October 25, 2018 | By Angela Lee, Paul Schickler, Vivian Lin Thurston

Deep Dish: What's Happening to China's Economy?

Two big shocks are hitting the Chinese economy at once. The first shock is within China—slowing growth, increasing debt, an aging population, and an underdeveloped consumer base. The second shock is with the United States as tensions rise and a trade war looms. Angela Lee, professor of Marketing at Northwestern’s Kellogg School of Management, Paul Schickler, a former president of DuPont Pioneer, and Vivian Lin Thurston, a partner and global research analyst with William Blair, discuss the changing Chinese economy with the Council's Phil Levy.



Phil Levy: This is Deep Dish on Global Affairs, going beyond the headlines on critical global issues. I'm Phil Levy, senior fellow on the global economy at the Council, filling in for Brian Hanson. Today, we're talking about two big shocks hitting the Chinese economy. The first shock is within China. Slowing growth, increasing debt, an aging population, and an underdeveloped consumer base are all striking the Chinese economy at once. The second shock is with the United States. In a recent speech, Vice President Mike Pence listed the problems of doing business in China. Forced technology transfers, strong-arm acquisitions, and intellectual property theft were the norm, he said. He promised a major reset in the economic and strategic relationship. To help us make sense of these issues, I am joined by three guests. Angela Lee is the Mechthild Esser Nemmers Professor of Marketing at Northwestern University's Kellogg School of Management. Welcome, Angela.

Angela Lee: Thank you, Phil.

Phil Levy: Paul Schickler is a former president of DuPont Pioneer. Welcome, Paul.

Paul Schickler: Good to be here.

Phil Levy: Vivian Lin Thurston is a partner and global research analyst with William Blair. Welcome, Vivian.

Vivian Lin Thurston: Thank you, Phil.

Phil Levy: Vivian, let me start with you. China is attempting a massive pivot to consumption rather than investment. Their consumption levels have been relatively low. Is there a concern that this increase in consumption is being driven more by debt than the requisite growth in income? What do you see happening?

Vivian Lin Thurston: First of all, I would say that consumption growth in China remains a structural growth story. We still see massive room for acceleration of the growth going forward, given that if you look at the composition of the population, we're still talking about a very big middle class emergence, if you will, in China, and the large millennials in China, which are about 415 million people. That's higher than the combined workforce in the US and western Europe, which are about 350 million people. As we start to see these millennials and middle class continue to increase their per-capita consumption and continue to migrate to better, and bigger, and higher-quality consumption, we believe the consumer growth story in China will continue to be structural growth going forward. What you alluded to about the debt issues, I would say actually the consumer debt in China is very low, both on the consumer level and household level, way below the Western country or US level. That actually will act as a supporting factor going forward. If they increase the leverage to a healthier level, that can also release very strong consumption power. The last thing I want to mention is the wealth effect in China is also very, very strong. Consumption is not just coming from income and also leverage, but it also comes from the wealth effect. China has 30 years of one-child policy. As a result, you get this couple generations of older people fund the younger generation consumption. Therefore, that wealth effect is also going to release massive consumption power going forward. We're pretty positive about the consumption growth story in China going forward.

Paul Schickler: I would simply add to that, my business is agriculture and food. When I look at China and see the consumption increasing, and the economic growth being positive, the rural-to-urban migration, and then the attractiveness of the middle class or slash millennials, that drives directly into additional quantities of food, but even more importantly, qualities of food. Better nutrition, better sources of food. That's an interesting comparison to other areas of Asia and Africa, where most of the growth there is coming from population growth, less from income growth. In China, the income growth is overcoming the lack of position growth, and therefore still making it an attractive consumer market.

Phil Levy: Okay. Angela, you are a leading authority on how Chinese consumers qualitatively behave. How are they different from consumers anywhere else?

