China's Global Impact

China’s Global Impact

THE BUSINESS EXPOSURES AND ECONOMIC IMPLICATIONS OF A GLOBALIZING CHINA China’s Global Impact The Business Exposures and Economic Implications of a Globalizing China

RESEARCH REPORT R-1642-17 by David R. Hoffman, Ethan Cramer-Flood, and Erik Lundh

3 Executive Summary 3 Consequential and Intentional China Impacts 5 Often Overlooked China Exposures 6 Planning for China Exposure

8 China on the World Stage

10 The Rippling Effects of Global China Exposures 10 Stock Market Movements by Design 11 A Gap in Understanding 13 China as a Masterful Game Player

18 Using a Geo-Economic Framework to Assess China’s Global Impact 20 The Global Reaction

23 Transmission Channels Connecting China to the World 24 Snapshot on China’s Economy 24 Defining and Measuring Transmission Channels

41 Assessing China’s Major Geo-Economics Projects 41 The One Belt, One Road Initiative 43 Outbound Foreign Direct Investment 46 China-Centric Free Trade Agreements 48 International Development Banks 49 Made in China 2025 and the New Economy Plan

53 The Status of China Inc. 56 The Scale of Geo-Economic Levers 59 The Statist Tools 60 Forceful Leadership 61 Looking Forward

62 About the Authors 63 Related Publications from The Conference Board

Executive Summary

China’s global influence on markets and economies is significant and growing, spanning most sectors, regions, networks, and industries. Whether or not multinational companies operate there, China factors will inevitably impact their business. Executives need to understand the gamut of potential China exposures, so they can position their companies to exploit associated opportunities and mitigate risks.

“China exposure” is the positive or negative impacts that China-related developments could have on a business, directly or indirectly. Prospective China exposures are myriad and stratify across three dimensions: likely to plausible; major to minor; and near-term to longer-term. Many business leaders intuitively grasp, and continually assess, their respective business exposures related to market, economic, or political conditions or unfolding events inside China itself. However, global propagations in August 2015 related to China’s equity market collapse and “surprise” RMB (renminbi) devaluation alerted us to a critical gap in understanding by global businesses and financial institutions regarding China’s probable and plausible impacts on the global economy and the business environment, both inside and outside China. This report and our ongoing research and engagement program attempt to close that gap and better position multinational companies (MNCs) to be more agile and resilient to China geo-economic exposures.

Global China exposures for national economies, MNCs and financial institutions are many, and they are intensifying in terms of reach and magnitude. These exposures are both unintentional—the inadvertent consequences of changes in China’s economic conditions—and intentional—the result of China’s national and global economic development initiatives and purposeful international exertions.

Consequential and Intentional China Impacts On the consequential side, China’s economy, the world’s second-largest, is deeply and substantively connected with global trade, investment, production, and financial networks. For example:

• Changes in Chinese growth exert material influence on global commodity demand, the economies of commodity-producing countries, and on the workers and investors in affected sectors.

• China’s industrial sector (a major buyer of capital machinery and equipment) has significant impact on capital good exporting countries: Germany, Japan, Korea and the United States.

• Many major MNCs have material interests in the Chinese market. Any impact on the local economy propagates through MNC bottom lines to home markets and to institutional investors who own their shares on behalf of households and pensioners.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 3 • Global banks and investment funds are substantially active in Chinese financial markets and corporate finance activities. High positive demand diverts financial capital from other destinations; defaults can transmit globally, causing wealth destruction and associated economic drag both inside and outside of China.

• New volatility in China’s currency can unexpectedly change the price of goods and services flowing in and out of the country, impacting revenues and costs on both sides of the Chinese border.

• Chinese hot money1 flows, recently seen in surging capital flight, can and do impact asset markets worldwide, including city real-estate markets and share prices around the world.

On the intentional side, China is well underway with, or has recently initiated an array of ambitious global development projects of significant scale and reach that bear watching for both first- and second-tier impacts on regional economies and businesses:

• The vaunted “One Belt, One Road” (OBOR) initiative (see page 41) could significantly alter supply-chain economics and national competitive dynamics in Asia by either catalyzing a new set of emerging markets in Central Asia, Indochina, and the Indian subcontinent or creating a set of dependency risks across these regions if large-scale projects, once started, fail or if project encumbrances ignite political or social instability.

• Development aid programs in Africa or the Middle East could enhance economic prospects in these regions, or, if governance failures occur, further weaken political and institutional foundations.

• High-speed rail (HSR), nuclear, and civil works exports could provide much- needed infrastructure enablement to reignite stagnant growth in advance markets, but they could lead to instability if quality standards aren’t met or financing arrangements prove to be commercially unfeasible.

• China’s engagement with key international economic institutions—e.g., the IMF, the World Bank, the ADB (Asian Development Bank)—and the promotion of new adjunct institutions it has founded, like the Asia Infrastructure Investment Bank (AIIB) and the China International Payment System (CIPS), could positively impact the current inertia of institutional systems arguably in need of renewal, or it could upend these systems by virtue of China’s different ideological orientations with respect to cornerstone concepts such as independence, intellectual property, transparency, and rule of law.

• China’s national champions firms, both private and state-owned, are actively acquiring or investing across resource, industrial, and technology sectors, and portend to change the competitive dynamics for previously entrenched MNCs in many market spaces around the world, while significantly impacting valuation metrics and investment planning considerations. On the other hand, overpayment and/or integration or financing challenges raise many sustainability questions.

1 “Hot money” refers to investment funds that are intended for the highest short-term rate of return.

4 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org • Chinese outbound direct investment in Western developed economies—as manifested primarily in an explosion of M&A activity in recent years, but also in increasing greenfield developments—radically, if only momentarily, changed sell-side calculations among Western companies seeking buyers and churned up a range of political sensitivities among US and European citizenries.

Often Overlooked China Exposures In addition, there are many important China exposures that do not register on the dashboards of senior executives even though they (could) exert very real effects on local markets across the world the world, if China continues to decelerate.

Real estate Chinese buyers are substantially driving local residential housing markets—from Toronto to Singapore and from Manhattan to Sydney. In addition, many of the largest new residential and commercial developments in cities across the world are Chinese-backed or Chinese-developed. Local economies depend on whether these developments boom or bust.

Tourism Chinese tourists took an estimated 122 million trips abroad in 2016, spending an estimated US$109.8 billion.2 Cities and local businesses worldwide have come to rely substantively on income from Chinese tourists.

Talent flows Approximately 900,0003 Chinese students study abroad these days, and this cohort has become a vital source of revenue for universities in the United States and Europe. Increasingly, Chinese talent is flowing into international labor markets and is a critical channel for high-tech sectors in Asia and North America.

Disruptions in these and many other areas could have material impact on affected cities, their regional economies, and beyond.

It is important to note that, while many of these exposures suggest downside outcomes for global business in the near-term, many upsides are visible from a longer-term view. Economic corrections in China that might yield volatility for the financial sector in the near-term will very likely yield greater stability longer-term for the real sector in every- thing from the pricing environment to capital flows and commodity prices. Similarly, while China’s industrial policies can be very disruptive to global cost structures and supply-chain configurations, many winners and losers can be found along the way. China’s super-scaling in the solar panel industry from 2008 to 20134, for example, created supra-profitability for many players, followed by significant wealth destruction from overcapacity effects thereafter.5 But now, rising from the ashes, is a booming installation and servicing business around the world that was arguably enabled by new low price- points attributable to “the China factor.”

2 Sun Wenyu, “122 million Chinese tourists make outbound trips in 2016, spend $109.8 billion “ The People’s Daily Online, January 26, 2017 3 “A Record Number of Chinese Students Abroad in 2015 but Growth Is Slowing,” ICEF Monitor, April 6, 2016. 4 John Fialka, “Why China Is Dominating the Solar Industry,” Scientific American, December 19, 2016. 5 See: China solar industry case study in Anne Stevenson-Yang, China Alone: The Emergence from and Potential Return to Isolation (Mexico: J Capital Research Ltd./Universidad Nacional Autonoma de Mexico, December 24, 2013)

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 5 Planning for China Exposure How should executives think about all these exposures? We recommend a two-pronged approach:

For consequential exposures, a deep understanding of China’s economic condition and its likely future evolution is paramount. Dedicated resources, internal and/or external, should be assigned to this task. Furthermore, knowledge about the channels through which domestic events in China can propagate abroad and impact business operations is critical.

For intentional exposures, Chinese outbound projects should be monitored for potential company-specific business impacts, both direct and indirect. For projects with potentially high impact, progress and feasibilities should be monitored against funding considerations and international receptivity factors. Said another way—MNCs must assess whether project funding from China and its partners is likely to materialize and, if so, whether a given host country is likely to follow through on the project in question and at what level of vigor and enthu- siasm. A host of factors inform the answers to these two questions, and these factors need to be identified and scrutinized continually. It is not a static situation.

For near- and medium-term planning purposes, the consequential exposures we consider highly plausible and most important for the C-suite and strategy functions to consider are:

• A more significant GDP slowdown in China than is currently anticipated and the deflationary impacts this could have.

• Defaults of Chinese loans and bonds held by international commercial banks and sovereign central banks.

• Significant deterioration in geopolitical relations between China and its key economic partners.

• Dramatic new volatility in the value of the RMB, or a major retreat in the RMB internationalization program, and the surge in outflows this might encourage that would possibly overwhelm monetary environments in recipient markets.

• Unexpected demand-side shifts in China’s domestic market—in the consumer, industrial, or commodity space—whether positive or negative.

For near- and medium-term planning purposes, the intentional exposures we consider highly plausible and most important for the C-suite and strategy functions are:

• Retaliatory trade and investment policies undertaken by Beijing in the event of more stringent treatment of Chinese international players and exporters by Western capitals.

• Substantial investment projects along the OBOR region and the opportunities/ risks that they present—along with the (less likely) long-term changes they may induce—including medium- and high-speed rail (HSR) in Southeast Asia and Africa, port build-outs in South Asia and Africa, the China–Pakistan Economic

6 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Corridor, energy infrastructure in Central Asia and Southeast Asia, and general “special economic zone” construction across the entire region.

• Global market disruptions caused by newly competitive and strongly supported Chinese digital industries that ascend in line with the Made in China 2025 domestic initiative and portend impacts like China’s super-scaling in the solar panel sector, and in telecom switching equipment before that.

• Volatility in outbound Chinese capital caused by opaque and unpredictable capital control regimes and the strain those same regimes inflict on MNCs’ ability to repatriate cash.

Looking forward, The Conference Board China Global Impact Program intends to identify and dimension—and quantify when/where possible—the major exposures to the MNC business environment emanating from China, across both the short and long term, and help top business and financial service executives understand and position their companies for associated opportunities and plan for associated risks.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 7 China on the World Stage

In the great flow of information and opinion on China, we propose to address the need for a coherent, integrated, MNC- and financial investor-oriented analysis of China’s impact on the world economy and global business environment. The estab- lished measures of China’s impact—including GDP, population, trade, and investment data—represent only the beginning of what is required to understand the country’s full impact on the global economy since the 1980s and to plot out likely scenarios for the coming decade.

Chinese hypergrowth has not only driven many established economic measures into new and sometimes unknown territory, but it also has profoundly impacted the very way in which the world does business. In the cases of solar panels, telecom switching equipment, consumer electronics, machine tools, and digital displays, among others, China has reshaped entire global value chains and repainted the global competitive landscape.

Neither China’s economy nor its economic relationship with the global community has reached anything resembling a stable “new normal,” despite official claims. The situation is very much in flux, more now than ever, given the strong nativist influences now reshaping trade and geopolitics in the United States, Europe, and elsewhere. Global pushback vis-à-vis China’s trade and investment practices is growing in some places,

Figure 1 China's share of global manufacturing continues to climb Value of Chinese and non-Chinese manufacturing, and China's share of total

US$ Tln China's Share of Total (%) 14 35% Rest of World (left scale) China Share of World (right scale) China (left scale) 12 30

10 25

8 20

6 15

4 10

2 5

0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Sources: World Input Output Database, The Conference Board Inc.

8 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org yet Chinese investment is being welcomed in other places with open arms (though not often to the delight of local citizens or broad polities). Meanwhile, the global investor community remains enamored with Chinese listed companies, especially the new economy juggernauts like Alibaba and Tencent, and the Chinese technology “tsunami” investors envision will imminently come in their wake. A watershed moment occurred when President Xi Jinping spoke at Davos in early 2017 as the new champion of staying on the course of globalization and pushing for a more open global economy,6 a speech that many Western executives found more disingenuous than honest.

Contradictions abound regarding “the China question” from all corners—whether viewed through the lens of politics, society, trade, or business. China has not become like the West in its trade, investment, and global financial activity, notwithstanding the size of its economy. Significant opportunities and threats reside in things as mundane as the structure and reporting practices of Chinese listed companies abroad. If these companies accede to global norms in trade and commercial practice, they may herald a next wave of globalization. But if they maintain and promote abroad the “Chinese characteristics” common to the domestic China market—e.g., low transparency, weak quality controls, fraudulent behavior—markets and institutions globally could face a tough test.

Top executives, trusted with the power of the world’s major corporations and investment funds, have a huge stake in a deeper analysis and understanding of China’s imminent and potential future impact on the global economy and marketplace. The journey begins with defining and dimensioning “China exposure” globally within a holistic “geo-economic” framework.

What Is “Geo-Economics”?

For our purposes, The Conference Board defines geo-economics as the international economic consequences (actions and reactions) of a given set of domestic or geopolitical trends and national exertions, both intentional and unintentional.

In plainer English, geo-economics encompasses the way in which a country (or countries) impacts the global economy, either on purpose or through internal factors beyond its control. Thus, the study of China’s economic phenomena and how these exertions and influences affect geopolitics and commercial and financial markets globally can be included in the field of geo-economics.

China has become a major geo-economic actor across many spheres.*

* For a good reference work on geo-economics, see Robert D. Blackwill and Jennifer M. Harris, War by Other Means: Geoeconomics and Statecraft (Cambridge, MA: Belknap Press, an imprint of Harvard University Press, 2016).

6 Speech by Xi Jinping, Davos 2017, World Economic Forum Annual Meeting, January 17, 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 9 The Rippling Effects of Global China Exposures

Stock Market Movements by Design Despite a lackluster economic outlook in China at the time, political economy tools— e.g., state capital, media support, and top-down trading and investment directives to companies and investors—were marshaled in early 2015 to promote a publicly encouraged stock market rally,7 presumably to project confidence in President Xi and the new Chinese leadership that had assumed power in late 2012. Underneath the surface, the market ramp-up was, we assert, also an attempt to engineer an asymmetric capital account opening and, more specifically, a way to get international market support for China’s inclusion in both the IMF SDR (International Monetary Fund Special Drawing Rights) club of currencies and the MSCI emerging market indices.8 Why? Because achieving these milestones, particularly the latter, would encourage billions of dollars of passive inflows to come into China’s stock and bond markets from Western sovereign and pension funds via benchmark weighting machinations, providing a much-needed liquidity cushion for China’s over-leveraged credit market and wedding ever more Western financier interest in China’s success.

Over time, China got what it wanted from the IMF and from MSCI, but otherwise this political and geo-economic exertion backfired. After a bull run of seven months and a 111 percent rise in the Shanghai Composite Index (SCI) over that period, the market began to lose footing in mid-June 2015 and proceeded to plummet 43 percent over the next two-and-a-half months. Anxieties surrounding the stock market crash were exacerbated when the People’s Bank of China (PBoC) undertook a “surprise” devaluation of the RMB on August 11, 2015—in part, to decouple the China’s currency from the ever-appreciating US dollar and to contend with capital outflow pressures caused by the stock market decline.

The China equity market collapse and the RMB devaluation seemed to catch the world off guard. Major markets recoiled, as investors grappled with the potential spillovers in their respective corners of the world. Between June 12, 2015, when the SCI peaked at 5,166, and August 26, 2015, when it bottomed at 2,927, the US S&P 500 fell 7 percent, the Japanese Nikkei 225 fell 10 percent, the Hong Kong Hang Seng Index fell 23 percent, the London FTSE 100 fell 12 percent, the Korean KOSPI fell 8 percent, the Australian AS30 fell 7 percent, the Singapore STI fell 14 percent, the Indian SENSEX fell 3 percent, and the Indonesian JCI fell 14 percent. The impact was truly global.

