Preliminary US Greenhouse Gas Emissions Estimates for 2022

The year 2022 was marked by the emergence of longer-term economic repercussions of the COVID-19 pandemic and an unexpected war in Eastern Europe that caused turmoil in energy markets. Despite efforts to continue stimulating the US economy in the wake of the pandemic, high inflation put a damper on economic growth, which was exacerbated by a spike in oil prices as a result of Russia’s invasion of Ukraine. Consequently, the US economy grew 1.9% in 2022, down from a 5.7% GDP increase in 2021.

Based on preliminary economic activity and energy data, Rhodium Group estimates that greenhouse gas (GHG) emissions in the US slightly increased in 2022, rising 1.3% compared to the previous year. While this is the second year in a row that emissions have increased, it nonetheless marks a change from 2021, when emissions rebounded faster than the economic growth rate. This reversal in 2022 was largely due to the substitution of coal with natural gas—a less carbon-intensive fuel—and a rise in renewable energy generation.

Economic and energy market turmoil in 2022

The year 2022 was characterized by economic challenges and uncertainty, with inflation emerging as a key source of concern for the US economy. The rising prices of goods and services, initially caused by the disruption of the COVID-19 pandemic on global supply chains, were further exacerbated by a spike in oil prices due to Russia’s invasion of Ukraine. Natural gas prices were also up in 2022 relative to 2021, owing to increased demand for gas from Europe due to reductions in Russian gas supply, as well as a colder-than-normal first quarter in the US. As actions to mitigate inflation were put in place, the outlook for US GDP growth dimmed considerably over the past year, with the consensus now forecasting a 1.9% increase in 2022.

Although we won’t have official GDP data for 2022 until September, preliminary activity data suggests that total greenhouse gas (GHG) emissions in the US slightly increased in 2022, rising 1.3% compared to the previous year (Figure 1). Even with the slight increase, this indicates that the GHG intensity of the US economy declined in 2022, a turnaround from the more carbon-intensive rebound experienced in 2021.

Over the past few years, the COVID-19 pandemic has shifted the underlying forces that shape the carbon intensity of the economy. In 2019, the downward trend in coal consumption helped to reduce GHG emissions, despite GDP growth. In 2020, the pandemic had a significant impact on the economy, causing GDP to decline by 5.9% and emissions to drop by 10.6% compared to 2019, the largest decrease in emissions since the 2008 recession. However, in 2021, GHG emissions rebounded faster than economic growth—GHG emissions rose by 6.5%, while GDP rose by 5.9%—primarily due to an increase in coal generation and a modest recovery in transport demand. By contrast, in 2022 GDP growth outpaced the increase in GHG emissions.

Figure 1

This reversal in 2022 was primarily driven by a drop in emissions from the electric power sector, mostly due to the displacement of coal by natural gas and an increase in renewable energy (Figure 2). Outside of the power sector, emissions increased slightly. The most significant increase was seen in direct emissions from buildings, which rose by 6% and was the only sector to rebound to pre-pandemic levels (Figure 3). This was largely due to increased energy consumption for heating in homes, as 2022 reported below-average winter temperatures.

Figure 2
Figure

Coal generation displaced by natural gas and renewables

In the electric power sector, which accounts for 28% of overall emissions in the US, emissions decreased by 1% in 2022. Coal generation in the US fell in 2022, returning to the downward trend that had been in place until last year’s modest increase. Based on monthly and daily generation data from EIA, we estimate that coal generation declined by 8% compared with the previous year, with several factors contributing to the drop (Figure 4). Among these was the retirement of coal-fired generators and disruptions to the railroads that deliver coal to power plants, which hindered power plants’ ability to replenish their coal stocks and led to a reduction in coal generation. The EIA also forecasted that these factors contributed to a 19% increase in the price of coal for the power sector relative to 2021. Given these conditions, we anticipate that coal’s contribution to electricity generation will continue its downward trend and reach 20% in 2022, a decrease from the 23% it represented in the previous year (Figure 5).

Natural gas and renewable energy sources compensated for the decline in coal-based power generation in 2022. Despite high Henry Hub prices (up  65% higher from 2021), gas consumption for electricity generation increased by 7%, largely due to its ability to meet peak demand during record-high summer temperatures. As a result, the share of natural gas in total electricity generation in the US rose slightly from 37% in 2021 to 39% in 2022.

Renewable energy generation also saw a significant increase, rising by 12% compared to the previous year. For the first time in over sixty years,[1]  renewables surpassed coal in the US generating 22% of total electric power, with coal dropping to only 20%.

Figure 4
Figure 5

Little change in transportation and industry

Emissions in the transportation and industrial sectors—the two highest-emitting sectors which together account for two-thirds of total US GHG emissions—rose slightly by 1.3% and 1.5%, respectively (Figures 2 and 3).

The changes in industrial and transportation sector emissions reflect the impact of inflationary uncertainty. Industrial production was affected by supply chain turmoil and rising oil prices, leading to higher production and shipping costs. This led to a limited increase in the manufacturing of goods, and emissions in the industrial sector remained mostly unchanged. Meanwhile, in the transportation sector, emissions remained relatively flat due to the impact of rising oil prices on demand. The slight emissions increase in this sector was driven mainly by the demand for jet fuel as air travel increased relative to 2021 (Figure 6). In the first quarter of 2022, fuel demand in the transportation sector, including gasoline, jet fuel, and diesel, rose slightly. However, once the cost of oil began to affect transportation fuel costs, demand remained below 2019 levels for the rest of the year.

Figure 6

Still off track for meeting the US target under the Paris Agreement

With the slight increase in emissions in 2022, the US continues to fall behind in its efforts to meet its target set under the Paris Agreement of reducing GHG emissions 50-52% below 2005 levels by 2030 (Figure 7). In 2022, emissions reached only 15.5% below 2005 levels. In order to meet the 2025 target of 26-28% below 2005 levels and get back on track for the 2030 Paris goal, the US needs to significantly increase its efforts.

The passage of the Inflation Reduction Act (IRA) by Congress is a significant turning point, and we may start to see its effects on emissions as early as this year if the government can fast-track implementation, with progress expected to accelerate by 2025. However, even with the IRA, more aggressive policies are needed to fully close the gap to 50-52% by 2030. In 2023, federal agencies can close this gap further by proposing aggressive regulations that drive down emissions. These actions, together with additional policies from leading states as well as action from private actors, can put the target within reach—but all parties must act quickly.

Figure 7

[1] Prior to the 1960s, hydropower exceeded coal generation.

The End of China’s Magical Credit Machine

China’s economic growth will slow significantly over the next decade. One of the most important drivers of this slowdown is the unwinding of an unprecedented credit bubble. China’s financial system simply won’t be able to generate the same levels of credit growth that it has in previous years. This means that Beijing will have far less control over the direction of its economy than it has in the past. Growth in total societal financing (TSF), a measure of funds provided by the financial system to the real economy, is at all-time lows, and other credit metrics are decelerating. Over the next decade, we expect rates of credit growth in China to fall below 10%, with knock-on effects for investment growth and the broader economy. Credit growth is under pressure for three main reasons:

  • Credit demand is slowing sharply, because households and corporates have reined in their expectations for economic growth.
  • Lenders are becoming more cautious in response to rising credit risks in several asset classes, as implicit government guarantees for borrowers lose credibility. This is particularly apparent in lending to the property sector.
  • Credit supply is constrained by the massive size of China’s financial system, and the difficulties of maintaining high rates of credit growth while complying with regulations related to capital requirements and loan loss provisions.

Pretending Prevents Extending

China’s economy depends on investment, which depends heavily on the flow of new credit to fund that investment. Investment (gross fixed capital formation) makes up around 42% of China’s GDP, far above other economies at China’s stage of development. Savings rates remain extremely high, putting downward pressure on household consumption. Significant changes in the direction of China’s credit impulse can meaningfully change the direction of the economy and global cyclical signals, with recent research by the Federal Reserve highlighting the importance of China’s credit conditions.[1]

In the past, China’s financial system grew much faster than the real economy: credit grew by 18.1% on average between 2007 and 2016, and the banking system added $26.8 trillion in assets over that period, compared to “only” $7.6 trillion in GDP growth. Credit expanded rapidly because financial losses were unthinkable because of implicit government guarantees for both borrowers and lenders. In essence, markets assumed that Beijing would always intervene to prevent financial instability. (See Credit and Credibility for a much more detailed discussion of this argument.) This led to a dramatic expansion of China’s shadow banking system, which extended large volumes of credit to both property developers and local governments. China’s authorities did not consider moral hazard a problem. On the contrary, it was a core element of their strategy for expanding the economy.But China’s financial system can no longer generate the same pace of credit growth as in the past.  The system is simply too large, at $53 trillion in assets—over half of global GDP—to grow at double-digit rates indefinitely. The upper ceiling for credit growth over the next decade is probably 12-13%, and in most years, it is likely to be much lower. This means that China’s financial system will no longer be able to serve as a shock absorber for the real economy, cushioning losses for enterprises and projects that cannot service their debts out of profits or operating cash flow.

The unwinding of this dynamic, under which quasi-fiscal investments were pumped into the economy without an expectation of financial returns (and loans rolled over year after year) is now a key constraint on China’s future economic growth. Declaring losses, cutting off non-performing companies and projects, and writing loans off within the banking system would reduce banking system profits, which are the only consistent source of capital for the banks, and key channels of financing for investment in China’s economy. It is far easier to simply roll over the loans and keep local government projects and companies operating, even if that means credit continues flowing to low-productivity industries. Pretending these loans are still performing prevents Beijing from extending the life of its previous growth model, with constraints building year by year.

As credit growth continues slowing, interest rates must trend lower to allow companies and local governments to manage their previous debt burdens. A larger proportion of a smaller pool of credit will be used to manage debt servicing costs, rather than fund new investment, and economic growth will slow as the costs of past debts crowd out future private sector investments. This is not necessarily a recipe for a full-blown financial crisis, although that possibility cannot be ruled out. But sand in the gears of China’s credit machine does portend slower economic growth over the next decade.

Credit Demand Under Pressure

Overall credit demand in China is weakening, consistent with the economic slowdown. Throughout the pandemic, businesses have grown increasingly reluctant to borrow and invest, given the uncertainty of operating conditions. Moreover, the crackdown on education technology firms and Internet platform companies had a significant impact on private sector confidence.

There have been a number of warning signs in recent months that corporate credit demand is on the wane. First, short-term (1-month) bill financing rates have plummeted close to zero in most months over the past year. These rates fall when banks struggle to find borrowers at close to benchmark interest rates, and need to bid for lower-return assets in the secondary market.  In normal times, bill financing rates have only fallen to zero toward the very end of the month, but in December, they stayed at zero for almost the entire month. More worrying was the fall in 3-month bill financing rates to zero in the final week of December, suggesting banks’ expectations for credit demand in Q1 2023 are already very weak.

Second, throughout the past year, there has been a persistent gap between actual money market repo rates and the policy rates at which the PBOC extends financing via reverse repos. Current 7-day repo rates are still around 1.6%, while the PBOC offers 7-day financing at 2.0% (Figure 2). This indicates a consistent weakness in credit demand, when banks cannot find borrowers and must park the excess liquidity in the interbank market, keeping money market rates below policy rates.

Figure
Figure

Household credit growth has also declined sharply throughout the pandemic, but particularly since the slowdown in the property market began. Households are repaying mortgages faster than they are being extended, and the overall pace of household credit growth has slowed to a new all-time low of 5.7% y/y as of November. The latest PBOC quarterly survey, conducted in December, suggested Chinese families now see an even weaker outlook for jobs and income growth, and the proportion of survey participants choosing to save more in the future rose to yet another record high of 61.8% (choices were to save, consume, or invest more). At the end of 2019, before the COVID-19 outbreak, the share of survey respondents who were inclined to save stood at 45.7%. It has been rising since the end of 2017, as consumer credit has declined as part of a deleveraging campaign. The pandemic merely accelerated this process.

Figure

Most corporate credit demand this year will be driven by infrastructure projects and local government borrowing. This includes 630 billion yuan in pledged supplementary lending (PSL) from the PBOC between September to November, 740 billion yuan in policy bank financing for infrastructure projects, and an additional 800 billion yuan in loan quotas for policy banks. The PBOC said in its Q3 monetary policy report that commercial banks also provided 3.5 trillion yuan in credit lines to supplement these policy bank financing tools to fund infrastructure projects. Still, this is not enough to offset the obvious weakness in private sector borrowing, both from households and corporates. TSF growth slowed to just 10% at the end of November and is likely to be in the single digits, for the first time on record, in December 2022.

The end of China’s zero-COVID policies could well support credit demand among private businesses over the coming year. But the slowdown in credit demand is a longer-term phenomenon, consistent with the structural slowdown of the economy, and weakness in the property sector.

Lenders Risk-Averse Given Rising Defaults

On top of the decline in overall credit demand, lenders within China’s financial system have become far more reluctant to lend over the past five years, and particularly since the property sector began weakening. This is primarily because credit risk has begun spreading into more and more asset classes since China’s deleveraging campaign to manage the shadow banking sector began to show its effects in 2017 and 2018.  Overall credit growth has slowed, of course, which leaves more and more borrowers cut off from refinancing and at greater risk of default.

But the broader trend of rising credit risk is unprecedented, because it reflects the end of a decades-long period in which moral hazard permeated China’s financial system. Until the deleveraging campaign, defaults in any Chinese asset class were extremely rare.  The financial system expanded quickly based on the widespread expectation that both borrowers and lenders were backed up by implicit guarantees. As a result, anytime there was a credit event in China’s financial system—such as the interbank market crisis of June 2013—the natural response from Chinese investors was a “flight to risk” rather than a “flight to quality.” Most investors saw the government’s aversion to perceived political instability and assumed they would be bailed out, even when investing in stocks, as was the case during the 2015 equity boom and bust. Now, investors can no longer count on the government as a backstop. In an article in early November, PBOC governor Yi Gang wrote that individuals and firms would have to manage financial risks on their own from now on.

