Xi meets Trump: What next for China?

Hello. It's Friday, the 25th of September, and this is your capital economics weekly briefing. I'm Jennifer McCain, Chief Global Economist, filling in for Neil Shearing while he visits clients in North America. This week, we're turning our attention to China and to a relationship that continues to have enormous implications for the global economy. President Xi Jinping is in Washington for his first US state visit in more than a decade, meeting President Trump at a time when the relationship between the world's two largest economies looks a bit more stable, but we're underlying tensions certainly haven't gone away. There's a lot on the table from tariffs and rare earths to technology, AI and Taiwan. The meeting may not produce any dramatic breakthroughs, but it should give us some clues about where US-China relations go from here. Then we'll step back and look beyond the headlines. China's economy has weathered a shock from the Iran war, better than many expected, helped by exports booming, but beneath the surface familiar challenges remain from weak domestic demand and falling property prices to over capacity and deflation. We're publishing the latest edition of our China Economic Outlook today. I've had a sneak peak, and there are some pretty striking conclusions in it. So joining me today is Julian Evans-Prichard, our head of China Economics, to help us make sense of both the politics and the economics. Julian, welcome back to the podcast. Thanks, Jenny. Pleasure to be here. So let's start with the big picture then. We were fairly skeptical beforehand that this meeting or these meetings would produce much in the way of major breakthroughs. Having now seen at least some of what's coming out of it has anything materially changed your assessment of the US-China economic relationship? Well, there's been plenty of pomp and ceremony, but not a lot concrete has come out of the summit so far. Now, it's possible that we may have to wait a day or two before we know the full details that were certainly the case following previous meetings between the two leaders, but based on what we know so far, the key development really is the trade truce, which had been due to expire on the 10th of November, has been extended by two months to the 10th of January. Now, that's a little bit underwhelming to be honest. Coming into the summit, the reporting has suggested that the Chinese side were requesting an extension all the way to the end of Trump's second term, and the US side, by contrast, wanted a shorter extension, but still in the range of around three to six months. So given that the truce is just being extended by only two months, it does suggest that there are some underlying issues still in terms of or concerns really that the US side in particular has about China's compliance with some of the agreements that were already made back in May, and earlier during the Busan agreement last year as well when the trade truce started. And in particular, the area where there are the peer to peer the greatest concerns are around raref's. We've seen in recent months that Chinese exports of raref's to the US have continued to decline despite China's commitments to provide raref's to the US buyers, and that seems to have led the US to want to keep the truce extension relatively short so that they can continue to monitor compliance on that front. Other than the truce extension, not really, as I said, not much to come out of it yet, and I think really the key conclusion is that these leadership meetings between Trump and C are helping to stabilize the relationship somewhat, putting some kind of guard rails on how much each side is willing to escalate, but they're not really fundamentally altering the course of US-China relations. Both countries still view each other as a geostrategic competitor, and so they're unwilling to really offer too much in the way of significant concessions, and that seems to remain the case this time too. Okay, thanks, Julie. So just to unpack that a bit, this extension of the trade truce, is it just a matter of buying time then? And what do you think can actually happen in the short time before the truce ends to reassure both sides? Well, there will be at least a couple of opportunities for both sides to meet again. There's the APEC forum coming up in Shenzhen in November, and then the G20 meetings in Miami in December, and there's been talk of perhaps the two leaders meeting again at those gatherings, and perhaps that could be an opportunity for them to extend the trade truce further if they feel that more progress has been made in complying with the existing commitments. So I certainly wouldn't rule out a further extension beyond January 10th. In fact, I think that's probably the most likely outcome. There is talk of maybe eventually working towards a broader deal, but I think it's got best in comments earlier this week acknowledged that he's still unsure whether they'd be able to achieve that. It sounds like it's something that the Chinese are keen on working towards, but there still seems to be some skepticism on the US side of whether they will reach a broader agreement or whether they will simply continue to roll over the current trade truce. Okay, thanks. So if that broader truce is achieved, what kinds of