Road to 2030

The Rise of China revisited

China’s economic rise to the world’s second largest economy has been spectacular and exerts substantial geopolitical influence in the current landscape.

27 Nov 2023

25 minutes

The Rise of China

Apocryphally, Napoleon said that when China awoke, she would shake the world, and indeed since Deng Xiaoping’s rise in 1978 that is what the world has experienced. Over the last five years, the narrative has certainly been complicated by China’s economic troubles. Investors have experienced a shadow bank implosion, bankrupt local authorities, record high youth unemployment, a property market collapse, and relative incoherence in central government economic policy. For investors over the last few years, there is no sugarcoating it, investing in China has been a very difficult experience.

What is the next stage of China’s rise, how will it impact the world, and what tailwinds and headwinds should investors be mindful of?

We think investors should view ‘The Rise of China’ theme in terms of the key drivers as articulated by three sub-themes:

  • China’s shift from investment to consumption
  • China’s growing multipolarity
  • China’s ascent up the value chain

The Rise of China revisited - mind map

Chapters

01
China's shift from investment to consumption
02
Growing multipolarity
03
China's ascent up the value chain
04
Potential investment implications
01

China's shift from investment to consumption

The Shanghai Mansions hotel
China’s post-GFC stimulus was one of the most extraordinary macro-stabilisation policies ever undertaken by any group of policymakers. Famously, China used more cement between 2011-2013 than the US used in the entire 20th century.1 While the intensity of the post-GFC stimulus has since moderated, China has maintained gross fixed capital formation, also known as investment capital expenditure, at above 40% of GDP for over 13 years, which must be a peacetime record for a large economy.2

The broad features of China’s investment-centric political economy are by now well understood, and there is a widespread consensus that the investment-centric model is reaching its limits.3 It is not a coincidence that China has the highest investment share of GDP in the world and one of the fastest growing debt burdens in history. As economists have pointed out, these facts are related.

China’s model allowed it to maintain consistently high growth rates in response to domestic or external setbacks until the mid 2000s by unleashing waves of infrastructure and property investment. After that point, the solution itself began to cause problems. This led to a growing number of unproductive assets, especially in property, as well as rising financial leverage, which has been supported by high savings rates in the financial sector. Unsurprisingly, this has gone hand in hand with weak household consumption.

China is now at a turning point. Effectively, its growth model is unsustainable, with low levels of capital productivity, and financed by excess debt growth. The government’s ‘three red lines policy’, introduced in 2020, and its mantra ‘houses are for living in not for speculation’ have marked the start of what has been called a ‘controlled demolition’ of the relationship between credit growth, property, and the local government funding model.4

This restructuring process will be difficult and lengthy because it involves restructuring the sizeable past debts incurred, as well as changing an economic model that is dependent on continuous debt growth, especially at the local government level. There may be periods when China will have to pursue cyclical stimulus to maintain confidence in the economy amid this structural change —and we may be in one of these times now. At the heart of these views is a sense that China’s ‘40-year boom is over’, and what comes next will be different.5

That might be correct, but it doesn’t have to be an adverse outcome. Undertaken correctly, reform could be part of becoming a richer and more developed economy. Ultimately the prize for China is a more sustainable economy. It is one that requires less debt to grow, and where economic activity will become less volatile and less dependent on overseas demand (incidentally, this would be in line with China’s dual circulation policy). China will also be able to create strong demand for its own substantial production base, allowing Chinese households to have a better quality of life.6

China would still have a significant growth runway. If the government was to grant hukou-linked social benefits to the 18% of Chinese (some 250 million migrant workers) who do not have access to them in big cities, it would boost spending (and housing demand) immediately.7 China’s GDP per capita remains below Russia or Bulgaria and Chinese capital stock per worker is still below that in advanced economies.8 Former Premier Li Keqiang’s jaw-dropping statement in 2020 that 600 million Chinese people earn just RMB1000 (or $140) per month shows that there is still significant room for economic growth.

What might a rebalancing scenario look like? The basic transformation is continuous consumption growth. Within investment, the mix shifts away from property and infrastructure towards manufacturing. That would allow the economy to concurrently climb up the value chain, handle the property downturn, and increase household consumption.

Playing through that scenario, real consumption expenditure in China was consistently around 4% from 2014 to 2019. Economist Michael Pettis, who is on the more pessimistic end of forecasts, has a ‘moderate’ rebalancing scenario in Figure 1 that sees consumption growing at 3.5%, investment growth at -1.5%, and GDP growth coming out at 1.5%.9 That would reduce investment share of GDP growth from 42% to 36% in ten years (Figure 2). Within investment, infrastructure and real estate investment would shrink, while investment in other areas, like advanced manufacturing increase.

