withheld some graphite exports from Swedish producers of lithium-ion battery cells. The new measures specify synthetic graphite, needed for battery production, just weeks after the European Commission announced an anti-subsidy investigation into imports of battery EVs from China. Retaliation and the defense of industrial interests can go hand in hand. Crucially, supply chain security goes beyond raw materials. It also includes technology and intellectual property required in mining, refining, and manufacturing processes. In proposed amendments to its Catalogue of Technologies Prohibited and Restricted from Export, Chinese authorities initially mulled new licensing requirements for technology needed to make solar wafers for PV panels. They then dropped those changes in the final version of the amended catalogue, but proceeded to ban the export of technology used to process rare earths and manufacture magnets from them”.
Chen Jing notes “on 19 April, its Ministry of Commerce determined that the US is dumping propionic acid products into the country, and announced its decision to impose an increase of 43.5% in deposit requirements for such imports…On May 19, MOFCOM initiated an anti-dumping investigation into American (and other countries’) exports of polyoxymethylene copolymer, a material used in consumer electronics and automobiles. China is also considering a 25 percent tariff on certain US automobile exports”. “The average Chinese tariff rate on imports from countries other than the United States has fallen from 8.0 percent to 6.5 percent since the start of the US-China trade war in 2018, with most of that fall occurring right after the trade war began”. Jeff Pao also notes China has reacted strongly to the EU escalations. A spokesperson of the Commerce Ministry’s Trade Remedy and Investigation Bureau said “in recent probes, the EU has set clear targets, abused its procedures and weaponized its investigation tools…These protectionist acts have distorted the fair competitive environment in the name of so-called fair competition…China will closely monitor the EU’s subsequent actions and take all necessary measures to resolutely safeguard the legitimate rights and interests of Chinese companies”.
So far, analysis seems to show the West has lost more than it gained from the trade war with China. Mary E. Lovely points out “US has reduced both its imports from and exports to China since the onset of the 2018-19 trade war. A review of recent research on these developments finds that decoupling from China has been costly for US consumers and producers. Analysis of the four waves of trade-war tariffs finds that they fall heavily on producer inputs, that they tax imports that have no obvious relation to the cause for action, and that they omit exports that may have unfairly benefited from the practices identified by the investigation. This pattern of levies raises basic questions about the efficiency and fairness of their design. Tariffs on China has allowed a set of third countries to increase their share of US imports. Recent analysis of their trade patterns finds that they have raised the share of their imports from China in pace with gains in the American market. Countries replacing China tend to be deeply integrated into China’s supply chains and are experiencing faster import growth from China, especially in strategic industries”.
Matteo Crosignani, Lina Han, Marco Macchiavelli and André F. Silva found “export controls prompt a broad-based decoupling of affected U.S. suppliers from Chinese firms…affected suppliers are more likely to terminate relations with Chinese customers – both those that are directly targeted by export controls and those that are not. Moreover, affected suppliers are also less likely to form new relations with other Chinese customers…consistent with concerns by affected U.S. suppliers that other Chinese firms may re-export their sensitive technology to the targeted Chinese firms, a violation of export control. Despite export controls achieving their main purpose of reducing transfers of U.S. goods and technology to Chinese targets, we do not observe new supply chain relations formed by U.S. firms with alternative customers located outside of China, nor specifically with domestic ones. In other words, we do not find any evidence of friend-shoring or reshoring in the three-year period following the imposition of export controls. The inability of affected suppliers to quickly find alternative customers may therefore harm the very same firms whose technology U.S. export controls are trying to protect”.
Matteo Crosignani, Lina Han, Marco Macchiavelli and André F. Silva note significant collateral damage with affected US suppliers experiencing a negative stock market reaction immediately “after the export control announcement and is economically significant, representing a 2.5% abnormal decline in stock prices. Our estimates suggest that export controls cost the average affected U.S. supplier $857 million in lost market capitalization, with total losses across all the suppliers of $130 billion”. Affected suppliers also “display a decline in revenues and profitability, which represents real collateral damage from export controls. In addition, we estimate a significant decline in employment among the affected U.S. suppliers, while the effect on capital expenditures is not significant. The last result is consistent with export controls not considerably changing the long-term investment opportunities of firms, but with the decline in profitability requiring a cut to some segments of the labor force…also find a decline in bank lending to affected U.S. suppliers”.
Matteo Crosignani, Lina Han, Marco Macchiavelli and André F. Silva note targeted Chinese firms strategically respond to U.S. export controls “by both forming a new network of alternative Chinese suppliers and increasing purchases from firms which are not affected by U.S. export controls and with whom they have pre-existing relations…another strategy deployed by China to blunt the effect of U.S. export controls is to boost domestic innovation via government subsidies”. “There is evidence that, following U.S. export controls, China has boosted domestic innovation and self-reliance, and increased purchases from non-U.S. firms that produce similar technology to the U.S.-made ones subject to export controls. We lack a comprehensive framework to assess the optimality of these geopolitical tools. If national security is a public good, are these export controls a way to make firms internalize their negative externalities? Is it actually beneficial to penalize the same domestic firms that produce cutting-edge technologies?”
Global Times argues “the trouble now is that decoupling not only causes more losses for the US but also rebuilding supply chains is not an easy task, and some may be impossible. This is because Chinese manufacturing has achieved large-scale, diversified and multi-tiered system development, with many sectors being irreplaceable, and the aggressive expansion of Chinese manufacturing in the global market is unstoppable, especially in sectors like EVs, renewable energy, shipbuilding, high-speed rail and steel, where it already has the upper hand. As Chinese enterprises gradually reduce their dependence on American technology and enhance their own innovation capabilities, the influence of US enterprises in the global market may further weaken. The position of Chinese manufacturing in the global supply chain is becoming more solid. Extensive decoupling of US businesses from China could potentially cause irreversible damage to the global industry and supply chains, as well as their own. Washington has already had to start assessing the consequences brought about by this. Chinese enterprises are also seeking breakthroughs by establishing new supply chains and innovation paths. The friction and conflict between US and Chinese manufacturing will unfold on a broader scale”.
As decoupling deteriorates into a “beggar-thy-adversary” trade war, the damage would be more extensive in both directions. The inefficiency costs – from duplication, compliance, substitution and non-optimisation frictions – will have a significant negative impact on global economic growth. The West’s attempt to make a dent in China’s manufacturing fortress is easier said than done and rely on some novel propositions. First, to what extent can Western countries successfully reindustrialise[8] and achieve supply resiliency? Second, and in relation to this, what are the consequences for their services sector?
The on-the-ground reality is that the West face considerable difficulties in gaining a foothold if China does not back down. This is because the West can at best target selected spots of the supply chain but it can’t recreate the whole supply chain within a short space of time. In the meantime, Western tariffs, sanctions, export and investment restrictions are hurting their own MNCs. Western MNCs have lost the Russian market – which is sizeable – and find themselves being pressured to exit China by their own governments while facing fierce competition from emergent world-class Chinese and Global South competitors in China and third markets. Exiting from China will be costly because China is an important, if not the largest, and most competitive market for many products. Western MNCs that don’t have a presence in China lose out on access to China market and technology. In fact, Western MNCs continue to collaborate with Chinese players. While the West can protect their MNCs from Chinese competition, generally Global South countries find the lure of Chinese bilateral relationships, low-cost and innovative Chinese products, FDI, financing and technology transfer too attractive to resist.
Of course, Western MNCs – as the private sector is apt to do – tend to complain loudly to governments in the hope of gaining protection, regulatory concessions and financial incentives. These are early days though and there are likely more surprises down the road. Western firms and start-ups rank among the most competitive and innovative companies in the world and they certainly have the capabilities to take on China Inc. However, governments may not be in a position to pick the “winners and losers”. At the end of the day, Western firms need to cannibalise their “profitable but uncompetitive” offerings by innovating products with better features at lower prices to survive and thrive. Western governments should also take care not to overly rely on tariffs and sanctions to protect their domestic industries as this might make them more complacent and less competitive.
Overall, is the West better off intensifying the trade war with China? It is probably a “lose-lose” situation. Given the current trajectory, the adverse effects of geoeconomic fragmentation might materialise sooner. One difference with the 1930s trade war to bear in mind is that countries have not engaged in competitive devaluations thus far. Export competitiveness position can be altered overnight with a 30% depreciation in the USD against the yuan. This would close the gap between China’s GDP measured on a purchasing power parity and on a nominal basis and buttress its market share of global GDP and currencies. Yet, China’s yuan has not appreciated so far despite the large trade surpluses and the USD has not weakened despite their large deficits. But the yuan can’t appreciate because the US has been encouraging capital outflows from China and are unlikely to return in a major way into China due to rising geopolitical tensions.
Analysis of the car industry
The over-capacity dynamics is playing out across many industries and particularly in the car industry where China is threatening to make significant inroads. Jacob Funk Kirkegaard estimates the automotive sector accounts for 3% of global GDP. Erik-Jan van Harn and Teeuwe Mevissen notes “the automotive industry employs approximately 6% of Europeans, and it is deeply ingrained in the self-image of countries such as Germany, but also because there are a lot of specialized companies that supply the automotive sector with sensors, steel and rubber”. “There is currently a glut of overproduction in China (some estimates put it at 20 million cars per year, double the amount of cars sold in the EU), which has led homegrown brands to aggressively cut prices in order to gain market share. As a result, after years of dominating the market, BYD recently dethroned Volkswagen as China’s top brand. BYD has even surpassed Volkswagen in the top three most valuable car brands (Tesla, Toyota, BYD)…Chinese automakers are now making their way to Europe, where they are rapidly flooding the market with low-cost, high-quality electric vehicles. According to the European Commission, China’s share of EVs sold in Europe has risen to 8% and could reach 15% by 2025. This is especially painful for German automakers, who are losing market share in both China and Europe”.
David P Goldman notes the Biden administration slapped “a 100% tariff on Chinese EV imports, except that no Chinese cars presently are offered for sale in the United States. If they were, they would crush the American competition, even with the present 25% tariff. Chevy’s Bolt, a starter EV with a US$29,000 sticker price, has the same size and less range than the Dongfeng Nammi 01 hatchback priced at just $11,000”. “Henry Ford’s Model T sold for $850 in 1908, roughly the US per capita GDP at the time. By 1925, the price had fallen to $260 thanks to economies of scale. China’s EV makers are compressing this time scale into as many months as it took Ford years to bring down the price. At a $10,000 or lower price point, demand for Chinese EVs in the Global South is effectively unlimited”.
Erik-Jan van Harn and Teeuwe Mevissen highlights Ursula von Der Leyen’s State of the Union speech on September 2024 emphasised Europe will do “whatever it takes to keep its competitive edge. This time, Europe should not repeat the mistake of a few years ago, when China flooded the European market with cheap solar panels, driving European manufacturers out of business”. Thus, EU recently decided to impose tariffs on EV imports from China.