things do you think that might involve? Is it about even more purchases from China review us goods? I think that's the most likely outcome. They've set up this board of trades, which aims to allow for para-productions in both directions on non-strategic goods, and they've so far apparently identified around 30 billion of goods in each direction. I think that could probably be broad and a bit further. Obviously, 30 billion is not very much in the context of how large the bilateral trade relationship is. So there's probably scope to widen that further. There has been a bit of talk potentially about doing something similar for investment, so identifying some industries or sectors where maybe a bit of Chinese investment in the US is allowed and vice versa. So there's certainly some areas where there's potential things to broaden out a little bit, but I think it's going to be quite tricky given the underlying picture is that both sides, as I said, view each other as competitors, don't really trust each other. It's interesting, for example, with the Boeing purchases that the Chinese have committed to back in May, so they agreed to purchase 200 Boeing aircraft. So far, those purchases are still being negotiated partly because the Chinese are quite concerned that if they buy these planes, they could get cuts off from access to engines and parts and maintenance in the future, so that they're pushing quite hard for long-term commitments to continue to provide engines and parts, et cetera, for those planes. And I think it's just a good example of the lack of trust in the relationship and that both sides are a bit reluctant to touch ever too closely because they know that at some point the relationship could deteriorate again. So any efforts that they engage in now to strengthen economic ties may actually involve increasing economic vulnerabilities to one another down the line. Yeah, okay, a difficult situation. So ahead of this rarer, so one of the biggest potential flashpoints, did we learn anything from the meeting so far about how much leverage China has really prepared to use there? Not a great deal, to be honest. I think the key thing to come out of the meeting is that rarer apps are really the main source of contention and leverage. It does seem to be that rarer apps are the main reason that the Trump administration only extended the truce by two months. And I think USDR Greer made the link between the two fairly explicit. So it does seem to be the area in particular where the US has the greatest concerns. And it's clearly the area where China has the greatest leverage. I mean, we saw that last year during the US China trade war where it was basically the rarer export controls that led to the US backing down in terms of the very high top rates that it had at the time. And so I think that as far as China's concerns, they have judging from the export data rarest continue to deploy this tool to apply a bit of pressure on the US. I think maybe just try and remind them that they still have this vulnerability. But of course, there's a risk of going too far if they don't follow through on those commitments, then the whole truce could potentially break down at some point. So I do think it's an area where there's the greatest risk for a miscalculation on both sides. Yes, yes, I'm sure it is. And it's very clear that China I mean, does have a pretty strong position here for all the efforts to diversify supply rarestle away from China. It still controls, I think, about 90% of refined rarest production. And therefore it is going to be a very long-term plan to diversify away. Yeah, exactly, yeah. So what's striking me from these meetings so far, one of the key elements, I think, around rarest, AI, Taiwan, Iran, is that this is all really about strategic competition rather than traditional trade policy. I mean, it seems that the relationship is changing, shifting, concerns of broadening. Do you think that's a fair assessment? Yeah, I think the focus has definitely shifted over time. I mean, it's notable that Trump no longer talks as much about the US trade deficit with China. I think that's partly because the bilateral deficit has narrowed in response to tariffs. But I think it's also because the Trump administration has realized that the much more pressing issue is not the deficit with China, but some of the strategic vulnerabilities that it has in areas like rarest, for example, but also aerospace batteries, et cetera. And that's really where a lot of the focus has now shifted. And in some ways that provides some kind of guardrails around conflict over trade simply because of China's leverage in these areas. I think coming into Trump's second term, the Trump administration believed that they had all the cards on their side and that they could sort of force China to come to the table and offer sort of concessions. But I think what they've learned from the past couple of years is that that's clearly not the case. China has just as much leverage if anything as the US does. And so as a consequence of that, there's an incentive for the US and China to try and kind of keep the relationship relatively stable while they continue to try to tackle some of these strategic vulnerabilities. And I think a key point to keep in mind is that the stability in the relationship that