Hollowing-out in China

Ichiro Suzuki

Chinese companies are aggressively expanding outside of the mainland, it’s been reported. Amid persisting sluggishness of domestic demand, Corporate China is making their bets away from home. Belt & Road Initiatives has prompted their move ten years ago. From one perspective, BRI is a project to export China’s excess capacity, from steel, building materials, engineering prowess to people. BRI recipient countries raised eyebrows when Beijing sent Chinese men to work on railroads, bridges and ports, denying employment opportunities for local people. With these workers, a variety of factories and services followed to where projects are, bringing in young and aggressive Chinese men and women to work on such businesses in a faraway land. 

On top of such moves, Chinese car makers are beginning to expand into the overseas markets, getting out of fierce competition and weak demand in the domestic market. Chinese EV makers are a class of their own, setting themselves apart from developed world incumbent rivals. Amid marked slowdown of EV demand in North America and Europe, Chinese people kept buying more EVs, pushing car makers to improve their quality at more reasonable price. They are beginning to eat market share of internal combustion engine car leaders in the U.S., Europe, South Korea and Japan, eyeing for greater market share especially in Europe and Southeast Asia. How Chinese car makers are going to do in the U.S. in the near future is highly uncertain under Trump 2.0. BYD had a plan to build their EVs in Mexico to be shipped to the U.S. but this plan has to be on hold amid Trump’s protectionism. Trump or else, it doesn’t seem likely that the U.S. is going to be tolerant on cars that run on Chinese software.

Since the early days of opening up the country under Vice Premier Deng Xiaoping, China has closely followed the footsteps of post WWII Japan: export-driven boom to begin with, then real estate mania and its collapse, the beleaguered banking system, weakened domestic demand and mild deflation to name with. Here comes perhaps the last leg of the ordeals of Japan in the aftermath of the bubble’s bust, hollowing out of the country as capital moves out to where corporations choose to go. 

There were three factors that drove the Japanese economy into a low growth mode in the 1990s. The first factor was the yen’s frenzied rise that was triggered by the Plaza Accord in 1985, and its first leg lasted until 1995. The sharp rise of the yen against the U.S. dollar hit Japanese industries’ cost competitiveness to Asian countries, whose currencies were and still are more or less tied to the greenback. Japan’s car makers have survived the yen’s supernormal rise but their survival required aggressive relocation of production facilities to where demand for their cars was: the NAFTA areas, the EU and Southeast Asia. Then support industries followed car makers. Other industries acted in the same fashion. Exodus of Japan’s export industries left an immense hole in the Japanese economy, in terms of employment, demand for a variety of kinds, tax revenue, etc. Three decades after hollowing out began, Japan has found itself an inexpensive place to do business. Factories, however, don’t come back, opting to stay at where their products are sold.  

Then there was a collapse of domestic demand in the aftermath of the historic bubble’s bust at the beginning of the 1990s. Demand simply has evaporated in a balance sheet recession. Finally, Corporate Japan has failed to embrace the burgeoning new technology, the Internet. Worse, fighting for their survival amid the bubble’s bust and overvalued currency, Corporate Japan was in no mood to make a strategic move to invest in the new technology. This failure gave a fatal blow to its once mighty electronics industry. 

As a compensation for profound effects on the Japanese economy, businesses that left the country are today contributing to Japan’s current account as profits overseas are reflected into the balance sheets of their headquarters at home. They boost service surpluses of the current account, along with tourists from abroad, whose robust spending is contributing to the economy. That’s a relatively small compensation for their big decision to get out of the country. (In recent years, it is believed that profits made abroad are not returning to Japan, in terms of cash flow, opting to stay where they are generated to finance local operations.)

Corporate China did not have to be driven out of the mainland by its currency’s appreciation. While there was a period through the middle of the 2010s when the RMB’s appreciation made headlines, it was nothing comparable to a meteoric rise of the yen from 250 to the dollar to 80 in just ten years. Until recently, wages in China rose sharply, pushing Chinese factories’ move into Southeast Asia. Sluggish demand, however, is the main reason behind their decision to leave the country. The Chinese Communist Party shows no sign of embarking on a major structural reform to fix the ailing economy since the growth model that depended on rising real estate prices has run its course. The CCP is probably aware that something needs to be done as long as a change would not undermine their credibility and that is a big question. There is far too much production capacity in the Chinese economy, but eliminating it comes with  job losses, which the CCP doesn’t afford to embrace. While the CCP does little, the Chinese population continues to age and the middle class remains struggling with their damaged balance sheet, making China less attractive to invest.

While the RMB has never gone through a frenzied revaluation phase, a different factor unique only to China today is exacerbating hollowing out of China. That is departure of foreign capital. China’s economic boom in the early years of the 21st century was fueled by massive foreign direct investment inflows that built factories across the coastal regions of the country. With the real estate market’s collapse, the CCP’s mishandling of the bust, China’s rise as a strategic competitor to the United States, rising risks of doing business in China, etc, inflows of foreign capital has dwindled and capital already invested there is leaving. Hoping to solicit foreign capital, the CCP has recently dropped ‘wolf warrior diplomacy’ but becoming a little nicer is far from enough to win back disillusioned long-term investors. 

Chinese companies are leaving the country while remaining cost-competitive, unlike Japanese companies in the old days. On top of their competitiveness, some Chinese companies are boasting of leading edge technologies in areas such as renewable energy, EVs, AI, etc. While competitive, they would face a fair degree of frictions and resistance wherever they go, but especially in Europe. On the other hand, their departure is likely to contribute to prolonging weakness in the subdued Chinese economy, in terms of employment, investments, capital expenditure, etc. Since they are not leaving for cost reasons, they are unlikely to come back. The profound problem of debt hangover is going to be worked out one day, but the Chinese economy that comes out of it would hardly resemble the one the country once boasted of. Even if balance sheets are recapitalized, the aging demography continues to weigh on the economy. Lack of investments is going to contribute to further softness. 

Mr. Suzuki is a retired banker based in Tokyo, Japan.