Levelling the playing field - incentivising exports

In the context of China’s stifling dominance across manufacturing supply chains, and as industrial policy interventions proliferate globally and the WTO is rendered comatose due to the dysfunction of its Dispute Settlement Body (DSB), it may be time for India to re-assess its industrial policy instruments, especially concerning export promotion. 

The WTO’s Subsidies and Countervailing Measures (SCM) Agreement categorises two kinds of “prohibited” subsidies - those “contingent on export performance” (Article 3(1)(a)), and those “contingent on the use of domestic over imported goods” (Article 3(1)(b)). It allows for subsidies that are specific to enterprises, industries, and regions. 

When the SCM and other WTO Agreements were being negotiated in the nineties, it was thought that only the subsidies contingent on export performance would be trade-distorting in any significant manner. It was thought that the subsidies specific to enterprises, industries, and regions (or the economy as a whole) could not be sustained at the scale required to distort trade in particular products much less global trade in general. 

Nobody anticipated China’s extraordinary scale of economy-wide industrial policy subsidies. It’s estimated that China spends 5% of GDP annually on its industrial policy, compared to 0.4-0.6% of GDP for US, Japan, and France and 0.9% of GDP for South Korea. India’s annual expenditure on its flagship production-linked incentive (PLI) scheme is a modest 0.15% of GDP. In the 2000-18 period, Chinese Government Guidance Funds have given over $1 trillion in capital and guarantees to more than 28,000 companies. As part of the Made in China 2025 initiative, the government committed nearly $300 bn in 2018 with an additional $1.4 trillion after Covid 19 to achieve technological self-sufficiency and global leadership in critical sectors. All told, in sectors like semiconductors, steel, and aluminium, China makes up 80-90% of all global subsidies.

Its domestic policies artificially suppress business costs and give its firms an unmatched competitive advantage. Its financial repression keeps the cost of capital suppressed, the hukou system has depressed wages, and intense competition by local governments has kept land and utility costs low. Add to this all the direct state support of the kind mentioned above and the massive economies of scale, and it becomes almost impossible to compete with Chinese firms. Further, the scale and scope of these subsidies have allowed even loss-making firms to expand production and flood the market at deeply discounted prices. 

Accordingly, Chinese firms have built up production capacities in steel, cars and electric vehicles, EV batteries, solar panels, metro railways, heavy equipment etc., that are far in excess, often in multiples, of domestic demand. In many of these sectors, they make up 50-90% of the global production capacity. Finally, with the domestic economy slowing and demand weakening, these firms have come to rely even more on exports and further discounting to capture foreign demand. There cannot be any doubt that China’s excess capacity and discounted sales that render its trade partners uncompetitive should be treated as “prohibited subsidy”. 

In this context, two IMF papers by Lorenzo Rotunno and Michele Ruta examined the trade spillover impacts of domestic subsidies generally and specifically by China. They quantify the significant impact of domestic subsidies on exports from G20 EMs. Exports of subsidised products increased for eight years since its introduction relative to exports of other products, whence the growth rate of exports of subsidised products is 15% higher. Similarly, at extensive margin (new products being exported), domestic subsidies increase the probability of a new product being exported by 3 percentage points relative to other products. 

They also quantify the impact of Chinese subsidies.

Our results point to significant effects of China’s subsidies on its trade flows. On the export side, exports of subsidized products are 0.9% higher (relative to non-subsidized products) after China’s subsidies… This average effect masks significant heterogeneity across destination markets and sectors. Our estimates suggest that exports of subsidized products from China to other G20 emerging economies (G20 EMs) are 2.1% higher after the subsidy than exports of other products to the same destinations. Furthermore, the export effects of China’s subsidies vary considerably across sectors. Within electrical machinery – one of the new ‘strategic’ sectors – for instance, exports of subsidized products are found to be 7% higher than exports of other products after China’s subsidies.

On the import side, China’s subsidies are found to depress imports of targeted products relative to imports of non-subsidized products – an effect that is not found for other countries. Across origin countries, the implied effect on imports of subsidized products is stronger for Advanced Economies (AEs) – a 3% and 4.8% decrease in imports of subsidized products from G20 AEs and other AEs, respectively. Electrical machinery and metals are among the sectors where China’s subsidies have strong import-substitution effects. Our estimates therefore suggest that China’s subsidies have increased the country’s share in export markets and reduced its share in import markets of subsidized products.

The effects of China’s subsidies are amplified by supply-chain linkages… the exposure of downstream sectors to subsidies in upstream industries (through cost shares) and the exposure of upstream sectors to subsidies in downstream industries (through sales shares)… The results reveal strong effects of subsidies propagating from upstream industries. More subsidies given to supplying industries are associated with higher exports in the buying industry… consider the case of subsidies provided to the steel industry, which is the main supplier of inputs to the automotive industry (10 % of its total costs). The empirical results imply that increasing subsidies to steel by the number observed over 2015-2022 is associated with a 3.5% increase in exports of autos from China. These indirect effects are concentrated on exports to G20 AEs. The findings on the indirect effects of subsidies are consistent with upstream industries expanding supply and lowering their prices following the deployment of subsidies. This upstream effect allows industries downstream to become more competitive in export markets. Results from import regressions point to a negative effect of upstream subsidies on imports in downstream sectors. This result suggests that upstream subsidies allow downstream industries to also expand domestically and substitute for imports.