Figure 1: China rebalancing scenarios

Consumption growth Investment growth GDP growth
(A) Optimistic scenario: Rebalance with a surge in consumption 6–7% 0–1% 4%
(B) Moderate scenario: Rebalance while maintaining current consumption growth rates) 3–4% -1–2% 1.50%
(C) Difficult scenario: Rebalance with a sharp decline in consumption growth 1–2% -2–3% 0%
(D) Crisis scenario: Rebalance with a sharp contraction in GDP NA NA NA
(E) Rebalance over a much longer period 3–4% 0–1% 2.50%

Source: Carnegie Endowment for International Peace, October 2023.

Figure 2: Moderate scenario: Rebalancing while maintaining current consumption growth rates over 10 years

Average 10-year growth rate 3.5% -3.5% -3.5% 1.5% -1.5% 1.5%
Year Consumption Trade surplus Infrastructure investment Real estate investment Other investment Total investment GDP GDP growth
1 54.0 4 14.0 13.0 15.0 42.0 100.0 NA
2 55.9 4 13.5 12.5 15.2 41.3 101.2 1.2%
3 57.8 4 13.0 12.1 15.5 40.6 102.4 1.3%
4 59.9 4 12.6 11.7 15.7 39.9 103.8 1.3%
5 62.0 4 12.1 12 17.5 42.5 115.9 4.00%
6 64.1 4 11.7 10.9 16.2 38.8 106.9 1.5%
7 66.4 4 11.3 10.5 16.4 38.2 108.6 1.6%
8 68.7 4 10.9 10.1 16.6 37.7 110.4 1.7%
9 71.1 4 10.5 9.8 16.9 37.2 112.3 1.7%
10 73.6 4 10.2 9.4 17.2 36.7 114.3 1.8%

Source: Ninety One, adapted from Carnegie Endowment for International Peace, October 2023.

Is it plausible to have such a smooth rebalancing? Time is one variable, with an optimistic scenario suggesting Chinese growth would decelerate gradually over years, to the 2% rate that rich countries like the US manage, and a more pessimistic scenario showing abrupt declines, encouraging an economic crisis. We tend to see the base case as a gradual deceleration because of the policy credibility that Chinese policymakers have built up over the years in cyclical management of the economy. Moreover, Chinese authorities are institutionally incentivised to achieve this outcome.

But will not reducing investment also hit consumption? After all, many household incomes are dependent on investment spending. Certainly, the authorities will need to actively support consumption during this period of structural change. This can be done by liberalising hukou rules, which limit social benefits to those who have a household registration permit in a particular city; supporting a deeper safety net to reduce precautionary savings and reducing financial repression on household cash balances. There is evidence some of this is happening. Indeed the gradual hukou reform in provinces like Zhejiang, Jiangsu and even Shanghai has been one of the brighter spots of the reforms announced in 2023.10

We have framed China’s key economic transformation over the next decade as a shift from investment to consumption. The new growth model is lower, steadier growth that is relatively sustainable and has a decent runway given China’s starting point. We think this is the path China’s policymakers have been trying to put China on for several years now.

Is this the correct framing? There are a number of potential objections that warrant discussion.
  • Why should investors get excited about 3.5% consumption growth? Is that really a ‘tailwind’?

We think it is. Consider that in the five years prior to COVID, real personal consumption expenditures in the United States grew at 2.7%11 a year and provided a healthy environment for growth for US businesses. Real Chinese consumption will grow at a rate that is 30% faster.

Also, headline economy-wide real consumption growth at 3.5% means some provinces and businesses will be growing at much faster rates. Economists have made the argument that the Chinese economy is splitting into two very different parts: ‘the 6-7 wealthier provinces and municipalities with higher incomes, diversified economies, high but manageable debts and growing working populations versus the rest.’12 Those provinces are Shanghai, Zhejiang, Jiangsu, Fujian, Guangdong, Beijing, and perhaps Tianjin and Chongqing too.13 In other words, there are bottom-up opportunities in China that will be attractive to investors.

Finally, if China manages to rebalance towards consumption, productivity would rise from very low levels. From 2011-2019 China’s Total Factor Productivity (TFP) growth was around 0.8%, less than half the level from the decade prior.14 Median TFP for countries after reaching China’s GDP per capita level are north of 1%. So China is underperforming its peer group15. Reducing capital outlays for property and infrastructure projects as well as inefficient State-Owned Enterprises would, if output levels were maintained, boost productivity. This is what matters for long-term living standards and spending power.

  • China has not indicated that it will shift its investment- centric model. Why should we be confident it will do so?

China’s most recent growth roadmap does not focus on a shift towards consumption.16 In fact the latest five-year plan, its 14th, is very conservative on structural change,17 and there is no plan for manufacturing to decline significantly as a share of GDP (manufacturing is one component of investment spending). Rather, policymakers are targeting a multi-faceted focus on boosting innovation capacity, well-being, environmental targets, and security targets, instead of just focusing on economic growth. To deliver this, commitments to infrastructure spending will be substantial. In other words, China’s planners seem to be slowing down China’s shift to a service-driven, consumption-driven economy.

