China: Rising tensions

China’s political tensions with several countries have risen substantially over the past month. The EU, US, UK and Canada have sanctioned Chinese officials over the alleged use of forced labor in the Xinjiang province. China has retaliated by sanctioning ten EU individuals and four companies, followed up by additional sanctions on Canadian, US and UK individuals and entities. These developments might have wide-ranging effects.

First, they put a dent in the chance that the recently signed EU China investment deal (CAI) will be ratified by the EU. A recent FT article, for example, quotes EU trade commissioner Valdis Dombrovskis saying, “the prospects for the CAI’s ratification will depend on how the situation evolves”.

Second, this does not bode well for US China relations as well. Hopes for a US China reconciliation under the Biden administration have all but faded into the background. Such hopes were already diminished after the recent summit between the US and China in Alaska has shown that relations between the two countries are not thawing. US president Biden has stated in a recent speech that he expects “extreme competition” with China. In addition, the recently appointed US China trade representative Katherine Tai has openly stated that the US is not ready to lift its current trade tariffs on China anytime soon.

Third, the situation highlights that big brand international firms operating in China might increasingly come into the political crossfire between China and western countries (next to firms in strategic industries such as the semi semiconductors industry, which we previously flagged in this special). The prime example here is that H&M, Nike and Adidas are already facing boycotts after voicing concern over forced labor in Xinjiang.

Fourth, China’s textile exports and the economy of Xinjiang could get hurt badly. Xinjiang is responsible for 80% of China’s cotton production and much of China’s textile exports contain either cotton or viscose from this region.

Finally, but importantly, the Xinjiang situation is another example of how vulnerable international supply chains are to what happens in China.

China is responsible for 25% of global cotton exports (figure 1). The highlighted vulnerability could accelerate further diversification of supply chains away from China. Vietnam, Pakistan and India could benefit from this, as they are also major cotton exporters. India has apparently been benefitting already. That might fuel further tensions between India and China. Given the importance of China as a cotton producer this could also imply higher global prices for cotton and cotton-based products.

All in all, China’s tensions with a host of (western) countries are not likely to reduce in the short term, which means geopolitical risk will remain a key risk to watch for firms that operate in China or depend on the Chinese economy in other ways.

From the macroeconomic side, China’s recovery seems to be doing well. As expected, given the very low base in January and February 2020, several economic indicators such as sold floor space (an indicator of the real estate market) and exports have shown very high growth rates of 105% y/y, and 61% y/y respectively. Still, even compared to the levels in Jan/Feb 2019, these growth rates are high (23% and 33% respectively) which implies that China’s recovery is still on track.

Moreover, China has scaled back containment measures, which are currently below most G7 countries. China’s containment measures currently score 57 on Oxford University’s Stringency Index, while the G7 average is 69 (and index number of 100 represents the most stringent measures). That should help consumer demand in the months to come. In contrast to the positive short-term outlook, we remain more pessimistic about China’s long-term outlook, due its structural challenges of high debt, weak productivity, an ageing and ultimately shrinking workforce and ongoing geopolitical tensions.

The NBS has released producer and inflation figures for February, which show an uptick in producer price inflation, while consumer price inflation remains negative (figure 2). We think consumer price inflation will pick over the coming months as well. The decline in CPI in the past four months has been mainly driven by lower transportation costs (figure 3). However, core inflation (which excludes food and energy), has picked up to 0% y/y, up from -0.3% y/y in January.

Moreover, if producer prices continue to edge higher, they will feed into consumer prices sooner or later (unless producers do not pass through the rising prices, which seems unlikely, as that would cut their profit margins). We do not expect inflation to average much above the government’s target of 3% this year. China’s central bank (the PBoC) is looking to tighten monetary policy and could be bolstered in its aim if the recovery in China exceeds its expectation.