Neil Shearing on China Shock 2.0

It's Thursday the 10th of September and this is your Capital Economics Weekly Briefing. I'm David Wilder and this is a special episode all about China Shock 2.0. This is a buzz term that emerged last year. It captures worrying developments in the global macro picture, developments that some believe could contain the seeds of the next global economic and financial crisis. Capital Economics has just started publishing a comprehensive series of work looking at China Shock 2.0 from basically all angles to find out what this all means and to touch on just some of the critical issues raised in this new series. I've got Group Chief Economist Neal sharing with me. Hi there Neal. Hi David. Let's get straight into it. I mean, the first thing's first for the uninitiated China Shock 2.0. What is it? Well the roots of this China Shock really are in China's export dominance and the surge in China's exports that we've seen really over the last three or four years since the pandemic. And now why is it a China shock? It's partly about the scale of the export surge that we've seen, but also it has echoes of the first China shock, if you remember, in the early 2000s when China joined the WTO, integrated into global supply chains, reshaped global manufacturing and trade in ways that at the time we thought were relatively benign and indeed the economic establishment, if you like, welcome that and indeed it did convey several benefits to the global economy. But then there was this groundbreaking series of research in the 2010s that actually suggested that we had underestimated some of the economic costs associated with the first China shock, particularly in terms of manufacturing employment and the impact on not just GDP and jobs, but also communities and that those were quite geographically concentrated. And so you get a second China shock now, which is in some ways we'll get onto this even bigger in scale. And so obviously raises inevitable kind of parallels both with that first China shock, but also concerns that it too may impose similar costs. Let me pick you up on that because historians will debate whether there was a First World War and a Second World War or whether it wasn't just one big 30 year war centered on Europe. When we talk about the first China shock and China shock 2.0, how do we see them as two distinct shocks or is it as with those world wars, there are the same sort of underlying issues bubbling away beneath the surface? Yeah, it's a really good point and then there are clearly some similarities, not least the fact that they are rooted in the similar structural issues within China's economy that have not changed for the past 30 years. That is to say this growth model that rests on very high savings rates, very high investment rates therefore prioritises the development of the supply side of China's economy over the demand side. And so generates very strong exports and large external services trade and current account services. So that was the essence of the first China shock and is the essence of the second China shock too that in some ways the kind of structural drivers of these shocks have not changed. So the fact that it's been driven by the same forces in China and it's manifesting itself in the same way in the global economy that is to say through a large surge in Chinese exports, I think means you can view it through a similar lens, however I would argue that this shock is different in at least three important respects. The first as I hinted at the start is just the sheer size. In the early 2000s, China was responsible accounted for about 5% of global exports today and accounts were just under 20% of global exports by volume. I'm so clearly a much bigger player within the global economy. On some measures, it accounts for about a third of global manufacturing production now. The second important point is that China has moved up the value chain. So in the mid 2000s, this was really about kind of low to middle end manufacturing toys, furniture, flat screen TVs and the like. And today, it's still a bit about that, but it's also about electric vehicles. It's about batteries, it's about pharmaceuticals, it's about advanced manufacturing products. And so what China was doing is grabbing export share in these high tech markets from advanced economies. And of course these are the industries that are going to be critical to future growth and prosperity. So there's a challenge there. And then the third important way, which is different, is that there's a geopolitical dimension to this China shock that was largely absent from the first China shock. And that is because China has emerged over the past decade, as we've discussed, as a peer competitor to the US and a strategic rival. So there's this geopolitical angle to this China shock. Today, there wasn't president in the mid 2000s, which is, do you want a country? Is it wise to have a country that in many ways is viewed as a strategic rival, a peer competitor, that is so dominance in so many critically important industries, particularly when it has shown its willingness to use its kind of stranglehold over those industries as leverage in geopolitical standards, like it did, for example, with the US over rare earths. I want to pick up on this issue of growing dominance in critical industries, because earlier this week we had Chinese trade data for August. And it suggested, at least looking at the January/August rate, that this year's trade surplus could be even bigger than last year's record, $1.2 trillion. But we're also in the midst of an AI boom, like this global AI investment frenzy China is at the center of that. So how to disentangle the China shock, this idea of these global