But that’s not the whole story. China has indicated major changes in its long- term objectives that are not captured by its most recent five-year plan. At the 19th Party Congress in 2017, China shifted its ‘principal contradiction,’ a Marxist- Leninist concept denoting the direction of social progress, to ‘quality of growth’ from ‘quantity of growth’ (or ‘unbalanced and inadequate development’). The only time this had happened before was in 1981, when under Deng Xiaoping, the party shifted from ‘class struggle’ to ‘economic development’.

Similarly, China’s shift to consumption is also consistent with the ‘dual circulation’ strategy articulated in 2020 that requires it to generate more domestic demand to consume domestic production.

Finally, in speeches over the past year it has become clear to several domestic observers that China will have to shift away from its investment-centric model, because not doing so risks perpetuating a financial model that is straining at the seams.18 China’s choice in this sense is not whether to rebalance, but how to do it while minimising disruption.

  • Is China is facing a ‘middle-income trap’?

Whether or not a specific ‘middle-income trap’ exists is the subject of academic debate.19 Catch-up growth is always challenging, and there may be no evidence for stagnation at the middle-income level rather than any other level. Economist Robert Barro has gone as far as to dismiss this as a myth.

But let’s say it does exist. At the very least one could argue that China’s unique circumstances make it difficult to draw firm conclusions from comparisons with other countries, particularly those that are smaller and have lower levels of technological capability. For example, China’s large markets attract investment inflows on terms that would be considered unfavourable when applied to a smaller country. For instance, many companies have been compelled to set up manufacturing facilities or transfer technologies to China in exchange for access to the Chinese market, something they would have been less likely to do if selling to a poorer, smaller country.

There is probably a straightforward rationale that China should be treated as a separate case. Certainly, the combination of gradual real consumption growth with strong leaps in key technological areas means that the assertion China is facing a ‘middle-income trap’ does not capture the transformation underway in China’s economy.

  • Isn’t the real structural challenge for China’s economy the impact of its authoritarian and tightening political system on its free-wheeling and entrepreneurial economy?

This topic is contentious, and it’s important to note that some investors may have reservations about investing in a country with China’s system of government. As a result, China may not be the right investment choice for them.

Others, while open to investing in China, may have concerns about how China’s government system could affect its markets. This discussion is intended for those investors. It is true that a heavy-handed and opaque political system can dampen animal spirits. And there is no doubt that China’s policymakers have shifted policy towards a more statist economic model in recent years, and that this transition has not been particularly smooth. China has lurched from one policy configuration to another.

However, not too long ago, Chinese policymakers enjoyed greater credibility among Western investors and businesses because of their more flexible political system, compared to democracies with more checks and balances. In the 2010s, there was widespread discussion in the West about a ‘Beijing Consensus’, which posited that China’s mix of autocracy, technology and dynamism would fuel long-term growth.

Despite growing evidence of ideological rigidity in China’s policymaking, there have been flashes of pragmatism in recent years. These include the ending of COVID restrictions in 2022, which had been in place for too long, easing the crackdown on internet companies in July 2023, and easing the property crackdown at the margins. From a philosophical perspective, it’s worth being cautious when attributing China’s challenges solely to authoritarianism. If we argue that authoritarianism explains the clumsy policymaking observed since 2020, we must consider the counterfactual scenario. Democracies, too, have faced a mixed track record in addressing issues such as COVID-19 and property market fluctuations.

The question arises: ‘How many governments around the world – whether democratic, populist, or authoritarian – can genuinely boast about their COVID response? Furthermore, when we assess China’s remarkable economic growth since the late 1990s, it’s worth noting the performance of economic policy-makers in Japan, Europe and the US, who grappled with comparatively smaller real estate booms. Therefore, it’s reasonable to question whether China’s primary challenge lies in its authoritarian system.’20

Finally, many parts of the government do understand that China needs a vigorous private sector, especially as it transitions towards a more service-oriented economy. Nicholas Lardy has pointed out that private investment still accounts for more than half of all investment, despite a relative slowdown in recent years. If China is to have a good economic outcome over the next decade, the private sector will need to be given the space and encouragement to grow, and in our view, enough people in Beijing understand that.

In summary, China’s political system is different, possessing both strengths and weaknesses. We believe this difference is not always detrimental to businesses and markets; in fact, it can often provide significant advantages.

There are other concerns about China’s structural growth model. These include a population that is shrinking and aging, while at the same time, debt is spiralling. In the section on Demographics, we suggest China’s demographics is less of a binding constraint than the cliché ‘growing old before growing rich’ indicates. And in the Road to 2030 section on Debt, we examine the risk of a balance sheet recession in China, and why China is not Japan.

