China is No Longer an Expanding Economy that Allows Everyone to Succeed

Simone:
Tesla CEO Elon Musk was showered with compliments and feasts in China last month. He also met with China’s foreign and commerce ministers and industry leaders.

According to Reuters, the foreign ministry quoted the billionaire as describing the U.S. and Chinese economies as “conjoined twins” and said he opposed their decoupling.

On the same day, in the same city – Shanghai – Jamie Dimon took center stage at JP Morgan Chase & Co.’s China Summit, which opened with a speech titled “We’re Back!” Dimon said in an interview that the largest U.S. bank he runs will be in China through good times and bad, and that he doesn’t see a decoupling between the West and China, while acknowledging that the situation is “much more complex now.”

They are not alone. In recent weeks, executives from Starbucks, GM, Apple, and a host of high-profile investors have made appearances in the country.

These appearances are no accident. The Chinese government wants to use them as positive examples to entice skeptical foreign investors back into the country. And it is fair to say, at least for Mr. Musk and Mr. Dimon, that they were sincere when they said that the two economies should not decouple.

They made it in China and they continue to profit in China. But the question is whether their stories can be repeated by others.

Most foreign companies are having a hard time in China these days, and so are China’s own companies. These two success stories are the product of unique circumstances.

China’s burgeoning EV industry not only owes its birth to Tesla’s open-source technology, but continues to rely on the industrial chain that Tesla created. The number of EVs sold in China has increased fivefold since Tesla began manufacturing in the country. Tesla’s Shanghai Gigafactory now produces 95% of its parts in the country. The Texas-based company is effectively driving China’s entire EV industry ecosystem.

The relationship is reciprocal. Tesla is also betting on the Chinese market, which accounts for 52% of its total global sales by 2022. It is not an exaggeration to say that Tesla China is funding Mr. Musk’s real dreams, such as sending people to Mars. He will not leave China until he has to.

Can Musk’s story be repeated by other foreign manufacturers? Almost impossible. Most companies would not open source their technology, and China does not allow its industrial chain to be driven by a foreign company if it has other options.

Even for Tesla, while it has increased sales in China, it has also lost significant share. From 15% in 2020, its share of China’s EV market fell to just 10% in 2022, according to CPCA data. Even Musk himself has acknowledged that China is where his company could face its toughest competition.

Chinese financial expert Zang Qichao once famously decoded China’s three-step strategy toward foreign companies: form joint ventures, acquire technology, and eventually dump foreign partners.

Zang Qi Chao:
40 years after China opened up, now we are at a place where the factory is ours, the equipment is ours, the patent is ours, the products are ours, the market is ours, the brand is ours, and the foreigners are all gone.

Simone:
It is an exaggeration, but largely true.

J.P. Morgan has a different kind of success story in China. Besides being one of the most prestigious investment banks, JP Morgan also understands the secret for victory in China’s financial industry. The Wall Street Journal reported in 2016 that the U.S. bank agreed to pay $264 million and admitted to violating the Foreign Corrupt Practices Act – which prohibits U.S. companies from paying bribes to foreign government officials to win business – by hiring so-called princelings.

According to the settlement document, J.P. Morgan hired about 100 candidates referred by government officials at Chinese state-owned enterprises. This means that in addition to winning business, the bank would receive regulatory favors and insider information, which is critical in a financial system run by power and connections. As one of the world’s most prominent investment banks trying to make it in China, this kind of operation is inevitable.

In 2021, JP Morgan received regulatory approval from Beijing to become the first full foreign owner of a brokerage firm in China.

Many see this as a result of China’s lifting of foreign ownership limits in securities and fund management companies in April 2020, after the trade war. However, according to Bloomberg, the number of foreign companies that have received such status remains low, at five as of January 2023.

This raised a question: Just because companies like Tesla and J.P. Morgan have succeeded in China, does that mean anyone else can make it in China? The answer is no. The truth is China faces serious challenges that make it unable to sustain an expanding economy in which most companies can thrive.