China responded with an array of nonmarket activities to support its stock markets, stave losses, and prevent outflows. This included suspension of all IPOs, various selling bans among institutional investors, an opaque state share-buying campaign coined

7 Wang Ruoyu, “4000 Points is just the beginning of the A-share bull market,” People’s Daily, April 21, 2015. 8 MSCI, formerly Morgan Stanley Capital International, compiles of one of the world’s most followed emerging- market indexes. “Results of MSCI 2016 Market Classification Review,” press release, MSCI, June 14, 2016.

10 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org “The National Team,”9 and, at one point, suspension of trading on more than 50 percent of all Chinese A-shares. Dozens of traders and executives in China were jailed for illegal stock market activities. SDR inclusion was put on pending status for a year by the IMF, although it was eventually granted with special dispensations on September 30, 2016. MSCI inclusion was not granted at the time either, although a limited inclusion was eventually approved two years later, in June 2017. Both the IMF and Morgan Stanley cited nonmarket intervention and related transparency issues as primary concerns with respect to the governance and regulation of China’s financial market.

A Gap in Understanding That the manufactured nature of the initial stock market run-up and eventual rescue went unnoticed was not surprising; it was very cleverly disguised and even promoted ardently by State media as evidence of China’s market-economy status. But the global market reactions to the SSE sell-off and associated RMB devaluation surprised us. The bull market was never supported by fundamentals, and the managed devaluation wasn’t even close to where markets would likely have pushed the currency if they had been permitted to act. The world seemed largely unaware of China’s economic condition and arguably

Figure 2 China's GDP growth has already dropped significantly Offical National Bureau of Statistics (NBS) data versus The Conference Board (TCB) alternative estimation

Percent Y/Y 16%

14

12

10

8

NBS 6

4 TCB

2

0 ‘80 ‘82 ’84 ‘86 ‘88 ‘90 ’92 ‘94 ‘96 ‘98 ’00 ‘02 ‘04 ‘06 ’08 ‘10 ‘12 ‘14 ’16

Note: For detailed information and methodology regarding The Conference Board Global Economic Outlook and, specifically, the alternative estimation of GDP for China, see www.conference-board.org/data/globaloutlook/ index.cfm?id=27457. Responses to frequently asked questions about China calculations can be found at www.conference-board.org/retrievefile.cfm?filename=FAQ-for-China-GDP-vs4_10nov15.pdf&type=subsite. Sources: National Bureau of Statistics, The Conference Board Inc.

9 Gabriel Wildau, “China’s ‘National Team’ owns 6% of Stock Market,” Financial Times, November 27, 2015.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 11 still is today, as evidenced by the fact that economic and business media consider noteworthy the recent downward adjustments to China’s GDP growth targets, even when, according to our projections, China’s actual growth today is already sub-4 percent.10

These events of late 2015 alerted us to a critical gap in understanding on the part of global businesses and financial institutions regarding China’s probable and plausible impacts on the global economy and business environment. Potential stock market and currency value propagations are only the tip of the iceberg in terms of the world economy’s exposure to China, and adjustments in these factors portend to be much more significant, if not outright severe, in the coming years. China’s economy faces enormous structural challenges, not least including a massive amount of accumulated debt that must be dealt with. Someone will need to take the pain of digesting the debt—the only question is who it will be: the Chinese State, Chinese workers, Chinese companies, or its banks? Some foreign creditors will be caught in this web. Volatility is certain to increase,

Figure 3 Chinese debt as a share of GDP Total social financing versus reported GDP

RMB Tln Percent Share 250 250%

Debt (left scale) Debt/GDP (right scale) GDP (left scale) 200 200

150 150

100 100

50 50

0 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Sources: National Bureau of Statistics, People's Bank of China, The Conference Board Inc.

10 See The Conference Board Global Economic Outlook 2017, StraightTalk, February 2016. The Global Economic Outlook uses alternative GDP estimates for China, which are adjusted for overstated official Chinese data. Based on China’s Growth and Productivity Performance Debate Revisited - Accounting for China’s Sources of Growth with a New Data Set, growth rates of Chinese industrial GDP are adjusted for misreporting bias, and non-material services GDP are adjusted for biases in price deflators. This adjustment has important implications for our assessment of the growth rate of the global economy in general and that of the emerging markets in particular – both reflecting a downward adjustment in their recent growth rates. For responses to frequently asked questions on the China adjustment see China GDP FAQ.

12 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org and the probability of financial crisis (or it’s corollary, stagnation) is rising the longer that structural reform, and the deleveraging and/or debt resolution it necessarily must involve, remains stalled.11

The global consequences of China’s economic conditions are only part of the China exposure story. Much, much more is at stake, and it is either dependent on or could be highly influenced by China’s more proactive geo-economic actions at home and abroad. By “geo-economic action” we mean the use of its economic tools and resources to effect competitive advantage for its national economy and/or its firms and investors in China and internationally. The asymmetrical capital-account opening play mentioned above is an example of the kind of geo-economic action to which we refer.

China as a Masterful Game Player China has many powerful points of economic leverage: The country is now integrally connected into the global economy and its trading and supply chain networks. China’s activity and influence in global capital and financial networks is surging,12 as is its outbound investing. So, too, are its efforts to play a leading role in global governance and trade architectures and to do so “China style.” The AIIB juxtaposed to the World Bank and ADB (Asian Development Bank), and the RCEP (Regional Comprehensive Economic Partnership) as an alternative to the TPP (Trans-Pacific Partnership) and other free-trade agreements are two prominent examples. To top it all off, there is an array of domestic industrial development initiatives that are larger and more ambitious than ever. Made in China 202513 (including the Internet-Plus/New Economy plans) is surpris- ingly overt in its techno-nationalist orientations.14 If successful, the exertions China is making to transform itself from “factory of the world” to “high-tech superpower” could have profound impact on the global economy and operating environment. MNC business leaders need to understand these potentialities.

It is important to note that, even though dramatic economic corrections are generally considered bad for business, this assumption in China’s case arguably warrants second thought. The left column of the table (below) outlines a set of China impacts seen as plausible in the near- to medium-term, many of which suggest downside outcomes for global business. However, the longer-term scenario suggests that many positive correc- tions could follow, ultimately yielding a more stable and rational business environment, especially for the real sector, at both country and global levels.

11 See The Long Soft Fall in Chinese Growth: Business Realities, Risks, and Opportunities, The Conference Board, October 2014. 12 Going Global: Trends and Implications in the Internationalisation of China’s Currency, KPMG, January 2017. 13 Broadly speaking, Made in China 2025 is China’s latest official initiative to upgrade its national industry. See Scott Kennedy, “Made in China 2025,” Center for Strategic and International Studies, June 1, 2015. 14 See Jost Wübbeke et. al, Made in China 2025, Mercator Institute for China Studies (MERICS), 2016; and China Manufacturing 2025: Putting Industrial Policy ahead of Market Forces, European Union Chamber of Commerce in China,2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 13 Figure 4 Envisioning plausible short- and long-term global impacts of a sharp China economic correction Examples of predictable or plausible impacts and corrective outcomes

NEAR-TERM LONGER-TERM (predictable/plausible impacts) (predictable/plausible corrective outcomes)

• Global financial market volatilities caused • Reset and rationalization of energy and by RMB and A-share gyrations, and mineral prices—return to pre-Chinese corporate-earnings’ misses caused by China demand stability. Material disintermediation slowdown—countervailing impacts on QE of speculative, destabilizing, derivative (quantitative easing) programs in Europe and financing activities elsewhere • Positive real-estate market corrections: • Volatilities caused by escalated geo-economic reduction in irrational Chinese buyers that exertions — devaluation, State-supported have made housing unaffordable in many international investment and M&A, large-scale markets worldwide and have knocked-on State industrial investment: Made-in-China cost-of-living inflation in those markets 2025, the One Belt, One Road Initiative, etc. • Positive re-distribution of global financial, • Painful structural adjustments associated with material, and environmental resources China “de-bubbling,” especially: • Intensified reform pressures, sans China ®® On asset pricing and valuations — financial windfalls, on countries that coasted on the losses, demand reduction impacts of wealth China boom, especially the most retrograde destruction, lower investment states

®® On commodity export economies — • Healthy de-concentration of manufacturing prolonged low growth and substantial capacity, with more diversified emerging declines in commodity and energy sector market re-distribution in the future investing • Reduction of the value destruction imposed ®® On capital good exporting economies: on MNCs by Chinese IP theft and subsidized Korea, Japan, Germany—reduced competition (and its resultant forced cost- investment, painful capacity adjustments cutting and product commoditization) ®® On adjacent “Greater-China” economies: Hong Kong, Taiwan, Singapore • Recipient country benefits of healthy Chinese capital outflows and ODI (outward direct ®® On emerging markets globally, if and when investment) major China-backed developments stall or bust • Recipient country benefits of Chinese talent outflows • International impacts of large-scale China corporate debt defaults (China’s non-financial • Reduction in Chinese military spending and corporate debt stands at a staggering consequent de-escalation of sovereignty 169% of GDP—or about US$18 trillion*) — frictions in Asia depending on where debt is held • Reduction in State-backed “Go Out” ®® Foreign equity holders in Chinese banks expeditions and the negative host‑country (e.g. pension funds) impacts it entrained (government corruption, ®® Correspondent foreign RMB creditors on counterfeit goods, environmental USD lending by Chinese banks to Chinese degradation, etc.) corporates ®® Foreign holders of Chinese fixed-income property and property‑collateralized bonds • MNC losses from RMB depreciation and/ or repatriation controls —impacts on MNC investment in home/other markets • Inflationary and deflationary pressures

* See “China unveils plans to cut corporate debt, to push debt-to-equity swaps,” Reuters, October 10, 2016. Source: The Conference Board

14 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org China is understandably making great effort to avoid economic correction, much less crisis, given the importance of economic growth and promise to its political stability. So far, these efforts have not involved market-driven reforms, but instead rely on continuous tweaks and adjustments to monetary policy and credit markets, top-down investment directives, and hands-on macro-prudential management of the economy and its main actors, including direct interventions into problem areas (such as defaults). These efforts do serve to prevent a “Lehman moment” from occurring and have arguably been successful in forestalling crisis and maintaining growth, or the semblance thereof. Meanwhile, underlying structural problems remain unresolved and growing. Concerns regarding accumulating risks are now commonplace, albeit understated, and seem lost amid more sensational political headlines.

For instance, here is a selection of recent statements from leading global financial institu- tions regarding China risks:

OECD “Financial risks are mounting on the back of high and rising enterprise debt, expanding non-bank activities and enormous over-capacity in some sectors. A burst of the housing bubble would hurt the real estate, construction and several manufacturing industries.”15

IMF “…continued reliance on policy stimulus measures, with rapid expansion of credit and slow progress in addressing corporate debt, especially in hardening the budget constraints of state-owned enterprises, raises the risk of a sharper slowdown or a disruptive adjustment.”16

BIS “Early warning indicators for financial crises continue to signal vulnerabilities in several jurisdictions….The credit gap for China remained high at 26.3% of GDP, well above the threshold of 10%.”17

Fed “In China, the price of near-term stability has been an increase in leverage, particularly in the corporate sector. China’s overall debt–GDP ratio is elevated for an emerging market economy, especially considering that Chinese growth is likely to slow noticeably in coming years.”18

15 OECD Economic Survey – China, OECD, March 2017. 16 World Economic Outlook – A Shifting Global Economic Landscape, IMF, January 2017. 17 BIS Quarterly Survey - International banking and financial market development, BIS, March 2017. 18 Transitions in the Outlook and Monetary Policy, speech by Fed Governor Lael Brainard, Harvard University, March 1, 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 15 Figure 5 Chinese banking assets have skyrocketed in recent years Bank assets as a percentage of world GDP

Percent of World GDP 50%

45 China

40

35

30

25

US 20

15

Japan 10

5 1984 1989 1994 1999 2004 2009 2014

Source: Grant’s Interest Rate Observer

While buying time domestically, a slew of large-scale domestic and international investment programs have been initiated to engineer new growth, effectively create demand for Chinese overcapacity, and deliver demand to uncompetitive, sinking Chinese firms. Many of these initiatives will be explored in this report, including:

• The One Belt, One Road (OBOR) initiative (see page 41) and the associated “Capacity Cooperation” plan

• The four megacities,19 the Xiong’an special development zone, and China’s endless public works (rail, road, airports, seaports, special economic zones, etc.)

• High-speed rail, nuclear, and civil works exports • Developing country aid, loans, development grants, BOTs (build–operate– transfer), etc.

• Made in China 2025 (see page 25)

19 China’s four megacity clusters are set to be built out around the Pearl River Delta, the Yangtze River Delta, the Chuanyu mega-region, and the so-called “Jingjinji” capital region.

16 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org The reference investment budgets for these projects—for example, US$7 to 8 trillion over five years is the back-of-envelope calculation for the megacities project alone—defy prevailing budgetary theory. But even if the projects aren’t successful or only involve a portion of the proclaimed sums and scope, the stimulus effects would nevertheless move growth and investment-flow needles globally and potentially generate considerable business opportunity for value-add MNC suppliers.

All of these initiatives—especially the outbound investment projects and geo-economic exertions—raise questions about global China exposure for MNCs and financial insti- tutions in both positive and negative connotations. How likely is it that these global initiatives will come to fruition? If they do, will they do so under the rubric of estab- lished global trade and commercial practices or in ways more akin to the opaque, State capitalist business environment characteristics of the domestic Chinese market (i.e., the Chinese “socialist market economy”)? Xi Jinping’s statements at Davos20 in early 2017 imply a future China more aligned with global norms; but tightening control and containment of MNCs and foreign investors in China over the last several years and the more overt engineering of market outcomes domestically suggest reversion to the more Statist, more isolated and insulated China of the past. The jury is now out on which China will emerge preeminent on the world stage.

20 Speech by Xi Jinping, Davos 2017, World Economic Forum Annual Meeting, January 17, 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 17 Using a Geo-Economic Framework to Assess China’s Global Impact

The scholarly community applies varied definitions and usages to the term “geo-economics,” but for the purpose of this report, The Conference Board defines geo-economics as the international economic consequences (actions and reactions) of a given set of domestic or geopolitical trends and national exertions, both intentional and unintentional.

In plainer English, geo-economics encompasses the way a country (or countries) impacts the global economy, either on purpose or through factors beyond its control.

China’s geo-economic sphere has become a massive space, encompassing and driving enormous new capital flows, currency values, commodity price volatility, foreign direct investment and M&A activity, trade negotiations and relations, new multilateral gover- nance and development institutions, and multitudinous and accumulating pain-points at the nexus of geopolitics and economic interests.21 Our analytical framework for assessing the meaning, impact, and significance of these diverse influences—particularly for the business community—involves a three-pronged approach:

China’s domestic economic condition, and how that condition allows for international economic exertions and creates unintentional economic transmissions.

China’s myriad geo-economic platforms, i.e., the international development exertions themselves that are enabled (or hampered) by China’s economic condition at home.

The global reactions to those exertions, whether positive or negative, receptive or resistant.

The infographic (below) frames the gamut of “China exposure” globally via a geo-economic analytical framework.

It is important to note the equal significance between the ways China impacts the world purposefully and the ways it does so unintentionally, or consequentially. China’s unmatched growth and scale allow it to, for instance, undertake (and fund) foreign infrastructure build-outs at a level no other country can match. However, that same scale is the reason why global equity markets panicked in 2015 (as discussed previously), when China’s A-share markets collapsed, and the reason why Australia’s major mining companies found themselves in desperate straits when China’s commodity demand dramatically slowed in recent years.

