Testing confidence in China

Stephen Mulrenan, IBA Asia CorrespondentWednesday 19 July 2023

With the cost of doing business in China increasing, the confidence of foreign business leaders has been dented. Global Insight assesses China’s economic prospects and moves by jurisdictions in Southeast Asia to attract foreign capital.

Earlier this year, the chief executives of some of America’s largest companies took the opportunity to gauge business sentiment on the ground in China, following almost three years of pandemic restrictions. A ‘who’s who’ of chief executive officers revisited China – Tim Cook of Apple, Mary Barra of General Motors, Jamie Dimon of JPMorgan, Laxman Narasimhan of Starbucks and Elon Musk of Tesla, for example. And these visits followed those by the leaders of Aramco, HSBC, Kering, Samsung, Standard Chartered and Volkswagen.

While the importance of the world’s second largest economy for these blue-chip companies may be obvious, less so is China’s immediate economic prospects. An increasingly stuttering economic recovery from Covid-19, compounded by policy decisions of the Chinese government and broader geopolitical concerns, has led to a significant loss of private sector confidence in the country.

Against this backdrop, the notion of ‘de-coupling’ from China has gathered pace. This concept has now morphed into ‘de-risking’, much to the ire of Beijing. During his meeting with China’s Foreign Minister Qin Gang in May, Musk offered his thoughts on ‘de-coupling’. Quoted by the foreign ministry, he said: ‘The interests of the United States and China are intertwined like conjoined twins’. According to China’s commerce ministry, Musk also said that relations between the two countries were not a zero-sum game (in which for one side to win, the other must lose).

But despite the commercial diplomacy, many multinational corporations have been making and exercising contingency plans, including moving production out of China. In addition to Apple’s well-documented efforts to expand its footprint in India, Samsung announced in May that it was looking to establish a $200m research and development (R&D) centre in Japan. ‘You are not really going to get honest feedback from some of these CEOs because they’ve got too much at stake’, says Ramesh Vaidyanathan, Co-Chair of the IBA Asia Pacific Regional Forum and a partner at Advaya Legal in Mumbai. ‘But there is obviously an underlying concern on where this is all heading.’

Misplaced optimism

China’s economy enjoyed a robust recovery in the first quarter of 2023 following the lifting of strict Covid restrictions in December. Achieving gross domestic product growth of just three per cent in 2022, the economy recorded growth of 4.5 per cent in the first three months of 2023, albeit still someway short of Beijing’s five per cent target for 2023, its lowest target in decades.

This led strategists at Goldman Sachs to predict that ‘China looks well positioned across the growth, policy and inflation cycles in a global context in 2023’. Such optimism was based on three factors, namely that: tensions with the US would subside with the resumption of diplomatic exchanges; consumer spending would return in earnest following lockdowns; and, if all else failed, the government could be trusted to intervene with a stimulus package significant enough to correct the economy.

However, since 18 April, when China released figures on its first-quarter economic output, stocks of Chinese companies around the world have lost approximately $540bn in value, pushing the economy into a bear market. China’s property sector, which accounts for more than a quarter of activity, is in a prolonged slowdown, manufacturing activity has contracted three months in a row, services are at their weakest in six months, youth unemployment is above 20 per cent, trade is down and exports shrank 7.5 per cent year-on-year in May.

‘The Chinese economy is rather gloomy at the moment’, says one partner from an international law firm in Hong Kong, who wishes to remain anonymous. ‘The private sector has lost confidence in spending money and the failing of the real estate sector has a substantial part to do with economic conditions in China. So, there’s no confidence from private investors, the private sector, nor from the entrepreneurs of these private companies.’

Private investors remain sceptical about China in part because of the less-than-robust economic recovery but also because the country’s fundamental ‘investability’ has taken a hit due to geopolitical risks and government policy.