The bottom line for investors, is that China does need to shift its economic model, allowing growth to slow while becoming more balanced and sustainable. As we explore next, this decade’s shift to a consumption-led model will create tailwinds in some sectors, especially given valuations and of course headwinds for others.

Opportunities and challenges
The end of financial repression of household savings is a major consequence of the shift to consumption.

As returns on property and bank wealth management products look less attractive, Chinese household allocations to financial assets could increase, allowing the financial system to become deeper and more sophisticated. This will lead to major tailwinds for some Chinese financial services firms and the broader investment ecosystem in China. It will also lead to major headwinds for some businesses. (Interestingly, the development of Chinese financial markets is also supported by demographic shifts. Whereas Chinese citizens in their 30s today have on average 5x as many cousins as in the 1960s, by 2050 they will only have a fifth as many cousins, restricting opportunities for kinship lending/borrowing and boosting demand for financial services.21)

The shift towards consumption will bring favourable conditions.

These conditions will support for product premiumisation and improved quality of life, propelled by the expanding Chinese middle class (Figure 3). It will also provide a boost for domestic brands, supported by guochao, or nationalism-driven consumption patterns.

Figure 3: China will see a rise in the number of the most affluent households

China will see a rise in the number of the most affluent households

Source: Mckinsey Global Institute.

In Chinese industry, supply-side reforms will create headwinds in the old economy.

This includes a shift in antimonopoly regulation, and the reduction of capacity in old economy industries. We can expect headwinds for these industries in the coming years - outside of cyclical turning points - at least until those reforms finish.

Falling commodity intensity will impact the $bloc.

As investment declines, a reduction in commodity intensity of production in China will generate profound headwinds on the demand of $bloc economies and their overheated housing markets, given that China is the world’s biggest buyer of natural resources.22

02

Growing multipolarity

The view looking down a tall building
The United States’ diminishing superiority in economic and military terms in the last few decades is an uncontroversial fact, but this does not imply the inevitability of multipolarity.23 The ‘Chimerica’ configuration, as described by Niall Ferguson and Moritz Schularick, and characterised by deep economic and financial integration, could have just as logically, though perhaps not plausibly, entailed a world of increased cooperation within existing global institutions rather than less.

Today it is evident that multipolarity is a fact of life—a glance at how countries voted on the UN resolution condemning Russia after the Ukraine invasion will make that clear. We’ve witnessed a shift in the adversarial stance of both the US and China towards each other, currently framed as ‘derisking’, but some analysts view it as being entangled in the dynamics of ‘economic war’.23 Meanwhile, the areas where the US still has overwhelming superiority—dollar dominance and military spending—stand out ostentatiously; but they are being chipped away every year.

In many ways, multipolarity is a return to normal after the strange unipolar period from 1991 to about 2016, which was characterised by the ‘hyper- globalisation’ of extraordinarily integrated global markets for capital, commodities, products and people, and little to no great power conflict. On the other hand, China is not the Soviet Union, and the number of powerful middle powers is greater than it ever was in the Cold War Period. Either way, it is a reminder that the unipolar moment from 1991 to 2016, which underpinned powerful disinflationary forces that some mistook for ‘secular stagnation’ is over.24

In global trade, we think regionalisation, not deglobalisation, is the right way to frame the disruption. There is little evidence of deglobalisation. China’s share of European value chains has increased since 2019; it is the same for China’s share of global exports.25 In any case, trade has thus far evolved along regional lines anyway – inter-regional trade is dwarfed by intra-regional trade and remains relatively uncontroversial.26 One-third of ASEAN exports are now consumed close to home, up from 12% in 2000 (see Figure 4). EM-EM trade continues to rise, and most EMs already trade more with each other than they do with the West.27

Figure 4: Decomposition of final demand for emerging East Asia’s exports

Decomposition of final demand for emerging East Asia’s exports

Source: OECD Inter-Country Input-Output (ICIO) Tables, staff estimates. Note: East Asia: EM (excl. China refers to Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Thailand and Vietnam.

At the global level, we are seeing some stabilisation in trade shares of GDP, but this has a lot to do with financial derisking since 2008, particularly driven by European banks, rather than by worsening US-China relations since 2016, as Hyun Song Shin points out.28 In any case, China’s trade intensity peaked in 2006 as it prepares for a shift towards domestic consumption, arguably an inevitable shift.29

That is not to say that huge changes are not happening under the surface. Apple, for instance, has started to diversify its manufacturing beyond China. In 2020 nearly all iPhones were made in China, but some analysts now anticipate that Apple’s longer-term goal is to ship 40-45% of iPhones from India.30 Meanwhile, some economies, like Mexico and Vietnam, have already reaped substantial benefits from the US pivot away from Chinese supply chains. Foreign direct investment (FDI) is increasingly flowing towards geopolitically proximate countries, while interest in reshoring has rocketed (Figure 5).31

