Unraveling links between China and the world could increase risks in the global economy; reimagining ties could drive global growth for all.
China has changed itself—and changed the world. By 2017, China accounted for 15 percent of world GDP. It overtook the United States to become the world’s largest economy in purchasing-power-parity terms in 2014, according to International Monetary Fund (IMF) data—for the first time since 1870.1 In nominal terms, China’s GDP was 64 percent that of the United States in 2017, making it the second largest economy in the world. China is a considerable player on a global stage—and the strategic choices it makes could be pivotal for global growth. We freely acknowledge that there are many other dimensions than the economic to China’s global impact; however, in this article, we focus on China’s economic relationships with the world.
China’s growth story is far from over
There is every prospect of China continuing its impressive growth path with powerful domestic tailwinds, including urbanization and plenty of scope to boost per capita GDP and productivity (Exhibit 1).
Comparison with Japan as it stood in the 1990s—when it was the world’s second-largest economy behind the United States—is instructive. At that point, Japan’s per capita GDP was already around 50 percent above that of the United States (about 20 percent lower on a purchasing-power-parity basis); China’s nominal per capita GDP remains only around 15 percent of the US level (28 percent on a purchasing-power-parity basis). In addition, Japan’s urbanization rate was already 78 percent; China’s today is 58 percent, still 20 to 30 percentage points below that of high-income economies. Since the mid-1990s, Japan has struggled to achieve significant growth momentum. China is different. It has a large population on relatively low incomes, and plenty of room for further urbanization and productivity gains enabling further income growth. If realized, these gains could propel China to become not only the world’s largest economy and manufacturer, but also its largest investor and market.
China and the world are not as close as they once were
China’s relationship with the world seems to be at a turning point. The changing dynamics of global political leadership are pivotal, but beyond the scope of this article.
Consumers around the world have been benefiting from trade with China. For example, it is estimated that Chinese imports have cut US consumer-goods prices by an estimated 27 percent.2 China is today a major market for multinational companies seeking new growth—the revenue of foreign invested enterprises increased 12-fold between 2000 and 2017, according to China’s National Statistics Bureau.
However, the nature of China’s rise is coming under scrutiny. Criticism has been voiced about, for instance, China’s policies to support technology transfer from foreign to local firms, weak intellectual-property (IP) protection, and industrial policies that favor domestic players. And China’s foreign investment is being examined closely amid fears that foreign deals are facilitating large-scale technology transfer.
There are concerns, as noted, about the “China shock” displacing manufacturing jobs in advanced economies such as the United States, although automation technologies have also played a role.3 One studyestimates that at least two million US manufacturing jobs were displaced between 1999 and 2011, a period when imports from China were surging.4However, correlation should not be confused with causation. When China joined the World Trade Organization (WTO) in 2001, the dynamics of US trade with Asia changed. The United States has historically run large trade deficits with Asia. After China’s accession to the WTO, a great deal of assembly and trade was consolidated in China. By importing inputs from other Asian economies and exporting finished goods to the United States, China became the consolidated trading hub for the US–Asia trading relationship.
More fundamentally, the past decade appears to have ushered in a new context for China and the world. China’s exposure to the world (measured by the magnitude of flows with the rest of the world relative to its economy) has declined over the past decade. At the same time, the world’s exposure to China (the magnitude of flows with China relative to the global economy) has increased since 2000.
The McKinsey Global Institute (MGI) analyzed the mutual exposure of China and the rest of the world on trade, technology, and capital. On trade, we measured the importance of China as a market and as a supplier of goods and services to the global economy.5 On technology, we measured the importance of Chinese technological exports to global R&D spending.6 On capital, we measured the importance of China as a supplier of financing and as a destination for investments.7 We found that from 2000 to 2017, the world’s exposure to China has increased on all three dimensions, and the aggregate index rose from 0.4 in 2000 to 1.2 in 2017.8 In contrast, China’s exposure to the world peaked at 0.9 in 2007 and had declined to 0.6 by 2017 (Exhibit 2).9
China has increased its role in global trade since its accession to the WTO. Consider that 2.6 percent of consumption in the rest of the world is imported from China today, compared with only 0.8 percent in 2000. Chinese imports now account for 2.0 percent of the gross output of the rest of the world, compared with 0.4 percent in 2000. However, China has become far more reliant on its domestic economy to drive growth. As recently as 2008, China’s net trade surplus accounted for 8 percent of GDP; by 2017, that figure was only 1.7 percent—less than either Germany or South Korea, where net trade surpluses amount to between 5 and 8 percent of GDP. Between 2010 and 2014 (the latest available data), China’s gross exports amounted to 34 percent of real GDP growth; using the domestic value-added measure (measuring exports by subtracting imports used in the production of goods and services that are subsequently exported), the share was about 25 percent.