Lending to peer-to-peer networks became risky in 2017 and 2018 as many of these speculative lenders defaulted, generating numerous protests among angry investors facing losses. Then small banks such as Baoshang and the Bank of Jinzhou began to fail in 2019. Corporate bonds defaulted in far larger volumes starting in 2020. Then even local government state-owned companies started to default, as Yongcheng Coal’s default in November 2020 raised the risk that local governments could shift priorities and resources away from repaying bondholders. Trust companies showed the first signs of weakness in property-related credit, as more and more faced defaults starting in 2020 and early 2021. Well before Evergrande’s financial distress, property developers were already defaulting on their debt. (See Feb 2021, “China’s Financial System is Cracking—What Next?”) Many more followed after the imposition of the “three red lines” and the dramatic economic slowdown of 2022.

Throughout the deleveraging campaign, China’s shadow banking system—most of which consisted of “channel business” from banks to third party asset managers—has contracted, creating new credit risks among the shadow banks’ traditional borrowers. These included lower-income households accessing mortgages and down payments from peer-to-peer lenders, as well as property developers and local government financing vehicles (LGFVs) borrowing from trust companies. Over the past three years, loan officers and bond investors began determining credit risks based on the perceived stability of local governments backing certain companies, a trend we called “geographic counterparty risk.

As a result of these rising credit risks over the past five years, banks are far more reluctant to lend in the same volumes as in the past, because they cannot do so and minimize credit risk at the same time. Several attempts at window guidance to encourage banks to increase lending this year have been unsuccessful, with banks simply channeling more resources toward companies considered safe, notably state-owned firms, or to “safer” local governments. This risk aversion is a more conventional response to a slowing economy, and it is increasingly apparent within China’s financial system.

Capital and Regulatory Constraints Limit Credit Supply

Banks have also faced more mechanical and regulatory constraints to expanding credit in recent years. China’s banking system is extremely large, but not very profitable. Aggregate returns on assets have remained extremely low in the last five years, below 1%. This is problematic because the banking system needs to generate large amounts of new capital every year in order to continue to expand asset books at the same rates. Retained earnings are the only realistic source for adding to banks’ capital bases—some banks can issue new shares or issue subordinated debt, but for smaller banks that lend to local governments and property developers, access to capital markets is limited.

Figure

This explains banks’ difficulties in writing off large proportions of non-performing loans with the hope of improving credit efficiency: to do so across the entire banking system would decimate profitability. As a result, banks have only written off an average of 0.34% of assets annually over the past five years. Much of the expansion of the shadow banking system from 2013 to 2016 was designed to work around requirements for capital risk weightings on loans, by reclassifying assets in other forms, such as “interbank placements” and “investment receivables.”

Figure

Of course, regulators could encourage faster credit growth by relaxing capital requirements for banks. But this would likely make the entire system far riskier, and more vulnerable to a banking crisis and insolvencies. One could argue that banks’ balance sheets simply do not matter, as equity capital has no meaningful role within a state-owned banking system. But China must pretend that they are important because shares of banks have been listed on public exchanges and sold to both Chinese and foreign investors. The perceived stability of the banks is important if Beijing wants to continue to play a part in the international financial system and seek access to foreign capital.

The End of China’s Great Ball of Money

There are several implications for China’s economy from the broader slowdown in overall credit growth. First, Beijing is losing control over a critical policy tool which gave it outsized influence over the financial system.  If Beijing can no longer provide the guarantees that ensured lending was safe, then financial institutions must protect themselves and reduce their exposure. Lending will become increasingly concentrated in a group of state-protected borrowers and quasi-fiscal institutions at the local government level—those that still feature more explicit government guarantees.  Beijing’s capacity to encourage private sector investment will be weaker, as state-directed credit will crowd out private borrowing.

Second, this has major implications for asset markets as well. For years, the large expansion in credit had created a “great ball of money”. Surplus liquidity sought returns within China’s economy—flowing into equities, then to property, then to commodities, and back again. The slowdown in credit growth reduces surplus liquidity in the financial system that could fund speculative investments. China’s liquidity-sensitive markets and industries may be operating in the future with far less money swirling around the economy, particularly if there are no meaningful changes in credit allocation.

Third, the slowdown in credit accelerates the reckoning China faces with its existing growth model. Weaker credit growth means less credit available for refinancing old debts and keeping quasi-fiscal local government infrastructure lending alive. The economic growth generated from a marginal yuan of new credit will be much smaller over time—unless, and only unless, structural reforms within the economy allow China to transition toward a less credit-intensive and more private sector and consumption-centric growth model. Whether by active policy choice or the gradual pressure of rising debt, investment-led growth is finished in China. Whatever the future brings for China’s economy, it will not look anything like the past.

[1] William L. Barcelona et al, “What Happens in China Does Not Stay in China,” Federal Reserve International Finance Discussion Papers, No. 1360, November 2022, https://www.federalreserve.gov/econres/ifdp/files/ifdp1360.pdf.

Now for the Hard Part: China’s Growth in 2023 and Beyond

Since reform and opening began in 1978, China has had the benefit of catch-up growth on its side. The country was coming from such a low base, and its vast market had so much potential, that its leaders did not have to do much, besides get out of the way, to deliver impressive growth. Cyclical slowdowns, even severe ones, were always followed by a return to rapid expansion. Will the end of China’s zero-COVID policies produce the same result in 2023? Some economists believe so, predicting a robust recovery in the world’s second-largest economy, driven by pent-up household demand. Foreign governments and multinational corporations must decide whether to believe the optimists. In this note, we consider China’s economic outlook and conclude that even the best COVID endgame is unlikely to deliver a rosy 2023. While GDP growth above 4.5% may seem reachable at first glance, the more one looks at the assumptions needed to achieve that level of expansion, the less realistic it seems. We believe that growth as low as 0.5% is within the realm of the possible. If Beijing starts crucial, long-deferred structural reforms in earnest, growth between 1-3%, in 2023 and over the medium-term, would be a reasonable expectation.

2022 in Review

Many analysts assumed Beijing would deliver its stated GDP growth target of “around 5.5%” in 2022. Few imagined that the downturn in the property sector would place a hard ceiling on expansion. Even fewer thought that China would continue to insist on draconian COVID lockdowns at a time when the rest of the world was opening up, in part thanks to mRNA vaccines. But by June 2022 the reality had begun to sink in, and officials gave up on 5.5%. Premier Li Keqiang, according to reports at the time, urged local bureaucracts to rush out pro-growth measures to prevent a second-quarter economic contraction. The growth target set just three months before was already out of reach.

Preliminary GDP data for 2022 will not be released until late-January, but for the first three quarters, growth was reported to average 3% on an annualized basis, supported by modest increases in household and government consumption (+1.2%), business investment (+0.8%), and net exports (+1.0%). Some questioned whether this was an accurate reflection of the actual performance of the economy, but for the sake of discussion we will accept the 3% growth story through the first nine months of the year.

Should we assume that the final quarter of 2022 came out better? No, given the serious worsening of economic conditions as the year ended. The zero-COVID lockdowns were extended through October (to ensure stability for the 20th Communist Party Congress) and November, before they were abandoned abruptly without much in the way of additional policy guidance in December, following the outbreak of protests over the lockdowns. This means weaker fourth quarter and full-year performance than we saw in the first three quarters. In terms of household consumption, retail sales fell 0.5% in October and again by 5.9% in November. Government spending is difficult to proxy but there is little reason to expect it to offset depressed household activity. If we conservatively assume a 2% contraction in fourth-quarter consumption, similar to what we saw in Q2, we could expect a full-year GDP contribution from households and the government of around 0.8 percentage points.

The lockdowns at the start of Q4, and the rampant spread of COVID thereafter, impaired business investment activity. New property starts plunged by a record 49.7% in November, and completions fell 18.3%. Industrial output fell for construction-related products, including cement (-3% y/y), asphalt (-7%), and UPR, a chemical used in roofing and piping in real estate construction (-39%). Given these indications, China will be lucky to report another 0.6 percentage points of GDP growth from investment for the full year 2022.

China’s net exports (exports minus imports, the external component of GDP by expenditure), rose to an all-time high in 2022, above what was already an epic level in 2021. This surprised many analysts, who assumed there was nowhere to go but down. But by late in the year, with a global recession in the air because of rising global interest rates and inflation, the trend for China’s net exports finally turned. At best, there may have been a modest increase in the fourth quarter, resulting in a maximum contribution of net exports to 2022 GDP of 1.1 percentage points. However, it is just as likely that exports have been overstated this year by 10-15%, as companies inflated them in order to claim export tax rebates.

Figure

Put together, the official data and our observations of fourth quarter performance suggest full-year 2022 GDP growth of about 2.5%, with numerous reasons to suspect that the real performance was even weaker. In Q1, Beijing’s statisticians reported accelerating growth from the prior quarter, despite a deepening property sector slowdown and lockdowns in numerous cities. The property sector continued to decline throughout the year, with completed floor space down nearly 20% in the first eleven months of 2022 compared to the same period last year, and new starts down nearly 40%. Yet Beijing continued to report growth in fixed asset investment of over 5%—roughly the same pace of growth as in 2018, long before the slowdown in the property sector took hold. Given China’s preoccupation with delivering strong results, we expect official 2022 growth to come in as high as 3%. In reality, the economy is likely to have grown by less than 2%, and possibly not grown at all.

2023 Outlook

With a 2022 baseline to work from, we can look ahead to 2023. While the zero-COVID millstone around the neck of the Chinese economy will be cast off over the course of the year, the sudden, chaotic way in which pandemic policies have been changed means that growth will be hampered in new ways. Importantly, the economic headwinds that are unrelated to COVID are likely to persist or even worsen. We look at each in turn.

Investment

Diminishing property sector investment will continue to be the main structural drag on growth in 2023. New construction starts, which presage the volume of real estate activity to come, fell by 44%, 36% and 50% in September, October, and November, respectively. The property sector downturn is hard-wired into the first half of 2023.

Yet even after the 2022 downturn, property is still running too hot for underlying real demand. We estimate a sustainable level of demand—a level consistent with buying houses to live in, rather than for speculation—at 550-750 million square meters annually. China’s annualized housing sales are still at 1.24 billion square meters after peaking at 1.73 billion in June 2021. To reach sustainable levels, construction will need to continue contracting at the current rate for four to six more quarters.

Infrastructure investment is likely to be a drag as well. Local governments are under fiscal pressure due to declining revenue from land sales. Local government financing vehicles—LGFVs, the primary mechanisms for implementing infrastructure projects—are in the midst of a credit crunch, and are likely to see defaults in 2023. Policies have been geared toward reducing the number of low-return investment projects, though rules were loosened somewhat in April 2022. Policy bank lending has been used to close the worst gaps, but these spigots cannot match last year’s 1.4 trillion yuan in quasi-fiscal lending. Put together, these constraints mean that infrastructure will probably be a modest drag on growth in 2023, rather than a positive.

Finally, it is hard to imagine private sector investment—in new factory lines or retail spaces, for instance—driving growth given the current COVID-19 chaos and ongoing confusion about the state’s attitude toward market forces. Private firms often take their cues from foreign consumers rather than Beijing. The IMF expects global trade growth to fall from 5.5% in 2022 to 3.8% at best in 2023, or as low as 1.2% in a global recession scenario. Under these conditions, China’s export-oriented manufacturers will be wary about investing in new capital stock and facilities.

In typical pre-COVID years, investment would contribute between 2 and 4 percentage points a year to China’s headline GDP growth. Given the headwinds buffeting the investment climate in 2023, China would do well to match or slightly exceed last year’s pace, wringing out ¼ to 1 percentage point of additional investment growth, at best. A deeper property contraction, local government financing vehicles defaults, or a bigger hit from a slowing global economy could easily lead to weaker investment, or a drag on GDP growth of 0.5 to 1 percentage point.

Net exports

Exports were an important growth driver for China during the pandemic. In pre-pandemic years the contribution of net exports to GDP generally ranged between -1 to +1 percentage point, but net exports contributed 1.7 percentage points to growth in 2021, propelling the nation to reported growth of 8.1% in that year. With China enjoying a record trade surplus, net exports will probably account for one-third of 2022 growth.

Figure

But in 2023, we can expect external demand to be weaker. In addition to weaker global conditions, policy confusion at home is likely to hamper export performance. Manufacturers had developed “closed-loop” systems to keep employees isolated from the virus. Now, in a rush to get past lockdowns, there are reports of employees with COVID being told to come to work. In a chaotic environment of high infections and worker absenteeism, it is realistic to expect production to be hampered for a substantial part of 2023.

For net exports to contribute to 2023 growth, an already historic surplus would have to expand further despite these conditions. In theory this may be possible, but we consider it unlikely. Perhaps if China’s terms of trade shifted heavily in its favor—with import prices for oil and other commodities falling and export prices holding up—an additional 0.5 percentage point GDP contribution from net exports might be possible. However, it is more likely that China’s export growth continues to slow and net exports act as a drag on growth of about 0.5 percentage points.

Consumption

In GDP accounting, total consumption demand is made up of two sub-components: household and government spending. The biggest wildcard for overall growth in 2023 is household spending. Households were heavily constrained in 2022 due to lockdowns and travel restrictions, and hopes for a consumption rebound in 2023 hinge on a surge of pent-up demand being unleashed in response to the zero-COVID exit.

