Decoupling, and its impact on growth - Capital Economics
China Economics

Decoupling, and its impact on growth

China Economics Focus
Written by Mark Williams

The rift that has widened between China and the US was caused by China’s emergence as a geopolitical competitor to the US, rather than the personality of Donald Trump. Decoupling will continue whether or not the two reach a deal on tariffs. This may spur technological advances in some areas, but the net impact is likely to be slower productivity growth, and a more antagonistic relationship that could steer the two sides towards wholesale disengagement.

  • The rift that has widened between China and the US was caused by China’s emergence as a geopolitical competitor to the US, rather than the personality of Donald Trump. Decoupling will continue whether or not the two reach a deal on tariffs. This may spur technological advances in some areas, but the net impact is likely to be slower productivity growth, and a more antagonistic relationship that could steer the two sides towards wholesale disengagement.
  • China’s rapid emergence as an economic superpower was always likely to strain the global status quo. But this would have been manageable if China had evolved in the way that Western proponents of economic integration had hoped.
  • Most had assumed that market forces would compel China to step back from state intervention in the economy. But Xi Jinping has instead shored up the position of state firms. This has contributed to China’s economic deceleration. But the Party has shown itself willing to pay that price to retain control. The extensive use of industrial policy to support Chinese firms is raising hackles among competitors, which are increasingly from the major developed economies, too.
  • Hopes outside China that economic integration would lead to political liberalisation have not been realised either. Official measures to control flows of information, including the Great Firewall, and heavy spending on state security have been effective. Xi has reasserted the primacy of the Party over all aspects of society.
  • The result is that China has emerged as a superpower with a different approach to economic management and an entirely different set of values to the major developed economies. Given this set of circumstances, it was inevitable that Western powers would start to treat China as a strategic rival rather than a partner.
  • It was not inevitable that the US would respond by raising tariffs – that much can be laid at the door of Donald Trump. Subsequent US administrations (or perhaps Mr Trump after a deal) may roll them back.
  • But other efforts to decouple will continue. These include steps now underway to reduce dependence on each other for key inputs (such as semiconductors from the US and rare earths from China), and to put tighter limits on flows of investment, technology and people. China will step up efforts to promote the international use of the renminbi to reduce its dependence on the dollar for global payments.
  • As critical infrastructure becomes increasingly reliant on internet-connected components, wholesale decoupling in large parts of the tech sector is a rising possibility (though not an entirely new one: it already exists for internet services). Other countries are already coming under pressure to align with one side.
  • How far decoupling goes depends on decisions yet to be made in Beijing, including on non-economic issues such as Hong Kong, Taiwan, and the succession to Xi Jinping, and on how Western governments respond.
  • But integration is already going into reverse. The world is edging towards distinct economic spheres centred on the US and China, with different technology and standards. We continue to think it unlikely, but if the renminbi did take off internationally, there could be separate dollar and renminbi blocs for international trade too.
  • Geopolitical rivalry can generate productivity gains, as it did with the space race between the US and USSR. But it is more likely that limits to flows of people, technology and ideas hold back productivity improvements. As an economy that is still catching up, and that appears likely to double-down on a state-led economic approach if tensions rise further, China has more to lose.

Decoupling, and its impact on growth

Discussions about the origins of the trade war between the US and China typically focus on the role of Donald Trump. The central argument of this China Economics Focus is that the causes of the rift that has opened across the Pacific lie primarily in China. The relationship between the world’s two largest economies was set to change whoever won the 2016 US election. Tensions won’t go away when Donald Trump leaves the White House. That should influence how we think about the outlook for the global economy, and for China most of all.

This Focus is part of a series of reports from Capital Economics on the end of globalisation and the consequences for global growth and financial markets. Companion pieces can be found here.

The emergence of an economic superpower

China’s emergence has been the defining event of the latest wave of globalisation. In 1990, China accounted for 1.7% of global output measured at market exchange rates. By last year, its share had jumped nearly tenfold (to 16.3%). (See Chart 1.)

Chart 1: Share of Global GDP (%)

Source: IMF

The impact on global trade has been particularly dramatic. In 1990, the rest of the world traded more with Africa than it did with China, despite China’s population being 80% higher. (See Chart 2.) Now, China rivals the US as the largest node in the network of global trade. (See Chart 3.)

