Where is China+1?

April 2024

The return of Chinese exports and disinflationary force

The prevalent narrative is around shifting of manufacturing capacities out of China with
the objective of reducing the world’s dependency on Chinese exports. If this were to be
playing out, then there should be some signs of slowing exports out of China or a loss in
market share for Chinese exports. Initial data seems to suggest otherwise.

Contrary to the running rhetoric of China +1, China has recently gained exports market
share by 1.7% pt. in last five years (Chart 1). Over the past 5 years, China’s exports mix Namrata Mittal
has also shifted away from consumer goods and increasingly towards capital goods. Economist

China is investing significant resources towards its industrial policy, more so post COVID.
The Chinese government has identified a few strategic sectors, specifically in the realm
of new age industries, and has gone all out in terms of tax breaks, subsidies, preferential
access to funding and state support to accelerate manufacturing sector investment and
production.

China spends far more on supporting its industries than most other key economies. And Varnika Khemani
consequently, we can see significant capacity addition and production out-performance Economist
in the automobiles, electrical machinery, chemicals, nonferrous metals, railway
shipbuilding and aerospace sectors. Gradually, the production capacity is outpacing the
demand, leading to reduced capacity utilization in a few sectors. At the current pace of
industrial capex push, the problem of overcapacity could accentuate in the future. And
hence, Chinese manufacturers with excess capacity coupled with cost advantages will
Chart 1: China shares in global exports
have adequate incentive and capability to be price competitive.
4,100 16
3,600
15
This means that at least one of the factors (i.e. China’s cheap exports) that contributed 3,100
14
to structurally lower inflation over the past two decades is not going away, and 2,600
2,100 13
potentially even getting stronger. 1,600
12
1,100
11
600
Today, globally, policy making is focused on the industrial capex. Knowing the 100 10
2015
2013
2014

2016
2017
2018
2019
2020
2021
2022

competition is critical for India while designing its policy framework and for us as an
investor while riding on the manufacturing sector and industrial capex theme. Some of China's exports to the world (US$bn)

the sectors like electric vehicles, solar-panels, semiconductors, and other high-end China's share in world exports (%)
equipment manufacturing may face stiff competition from increased Chinese supply in
Source: ITC Trade Map, SBIFM Research
the future. At the same time China is indeed vacating the space in some of the low value
consumer products.
Secondly, China +1 has so far been a limited exports opportunity for India. It provided
an increased market share gain in the US market. But more than the China+1 policies or
shift in sourcing, there has been the reduced industrial production in Germany and few
other European countries (probably driven by the energy crisis post the Russia-Ukraine
war) which has played out favourably for Indian exporters.

Third, we often debate on industrial policy support and whether taxpayers should
subsidize ‘rich’ businesses. In today’s environment, if Indian manufacturers do not
receive sufficient policy support, perhaps the Chinese manufacturing process could
hollow out India’s production potential and leave India as a permanent import
dependent and current account deficit nation. No nation is playing by the fair rule of
comparative advantage. In fact, we find that other countries (both US, and China) have
increased support to R&D spending by the industries. Perhaps, India could also design
our policy with a greater bias towards innovation.
China officially launched its policy prioritization of emerging industries in 2010, and within a
decade, it has become one of the major players in a wide range of cutting-edge technologies
such as green energy, 5G telecommunications, and the manufacturing of various industrial
equipment. Now, with the Chinese real estate sector on a clear decline and the United States
blocking the availability of select technology intensive products to Chinese manufacturers,
China has doubled down on expanding its manufacturing sector’s capabilities.

In 2018, Chinese policymakers charted out an agenda to focus on nine strategic emerging Chinese policy prioritizes
industries, such as new age information technology (includes semiconductors), high end the growth of nine
equipment manufacturing (includes solar panels), new energy, new energy vehicles and strategic emerging
biotech, to name a few (Exhibit 1). These are the industries that are knowledge and technology industries that are
intensive and consume few material sources1. knowledge and
technology intensive.
At present, India is promoting its manufacturing sector largely by providing a subsidy to a
specific set of companies in identified sectors. The subsidy grants are conditional on yearly
milestones in investment, production, and domestic value addition in specific cases (see SBIFM
Market Insights July 2023, A manufacturing renaissance?). On the other hand, China has gone
all out and appears much more aggressive than other countries in its industrial policy support
(Exhibit 3). As a share of GDP, China spends over twice as much as South Korea on its industrial
policy. And in dollar terms, China spends more than twice as much as done by the United States
(as of 2019) 2.