As the head of shipping and logistics business UPS told the Financial Times in 2021, the full impact of these shifts will only be evident in five to ten years.32

Figure 5: FDI is increasingly directed to geopolitically close countries
Share or total FDI between geopolitically and geographically close countries

FDI is increasingly directed to geopolitically close countries

Source: Atlantic Council; Bailey, Strezhnev, and Voeten (2017); CEPII, Gravity database; fDi Markets database; NL Analytics; and IMF staff calculations. Note: Figure shows the annual share of total foreign direct investment between countries that are either geopolitically or geographically close. Two countries are close if they are in the same quintiles of the distribution of the relevant (geopolitical or geographical) distance from the United States. Geopolitical distance is measured by the Ideal Point Distance in Bailey, Strezhnev, and Voeten (2017).

Opportunities and challenges
These global trade shifts will have important investment implications.

The broad story is of trading patterns being disrupted, of countries pursuing near-shoring and friend-shoring rather than re-shoring, or of countries pursuing ‘China + 1’ strategies of diversifying their supply chains from China, not deglobalisation.

There will also be tailwinds for localisation of production in US and China, driven by reshoring activities.

This is particularly true in China, where the state has extensive targets for local manufacturing, for example in medical devices.

Software companies in China benefit not only from localisation tailwinds, but also those from general technological development and digital inclusion. Notably, Chinese companies of all sizes spend very little on IT – only 3% of GDP in 2020 – which is half that of developed markets. And most of it is spent on hardware and telco devices while software spending only accounts for 12 bps of GDP. This is an early stage and exciting growth opportunity.

There will also be international winners from re-shoring and near-shoring and defence spending in developed markets, while there could be material risk to the earnings of developed market companies selling into China given potential bans and boycotts.

We think the shift in trade patterns is likely to put some upward pressure on inflation. This will manifest at a global level since inflation is a global phenomenon.33

Figure 6: Rising geopolitical tensions and foreign direct investment fragmentation34
(index; frequency of mentions of reshoring on right scale)

Rising geopolitical tensions and foreign direct investment fragmentation

Source: Bailey, Strezhnev, and Voeten (2017); Hassan and others (2019); NL Analytics; and IMF staff calculations. Note: The interest in reshoring measured the frequency of mentions of reshoring, friend-shoring, or near-shoring in firms’ earnings calls.

Dedollarisation has legs, as previously discussed.

However, we expect the cyclical rather than the structural drivers of the dollar’s moves to be foregrounded over the next cycle; in other words, we are not predicting a dollar decline on the scale of sterling’s precipitous decline in the 1970s.35 As Adam Tooze highlighted, the increasing multipolarity of power, trade, and economic activity has led to widespread discussions on the asymmetry between the US dominance of the financial system and the status of the dollar on the global stage. But, it’s important to note that ‘the dollar system is well buttressed, partly because it is enmeshed in a variety of de-risking strategies’.36 Specifically, private investors globally prefer to save in dollars, EM countries prefer to hold reserves in dollars, companies find it cheaper to trade in dollars, and rich individuals often prefer to hold savings in dollars.

Also, historical ties between military alliances and financial relationships persist, with the US remaining the preferred choice of many countries, and its alliance system retaining a relatively resilient and broad-based presence.37

Nevertheless, there has recently been a reassessment of the plausibility of China globalising the renminbi without opening its capital account, which now appears the probable path for renminbi internationalisation.38 There is also the obvious fact that weaponising the dollar against the Russian central bank in the aftermath of the Ukraine invasion has heightened the importance of diversifying dollar holdings. In some tail-risk scenarios this could potentially pave the way for a shift in the global monetary system favouring ‘commodity-backed currencies in the East’.39

Defence spending as a share of GDP has probably reached its trough and is likely to rise from here.

The shock of the Ukraine war is playing its part, but also the underlying structural rivalry between the US and China is becoming more salient. Observers like Henry Kissinger have stated that we are in the ‘foothills’ of a second Cold War.40

All of this is happening despite the inherently harsh guns-for-butter trade off in ageing societies.41 In the US, the current level of 3.6% of GDP is half the level it was in 1990. European defence spending is similarly on the rise and is now projected to meet the 2% of GDP NATO spending target by 2030, though much of European procurement remains hopelessly duplicative and inefficient.42 EU defence ambitions can be summed up under the doctrine of ‘strategic autonomy’, and imply a strengthening of domestic capabilities, including in defence production.43

In many cases, advanced economies are realising they have lost capacities that will now need to be rebuilt at considerable cost. For example, while Britain had seven pyrotechnic firms in 1990, today it has just two; a similar story can be told for gunpowder, shells, and detonators. In 2023, there was a three-year waiting list for some gun ignition parts.44

In purely numerical terms, Austria-Hungary in 1916 produced 18 times, tsarist Russia 80 times and imperial Germany 129 times as many artillery shells as the entire EU can produce in 2023 (650,000). The US has declared it will increase its total ammunition production fivefold in the next two years, as part of a 15-year plan to boost ordnance output at a cost of about US$15 billion.45 But even after completing a planned 500% increase by 2028 the US will only be at 1/12th of peak Habsburg output.46

Finally, we see the rise of a group of non-aligned economies as a key theme.