21 See Ethan Cramer-Flood, “China’s New ‘Going Out’,” China Center Quick Note, The Conference Board China Center for Economics and Business, August 2016

18 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org [INSERT FIGURE 6: Graphic - Defining and Dimensioning “China Exposure” Globally]

Figure 6 The Geo-Economics of China Exposure

China’s Economic China’s Geo-Economic Global Condition Platforms Reactions

Enables Provokes exertions push back • One Belt, One Road (OBOR) and • Growth and scale • Exclusion from “capacity cooperation” • Currency value next-generation free-trade • RMB internationalization agreements • FX reserves • International loans and equity • Increasing public and polity • Fiscal strength investments distrust in partner countries • Financing • New Keystone International • Anti-China populism / capability/capacity Economic Organizations (KIEOs): nationalism in the West Asian Infrastructure Investment Bank • etc. • Currency and trade wars (AIIB), BRICS bank (NDB) • South China Sea — pivots • State Reserve Bureau market making and blocs in commodities • Strengthened US alliances in Transmitters • High-speed railway (HSR), nuclear, ASEAN, South Korea, Japan civil works’ exports • Increased military spending • International listings, fund raising, in Asia • Commodity demand / State-sponsored M&A and OFDI • Market Economy Status pricing • Aid, development grants, non-designation (WTO) • Defaults of commodity firms Build-Operate-Transfer projects (BOTs) • No more conditionalities — • FTAs: Regional Comprehensive • Emerging Market currencies FTAs, US-China BIT, U-China, Economic Partnership (RCEP), Free WTO, etc. • Global equity market Trade Area of the Asia-Pacific (FTAAP) volatility • OBOR project skepticism • Security services abroad and PLA • Capital flow & trade expansion imbalances • China International Payment System • China creditor defaults? (CIPS) • etc. • Multilingual outward-facing media propaganda organs Propagations Propagations

Global Business Environment & Financial Market Impacts

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 19 Similarly, it is vital to account for not only all of China’s myriad international geo-economic platforms (e.g., exertions, goals, toolsets, strategic policies, physical presence, etc.) and how they might impact countries, the investor climate, and the MNC operating environment, but also how those exertions engender reactions at the global and host-country level. Any given implementation along a project like the “One Belt, One Road” (OBOR) initiative (see page 41) may result in increased diplomatic influence and/or soft power for China, but it equally might create blowback, strife, and instability on the ground where local polities may not be aligned with China’s ambitions—as has already happened in Sri Lanka, Myanmar, Vietnam, and other places. The OBOR projects, for example, have the potential to remake energy, logistics, and supply-chain channels across Asia, but they also might drown host-countries in debt and overcapacity and lead to regime instability where populations or political factors resent Chinese intrusions. Meanwhile, in developed countries, the recent explosive growth of Chinese firms’ outbound M&A activity has, at times, been treated as a welcome injection of much-needed capital, but more often has been regarded as a hostile incursion and a national security threat. And in a whirlwind development, an emerging story now is the disruptiveness of unreliable Chinese M&A activity abroad, where overstretched Chinese conglomerates overpromise on purchase prices and eventually walk away from seemingly finished deals—either due to regulatory problems at home (capital controls) or due to their own cash shortages. The fact that this is already happening, after only two years of a significant Chinese M&A presence in the West, is indicative of China’s pattern of exporting its “bubble cycle” tendencies to the rest of the world.

The Global Reaction Regionally and globally, China’s increasing assertiveness in the military sphere has been well-covered by the mainstream media and other security-focused think tanks, but the local arms races and regional tensions generated by the PLA’s (People’s Liberation Army) growing power-projection capabilities must also remain on the radar of the business community. Possibilities for significant “black swan” disruptions that previously did not need to be considered (in areas like the South China Sea) add to business uncertainties in emerging Asia.

For this and other reasons, geo-economic resistances to China’s ambitions have already begun to proliferate:

• increased CFIUS22 reviews in the United States; • sudden alarm in Germany over Chinese technology acquisitions;

22 The Committee on Foreign Investment in the United States (CFIUS) is an inter-agency committee authorized to review transactions that could result in control of a US business by a foreign person, to determine the effect of such transactions on the national security of the United States.

20 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org • all of China’s major trading partners rejecting its “Market Economy Status”23 in the WTO (World Trade Organization) at the end of 2016;

• Vietnam and other ASEAN countries rapidly increasing their defense spending and reaching out for closer ties to the United States;

• a whole range of local communities along the OBOR project rising up in protest over intrusive, environmentally degrading, and sovereignty-eroding Chinese developments; and

• the TPP trade agreement—which arguably always was a geo-economic response to China’s growing trade power, intransigence at acquiescing to free trade norms, and resistance to moving toward next generation trade liberalization—is surprisingly still alive and viable even after US withdrawal from the deal, partially because some of its members still seek to contain China and the agreement still excludes China.

Collectively, the world is demonstrating an unprecedented degree of resistance to China’s ambitions, presumably because these ambitions have become so overt. However, leaders in Beijing could just as easily point to an equally long list of successes, such as the AIIB rollout, the RMB’s inclusion in the IMF’s SDR,24 unusually positive relations with Russia and (sometimes) the Philippines, the warm welcome China’s transportation infrastructure projects generally receive across the developing world, and Xi Jinping’s sudden—and arguably awkward—positioning as a leading champion of globalization and economic interconnectivity in the age of anti-globalists like US President Donald Trump and his ideological peers in Europe.

When envisioning how all the stories of China’s geo-economic exertions will unfold and what it will mean for business, the two most important factors inevitably resolve down to (1) China’s funding capacity for its projects and (2) the international community’s recep- tivity to China’s goals and preferred policy outcomes. Among these two factors, any analysis must begin with the question of whether and how long China’s funding capacity will endure. As with the sudden decline in China’s outbound foreign direct investment in the realm of international M&A, many jarringly significant and sudden Chinese influ- ences abroad can vanish just as quickly as they appeared if the money back home dries up. Beijing’s concerns over capital flight and declining foreign exchange reserves and the capital controls they have engendered have so far mostly hindered only private Chinese

23 When China acceded to the WTO 15 years ago, the terms required a phase-in transitional period to adjust and reform the elements of its economy that were blatantly distorted by nonmarket forces; this period is now complete. China is therefore putting pressure on the United States, the European Union, and its other major trading partners to grant it market economy status (MES), which would make it harder for the US and EU governments to gain legal redress against unfairly priced Chinese exports. Thus far, the United States, Europe, and Japan have refused to acquiesce to China’s demands. In other words, China’s major trading partners have essentially chosen to ignore the “letter of the law” in China’s WTO accession agreement, and thereby retained their right to more easily use the WTO dispute-resolution mechanism to initiate antidumping actions against Chinese firms and industries. 24 The IMF’s special drawing rights (SDRs; currency code: XDR) are an interest-bearing synthetic asset used by central banks to help them manage their foreign exchange reserves. The value of the SDR is determined based on a weighted basket of “prestige” currencies: the US dollar, the euro, the Japanese yen, the British pound, and, since late last year, the Chinese yuan.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 21 conglomerates operating abroad in nonstrategic industries. But the next time Chinese regulators feel the pinch, it would not be surprising if certain noncommercially viable economic projects abroad (such as the notorious China–Pakistan Economic Corridor) found themselves suddenly defunded or at least in long-term stasis. China never has had the capacity to fund all projects to the full scope it has articulated, and its funding capacity is naturally diminishing with slowing growth. It was always the most commer- cially viable or geopolitically advantageous projects that stood the best chance of getting off the ground.

The era of warm receptiveness to China’s international activity appears to be waning, but many collaboration vectors still need to be considered—particularly as the West enters a period when “values alignment” no longer appears to be as determinant as it once was. Significantly, China’s own aptitude for playing this game is considerable, and it is a variable that needs to be understood alongside other emerging trends. Amid the populist chaos afflicting the United States and parts of Europe, the (seemingly) relative stability of China’s State-led governance and development models may be rising in international appeal.

22 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Transmission Channels Connecting China to the World

As we have outlined, our framework for assessing China’s impact on the global economy and business environment involves assessing both intentional actions engineered by China’s leadership and consequential “spillovers” resulting from China’s increased integration into global economic, financial, and commercial networks. These consequential propagations are poorly understood and are increasingly impacting outside sectors, economies, and firms with direct and indirect exposure to China. Recent examples of this include:

• the 2014 housing downturn that crushed global hard commodity prices and deeply wounded China’s suppliers: Australia, Brazil and Mongolia;

• the aforementioned 2015 China equity market collapse (see page 10) that roiled global stock markets; and

• the chronic overcapacity in China’s steel sector, which has led to a flood of cheap Chinese steel abroad that has pulverized foreign producers and gutted whole sectors.

Businesses around the world are often blindsided by these events because (1) China’s economy is difficult to read, (2) transmission channels are poorly understood, and (3) the resulting exposures can be both direct and indirect. Clearly, no one is looking at this in a holistic way.

It is important to note that our intention in framing (and eventually quantifying) China’s consequential exposures, much of which suggests downside outcomes for global business at first glance, is not to be alarmist. Our reasoning is thus: First, it is unarguable to say that China is experiencing a momentous and very challenging economic transition away from investment-led growth that precedent shows is very difficult to navigate unscathed; Japan, the Four Little Dragons,25 Indonesia, Thailand, and others are testaments to this point.

Second, with all due respect to the Chinese leadership, who have, time and again, proven to be masterful stewards of economic growth and stability and no doubt will continue to be so, the probability that China will smoothly sail over the unprecedentedly massive capacity and debt reductions necessary for future economic sustainability without schisms of some sort must be considered low. The scale and complexity levels involved are already extraordinarily difficult to manage and will become even more so. While a crisis is not imminent, thanks again to the macro-management acumen of China’s regulators, a prolonged period of slow growth is considered imminent due to unresolved overcapacity and debt drags and their structural causes. Given the scales involved in China, and the precedent already seen in other countries at much smaller scales, China exposures warrant special attention. This makes good business planning and risk management sense.

25 The Four Little Dragons comprise Taiwan, Hong Kong, South Korea, and Singapore.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 23 Snapshot on China’s Economy It has been widely claimed in Chinese State media that China’s economy has found a “new normal” and that the outlook, at least in the short-run, is for slower but still moder- ately fast growth in the 6 to 7 percent range. The Conference Board disagrees with this assessment. China’s economy has not stabilized, and volatility is more likely, not less. We continue to believe that the scenario outlined in The Long, Soft Fall in Chinese Growth,26 holds true, and we expect China’s real GDP growth to slow from an average of 7.4 percent year over year (2010–2015) to 3.3 percent year over year (2017–2021) and then to 2.9 percent year over year (2022–2026).27 This assessment is based on an alternative China GDP series28 that The Conference Board has generated and differs significantly from the official figures reported by China’s National Bureau of Statistics (see Figure 2 on page 11).

With the above said, the current Chinese economic uptick—whether a function of improvements in economic fundamentals or global reflation—may give Chinese leaders an opportunity to proactively tackle some of these problems and adopt much-needed economic reforms. Doing so would serve to mitigate some of the risks mentioned above and to improve the nation’s longer-term growth prospects. We remain skeptical that this will happen, however, as we do not believe the current political environment lends itself to instituting major changes. President Xi has clearly demonstrated that he prefers adopting stronger centralized control mechanisms instead of market liberalizations as the means for managing the economy (what we term “re-form,” as compared to market- oriented reform29), and in the run-up to this autumn’s National Party Congress, China’s leaders have remained obsessed with presenting an image of stability. How long market management and engineered stability and growth can suppress market forces seeking capacity consolidation, debt deleveraging, and asset repricing is the critical assumption for business planners. Given the size of the PBoC’s balance sheet and the country’s massive fiscal resources, our operating hypothesis is that the current status quo can continue for some time, perhaps several more years. In the meantime, absent reform, city-level stagnation will spread across the most moribund industrial sectors.

Defining and Measuring Transmission Channels In aggregate, the economic inertia in China remains troubling, and the probability that the country will be the source of larger, more frequent global shocks is growing. As mentioned, global institutions increasingly cite this risk, but most couch the specter in muted ways, presumably for political reason, resulting in messages that are lost on the business community.30 Few doubt that the risks are imminent; it is just a question of when. It is therefore critical that global business leaders understand how distortions and

26 Hoffman et al., The Long Soft Fall in China’s Growth, 2014. 27 The Conference Board Global Economic Outlook 2017, Nov 2016. 28 2015 GDP Assessment for China Update of Alternative Estimates, 2000-2015 29 This is a stylized concept. Reform in the Western sense is generally associated with policy and structural changes involving marketization, liberalization, deregulation, institutionalization, etc. By contrast, “re-form,” in Chinese practice, is typically not market-oriented and instead involves parsing, combining, restructuring, and/or reorganizing State entities using nonmarket management means to achieve incremental performance improvement or to forestall painful market force impacts. 30 See page 15 for warnings from IMF, OECD, BIC and the US Federal Reserve.

24 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org disruptions in China’s domestic economy will or could propagate beyond its borders. With that in mind, The Conference Board China Global Impact Program is working to identify these channels, quantify them, and explore how events in China may impact foreign nations, markets, and businesses.

The table (below) lists the transmission channels that we believe play an integral role in connecting China’s economy to the global economy. We have sorted them into categories, provided a short description of their importance, and offer key questions that need further explorations.

The Conference Board has already begun to quantify several of these transmission channels and assess the associated exposures. In doing so, we have started assem- bling data into a “China Exposures Database” that will be available to members of The Conference Board as modules are completed. We are utilizing a variety of data sources to build this database, including national economic statistics, granular financial and corporate data, and nascent academic datasets.

In this initial assessment, we begin to peel the onion with the first transmission channel listed in the table (below): trade-related exposures to China.

Figure 7 (continued) Consequential China geo-economic transmission channels

REFERENCE CATEGORY CHANNELS MAGNITUDES IMPACT 1 Chinese Imports • Second-largest gross National dependence on China as a buyer of key goods importer in the world; and services Trade 9% share of global • Share of trade partners’ total exports; criticality of these exports imports in 2016 to overall country GDP • $1.9tln in gross • Critical sector and regional concentrations imports of goods and services in 2016 (*Taking into account the degree to which the value of China’s imports are generated in trade partner economies versus content generated in upstream supply chain nations) SECOND ORDER IMPACTS: GDP, employment, public finances, shareholders

Chinese Exports • Second-largest gross National dependence on China as a supplier of key goods exporter in the world; and services 11% share of global • Share of trade partner’s total imports; impact of these imports to exports in 2016 overall GDP • $2.2tln in gross • Criticality of Chinese exports to the supply chains in other exports of goods and countries services in 2016 • Critical sector/industry/product concentrations (*Taking into account the degree to which the value of China’s exports is generated in China itself versus content generated in upstream supply chain nations) SECOND ORDER IMPACTS: inflation, upstream and downstream suppliers

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 25 Figure 7 (continued) Consequential China geo-economic transmission channels

REFERENCE CATEGORY CHANNELS MAGNITUDES IMPACT 2 Inbound Foreign • $136bln in FDI flowed Stock and flow of inbound FDI to China Direct Investment into China in 2015 Investment • Source of this capital and share of source country FDI (FDI) • Aggregate FDI stock • Alternative costs of this capital to source country of $1.2tln in 2015 • Potential losses on this capital in China • Upside potential of a reformed, more reciprocal and equitable environment for foreign investors; negative impacts of re-direction of FDI from other countries to China SECOND ORDER IMPACTS: supply chains, MNC balance sheets

Chinese Outbound • $128bln in outbound Stock and flow of outbound FDI from China FDI FDI flowed out of • Share of Chinese FDI to total FDI, money supply, and overall China in 2015 investment level of host country • Aggregate OFDI stock • Host country valuation impacts of Chinese investment calculus of $1.0tln in 2015 • Host country dependencies on Chinese capital and the assets it finances SECOND ORDER IMPACTS: global asset prices, M&A activity, supply chains

Inbound Portfolio • As of March 2017, Stock and flow of foreign capital coming into China’s Investment $91bln in foreign funds capital markets invested in China • Amount of foreign capital exposed to Chinese public markets, under QFII vs. $10bln magnitude of potential losses ten years earlier. • Alternative cost of capital to home market and other markets • Repatriation and trapped capital risks (if capital controls instituted) SECOND ORDER IMPACTS: Chinese asset prices, global investors

Chinese Outbound • As of March 2017, Stock and flow of Chinese outbound portfolio investment Portfolio Investment $90bln in Chinese • Level of Chinese portfolio investing in host markets, degree of funds invested abroad dependence under QDII, vs. $24bln ten years earlier. • Speculative behavior impacts on volatility, bubble-making • Licit versus illicit capital impact on money manager actitivity/ behavior SECOND ORDER IMPACTS: global asset prices, global investors

Chinese Outbound • In 2016, Chinese Stock and flow of Chinese real estate holdings abroad Real Estate Investment buyers invested • Share of Chinese investment in local real-estate markets, level of a record $33bln depency in commercial & residential property • Chinese buyer impacts on pricing environment and local worldwide affordability thresholds SECOND ORDER IMPACTS: global real-estate prices, inflation, consumers

26 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Figure 7 (continued) Consequential China geo-economic transmission channels

