Why Beijing might create a financial bust

The NY Fed paper says that, contrary to the perceived wisdom, while the increased supply would tend to lower prices for manufactured goods, it would generate significant upward pressure on global commodity and intermediate goods prices and the broader global manufacturing supply chain, increase global trade volumes and lead to higher producer price inflation in the US and, inevitably, other economies.

China already has a massive presence in the global manufacturing sector, accounting for about 30 per cent of manufacturing output and 20 per cent of global exports.

It is almost inevitable – indeed it is already happening – that its manufacturing-led growth strategy will generate a backlash that will constrain its potential and potentially leave it with a lot of expensive excess capacity.

Europe and the US already have restrictions on some high-tech imports from China. The European Union is about to put a tariff on imports of Chinese EVs under its anti-subsidy laws and is considering import restrictions on solar panels and wind turbines made in China.

The US, apart from a plethora of sanctions on China’s high-tech exports and the broader tariffs that remain from the Donald Trump presidency, has eliminated EV subsidies for vehicles using Chinese-made batteries.

Chinese companies have attempted to circumvent the US tariffs by building plants in countries not subject to them, with a growing presence in Mexico that enables them to exploit Mexico’s free trade agreement with the US. That agreement (which includes Canada) is set for review in 2026 amid increasing bipartisan concern. It’s almost inevitable that the Mexican backdoor to the US market will be closed.

China’s state-driven economic strategy envisages global dominance of  a number of highly strategic advanced manufacturing sectors that the Europeans and Americans are highly protective of.

China, confronted with an ever-expanding range of trade barriers in the West, has been trying to diversify its export markets, signing bilateral and multilateral free trade agreements with about 28 countries in its region and the “Global South,” using its “Belt and Road” program as leverage. Those markets account for about 40 per cent of its exports.

The US and Europe, however, are its major export markets and therefore the manufacturing exports-led strategy will founder if they won’t allow a big increase in Chinese imports.

China’s state-driven economic strategy envisages global dominance of a number of highly strategic advanced manufacturing sectors – semiconductors, EVs, solar panels, wind turbines, artificial intelligence, aviation – that the Europeans and Americans are highly protective of.

Take EVs. China’s exports of EVs to Europe fell almost 20 per cent in January and February relative to the same months last year – even before the tariffs are imposed. While the European Union accounts for about 30 per cent of China’s EV sales by volume, three years ago it was more than 50 per cent. America’s tariffs means China has minimal EV market presence there.

Even on the NY Fed’s analysis the “sugar hit” from manufacturing-led growth will be short-lived, with China’s goal of maintaining a “complete” manufacturing ecosystem, it says, amounting to a commitment to subsidise low-return, labour-intensive industries where it will no longer maintain a competitive advantage.

“The risk for China is that a sustained focus on manufacturing will lead to low returns and a new cycle of bad debt.” In effect, having encouraged a property bubble that ended in a bust China might be making the same mistake with its massive incentives for increased manufacturing.

In a follow-up paper released on Tuesday, the same NY Fed researchers asked what would happen if China’s property sector continues to deteriorate.

Further stress in the sector would amplify the existing fiscal pressures on local governments that have traditionally be reliant on income from property sales and undermine their ability to support developers and local manufacturers.

The outsized role of the sector means trouble within it is a plausible trigger for an economic hard landing and financial crisis, they said, saying that even after the slump it still represents an out-sized share of activity by international standards.

In its property crash scenario China’s GDP growth would fall to zero this year and a “tepid” 2 per cent recovery in 2025.

A hard landing for China’s economy and the plunge in Chinese domestic demand it would reverberate through China’s global value chain partnerships, would materially weaken US growth (and wouldn’t be good for Australia’s commodity exporters) and, unlike the manufacturing boom, would lead to lower inflation in the US and elsewhere.

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While both of the scenarios canvassed by the NY Fed’s reflect extreme outcomes, they do illustrate the risks latent within China’s economy and within an economic strategy that is now increasingly reliant on advanced economies being willing to accept a swelling flood of subsidised imports and Chinese dominance of key growth areas of 21st century economies.

The actions of the US and European Union to date suggest strongly that they won’t.

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