Some of this was just a matter of time. From the perspective of a Martian economist, the anomaly in Charts 1, 2 and 3 is not that China is an economic powerhouse now. It has been for most of history. It is that a country with one fifth of the world’s people was economically so small in 1990.

Chart 2: Global Goods Trade in 1990

Sources: IMF DOTs, Capital Economics. Circle size is proportional to share of global trade and line thickness to bilateral trade.

Chart 3: Global Goods Trade in 2018

Sources: IMF DOTS, Capital Economics. Circle size is proportional to share of global trade and line thickness to bilateral trade.

But the speed of China’s emergence has been extraordinary. Over the past ten years, China has gone from one-third to two-thirds the size of the US economy. When the US was on its way to overtaking the UK as the world’s largest economy in the nineteenth century, it took 30-50 years to do the same. (See Chart 4.) And the US didn’t dethrone the UK as the world’s largest trading economy until the First World War.

Chart 4: Size of US & Chinese economies as they caught up with global leader (size of global leader=1)

Sources: Bolt, Jutta & Jan Luiten van Zanden, 2015, World Bank, CE

The speed of China’s emergence has contributed to the current push-back against China, particularly from within the US. A series of influential “China shock” papers by David Autor and academic colleagues estimates that competition with Chinese producers resulted in 2.4 million job losses in US manufacturing between 1999 and 2011. Adjustment was made harder for firms and communities affected by the speed at which the shock occurred.

Admittedly, 2.4 million is not a huge number of jobs in a US labour force of 140 million, as it was in 1999. But this was a period of heightened economic insecurity. Overall manufacturing employment fell much more sharply in the US (see Chart 5), contributing to the perception that reverberations from the China shock were being felt and doing damage more widely.

Chart 5: US Manufacturing Employment (Millions)

Source: Refinitiv

However we shouldn’t overdo this point. The losses that some suffered would have been far outweighed by gains elsewhere, if China had evolved economically and politically in the way that proponents of engagement had hoped. But it didn’t.

From supplier to competitor

Outside a few sectors, China has not developed into a major market for producers from most advanced economies. The auto sector is an important exception: China is now the biggest global market for many manufacturers, including Volkswagen and General Motors. But Chinese demand is met mostly from factories within China. The benefits to Western auto producers have not translated into equivalent gains for their home economies.

In aggregate, China has for a decade run a surplus in manufactured goods that has remained close to 1% of global GDP. It’s manufactured goods imports have been only a little over half its exports. That has been partially offset by a deficit in commodities: China’s growth has been a significant source of demand (and delivered a positive terms-of-trade shock) for commodity producers. (See Chart 6.) For example, China has built more homes in the past five years than the US has in the past 100, to the great benefit of iron ore producers the world over. But Europe, Japan and the US are not among them.

Chart 6: China’s Goods Trade Balance
(% of Global GDP)

Sources: Refinitiv, Capital Economics

China’s persistent surplus in manufactured goods is the result of economic imbalances that favour investment over consumption, and of the extensive use of industrial policy to limit market access for foreign firms and to give domestic firms a leg up.

Chart 7: Informal Targets for Domestic Market Share in 2025 (%)

Sources: Ministry of Industry and IT, US-China Business Council

The latest example of industrial policy is the Made in China 2025 policy. This is a set of initiatives intended to raise China’s capabilities in sectors that the Party thinks will be the key drivers of future productivity growth. Other countries have similar aspirations (Germany’s Industrie 4.0 initiative is probably closest in its focus on advanced manufacturing). But China’s government is far more aggressive in pursuing them. Made in China 2025 includes massive financial support, restrictions on market access by foreign firms and informal targets for the domestic market share of Chinese producers in the selected sectors. (See Chart 7.)

Western businesses operating in China also complain about weaknesses of intellectual property protection, the difficulty of obtaining judicial or civil remedies, and procurement rules and licensing requirements that put them at a disadvantage.

These are not new issues. China has been publishing and following targets since the first Five-Year Plan was produced in 1953. Disputes over intellectual property protection have been a constant theme of foreign economic engagement with China for decades.

But two things have changed that have an important bearing on China’s economic relationship with the US and other advanced economies.