REFERENCE CATEGORY CHANNELS MAGNITUDES IMPACT 3 Chinese Banking • Chinese bank assets Borrowing and lending activities of Chinese banks abroad Activities Abroad have grown to the Financial • Activity levels of Chinese banks in localities, share of debt/credit equivalent of over 40% creation; local firm and project dependencies of global GDP • Counterparty dependencies and risks • Four of the world’s 10 largest banks are SECOND ORDER IMPACTS: global banking institution, interest Chinese rates

Insurance Markets • Since 2010, Chinese Offshore activity of Chinese insurers insurance assets have • Size and breadth of Chinese insurer asset holdings in host country tripled in size to RMB 15tln • Valuation and business continuity dependencies • Reinsurer exposure • Integrity of Chinese underwriting to host country customers SECOND ORDER IMPACTS: global asset prices, global investors

Chinese Global Bond • Unable to tap Issuance of bonds by Chinese entities abroad Issuance domestic markets, • Location and currency of issuance China’s riskiest corporate borrowers • Size of Chinese issues raised $6.1bln offshore • Share of local bond market in 1Q17, vs. just • Issuer, buyer and underwriter concentrations $4.5bln onshore SECOND ORDER IMPACTS: global investors, global banking • As of 2016, China’s institutions offshore debt was $1.42 tln

Chinese Global Equity • Of the world’s 69,499 Issuance of equities by Chinese companies abroad Issuance listed companies • Location and currencies of listings that are actively traded, just 4,411 • Amount of public proceeds raised (6%) are registered as • Market caps of Chinese issues domiciled in China. • Share ownership — institutional and retail concentrations However, of that set, • Levels of gains and losses 1,056 (24%) are listed on exchanges outside SECOND ORDER IMPACTS: global investors, global banking of China institutions 4 Foreign Exchange • At $3tln, China’s Forex RMB volatility and the impact on China’s Foreign Exchange (Forex) Reserves Reserves are the Reserves Currency largest in the world • Sovereign debt holdings — levels, relative shares and • Reserve includes an dependencies estimated $1.09 tln in • Sovereign debt trading activities and price influences US sovereign paper SECOND ORDER IMPACTS: public finances, interest rates, exchange rates

RMB Deposits and • As of 2015, an RMB deposits and markets outside of China Currency Usage estimated 2tln RMB • Size of pools held offshore (mostly in Hong Kong, • Share of trading Singapore, and • Holders of currency, concentrations — local bank exposure London) • Hedging liabilities • Sixth most-used SECOND ORDER IMPACTS: exchange rates, global banking currency in the world institutions (SWIFT data)

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 27 Figure 7 (continued) Consequential China geo-economic transmission channels

REFERENCE CATEGORY CHANNELS MAGNITUDES IMPACT 5 Global MNC China • While few US Share of global MNC revenues generated in RMB in China Revenues companies report Corporate • Bottom line and equity price dependencies, public shareholder their China revenues knock-on impacts publically, the country is material to many of • Upside exposures of a reformed, more level business environment the Fortune 500 for foreign investors • Apple, for instance, • China loss/gain impacts on investment elsewhere derives nearly 50% of • Trapped cash risks (if capital controls instituted) its earnings from China SECOND ORDER IMPACTS: global investors, supply chains, employment

Global MNC China • Of the $2.5tln in China supply chain dependencies Supply Chains goods and services • Chinese share of production that China exported in 2014, 25% came from • Criticality of China supply chain components; redundancy foreign suppliers safeguards • Industry/company/product concentrations • Discretionary versus nondiscretionary products SECOND ORDER IMPACTS: global FDI flows, exchange rates, GDP 6 China and Global Hard • Chinese demand is Chinese demand for and supply of iron ore, cement, copper, Commodities central to most major aluminum, nickel, zinc, lead, tin, lithium, uranium, gold, silver, Commodities hard commodity rare earth elements markets • Chinese share and price influence • Chinese trading • Suppliers and consumer concentrations — companies and sectors activity then adds substantively to these • Country economy, sector, firm dependencies consumption figures • Public shareholdings exposed at firm level SECOND ORDER IMPACTS: employment, public finances, sector suppliers, asset prices

China and Global Soft • China is the world’s Chinese demand for and supply of coffee, cocoa, sugar, corn, Commodities largest agricultural wheat, soybeans, livestock, etc. importer, accounting • China’s share of demand and nominal dollar values for 20% share of global imports • Supplier concentrations, and importance to country SECOND ORDER IMPACTS: employment, global investors, public finances

China and Global • China is the world’s Chinese demand for and supply of coal, oil, natural gas and Energy Commodities largest energy other energy commodities consumer, accounting • China’s share of demand and nominal dollar values for 23% of global energy consumption • Supplier concentrations, and importance to country SECOND ORDER IMPACTS: employment, global investors, public finances, inflation

28 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Figure 7 (continued) Consequential China geo-economic transmission channels

REFERENCE CATEGORY CHANNELS MAGNITUDES IMPACT 7 Chinese Pollution • China is the world’s Global implications of Chinese air, water and soil pollution largest source of CO Others 2 • Pollution drift impact on other country environments and emissions, accounting associated costs (e.g. air pollution, ocean pollution, etc.) for 27% of the global total • Inflationary and demand impacts of cost increases needed to ensure environmentally sustainable production • Sector, industry, product concentrations • Industrial and export competitiveness impacts on countries with stricter rules and enforcement SECOND ORDER IMPACTS: inflation, consumers, public finances

Chinese Outbound • Chinese travelers Chinese outbound tourism flows and associated economic Tourism reportedly spent activity $109bln abroad in • Contribution city and locality retail economies, companies and 2016 products — city concentration • Share of hotel and transportation sector capacity, revenue and profitability • Financial services volumes and revenues SECOND ORDER IMPACTS: local businesses, hospitality industries

Chinese Overseas • Approximately Flow and stock of Chinese students studying abroad Education 900,000 Chinese • Academic revenue volume and share — financial dependency students are currently levels studying abroad, more than any other • Student body share and scale dependencies nationality • Local / national labor market dependencies — sector, industry, company dependencies SECOND ORDER IMPACTS: local economy benefits of resident Chinese students

Chinese Supply of Flow and stock and composition of Chinese labor abroad Human Capital • Labor market impacts — supply, wages SECOND ORDER IMPACTS: local labor politics

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 29 Effects of Indirect China Exposure in Brazil

Many of the exposures identified in the table (above) are of the first order in that they relate to specific nations, markets, and sectors. However, given a sufficiently large disruption, there may also be additional indirect, or second order, impacts. For instance, Brazil’s economy saw significant disruption starting in 2014—largely due to events that occurred in China. China’s infrastructure and housing boom had previously generated a high demand for hard commodity inputs, like iron ore, for which resource-rich Brazil was a primary supplier. This resulted in a commodity boom in Brazil that helped drive economic growth, but it also created a high degree of exposure to China via the resource extraction sectors.

According to data from the World Input–Output Database, Brazil’s mining and quarrying industry accounted for 4 percent of the nation’s GDP in 2014 and it was dependent on Chinese consumption for 10 percent of the value it generated. When China’s economy began to slow and its housing market lost its footing, construction activity dropped off and the need for iron ore, copper, and other raw commodity inputs ebbed. This reduced China’s global demand for these inputs and sent commodity prices plummeting. These China-specific events propagated strongly through China–Brazil trade flows and hit Brazil’s commodity industries. The propagations were so hard, in fact, that it helped send Brazil’s economy into a tailspin from which the country has yet to fully emerge. The second order, or indirect, impacts of this exposure shock are therefore quite real— they’ve touched nearly every aspect of Brazil’s economy and, indeed, hurt unrelated MNC sales in the country and the economic welfare of the citizenry. Moreover, these economic travails are arguably one root cause of the recent political instability in Brazil.

Trade-related exposures At the terminus of this causality chain are the foreign economies, markets, and businesses that ultimately benefit or suffer due to their exposure to China. We have established an ongoing research program to explore these connections quantitatively.31 What follows is our initial assessment of key trade-related transmission channels and exposure points derived from value-added trade data and an overview of global exposures related to the iron ore and crude oil trade and markets.

Trade dependencies and imbalances have long been contentious political issues, and recently they have become acutely so with the advent of populist, nativist movements in polities around the world. Moreover, many analysts consider a trade war with China to be a topmost downside exposure to global business. Contrary to this thinking, our analysis shows that global exposures to Chinese trade are rather limited in aggregate, but concentrated in a fairly narrow set of industry and product categories and the countries originating these products. Commodity trade exposures are, of course, paramount

31 The Conference Board China Global Impact Program intends to identify and dimension—and quantify when/ where possible—the major exposures to the MNC business environment emanating from China, across both the short and long term, and help top business and financial service executives understand and position their companies for associated opportunities and plan for associated risks.

30 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org and very large in scale. For most other products, this is not the case. China’s import substitution regime imposed on MNCs is certainly and largely responsible for this, and that same imposition creates other global exposures related to supply chain risks and revenue/profit dependencies. But contrary to prevailing thinking, at least from a trade perspective, the world, by and large, bears low dependencies on China. Moreover, China exhibits comparatively high dependencies on global trade for its growth. (We highlight this dynamic in a case study on the US–China trade relationship on page 36. Future work of The Conference Board China Global Impact Program will illuminate this dynamic across a broader set of Chinese trading partners.)

China is, of course, among the largest trading economies on Earth. In 2016, China’s total trade (gross exports + gross imports of goods and services) amounted to US$4.146 trillion versus the world’s largest economy, the United States, whose total trade is US$4.925 trillion.32 These data correctly reveal that China is a critical hub in global trade, but fail to capture the full nuances of the contemporary global trading architecture.

Traditionally, gauging trade-related economic exposures has been done using the above-cited gross import and export data—which captures the total value of goods and services that flow across international borders. These data were conceptualized during a time when the bulk of trade took the form of exchanges of finished products. Today, however, the nature of cross-border trade is starkly different. The rise of global value chains (GVCs) has created a new paradigm wherein many of the goods and services that are now sent and received from abroad are simply components for final goods that will be assembled and then re-exported to final markets for consumption. For example, the entire value of an iPhone assembled in China and then shipped to the United States is included in US–China gross import data, even though many of the device’s components are actually produced in Japan, Korea, and Taiwan. Similarly, many dresses imported into the United States from Italy are made from Chinese-produced silk, but that silk’s value is not captured in conventional US–China gross trade data.

This flow of intermediate inputs has thus distorted our understanding of international trade flows and economic dependencies. For instance, according to data from the US Bureau of Economic Analysis,33 the United States imported US$484 billion in goods and services from China and exported US$169 billion to China in 2014, resulting in a trade deficit of US$315 billion. Upon isolating the value of goods and services actually produced within these two countries and then traded between them, however, the values change dramatically. Chinese value-added imports (VAM) into the United States were US$320 billion (34 percent below the value reported above) and US value-added exports (VAX) to China were US$120 billion (29 percent below the value reported above) in 2014. On this new value-added basis, the United States’ trade deficit with China shrinks from the reported US$315 billion to US$200 billion. This more accurate accounting is an important input both economically and politically as American voters debate the best course for the country’s relationship with China.

32 UNCTADSTAT, United Nations Conference on Trade and Development (UNCTAD). 33 U.S. International Trade in Goods and Services, January 2017, Bureau of Economic Analysis, US Department of Commerce, January 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 31 To assess the true economic exposures that one nation has with another vis-à-vis the trade relationship, it is critical to work with data that differentiate between gross trade flows and value-added trade flows. Fortunately, this kind of analysis is made possible using new statistics from the World Input–Output Database (WIOD).34 Not only can this dataset be used to identify both the direct and indirect flow of value-added goods and services between countries, but it can also isolate the value-added trade flows between individual sectors and industries within these countries. These features provide a new lens through which to assess geo-economic exposures related to trade that was not previously possible, and the conclusions are powerful.

In the (below) table, we’ve identified the degree to which several key economies are exposed to China via trade channels on a value-added basis, drilled down into specific sector exposures, and identified the top-five exposures at the individual industry level. (We’ve conducted additional analysis on other major economies as well, but will publish our full findings at a future date.) In general, there appear to be three broad categories that encapsulate the nature of most national China exposures:

1 Economies that supply China with high-end global value chain (GVC) intermediate inputs

2 Economies that supply China with raw materials

3 Economies that supply China with IP-intensive goods and services and capital goods.

While there are certainly outliers to these classifications, these exposures appear to hold more often than not.

INTERMEDIATE INPUT SUPPLIERS Economies that fall within this category are generally located in Asia and are deeply integrated into the region’s information and communication technology (ICT) value chain. This group also appears to be more exposed to China than others due to the highly specialized nature of their economies. China’s ICT industry is primarily focused on manufacturing mid- to low-end products and final assembly, and it depends on importing higher value-added components from more advanced manufacturers in neighboring countries. While many of the nations that fall within this group have benefited from the clustering of global ICT manufacturing in the region, their high dependence on Chinese demand for their products is also concerning. For instance, Chinese policymakers are stressing the imperative to move Chinese businesses in ICT manufacturing higher up the value chain. Successful execution of this industrial policy would likely hurt existing suppliers in these countries and damage their economies. Furthermore, a degeneration of trade relations between China and end-consumer markets, like the United States, would certainly propagate through China to hurt ICT component supplier economies as well.

34 The World Input-Output Database (WIOD) is a statistical compendium that measures the value of traded goods and services between 43 economies in 56 industries.

32 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Figure 8 Key country and industry exposures to China

European Union United States Japan Australia South Korea India Indonesia (EU27) 121 Bln 256 Bln 95 Bln 59 Bln 87 Bln 18 Bln 21 Bln China Exposure USD 0.7% USD 1.6% USD 2.1% USD 4.4% USD 6.8% USD 0.9% USD 2.4% 17348 Bln of GDP 16542 Bln of GDP 4438 Bln of GDP 1357 Bln of GDP 1287 Bln of GDP 1994 Bln of GDP 869 Bln of GDP Gross Domestic Product USD USD USD USD USD USD USD

Exposure Trend – Flat  Increasing  Increasing  Decreasing  Decreasing  Decreasing  Decreasing

Share of China Share of China Share of China Share of China Share of China Share of China Share of China SECTORS GDP Exposure GDP Exposure GDP Exposure GDP Exposure GDP Exposure GDP Exposure GDP Exposure Agriculture, forestry and fishing 1.2% 3.2% 1.6% 1.2% 1.4% 0.9% 2.5% 7.6% 2.3% 2.5% 16.1% 0.6% 13.7% 2.0% Mining and quarrying 2.6% 1.3% 0.7% 4.0% 0.2% 7.1% 7.2% 26.7% 0.2% 13.4% 1.9% 4.4% 10.1% 7.8% Manufacturing 12.2% 2.3% 15.6% 4.3% 18.9% 7.2% 6.8% 5.5% 30.3% 14.5% 14.0% 1.4% 21.5% 3.6% Electricity, gas, steam & A/C supply 1.6% 0.4% 1.9% 1.4% 1.0% 2.8% 1.6% 4.9% 2.0% 6.5% 1.4% 1.0% 1.1% 1.2% Water supply; waste & remediation 0.3% 1.6% 0.9% 1.8% 0.8% 1.4% 1.0% 2.3% 0.8% 5.9% 0.2% 0.1% 0.1% 0.5% activities Construction 3.8% 0.1% 5.4% 0.4% 6.4% 0.3% 8.8% 1.2% 4.9% 0.2% 6.8% 0.1% 10.1% 0.2% Wholesale & retail trade; MV repair 12.2% 0.5% 11.0% 1.6% 13.4% 1.6% 9.6% 3.2% 8.6% 9.0% 17.9% 0.6% 13.8% 1.3% Transportation & Storage 2.9% 2.3% 5.1% 2.2% 4.6% 2.8% 5.1% 5.8% 3.7% 7.6% 6.2% 0.7% 4.6% 1.2% Accommodation & food service 2.8% 0.2% 2.8% 0.4% 3.0% 1.1% 2.7% 2.0% 2.6% 2.7% 1.4% 0.3% 3.1% 0.6% activities Information and communication 6.2% 0.4% 4.9% 1.2% 4.8% 1.4% 4.4% 2.1% 3.8% 3.0% 4.9% 1.0% 3.5% 2.0% Financial and insurance activities 7.0% 0.4% 5.5% 1.2% 4.7% 1.7% 9.3% 2.5% 5.6% 3.8% 5.7% 0.7% 4.0% 1.5% Real estate activities 11.9% 0.1% 11.1% 0.4% 12.6% 0.1% 12.2% 1.0% 7.7% 1.7% 6.4% 0.0% 2.9% 0.2% Professional, scientific and technical 7.4% 1.0% 6.5% 2.7% 5.3% 1.9% 5.0% 5.3% 5.2% 5.1% 1.5% 2.5% 0.8% 13.1% activities Administrative and support service 3.9% 0.8% 4.2% 1.8% 0.9% 2.8% 3.4% 3.8% 2.4% 6.0% 0.1% 0.7% 0.9% 2.7% activities Other* 23.9% 0.1% 22.8% 0.2% 22.1% 0.2% 20.3% 0.7% 19.7% 0.5% 15.3% 1.5% 9.9% 0.6%

