US-China: A silver lining in a strained relationship
- A sudden rise in tensions has cast a dark shadow over Sino-US relations. While the trade war has been the most eye-catching instance, increased “decoupling” has also occurred in areas of technology, investment and social exchanges as the two countries have put up “walls” against one another.
- The short-term economic pain from these disengagements is already visible. Less discussed are the structural changes undertaken by Beijing in response to the external shocks. These changes have hastened the opening of the Chinese economy, quickened the pace of domestic reforms, strengthened systemic-risk management and localised technology development.
- A successful implementation of these reforms will be key to quell the trend decline in productivity growth and cushion China’s long-run economic slowdown. Ultimately, it is up to Beijing to determine if the rising external pressure is a blessing in disguise that accelerates China’s economic transformation or a path-altering shock that ends its growth convergence. The evidence so far points to a more benign scenario, consistent with our base case.
Pain already visible from “decoupling”
The world has been watching the deterioration in Sino-US relations with trepidation. Fears of increasing disengagement have created uncertainties for the global economy and financial markets. At the eye of the storm has been the bilateral trade relationship, where escalating tariffs over the past 18 months have shrunk trade flows by more than 20% (Exhibit 1). While the recent Phase One deal has brought some relief, the two sides are still far from striking the kind of comprehensive agreement needed to restore normality.
Trade is not the only area of contention. Cross-border investments, or FDIs, have come under increasing scrutiny in the US as many investments from China have been deemed national security threats. This has led to a whopping 88% plunge in China’s investment in the US since 2016 (Exhibit 2).
The exchange of people is not immune from the increasingly strained relationship either. The number of first-time Chinese students to the US has fallen by 33% since 2016, while the number of tourists has dropped by 16%. There are also numerous reports of Chinese scholars, business executives and government officials being denied entry visas to the United States. These restrictions will have a short term economic impact, but the long-term consequences of reduced people exchange – fuelling further misunderstanding between the two countries – are more concerning.
The final area of disconnect is technology, which has received almost as much attention as the trade conflict. Besides the ban on Huawei and its 5G equipment, the number of Chinese tech firms on the US blacklist has grown sharply in 2019. Continued disengagement in this area could slow technological progress in both countries, but the bigger fear is that the world could be split into two incompatible tech systems, resulting in enormous inefficiencies for all. In his 2019 New Year address, President Xi Jinping warned that “China and the world are experiencing once-in-a-century changes.” So far, these changes have come mainly in the form of challenges and headwinds. But every cloud has a silver lining. Looking beyond the short-term struggles, there are signs that favourable structural changes have been enacted by Beijing in response to external shocks. This note discusses three of those changes and assesses their impacts on China’s long-run development.
1. Beijing counters protectionism by opening up
At the core of the Sino-US dispute is a belief that protectionism is an effective means to force structural changes in China that resolve bilateral imbalances. Beijing has voiced its disapproval of such hostile methods – and has retaliated with its own trade measures – but the bigger response has in fact been an accelerated opening of the Chinese economy and financial system.
To see the rationale of this, one must recognize that China’s role in the global economy has been changed profoundly by its pursuit of globalization. Its successful integration into international trade saw China’s role change from an insignificant regional player to one of the three vital connectors of the global supply chain (Exhibit 3). This integration has contributed to China’s rise to become the world’s second largest economy and helped lift almost a billion people out of poverty.
Hence, instead of following the US to withdraw from the existing world order, Beijing has taken the opposite step of deepening its integration with others. In trade, the government has undertaken two rounds of tariff cuts on non-US imports over the past year, despite retaliating against US tariffs (Exhibit 4). China also hosted its second Import Expo in the heat of the trade war to demonstrate its commitment to open up. Over $71bn worth of deals were signed in the event, up 23% from last year.
In investments, the so-called negative list – containing industries restricted to foreign investments – has been shortened from 180 to 40. Within it, the liberalization in the financial industry was particularly notable. An accelerated opening of the onshore markets has brought renminbi (RMB) assets into global indices, prompting over $230bn of capital inflows since the beginning of 2018. The State Council last year also scrapped the ownership caps on foreign joint ventures in banks, brokers and insurance companies. Finally, the Chinese leadership has continued to voice support for multilateral institutions, such as the World Trade Organization, and accelerated negotiations on regional free trade agreements. A successful implementation of these reforms could help to further integrate China into the global system at a time when the US is withdrawing from it (Exhibit 5).
