Where is China + 1 ?

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

To sum, the main mechanisms of support are tax incentives, subsidies, and preferential access to funding (Exhibit 4). These factors work in combination with other state assistance to potentially improve the return on invested capital and make it more attractive for private investment.

Consequently, the manufacturing sector has taken the capex baton in China- enabling gross capital formation growth to match the overall growth in the economy even as real estate investment is on decline. In 2022 and 2023, manufacturing sector fixed asset investment accounts for majority of the incremental growth in China’s fixed asset investment (Exhibit 5). Apart from manufacturing, China is also focusing on utilities investment after widespread power shortages in Dec 2020 and Sep 2021. The share of utilities and manufacturing investment has risen from 7% and 46% during the last decade to 9% and 50% respectively in 2023 while the share of real estate in annual fixed asset investment has dropped from 34% to 27% during the same period (Exhibit 6).

Within the manufacturing sector, most of the incremental investment comes from electrical equipment and machinery, automobile, special purpose machinery and chemicals. These sectors capture the supply chain for electric vehicles, semiconductors and solar.

We can clearly see significant production out-performance in the automobiles, electrical machinery, chemicals, nonferrous metals, railway shipbuilding and aerospace sectors (Exhibit 7). These sectors have also seen a significant jump in China’s exports and China’s share on overall global trade of those products. Contrary to the running rhetoric of China +1, China has gained exports market share by 1.7% pt in the last five years (Exhibit 8). Over the past 5 years, China’s exports mix has shifted dramatically towards capital goods.

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

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

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

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

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

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