- Over-capacity due to competition
There is more to China’s dominance than “over-capacity”. China is actually riding a wave of technology disruption and survival-of-the-fittest competition that are driving far-reaching changes in the global manufacturing landscape. Han Feizi argues conditions in the Chinese car industry resembles more closely the Japanese motorcycle rather than its car industry. “Out of nowhere in the 1950s, over 100 companies in Japan started making motorcycles. The ensuing competition, now known as the Japanese motorcycle wars, was wild, untamed, often unscrupulous and dazzlingly innovative. It was a blood sport, piling up corpses all over the dohyō. All British makes were wiped out. Harley Davidson was the only American left standing. Italians were dismembered. The Japanese also savaged each other, leaving only four surviving Samurai – Honda, Kawasaki, Suzuki and Yamaha. Those were glorious days for Japanese industry”. In contrast, Japan’s car industry was more “a story of perseverance, incremental improvement (kaizen), lean production with a laser focus on quality, lacking the kill-or-be-killed bet-the-farm reckless abandon of the motorcycle wars. Toyotas, Nissans and Hondas were exquisitely engineered but they didn’t revolutionize the car”. “The Chinese car wars will play out like the Japanese motorcycle wars – full of blood, guts and spectacular innovation”. “China’s car market is the largest in the world (twice the size of the US) and gladiators from all corners of the world have come to fight it out in an epic battle royale. It’s a free for all and there are no loyalties. Alliances are being formed. Alliances are being severed. Fighters are selling each other weapons and inventing new ones. Everyone knows that this is a kill-or-be-killed blood sport and that only a handful of combatants can survive”. This is also reminiscent of condition in the US car industry in the 1920s.
Governments can intervene by simply withdrawing support when over-capacity is motivated by protection. But how do governments intervene when over-capacity is due to competition and when it is a fight for survival. The momentum belongs to the EV players (Tesla and Chinese manufacturers) which are gaining market share at the expense of legacy manufacturers. Draconian interventions such as regulating prices, imposing output quotas or attempting to pick winners and losers by forcing companies to close or merge are likely to backfire. If China’s government were to intervene, they could end up interrupting innovation and damaging the domestic industry.
- Multipolarity weakens impact of Western tariffs
Han Feizi points out the “US – accounting for a third of the global car market in 1990 – could easily sidestep its Japan reckoning. This perhaps convinced a generation of policymakers that they can perform the same magic trick again on China. That would be a stupid move. China’s car market is now twice that of the US and the Global South’s is more than three times that of the US (up from two thirds of the US figure in 1990). The US market simply does not matter as much as it used to”. David P Goldman notes “if China wanted to retaliate against the new American tariffs, it has a target-rich environment. General Motors last year sold 2.1 million cars in China”. “China’s automotive industry association forecasts a 22% increase in the country’s auto exports during 2024, following a more than 60% increase in 2023, with the strongest growth in East Asia and the Middle East”. US and EU don’t have the same bargaining power as they used to and Japan and Korea are even worse off in terms of market vulnerabilities and dependencies on China.
Regardless of the rhetoric, Western car manufacturers are fast losing ground in China. While they can somewhat defend their home markets against the Chinese onslaught, their grip on Global South markets are at risk. Global South countries have generally received Chinese cars enthusiastically for several reasons. First, governments are keen to leapfrog into renewable energy technologies. This will help to reduce oil imports which are heavily subsidised and a fiscal burden in several countries. It will cut down on air pollution in cities. Second, the low prices and extraordinary value of Chinese cars make it affordable to the general public. Third, some governments are keen to attract Chinese FDI and to get Chinese car makers to establish assembly plants and research centers.
- Industry disruption and legacy obsolescence are major challenges
The stakes are very high as EVs compass not one but three ecosystems – the convergence of industrial manufacturing with battery technology and with AI. A key point in industry disruption is being reached as innovation, scale, vertical reintegration and robotics allow the costs of EVs to match that of ICE cars. This is quickening the pace of EV adoption and in China, their share of sales has crossed 50%. These trends are endangering the legacy industry ecosystems in the West.
Han Feizi points out in China, “every facet of the auto industry is now being disrupted…Every company is swimming in violent waters roiled by technology’s merciless march. Batteries are getting cheaper, safer, lighter and more energy dense. AI- and 5G-enabled automation is lowering manufacturing costs across the supply chain. Self-driving capabilities are continuously improving. Companies are field testing business models from battery-as-service to partnerships between carmakers, battery producers and digital architecture providers. A Foxconn style contract manufacturing model may be taking shape. China is transitioning to solar power at an exponential clip – this could potentially collapse electricity prices, further accelerating the EV transition. Everything is in flux. Nothing is certain. Legacy carmakers are either getting their ducks in order, up a creek without a paddle or sticking their heads in the sand”.
Paolo Gerbaudo argues “the rise of the Chinese EV industry has been enabled not only by generous government subsidies but also by profound changes in strategy and organization, and in particular by a distinctive revival of vertical integration – at both individual firm and national levels. The approach is perfectly exemplified by BYD, which has sought to bring virtually all aspects of the value chain under its control: from battery technology – which was its initial core business – to microchips and even expanding to ownership of lithium mines and car carrier ships. Further, exploiting significantly lower labor costs in China compared to countries like Japan, Germany and the US, the firm has availed itself of a massive army of factory workers with a significantly more labor-intensive production process than its competitors…BYD has moved to control the production and assembly of battery cells; the manufacturing of the electric powertrain; the semiconductors and electronic modules; and now even the mining of lithium. It also builds its cars’ axles, transmission, cockpits, brakes, and suspensions in-house. And, just like the Fordist giant plants of Highland Park and River Rouge, BYD has built enormous industrial plants to produce batteries and other critical components, and for the assembly of cars. Four of them are located in BYD’s hometown, Shenzen, and twenty elsewhere around China, while several new plants are currently being built abroad, from Hungary to Brazil…A report by the New York Times highlighted that, in the manufacturing of the hatchback Sedan Seal, BYD produces internally a whopping three-quarters of all components – compared to just one-third for a comparable Volkswagen electric car, giving it a 35 percent cost lead”.
Paolo Gerbaudo notes “in parallel, the Chinese government has been pushing for vertical integration at the national level, ensuring that 80 percent of the EV value chain is contained within the country through the Made in China 2025 plan, which has the aim of minimizing the effects of disruptions and setting the conditions to reinforce and maintain technological supremacy. While the model is likely to shift as labor relations evolve, this turn towards re-integration and re-internalization carries important lessons about the future of economic organization and industrial policy”. “China now finds itself in a place of seemingly unassailable supremacy in this industry: 60 percent of all EVs produced in 2023 were made in China. Furthermore, Chinese firms have a formidable cost advantage over legacy competitors…controls key elements of the supply of critical materials: over half of the Lithium world production, over 60 percent of Cobalt production, and 70 percent of rare earth materials. Furthermore, the Chinese industry accounts for over 70 percent of the cell components of batteries and the production of battery cells. Two-thirds of global battery production is located in China, with CATL and BYD accounting for over 50 percent of the global output. This push to develop an independent and largely self-sufficient value chain has proven far-sighted in anticipating the disruptions faced by global supply chains because of extreme weather, war, and growing inter-power rivalry. A high share of the EV value chain gives China a significant comparative advantage vis-à-vis competitors while also providing the conditions to defend the supremacy in innovation and intellectual property that China is likely to achieve in coming years”.
Robert Ferris points out “companies that make parts for internal combustion engines are facing a harsh future. Revenues for internal combustion engines, as well as fuel and exhaust systems, are expected to decline 44% through 2027, according to the 2023 Deloitte Automotive Supplier Study. Meanwhile, revenues for electric drivetrains and batteries or fuel cells are expected to rise 245%”…the total powertrain part supply pie is also shrinking. An internal combustion powertrain has about 2,000 parts. Battery electric vehicle powertrains have about 20, sometimes less. Automakers are also finding new ways to more efficiently manufacture parts through methods like giga casting. Attributed to Tesla, the technique involves using large machines to cast very large chunks of a vehicle all at once, instead of assembling one out of smaller parts…While automakers bring more of their supply chain in-house, there are thousands of parts in cars that come from companies all over the world – a branching supply chain of firms each dependent on the success of the others. Many of those companies are small, family-owned firms that have been around for decades. But even the large, publicly traded suppliers such as Bosch, Denso, Magna and ZF are affected. Bigger firms are either spinning out their internal combustion divisions or just winding them down to pivot toward EVs”.
David P Goldman argue “economies of scale through automated manufacturing as well as standardization of parts allow Chinese automakers to sell cars at much lower prices than their American counterparts. Labor costs comprise just 7% of the cost of an American car, so the difference between American and Chinese labor costs explains a negligible part of the price differential. Although more than 100 automakers are fighting for market share in China, most of them use standardized parts that reduce costs. According to a LinkedIn post by automotive engineer Alan Smith, All automobiles manufactured or sold in the United States today (except for Tesla and a very small number imported from China by GM) are produced using a parts churn manufacturing method, in which parts are used for approximately 1 to 6 years before they are replaced with new, non-interchangeable parts which offer no benefit over the previous part. Western automobile makers churn parts – use proprietary, non-standard, non-interchangeable parts which are churn producing vehicles that are more expensive, more prone to defects and become manufacturer specific mini-monopolies…Chinese automakers as well as Tesla follow the original Ford approach that made the Model T everyman’s car…Biden’s tariffs protect the monopoly practices of the American auto industry at the expense of American consumers”.
China has gone all in to develop their new energy industry and this enabled it to bypass the technological chokeholds (patents and parts) that safeguarded legacy car makers. In contrast, Western manufacturers EV initiatives were half-hearted. They prefer to protect the golden goose by increasing prices to boost profits and share prices. Coming out with innovative low-cost offerings would have cannibalised their earnings from high-priced models.
Han Feizi points out the big three US carmakers were protected by tariffs in their domestic market. “In good times, selling +$60K pickup trucks and SUVs in a protected market is a highly lucrative business. Ford and GM generated $4B and $12B in profits last year. In bad times, the Big Three find their product lines wanting and uncompetitive. After oil price surges in the crisis of 1973 and the deposition of the Shah of Iran in 1979, Chrysler was bailed out by the Federal government for the first time. In the 1980s and 90s, the Big Three lobbied for and were granted voluntary export restrictions on Japanese cars. During the 2008 financial crisis, both GM and Chrysler (again) were bailed out with loans from the Federal government”. In the 1990s, “Nissan would stagnate with Japan, easily neutered by Yen appreciation (thank you, Plaza Accord) and export restrictions. The US was the largest car market in the 90s and it ultimately called the shots, no matter how much better Japanese engineering was. Today’s reckoning is far more profound. This isn’t half a dozen Japanese carmakers exporting cars to the US – that was easily swatted down. This is 100 Chinese carmakers revolutionizing the industry with reckless ambition in what is now the world’s largest and most competitive car market. The Chinese car wars are in their early days but already threaten to unleash onto global markets a tsunami of EVs honed by intense competition. Nations with auto industries view this as an existential threat. Nations without auto industries are climbing all over each other trying to secure an offshore assembly plant from a Chinese carmaker. Faced with imports of Chinese EVs, the once climate-obsessed EU is watering down its target of phasing out sales of cars with internal combustion engines by 2035. EU commissioners in Belgium are busily formulating tariff strategies for Chinese EVs. The US is expectedly unhinged, with Senators already calling for a straight-up ban on Chinese cars for, you guessed it, national security reasons”.
The restructuring of the global car industry is as inevitable as is the likely fall-out in the China car industry. Western automakers cannot sustain their future with over-priced legacy cars. Customers would be unhappy to be deprived of an opportunity to buy cheap, quality EV cars because of tariff protection. As ICE cars lose market share, they will lose scale and this will increase production costs. In addition, legacy manufacturers have to drastically re-organise their production process, shrink the workforce and supplier ecosystem and invest in production and driving technology to match leading-edge firms like Tesla and other Chinese firms. In this regard, Han Feizi adds the US car industry will be hamstrung by a shortage of STEM graduates. “BYD and Huawei have 6 million college grads to choose from – and they are considered top employers to work for”. The problems of Western car manufacturers are thus deep-rooted and governments should be prepared to manage the fallout from stranded legacy assets and the restructuring of their car industry ecosystems. The appreciation of the yuan though could be a quick fix but it could create other problems
- 2030 scenario: Trade war or peaceful settlement and coopetition
Europe has so far followed the US lead on hiking tariffs. Jiri Opletal reports the European Commission (EC)’s investigation[9] deemed China’s EV supply chains benefit from unfair subsidies and announced provisional import duties on China-made EVs ranging from 17.4% to 38.1% on top of existing 10% tariffs to effect from 4 July 2024. China has responded by threatening retaliation with investigations and potentially imposing tariffs on ICE cars with large engine capacities, luxury products, brandy, pork and agriculture imports and even on aircraft. Subsequently, EU and China agreed to enter into consultations.
