- China's ability to sustain stronger economic growth than most has been a key credit support factor for the sovereign.
- Recent developments could see some manufacturers reduce investment in the country, which could affect future growth negatively.
- However, we expect domestic demand to help maintain growth at rates higher than most. Many foreign manufacturers are also likely to continue investing in China due to the fast-growing domestic market.
Once the economic shock of COVID-19 passes, a broader question about China's growth trajectory will remain. Geopolitical tensions and supply disruptions threaten to accelerate the migration of manufacturing out of China. Departing producers could make it harder for the country to continue on a structural strong growth trajectory.
Short of a major change of heart among economic policymakers, S&P Global Ratings believes the Chinese economy will continue to grow faster than most for many years. The country's future economic expansion remains pegged to its huge and growing domestic market, as well as many opportunities to make efficiency gains through reforms. While absolute growth rates will moderate, we believe China's economic performance will continue to be a key sovereign credit support.
We also believe China will retain its manufacturing prowess, given its competitiveness, as well as the desire of foreign producers to continue to access the Chinese market.
The proximate risks to the sovereign ratings continue to be a further weakening of financial stability if credit growth rebounds strongly. This could also damage the fiscal position more directly if strong credit growth reflects a resurgence of lending related to off-budget government financing.
Strong Economic Growth A Key Sovereign Rating Strength
China's economy is a strength for the sovereign credit ratings. The World Bank considers China, with GDP per capita at about US$10,000 this year, a middle-income country. Its growth performance is consistently above other economies of its income level. We estimate China's average real GDP per capita growth over 2014-2023 to be close to 5% annually. For the same period, the median for sovereigns with average income of up to US$17,700 is 2.3% per annum by our estimates.
China's strong economic growth up to 2008 was associated with its rise as a global manufacturing and export giant. This was especially so after it joined the World Trade Organization in 2001. Chinese exports rose rapidly to over 35% of GDP in 2007 from about 20% in 2001 (see chart 1). In 2005-2007, the increase in net exports contributed between 1.1 and 1.8 percentage points of real GDP growth. If we include the contribution of related investment spending, the manufacturing sector was an even more important source of growth during that period.
Threats To Exports And Manufacturing Growing
Recent developments have cast doubts about the continued growth of Chinese manufacturing and export activities. Manufacturers have been shifting away from their traditional bases in the coastal regions of China for a number of years. Although some factories moved to the inland parts of China, many relocated out of the country. Cost pressures--associated with higher wages and stricter environmental requirements--on profit margins were important reasons for this trend. In a few cases, tensions between China and its neighbors could also be a reason.
Escalating U.S.-China tensions accelerated this trend. The U.S. is one of China's top export markets. Persisting bilateral tensions have led some producers to move production meant for the U.S. market out of China. For instance, a recent report from Panjiva, a product offering from S&P Global Market Intelligence, noted that U.S. imports of solid-state memory from China fell sharply in March this year even as imports from Korea and Malaysia more than doubled. Manufacturers are also more likely to consider geopolitical reasons in their investment decisions. This could reduce their willingness to set up big operations in any single country.
Some governments may encourage geographical diversity of manufacturing production using regulations, laws, or incentives. Recent supply disruptions associated with the COVID-19 pandemic have increased awareness of the risk of production concentration in one country. In April, the Japanese government announced financial support of nearly 250 billion yen (US$2.2 billion) for Japanese manufacturers who are moving their production out of China. In the near future, it is likely that some governments will introduce rules and laws that encourage the production of certain items within their national borders.
These trends could weaken Chinese economic growth prospects and the government's credit metrics. Export growth may come under increased pressure. Fixed asset investment in the manufacturing and related sectors could weaken. This weakness could be exacerbated by U.S. restrictions on sales of certain technological goods to Chinese entities. And the knock-on impact on employment in these sectors could also subtract from household income, government revenue, and consumption growth.
Growth Should Still Outperform Despite Weaker Exports
Future Chinese economic growth is likely to be negatively affected by these relocations. However, they should not cost China its outperformance in trend economic growth, in our view. In the past few years, the manufacturers that had moved elsewhere owing to rising costs and U.S.-China tensions have not materially slowed China's real GDP growth. An acceleration of departures for the reasons mentioned earlier could certainly tug future growth lower. However, we do not expect the damage to be severe.
One reason is that export plays a relatively small role in China's growth. According to the Chinese statistical agency, the contribution of net exports (of both goods and services) to real GDP growth has been well below one percentage point each year since 2008 (see chart 2). This indicator likely understates the importance of exports because indirect negative impact exists. Nevertheless, adjusting for this indirect impact is unlikely to increase the importance of exports markedly. The damage of falling exports to China's economy is likely to be gradual, with possibly more visible impact in the long term if the policy responses are insufficient or inappropriate.
China's growth is likely to rely even more on domestic demand in the future. Over time, consumption has become the main source of economic growth in China. This reflects structural changes that helped to raise the share of household income in economic output. Workers' compensation as a share of total value added, for instance, has increased to above 50% from about 41% just before the 2008 global financial crisis (see chart 3). This increase brings the wage share of income in China closer to where other Asian economies are. And it means that China, like other large economies, depends mainly on domestic demand to sustain economic growth.