But there are several reasons to be cautious about a surge in consumer demand in 2023. Households are putting money into savings at record levels, particularly in time deposits with 3 to 5-year maturities that are expensive to redeem in the short term. Unemployment rates among workers aged 16 to 24 reached nearly 20% earlier this year and are still high at 17%. The global slowdown is likely to affect employment in China’s export-oriented manufacturing sector. China’s property sector slowdown will continue to hurt job prospects in construction and related sectors, affecting employment and income. The government is trying to stabilize expectations about property values, but housing prices in the less-regulated secondary market are already falling in Tier 2 and Tier 3 cities. Falling home values typically weigh on the propensity to consume, because a substantial share of household wealth is tied up in real estate.

A rebound in consumer spending in 2023 would require a successful rollout of consumer stimulus measures, but Beijing has few tools at its disposal to achieve that. Individual income taxes are already very low, at around 1% of GDP. Tax breaks on autos and subsidies for rural purchases of durable goods are already in place. One possibility is consumption coupons, though prior programs have been limited in scale. More widespread deployment of coupons would require both new programs taking advantage of ubiquitous digital payment platforms like WeChat and a major paradigm shift away from supply-side-focused stimulus.

Household consumption growth approaching pre-pandemic trends would mean a 2 percentage point contribution to 2023 GDP growth. An outcome between 2022 levels and pre-pandemic trends would be closer to a 1 percentage point contribution.

Government spending is constrained by the same fiscal headwinds that are undermining infrastructure investment: weak local government revenues from taxes, fees and land sales. A return to pre-pandemic “normal” would mean a 1 percentage point contribution to 2023 GDP growth from government spending, while a continuation of the constrained government spending growth seen in 2022 would result in a 0.5 point contribution at best. As 2022 comes to an end, government budget deficits are hitting record highs. In that environment, more debt is not a prudent solution. But local government obligations have nowhere to go but up, as they are forced to assume “quasi-fiscal” debts run up by nominally private, but in reality state-directed, LGFVs.

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We have presented a high and low range for each of these four components (Table 1). If everything—including factors (like exports) that are not under Beijing’s influence—moves in the right direction for China, GDP growth could reach 4.5% in the coming year (though this would probably mean pushing the real estate correction further into the future, resulting in higher deferred costs). This is close to the latest World Bank forecast for China’s growth, and a little below the median forecast of economists in a recent Bloomberg survey. In other words, many organizations are predicting growth levels that, in our view, only make sense if everything goes right for China. The low end of our range shows the Chinese economy barely expanding in 2023 (0.5%).

The Age of Slow Growth

China’s highly restrictive COVID policies played an important role in its weak economic performance in 2022, and the end of these policies should provide a boost once disruptions associated with the rampant spread of the virus begin to ease. But zero-COVID was just one of many brakes on growth, and the others will not vanish with a wave of Beijing’s policy wand.

Demographics are a persistent, long-term drag. The National Bureau of Statistics (NBS) reported population growth of only 480,000 people (+0.03%) in 2021, meaning China’s demographic peak has arrived. The working age population has been declining for several years, with fewer young people entering the workforce and more people retiring. Moreover, there are serious concerns about the educational preparedness of tens of millions of young, rural Chinese who are entering a 21st century economy.

After a decade of credit-fueled growth, China’s financial system has reached its limits. Banks are saddled with a decade of unrecognized non-performing loans that must be rolled-over year after year. As that pool has grown, banks have had to employ an ever larger share of new credit to keep the engine going at the same speed. Unable to grow its way out of these liabilities, China must gird for a wave of new financial risks, which will test the credibility of the country’s technocrats.

Productivity growth should be a driver of economic expansion at the middle-income stage in which China finds itself. But the wellsprings of productivity are not flowing as they used to. The economic reform agenda has stalled or shifted into reverse in some areas. Beijing continues to push expensive industrial policy programs with little to show for them in terms of productivity or self-reliance. Private sector and foreign firms are increasingly wary of regulatory directions and ideological signals.

As China’s leaders consistently point out, external conditions are becoming more challenging as well. Geopolitical headwinds are constraining China’s access to foreign capital, markets, technology, and talent. Permissive access to foreign consumers has allowed China to achieve economies of scale and scope in the past. This is changing, especially in important sunrise sectors. Rather than add to China’s growth, the external dimension may increasingly act as a drag.

Finally, China faces formidable challenges related to climate change. While the green transition will affect all developed and developing economies, China’s reliance on heavy, carbon-intensive industries make its burden heavier than most.

Given the stack of structural constraints that China faces, adjusting expectations for 2023 and beyond is necessary. Lower expectations are critical to re-establishing credibility and justifying painful, but necessary policies to shore up China’s economic potential. Slower growth is the new normal for this decade. Lower but sustainable growth in the 3% range per year would still amount to $600 billion in additional output annually, when set against the $20 trillion base that China will have established in a few years. That best case long-term growth rate is substantial and it is achievable. While it requires sacrifices and concessions to the need for political and market reforms in the near-term, it would mean less sacrifice down the road. The reform work involved is not new to Xi Jinping or the Party, nor is a tough period of adjustment. Acknowledging lower growth potential in 2023 would be a signal that China is ready to get started today.

Global Greenhouse Gas Emissions: 1990-2020 and Preliminary 2021 Estimates

Tracking greenhouse gas (GHG) emissions across the 190+ Parties to the Paris Agreement provides valuable data for decision-makers in both public and private sectors as they develop strategies to meet global net-zero emissions goals. This data can inform policies and interventions that target the most carbon-intensive industrial and economic activities.

Every year, Rhodium Group provides the most up-to-date global and country-level GHG emissions estimates through the ClimateDeck. This year’s update features final emissions estimates from 1990-2020 and preliminary estimates for 2021. This data includes estimates for all six Kyoto gases from across all sectors of the economy, consistent with UN reporting guidelines. In addition, this year, we add a new level of disaggregation in our emissions from industry by including historical estimates for process and thermal emissions from cement production by country.

Total global emissions increased 4.6% in 2021 based on preliminary estimates

In 2021, as countries and economies began to reopen and recover from the worst of the COVID-19 pandemic, global GHG emissions bounced back, but not quite all the way to pre-pandemic levels. Based on our preliminary estimates, global emissions—of the six Kyoto greenhouse gases for all sectors, including land-use and forests as well as international bunkers—increased from 47.3 gigatons of CO2e in 2020[1] to 49.5 gigatons in 2021 (Figure 1). This marks an increase of 4.6% from 2020 levels, getting close to but not fully rebounding from the 5% reduction caused by the COVID-19 pandemic in 2020. The 2021 rebound was driven in part by a rise in the carbon intensity of the economy.

Figure 1
Figure 2

At the country level, nearly two-thirds of global emissions in 2021 came from only eight major economies (Figure 3). China remained the largest single-country contributor to global GHG emissions, with an overall share of 27% of global emissions, followed by the US at 11%, and the EU and India at 7%.

Figure 3

CO2 emissions from the combustion of fossil fuels increased in every major economy in 2021 compared to 2020 (Figure 4). In four major economies—Brazil, India, Russia, and China—emissions from fossil fuels rebounded above pre-pandemic levels in 2021. China, the only major economy where CO2 emissions increased in 2020, increased its emissions again in 2021 by an estimated 5.5%. The most significant increase in CO2 emissions from fossil fuels among major emitters was in Brazil, where emissions increased by 12% in 2021, compared with a 6% drop in 2020. Although emissions increased in both the US and EU-27 in 2021, by 6.5% and 6.3%, respectively, they did not fully reach pre-pandemic levels.

Figure

The major drivers of increased emissions in countries that bounced back to pre-pandemic levels differ across regions. Last year, Europe and Asia experienced a colder-than-average winter followed by a warmer-than-average summer, which increased the demand for coal and natural gas. Without a significant increase in supply, coal and natural gas prices rose around the world.

In India and China, where coal is cheaper than natural gas, coal consumption was the primary driver of their CO2 emissions rebound in 2021. According to BP Statistical Review, coal consumption in dropped by 6% in 2020, but increased by 15% in 2021. In China, where coal comprises 66% of its fossil fuel consumption, coal consumption increased by 0.7% in 2020 and 4% in 2021.

Russia decreased its oil and natural gas consumption in 2020 (4.7% and 5.6 %, respectively) and rebounded with a 5.8 % increase in oil consumption and a 12% increase in natural gas in 2021. In Brazil, where 90% of its fossil fuels consumption comes from oil and gas, consumption dropped in 2020 (by 12% and 12.3%, respectively) and rose by 5.6% and 28% in 2021.

For every major emitter except for China, the 2021 rebound was driven by a significant rise in the carbon intensity of their economies, as fossil fuel demand rose faster than the economy as a whole. In Brazil, fossil fuel demand (and associated CO2 emissions) increased nearly three times faster than GDP growth in 2021 (Figure 5). Similarly, Russia’s CO2 emissions grew 8.8%—nearly double the pace of overall economic growth (4.8%). India, where CO2 emissions from fossil fuels increased by 11.8% in 2021, experienced an economic rebound of 8.9%. In the US and the EU, emissions increased roughly one percentage point higher than their economic growth. By contrast, China’s CO2 emissions from fossil fuels increased by 5.5%, while its economy grew 8.1%, driven primarily by the shift in consumption from coal to natural gas, a less carbon-intensive fossil fuel.

Figure 5

Emissions by sector: Industry and electric power generate more than half of global emissions

In 2020—the latest year for which there is sufficient data to provide sectoral level detail—industry remained the largest emitting sector, generating 31% of global emissions (Figure 6). Emissions from the electric power sector contributed 28% of global emissions, the vast majority of which came from coal combustion. Combined emissions from land use, agriculture and waste made up 18%, followed by transportation at 16% and buildings at 7% of the global total.

Figure 6
Figure 7

All the data described here are available in Rhodium’s ClimateDeck data platform. The ClimateDeck features GHG and energy data for all 190+ countries in the world and all 50 US states and provides users the ability to filter by region, GHG, sector and sub-sector, as well as socioeconomic indicators (e.g., emissions per capita and per GDP), and full inventory tables for each country.

[1] Changes in magnitude differ from previous versions of our estimates for global greenhouse gas emissions data due to methodological improvements to account for methane from coal mines, HFCs, and agricultural emissions.

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The Global Economic Disruptions from a Taiwan Conflict

Recent tensions in the Taiwan Strait have stoked fears of a conflict between China and Taiwan, and raised questions about the implications of such a scenario for the global economy. How a conflict would unfold is impossible to predict, complicating any assessment of its economic and commercial consequences. Yet the risks of a crisis around Taiwan have risen, making these questions more important than ever for policymakers and business leaders.

Over the course of 2022, as the war in Ukraine shone a spotlight on geopolitical risks, Rhodium Group examined the potential global economic disruptions resulting from a hypothetical conflict between China and Taiwan. Our work builds on research dating back to 2004 that examined Taiwan’s global economic relationships.[1] Unsurprisingly, we find that the scale of economic activity at risk of disruption from a conflict in the Taiwan Strait is immense: well over two trillion dollars in a blockade scenario, even before factoring in international responses or second-order effects. The disruptions would be felt immediately and would be difficult to reverse. They would impact trade and investment on a global scale, leaving few countries untouched. Such disruptions could occur even if the conflict does not become kinetic.

The challenge of estimating disruptions from a conflict between China and Taiwan

Estimating the economic consequences of a Taiwan-centered conflict is challenging. Such a conflict could take many forms, varying in duration, scale, and in terms of the parties involved. Crucial data, particularly on semiconductor supply chain activity, is not publicly available. Important aspects of disruption scenarios are not easily quantified and often left out of trade shock models, including impacts on cross-border flows of people and ideas.[2] The ripple effects from trade and supply chain disruptions are also very difficult to estimate.

With these challenges in mind, our analysis adopts a necessarily simplified and partial approach to estimating the range and nature of economic activities at risk of disruption in a Taiwan-China conflict. We define conflict—for the purposes of our hypothetical assessment—as a blockade of Taiwan by China that halts all trade between Taiwan and the rest of the world. Based on these parameters, we identify the main channels of economic disruption, and where possible, provide an estimate of the minimum scope of economic activity at risk. We do so by using conservative assumptions throughout our analysis and by focusing our attention on the most serious areas of economic disruption.

We do not purport to estimate GDP losses or other measures of foregone economic welfare. Instead, we provide a snapshot of activity at risk at the beginning of a blockade, were it to happen today, making no predictions or assumptions about how such a crisis might evolve. Where we provide estimates of economic flows at risk, they are annualized figures. We discuss potential longer-term risks in qualitative terms throughout this note, but our quantitative estimates do not factor in second-order effects. Importantly, our analysis does not attempt to estimate the costs associated with additional disruptions from a military escalation or the imposition of international sanctions.[3] As such, our analysis should be considered a conservative and partial estimate of potential economic activity at risk.

Immense global disruptions, even under conservative assumptions

In a blockade scenario, the most significant disruption to global economic activity would come from a halt to Taiwan’s trade with the world, particularly in semiconductors. Associated disruptions to global supply chains—especially in major chip-consuming sectors such as electronics, automotive, and computing—would have grave repercussions for the world economy. Global trade with China would also decline due to a contraction in global trade financing, shocking the global economy and potentially triggering debt crises among China’s more fragile trade partners.