The China-EU negotiations are important because the outcomes will have a significant bearing on whether the trade war will worsen or whether there is room for a peaceful settlement. Global Times articulates China’s perspective that Europe “faces its own complexities in navigating its economic and trade policies toward China…The EU aims to protect its industries to safeguard the economic interests of its member states, decrease economic reliance on China in global industrial and supply chains, and foster economic growth and social development. Balancing these conflicting objectives means that the EU must meticulously coordinate various interests and strive for the best policy approach. Nevertheless, the EU’s economic progress cannot be disentangled from that of China. In numerous industrial sectors, trade and economic collaboration with China is advantageous for the EU. As a global manufacturing powerhouse, China possesses significant advantages in many strategically crucial areas. Collaboration between the EU and China facilitates the enhancement and transformation of EU industries and offers more market opportunities and scope for development for EU companies. This is the reason why the EU’s current policy toward China is encountering divisions and facing a dilemma, with different views among its member states due to different interests. Addressing this challenge necessitates meticulous and thorough coordination between China and the EU to identify shared interests and areas for cooperation. At the same time, the EU must refrain from implementing trade barriers that squeeze China out of industrial chains and supply chains, and instead uphold a fair and transparent international trade environment”. Hence, Global Times advocate that differences between China and the EU should be resolved “through strengthening communication, removing trade barriers, promoting technical exchanges and cooperating on investment”.
In this context, the degree of interdependence between China and Europe is much deeper than that between China and US. Both China and Europe therefore have an incentive to avoid a bruising trade war. For China, the US market has been closed off and entering into a negotiated cooperation with Europe is geopolitically advantageous and becomes a model for other countries to follow. For Europe, the loss of cheap Russian energy and access to its consumer market already dealt a major blow. Their economies may not be able to withstand the potential damage from a trade war with China. However, if Europe chooses to negotiate a settlement with China, this would leave the US isolated in its attempts to curb the Chinese EV industry and, more broadly, to decouple from China. Several points are worth noting.
First, there are differences between the US and EU approaches to the Chinese EV car industry. Jacob Funk Kirkegaard thinks the “EU EV strategy would dramatically differ from the emerging protectionist US policy response to the Chinese EV sector. As stated by Commission president von der Leyen, the European Union will not join the United States in imposing blanket tariffs on China. Biden administration policies look likely to isolate the US EV sector behind high tariff barriers…Such a strategy will not…propel the US EV sector to global leadership. Rather the risk seems to be that the US EV sector chooses to service a relatively small US domestic market with profitable but also idiosyncratic EV models – e.g. electric pickup trucks – with limited export appeal elsewhere in the world. That in turn would set back the goal to decarbonize the US transport sector”.
Jacopo Pastorelli and James Batchik notes the proposed EU tariffs are structured as “an attempt to strike a balance between protecting Europe’s internal automobile industry and avoiding escalation into a trade war with Beijing”. “Europe’s tariffs on battery EVs will cover a wide umbrella of companies, including Western brands with production facilities and joint ventures in China. This leaves open the option for carmakers to relocate their production to Europe, thereby avoiding the tariffs. Much of the difference between Washington and Brussels is due to the different immediate market threats posed by Chinese EVs. The United States imported fewer than three thousand EVs from China last year, and the tariffs are in part intended to prevent Chinese market share from growing. In Europe, in contrast, China is already a major player. Chinese-made EVs account for around 25 percent of the European market, with Beijing exporting 430,000 such vehicles to the continent in 2023, a number that has quadrupled in the past five years”.
Second, the EU tariffs do not seem supported by European automakers. Jiri Opletal notes “many EU automakers have lobbied against the EC investigation, and it is no wonder their stakes are high. For Volkswagen, China is the biggest market, and Mercedes-Benz is 20% controlled by Chinese companies (10% belongs to state-owned Beijing Auto, and 10% belongs to Geely founder Li Shufu). Volvo, for example, is wholly owned by Geely. Moreover, EU automakers have growing ties to Chinese EV makers as Audi will use SAIC’s IM electric vehicle platform for its new Audi EVs as its PPE takes too long to develop. Volkswagen established joint ventures with Chinese firms for lithium production and will build a couple of EVs based on Xpeng platform and Stellantis acquire a stake in Leapmotor to produce their EVs globally. Thus, it is not surprising Germany, Sweden, and Hungary have said they disapprove of the new tariffs, fearing Chinese retaliation. Moreover, tariffs might soon not be enough to protect the EU’s Chinese EV competition. Many have already built or prepared vehicle factories in the EU. BYD plans a plant in Hungary, Chery chose Barcelona for its first EU EV plant, Great Wall Motor is choosing between Poland, Germany, Czechia, and Hungary, and Leapmotor vehicles will be assembled in Stellantis Polish plant. When the Chinese build cars in the EU, how will the EU protect itself from potential Chinese government subsidies?”
Erik-Jan van Harn and Teeuwe Mevissen points out roles have shifted. “Rather than Volkswagen building factories in China, BYD, for example, is now planning to construct factories in Europe. If the current trend continues, European automakers will lose a significant portion of their market share in Europe”. “Currently, electric and plug-in hybrid vehicles account for 28% of new car registrations in Europe, but this figure is expected to rise to 65% by 2030, and close to 100% by 2035, when all cars sold in the European Union must be zero-emission vehicles. Assuming that Chinese brands can secure a solid position in this market, as von der Leyen suggested, the share of Chinese vehicles could rise from 2% now to 15% by 2035. The question is whether Europe can truly scale production to the point where it is competitive with China without first securing the necessary inputs. The second issue is financing. As a result of sharply rising interest rates, European governments are already struggling to balance their budgets”. They also note China is capable of retaliation by denying Europe critical minerals and products for domestic car production; given its dominant position in the battery value chain and several other clean-tech inputs. “This would stall the development and production of European cars, as it would take years for domestic extraction and processing of minerals, as well as battery production, to be sufficient to meet European demand”.
Hence, European (and other) automakers recognise the need to engage in coopetition – a term describing the amalgamation of cooperation and competition – with their Chinese counterparts. This concedes the China auto industry have leapfrogged Western automakers (excepting Tesla). David P. Goldman notes “American, Japanese and South Korean automakers depend on Chinese automotive technology…With 3.4 million 5G base stations installed versus America’s 100,000, China is also well positioned for autonomous driving. Low latency (nearly instant response) and high data capacity on 5G networks – ubiquitous in all Chinese cities – support artificial Intelligence applications for AVs as well as accident prevention. Chinese cities, moreover, feature new roadways amenable to autonomous driving”. It will take too long and too much investment for European automakers to proceed on their own. Alliances with Chinese firms are an attractive stop-gap measure.
What would a peaceful settlement look like? Erik-Jan van Harn and Teeuwe Mevissen thinks that “first, China could agree with a quota that would limit the amount of cars sold on the European market. Secondly, China and the EU could agree upon a share of Chinese cars and/or batteries being produced within the EU. In both cases this could go together with measures that, for example, include the transfer of certain technologies by Chinese car- or battery producers…Finally, China’s growing trade surplus with the EU – which last year reached more than 400 billion, has become a growing concern for the EU. It seems clear that the current unbalanced trade relationship is up for renewal. China seems to realize very well that it is better to negotiate a new trade relationship with the EU than to passively await unilateral decisions from the EU that could further deteriorate China’s access to the European market”. “We think that the European Union’s probe into Chinese state subsidies is unlikely to result in a full-blown trade war, but it seems just as unlikely that the probe will not result in some significant changes with regard to the current largely uncontrolled EU market access for the Chinese automotive sector. One of the most key factors mitigating the risk of a full-blown trade conflict is the simple fact that both China and the EU already have more economic challenges than they wish for. Risking their $900bln trade relationship may seem rather unattractive to both parties…Moreover, at this moment China and the EU are still too much mutually dependent to be able to deal with a fall out from such a trade conflict. This may explain why China recently seemed to adopt a more conciliatory approach vis-a-vis Europe…China is realising that Western firms are in the process of de-risking and slowly turning away from China. By showing good faith, China may be hoping to slow this process. Finally, while the EU and the US do agree that the current trade- and investment relationship with China needs a serious revision, the EU’s desire for more strategic autonomy will likely imply that the EU will largely determine its own course when it comes to their overall relationship with China”.
Jacob Funk Kirkegaard feels “the EV sector trading relationship between the European Union and China looks likely to replicate the relationship between the United States and Japan and South Korea after the car wars of the 1980s…Chinese EV manufacturers and suppliers are setting up factories in the European Union and look likely to expand. In the 1980s, Japan bowed to US demands to set up voluntary export restraints (VERs) on cars and relocate production to the United States. By contrast, the EU-China EV case is driven more by commercial auto industry logic in both China and the European Union, as well as Europe’s political desire to promote the green transition and retain access to China’s car market. The imposition of relatively low-level EU anti-subsidy tariffs on Chinese-made EVs will add an accelerating tariff hopping element to this process of Chinese investments in the European Union. Crucially, however, EU EV tariffs could be only a fraction of the 100 percent rate the United States recently imposed. It could well be that China is already implementing its own version of VERs on EVs shipped to the European Union, voluntarily limiting exports to a stable level until the European Commission decides whether to impose anti-subsidy tariffs in July…The most probable future path for this crucial sector would be for the European Union to cap EV imports from China at a relatively high, mutually acceptable level, while hosting a rising share of Chinese brand EVs made and sold in the European Union, combined with a continued presence of EU brands in the Chinese market, and some high-end German-made EVs exported to China. Under this stable situation, Chinese and EU firms would enjoy reciprocal market access for EV sales, and parts and the European Union would accelerate its green transition…Such arrangements would probably not shrink the aggregate EU-located auto industry output. But Chinese EV producers will become an increasingly large part of the local sector…Meanwhile, the technological shift to EVs will almost certainly result in less employment in the EU auto sector, resulting from shorter supply chains for EVs and accelerating automation. For EU consumers, this path ensures further access to the technologically best and cheapest EVs in the world, overwhelmingly produced within the European Union by all the world’s major EV producers. Some of these EU-produced EVs might even in turn find their way to the US market, though at the risk of triggering a politically driven US trade response”.
However, if recent trends are an indication, countries have tended to double-down on tariffs and restrictions, and to favour national security imperatives over economic ones. It is difficult to see Europe breaking from the US position despite the economic costs. In the meantime, the Chinese are hedging their bets by expanding their investments in EV-related industries in the Global South. Gregor Sebastian, Reva Goujon and Armand Meyer notes “Chinese EV OFDI shifted away from North America…Three-quarters of Chinese investment went to Europe, the Middle East and North Africa (MENA), and Asia, with the greatest gains experienced by Morocco, a free trade partner of the EU and the US. OFDI in North America fell to 10 percent of the total as Chinese companies faced regulatory uncertainty and political pushback…Chinese battery investments – driven by greenfield projects – are increasingly diversifying, including inputs like anodes and cathodes. Chinese battery manufacturers are bringing more of the supply chain with them in their overseas expansion…Key drivers will include China’s slowing home market and host economies’ demands for higher value-added and job-creating investments in return for market access. Investment in North America will remain volatile due to regulatory uncertainty, but Mexico could see an influx of Chinese projects”.