China’s tech sector has been particularly vulnerable. For example, online entertainment platform Bilibili was valued at $54bn two years ago, as Wall Street investors seized upon the country’s tech surge. But the Nasdaq-listed group’s market capitalisation has since fallen to approximately $6.5bn. Caroline Berube, Co-Chair of the IBA China Working Group and Managing Partner of HJM Asia Law & Co in Guangzhou, says foreign investors are even selling shares in profitable tech giants such as Alibaba and Tencent, while becoming less supportive of the China’s most promising startups. ‘There has been a recent trend of individual investors “dumping” their China shares, resulting in sizable devaluing of stocks on the China markets’, she says.

Since the start of the pandemic, China’s ten largest tech groups have collectively lost $300bn in market value, according to S&P Capital IQ. Over the last 12 months, US investor Warren Buffett has quietly sold down about half his stake in Chinese electric car group BYD.

Even Western pension funds, which have historically been very supportive of Chinese tech in both private and public markets, are backing away. Two years ago, the Ontario Teachers’ Pension Plan, a major Canadian pension fund, had almost $1bn of shares in Alibaba and Tencent for example. These days, however, neither tech company is among the Plan’s top investments.

With geopolitical concerns persisting and consumer spending down, there have recently been high expectations among strategists that policy-makers will bring forth a stimulus package. While the People’s Bank of China – the country’s central bank – cut interest rates in June, many anticipate that additional measures will be put forward, from spending on infrastructure to potential relaxation of property purchasing restrictions.

Although the Politburo, the Chinese Communist Party’s (CCP’s) top policy-making body, is expected to consider a more comprehensive package when they meet in July, Chinese Premier Li Qiang recently told an audience at a World Economic Forum event in Tianjin that Q2 growth would surpass the 4.5 per cent recorded in Q1.

‘The market is always a little forward looking from an economic perspective’, says Weiheng Chen, Head of Wilson Sonsini’s Greater China Practice in Hong Kong. ‘The sluggish market performance after the December-to-January rebound may be viewed as a foretelling indication of a weaker-than-expected economic recovery. The economic statistics since March have further endorsed such a view, which remains an overhang for investor confidence in both private and public markets.’

Policy predicament

Recent political developments as well as the onset of a full-blown ‘sanctions war’ have resulted in relations between China and the US sinking to their lowest level in decades. While the West has become increasingly concerned about China’s military assertiveness in respect of Taiwan and support of Moscow – despite Russia’s invasion of Ukraine – Beijing blames geopolitical tensions in part on Washington’s imposition of controls on high-technology exports to China, as well as the downing of what the US claims was a Chinese surveillance balloon off the coast of South Carolina earlier this year.

The war of words may have escalated since February’s balloon episode, but tensions over the trade war that began in 2018–19 during former US President Donald Trump’s administration have also reached new heights in recent months. Of most concern to the US is China’s ability to obtain advanced computing chips, develop and maintain supercomputers and manufacture advanced semiconductors.

Ever since the US Commerce Department Bureau of Industry and Security announced a sweeping set of export control rules in October last year, both sides have put forward a series of measures and countermeasures. For example, immediately following February’s balloon episode, Beijing sanctioned US companies Lockheed Martin and Raytheon Technologies over arms sales to Taiwan. Perhaps the clearest evidence of retaliation came in late May, when China banned its infrastructure operators from buying chips from US company Micron Technology. The targeting of Western business interests continued in early July, when China enacted a new foreign relations law that strengthened Beijing’s legal basis for countermeasures against Western sanctions and export controls and tightened President Xi Jinping’s control over matters relating to national security. Most recently, Beijing announced restrictions on the export of gallium and germanium, metals used in chipmaking that the US government has classified as ‘critical to economic and national security’.

The US, for its part, announced in late June that it was contemplating new export controls on chips for artificial intelligence. While this will make it harder for US companies such as Nvidia and Advanced Micro Devices to sell chips to China, it’ll also make it more difficult for China to obtain tech with military applications. There’s an expectation too that US President Joe Biden is preparing to introduce a new strategic US outbound investment review programme, or ‘reverse CFIUS’ (referring to the US Committee of Foreign Direct Investment), later this year. ‘China’s recent perceived crackdown on certain sectors of its foreign invested domestic economy is wholly due to the ongoing “tit-for-tat” so-called “sanctions war” with the US’, says Berube. ‘Inevitably, the losers in such a war are both [Chinese] companies seeking to invest in the US and US companies seeking to invest in China.’