Subsidies form the overwhelming share of Chinese industrial policy instruments, representing 95% of all trade-distorting policies implemented in the 2009-22 period. This compared with 60-65% for other emerging economies in G20. Further, 98% of subsidies are monetary transfers to firms - state aid and grants.

Chinese subsidies are focused on the manufacturing sectors.

The significant impact of domestic subsidies on exports in general (for all subsidising countries) and the especially higher impact of domestic subsidies observed in case of China is a reminder on the limitations of the SCM Agreement and WTO provisions in containing trade-distorting subsidies. As industrial policy interventions proliferate and as China exports its excess capacity aggressively, fixating on a narrowly defined set of subsidies that are “contingent on export performance” is meaningless. Other trade-distorting subsidies are allowed to expand without infringing on any WTO provision. 

This is a matter of great significance for developing countries like India with limited fiscal space to provide subsidies at anything remotely close to China, and also especially because the Chinese subsidies are having a greater impact on exports to G20 EMs and imports from them. 

As it seeks to expand its manufacturing base, India faces an onerous challenge across sectors. Competing with Chinese manufacturers requires significant levelling of the playing field to balance the massive subsidies that its exporting firms receive. This may no longer be confined to competition with exports coming directly out of China, but even those from countries like Vietnam. As FT reports, Vietnam is rapidly becoming an off-shore site for Chinese manufacturers, fuelling a third of all new investments in the country. 

India’s industrial policy response has been to support its domestic manufacturers with its own subsidies, mainly through the PLI scheme and Basic Customs Duty (BCD) tariffs on imports. 

But this has its limitations for at least two reasons. One, given the extent of the competitiveness gap, these subsidies and tariffs may not be adequate in many industries. Two, shorn off the BCD support, Indian firms fall behind even further in the export markets.

The first can be bridged to some extent by increasing the domestic value addition. This can help domestic manufacturers lower costs and increase their competitiveness. However, given the limited component manufacturing ecosystem, this can only be done in a phased manner. A possible strategy in this regard would be to target a handful of products with high domestic demand volumes and double down on the creation of a component ecosystem, thereby maximising domestic value addition. It might be required to provide a higher level of incentive than currently provided under the PLI for products to encourage component ecosystems to relocate. Once a critical mass of the component manufacturing ecosystem emerges, it may become possible to expand the base faster. 

The second point on levelling the playing field on exports is equally important. Like maximising domestic value addition, another channel to improve the competitiveness of Indian manufacturers is economies of scale. Here, the small size of the Indian domestic market is a problem. For all its population size, India does not have the domestic market size to be able to generate the scale of demand required to reap the benefits of large economies of scale in most export market segments. This means that capturing export markets is an essential requirement. But the competitiveness gap is even higher in the export markets. 

It is, therefore, essential that these domestic firms have some form of export subsidies. An option is to provide a higher level of incentives such that they are enough to match the competitiveness gap after excluding the BCD. But that would require a higher fiscal allocation and would also entail giving excess incentives for domestic sales. Another option would be to provide concessional trade finance or reimburse taxes on exports. Other instruments from the Table above could be considered. 

In conclusion, for domestic industrial policy to be effective in expanding the domestic manufacturing base, it must necessarily include both some form of import protection and export incentives. Notwithstanding their WTO commitments, this choice is unavoidable for any country.

Weekend reading links

1. The US Government under Donald Trump is rapidly degenerating into a lawless one. Sample this from the happenings in the Treasury Department. 

Treasury Secretary Scott Bessent gave representatives of the so-called Department of Government Efficiency full access to the federal payment system... The new authority follows a standoff this week with a top Treasury official who had resisted allowing Mr. Musk’s lieutenants into the department’s payment system, which sends out money on behalf of the entire federal government. The official, a career civil servant named David Lebryk, was put on leave and then suddenly retired on Friday after the dispute, according to people familiar with his exit. The system could give the Trump administration another mechanism to attempt to unilaterally restrict disbursement of money approved for specific purposes by Congress, a push that has faced legal roadblocks... Mr. Bessent granted access to the payments system to a handful of staff members affiliated with DOGE, including Tom Krause, the chief executive of a Silicon Valley company, Cloud Software Group, according to one of the people familiar with the change. Access to the system has historically been closely held because it includes sensitive personal information about the millions of Americans who receive Social Security checks, tax refunds and other payments from the federal government... In a process typically run by civil servants, the Treasury Department carries out payments submitted by agencies across the government, disbursing more than $5 trillion in fiscal year 2023.

Besides, this also poses serious conflicts of interest since it will allow Musk to access the details of payments being made to his competitors and in theory even control it.

With the likes of Robert Kennedy Jr heading the Health Department, Pete Hegseth leading the Defence Department, and Kashyap Patel heading the FBI, it's hard to not feel that the US government has become a banana republic where the President selects his Cabinet based purely on loyalty with no concern for any merit. 

Crony capitalism without any pretensions is invading US with vengeance, in a manner that would put to shame even those developing countries that Americans once scorned upon.

