China Forges Ahead Amid Challenges and Shifting Global Dynamics

This article presents a critical analysis of navigating headwinds and seizing opportunities in China's economic crossroads, based on Yaroslav Lissovolik's blog.

Yaroslav Lissovolik, a prominent economist, recently returned from a trip to China brimming with insights into the country's economic trajectory. His observations paint a nuanced picture of a nation navigating challenges while adapting to shifting global dynamics.

During his visit from April 11th to 20th, Lissovolik met with representatives from China's corporate sector, universities, and think tanks. Despite concerns about a "confidence crisis," he found no signs of lost direction. Instead, he was struck by the intensity of competition and innovation within China's corporate landscape, which he believes will be a driving force behind the economy's long-term dynamism.

One of the most encouraging aspects of his trip was witnessing Beijing's transformation over the past decade. The city's modernistic architecture, coupled with a focus on environmental sustainability and the digital economy, reflects China's broader economic evolution. Notably, Lissovolik observed significantly less air pollution compared to his previous visit seven years ago, a testament to China's efforts to promote environmental awareness.

The March 2024 macroeconomic data release underscored the challenges China faces in reviving household consumption, a crucial component of its economic revival. While GDP growth exceeded expectations at 5.3% year-over-year, retail sales fell short, growing by only 3.1% year-over-year in March. This disparity has intensified discussions surrounding the state of the Chinese consumer.

Interestingly, Lissovolik noted regional variations in consumption trends. While Beijing's shopping malls have yet to experience a robust comeback, e-commerce companies reported positive spillovers from major cities to surrounding regions. Additionally, regions like Heilongjiang and parts of northwest China exhibited promising consumption dynamics, buoyed by a rise in domestic tourism following the lifting of COVID-19 restrictions.

A notable trend observed by Lissovolik is the influence of generational shifts on consumption patterns. Generation Z, accounting for nearly 19% of China's population, is driving trends toward health and wellness, brand consciousness, and digital product adoption. Moreover, this generation exhibits a greater inclination towards environmental and sustainable consumption, a factor that corporations will need to increasingly consider.

On the environmental front, the adoption of Environmental, Social, and Governance (ESG) standards by Chinese corporations remains moderate. However, companies planning to go public are almost universally following disclosure rules governing these standards, suggesting a link between ESG adoption and capital market development.

Addressing the long-standing "China overcapacity" concern, Lissovolik's respondents highlighted the global proliferation of industrial policy and state support, including in advanced economies. China appears to be strategically directing state support towards priority sectors crucial for international competitiveness. Concerns about overcapacity may diminish if China transitions towards a consumer and service-driven growth model, reducing reliance on state-funded manufacturing investments.

Regarding the BRICS alliance, China views this platform as pivotal for outreach to the developing world, including through the BRICS+ framework. However, Lissovolik noted a lack of clarity on key trajectories, such as trade liberalization, which could facilitate China's export-led growth to the Global South.

Notably, discussions around former U.S. President Donald Trump and American politics were largely absent, suggesting that China has already adjusted its expectations and redirected trade flows away from the developed world towards the Global South in response to increasing protectionism.

Lissovolik encountered skepticism regarding the "peak China" paradigm, with scholars arguing that it is premature to write off China due to demographic challenges or lower investment levels. Technological advancements in the digital and green economy sectors bode well for China's ability to transition to higher-quality, broad-based growth. Nevertheless, challenges abound, particularly in the AI race, where attracting top talent remains a hurdle for China compared to the U.S. and the EU.

Lissovolik's main conclusion is that the "peak China" rhetoric and outflows of foreign direct investment (FDI) may have been overblown. China holds a strong position in key global economic segments, such as electric vehicles, batteries, solar panels, and rare-earth minerals. Its international alliances, including BRICS+ and the Belt and Road Initiative (BRI), are set to expand further. With localization being crucial for reaching the Chinese consumer, a recovery in demand and household consumption may necessitate a rethink for multinationals that scaled down their presence in China.

