G20 Meeting

As the G20 meeting approaches, many of our clients have asked us how the US-China trade war has impacted China’s economy. President Xi’s top think tank advisors at Qinghua University are telling him that China’s GDP will hit 6.3% this year (within the government target), the impact of the tariffs/trade war is minimal and can be contained, and U.S. demand for an agreement that complies with law and is enforceable violates Chinese sovereignty and must be resisted. Chinese analysts believe this is the message President Xi will be taking to the G20 summit with President Trump.

This analysis of China’s GDP is supported by the International Monetary Fund, which in recent reports, reduced its 2019 estimate of PRC GDP down from 6.3% to 6.2%, a minimal reduction. So if impact on China’s GDP is the measure, the trade war’s impact on the Chinese economy has been minimal.

So China is off the hook, right? No, it is not this easy. This focus on GDP is a fundamental mistake because Chinese GDP numbers (like most economic data from the Chinese government) is fake. The PRC GDP number is a manufactured number calculated in a way to allow the PRC government to always hit its artificial target. This has been explained in detail by Professor Michael Pettis in What is GDP in China?

The Chinese economy is not growing at 6.5 percent. It is probably growing by less than half of that. Not everyone agrees that the rate is that low, of course, but there is nonetheless a running debate about what is really happening in the Chinese economy and whether or not the country’s reported GDP growth is accurate.

The reason for the widespread skepticism is the disconnect between the official data and perceptions on the ground. According to the National Bureau of Statistics, China’s economic growth in every quarter last year exceeded 6.5 percent. While that is much lower than the heady growth rates China has experienced for most of the past forty years, it is still, by most measures, a very brisk rate of growth.

And yet, when you speak to Chinese businesses, economists, or analysts, it is hard to find any economic sector enjoying decent growth. Almost everyone is complaining bitterly about terribly difficult conditions, rising bankruptcies, a collapsing stock market, and dashed expectations. In my eighteen years in China, I have never seen this level of financial worry and unhappiness.

Professor Pettis’ skepticism regarding China GDP growth is borne out by the most recent Purchasing Manager Index numbers for China. Virtually every PMI number from every agency and for every manufacturing sector shows that China’s manufacturing sector is either at steady state or is in a decline. China’s June factory PMI seen in contraction as demand falters.

China’s manufacturing sector has been directly impacted by the trade war. If we ignore the rest of the Chinese economy and focus solely on its manufacturing sector, we can see there is no growth now and there is no growth anticipated for the rest of 2019.

So what is really going on with China’s economy? To understand we have to dig down and look at the impacts of the trade war on the ground. We can do this by looking at three areas of major impact.

First, with respect to the manufacturing sector, China is still an export led economy with two sectors for export: low end and high end. The low end is labor intensive/low technology/low margin products like textiles, shoes, and furniture. In a policy mistake, the PRC at least a decade ago decided it would get rid of this sector on its developed coast. The plan was to drive this sector to the interior or eliminate it entirely as China moved up the product manufacturing value chain. This is the core concept driving the Made in China 2025 program.

The move to push its low end manufacturing to the interior failed; though disfavored, this sector survives in coastal China because Chinese private manufacturers have been able to maintain the “China price.” But U.S. tariffs eliminate the China price for most products. So exports from this sector from China are now finally being shut down and orders are disappearing. My law firm is spending huge amounts of time these days helping foreign companies in this sector move their production out of China, mostly to Thailand, the Phillipines, Malaysia, Indonesia, Vietnam, Turkey, India, and Mexico.

The list of foreign owned manufacturers that are leaving China is a long one. Korean companies are following Samsung out of China. See South Korean companies shift production out of China.Taiwan companies are moving back to Taiwan or are moving to lower end countries in S.E. Asia such as Indonesia and Myanmar. See 30 Taiwanese companies return home to invest total of more than NT$120 billion and a further 50 companies consider following suit and Action Plan for Welcoming Overseas Taiwanese Businesses to Return to Invest in Taiwan. Japanese companies are either going bankrupt due to the pressure or setting up shop in S.E. Asia. See Why 110 Japanese firms went bankrupt in China last year and Japanese and other Asian firms shifting production from China as U.S. tariffs take toll.