America’s largest companies are cutting deals with Elon Musk’s businesses or touting links with the world’s richest man as he solidifies his power within Donald Trump’s administration and begins to radically restructure the US government. A rush of announcements in recent days included Visa finalising a payments processing deal with Musk’s social media site X and United Airlines accelerating a plan to use Musk’s Starlink satellites for in-flight WiFi. Amazon has also boosted marketing spending on X... On Monday, Apple updated its iPhone operating system, allowing T-Mobile users in the US to connect to Musk’s Starlink satellites. Boeing’s chief executive Kelly Ortberg said he had been working with Musk... to accelerate delivery of two Air Force One planes that are over budget and years late. Oracle, the enterprise software company run by Trump supporter Larry Ellison, also announced a Starlink collaboration, while Intel touted a “growing media partnership” with X before broadcasting a live event together with Microsoft on the platform. Separately this week, roughly $3bn of debt tied to Musk’s purchase of X, held by banks including Morgan Stanley for more than two years, began to move, with investors including Apollo interested in a tranche... Following Trump’s win in November, JPMorgan dropped a three-year lawsuit against Tesla, in which it was seeking $162mn over alleged breaches of a stock warrants contract... Since the election, Musk has been a near-constant presence at the president’s side and been involved in everything from cabinet appointments to AI, defence and economic policy discussions.

State capture by plutocrats. 

2. Mexico, China, and Canada made up 42% of US imports in 2024.

These are the main imports of the US from the three countries. 

President Trump has signed executive orders imposing tariffs on the three largest US trade partners - 25% each on Canada and Mexico (though only 10% of Canadian oil exports), and 10% on China. It covers all US imports from these three countries.

Collectively, EU has the largest share of US imports

The FT has an editorial pointing to the absurdity of the trade war.

The harm to American diplomatic power is no less profound. From the 1980s, both Canada and Mexico set aside decades of scepticism to make a strategic bet on free trade with the US, culminating in the Nafta deal of 1994. The economic benefits, especially to Canada, have been plentiful. Both were coerced by Trump in his first term to renegotiate that deal. That the president is now riding roughshod even over the revised deal, the USMCA, sends a message America’s word cannot be trusted.

Janan Ganesh makes some important observations of the Trump era of deal making, describing it as one of "aggressive soft touch".

Because Trump is so quick to quarrel, people tend to miss that he is also quick to settle. He almost never drives as hard a bargain as his belligerent manner seems to promise. In 2020, China bought some peace with a vague and hard-to-enforce pledge to cut the two countries’ trade imbalance... Likewise, he didn’t abandon Nafta so much as pass off a revised version of it as a personal coup. Being an egoist, not a fanatic, what he cares about is his reputation as a maker of deals. To keep it going, he needs a regular flow of them. And so their content becomes secondary. We can mock, but the lesson here for countries faced with Trump is an encouraging one: give him something that he can call victory. The concession needn’t be huge, and he will in fact co-operate in talking up its significance. 

Nor does he seem to mind all that much which coin he is paid in. Trump is open to what Henry Kissinger called “linkage”. If he is upset about one thing, he can be mollified with a gesture on something apparently unrelated. Want to avoid a trade war, Europe? Spend more on defence. Want to prevent the betrayal of Ukraine? Soften the regulation of the tech sector. It is hard to know what is more telling about Trump’s truce with his northern and southern counterparts: the smallness of their concessions (Justin Trudeau is appointing a fentanyl “czar”) or the fact that economics and drug policy are mixed up like this in the first place. So yes, Trump threatens to displace industrial investment from Europe to the US. But Europe is spoilt for things to offer him, precisely because his grievances are so numerous. In that sense, he might be easier to defang than Joe Biden, who didn’t think Nato was a club of free-riders or the EU a conspiracy against Silicon Valley. There was nothing Europe could offer him on those fronts that would make him ease up on the America First industrial plan. With Trump, there might be. The very paranoia of his worldview — in which the US is being ripped off by almost everyone, almost all the time — means there are lots of entry points for a negotiation.

3. Alan Beattie makes an important point about the possible unintended effects of Trump's policies.

Currently, as trade has recovered from the initial shock of the Ukraine war, US imports have increased far faster than the world as a whole, while Chinese import growth has fallen... As for other sources of final demand, emerging economies themselves, particularly in Asia, have been consuming more as they get richer. But east Asian countries are typically net exporters: Malaysia, Singapore, Thailand and the Philippines have generally run current account surpluses since the Asian financial crisis in 1997-98, as have South Korea and Japan. Meanwhile, the EU, struggling to raise growth while Germany remains obsessed with exports, is also unlikely to pick up the consumption baton. This may add up to trouble ahead for countries exporting to the US, especially heavily exposed economies like Canada and Mexico.

Trump’s economic policies will encourage a wider US trade deficit, the opposite of what he wants. His planned sweeping tax cuts will increase consumer demand and suck in imports. His tariffs will make US exporters less competitive by strengthening the dollar, which import taxes tend to do. It will not be pretty if Trump starts deploying tariffs all round to stop the US being a consumer of last resort while implementing policies that will ensure it remains so. Exporters will be hunting round the world for scarce demand. As I’ve said before, the real threat to the global economy is not the rejigging of supply chains. It’s the danger that the most reliable market for global exports decides to crunch economic growth to get its trade deficit down and there’s not enough demand elsewhere to replace it.

The article has an important snippet that conveys the extent of China's predatory trade policy.

In terms of volume, Chinese exports rose at an annual rate of 13 per cent in the third quarter of last year, far faster than world import growth at less than 1.5 per cent.

It has a graphic on the estimates of trade growth between various categories of countries. 

4. Trump effect on US-China trade

One sector where the impact will be concentrated and immediate will be in the agriculture sector and in the US mid-west.