One final point. Would the trade restrictions change the fate of the global car industry? Protection by tariffs doesn’t change the fact that the global car industry faces disruption. Western automakers need to think about managing their transition into renewable energy. There are too many players in China and a shakeout is inevitable.
Battle of economic models
China and India took different routes to development with China becoming the “world’s factory” and India its “back office”. In the end, India’s economy lagged China in many aspects as the service sector became a foreign enclave with low value-add to India’s domestic growth and corporate formation. Thus, more countries, including India itself, are taking their lead from the success of China’s techno-industrialisation model. This has cast a shadow on the credibility of service-centric models and that governments should react strongly to hollowing-out of domestic manufacturing. Thus, a battle over industry can be viewed as arising from a global contest between rival economic models to reshape globalisation. Chinese business models have disrupted Western dominance across industry segments. They have replaced the service-centric (US and UK) and legacy export-led industrialisation models (Japan and Germany).
It is ironic but few expected China’s blended government-directed and market-based model to be as successful as it has been. Other countries have tried before, in one form or another, to do some of the things that China did but generally without success and at the cost g high-profile white elephants. Tanner Greer notes “the escalating Sino-American tech war has dramatically raised the policy salience of science and technology in Beijing policy circles. This occurs at a moment when the limits of China’s aging economic model can no longer be ignored. If there was ever a time that China needed a new round of techno-scientific revolution, that time is now. However, this strategy is a gamble…rests on two bets: first, that the world truly is on the cusp of an economic transition comparable to the Industrial Revolution in scale, and second, that if this new technological revolution occurs, China will lead it. Neither bet is certain. Here, the fate of the Soviet Union and the Eastern Bloc should stand as a warning to Beijing. This is not the first time a communist regime hoped that investments in new technologies and industrial processes might reverse slowing growth…These bets did not pay off. New industries were not successfully developed, new technologies did not successfully diffuse, and new products were not price competitive with their counterparts in East Asia or the West. Soon, the bills came due. By the 1980s, one communist regime after another was forced first into austerity and then to outright collapse”. I would add that in China’s case, the bets seem to have paid off in terms of its domination of global manufacturing.
China’s economic model has often been mischaracterised as a top-down authoritarian model. It is hardly the case. China’s economic model resembles a government-led platform or digital model[10]. Tanner Greer point out Western analysts, used to their macroeconomic template, have difficulty comprehending China’s aspiration to “strive to modernize the industrial system and develop new quality productive forces at a faster pace” and to “invigorate China through science and education and consolidate the foundations for high-quality development.” “There is a logic behind Chinese techno-nationalism…one must first understand the historical narrative that informs them…the historical materialism of Karl Marx; attempts by early 20th-century New Culture intellectuals to explain why China had fallen victim to imperialism; triumphal propaganda accounts of China’s modern rise; and a close study of Western scholarship on the rise and fall of great powers. Endorsed by President Xi Jinping[11] and popular among Chinese policy elites, this set of ideas argues that there are hinge points to human history. In these rare moments, the Chinese leadership believes, emerging technologies can topple an existing economic order. Grand changes mean grand opportunities: The British Empire and the United States rose to global hegemony because each pioneered a global techno-economic revolution. Now the past repeats. Humanity again finds itself on the precipice of scientific upheaval. The foundations of global economic growth are about to be transformed – and Xi is determined that China will lead this transformation”. “In Beijing’s view, each round of techno-scientific revolution does not just change the world economy, but also the global political order”. In 2016, Xi noted “there are points in history when major technological breakthroughs promise to greatly enhance humanity’s ability to understand and utilize nature as well as to increase societal productivity. Xi argued that historical experience shows that [these] technological revolutions profoundly change the global development pattern. Some states seize this rare opportunity. Others do not. Those who recognize the revolution before them and actively take advantage of it rapidly increase their economic strength, scientific and technological strength, and defense capabilities, thereby quickly enhancing their composite national strength. For Xi, as for most Chinese, the Qing dynasty is the paradigmatic example of a great power that refused to see the revolution unfolding before it. Due to various domestic and foreign reasons, our country has missed technological revolution time and again…The result was what Chinese nationalists call the century of national humiliation, a period when China was victimized by imperial powers and fractured by contesting warlords. By failing to seize the opportunities presented by emerging technologies, China was transformed from a world power into a semi-colonial, semi-feudal country subject to bullying”.
In fact, Chinese thinkers perceive US as the embodiment of scientific strength and adopt it as the benchmark for China’s modernization. Wang Huning argued that “if the Americans are to be overtaken, one thing must be done: surpass them in science and technology”. “This is the broader context for China’s techno-nationalist drive. The drive is premised on three ideas. The first is that technological and scientific power is the most critical element of national strength and economic growth. The second is that advances in technological and scientific power are not isochronal. Advances occur in sudden leaps and bounds; disproportionate power and wealth go to those who successfully leap first. The final idea, and perhaps the most important, is that we are in the opening stages of the next round of techno-scientific revolution right now”.
China’s model can be characterised as the government setting a clear vision supported by macro planning to ensure there is supporting infrastructure, financing and incentives. The government invites the most globally competitive firms to become the hare – to set the lead for Chinese firms to race after. Generally, Chinese firms have to survive and flourish under the very tough conditions. In contrast, foreign firms have difficulty coping with no-holds barred competition in China – with over-capacity as a side effect. It should be noted that China has already moved on from a “copycat” approach and is adopting business disruption strategies. It advances by bypassing sanctions and patents through leapfrogging or workarounds, by setting rather than following standards, and by relying on IOT, robotics and AI rather than “labour standards”. For example, its EV success illustrates how it has leapfrogged the defences of legacy car-makers and by adopting vertical reintegration, Chinese firms has substantially minimised reliance on foreign components. China’s techno-industrial transformation has surpassed industrialisation in developed countries in terms of scale and speed. China’s ability to achieve global dominance across many industries suggests that its success is neither accidental nor lucky. The fact that several Western and Global South countries are copying China’s techno-industrialisation policies is perhaps the sincerest form of flattery.
The problem now is that if more countries adopt China’s techno-industry policies, it will exacerbate the over-capacity problem. In this regard, decoupling, reshoring and reindustrialisation are likely to create a lot of duplicate capacity and redundancies. Overcapacity, in this sense, will lead to an all-out global industrial war with an ensuing blood-bath to follow. This may explain why China is doubling down on industry expansion. If China is unwilling to concede ground to allow Western firms some breathing room, then Western economies and MNCs must be prepare to take on China. But the West face non-geopolitical obstacles. First, they need to manage business model transformation as ruthlessly and as efficiently as China. It is questionable whether this is possible in a democracy. Second, they have to manage the impact of reindustrialisation on their matured service-based economy. There are issues in relation to work-force availability, skills and relative compensation as well as energy and environmental challenges. Third, the failure of import substitution strategies in the 1960s-70s suggests trade protectionism has a cascading impact on costs, encourage domestic firms to neglect customer trends and to postpone their transformation. Western reindustrialisation policies needs to have incorporate the goals for firms to be competitive, innovative and export-oriented. In this context, Western firms should be prepared to capture market share at the expense of profits. But if they do so, their current lofty share prices are vulnerable. Lastly, Global South countries have enthusiastically adopted the China model strategies of leapfrogging and digitalisation. They will eventually pose a competitive threat to the Western and Chinese economies and MNCs.
Peak China and its implications
With decoupling and increasing resistance to China’s industrial domination, are we approaching peak-China? China’s secular growth rate has already fallen by half from around 10% to around 5%. Some think China’s growth trend is caught in a structural downshift to even lower levels. Keun Lee argues “China’s growth is subject to two economic and geopolitical constraints. The first is the middle-income trap, in which economic growth slows as a country reaches middle-income status. The second is the economic Thucydides trap, in which an incumbent economic hegemon seeks to slow the growth of a potential rival…China’s growth trajectory suggests that the country could break free of the middle-income trap (MIT) by the mid-2030s to become a high-income country”. “China’s prospects for overcoming the economic Thucydides trap, however, are less optimistic…over the last five years, the size of China’s economy has decreased from 67.4 percent of U.S. GDP in 2018 to 65.7 percent in 2023. If China cannot reverse this trend, it will never catch up with the United States. However, if we look at a longer time frame, over the last 10 years, China has increased from 57.1 percent of U.S. GDP in 2013 to 65.7 percent in 2023. If we assume that China can maintain this long-term pace of catch up – which incorporates the short term reversal of the past two years – that means that China will maintain a pace of 8.6 percentage points per decade. Given the 35 percent difference in sizes between the U.S. and Chinese economies, at the current per decade rate, it would take 40 years for China’s GDP to equal that of the United States. The prediction that China would not catch up until the mid-2060s is a big retreat from previous and widespread forecasts that China would achieve parity by the mid-2030s”. “Based on the data, it appears that China’s economy reached a peak in 2021 relative to the U.S. economy. Questions remain as to whether Chinese policymakers can reverse the country’s relative economic decline”.
Keun Lee notes “despite rising per capita incomes in the country, China remains a long way from rivaling the economic power of the United States. This may be due to the weakness of China’s currency, which might hint at deeper economic vulnerabilities…After attaining its peak value of 6.05 yuan to the U.S. dollar in 2013, the yuan moved sharply downwards to 6.4 per dollar in 2021 and 7.2 in February 2024. A depreciating currency often reflects a weakened economy, an outflow of foreign capital, or both. Second, the puzzle may represent a relative success of China’s new growth strategy emphasizing so-called domestic circulation, which involves relying more on domestic demand and central and inland provinces for growth, rather than coastal provinces which rely on exports”.
Lucio Vinhas de Souza argues China “cannot continue to rely on capital accumulation for sustaining growth, while the country’s ongoing demographic transition also implies that there are limits to a continued positive contribution of labour to growth, leaving technological innovation as the credible future growth motor for China. The fear of a trap could lead to more effective policies, recognising that capital and labour accumulation has reached a decreasing returns to scale state, but it could also lead to a further doubling down on factor accumulation”.
Another sign of China’s diminishing global influence is the shrinking effect of its credit impulse. Dhaval Joshi notes “after the global financial crisis of 2008-09, China unleashed a stimulus bazooka. A stimulus so big that China’s credit impulse peaked at a massive and unprecedented 25% of China’s GDP. In the subsequent stimuluses of 2013 and 2017, China’s credit impulse peaked at a sizable, albeit lower, 15% of GDP. Then in 2020 came the global pandemic. Yet even after this once-in-a-century shock, China’s credit impulse peaked at a still-lower 10 percent of GDP, less than half of the post-GFC peak. In the so-called stimulus that has come more recently, the impact has truly dwindled. China’s credit impulse has peaked at little more than 3 percent of GDP, equating to barely a tenth of the post-GFC impact. Of course, China is a bigger part of the world economy now than it was during the global financial crisis. Nevertheless, a peak stimulus of 25% of China’s GDP in 2009 equaled 2% of the world economy. Whereas a peak stimulus of 3% of China’s GDP today equals less than 0.5 percent of the world economy. It follows that China’s credit impulse is becoming less relevant, both for its own economy and for the world economy”. But is made sense for “The trouble is that exponential credit growth cannot last forever because credit must be put to productive use, and credit cannot be put to productive use exponentially”. “Yet this carries huge implications for the world economy – because China’s construction and infrastructure boom, fuelled by exponential credit growth, was the world’s main growth engine. Absent exponential credit growth, China’s trend growth rate will fall to 4 percent and the world’s trend growth rate will fall to sub-3 percent…it will be impossible to have a so-called commodity super-cycle. Instead, commodities will now follow shorter sharper cycles…it will be difficult for China’s stock market to produce long-lasting rallies”.
