As markets crash, where does Beijing turn next?

October 14, 2024

This week in The Red Report

From Zhongnanhai: This week in Chinese Politics

Stimulation turns to disappointment

Efforts to boost China’s economy have failed to make lasting and necessary improvements in market confidence, which will likely lead to additional–and increasingly ineffective–stimulus measures.

Analysis

In contrast to the usual party fanfare, Xi Jinping marked the 75th anniversary of the founding of the People’s Republic of China with sweeping fiscal measures and a plea for patience as CCP leaders try to re-energize China’s faltering economy. In an unexpected Politburo meeting, Xi called for officials to boost the economy without concern for making mistakes, a nod to the decision paralysis that often grips decision makers in China, who often fear political repercussions for “incorrect” choices. These moves are broadly designed to prop up the real estate sector and reassure markets that Chinese stocks are stable. 

Yet despite an initial surge in stocks after Xi’s announced stimulus, markets cooled after it became apparent that there would be additional immediate government stimuli. Investors are still uncertain about how the government is willing to go to secure the economy. The result? The biggest stock dive since 2020. Notably, commodity prices, a benefactor of earlier fiscal stimulus announcements, fell as markets readjusted to the new stimulus package. An announcement over the weekend that China would expand its debt and deficit to help with its fiscal package also did little to move the needle.

As we previously argued, short-term boosts have done little to address broader concerns about China’s economic performance and underlying weaknesses that are only exacerbated by heightened government intervention. Moves to prop up China’s economy point to deeper concerns about how short term measures may be insufficient compared to the need for more fundamental economic restructuring. Beyond government initiatives, like interest rate cuts, one issue exacerbating deflation is e-commerce, where algorithms encourage race-to-the-bottom pricing that is minimizing small businesses’ profit margins. This deflationary pressure remains broadly unaccounted for in the CCP’s recent economic measures, with China’s gross domestic product deflator continuously contracting for over a year. A major challenge for the CCP is how to confront issues like deflation that are baked into the system, particularly when that system is designed to prop up the interests of senior political leaders and their intent to retain control over China’s economic levers.  

Added to this, an even greater challenge for Chinese economic leaders will be how to maintain increased demands for even more interventionary measures through fiscal and monetary stimuli as a way to maintain growth. Companies should therefore expect additional stimulus announcements in China, with the caveat that markets will likely temper their responses as the effects of these announcements fades over time. What might make for short term leaps in stock prices will therefore be precisely that: a blip that will reset as China’s economy continues to splutter.

On the Hill: Developments in US China policy

How should the US respond to China’s economic policies?

Political support for globalization flags as national protectionism emerges as the winner of US-China tensions. Is the US capable of promoting the scale of industrial policy needed to compete with China?

Analysis

As the CCP intensifies its intervention in China’s economy through fiscal and monetary stimulus and a swelling state-owned sector, the US faces an increasing realization that economic security is inseparable from national security. This makes for a more challenging global economic environment. As “de-risking” and securing supply chains become increasingly prioritized, tariffs and trade wars are more likely to determine who can trade or engage with whom. This is particularly the case with the tech sector, as Washington and Beijing try to push for zero-sum decision making by third countries to choose either American or Chinese tech, but there are signs that this logic is expanding into multiple other sectors. 

In the US, rhetoric about a pivot towards reindustrialization and a prioritization of industrial policy has the added challenge of needing to wrestle sectors back from private capital. Without the same levers over the economy as in China, US policymakers therefore need to think clearly about where government incentives can steer corporations to support national security priorities, but they need to do so with a clearer sense of what it means to “win” against China. Securing supply chains by promoting onshoring or “friendshoring” of manufacturing, for example, will be necessary, but will also require the US to rely heavily on its allies to remain economically viable. At the same time, there are very real risks for pushing for exclusionary economies, notably that levers like export controls have arguably had the opposite effect to their intentions in that they have accelerated Chinese state-driven efforts to produce their own systems and products without relying on US parts. 

As the US considers how heavily it wants to lean into industrial policy as a function of national security, corporations should be aware of increasing demands from Washington to ensure that their supply chains do not source from China or Chinese allies. In part, this pressure to assuage US consumers that products are indeed “Made in the US” when in fact they are not, or that they are merely assembled in the US from imported parts, is leading to a renewed corporate nationalism that companies once tried to eschew. At the same time, which countries count as “safe” for US corporations is likely to change with shifting geopolitical alignments. This means that relocating manufacturing or supply chain sourcing out of China is not a guarantee against future regulatory punishment, although it will likely buy time. Global companies therefore need to be increasingly attentive to the evolution of the US government’s thinking about industrial policy, which looks set to continue on its current path regardless of the administration.