The opening salvo of a new trade war has sent a chill through the Midwest. Canada, Mexico and China together account for half of all American agricultural exports. Just last year, the US sold more than $30bn in farm products to Mexico, $29bn to Canada and $26bn to China, according to American Farm Bureau statistics. Suddenly, farmers were facing the spectre of retaliatory tariffs and the prospect of a full-scale conflict that some fear could decimate America’s rural heartland. Farmers in an area of the country that has become a bedrock of support for Trump now worry that the president’s tariffs, though suspended at the last minute, have permanently damaged the image of the US in the eyes of its most important trading partners...

Few US states better embody the agricultural wealth of the Midwest than Iowa. It is a land of vast corn fields stretching as far as the eye can see, the landscape broken by the occasional grain silo, hay bale or low-slung barn. Hogs outnumber people more than seven to one. It is also Trump country. Although Iowa voted for Democratic presidents Bill Clinton and Barack Obama, it backed Trump in 2016, 2020 and 2024 in ever greater numbers. More than a fifth of Iowa’s economy — or $53.1bn — is tied to agriculture, from crop and livestock production to food processing and manufacturing. It is the country’s largest producer of corn, hogs, eggs and ethanol and a top-three grower of soyabeans. That makes it particularly vulnerable to any downturn in agricultural exports. 

This article explains how the tariffs will impact automobile imports into the US.

5. Bloomberg reports that China's muted and largely symbolic response to Trump's 10% tariff on $525 bn of Chinese exports is a reflection of China's weak bargaining hand. China exports to the US three times as much as the US does to China. 

Apart from retaining the 10% tariff on China, for at least now, Trump has also scrapped the "de minimis" rules exempting shipments under $800 from duties. This loophole had been a major contributor to the growth of Chinese online sellers Temu and Shein. This will sharply increase the cost of the 4 million parcels a day arriving in the US under this exemption, of which 30% come from the two ecommerce groups. 

6. Richard Baldwin points to a possible four stage trade war scenario arising from Trump tariffs. 

American cars are not really made in America. They are assembled in America from parts produced in the US, Canada, and Mexico. I coined the phrase “Factory North America” 14 years ago to describe the tightness of the industrial integration. Nowadays, production processes are so interwoven that an engine could cross US-Canada and US-Mexico borders seven times before it ends up in a finished, US-made car. With each border crossing into the US, a 25% tariff will be applied, so the cost of the engine will soar. And costs will jump for all the other parts from Mexico and Canada and China. That’s step 1: The tariffs will raise the cost of US-made cars.

All cars made in Factory North America will become less attractive to US buyers. That will trigger Step 2. Before Trump’s tariffs, about half the cars sold in the US were imported. Mexico and Canada were big suppliers, but their competitiveness will be hobbled by the 25% tariffs. About half of US imported cars come from Japan, Germany, and Korea. They have not been subjected to the 25% tariffs... Cars made in the US, Canada, and Mexico will get more expensive inside the US, but German, Japanese and Korean cars will not... Almost surely, many US buyers will switch to German, Japanese and Korean cars that the tariffs made relatively cheaper. That’s step 2: A flood of imports from Germany, Japan and Korea. 

And how do you think President Trump will react to this import surge? My guess is that the US president will view it as unfair competition that he has to counter. He has a couple of time-honored options. He could lay a 25% tariff blanket on all imported cars, or negotiate “voluntary” export restrictions with Japan, Germany, and Korea. Given his love of tariffs, I’ll put my chips on option 1. Soon, it’ll be the “presidential all-you-can-eat tariff buffet.” That’s step 3: The US expands its war on trade to include its main trade partners in Asia and Europe... These US trade partners will retaliate against US exports. That’s step 4: The main US trade partners retaliate against US exports... When he sees US exports hit with new tariffs, which he will surely blame someone else for, he is very likely to impose counter retaliation tariffs. And that, ladies and gentlemen is how future historians will say that the World Trade War started.

7. A natural experiment in the works from the Indian government's Income Tax policy change of increasing the limit for tax rebates from Rs 7 lakh to Rs 12 lakh. 

While those earning up to Rs 12 lakh a year will have zero tax liability under NTR, the tax outgo would shoot up to Rs 61,500 if the taxable income breaches Rs 12 lakh by just Rs 10,000. Thus, an employee having an annual taxable income of Rs 12.1 lakh would actually take home Rs 51,500 less than the one earning Rs 12 lakh. A back-of-the-envelope calculation shows that parity is achieved only at the income level of Rs 12.71 lakh in terms of take-home salary. At Rs 12.71 lakh, the tax is Rs 70,500, which means the take-home salary at that level would be almost equal to Rs12 lakh.

8. Paul Krugman makes an important under-appreciated point about the value of FTAs in bringing predictability that in turn promotes business investments. He points to the example of NAFTA which did not as much as lower tariffs (which were already low when it kicked into effect in 1994) as it reduced uncertainties and allowed businesses do long-term planning and investments. 

9. Airline reward points 

In 1987... American Airlines partnered with Citibank to launch a co-branded credit card offering users air miles for every dollar spent. This scheme of selling frequent-flyer points to financial institutions transformed mileage programmes into complex but highly profitable businesses in their own right. In theory at least, it seems like a near-perfect business model: airlines can create as many points as they like out of thin air, and then sell them on to banks and credit card companies. They can also sell miles to partner hotels, car rental companies or shops, in effect becoming the central banks of a lightly regulated financial ecosystem. While airlines can enjoy instant revenue from selling air miles to banks and other third parties, the cost of customers redeeming their points through booking seats is deferred into the future, says John Grant, an executive at airline data company OAG.