Keun Lee concludes “the relative size of the Chinese economy is affected not only by performance of China but also by that of the United States. The share of the United States in global GDP has been quite stable around 25 percent over the last 10 years, declining from its peak of 30 percent in the early 2000s after the burst of the dot-com bubble. Recently, however, the relative share of global GDP of the U.S. economy has been increasing from 24.4 percent in 2021 to 25.7 percent in 2022 and to 25.9 percent in 2023, a trajectory which is quite different from other G7 economies. Of course, this is primarily due to U.S. dollar appreciation, but the United States has recently outperformed other economies in real terms as well”. “Based on the last ten years, China will reach 75 percent of U.S. GDP by the mid-2030s and over 80 percent by the early 2040s”.
However, it should be noted comparative analysis is highly sensitive to currency movements. The currently strong USD, due to wide US-China interest rate differentials, is a major factor that lengthens the time that it would take for China to catch up with the US. But if USD was to ever weaken significantly, this would shorten the time it would take for China to close its nominal GDP gap with US.
Peak-China is also synonymous with structural change – a switch from reliance on property and legacy industries to the “new productive forces” in manufacturing and from focus on quantity to quality. Bloomberg Economics estimates “GDP related to high-tech industries – including medicine, advanced equipment, information technology and communications equipment and services, and research and development – expanded 12% on average between 2018 and 2023, significantly faster than the nominal GDP growth of 7%”. It “forecasts the hi-tech sector will account for 19% of gross domestic product by 2026, up from 11% in 2018. Combining what Beijing has dubbed the new three – EVs, batteries and solar panels – the proportion of GDP swells to 23% of GDP by 2026, more than enough to fill the void from the ailing real estate sector, which is set to shrink from 24% to 16%”.
Bloomberg notes medium-sized cities like Xuzhou, with a population of 9 million, used to rely on heavy industries like coal, steel and cement and on the property sector to drive economic growth. “Worried about rapidly rising debt levels, authorities then applied the brakes. In Xuzhou, like other so-called second-tier cities, the fallout has been severe with home prices in some areas down by more than half since 2021. With its natural resources depleted, the city has also been shutting down coal mines and steel factories, turning instead to three sectors: New energy, machinery construction and new materials”. Companies such as GCL Technology, the world’s second-largest maker of polysilicon (raw material for solar panels), excavator makers Xuzhou Construction Machinery Group and Caterpillar Inc., and BYD is fostering a supply ecosystem shaped by technological innovation and creating jobs.
However, Bloomberg points out “China’s total factor productivity – a measure of how efficiently resources are used to generate output – has been stuck at around 40% of that of the US since 2008… Korea and Japan reached 60% and 80% of US productivity”. “Across China, weakness in the property market has undermined consumer sentiment, youth unemployment is worryingly high and raging price wars in sectors like automobiles are weighing on company revenues”. “Chinese consumers haven’t yet bought into the hype” and “ill-designed government efforts targeted at promoting income equality have turned into crushing crackdowns on industries such as private tutoring, costing thousands of jobs and turning entrepreneurs cautious”. “The flood of cheap electric vehicles and solar panels onto global markets – a key reason the economy has been so resilient – has sparked a protectionist response from governments in the US and Europe who worry about a whole new wave of job losses at the hands of China’s industrial might”.
Thus even as China’s government doubles down on techno-industries, global pushback – coordinated among Western countries and with global South countries increasingly require China to localise production – will thin out China’s domestic manufacturing base and hinder China’s efforts to defend its global share of manufacturing. This may prevent China’s manufacturing sector from generating sufficient growth to offset the drag effects from the structural property downturn and creative destruction of legacy operations.
Nonetheless, China has implemented several strategies to sustain its economic growth. First, its dual circulation strategy aims to position domestic consumption as a driver of growth. In this context, there are a lot of misperceptions on China’s consumption. Vice-chairman of the China Center for International Economic Exchanges Zhu Min[12] points out “over the past 20 years, China’s consumption of goods actually remained pretty high, accounting for 31 percent of GDP, even higher than [that of] the US. The Americans consume only 27 percent of GDP on goods, but they consume 44 percent of GDP on services…I do confidently feel that China has a huge potential to boost domestic consumption, because of the [potential in] services consumption…which are the key areas to grow“. “At present, China’s deposit balance stood at nearly 300 trillion yuan, of which 145 trillion yuan are household savings. Household deposits increased by 9 trillion yuan in the first five months of 2024, and increased by nearly 60 trillion yuan in the past three years”. He anticipates China’s services consumption will grow strongly in tandem with its rising per capita GDP and aging demographics. “Developing a consumption bundle for this portion of the population becomes ever important, as they are the future consumption power for the whole society”.
Gene Ma and Yu Yongding argue China’s actual household consumption is much higher when properly adjusted for social transfers, purchasing power and housing expenditure. China’s consumption and living standards are comparable to other countries with similar incomes “when measured in terms such as calorie intake, child stunting rate (4.6 per cent), urban living space (41 square metres or 441 sq ft per person), home ownership (at least 74 per cent), average years of schooling (about 10 years) and luxury goods sales”. They note China ranks among the leading consumers of protein, fruit and vegetables on a per capita basis and enjoys world-class transport infrastructure and mobile and internet coverage. After purchasing power parity (PPP) adjustments, China’s consumption in residence, education, leisure and healthcare was more than double those using the market exchange rate. However, China’s household consumption may be crowded out by China’s high home prices and household leverage. “Large income and wealth gaps can also depress spending. So China’s low consumption is not the result of policy design”.
Second, while China’s share of global GDP and manufacturing may be approaching peak levels, rebalancing ultimately involves unlocking higher levels of service consumption from household savings and the expansion of service products. In this context, China’s level of financialisation is rather low. The large discrepancy between China’s GDP by purchasing power parity (PPP) as compared with its nominal equivalent suggests China has the option of repositioning the services and financial sectors as new growth engines. However, China’s government has preferred to restrain services “financialisation” for two reasons. One reason is that the government prioritises price and social stability. It has maintained rearguard policy action to dampen Baumol’s cost disease as this would contribute to inflationary pressures and increase social costs. The other reason is that the government prioritises financial stability. China’s government knows its financial oversight, governance and risk management capabilities and cultures are still lacking. Therefore, they have maintained tight controls, such as capital controls, as a means of maintaining financial stability.
Third, China is diversifying its trade away from adversaries towards friendly nations – it is friendshoring its consumption. The focus on reciprocal bilateral relationships implies the two-way flows between China and the West will diminish but that between China and the Global South will rise.
Overall, China has taken on board the need for “more orderly” conditions in domestic manufacturing. At the same time China will resist the erosion of its manufacturing dominance by upgrading and retaliating. In this regard, arresting China’s manufacturing dominance presumes other countries can grow their manufacturing to displace China. The challenge for the West is that it is unlikely China’s grip on global manufacturing can be loosened by government policy alone. Western governments must demonstrate they are able to raise the manufacturing share of GDP and exports. Western MNCs must demonstrate they are able to offer cheaper and better products. Perhaps, peak-China manufacturing scenarios would materialise as geoeconomic fragmentation deepens.
Geoeconomic fragmentation in a multipolar landscape
The value of globalisation is well understood and no country is willingly walking away from it. Instead, the great powers are trying to reshape (and weaponise) globalisation into a form that promotes supply chain and technological self-sufficiency over free trade (with specialisation and high interdependencies); and in a manner that disadvantages or excludes its adversaries. Faced with a near-peer rival for the first time, the US has revived containment strategy to reenact a “Cold War” alignment of spheres. China once again feels they are facing a hostile coalition of Western nations (including Japan, South Korea and India) as they did during its Century of humiliation[13]. China, together with Russia, are now seemingly prepared to openly defy Western sanctions. We are at the phase where escalations would entrench the trade war and deepen geoeconomic fragmentation. This will affirm the exit from the Goldilocks paradigm of “China produces and US consumes” and augurs a global economy fragmented into at least two spheres where US and China will seek to minimise each other’s presence.
Gita Gopinath relates “there was an explosion of international trade during the long 19th century, a 125-year period beginning with the French Revolution in 1789. But WWI brought that golden era of globalization to an abrupt end with world trade collapsing as a share of income. The protracted economic hardship that followed the war paved the way for the rise of nationalist and authoritarian leaders that later plunged the world into WWII. After WWII, a fragmented bipolar world emerged with two superpowers – the US and USSR – divided by ideology, and political and economic structures. Poised precariously between them was a set of non-aligned countries. This Cold War period, between late 1940s and late 1980s, was not a period of de-globalization as it was marked by rising global trade to GDP driven by the post-war recovery and the trade liberalization policies adopted by many countries in the Western bloc. However, it was a period of fragmentation as trade and investment flows were heavily shaped by geopolitical considerations. Trade between opposing blocs collapsed from around 10-15 percent to less than 5 percent of global trade during the Cold War. With the end of the Cold War, trade between previously rival blocs expanded rapidly, reaching almost a quarter of world trade in the following decade. The end of the Cold War also coincided with the hyper-globalization period of the 1990s and 2000s: technological innovations, unilateral and multilateral trade liberalization, and geopolitical and institutional changes all coalesced to lift economic integration to levels not seen before. Since 2008, however, the pace of globalization has stagnated – the so-called slowbalization – with trade to GDP stabilizing as the forces that helped spur hyper-globalization naturally waned”.
Gita Gopinath asks “so are we at the beginning of Cold War II? The key driving force is similar – that is the ideological and economic rivalry between two superpowers. In the Cold War it was US and Soviet Union, now it is US and China. But the stage on which these forces are unleashed is fundamentally different along several dimensions. To start, the degree of economic interdependence between countries now is higher, as economies have become much more integrated into the global marketplace and through complex global value chains. Global trade to GDP is now 60 percent compared to 24 percent during the Cold War. This will likely raise the costs of fragmentation. There is also greater uncertainty on the bloc with which countries may choose to associate. Within-country swings in the ideology of the political leadership have increased compared to the Cold War era and make it difficult to pin down allegiances. This uncertainty can further raise costs. On the other hand, the potentially non-aligned countries now have greater economic heft in terms of GDP, trade, and population…In 1950, the Western (US and Europe) and Eastern (China and Russia) blocs together accounted for roughly 85 percent of global GDP. The two blocs that we hypothetically have today account for roughly 70 percent of GDP and only one-third of the world’s population. And they have to compete with non-aligned emerging players. Given their increased economic integration – in 2022 more than half of global trade involved a non-aligned country – they can serve as connectors between rivals. They can benefit directly from trade and investment diversion in a fractured global economy and cushion the negative effect of fragmentation on trade, therefore reducing its costs”.
