Ideology Trumps the Economy - Reform Needed to Turn the Tide for China’s Economic, Geopolitical & Policy Woes
This article was originally published in Italian in Panorama on 04th Oct 2022.
Please note that this is a courtesy translation of the Italian language article originally published in the Panorama Magazine Issue at:https://www.panorama.it/economia/cina-ideologia-crisi-economica
Introduction
The European Union Chamber of Commerce in China has just released its European Business in China Position Paper 2022/2023 (Position Paper), its landmark publication which it has been issuing on an annual basis since 2001 (the year in which China joined the World Trade Organization). The first edition, published over two decades ago, outlined the challenges which European businesses faced while operating in China while also providing recommendations (68) which could lead to an improved business marketplace to both the Chinese & European authorities.
This year, a total of 967 recommendations have been compiled representing the views of the European Union Chamber of Commerce in China’s many working groups, fora and more than 1,800 member companies nationwide.
From the data compiled it is clear to see that companies are increasingly viewing the country as less predictable, reliable and efficient, and with geopolitical tensions on the rise, its future is less certain. Lets take an overview of some of the main findings and assess the path ahead.
Harsh COVID Control Measures Crippling the Economy
Mass lockdowns and strict quarantines saw China’s economy slump in 2022. China’s National Bureau of Statistics reported 0.4 per cent year-on-year growth for the second quarter, the lowest since the first quarter of 2020 when China closed down almost completely and its economy contracted for the first time in nearly three decades. In July 2022, the unemployment rate reached 19.9 per cent among 16- to 24-year-olds; and the Purchasing Managers Index (PMI) employment index was 48.6 per cent for manufacturing and 46.7 per cent for services, down 0.1 and 0.2 percentage points respectively from the previous month.
Other significant internal challenges include China’s debt crisis, which has been exacerbated by the COVID-19 pandemic as lending accelerated to help businesses recover; the unravelling of the real estate sector, with property sales forecast to drop by around 30 per cent in 2022; demographic headwinds; and stalling consumption growth. On top of this, local government finances are being drained as they remain under pressure to continue with the continuous mass testing of their citizens in the pursuit of ‘zero COVID’.
If China persists with its “Zero COVID” approach, the business environment will continue to become more challenging. For example, COVID-related restrictions have already had a disastrous effect on the attraction and retention of foreign and Chinese talent. The ever-changing visa and work permit procedures, and extreme limitations on travel in and out of China, have provided additional impetus to the exodus of foreign nationals from the European Union (EU).
Priority should be afforded to fully vaccinating the entire population, with special attention paid to those at higher risk of disease, in particular the elderly and those with chronic conditions. It would also be advisable to permit the best mix of vaccinations and boosters to be used (although foreign vaccines have not been approved for use in Mainland China at the time of writing)
The European Chamber fears that China will not be able to fully reopen to the rest of the world until at least the latter half of 2023, handing yet another advantage to other markets that can provide more openness and predictability to investors
China Isolated From the World
China operations are also becoming increasingly isolated because staff, both foreign and Chinese, are unable to travel freely to European HQs for regular business exchanges, networking, training and experience/expertise sharing. Senior decision-makers from HQs are also being deprived of first-hand China experience, which is resulting in less understanding of—and therefore less desire to engage with— China. European HQs will only become more averse to committing to investing in a country they have a diminishing understanding of, particularly when they perceive political, economic and reputational risks to be increasing.
To justify their investments, European companies therefore need China to demonstrate more transparency and predictability, as the challenge of aligning China operations with both global corporate pledges and legislation increases.
Meanwhile, as the rest of the world operates largely under pre-pandemic levels of openness, a vacuum is being created for other emerging markets (India, Vietnam, the UAE etc.) with more predictable and reliable business environments to step in and aggressively pursue foreign investment that may have previously been China-bound.
An Increasingly More Politicized Business Environment
Businesses with China operations are coming under increased pressure, both through legislation and from consumers, to demonstrate transparency in their China operations. For example, the EU is planning the Corporate Sustainability Reporting Directive (CSRD)—which will introduce strict reporting requirements, obliging large public-interest companies to report on sustainability issues such as environmental, social and governance (ESG) and human rights.
For companies to align their global corporate pledges with realities on the ground, they need a business environment that is transparent and predictable. Crucially, they need China to provide the conditions that allow them to conduct trusted, third-party audits of their operations so that they can be certified as being fully compliant with global legislation. They also need Chinese partners that are willing to demonstrate a similar commitment to corporate sustainability. Until this is possible, businesses will face mounting pressure to relocate operations away from sensitive regions.
Shifting Supply Chain Strategies
China’s position at the centre of global supply chains looks set to be challenged. There will not be full decoupling with companies leaving China altogether as the size and potential of the market are still too great to ignore. Instead, more nuanced strategies will emerge.
Prior to the Omicron outbreaks that led to full or partial lockdowns in at least 45 cities, several European companies were further onshoring supply chains into China to better service the domestic market and isolate themselves from potential global shocks. However, this strategy is not without significant drawbacks: initial costs are steep, and communication and data flows between HQs and China operations will be impeded for those that pursue this option. Furthermore, 31 per cent of European manufacturers import critical components into China for which they cannot source alternatives, meaning that full onshoring for them is not possible.
In addition, several European companies have begun, or were already exploring the possibility of, creating separate supply chains ‒ one to serve China and one for the rest of the world, as some customers in China are already asking for ‘US-free’ products, and some customers in the US are asking for ‘China-free’ products, due to demands from both the state and private sectors. Producing two separate products, one for each market, can allow companies to avoid import and export restrictions. However, it also carries considerable risk. Operating costs will increase while efficiency and economies of scale decrease, and any changes to regulations may lead to this solution becoming redundant.
While the business strategy of China +1 (avoiding investing only in China and diversify business into other countries) seems set to continue, in order to further strengthen risk management and reduce the risk of supply chain failures, many are increasingly looking into a ‘China+1+2+3’ strategy, as European companies look to maintain a strong presence in this important market while identifying viable back-up options.
Conclusions
China’s goal of achieving its 2022 5.5 per cent growth target suffered a major blow when economic growth fell to just 0.4 per cent in the second quarter. This was attributed predominantly to the impact of the lockdown measures, and, with no exit strategy in sight, it is difficult to see how this will change in the near future. Despite the heightened difficulties facing European companies in China, they are committed to staying and improving the business environment, as illustrated by the 967 constructive recommendations and the European Chamber believes that comprehensive market reforms would be the most effective way for China to realise its economic potential and quickly rebuild investor confidence.
Focusing on comprehensive reforms, accelerating market opening and avoiding decoupling would be the most effective way for China to once again reinvent itself and quickly rebuild investor confidence. With the 20th National Congress of the Communist Party taking place on the 16th of October 2022, China has the platform to signal the direction in which the country is headed. The European Chamber believes that by keeping the channels of communication open with business and adopting the 967 recommendations outlined in this European Business in China Position Paper 2022/2023, China will be able to re-establish a predictable, reliable and efficient market, and set itself on a course towards achieving its full economic potential.