Many never spend them at all. In 2018, the consultancy McKinsey estimated there were 30tn unredeemed air miles in passenger accounts, enough for almost every airline passenger in the world to take a free one-way flight. These asset-light businesses are particularly attractive to airlines. The actual work of operating flights is capital intensive, exposed to economic downturns and has high fixed costs, some of which such as fuel are out of airlines’ control. The reliance of airlines on their loyalty businesses became clear during the pandemic, when the four biggest US carriers put up their customer loyalty schemes as collateral to help them raise new debt. At the time, the valuations put on the loyalty schemes far exceeded the market capitalisations of the ailing airlines, suggesting they were worth more than the flight operations. Even at the height of the disruption in July 2020, American Express paid £750mn to extend its partnership with BA owner International Airlines Group, a significant part of which was to pre-purchase Avios frequent-flyer points. IAG Loyalty, the home of Avios, reported an operating profit of €321mn in 2023, more than Aer Lingus, one of the group’s airlines, and up by 14 per cent from the previous year. Its operating margin in 2023 — 21 per cent — was more than double that of Aer Lingus or BA.

10. DeepSeek has thrown egg at the faces of everyone, including the Chinese government.

DeepSeek’s achievements did not emerge from one of China’s myriad government-backed research institutes or state-controlled companies. Mr Liang seems to control most of the shares in DeepSeek, and has steered clear of China’s state-dominated venture-capital industry.

11. India's tariffs

India’s average import tariff stands at 17 per cent, while the trade-weighted rate is lower at 12 per cent, according to the World Trade Organization’s 2024 report.

12. FT has a good read on Paul Kagame's support for the Tutsi militia M23 in Eastern Congo. After its successful takeover of Goma last month, the rebels have been conquering other towns in the mining rich Eastern part of Congo. Rwandan troops are reportedly providing ground support for the invasion. Kagame argues that he's only providing protection for Tutsis against the DRC-backed Hutu FDLR militia who have been terrorising Tutsis in the area. The UN has reported that in a single year, 150 tonnes of coltan, used in electronics were fraudulently exported to Rwanda and mixed with Rwandan production, thereby benefiting Rwanda at least $1 billion. 

13. The fourth quarter results of Big Tech companies point to spending on CapEx to top $300 bn in 2025.

Microsoft, Alphabet, Amazon and Meta have reported combined capital expenditure of $246bn in 2024, up from $151bn in 2023. They forecast spending could exceed $320bn this year as they compete to build data centres and fill them with clusters of specialised chips to remain at the forefront of AI large language model research... On Tuesday, Google’s Sundar Pichai said in defence of his plan to spend $75bn in 2025 — up 42 per cent from $53bn last year... Microsoft’s Satya Nadella said... going to spend $80bn building out Azure... And on Thursday, Amazon CEO Andy Jassy topped Google and Microsoft by forecasting more than $100bn in capital expenditure this year, up from $77bn in 2024 and more than double the $48bn of the previous year. The vast majority will go towards data centres and servers for Amazon Web Services... Meta... pledged to spend “hundreds of billions” more on AI, on top of the $40bn invested in 2024.

Such spending is opening up a widening gulf between the Big Tech and the rest.

Spending among the “Magnificent Seven” — which also includes Apple, Nvidia and Tesla — dwarfs the rest of the US benchmark S&P 500. Their capital spending rose 40 per cent in 2024 compared with 3.5 per cent among the remaining 493 companies, according to Société Générale. Profits among the elite group soared by a third in the same period, versus 5 per cent among the rest.

14. In another reflection of the issues with US capitalism, it's being pointed out that US defence contractors are spending their surpluses on share buybacks instead of modernising their weapon sytems.

In 2023, Lockheed Martin and RTX spent a combined total of $18.9 billion on stock buybacks, compared with just $4.1 billion on capital expenditures, according to data compiled by Bloomberg.

15. In a reflection of the problems with climate transition, NYT reports that US "utilities have extended the life of nearly a third of coal units with planned retirement dates, either through delays or by reversing course and canceling retirements entirely, between 2017 and today".

Weekend reading links

1. Jared Bernstein, Chair of the White House Council of Economic Advisors, makes an important point while justifying the Biden administration's large fiscal stimulus.

Twenty-twenty hindsight is an analytical luxury — certainly one we didn’t have in January of 2021. Back then, we had millions of unemployed people. We had Covid deaths peaking. The economy was improving, but it was far from reopened. And vaccinations hadn’t been anywhere near adequately distributed. So the extent of uncertainty regarding the impact of Covid on the economy warranted a very strong rescue plan. And I don’t regret the plan. We certainly got more heat than I envisioned at the time, no question, but we also got a lot more growth, less child poverty, fewer evictions, more business survivals, and a much quicker return to full employment and very little economic scarring... I used to say, back then, “The risk of doing too little was greater than the risk of doing too much.”

2. NYT on the China risk that Elon Musk is riding on. In every industry Musk is in, his main competitors are the Chinese - EV, batteries, solar panels, boring machines, and satellite launches. Tesla is still awaiting permission in China for full-self driving, something which domestic competitors have already secured. 

As an illustration, during President Xi's latest visit, SpaceSail, the state-backed Chinese satellite launch company, signed a deal with the Brazilian government to launch satellites for Brazil. 

In terms of corporate risk, brand Elon Musk stands completely at the mercy of two forces he cannot control at all - Donald Trump and China. Worsening matters, the two conflict with each other at several points, making it tails he loses and heads the other side wins!