Disruptions from lost trade with Taiwan

Taiwan is the world’s 16th largest trading economy, having imported and exported $922 billion in goods and services in 2021. Almost all of this trade would be severely disrupted in the event of a blockade. Setting aside the value of imports that end up being re-exported and ICT-related trade that we cover below, approximately $565 billion in Taiwanese value-added trade would be at high risk of disruption from a blockade.[4]

While absolute trade values at stake are high, the most serious economic impact would come from disruptions to semiconductor supply chains and related downstream industries. Taiwan produces 92% of the world’s most advanced logic chips (at node sizes less than 10 nanometers in size), as well as a third to half of the global output for less sophisticated but nonetheless critical chips.[5] By some estimates, Taiwan’s leading chip foundry TSMC produces 35% of the world’s automotive microcontrollers and 70% of the world’s smartphone chipsets. It also dominates in the production of chips for high-end graphics processing units in PCs and servers. A rough, conservative estimate of dependence on Taiwanese chips suggests that companies in these industries could be forced to forego as much as $1.6 trillion in revenue annually in the event of a blockade.[6]

Beyond the immediate effect on corporate revenues from lost semiconductor production, the global economy would face significant second-order impacts that would likely add trillions more in economic impact. Many industries depend on the availability of goods and equipment containing Taiwanese chips. These include e-commerce, logistics, ride-hailing, entertainment, and other industries that collectively employ tens of millions of people. Spare parts and components for critical public infrastructure, such as telecommunications and medical devices, could become scarce. Ultimately, the full social and economic impacts of a chip shortage of that scale are incalculable, but they would likely be catastrophic.

Disruptions to global trade with China

A conflict over Taiwan would affect not only economic activity with Taiwan but with China as well. Even assuming no sanctions or military escalation between the US and China, trade between China and the rest of the world would be severely affected by disruptions to global trade finance.

Every year, banks provide $6.5 to $8 trillion in finance to help importers and exporters facilitate trade while goods are in transit. This short-term finance underpins as much as one-third of trade flows. In the event of a conflict between China and Taiwan, risk-averse global investors would pull back from lending activities, reducing the availability of trade finance and thus impairing international trade. During the global financial crisis, the collapse in trade financing was estimated to be responsible for almost one-fifth of the total drop in global trade.[7] In a Taiwan conflict, the effect could be even starker as banks reduce exposure to Chinese counterparties in anticipation of financial sanctions. Between a global liquidity crunch and the threat of sanctions, trade finance with China would likely become at least as scarce as it was in the global financial crisis, with the potential to disrupt more than $270 billion in trade between China and the rest of the world—even before any sanctions were put in place.

Trade with China would be affected by other forces as well. Domestic economic conditions in China would deteriorate quickly, not least from the disruptions to global semiconductor value chains described above. China is the world’s largest exporter of ICT goods, as well as the number one global production hub for automotive goods (Figures 1 and 2). Losing access to Taiwanese semiconductors would virtually guarantee a major economic shock to China’s manufacturing sector and the overall economy.

Figure

In addition, global and domestic investors would almost certainly seek to move money out of China, straining China’s exchange rate to the degree that even China’s strong capital controls and intervention by the PBOC would be unable to fully contain. Against the backdrop of a faltering domestic economy, a weaker RMB would reduce China’s imports from the rest of the world.

Other major disruptions to global economic activity

In a Taiwan conflict scenario, foreign investors are likely to dump their holdings of Chinese securities. As of June 2022, foreign investors held over one trillion dollars in onshore Chinese bonds and equities, and as of September 2022, more than $775 billion in offshore Chinese equities listed in the United States.[8] In the event of a conflict, investors would shed Chinese securities to reduce their exposure to possible financial sanctions and broader economic risks. Even prior to the imposition of Western sanctions on Russia, the value of Russian-linked portfolio assets collapsed as war risks began to mount: by February 24th, the day Russia launched its latest invasion of Ukraine, the Russian MOEX stock index had fallen nearly 30% from its October 2021 peak. A conflict could trigger a similar sell-off in Chinese assets, with hundreds of billions of dollars in investor value at stake. The sell-off could, in turn, trigger stronger capital controls from Beijing, preventing foreign investors from moving money offshore.

A conflict is also likely to have a far-reaching impact on Chinese outbound investment and lending activities. Amid a crisis-driven currency crunch, China would likely pause overseas direct investment activities and new lending and aid, putting around $100 billion in annual investment and lending flows at risk. Countries that have relied on rollovers and refinancing of Chinese loans in recent years—such as Sri Lanka, Pakistan, and Laos—would be hurt the most. Beijing could decide to pull out of debt renegotiation talks under the G20 Common Framework as well, putting other countries at risk.

Multinational companies (MNCs) selling into the Chinese market would face immediate revenue risks. The impact would come first and foremost from disrupted global semiconductor trade, given the concentration of foreign investment in China in the auto, manufacturing, and ICT sectors. Beijing could also impose capital controls in response to global capital flight, hindering the ability of multinational companies to repatriate profits. Companies could also face boycotts and protests, both in the Chinese market (due to home country statements of support of Taiwan), and in their home countries if they continued to operate in China during a period of aggression against Taiwan. At the extreme, foreign businesses in China could face risks of nationalization or asset seizure.

A conflict over Taiwan would also affect direct investment to and from Taiwan. Taiwan invests about $18 billion per year overseas, and foreign multinationals repatriated about $22 billion from Taiwan in 2021. A conflict could easily put these flows and foreign assets in Taiwan—including $127 billion in direct investment—at risk.

A truly global impact

Because the channels of disruption from a Taiwan conflict are so far-reaching across trade, investment, and financial channels, even countries that, on the surface, appear only remotely linked to Taiwan would also face risks. A rapid slowdown in Chinese demand for imports would impact commodity export-oriented developing economies that may only have tangential links to Taiwan. Disruptions to ICT and auto value chains would hurt countless economies up and downstream from semiconductors. The world would likely suffer shortages of critical goods ranging from agriculture and mining equipment to medical and telecommunication devices.

Effects on Taiwan-exposed value chains

A conflict between China and Taiwan would be highly detrimental to countries exposed to semiconductor-related value chains. These include major global producers of auto components and vehicles such as China, the US, Japan, or Germany, but also economies for which auto production represents an important share of GDP, as is the case with Slovakia, Czechia, and Hungary (see Figure 3 below). During the 2021 semiconductor shortage, average European passenger vehicle production fell around 13%, with German production tumbling nearly 20% and Italian production over 25%. While this shortage was severe, the impacts of a full-blown blockade of Taiwan would be far greater.[9]

Figure

A conflict would also hurt Taiwan’s regional trading partners, who rely heavily on Taiwanese chip inputs for downstream semiconductor assembly and testing operations, as well as electronics assembly. Among them, the Philippines, Vietnam, Malaysia, and Singapore could experience major disruption (Figure 4).

Effects on China’s trading partners

The stress on China’s trade and domestic performance from a Taiwan conflict would also have major global ramifications. With a weaker exchange rate, export manufacturing disruptions, and faltering domestic consumption (a common consequence of geopolitical shocks), China’s demand for global inputs would fall.[10]

Given the composition of China’s imports, it is fair to assume that commodity exporters would suffer from significantly lower demand from China, putting pressure on their own currencies and balance sheets. In a context of already high emerging and developing market debt levels, and financial stress in much of the developing world, the shock from China’s import demand drop could push yet more debt or fiscally stressed emerging and developing economies to the brink.

Given China’s crucial role in regional value chains, trade disruptions from a conflict would also directly impact China’s Asia-Pacific trading partners. For example, over 14% of Vietnam’s export value reflects imports of intermediate goods from China (Figure 5). The number is similarly high for Cambodia (13%), Hong Kong (9%), and Mexico (7%). Delays of shipments of key intermediate goods from China could quickly cause production slowdowns and lost revenue.

Figure

Effects on other global economies

Finally, due to major trade and global manufacturing disruptions, countries around the world would face the risk of spiking inflation and shortages in key industries. This would range from critical infrastructure inputs, such as medical and telecommunication equipment, to less strategic yet equally vital equipment goods for harvesting or mining, with the potential to disrupt business as usual in countless economies (see Figures 6 and 7). All these forces could, combined, increase the risks of a global economic recession, sustained inflation, widespread sovereign defaults, rising unemployment, and potential social unrest.

Figure

Conclusion

When taken together, our estimates suggest that the global disruption from a Taiwan conflict would put well over two trillion dollars in economic activity at risk, even before factoring in the impact from international sanctions or a military response. This note offers a look at just some of the likely disruption channels in a blockade scenario, and this figure should be regarded as a floor; the full scope of imperiled activity would surely be greater. Importantly, most of these disruptions would materialize almost immediately (particularly the impacts in financial markets) and would be hard to reverse. These impacts would be felt across the global economy, including in countries that may appear to be only tangentially linked to Taiwan.

Some of the impacts of a blockade could be mitigated, if only partially. A share of global trade could be redirected, and smart policy and business decisions in advance of a crisis—such as increasing stockpiles of critical chips—could mitigate the impacts from a short-lived conflict. Yet Taiwan’s centrality in the global semiconductor manufacturing ecosystem means there would be few alternatives in the short-run, and thus disruptions from a blockade would lead to very high, unavoidable costs to the global economy.

Our work sets aside, for now, the economic costs of international policy responses such as financial sanctions against China, but the potential application of these tools needs to be better understood. Additionally, while we have focused on the direct economic activity at risk from a blockade, there are a wide range of economic risks associated with lower-level tensions in the Taiwan Strait that need to be better understood. These might include Chinese economic coercion against foreign companies and countries in response to Taiwan-related statements or actions, rising shipping costs from intensifying military activity in the Taiwan Strait, or the reaction of financial markets to a further escalation between China and Taiwan, possibly involving the US. Preparing for these risks, including through rigorous contingency planning, will be important, whether or not one believes a full-blown conflict is coming.

[1] Daniel Rosen and Nicholas Lardy, “Prospects for a US-Taiwan Free-Trade Agreement,” December 2004; Daniel Rosen and Zhi Wang, “The Implications of China-Taiwan Economic Liberalization,” January 2011.

[2] See Understanding US-China Decoupling (2021), in which we suggest the need for a four-channel stock taking covering trade, finance, people and ideas.

[3] Other studies have attempted to estimate the economic costs of a war with China. See Gompert, Cevallos, and Garafola, “War With China: Thinking Through the Unthinkable,” Rand Corporation, 2016.

[4] Because gross trade volumes include intermediate inputs to goods that may later be exported, a “trade in value-added” approach is helpful to avoid double-counting the value of trade at risk. Using the OECD’s Trade in Value-Added database (2016), we estimate that $373 billion of value-added exports to Taiwan would be at risk, and $192 billion in Taiwanese value-added exports to the rest of the world would be at risk from a blockade, totaling $565 billion. Note that this excludes value added in computers, electronics, optical equipment, and motor vehicles to avoid double counting the value of trade in ICT supply chains, covered in the following paragraph.

[5] Varas et. al, “Strengthening the Global Semiconductor Supply Chain in an Uncertain Era,” Semiconductor Industry Association and Boston Consulting Group, April 2021.

[6] This figure is derived by adopting a simplifying assumption that annual industry revenues at risk are directly proportional to the share of chips sourced from TSMC. Industry revenue figures are from Counterpoint Research, Canalsys, and IbisWorld.

[7] Bank for International Settlements, “Trade Finance: Developments and Issues,” January 2014.

[8] U.S.-China Economic and Security Review Commission, “Chinese Companies Listed on Major U.S. Stock Exchanges, September 2022.

[9] Attinasi et. al., “The semiconductor shortage and its implication for euro area trade, production and prices,” European Central Bank, April 2021.

[10] Sinem Hacioglu Hoke, “Macroeconomic Effects of Political Risk Shocks,” Bank of England, December 2019.

Cutting Through the Fog: FDI in China Since COVID-19

The resilience of foreign direct investment (FDI) in China has been the subject of intense debates in recent years. China’s official figures show record FDI inflows since the COVID-19 outbreak in 2020 but a rapid decline in the second half of 2022. Alternative data points suggest a more prolonged slowdown in new investment that began in 2020. In this note, we examine available data sources to assess China’s FDI performance since 2020 and discuss the outlook. Our key findings are:

Official figures showing record FDI in 2020 and 2021 were inflated by short-term investments fueled by unique macroeconomic conditions. China’s high interest rates and currency strength enticed global investors to move money into China. A substantial portion of these short-term capital flows was recorded as FDI, rather than portfolio (or other) investment—as they would have been in an open market economy without capital controls and foreign ownership restrictions.

The reality of China’s FDI trajectory in the first two years of the pandemic is more subdued. Alternative datasets point to a sharp decline in new greenfield projects and foreign acquisitions over the 2020-2021 period, in line with real economy trends. While datasets that aggregate disclosed FDI transactions may be underestimating inflows—because MNCs have grown more reluctant to announce their China investments publicly and because these datasets do not fully capture multi-year greenfield projects—the reality is less rosy than the official figures suggest.

Since 2Q 2022, inflows have slowed sharply in response to global monetary conditions as well as macroeconomic and geopolitical headwinds. The sea change in global interest and exchange rate expectations, a downward revision of China’s growth prospects, and an increasingly challenging international policy environment suggest China is headed into a period of structurally lower FDI inflows, barring meaningful policy reform in Beijing that rekindles foreign investor enthusiasm.  

Macro Factors and Capital Control Circumvention Behind Robust Official Data

China’s official FDI statistics show that it became the world’s largest recipient of FDI in 2020 and continued to attract investment from abroad at a high level in 2021 and through 1H 2022. Both available measures—data from the State Administration of Foreign Exchange (SAFE), which uses balance of payments (BOP) standards, and data from the Ministry of Commerce (MOFCOM), which measures “utilized FDI” based on the directional principle—show record inflows since the pandemic outbreak (Figure 1). SAFE data records an average quarterly FDI inflow of $89 billion, almost double the pre-pandemic average.
Figure

The strength of FDI inflows during a period of severe pandemic-related disruptions and rising geopolitical tensions is curious but needs to be seen in the context of China’s peculiar external economic policy configuration. Openness toward FDI was an early feature of China’s economic policy approach, but other types of cross-border capital flows–-especially portfolio investment and other short-term flows of a more speculative nature—remained more tightly controlled. Market participants have thus relied upon FDI structures to funnel money in and out of China, including for financial purposes that would ordinarily be captured in other channels of the financial account.