We think it is also possible that the economic contributions of Chinese exports may not fall by much even if they grow more slowly. Today, China adds relatively little value to many of its high-tech exports--mainly computer and telecommunications equipment or components. Various studies examining the Apple iPhone, for instance, have concluded that only a small fraction of the production cost of the device was incurred in China. However, Chinese domestic content in its exports have risen over the years, according to a paper published in the American Economic Review (see "Domestic value added in exports: Theory and firm evidence from China"). If the trend picks up pace, weakening export growth may not subtract much from overall GDP growth.
Manufacturers Have Reasons To Remain In China
China's policymakers are aware that domestic content of the country's exports may not increase further if foreign manufacturers shun China as a production base. In this case, the transfer of technology and management know-how into the country may slow. Advanced economies are already increasingly wary that such transfers could harm their competitiveness and economic security.
China is mitigating such damage by making changes to increase the country's attractiveness to foreign investors. Early this year, it implemented fundamental changes to the legal environment facing foreign businesses by amending the Foreign Investment Law. During the past few years, China also introduced changes that resulted in its World Bank's Doing Business 2020 ranking improving to 31 from 78 in the 2017 survey. Over 2020, it is also lifting foreign shareholding restrictions in key areas of the financial sector. These changes signal China's continued eagerness for foreign businesses to participate in its economic development despite the deteriorating global environment.
China's market potential is another reason why foreign manufacturers may continue to produce in the country. Already, companies such as General Motors, Samsung, and Toyota count China as one of their top markets. The growing role of consumption mentioned above also means that many foreign-owned factories in China will produce more for the domestic market than exports. A survey of American firms in China conducted in March this year showed that most are intending to make new investments in the country to tap its domestic market.
China also remains a very competitive base for factories. The reason why so many manufacturers are found in the country is due to advantages that help to keep overall costs down (see chart 4). These include the large pool of skilled labor, the generally high level of education, strong infrastructure, and heavy investment in research and development. Moreover, due to the size of the Chinese manufacturing sector, suppliers are plentiful. Businesses can therefore respond quickly to changes in consumer demand.
These conditions make possible profit margins for some producers that are unsustainable elsewhere. Large manufacturers with stronger pricing power can afford to diversify their production across more than one location. Smaller companies in competitive industries may become unviable if they move to more costly locations.
Nevertheless, some such companies may still shift out of China with government support. For certain products, such as key medical equipment or medicine, governments can encourage production within their borders or in third countries through subsidies such as guaranteed price levels or import tariffs. The U.S. government, for instance, recently signed a contract with a firm to produce ingredients needed for the treatment of COVID-19 in the state of Virginia. However, such subsidies are costly if applied across a wide spectrum of products. While some advanced economies may be able to sustain such costs, it is unlikely that many of China's fast-growing neighbors will be able or willing to do so.
Technological restrictions may also lose effectiveness over time if China continues to be an attractive market. The damage that COVID-19 is doing to government and household balance sheets could have a prolonged impact on economic growth of many countries. If Chinese policies help to keep domestic demand growing more strongly than other large economies, firms that are restricted from selling to the country will face important lost opportunities. Some may change their business or operating models in order to regain market access.
Sudden Change In Policy Orientation Still The Main Threat To Strong Chinese Growth
We believe China's trend growth at this stage of its development depends most importantly on policy continuity. A large and highly competitive manufacturing sector nested within a middle-income economy suggests that economic efficiency is unevenly distributed in China. Lifting the efficiency levels of the less competitive sectors is the key to sustained growth in the next decade or so.
China does not face the usual impediments that many middle-income economies face. A large pool of domestic savings and the high penetration of financial services make financing widely available at relatively low cost. The potential for skill and knowledge upgrading is strong in a population with a high level of education. And, after years of heavy investment, Chinese infrastructure can hardly be considered a constraint on growth.
Policy changes in the past few years could help to further China's economic development. These include:
- Introducing measures to include the private sector in more public sector projects.
- Removing excessive administrative approval for business activities.
- Improving the credit availability of private enterprises.
- Reducing the taxes and charges on individuals and private enterprises.
- Improving the business environment facing foreign enterprises.
In our view, the continuation of policy changes in these directions could help keep growth stronger than other economies at similar income levels. Absolute growth levels are likely to be lower than before for a few reasons. However, policy changes that facilitate the allocation of more income to the household sector and level the playing field for foreign and domestic private businesses will help unleash the country's economic potential.
The biggest risk to continued superior economic performance is a major change in economic policy orientation. In the past few years, China has seen mounting geopolitical pressures. Domestic changes also had, at one point, encouraged a more nationalistic approach toward economic development. If future developments cause the policy settings to turn hostile toward foreign businesses or to favor public sector firms more explicitly, the impact on China's growth could be quite negative. The closing of the economy stemming from such changes may be the most likely reason for the country to lose its luster among peers.
Kee, H and H Tang (2016), "Domestic value added in exports: Theory and firm evidence from China," American Economic Review 106 (6): 1402-1436.
This report does not constitute a rating action.
|Primary Credit Analyst:||KimEng Tan, Singapore (65) 6239-6350;|
|Secondary Contact:||Rain Yin, Singapore (65) 6239-6342;|
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