The Faltering of “Global Circulation”

In economics, exports, investment and domestic consumption are often thought of as the troika that drives GDP growth. Over the past 40 years, exports and investment have together shouldered the burden of China’s economic growth: exports generate foreign exchange, enabling China to buy foreign machinery and technology; while domestic investment, especially infrastructure investments including roads and bridges, lowers costs of trade and doing business as transport costs fall. Exports and investment complement each other and together form a “global circulation”, in which China uses its trade surplus to invest in fixed assets. And in this way, the second largest economy came into being.

Compared to exports and investment, domestic consumption relatively lagged behind in driving economic growth. However, in the past decade, the explosive growth of China’s urban middle class and the soaring household income significantly lifted China’s domestic purchasing power. As such, the Chinese central government is pivoting to domestic demand as the economic mainstay.  

If we look back, it is notable that China has experienced enormous changes, internally and externally, in past decades. At the time when China’s economy relied heavily on exports and investment, externally, it had friendly economic ties with the US. In the “global circulation”, on one hand, China’s manufacturing industry boomed under the stimulation of foreign demand; its economy grew rapidly, and people’s livelihood therewith improved. On the other hand, western countries benefited from China’s cheap and high-quality exports and enjoyed decades of low inflation. This was definitely a win-win situation.

However, in the past few years, as China’s economy continued to expand and its GDP gap with the US tightened, the US has begun to see China as one of the biggest threats to its hegemony. Therefore, the US Administration, being increasingly hawkish, has sanctioned China in different spheres, from technology, trade, to finance, mainly aiming to slow down China’s economic growth. Furthermore, with more and more companies moving their low value added production bases to cheaper alternatives, China is gradually losing its status as “the factory of the world”. After all, rising wages, land prices, and materials costs on the mainland naturally squeezed out China’s low cost production base. The COVID-19 pandemic was the last straw that broke the camel’s back; the economic recession has prompted the rise of trade protection policies of various countries, and the voice of decoupling supply chains from China has appeared.

Under such circumstances, the “global circulation” has begun to falter.

The Debut of “Domestic Circulation”

Every cloud has a silver lining. China’s policymakers are also well aware of the current situation and have been exploring another way to stimulate economic growth in recent years, and this path exactly points to domestic consumption.

At a forum with more than 50 Chinese and foreign enterprises on July 21, President Xi Jinping reiterated a strategy laid out in May that China would further unleash domestic demand, rather than exports and investment, to fuel economic growth, which he called a “domestic circulation”[1].

Why domestic consumption?

First, China has a large population; more than 1.4 billion people make up a huge domestic market and fertile soil for consumption growth. Second, there is much room for growth; China’s domestic consumption accounts for only about 39% of its GDP, which is far lower than those of other East Asian countries, such as Japan (55%), South Korea (48%) and Taiwan (52%)[2]. Third, the increasing household income, the still very high saving rate altogether with the rising demand for consumer discretionary powered by the expanding urban middle class, bring further force to the growth of domestic demand.

The relationship between China and the World Economy

As China put forward the strategy of “domestic circulation,” there are worries that China might stop opening up.

We see clear signals that China’s domestic consumption has to be supplemented and supported by global development. History has also shown us that closed-door policies usually bring decay. It is apparent that China’s top decision makers are mindful about the risks behind being domestically oriented. Mobilizing the latent domestic consumption power never meant overlooking exports and investments’ contributions to economic growth. In fact, the key to China’s next stage of growth is to integrate domestic circulation and external circulation.

For foreign investors, a stronger domestic consumption power will help shift China’s role in the global industrial value chain. Today, China is gradually evolving from a “cheap production base” to a competitive consumer market. Indeed, production base and consumer market have their own advantages, and it is hard to say which of these foreign investors may prefer more. For China, however, it is impossible and unnecessary to return to the state of “the factory of the world”, and it is better to accept its new identity as a consumer market, which is also what current policy makers have chosen.

In fact, the enhancement of China’s consumption power has already occurred and is obvious to all. With the escalation of the Sino-US trade war, international manufacturers that have facilities in China have gradually developed an “in China, for China” strategy, which means as the US tariff barriers increase, more and more multi nationals are reorienting their China investments to serve local consumptions rather than for the international market. We see this trend is made possible on the back of China’s enormous and still increasing domestic spending power.

Morgan Stanley pointed out that the essence of the “domestic circulation” is opening-up. According to Morgan Stanley, “domestic circulation” can attract multi nationals to retain their supply chain, factories and stores in China by releasing the potential of China’s consumption. Together with the protection of intellectual properties, improvement of the business environment and reduction of access restrictions, foreign businesses can have a slice of the China’s consumer market pie.

Of course, in addition to the role as a growing consumer market, there are other advantages that foreign businesses may factor into the equation when investing in China, including the strong technical expertise of suppliers, industrial supply chain aggregation, and a disciplined and high-quality labor force. These factors have kept a lot of global supply chains in China and have discouraged large scale decoupling.

In strengthening the domestic circulation, the Chinese government also needs to carefully balance various economic factors, including the possibility of the international trade and service account balance turning from a surplus to a deficit. However, we believe that there are still a lot of measures that China can employ to assuage this risk, one of which is to turn its residents’ overseas consumption into spending back home.

In short, the relationship between China and the global economy is just like the relationship between water and fish. Fish cannot survive without water, and water will slowly stagnate and dry up without fish. Only when the “domestic circulation” and “global circulation” work together can China and the world move towards fulfilling common interests.

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[1] Source: Xinhua Net, as of Aug 2020

[2] Source: CEIC, as of Aug 2020

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