One such channel is capital from offshore fundraising in Hong Kong and other jurisdictions. Offshore fundraising by Chinese firms boomed from 2017 to 2021, and the peculiar legal structures used to get around capital controls (such as variable interest entities, where offshore entities “own” a subsidiary in China, which then “owns” the interest in the operating entity in China) resulted in some of these funds being classified as FDI instead of portfolio investment. A significant portion of these funds flows from Chinese state banks and investors to Hong Kong and is then funneled back as FDI into China (“round-tripping”).

A breakdown of China’s official FDI statistics illustrates how important this phenomenon is. Hong Kong, the Cayman Islands, and Singapore together accounted for 78% of MOFCOM’s total utilized FDI in 2020, a figure that has increased steadily from 60% in 2010. Over that same period, China’s official data on FDI inflows has increasingly “decoupled” from mirror data on FDI outflows to China provided by counterpart governments (suggesting that these governments are recording these outflows in other BOP categories). For example, official data from Hong Kong and Singapore–-two of the most important sources of FDI for China—show that FDI flows are either flat or declining and at much lower levels (50-60%) than what MOFCOM figures suggest since 2015/2016 (Figure 2).

Figure

One way to illustrate how much financial and macroeconomic arbitrage considerations are influencing China’s FDI inflows is to plot SAFE’s quarterly FDI inflow data against the interest rate spread between the US and China (see Figure 3, using the USDCNY 12m FX swap points). It shows that FDI inflows strongly correlate with market expectations of rising exchange rates and high interest rate spreads. Inflows have skyrocketed since 2Q 2020 as investors decided to keep existing earnings in China and raise additional cash at low interest rates abroad and channel it into China to benefit from higher interest rates and exchange rate appreciation. Conversely, the rapid shift in global monetary conditions since 1Q 2022 has triggered a complete reversal of China’s FDI fortunes: Inflows went from a record high ($102 billion in 1Q) to a 20-year low ($13bn in 3Q) within just six months.

Figure

Alternative Data Show Decline in New FDI Transactions 

With all of these factors distorting the official statistics, it is important to consider micro-level transaction data to get an alternate perspective on FDI trends in China. There are a number of these transaction-level datasets out there, all of which show a significant decline in activity in recent years.

One of the most comprehensive sources for global greenfield FDI trends is fDi Markets from the Financial Times. According to fDi Markets, the value of newly announced greenfield FDI projects in China started to decline from previous trendlines in 2020, then stabilized in 2021 before falling to its lowest level in almost 20 years in 1H 2022 (Figure 4). The recorded total for 1H was $6 billion, which puts China on track to receive only a fraction of the $69 billion a year it received on average in the period from 2015 to 2019.

Data on inbound mergers and acquisitions (M&A) to China is available from many commercial data providers and shows a similar trend. Data from Bloomberg shows that, on average, China attracted foreign M&A bids worth around $60 billion annually from 2015 to 2019. In 2020 cross-border M&A transaction value dropped 38% before stabilizing in 2021. From January to July 2022, China only recorded $15 billion worth of inbound M&A transactions, putting it on track for the lowest annual level in more than ten years if the trend holds.

Figure

A Floor for FDI: The Stickiness of “Made in China, for China”

While the alternative data pointing to a sharp decline in FDI is more in line with the economic realities in China in 2022, it also has its flaws. It most certainly undercounts large greenfield investments by established foreign players for local consumption, which has become an increasingly important driver of FDI in China. These investments are undercounted for two reasons.

First, spending on large greenfield projects is spread out over multiple years. If a $10 billion project was announced in 2015, that total is often prescribed to the quarter in which it was announced, whereas the actual cash flow is disbursed over a longer period, sustaining FDI flows even if no new projects are announced. Long-term investments, with spending spread out over time, have played a significant role in supporting China’s inbound FDI. Figure 5 shows a Rhodium Group dataset on EU FDI transactions in China to illustrate the importance of multi-year projects.

Second, once a project has been completed, it will often lead to further expansions. These expansions, often funded by retained profits, are missing in some measures of FDI in China because they focus on initially announced values. As operating and expanding in China has become politically sensitive, companies are increasingly reluctant to publicly announce further spending or new projects.

Figure

Firm-level surveys and media reporting show that foreign companies are reconsidering their China strategies in light of recent challenges, but that only a small portion is planning to significantly reduce their existing footprints. A flash survey of European investors released in May revealed that the number of companies considering shifting current or planned investments out of China to other markets had doubled, and a position paperfrom the European Chamber of Commerce in China, released in September, confirmed the worsening sentiment.

However, nearly 80% of respondents in the May survey had no concrete plans to shift investments. Companies with ongoing operations in China cannot unwind them so easily, and many continue to expand their existing footprint. In the second half of 2022 alone, Volkswagen announced investments of up to $3 billion in two new R&D-focused joint ventures; INEOS paid $1.5 billion for a 50% stake in Shanghai SECCO Petrochemical; and BMW announced that it plans to move the production of electric Minis from the UK to China.

The Outlook: Lower for Longer

Foreign direct investment in China in 2020-2021 was lower than rosy official data suggests if one controls for distortions from financial arbitrage and capital control circumvention. Alternative datasets suggest that “real economy” investments have, in fact, been declining since 2020, in line with slowing growth and global FDI patterns.

This slowing FDI trend fits into the picture of a China that is more inward-focused and less open to the international economic engagement that characterized the first three decades of reform. Even if one uses the inflated official Chinese statistics, China’s inward FDI stock has grown at a slower pace than its overall GDP, and the FDI intensity of China’s economy is far behind most OECD countries (for more on this comparison, see China Pathfinder).

At the same time, we are not (yet) seeing a mass exodus of foreign firms from China. Most large multinationals have taken steps to localize their China operations in recent years, so even the migration of expats and pandemic-driven isolation of China from the rest of the world has not triggered a run for the exits. The largest firms that have sunk billions of dollars into local assets are staying put and following through on their investment plans (for a perspective on the changing European investor mix, see our September 14th note, “The Chosen Few”).

Looking forward, China is facing a much more challenging FDI environment. Inflows dropped to a 20-year low in 3Q 2022 as investors are unwinding interest and exchange rate carry trades. China’s zero-COVID policies and increasingly troubled growth outlook have dampened capital expenditure plans by multinationals, especially those that rely on strong Chinese consumption growth.

In addition to the domestic headwinds, a diversification and resilience push are complicating the outlook. The supply chain problems created by China’s strict COVID-19 policies have led some multinationals to reassess the practice of offshoring manufacturing capacity. We are also seeing the first signs of diversification and “friend-shoring” in sectors that have attracted large amounts of FDI in the past (electric vehicles, clean technology components, semiconductors, etc.). The introduction of an outbound FDI screening regime in the US could cause further complications, especially if the idea gains traction with other governments. Barring meaningful policy reform in Beijing that rekindles foreign investor enthusiasm, these factors suggest that China may be heading for a prolonged period of lower direct investment inflows from abroad.

Freeze-in-Place: The Impact of US Tech Controls on China

On October 7, the Biden administration unleashed a barrage of new controls on China-bound technologies, with a clear intent to constrain the development of China’s semiconductor industry and keep cutting-edge chips out of China’s hands. As we explained in a note published before the announcement of the controls, the evolving US technology strategy features both narrow and broad elements. The rules are narrowly focused on critical technology domains like high-performance computing, while at the same time far-reaching in their ambition to choke off China’s capacity to develop and scale leading edge semiconductors. This note explains the new controls, discusses the policy objectives behind them, assesses their potential impact—from short-term industry costs to broader spillover effects—and considers possible responses from foreign partners and China. 

Below are our key takeaways:

  • The new controls are far-reaching and comprehensive. They target key semiconductor chokepoints and are designed to thwart attempts by China to innovate its way around the constraints. Even as Washington grants licenses to mitigate some of the immediate costs to US-based firms and those based in foreign partner countries, the restrictions could be tightened over time to steer firms away from China.
  • The immediate costs to US semiconductor manufacturing equipment (SME) firms arising from a narrow implementation of the controls would be fairly limited (between $1.4-$3 billion in annualized sales, according to our estimates). However, if these controls were to be applied more broadly, for example to target foreign fabs in China, costs could rise quickly (to $4.6-$5.2 billion in annualized sales, based on our calculations).
  • The memory chip industry could be most affected in the long-term, with the risk of collateral damage to firms based in US partner countries. Restrictions on Chinese memory champion YMTC could rectify market imbalances by keeping a highly subsidized Chinese NAND supplier out of the market. However, foreign chipmakers SK Hynix and Samsung, now at the mercy of US licensing decisions, are likely to face significant costs linked to the restructuring of their supply chains.
  • The US administration appears willing to bear the diplomatic and economic costs of imposing unilateral controls. There is a real risk that foreign SME competitors, over time, could remove US inputs from their supply chains. At the same time, the US has signaled that it will not hesitate to pursue extraterritorial measures if partners fail to fall in line with the new tech restrictions.
  • Beijing has few retaliatory options. Restrictions on critical inputs like rare earths would only accelerate diversification efforts and hurt exports at a time when China’s economy is already struggling. Still, US firms in China could be targeted as China intensifies its efforts to replace US inputs. Beijing could also use anti-monopoly tools to disrupt cross-border mergers and acquisitions in strategic tech areas.
  • More controls are in the pipeline. The White House is advancing plans to create an outbound investment screening regime to prevent US capital from contributing to the development of force-multiplying technologies in China, including advanced semiconductors, high-performance computing, and possibly bio-manufacturing and high-capacity batteries.

Key features of the US export control package

The US Commerce Department’s Bureau of Industry and Security (BIS) published a densely layered package of rules on October 7 targeting China’s indigenous development of critical technologies, with an emphasis on semiconductors. The new controls, detailed in Appendix 1 of this note, are based on the following policy objectives:

  • Slow China’s progress in high-performance computing for possible military applications with tight controls targeting high-end computing chips. The rules cover the high-performance chips themselves (i.e., AI accelerators like the Nvidia A100 graphics processing unit (GPU)) as well as the products that contain these chips and associated software and technology. These rules also have a strong extraterritorial component to ensure no such inputs reach China.
  • Freeze in place China’s semiconductor industry by targeting chokepoints in semiconductor design software and manufacturing equipment. The rules include end-use controls for any item that could be used to produce or develop advanced semiconductors (defined as logic chips at 16/14nm or below or using non-planar transistor architecture; memory ICs with 128 layers or more for NAND and 18nm half-pitch or less for DRAM). They also reach much further in restricting the activities of US citizens that could contribute to China’s production or development of advanced semiconductors. Bigger questions loom over how pliant BIS will be in issuing licenses for a comprehensive list of controls for semiconductor manufacturing equipment as US-China tech competition escalates.
  • Facilitate blacklisting of Chinese entities with an unverified list (UVL) that puts the onus on Chinese entities to demonstrate non-military end-use within 60 days or else get placed on the BIS entity list (or worse). An adaptation of the foreign direct product rule (FDPR), under a new “footnote 4” designation, also enables the US to target a broad set of tech categories that could be linked to weapons of mass destruction (WMD) end-use.
  • Compel foreign partners to follow the US lead by expanding the use of FDPR, invoking far-reaching restrictions on the activities of US citizens linked to China’s development of advanced semiconductors, and implicitly threatening to expand extraterritorial measures if US allies fail to implement their own controls.

Narrow costs, broad spillovers

Several recent analyses argue that the costs of the new controls will be limited for the US semiconductor industry. A number of companies, including Dutch SME champion ASML, have said they expect the impact on their business to be manageable. While we agree that the short-term impact from a narrow application of the rules would be limited, we believe these costs could balloon quickly under a tightening of controls (for example to cover non-Chinese leading edge chip manufacturers in China)—a scenario we consider highly plausible. These estimates also do not take into account significant unintended spillovers for US and global players up and down the value chain.

Figure

Direct short term costs

The new controls target US SME sales to China for use in leading edge semiconductor development and production. Because one-year licenses have already been granted to the dominant foreign semiconductor producers in China— SK Hynix, Samsung and TSMC —the controls, for now, affect only Chinese fabs producing leading edge chips or planning to upgrade for such production.

Such limited implementation of the controls would result in arguably manageable costs. Using a mix of top-down and bottom-up approaches (see Appendix 2), we find that US SME firms could lose between $1.4 billion and $3 billion in annualized sales as a result of the new controls. The impact is not insignificant, representing between 9% and 19% of US firms’ sales in China, and about 3% to 6% of their global sales—but it would probably not be life-threatening for many of them. In the near term, sales could be redirected to fabs outside of China given that most SME suppliers are currently trying to manage large order backlogs of a year or more.

Although the controls apply to both logic and memory chip production, the impact would be most acute in the memory market. This is because Chinese companies are much more competitive in memory (90% of China’s leading edge capacity) compared to logic chip production (only 10% of China’s leading edge capacity). Nearly all of China’s memory chip capacity build-up would be happening at or below thresholds defined by the BIS as leading edge. Since memory fabs need to upgrade regularly to remain competitive, the US freeze-in-place strategy targeting this SME chokepoint is particularly hard-hitting.

Foreign memory chip makers, Samsung and SK Hynix, will need to consider the reliability of US one-year waivers in assessing whether it still makes sense to continue investing in leading-edge production in China. In contrast, logic foundries, such as Taiwan-based TSMC and UMC, could more easily justify maintaining trailing-edge fabs (TSMC at 16nm and UMC at 22nm) in China.

