Executive Summary

The last two decades have witnessed a new industrial revolution. Galvanised by its accession to the World Trade Organisation in 2001, China has grown at lightning speed to become the world’s leading manufacturer. Now, new far-reaching changes are at hand. Rising costs and a wrenching rebalancing of its economy are dimming China’s attractiveness as a platform for exporting to the global market. This in-depth report explains why an increasing number of manufacturers are likely to repatriate production and how the global industrial landscape will once again be reshaped in the process. It takes a comprehensive look at which sectors are most likely to move production specifically back to America.

By 2018, the unfettered access to world markets granted by WTO membership had enabled China to grab fully a quarter of global manufacturing value. Xi Jinping wants what is now Made in China to be Made by China. But the country’s sheer size makes it impossible just to keep expanding its market share.

China’s strategy to move up the value chain and become more self-sufficient, especially in high-technology, has placed it on a collision course with the US.

Another critical factor in China’s rise was the yuan’s quasi peg against the dollar, which enabled it to industrialise fast while keeping international influences at bay. However, China failed to realise that it had become too big to keep enjoying this free currency ride. Imbalances built up, as surplus Chinese savings fuelled a dangerous build-up in US household debt, resulting in the Great Financial Crisis.

A rebalancing was clearly urgent. Ideally, this should have taken the form of a big nominal exchange rate adjustment and the freeing-up of Chinese capital flows. Instead, it occurred principally via a big increase in China’s relative unit labour costs. This adjustment, now more or less complete, coupled with the tariffs president Trump has imposed on Chinese imports, is now almost sufficient for US manufacturing to rise as a share of GDP.

Against this background, the report sets out three possible policy paths for Beijing in the next few years – financial liberalisation; continued financial repression of households; and the three Ds of dealing with China’s excessive debt – default, demand deflation and devaluation.

The problem is that all three involve either a rise in the cost of capital or the drying up of cheap credit or both, making it harder for Chinese firms to sustain the economies of scale which turned the country into such a powerful export platform.

At the same time, the ever-tightening grip of the Communist party over every aspect of life is making it harder for foreign companies to do business in China. To this mix can be added the high-tech stand-off between Washington and Beijing, epitomised by the US ban on 5G equipment supplier Huawei, and a bad-tempered blame-game over the handling of the coronavirus epidemic.

With politics and economic giving US companies in particular cause to think hard about heading back home, the report introduces the Enodo Reshoring Index (ERI).

Our proprietary index is a comprehensive ranking of China’s manufacturing sectors according to how likely production is to move to the US based on factors such as labour costs, productivity, trade barriers, reliance on scarce Chinese bank credit, etc.

The purpose is to help you identify the opportunities – as well as the risks – thrown up by what we at Enodo Economics call the Great Decoupling of China and the US.

Introduction

Nothing lasts forever. China is so big that it can no longer expect to increase the huge share of global manufacturing and exports that it has carved out in short order since joining the WTO. Three principal forces – two well-established; the third, new - argue for a gradual shift in manufacturing away from China.

The first driving force is the changing cost equation in China, where a steady rise in productivity-adjusted labour costs has all but eroded its competitive advantage over the US.

The second is the Great Decoupling - a tectonic shift in the world economic and political order as the rules of engagement between the existing superpower, the US, and the aspiring superpower, China, are being rewritten.

The third is the global coronavirus epidemic, which has brought home to multinational companies and governments alike the need to reconsider the security and resilience of supply chains for vital industries. Policymakers around the world are concluding that they should never have become so reliant on China.

A shift is thus shaping up from globalisation to bifurcation to localisation, depending on the importance of each industry to national security and survival. This will inevitably lead to lower efficiency and higher costs overall. But within both China’s and America’s sphere of influence, as well as in each country individually, these forces will create opportunities.

Size matters

China’s entry into the WTO ignited the economy, quickly transforming it into a global industrial powerhouse. By 2010 China had surpassed the US to become the world’s largest manufacturer measured in dollars; by 2019 its share in global manufacturing value added had risen to 29%. Its stratospheric ascent met with little resistance from the rest of the world… until the election of President Trump. 

Leading manufacturing economies share in world MVA (at constant 2015 prices)

Country/Economy	2005	2010	2019
China	13.69	21.51	29.67
United States of America	22.8	19.66	16.31
Japan	9.47	8.33	7.01
Germany	6.6	5.9	5.42
India	1.73	2.3	3.11
Republic of Korea	2.64	3.05	3.05
Italy	3.24	2.55	2.03
France	2.82	2.32	1.95
United Kingdom	3.09	2.47	1.91
Indonesia	1.34	1.37	1.58
Mexico	1.98	1.7	1.52
China, Taiwan	1.02	1.26	1.32
Russian Federation	1.78	1.56	1.29
Spain	1.88	1.44	1.22
Turkey	0.93	0.93	1.2

Source: UNIDO

In the run-up to the GFC over a quarter of the value added in China’s exports was generated overseas, locking its economy tightly into global supply chains. But by 2016 this ratio had fallen to just over a sixth. As China has moved rapidly up the value-added chain, the domestic content of its exports has risen significantly across all sectors.

