FOR PROFESSIONAL INVESTORS – 16 September 2020

Chi on China

CHINA’S “DUAL CIRCULATION” STRATEGIC PIVOT TO COUNTER
EXTERNAL EXIGENCIES AND GLOBAL DEMAND SHIFTTactics without strategy are the noise before defeat.
Sun Tzu
SUMMARY China’s “dual circulation” strategy is a move to counter geopolitical hostility by strengthening the domestic
sector while still engaging, but reducing reliance on, the external sector to sustain stable growth andresilient investment in the face of strategic competition with the US.
 It reflects China’s new worldview of de-globalisation forcing a structural shift in the global supply chains andprompting it to counter de-coupling by industrial upgrading and import substitution. Such an inward policy
shift will create disruptions to the global markets.
 This new policy is redolent of China’s supply-side reform that started in 2015 and is an evolution of Beijing’s
reform motto of using the market as a strategic tool for making changes under the guidance of the Party.
This has far-reaching implications for investing in China.
China’s “dual circulation” (DC) policy framework, first announced in the May 2020 Politburo meeting andreiterated in the July meeting, is the latest strategy to counter the global volatilities and sustain domestic growth.
It reflects Beijing’s new belief that China had entered a new paradigm of increasing global uncertainties andgeopolitical hostility that, ironically, would create new opportunities for China as the US global leadershipflounders.
THE “DUAL CIRCULATION”
The DC framework has two elements: the “external” and “internal” circulations. The external circulation in
China’s policy thinking is a paradigm focussing on the US as the global demand hub which is built on
globalisation and reflects the US’s post-World War global leadership and international cooperation. But thismodel is failing, in China’s view, due to the withdrawal of the US from the global stage.

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This has led China to believe that de-globalisation, leading to economic de-coupling and breaking up of theglobal supply chains, had become a secular trend that would threaten its long-term stability. Rising geopoliticaltensions and exogenous shocks such as Covid-19 have aggravated this global structural change. Hence, it canno longer rely on global integration as a growth driver; it must focus on domestic demand, or the internal
circulation, to hedge against external risks.
China’s new worldview sees itself moving into a new paradigm where the global system would be divided into
three main regions, Asia, North America and Europe, with each region led by a super-regional power. This willlead to the rise of regionalism with strong intra-regional economic linkages on the back of de-globalisation withweak inter-regional linkages, in my view. The rest of the world will fit in somewhere among these regions.
China also sees its internal circulation sit in the centre of Asia, engaging regional and global capital, financial
and technological markets for enhancing domestic growth and driving regional growth, hence, the dual
circulation strategy (Chart 1).
Chart 1: "Dual circulation" in China's new worldview
A new paradigm of regionalism: Asia (led by China), North America (led by theUS) and Europe (led by Germany/France), with thriving intra-regional trade but
weak inter-regional trade; and China's "internal circulation" driving Asia'sgrowth while also engaging "external circulation" for new growth impetus

North America

core: USAEurope
core:
Germany/FranceAsia

core" China's"internalcirculation"

source: BNPP AM (Asia)

IMPORT SUBSTITUTION AND SUPPLY-CHAIN STABILISATION
Arguably, the DC policy is Beijing’s effort to balance between self-sufficiency and internationalisation to deal
with an increasingly volatile world. It strives to engage global forces, including capital and technology, to gain
advantages for domestic development while simultaneously boost indigenous capabilities to minimise the impact
of global volatility on the domestic system.
However, reducing reliance on the global economy does not reflect a loss in China’s competitiveness. It has still
gained global export market share, even though it has lost market share in the US due mainly to the trade war(Charts 2 and 3). In recent years, China’s changing role in global trade has already prompted changes in theglobal supply-chain structure and reshuffled country winners and losers1. China’s move to reduce reliance on
global trade will aggravate this disruptive force.

1 See “Chi on China: Trade War’s Benign Disruption on China and the Global Supply Chains”, 26 June 2020.

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The external circulation is not just about China’s exports. It also encompasses China’s imports. And this islinked to the internal circulation through reducing dependence on certain imports and boosting indigenous
capabilities to counter export controls by the US and its allies. In the short-term, the policy efforts are focussed
on import substitution, especially in the semiconductor industry that is under increasing US sanction pressure,and redirection of Chinese outbound tourist spending back to China.
Crucially, stabilisation of supply chains lies in the heart of the internal circulation. Since China’s recovery from
Covid-19 in April, Beijing has created a “heads of industry value chains” system to supervise local governments
to identify the local firms and technologies critical to the industry value chains and boost their development. The
local governments are asked to adopt bespoke policies to finance public investment in these industrial valuechains. The investment focusses on technologies in integrated circuits, 5G, electric cars, biomedicine, cloudcomputing and AI.
In this effort, Beijing has asked the state-owned enterprises (SOEs) to take a leading role. President Xi has
placed great importance on the SOEs to play a strategic role in China’s long-term economic transformation. He
has significantly enhanced the Party’s control over the state sector since 2013. In my view, this supply-chain
stabilisation effort is an evolution of China’s structural reform motto that the market is a strategic tool for makingchanges under the guidance of the Communist Party. Now that the Party has a tight grip on the SOEs, it canmobilise their resources more easily than ever before, including in implementing Beijing’s dual circulation
strategy.