Costs under ramped-up controls

Our above estimates do not take into account the possibility that controls could be extended to cover non-Chinese chip manufacturers in China. SK Hynix and Samsung were granted one-year licenses within a week of the BIS announcement, but these firms cannot be certain these licenses will be renewed and for how long. If restrictions were expanded to non-Chinese fabs in China, which command most of the market for both logic and memory, then costs could rise quickly. We estimate that these could range from $4.6 billion to $5.2 billion in annualized sales. That said, lost US SME sales to the Chinese market could be compensated if leading memory chipmakers follow through in their plans to expand capacity outside of China.

Under a more assertive GOP-controlled Congress, or should the White House conclude that US allies and partners are moving too slowly in aligning their own export controls, Washington could choose to ratchet up entity listings targeting Chinese semiconductor firms using FDPR designations. We have not modeled out for this possibility, but billions more in global semiconductor and SME revenues would be at risk of disruption.

Co-travelers

Our estimates do not include consideration of “co-travelers,” or semiconductor inputs tightly linked to the sale of SME to China. Should US controls prevent the upgrade or construction of several fabs in China, the effect would also be felt by other players in the semiconductor value chain. This could be the case for semiconductor materials (including chemicals), for which China is the second-largest market globally, representing $11.9 billion in global revenues in 2021.

Psychological effect

Even though the new US controls are aimed only at leading-edge semiconductor development and fabrication, they could lead to an industry over-adjustment. Many SME inputs cannot easily be defined as “specially designed” for the production of leading edge chip at the 14nm threshold. The same tool (for example, deep ultra-violet (DUV) lithography or chemical vapor deposition) could be used in a 14nm process node or a 22nm process node. Given the broad framing of the rules—meant to deter transfer of any item that could be used for the development or production of leading edge chips—SME players could exercise extreme caution in China-related sales, ultimately creating a higher price tag.

Second-order impacts

Our estimates do not take into account second-order impacts on the industry from the recent controls. These include the longer term costs of supply chain reorganization stemming from tightened controls. These also include the possibility of short-run price increases in the industry. For example, the memory market, most affected by the measures, is currently running at overcapacity but industry experts estimate that this surplus may last for only a couple of quarters at most. If China-based memory production were to be severely disrupted by the controls, the memory industry could see significant price hikes within half a year— at least until more capacity is brought online outside of China over at least a couple of years. This would have spillover impact on downstream industries with low profit margins and which rely heavily on semiconductor content in their bill-of-materials—such as smartphones, consumer electronics and information and communications technology. Surging memory chip prices could lead to loss of production in these industries.

Strategic implications

The US administration is consciously taking a long-term, expansive and extraterritorial approach to redefining its technology relationship with China. While most market analysis has tended to focus on the immediate impact of the controls, a longer term perspective may be warranted to fully appreciate this sea change in policy and its possible spillover effects.

Below we lay out key considerations in this context:

With these rules, the US has created a loaded weapon to strangle China’s indigenous technology development. There is ample room to build on the foundation that the new controls have created. Ultimately, the impact of new rules depends on how they are applied. In this case, the tone of the US political debate on China policy, and the risk of rising tensions between the US and China over Taiwan, suggest that we could be headed for a more stringent implementation of the tech controls.

The breadth and depth of controls carry significant hidden costs. BIS put considerable effort into setting technical thresholds when devising the controls, including performance parameters on how many tera operations a chip can compute per second and defining what the US considers “leading edge” for semiconductor development. The controls aim for precision in drawing hard restrictions around priority areas, but also breadth in enabling BIS to track a comprehensive list of inputs for chip manufacturing. This includes mature technologies for both leading- and trailing-edge nodes. BIS’s laborious licensing process is a de facto constraint, but more severe spillover effects are possible if restrictions are applied more broadly.

US attempts to wall off American tech talent may encourage foreign firms to seek alternatives. In recognizing that brainpower lies at the heart of innovation and is the key to creating “as large a lead as possible” over China, the US administration is taking a novel approach to restricting the role that US citizens play in the development of advanced semiconductors in China. In doing so, the US is making a bet that foreign partners will see the costs of replacing US talent and removing US inputs as too high to bear. However, in certain areas of chip toolmaking, these controls could accelerate diversification away from the United States for firms that are keen to keep a foothold in the Chinese market.

Building a strategic one-way dependency with China requires restraint. Some US policymakers have argued that their intent is not to destroy US market share in China. On the contrary, if China’s indigenous development remains crippled and thus dependent on the import of US-origin chips for everything from data centers to smartphone devices, then the US can build-up its strategic leverage over China. However, this argumentation only holds so long as the United States avoids excessive application of FDPR. Just as Beijing is trying to steer its most dynamic private tech giants toward hard tech industrial priorities, including semiconductors, sprawling tech conglomerates developing AI chips alongside IoT devices may run a higher risk of getting blacklisted by the US. A proliferation of Huawei-like targets would inhibit the ability of US companies to sell to major Chinese tech consumers and undercut the strategic aim of building one-way dependencies.

Don’t underestimate BIS’s efforts to compensate for obvious resource constraints. BIS is under-resourced, particularly when it comes to the technical expertise needed to regulate the semiconductor industry. The new controls risk creating exponentially more work for the Bureau. Some observers, therefore, are assuming that implementation will be limited. However staffing constraints could be overcome in two ways. First, BIS could take a shortcut to enforcement by making examples of high-profile companies in order to induce broader industry compliance. With CHIPS Act disbursements underway, the US has more leverage than usual over recipient firms. Second, the latest rules respond to China’s opaque military-civil fusion strategy by stepping back from the game of whack-a-mole and shifting the end-use compliance burden to Chinese entities. If the Chinese entitites on the Unverified List fail to establish their bona fides within 60 days, they will be added to the Entity List.

The US is establishing itself as the de facto regulator of the global semiconductor industry, and is willing to apply far-reaching provisions, when it is deemed necessary, to compel foreign partners to fall in line. By including several extraterritorial measures in this package of controls, the administration is signaling to partners that they could be facing more pressure after the 2024 presidential election if they don’t align controls independently or in plurilateral working groups like the US-EU Trade and Technology Council (TTC) and the fledgling Chip 4 Alliance (involving the United States, Japan, Taiwan, and South Korea). Looking forward, it will be important to watch where gaps are created, as partners—who take a traditional country-agnostic, product-specific approach to export controls—shy away from matching the new US restrictions. It is likely to be easier for the US and Japan to align their approaches to semiconductor controls than it will be for the US and EU.

China will be cautious in how it responds, but will look for ways to capitalize on the leverage it does have. China’s continued reliance on US-origin technologies and concerns about doing further damage to its struggling economy are behind Beijing’s decision to comply with far-reaching FDPR sanctions on Russia. These factors have also played a role in the US decision to press ahead with far-reaching tech controls now. China could impose export controls on critical inputs like rare earth elements, but it only has to look at Europe’s accelerated push to wean itself of Russian energy sources to understand the longer term costs of wielding raw material leverage for geopolitical purposes. With electoral politics in the US heating up ahead of the the 2024 presidential campaign, China may be tempted to impose trade restrictions that target the politically-sensitive agriculture sector. China could also use tools like the Anti-Foreign Sanctions Law and blocking statute to push back on US measures. But Beijing has refrained from using these tools for good reason: why force multinational firms to choose between the US and Chinese markets at a time when China still needs foreign investment to move forward in critical technology areas?

China’s response may therefore be incremental. On the global front, China’s State Administrator Market Regulator (SAMR) has shown a willingness to disrupt tech mergers and acquisitions in the past—a particular focus area for Beijing as it works to undercut US-led friendshoring initiatives. Foreign companies operating in China, or heavily reliant on sales in China, could become targets of Chinese authorities. Because Beijing cannot respond to the US in kind, it may rely on nationalistic indigenization campaigns to save face at home. In practice, this could mean US-linked companies getting sidelined and growing state pressure on Chinese private entities to purge US links in the name of national security resilience.

Get ready for more controls. The October 7 BIS release has set a baseline for tech controls on China, but we can expect more regulatory action in the months ahead. The White House is poised to create a new regulatory regime, housed under the Treasury Department, that would allow for the screening—and possible blocking—of outbound investments. The new body is likely to focus on the same force-multiplying technologies that were contained in the BIS package (advanced semiconductors and high-performance AI and quantum computing), but its scope could also be expanded to include areas like bio-manufacturing and high-capacity batteries.

This note has been prepared in cooperation with Jan-Peter Kleinhans and the Stiftung Neue Verantwortung

Click here for the AppendixClick here for the Appendix

 

Meet the New (Same as the Old) Boss

What to Watch for at the 20th Party Congress

In October, China’s Communist Party will unveil changes in its leadership—except at the very top.  Xi Jinping is expected to receive a third five-year term as General Secretary of the Party, state President, and Chair of the Central Military Commission. That development alone will dominate coverage of the event, and be the focus of international reaction. 

Other critical questions include:

  • Does the makeup of the new leadership below Xi point to greater pushback against his policies or a consolidation of his authority?
  • Will political priorities continue to dominate policymaking, or will newly appointed technocrats be able to shift the system to focus more on economic performance?
  • Will these technocrats be able to change China’s highly restrictive approach to COVID-19 containment?
  • Will changes in China’s foreign policy approach and relations with the West emerge once the Congress comes to an end?

For investors and corporates, the media narratives surrounding the 20th Party Congress will be just as important as the leadership changes themselves, as conservatism and continuity of leadership and policy under Xi will be seen as negative signals for markets and for China’s medium-term economic trajectory.

The Importance of the Public Narrative

The results of the 20th Party Congress of the Chinese Communist Party will be difficult for even informed observers to interpret. The Congress is not a policy event and new policies are unlikely to be announced, besides broad objectives for the Party detailed in an extensive five-year work report. Instead, the primary outcomes of the Congress will be the announcements of new members in the Communist Party’s Central Committee, Political Bureau, and Politburo Standing Committee. It is difficult to discern the individual policy preferences of individual Chinese leaders, if these can even be known. Factional alignments among these leaders are opaque and have not been as relevant in policy debates during the Xi Jinping era.

As a result of this ambiguity, the narratives that major media outlets develop around China’s leadership changes will be significant and are likely to influence both the reaction from foreign governments and financial markets. The most important decision coming out of the Congress will be the widely expected announcement of Xi Jinping’s third term as General Secretary of the Communist Party. Virtually every other appointment will be viewed through the lens of whether or not it points to a further consolidation of Xi’s authority within the Party, or pushback against Xi’s rule.

The fact that Xi was willing to travel abroad ahead of the Party Congress—he visited Kazakhstan and Uzbekistan in recent weeks—suggests that any challenge to his leadership at the top of the Party is not a serious threat. The formal announcement of Xi’s third term will cement the global narrative of a more authoritarian China that is distancing itself from the notion of collective leadership. The Chinese Communist Party may have been moving inexorably toward one-man rule over the past five years, but many analysts will conclude that Xi’s third term marks the arrival at that destination. This development will also mark a new era of uncertainty in Chinese politics, as the question of succession will emerge almost immediately after Xi’s reappointment, with questions about whether or not the 69-year-old leader’s third term will be followed by a fourth.

Financial markets are hoping for some evidence of internal resistance to Xi, given the arbitrary policymaking over the past three years that has created significant market volatility. But for market confidence to grow, there would need to be clear evidence that a new team of economic officials plans a different approach to shoring up a Chinese economy hit by strict COVID-19 containment measures, a property crisis, and in the longer term, formidable demographic challenges. A further consolidation of Xi’s authority, in contrast, would imply continuity in policy, and more importantly, continuity in the elevation of Party priorities above those of China’s economic technocrats. This could deepen investors’ concerns about regulatory overreach.

New Economic Leadership—What Changes?

While the Congress is not the place for major new economic policy announcements, it will have important implications for longer-term economic dynamics, as Politburo Standing Committee lineups tend to reveal preferences for China’s economic governance. The past ten years have seen increasing Party involvement in economic policymaking, less policy coordination and balancing of interests, and a marginalization of the State Council and economic technocrats. The Congress will offer key signals for whether these trends are likely to endure in the next five to ten years.

If they do, optimism will wane that Beijing can make the tough choices required to tackle structural headwinds to the economy—demographic changes, the property market contraction, financial sector instability, external pushback—and push the economy closer to potential growth. The drastic economic slowdown of 2022 was precipitated by COVID-19 lockdowns but driven by much deeper weaknesses in China’s economy, as well as a series of policy mistakes, including an attack on the private sector and an absence of meaningful consumer stimulus.

Some might argue that in cementing his authority over the Party, Xi will be in a better position to delegate power back to the technocrats. This could be true, but it is equally true that his empowerment of government agencies like the Cyberspace Administration of China (CAC) over the past two years (the agency which led the push to delist Didi Chuxing from overseas exchanges) will be hard to reverse. Decisions made over the past decade have created new interest groups that will be strong obstacles to reform. Their continued influence could produce more surprise regulatory actions, such as those taken again Internet platform companies, education and tutoring firms, and firms such as Didi.

Two nominations will be closely watched: Li Keqiang’s replacement as premier (and the possibility of Li taking up another high-level position, which would signal continued influence); and Liu He’s replacement as vice-premier in charge of finance and economics.

Realistic candidates to replace Li as premier include current Politburo Standing Committee member Wang Yang, Vice-Premier Hu Chunhua, and Executive Vice-Premier Han Zheng. The emergence of another surprise candidate is possible, though unlikely. Neither Wang nor Han would be viewed by markets as denoting a change in economic policy, given their identification with the current leadership—though Han’s inclination toward fiscal austerity, which may be negative for economic momentum in the short term, could be more favorable for the private sector in the long run. Because Hu Chunhua is seen as closer to former General Secretary Hu Jintao, his appointment as premier could be viewed as heralding a change in approach to economic policy. But for that to materialize, other officials that do not have close ties to Xi would need to be put in place.