Continuing with this strategy is a priority for Beijing. In 2015 the State Council unveiled its “Made in China 2025” plan for a comprehensive upgrade of the country’s industrial base. It sets out the goal of raising the domestic content of core components and materials to 40% by 2020 and 70% by 2025.

Xi Jinping wants to transform “Made in China” into “Made by China” with the purpose of reducing the economy’s vulnerability to a disruption of global supply chains.

But by 2011 the sheer size of its economy was already making it tougher for China to clamber up the value-added ladder by grabbing ever-bigger shares of global manufacturing and export markets. The headwinds were stiffening even though China’s average standard of living was still only a fifth of America’s at purchasing power parity – that is, with goods and services output valued at US, not Chinese, prices. By contrast, after Japan’s comparable long period of near-10% growth ended in the mid-1970s, its average standard of living had climbed to more than 70% of America’s.

Little countries can go on capturing shares in world markets until their income per head catches up. Big countries cannot, unless they make those markets commensurately bigger.

In relative terms China still has plenty of catch-up potential; its average standard of living was still just 29% of America’s in 2018. But in absolute terms its GDP measured at PPP is already more than 120% that of the US - over three-and-a-half times Japan’s 1970s ratio. Unfortunately, China’s development model has so far not made world markets commensurately larger. Global consumption grew by just 2.7% a year in real terms in 2001-2018, down from 3.2% in 1971-2000.

Instead, China’s economic policies contributed to a global savings glut that precipitated the GFC in 2008 and shares the blame for the weak global recovery since then. 

Meanwhile, China’s vast pool of cheap labour resulted in its manufacturing catch-up being concentrated first at the low-value-added assembly end of industrial processes; the high-value, sophisticated parts that China’s armies of low-skilled factory workers were putting together still came to a large extent from Japan, South Korea and Taiwan.

But within less than a decade after joining the WTO, China had begun both to dominate and to saturate global output and capacity in many low-value-added industries.

Since the GFC, China’s share in global manufacturing value added has risen at a slower pace, but nonetheless it continues to expand. 

Put simply, over the coming decade China cannot reasonably expect to end up making most of the world’s manufactures.

Even more so now that Xi has made it clear that China will stick to its own economic and political model and has no interest in trying to converge with the practices of free-market democracies. In these circumstances, the West will become extremely vulnerable to a disruption in global supply chains and critical infrastructure.

This is especially the case with the advent of 5G technology. By providing much greater connection speeds, lower latency and vastly increased bandwidth, 5G networks will in principle enable the Internet of Things, autonomous manufacturing and driverless vehicles. They will also play an important role in determining the future of Artificial Intelligence.

The consequences for the West of China’s ambitions to be the global standard setter for 5G are even more serious than its long-term plans to make its industry self-sufficient within its geopolitical sphere of influence. The clash of the two world views – China’s and America’s – is nowhere more fundamental than in the technology sphere. 

Binding Chimerica together through the yuan-dollar peg has been a disaster for the global economy

Chimerica emerged as the principal driving force in the global economy after China acceded to the WTO. Niall Ferguson, the Harvard history professor who is credited with coining the term, describes it as a symbiotic marriage. He is wrong.

Chimerica hasn’t been a marriage at all. Bondage is a better word.

China and America are yoked together in a common currency zone imposed by Beijing over continued US objections. The yuan has been either pegged to the dollar or managed against the dollar for more than 25 years, forcing two countries to cohabit that are massively different in both economic and political structure.

As I have argued since 2006, when I co-wrote “The Bill from the China Shop: How Asia’s Savings Glut Threatens the World Economy”, the sheer unsuitability of the yuan-dollar peg was the wellspring of the imbalances that helped spawn the GFC and, after a decade of slow, painful efforts to right those imbalances, has now resulted in the global rupture we call the Great Decoupling.

The collapse of the Bretton Woods system of fixed exchange rates in the early 1970s showed that national autonomy could co-exist with free global trade and capital movements – and all the benefits they brought until 2001 – only under a regime of floating exchange rates. This is even more pertinent when the countries yoked together in a currency zone are massively different in most economic aspects, which is the case with China and America. 

That it was inappropriate to shackle together the Chinese and US currencies was obvious from the start. Initially, China’s economy was still much smaller than America’s, so preserving the blatant undervaluation of the yuan seemed like a “win-win”.

Beijing thought that the yuan-dollar peg was serving China well, allowing it to industrialise fast while keeping international influences at bay. Its conviction was fortified after the 1997-1998 Asian Financial Crisis, when it concluded that its weak financial system should not be subjected to the vagaries of international capital flows.

China’s policymakers failed to realise that the free ride was over once China became too big. This failure has had a major impact on global economic developments, and they in turn have had a big impact on China itself.