Legal, Acct, Key Industry Exposures Air Transport Mfg Machinery & Mfg Cmptr, Electr, Mining & Quarrying Mfg Cmptr, Electr, Mining & Quarrying Consulting Serv to China (6.5%) Equip (8.0%) Optical (17.1%) (26.7%) Optical (26.5%) (4.4%) (13.1%) Mfg Other Mfg Electrical Equip Mfg Electrical Equip Mfg Basic Metals Mfg Chem & Chem Water Transport Mfg Chem & Chem Transport Equip (7.0%) (12.8%) (20.0%) Prdcts (20.0%) (3.8%) Prdcts (9.8%) (4.8%) Legal, Acct, Mfg Cmptr, Electr, Mfg Motor Vehicles Mfg Chem & Chem Forestry & Logging Mfg Furniture, Mining & Quarrying Consulting Serv Optical (3.5%) (6.6%) Prdcts (12.0%) (9.2%) Other (16.1%) (7.8%) (3.7%) Crops & Animals Mfg Basic Metals Mfg Machinery & Crops & Animals Mfg Electrical Equip Air Transport Mfg Paper & Paper (3.3%) (6.3%) Equip (10.6%) (7.9%) (15.9%) (3.0%) Prod (7.0%) Mfg Other Mfg Machinery & Mfg Basic Metals Mfg Machinery & Mfg Rubber & Mfg Chem & Chem Mfg Wood & Wood Transport Equip Equip (3.2%) (10.5%) Equip (7.7%) Plastics (14.5%) Prdcts (2.8%) Prod (6.1%) (4.9%)

Source: WIOD, The Conference Board South Korea’s overall economic exposure to China is startling. Of the nation’s US$1.3 trillion in national income in 2014, US$87 billion can be attributed to Chinese final use.35 This exposure equated to 6.8 percent of Korea’s GDP in 2014, down slightly from 7 percent in 2013. At 30.3 percent of GDP, Korea’s manufacturing sector relies on Chinese demand for 14.5 percent of the value it generates, which equates to about 4.4 percent of the nation’s GDP. Within this sector, however, the computer, electronic, and optical product manufacturing industry is critical. This industry accounts for 22 percent of the sector’s overall output and sends 26.5 percent of its output to China. Other major Korean industries with high China exposures include: chemical and chemical product manufacturers (20 percent), electrical equipment manufacturers (15.9 percent) and rubber and plastic manufacturers (14.5 percent).

Japan’s economy also falls into this category, although its exposure is smaller—in part, because its economy is larger and more diversified than Korea’s. Of the nation’s US$4.4 trillion in national income in 2014, US$95 billion can be attributed to Chinese final use. This exposure equates to 2.1 percent of GDP, up from 1.9 percent in 2013. At 18.9 percent of GDP, Japan’s manufacturing sector relies on Chinese demand for 7.2 percent of the value it generates, which equates to 1.4 percent of the nation’s GDP. Within this sector, the computer, electronic, and optical product manufacturing industry and the electrical equipment manufacturing industry account for nearly 16 percent of total output. Combined, they send 15.9 percent of their output to China. Other major Japanese industries with high China exposure include: chemical and chemical product manufacturers (12 percent), machinery and equipment manufacturers (10.6 percent), and basic metals manufacturers (10.5 percent).

RAW MATERIALS SUPPLIERS This group of economies provides China with raw material inputs, like iron ore and food products. They are less concentrated regionally and are instead (largely) associated with domestic resource endowments. Furthermore, both advanced and developing economies fall within this group. These economies have benefited from China’s voracious appetite for raw materials to build its cities and feed its people. However, too high a degree of exposure to China can create problems. For example, Chinese imports of hard commodities, like iron ore and copper, were significantly curtailed during a housing- and infrastructure-related economic downturn that occurred in 2013 and 2014. The lapse of Chinese demand for these inputs severely damaged global prices for these materials, which negatively impacted global producers and their national economies.

Australia’s economy is a prime example for this group. Of the nation’s US$1.4 trillion in national income in 2014, US$59 billion can be attributed to Chinese demand. This equates to 4.4 percent of GDP, down from 4.7 percent in 2013. At 7.2 percent of GDP, Australia’s mining and quarrying sector relies on Chinese demand for 26.7 percent of its total output. This equates to roughly 2 percent of GDP. Additionally, Australia’s agriculture, forestry, and fishing sector is also heavily exposed to China. Collectively, the indus- tries in this sector account for 2.5 percent of GDP and depend on Chinese demand for

35 “Final use” is private and public consumption and investment.

34 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org 7.6 percent of total output. Other major Australian industries exposed to China include: basic metals manufacturers (20 percent), machinery and equipment manufacturers (7.7 percent), and coke and refined petroleum manufacturers (6 percent).

SUPPLIERS OF IP-INTENSIVE GOODS AND SERVICES AND CAPITAL GOODS This set of economies tends to be more advanced and focused on producing IP-intensive goods and services. Primarily located in Europe, the products they provide China are generally higher up the value chain than what is available in the Asia region. The rise of Chinese consumerism and growth in Chinese manufacturing has benefited this group of economies, but they also face risks. While China is well on its way to upgrading industries in the ICT space (discussed above), policymakers are also working to advance China’s ability to produce goods and services at the top end of the spectrum in several other industries. Made in China 2025, an industrial policy designed to accomplish this goal, has targeted key industries on which economies in this group rely. Thus, high exposure to China in this category may damage economic welfare in the decade to come.

Broadly speaking, the European Union is the dominant member of this group. Of the EU27’s US$16.5 trillion in aggregate national income in 2014, US$256 billion is attributable to Chinese final use. This equates to roughly 1.6 percent of the EU’s GDP. According to data from the World Input–Output Database (WIOD) and our calculations, the EU’s manufacturing sector, which comprises 15.6 percent of its GDP, relies on China for 4.3 percent of its aggregate output. Top industry exposures include machinery and equipment manufacturers (8 percent), electrical equipment manufacturers (7 percent), and motor vehicle manufacturers (6.6 percent). Within the EU, the degree of national exposure to China varies, but it is worth noting the following countries: Germany (2.8 percent of GDP), Ireland (2.4 percent), the Netherlands (2 percent), and Denmark (1.9 percent). Among these four countries, the top industry exposures are German machinery and equipment manufacturers (10.8 percent), Denmark’s air transport industry (20.2 percent), Ireland’s scientific research and development industry (13.1 percent), and the Netherland’s legal, accounting, and management consulting industry (6.7 percent).

THE UNITED STATES IS AN OUTLIER ECONOMY The three categories explored above are by no means exhaustive ones. There are likely more outliers to these three groups than members, but there is certainly a pattern to be seen. Perhaps somewhat surprising, the world’s largest economy—the United States—does not readily fit these typecasts. At just 0.7 percent, America’s economic exposure to China is on the lower end of the rankings. Indeed, of the 43 economies that the WIOD has data on, only Spain, Greece, and Mexico are less exposed. Of the United States’ US$17.3 trillion in national income in 2014, just US$121 billion can be attributed to Chinese final use. This exposure has been relatively stable in recent years, neither growing nor shrinking. Of the United States’ 21 economic sectors,36 exposure to China is greatest in:

• Agricultural, forestry and fishing (1.2 percent of GDP, China exposure 3.2 percent),

36 International Standard Industrial Classification of All Economic Activities, Rev.4.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 35 • Manufacturing (12.2 percent of GDP, China exposure 2.3 percent), and • Transportation and storage (2.9 percent of GDP, China exposure 2.3 percent).

Furthermore, there are individual industry exposures within these sectors that are worth noting. The air transport industry, which includes passenger and freight air transport, depends on Chinese demand for 6.5 percent of its business, and the manufacture of other transport equipment industry, which includes American production of aircraft by companies like Boeing, depends on China for 4.8 percent of its business. Other US industries with high exposures include computer, electronic, and optical product manufacturers (3.5 percent) and the crop and animal production industry (3.3 percent).

From this analysis, it’s easy to see how slowdowns or ramp-ups in China—in the aggregate economy or in specific sectors or industries—ripple through the global trading network and affect localities and their businesses. For the global economy, nowhere is the connection stronger than in commodities, where, across the board, China is the largest consumer, the largest user, and now arguably the key market maker in global commodity trading.

US–China Trade Relations—Who Needs Whom More? Global Value Chain & GDP Exposures

Figure 9 Figure 10 Chinese economic exposure to US economic exposure to US & Rest of World China & Rest of World

(Percent GDP) 30% (Percent GDP) 30%

25 25

20 20

15 15 Exposure to Rest of World 10 10

5 Exposure 5 Exposure to Rest of World Exposure to US to China 0 0 2000 2002 2004 2006 2008 2010 2012 2014 2000 2002 2004 2006 2008 2010 2012 2014

Source: The Conference Board, WIOD Database,

In a previous China Center Chart Dive (See: “New data reveal less severe trade imbalance between the US and China”), we offered an alternate view of the US-China trade imbalance by factoring global value chains and value-added trade content into the equation. This was accomplished using a new data set from the World Input-Output

36 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Database (WIOD). We found that roughly one-third of the value of China’s gross exports to the US is actually generated outside of China by supplying countries. This foreign content inflates America’s bilateral trade deficit with China and obfuscates the US’ true trade relationship with other East Asian economies.

Using these same WIOD data, we are also able to identify the extent to which the economies of China and the United States are mutually reliant in terms of total national output—in trade-related terms, at least. The above-left chart details the extent to which China relies on foreign consumption generally, and US consumption specifically, for domestic GDP generation. The above-right chart shows the same dynamic for the United States vis-à-vis China. According to these data, Chinese goods & services worth USD 1,923bln were consumed abroad in 2014, of which USD 320bln was consumed within the United States (about 17 percent of total). That same year, US goods & services worth USD 1,545bln were consumed outside its borders, USD 120bln of which was consumed in China (about 8 percent of total). In absolute terms, therefore, China’s GDP exposure to the US is nearly 3x higher than the US’ exposure to China. However, upon weighing these foreign dependencies against the relative size of each economy the asymmetry becomes even more pronounced. In 2014, nearly 19 percent of China’s GDP was dependent of foreign demand for its domestically produced goods and services, vs. just 9 percent for the US. In bilateral terms, 3.1 percent of China’s economy was reliant on US consumption, while just 0.7 percent of the US’s GDP was dependent on China. On this weighted basis, China’s economic exposure to the US is nearly 5x higher than America’s exposure to China.

While the degree to which the US and Chinese economies are intertwined and interde- pendent is much more nuanced than this dataset suggests, within this one dimension China is clearly the more dependent party. Given the importance that President Trump has put on identifying and exploiting leverage as a part of his negotiation strategies in the past, it stands to reason that this asymmetry could be utilized by US negotiators in the coming years. China, of course, has its own points of leverage against the US, such as its holdings of US government debt, its linkages to the global financial system, and the high levels of US-originated FDI deployed in China and the importance of the Chinese market to many major US firms, which it could use to counter US pressure. For MNCs with exposure to the US-China trade relationship—which are most firms—understanding these underlying economic linkages and exposures is critical to identifying the pragmatic confines of policy choices on both sides—assuming, that is, that pragmatic choices ultimately win out in favor of positive-sum outcomes. Still a big IF.

Source: “US-China Trade Relations—Who Needs Who More? A Global Value Chain & GDP Exposure View,” Chart Dive, The Conference Board China Center for Economics and Business, April 13, 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 37 Iron Ore Exposures China’s economy has gone through a number of developmental stages over the last four decades. After cornering global foreign direct investment (FDI) in the 1990s, it came to corner global trade in the 2000s. As this export-oriented growth model peaked and began to diminish as a driver, Beijing began to rely on infrastructure spending to maintain economic growth and development. Bridges, roads, airports and electricity networks were built and vast resources were dedicated to their development. While this was occurring, China became the largest consumer of myriad commodities in the world. Copper, cement, aluminum, and iron ore were processed and consumed in vast quantities, and China, due to its limited domestic resources, was forced to look abroad to find suppliers. In doing so, it disrupted international commodity markets and sent prices soaring. This was especially the case for iron ore—the central input for manufacturing steel.

Between 2000 and 2016, China’s apparent consumption (A/C)37 of iron ore jumped from 281 million tons per annum to 2,302 million tons per annum—an increase of more than 700 percent. Over this same period, its imports grew from 69 million tons per annum (25 percent of A/C) to 1,024 million tons per annum (45 percent of A/C)—an increase of 1,364 percent. This 954 million ton increase in annual iron ore imports accounted for approximately 40 percent of the increase in annual iron ore production globally. This increase in demand had a significant impact on iron ore prices around the world. Chinese iron ore import prices rose from US$12 per ton in 2000 to a peak of US$177 per ton in Figure 11 2011 before plummeting to US$41 per ton Share of national iron ore production at the end of 2015, when China’s economy exported to China (2015) and housing market ran into trouble. These gyrations in China’s domestic economy inflicted a great deal of pain on countries Australia 73.7% supplying it with iron ore (see page 30 for South Africa 56.7

our analysis on China’s impact of Brazil’s Brazil 44.8

economy for one example). Iran 39.8

According to data we have compiled on Ukraine 29.8 Chinese iron ore import exposures, the Canada 24.1

vast majority of imports in 2016 came Russia 6.4

from Australia (62 percent) and Brazil India 1.6 (21 percent). China is, therefore, heavily Kazakhstan 1.3 vested in these supplier relationships and US would be hurt by any supply disruption— 0.5 until, at least, it was able to find alternate Sweden 0 suppliers. The inverse is also true, however. Others 44.8

According to our analysis, China is respon- World 28.7 sible for an incredibly large share of iron

ore production for a number of countries. Source: US Geological Survey For instance, in 2015, three-quarters of

37 Apparent Consumption = Domestic Production + Imports - Exports. This metric is often used when reliable inventory data is unavailable, as is the case with iron ore.

38 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Australia’s and nearly half of Brazil’s iron ore production was sent to China. These indus- tries make up a meaningful share of GDP in both nations and their economies are thereby dependent on China’s demand. For Australia, the 2015 slowdown in China’s economy and the accompanying plunge in iron ore prices threatened to send the country into recession for the first time in 25 years. With China consuming 74 percent of the iron ore that Australia produced in 2016, and the mining and quarrying industry accounting for more than 7 percent of Australia’s GDP, the country is extremely dependent on Chinese demand, as are all the intermediaries involved in the trade in Australia and across the globe: equipment makers, transporters, traders, brokers, financiers, wharehousers and so forth—and some in this chain are known to be highly leveraged, wherein risk lies.

Crude Oil Exposures As China’s economy has grown, so too has its hunger for energy resources. While its economy is becoming more energy efficient (its GDP/unit of energy consumption has improved recently), the overall degree of economic expansion is still sufficiently high as to warrant a steady increase in energy consumption. Indeed, China’s Primary Figure 12 Energy Consumption (PEC)38 is today three Share of national crude oil production times what it was in 2000. The composition exported to China (2015) of its energy consumption is changing as well. To mitigate continued environ- mental degradation, China is steadily S. Sudan 91% (although slowly) moving away from its Yemen 73

chief energy source, coal, and adopting Oman 69 cleaner alternatives. This government- Angola 44 led transition has resulted in a steady expansion into alternative energy sources, Rep Congo 41 like solar, wind, and hydro, as well as Sudan 27

nuclear, natural gas, and crude oil. While Colombia 17 crude oil may not be the best solution to Iraq 16 China’s environmental problems, it is seen Eq. Guinea as an improvement over coal and one 15 that won’t necessarily constrain continued Iran 15 economic and energy growth. Australia 14 Gabon According to data from BP, Chinese crude 13 oil consumption has increased from 224 Vietnam 12 million tons per year in 2000 to 448 in Venezuela 12 39 2010 and 560 in 2015. However, due to Libya 11 limited domestic resources, China can Brazil 11 only produce about one-third of what it consumes—the rest is imported from Source: Chinese General Administration of Customs, overseas. According to data that we have BP, The Conference Board Inc.