Over the coming cycle, reminiscent of the 20th century non-aligned movement that was centred on the Bandung conference in 1955 and Belgrade Conference in 1961, we see the rise of a group of non-aligned economies. These are countries that do not want to pick sides in the emerging conflict between the US and China and are instead transactional on key issues. The Economist has christened these countries ‘the Transactional 25,’ a subset of the 127 states that were not clearly in any camp in response to the Ukraine invasion.47 They represent 45% of the world’s population and 18% of the world’s GDP. Almost 43% of their trade is with the Western bloc, 19% with China-Russia, and 30% with countries in neither of those camps. There is no coherent governing body for this bloc; instead, it is a variety of disparate organisations that provide a forum for these countries.47

03

China's ascent up the value chain

Sun breaking through cloud over a city
China’s leadership has been concerned about its core technology capabilities since at least 2016, despite significant achievements in areas like clean technologies.48 For instance, China in 2024 will install twice as much solar PV as the US and the EU combined.49 Meanwhile, China’s manufacturing value added has risen to twice that of the US.50

In response to concerns about its tech capabilities, China has embarked on an extensive industrial policy initiative, targeted at specific industries, including semiconductors and clean technologies. The programme is known as the IDDS (Innovation-Driven Development Strategy) and was launched in 2016. The once prominent ‘Made in China 2025’, though now rarely mentioned, is in fact a component of this broader strategy.51 China’s industrial policy is not about ‘catch-up’ but is intended to operate at the forefront of industrial innovation. China is serious about catching up. As Cherry Yu has pointed out, the appointment of five prominent scientists to the Politburo of the CCP in October 2022 signals a fundamental shift in policy emphasis within the leadership, moving beyond mere double-digit economic growth to building resilience against external shocks, which means addressing technological ‘chokepoints.’52

The plan is vast, as the semiconductor component illustrates. Tai Ming Cheung, Barry Naughton, and Eric Hagt, for instance, have characterised Chinese support for the semiconductor sector as ‘essentially unlimited.’53 Over US$1 trillion has been committed to semiconductors against the US$52 billion the US committed to the industry in the 2022 CHIPS and Science Act. In Ninety One’s collaboration with Chris Miller, we evaluated China’s historic experience with industrial policy, which has yielded mixed results. While Huawei achieved remarkable success in telecom equipment, the electric vehicle sector has seen only partial success. Breaking into the semiconductor industry poses exceptional challenges, not only because China produces just under 10% of the value of global semiconductor value chains, but also because of the formidable moats surrounding semiconductor equipment companies.54 Nevertheless, the government is committed, and success would be transformative. Western analysts, meanwhile, have a history of underplaying Chinese capabilities.

Huawei’s new smartphone chip used in its new Mate 60 Pro phone has a sophisticated homegrown 7nm chip, that, while probably not cost competitive without subsidies yet, shows that US, Dutch and Japanese tech controls are far from watertight.

Opportunities and challenges
We think there are opportunities to invest in the global winners from China’s focus on moving up the value chain.

For instance, China is cultivating ‘little giants’ in a variety of advanced manufacturing sectors, like aerospace and telecom. These are small, specialised companies with the capacity to excel in essential key technologies — effectively, a Chinese version of the ‘Mittelstand’ complex.55 These are companies that favour continuity and aim for long-term success. It also refers to firms strongly attached to their region. It is already clear China’s auto sector is on track to become a global success story (Figure 7).

Figure 7: China: trade in finished vehicles (autos mostly). Chinese customs data, trailing 12m sums, US$ billions

China: trade in finished vehicles (autos mostly). Chinese customs data, trailing 12m sums, US$ billions

Source: China’s General Administration of Customs. Recreated by Ninety One based on Brad Setser post.

There are also tailwinds for Chinese cleantech leaders.

Cleantech is an area where China’s ascent up the value chain is clear. Structural growth in decarbonisation industries including solar (and solar equipment), battery production (and battery management) and electric vehicles are areas where China’s market leadership and scale advantages can continue taking market share.

China leads in several critical technologies.