Beijing’s moves against foreign companies are part of its wider effort to increase oversight into what’s deemed sensitive information pertinent to national security. In the spring, its anti-spy crackdown went into overdrive, with direct raids on the Chinese offices of several US consultancies. Then, in early July, Chinese lawmakers enacted a wide-ranging update to Beijing’s anti-espionage law, banning the transfer of any information related to national security and broadening the definition of spying.

While foreign investors carefully watch to see how the new law will be applied in practice, Xi continues to talk about the ‘profound unity’ of economic development and national security. In other words, Beijing will continue to take steps to boost growth, including encouraging more foreign direct investment (FDI), so long as it doesn’t jeopardise national security – more specifically, the authority of the CCP. ‘Although China has cracked down on companies in the consultancy services sector, it has also welcomed FDI into fields such as manufacturing services and R&D’, says Berube. ‘More than 10,000 new foreign invested companies were established in China in Q1, representing a 25.5 per cent year-on-year increase. So, it is likely that while the target sectors of FDI oscillate, FDI as a whole will continue to increase in China overall.’

Fund managers and analysts have suggested that Beijing’s moves to reduce foreign access to domestic information and business intelligence have made equity investment in China more challenging. But although an enhanced focus on national security in economic policy-making is typical of Xi’s leadership, Chen says not all foreign companies will be exposed to political risk. ‘The shift of focus from economic growth to a balance between national security and development is likely to increase the cost of doing business in China’, he explains. ‘20 years ago, a primary driver for foreign investors investing in China was the high growth investment story. But economic growth has naturally been slowing down and investors are also facing increased direct and indirect costs. Such combined forces may have moved the scale for certain investors.’

So, are the good days over for foreign investors in China? Chen says it will largely depend on the cash flows and profitability of each company’s underlying business, adding that ‘we see continued success stories as well as failures across the sectors’. In some areas, there’s still a willingness to do buy-out deals. For example, luxury goods sales and foreign fast food chains continue to do very well in China. Subway, the world’s largest sandwich chain, has announced it’ll open 4,000 new stores in China over the next 20 years. And while many pre-eminent global pharmaceutical companies have sold their China plant facilities, other sectors such as electric vehicles continue to demonstrate strong growth in investment appetite. ‘It may not be that different from countries like Japan or Korea’, says Chen. ‘After those economies grew to a certain stage, the labour-intensive manufacture sectors needed either to upgrade technology-wise or diversify geography-wise.’

China plus-one

Although the focus in China may be on the unity of economic development and national security, weaker economic recovery has led to growing speculation over Beijing’s priorities moving forward. There’s a question as to whether the government will be forced to choose the former over the latter, or whether it’ll tolerate relatively low growth while continuing to clamp down on external threats. ‘When the environment picks up again, and China goes into [a] shopping spree with private investors and entrepreneurs becoming more confident in their spending, deal activity will pick up’, says the international law firm partner in Hong Kong. ‘How long that takes will depend on the stimulus packages that the Chinese government is going to implement for companies.’

Although there are high expectations that Chinese policy-makers will introduce additional stimulus measures in the second half of the year to help compensate for low consumer confidence, China is not the only country in the region making plans to attract foreign investment. Many regional rivals are positioning themselves for a second wave of company relocations, particularly after witnessing the exodus of investment and foreign talent to Singapore following China’s imposition of a national security law in Hong Kong. ‘We’re going to have organisations still going into China except that, with the geopolitical situation as it is, people are looking at “China plus-one”’, says Vaidyanathan. ‘And countries like India, and other similarly placed countries, will obviously get some offshoots of that concern or anxiety.’

‘China plus-one’ refers to a strategy of not only investing in China, but also diversifying business operations and supply chains into other countries. The most high-profile example of this in recent years is Apple’s diversification of its manufacturing supply chain to India, which has recently surpassed China as the world’s most populous nation. With its large population and pool of tech talent, the subcontinent is hoping to have its ‘China moment’, says Vaidyanathan. ‘India is aggressively pushing companies to set up their manufacturing facilities in the country and Apple has really become the poster boy for this. Apart from Apple’s own ecosystem, the company is also now part of the Production Linked Incentive scheme, which is trying to promote local manufacturing.’