The first is that China’s move up the economic ladder is bringing more of its firms into direct competition with those from advanced economies. In the 1980s, 1990s and 2000s, industrial policy helped Chinese firms dominate in turn textiles, low-end manufacturing, and consumer electronics. But the firms bearing the brunt and forced to adapt were mainly elsewhere in Asia. (See Chart 8.)

Chart 8: Laptop Production in Taiwan
(million units, 12m sum)

Source: Refinitiv

The second is that it had been widely assumed that China would continue to step back from central-planning and from state control of its economy after it joined the WTO. This was a reasonable assumption at the time. China’s state sector was shrinking in the 1990s and early-2000s. (See Chart 9.) The experience of other fast-growing emerging economies in Asia was that industrial policy became less effective at generating growth as productivity levels rose. If it wanted to sustain rapid growth, the Party would have no choice but to step back.

But it has become clear since the Global Financial Crisis, and certainly since Xi Jinping became Party leader in 2012, that the state is no longer receding and that the Party intends to shore up rather than retreat from its control of the economy. Xi Jinping, General Secretary of the Communist Party of China, is, it turns out, a Leninist.

Chart 9: SOEs’ Share of Industrial Assets (%)

Sources: CEIC, Capital Economics

In retrospect, this now seems predictable. Western proponents of engagement with China argued forcefully that economic liberalisation would lead to political liberalisation. The Party set out to make sure that it didn’t. and its efforts to control information flows, including with the Great Firewall, have been effective. It has prevented the emergence of any groups in civil society than could grow into an alternative to the Party. The Global Financial Crisis increased confidence within China in its own approach.

Our view is that by preventing market forces from allocating resources, the leadership’s approach is contributing to a sizeable deceleration in growth. The Party is aware of this trade-off but considers economic slowdown preferable to loss of control.

Chart 10: Revenues of Major Listed SOEs (% of GNI)

Source: OECD

The result is that China, 18 years after WTO entry, operates in a very different way from any other major economy in the developed or emerging world, with a larger state sector (see Chart 10), considerable state oversight of major private firms, and aggressive use of state resources to benefit selected firms.

From competitor to rival

In any circumstances, China’s pursuit of its own, distinct economic model would have created global strains as it emerged as one of the world’s largest economies. But the key development that has pushed US-China relations in a different direction is that China has simultaneously emerged as a geopolitical competitor with a very different set of values to the major developed economies.

The emergence of a new power is not always disruptive to the status quo. Japan was the last country to trigger worries in the US that it was being overtaken, in the 1980s. But Japan was a US ally that hosted US military bases. Similarly, when the UK finally accepted that it was no longer the global superpower, it gave way to an ally, the US. There is nothing inevitable about the Thucydides Trap.

In the 1990s, many in the West argued for economic engagement on the grounds that it would steer China towards embracing more of the West’s values and so help it evolve into an ally. Bill Clinton made this the centrepiece of his calls to support China’s entry to the WTO, saying in 2000 that “By joining the WTO, China … is agreeing to import one of democracy’s most cherished values: economic freedom… and that may lead to profound change. The genie of freedom will not go back into the bottle”.

As noted above though, China’s leaders have been proactive in countering this threat to their power. Under Xi Jinping, China has become more authoritarian, not less. Tens of thousands have been imprisoned on corruption charges. A million Uighurs are in camps in Xinjiang. Space for civil society has been further reduced and the primacy of the Party has been reasserted. Xi told the Party Congress in late 2017 that “Government, military, society and schools, north, south, east and west – the Party is the leader of all”. And China is becoming more assertive globally. It has expanded military bases in the South China Sea, and is using its Belt and Road initiative to increase its influence further afield. The Party is promoting its model (as Xi put it in September) as a “new option for developing countries”.

As a result, the premise on which arguments for economic integration were based no longer hold. Bill Clinton argued that engagement would help steer China to becoming an ally. Instead, viewed from the perspective of the incumbent global superpower today, it seems to be enabling the rise of a strategic rival.

Decoupling is already underway

This is the challenge that China under Xi Jinping poses to the existing order: it is large and powerful; it uses policy aggressively to benefit Chinese firms over foreign competitors including, now, many from the advanced economies; and it has made a clear choice not to embrace liberal democracy. Any deal that Donald Trump and Xi Jinping agree on tariffs will not relieve these underlying tensions. And when Donald Trump is no longer US president, the West will still have to respond.