Starting 2018, China has reduced corporate income tax from 25% to 15% for high and new China is much more
technology enterprises3. Theoretically, to qualify for this status, a company must meet a whole aggressive than other key
bunch of criteria. However, two thirds of China’s onshore-listed enterprises reported their economies in its industrial
statutory tax rate at 15% or below4. A full refund of VAT to exporters has been in practice since policy support.
19945. From 2022 onwards, a 200% pre-tax super deduction of R&D expenses is also granted
to these strategic industries (the measure was first introduced in 2018 and the criteria got
relaxed to 200% in 2022)5. These industries also get a favourable treatment in their dividend
payout policy as opposed to a general mandate for listed Chinese firms to pay dividend ranging
from 20% to 80% depending on development stage and capex requirements4 (Exhibit 2). In
March 2021, in its work report from the National People’s Congress (NPC) session, China set a
target of increasing the annual R&D spending by more than 7% every year for next five years,
as part of its commitment to boosting technology and research. In 2022, it increased by 10%6.

To sum, the main mechanisms of support are tax incentives, subsidies, and preferential access Tax incentives, subsidies,
to funding (Exhibit 4). These factors work in combination with other state assistance to preferential access to
potentially improve the return on invested capital and make it more attractive for private funding and state
investment. assistance are key policy
support.
Consequently, the manufacturing sector has taken the capex baton in China- enabling gross
capital formation growth to match the overall growth in the economy even as real estate
investment is on decline. In 2022 and 2023, manufacturing sector fixed asset investment
accounts for majority of the incremental growth in China’s fixed asset investment (Exhibit 5).
Apart from manufacturing, China is also focusing on utilities investment after widespread
power shortages in Dec 2020 and Sep 2021. The share of utilities and manufacturing
investment has risen from 7% and 46% during the last decade to 9% and 50% respectively in
2023 while the share of real estate in annual fixed asset investment has dropped from 34% to
27% during the same period (Exhibit 6).
Investment thrust in
Within the manufacturing sector, most of the incremental investment comes from electrical
electrical equipment,
equipment and machinery, automobile, special purpose machinery and chemicals. These
machinery, automobile,
sectors capture the supply chain for electric vehicles, semiconductors and solar.
special purpose
machinery and chemicals.
We can clearly see significant production out-performance in the automobiles, electrical Shift in China’s export mix
machinery, chemicals, nonferrous metals, railway shipbuilding and aerospace sectors (Exhibit away from consumer
7). These sectors have also seen a significant jump in China’s exports and China’s share on goods towards capital
overall global trade of those products. Contrary to the running rhetoric of China +1, China has goods.
gained exports market share by 1.7% pt in the last five years (Exhibit 8). Over the past 5 years,
China’s exports mix has shifted dramatically towards capital goods.

Although there has been pretty strong growth in demand for some policy favoured products,
like semiconductors and electric vehicles, these high levels of capex have nonetheless pushed
down capacity utilization. For instance, in the auto sector, while the utilization for new EV
production lines runs tight, the sector witnesses low utilization for older internal-combustion-
engine lines. Such levels of utilization create a strong incentive for firms to cut prices to increase
their volume of sales and drive rivals out of business. Government’s policy support may allow
the Chinese firms to keep pursuing a price cutting strategy.