As China navigates its post-COVID growth trajectory, discussions surrounding revitalization strategies have taken center stage globally. While markets expected an impressive stimulus package and measures to support consumption, China's priorities appear more nuanced, focusing on broader drivers of long-term competitiveness.

Amid concerns about China's "overcapacity" ravaging Western manufacturing bases, observers advocated for prioritizing consumption over export growth. However, China has pivoted toward redirecting trade flows to the Global South, away from the increasingly protectionist developed world. In 2023, China recorded record-high trade turnover with its BRICS partners, including substantial increases with India and Brazil.

China aims to upgrade its free trade agreements (FTAs) with ASEAN and potentially revive the Regional Comprehensive Economic Partnership (RCEP) in 2024. Additionally, it seeks to complete FTA negotiations with Honduras and upgrade its agreement with Peru, while advancing talks with the Gulf Cooperation Council.

This shift towards the Global South offers several potential benefits for China, including tapping into the developing world's growing capacity to absorb exports, reducing import barriers through preferential agreements, and mitigating geopolitical risks while building secure value chains.

To increase the developing world's capacity to absorb its exports, China may pursue a more emphatic redirection of outward foreign direct investment (FDI) towards the Global South. This realignment could partially compensate for the decline in FDI inflows China has experienced in recent years, with investments likely focusing on sectors like IT equipment, digital technology, and the green economy.

Addressing structural imbalances will require a range of measures in the property sector and labor market. Decisive steps to reduce the stock of unfinished housing and allow market-based corrections in the property sector could accelerate the resolution of current issues and boost consumer and investor confidence. Additionally, elevated youth unemployment calls for active measures to deregulate and boost the competitiveness of the startup sector, an area where China has lost ground in recent rankings.

Looking ahead, China's economy will increasingly need to rely on productivity gains rather than labor and capital inputs due to demographic challenges and the limitations of sustained investment-led growth. China appears to be aiming to rebalance its growth mix towards higher productivity in high-tech sectors like AI and the digital economy. This balanced approach would address weaknesses in labor and capital inputs through greater scope for migration, increased female labor force participation, and a more prominent role for capital markets in driving investment growth.

A more balanced set of growth drivers, less dependent on massive investments in priority sectors, may also alleviate concerns about overcapacity prevalent in the developed world. Moving forward, such sectoral investments will need to be considered with foreign demand levels, potentially involving a broader evaluation strategy that incorporates regional/bilateral trade deals and strategic outward FDI to expand absorptive capacity in foreign markets.

While headwinds like demographics and lower FDI inflows pose challenges, China also possesses significant reserves that could revitalize GDP growth dynamics. These include potential catch-up plays, such as further increases in migration and urbanization, catch-up growth in inward regions to match coastal affluence levels, and a greater share of services and welfare in GDP and consumption.

Perhaps China's most significant reserve is the substantial pool of savings accumulated from decades of high savings ratios. According to the IMF, in 2023, China accounted for 28% of global savings, comparable to the combined 33% share of the U.S. and the EU. Proper management of these savings could be pivotal in strengthening China's capital markets and bolstering its presence in innovative segments of the global economy.

Overall, China faces multiple dilemmas – balancing consumption with investments and exports, reconciling short-term exigencies with long-term goals, and deciding between providing more stimuli and emphasizing structural adjustment. The choices China is currently making appear more balanced and broad-based in terms of potential growth drivers compared to the past, with productivity likely being the key determinant of success in proving the naysayers wrong once again.

This success will hinge largely on China's performance in the innovative sectors of the global economy, notably the AI race and the "green economy." The rising tide of protectionism from the West suggests that China has been prescient in its long-term planning, strategically positioning itself for the competitive battles that lie ahead.

As the global economy continues to depend on China's performance, all eyes will be on how the nation navigates these challenges and seizes the opportunities that emerge from shifting global dynamics.