we've seen since the Busan agreement and also following the Trump's visit to China has not really changed the fact that both sides are still trying to decouple in these strategic areas. And we've seen in the past few months, even after Trump visited Beijing, that both sides have continued to impose introduced new export controls, new measures on specific goods like humanoid robots, drones, et cetera. So despite having this high level leadership dialogue and providing this anchor of stability in the relationship underneath that both sides are still essentially trying to reduce their vulnerabilities to one another. And that's really the focus. The truth itself is just a way for both sides to buy time for them to reduce these vulnerabilities. - Yes. And what about AI? We've got two countries that are competing fiercely for technological leadership, but also potentially have an interesting cooperating on AI's safety. Is there actually much scope for economic cooperation there? - Yes, AI is interesting because aside from the trade-true extinction, AI is one of the few areas where there was something concrete that came out of the summit, at least so far, in that both the US and China have agreed to create a bilateral AI dialogue, the first meeting of which already happens informally last weekend, the weekend before the summit between Scott Bessent and Harley Fung, the Chinese vice premier, and they're planning to meet again in Shen Zhen in November on the sidelines of the APEC summit, so that you clearly, you know, willing to talk to each other, which is a good development. But I do think any cooperation is going to be very narrow in scope and the one area, you know, so one concrete thing to come out of this dialogue. So far, it's talk about a potential notification system that would basically allow both sides to warn each other whenever they discover an AI-related incident, so an AI going rogue, creating some kind of national security risk or maybe even biotech risk. So, you know, from a very narrow AI safety perspective, yes, maybe a bit of cooperation, but more generally, you know, I think the big picture is that the AI in China and the US are engaged in quite fierce competition in the AI industry, you know, they both want to be the leaders in AI, they both want to dominate kind of global standards in terms of AI and dominate foreign markets. And I don't think either side is really willing to offer any compromises that would set them back relative to the other side. So yes, maybe a bit of cooperation around safety, but when it comes to the fierce competition that we're seeing between the two countries, I don't think that's going to change. And if anything, obviously the US is trying to hold back China through its export controls of AI, semiconductors and China is starting to sort of experiment with similar export controls in the other direction in terms of its AI models. So I think that competition is going to remain in place, even if there's a little bit of cooperation around safety. - Okay, let's move from the geopolitics to the economy because you're about to publish our latest China economic outlook. And I think the central message is quite interesting. Things may look better over the next few months, but the underlying problems haven't gone away. So looking at that near-term outlook, what's going to drive the Chinese economy to reaccelerate from here? - Yes, I think one of the underappreciated factors that's weighed on Chinese growth this year is just fiscal tightening. Now coming into the year back in March when they announced the annual budget, they actually announced a pretty supportive budget. They were targeting an overall deficit that was slightly larger than last year. So there wasn't sort of an intentional effort to tighten fiscal policy, but what's happened in practice is that a lot of local governments have made use of their bond issuance to deal with hidden off budget debt rather than to fund new spending. And so in practice, the fiscal deficit is actually narrowed quite substantially and that's been a major drag on activity, particularly in areas like infrastructure spending. Now the government is aware of this issue and in recent past couple of months, we've seen a ramp up in efforts to try and step up the pace of fiscal spending. Make sure that local governments are using it in the right areas to support the economy. And I do think that some of that will come through in the next few months. And so towards the end of the year in Q4 in particular, we're likely to see a bit of a year-end fiscal boost. So I do think that will lift growth at least for a quarter or two, but that doesn't really change the fundamental medium term picture, which is that the economy is under a lot of pressure, at least when it comes to domestic demand. Consumption growth is weak partly because the property downturn is still ongoing, resulting in quite substantial negative. Well-fifx consumers are still very uncertain about their economic prospects. So consumer confidence is still relatively low. The household savings rate is still relatively high. And there doesn't seem to be a great deal in the pipeline in terms of government policies to really change any of that. And then at the same time, the outlook for investment spending looks pretty challenging. Obviously