38 Primary Energy Consumption (PEC) measures the total energy demand of a country. Calculation is based on data from BP Statistical Review of World Energy—underpinning data, 1965–2016. 39 BP Statistical Review of World Energy—underpinning data, 1965–2016.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 39 compiled, in 2016, China imported 381 million tons of crude oil from abroad, half of which came from just four countries: Russia (14 percent), Saudi Arabia (13 percent), Angola (12 percent) and Iraq (10 percent). These energy partners should not come as a surprise, given China’s geographic location and obsession with carving out strategic relationships with its energy suppliers to hedge against disruption—something it considers a national security imperative.

Examining the national exposures associated with China crude oil imports reveal some interesting insights. According to our calculations, there were 15 countries that sent more than 10 percent of their national crude oil output to China in 2015 (see the below table for details). These high exposures to China are centered among nations with troubled relations with the West, but with whom China is willing to work. Indeed, it is common knowledge that China’s State-owned oil companies readily engage with governments with troubling human rights records, like South Sudan, Iran, and Angola. However, many mainstream producers are also important sources of Chinese crude oil. Australia, for instance, sends 14 percent of its crude oil production to China. While this percentage is lower than its iron ore exposure to China, this level of exposure is still quite significant.

As with iron ore, the oil trade involves a vast number of intermediaries, all of whom are now highly dependent on China demand, as are their employees, tax authorities, pensioners, and the myriad business product and services firms that support them. This adds to countries’ China exposure.

40 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Assessing China’s Major Geo-Economic Projects

In parallel with the consequential exposures discussed in the last section, there is another set of China exposures related to its deliberate and intentional globalization initiatives, which under the current Chinese administration have been greatly elevated, amplified, and empowered. China’s array of outbound geo-economic initiatives and plans are many, but the primary ones that MNCs need to be thinking about are:

• The “One Belt, One Road” initiative • Outbound foreign direct investment • China-centric free trade agreements • China’s new international development banks

• Made in China 2025 and the New Economy Plan

The One Belt, One Road Initiative Announced in late 2013 (and then haltingly launched with related projects throughout 2014 and 2015), China’s “Silk Road Economic Belt and 21st Century Maritime Silk Road,” known as One Belt, One Road (OBOR) is clearly President Xi Jinping’s most cherished international initiative. In reality, OBOR is primarily an umbrella brand name Beijing rolled out to bring a sense of coherence to a wide-ranging effort to engage more deeply with a huge swath of countries in Southeast Asia, Central Asia, the Middle East, Eastern Europe, and Africa. This engagement is political at its core, but it is designed to manifest primarily via the optics of seemingly exponential growth in Chinese economic engagement across the region and what appears to be nearly limitless Chinese capacity for infrastructure spending and building. China’s offers to drive, fund, and develop massive new infra- structure, energy, logistics, and transportation initiatives across the OBOR geography can seem endless, particularly when calculated via reported memoranda of under- standing (MOUs)and hand-shake deals, rather than ratified project specifications or actual project starts.

The domestic drivers of OBOR are numerous. Clearly, Beijing seeks to create demand for its acute industrial overcapacity and support its distressed State industries by generating new markets abroad, even if China has to engineer this new market activity financially from its own coffers. But Xi Jinping is also interested in the potential soft power and diplomatic gains generated for China via the optics of knitting together the old Silk Road with modern infrastructure and the perception that these new trans- portation and trade links will lead to win-win outcomes and economic development for all. This supports Beijing’s overt goal of securing the world’s recognition of China’s position as the next great global power. OBOR also, in theory, can support the RMB internationalization project, the PLA’s goal of securing friendly landing spots across the region, and China’s long-term designs on pulling nations away from the United States’ orbit and toward its own.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 41 The reality of what OBOR has become since its launch, however, is somewhat less than meets the eye. Many projects have stalled out, and the noncommercial nature of many of the initial proposals ran into the stark reality of investor disinterest in questionable projects and banker risk adversity vis-à-vis volatile security and political situations in many of the host countries. That said, OBOR remains quite real and, in some respects, is chugging right along (albeit slowly). The sheer scale of the ambition—unrealistic or not—is indicative of the kinds of geo-economic resources China can bring to bear given the fiscal capabilities it has built up over time. The global perception that China has essentially limitless money means that China’s diplomats and state-owned enter- prise representatives can propose nearly any development project abroad and be taken seriously. This ensures the red carpet will always be rolled out and the phone will always be answered in foreign capitals. As long as the China Development Bank and the China Exim Bank continue to provide nearly limitless financing for Chinese firms to engage with politically favored projects along OBOR, the overall initiative will remain in place and MNCs will need to remain attuned to its progress. Whether or not the long-term results of all of this activity will be a dynamic, integrated New Silk Road and a modernized Asian trading regime remains to be seen, but in the near- and medium-term, OBOR is (and will remain) China’s single-largest geo-economic exertion. In that respect, it is entirely reliant on China’s ability to maintain its fiscal capacity. How long China can maintain this pace of spending and financing has, as of 2017, become a very real question.

For host countries throughout Asia, many OBOR-marked projects are among the biggest investment projects they have in the works, such as

• the proposed Kunming–Singapore high-speed rail (via Bangkok and Kuala Lumpur)

• the Jakarta–Bandung rail project in Indonesia • Hambantota port in Sri Lanka • Piraeus Port in Greece • the massive China–Pakistan Economic Corridor (CPEC) project • new rail lines through Ethiopia, Djibouti, and Kenya.

Herein exposure lies—from the economic activity they may enable and the opportunities jettisoned therein to the “Chinese characteristics” they may entrain in the local business environment that change playing fields for MNCs active in the market to the risks that a project will collapse or struggle commercially due to financing or partnership issues or whatever the cause.

42 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Indicative exposures • Investment dependencies created in host countries • Bubble and up-leveraging impacts of massive investment-led growth programs • Project financing and project quality risks • Potentially significant adjustments in regional supply chain configura- tions and economics

• New economic activity and investment opportunities in host countries • Long-term economic enablement from supporting infrastructure • Sudden political instability caused by anti-China sentiment among polities

Outbound Foreign Direct Investment Although greenfield investment along OBOR is a significant element in China’s overall outbound foreign direct investment (OFDI) schema, the majority of growth in this category in recent years has come from an explosion in M&A activity in advanced Western countries. According to data compiled by Rhodium Group,40 China’s overall OFDI in the United States has grown to over US$100 billion (cumulative) since 2000, and most of that increase has come in exponential leaps in just the past few years, including US$45.6 billion in 2016 alone. Of last year’s total, an overwhelming 96 percent was in the M&A space. Similar figures and ratios prevail in the European market. Not that long ago, China’s M&A activity in the United States—and the West in general—was hardly more than nil; but by the end of last year, China’s total US investment had increased tenfold in just five years.

This new approach to OFDI is the latest prong in China’s existing “Going Out” national strategy of investing abroad. As a geo-economic exertion, increasing activity abroad by China’s State-owned enterprises (SOEs) and private corporate champions has long been a part of the State’s overarching plan for China’s emergence. However, the focus on acqui- sitions rather than market creation, and, in particular, the focus on developed markets in the West rather than along China’s periphery, is something new.

China’s new “Going Out” game can be delineated along three lines, based on the nature of the Chinese players involved:

• Old economy SOEs • Private enterprises • Anointed new economy SOEs

40 Thilo Hanemann and Cassie Gao, “Record Deal Making in 2016 Pushes Cumulative FDI in the US above $100 Billion,” Rhodium Group, December 30, 2016

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 43 While China’s old economy SOEs focus on the OBOR initiative and resource security prerogatives, its newest high-flying “private”41 enterprises are making waves in Western markets with their seemingly cavalier, incredibly high-profile buying sprees. A portion of this activity is surely State-directed and State-approved, based on its adherence to explicit strategic national priorities, but a seemingly large portion represents freelancing by some of the major private players. Almost certainly, capital flight on behalf of elite stakeholders is part of the calculus in some or many deals, and money laundering as well. But this genuinely private decision-making—whatever the drivers may be (see the table above for more examples)—sits apart from China’s typical Statist toolset, and it is an important part of China’s geo-economic story and an important way in which Chinese influences can disrupt international business environments. Pricing and valuations on targeted assets during these buying sprees are sometimes disengaged from reality, as

Figure 13 China’s new “going out” game

Old-economy SOEs Private enterprises Anointed new-economy SOEs

DRIVERS: export domestic DRIVERS: acquire advanced IP, access DRIVERS: fulfill national economic and overcapacity, fulfill geo-political new commercial markets, facilitate capital security policy goals, acquire advanced mandate flight, hedge against RMB devaluation, IP, remain relevant, build large and secure safe-harbor assets, fulfil national globally competitive new export policy goals on innovation / ICT / digital, industries build global brand and presence

IMPLEMENTATION: mega projects, IMPLEMENTATION: M&A, real estate, IMPLEMENTATION: M&A, HSR, nuclear, “capacity cooperation,” and minority equity investments, some advanced civil engineering overcapacity-relieving initiatives, greenfield projects, e-commerce mainly in rail, road, ports, energy, and traditional civil engineering

EXAMPLES: China State Construction EXAMPLES: Alibaba, Tencent, Anbang, EXAMPLES: ChemChina, Tsinghua Engineering Corp, COSCO, Three HNA, Dalian Wanda, Fosun, LeEco, etc. Holdings, China National Nuclear Corp, Gorges Corp, CCCC, China Harbour China General Nuclear Power Group, Engineering Co, Sinomach, etc. CRRC Corp, CRCC, CRC, China Railway Engineering Corp, etc.

FUNDING TOOLS: CDB, China Exim FUNDING TOOLS: state banks, VC & PE, FUNDING TOOLS: CDB, China Exim Bank, AIIB, BRICS bank, big state CIC, IPOs, foreign investors Bank, big state banks, CIC banks, Silk Road Fund

DESTINATION: developing DESTINATION: developed economies / DESTINATION: OBOR and the West countries/OBOR the West

Source: The Conference Board Inc.

41 Arguably, all of the major so-called private national champion Chinese firms have been subsidized, coopted, and exploited by the State and its elites to such a degree that it is inaccurate to refer to them as “private” in the same sense as US firms. And regardless of any Machiavellian theories, all major Chinese corporate players are beholden to the State by law, under China’s system of State capitalism.

44 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Chinese players bring to bear seemingly limitless cash. The presence of these buyers has reverberated through the industry for a brief moment, as every dealmaker for the last few years has been chasing this Chinese money. And, for a while, these private or semi- private Chinese conglomerates were able to fly under the political radar with their M&A activities in places like the United States in ways that government-run Chinese SOEs have never been able to do.

Both of these private-sector stories, however, seem to have run their course, thanks in part to the populist resurgence that has swept political capitals in the United States and Europe and in part to the implementation of capital controls in China that constrain firms’ abilities to get financing out of the country for acquisitions. Politicians in the United States, Europe, and Australia are now almost equally suspicious of championed Chinese “private” players like Dalian Wanda, HNA, and Anbang as they are of the Sinopecs and CNPCs (China National Petroleum Corporation) of China’s SOE world. At the same time, powerful factions within the Chinese government have apparently grown irritated with those same private players moving so much capital out of China.

Chinese outbound M&A is, therefore, running into a range of new constraints and sensi- tivities that have collectively served to derail the previously emerging storyline. As of the end of Q1 2017, Chinese M&A activity globally has fallen off a cliff, dropping back to its unremarkable 2014 levels.42 According to CNBC, US$75 billion worth of Chinese overseas acquisitions have been canceled over the past year,43 and countless more anecdotes suggest that Chinese buyers have become gun-shy across a range of sensitive or high- impact industries in the face of congressional hostility in the United States and public scrutiny in places like Germany. More important, perhaps, is that capital controls and cash shortages have begun to erode the capability and reputation of Chinese buyers in the West, as an increasing amount of hand-shake deals never come to fruition because the financing never materializes. In the final accounting, the story of China’s explosive M&A action abroad may yet become just another part of the narrative of China exporting its bubbly monetary cycles to the world.

42 Don Weinland and Javier Espinoza, “Chinese capital constraints send shock through global M&A,” Financial Times, March 29, 2017. 43 Claire Jones, Javier Espinoza, and Tom Hancock, “Overseas Chinese acquisitions worth $75 billion cancelled last year,” Financial Times, February 5, 2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 45 Indicative exposures • Company valuation irrationalities • China market maneuvers to support championed buyers that materially disadvantage other foreign players—e.g., the GMO competitors to Syngenta in China

• Equity-price volatilities based on announced M&As that may or may not materialize

• Unexpected cash-flow problems among major Chinese players and among Western firms expecting cash injections from Chinese buyers

• M&A bubble cycles featuring inflationary asset pricing driven by Chinese capital, followed by rapid curtailments

• Increased friction and sell-side blockages of strategic technology acquisitions • Chinese retaliation against MNCs in response to actions against Chinese firms investing in other countries

China-Centric Free Trade Agreements A prevailing notion among some China-watchers is that, in the absence of the US-led Trans-Pacific Partnership (TPP)—which the Trump administration has partially derailed— the door has opened for China to rewrite the rules of global trade or at least to create new architecture for the Asian trading economy. Pundits in the United States sounding this alarm generally point to something called the Regional Comprehensive Economic Partnership (RCEP), a new free trade agreement (FTA) that is currently under negotiation between the 10 countries of ASEAN and the six countries with which ASEAN already has a standalone FTA, including China. Polemicists often refer to RCEP as “China-led” or “China’s answer to the TPP,” although, in reality, RCEP was conceived by ASEAN and was never meant to be as much of a game-changer or comparable in sophistication to the TPP. It is true that China has emerged as RCEP’s biggest cheerleader in recent years, and indeed this came about most likely for political reasons related to China’s un-involvement with the TPP. But RCEP—an old-fashioned FTA focused on tariff reduc- tions for trade in goods and services—is no threat to the prevailing rules of global trade. It is, in many ways, a status-quo style agreement focused on incremental improvements in openness in the region.

46 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org China’s approach to global trade negotiations has not generally involved a substantial effort at generating conceptual revisions or a new model. Rather, Beijing’s priority has mostly been to:

• slow the rate of trade’s evolution toward behind-the-border interactions, • delay the finalization or implementation of the kind of next-generation globalization with which it is not yet comfortable, and

• generally maintain the status quo of the “WTO-era” version of free trade.

The WTO’s focus on trade in goods fits China’s geo-economic strengths extremely well, whereas the extensive domestic liberalizations required by US-led new-model agree- ments like the TPP and the Trade in Services Agreement (TiSA) go beyond where China is willing to go in terms of introducing market-based competition or institutional indepen- dence or the preeminence of rule of law.

Although China formally seeks to join nearly all major global trade initiatives and would be delighted to be allowed to participate at the negotiating table (during the TiSA talks, for instance), practically speaking, China’s Ministry of Commerce has focused most of its FTA negotiating energy on developing bilateral deals. FTAs of this nature are almost always just as politically motivated as they are economically motivated—meaning the GDP impact often ends up being considerably less than the diplomatic impact—but China has nonetheless concluded non-trivial FTAs with Switzerland, Australia, and South Korea in recent years that each represent incremental improvements in China’s willingness to offer concessions and open itself up ever more slightly to developed economy players.

These deals, plus China’s willingness to play along at the WTO, its rhetoric in favor of WTO-related FTAs like the Environmental Goods Agreement, its successful conclusion of the Information Technology Agreement FTA, its support for RCEP, and its promotion of an APEC-modeled Free Trade Area of the Asia-Pacific (FTAAP)44 collectively allow Xi Jinping to position China as the new defender of globalization and free trade in the age of Donald Trump-led skepticism. In reality, China seeks not to move the global trading order forward in any kind of dynamic or meaningful way nor does it seek to undo what is already in place. In this respect, Xi may have a point that, as of 2017, China could accurately be described as the leading defender of status quo free trade. In many ways, it’s safe to say with respect to trade China has always adhered to a “China first” policy, but has kept this disguised—even going so far as to continuously claim the opposite and aggressively berate any critics in the public domain.

