Ideology trumps the economy

Over the last year, there has been a significant shift in focus at the headquarters (HQs) of European companies when evaluating China. Where discussions once centred primarily on investment opportunities, they are now focussed on supply chain resilience, the challenges of doing business, the risk of reputational damage and global compliance.

How did China, the architect of the greatest economic growth story in history, lose its allure as an investment destination so quickly?

After China embarked on its programme of reform and opening up in the late 1970s, its economy came to be guided predominantly by pragmatic principles, as state planners sought to ensure stability.[1] Immense economic returns followed, and reforms facilitated significant inflows of foreign direct investment. International companies recognised China’s enormous market potential and its increasingly stable business environment.

The picture has now changed. With China confronting mounting internal and external challenges, policymakers’ attention has been drawn away from implementing a market reform agenda.

One of the most immediate internal challenges the country faces is justifying its stringent COVID-19 policy at the expense of economic growth and stability. Mass lockdowns and strict quarantines saw China’s economy slump in 2022,[2] while unemployment rates amongst key groups have risen sharply.[3] China’s debt crisis, the unravelling of the country’s real estate sector, demographic headwinds and stalling consumption growth also weigh heavily on the economy.

Key external challenges include rising geopolitical tensions, stemming primarily from the trade war with the United States (US), and growing calls for China to address alleged human rights abuses, most notably in its Xinjiang region. Changes in global consumer demand and a growing number of global regulations present additional challenges.

In the past, China would have confronted these challenges with the same kind of pragmatism that accelerated much of its development over the decades. Instead, Beijing has turned inward to increase its level of self-reliance, as described in its 14^th Five-year Plan, and is moving away from the rest of the world as embodied by the restrictions imposed under its COVID policy. Whereas policy once focussed on ensuring economic growth and a stable business environment, ideology now trumps the economy.

Consequently, China’s business environment is becoming more challenging. For example, COVID-related restrictions have had a crippling effect on the attraction and retention of talent and added impetus to the exodus of foreign nationals that was already underway. Companies’ China operations are becoming increasingly isolated, with China-based staff unable to travel freely to European HQs for regular business exchanges, networking and training, and senior decision-makers from company HQs are being deprived of first-hand China experience.[4] These challenges look set to continue indefinitely as China continues to focus on mass testing campaigns and dynamic local lockdowns while vaccination rates remain low.[5]

The nature of how European firms engage with China is changing as company HQs respond to these difficulties. In order to mitigate their exposure to potential shocks, many companies are beginning to localise and silo their China operations. An increasing number are creating two separate systems, one for China and one for the rest of the world – an expensive and inefficient solution. Several businesses are also now looking into the options of reshoring, ‘nearshoring’ and ‘friend-shoring’,[6] in order to retain a foothold in this important market while avoiding over-reliance.

European investment into China is set to remain below its potential in the medium term. While the very largest players continue to invest, most European companies already in China are putting their operations on autopilot, seeking to maintain a presence while making future investments elsewhere.[7] Perhaps most tellingly, despite China being the world’s second largest economy, as the challenges of doing business proliferate, virtually no new European firms entered the Chinese market in recent years.[8]

This all comes at a substantial cost to China. Not only is the country opening the door for other regions to attract investment, but the chances for miscommunication and misunderstanding—including at the political level—are increasing. The closing-off of people-to-people ties is coinciding with a rise in negative public opinion towards China internationally, something that is pushing foreign governments to take harsher stances towards the country and which risks locking everyone into a path of less engagement and cooperation should it go unchecked.[9]

China’s longer-term economic trajectory also looks less optimistic, particularly as the authorities stall on implementing market reforms needed to shore up the business environment. Analysis from the World Bank indicates that if China were to implement comprehensive market reforms, its gross domestic product (GDP) per capita would reach US dollars (USD) 55,022 by 2050, over 63 per cent higher than if it were to follow a path of limited market reforms, which the World Bank estimates would result in GDP per capita of USD 33,745.[10] It is yet to be seen whether China is willing to sacrifice USD 22,000 per capita GDP on the altar of idealogy.

Still, it would be premature to write off China’s ability to respond. The country is proficient at reacting and adapting to tectonic shifts and turning a crisis into an opportunity. The stage is set for it to do so again, with much of the world expected to face strong economic headwinds in the second half of 2022 and into 2023. This could provide the opportunity for China to roll out its proven toolbox from the 1990s and turn its attention back to reform and opening up, and reaffirm its credentials of being a reliable, predictable and efficient market.

