A decade after the global financial crisis prompted China to pursue a different economic path, the country continues to push toward a more sustainable model for growth. And now, it's facing a new challenge in the form of massive U.S. tariffs and investment restrictions. But the lessons China has learned over the past decade will come in handy in its current efforts, and the government in Beijing may be able to manage the Chinese economy better than it did in 2008.
Unlike the financial crisis, which ultimately prompted China to abandon its old low-cost, export-oriented growth model, the looming trade frictions with the United States represents challenges to China's goal of establishing a new, tech-based development model. Fundamental disputes between the two major powers over China's state-led economic system versus the United States' market-dominated one have surfaced, especially as Beijing continues working aggressively to ramp up Chinese innovation and technology development. The once complementary trade relationship between China and the United States is now a growing competition, which will impact Chinese authorities' ability to manage their country's economy for years to come.
In preparation for Stratfor's upcoming 2018 Third-Quarter Forecast, we are releasing a series of supporting analyses, focusing on critical topics, regions and sectors. These assessments have been designed specifically to contextualize and augment the quarterly global forecast.
The global financial crisis in 2008 called for an end to China's low-cost, export-oriented growth model. It unleashed the country's decadelong process of making its economy more sustainable, a process that is by no means finished. Now U.S. trade penalties and technological restrictions are adding more complications — especially as Beijing strives to become an equal to the United States in the technology realm.
China in 2008
China's efforts to move up the industrial value chain from a low-cost, export-driven economy into a consumer-driven one began in the early 2000s, but the process lagged. In 2008, the country still enjoyed its status as essentially a factory to the world, utilizing its massive population to provide low-end manufacturing. And the Chinese government was also freely supporting infrastructural investments for the sake of rapid growth. Though the country's leaders had begun realizing that a reliance on external demand was unsustainable and would ultimately lead to unbalanced economic development, they intended to move to a more sustainable, consumer-driven model at a slow pace they could control. But then the global financial crisis hit.
China's government was almost entirely unprepared for the downturn. In a year, exports plunged by 16 percent, or $230 billion, and around 10 million people along China's coastal economic belt lost their jobs. With no consumption- and service-driven system yet in place to keep the economy afloat and provide jobs for returning migrant workers, Beijing had no choice but to implement monetary and fiscal stimulus measures. Those decisions further increased the country's massive investment expenditures, which already accounted for 50 percent of China's gross domestic product (GDP).
Thus the financial crisis not only postponed China's efforts but also made it even harder for Chinese authorities to restructure the country's economy into one driven by consumption, services and value-added manufacturing. Even at its most simplistic, such a process entails massive risks and internal overhauls, financially, politically and socially. And China's situation was hardly simple: Its system was marked by indulgence, driven by inefficient, debt-fueled investments as a result of the stimulus. Beijing was left with very little space to enact changes yet very little time to do anything but move forward.
What's Changed Over a Decade
There are a lot of similarities between the challenges China faced during the financial crisis and those it will encounter because of U.S. trade penalties. Both are critical external forces that interrupt China's focus on its domestic economic priorities. And to differing degrees, they both threaten China's trade-oriented growth path and the social and industrial system underpinning it. Still, much has changed in the last decade.
Chinese leaders today are still dealing with the high costs brought on by the crisis, but a look at the Chinese economy in 2018 indicates there has been major progress. In 2008, exports accounted for 37 percent of the economy, whereas today, that number has been nearly halved. Domestic consumption has become a more important growth engine in China than investment and exports combined. Meanwhile, the country's services industry — comprising sectors as varied as finance, e-commerce and logistics — is booming, now absorbing roughly 45 percent of total employment. That's nearly double the 23 percent that it accounted for a decade ago. And export-related employment is estimated to have dropped from 9 percent of total employment in 2008 to 6 percent today.
Beijing has shown a continued commitment to its economic rebalancing process, even though that has meant slower growth. The reduced reliance on external trade and trade-related employment has given China the space to continue its efforts, which have included tamping down real estate speculation, limiting excessive infrastructural investments and redirecting resources toward improving social security. And the results arguably give Chinese authorities a feeling of security as they prepare to weather another external shock in the form of potentially massive U.S. tariffs and investment restrictions.