A closed capital account and a managed currency were far from sufficient bulwarks against global volatility. 

As long as American families could rack up debt to finance excessive consumption before the GFC, providing the final demand for China’s surplus products, the yuan-dollar zone chugged along fine. But the accumulation of debt could not last forever. Once US households had exhausted their borrowing capacity, the edifice of strong growth collapsed, threatening the entire global financial system.

Put simply, the adjustment necessary to recover sustainably after the GFC involved America consuming less and producing more and China consuming more and producing less.

For both countries the fastest and most beneficial route to achieve this rebalancing would have been a big nominal exchange rate adjustment and the freeing-up of capital flows in and out of China. But that did not happen.  

Sino-US economic rebalancing has eroded China’s relative labour cost advantage

An adjustment of China’s real effective exchange rate did occur, but the change in its nominal exchange rate was modest.

Instead, the Sino-US rebalancing came about principally via a significant increase in China’s relative unit labour costs. The adjustment is now more or less complete.

China’s wages measured in US dollars rose more than four-fold between 2005-2017, pushing up the share of wages in gross value added from 16% to 20%. Meanwhile, wages per employee in the manufacturing sector in the US rose by just 34% during the same period, with the share of labour costs in value added increasing by less than 1 percentage point.

As a result, the US’s bilateral competitiveness vis-à-vis China has improved since early 2011. It has now clawed back most of the competitive advantage that China used to enjoy.

The effective revaluation of bilateral relative unit labour costs and the tariffs Trump has imposed on Chinese goods are now almost sufficient for US manufacturing to rise as a share of GDP, either through substituting imports for domestic products or gaining export share or both.

Wage inflation and lower productivity growth in China have combined to lift unit labour costs. The pace of wage gains accelerated not only on the back of the massive stimulus Beijing injected after the GFC but also due to structural demographic shifts: first, the pool of cheap migrant labour shrank; now, the overall labour force is declining.

There is little the authorities can do about these population trends over the next two decades and even longer, not least because immigration is culturally unacceptable to the Chinese. One aim of Beijing’s Belt and Road Initiative (BRI) is to tap into pools of cheap labour abroad, but the developing economies targeted by the BRI lack China’s scale.

The onus, then, will be on boosting productivity growth. But China has exhausted the easy gains from shifting unqualified, cheap workers from agriculture into low-value-added but higher-productivity manufacturing.

Moving up the value-added production chain fast will require educating and training blue-collar workers capable of performing sophisticated tasks.

Low-skilled workers can easily be taught to produce garments or assemble parts. It is much harder and more time-consuming to mould them into a skilled labour force. The leadership has made vocational training its education policy priority since 2009 and has been experimenting with how to improve results for some time now.

But 10 years later, the structural problem endures: China has too many low-skilled workers ill-equipped for automation and knowledge-intensive manufacturing. 

Data from the Ministry of Human Resources and Social Security show that in 2013 skilled workers accounted for only about 19% of China’s entire workforce; highly skilled workers made up a mere 5%. A serious mismatch between the needs of employers and the capabilities of the labour force persists. There is another gulf: college graduates prefer to work for the government and state-owned enterprises, whereas the vast bulk of new jobs are in the private sector. 

China’s leadership must redouble its training and retraining efforts to raise the quality of the labour force and make sure the newly acquired skills are applied where they are needed most.

China needs consumer-led growth but the nascent domestic rebalancing of the past couple of years has begun to reverse

By 2011 China’s export-led growth model had reached its end-by date, as I argued that year in “The American Phoenix: And Why China and Europe Will Struggle After the Coming Slump”. Beijing was able to keep the economy expanding by pouring vast additional sums into investment, but at the expense of a fast increase in debt to GDP and a structural decline in its growth rate.

By 2015 the authorities realised that they needed to make fundamental changes to foster consumer demand and bring about a supply-side productivity boost.

China’s development model has relied on a closed capital account to bottle up its large domestic savings at home and use them to subsidise its industrial rise with underpriced credit. The victims of this deliberate policy of repressing returns on savings were China’s households: real consumer spending as a share of GDP fell to an unprecedented low of 34.4% in 2007.

While labour was plentiful, employees lacked bargaining power and could not demand a larger share of national income. But as the migrant labour force started to decline, the share of wages in GDP began to climb.

At the same time, the exorbitant household savings rate started to fall thanks to progressively better provision for medical care and social security and the birth of wealth management products (WMPs). 

The explosion in WMPs in the past few years was the markets’ response to financial repression, offering households a higher return on their financial assets. The Chinese hold two-thirds of their financial wealth in interest-earning bank deposits. Beijing’s policy of keeping deposit rates artificially low has supported successive investment booms over the years, but at the cost of paltry real returns on households’ financial wealth.

WMPs and other so-called shadow banking products such as peer-to-peer (P2P) loans have offered well-off urbanites the chance to earn a few percentage points more on their financial assets than they can in a savings account. WMPs have also been perceived as just as safe as bank deposits.