Angela Lee: I'm going to add to what Vivian and Paul have just mentioned. Not only is there wealth, but there is also a very different openness to spending. This willingness to spend and to consume is not historically part of the Chinese culture. That used to be fairly frugal, but I think that the one-child policy, given the newly increased wealth, is really prompting the millennials to spend money. Now, in terms of the difference between the Americans and Chinese consumers, the biggest difference is their focus on what do they want to approach versus what do they want to avoid. Americans, as we all do, we like wonderful things. We don't like bad things, but Americans, actually, they love to approach or to get wonderful things and to avoid not having wonderful things. Their focus is on positive outcomes. The Chinese consumers, on the other hand, are more focused on negative outcomes. They want to approach the absence of negative outcomes and to avoid negative outcomes. It's not just in food that they care about safety and security. This emphasis on quality transcends to other product categories, from shampoo, to clothing, to other products, to automobiles. That emphasis on safety is also what sets them aside from the rest of the Western consumers.

Paul Schickler: Let me give you a real-life example of that in my business, because it's real interesting. We sell inputs to agricultural production. Farmers will look at their plans for the next year in September, October, and November. They will pay cash, so there's no debt. Back to the point about consumer debt, really not an issue because of consumer demand. In this case, farmers are not using debt. They pay cash, and the other aspect of that is they want to invest in this to avoid the food security issues.

Phil Levy: This is a fairly upbeat take on the Chinese market, and yet we are in the middle of a conflict between the United States and China. We talked about this. Vice President Pence has put out a number of complaints. Paul, does he have his complaint list correct? Are there real concerns? You've done business in China. What should we be emphasizing?

Paul Schickler: Well, let's step back. This started all with a trade war built upon an imbalance between trade between the United States and China, and then attacked through tariffs. From the beginning, I think many of us, particularly in the business community, thought that was an inappropriate issue to be dealing with, a trade imbalance, because that's just the nature of developing versus developed countries, or consumer economies versus production economies. That's an outcome of your, you might say, capabilities, as compared to the real issues that I looked at in my business in China were intellectual property protection and the different business rules of doing business in China as compared to doing business elsewhere in the world. Now, in those two issues, intellectual property rights and business practices in China, we were making solid progress. My fear is that progress is going to be interrupted by the current conflict.

Phil Levy: When you say we, do you mean the United States or businesses?

Paul Schickler: We, the business community, were making progress on those important issues that now have been distracted by the trade deficit and now this listing of all the other challenges that might exist between the US and China.

Phil Levy: Just to play devil's advocate here, the administration would say, "All right, well, you should make even faster progress now that we're applying additional pressure." You don't see that happening?

Paul Schickler: I think now both sides are dug in deep. I don't see a movement towards a solution.

Vivian Lin Thurston: There is a saying in China, I'm going to say it in Mandarin, called, "[foreign language 00:08:24]." It means, if you want to go very fast, guess what? You actually compromise your goal. It means that you're not going to get there. To Paul's point, which I agree, that IP is an issue in China, but the issue probably is more long-lasting, more cultural practice embedded, versus just policy. You are dealing with a massive country with different layers of government and different layers of enterprises. Therefore, at the end, the bottom of the operations, a lot of those rules on IP probably are not really recognized, enforced, or paid attention to. For the US to tackle that issue or to help China improve that, I think we need to take a little bit longer-term approach, a little bit more patient, and come up with a more holistic, strategic plan, instead of just using this very forceful way to get there. Because to Paul's point, you probably slow down the normal progress that the country is trying to go through.

Phil Levy: I want to go back to something you have said. We've gone through a number of the complaints that have been prominent that the US has put forward. You've talked about the bilateral trade deficit. We've talked about intellectual property. There's also the role of the state, whether it's state-owned enterprises. Is this a level playing field? Is this capitalism? How should we be thinking about that? Is that a reasonable expectation with China, and are we getting there?