This means that at least one of the factors that contributed to structurally lower inflation over China to stay as a global
the past two decades is not going away, and probably even getting stronger. Chinese export disinflationary force.
prices have given up most of the gains seen during COVID supply disruptions even as those
from competitors like Mexico and Japan is on the rise. In last 13 years, China’s PPI has grown at
just 0.3% CAGR, significantly lower than other countries. For automobiles, and multiple
machinery, the industry has seen a deflation (Exhibit 10). China’s real estate boom drove the
commodity upcycle in 2003-2011. However, the current policy focus is strictly towards
industries which are less material intensive (barring a few exceptions). More so, even as
manufacturing investment is on the rise, overall fixed asset investment in China is growing at
low single digits (3% in 2023). Thus, the current investment cycle in China may not lead to a
parallel surge in commodities.

But in the past, other countries gave in to the Chinese industry hollowing out their own Measures to restrict
manufacturing sector. Today, they are pushing back. While the scale of industrial sector support China exports would
in China is by far the most aggressive, a combination of protectionism and subsidies is already continue to rise in coming
leading to some revival in the US’ factory construction. After the US, Europe is aiming at more years. More nations
aggressive anti-dumping policies against Chinese automobiles and solar equipment exports7. would join in.
India has been increasingly active in blocking Chinese investment and banning mobile apps and
attempting to enforce import restrictions on electronics imports. And since August 2023,
Mexico has temporary import duties up to 25% on goods (including steel, aluminium, textiles,
footwear, tires, plastics, glass, paper, cardboard, electrical equipment, and ceramic products)
from countries with whom it does not have a preferential or free trade agreement, of which
China is by far the most prominent. However, it wouldn’t be a one-way battle. China would
likely impose countervailing duties and try to arm-twist nations where it has significant loans.

Over the coming years, every key nation is focused on increased industrial capex. This means
that over the coming years, we could potentially see a higher duplication of production
capacity.

Knowing the competition is critical for India while designing its policy framework and for us as
an investor while riding on the manufacturing sector and industrial capex theme. Some of the
sectors like electric vehicles, solar-panels, and semiconductors face stiff competition from
increased Chinese supply in the future while China is vacating the space in some of the low
value consumer products. China +1 has so far had been a limited exports opportunity for India.
It provided an increased market share gain in the US market (Exhibit 9). More than China+1,
there has been the reduced industrial production in Germany and few other European
countries (probably driven by the energy crisis post the Russia-Ukraine war) which has played
out favourably for Indian exporters. In today’s environment, if Indian manufacturers do not
receive sufficient policy support, Chinese manufacturing process could hollow out India’s
production potential and leave India as a permanent import dependent and current account
deficit nation. No nation is playing by the fair rule of comparative advantage.
Exhibit 1: Strategic emerging industries of China: Exhibit 2: Chinese ways and means to support industries:

1. New-generation information technology 1. Direct Subsidies to Firms

2. High-end equipment manufacturing 2. Reduced Corporate Income Tax and VAT refunds

3. New Materials 3. R&D Tax incentives

4. Biotech 4. Government financed R&D

5. New Energy Vehicles 5. Below market credit to SoE and targeted sectors

6. New Energy 6. Below market land sales to firms

7. Energy Saving & environment protection 7. State Investment Funds (Government financed funds)

8. Digital creative 8. Preferred access to IPO

9. Related services industries 9. Dividend relaxation

Source: China NBS 2018, SBIFM Research Source: SBIFM Research

Exhibit 3: Comparison of industrial policy spending in 2019 Exhibit 4: China’s loan growth directed towards industries
1.73

1.48

2.0 40
1.6
% growth
30
0.67

1.2
0.55

0.41

0.41

0.39
0.5

0.33

0.8
20
0.4
0.0 10
China

United States
Japan

Brazil
South Korea

France

Taiwan
Germany
(comparitive)

0
China

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16

Mar-17

Mar-18

Mar-19

Mar-20

Mar-21

Mar-22

Mar-23
Sep-14

Sep-23
Sep-11

Sep-12

Sep-13

Sep-15

Sep-16

Sep-17

Sep-18

Sep-19

Sep-20

Sep-21

Sep-22
-10
Industrial policy spending (% GDP)(2019) Bank loan to real estate Bank loan to industries