you've got the downturn and property investment, which we think will continue for a while longer. But on top of that, it's just becoming increasingly difficult to find viable infrastructure projects to allocate fiscal spending towards and manufacturing spending with investment, which had been a key source of strength over the past couple of years. It's also getting harder to support spending there simply because of the scale of overcapacity and the losses that are building up within the manufacturing sector. So looking like investment spending will continue to come under pressure over the next few years, consumption will remain weak. And so the outlook for the economy is pretty challenging. A lot will depend on exports, which we expect to remain strong, but I don't think that will fully offset the weakness in domestic demand. Throughout the report, you make a pretty striking distinction between the official growth figures and our own China activity proxy. What's going on underneath the headline GDP numbers? And do you still believe that growth is somewhat weaker than the official figures imply? So the official figures point to growth above 4%, 4.3% in Q2. By contrast, our China activity proxy suggests growth has been around 3% for the past couple of years. There hasn't been a substantial deceleration, or at least there wasn't in the first half of this year, but in the past few months, we've seen on the China activity proxy, the cap, at least quite a substantial deceleration in growth, with growth currently running at just around 1.5%. Now, a lot of that seems to be temporary disruptions from the typhoons that we had over the summer, some of it's to do with the drag from fiscal spending. And if you look at where the cap is most different from the official GDP figures, it's particularly in the construction sector, so we think there's a bigger drag on growth than the official GDP figures are letting on in terms of construction activity, but also services as well. Services growth, we think, is sort of growing it at one or two percentage points, lower than what the official figures claim. In terms of why there's a gap between the two, I think it comes down to politics, as everybody knows, the government sets. Growth targets for the official GDP figures and the system, sort of the government as a whole, puts a lot of emphasis on achieving those targets, and there's two ways to achieve those targets. One is through conducting lots of policy stimulus when growth undershoots, but the other is simply to just massage the data here and there and get a figure that's just in line with the targets. And I think in recent years, we've seen a shift towards the latter. There is a feeling that it doesn't make sense to do engage in excessive stimulus, or the government has growing concerns about the trajectory of debt levels in China, which are holding them back from doing large scale stimulus. And so instead, one way, the key way I would argue in which the targets are being hit is through some manipulation of the data, and we would argue that our China activity proxies tells a better picture of the underlying growth rate of the economy. - Yes, okay, thanks, and that's available to clients via our website. One of the things that really jumps out from your report as well, Julian, is how dependent China has become on exports and how your forecasting continued strong growth in exports, much driving that strength, and how long can it really continue when China's trading partners are increasingly pushing back? - So exports have definitely been the star performer in the Chinese economy this year, exports in nominal terms, US dollar terms up, around 20% year and year. Now, a lot of the acceleration this year is price effects, particularly in semiconductors and chip computing equipment, and that's very much related to the AI boom and the shortages of some electronics components that are resulting from that. But even when you look in volume terms, growth has slowed a little bit in recent months, but over the first eight months of the year, export volumes still up 11% to year and years. They're still very strong, China's still gaining global export market share, both in nominal and real terms. So clearly, China's export sector doing much better than the rest of the economy. I think that that will continue as long as two things hold. One, as long as the rest of the world doesn't impose very broad based and effective trade barriers on China. Now, obviously the EU is currently leaning towards imposing some trade barriers on China, but I think those will likely be relatively narrow in scope, focused on a few sectors and probably also suffer from some of the same challenges that US is faced with its tariffs on China in that it's relatively easy for supply chains to sort of work their way around the tariffs by, for example, shifting the final per stage of production to third countries. But those kind of work around still allowed the China's export sector to capture a lot of the global demand, even if the final point of production is not necessarily China. So I think, you know, we're not expecting trade barriers to really pose a big threat to Chinese exports over the next couple years. The other key factor here is really domestic industrial policy because the over capacity that we've