China Trends #18 – Searching for Growth Engines Via Innovation

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By François Godement

The latest official Chinese figures on the economy confirm two simultaneous truths. 

One: deflation, lower demand for durable goods and lower imports persist, even if there is some consumption rebound. New fiscal stimulus and a strong push for local government bonds to rescue the real estate sector have not had an impact on new borrowing and investor trust. Moody’s downgrading warning can well justify Xi Jinping’s reported remark that the Chinese economy is still "at a critical stage (​​经济恢复仍处在关键阶段)" - and vice-versa. 

Two: there remains policy space to boost the economy. Even officially, China’s currency reserves have risen again, while the true extent of holdings in foreign denominated assets is generally underestimated. Official policy has consistently refused monetary expansion, on grounds of financial security and because the interest gap with other major currencies has narrowed or disappeared, suggesting there is a risk of hot money outflow. But Xi now talks of an "effective (有效)" if stable monetary policy. And exports, after five years of boom, are holding up, even as the Chinese government cites weak international demand as a factor weighing on a sluggish domestic economy.

Let’s not focus purely on foundational or critical technologies: in the auto industry, for instance, exports of thermal vehicles increase just as rapidly as that of electric vehicles (EVs). Even if national subsidies have now been stopped, provincial competition has created production capacities of 40 to 50 million cars per year. Chinese solar panels are currently selling at a heavy discount in Europe. In spite of the chip export denials that impede Huawei, China still makes two-thirds of the world’s mobile phones. 

The drive for new export niches will not stop. In the measures announced to boost the economy, the accent is now put on innovation, including immaterial infrastructures. Support for "infrastructures (基础设施)," long a mainstay of China’s economic policies, is now tilted towards greening or digital infrastructures, as well as to education. China’s government is taking measures to unify the standards of domestic products with those prevailing internationally. In the past, this would have been interpreted as a gesture of opening up the market to imports. Today, it is much more likely to result in more exports from overcapacities in domestic production. Raising industry standards also means that public policy is now anticipating new international criteria for emissions and sustainability. It is a response to the requirements for sustainability that Chinese officials call protectionism in disguise. 

From inside China, it is only a political or societal crisis that could challenge the present course. Unemployed youths are candidates, as are poorly compensated migrant and gig workers. So are indebted home buyers, who in China have no available debt resolution and must repay their loans to the last penny: in the words of one proud investment adviser extolling China’s economic strength, they "cannot flee from the temple." Such events as a political upheaval, not to mention factional strife at the top, are basically unpredictable.

It is therefore China’s partners who now face a dilemma. The news about the death of the Chinese economy has been greatly exaggerated. According to reports, Xi Jinping may have expressed this dilemma crudely to the EU leaders at their recent meeting in Beijing: Europe cannot achieve its greening transition without Chinese exports, given the higher cost of all alternatives. At the end of the day, after everything has been said about the unequal playing field, subsidies and dumping, it remains that imports from China are a hedge against producer inflation, even more so in the sectors where innovation has been most strongly supported by decades of government intervention and funding. Where tariffs are a problem, Chinese goods transit through third countries, or are assembled there.

This is exactly the goal that Xi Jinping has explicitly pursued in the last decade - to make China’s partners more dependent on China than it is relatively to those same partners. And to a large extent, he is still succeeding, in part because political democracies are also consumer societies with a low threshold for economically unsatisfactory options. Decoupling is a no-no, even though a pioneering study is claiming lower costs for Germany than for China.

Western hopes that China will change its economic model have floundered on unavoidable realities in the past two decades. Rebalancing the economy towards household income, consumption and a service economy with increasingly powerful private companies and individuals would challenge Party power, and in fact its own income base. That is precisely the reason why this generation of political leaders will not let this happen. China has the management capacity to steer extraordinary industrial, urban, energy and transport development. It does not have the checks and balances necessary to create an independent central bank, liberalize capital markets or become a significant international borrower - which would signal the true emergence of the renminbi as a reserve currency. 

It must therefore accumulate, invest - and depend on the rest of the world to absorb its productive surpluses. Short of international crisis scenarios, this is where China’s true dependence lies.

The instinctive emphasis on limited de-risking as opposed to broader decoupling seems mistaken, particularly for Europe. Not only, as is often pointed out, because China literally invented one-sided decoupling. But also because Europe, thanks to its adherence to multilateral trade and institutions such as the WTO, has a larger dilemma than most. The United States and India have closed their doors to Chinese solar panels. They, with Japan and more recently Turkey, are essentially banning Chinese EVs from their roads. The result is that China’s overproduction in these key sectors is, by default perhaps, directly aimed at the European market.

This is in fact what the EU tried to get through to China’s leaders at their recent Beijing meeting. In a trade world where WTO no longer serves for conflict resolution, barriers are going up for various reasons - national security, economic security or plain and simple retaliation for China’s own policies. 

This is not Europe’s preferred course of action. The Single Market itself was built on multilateral rules. Free marketeers rightly point out that targeted protectionist measures shift China’s export through third markets. They also point out our own higher costs due to increased import prices or reduced competition. Adversaries of de-risking, whether it is conducted for reasons of national security or for broader economic security purposes, emphasize that this may also reduce our access to Chinese innovation (truly present in many logistical processes such as 5G, port control or auto production processes), and stimulate even more support in China for self-sufficiency in science and technology. All very true, but less consequential than letting a command economy abuse its "developing economy" status gained a quarter of a century ago, when its GDP per capita was circa 1000 dollars. Of course, the strategic competition and "struggle" initiated in the Xi era add a political dimension, as hopes for change and convergence are put off to a future generation. 

There is currently no real self-correcting mechanism in China’s political economy. The imbalances have been there for a very long time, and it is naive to expect that a leadership so devoted to struggle and strategic competition will commit by itself to fair trade and updated multilateral rules. Indeed, our defensive measures will in some cases create added costs for our societies - and Xi is right when he refers to these costs. We may have to delay some greening to avoid over-dependence on China or face popular revolts if doing without China indeed proves very costly. The EU is particularly vulnerable, as it has the most ambitious plans combined with a relatively small carbon footprint in all but some energy production sectors. 

Let’s tell them that it is only the advent of European trade defenses and other new tools under development, and a new firmness in refusing empty talk from Beijing, that may bring China to the table. 

Image Copyright : STR / AFP