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A Deep Dive into Chinese Industrial Production
Part 1 - Understanding Chinese Trade Strategy
Will Thomson
April 08, 2024
Summary
This post examines China's economic strategies and their impact on global trade and geopolitical dynamics, focusing on the shift from low-value-added goods to high-value-added industries like lithium-ion batteries, solar cells, and EVs. It highlights China's approach of integrating economic and political strategies under the concept of "China, Inc." where the state uses overcapacity as a strategic tool to further its geostrategic interests.
The current Chinese export-led strategy challenges the principles of free trade, raises concerns about the sustainability of global economic interdependence, and is the basis for fear about China dumping industrial products on developed markets. This post underscores the need for the West to adapt and evolve its trade policies in response to China's maneuvers, suggesting a more strategic and forward-looking approach to economic policy to maintain balance and competitiveness in the global market.
Read Time at 200 words per minute: ~10 Minutes.
This blog post arose from comments/concerns from an existing Massif Capital Real Assets Fund investor regarding the forward-looking operating environment for a specific portfolio position. Incidentally, those operating environment concerns also directly impact their day-to-day business.
At Massif Capital, we possess valuable and unique insights into fundamental, technical, and operational aspects of the businesses and industries we invest in. These insights do not exist in a vacuum and can be applied broadly. By incorporating our insights into your broader investing decisions, we can help you achieve superior returns and mitigate risk beyond your investment with Massif Capital.
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This will be the first of five posts exploring the impact of Chinese Industrial Capacity on various real asset industries.
Part 1 – Understanding China Trade Strategy
Part 2 – Solar Supply Chains and a Battle Lost
Part 3 – Gas Turbines
Part 4 – Wind Turbines
Part 5 – Electrical System Equipment
Part 1 - Understanding China Trade Strategy
It is hard to invest globally without spending considerable time thinking about China and specifically about the impact of the Chinese Communist Party's (CCP) policy decisions on the global economy. As one of the primary engines of global growth in the last decade, the negative turn in the Chinese economy over the previous two years should leave everyone concerned. Last year’s 5% GDP growth was a lucky achievement that will be hard to repeat absent the boost the Chinese economy got from the COVID-19 opening; nevertheless, as was outlined at this year's “two sessions” meetings, held early last month, that is again the party’s goal for the economy.
Investors worldwide, especially those invested in the real asset ecosystem, would be correct in asking how this will be achieved. From our point of view, the critical question is: Will China double down on its beggar-thy-neighbor export-led state capitalism of the last thirty years, and if so, which industries and businesses are most at risk?
The Challenge
The challenge of achieving 5% GDP growth is not lost on the CCP, as Li Qiang, the current Chinese Premiere, laid in stark language at the “two sessions.”
“The foundation for China’s sustained economic recovery and growth is not solid enough, as evidenced by a lack of effective demand, overcapacity in some industries, low public expectations, and many lingering risks and hidden dangers. Furthermore, there are blockages in domestic economic flows, and the global economy is affected by disruptions. Some small and medium-sized enterprises (SMEs) face difficulties in their operations. We are confronted with both pressure on overall job creation and structural employment problems, and there are still many weak links in public services. Some primary-level governments are facing fiscal difficulties.”
Mr. Li’s work report shows that the CCP/government appears likely to pursue three primary strategies to address the economic situation. The first two revolve around domestic government spending and capital raising. Still, the key plank is the focus on investment in ramping up what President Xi calls “New Productive Forces,” primarily high-efficiency medium to high-value add, industrial manufacturing, a trend underway for several years:
One would rightly ask, how is it possible that China needs to build out further manufacturing capacity? While excessive manufacturing capacity is nothing new for China, the nature of the current build-out is different. For many years, the Chinese investment and export-led development plan has hinged on overbuilding everything from real estate to low-value-added goods manufacturing in what is often called the “old three” (things like household appliances, furniture, and textiles). The current thrust focuses on the “new three” (Li-Ion Batteries, Solar Cells, and EVs) and other higher value-added manufacturing within complex industrial processes. The Chinese economy has regularly exported this malinvestment in capacity expansion of low-value manufacturing to the rest of the world in the form of rock-bottom-priced goods that most foreign competitors could not compete with. Over the last thirty years, this export wave has created an offsetting deficit in manufacturing capability elsewhere in the global economy. As the Chinese economy has continued to evolve, skills and abilities have improved, and excess capacity has now spread from low-value-added goods up supply chains to more complex and higher-value-added goods such as solar panels and EVs. This is all part of the plan, or so we believe. | “Two Sessions” The “two sessions” are annual events held by both the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC), which are held separately but at the same time. The CPPCC is an advisory body, and the 3,000-member NPC is the CCP’s legislative body but is largely a “rubber stamp” parliament. The “two sessions” are important because major policy announcements often occur:
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CCP Political Economy as Massif Capital Understands It
At Massif Capital, we believe China is best viewed as a single integrated entity. We do so because it seems clear that China views the world through the prism of political economy, not politics and economics. To paraphrase Carl von Clausewitz, in China, politics is economics by other means, and economics is politics by other means, and both serve only to further the CCP. Some companies may have a degree of independence, but by and large, Chinese companies and industry should be considered within the context of “China, Inc.,” a wholly owned and operated subsidiary of the CCP. Via “China, Inc.,” the CCP seeks to retain state control of domestic markets while simultaneously integrating into the global system, but only on favorable terms.