That response will be led by the US, but it notable that pushback to the status quo is not coming only from the US. Several countries have restricted use of Huawei equipment over the past two years. The European Commission this year warned that China is a “strategic competitor” and “systemic rival”. Many governments are still trying to figure out what to do.

It was not inevitable that the set of challenges posed by China would lead to a trade war fought with escalating tariffs. Tariffs can reshape supply chains but are a blunt tool. It is possible that they will be rolled back after the 2020 US election or as the result of a deal agreed by President Trump. But other forms of decoupling are underway and are likely to persist.

Chart 11: Share of China’s Soybean Imports from US
(%, 12m sum)

Source: Bloomberg

One is that the US and China are making efforts to reduce their dependence on each other for important inputs. China used to rely on US farmers to provide nearly half the soybeans it imports to feed its pigs. That share has fallen to under 10% as part of the tit-for-tat of the trade war. (See Chart 11.) That share will rise if a short-term trade deal is signed. But China won’t allow itself to become so dependent on US farmers again. Soybeans were already an anomaly: Despite a lack of arable land (only 7% of the world total), China is largely self-sufficient in other grains.

Similarly, US threats to stop US firms selling to Huawei have brought home how reliant China’s tech sector still is on some high-end components that only the US produces. China still spends more each year importing semiconductors than it does oil. That is a vulnerability it is working hard to reduce.

In the other direction, the world is waking up to the vulnerability created by China’s near monopoly in the production of rare earths, which are essential for many tech products. Until recently, China accounted for 90% of global production. But there are deposits in many countries and there is now pressure to diversify supply, in part in response to explicit Chinese threats to cut off exports for leverage in political disputes. Output outside China last year was the highest ever. (See Chart 12.)

Chart 12: Global Rare Earth Production
(Thousand Metric Tons)

Source: US Geological Survey

Soybeans, semiconductors and rare earths are examples of disengagement at the level of individual products.

Decoupling is also happening now through tighter visa rules in the US for Chinese students and researchers, stricter controls on exports of technology, and tighter oversight of investment. Net investment by Chinese firms in the US was negative in each of the past two years.

A new front is likely to be over standards that could lead to incompatibility between products from the two sides. And Elizabeth Warren has proposed embedding the concept of reciprocity in any future US trade deals: other countries would have to meet US standards on labour conditions, human rights and the environment. That would have the effect of restricting trade – and it is a reminder that the pushback to China in the US is not coming solely from Republicans.

The splinternet and beyond

In the tech sector in particular, these incremental steps could soon lead to wholesale decoupling. This isn’t new. China already bars Facebook, Google and Twitter. The splinternet is already here. But it is now spreading to hardware.

Some are arguing that any sort of internet-connected device is in principle vulnerable to being compromised by a hostile government and so the only safe course of action is to ban devices that aren’t made at home or by a trusted ally. Huawei is the most talked-about example, but the issue is about any device that can receive or transmit data. A number of US senators have recently started moves to restrict sales in the US of Chinese-made drones.

These debates are being conducted in the open in the West. But similar debates have been taking place behind closed doors in China about the risk of using US or European equipment and software in telecommunication networks, self-driving cars, power systems and other infrastructure. So we may be moving to a world in which US and European tech firms can’t sell many of their products or license their technology to China and vice versa.

There are also efforts to decouple financially. The US is reportedly considering blocking portfolio investments from the US to China and Chinese firms from listing in the US. China has been trying to promote the international use of the renminbi to reduce its reliance on the US dollar (those efforts go back to the Global Financial Crisis, which exposed how dependent China was on the dollar clearing system for trade, but have been given extra impetus by the US leveraging its position to impose sanctions on Iran).

Decoupling’s impact on growth

In other words, economic decoupling is already happening in many different ways. In terms of how this will play out, the obvious analogy to draw is with the Cold War split between the US and Soviet Union. But this was an extreme situation. China is tightly integrated into the global economy in a way that the Soviet Union never was. The Soviet Union did not just not trade with the US. It barely traded with anyone. (See Chart 13.) There is no realistic prospect of China choosing to return to such isolation or having it imposed.

Chart 13: Goods Exports Plus Imports
(As a % of Global GDP)

Sources: World Bank, Capital Economics

But there is a wide spectrum of outcomes falling short of complete disengagement that would still constitute a significant change to the status quo. And the severity of the impact is likely proportional to how completely the two sides split.