Vivian Lin Thurston: First of all, trade deficit, it's normal. Whoever thinks trade deficit is something wrong, I think you need to just learn Economics 101. That is the beauty also of global trade, but whether there is something there not on a level field, that's a different discussion. I think that's what the US administration tried to get to, because I think that they believe China has not done the part to the standard the US wants them to be. I think this perspective should also be more broadened, because China has become a much more opened economy and become a better player in the global economic environment than before. Definitely, in 20, 30, even 10 years ago, I think China has done a much better job, so from the incremental perspective, I think China has traveled in the right direction, but whether the speed is up to what the US wants it to be, maybe it's different. That's back to my earlier point. Maybe you need to come up with maybe a more effective plan. Whether this way of pushing one way, will that accomplish the goal or not? It's hard to say, because in the end, the US can be hurt, too. This was about the beauty of the global economy, as everyone is intertwined. It's not going to be one side. Actually, a lot of impact from the increased tariffs of Chinese exports to the US is going to be borne by US communities, US consumers, and US companies. When they come through, inflation is going to grow up, growth is going to slow, and there's the consequences of it. This is why I think we have to take a more holistic view and think about both near term, longer term, and then try to get to the goal more effectively.

Phil Levy: Now, it's interesting, because Vice President Pence had a list of particulars where he was claiming that China was doing substantially worse than before. Do you have particular things that you'd point at where you'd say China has been doing better on the global stage?

Vivian Lin Thurston: If I look at import tariffs in China, for example, they just recently reduced import tariffs on cars from 25 to 5%, even in the middle of all the trade war friction. This is one data point to say that China actually doesn't want a trade war. They don't want it, but they have to react, because they know the trade war is not going to be good for them, also not good for the global economy. During the time when China continued under pressure, they actually continued to broaden and open up the economy. For example, Tesla is going to probably have a great plant in China and get a very good tax benefit there. Then, BMW has started to set up the shop there. Even Google has started to go into China in some reformed way, which was forbidden before. The Chinese government continues to show the positive moves even though they are under the pressure of the US, but then, they probably have to react. Therefore, we saw some other acts which was not probably conducive to the whole China growth or the US growth. Rather, it becomes more strict about checking the consumers coming from abroad back to China in terms of how much goods purchase they have done. That's in today's news. When LMH reported their quarterly earnings, the stock went down 7-8%. It was because they were mentioning that some of those restrictions impacted their duty-free sales. Those are some things on the nuances side. I think on the margin, it's unhealthy.

Angela Lee: I agree with Vivian that from the Chinese government's perspective, it is really a matter of timing rather than a matter of unwillingness to comply or to actually be one of the more respectable global players. If you think about IP and private property rights, communism was a very new thing to China. Throughout their history, China was a capitalistic country. In any capitalistic country, the private property rights and intellectual property have to be respected. That is actually in the norm and the custom, but under a more socialistic or communistic system, it is indeed the government's responsibility and no longer up to the family to put food on the table for so many people. It is not that they think that having counterfeit is a good thing or is the right thing, but they have to balance. If I close down this factory, 600 families will have no food on the table. Maybe my cousins, my uncles, they will be out of a job. Am I going to do that? Their system also does not allow the judicial as well as the police to work together. You will have someone, let's say, shutting down the factory, but no one to follow up with the legal system. I think over the last 15 years, as Chinese companies are becoming more successful, and as the state-owned enterprises become privatized, they have a self-interest to make sure that IP is protected, because they will also be the victim. We're really seeing the government taking the initiative now to crack down on some of these things, but again, as Vivian pointed out, it's probably not at the same speed that the US government would like to actually see. I think it's always a dance of how you get your foreign partners to play nice, and it's a matter of give and take.

Phil Levy: Paul, you were working with intellectual property issues in China. What was your experience working in the system? You said there was some progress being made. Were things getting easier? If so, how?

