The "dual circulation" and "China plus one"

There are two very interesting global dynamics at play about China. On the one hand, China has started pursuing a policy of economic growth anchored on the domestic market, with the global market as support cast. On the other hand, the multinational corporations are pursuing a policy of making in China for China, and making elsewhere for the rest of the world.

It will interesting to see how each of these two trends play themselves out in the years ahead. The architecture of the global value chains as well as global trade and economic growth will depend on them. 

Internally, following President Xi Jinping's announcement in May, the Chinese have formally adopted a dual circulation growth strategy, "a new development pattern in which domestic and foreign markets boost each other, with the domestic market as the mainstay". The world to revolve around the big Chinese economy! 

Externally, hastened by the events in the aftermath of the Covid 19 pandemic, major economies have realised the over-dependence of the global manufacturing supply chains on China. Accordingly, global businesses have resolved to diversify away from China by pursuing a China plus one strategy - use China as the manufacturing hub for its domestic market, but cultivate manufacturing bases in other countries to serve the global market. China for China, and some others for rest of the world!

Yukon Huang and Joshua Levy have a good analysis of the problems facing dual circulation strategy. Whatever the strategy, China's future will depend on it being able to address egregious distortions - between regions, between rural and urban, between producing and consuming, public and private sectors, and the massive debt overhang. Sample this,

Last year investment accounted for 43% of China's gross domestic product. That is not, in itself, a reason for worry, but capital's diminishing efficiency is a cause for concern. Economists evaluate returns on investment with an indicator called the incremental capital-output ratio, which measures how many units of investment are needed to generate a single unit of GDP. Since 2005, that number has nearly doubled from 3.3. to over 6 in 2017, reflecting a halving in returns on investment in China... The International Monetary Fund estimates that fixed-asset investment accounted for about half -- roughly 5 percentage points -- of China's GDP growth over the past several decades... Today, private companies' rate of return on assets is around 9% whereas SOEs only offer around 4%.

There is little to suggest that any of the cleavages are narrowing in a meaningful and sustainable manner.

Besides, there are three aspects of President Xi Jinping's economic paradigm, of which "dual circulation" is an important part, which have the potential to engender distortions. One, a feature of the new paradigm has been the return of state-owned enterprises (SOEs) as important economic actors. The SOEs are being cultivated to become dominant players in their respective market segments. Second, the China 2025 plan seeks to achieve not only self-sufficiency but also global market dominance in several identified industries. Three, the Communist Party's control over Chinese businesses, even private ones, has become more direct and institutionalised in recent years. This effectively forces multinationals dealing in China to engage directly with the Party. 

If these three aspects end up having an inordinate influence on "dual circulation" then it is also likely to end up hurting the interests of multinational corporations and create one more reason to reduce their exposure to China for non-economic reasons. 

The recent decision to pull the plug on the ultra-high profile IPO of Ant Financial at the very last minute came at a very high cost to China's credibility. It points to Xi's willingness to incur any cost to drive home the message about the supremacy of the Party and the system. No one matters. It clearly signalled the boundaries of engagement for the Chinese private sector. It's only the latest illustration of the authoritarian nature of the regime. The same attitudes underpin foreign policy too, with the numerous recent instances of take-no-prisoners Wolf Warrior approach to diplomacy. See this and this. 

The China plus one strategy has its roots going back to at least a decade, arising from the trend of high labour costs causing businesses to shift some of their more labour-intensive activities to countries with lower labour costs. So, it was more a case of giving a name to a practice which was already afoot rather than any conscious effort to move out of China. However the trade war with the US initiated by President Trump may have introduced the risk mitigation by diversification of supply chains and production locations. The pandemic has surely introduced an element of urgency and importance to this trend. Countries like Japan have even offered financing support to help their companies to shift production out of China. 

Be that as may, there is also a need to be cautious about reading too much into the shifts happening to a neighbouring country like Vietnam. For a start, there is only so much that Vietnam can absorb. Then, it's one thing to shift to Vietnam across the border, and an altogether different thing to shift into South Asia or Sub Saharan Africa.

As I have blogged here, any attempt to shift out of China is easier said than done. Apart from the inertia associated with breaking apart comfortably ensconced supply chains, China offers important factors which few, if any, others can match - large pipeline of skilled workers; localised manufacturing ecosystems that encompasses design, prototyping, and production; strong supplier networks; world-class infrastructure; and a massive domestic market. Only when the extenuating factors - labour cost and concentration risk - start to offset these considerable advantages in a significant manner would commercially attuned firms feel compelled to shift in a meaningful enough manner. 

But the non-economic extenuating factors appear to be growing in importance. For example, the changing geo-politics appears to have already influenced the plans of the largest manufacturers like Foxconn. They appear to be shifting towards a strategy of producing in China for China and gradually shifting production, at least in terms of new investments, toward other countries for their export markets. 

Another extenuating factor can be the rise of protectionist tariffs and other non-tariff barriers which slows down and reverses trade. And China's aggressive foreign policy actions may actually be triggering and hastening this trend. A full-fledged Cold War between China and several western countries is well within the realm of possibilities. It is safe to argue that, even with the exit of President Trump, any form of technology related trade between China and the west is now off the table. 

In the final analysis, the repressive, completely centralised, and individual-cult based nature of the regime shift during President Xi Jinping's tenure will be the Achilles heel of "dual circulation" or any other reform. See this, this, and this. History does not have precedents that point to any other direction. 

Francis Fukuyama says that historically China's biggest issue has been the bad emperor problem. Democracy puts a floor on the bad emperor - if he gets too bad, then he can be removed. It has had a long history of recurrent bad emperors. Its recent four decades of prosperity has been due to its ability to keep out bad emperors. Xi Jinping may well have ended that period of good fortune!