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Amidst the tense US-China bilateral environment, Rhodium group is lighting the way with insightful analysis on impacts for the private sector and the direction of reforms from Beijing. As one of the largest independent private China research groups, Rhodium supports clients in anticipating macroeconomic, political, and financial regulatory changes. For 20 years, they have turned geostrategic insights into sector-specific insights for decision-makers.
Co-Founder of Rhodium and leader of the China, India, and Asia research advisory team, Dan Rosen has received wide recognition for his expertise on the US-China relationship. He sat down with AmCham China to share his expertise on the future of bilateral relations and what’s in store for the Chinese economic trajectory, Chinese FDI in the US, and American business in China.
China’s reliance on state-led industrial policy strategies is definitely not a new phenomenon. After all, that was the overwhelming approach that China took just a few decades ago. What concerns us today is not just the major elements of state planning at work, but the question mark hanging over whether China is still intent on making room for the market. The many indications of ambivalence about that mix of planning and marketization give us pause today. A reason to be optimistic is that this reversion toward planning is not really working.
By most practical, on-the-ground indications, the Chinese economy is not doing great right now. This attempt to administer the performance system is not really paying dividends. I think it is inevitable that Beijing will be circling back again toward tried and true market solutions to basic economic efficiency. What is getting in the way is that any such transition is going to entail some instability, and there’s a tremendous allergy to dealing with that period of instability on the road to a more sustainable future.
There’s no one answer to that good question. China could choose to deal immediately with these economic policy problems and challenges, try to go ahead and bite the bullet so as to get to a more sustainable future faster. However, there has been a revealed tendency over the past couple of years to draw the process out in hopes that some of the problems will just go away. Of these two options, getting to reform faster but having to deal with the near-term consequences immediately versus trying to defer reform but ultimately paying a higher price is a political decision that Beijing will have to make.
Those three things are acid tests. They are each critical – they have to be in the mix. Definitely, that’s not a comprehensive list of all the reform work that China needs. Ideally, with a little time to work with, policy people would want to talk about the depth sequencing about reform in those three areas. Unfortunately, the reality is that China needs to deal with all three pretty much simultaneously today. Financial intermediation is nearing a crisis point. We see bankruptcies, peer-to-peer financing failures, the urgent need for deleveraging showing up as an immediate priority throughout the country. In terms of intellectual property, not only have the weaknesses in IPR protection caused an acute amount of stress with other nations around the world, but it’s also anecdotally causing Chinese innovation investors to think twice about whether they want to put new activity in China.
As for shifting from ensuring producers are strong to ensuring they are happy, I think the 2018 results underscore that. We saw some profit recovery, especially for state firms. That tells us once again that extraordinary efforts are being made to keep, especially the big industrial companies, solvent and doing okay. But customers are really starting to go on strike, as seen in a fall-off in consumer spending growth and many benchmark product areas. All three have to happen urgently.
It’s a great question, and kind of a philosophical one. I think the problem today is that economists understand that any kind of productive resolution of the current tensions has to be more than zero-sum – both sides have to benefit from an outcome. Politicians even understand that. You don’t ultimately get what you want by preventing your negotiating counterpart from being able to report some success back to their own constituencies.
The art of the deal entails making it possible for both sides to gain some benefits. Where that proposition is not so intuitive is in the security community, where win-win is not part of the normal construct that those managing military and strategic security affairs bring to the table. I think the signature change in how we think about the relationship over the past two years has been an elevation of the security mindset, relative to looking at the economic benefits, or just the long-term political nature of the relationship. It will have to do with understanding that change and who is at the table. It’s going to be important for the political and economic communities to step back into the fray with a message of what will be constructive for the long-term.
The reality is that the American business community in China has hundreds of billions of dollars of fixed assets that have been built up painstakingly over decades, and there is no easy way to moth-ball those. There is a need for companies involved in manufacturing most connected to new national security concerns to make sure there are production chain options not vulnerable to the most pessimistic projections. I’m thinking about telecommunications, computing, technology, and equipment.
For the most part, consumer-oriented products should not be caught up in the net of national security concern currently being debated. Nonetheless, if China doesn’t get its reform plans in order, the underlying GDP growth of the Chinese economy will be softer. There are multiple pieces to this equation. There needs to be an analysis of where there are national security concerns and bifurcation of production chains, and that’s likely to weigh on a company’s existing assets and footprint.
The first thing to understand is that engagement is not an all-or-nothing proposition, that you have economies that are maximally-engaged with one another, say Australia and New Zealand, and you have pairs that are completely disengaged, but the vast majority of pairs around the world have always been somewhere in the middle of those two extremes. Whatever the future holds for China and the US, it will be in the middle as well. Second, two nations which are not converging on the same basic ideas about how the economy is run and organized cannot be as engaged as two like-minded economies. The convergence the US and China have enjoyed over the better part of the past 40 years has underwritten the logic of deepening engagement between the two sides.