Gita Gopinath notes “we are beginning to see signs of fragmentation with meaningful shifts in underlying bilateral trading relations. While the growth of trade has slowed everywhere after the war in Ukraine, growth between blocs that are not politically aligned has slowed more…There are also clear signs that global foreign direct investment (FDI) is segmenting along geopolitical lines…This occurred alongside the resurgence of trade tensions between the US and China, between whom direct links are being severed. China is no longer the largest trading partner to the US, and its share of US imports has fallen by almost 10 percentage points in 5 years: from 22 percent in 2018 to 13 percent in the first half of 2023…China is also no longer a prominent destination for outward US FDI, losing rank to emerging markets such as India, Mexico, and UAE in the number of announced FDI projects…evidence that direct links between US and China are simply being replaced by indirect links. Countries that have gained the most in US import shares – such as Mexico and Vietnam – have also gained more in China’s export shares…connector countries that are uniquely positioned to benefit from the US strategy of de-risking from China. This is due to factors such as their location, natural endowments, and free trade agreements with both sides”. IMF estimates the economic costs of fragmentation[14] could vary from about 2.5 percent to about 7 percent of global GDP – depending on the severity and breadth of the fracture. At the country level, losses are especially large for lower income and emerging market economies”.
Overall, Gita Gopinath notes “global economic ties are changing in ways we have not seen since the end of the Cold War. After years of shocks – including the COVID-19 pandemic and Russia’s invasion of Ukraine – countries are reevaluating their trading partners based on economic and national security concerns. Foreign direct investment flows are also being re-directed along geopolitical lines. Some countries are reevaluating their heavy reliance on the dollar in their international transactions and reserve holdings. All of this is not necessarily bad. Given the recent history of events, policymakers are increasingly – and justifiably – focused on building economic resilience. But if the trend continues, we could see a broad retreat from global rules of engagement and, with it, a significant reversal of the gains from economic integration”.
Despite these trends, there are not yet clear signs of deglobalization at the aggregate level. Since around the time of the global financial crisis, when the 1990s-early 2000s hyper-globalization came to an end, the ratio of goods trade to GDP has been roughly stable – fluctuating between 41 and 48 percent”.
Bruno Casella, Richard Bolwijn and Francesco Casalena highlights emerging trends reshaping the global FDI landscape include the triple divergence and the rise of economic fracturing. The triple divergence trends are:
- Divergence between trends in FDI and GVCs, and trends in GDP and trade. Historically intertwined under the common shaping force of GVCs, global trends in FDI and GVCs and in GDP and trade have been growing apart since the 2010s. While global GDP and trade have grown steadily, cross-border investment and GVCs are experiencing long-term stagnation.
- Divergence in FDI trends between services and manufacturing. FDI’s long-term stagnation is characterised by starkly divergent trajectories between rapidly growing investment in services and shrinking investment in manufacturing activities. The transition from manufacturing to services is part of a broader change in the role of FDI in global value creation, whereas cross-border investment is moving from the centre to the two ends of the smile curve. This major shift, involving developed and developing economies, is blurring the traditional boundaries in terms of their FDI sectoral footprints.
- Divergence in FDI trends between China and the rest of the world. Chinese share in cross-border greenfield projects has been consistently declining for two decades, with an acceleration after the pandemic. Despite waning foreign interest in initiating new investment projects in China, the country continues to maintain a dominant position in global manufacturing and trade. Far from downsizing, Global Factory China is changing its operational model from globally integrated to more domestically focused production networks, while still maintaining its leadership in global trade.
Bruno Casella, Richard Bolwijn and Francesco Casalena note “fracturing is associated with heightened uncertainty and unpredictability in the FDI landscape, and limited possibilities for countries to strategically benefit from diversification…Overall, between 2013 and 2022, the share of FDI projects between geopolitically distant countries decreased by 10 percentage points, from 23% to 13%”. They conclude “the long-term stagnation of investment in GVCs and the sectoral shifts in investment patterns fundamentally alter the development paradigm based on promoting investment in manufacturing and export-led growth”. These shifts are adversely affecting “the prospects for developing countries to increase their GVC participation and to gradually upgrade to higher value-added industrial activities”; “as the least developed countries face declining manufacturing investment and a shrinking pool of efficiency-seeking, lower value-added projects to leverage for GVC participation”. “Changes in the patterns of sources and destinations of investment due to global economic fracturing, de-risking, and resilience trends…not only reinforce the effects of the long-term trends but also introduce new complexity into international production and increased uncertainty for both investors and investment policymakers as geopolitical considerations become more important FDI determinants”. While opportunities in traditional GVC-intensive industries are diminishing, there are opportunities in “industries where growth is driven by policy factors other than those influencing the general trend in GVCs. Notably, the promotion of investment in environmental technologies and sustainable energy serves as a notable example, albeit not the only one”.
There are major differences in geoeconomic fragmentation today as compared with during the Cold War[15]. The US dominated the global economy then but today the global economy is multipolar with the West and Global South countries holding roughly equal shares. During the Cold War, coming under the US umbrella meant better economic growth prospects and higher living standards. Today, being part of the US alliance implies commitment to economic sacrifices to maintain Western “sanction power”. Then, the US had a clear economic vision based on free trade and markets. They cheered when their companies expanded into Russia and China. Today, there is a lack of clarity on its future direction even as it resorts to protectionism and industrial policy. Today, they cheer when their companies withdraw from Russia and China. The US still has its strengths and staying under its umbrella advantages offer security and technology advantages but increasingly the value proposition from being a member of the alliance is questionable. As economic costs mounts, allies may be tempted to choose strategic autonomy to pursue their own economic interests.
Assuming US and China hold steady and hinterland economies like India, Indonesia, Mexico and Vietnam outgrow everyone else, the interesting question is which developed economies are likely to bear the brunt of the costs of geoeconomic fragmentation; i.e. lose the most ground in global GDP rankings. Countries in Europe and North Asia appear the most vulnerable. Those that benefitted substantially from hyper-globalisation had developed heavy interdependencies with “adversaries” and could suffer substantial costs from the unwinding of interdependencies. In theory, Europe as a hinterland economy should be well positioned. Yet, European economies seemed the most precarious because they doesn’t have a sense of their own space, interests and identity. Europe’s economic interest has become subordinate to NATO which is a military alliance rather than to the EU. Michael Every note “ECB’s Panetta gave a speech echoing Mario Draghi’s call for radical change. He stated for the EU to thrive it needs a de facto national-security focused political economy centered round: Reducing dependence on foreign demand (i.e., fewer net exports – sorry, Germany/Netherlands!); enhancing energy security (green protectionism); advancing production of technology (industrial policy); rethinking participation in global value chains (tariffs/subsidies); governing migration flows (so higher labour costs); enhancing external security (huge funds for defence); and joint investments in European public goods (via Eurobonds…to be bought by ECB QE for a strategic bond portfolio?)”. Similarly, Japan, South Korea and Taiwan are aligned to the West but are at odds with their neighbours China, Russia and North Korea. The dilemma for Western allies is that as they re-organise their economies to support US hegemony, they are, as bystanders, susceptible to collateral damage in an increasingly brutal trade war.
In the face of Western sanctions, the Global South is now able to pursue “globalisation” as they are anchored by China and collectively have a sufficient base of resources, technology, markets and financing. In this context, Western exits are welcomed as it vacates space for eager Global South companies to exploit. David P Goldman notes “China’s exports in April (2024) surged towards the Global South while shrinking in developed markets, following a pattern of geographic divergence that began four years ago…Exports to Algeria, Qatar, Oman, Morocco, Iraq, Tunisia and Egypt all registered year-on-year growth in excess of 25%. Algeria and Qatar more than doubled their purchases from China. China’s major Asian and Latin American markets, including Vietnam, Singapore, Indonesia and Brazil, showed growth of about 20%. Exports to the US were flat year-on-year in April, by contrast, while exports to the European Union and Japan fell”.
To an extent, the West is pinning its hopes on India – with its large population, IT base and influential diaspora – to become a substitute for China’s role in the global economy. It should be noted India has taken a hostile position to Chinese participation in its economy. India can afford to do so because does not have a large presence in China’s market and has less to lose. Towards this end, India has boosted its growth by harvesting low-hanging fruits with the diversion of large Western investments probably intended for China. However, India still needs to overcome its disadvantages in infrastructure, administration and global connectivity if it wishes to build an industrial ecosystem to rival China. If India aspires to replace China to position itself as an important cog in global supply chains, would India be willing to open up its market and industries in exchange for access to Western markets? In relation to this, is India’s approach of multi-alignment viable or will it eventually find itself penalised for attempting to straddle the two camps? We shall see.
If we take decoupling in 2016 as the starting point, then we are probably at the start of the middle phase – the deepening of geoeconomic fragmentation. The next milestone will be reached in 2026 when the West reindustrialisation and supply chain relocation come onstream. China and Russia’s path are more predictable – they need to surmount Western sanctions, technology blockades and protectionist barriers. The Western path is more unpredictable – whether it would become more conciliatory or aggressive with adversaries. This is unsurprising given the frequent changes in governing political regimes.
As 2030 approaches, it is likely deepening geoeconomic fragmentation will disadvantage the West more than China. For the West, it is a complex conundrum. Most of the West are now pursuing some form of re-industrialisation to reduce dependence on imports from China. Some Western countries have gone further to the extent of discouraging other forms of two-way flows (e.g. investments, technology, people and culture). However, others still want to maintain access to China’s market and welcome their investments to boost their own economy. Generally, fragmentation losses will be highest for countries that retreat furthest from globalisation and competition; that cut off sources of cheap and better supplies and curtail their network connectivity, and that forgoes international talent. The growth generated from pushing China out of the Western sphere would hardly be sufficient to compensate for the loss of access to the vast China market. In this regard, Western markets are affluent but they are matured and saturated and growth prospects are limited.
In this regard, the lack of visibility on post-decoupling Western economic prospects is disconcerting and consistent with the “decline of the West” thesis. How is the West to compete with the emerging Chinese and Global South challengers who benefit from access to low-cost “sanctioned” resources and markets and are eager to pounce on new market opportunities? The West also needs a game plan for a time when its sanction power gets weaker. How will US, Europe and North Asia respond if China and Global South ignores Western “sanctions” and chooses to fully decouple from them? It is clear sanctions and trade barriers are not delivering anticipated outcomes and are causing self-harm. Though sanctions may have played a major role in accelerating the decline of the West, the dilemma is that it is difficult to unwind sanctions.
China may be losing access to the Western and Indian markets, nonetheless China is playing a central role in shifting economic power from the West to the Global South. According to IMF’s World economic outlook, “as G20 emerging markets account for almost one-third of world GDP and about one-quarter of global trade, spillovers from shocks originating in these economies can have important ramifications for global activity…since 2000, spillovers from shocks in G20 emerging markets – particularly China – have increased and are now comparable in size to those from shocks in advanced economies. Trade, notably through global value chains, is a key propagation channel. Spillovers generate a reallocation of economic activity across firms and sectors in other countries. Looking ahead, a plausible growth acceleration in G20 emerging markets, even excluding China, could support global growth over the medium term and spill over to other countries”.
On a net basis, China will probably experience a marginal loss in growth momentum. In this context, China is cannibalising foreign share of its domestic market, generating rapid growth in bilateral trade and investments with sanctioned countries, and is solidifying economic relationships with friendly Global South and Western countries. The gains at the corporate level may be even more substantial as China reduces dependence on Western firms, currencies and intermediaries.
Overall, geoeconomic fragmentation can be viewed as a pushback against all forms of dominance in a multipolar landscape – whether it be China’s manufacturing and supply chain dominance and control over minerals; US geopolitical, technological and financial hegemony; or private sector monopolies. The trend is towards diversification and network competition. Nobody is getting a free ride in a multipolar landscape and while Global South countries will calculate their benefits, US allies need to think about what they are going to do to secure their future.