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CHINA’S SUPPLY SIDE REFORM AND DECOUPLING
The DC policy is reminiscent of China’s supply side reform that started in 20152, which most observers
dismissed in the beginning as a set of vague and vacuous policy statements3 that would lead to nowhere. Butthese uninformed views were proven wrong. In the following years, Beijing had shown persistent reform efforts
to cut excess industrial capacity (notably in steel and cement, which played a major role in creating bottle-neck
supply conditions and sent key commodity prices soaring in between late 2016 and 2017) and de-risk thefinancial sector aggressively4 even at the cost of slowing GDP growth.
To fortify the inner circulation, the DC seeks to bolster the strengths and correct the weaknesses of the domestic
economy to improve economic resiliency and self-sufficiency. That means boosting domestic demand while
simultaneously finding ways to reduce reliance on external inputs in key areas, notably food, technology andenergy. The policy emphasises on import substitution and high-end manufacturing and industrial upgrading toboost domestic growth impetus.
Arguably, the DC was born out of China’s new worldview that decoupling, especially from the US, is not aquestion of if, but of when and how fast. The policy is, in my view, a proactive strategy for preparing for a
divorce on China’s own terms rather than reactive to what would be imposed on it by external forces.
THE IMPACT
While China does not want a total withdrawal from global economic integration, even a small policy shift awayfrom the external circulation could significantly shock global trade and investment flows due to China’s sheersize. So the DC strategy, if successfully implemented, will have far-reaching effects on the global markets. Theinternal circulation’s emphasis on high-end manufacturing and technology implies that China might seek toreplicate the German manufacturing model.
Indeed, in recent years, China has been squeezing developed economies’ exporters in other markets outside
the US and supplying a third of the world’s demand for intermediate goods5. This suggests that China is posing
an increasing challenge to the industrialised economies, with its production scale beginning to disrupt a range of
new market segments, as has happened with solar and lithium batteries in recent years6.
The strategy of redirecting Chinese consumers’ overseas spending (USD250 bn a year just by those outbound
Chinese tourists) to the domestic market is clearly positive for domestic retailers. It also implies that
preferences of domestic consumers would become more important than foreign consumers in shaping corporatedecisions. This makes “investing in China for China” an increasingly important force in affecting FDI decision.
To switch Chinese tourists spending abroad back to China, Beijing has cut import duties for many tourist favorite
products to narrow the tax gap, which is a major tourist spending incentive. It has also planned to open up more
duty-free stores and duty-free zones, like the Hainan duty-free zone established in June 2020, in China to attract
domestic and foreign tourist. The pandemic has enabled China to speed up this expenditure-switching bygrinding international travel to a halt. So companies catering for Chinese buyers who previously bought items
abroad will benefit. But this will be bad news for companies and other Asian countries whose retail business
depends on Chinese tourists.
2 For example, see Boulter, John (2018), “China’s Supply-side Structural Reform”, Reserve Bank of Australia Bulletin, December.
3 See The Economist (2016), “Reagan’s Chinese Echo: The Mystery of Xi Jinping’s Supply-side Strategy”, January 2.

4 A notable example is the sharp fall in the number of P2P lending platforms (many of which are Ponzi games) from its peak of more than

3,800 in 2015 to only 340 in 2019 and 15 in August 2020.
5 See reference in footnote 1, and “Chi on China: Global impact of the Covid-19 Shock”, 19 February 2020.
6 Since 2015, China has been the largest producer and buyer of solar panels. It is number two in producing the most solar energy, justbehind Germany and ahead of Japan, Italy and the US. In 2019, of the world’s five largest lithium battery producers, China’s CATL and BYD
were ranked the second and the third, behind Korea’s LGChem and ahead of Japan’s Panasonic and the US’s Tesla.

China’s “dual circulation” strategic pivot – 16 September 2020 - 5Experience shows that China’s top-down policies mean business. So it would be rewarding to follow thegovernment’s lead when investing in China. This also argues for an investment strategy to cut exposure to firmsthat have high overseas exposure, such as consumer electronics, and increase allocation to companies andsectors that are related to state investment in the priority sectors on the DC policy agenda, such as aerospace,defence and domestic high tech industries.
From a macro perspective, the DC strategy could help China’s equities better withstand external market volatility
and, thus, attract global investors seeking to diversify returns. As China steps up efforts to substitute imports
and strengthen self-sufficiency, domestic brands in technological and financial innovation, industrial
consolidation and consumer-upgrading should drive the long-term trend of China’s equity market.
Chi Lo, Senior Economist
BNPP AM

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