44 APEC is the Asia-Pacific Economic Cooperation forum that is made up of most of the Pacific rim nations, and FTAAP is the aspirational trade deal that may someday exist between those same member countries.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 47 Indicative exposures • Supply chain and market access implications of bilateral FTAs • Smoother supply-chain operations and cross-border activities in Asian region if RCEP completes

• Stagnation and/or deterioration within current global trade “rules of the road” rather than advancement to much-needed twenty-first century solutions

• Competitive advantages for MNCs from countries able to secure bilateral deals with China

• Increased regionalization and/or market fragmentation as individual countries more often write their own rules regarding digital-age trading regimes

• Extreme populist reactions to the WTO-era “China shock” that is inducing the spread of protectionism

International Development Banks It is important here to mention China’s highly-publicized—although arguably lower- impact—creation of a new set of international economic organizations in the development sphere. These new institutions have been positioned, perhaps accurately, as a part of China’s desire to create alternative global economic governance systems alongside the long-standing and Western-dominated Bretton Woods architecture.45

First and foremost, over the past three years, China successfully invented, promoted, developed, rostered, and launched the Asian Infrastructure Investment Bank (AIIB), and, by most accounts, it has been operating smoothly since early 2016. China’s intention to create the AIIB was announced in conjunction with its rollout of OBOR, and the institution has been tightly co-branded with the OBOR concept. Although the AIIB is a relatively small global player compared to the World Bank (and even the Asian Development Bank), there can be no doubt that its creation and deployment was a massive diplomatic success for China. More than 50 nations joined the AIIB when it launched and dozens more are in line to participate. Although the bank has only US$100 billion in capitalization (a relatively small amount, given the bank will only lend a small percentage of its total base in any year), its presence looms large as a symbol of China’s credibility in the realm of international economic development and infrastructure construction. The United States and Japan opposed AIIB’s creation and pressured their allies not to join it; they were famously rebuffed nearly universally. Clearly, China has carved out a role for itself in this space, and although the AIIB is not likely to be a game-changer financially for developing countries along OBOR, it may represent an important first domino in China’s push for

45 Meaning the IMF, World Bank, and other long-standing institutions and arrangements that emerged post-WWII after the famous United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire, in 1944.

48 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org revisions to global governance institutions and frameworks. The AIIB is based in Beijing, and China reserved for itself the highest ownership stake and voting bloc and permanent control of the presidency.

Brazil, Russia, India, China, and South Africa also collaborated on the creation of what is colloquially known as the BRICS Bank, but is officially the New Development Bank (NDB). The NDB is also capitalized at US$100 billion, although control of the bank is split equally across the five partners. As a driver of the concept and the largest funder, China secured Shanghai as NDB headquarters, although the presidency will be on permanent rotation and the bank itself will raise and distribute funds in all five currencies. The NDB so far has been active only within the borders of the five member countries, so its scope and mission are not entirely comparable to the AIIB, which has a sprawling mandate (and, ironically, does business entirely in US dollars). But the NDB nonetheless represents another spoke in China’s wheel of new, non-Western global economic architecture.

Indicative exposures • New economic activity and investment opportunities in grantee countries • Competitive advantages for MNCs from countries that are party to AIIB or NDB • Longer-term economic enablement from supporting infrastructure • New global economic governance with “Chinese characteristics” decision-making that must be deciphered to be anticipated and leveraged

Made in China 2025 and the New Economy Plan For some time now, China Inc. has been working concertedly to create and super-scale a competitive digital sector, comprising its own championed and controlled firms that can contend with, if not beat out, the digital giants of the West across the span of the core digital ecosystem, from semiconductors up.

The industrial architecture now coming into resolution—and described in a variety of ratified national plans and policies, most notably Made in China 202546—features deep and sturdy State controls to ensure that the sector never strays or decouples from national development, national security, or political economy objectives. The Statist tools being deployed to construct the “walled garden” environment are many, but most importantly include:

• preferential market access through licensing; • national security market access constraints applied to foreign operators;

46 See www.miit.gov.cn/n11293472/n11293877/n16553775/ or Jost Wübbeke et. al, Made in China 2025, Mercator Institute for China Studies (MERICS), 2016; and China Manufacturing 2025: Putting Industrial Policy ahead of Market Forces, European Union Chamber of Commerce in China,2017.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 49 • preferential access to credit resources and capital markets; • huge venture funding resources from political-economy sources; and • un-level compliance assurance and enforcement practices that effectively, but artificially, render nonpreferred firms uncompetitive.

The digital battle began with the re-regulation of markets and ownership rules in the mid-2000s, which effectively forced Western operators out of key internet and ecommerce platforms by containing them to minor niches, putting their critical IP at risk via rules and regulations that conveyed critical IP rights to local partners, or by subjecting them to operational practices inconsistent with their global standards (e.g., censorship requirements). Google is a major case in point.47 This initiative to contain and envelop MNCs has been hugely successful from the Chinese perspective. Monopolies or oligop- olies have been effectively installed in all major consumer internet verticals—commerce (Alibaba and JD), search (Baidu), travel (CTrip and Qunar), fintech (ANT and WePay), and, most recently, ridesharing, with the high-profile knockout of Uber in China by local champion Didi Chuxing. Most outside observers believe Western firms were simply beaten by more agile, innovative Chinese competitors. While Chinese entrepreneurism and innovative prowess is indeed impressive, it is unfortunately the case that protec- tionist and State capitalist forces did most of the beating. The way China’s antimonopoly law has been applied to support industrial development policy provides ample evidence to support this assertion,48 and there are myriad other examples of policy and institutional support being applied to advantage championed Chinese firms.

Yet, despite the nonmarket characteristics of China’s internet sector, global capital markets have rewarded the ascendant “new age” Chinese firms and their stakeholders, as exemplified in 2014 by Alibaba’s US$25 billion IPO—the largest of all time on the NYSE. Chinese dotcom valuations continue to be stratospheric, even though many, if not all, are absent the operating performance investors expect from peer firms in Western markets. Valuations, it seems, are driven by what these companies can become, given the Chinese Dream of the world’s largest middle class—that is, if it occurs49—and not on their real performance levels of today. In the present day, questions abound regarding the realities of Chinese digital markets: true revenues, true traffic volumes, true value of assets— no one really knows. The firms are essentially un-auditable. Many believe that China’s internet surge rivals or exceeds the US dotcom bubble of the late 1990s. Yet, despite the risks, a huge swath of the global investment community has been coopted into the value-creation dynamic now in play—and is thus beholden to promoting a narrative that supports bullishness on China to investors worldwide.

The New Economy Plan, as it were, extends well beyond consumer internet. Its sights are firmly set on the industrial internet, the internet of things (IoT), and the enterprise cloud—in essence, all things digital. Leading US ICT firms—termed the “Eight Guardian

47 See, “Google Shrugged,” The Conference Board China Center Quick Note, 2009. 48 See Competing Interests in China’s Competition Law Enforcement: China’s Anti-Monopoly Law Application and the Role of Industrial Policy, US Chamber of Commerce, September 9, 2014, for a detailed analysis asserting China’s use of its anti-monopoly law to support industrial policy. 49 See No More Tiers – The Future of Chinese Consumption, The Demand Institute and The China Center for Economics and Business, November 2014.

50 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Warriors50” by Chinese State media—have been forced into minority positions in new partnerships to effect technology transfer and ensure that Chinese stakeholders, not Western shareholders, capture the lion’s share of development benefits and eventually gain full control over the core technological components of China’s digital future. China’s antimonopoly law has been vigorously deployed to support industrial policy in this area.51

Meanwhile, the State-backed M&A machine has ramped up to acquire key techno- logical components that China is unable to produce locally. Western semiconductor firms are the top priority of State-backed buyers, and high-profile bids have been made for Fairchild Semi, Lattice, and Germany’s Aixtron. Meanwhile, inside China, major Western players have essentially been pushed out of the enterprise cloud arena or relegated to contained niches or service provider roles, and there is an all-out push to super-scale China’s robotics and industrial automation sector as the key pillar of Made in China 2025. Futurists predict that the digital economy will soon span all goods and services sectors and encompass all firms of any scale. China Inc. aims to capture a major piece of this pie and play a leading role in infrastructure and governance systems that underlie it all, globally. The State-backed promotion of the China International Payments Systems (CIPS) as an alternative to SWIFT, CHIPS, and Fedwire is one example of the global projection now underway in the digital sphere.

Even if only moderately successful, China’s nationalistic designs on the internet and digital industry vectors imply significant exposure for the global business environment in the future, and most plausible outcomes suggest downside outcomes for Western MNCs. On the upside, clearly some foreign firms and investors will win through new partnerships and supply relationships. But downside risks are many. Chinese practices regarding data privacy and use essentially convey all power to the championed operators as long as, quid pro quo, they provide unfettered State access to the data resources and satisfy the State’s demands for political and social control and (foreseeably in the future) economic patriotism with respect to State-vested goods and services firms. The subsidies and preferences given championed firms enable scale advantages that stifle competition and threaten innovation processes. This stands in stark contrast to the creative destruction rife in internet markets of the West. For all its market power, Google, for example, has not been able to win most races in new verticals—upstarts such as Snapchat, Instagram, Twitter, Facebook, and others arise over and over again, first on Google’s flanks and then as leaders in new and huge categories of their own making. In China’s model, the preferred monopolies and oligopolies capture these prizes, and innovative startups are crushed and subsumed. Innovation suffers, and the consumer experience suffers too, eventually. As soon as Didi knocked Uber out of the Chinese market, prices were raised for riders, payments lowered for drivers, and service levels deteriorated markedly. Now that China’s flagship internet giants are expanding internationally, how will they shape the international playing field, and how will their presence change digital commercial practices?

50 Cisco, IBM, Google, Qualcomm, Intel, Apple, Oracle and Microsoft. See Daniel H. Rosen and Beibei Bao, “Eight Guardian Warriors: PRISM and Its Implications for US Businesses in China,” Rhodium Group, July 18, 2013. 51 See Competing Interests in China’s Competition Law Enforcement: China’s Anti-Monopoly Law Application and the Role of Industrial Policy, US Chamber of Commerce, September 9,2014.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 51 Indicative exposures • Wealth destruction potentialities associated with overvalued Chinese new economy firms losing substantive value (something that could happen suddenly and with potentially shocking effect)

• Margin compression along new economy value chains imposed by capital cost-structure distortions and the associated underpricing practices of many Chinese firms

• The potential market opportunity cost of foreign technology vendors being locked out from the Chinese market

• The corporate and financial losses associated with deficient IP protection

The China exposures emanating from these major geo-economic exertions and the many other outbound investment and development initiatives now emerging from China and in play will be the subject of immersive future projects as part of The Conference Board’s China Global Impact Program.

52 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org The Status of China Inc.

A look at China’s momentous economic rise through a geo-economic lens sheds light on how China has cultivated and exercised its various economic and Statecraft leverage points to accrue competitive advantages and favorably influence, from its standpoint, the global economy and business environment over the last three decades. Indeed, this is geo-economics at work. Given that economic power stands at the core of geo-economic leverage, China’s geo-economic activity and forcefulness have naturally increased as its economic power has grown. Retrospective learnings provide guideposts for assessing how China’s current and planned geo-economic exertions may shape the future global business environment.

China’s vaunted progress from economic pauper to powerhouse over the last 30-plus years is well documented along conventional dimensions of industrial development and source-of-growth metrics. Among scholars, there has long been debate about which factors have determined China’s success and the role that policy acumen has played specifically. Recent debate even challenges whether China’s success should be considered so standout as compared to other hypergrowth Asian countries of the recent past—such as Korea, Taiwan, and Singapore—that grew nearly as fast and for nearly as long during their export and investment-led growth phases, but have created more sustainable economic structures and effectively escaped the middle-income trap. This trap, driven mostly by overinvestment and indebtedness drags, looms large for China, some argue, and may even be imminent. Our own base-case prediction is that China will need to endure a prolonged period of below-trend slow growth during which capacity is slowly consolidated and debt is slowly digested.52 Furthermore, crisis scenarios are becoming more plausible the longer structural reforms are delayed.53 But debate and predictions aside, there is no doubt that the pace and scale of China’s growth these last 30-plus years was indeed extraordinary—particularly, the uplift of more than 700 million Chinese citizens out of poverty since the beginning of China’s reform and opening-up period in 1978. This achievement is truly laudable.

Behind the veil of growth and policy analysis, however, is something that has not been much discussed or even duly recognized: the masterful accumulation, refinement, and use of geo-economic resources and Statist tools, often quite invisibly, that enabled China’s ascendance as an economic superpower. Some might refer to this as the “China Inc.” phenomenon—i.e., the uncanny ability of the Chinese State and its leaders to run the country as a business. The acumen by which China’s leaders have developed Statist tools, and the purposeful and concerted way in which the tools have been applied to the benefit of the Chinese State and its commercial elites, is unquestionably real and often appears outright Machiavellian in execution. There are simply too many observable cases to ignore.

52 See The Long Soft Fall in China’s Growth, The Conference Board, 2014. 53 See Martin Wolf, “Too big, too Leninist – a China crisis is a matter of time,” Financial Times, December 12, 2016.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 53 Figure 14 Looking at recent trajectories… China megatrends in the span of one generation

30 Years Ago Now The Near Future?

 Almost immeasurably  World’s second largest  Leverage relative economic small GDP economy strength and political cohesion to project influence globally  Financially detached,  Among the largest trading trader of barest necessities nations  Strengthen CCP monopoly on power  An isolated, hermit-like  Deeply engaged with the kingdom world through multiple  Balance domestic carrots and vectors sticks to engineer new growth  The poorest of relatives and re-establish discipline at among poor nations  Effectively the leader and home savior of poor nations via  Internally obsessed with its development finance  Manifest “China Dream” own issues and instabilities abroad—visibly be a great  Externally obsessed with power with respected geopolitical power and statesmen, topmost economic influence clout and feared military

Importantly, China’s acumen in leveraging geo-economic resources and applying Statist tools to affect desired outcomes has continually improved over time, as Chinese political elites and regulators have learned and mastered the ways that money can be made. They’ve done so largely by observing the ways and means of the most successful companies and financial firms in the Western world and by playing catch-up in ever- quickening cycles—a remarkable feat for a country and economy so large, diverse, and complex. The acumen and strength of the toolkit has been amplified greatly under President Xi Jinping and his overt consolidation of power and recentralization of control over the economy and its actors.

Unlike Japan in the ’60s and ’70s or the Four Little (Asian) Dragons54 of the ’80s, China is a very different type of emerging-market player and economic force. Growth for the sake of modernization and the continual, incremental improvement of public welfare is only part of the story (and, arguably, not the main part). Instead, the paramount objective has been achieving a nation-state of world-leading strength and influence. Going back to the dialectics of Chairman Mao Zedong and the founding elders of modern China, the

54 South Korea, Hong Kong, Taiwan, and Singapore.

54 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org guiding plan has been in place and in play since the early ’50s and its objectives both clear and resolute: to overtake the United States as the world’s leading economy and great power nation.55

Many Sinologists, economists, and business leaders have considered these early Chinese Communist Party declarations to be mere propaganda and, in more recent times, irrelevant relics of the past. But this is not proving to be the case. Xi Jinping’s “China Dream” and the series of maneuvers China has made since its fifth-generation leadership assumed power in November 2012 indicate that the plan remains a key driver of both policy and practice or, at least, has been made so again by Xi and his current ruling group. China’s nationalist intentions have become more overt than ever, as evidenced by the Made in China 2025 plan, for example, and the recently emphasized “overall national security outlook,” which effectively makes everything in China—military, economic, social, and cultural—a matter of national security interest. Numerous other plans and policy documents released in recent years are equally protectionist, nationalist, or outright anticompetitive.56 And it has been made crystal clear that China envisages a different integration, coexistence, and leadership model with the global economy and community of nations, and it intends to fervently and enduringly resist the liberal democratic “peaceful evolution”57 theory that has long been the operating hypothesis of Western geopolitical strategists. We assert that these leadership statements and the publicly released and promoted documents that affirm and detail them should be heeded by Western policy analysts and business strategists as the mainstream view and the prevailing trajectory that China’s leaders intend, not as appeasements by “reformers” to mollify the conservative minority. The latter interpretation would be folly.