2. Tech barriers hasten home-grown innovation
Technology is another area where major policy shifts have occurred in response to increased US-China frictions. Our previous research has shown that China has, in recent years, leapfrogged many developed countries in some areas of technology, thanks to its significant investments in research and development (R&D), patents and tech infrastructure. However, China still lags the US in foundational research and relies on the latter to provide core components in certain areas (Exhibit 6 and 7).
This reliance on external technology has dictated Beijing’s response to what some have regarded as a tech war. First, the inability, and unwillingness, to decouple from the rest of the world has prompted Beijing to respond to the legitimate concerns around China’s lax protection of intellectual property (IP). The National People’s Congress last year passed a new law to strengthen IP protection and prohibit Chinese firms from “forcing” their foreign counterparts to commit technology transfers. Various government agencies have since issued detailed guidelines to make the law enforceable.
Second, China has stepped up efforts to produce indigenous technology. On the official front, financial support for R&D has increased via tax-waivers and subsidies. In June, a new technology innovation board – dubbed China’s Nasdaq – was launched to facilitate fund raising for tech start-ups. The government also rolled out 5G networks ahead of schedule, and issued an ambitious blueprint for the Great Bay Area, benchmarking it against Silicon Valley in aspects relating to tech.
In the private sector, R&D spending by A-share listed companies grew by 23% year on year in 2018 and another 21% over H1-2019. Tech related investment has bucked the trend of other fixed-asset investment which has been hit hard by the weak economy and elevated uncertainties (Exhibit 8). Companies subject to US sanctions – such as ZTE and Huawei – have ramped up developments of their inhouse substitutes to US components. Huawei’s latest smartphone, the Mate 30, is equipped with its own chips and operating system, with reportedly zero US parts6.
Compared to the trade war, the Sino-US technology rivalry is likely to be more enduring and intense. Even if all Chinese firms are removed from the US ban-list, a breach of trust has already occurred, which could lead them to continue to seek and/or develop alternatives to US technology. For China, increased barriers for tech transfers would be detrimental to its long-run development. But that curse could be turned into a blessing, if the right policies are put in place to nurture organic innovation at home.
3. Faster reforms to foster quality growth
The third area of notable change is in domestic reform. If Beijing’s response to trade and tech disputes is seen as fighting a frontline “war”, domestic reforms are akin to setting its house in order. We summarise these changes in two categories: those relating to fostering new growth engines – such as urbanization and corporate-sector reforms – and those relating to risk management, including deleveraging and housing market controls.
Our 2018 paper describes China’s new urbanisation strategy as creating regional clusters to better coordinate resources among cities of different comparative advantages. Over the past two years, Beijing has issued development plans for three of the five city clusters: the Great Bay Area, the Yangtze Delta Region and the Beijing-Tianjin-Hebei cluster. Different from the bottom-up construction of cities scattered all over the country, this Urbanization 2.0 is driven by careful top-down planning designed to make mega cities bigger, safer, greener and smarter.
To achieve this, investments in modern infrastructure – such as high-speed railways, 5G telecommunication networks, roads suitable for autonomous driving, smarter schools and better hospitals, etc. – will continue. Besides the short-term boost from capex, the long-run productivity gains from these investments will also be critical to “soften” China’s trend growth slowdown and continue its convergence with the most advanced economies.
Restructuring the corporate sector has lagged other reforms but rising external pressure could speed up the changes. Contrary to popular belief that little has been done to reform State-Owned Enterprises (SOEs), the reality is that these companies have seen visible improvement in their fundamentals thanks to supply-side reforms and deleveraging over the past few years (Exhibit 9). In addition, the government has issued four batches of mixed ownership – involving over 200 SOEs – helping to improve their corporate governance, increase dividend pay-outs, and transfer some of the official stakes to social security funds (moving towards Singapore’s Temasek model). For the more productive private-owned enterprises (POEs), Beijing has directed support through tax cuts and targeted reserve requirement ratio (RRR) reductions. These measures are a good start, but far from enough to level the playing field between SOEs and POEs, leaving plenty of room for further reforms.
Finally, there are notable changes in the way in which Beijing operates countercyclical policies. The traditional method of stimulating growth via credit and housing-market measures has given way to fiscal stimulus, particularly tax cuts, as managing debt and housing market risks has become a priority. This resistance to aggressive easing has slowed headline growth, but the quality of growth has improved by the rebalancing of the economy. The solid performance in RMB assets last year, despite the weak economy and trade war, may be a testament to investors’ approval of this cautious stimulus approach.