A little more difficult to envisage over the next decade is how China’s lead in critical and emerging technologies could influence access to key technologies. China doesn’t have a leading edge semiconductor industry, but there may still be tailwinds for the ‘picks-and-shovels’ of the semiconductor industry including equipment and fabrication. However, according to the Australian Strategic Policy Institute, China leads the US in 37 out of 44 critical technologies that will drive the future. These technologies are in the areas of defence, space, energy and biotechnology with leadership based on the share of high-quality and high-impact research. For example, over the last five years, China has generated half of the world’s high-impact research papers into advanced aircraft engines, including hypersonics, and it hosts seven of the top 10 research institutions. China’s dominance is also visible in synthetic biology, 5G and nano manufacturing.56

04

Potential investment implications

Decor temple of Heaven Beijing
Practical ideas on how the tailwinds and headwinds created by China’s rise can be implemented in a portfolio.

Headwind on demand for $bloc economies

A reduction in commodity intensity of production in China will generate profound headwinds on the demand of $bloc economies and their overheated housing markets, given that China is the world’s biggest buyer of natural resources.

No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.

References

1 Smil, V., Making the Modern World – Materials and Dematerialization, 2013.
2. The World Bank.
3. Pettis, M, How China Trapped Itself, Foreign Affairs, 5 October 2022.
4. Tooze, A, Adam Tooze’s Top Links: Is Evergrande “China’s Lehman moment”, 19 September 2021.
5. Lingling, W. and Xie, S.F., China’s 40-Year Boom Is Over. What Comes Next?, The Wall Street Journal, 20 August 2023.
6. Premier Li Keqiang, quote from the National People’s Congress based on an extract from China’s 2019 Statistical Survey, May 2020.
7. JZhu, H., JP Morgan China 2023 Mid-Year Outlook, 4 July 2023.
8. Brandt, L et al., China’s Productivity Slowdown and Future Growth Potential, World Bank Group, June 2020.
9. Pettis, M, Can China’s Long-Term Growth Rate Exceed 2–3 Percent, Carnegie Endowment For International Peace, April 2023.
10. Yu, E, Rules to Promote Equality Bloomberg, July 2023. In April, citizens without Shenzhen Hukou can apply for an additional NEV plate number without 24 consecutive monthly local health insurance payment. In August Jiangsu 1) to scrap household registration restrictions in most areas except Nanjing and Suzhou. In August, Ministry of Public Security also announced on Aug 3 to help push for ‘comprehensive lifting’ of Hukou registration restrictions in cities with a permanent resident population of less than 3mn, part of the 26 measures that day.
11. Bureau of Economic Analysis, October 2023.
12. Cang, A., Li. C., “Bankers Chasing Deals in China Turn to ‘Throwing Eggs’ Card Game”, Bloomberg 7 August 2023.
13. Pettis, M. (2023) [Twitter] 10 August. Available at: https://twitter.com/michaelxpettis (Accessed: 6 November 2023).
14. The Conference Board, Total Economy Database, April 2023.
15. Clark, H.L, Higgins, M, Can China Catch Up with Greece?, Liberty Street Economics, 19 October 2023.
16. In 19th Party Congress in 2017, China shifted its ‘principal contradiction,’ only the second time this has been revised. 1981 it was changed from ‘class struggle’ to ‘economic development.’ In 2017 it was changed from ‘quantity of growth’ (or ‘unbalanced and inadequate development’) to ‘quality of growth’ or the need to improve people’s lives. A ‘principal contradiction’ in Marxist-Leninist thought is the interaction between progressive forces pushing towards socialism and the resistance to that change.
17. In the 14th Five Year plan documents released in 2021, China is targeting a growth in per capita disposable income in line with GDP growth, a sign that consumption is not expected to rise faster than investment. Similarly, policymakers named three imbalances in Section 2 of the document that they wanted to fix; a shift to consumption is not considered one of the main imbalances ‘Our capacity for innovation is insufficient for the requirements of high-quality development. The agricultural base is relatively weak. The disparities in development and income distribution between rural and urban regions remain stark. We have a long way to go in environmental protection, there are shortcomings in livelihood protection, and weaknesses in social governance.’
18. Shangxi, Liu. The tendency to hold on to the money bag is still obvious. What is the key to recovery?, Economists 50 Forum, 6 July 2023.
19. The middle-income trap has little evidence going for it. The Economist, 5 October 2017.
20. Tooze, A, Whither China? Part III: Policy hubris and the end of infallibility, August 2023.
21. Eberstadt & Verdery, China’s Revolution in Family Structure: A Huge Demographic Blind Spot with Surprises Ahead, American Enterprise Institute, February 2023.