This is not to say that either side wins. My hypothesis is that modern wars – whether military or economic – are generally unwinnable and mutually destructive. In a trade war, there is likely to be overall net losses. While regionalisation and supply chain reorganisation will unlock the growth potential of some countries, the displacement effects such as losses from stranded assets, productivity inefficiencies, loss of connectivity and high friction costs will be greater. The multipliers for consumption, investment and liquidity will contract with the unravelling of global economic and financial interdependencies. Markets will become inefficient – with widening bid-off spreads, segmented pricing, rising risk aversion, fragmented intermediation channels, information opaqueness and growing mistrust. Governments would struggle to manage the adverse impact of geoeconomic fragmentation on its citizens who are already struggling to cope with higher living costs, an endemic, widening inequalities, migrant overload, and political polarisation.
Implications of changing global interdependencies
Geopolitical policies such decoupling, derisking, reshoring and de-dollarisation reflect US and China’s efforts to redirect trade, financial and information flows away from each other. In the rebalancing process, old interdependencies are being unwound and replaced by new ones. The changing patterns of global interdependencies have massive implications as geoeconomic fragmentation results in disjoints between the real (output), monetary (financial) and virtual (digital) sectors. It is thus critical to analyse the implications of changing global interdependencies.
- Changing global production and consumption patterns. China’s share of global manufacturing could be approaching near-peak due to reindustrialisation and reshoring in the West, rationalisation of Chinese domestic manufacturing capacity and hollowing out as Chinese MNCs respond to international demands to establish local production facilities. The rebalancing of China’s global manufacturing share is likely to be accompanied by a rise in China’s share of global consumption.
Han Feizi argues China’s consumption is grossly under-estimated. “26 million vehicles were sold in China last year, 68% more than the 15.5 million sold in the US. Chinese consumers bought 434 million smartphones, three times the 144 million sold in the US. As a country, China consumes twice as much meat and eight times as much seafood as the US. Chinese shoppers spent twice as much on luxury goods as American shoppers. In 2023, Chinese travelers took 620 million flights, 25% fewer than the 819 million flights taken by Americans, but Chinese travelers also took 3 billion trips on high-speed rail (and 685 million on traditional rail), significantly more than the 28m Amtrak trips”. He explains the under-estimation is due to (1) China not fully adopting the United Nations System of National Accounts (UNSNA) and leaving out items like imputed rent, legal fees and R&D which most Western countries capture in their GDP; (2) “The affordability crisis in Western economies, the US in particular, is largely driven by inflation of necessary services – rent, healthcare, education and childcare – not by manufactured goods. While these costs have also gone up in China, they have increased less and much are left out of GDP anyway”; (3) The effects of price wars in China. “Service quality in China, impossible to quantify, is now head and shoulders above the West and probably even Japan”; and (4) the systemic under-reporting of inflation that led to ever-increasing services share of GDP in the West; i.e. Baumol’s cost disease. “As necessary services become an ever larger share of Western economies, their growth does not appear to result in discernible improvements in living standards. Are US healthcare and universities twice as good as they were in the year 2000? If US households have not gotten vastly improved healthcare, education, housing and childcare over the past two decades, then inflation has been systematically underreported and GDP growth may have, in fact, been less than 1% per annum (instead of 2%), which equals stagnation given 0.8% per annum population growth”.
Rebalancing also implies the US share of global consumption is likely to shrink as consumption in China and other Global South countries rise. The implication is that the US role as the N-1 consumer economy – the main importer from the rest of the world – fades in importance. In addition, the US may be required to curb consumption (cutting fiscal spending and imports) due to financing constraints. Alternatively, US can produce (with reindustrialisation) and export more. Hence, rebalancing may imply a recovery in US’s role in production and trade.
Thus, rebalancing will result in intensified competition on both the industrial consumer fronts. Based on population size, China’s annual consumption could potentially be roughly three time larger than the US. In an ideal rebalancing scenario, rising Chinese global consumption share could replace stagnating or diminishing US global consumption share. Due to geoeconomic fragmentation, the redistribution of production and consumption will be within spheres. Hence, Western countries may not benefit as much from rising Chinese consumption because most of it will be directed towards absorbing growing Global South production. Consumption will likely remain circulated within the West. This highlights the role of India as a major swing factor in global production and consumption trends.
The rebalancing of global production and consumption could end up eroding US global influence and the standing of USD. Global Times argue “During a crucial period when Western nations are working to reorganize production and supply chains, bolstering China’s consumer market has emerged as a vital objective to strengthen China’s manufacturing edge and negotiating leverage in global trade…Today, China is the world’s most important manufacturing hub and a crucial export market for many countries. In an era where consumption is paramount, greater import capacity means greater bargaining power in international trade, which is especially important for China as a manufacturing power. However, when compared to developed countries like the US, the contrast in retail sales of consumer goods is striking. In 2022, the US reported total retail sales amounting to $7.04 trillion. In contrast, China’s total retail sales of goods reached 39.58 trillion yuan ($5.88 trillion, converted using that year’s exchange rate). While these figures are not directly comparable due to various economic factors, they nonetheless illustrate the significant gap in total consumption and individual purchasing power between the two nations. As the world’s largest consumer market, the US can convert its strong consumer power into global market regulation, giving it significant influence and voice in the global economy, and consolidating its world power…In the trade war initiated by the Trump Administration, the US’ willingness to impose tariffs aggressively is largely due to its strong purchasing power as the largest buyer of Chinese products. The US’ efforts to decouple from and sever links with China, forcing many third-country companies to relocate or cut ties with China, stem from its position as the largest buyer. What Americans buy or don’t buy, how much they buy of certain goods, and from which countries they buy, not only significantly impact the global economy but also have important implications for global politics and diplomacy”. “Although China is the world’s most important trading nation and manufacturing powerhouse, it is not yet the world’s most important consumer nation, which often weakens our ability to get into global markets. Enhancing our consumer power will help us maintain an advantage in the US and EU restructuring of industrial and supply chains and strengthen our initiative in global economic governance. If our diverse market can evolve into a vital export hub for an array of products from numerous countries, those aiming to impede Chinese manufacturing advancement will need to ponder the repercussions”.
- Savings recycling. Geopolitically-driven changes in production and consumption patterns will be mirrored by changes in the pattern of global capital flows. As China divert its production and consumption away from the West, it will deploy its export surpluses to finance Global South deficits. Correspondingly and in tandem with de-dollarisation, cross-border use of USD (for trade, financing and investments) will decline. During the Goldilocks era, capital flows were recycled from emerging countries (e.g. China) to the developed countries (e.g. US). Geoeconomic fragmentation will correct this anomaly by re-directing China’s excess savings to the Global South. The influx of Chinese capital will enable the Global South to grow more quickly and to compete with the West.
Agatha Kratz, Max J. Zenglein, Alexander Brown, Gregor Sebastian and Armand Meyer notes Chinese investment in Europe slipped to EUR 6.8 billion in 2023 from EUR 7.1 billion in 2022. This was the lowest level since 2010. China’s economic difficulties and strict capital controls, alongside increased scrutiny of foreign investment into Europe, contributed to 58 percent fall in M&A deals to EUR 1.5 billion. Only greenfield investment, headlined by CATL, AESC and Huayou Cobalt investments in battery plants in Hungary, Germany and France, kept FDI levels from falling off a cliff: The share of greenfield investment shot up to 78 percent in 2023, a further increase from 51 percent in 2022. Generally, Chinese FDI is focused along the EV value chain. “Chinese suppliers of battery inputs like cathodes and anodes have announced two greenfield projects worth over a billion euros each, and which are expected to break ground in 2024. BYD has announced plans to produce EVs in Hungary by 2026…The healthcare, consumer and ICT sectors remain relatively resilient: Europe’s healthcare, consumer products, entertainment, and information and communication technology (ICT) sectors continue to appeal to Chinese investors”. However, the EU has been expanding its scope of investment screening regimes; in particular targeting Chinese investments in strategic sectors…Chinese firms must also weigh up market opportunities in Europe against the backdrop of growing EU-China trade tensions”.
In contrast, Liu Sha notes that according to Global SWF, “the sovereign funds of six Gulf countries, including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE, made direct acquisitions and investments totalling US$2.3 billion in China last year. In 2022, the total amount was only approximately US$100 million”. This does not include investments by SWF-owned companies and funds. In 2023, Saudi-owned Aramco invested more than 32.9 billion RMB; Abu Dhabi-backed CYVN Holdings invested more than US$3 billion in Nio. “While Middle Eastern funds’ investment portfolio in China runs the gamut from social gaming to smart manufacturing and logistics”, NEV manufacturers like Nio, BAIC Bluepark, Great Wall Huaguan and Geely Auto are favoured. “When it comes to investing in China, especially in corporate equity investments, these funds look beyond monetary returns to focus on attracting foreign investments and bringing Chinese companies into the Middle East to catalyse economic transformation…in the NEV industry, Middle Eastern investors are not just investing in car manufacturers, but also in other parts of the supply chain”. “Chinese media outlets reported that the ADIA and the Kuwait Investment Authority are among the top ten biggest shareholders of A-shares at 51 publicly-listed companies at the end of the third quarter in 2023. In February this year, Saudi Arabia’s leading asset management company, Riyad Capital, and China’s largest public equity fund, E Fund, signed a memorandum of cooperation to cooperate in stock market investment. In any case, both the acquisition of undervalued Chinese assets and investment in emerging industries in China are inseparable from the strategic considerations of Middle Eastern funds”.
US production, consumption and capital will increasingly circulate within the West and friendly Global South countries. In this regard, if the US maintains a high level of deficits and imports, it would need to count on its trade counterparties to recycle their export surpluses by investing in US government debt. In this context, the West faces a dilemma. They need foreign financing to sustain their large fiscal deficits and to fund reindustrialisation. Yet, at the same time, they have been restricting Chinese (and other) investments in their backyard. On this note, there are concerns on the ability of allies and trade partners to absorb large amounts of the US fiscal debt. It is interesting to note that the West continues to rely on higher interest rates and carry trades to suck in private capital from the Global South.
- Sectoral shifts. Several major sectoral shifts are occuring in tandem with geoeconomic fragmentation and global rebalancing. The revival of industrial production in the West, if it is successful, implies manufacturing share of the economy must grow relative to services. Otherwise, its efforts to challenge China’s manufacturing dominance will falter. The other interesting sectoral shift is that though the agriculture share of GDP have shrunk over decades, yet the West remains major exporters of agricultural produce. This may change if China sources its agricultural imports from the Global South instead. Thus, Western countries may need to consider the trade-offs (impact on their services and agriculture exports) arising from their decision to challenge China’s industrial dominance. In particular, the trade war in services – with US weaponising IT-related services, education and finance and China weaponising tourism – has received less attention but is likely to also have consequential effects.
Overall, global rebalancing is essentially part of the contest on interdependencies. US and China are pulling in different directions but their influence is diminishing in an increasingly multipolar landscape. It is the reactions of the next tier of powers – the Western and emerging Global South economies – that may be decisive. Countries that are best able to reduce their dependencies and vulnerabilities over the next few years will strengthen their bargaining position and will most likely to defend or improve their share of global GDP. As globalisation recedes and geoeconomic fragmentation deepens, the global economy will look and function differently. I don’t see a reenactment of the Cold War containment model as Western sanction power is considerably weaker than it used to be. Instead, an era of global disorder is likely to ensue as Global South countries increasingly disregard the West and trade with each other and use their own currencies.
Fiscal gravity in anorexic economies
A decade filled with crises – pandemic, military conflicts and an economic war – created opportunities for politicians to play Santa Claus and shower their electorate and corporate backers with helicopter money with little accountability for the reckless spending. During the pandemic, Western central banks reacted by injecting so much liquidity that for over the past two years, they have been able to withdraw the liquidity by downsizing their bloated balance sheets without causing market tantrums.