3. DHL and NYU have a Global Connectedness Tracker which gives a wealth of information.

4. EV car manufacturing in China

The business of car-making in China is far more promiscuous. Huawei has Seres-style alliances with three other major local manufacturers and presents itself as a provider of smart software, hardware and retail expertise that more traditional automakers can put on four wheels. It’s also joined forces with Anhui Jianghuai Auto Group Corp., or JAC, which manufactures cars for US-listed EV-maker Nio Inc., on a soon-to-be-released luxury people mover. Xiaomi is now making its SU7 in-house, but even there it initially tied up with BAIC Motor Corp. in developing it.

5. The problems with Trump's threat to tax Canadian imports.

“How do you compete with China if you price Quebec aluminum, Ontario cars, Saskatchewan uranium and Alberta oil prohibitively?” Flavio Volpe, the president of the Automotive Parts Manufacturers’ Association, a Canadian industry group said, citing some top Canadian exports to the United States. “Half of the cars made in Canada are made by American companies, and half of the parts that go into all the cars made in Canada come from U.S. suppliers, and more than half of the raw materials are from U.S. sources,” Mr. Volpe added. “We are beyond partners. We are almost as inseparable as family.”

6. China EV market facts 

BYD, Tesla’s biggest rival in China, has demanded its suppliers slash prices by 10 per cent, as the world’s largest auto market braces for a fresh salvo in a cut-throat price war. The carmaker urged its suppliers to send over their quotes by December 15 and officially mark down prices starting next year, executive vice-president He Zhiqi wrote in an email circulated on social media on Wednesday. “In 2025, the EV market . . . will go into a grand final battle and a knockout tournament,” he said. “To enhance BYD cars’ competitiveness . . . you and your team must take it seriously and effectively exploit space for cost reduction”... “The rise of China’s auto industry cannot come at the expense of the livelihood of domestic workers and suppliers,” one supplier responded. “We are unable to accept your company’s request and unwilling to take part in this type of co-operation that violates business ethics and human nature.” In the first nine months of 2024, the average time BYD took to clear its bills payable, most of which were attributed to suppliers, was 144 days, longer than the 124 days a year earlier, according to company filings.

7. Claudia Sheinbaum is pushing ahead with radical reforms as the new President of Mexico.

During her first weeks in office, she has thrown her weight behind a package of López Obrador’s most controversial ideas, branded “Plan C”. Her first year in office will be spent implementing elections for judges, dismantling regulators and cementing the dominance of state companies in the energy sector... Mexico will be by far the biggest country to elect all its judges via popular vote, in a process Sheinbaum backed enthusiastically throughout the campaign, arguing that it would reduce corruption and make the distrusted judiciary more accountable... Together we are going to transform the judiciary, truly from the bottom, from the people of Mexico,” she said at a recent rally in Zacatecas. “What is democracy? The power of the people by the people and for the people.” Despite warnings from the US government, business leaders and lawyers that it would damage judicial independence and democracy, Sheinbaum pressed ahead.

But she has to preside in the long shadow of her predecessor and mentor Andres Manuel Lopez Obrador (AMLO) 

Much of Morena’s leadership — in the party and congress — is seen as more loyal to its founder than to her, a profound risk as she faces a recall referendum three years into her six-year term.

8. As President designate Trump threatens a full-scale tariff war, here's a graphic pointing to who will likely be hurt the most.

There are many worthy academic studies of the Trump tariffs from 2018. While not the most riveting reads, they give a reasonably clear account of the evidence... The evidence suggests: US importers bore the vast majority of the cost of tariffs. Overall, for a 20 per cent tariff, the importer paid 18.9 per cent higher prices with the ex-tariff price reducing just 1.1 per cent. Tariffs were passed on to US importers much more than US exchange rate depreciations, where contracts tend to be fixed for a period in dollars... While US importers paid, these costs were not always passed on directly to US consumers. Washing machines were a bit of an exception where prices rose. In other areas, prices barely increased. It is less certain whether retailers spread the tariff effect over multiple goods, margins were squeezed or products were bought ahead of tariffs being imposed... The incidence of US tariffs clearly appears to fall on the US corporate sector, with it then passed on to households in a combination of lower profits, higher prices and lower wages.

9. We are not yet at peak fossil fuel emissions.

And this on off-shore oil drilling

10. The souring of China market ambitions of Western financial institutions.

In spring 2009, Beijing’s state council, the country’s top decision-making body, set an ambitious target: Shanghai would become an international financial centre by 2020... More than 15 years after China pledged to turn Shanghai into an international financial centre, the port city has failed to live up to its early promise... American law firms, once participants in huge cross-border financial flows, have left the city as foreign investment plummets. No western bank has participated in a single IPO on Shanghai’s stock market this year, and, in a domestically-focused market, the need for foreign staff is increasingly unclear. Asset management firms that flocked to the city in the hope of a loosening of China’s capital controls must reckon with the prospect that Beijing will tighten them instead.

11. Important point about Tamil Nadu's manufacturing base

Tamil Nadu has been pursuing a policy of creating multiple electronics manufacturing clusters across the state rather than locating them in one area. Apart from Sriperumbudur, it is creating a cluster near Tiruchirappalli where Jabel Inc, an American electronics major, will set up a production facility. Coimbatore, the minister said, will focus on electronics and semiconductor design. Madurai, meanwhile, is being prepped to house large global capability centres.

12. For all punditry around what to expect from the Trump White House, Alan Beattie has, in my opinion, the best assessment.