And the higher return on household financial wealth has led urban consumers to save less.

These developments put a floor under the relentless decline in the consumption rate, which started to climb in 2011. From 2015 onwards two more factors came into play that supported consumer spending. The first was Beijing’s drive to revitalise the rural economy - a structural initiative that helped lower the household savings rate.

Using e-commerce, the authorities managed to begin unlocking the pent-up spending potential of people living in the countryside, who often lacked easy access to the things they wanted to buy.

The second factor was a much faster increase in household credit as a share of GDP. Almost non-existent a few years before the GFC, the rise in household credit from very low levels starting in 2011 was a welcome structural transformation. But when additional cyclical demand kicked in after 2016, the ratio shot up dangerously close to developed country levels within a short space of time.

In response, in 2017 Beijing started to rein in the shadow banking sector in order to reduce systemic financial risk. The campaign has begun to choke off WMPs, not least by removing the implicit bank guarantee behind these products. Both issuance volumes and yields are falling as a result. And China’s once-booming P2P lending industry has collapsed, inflicting capital losses on households that have triggered sporadic protests.

De-risking is sensible policy, even if the overarching purpose is to restore state control of the financial system. But it has not been accompanied by a proper liberalisation of bank interest rates, which until recently were still set de facto by the People’s Bank of China (PBoC).

In a potentially important reform unveiled in August 2019, the central bank replaced its benchmark lending rates with a market-based alternative.

But, unfortunately, interest rate liberalisation is one-sided. The PBoC has phased out its benchmark lending rate, but not its cornerstone deposit rate. Policymakers worry that competition among banks would raise deposit rates and thwart government efforts to lower borrowing costs in order to help cushion the economic slowdown.

Chinese consumers will thus continue to be deprived of the opportunity to earn a decent return on their savings, hampering the needed rebalancing of the economy and dampening sentiment.

The egalitarian thrust of Xi’s economic policies has also been undermining the confidence of well-off urbanites. Under Xi, Deng Xiaoping’s dictum that to get rich is glorious no longer applies. Frugality has become the new norm.

Xi is determined to arrest house price inflation, which he views as socially divisive, making rich people richer and poor people poorer. He has said many times that homes are for living in, not for speculation. The authorities do not want the market to crash, but nor do they want to see a resumption of unchecked house price rises in China’s bigger cities.

Property is the principal asset of Chinese urban households.  So, as the realisation has eventually dawned that this time Xi really does mean business, homeowners have had to scale back their future wealth expectations.

Despite much weaker growth and a switch towards policy easing since the middle of 2018, policymakers continue to keep the housing market and mortgage borrowing on a tight leash. This has remained the case even after the severe damage the coronavirus inflicted on the economy. 

Slowly but surely, Xi’s economic policies have now started to sap urban household wealth and income. No respite is in sight. 

Moreover, tax and other measures to stimulate consumption are targeting rural Chinese and those on lower incomes, not urban high earners.

But with towns and cities accounting for 80% of consumer spending, rural households, struggling to upgrade their skills, will find it hard to carry the economy on their shoulders.

 

The end of cheap credit will make economies of scale harder to come by

I see the following three broad policy paths for Beijing in the next few years. All three involve either a rise in the cost of capital or a substantial decrease in the availability of cheap credit or both. Deprived of cheap and abundant finance, it will be harder for Chinese firms to achieve and/or sustain the economies of scale which turned the country into a powerful export platform.

1.   Financial liberalisation is good but means a higher cost of capital

Policymakers need to liberalise financial markets and interest rates fully and swiftly to support a genuine rebalancing of growth towards consumer spending as well as a quicker transformation of the supply side of the economy. If all went well, this would fuel decent nominal GDP growth and help with the huge task of cleaning up past debt excesses. 

If Beijing allows the market to set interest rates and lets banks lend according to proper risk and profitability assessments, the cost of capital is set to rise.

This will certainly be the case for state-owned enterprises (SOEs), which have been the main beneficiaries of the unnaturally low cost of capital. The bulk of bank lending has gone to SOEs while private firms have had to borrow in the shadow banking sector at much higher cost.

A successful transition of China’s banking sector to serve the needs of the whole economy will not only help weed out zombie SOEs but also give private firms access to cheaper finance. Capital will be used more efficiently, providing a welcome boost to productivity growth.

Unfortunately, the leadership is unlikely to stride out purposefully on this path.

Even if it did, it is unrealistic to expect that such a radical overhaul could be accomplished within a couple of years and without the substantial upheaval that an extensive debt clean-up would entail.

2.   Household financial repression, supply-side changes and old-style investment-led growth will sap the availability of credit

Beijing is more likely to resist further liberalisation and to continue with financial repression of the household sector. This would mean relying on a mixture of supply-side improvements and old-fashioned, investment-led stimulus directed from the top to boost growth.

Certainly, this is the course that China is on at present and will probably stay on in coming quarters. But it will make dealing with the large bad-debt problem even harder because real and nominal GDP growth will continue its structural slide.