Paul Schickler: Yeah, intellectual property protection is an issue around the world. China is not unique, but in China, we were making progress both in our internal controls for intellectual property but also at the policy level with the central government. They were very supportive, and we were having success in the court system, as well. As has been said, as Vivian said, taking central government policy from the top down to the provincial level, down to the township level, actually down to the city level is very difficult, because in some cases, you've got some conflicting interests. Back to the point about if you make a change, it could disrupt the income or the food situation in a family in that township. That's where things break down, but over time, those policies will be distributed down into the rural populations. Likewise, we had business restrictions placed upon us doing business as a multinational in China. We were able to build an agreement or put in place business practices that accommodated those restrictions that were placed upon us. At the same time, the central government was moving to modify those persuasive or harmful business practices. We had overcome them. We were making progress, and the central government was giving a signal that they were going to make change. Now, my fear is, with the current relationship between the United States and China, that progress will stop.

Phil Levy: Angela, you have spoken about the desire on the part of the Chinese to avoid negative outcomes. We seem to be getting a negative outcome. How do you think this conflict is being perceived, and will that play into Chinese consumption decisions, for example?

Angela Lee: Right now, this negative outcome of the trade negotiation is actually not felt at the consumer's level yet. Most people are fairly oblivious to all these negotiations, which they think is so high level, the government is going to take care of it. In fact, consumption continues to increase. I just saw some numbers. Louis Vuitton actually posted their largest growth in the last period in China. So, it hasn't actually been felt at the consumer level yet.

Vivian Lin Thurston: I'm just curious, Angela, because you've been doing this for a long time. I wonder whether there's some historical data points you can point to. At what point, maybe if this trade war continues on, that would impact the psychology of Chinese consumers? Last time, when there was a China-Japan conflict, or US-China conflict, all that, eventually has it impacted? If so, how long would be the time lag?

Angela Lee: The conflict with Japan was actually more at the emotional level rather than at the consumption level. I know they tried to have some movement to actually say, "Let's stop ..." Not talking about purchasing. "Let's just stop using Japanese supplies for one day." Even that was not very successful, because most families have a Japanese rice cooker, and they eat rice. They can talk about it emotionally, but in terms of their behavior, it doesn't. Now also, traditionally, culturally, China is a hierarchical society. Everybody believes that, "This is my position, and these are the things that I worry about. There are certain things that is actually beyond my position, and I don't have to worry about it." The only time when it will really be felt and be implemented or executed, manifested, will be when the income is impacted. Right now, it hasn't gotten to that yet. Now, I do know some small businesses over the last 10 years, they have seen the opening of China. They are suffering because they don't have the quality of products, and so their customer base is getting smaller and smaller. They actually do worry about will they ever go out of business, because the Japanese companies, the German companies are coming in. They have much better quality products. Even on a B2B level, they are not very competitive, and so for these smaller companies, they are feeling the crunch, but the consumer is not yet.

Phil Levy: Paul, because of the imbalance in trade flows, the original idea that China would match tariffs with the US on imports all the way up, that doesn't quite work. They run out of ammunition, as it were. One of the concerns has been that China is left with the possibility of making life more difficult for foreign investors, especially American investors in China. Do you think that's a real concern?

Paul Schickler: Yes, I do. The most recent five-year plan had items within it regarding openness of the economy within China, improved business practices, continued advancement on environmental issues. All those things were set at the policy level by the central government in the five-year plan. Now, with the trade war in place, and as you said, the ammunition on China's side limited from a tariff standpoint, my fear is that what is left for them to deal with the trade war is business practices, intellectual property, and the other advances to create a more open economic environment in China will be paused or perhaps even further restricted, because that is the only ammunition that they have. We have a stalemate here between the US, more tariffs, China, more business restrictions, neither in the interests of their own selves.

Phil Levy: Vivian, as we think about how this is all going to play out, if one is looking at this from an investment perspective, one has to forecast this a bit. Is this enough to scare one away from China?