On technology, China has been increasing domestic R&D capacity and is now the second largest R&D spender in the world, after the United States. China today leads key segments of the digital economy such as e-commerce and on-demand services. However, it is not yet a major technology supplier and exporter of R&D. China’s intellectual property exports account for about 1.8 percent of R&D spending by the rest of the world. China’s imports of technology in the form of IP and tech services and equipment grew significantly from just over $11 billion in 2007 to $48 billion in 2017, according to the IMF. However, these imports declined as a share of domestic R&D spending from 24 to 16 percent.
On financing and capital, China has become an increasingly important source of global capital and remained a significant destination for investment. China accounted for about 10 percent of global outbound foreign direct investment (FDI) in 2017, up from just about one percent in 2000. However, relative to the domestic economy, FDI has been relatively stable and may even have declined somewhat. In 2007, inbound FDI amounted to 9 percent of domestic investment; by 2017, that number had shrunk to 8 percent. Although exposure to Chinese capital is growing abroad, growth in domestic investment has reduced China’s exposure to overseas capital and investment opportunities.
China’s declining exposure to the world is also evident in its trade policies related to imports. Since joining the WTO, China has halved tariffs from an average of 16 percent in 2000 to 8 percent in 2008. But since then, the average tariff rate has edged up to 9.6 percent as of 2016—which is more than double the US and EU average. China has opened up doors to foreign capital, but barriers still persist. On the Organisation for Economic Co-operation and Development’s (OECD’s) FDI restrictiveness index in manufacturing, China’s restrictiveness has declined from 0.38 to 0.1 over the past two decades. However, the index for services remains at 0.39 (down from 0.74 in the same period), far higher than the 0.08 OECD average. In addition, China’s government is promoting the growth of local companies in key industries. In the Made in China 2025 plan, China indicated guidelines for domestic companies’ market share of 40 to 90 percent in 11 of 23 subsectors prioritized by the government.
If trade isn’t driving China’s economy, what is? The answer, in a nutshell, is Chinese people. In ten of the 15 quarters since 2015, consumption contributed more than 60 percent of total GDP growth. In the first half of 2018, the ratio increased to 80 percent. In many consumer categories, China is the largest market in the world. For instance, China overtook the United States as the world’s largest box office in the first quarter of 2018. Today, China accounts for 30 percent of global auto sales, 43 percent of unit sales of electric vehicles, and 42 percent of global retail e-commerce transaction values.
Further unraveling the China connection poses significant risks to China and the world
Recent trade tensions between the United States and China dissipated somewhat since the G20 meeting in early December but raise questions about whether we are set for a new era of trade disputes, new investment barriers, protectionism—particularly in the case of technology—and limits to the supply of essential inputs such as rare earths.
It could be that trade tensions are far from temporary. Major economic powers have recently put in place policies that signal a potential shift in their behavior toward foreign countries. In August 2018, the US Foreign Investment Risk Review Modernization Act expanded the jurisdiction of the Committee on Foreign Investment in the United States to include nonpassive minority investment in companies with critical technologies or industries and sensitive personal data of US citizens, joint ventures that would result in the transfer of technologies overseas, and real-estate investment near military facilities. The EU has approved a proposal that expands the list of critical sectors to include election infrastructure, biomedicine, and automobiles. It is also increasing its scrutiny of investments made with state influence or technology transfer to third countries. In October 2017, Japan amended its Foreign Exchange and Foreign Trade Act to allow for involuntary divestment of unreported foreign ownership in Japanese companies that may result in national security risks.
In the short term, the profile of both the US and Chinese economies suggests that the risk that either will be derailed by higher tariffs and a slowdown in trade may be relatively limited. Both economies are large and domestically driven. China’s exports to the United States amount to 4 percent of GDP, while imports account for 1 percent. Even as advanced economies suffered from the 2008 global financial crisis, China’s robust, domestically fueled growth continued. The story is similar for the United States, whose exports to China are equivalent to 1 percent of its GDP and imports are equivalent to 3 percent.