macro imbalances with what at the same time is happening is there's once in a generation technology build up. In some cases, I think you're right, there's an element of China's export boom, and indeed there's dominance in areas of technology that are associated with the cross-wonding boom in AI investment. So it produces a lot of the component parts that are necessary and necessary components within the AI build out. However, I think it's wrong to suggest it's just an AI story for one thing. This latest export surge predates the big surge in AI investment globally. What's more, as we'll unpack in this research piece, China's overcapacity in domestic industries is pretty broad-based, it's not just concentrated in one or two industries like a high-tech goods going into the AI build out or electric vehicles or batteries, it's really broad-based. And what's more, it's taken export share from other countries in a whole host of industries too, not just those that might be associated with AI. So I think it's wrong to suggest that this is simply an AI story because the timing doesn't quite add up, and when you look at things from a sectoral perspective, it's pretty broad-based. So I think this is widespread in terms of overcapacity. It's, as I say, rooted in China's, the structure of China's economy and its economic model, and I think it will persist even if we start to see AI investments start to cool. What does that mean for China's trade partners? As you mentioned, China joining WTO, that was in 2001, we're on the eve of the 25th anniversary of the 9/11 attacks, China joining WTO, said it from a global macro standpoint, was possibly the more important event that year, and I know this isn't the podcast to argue that point, but I want to pick up on something that European Commission President Celevantelain said last year. She said, "The sources of the biggest collective problem we have has its origins in the accession of China to the WTO in 2001." Now, I know she said this in front of Donald Trump. It was probably designed to butter him up, align US and European interests, and for Brussels to avoid the worst of Trump's tariffs. But it's a line, isn't it, that speaks to growing impatience with this Chinese economic policy, this persistence that you talk about, that is driving these imbalances. The outlook for Europe is part of this research series that we're pushing out, but what can you tell us about how European and other governments are going to handle a situation in which Beijing doesn't appear willing to change the policy, or to pull on the policy levers that could ameliorate these trade conditions? Yeah, I mean, there's lots to unpack there, but I think there's a couple of important points to stress. The first is that this is a point we'll make in the series of work. It's easy to point to the costs, and I think it's certainly the case that policy makers as evidenced by the Fundal Alliance comments are more aware now, are focused on the costs than they are on the potential benefits, but there are some benefits, right? So I think it's important that we don't just view all of this as a kind of China problem and a problem for the global economy, most notably China is contributing to global disinflation. So we think that price competition from China is probably knocking about 0.2 percentage points, something like that, a year off of OECD inflation. So there are some benefits, and of course the flip side of China moving up the value chain is that it's making a wide, wider range of, in some cases, technologically advanced goods available at much lower prices. So it's important that we don't view everything now as a cost and ignore the benefits. That being said, I think it's striking that it was von der Lyon that made these comments rather than Trump, and that's because that gets a second point to your question, which is that where the costs now concentrated, in our analysis, it's pretty clear that a lot of the costs now are falling on advanced economies, and in terms of a lot of market share, that's hitting Europe harder than the US at this stage. So Germany, in particular, a big beneficiary of China's development in the 2000s, because it was produced through these lots of capsule goods that would be as such. in by China for the investment buildouts. Now it is on the other side of that and facing extreme export competition from China in some of its core industries, not just vehicles, but also things like petrochemicals. So I think it's striking that it's won the lion making that point because a lot of the costs are now falling on Europe. Now your question is what are they going to do about that and we'll get into all of this in the series of work, but there's several things they could do. We could, at one extreme, see coordinated pushback against China across western allies, coordinated efforts in terms of tariff increases, export bans, export restrictions. That's possible. I don't think it's particularly likely at this stage, not least because it would impose some quite significant economic costs on the rest of the world. It's possible too that China comes to the table and realises that this particular form of economic model that it has is imposing costs on the rest of the world and there's coordinated adjustment from the US Europeans and China that will include some element of currency adjustment but also structural reform which would be necessary too. I think the more likely path though at this stage is that we struggle to get coordinated action not just across the US side, the European side in China but also within the western block and that we have these peace built measures. Peace built tariffs impose the restrictions imposed by Europe protecting particular sectors. We've