In 2018 Enodo estimated the expected losses from bad debts at Rmb16.5trn, or 19% of GDP. Banks would bear the bulk of the losses, Rmb13trn by our calculation, implying the need for substantial recapitalisation.

The sector is also likely to experience consolidation as weaker smaller-city lenders get a helping hand from China’s better-cushioned big banks. Since May 2019, the state has felt compelled to prop up four of China’s 60 biggest banks in a mix of interventions that include bailouts, nationalisation and conservatorship.

The good news is that at the end of the day the buck stops with the state, and China’s government leverage, at just under 50% of GDP, is not excessive at this point. 

Even if the government were to take the entire bad-debt loss explicitly onto its balance sheet, overall public debt at 70% of GDP would not be unsustainable. The US government debt ratio surged by 45 percentage points to 103% of GDP in the wake of the GFC.

But the bad news is that it is naïve to expect that this clean-up could pass off smoothly and without much weaker nominal GDP growth.

Moreover, this is surely the last time China can backstop the fallout from its chosen mode of credit-driven development without ultimately triggering major economic, if not political, upheaval.

This is the first time in my 20 years of covering China that I am saying this. In 2015, at the peak of worries about China’s debts, I argued that Beijing had not reached the end of the road. Yes, China was staggering under a burden of local government and corporate debt that had been rising at an alarming pace, and the economy was losing altitude fast as a result. But I judged that overall debt was not yet excessive, so policymakers had time on their side.

Back then, I said Beijing would not be able to dodge tough decisions for another decade. This timeline has not changed.

But we are now five years into that decade, so China has at best five or so years to wean itself off its reliance on debt to power its development.  

Along this path, as the diminishing returns of wasteful investment deepen and nominal GDP flags, the debt-to-GDP ratio will increase further. Initially both non-financial non-government and government debt are set to rise as a share of output.

But, as defaults mount and banking sector recapitalisation and consolidation get into a full swing, new bank credit to the non-financial non-government sector is likely to become scarce, even if the authorities keep interest rates low.

Consequently, with Beijing unable to use the banks as an ATM, increasingly explicit government borrowing will progressively fuel the rise in total debt. In fact, this has already been happening over the past few years. Witness the rebirth of the municipal bond market and the surge of borrowing from China’s policy banks. But much more is on the cards.

Beijing is keen on getting non-banks to invest more in local and central government bonds as well as in policy bank bonds. Indeed, over the past couple of years non-banks have started to buy a larger share of such debt even though banks remain the dominant holders.

Officials are also keen on getting foreigners to buy more government debt and, in general, on enticing foreign portfolio inflows into Chinese bonds and equities. This is why the inclusion of China’s bonds and stocks in global emerging market indices is an important development.

Here it is worth noting that, unlike the US, China does not benefit from issuing the world’s reserve currency. So it will find it harder to sell its government debt abroad, especially as geopolitical tensions are unlikely to subside in coming years.

If foreigners do not help with the bad debt clean-up and the necessary expansion of China’s budget deficit, then China does indeed face a “long march” of demand deflation.

The impact of government debt purchases on broad money and, hence, on economic growth depends on who the buyers are. If they are banks or foreigners, broad money receives a boost; if they are non-banks, broad money contracts.

This, in turn, suggests that within the next couple of years Beijing is likely to have to turn on the economy’s only remaining release valve – the yuan.

3.   The three Ds of dealing with excess debt – default, demand deflation and devaluation

Throughout its miraculous growth phase China avoided the plight of emerging markets in Latin America, whose low domestic saving rates spawned recurrent balance-of-payments crises. But since the GFC China’s current account has rapidly deteriorated while its capital account has improved largely thanks to heavy-handed government intervention, not because of an inflow of free-moving, yield-seeking capital.

Over the next couple of years this position could well become untenable. The authorities would then have to let the currency take the strain.

Ideally, the market should be allowed to determine the exchange rate amid a fully open capital account, which would be part of the full liberalisation I described as the first policy option. But the third path I am discussing now involves a sharp devaluation, achieved in one go or over a short period of time. Either way, it would be a big shock for China and the global economy.

Over the past 10 years China’s massive current account surplus, 9.9% of GDP at its peak in 2007, has nearly disappeared. In 2018 it shrank to just 0.4% of GDP, the lowest reading since the current account was in near balance in 1995. Since the GFC China’s domestic savings rate has been trending down at a faster rate than its domestic investment rate.

China is sitting on a $3.1trn stockpile of foreign exchange reserves. It can withstand a year or two of net capital outflows, were they to materialise, and still maintain the yuan’s exchange rate roughly stable. But China needs to find a way to lure foreign investors who do not respond to the Party’s directives in the same way that domestic firms and banks have done so far. 

If China’s current account swings into the red, Beijing’s ability to keep its command-and-control show on the road will get that much harder.       

