Fred Hu’s conversation with Michael Spence: Pressing strategies for revitalizing China’s economy
20.11.2024
At the recently concluded Primavera 2024 Global Investment Conference, Primavera Capital’s founder, Dr. Fred Hu, and Nobel Laureate in Economics, Professor Michael Spence, delved into the geopolitical dynamics between China and the U.S. and the complexities of the global macroeconomic landscape. They also discussed some of the most pressing economic issues of the day, including China’s response to growth challenges and the impact of AI.
Both economists agreed that the economic decoupling between China and the U.S. would impose substantial costs on the global economy, and the world needs to find new forms of interdependence. They emphasized that China’s immediate priority in addressing its current economic difficulties should be to repair household balance sheets and boost confidence among consumers and private entrepreneurs. Relying solely on investment-driven growth is mis-guided and unsustainable. Despite short-term challenges, China’s substantial investments in technology, innovation and education remain among the highest globally, which will be a key source of resilience for the Chinese economy.
Participants:
Fred Hu | Founder of Primavera Capital
Michael Spence | former Dean at the Stanford Graduate School of Business, Nobel Laureate in Economics
Fred:
We are pleased to welcome Professor Spence back again to our Global Investment Conference. Professor Spence is an outstanding economist, known not only for his well-recognized academic achievements but also for his broad vision and rich experience. What is the most striking to me for Mike is his curiosity—always asking me a lot of questions about China, and now he is definitely a top expert on the Chinese economy.
Currently, the global economy is gripped by uncertainties. Besides factors such as the direction of US Federal Reserve policies, regulations, geopolitical issues have the most significant impact.
Despite the shadow of the trade war, China has so far maintained its position as the world’s largest manufacturing hub, with its output accounting for 32% of the global total, more than that of the U.S., Japan, Germany, India, and South Korea combined.
When Trump initiated the trade war with China in 2018, he was seeking “decoupling” with China in hopes of bringing manufacturing back to the U.S. and reshaping supply chains. Do you think this trend will significantly weaken China’s position as the world’s factory? If “decoupling” were to occur, what price would the global economy pay?
Michael:
So for the first question, no. And second, the answer is enormous, so let me elaborate.
Firstly, I think there’s no way to take a 32% market share down really fast without blowing up the global economy. And I don’t think that’s what is happening.
What is happening is a very distinct pattern that depending on which sector you’re in, which is rapid diversification. It’s partly a response to geopolitical tensions, the pandemic, and sanctions in recent years, every country is rethinking the security of their supply chains.
We are living in a global economy that is continuously adjusting, and the private sector is quick to respond. , I see the global supply chains moving to satisfy the rules of origin. Chinese entrepreneurs in the manufacturing sector are going to invest in other places. You can see this happening. I don’t think it’s a calamity. But it is an additional inflationary trend.
In the three to four decades following China’s reform and opening-up, global supply chains were constructed almost entirely on efficiency and comparative advantage considerations. But now, the world has changed, factors such as national security are now also important considerations.
So I think the challenge now is how countries can build a functional version of interdependence in response to these new realities, including the lack of trust, national security and defense considerations, geographical fragmentation, yet still maintain a certain level of openness. I believe the jury is still out on whether we can do that.
Unfortunately, there have been disruptions in all the dimensions of globalization, including trade in goods and services, capital and technology flows, and even people.
Five years ago, AI experts from China and the U.S. could maintain close communication and share ideas, but now it is almost impossible.
I thought I was exempt because academic economists don’t know anything sensitive. However, when a Chinese university invited me to become an honorary professor. I said I have to check to see if it’s a problem on the American side. And it turned out it was problematic. It is unfortunate, as the global system that once fostered powerful advancements in science and technology is becoming fragmented.
Fred:
Globalization has propelled world economic growth through trade, financial flows, technological cooperation, and the sharing of innovations. However, many countries are now experiencing a rise in protectionism, often framed as a matter of national security, which is hindering the process of globalization. As noted, this increases the costs associated with technological exchange and progress.