Critical to understanding this strategy is familiarity with crucial documents. In the US, we have the constitution; in China, they have similar documents, but the documents are more strategic and less philosophical. Regarding trade policy, one needs to look at documents from the 1980s, specifically those in which the “Two Markets, Two Resources” framework is spelled out. This framework governs the state's treatment of domestic and international markets and resources. The domestic market is to be protected even as China seeks to integrate into and benefit from global markets. As Nathan Picarsic and Emily De La Bruyere of the Hinrich Foundation outline in a recent essay, The Price of Dependency: The Rhetoric and Reality of De-Risking US-China Ties:
“China’s centralized industrial policy orients around twin goals. First, through a “draw in” prong, Beijing works to attract foreign resources to fuel its domestic markets. Second, the “go out” prong of China’s industrial policy propels players that have reached an “international advanced level” to accelerate the process of resource accumulation and to develop positions of international influence by investing in the global system. The strategy is made easier by an open global economic and financial exchange system.”
This “drawing in” and “going out” approach serves an overall strategic vision of the CCP but necessitates different governance approaches for the domestic and international markets based on China’s relative global standing. Philosophically, this strategy contradicts the general thrust of trade policy in the modern era, specifically WTO policy. It would be right to view China as having reviewed the rules of the West’s trade policy and figured out how to best take advantage of and circumvent those rules for the benefit of the CCP.
Fast forward from the ‘80s and ‘90s to the present, and President Xi Jinping has put his spin on this framework, which he calls the “dual cycle.” The “dual” refers to the distinction between the domestic and international. China’s domestic system, or cycle, is to become the driving force for the country’s development and the global economy. At the same time, Beijing will continue to leverage access to international markets and resources and use the strength of its domestic cycle to attract global resources and influence global markets.
This strategic approach in industrial and technological industries now drives China-based joint ventures, research and development partnerships, and production through which China draws expertise and technology into a government-controlled sandbox. State-backed Chinese champions establish monopolies at critical nodes of global industry chains, build R&D hubs and infrastructure systems abroad, and seek to influence and dominate international technical standards and market norms.
The same logic applies in trade and capital markets. Chinese companies and industries extend Beijing’s global influence, benefiting from foreign exchange and capital flowing into China on bullish sentiment over the country’s enormous market potential and a sophisticated set of Chinese regulations, incentives, or sometimes state pressure. The CCP maintains control over that influx.
Internationally, the same centralized guidance and support that enable Chinese champions of its state-designed Belt and Road Initiative to invest in key strategic markets or resources globally also help these champions secure financing in crucial capital markets.
The strategic value of the Chinese domestic market provides a compelling inducement for the world’s most significant companies to collaborate with Beijing’s state-backed enterprises seeking to access Western capital markets. In short, overcapacity is a feature, not a bug, of the Chinese development system and a tool of geoeconomic coercion, not just benign malinvestment. Political-economic policy in China is focused, first and foremost, on unequal interdependence. In this way, trade is always viewed as a zero-sum game, with clear winners and losers, perhaps not on every transaction but certainly at a global level.
Should the West Expect More of the Same
The West should expect more of the same, but it should respond differently than it has.
The global trading system was built on the concept of mercantilist reciprocity, the idea that governments could use the promise of greater access to their domestic markets (or the cudgel of limited access) as leverage to obtain better market access for their exporters to foreign markets. A game theory-infused mindset that positions trade policy in the context of winners and losers and us vs. them. Within this context, China has played the game better than the West over the last thirty years, figuring out which rules to flout and how best to disregard them. In some regards, the hollowing out of Western industrial capacity is well deserved; we got outplayed and complaining about China not playing by the “rules” after the fact, looks weak.
The underlying economic reality is that trade barriers impede sensible domestic economic policy when used as foreign policy tools. Western economists acknowledged this reality early in the 1990s but have mostly failed to convince the world of its truth; even domestically, it remains a contentious line of thought in the West. Trade barriers raise the cost of production for domestic producers and the cost of living for citizens. They deter the inflow of direct investment, which retards capital formation, employment, and economic growth. The roots of the modern free-trade movement in mercantilist reciprocity, with its implicit us vs. them qualities, has facilitated the rise of countries like China and a newly resurgent protectionism throughout most of the world's developed economies.
The West may have developed the modern international trading system, but we have not evolved it.
Today, policymakers are more inclined to doubt the prudence of interdependence and global supply chains. There is a growing tendency to view trade through a geopolitical lens and to subordinate trade policy to national security considerations. There is evidence of a general failure to reconcile, if not align, domestic and international objectives. There is mounting tension between unilateralist instincts and multilateral trade rules.
China's economic decisions over the next few years may lessen or increase these tensions. As Huang Yiping, a former advisor to China’s Central Bank, recently noted during an online forum held by China Macroeconomy Forum: “We should pay serious attention and recognize that this [backlash due to industrial produce dumping] could be an important development in geopolitics, a widespread protectionist wave against Chinese products would be bad for China’s future development and innovation.”
As discussed in the coming posts, it isn't easy to foresee the CCP following Mr. Huang’s sage advice. At the same time, it appears that Chinese development efforts will likely be more focused and specialized. This is in keeping with the evolution of higher-value-added manufacturing, which requires more significant upfront investment than lower-value-added consumer goods and the development of technical know-how.
Meanwhile, China’s specialization creates opportunities for specific Western industries, even as it creates headaches for others. The West would be well served by being as strategic and forward-looking in our thinking about economic policy as the Chinese often seem to be. We cannot dominate all economic realms, and while the West should seek to dominate some, we should cede others and compete only where necessary.
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