China’s swing towards more Party control has raised the cost of doing business for foreign firms

Doing business as a foreigner in China has never been for the faint-hearted, as Tim Clissold memorably laid out in “Mr China” (one of my recommended summer reads). Murky regulations arbitrarily enforced, unannounced visits by fire-safety or health inspectors, abrupt demands from the tax office have long been par for the course.

But they were no more than an irritating stone in the shoe. Since Xi came to power in 2012, however, that stone has gradually got bigger. Foreign firms are now hobbling badly.

On the face of it, the business environment is improving. In the World Bank’s 2019 ease of doing business rankings, China jumped to 31st place from 46th spot in 2018, leapfrogging France, the Netherlands and Switzerland. But that ranking is deceptive because it applies to the experience of domestic firms.

For foreign companies, the business climate is turning increasingly chilly as a result of Xi’s determination to strengthen the grip of the Communist Party in every sphere of Chinese life.

The Party has been formally represented within foreign companies for years. A survey conducted by the Central Organisation Department in 2016 found that 70% of them had a Party cell or a Party-controlled union. Under Xi, however, these bodies are becoming increasingly assertive.

In late 2017, the EU Chamber of Commerce in China formally complained that the Party’s representatives were trying to extend their influence over its member companies’ business decisions, undermining the authority of their boards.

In another example of the Party’s tightening chokehold, China is preparing a corporate version of the “social credit” system it is already using to punish people for anti-social behaviour. According to the EU chamber, companies are being rated by different agencies for their compliance with regulations; those found to have violated rules are blacklisted. Beijing plans to combine those ratings into a single database that could be up and running in 2020.

These new irritants compound the long-standing grievances of foreign businessmen that the cards are stacked against them. A lack of regulatory transparency and restricted market access are common complaints. Forty sectors are still off-limits to foreign investors. In the latest survey by the American Chamber of Commerce in China, 73% of R&D-intensive companies said market access restrictions were inhibiting their operations.

No wonder that, in AmCham’s words, “The overall outlook has shifted from cautious optimism to cautious pessimism.” 

Poor intellectual property protection is another headache. One-third of AmCham members said they limited their investment in China because of IP concerns. This is one area where Beijing is prepared to make significant concessions, not least because it is now in its own interest to benefit from IP protection abroad.

But even if China does improve aspects of doing business for foreign firms, companies must bear in mind that broader attitudes towards China are hardening, especially in the US, in light of the repression of Muslims in Xinjiang and months of pro-democracy protests in Hong Kong.

In the US, lawmakers from both parties have introduced more than 150 bills in the current Congress pushing back against Beijing.

US firms, regularly criticised by Trump for manufacturing in China instead of back home, will be conscious of the need to stay on the right side of public opinion when they make their investment decisions.

They will also be all too aware of China’s strategic goal to produce more high-value goods at home instead of importing them. Self-sufficiency does not automatically translate into hostility towards foreign firms. But it helps frame Beijing’s political response to developments such as the Trump administration’s recent blacklisting of an array of Chinese high-tech firms, notably Huawei.

Sure enough, Beijing is reportedly drawing up its own list of “unreliable” foreign business partners – just one more reason for US companies to think hard about whether to stick with China or call it quits and head back home.  

Beijing aims to cut electricity and logistics costs, while water shortages are a serious threat

Over the past few years China has focused on cutting two key input costs for its producers – electricity and logistics prices – with some success. Industrial users pay a lot more for power in China than in the US, while overall logistics costs in China as a share of GDP are almost double those in America. 

Lower costs amid improved efficiency are welcome. But other fundamental problems still loom large, including a serious water shortage that makes Chinese industry’s current usage unsustainable.

All wholesale power tariffs were administered until China began its liberalisation drive.

Overcapacity in power generation meant that as Beijing began to let supply and demand determine electricity prices for industrial users, they fell. 

But, with trade tensions rising, Beijing could not afford to wait for market forces to bring about the coveted reduction in power prices. The National Development and Reform Commission, China’s state planning body, cut administered electricity prices by 10% in 2018, another 10% in 2019 and has pledged a further cut in 2020.

By 2017 Beijing’s marketisation efforts had resulted in a 7.5% fall in electricity prices for industrial and commercial users.

The cost gap with the US had started to close.

But Beijing’s overhaul of its energy sector since 2015 has focused not only on liberalising electricity prices but also on weaning the country off coal and shifting the energy mix to less polluting but dearer sources of energy.

Its drive to cut coal capacity pushed up thermal coal prices by 23% on average between 2014 and 2017. This pincer movement has put power generators in a difficult spot, and their fate is set to get worse.

Beijing is determined to make its energy sector more efficient and cleaner, driving out weaker producers and bringing about substantial consolidation in both heavy industry and power generation.

But the social dimensions of reducing overcapacity should not be underestimated. According to calculations by the Ministry of Human Resources and Social Security, 1.3m workers will have to find new jobs as a result of reducing overcapacity in power generation.