The European Business in China Position Paper 2022/2023 is available to download from our website.

[1] China’s accession to the World Trade Organization in 2001 saw it abolish, revise or introduce more than 2,300 national laws and nearly 200,000 local regulations, which led to further market opening: China and the World Trade Organization, State Council Information Office of the People’s Republic of China, June 2018, viewed 16^th September 2022, <http://english.www.gov.cn/archive/white_paper/2018/06/28/content_281476201898696.htm>; and China’s Economic Rise: History, Trends, Challenges, and Implications for the United States, Congressional Research Service, 25^th June 2019, viewed 17^th September 2022, <https://sgp.fas.org/crs/row/RL33534.pdf>

[2] China’s National Bureau of Statistics reported 0.4 per cent year-on-year growth for Q2 2022, the lowest since Q1 2020. Sorkin, Andrew Ross, Giang, Vivian, Gandel, Stephen, Hirsh, Lauren, Livni, Ephrat & Gross, Jenny, China’s Shuddering Economic Engine, The New York Times, 15^th July 2022, viewed 16^th September 2022, <https://www.nytimes.com/2022/07/15/business/dealbook/chinas-shuddering-economic-engine.html>

[3] For instance, in July 2022, China’s youth unemployment rate (amongst 16–24-year-olds) reached 19.9 per cent. Cheng, Evelyn, China’s consumer and factory data miss expectations in July, CNBC, 14^th August 2022, viewed 16^th September 2022, <https://www.cnbc.com/2022/08/15/chinas-consumer-and-factory-data-miss-expectations-in-july.html#:~:text=Retail%20sales%20grew%20by%202.7,growth%20of%203.1%25%20in%20June.>

[4] European Business in China Business Confidence Survey 2022, European Union Chamber of Commerce in China, 20^th June 2022, viewed 17^th September 2022, <https://www.europeanchamber.com.cn/en/publications-archive/1020/Business_Confidence_Survey_2022>

[5] As of April 2022, only half of those aged 80+ had received two vaccine doses and more than 50 million people aged 60+ were yet to receive two jabs. In addition, the rate of vaccination in China is lacklustre. As of mid-July 2022, the rate was around 610,000 shots per day, far below its peak of 20 million shots per day during the summer of 2021. Reuters COVID-19 TRACKER: Mainland China, Reuters, last updated 15^th July 2022, viewed 16^th September 2022, <https://graphics.reuters.com/world-coronavirus-tracker-and-maps/countries-and-territories/china/>; Why so many elderly Chinese are unvaccinated: Some are complacent, others are afraid, The Economist, 2^nd April 2022, viewed 16^th September 2022, <https://www.economist.com/china/2022/04/02/why-so-many-elderly-chinese-are-unvaccinated>

[6] Reshoring is the act of bringing manufacturing from a remote location to the company’s home country; nearshoring is the act of bringing manufacturing nearer to the point of use; friend-shoring is the act of relocating manufacturing to a country that is considered a trusted partner to the company’s home country.

[7] European investment into China has become more concentrated over the past decade and a half. A handful of large companies increasingly account for the vast majority of total European investments made in absolute value terms. Between 2017–2021 the top ten largest investors alone accounted for nearly 80 per cent of all European FDI into China, up from an average of 49 per cent between 2008–2017. Kratz, Agatha; Barkin, Noah & Dudley, Lauren, The Chosen Few: A Fresh Look at European FDI in China, Rhodium Group, 15^th September 2022, viewed 16^th September 2022, <https://rhg.com/research/the-chosen-few/>

[8] Ibid.

[9] The Pew Research Center’s Spring 2022 Global Attitudes Survey found that negative attitudes towards China were at the highest level on record in 10 of the 19 countries surveyed. Results are recorded annually and date back to 2002; Negative Views on China Tied to Critical Views of Its Policies on Human Rights, Pew Research Center, 29^th June 2022, viewed 16^th September 2022, <https://www.pewresearch.org/global/2022/06/29/negative-views-of-china-tied-to-critical-views-of-its-policies-on-human-rights/>

[10] Based on unpublished analysis conducted by the World Bank at the request of the European Chamber.