In May, as China caught its breath from the COVID-19 outbreak while Western countries floundered, Chinese president Xi Jinping proposed a new economic model – the “dual circulation strategy” (DCS) – at a Politburo meeting. While the DCS quickly became a frequently mentioned topic among China’s leadership, an absence of concrete details prompted discussion among China market watchers. This article will briefly explain what the DCS means, why China is pushing for it now, what changes can be expected and what the policy implies for foreign investment.

What is the dual circulation strategy?

The dual circulation strategy is a two-pronged development strategy that seeks to spur China’s domestic demand (“internal circulation”) as well as cater to export markets (“international circulation”). The plan aims to create conditions that allow domestic and foreign markets to balance each other. In essence, the country will continue seeking to improve its ability to participate in global trade, finance and technology, while strengthening domestic consumption, production and technological capabilities to hedge against global market disruptions. The strategy has become the underlying policy refrain behind China’s policies to spur economic recovery following the COVID-19 outbreak. Some analysts assume that it signals that China’s economy will become more self-reliant to reduce its exposure to the vagaries of the global economy.

Why is China pushing the DCS now?

The DCS follows China’s long-held goal of shifting itself from being an “export and investment-led” economy to a “demand and innovation-driven” economy, to achieve long-term sustainable growth, make the economy more resilient to external markets and move up the global value chain. However, in the face of unpredictable global market dynamics, the strategy is given a new purpose – preparing China for changed global trade patterns. The COVID-19 pandemic, for instance, provoked global concerns over supply chain dependency as countries were forced to rethink their reliance on other states (especially in strategic industries such as medical supplies and pharmaceutical raw ingredients); these concerns will likely accelerate supply chain shifts out of China.

Further compounding matters are growing concerns in Western countries over China’s influence on the global trading system, which has pushed the US as well as the European Union, Australia and Japan to reconsider their trade ties with China. The widening rift with the US has already triggered a decoupling of sorts between the world’s two biggest economies. It seems inevitable that the US crackdown on Chinese technology companies and the rise of techno-nationalism will push China towards developing self-reliance in key technologies, already a long-professed goal by Beijing and an objective of the Made in China 2025 plan.

Besides these tensions, the impact of COVID-19 and ensuing shutdown measures have plunged the global economy into the worst recession since World War II, resulting in a shrinking export market for China. Commenting on these changed realities, Stephen Olson, a research fellow at the Hinrich Foundation says, “The trade landscape China will have to navigate henceforth will be considerably less benign than the one it traversed for the past two decades.” The DCS is a signal that the Chinese leadership comprehends this.

What will be China’s next steps under DCS?

Policymakers have yet to reveal the details of the dual circulation strategy. What is certain, however, are its desired outcomes. In order for China to achieve more sustainable long-term economic growth and hedge against the impact of external shocks, the world’s second-largest economy will focus on building an unblocked “internal circulation” of domestic production, distribution and consumption instead of over-dependence on the “external circulation” of the global market. This of course is predicated on the belief that China will not simply forsake the export goose that once laid it golden eggs.

Boosting domestic demand

China has attempted to boost private consumption for years, and this has been reignited by the impact of recent external ripples in the global economy. Key projects in this regard include faster reform of China’s land and residency (hukou) system, the ongoing urbanization program to turn millions of migrant workers into city dwellers. The plan’s success, however, hinges on its ability to build a highly consumer-driven economy and to tackle the inequality gap. To achieve the latter, China must deepen the social safety net and successfully implement poverty alleviation campaigns, which has weighed on local spending capacity. China is already a “hyper-sized” consumer market with 1.4 billion people. Although its private consumption lags behind production amid unemployment and economic uncertainties, its 400-million-strong middle class is steadily growing and offers extraordinary market potential. Given this trend, and in light of the pandemic, we expect opportunities to grow in areas like F&B, healthcare services and allied industries, contactless technologies, online education and e-commerce, among others. China’s youth, middle class, and a sizeable affluent consumer cohort are highly aspirational and foreign investors would do well to tap into key interest segments. The Chinese government on its part will continue to loosen restrictions on market access.

Focusing on strategic chock-point sectors

The other key element of DCS will be “reducing risks tied to import dependency.” As a report by The Economist Intelligence Unit analyzes, “technology, energy and food will be the sector focus.”

Tensions with the US have exposed a vulnerability in China’s supply chain – it relies on $300 billion worth of imported semiconductors to meet over 85% of its domestic market demand. Because of this, the technology sector is poised to receive the most overt support to help it achieve self-sufficiency, with semiconductors or integrated circuits (ICs) getting the most attention. In fact, this August, China announced corporate income tax (CIT) breaks for IC and software companies.

In the energy sector, in 2019, almost 85% of China’s oil consumption and over 40% of gas consumption was driven by imports. Although China is less dependent on the US in this sector, compared with technology, recent geopolitical tensions have raised concerns about potential disruptions to energy shipments. The key to avoiding this danger is to encourage renewables and diversify international relations in the energy sector, which could increasingly be pursued under the umbrella of the Belt and Road Initiative (BRI).
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In the food sector, the Chinese Academy of Social Sciences forecast that there could be a production shortfall of 25 million tons in wheat, corn and rice by 2025 in China. Possible shortages in food supply would affect food prices and risk social stability. Due to rural labor shortages, lower agricultural productivity and slow progress in rural land reform, China still relies heavily on imported foods, especially soybeans, imported seeds and foreign planting and processing technology. Here, US farmers will enjoy some short-term opportunities, derived from the agricultural product purchasing agreement set out under the phase one trade deal. But over the longer term, China will be keen to tap into a diversified group of suppliers, which should yield opportunities for farmers in Europe, Latin America and those who are part of the BRI.

How will DCS impact China’s foreign investment environment?

China’s DCS is currently vaguely defined but should be fleshed out in more detail in the upcoming 14th Five-Year Plan (2021-2025). Given its outsized role in global trade, a minor shift in China’s trading patterns could elicit huge effects. Foreign investors engaging in this market should stay abreast of the latest developments and assess exposure to possible consequences.

So far, we believe that China will see this time as a critical chance to deepen market-oriented reforms. This would address concerns about the allocation of production factors (land, labor, capital and data) in the market, further encouraging local producers to meet growing domestic demand and expand industrial output for both the domestic market and exports. For key sectors tied to national security, such as technology, energy and agriculture, China’s policymakers are expected to encourage more rapid foreign investment in high-end manufacturing and R&D, besides supporting global supply chain diversification.

Considering factors such as China’s huge domestic market, comprehensive supply chain network and strong business ecosystem on one hand, and rising labor costs and an aging population on the other, many foreign investors are adopting “in China, for China” and “China plus one” strategies to tap into China’s market demand growth while also lowering costs, diversifying risks and accessing new markets.

While the overwhelming challenge in the short term for some investors will be managing exposure to pressures in home markets, there is still great opportunity in China and Asia whose economies account for some of the strongest growth engines in the world.

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