If you enjoy watching narratives disintegrate and re-form like crystals in a supersaturated solution, you’ll have loved the last few days in Washington... The value of palace politics in analysing the Trump administration will be strictly limited. The economic and trade team will be a gaggle of vying courtiers under an erratic president motivated by instinct and prejudice. This was, after all, exactly what we got during Trump’s first term. This time, his compulsion to listen to voices outside that circle urging him to deport foreign-born workers or pursue security goals even if they damage the US economy will be even stronger. It’s more productive to look at what powers the administration has and what it can get done if it tries... As in Hollywood, nobody knows anything. The one pretty safe bet is that Trump will use tariffs over the next four years. But it is very unclear how they might be employed, or for what end, or what other economic and financial tools might also be deployed, or whom he will be listening to at any given time. This week is a warning to anyone who thinks they have the Trump administration all figured out. They do not.

China economy summary - October 2024

This is the latest in the series on the Chinese economy - here, here, here, and here. See also this and this. 

Four aspects of China’s economy should be of big concern—low household consumption expenditures co-existing with a high savings rate, excessive reliance on investments to drive growth, low bang for the buck from its high investment rate, and a debt overhang that threatens the finances of its subnational governments and corporations. While they have been concerns for some time, the combined effect of all three is now a binding constraint on economic growth. Addressing them is critical to the country’s long-term prospects. 

In an economy, aggregate demand reflected in consumption leads to investment and job creation, which fuels further demand in a self-reinforcing cycle. While government consumption too creates demand, household consumption is the primary driver of economic growth. China’s domestic consumption has remained unusually low even when compared to other developing countries and remarkably, has steadily fallen from 53.38% of GDP in 1984 to 46.96% in 2000 to 37.46% in 2022. Its share ranges from 60-70% for most countries, including India. 

This economic structural problem of low and declining base of household consumption has been the biggest challenge for the Chinese government in its pursuit of sustaining high growth rates. As we shall see, a confluence of other problems that have become more acute is making it a binding constraint.

For a government which has historically tightly managed the economy and shown a willingness to step in at the slightest sign of distress, Beijing, especially under Xi Jinping, has shown a surprising reluctance to support household consumption. To be fair, historically Chinese governments have preferred to intervene on the supply side. It has resisted demand-side interventions like expanding affordable access to services like healthcare and education (one reason for the propensity for large savings), leave aside any fiscal stimulus. 

The low consumption has co-existed with very high household savings, which finds its way into supporting the country’s high investment rates. The persistent high savings must find an outlet within the economy or outside. 

It’s the source of at least two important distortions in the economy. One, for a long time, the real estate sector absorbed a significant part of the savings. But once it started floundering and with domestic consumption weak, it became inevitable that the surplus find its way out as external surpluses from the surge in exports. Two, the high level of savings fuels a repressive financial system, where it gets directed to the government’s prioritised sectors and sustains a distorted investment-driven economic growth model. 

It’s been remarkable that all through its high growth decades, especially since the turn of the millennium, Chinese households have preferred to increase their accumulation of savings and reduce their relative share of consumption. This propensity to double down on savings and avoid spending speaks of economic insecurity. 

With the standard driver of economic growth out of the equation, the government has no option but to rely on investments to drive economic growth. This creates the challenge of figuring out the sectors to funnel credit and drive investment. Here the Chinese industrial policy has consistently targeted sectors for government support. 

For long, perhaps the longest period of its high growth era, export-driven manufacturing and infrastructure investments have been the government’s primary drivers of economic growth. The former served the export markets and made China the factory of the world. Once domestic infrastructure demand plateaued, real estate, which was always an important source of growth, became the government’s preferred destination for credit. It was supplemented with the export of domestic excess capacity into building out the Belt and Road Initiative (BRI). But by about 2020, the authorities had come to realise the perils of the real estate bubble and had started introducing measures like the “three red lines” to cool the real estate market. The property market defaults were to duly follow. 

Beijing’s latest preferred investment destinations have been green technologies like solar panels, electric vehicles, and batteries, critical technologies like semiconductor chips, and critical minerals like lithium. It has channelled fiscal incentives and credit to these industries, and these investments have propped up economic growth. This focus is in line with President Xi’s stated objective of unleashing “new quality productive forces” and achieving self-sufficiency in frontier technologies. 

The problems with this investment-based economic growth strategy were papered over during the years of high growth. But once the economy began weakening after 2018, its limitations came to the fore. 

Thanks to the long years of investment-driven growth, the country is awash with massive overcapacity across sectors. In sectors like steel, solar, and internal combustion engine (ICE) vehicles, the Chinese production capacity is often comparable to or higher than the rest of the world put together. Worsening matters, domestic demand has plateaued or is declining. The excess capacity has no outlet except exports. Accordingly, Chinese firms compete to dump their produce in export markets, forcing the inevitable backlash and protectionism in those countries. 

This backlash is no longer confined to the US and Europe, but is rising even among China’s developing country partners. Factory closures and job losses due to cheap Chinese imports have become a uniform source of discontent and anger across countries. The cheap Chinese imports are one of the biggest problems facing the world economy today. 

The combination of weakening domestic demand, corporate indebtedness, and protectionism among trade partners is exposing the limits to such an investment-driven strategy. 

In this context, Brad Setser points to an important observation about the Chinese economy. He shows that for over a decade since the global financial crisis, Chinese exports and imports grew slower than its GDP growth rate, thereby driving down the share of exports to GDP. He argues that the de-globalisation observed in this period was driven by this trend. 