Business Matters

Market confidence in China hits new lows as companies remain skittish

New numbers indicate that the Chinese economy is doing even worse than before, with mergers & acquisitions down, market confidence at a nearly all-time low, and risk of deflation on the rise

Analysis

If China’s current stimulus package is the best that Beijing can do, it is no surprise that all signs continue to point to hard times ahead. UBS, JPMorgan, and Nomura all predict that China remains set to miss its 5% GDP growth target this year, and the IMF predicting that growth will slow to as little as 3.3% by 2029. We have previously covered how the struggling property market serves as a tremendous downward drag on all efforts at economic recovery, and can now complement that position with new data points. The major takeaway from this data for non-Chinese companies is that foreign investment in China is declining precipitously, whether because foreign companies are reluctant to invest, or domestic companies refuse to engage in international cooperation.

One highly visible example of this was the China Securities Regulatory Commission’s recent levying of a record fine totaling $62M against PwC after determining that its failed audit of the China Evergrande Group–the now-liquidated property developer–was central to the company’s demise. While PwC global headquarters has already assigned blame and cleaned house in its China operations, the reputational damage is already done. PwC has lost dozens of clients, with many moving to other Big Four companies–Deloitte, KPMG, and EY–but a growing share choosing to partner with the Chinese firms among the “local top six.” The Big Four’s portfolios include representatives from all major industries, but this means nearly all property developers, like Evergrande, have become a significant liability. Conversely, the local top six have dominated the A-share clients in China and are better insulated from such instability, suggesting that a rebalancing may be coming. 

It is not only the Big Four that are concerned about Chinese regulatory authorities, as US companies’ confidence in the Chinese market continues to decline. China is fewer companies’ top investment destination, and only accounts for 34% of companies' top-three investment choices, down from 54% four years ago. Data shows similar trends for European counterparts. The impact of this can be seen clearly in the 45% drop in Chinese mergers and acquisitions (M&A) over the first half of this year. For comparison, M&A globally rose 3% over the same period and China’s share was only 8%. This is in part because Chinese companies are being incentivized to select domestic partners and keep Chinese wealth in China, while foreign companies are becoming increasingly reluctant to take on Chinese partners due the volatile state of international affairs and mercurial tariff structures. For R&D-based companies, in particular, this remains especially true. As we pass the one-year anniversary of the Chinese espionage law, we see companies avoiding taking IP risks and unnecessary exposures.

Freight rates are also declining, with routes to the US dropping up to 40% versus July rates after reports that US inventories are finally replenished after the pandemic. For a country struggling with overproduction, it looks like things will only get worse. Because demand for Chinese products is shrinking overseas, rates will likely continue to drop, or demand will dry up altogether. And, if those products end up flooding China’s domestic market, they will likely contribute to the downward deflation spiral already initiated by e-commerce retailers like Pinduoduo. With these twin forces of overproduction and e-commerce price-under-cutting, China has created a perfect storm for domestic turmoil

In short, signals all point to reasons for pessimism about the current and future state of the Chinese economy on multiple fronts: inadequate government responses, plummeting market confidence, decreasing M&A, and domestic overproduction and deflation. Notably, a declining Chinese economy, while advantageous for the US insofar as China’s waning economic strength will equate to China’s receding political influence on the world stage, is not something to necessarily celebrate. A slowing Chinese economy also means a slowing driver of global growth, with knock-on effects likely to be felt worldwide.

Tech Futures

AI competition heats up

US-China rivalry heats up over AI innovation, with hardware and talent at the frontline.

Analysis

The US-China rivalry will be increasingly about AI innovation, with AI representing the latest manifestation of how politics and business are increasingly intertwining on the world stage. Within the AI race, two factors will likely dominate geopolitical strategy: hardware and talent. 

As Chinese entities, like Huawei, unveil new AI chips that they hope will exceed those produced by competitors, like Nvidia, China is demonstrably intensifying its push for self-reliance and circumvention of US sanctions and export controls against critical technologies. Google’s recently announced data centers in Southeast Asia similarly highlight corporate attempts to hedge against US-China rivalries by investing in third countries and to lure potential customers as governments face pressure from Washington and Beijing to choose sides. This fusion of national security and industry is increasingly pervasive in the start-up world, with defense start-ups in particular feeling the pressure to ensure that they are not reliant on Chinese-made components or technologies. 

While breakthroughs in hardware like memory chips are the latest front for geopolitical rivalry, US-China contestation is not limited to hardware. As with Google’s opening of data centers across Southeast Asia, OpenAI’s hiring in Singapore similarly underscores how corporations are shifting in response to geopolitics, with hiring of talent outside the US and China a growing priority. Yet this approach has its risks. The pressure from senior CCP leaders for Chinese companies to ramp up innovation and out-compete US competitors means that Chinese entities–both government and private–are increasingly incentivized to try to steal IP through industrial espionage, particularly in the tech sector. OpenAi, for example, recently noted a China-backed attempt to steal IP through phishing attacks against its employees. Where competition for talent will certainly heighten, attacks against current employees working in AI-related fields therefore poses a risk to the targeted companies and users of their products. 