Since the onset of the trade war, the U.S. government has consistently claimed that China’s technology exports would see a substantial decline. Contrary to these claims, data shows that by 2023, China’s technology exports have actually increased. While the U.S. might be sourcing final assembled products from countries like Vietnam, Indonesia, and Mexico, there remain significant intermediate goods- such as essential parts and components – sourced from China. Thus, while U.S. imports from China may have decreased, imports from China to ASEAN and other regions have risen. A new Trump administration may impose global tariffs, but that would bring substantial costs and turmoil to world trade.
Michael:
I completely agree. Take the semiconductor industry as an example— removing China from the tech sector would make manufacturing nearly impossible.
Many Americans misunderstand the goal: we are not trying to relocate all semiconductor manufacturing back home. Instead, the aim is to ensure that if global conditions deteriorate, we can scale up production quickly.
To achieve large-scale production of advanced semiconductor chips in the U.S. under extreme circumstances, it would require engineers from both the U.S. and Taiwan to repeatedly travel to and from Arizona for construction, debugging, and implementation. This could potentially increase chip costs by 50%. I think you just have to accept that in certain areas, there’s a set of policy priorities that have nothing to do with economics.
Fred:
In fact, amid the same geopolitical changes, the responses of different countries and regions are diverging. For instance, ASEAN, Africa, Latin America, and countries involved in the Belt and Road Initiative are maintaining close trade relations with China. Additionally, many companies are expanding their operations from China to other parts of the world. Do you see this as a helpful trend in terms of offsetting some of the geopolitical & protectionist headwinds
Michael:
Absolutely. Many emerging economies prefer not to choose sides between China and the U.S.; instead, they focus on conducting business based on their own interests. I think China is a major investor both in Africa and Central Asia. There may be a bit of learning curve as to learn how to make those investments effectively, that’s just positive.
Many African countries are eager to learn from China’s development experience. Former Governor of the People’s Bank of China, Zhou Xiaochuan, once shared with me that numerous countries are interested in understanding China’s financial development, particularly in creating secure savings channels and efficiently directing those savings into investments. In this context, China can play and indeed has played an outsize role in the Global South, trade, investment, finance, and technology.
Fred:
In recent years, China has faced macroeconomic headwinds, including the real estate crisis, deflationary pressures, and local government debt. If you were to give policy advice, what would be your single most important piece of advice for China?
Michael:
I don’t think there’s a great mystery about the immediate challenges in China. The immediate challenge is an aggregate demand problem from an economist point of view.
The net worth the household sector is heavily dependent on real estate holdings. Real estate values have taken a major hit, which translates into reduced consumption.
Once at a forum in China, I was asked to give a 10 minute speech and then somebody ran up to me, and said we’re running overtime. You only have 5 minutes, just say one thing.
I said, if you hammer the balance sheets of the household sector, it’ll take you a long time to recover. After the U.S. subprime mortgage crisis, it took a decade for households to rebuild their balance sheets. If you kill off the balance sheets in the financial sector, even the corporate sector, it’s much more concentrated, there are ways to fix it.
My first piece of advice for China is to exercise patience; recovery will likely take two to three years. And I believe some effective programs are already being implemented.
The second challenge is the current hesitance of the private sector to invest. Corporate savings are unusually high relative to investment, which is atypical for China, where tangible assets investment has run around 45% of GDP. Restoring entrepreneurs’ confidence willingness to invest is essential.
My third piece of advice is to avoid making investments solely to boost aggregate demand. Low-return investments do not foster growth potential or valuable assets and can lead to overcapacity. Instead, the government should consider subsidizing consumption.
Fourth, I advise China to stop frequently changing its stance on the role of the private sector. Clear boundaries must be established, and once a development model is chosen, it should be adhered to. I don’t think there’s a right answer. Certainly I don’t think the American answer is the right answer for other countries. It’s different from the European answer. But inconsistency creates uncertainty. Clearly defining their approach and sticking with it is crucial. While every country has regulatory laws, the boundaries must be clear; uncertainty about legal parameters creates confusion and has adverse economic effects.
Lastly, investment in human capital and technology is vital. In the U.S., organizations like the National Science Foundation, the Department of Energy, and the National Institute of Health (NIH) invest approximately $80 billion annually in basic science and engineering. This investment is a significant driver of scientific research and startup growth. China has also performed very well in this crucial dimension.
