The high costs of disengagement for China

 

For more than three decades, the global economy was defined by unbridled integration and unprecedented interdependence. Neither political spats nor localised wars could slow the globalisation train. Markets were markets, business was business, and multinational firms became more multinational. Not anymore.

In this new era of strategic competition between China and the West, disengagement is the order of the day. While this trend will impede economic growth, increase business costs (via supply-chain restructuring), and raise prices for everyone, the economy that loses the most may well be China’s.

The People’s Republic would not be where it is today without globalisation. International trade, investment, and capital-market access drove economic growth, while knowledge transfer – aided by engagement among students, scientists, and scholars – enabled technological levelling-up.

Ties with the outside world also forced China to introduce a legal system capable of establishing and enforcing contract and intellectual-property law. And the expansion of China’s economy might enable the country to project power abroad.

But, in recent years, the openness that underpinned globalisation – the “rising tide that lifted all boats” – has given way to a geopolitically focused, zero-sum mindset.

International commerce and finance have increasingly been shaped by national-security considerations. Export controls, the blacklisting of companies, and restrictions on market access in sensitive sectors, such as certain cutting-edge technologies, have become commonplace.

The Sino-American rivalry has reflected and accelerated this shift. The US has targeted China with a variety of measures – including restrictions on imports, exports, and investment – and added dozens of Chinese companies to its so-called Entity List.

Other countries have also increased their scrutiny of Chinese investment and restricted certain types of commercial exchanges with China. Sanctions over China’s human-rights abuses in Xinjiang and Hong Kong have been introduced as well.

China might not have initiated the disengagement process, but it seems committed to seeing it through. In refusing to condemn Russia’s war on Ukraine, its leaders made clear that, in their view, the US – and the West more broadly – is in terminal decline, and now is the time to challenge the existing world order.

Beyond retaliatory sanctions and tariffs, China has been ramping up its efforts to become self-reliant in advanced technology and science, through highly state-centric and protectionist industrial policies. Its goal is to “sanction-proof” its economy, especially by de-Americanising its supply chains.

The extent to which this is possible is impossible to know precisely. But China’s efforts to achieve self-reliance will certainly not succeed across the board.

As The Economist reported in February, China is struggling the most in areas where supply chains are longer and more complex, such as mRNA vaccines, agrochemicals, computer operating systems, and payments systems.

In semiconductors, China remains dependent on foreign suppliers, despite government investment worth tens of billions of dollars. China has similarly failed to break its foreign dependency in aerospace and automobiles.

And its efforts to develop a renminbi-based alternative to US-dollar-based finance and payments systems have yet to gain traction.

But China’s bid for self-reliance might not only fail; it could backfire. As The Economist report also pointed out, when Chinese companies are cut off from foreign competition and expertise, their capabilities are stunted.

Despite the unfavorable economic consequences, we should expect geopolitics-driven disengagement to continue. China will try to build an alternative financial infrastructure, and the US will delist Chinese firms from its stock exchanges.

The US Congress is already reportedly considering legislation to restrict or prohibit US foreign direct investment abroad in several sensitive sectors, much as it does to Chinese investment in the US. Trade measures aimed at diversifying supply chains and ensuring supplies of critical inputs, such as rare earths, are also to be expected.

As disengagement progresses, many critical sectors – such as the internet – will likely split into two distinct blocs, each with its own rules and standards.

The divide in digital standards, data management and usage provisions, and network equipment and telecommunications services will grow. Market-access restrictions and new approval and licensing requirements will proliferate.

These changes will come at a time when China is already grappling with several serious challenges, including unfavourable demographics, a weak property market, an over-extended banking sector, stalled productivity, politicised governance, and the consequences of its zero-Covid policy.

China’s economic “miracle” seems to be well past its peak. Annual economic growth could well drop to 2-3% in the coming years, meaning that the official goal of doubling per capita income and gross domestic product between 2020 and 2035 would not be realised.

This slowdown will have far-reaching consequences. For starters, China’s ability to compete with the US will be compromised. China’s economy might never overtake America’s, especially if the renminbi’s value falls by 20-25% over the next few years.

Moreover, prices for commodities – especially those that are key to China’s housing and construction sector – will decline. While the higher costs of newer, more regional supply chains will generate inflationary pressures, weaker Chinese demand and a cheaper renminbi will reduce them.

Foreign investment flows into China will decline, with funding increasingly allocated to other Asian countries or emerging markets. While China will not become “uninvestable” (as long as military conflict does not break out), international investors will keep their China portfolios underweight.

Though the renminbi will enjoy a status on par with the Japanese yen, the British pound, and the Canadian dollar, it will not come close to displacing the US dollar.

Chinese President Xi Jinping has staked his government’s legitimacy on China’s continued prosperity. But that is becoming increasingly difficult to deliver – and disengagement is an important reason why. - FMT

George Magnus is a research associate at the University of Oxford’s China Centre and SOAS University of London.

 

The views expressed are those of the writer and do not necessarily reflect those of MMKtT.