China’s increasing role in China+1

China’s growth story is one for the books: it is the only large economy that for the better part of the last few decades has been able to grow at more than 10% per annum. It is an $18 trillion economy now, the second largest in the world, representing 17% of the global economy. So any growth or slowdown in China is a global economic story, said Arvind Shah, Head of Asia ex-Japan Equity Sales at Nomura at the China Investor Forum 2024 in Shenzhen on 3 September. As the nation has grown in economic dominance and to counter geopolitical pressures, countries around the world have been diversifying their supply chains, manufacturing capabilities and investments outside China to other countries over the past eight years.

China’s role in China+1

To substantiate the China+1 narrative, Nomura economists looked at 129 companies that have been a part of these recent supply chain reconfigurations.

“Asia is benefitting quite substantially from the China+1 strategy,” said Sonal Varma, Chief Asia ex-Japan Economist at Nomura. China is the lead goose in a flock of beneficiaries that includes India, Vietnam, Malaysia and Thailand. In India and Malaysia, most of the supply chain shift is concentrated in electronics and semiconductors. In Vietnam, it’s a mix of electronics and automobiles, while Thailand is benefiting in the automobiles sector.

Interestingly, Chinese companies themselves are the biggest source of investment in these supply chain reconfigurations, investing into Southeast Asia, particularly Vietnam, Thailand, Indonesia and Malaysia in sectors such as solar energy, batteries, electric vehicles, metals, minerals and electronics. The second-biggest investor is the US.

Despite all the trade tensions and supply chain shifts, China’s export market shares across most product categories have either remained unchanged or increased over the past eight years. Whether it’s low-end or high-tech manufacturing, China’s competitive advantage in price, scale and quality are hard for other countries to replicate. As a key investor, China is still very much the lead goose in the global supply chain. Its role within that value chain is changing from that of a final assembler to a supplier of intermediate goods. Weaning off of China will be difficult.

Is China undergoing Japanification?

There are a few characteristics of China’s current economic state that resembles Japan in the late 1980s, said Naka Matsuzawa, Chief Strategist at Nomura. China currently has a trade conflict with the US, similar to Japan, which was the second-largest economy in the late 1980s and was forced to appreciate its currency to the extent that its exports became less competitive. China currently has an expanded balance sheet and a real estate bubble that is looking to pop, similar to Japan then, which went through a protracted period of monetary easing and expanded government spending. Lastly, China is beginning to experience a downshift in its potential growth rate and is seeing the emergence of bad debt, which could destabilize the banking system, as it did in Japan.

China is aware of Japan’s policy errors and has been taking a different path to avoid similar consequences. Since 2018, China has been using monetary policy instead of excessive fiscal stimulus to stimulate the economy. The Chinese government has also used monetary easing to stop the currency from appreciating too much and avoiding economic deflation. Lastly, China’s nationalized bank systems could help contain the spillovers of bad assets from the real estate sector. To save the economy from secular stagnation, however, the Chinese government will have to separate the bad assets from banking sector and liquidate them through the market, as well as inject public capital into banks, if necessary.

Cross-border investments

There is a narrative that China+1 strategy at work can be traced via China’s cross-border investment activities, said Ting Gao, Head of Research and Chief of Strategy, Nomura Orient International Securities. Foreign direct investment into China has decelerated sharply over the last two years, compared with prior to 2022, when flows were naturally volatile in nature but relatively steady in magnitude. Meanwhile, FDI in services, which are not tradable, also declined, and there has been a drop in profit growth in China’s industrial enterprises, which could indicate that these flows have decreased more as a result of the slowdown in China’s domestic economy rather than as a consequence of the China+1 strategy.

At the same time, outbound foreign direct investment from China has been growing steadily over the last decade. Last year, there was around $150 billion of FDI from China. In the first six months of 2024, the headline number is $85 billion. Currently, only 10% of outflows are going into manufacturing, but that proportion may rise in coming years, making Chinese firms multinational with better production capacity outside of the mainland. A sizeable chunk of the outflows has been targeted toward Asian economies, particularly in Southeast Asia. As Chinese firms continue to expand overseas alongside an already abundant production capacity onshore, the oversupply conditions may persist for some time.

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