Source: CISS, Red Ink: Estimating Chinese Industrial Policy Spending in Comparative Source: Bloomberg, SBIFM Research
Perspective, May 2022

Exhibit 5: Manufacturing investment growth outpaces the Exhibit 6: In 2022 and 2023, manufacturing sector accounts for
overall investment in China since 2021; real estate declines majority of the incremental growth in China’s FAI

50 China’s Fixed asset 60 % Share in Fixed

50 Asset Investment (in
40 investment in nominal terms 50 46
30 (% growth) nominal terms)
40 34
20
27
10 30
7
0 20 13 13
-8 7 9
-10
10
-20
0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023

2011-2020 2023
Manufacturing Real Estate Manufacturing Utilities Real Estate Others

Source: Bloomberg, SBIFM Research Source: Bloomberg, SBIFM Research

Exhibit 7: China’s Industrial Production by sectors Exhibit 8: Share of world manufacturing exports (1980-2020)
18
18 % share in world merchandise exports
Automobiles 17
15 16
Electrical Machinery&Equip 13
12
Processing of Petroleum Coking &… 10
10 14
Manufacture&Processing of Non-… 9
8
Railways Shipbuilding Aerospace 7 12
6
Mining of Ferrous Metal Ores 5
China Industrial Production 5 10
Paper and Paper Products 4
4
Tobacco 4 8
4
Metal Products 4
3
Special Purpose Machinery 3 6
3
General Purpose Machinery 3
2
Mining and Washing of Coal 2 4
1 China
Processing of Food from Agricultural… 0
0
Mining Support Activities -1 Industrial 2
-1
Mining of Non-Ferrous Metal Ores -2 Production
-3
Processing of Timber&Manu of… -3 2023 (% 0
-4

1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
Furniture -5 growth)
-6
Mining of Nonmetal Ores -6
-7
Leather Fur & its Products -9 China Germany United States
-15 -10 -5 0 5 10 15 20 Japan South Korea France

Source: Bloomberg, SBIFM Research Source: ITC Trade Map, SBIFM Research

Exhibit 9: US- the lone success story to restrict “Made in Exhibit 10: China sees lowest pace of producer price expansion
China”

20.0
18.0

China's share in respective country's total imports 190

15.0 PPI Rebased as 2010=100
(2022 vs. 2018)(%pt)
6.1

6.0

174
3.6

10.0 170
2.5

1.7

1.5

1.4

1.1

5.0
150 148
0.0
-5.0 137
130
-0.5

USA -4.3

119
110 106
Middle East
Africa

Europe
Russian Federation

North America

Japan
Asia & Pacific*

India
South America

United Kingdom

90
Jan-10

May-17

Mar-19
Feb-20
Jan-21
Sep-13
Dec-10

Jul-15

Dec-21
Nov-11
Oct-12

Aug-14

Apr-18

Nov-22
Oct-23
Jun-16

China US Japan
* ex Japan and India
South Korea Eurozone Mexico

Source: ITC Trade Map, SBIFM Research Source: Bloomberg, SBIFM Research

References:
1Classificationof Strategic Emerging Industries (2018), China NBS 2018
2Gerard DiPippo-et-al, Red Ink: Estimating Chinese Industrial Policy Spending in Comparative Perspective, May 2022
3What Are the Tax Incentives in Chinato Encourage Technology Innovation?(updated), March 2023, https://www.china-briefing.com/news/tax-

incentives-china-to-encourage-technology-innovation-updated/
4Thomas Gatley, How Markets Multiply Subsidies, Gavekal Dragonomics, September 2021
5Export VAT Rebate in China, August 2019, https://www.dezshira.com/library/qa/export-vat-rebate-

china.html#:~:text=What%20is%20an%20export%20VAT,opened%20up%20to%20the%20world.
6China ramps up tech commitment in 5-year plan, eyes 7% boost in R&D spend, March 2021, https://www.reuters.com/article/us-china-

parliament-technology-idUSKBN2AX055/
7Thomas Gatley et al, China’s coming Trade war with Europe, Gavekal Dragonomics, January 2024

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