To help them do so, China has set up a Rmb100bn industrial restructuring fund. Under the rules of the fund, only when capacity is permanently eliminated will local governments and enterprises be eligible for financial support. The needed restructuring in the energy sector is part of the needed bad-debt overhaul.  

The cost of logistics, another important input, has also attracted Beijing’s attention. In 2016 the NDRC published a plan to improve the sector’s efficiency and further lower costs.

As a share of GDP logistics costs have already declined sharply in the past few years.

The price of express parcels, the main delivery method for e-commerce firms, has fallen steadily.

Over the past couple of years Beijing has accelerated its efforts to reduce transport costs. In May 2018 it halved the vehicle purchase tax for trailers carrying goods for a period of three years. It also halved the land-holding tax on bulk commodity storage facilities leased by logistics companies.

While lower electricity and logistics costs are a positive part of the changing cost equation, severe water scarcity is a major negative.

Overall water resources in China are not significantly more constrained than in the UK. But the problem is that 80% of the water is in the south, but 85% of China’s coal reserves are in water-scarce provinces in the north and 64% of arable land is also in the north.

Agriculture accounts for 62% of China’s water consumption, power and industry for 22% and households for 14% (the remaining 2% goes on other uses). Twelve northern provinces suffer from water scarcity, eight of them acute, and they represent 38% of China’s agriculture, 50% of its power generation, 46% of its industry and 41% of its population.

China has 20% of the world’s population but only 7% of its water. The water crisis puts the ambitions of Xi’s “Made in China 2025” strategy in an important light.

Current usage is unsustainable. Beijing needs to tackle water demand because it is much harder to change water supply and its geographical distribution – as the $62bn south-north water transfer project demonstrates. A failure to set far higher water prices now, while understandable in terms of social stability, will exacerbate the water scarcity problem in the longer term.

The authorities cannot keep their head in the sand for much longer. Industrial users will face either higher prices or rationing in the future.

Introducing the Enodo Reshoring Index

In order to identify which industries in the US are most likely to benefit from the return of production from China we have created the Enodo Reshoring Index (ERI). It is compiled from a comprehensive list of factors that may prompt manufacturing companies to reduce their dependence on China.

Trade War and the Great Decoupling target Technology, Pharmaceuticals and Automobiles

According to the Enodo Reshoring Index, the sectors most likely to move back to the US are automobiles, electrical machinery and equipment, wood processing and chemicals, rubber and plastics, along with the rail, ship and aircraft sector and pharmaceuticals. 

Enodo Reshoring Index after the Trade War

China's industrial sectors ranked by likelihood of a shift in production back to the US with 0 being most vulnerable to reshoring

Source: Enodo Economics

The values of the index are normalised between 0 and 1. We do that in order to eliminate the impact of differences in the units of measurement for data used to construct the index. This enables us to compare data from different sources. The closer the value is to 0 for a given sector, the more vulnerable it is to reshoring. In other words, 0 in the ERI means that the sector does not have any buffers (advantages) to withstand reshoring pressures.

Source: Enodo Economics

We can see that the automobile and the electrical machinery and equipment sectors have been pushed to the top of the ranking of industries likely to head back to the US as a result of the sea change in Sino-US relations. It’s interesting to note that before the Trade War and the Great Decoupling, pharmaceuticals was one of sectors least likely to reshore based on all the criteria. No longer, especially after the havoc wrought by Covid-19.

The US has room to optimise its import tariff and non-tariff barriers to capitalise on Chinese vulnerabilities

Surprisingly, computer, communication and other electronic equipment has risen by only one place in the ranking to eleventh.

This suggests that the US should focus on optimising its tariff structure to benefit this sector in order to be more efficient in achieving its strategic objectives.

Computers and electronics – as well as cars, electrical machinery and pharmaceuticals – face non-tariff barriers in the US. These all have the value of zero in our index. So, clearly, the difference in their rankings is due to varying import tariffs. If the US administration were to raise tariffs or impose new non-tariff barriers, especially on hardware such as semiconductors, then the computer sector could quickly climb up the reshoring index.

Turning to light industry, low-skilled, labour-intensive tradeable sectors like textiles, garments and apparel, footwear and furniture are positioned in the bottom half of the reshoring index. This is mainly because wages are lower than in the US, transport costs are higher and these are sectors with healthier profit margins, making them poor candidates for relocation to the US.

America’s productivity advantage and China’s profit margin weakness are important reasons why manufacturing should move to the US

The ranking of each sector reflects a changing mix of factors. It is not simply that one constant set of criteria determines a high ranking and another set dictates a low ranking. See the Appendix for a description of the set of criteria, metrics within each criterion and their weights in the index.

Clearly, the greater the weight of each factor in the index, the more important it is likely to be in determining the ranking. So, it is interesting to examine which criteria contribute disproportionately to the ranking among the top 10 most exposed sectors.

The criteria with the highest assigned weights in the index are labour costs, productivity and profit margin stress. This reflects the importance of these factors for firms producing in China. Other indicators with a relatively high weight in the Enodo Reshoring Index are dependence on scarce bank financing, US expertise and non-tariff/tariff barriers.