Forty percent of U.S. companies surveyed by the American Chamber of Commerce in China are making plans to move to some other location beyond China. American Companies Plan to Leave China, How Will the Trade War Impact Your Business? This is a shockingly high number that requires some analysis. This 40 percent number comes from AmCham members. AmCham members are generally wealthier companies already in China and committed to China and with enough money and commitment to join AmCham. If 40 percent of AmCham members are planning to leave China, one can only imagine what the numbers are for those companies not in China that have their products contract manufactured there. Even Chinese companies are moving their low end manufacturing to Vietnam, Cambodia and Myanmar. See Chinese Exporters Shift Production to Low-Cost Nations to Dodge Trade War.

This is an irreversible trend; once companies move, they will not return. This means even if the tariff dispute is resolved today, the damage to China’s low end manufacturing sector has already been done and cannot be reversed. In the short term, the major impact of all this is and will be felt in China’s  employment sector. China’s low end manufacturing sector still employs a major portion of China’s migrant labor force. This sector employs migrant laborers without the skills or the hukou status that would allow them to move into the high end sector.

Reports from China indicate unemployment in this sector is rapidly rising and the central government is concerned about what to do with the swelling number unemployed migrant workers. Li Keqiang’s group at the State Council has urged local governments to find a way to keep these workers in place. A massive return to the countryside during the rest of 2019 is to be avoided. However, the Wang Huning faction has taken the opposite position and is urging these workers to return home and rebuild the countryside. So, though official Chinese employment statistics do not indicate any issues on unemployment, the mere fact this debate is occurring at the top levels in China shows unemployment is a very real issue and will likely to become more severe as the year progresses.

My law firm’s China employment lawyers are hearing from clients that local employment bureaus are subtly pressuring them not to lay off any employees and getting all sorts of pressures regarding their compliance with China’s employment laws. Our lead China employment lawyer, Grace Yang, mentioned this just yesterday in the first part of her new series on How to Avoid China Employment Law Problems, necessitated by rising employment law pressures.

From what we can see, China’s high tech sector has been less impacted by the tariffs because margins in this sector are high enough to so far blunt the tariff’s direct impacts. Having said that, many high tech/electronics manufacturers are also developing plans to diversify away from manufacturing in China and I expect that diversification will be felt within the next couple years. In fact, the Chinese electronics manufacturers that are being impacted by tariffs are not really high-tech. They are mostly makers of computer/smart phone peripherals or are simple assemblers in a way that does not significantly differentiate them from the low tech sector.

For the truly high-tech manufacturers in China it is not the imposition of tariffs that will have the most significant impact. As noted above, the plan of the Chinese government is to move out of the low end and into high tech manufacturing. This move is being led by companies such as Huawei, ZTE, HikVision, Sugon (Dawning) and other companies working in fields like artificial intelligence and automated vehicles. The Chinese government sees this sector as the future of Chinese manufacturing and the way to save the export led economy and China’s status as the “factory of the world”.

Unfortunately for China, these high tech sectors are currently dependent on U.S. technology. So though this sector can survive increased tariffs, it cannot survive being cut off from U.S. technology and the U.S. is using access to technology as a major tool in the trade war. Huawei has been put on the BIS entity list, cutting it off from U.S. technology. See The Huawei Sales Ban: Brrrrr. The entity list was recently expanded to include China’s major supercomputer companies. See U.S. Bans Chinese Supercomputer Companies with Presidents Xi and Trump Set to Talk Trade Next Week. It is probable the United States will soon expand its ban list to include China surveillance/facial recognition companies and drone manufacturers. The trend and the rumors are for this technology sales ban to extend to China’s entire high tech sector, impacting virtually every emerging technology described in the Made in China 2025 program. See The Top Ten Issues for China’s Economy.