The replacement for Liu He in the finance and economics post is arguably even more important for China’s medium-term economic trajectory, and current head of the banking regulator Guo Shuqing filling this spot would be the most positively received by Western observers and financial markets. The candidate generally seen as closest to Xi is He Lifeng, a former NDRC official and largely unknown to financial markets. If appointments like He’s produce a narrative that Xi is favoring loyalty over technocratic competence, this would be one of the strongest policy signals out of the Congress—and one that would be interpreted negatively for China’s economic outlook over the next five years.

Transitioning Away from Zero-COVID

The Party Congress itself is unlikely to be the venue for a shift away from China’s “zero-COVID” policy.  The more important period to watch will be the two to three weeks after the conclusion of the Congress, when easing political pressure on Beijing and local officials could produce a different approach. As the Congress ends, and as other countries in the region continue to relax controls and travel restrictions, China risks appearing more and more isolated from the rest of the world.

International travel restrictions are likely to be the first to be lifted, ahead of the early Chinese New Year holiday in late January. The fact that Xi Jinping is already traveling abroad makes it more difficult for Beijing to maintain travel restrictions for Chinese citizens. But how domestic pandemic controls are eventually eased will be significant for economic momentum. A formal  announcement for China’s exit from “zero COVID”, and a timeline for lifting restrictions, would be more beneficial for the economy than a slow and muddled easing—even if controls are not lifted right away. It would provide some sense of certainty for businesses and consumers, boosting investment and employment. However, it is more likely that the easing of controls will take place incrementally, led by local governments rolling back testing and other restrictions, without a “big bang” announcement from Beijing.

The wild card is the path of the virus itself.  Either the COVID-19 restrictions that China has imposed so far have been effective in controlling the disease, or the number of cases has been suppressed by local reporting. Either way, trouble looms. China will inevitably face a significant COVID-19 outbreak when restrictions are eased. The only question is how soon it comes. Such an outbreak, regardless of when it occurs, will disrupt the economy,  with many fewer people working and others

refraining from travel and spending given newfound caution about contracting the virus. Still, given the tendency of Chinese officials to favor the vague concept of “stability” ahead of major political events, the end of the Party Congress could bring something of a reprieve.

China’s Relations with the West

Another question surrounding the Party Congress is whether it will have a material impact on China’s souring relations with the US and Europe. The short answer is no. Xi’s trip to Central Asia and meeting with Vladimir Putin—despite an acknowledgement of concerns about Russia’s actions in Ukraine—showed that the anti-Western partnership between Beijing and Moscow, and its defense of the idea of regional spheres of influence, is here to stay. This has reinforced concerns that Beijing could use the same logic to assert its rights vis à vis Taiwan.

A third term for Xi would cement the idea in Washington and other Western capitals that China’s political and economic divergence from the West will continue—making deeper economic engagement increasingly difficult, including in green technology supply chains where China has an edge. Nominations of technocrats seen as somewhat distant from Xi’s personal networks could revive hopes for an embrace of limited reform, but promise fatigue is real. And any evidence of a hardening of Beijing’s policy toward Taiwan during the Congress would generate more discomfort in Washington and Brussels at a time when the US Congress is trying to advance the Taiwan Policy Act.

In short, continued multilateral cooperation to push back against China’s actions and policies in the economic, security, technology and human rights spheres should be expected in the highly likely event that Xi receives a third term. We expect the Biden administration to roll out new measures to control technology flows to China around the time of the Party Congress (see our latest note). In Europe, we can expect the development of further policy tools in the economic and human rights spheres aimed at China, a broader debate about dependencies, and steps toward closer engagement with Taiwan, particularly at the parliamentary level.

As China eases some of its pandemic restrictions, we will see more high-level visits to Beijing, including expected trips by Germany Chancellor Olaf Scholz and French President Emmanuel Macron in the coming months. But the political space for them to engage actively with Beijing will be limited by souring opinion at home, and increased concerns around China’s trajectory.

Running Target: Next-Level US Tech Controls on China

With the US midterm elections around the corner and the 2024 presidential race set to unfold after that, the White House is preparing the next phase of its China strategy, with a focus on preserving US technological leadership. The recently passed CHIPS and Science Act, which aims to revitalize US semiconductor manufacturing, forms the offensive prong of the Biden administration’s strategy. Now for the defensive components. From list-based export controls on specific technologies to the buildout of outbound investment screening, the White House is putting together a playbook with important implications for a range of actors—including US industry and America’s allies abroad. Among the key questions: Where should the US draw the line when defining technologies as “leading edge”? How far should it go in using “long arm” provisions that target certain Chinese entities? And what role should human rights, supply chain resilience, and data privacy concerns play in technology restrictions under a broader national security umbrella?

The signposts point to a concerted attempt by the White House to expand the technology control tent while applying more precision to how controls are applied. But in trying to minimize the chances of an electoral upset, the Biden administration is squeezing a lot of ambition into policies designed on a compressed timeline. This can have widespread ripple effects—on countries and companies that cooperate with the US in the technology sphere and on China’s self-sufficiency push. This note unpacks the most significant elements of the emerging US strategy on tech controls and associated risks for US policy and industry. 

Unpacking the White House Agenda on Tech Controls

The summer was full of clues about the White House’s fast-evolving agenda on tech controls:

  • August 9: Biden signed the CHIPS and Science Act into law, allocating $39 billion in subsidies for US semiconductor manufacturing (including $2 billion for legacy chips) and an additional $11 billion for boosting R&D.
  • August 12: The Commerce Department’s Bureau of Industry and Security (BIS) issued an interim final ruleon Wassenaar-level multilateral controls, including for Electronic Computer-Aided Design (ECAD) software designed to develop integrated circuits with Gate-All-Around Field-Effect Transistor (GAAFET) structures—innovative 3D transistors that support node sizes at or below five nanometers (nm).
  • August 31: US technology firm NVIDIAdisclosed in an SEC filing that, as of August 26th, it was being restricted from selling its most advanced AI-powered Graphics Processing Units (GPUs)—A100 and H100 chips—to China. US semiconductor company AMD confirmedthat it had alerted Chinese suppliers of the new licensing requirement. A Commerce Department spokesperson told Reuters that a “comprehensive approach” was being taken with regard to “technologies, end-uses, and end-users” in order to protect US national security and foreign policy interests.
  • September 1: NVIDIA disclosed in an SEC filing that as of August 31st, it had received licenses to export newly restricted A100 chips in support of US customers through March 1, 2023 and A100 and H100 chips through its Hong Kong facility through Sept. 1, 2023, giving the company time to adapt to the new restrictions.
  • September 2: Semafor reported that the White House was planning to move ahead with an executive order on outbound investment screening ahead of the midterm elections but was still debating whether to go beyond a notification requirement to include blocking authority.
  • September 11: Reuters reported, citing unnamed sources, that the Commerce Department intended to formalize new requirements to restrict a) AMD and NVIDIA from selling advanced AI-related GPUs and b) KLA, Lam Research, and Applied Materials from selling semiconductor manufacturing equipment for sub-14nm logic chip production. The restrictions would apply to China and Russia.
  • September 15: The White House issued an executive order providing presidential guidance on the risks CFIUS should consider when reviewing transactions, with a special focus on critical technologies, supply chain security, investment patterns, cybersecurity, and personal data protection.
  • September 16: US National Security Advisor Jake Sullivan delivered a speech at the Special Competitive Studies Project Global Emerging Technologies Summit, drawing attention to “force-multiplying” technologies and asserting that the US needs to go well beyond the objective of staying “a couple of generations ahead” in strategic technology development.

These developments show that a more coherent US strategy on technology controls is taking shape, but one which risks verging into more extreme regulatory territory. A White House shift toward more list-based technology controls—against the backdrop of rising US frustration over the readiness of key allies to restrict tech exports and domestic political incentives to out-maneuver the Republicans on China policy—is likely to give rise to more trade volatility, including in global semiconductor supply chains.

Narrowing tech priorities

An important policy debate in Washington in recent years has been over how best to design export controls, both in terms of technology subsets and thresholds for defining “leading edge” technologies. The BIS has fended off repeated demands by lawmakers to issue a master “emerging and foundational technology list”.  Meanwhile, the White House Critical and Emerging Technology List remains alarmingly broad. However, the executive order issued by the White House offering guidance to CFIUS, Sullivan’s recent remarks, and the leaks on the White House’s upcoming outbound investment screening order point to a narrowing priority list for critical technologies that includes: advanced semiconductors, artificial intelligence, and quantum computing (large-capacity batteries and biomanufacturing are also growing areas of focus.) These technologies will likely be the focus of new export controls and investment screening.

Broadening beyond entity-focused technology controls

The recently disclosed BIS restrictions on AMD and NVIDIA AI computing chips confirm a new focus on a smaller list of critical (or, to use Sullivan’s terminology, “force-multiplying” technologies.) Although NVIDIA was granted a license to fulfill pending orders for US customers, the intent was clear: Commerce is focusing on a number of cutting-edge technologies that it wants to keep out of China’s hands.

This could mean a shift in emphasis away from entity listings (an exasperating cat-and-mouse game of BIS chasing down spinoffs in labyrinthine party-state business ecosystems) to broader technology-based controls based on potential military end-use and applied against countries of concern, such as China and Russia. Ad hoc entity listings will remain a tempting shortcut for policymakers to ratchet up sanctions and score political points, but a deeper foray into list-based technology controls can have a much broader impact on transactions related to dual-use technologies.

As the White House sharpens its focus on “force-multiplying” technologies, the next logical step will be for Commerce to better define military end-use and end-users in justifying list-based technology controls. This could impose a much heavier regulatory burden on companies to make a determination on end-use if their products fall into a military-civil fusion tech ecosystem.

Defining “leading-edge” and “chokepoints” for advanced chips

The US administration is also creeping closer to defining thresholds for what constitutes the “leading edge” in “advanced” semiconductors:

  • Export controls that BIS is reportedly formalizing would target semiconductor manufacturing equipment (SME) “chokepoints” by restricting US suppliers (KLA Corp, Lam Research Corp, and Applied Materials) from exporting equipment capable of producing logic chips at or below 14 nanometers (nm).
  • The BIS interim final rule on Wassenaar controls restricts “Electronic Computer-Aided Design (ECAD)” software specifically designed for producing chips with Gate-All Around Field-Effect Transistor (GAAFET) structures. This is an advanced 3D transistor architecture that supports the production of cutting edge chips at or below 5nm.
  • The CHIPS and Science Act sets the bar for “legacy chips” at or above 28nm, for the purposes of restricting recipients of CHIPS funding from engaging in “significant transactions” that involve the “material expansion of semiconductor manufacturing capacity” in China.

The signs so far suggest the White House wants to freeze China’s capabilities in place at 14nm (chips that China’s SMIC is capable of producing) at a time when multilateral controls are geared toward more advanced technology thresholds (5nm and below). The White House is consciously taking a more rigid approach toward defining the leading edge. As US National Security Advisor Jake Sullivan stated in a September 16 speech:

“On export controls, we have to revisit the longstanding premise of maintaining ‘relative’ advantages over competitors in certain key technologies. We previously maintained a ‘sliding scale’ approach that said we need to stay only a couple of generations ahead. That is not the strategic environment we are in today. Given the foundational nature of certain technologies, such as advanced logic and memory chips, we must maintain as large of a lead as possible.”

It can be reasonably inferred from the Sullivan comments and recent reporting on emerging controls that the Biden administration intends to set a more stringent threshold at 14nm in order to prevent advances in China’s logic chip development instead of designing semiconductor export controls to keep pace with innovation. Such an approach is designed to give the United States “as large of a lead as possible,” but it comes with important side effects. For example, the US administration is also trying to target perceived chokepoints in the semiconductor supply chain to hamstring China’s indigenous chip development. Semiconductor manufacturing equipment (SME) is a growing area of focus for this chokepoint strategy. But many SME components are not specially designed for sub-14nm production, and are used for producing both leading edge and legacy node chips. Wider ripple effects in semiconductor supply chains can therefore be expected if a blunt 14-nm standard is applied across export controls.

Lithography—a complex patterning process in chip fabrication—attracts the most attention in the SME chokepoint debate. Dutch firm ASML’s current generation of extreme ultraviolet (EUV) lithography machines uses a wavelength of 13.5nm. These machines are already restricted from export to China. But SMIC is reportedly producing at sub-10nm, using less-advanced deep ultraviolet (DUV) machines. There is a big difference between developing prototypes and producing leading-edge chips at scale. However, SMIC’s recent progress has nonetheless reinvigorated the US policy debate on whether the SME threshold should be lowered to restrict DUV as well. Such a restriction would stray further from “leading edge” controls.

Long-arm provisions

The Biden administration has made a concerted effort to coordinate technology controls with its partners to avoid alienating allies and ceding market share to foreign competitors. To this end, it has created arrangements like the US-EU Trade and Technology Council, Indo-Pacific Economic Forum working groups, and the emerging CHIP4 alliance (including the United States, Japan, Taiwan, and South Korea) to try to harmonize technology development and controls.

Progress has been predictably slow, however. US tech partners are ready and willing to join the strategic conversation (partly out of fear of missing out) but would rather focus these forums on constructive themes (coordinating development) than on restrictions that risk provoking a backlash from Beijing or raising costs for businesses.