The biggest challenge is population. China’s population is now declining. 2022 marked the first drop in total population in six decades, since the famine of the Great Leap Forward. In 2022, around 9.56 million babies were born in China. China has sustained a steep birth rate decline since 1988. The current birth rate in 2023 has declined 2.36% from 2022. The official count is in dispute but demographer Yi Fuxian predicts China’s population will decline to 1 billion by 2050. The latest edition of the U.N. World Population Prospects report estimates it could fall to 767 million by 2100.

China’s rapidly shrinking population means that the property market will not recover no matter what the government does. Meanwhile, China has no other pillar industry to replace real estate. Without real estate, China will not be able to sustain the projected GDP growth which will in turn hurt investors’ confidence in the Chinese economy.

China’s population is aging as well. The two factors together will make China lack the labor force to maintain its status as the world’s factory. Consumption will also decline as the population shrinks, while local government debt piles up to the point of default.

On top of all this, Xi’s policies are unpredictable. Although China promises to open up and welcome foreign business, few are confident that won’t change.

China’s most profit-guaranteed industries, such as energy and telecommunications, are all dominated by state-owned enterprises or SOEs. With a pie not big enough to feed everyone, the CCP will ensure that SOE profits are protected first.

According to Bloomberg, foreign industrial companies saw a 16.1% drop in profits in Jan-May this year after China lifted Covid restrictions. In fact, among foreign companies, China’s private sector and SOEs, only SOEs have seen profit increase in the post-covid restriction era.

However, China’s macroeconomic downturn doesn’t seem to be causing foreign companies to leave China altogether, although they may pause building new factories and making new investments.

China is still one of the largest markets in the world. If they can still sell in China, they won’t leave.

Bloomberg reported that Apple plans to revamp and open new stores in China. But the company has also been reported to be gradually moving its manufacturing out of China. Apple CEO Tim Cook described his company’s relationship with China as “symbiotic. Apple’s sales in China account for 30% of its global sales.

There is also a herd effect. That is, if the West does not withdraw en masse, if the U.S. withdraws and Europe does not. Or if some U.S. companies leave and others do not, the companies that leave will suffer an immediate loss of market share and revenue decrease. Their place will likely be taken by their competitors. Most CEOs cannot survive such a balance sheet.

The CCP has a conviction: As long as they have Europe, or part of Europe, on their side, it will be hard for America to completely disengage from China. The G7’s Hiroshima Communique confirmed such an assessment by announcing that the West is seeking to de-risk rather than de-couple (from China). President Biden and Treasury Secretary Yellen have conveyed the same message before.

Xi Jinping is well aware of this dynamic and is making the most of it. His attitude toward foreign investors has changed markedly from that of his predecessors, especially from the Deng Xiaoping era. Back then, the Chinese government genuinely welcomed foreign investment. It is like as long as you come, I will give you preferential treatment. Now Xi’s attitude is that I don’t expect you to afford to leave the Chinese market entirely. If you want to stay, you have to listen to me. In his eyes, the private sector in China and foreign companies must be risk free and fully in tune with the Party.

In recent months, at least three foreign consulting and research firms have been raided by Chinese authorities as part of a national security-related investigation.

In March, billionaire investor Mark Mobius told FOX Business that he could not take his money out of China because of the country’s capital controls, and warned investors to be “very, very careful” about investing in an economy under tight government grib.

It is well known that China does not allow the yuan to be freely exchanged for dollars, Nor does it allow depositors to transfer money from dollar-denominated accounts out of the country at will. Such transactions are subject to national regulations and quotas.

While it is never easy for foreign investors to move their capital and profits out of China, if Xi Jinping decides one day to take Taiwan by force or to cut ties with the West altogether, will foreign capital be unable to leave China? Will their people and assets be held hostage by the Chinese Communist Party? The answer is it is entirely possible.

Therefore, shareholders should ask their CEOs to prepare a China contingency plan to best protect their assets. For the U.S. government, how to stay coupled but de-risk is a complex task, I am not sure it is entirely possible. But de-risk, if done right, also provides an opportunity to remove immediate threats by building trusted networks that will lead to a reorganization of the global technological and economic structure, a long-term solution to the CCP problem.