seen in China as a result of over-investment industrial policy has really played a key role in underpinning export strength. And as long as the Chinese government is willing to continue that strategy and sustain that strategy, even despite some of the sort of financial cost of doing so, then I think Chinese exports will continue to find markets for for their exports, just given that they're undercutting everybody else and they're willing to run, to continue to produce margins or even negative margins that other producers wouldn't be willing to do. Yes, okay. And I know you've done a lot of work, Julian, on why Beijing isn't doing more to boost household consumption. Could you just answer that question in a nutshell for us, why more isn't being done to be spending at home? Yeah, I think it reflects the leadership's diagnosis of the problem that China faces. I think we would argue that what's really needed for the Chinese economy is the government to redirect more of its support, more fiscal spending towards households, make them feel a bit more secure, encourage the household savings rate to come down, and that would address some of the supply and demand about this is inside the Chinese economy. I don't think the leadership views things that way. You know, I think they acknowledge that demand is weak, but I think they think it's a problem of both weak consumption and weak investment. So if you look at to the extent that they are trying to boost domestic commodities across both investment and consumption, rather than just specifically focusing on consumption, I think there's also a fundamental version to using debt in China to fund current consumption. I think that the Chinese philosophy in terms of economic development and fiscal spending is that it's okay to borrow, to invest, but borrowing to fund current consumption is irresponsible and that they can't afford to do that. They're not in the fiscal position to do that, and I think that really holds them back from meaningfully shifting fiscal spending towards consumption. Okay, so if we look two or three years ahead, what's the biggest thing you think people are getting wrong about the Chinese economy? I think maybe the main thing at the moment is to view the current strength of exports as a sign of strength of the Chinese economy. You know, a sign that the Chinese economy is succeeding, and I think that's perhaps the case in a few industries. I mean, there clearly are industries where China's been moving up the value chain, developing world leading technology, areas like robotics, EVs, green tech. But if you look at what's been driving Chinese export strength, it's not just exports of these products, it's across the board, and it's something more fundamental, it's more structural, is to do, as I said earlier, about the weakness of supply versus demand in the Chinese economy. And so I think both the Chinese leadership and many external observers are misinterpreting this as a sign that everything is going well in China and that China's development model is on track. You know, I think in reality, the cost involved in sustaining this development model are going to continue to increase. And at some point, I do think that it will push the leadership to change course. That may not happen immediately, but once that does happen, it could potentially happen quite quickly. We saw during the COVID pandemic, for example, that they retained their zero COVID policy for a long time, probably well beyond its its usefulness. But when they did finally decide the cost of maintaining it were too high, it was a very abrupt shift towards a completely different approach. And so it's possible that we see something similar at some point. It's not certainly not something that we expect in the next couple of years, but I do think at some point the cost of maintaining the current development model will become too unbearable even for China and that we will see a shift in their approach. Yes, okay. So if I really put you on the spot, what's the single most important economic indicator or development that you'd be watching over the next few years to tell us whether China is finally rebalancing or if that policy shift is happening? So I think looking at the consumption chair of GDP is it's a good starting point. I think if you look at the past few years, it started to rise a little bit, but it's still extremely low by global standards. So I think we need to see a substantial increase in that to address some of these imbalances that we're seeing. In terms of what policies are needed for that, I think a lot of it is to do with the composition of fiscal policy. So one of the indicators that we track quite closely is how much fiscal spending is being devoted towards investment versus consumption. And that has the shared devoted to investment has risen substantially over the past five years or so, but there's maybe some early sign of it sort of leveling up for or even coming down slightly. So that's something that we're watching. Excellent. Julian, thank you very much for joining us. It was a pleasure. Thanks. And thanks to all of you for listening. If you'd like to read more of Julian's work, including his latest China Economic Outlet, you can find it on the Capital Economics website. 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