That said, decoupling itself is probably less of a threat to long-run growth in China than many would initially assume.

Other things equal, barriers to flows of people, products, finance and ideas hold back productivity gains. At a global level, decoupling will also result in redundant investment.

But losses will be inversely proportional to the size and level of development of the economy concerned. Trade allows small economies to generate big productivity gains by focusing on areas of comparative advantage rather than meeting all needs domestically. Poor economies benefit from exposure to global markets to pull their technological capabilities closer to the frontier.

For these reasons, a wholesale move towards trade protection and self-sufficiency would have prevented China making the economic leap that it did if it had happened in the 1990s. China’s growth at that stage depended heavily on foreign direct investment and the import of technology and ideas as foreign firms – mostly from elsewhere in East Asia – relocated manufacturing facilities. Foreign demand catalysed faster productivity improvements than would have happened if manufacturers had targeted the domestic market alone.

Any movement of firms out of China in advanced sectors as a result of decoupling would at the margin hold back potential gains. But foreign firms are far less important than they were. Foreign demand matters less too in driving productivity. Exports generated 24% of GDP in 2006; that had dropped to 15% by 2016. China’s domestic market is large enough to generate significant competition and productivity gains (as we have seen with Tencent and Alibaba for example) even if isolated from the rest of the world. And if decoupling led not to China being isolated but to a world of separate economic spheres centred on the US and China and perhaps Europe, China’s sphere would be huge.

A key uncertainty is whether China is able successfully to decouple from the dollar. We have long been sceptical: widespread use of a currency in trade depends on there being easy access to the currency around the world. In turn, that depends on three things that the renminbi has long lacked: an issuer running a current account deficit, or large net outward investment so that global holdings of the currency rise; deep, liquid and open capital markets, so that foreign firms are willing to hold balances in the currency; and confidence in the issuer not to devalue the currency or restrict access to capital markets.

Despite China’s efforts, global use of the renminbi outside China is still miniscule (see Chart 14) and on many measures going backwards: a key driver of offshore accumulation until 2014 was the expectation that the renminbi would appreciate. As that belief has faded, so the speculative justification for holding the renminbi has gone away. Available data actually overstate the currency’s importance, since much “offshore” renminbi activity happens no further abroad than Hong Kong.

Chart 14: Currency Share of International Payments (%, August 2019)

Source: Swift. Excludes payments within the euro-zone

China has been opening its financial sector to more foreign involvement which would encourage offshore use of the renminbi over time if it continued. But there is an inherent contradiction between the leadership’s desire to attract foreign capital and its desire to maintain control over domestic financial conditions. Over time, increasing distrust of the West is likely to make China more cautious about opening its financial markets further, which will continue to hold the renminbi back.

China may have more success in encouraging use of the renminbi in commodity trade where it has greater leverage, but the global impact would still be small. Even trade with Russia is currently settled overwhelmingly in dollars: renminbi settlement accounts for only 14% of the total, according to Russia’s finance ministry.

The space race, revisited

Some argue that decoupling could drive a further jump up the productivity ladder by forcing Chinese firms to be more innovative. And there are examples of economic division leading to productivity gains. One is the invention of Fanta in 1940 by Coca-Cola Deutschland, when it was cut off from its usual foreign suppliers. More seriously, the space race between the US and the Soviet Union serves as an example of how geopolitical competition between rivals can spur technological advances.

But that was a very special case in which the state was able to focus resources on a defined goal. The Soviet Union’s successes in space did not catalyse broader productivity gains across its economy.

Similarly, the last decade in China should be a salutary lesson in the effectiveness of state-driven economic development. China has little to show for the vast amounts spent on developing a domestic semiconductor or commercial jet industry. As resources have been shifted to state firms and to programmes selected by the Party, economic growth has slowed, and by far more than most had considered likely a decade ago.

China’s use of industrial policy is often viewed as effective and, to set against the failures in semiconductors, it has succeeded in creating globally-dominant producers in areas such as solar power and steelmaking. But these successes have been characterised by excess capacity, the build-up of unsustainable debt, and misallocation of resources.

In other words, the key downside risk for China’s growth prospects from decoupling with the West is not that it cripples the economy, but that the leadership’s response does.

Mark Williams, Chief Asia Economist, +44 20 7811 3903,