A confluence of three factors makes China a different and most-powerful kind of geo-economic actor, specifically:

1 The number and scale of the geo-economic levers at its disposal.

2 The Statist tools it has developed and refined to utilize these levers.

3 The mastery of the Chinese autocracy in using these tools and levers to effect desired outcomes.

55 William A. Callahan, “History, Tradition and the China Dream: Socialist Modernization in the World of Great Harmony,” Journal of Contemporary China, Vol. 24, No. 96, April 27, 2015, pp. 983–1001. 56 These include, among others, the Safe and Secure IT Law, the National Security Commission, Cybersecurity Law, Cyberspace Administration of China, Foreign NGO Management Law, National Security Law, and the new Central Leading Group for Internet Security and Informatization. 57 After the collapse of the Soviet Union, many intellectuals in the United States and Western Europe came to believe that liberal democratic capitalism would prove an irresistible force and an unavoidable reality for authoritarian political systems that integrated with the global economy. In China, however, the phrase “peaceful evolution” has long been associated by the Communist Party leadership with foreign subversion of China’s political system.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 55 The Scale of Geo-Economic Levers China today boasts a geo-economic foundation that is broad, deep, and hugely influ- ential. The mainstay levers of this base of strength are threefold:

1 Size of production base China boasts a production base of unparalleled scale and diversity that is supported, for the most part, by world-class transport, power, and physical plant infrastructure. For a wide range of goods, production outside of China is simply not competitive, even amid the sharply rising cost environment in China today. Nowhere else comes close to matching the production scales that are possible in China. Importantly, it has also become the largest global buyer of commodities and manufacturing inputs, yielding great sway over global commodity and capital goods’ markets, including market corners in a number of areas (rare earths, for instance). Global business has to factor China into every aspect of the production-side and supply chain calculus.

2 Size of market Even at its comparatively low per-capita income levels, China has become the second-largest consumer market in the world, and its consumption growth, so far, remains resilient to the gradual and necessary slowdown in industrial investment China has seen in recent years. Even amid the ongoing GDP growth slowdown, China’s consumer market is expected to growth by a compound annual growth rate of 4.7 percent through 2025, roughly doubling between now and then, to become a market worth US$6.4 trillion.58 Policy support, if it is forthcoming—e.g., liberalization of the household financial services sector, including consumer credit—could boost China’s consumption outlook significantly.59

Thus, access to its market is a huge geo-economic lever that China can use to extract investment and development concessions from foreign companies and obtain trade and geo-political policy concessions from the countries in which these companies are headquartered. With the production base, China has effectively built a virtuous circle where market access is made contingent on production-side investment and technology transfer that is overtly designed for import substitution purposes in the long-term. The large capex footprints involved in these deals make change-of-course for the investing foreign firms unfeasible, if not impossible. This Catch-22 conundrum has always been present, but it is now becoming clear to MNCs active in China—and will become immensely so if the stated re-shoring ambitions of politicians in the United States and Europe gain policy support.

3 Size of financial resources The production and consumption dynamics described above, effectively engineered by the State, have yielded massive growth and financial rewards that China has captured effectively. Given the design of the economic and commercial system, the distribution of national income flows predominantly to the State and its various actors and only minimally to the

58 No More Tiers, The Demand Institute and The Conference Board China Center, 2015. 59 Ibid.

56 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Figure 15 China’s real economy versus China’s financial economy China's 'Financial Economy' has grown very quickly and now dwarfs the 'real economy'

RMB, trillion Percent of GDP 160 160% Equity market cap. (left scale) Equity market cap./GDP (right scale) 140 140

120 120

100 100

80 80

60 60

40 40

20 20

0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Sources: SSE, SZSE, CEIC, The Conference Board, Inc.

RMB, trillion Percent of GDP 160 160% Total New Housing Sales Value since 1995, price adjusted (left scale) 140 140 Total New Housing Sales since 1995 (ditto), Value to GDP (right scale)

120 120

100 100

80 80

60 60

40 40

20 20

0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Sources: NBS, CEIC, The Conference Board, Inc.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 57 Chinese people—just enough to demonstrate continual, but modest, public welfare improvements year after year and to fulfill the Party’s obligation under its “social contract”60 with the population. Moreover, the State’s interest and ability in driving and controlling asset prices (real estate, commodities, securities, company valuations, etc.) amplifies the country’s financial resources and financial clout multifold, especially during the past 10 years as financialization has spurred China’s “richness” and the 2008 global financial crisis undermined the richness of most everywhere else. China has amassed a massive war chest of capital, which today—in the wake of the global financial crisis—stands pretty much alone. “Beggar-thy-neighbor” opportunities abound, and these tactics are more and more evidently coming into play on the geo-economic stage.

With the vast financial sums of money accrued from trading surpluses throughout the 1990s and 2000s has come the financialization of the Chinese economy—i.e., the appre- ciation of its financial assets (company values, real estate, commodity prices) and the leveraging up of returns from trading these assets in financial markets. Once again, China is playing catch-up, but this time it is using Wall Street-invented models and focusing on the development and projection of its financial economy. And, once again, the catch-up cycle is moving at hyper-speed. China’s commercial banking sector has grown in the last 10 years to a size that took America decades or, by some analyst accounts, upwards of 100 years to achieve.

As the controller of most, if not all, of the country’s major assets and their valua- tions, the Chinese State and its elites are the prime movers in China’s financial sphere. Transparency, suspect valuations performance data, and conflict-of-interest issues abound. Despite all this, participation in Chinese markets and solicitation of Chinese assets has become the top prize for the global finance and investment community. Western corporate financiers, brokers, investment banks, and private equity funds have made huge fortunes in and on China, and they now vie forcefully to win stakes in China’s investment flows and to co-invest alongside China’s own funds and private equity players. In this financial bubble, many of the leading “powers that be” in the global financial world have arguably become coopted in support of promoting the idea that the China Dream of 1.4 billion middle-class consumers represents the imminent future. The valuations of most of China’s many high-flying public companies depend on the market’s belief in this dream. It is hard to be contrarian against such groundswell, and so the bubble grows and the global exposures inherent therein continue to scale up and proliferate.

Today, all three of these pillar geo-economic assets provide myriad sources of leverage over foreign investors, domestic and global financial markets and their players, and international trading partners and their leading firms. China is thus poised and capable of exerting great power globally, and it has articulated its intentions to do so, as demon- strated by the many geo-economic initiatives we have referenced in this report.

60 Since the beginning of “reform and opening” in 1978, the Communist Party has moved from grounding its legitimacy in spreading class struggle and material equality to its ability to ensure increasing economic prosperity.

58 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org The Statist Tools These geo-economic assets, advantages, and leverage points did not emanate per chance. They were purposefully built and developed over the last 30 years using an array of Statist tools that have been refined and honed for effectiveness. These tools include:

Bureaucratic control of markets China’s regulators maintain tight control over market access and playing-field features via voluminous, highly granular regulations that are, by design, either vague regarding permissibility and compliance or arbitrarily enforced to effect desired outcomes, or both. Access rights can be traded for concessions, and disfavored firms are easily blocked from markets.

Subsidies State subsidies are myriad in China, both direct and indirect. Preferred firms routinely receive direct financial outlays, tax deferrals, and price and supply concessions on resource use. Hidden subsidies, difficult to count but likely significantly larger than direct outlays, come in the form of lax enforcement of environmental rules, tax compliance, resource conservancy, and labor welfare contributions.

Credit creation and centralized allocations State banks dominate China’s banking sector, making credit flows essentially State-determined. The allocation of money directly affects the ability of firms to invest, price, and compete, often without supporting cashflows from commercial operations. This effectively crushes the margins of any firm competing without the same resources.

Investment resources and controls State fiscal resources are allocated toward ecosystem infrastructure-building that enable championed and vested firms supply-chain advantages and growth capital.

State bank financing State banks primarily direct their financing activities in relation to political cues and directives, often at lending rates far below market or with provisions for loan rollovers or restructurings should repayment challenges arise. This supports national champions and State-owned firms, at the expense of the true private sector of which foreign investors are part.

Currency and Forex controls and dealings Exchange-rate controls are toggled to impact export or import pricing and comparative costs of goods sold or to distort the pricing of international M&A in favor of Chinese buyers.

Commodity market trading State coordination of major commodity buyers and sellers enables pricing to be influenced and channels profits to insider players. It transmits volatilities, cost, and uncertainty to the out-of-group, market-based players in the system.

R&D funding R&D funding is lavished on State firms and national champions, enabling unfettered expeditions into commercially questionable areas. This funding is often treated as a subsidy for engineering staff and resources that would otherwise impact the bottom-line cost structures of Chinese firms.

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 59 Government procurement Government procurement is used to pad the cashflows of struggling Chinese firms that would otherwise be forced to exit markets or it is used to rapidly scale the revenues and financial resources of championed firms, enabling scale or scope advantages to championed and vested firms.

And the list goes on: foreign aid and lending, trade policies and agreements (explicit or covert), energy policies, etc. All of these tools effectively tilt competitive playing fields (or reshape them completely) to enable the building of national champions, to create artifi- cially competitive sectors, or to support the achievement of supra-normal profits that flow to the State and its stakeholders. Centralized control and deliberation sits at the core of the system.

Of course, these tools tend to be embedded in government policy, explicitly or implicitly, and are often legitimate components of policy programs. The important distinction between policy-driven outcomes and State-capitalist outcomes is the extent to which the tools enable market competition to perform better in pursuit of desired outcomes, or whether the tools enable the State to determine market outcomes and its agents to thereby derive majority benefits and competitive advantages that would not have accrued otherwise. It’s often hard to distinguish between the two, especially for external observers, far away government trade officials, and the headquarters offices of multinational companies.

Forceful Leadership Finally, as the icing on this cake, the effectiveness of these tools (and the precision with which they are deployed) is greatly enhanced by the unique top-down capabilities of China’s authoritarian governance structure. These capabilities include:

A long-term, strategic orientation that manifests in precise numeric targets for national industrial development and economic achievement, to which public good is subordinate.

An unmatched degree of central control and bureaucratic coordination that enables projects of scale and ambition not possible in fragmented, pluralist environments (like India or the United States).

An unmatched degree of ideological unity (especially among the ruling group) that fosters the consensus need to activate the forceful top-down support necessary for mass mobilization.

An ability and willingness to overtly and covertly use Statist tools in a highly skillful manner, as outlined in the list above. Many governments could attempt such Statism, but dare not for the public blowback it might create.

An ability and willingness to overtly and covertly use propaganda tools in a highly skillful manner to direct public opinion and obviate resistance and the risk of blowback, top-to-bottom, across the public and polity.

60 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org The ability to recognize the criticality of timing and move quickly vis-à-vis windows of opportunity, by virtue of a seasoned leadership making use of the five capabilities listed above.

All of these capabilities have been re-energized, greatly strengthened, and more precisely directed by Xi Jinping and his ruling group. Under Xi, China Inc. has effec- tively been shaped up and fully mobilized under the Leninist tenet of “discipline.”61 With the Party rectified and the market put back in “the birdcage,”62 we are seeing the impacts of Chinese Statism playing out more overtly than ever in commercial markets. In the internet sphere, for example, China’s ecommerce markets, as mentioned, have been effectively closed to foreign participants, and championed local firms are being installed as monopolies in all key verticals, both consumer and industrial. The resultant big data resources are being aggregated and exploited under the Social Credit Scoring System to ensure social stability and perhaps drive economic patriotism from Chinese consumers in the future. The company valuations emanating from monopoly positions are being used to fund massive super-scaling in emergent technology areas (drones, VR, autonomous vehicles) via large-scale R&D investing in China and massive and aggressive international M&A. While the entrepreneurial and innovative acumen of the Chinese people is unarguable, it is the “strong and visible hand” of the State that is bootstrapping China’s contention for leadership positioning in the fast-approaching internet- of-everything world.

Looking Forward All of this means that China is a very different type of geo-economic actor—powerful, precise, strategic, and specifically illiberal under the current ruling group. Given its bounty of economic and financial resources, we should expect China’s geo-economic exertions to be globally impactful, even if execution is glitchy. And, even while it is highly likely that the strength of China’s economic and financial resources will diminish over the medium-term, perhaps even due to economic crisis-type dynamics, China will undoubtedly remain capable of sustaining major portions of its outbound agenda for an extended period of time. These exertions will be needle-moving to country and regional economies and markets, and MNCs must plan accordingly, both for downside and upside likelihoods.

To ensure planning efficacy, MNC strategists and business planners need to recognize the differences in China’s internationalization approach, the Statist schemes behind the motions, and the different incentive structures in play. Knowing one’s business partner or opponent—and critically, understanding their mindset and motivations—is essential to success.

61 After 10-plus years of perceived ideological and organizational laxity, the new Chinese Communist Party watchword is “discipline” (纪律), something Lenin knew well, as per his quote from 1920: “The Bolsheviks could not have retained power for two and a half months, let alone two and a half years, without the most rigorous and truly iron discipline in our Party.” 62 “Enlivening the economy should be under the direction of the plan. It’s like the relationship between a bird and a cage. You can’t just hold a bird in your hand, for it will die. You have to let it fly, but you can only let it fly in a cage. Without a cage, it will fly away. The cage has to be the right size, and the cage itself has to be adjusted regularly. But no matter what, there has to be a cage.” – Chen Yun, 1982; Chen is considered one of the “Eight Immortals of the Communist Party of China.”

www.conferenceboard.org china’s global impact: the business exposures and economic implications of a globalizing china 61 About the Authors David R. Hoffman is vice president and managing director of The Conference Board China Center. Based in Beijing, Hoffman is responsible for the center’s strategy, research agenda, research program delivery, partner relationships with Chinese government organizations, and value delivery to members of both the China Center and The Conference Board. He leads numerous research projects and outreach activities, oversees a team of researchers in both China and New York, and coordinates the network of eminent advisors and scholars from The Conference Board who undertake China Center programs. Hoffman is also an independent, nonexecutive director of Eastern Broadcasting Corporation in Taiwan.

Prior to joining The Conference Board, Hoffman led the Technology-InfoComms- Entertainment Advisory practice of PricewaterhouseCoopers in China (“TICE Advisory”) for 20 years, where he served the senior-most executives of technology companies, telecommunications operators, information service providers, and tradi- tional and new media companies. He also provided extensive advice to regulators and service providers on sector development strategy, regulatory policy, regulatory risk management, and compliance.

Ethan Cramer-Flood is the associate director of The Conference Board China Center. Based in New York City, he helps direct the Beijing-based China Center and supports The Conference Board’s Asia-based operations in Hong Kong and Singapore. Cramer- Flood is responsible for building and driving the China Center’s expertise and thought leadership on China’s position in the international political economy and for engaging The Conference Board member companies and the media on the topics of geopolitical risk and international affairs with regard to China and Asia.

Previously, Cramer-Flood served as a professor of International Relations at China Foreign Affairs University in Beijing, where he specialized in international relations theory and US foreign policy and conducted research on US-China relations. He has been published numerous times in academic and scholarly journals focusing on international affairs, and has appeared in media in China and the United States, both on-screen and in print. Cramer-Flood holds an MS in global affairs from NYU, where his research focused on China’s engagement with Africa, Chinese foreign policy in general, and global scenario- based planning, and earned his BA in history from Haverford College.

62 china’s global impact: the business exposures and economic implications of a globalizing china www.conferenceboard.org Erik Lundh is a senior economist in China geo-economics at The Conference Board China Center. Based in New York, he is responsible for much of our work on the implications of China’s global economic integration and works closely with both the global economics team and our researchers in Beijing.

Lundh joined The Conference Board from ISI Group, a leading sell-side research brokerage, where he spent five years generating top-down research on China for institutional investors. His research focus included macroeconomic indicators, capital markets, commodities (hard, soft, and energy), and fiscal and monetary policies. He also spent time examining China’s bilateral economic relationships and various Chinese industries.

Earlier in his career, Lundh was an economic analyst at the US-China Economic & Security Review Commission and spent several years working at the Overseas Private Investment Corporation and the US-Taiwan Business Council. He earned his BA in Economics and International Relations at the University of California, San Diego, and his MBA from Thunderbird School of Global Management.

For CHINA CENTER membership information, please email Ethan Cramer-Flood at [email protected] , call +1 212 339 0286, or visit us online at www.conferenceboard.org/chinacenter.

For inquiries in China, please email Jude Blanchette at [email protected] or call +86 (10) 8532 4688.

Publications Team Creative Director Peter Drubin Production Kathleen Mercandetti, Pam Seenaraine Editor Marta Rodin

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