However, since 2019, there has been a surge in Chinese exports and its surplus in manufactured goods “has increased by about three-quarters of a percentage point of world GDP and is now at a record high.” In the last four years, its exports have surged by nearly a trillion dollars. This re-globalisation of the Chinese economy has coincided with its real estate troubles and plateauing of domestic demand. 

The surge in Chinese exports has been driven primarily by green technologies, critical minerals, and electric vehicles and their batteries. They have made entire supply chains critically dependent on China. Supply chain diversification by way of shifting of assembly to the likes of South East Asia, Mexico, and India, does not address the underlying exposure to component imports from China. The export focus to prop up a weakening economy also led to a sharp rise in exports to other developing countries. This more than offset the relative slowdown in exports to the advanced countries. 

It can be argued that the de-globalisation was driven by the demand generated by a fast-growing economy and associated domestic absorption of the country’s rising production capacity across sectors. On the same lines, the current re-globalisation has coincided with the weakening of economic growth and aggregate demand. It has created an imperative to backstop further declines by exporting the massive economy-wide excess capacity accumulated during the high growth years. 

Setser has a good summary

These data points highlight the surprising conclusion that, in years after the pandemic and after the imposition of Trump’s tariffs, China’s economy has become more integrated, not less integrated, into the structure of global trade. The recent surge in China’s exports and in its trade surplus stems primarily from China’s sharp domestic slowdown and its still-unresolved property market crisis. China’s internal demand growth has faltered, and it has instead relied again on exports and global demand to support its growth. This form of globalization is unhealthy to be sure, as it stems from unresolved imbalances inside China’s economy, but it is nonetheless globalization.

This brings us to the third problem. As the government has pursued a predominantly investment-driven growth model, the bang for the buck from every additional renminbi of investment has diminished considerably. This is reflected in the sharply rising incremental capital output ratio (ICOR). Even as investment has been range-bound at 43-45% of GDP since before the global financial crisis, the ICOR has nearly trebled from below 3.5 to touch 10. This period has also coincided with economic growth declining precipitously from above 12% to just 4%.

It’s likely to get worse with the ongoing investment spree in green and critical technologies, where as aforementioned, the limits to supply are becoming evident. 

As Setser and others have pointed out, a major source of competitiveness for Chinese manufacturers comes from their access to directed credit in the form of cheap equity and debt, provisioned by local governments and state-owned banks. But major fault-lines are now showing up there. As the real estate market flounders, the local government’s access to resources is drying up. And mounting defaults by real estate and manufacturing firms are starting to stress the financial system. 

With the deficient domestic demand and rising restrictions on export markets, the export-driven model appears to be at its last legs. Rebalancing towards domestic consumption is the only way to absorb the massive savings. 

The final piece is the debt overhang facing local governments and financial institutions. Since 2010, government debt has risen from 34% of GDP to over 86% today, and this is most likely a gross underestimate given the large value of off-balance sheet debts of local governments in the form of local government financing vehicles (LGFVs). 

The biggest challenge for the central government is in the management of real estate prices, which are critical to local government revenues. It’s estimated that property made up 23-27% of GDP from 2011-21, absorbing nearly half the total domestic savings of around 45% of GDP. This degree of importance of real estate places Beijing in a catch-22 situation. 

Elevated real estate prices are central for not only future revenue mobilisation but also to ensure debt repayments. If the property bubble gets deflated abruptly, it can result in a cascade of local government defaults, failure of banks, investment cuts, and job losses. It’s hard to manage such downward spirals. 

The counterparties to real estate and other corporate debt are financial institutions. Logan Wright writes in a Rhodium Group report

China saw the largest single-country credit expansion in over a century, adding $24 trillion in new assets over the eight years from 2008 to 2016, around one-third of global GDP. Banking system assets now total $59 trillion as of June 2024, over three times the size of China’s economy and around 56 percent of global GDP. In comparison, China’s real GDP grew by $6.1 trillion between 2008 and 2016, and a further $7.1 trillion between 2016 and 2023. China has by far the largest single-country banking system in the world in terms of assets. US banks hold around $23.4 trillion in assets, but the US has a far more diversified financial system than China. That volume of lending by Chinese banks was extended primarily on the basis of government guarantees rather than the potential financial returns of the underlying investments. As a result, this credit explosion generated significant numbers of loans that may have been made to “safe” state-owned companies, but they constantly require loan rollovers and extensions. A financial system this large and this impaired can no longer generate the same pace of credit and investment growth as it did in the past…

Bank profit margins and credit growth in China have already slowed significantly. China’s overall credit growth averaged 18 percent from 2007 to 2016. Its slowdown in credit growth began in earnest with the deleveraging campaign from 2016 to 2018, and since then credit growth has averaged just over 9 percent. Banks’ average net interest margins on lending have fallen from 2.77 percent in 2012 to 1.54 percent in the first quarter of 2024, according to data from China’s banking regulator.

The financial system too therefore has hit its limits in sustaining the government’s investment-driven economic growth strategy. This is showing up in “the collapse in property investment, a slowdown in local government investment, and rising local government fiscal pressures”. 

Beijing will be able to kick the can down the road with adhoc policy interventions like the recent monetary stimulus. Perhaps it’ll supplement with fiscal stimulus. It might reverse policy and prop up the real estate sector. Whatever the measures, there cannot be any substitute to rebalancing away from investment to household consumption for China to address its problems and achieve a sustainable growth path. This will be the biggest challenge yet for China in the last several decades and should become the top most priority for the government.