The amazing feat is that fiscal deficits – already at record levels prior to 2020 – are being taken up to even scarier heights. It is as though governments are attempting to validate the Modern Monetary Theory (MMT) hypothesis that “countries that issue their own currencies, such as the U.S., are not constrained in their spending…such countries can’t default on the securities they issue, as they can simply print or issue more currency”. So far, this view seems justified with equity markets flirting with all-time highs, and in the case of US a strong dollar and decent uptake of US government debt despite persistent USD sales by China’s central bank.
Surely, government spending, deficits and debt cannot continue climbing even higher without severe mishaps. However, many of these highly-indebted advanced economies have already turned anorexic. This is a term I coined to describe economies with world-leading “lean and mean” corporations but with anaemic economies that require constant fiscal and liquidity injections to sustain economic vitality. The anorexic economy tends to be financialised with fiscal expenditures, positioned as the main driver of growth, feeding into corporate profits (rather than wages) and inflated asset values. However, fiscal spending and government debt are now well stretched to the hilt. Red flags in the form of higher inflation and higher interest rates have surfaced. Their effects tend to be delayed as there are long and variable transmission lags in relation to debt servicing costs, interest mismatch and funding risks, private sector risk aversion and retrenchment, and domestic and international credit and liquidity risks. It is now a matter of time before fiscal gravity asserts itself; most probably by 2025-6 by my reckoning.
The US national debt is approaching US$35 trillion or 120% of GDP. Interest payments on debt have surpassed defence spending and entitlements in the US budget. Wolf Richter notes US government interest payments on its national debt have surged due to accumulating debt and rising interest rates. In April 2024 “nearly 22% of the $26.9 trillion in marketable Treasury securities outstanding are T-bills that the government paid an average of 5.36%…the average interest rate that the Treasury department paid on all its marketable and nonmarketable securities – on the whole $34.6 trillion schmear – was 3.23%. That’s still low, and it will keep rising”. Interest payments as a percent of tax receipts was 36.1% in Q3 2023…in the 10 years between 1983 and 1993, it ranged from 45% to 52%”. “Back in the late 1980s and early 1990s, interest payments were eating up about 50% of the national tax revenues, and the US was careening toward a serious crisis. It wasn’t until then that Congress, which decides fiscal matters, had a come-to-Jesus moment and dealt with the ballooning deficit, further helped along by the budding Dotcom Bubble at the time, which generated huge capital gains, employment, and wage growth”. “Interest payments jumped to 3.8% of GDP in Q1, the worst since 1998. This is relentlessly heading in the wrong direction at a disconcerting pace”.
Politicians are generally reluctant to end fiscal handouts as the painful economic outcomes will hurt their chances of staying in power. Surprisingly, this caution has not helped incumbent governments from being voted out of power across the West. I think this reflects widespread voter dissatisfaction with current politics and policies – which have de-prioritised their long-term economic and social needs relative to national security objectives. With governments unable to rein fiscal spending, central banks have limited policy choices to finance the government debt. They can choose to maintain high interest rates. This will control inflation but will crowd out the private sector and result in a deep and prolonged recession. The alternative is to print money (via QE) and lower interest rates. But this will add fuel to inflationary pressures (including through a currency depreciation) and, if the private sector retrench, there are risks this would turn into a liquidity trap.
It is a policy quandary – a choice between the lesser of evils. Nonetheless, the US is better positioned than its allies. It can continue to postpone fiscal gravity for a longer period of time. Chances are its allies in Europe (e.g. France, UK) could cave in earlier due to mounting economic stress, pressure on their fiscal debt and currencies. Japan’s revival remains problematic due to its difficulty in exiting its QE trap without triggering significant de-stabilisation risks.
It is not too difficult to guess what happens when governments around the world start cutting fiscal expenditures. This would puncture large holes in aggregate demand. If the private sector are hit by large investment losses at the same time, they would be incapacitated and unable to contribute to economic growth. As the economic dominoes fall, the weakness would spread across the global economy. This would place pressure on US policy because not only will US export and fiscal revenues fall, US intermediaries might have to deleverage their market positions and the US would face problems in finding buyers for government debt.
What would then be the new drivers of global growth? If large Global South countries are not accumulating Western currencies or investing in their economies and vice-versa, this implies the existing engines of growth are likely to shrink. It is not possible to re-leverage the global economy given the overhanging threat of sanctions and de-dollarisation. As economic challenges loom, government policy-makers find there is little room for cooperation to stave off the deterioration that is leading to a deep global recession or/and a financial crisis.
The dismal decade: Spectre of a global depression
The Goldilocks era of hyper-globalisation, and low inflation and interest rates is over. We’re not sure where we are heading for next in a post-Goldilocks, post-globalisation, post-pandemic, post-industrialisation and post-G7 era. But we know it will be an uneasy transition because it involves the unwinding or reshaping of globalisation, industrialisation, financialisation and informationalisation. Hence, rather than a “stable new normal”, the global economy seems to be transitioning towards a permanent “state of disorder” in a multipolar and fragmented landscape.
So far, the “doom and gloom” prognosis has not materialised. Despite a succession of shocks, global trade and economic growth has been relatively stable and markets have remained euphoric in several countries. I would argue there are reasons why a severe economic downturn hasn’t happened yet and why it is likely to materialise around 2025-26.
- Fiscal expenditures are still strong. Economic contraction would only begin once governments cut fiscal spending. My view is that rising inflation and interest rates signal we are nearing a phase where governments would find themselves forced to cut expenditures. In the meantime, liquidity (in the West) would be constrained by private sector balance sheet retrenchment and risk aversion, limited demand for Western government and private assets due to de-dollarisation, cross-border deleveraging and limited foreign central bank support.
- At the moment, government incentives for investments in new plants have a positive impact on economic growth, corporate revenues and profits because of the triple whammy effect (rising capital formation and employment; and capitalisation of costs). However, as plants come onstream during 2025-6, profit margins will be hit by production inefficiencies (higher production costs and depreciation charges) and redundancy costs (duplicate capacity, oversupply and lower prices). Worse still, 2025-6 could mark the culling of loss-making plants. Firms may be saddled with losses from write-offs on stranded assets, crystallisation of bad debts and rising interest servicing costs.
- Western asset markets remained exuberant despite QT. This is due to liquidity congestion arising from the sale of China, Russian and other Global South assets and deleveraging. However, it is likely the bull market is in its final phases. Participation in markets appear to be thinning and the major funds increasingly focus on a handful of stocks (e.g. the magnificent seven) to generate target annual returns. Central bank regulators are aware of the building risk concentrations and appear ready to inject liquidity should any event threaten to trigger a run on these funds. Experience suggests that despite their best efforts, “eventually” an unanticipated event would trigger a sequence of loss-making events that would force funds to liquidate their investments which could trigger contagion. In conjunction with this, there has been a steady build-up of “inert” unrealised losses. A crash in asset prices would trigger runs and deposit flight, liquidity and solvency problems, and negative wealth effects. Financial contagion would lead to a severe recession or even a depression.
- Over time, the adverse consequences from a breakdown of the global system will become more evident. The race for self-sufficiency and “beggar-thy-adversary policies” are leading to economic losses from duplicative production, logistical interruptions, demand and supply rationing, and higher friction costs (including risk premiums, and jurisdictional and compliance uncertainties). Geoeconomic fragmentation is impeding global recycling of savings. Investment opportunities are reduced for security reasons while entrepreneurs are being out-muscled by government-funded initiatives. Market inefficiencies will grow with price segmentation, volatility and widening spreads. Liquidity will tend to congest within spheres and will act as a major constraint on re-leveraging as a means of restarting global economic growth. Technology bifurcation will impede innovation and scale and damage network connectivity (talent, knowledge, finance, content and data). The forces of cost-push inflation have returned. Trade wars and pushback against migrants are cutting access to cheap imports and cheap labour. Worker power is being restored while local companies increasingly demand protection against cheap imports. Overall, global trade, investment and liquidity multipliers are beginning to contract.
Many economic effects thus operate with a lag. My prediction is that the wheels will come off the economic bus in 2025-2026. Reindustrialisation, connector economies and trade diversification supported economic growth during the initial phase of geoeconomic fragmentation. In the second half of this decade, the initial impetus will wear off and the side effects will kick in as the trajectories for deglobalisation, definancialisation and deinformationalisation steepen. The room for debt expansion is increasingly constrained and there will be pressure to cut fiscal spending. The few bright spots on the horizon are overwhelmed by a mushrooming of Black swan scenarios – a pandemic, economic and financial crises, comprehensive sanctions on China and hot disputes that could spiral into a third world war.
Is the global economy on the verge of entering into a great depression? Certainly, the symptoms associated with a depression are present – beggar-my-adversary policies, demographic aging, secular stagnation, industrial over-capacity, falling productivity, bank failures, debt crises, asset price collapses and risk aversion. In the recent past, the threat of a deep depression was warded off through global cooperation to generate sufficient global growth to help struggling economies survive their domestic challenges. Today, most governments have used fiscal and monetary tools to the point of exhaustion and their ability to respond to deteriorating conditions is limited. On top of this, governments seemed to have worked themselves into a corner and appear unable to reverse the geopolitically-driven policies that seem to be causing so much economic damage. It won’t matter much whose economy collapses first. Can the US and the global economy fare well if China’s economy collapses and vice-versa? Can there be economic recovery without coordination or political resolution? Certainly, a positive change in the geopolitical climate is needed for the great powers to embark on negotiations to achieve a genuine accommodation of disparate national interests.
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[1] See Frank Bickenbach, Dirk Dohse, Rolf J. Langhammer and Wan-Hsin Liu on industrial subsidies in China. See “Information and organisation: China’s surveillance state growth model (Part 2: The clash of models)” for arguments that there shouldn’t be differentiation between public and private (investor) subsidies and that they are tools to incentivise acceleration in innovation, expand markets and to promote scale and lower costs with large social benefits.
[2] See Michael Every.
[3] See Yuxuan Jia.
[4] See François Chimits.
[5] See Chi Jingyi and Zhang Hongpei.
[6] See William Alan Reinsch, Meredith Broadbent, Thibault Denamiel and Elias Shammas on the challenges of friendshoring the lithium-ion battery supply chain.
[7] “When an invading force crosses a river in its onward march, do not advance to meet it in mid-stream. It will be best to let half the army get across, and then deliver your attack.” (Sun Tzu, The Art of War)
[8] See Noah Smith “Why is US manufacturing so unproductive?”
[9] See Uri Dadush and Conor McCaffrey for detailed analysis. See Global Times for China’s view on the EU investigation. See Wendy Chang on issues relating to potential data security and cybersecurity risks of foreign EVs.
[10] See “Information and organisation: China’s surveillance state growth model (Part 2: The clash of models); “China’s model (Part 2: Digital China and the information society)”.
[11] See Zichen Wang’s translation of Xi Jinping’s recent speech on further deepening reform comprehensively to advance Chinese modernization.
[12] See Global Times.
[13] The “century of humiliation” is used to describe the period in Chinese history beginning with the First Opium War (1839–1842) typified by the decline, defeat and political fragmentation of the Qing dynasty which led to demoralizing foreign intervention, annexation and subjugation of China by Western powers, Russia, and Japan. https://en.wikipedia.org/wiki/Century_of_humiliation
[14] See IMF report by Shekhar Aiyar et al.
[15] See Rodolfo Campos, Benedikt Heid and Jacopo Timini on “The economic consequences of geopolitical fragmentation: Evidence from the Cold War”.