Of course, despite its progress, China will still suffer from escalating trade disputes with the United States. In a worst-case scenario, China will lose 6 percent of its total exports, or 1 percent of GDP, as a result of U.S. tariff measures on a combined $150 billion in Chinese exports. And the country's nascent consumer-led economy is still unable to totally buffer unexpected shocks to the global economy. In fact, as China's economy has slowed over the past two years, it has relied significantly on a robust international trade environment to cushion the impact of its rebalancing agenda.
In the case of a significant trade blow and declining employment rates, Beijing may again find itself with little room to maneuver while needing to rely on expanding credit and infrastructural investment in order to salvage the economy. But it's dealing with so much debt — and already diminishing investment returns — that it will struggle to find ways to pump more money into the economy without generating further risks.
From 2007 to 2018, the size of China's outstanding debt ballooned to an estimated 295 percent of the GDP, with the majority going to ineffective and oversized state-owned enterprises or the already highly speculative property market. Over the past three years, Chinese authorities have implemented massive institutional overhauls and politically sensitive reforms to try to contain debt. But while these efforts achieved initial progress, Beijing's debt likely won't reach its peak until the early 2020s, and its economy has long way to go before capital generation starts to normalize things. Even that scenario will then need to be followed by structural and liberalization reforms that could take years.
Consequently, Beijing is far from obtaining financial flexibility. In fact, The government's staunch campaign to deleverage the economy and halting aid to debt-fueling corporations is causing financial strain for some companies. And with U.S. tariffs still on the horizon, many targeted industries that are operating on a thin margin — for example, manufacturers of office machinery and consumer-related toy, textile or processing industries — or are heavily reliant on U.S. markets — such as electronic products and machinery — could be harmed.
In a scenario in which Beijing chooses to accept moderate external disruption, it could decide to allow some failing companies to die or to rethink some of its deleveraging campaigns where it needs to. In a worst-case scenario, however, Beijing may return to its old habits of massive spending and huge credit-driven investment projects to prop up the economy and employment rates. And of course, now that China has so much more debt and fewer returns from investments than it did in 2008, that decision would have much greater consequences.
Competing for the Future
Beyond the attention-grabbing tariffs and the haggling over a trade surplus, the Chinese economy is facing another serious threat from the United States: the U.S.-China disputes over China's technology and industrial policy. In its National Security Strategy, the United States articulated that it sees China's growing technological prowess as a major threat, and it intends to limit Chinese investment into U.S. technology. Washington has been targeting China's state-led technological development plan outlined in the Made-in-China 2025 initiative, as well as increasing scrutiny on high tech-related investment, companies and personnel from China.
Despite its decadelong process to phase out low-end and processing manufacturing, China still trails the United States when it comes to high value-added manufacturing and the development of technology such as semiconductors. (The latter was ruthlessly exposed when China's second largest telecom company, ZTE, was forced to cease operations after it was banned from its U.S. supplier.) But the country's immensity, state-funded development strategy and large, tech-educated population make China well positioned to narrow the gap with the United States in terms of developing and adopting emerging technologies. And its long journey toward a higher value-added and tech-driven economy is poised to remain a key source of conflict with the United States.
Unlike the global financial crisis in 2008, which called for an end to China's old economic structure built on low-cost, labor-intensive manufacturing, the looming trade war with the United States is exposing the kind of challenges that China must inevitably face in its quest for global economic power.
China will intensify global competition and face trade friction in capital- and technology-intensive industries as it increasingly upgrades its exports. With its demography already on a downward curve and with Beijing aspiring to be a leading tech power in its next phase of economic transformation, China has little room or appetite to compromise its tech development path, as the United States has demanded. On the contrary, the pressure China is facing is only going to harden Beijing's resolve to develop self-sufficiency in sensitive technological supply chains on an aggressive timeline, suggesting their trade disputes will last for many years.