had that in the auto industry, I suspect it will spread out into other industries that are affected and I suspect that viewed over the long term, it won't do a great deal in terms of pushing back against this wave of imports from that are flooding the Eurozone from China. We have spent a lot of time talking about China. There is obviously, as you'd like to say, for every surplus, there is a corresponding deficit and at the heart of this work that's coming up is this look at these global macro imbalances that have re-emerged previous episodes of macro imbalances have ended quite painfully not all but certainly some of them notably in the late 1920s and in the early 2000s with the global financial crisis. So one of the risks that these imbalances get resolved painfully. Right, so I think the first point to say here is that you're right, every surplus has to have a deficit and the fact that the US is running a large deficit which offsets China's large surplus is not a sign that the US is quote unquote losing as President Trump likes to say. So I think it's important that we kind of nail that point from the outset and make that clear. However, I think there are some concerns as they relate to the emergence of re-emergence of global imbalances and that's principally because not because the deficit countries are in some way losing it's to do with the fact that those deficit countries have to acquire what economists call external liabilities so essentially they're borrowing in some form to fund the overconsumption that's required to offset the fact that China's surplus is effectively a drain on global demand. So one way of thinking about this is China's surplus is a drain in aggregate on global demand so that requires another country to offset that by spending beyond its means and that's the US is doing the excess spending and China's doing the excess saving. None of that really matters. Some degree of imbalance is normal and the problem is that the scale of China's surplus now as a share of global GDP has never been higher on our measure. So that means that the scale of overconsumption if you like, in deficit countries has to be equally high and therefore the accumulation of external liabilities has to be large and of course that's compounding too. So we're layering deficits upon deficits upon deficits and these external liabilities are accumulating and to get back to your point and your question at some point that accumulation of liabilities, external liabilities has a habit of pressuring financial crises because something breaks in the financial system you keep accumulating liabilities it requires those countries that are doing that to maintain the confidence of foreign investors for a long period of time and that's possible but at some point something happens, some event happens that that calls that into question and when that happens you get a sudden stopping capsule inflows to those deficit countries that forces a rapid adjustment in domestic demand and therefore imports it closes the deficit but it comes at the expense of recession certainly a growth slowdown very often a recession and sometimes financial crises. So there's only really one example from modern history where we've had a resolution or a narrowing of these imbalances without there being a crisis and that was in the mid-1980s when we had the plaza record back then the surplus countries were Japan and Germany the deficit countries were the US everyone wouldn't be aware of the story they're meeting the plaza hotel in New York Germany and Japan agreed to strengthen their currencies the US agrees to some degree of fiscal retrenchments and the imbalances start to narrow. Now of course all of that happened between countries that were essentially allies the US, Germany, Japan in the 1980s were allies the geopolitical dynamic around these imbalances is very different the US and China as we've discussed as strategic rivals and what's more there is no evidence as far as we can see and we detail in these reports that either China sees these imbalances as a problem in the same way that Japan and Germany did in the mid-1980s or on the other side that the US sees the need for any fiscal retrenchment far from it at this stage. So it feels to us like the idea of kind of coordinated adjustment as a second plaza record is a bit of a long shot at the moment and that is why this piece of work this body of work is so important because the current path that we're on unless there's some change the current path we're on would suggest that at least when you look at history at some point these imbalances will get resolved through a form of crisis. That was Neil Shearing on our China Shock 2.0 series which began publishing this week. The plan is to publish a full suite of reports over the coming couple of weeks which tackle all angles of this global issue from the sustainability of China's policy setting to the sustainability of US government deficits to the global response to China's trade surplus to those winners and losers that Neil discussed. In addition to those reports we are holding a series of in-person events discussing the China Shock throughout North America, Europe and Asia later this month and into October. If you want to join those events and hear directly from Neil and the team check out our events page capitaleconomics.com/events for more details or contact your customer experience manager for more information. And if you're not yet a capital economic subscriber and you want to receive our China Shock series you can start a trial today by registering at our website capitaleconomics.com. But that's it for this week. We will be back next week with more from the world of macro and markets. Until then goodbye.