Indian government incentives include a more generous tax regime for organisations that establish manufacturing facilities on the ground. ‘Overall, this has been a great story for India and the impact has been very positive’, says Vaidyanathan. ‘India offers a strong alternative in terms of stability of policy over the last few years, the rule of law, and just the whole mass consumer base. That advantage will remain, and it is that advantage that makes the “China plus-one” story more interesting for countries like India.’

Elsewhere in Southeast Asia, Vietnam benefitted from a number of the first wave of company relocations from China, including those of retail brands such as Adidas and Nike. Of the 33 companies that shifted production away from the mainland as of October 2020, 23 moved to Vietnam, with the rest relocating to Cambodia, Malaysia and Thailand.

Other nations in Southeast Asia are readying for the second wave of companies. They include Indonesia, which plays a unique role in Asia, maintaining good relations with China, the Middle East, Russia and the US. It’s currently upgrading its labour and manufacturing competitiveness as it targets a more central role in global supply chains.

Berube says the second phase will not only involve Western multinationals but also Chinese corporations. ‘In recent years, there has been a growth in Chinese-owned companies also diversifying their supply chains to other parts of Southeast Asia and beyond, to move low-cost product manufacturing there and focus more on higher level manufacturing/technology in China’, she explains.

As a result of the current challenges of investing in China, the head of one US venture capital fund recently predicted that Tokyo was on course to become the ‘second city of the Western world’. In 2020, at the height of supply chain disruptions caused by China’s strict ‘zero-Covid’ policies, the Japanese government assisted 87 Japan-owned companies with manufacturing bases in China in returning their supply chain manufacturing back to Japan.

But Chen believes that no single hub will dominate in future. ‘I would call this the diversification of not only the supply chain, but also the capital market/financial system’, he says. ‘We are likely to end up with more hubs than one particular region/city taking a dominant position in the entire financial system. It may take many years to settle down, but assuming we are able to develop an open society in the financial world, major economies will eventually get their own share in the global financial system.’

Non-zero-sum

While sensationalist headlines might suggest that foreign investors are in the process of pivoting from China, it’ll take some years for multinationals to recreate an ecosystem with the necessary labour and raw material supplies as efficient as those in China. ‘A lot of this is driven by what happened during the Covid period, when there was tremendous stress on supply chains’, says Vaidyanathan. ‘To some extent, this has since been accentuated by geopolitical situations. But to say that there is going to be a fundamental shift or mass exodus from China is probably an exaggeration.’

A more likely scenario is the development of a more diversified global supplier system in which China maintains a share, but its concentration is reduced – for example, its percentage of global manufacturing in sectors such as textiles and the manufacture of certain machinery is likely to decrease.

Berube agrees that a ‘zero-sum’ game between the US and China is unnecessary, and that both sides can provide much benefit to each other. ‘In business, it is important that both sides receive, to the extent practicable, what they want’, she says. ‘Between the US and China, this is joint prosperity. And there is no reason why this cannot be achieved by each country focusing on its own unique strengths.’ In the case of the US, she says these strengths are high technology and innovation, as exemplified by Silicon Valley, while for China, they are its high base/low-cost manufacturing sector combined with its huge potential consumer market and growing middle class.

‘I don’t think there will be a total separation of the two largest economies as there are many areas, for example, from agriculture products to environmental protection, where both sides are naturally co-dependent or in need of cooperation’, adds Chen. ‘But, on the other hand, the trends of strategic competition and reducing the risk of economic dependency are also expected to continue. So, an entangled but persisting relationship is a more likely outcome in the foreseeable future.’

With multinational corporations increasingly capable of redomiciling to other jurisdictions more speedily than ever before, China will need to continue to sell itself as a reliable and stable economy for foreign direct investment if it hopes to attract and maintain small- and medium-sized businesses and major corporations alike.

Stephen Mulrenan is a freelance writer and can be contacted at smulrenan@lextelpartners.com

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