22. Project Syndicate, Helen Thomson Says More, July 2022. As Helen Thompson has pointed out, China’s growing energy consumption has caused two big price shocks over the past two decades. The first was an oil shock in the mid-2000s, when sharply rising Chinese demand ran into stagnating supply, which culminated in an all-time oil-price peak in June 2008. The second episode was a gas shock in 2021: Chinese demand for LNG imports grew by nearly a fifth last year, sending spot gas prices soaring in Asia and Europe. By analogy, moderating Chinese demand in any of these areas could have fairly profound implications fairly quickly.
23. Tooze, A, The US is addicted to greatness – and haunted by its loss, 9 December 2022.
24. This framing of multi-polarity is a return to normal is based on works published by Niall Ferguson and Dani Rodrik.
25. IMF. See figure 4.9, page 94 of the original document and JPMorgan, Great Supply Chain Disruption, 22 June 2023.
26. Mahtani, S. Will the pandemic spur deglobalisation, Ninety One Investment Institute, May 2020.
27. Can the West win over the rest? The Economist, 13 April 2023.
28. Shin, H.S, Globalisation: real and financial, Bank for International Settlements. ‘Shin connects the regression in trade to a parallel regression in the degree of financial globalization as measured by global cross-border bank lending. In 2008 this touched 60 percent of global GDP and now has fallen back to c. 37 percent.’
29. Trade (% of GDP) - China, World Bank.
30. Kuo, M.C, Wall Street Journal, November 2022.
31. FDi Markets and calculations provided by the IMF, April 2023.
32. Financial Times, September 2021.
33. European Central Bank, The globalisation of inflation: Isabel Schnabel speech, May 2022.
34. IMF World Economic Outlook, April 2023.
35. Mahtani, S, The Dollar May Be Knocked Off Its Pedestal, Wall Street Journal, May 2019.
36. Tooze, A, The World Is Seeing How The Dollar Really Works, August 2022.
37. Eichengreen et al., Mars or Mercury? The Geopolitics of International Currency of Choice, December 2017.
38. Eichengreen et al., Is Capital Account Convertibility Required for the Renminbi to Acquire Reserve Currency Status, Banque De France, November 2022.
39. Pozsar, Z, 7 March edition of his Global Money Dispatch newsletter Credit Suisse.
40. Foothills comment.
41. Ferguson, N, Cold War II: Niall Ferguson On The Emerging Conflict With China Hoover Institution, May 2023. Indeed, some observers have framed the Ukraine war as the first hot war in a Cold War between the US and China, in the same way that the Korean war of the 1950s proved to be the first hot war in a proxy contest between the US and the Soviet Union.
42. Tooze, A, European defense spending, Africa’s multi-speed demographics & would you work in Germany, March 2023. Estimate from NATO Public Diplomacy Division via BCA research via Tooze Chartbook.
43. Mahtani, S, Europe’s new ‘strategic autonomy’, Ninety One Investment Institute, March 2021.
44. Samuel, J, Ben Wallace’s farewell revelations are indefensible, July 2023.
45. Pentagon will increase artillery production sixfold for Ukraine, New York Times, January 2023.
46. X. Historian Nick Mulder on the basis of ‘King of Battle: Artillery in World War I’, History of Warfare, Volume 108: Sanders Marble.
47. The Economist, How to survive a superpower split, April 2023.
48. Jinping, Xi, Speech at the Work Conference for Cybersecurity and Informatization, China Copyright and Media, April 2016. In 2016, President Xi Jinping said, ‘the fact that core technology is controlled by others is our greatest hidden danger.’
49. Renewable Energy Market Update - Outlook for 2023 and 2024. International Energy Agency, June 2023.
50. The World Bank, 2022.
51. Lecture by Barry Naughton: Made in China 2025 and Chinese Industrial Policy, July 2021.
52. Jie, Y, China’s new scientists, Chatham House, July 2023.
53. Cheung et al., China’s Roadmap to Becoming a Science, Technology, and Innovation Great Power, July 2022.
54. Miller, C, China’s tech revolution: unprecedented scale, mixed results, Ninety One Investment Institute, October 2021.
55. Haro, K, China Cultivates Thousands of ‘Little Giants’ in Aerospace, Telecom to Outdo U.S., The Wall Street Journal, March 2023.
56. China leads US in global competition for key emerging technology, study says, Reuters, 2 March 2023.
57. Described in our paper with Bob Ash of SOAS on rural China.
58. Jung, E, Vietnam and Mexico could become major players in global supply chains, PIIE, August 2020. Mexico’s advantages are its demographics, low labour costs, an experienced manufacturing sector, available logistics, industrial network, and an array of free trade arrangements. ASEAN’s advantages are its supportive policies, cost competitiveness, industrial development, linkages to existing manufacturing hubs and rising middle-income consumers, all of which should keep FDI rising.
59. JP Morgan, 22 June 2023.
60. European Central Bank, The globalisation of inflation: Isabel Schnabel speech, May 2022.
61. Dempsey, H, ‘Colossal’ central bank buying drives gold demand to decade high, Financial Times, January 2023.
62. IMF World Economic Outlook, April 2023. There is already evidence that since 2018 geopolitical alignment, measured by similarity in un voting patterns, has become ever more important in determining the location of foreign direct investment. AidData also finds that a 10% increase in voting similarity with Beijing at the UN is associated with an increase in Chinese projects in that country.

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