Not only will technology sales to China be cut off, but Chinese company access will be further impacted. Chinese companies will be prohibited from investing or buying U.S. critical technologies. The U.S is also moving to ban purchases by any U.S. person of any high tech equipment from China. These things do not involve tariffs; they  involve absolute bans. Joint research between Chinese researchers and U.S. academic institutions is being restricted. Hiring of Chinese engineers and programmers in the high tech sector is also being restricted. There may eventually be a complete ban on such employment.

These moves will cut China’s high tech sector off from U.S. based technology and research. Since the Chinese high tech sector remains largely dependent on U.S. technology, the impact of this will be significant. For example, Chinese working in the semiconductor sector have stated that their development will reach a dead end without access to critical U.S. technology. The impact of this has not and even will will not be terribly apparent in China’s GDP or PMI numbers because sector that is right now so undeveloped and not generating much if anything for China’s economy. It is part of the China plan for the future of its manufacturing sector. If this trend continues, it is a future that will never be realized.

Development of China’s export manufacturing system has since 2001 relied largely on foreign direct investment and associated technology transfer. China’s export manufacturing sector was created by foreign investment, both in terms of investment dollars and in terms of the resulting transfers of technology. Chinese export manufacturers were taught by their foreign customers to make their export products. They did not learn how to do this on their own. The importance of capital from the U.S. has been underestimated. Consider one example. China’s e-commerce/Internet sector is dominated by AliBaba, Baidu, JD.com and Tencent. These are not Chinese companies; these are VIEs that raised their capital outside China, primarily in the United States public markets. Without U.S. capital they would not exist. The same applies in more general terms for China’s entire export sector.

But as a result of the trade war, United States foreign direct investment (FDI) into China has collapsed and FDI from Japan, Korea, and Taiwan has significantly declined. Since China’s low end manufacturing sector is already built out and in decline, this FDI collapse will not impact that sector much if at all. But China is relying on FDI to finance the build out of the critical industries in its high tech sector. China’s plan has been to use foreign capital and foreign technology to build out its new high tech sector in the same way it used foreign capital and foreign technology to build out its low value sector. This means the decline in foreign investment will have its primary impact on China’s plan to become a high tech superpower. This impact will therefore be felt in terms of the impact on China’s future, rather than on the current level of economic activity in China. It is therefore not an impact that can be accurately measured by looking at China’s current economic activity. As an additional blow, legislation currently being considered in the U.S. will bar all Chinese companies from access to the U.S. public stock markets. China and the U.S. Stock Market: Nowhere to go.

All of the above shows that even if China’s GDP numbers were real and meaningful (and they are neither), the impact of the trade war on China  has been and will be significant in ways that cannot be directly measured by a number such as GDP. These impacts include the following:

  • Social unrest due to unemployment from the collapse of the low value export market.
  • Job loss for low skill migrant workers due to export manufacturing leaving China for other countries rather than moving to the Chinese interior.
  • China’s high tech sector has been cut off from U.S. technology, crushing the Made n China 2025 plan.
  • Chinese companies have been cut off from U.S and other foreign investment, striking a major blow to China’s ability to convert from low end to high end manufacturing.
  • The United States is and will continue to relentlessly impose duties (these are different from tariffs) on incoming Chinese products. See Yet Another International Trade (AD/CVD) Petition Against China.

The trade war involves far more than tariffs. See The US-China Cold War Starts Now: What You Must do to Prepare. The impact of the US-China decoupling runs much deeper and is far more significant. This is why we continue to stress that what you are seeing with China above is the New Normal. As long as the New Normal continues, which it is virtually certain to do, a partial resolution of the tariff dispute at the G20 meeting (or even a fuller subsequent resolution) will not change the larger trend. China and the United States are decoupling and international businesses are starting to realize this and acting accordingly. See China-US Decoupling Continues and Will Continue, but Must be Done Right.

What are you seeing out there?