Vivian Lin Thurston: Yes and no. In the near term, we are concerned about the risk from the trade war impact, not just the trade war itself. To Paul's point, it's what China may have to do outside of trade, which is a much bigger implication, all the investment from US companies in China for a long time. This will pose a lot of risk to the growth and to the corporate earnings of the companies who invested into. However, from the equity market perspective, because the market already anticipated a lot of those risks, I would even be thinking that it's on the downside. If you look at the valuation of the China Asia market, which is the big market in China, equity market, the valuation on the PE side, price-to-earnings, is at minus one standard deviation below 10-year average. It's about 10 times earnings. Then, the earnings growth of this country, we're still talking about low teens to high teens level. It depends on which industry you're talking about. So, we do the math, actually the equity becomes very attractive if you look at the price you pay for it versus the earnings growth that will continue to come through. So then, that's why I say, "Yes, in the near term, we worry about the risk, but on the other hand, we do see the risk-reward on this equity market become very attractive at this point."

Phil Levy: That's equity investment. What about direct investment? How does China look?

Paul Schickler: It's an attractive market for the long term because of 1.2 billion people as consumers, because of the economic growth that has occurred and will continue to occur into the future, because of the rural-to-urban migration that requires increased agricultural productivity, and because of the modernization that needs to be brought to the agricultural and food sector. All those things point to a very bright future from an investment standpoint in China to go after the opportunity.

Phil Levy: As we're running to the end of our time, I'll let anybody have in future forecasts. Where do we see this heading? How does this get resolved? You've talked about the pacing, and China being at a different tempo than the US What does your crystal ball show?

Angela Lee: I think the resolution is going to actually come from companies negotiating with either Chinese companies or the Chinese government to really grow their businesses in China. There are certain things that the Chinese government really care about. For example, Disney opened the largest Disney resort in Shanghai. The partnership engaged in unheard of, really unprecedented cleaning up of hundreds and hundreds of acres of land by detoxification of the soil. Something like that is ... The Chinese government really welcomes companies coming in, and help them, and putting in an investment. There is a lot of returns in Shanghai Disney because of just the local, domestic consumption. The market size is just tremendous. I think it's really up to the companies rather than government to resolve some of these issues.

Paul Schickler: Now, I just said that I was very optimistic long-term about the opportunity in China. In the near term, I am concerned. The concern comes from the fact that in Asian economies, and in particular China, face is very important. We also know that face for the current administration is very important, so we have a stalemate. I am concerned that this stalemate will create tremendous uncertainty. It is creating that now, and uncertainty in the business environment is not positive.

Vivian Lin Thurston: Yeah. I agree with both Angela and Paul. I am more optimistic by nature, as an equity investor, so I do think over the history, if you look at the trade war, all the friction between countries eventually tend to be resolved. I think this time around will also be resolved. The key foundation of that is I still believe the US is still a capitalistic economy, which is still driven by this massive private economy. As long as the private economy interests are served well, which has to have a better China in my view, I think the trade war will come to an end, will come to a very pragmatic result that will be beneficial for the US and also beneficial for China. This is my hope, and I think eventually we'll get there.

Paul Schickler: Vivian, what is going to bring it to an end?

Vivian Lin Thurston: No war. No war.

Phil Levy: Thank you for joining us, Angela Lee, Paul Schickler, and Vivian Lin Thurston, and thank you for tuning in to this episode of Deep Dish. If you liked the show, do us a favor and tap the subscribe button in your podcast app. You can find our show under Deep Dish on Global Affairs wherever you listen to podcasts. If you think you know someone who would like today's episode, please tap share and send this to them. We'd like to invite you to join our Facebook group, Deep Dish on Global Affairs. You can ask our guests followup questions about anything you heard today, or submit questions for upcoming guests and episodes. That's Deep Dish on Global Affairs on Facebook. As a reminder, the opinions you heard belong to the people who expressed them, and not to the Chicago Council on Global Affairs.

Phil Levy: This episode of Deep Dish was produced by Evan Fazio, and our audio engineer is Andy Czarnecki. I'm Phil Levy. We'll be back soon with another slice of Deep Dish.


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