Throughout my career, I was able to identify and point to a preponderance of effort in Beijing to become more market-oriented. In the past six to 10 years, the momentum toward market orientation has slowed down. When Xi Jinping came to power, he put on the table a very broad and comprehensive plan that, for the most part, was designed to make the market more decisive. But after five or six major efforts to implement that liberalization impulse: fixing the interbank marketing system, opening up the equity markets, and currency internationalization, each turned into a mini crisis. The challenges involved in those reforms were going to be much harder than leadership expected. That had led Beijing to fall back on more state-based second-best or third-best options for keeping the economy from stalling out. The clarity of China’s long-term movement in a market-oriented direction just isn’t there anymore, triggering this discussion about how much disengagement might be necessary.
There has already been a significant amount of disengagement between the two sides just over the past two years. Rhodium has identified a two-year fall of 95% of Chinese direct investment into the United States, for example. There are a lot of shadows cast over the investment and trade environment right now, so we don’t do ourselves or our counterparts any favors by pretending this isn’t a possibility. The responsible thing to do is diagnose it properly, understand the nature of it, and try to keep the ultimate amount that takes place as limited and partial as practically possible.
I think it’s absolutely reversible. Almost every other advanced economy is taking a similar track with regard to Chinese investment. Throughout the OECD world, nations are asking themselves whether they need to modify or upgrade their screening mechanisms and processes. But we could quadruple our security screening diligence and there would still be room for expansive growth and inflows to our economies from Chinese companies and investors. The vast majority of falloff in Chinese FDI in the US over the past two years is in sectors like real estate and movie theaters, completely non-national security sensitive sectors.
We would gladly see Chinese companies come in and make tens of billions in investment in American real estate, which, for the most part, would not be problematic. That limitation on Chinese investment did not come from the US; it came from Beijing’s concern about the motives of private investors taking investment out of the country. We can put that back into gear in a fairly short order, provided we have a basic level of trust and goodwill between the two sides.
When we look at GDP growth from China in 2019, the official target will be something like 6.2 or 6.4% from the areas of business investment, then household consumption, government spending, and then net exports. Analysis of how much US tariffs would reduce China’s net exports growth globally would suggest that even a nasty trade war is not going to take the legs out of China’s economy, just take a nasty bite.
However, the reduced prospect for China to be able to serve US demand in the future also has an effect on business investment inside China. Capital expenditure plans start to get delayed and pushed off into the future as investors lose their basic confidence about China’s role in global supply and demand chains that have been so important to the country’s development. Likewise, consumer household spending and the more internationally-facing parts of urban China are unsure of how serious the breakdown in China’s global standing is and can start to differ from other discretionary spending. It’s not the trade war directly, but its indirect effects that starts to weigh on domestic investment and domestic consumption inside China.
It is not going to be a strong year for China. It could be a very steep downturn. But what’s important is not whether this one-year demand growth picture is really sour; what’s important is what China does about it. If the response to that reality from leadership is to surprise us with a pretty bold package of the kind of reforms that Xi Jinping put on the table in 2013, I would be more optimistic than I’ve been in years. I think, ironically, the dark clouds now hanging over the outlook might be the most important trigger for getting a return to a more reform-and-opening, as we used to know it, policy outlook.
The kind of reform we just talked about would create opportunities for American companies virtually across the board. I can’t think of a sector where US companies haven’t already had to live through the difficult adjustments that are tomorrow’s challenge for China, learning to operate in a more tightly-regulated market place. We’re just 50 years or more ahead of the Chinese marketplace, in that regard. There are going to be areas of high-tech, especially in telecom, which I think are going to continue to be somewhat disengaged. But in vast areas of high-tech, there are going to be opportunities there where America does still truly have comparative advantage, not just based on scale but on savvy, agility, creativity, and a multicultural way of looking at market opportunities and solutions to problems.
I think that China is going to step up in consumer orientation as opposed to the more industrial side of the economy. China’s overcapacity in virtually all industrial segments is undercapacity in almost all consumer-oriented ways, like in healthcare or entertainment. Also, there are very limited opportunities today for foreign financial services firms to operate on a level playing field in China. If that is leveled out with US or European standards of market access, there will be a huge opportunity for American financialists to play a great role and benefit both Chinese customers and Chinese companies who are ready for globally-competitive financial services.
It’s hard to imagine things going anywhere but up after 2018. The level of Chinese investment into the US and employment activity got so beaten down by uncertainty that it was really just a trickle. Even a modest resolution to the state of economic melancholy hanging over the relationship right now would probably open up room for some bounce back of two-way investment flow. Americans aren’t thinking about job creating too much right now, with unemployment this low. But that’s a tax-break phenomenon that will not last forever, and globalization can sustain employment gains and dynamism for the long term.
Rosen was speaking to AmCham China following an exclusive Policy Plus event. For more details on Policy Plus, please email policyplus@amchamchina.org