As companies embrace AI across a range of business practices, this therefore introduces risks into a range of sectors, including which AI platform a company uses, whether that platform is secure against hacking attempts, and how the platform secures sensitive company information. Even for companies that consider their sector as secure from geopolitics, AI’s expansive infiltration into the corporate world will ensure that geopolitics will increasingly color decisions made in the boardroom, regardless of whether a company is in the tech sector or otherwise.

Espionage Alert

Getting smart about hacks

China’s breach of US internet providers and infiltration of Western societies highlights the growing need for corporations to employ anti-espionage strategies.

Analysis

Cyberattacks are a major threat to national and corporate security. Most recently, a cyberattack backed by the Chinese government named “Salt Typhoon” succeeded in penetrating US broadband providers and network infrastructure, including infrastructure used by US government and law enforcement for court-authorized wiretapping requests. The attack, which targeted Verizon, AT&T, and Lumen Technologies, accessed internet traffic and represents a potentially devastating afront to US intelligence collection efforts. The attack, which broadly aims to collect large amounts of government, corporate, and private internet activity data, highlights the growing threat of cyber activities backed by foreign states, with China the primary culprit. 

China’s espionage attacks combine massive data breaches with highly personalized influence operations. A recent investigation in Europe, for example, reported 233 individuals operating on behalf of the CCP’s overseas United Front, including academics, employees at a nuclear technology firm, political staffers,  journalists, and others. These efforts–including 103 United Front-affiliated organizations in Sweden alone–demonstrate systematic attempts to infiltrate open societies. In the US, the FBI’s detention of five PRC citizens, all students at the University of Michigan, for attempting to obfuscate a visit to a US military site in Michigan where Taiwanese troops were conducting joint training exercises, highlights how these operations occur on US soil. Recent estimates put China-backed hackers as outnumbering the FBI's cyber personnel by 50 to one, with one European agency estimating that China employs 600,000 individuals in its espionage units. 

This multi-pronged strategy means that corporations need to be increasingly vigilant about potential infiltration and theft of IP from both individual employees and partners, as well as remotely via cyber attacks.  Importantly, these infiltrations not only challenge companies’ bottom lines in terms of IP theft, but also through reputational damage for being “weak” on security that may drive consumers to competitors. Company boards and security teams, in particular, should therefore press the need for companies across every industry to have strategies in case of cyberattacks or evidence of company infiltration.

One more thing…

Taiwan counters China’s “anaconda” strategy

Beijing’s attempt to constrict Taiwan’s capacity to resist invasion suggests a long-term approach to “unification” that companies will need to prepare for. 

Analysis

China’s strategy for Taiwan continues to dominate geopolitical concerns in East Asia. Recent analysis points to Beijing’s “anaconda strategy,” which, like the snake, aims to constrict Taiwan’s ability to defend itself in the case of a future invasion of the archipelago. While most Taiwanese are united in their skepticism that China will invade in the short term, China’s repeated pressure against the island points to Beijing’s preparing for the possibility of future invasion. As US support for Taiwan is welcome in the form of the US extending a $567m aid package to Taiwan’s military, the anaconda approach pressures Taiwan’s systems by diverting resources to defense and the need to increasingly scramble responses to China’s repeated incursions. Murmurs in the US, particularly among Republicans from the Trump wing of the party, that a future administration may not commit to defending Taiwan, similarly add unwelcomed uncertainty to East Asia’s geopolitical future. Breaking through Beijing’s anaconda should be the utmost priority for both US and Taiwanese officials. 

Disputing Xi Jinping’s claim that China and Taiwan were connected by “blood,” President Lai Ching-te used the opportunity of his National Day speech to instead stress policy proposals for strengthening Taiwanese society. While the CCP is keen to frame these comments as “incendiary,” Lai’s restrained comments point to a move from Taiwan to try to deescalate cross-strait tensions, although it remains to be seen whether the CCP responds in kind, considering that Lai’s very existence is an affront to Xi Jinping’s vision for a “unified” China. Despite these tensions, US companies, in particular, appear broadly ill-prepared for the “Taiwan Contingency,” which extends beyond companies with assets or investment in Taiwan itself to the potential for global shocks to supply chains, financial flows, and market stability. Effects of Beijing’s constriction against Taiwan, however, will affect global businesses long before a future invasion, which means that businesses need strategies now for how to reduce the effects of geopolitical external shocks on their operations.

Book Recs

What we’re reading to better understand China

If you would like additional information and analysis tailored specifically for your specific business or institution, please contact us at [email protected].

Reply

or to participate.