Slow progress on the multilateral front risks feeding US anxiety over technology competition with China, driving it toward broader controls, with an extraterritorial flavor. The areas we are watching as we assess the potential for US long-arm provisions include:

  • Outbound investment screening provisions: A June congressional proposal for outbound investment screening led by Senators John Cornyn and Bob Casey contained broad language on covered activities carried out by any US person, foreign person, or their affiliates, including any entity “influenced” by a country of concern. The White House has instead been focused on plugging holes in existing export controls to prevent US private equity and venture capital from reaching entities of concern.
  • The White House is likely to take a step-by-step approach to outbound investment screening, starting with a Treasury-run mandatory notification requirement, linked to the White House priority list of technologies (advanced semiconductors, AI, quantum computing, and possibly biomanufacturing and subsets of clean energy technologies like high-capacity batteries.) The White House may be tempted to broadly define the covered activities as it tries to prevent US companies from evading controls through foreign subsidiaries.
  • BIS controls on “activities of US persons”: In addition to the Entity List Foreign Direct Product Rule, which was applied first to Huawei and then more broadly to Russia in cutting off the supply of US-origin technology, the US government has another powerful weapon that could come into play as it narrows its technology priorities. Under Section 744.6 of the Export Administration Regulations (EAR), BIS could impose comprehensive controls on the “activities of US persons” that support the development for specific dual-use technologies, military-intelligence end-use, or end-user. Given the pervasiveness of “US persons” linked to technology supply chains, from design to financing, the extraterritorial reach of such a measure would be extensive and could damage relations with allies producing advanced technologies.The all-encompassing national security umbrellaBuilding resilience in critical supply chains, preventing human rights abuses, protecting US citizens’ sensitive data, and bolstering US cybersecurity are all big objectives that overlap with the national security goal of preserving US technology leadership. In trying to address these concerns (and score political points along the way), it may be tempting for US policymakers to package policy objectives together under the national security umbrella when developing new controls. The US government may also end up targeting Chinese technology conglomerates on multiple grounds, straying further from the technical approach that usually informs export controls.  The Biden administration has tried to differentiate itself from the haphazard approach of its predecessor in targeting Chinese entities. This approach was highly disruptive to businesses, prone to legal challenges, and polarizing to US partners. But the White House is still trying to link its broader objectives to its strategic tech agenda. For example, after launching an export controls and human rights agenda at the December 2021 Summit for Democracy, we expect the administration to roll out more on this theme ahead of the midterm elections. Going forward, this could mean a ratcheting up of long-arm sanctions on entities involved in surveillance and cyber intrusion technologies and focusing on Chinese tech conglomerates involved in developing “force-multiplying” technologies in the military-civil fusion ecosystem.

Loaded Assumptions

The White House is trying to balance its strategic goal of advancing US technology leadership with the political objective of getting out ahead of the Republican agenda on technology controls should Congress flip in November. As a result, we can expect a flurry of policy announcements this fall that underscore a “tough on China” approach.

The Biden administration would prefer to put the focus on export controls in its China strategy and avoid potentially provocative measures (such as the Taiwan Policy Act being developed in Congress) which could ratchet up tensions with Beijing. By quickening its pace on technology and related investment controls, the White House hopes to build an unassailable lead in the technology race with China and establish limits for US policymakers. This approach is based on several, still untested, assumptions:

  • That China, already falling short of its technology self-sufficiency goals (especially in semiconductors) and undergoing a deep economic slowdown, will mostly absorb hard punches while struggling to innovate around controls. Beijing has mostly held back on retaliatory moves over export controls given its overwhelming external dependency on external tech inputs. However, China has extraterritorial tools—including anti-monopoly veto power on foreign tech mergers and anti-suit injunctions for standard essential patents—that could be applied more forcibly as the US tightens controls.
  • That foreign partners will follow the US lead and align on controls rather than run afoul of US restrictions (or risk ceding the moral high ground on human rights). For more geopolitically exposed partners like Taiwan, the US may hold more sway. Japan will try its best to steer the US toward more pragmatic controls. But Europe may resist signing on to policies that are specifically aimed at Beijing on the grounds that space for engagement must be preserved. Plans by German Chancellor Olaf Scholz and French President Emmanuel Macron to travel to Beijing in the coming months to meet with Chinese President Xi Jinping attest to their desire to maintain dialogue.
  • That non-US technology firms from like-minded countries won’t feel compelled to whittle down US content and develop non-US alternatives in critical tech supply chains, especially in the medium- to long-term.
  • That new US regulatory tools, even if based on narrower technology priorities for now, will not end up enabling a more extreme approach to technology controls under a more hawkish US administration down the road.

The White House is moving beyond its mop-up of Trump-era policies to action on technology controls targeting China. In developing a more coherent framework for designing those controls, the Biden administration is taking a big step forward in defining the policy debate. But the pressure of election cycles can lead to policymaking that creates big spillover effects. As the US quickens its pace on tech controls, we are likely to see a ripple effect on US-China relations, existing US dialogues with like-minded technology partners, and on private industry in the months ahead.

The Chosen Few: A Fresh Look at European FDI in China

After decades in which China felt like a one way bet for European firms, market conditions have become far more challenging due to restrictive COVID-19 policies, slowing economic growth and rising geopolitical tensions. Against this increasingly uncertain backdrop, we have taken a close look at European (EU+UK) FDI in China to assess the current state of investment on the ground, and shed light on how it has evolved over the past decade. Our key finding is that European investment has grown much more concentrated, both in terms of the companies that are investing there, the countries they come from, and the sectors in which they operate. While a handful of large firms, many of them German, continue to pour money into their China operations, many other firms with a presence in China are withholding new investment. At the same time, virtually no new European firms have chosen to enter the Chinese market in recent years. And acquisitions of Chinese firms have stalled, with greenfield investments increasingly dominating the FDI landscape.

Our findings point to a widening gap in how European firms perceive the balance of risks and opportunities in the Chinese market. They also suggest that a more nuanced perspective on the issue of European corporate dependencies is needed. From a direct investment point of view, it is wrong to talk about a broad-based dependence of European, or even German, companies on the Chinese market. As policymakers in Berlin and other European capitals consider measures to reduce economic dependence on China, they would be wise to take the growing concentration of corporate risks into account.

The Chosen Few

Our review of core trends in European FDI to China over the past decade has yielded one especially striking finding: today, the overwhelming majority of European investment in the country comes from just a handful of companies. We find, for example, that the top 10 European investors in China in each of the past four years made up nearly 80%, on average, of total European direct investment in the country. In 2019, the trend toward greater concentration was especially marked, with the top 10 investors representing 88% of all European FDI (see Figure 1). In comparison, over the previous decade (2008-2017), the top 10 European investors in China made up just 49%, on average, of the total European investment value.

Figure

European investment has also become more concentrated in terms of sectors. Five sectors—autos, food processing, pharma/biotech, chemicals and consumer products manufacturing—now make up nearly 70% of all FDI, compared to 57% in 2008-2012 and 65% in 2013-2017 (see Table 1). Among them, the auto sector stands out. It now consistently represents about a third of all European direct investment in China. This proportion was even higher in H1 2022 as German carmaker BMW increased its stake in its China JV from 50% to 75% and other European automakers poured money into new facilities to build electric vehicles.

Figure

Finally, European FDI in China has become more concentrated in terms of countries of origin. Four countries—Germany, the Netherlands, the UK and France—made up 87% of the total investment value, on average, over the past four years, compared to 69% in the previous ten years (see Figure 2). Among them, Germany stands out as the top investor by far, making up 43% of the total, on average, over the past four years, compared to 34% in the previous 10 years. In 2018, German firms accounted for more than half of all European investment in China. This trend is driven by a number of factors: German companies were early entrants to the Chinese market and their presence there was actively encouraged and aided over decades by the country’s political establishment; they are typically in capital-intensive manufacturing and engineering industries, meaning large fixed investments; and they are present in sectors that have seen strong growth in China over the past decade.

Figure

Among German firms, the three big automakers (Volkswagen, BMW and Daimler[1]) and chemicals group BASF have led the way in China. These four firms alone contributed 34% of all European FDI into China by value from 2018 to 2021.

The biggest European investors in China have maintained steady investment flowing into large greenfield projects due to three main considerations: First, they have generated significant profits in China and believe the market will continue to be lucrative despite the economic and geopolitical headwinds. Second, these companies feel they must continue to invest and develop products in China in order to safeguard the value of past investments and remain competitive with increasingly innovative domestic rivals, for example in sectors like electric vehicles. Third, they are trying to insulate their China operations from rising global risks through greater localization—an approach that is also being actively encouraged by Chinese authorities. In this respect, recent FDI in China looks quite different than it did a decade ago. It has become more defensive, in a reflection of a more risky environment, in China and globally.

Figure

The Others

The concentration around a few major German players is notable, but it does not mean that companies from other European countries are showing no interest in the Chinese market. Firms from France, the UK and the Netherlands consistently rank among the top ten investors as well, with non-trivial FDI in the automotive, chemicals, pharmaceutical, insurance and consumer goods sectors. Among them, Ikea, Diageo or AXA stand out as companies that have continued to make new, sizeable investments in China.

A closer look at transaction count, rather than investment value, points to continued engagement from firms in other European countries as well—including Italy, Sweden, Finland, Belgium, Denmark, Spain, and Austria. Together, these countries’ firms made up a stable 20-30% of all FDI transactions in China over the past decade. Still, the profile of these companies is slightly different from that of the “chosen few”. Generally speaking, their investments are more sporadic, and although they are typically active in the same industries, they tend to specialize in more specific niches like automotive components or green energy supply chains. Smaller firms, particularly from Germany, Sweden, and Finland, are also prominent in lower capex industries like industrial machinery and equipment, which represented 11% of deals but just 3% of transaction value between 2018 and 2021.

Because our database of EU FDI in China only includes transactions over EUR 1 million, we may not be capturing some smaller scale investments in services, less capital-intensive industries, or R&D activities. Additionally, in focusing on FDI, we are not accounting for other forms of economic engagement with (and dependence on) China. French and Italian luxury brands, for example, rely heavily on trade with China but are not deploying the vast amounts of capital that we see in the above-mentioned industrial sectors.

The Missing

Finally, our analysis reveals another noteworthy category of European investors—those that are missing from the picture. Given the size and growth of the Chinese economy in recent decades, one would have expected the country to attract a much broader range of foreign firms. But three types of investors are conspicuously absent in our review of recent trends.

First among them are investors in the services sector. Our data shows that between 2018 and 2021, business services made up less than 2% of the value and just 7% of the total deal count, while software & IT services made up 0.5% of the value and 3% of the deal count. This is despite the fact that, as of 2020, services made up 53% of China’s GDP (compared to 65% in the EU and 72% in the UK)[2] and despite the strong competitive advantage that European firms enjoy in those industries. Explanations for this include continued market access problems and the belated opening of the Chinese market to European players.

Second, we are seeing far fewer European companies looking to acquire Chinese firms. Greenfield investment makes up the lion’s share of European investment in China, representing two-thirds of the total over the past five years. Its share of total investment has been steadily increasing since 2019. By contrast, the value of European acquisitions in China hit a four-year low in 2021. As an economy matures, one would expect acquisitions to become a more common investment channel.  That hasn’t happened in China, as European firms remain wary of buying Chinese companies given formal restrictions, high valuations and a lack of transparency around financial accounts and other liabilities. COVID-19 travel restrictions have amplified the M&A downtrend.

Third, China is seeing fewer and fewer new entrants on its market. Since the outbreak of the pandemic in early 2020, for example, stakeholders on the ground say that virtually no European investors that were not already present in the country have made direct investments. It’s true that many globally-minded European companies are already in China, and have been for some time. Still, one would expect new European players to be showing interest given the size and growth potential of China’s economy. This may be a temporary phenomenon, related to the pandemic and China’s zero-COVID response. However, conversations with stakeholders suggest that a longer-term dynamic may be at work, with smaller European companies reluctant to accept the growing risks of investing in China.

The absence of new players has contributed to the greater concentration of European FDI around a few big players. Incumbents have a distinct advantage in an increasingly politicized market where foreign firms face high barriers to access, an uneven competitive playing field vis à vis local players, and a less-than-transparent compliance landscape. This explains why fewer small and medium-sized enterprises (SMEs) are venturing into the country, and why in sectors like financial services, which have been opened to foreign investment in recent years, only a handful of big European players have made the leap, despite the growth opportunities.

Outlook

We have established that European investment in China is now increasingly dominated by a small number of big players, predominantly German companies, and their top suppliers. What is less clear is how this dynamic will play out in the years to come. China’s highly-restrictive zero-COVID policies will presumably be phased out over the coming years. This could encourage new firms to enter the Chinese market, reversing the concentration trend we have seen in recent years. However it is also possible, perhaps even probable, that the concentration of European investment in China around a small number of well established European firms whose presence is welcomed by the Chinese authorities becomes more entrenched.

As China’s economic slowdown accelerates, amid a real estate crisis and crackdown on private enterprise, and as policymakers in Berlin and other capitals press ahead with a resilience and diversification agenda, the proportion of China skeptics in European corporate boardrooms may continue to grow. We believe it is likely that the gap between the “chosen few” and the broader swathe of European companies that are reducing their China exposure, either by paring back their footprint on the ground or putting future investments into other markets, could become more pronounced in the years to come. What does the future hold for those firms that remain fully committed? We are already seeing what might best be described as an “internal decoupling” dynamic taking hold within some of these companies—as staff, supply chains and data flows are increasingly localized and ringfenced. This “in China for China” push risks opening up a greater divide between the headquarters of European firms and their China operations, a dynamic that poses long-term challenges for the companies concerned—reputational, cultural and financial (due to smaller economies of scale). Corporate boardrooms and policymakers will have to consider these risks as they weigh up their future relationship with China.

[1] The transaction value attributed to Daimler includes FDI by both Mercedes-Benz and Daimler Truck, which was spun off in December 2021.

[2] World Bank and OECD.