All comes down to productivity growth
Overall, the hardened Sino-US relationship has elicited multidimensional changes across China’s public and private sectors. The trade/tech wars have forced Beijing to accelerate the opening of the economy and encouraged private corporates to quicken the pace of home-grown innovation. Behind the scenes, domestic policies have also been adjusted to expedite reforms while resisting excessive short-term stimuli.
Connecting these changes to China’s long-run growth can help to appreciate their significance. Our previous report discussed the importance of productivity (TFP) growth in powering the Chinese economy as its population ages and capital formation slows. Successful economic reforms have been key to generating productivity growth over the past decades (Exhibit 10) and should continue to play a vital role going forward.
Recent literature estimating the impacts of the aforementioned reforms suggests some cause for optimism:
- Opening up: A recent McKinsey paper8 shows that a more open Chinese economy with freer flows of goods, services and capital, could add $37trn to China and the world’s GDP by 2040. Zhu (2019)9 stressed the importance of opening the services sector, where productivity level is less than 1/3 that of the most advanced economies. Faster liberalization could accelerate convergence, boosting annual growth by 0.5ppts more than the base case.
- Technology: Chen and Zhang (2018)10 show that the digitalisation of the economy – by integrating internet, big data and AI with traditional industries – has been a key driver of productivity growth. IMF estimates that about 33% of China’s current GDP is digitalized, with every additional percentage point increase in digitalisation raising trend growth by 0.3ppts.
- Urbanization: The United Nations projects China’s urbanization rate will reach 70% by 2030 from 60% currently. A more optimistic projection of faster and smarter urbanization could double labour productivity growth over the next 10 years. Some 40% of this enhancement will come from continued rural-urban migration, but the other 60% will be from the agglomeration effects of supercities.
- Corporate reforms: Beijing’s supply-side reforms have helped to resolve some zombie companies and reduce industrial overcapacities. However, the problems of unproductive SOEs and resource misallocation between SOEs and POEs are far from resolved. Lam (2017) shows curing these ills could lift potential growth by up to 1ppt per annum over the next decade.
This research highlights the importance of reforms in shaping the future of the Chinese economy. None of these are new, but the urgency of implementation has increased as the external environment has changed. Exhibit 11 shows our updated projection of China’s long-run growth, which we expect to moderate to 5.2% and 4.5% by 2025 and 2030. Reduced labour and capital contributions are the main drags, which are not fully offset by a modest recovery in productivity growth – to 2.5% from 1.8% currently.
Our assumption on the TFP recovery is not particularly aggressive, considering the still-large productivity gaps between China and the most advanced economies. However, achieving it against a more mature economy and less friendly global backdrop could still be challenging. Ultimately, the onus is on Beijing to deliver reforms in a bolder and more resolute manner, while leveraging on the external changes to buttress domestic transformation. We see the recent developments as consistent with an economy moving in the right direction.
 With China accounting for over a third of international students in the US, the economic impact of reduced education exports could amount to $13bn per annum.
 Despite this progress, China remains overall more restricted to FDIs than most OECD economies, and the level of control is more acute in services than manufacturing industries.
 While the timing of the move might have been influenced by the trade war, reforming the financial industry has been a strategic aim of Beijing to increase competition and improve resource allocation in the sector.
 The Regional Comprehensive Economic Partnership is a free trade agreement for the Asia Pacific region including the ten members of ASEAN, China, Japan, Australia, Korea and New Zealand. The China-Japan-Korea FDA is also in the final stages of negotiations.
 Yao, A., “Innovation made in China”, AXA IM Research, 21 July 2018.
 Yao, A., “China: continue the economic miracle”, AXA IM Research, 24 July 2014
 McKinsey Global Institute “China and the world: Inside the dynamics of a changing relationship”, July 2019
 Zhu, et al, “China’s Productivity Convergence and Growth Potential” IMF Working Paper, November 2019
 Zhang, LM. and Chen, S., “China’s Digital Economy: Opportunities and Risks”, IMF Working Paper, January 2019
 Morgan Stanley (2019), “The Rise of China’s Supercities: New Era of Urbanization”, 14 October 2019
 Lam, et al., “Resolving China Zombies: Tackling Debt and Raising Productivity”, IMF Working Paper, November 2017
 Given that these estimates of reforms are made on a standalone basis and not mutually exclusive, they cannot be added to derive the full impact on growth.
 The updated projections are slightly weaker than those from 2018 reflecting the changing environment.
 Zhu et al (2019) shows China’s industrial and services sector productivity levels are 33% and 29% of those of the US as of 2015.
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