This appeared in the Economic Times on 8 July 2024 as “Chinese takeaway plus one“.
Over the last few years, as the US-China strategic conflict has intensified, ‘China+1’ has become a popular phrase. Countries, including India, have jostled to be the ‘+1’, easing policies and providing incentives to attract foreign firms trying to reduce their dependence on China for manufacturing.
However, let alone a drop in China’s global share of manufacturing, we are seeing an increase – from an already high 35% in 2020, it may already be near 38%. Global industrial output is well below the pre-pandemic path, but China’s isn’t. Industrial production in the rest of the world is showing the strain, especially in the EU, Japan, Latin America and Africa.
This is not because foreign firms are not leaving China. Their share of manufacturing capacity in China is at a 25-year low, and their goods exports have indeed declined over the past decade. However, these have been offset by a surge in exports from Chinese-owned firms. Further, while goods exports are up about $1 tn since 2019, imports have risen by a lot less as China has also focused on import substitution (especially in mechanical and electrical products), nearly tripling the goods trade surplus.
Underlying trends suggest we are likely to see more of this going forward. When China had surplus labour but lacked capital, it out-competed labour-intensive industries globally. Given its larger economic size now, its ability to invest in capital-intensive industries is now a threat to firms globally.
China’s dominance in the fast-growing markets of RE generation, energy storage and EVs, and rapid strides in semiconductors means its manufacturing will grow faster than that of the rest of the world, which lags in these sectors. More importantly, this investment is also important for China to sustain its growth rate.
The much-anticipated slowdown in the Chinese housing market has been offset by growth in investments in infrastructure and manufacturing. In the last four years, as Chinese policymakers redirect loans away from real estate to industry, medium-to-long-term loans to industry have risen 2.4 times. In absolute terms, such loans have increased $1.9 tn (India’s total banking system loans are $2 tn). If loans to industry grow at the current pace of 24% y-o-y, another $2.5-3 tn of loans could be allocated to industry in the next few years.
This is not to say that all of China’s industrial policy is successful. Capital allocation that is devoid of the discipline imposed by market forces also tends to be inefficient. However, this onslaught of capital means that the return of assets in capital-intensive industries is falling sharply in China. Profits as a share of total assets in 2023 decreased to levels last seen in 2002. This is part of the policy of letting ‘a thousand flowers bloom’. Thousands, if not tens of thousands, of new firms enter greenfield industries. Many fail. But the ones that survive can be very competitive.
For these reasons, stress on profits is unlikely to remain contained in China. The country’s export price index has fallen sharply from 116 in mid-2022 to 107 in March 2023 and 97 in March 2024. Even as China cedes space in labour-intensive manufacturing, it’s rapidly growing exports of goods in capital-intensive industries is likely to affect profitability and return on assets globally. In industries such as flat panel displays that use legacy tech, several fabrication units in South Korea have shut down in recent years, unable to compete with China.
There is a long legacy of pithy aphorisms from Chinese leaders that scholars interpret for masses. Only now is the world beginning to understand the meaning of ‘new quality productive forces’ that Xi Jinping first mentioned last year.
China’s trading counterparties are beginning to erect tariff and non-tariff barriers. However, given China’s dominance, and rapid growth in its capital allocation, it’s unclear whether the drawbridges can be pulled up quickly. The decision to restrict imports will not be straightforward. There is likely to be a debate on whether importing low-priced goods in critical sectors with growing demand makes sense. China’s manufacturing share gains through import substitution will be harder to challenge.
In addition to attempts to restrict imports, other major economies are likely to increase industrial policy action, such as cheaper financing, tax rebates, or other fiscal aid, to develop alternatives to China. As challenges intensify, the scale of these responses is also likely to grow.
For example, Vannevar Bush’s seminal ‘Science, the Endless Frontier’ report to the US president just after the end of World War 2, making a case for why the US government must support science, initially faced some resistance, as the FDR government baulked at private sector control of taxpayer dollars. However, evidence of Russian advances in missile technology, like the ‘Sputnik moment’, galvanised active US government intervention in tech development.
This pattern might repeat itself. While the more ambitious Endless Frontier Act was watered down a few years back, policy support for local manufacturing is already picking up in the US.
For India, the challenge now lies in identifying strategic areas where it must not cede ground, finding ways to compete in areas necessary to sustain growth and create jobs for its growing workforce, and taking advantage of the inefficiencies created by Chinese over-investment and the return of industrial policies globally.