The chart below depicts the weight structure of the index set against the contribution of each criterion to the average index score of the top 10 sectors most likely to reshore. Despite the high weights of productivity and profit margin stress, their contribution to the sectoral score is modest. 

This means that the deterioration of these indicators in recent years has not allowed firms to build up buffers against reshoring pressure and to increase their score.

Remember, the closer the score is to zero, the more likely the sector is to reshore.

To bring production back home, US policymakers should reinforce America’s productivity advantage, not dilute it

The cost-effectiveness of automation is likely to speed up the relocation of supply chains to the US. Better computing, along with improvements in optical sensing, machine vision, voice recognition, environmental sensors, motion actuators and touch haptics are driving productivity gains and opening up new possibilities for automation.

The US will benefit from increased capital expenditure, job creation and higher wages and, importantly, from their multiplier effects on the broader labour market and economy.

Reviving US manufacturing by boosting productivity growth with whatever job creation this entails is likely to be a better strategy than trying to bring back manufacturing jobs by subsidising them.

A study by the Bureau of Economic Analysis reveals that every dollar in final sales of manufactured products supports $1.33 in output from other sectors. What is good for industry is also good for financial services that cater to these sectors. It could be expected that financial intermediaries in the US will benefit from greater activity in trade finance, working capital loans, forex and treasury services as well as transaction management services.

Upgrading and modernising manufacturing equipment and training the domestic labour force to use these new machines will be key to making US manufacturing more competitive.

Seventy percent of US manufacturers say they are either creating or expanding their internal training programmes, according to a January survey by the Manufacturing Institute. But the institute also expects that 2.4m manufacturing jobs could go unfilled by 2028.

In this respect Covid-19 could turn out to have a silver lining. It represents a massive supply shock which could result in substantial job losses. Whether the surge in unemployment turns out to be structural or frictional will in part depend on the right policy mix.

America, intent on bringing production back home for national security reasons, should seize this opportunity.

To battle against reshoring in the context of its rising labour and capital costs, China has focused over the past couple of years on cutting the cost of two key producer inputs – electricity and logistics. It has enjoyed some success, as we discussed earlier.

China has maintained competitiveness in sectors that have curbed labour cost increases and do not face non-tariff barriers

Conversely, labour costs, which have a lower weight in the index for the top 10 sectors, have made a bigger contribution to the index score, suggesting that they have helped firms strengthen their competitive advantage.

As six of the top 10 sectors are not subject to non-tariff barriers, their contribution to the index ranking is also higher than their weight in the index. This implies that, on average for the top 10 sectors, the absence of barriers has been beneficial to competitiveness.

But in those sectors where they do exist, non-tariff barriers have a significant negative impact – ‘Automobile’, ‘Electrical Machinery & Equipment’, ‘Rail, Ship, Aircraft, Spacecraft & Other Transport Equipment’ and ‘Pharmaceutical’.

Different sectors, different vulnerabilities

We list below the top 10 sectors most likely to relocate from China to the US according to the Enodo Reshoring Index and the driving forces in each sector.

• Automobile is mainly likely to face non-tariff barriers. The sector is highly leveraged, has large inventory costs and has seen the biggest deterioration in return on assets (ROA), despite low labour costs.

• Electrical Machinery & Equipment is also subject to non-tariff barriers and profitability is under severe pressure. US firms in the same sector are more productive and have a lot of expertise.

• Wood Processing, Wood, Bamboo, Rattan, Palm & Grass Product is highly vulnerable because of its reliance on scarce bank credit. It has low economies of scale and high transport costs. Profit margins are under stress.

• Chemical Fibre has seen an increase in labour costs and import tariffs. The sector is unproductive vis-à-vis the US, while transport costs comprise a large fraction of import value.

• Chemical Material & Product also uses labour unproductively and has faced an increase in wages and import tariffs. Transport costs are relatively high, and the sector is quite overinvested.

• Rail, Ship, Aircraft, Spacecraft & Other Transport Equipment is subject to non-tariff barriers. The sector is leveraged, profit margins are under stress and the US boasts solid expertise in the field.

• Rubber & Plastic Product ranks low on our economies of scale criterion. Transport costs and import tariffs are high, weighing on ROA.

• Pharmaceutical uses labour unproductively. Labour costs have increased, inventory costs are also high, and the sector faces non-tariff barriers.

• Non-metallic Mineral Product is highly vulnerable to bank stress and economies of scale are relatively low, while transport costs and import tariffs have increased.

• Cultural, Educational, Art, Craft, Sport & Recreational Product is highly exposed to the scarcity of bank loans. The sector has low economies of scale, it uses labour unproductively and its inventory costs are high, leading to a deterioration in profit margins.

• Computer, Communication & Other Electronic Equipment closely follows the top 10 sectors in the reshoring index as it ranks first on the overinvestment and debt burden criteria, faces non-tariff barriers and is under profit margin stress.