China is undergoing a transformation from export and investment-driven growth to consumption and innovation-driven growth. So, once you get past the short-run headwinds, I would say restoring 5% growth, in 2-3 years by the end of the decade is a pretty good bet on the Chinese side regardless of what the external environment looks like.
While the experiences of the U.S. and Europe may not be entirely applicable, China has tons of talent. The key question is whether the government will turn it loose and empower that talent to solve the problems.
Fred:
Although China’s economy faces short-term challenges, I believe that with determination and urgency, the country has both the capability and resources to address these issues.
Before we move on to the Q&A session, I have one final question. You mentioned earlier the importance of investing in education, and China is becoming home to the largest population of higher education graduates and engineers. We are in the era of artificial intelligence, and I know you have friends who are entrepreneurs in the AI industry. However, there are growing public concerns about safety and job loss. What is your view on the benefits and risks of AI technology?
Michael:
If we look at major stock indices like the S&P 500 over the past 25 years, we find that 80% of their value was attributable to tangible assets. Today, that figure has dropped to 20% or less, with 80% now represented by intangible assets such as data, software, and brand value. This marks a significant shift in value creation.
This shift requires ample funding and top-tier human capital, both of which China possesses in abundance. So, despite facing short-term economic challenges, China’s fundamentals and potential remain unchanged and impressive. On the other hand, I am more concerned about Europe. While there is talent, the region is underfunding the research that motivates creative young individuals.
Regarding artificial intelligence, there is no doubt it will have a tremendous impact on scientific research. DeepMind’s AlphaFold AI can now decipher the structure of nearly all proteins. I asked a Nobel Prize-winning biologist if biologists are using it, and she said everyone is utilizing DeepMind’s protein structure database, which now contains over 200 million protein structures. There are 2.2 million biologists using AlphaFold. I believe this will significantly propel advancements in biology.
In today’s forum hosted by Primavera, we heard about AI applications across various industries. The technological wave is unstoppable. Compared to the regulatory focus on misuse risks, I think we should first pay more attention to the inclusiveness and fairness of the technology, ensuring that large companies and dominant industries do not leap forward while small and medium-sized enterprises are left behind. The speed with which new technologies diffuse across sectors is crucial for realizing a productivity surge rather than just localized improvements.
Regarding employment, mass unemployment seems unlikely. Historically, technology has not led to widespread job loss, even during rapid advancements. Looking back at the history of technological development, we see that as technology advances, people’s working hours have decreased, so in the future, you may no longer need to work 40 hours a week.
People’s fear of unemployment stems from the belief that the demand is fixed. From my discussions with leaders in the AI industry, some jobs will be replaced, but many new job opportunities will also be created. Additionally, it is very likely that everyone will have an AI personal assistant. Ultimately, we should concentrate on helping people navigate these changes in jobs and skills rather than fearing catastrophic job losses.
Fred
Yes, there’s no doubt that artificial intelligence will significantly boost productivity and create wealth for humanity. While the journey will have its ups and downs, resulting in both winners and losers, AI revolution is to be embraced instead of being feared.
Q&A
Q:
NVIDIA’s Jensen Huang once stated that NVIDIA systems consist of 35,000 components, with 80% coming from TSMC and its supply chain. It may take the U.S. around 10-20 years to achieve an independent chip supply chain.
Technically speaking, without considering the 50% price increase you mentioned earlier, is it possible for U.S. chip suppliers to achieve decoupling?
Spence:
I think you’ve identified important issue. There is only one TSMC, and many stages of chip production occur not in the U.S. but in regions like Taiwan, the Netherlands, and Japan. Moreover, the high barriers to research and development make decoupling an unrealistic notion.
From what I heard, China’s semiconductor industry will get to the forefront eventually. Chinese tech companies, such as Huawei, possess top-notch software capabilities, and improvements in hardware are just a matter of time.
Fred:
I would like to add that, while Biden aims to establish an independent chip supply chain within the U.S., success is not guaranteed. Firstly, the semiconductor is fundamentally a global industry. Virtually no country can do it alone.
Second, it depends on the balance of supply and demand. Currently, China is the largest consumer of chips in the world. If China is cut off by brute force and the U.S. increases its own production capacity, who will buy these chips? Attempts at decoupling will ultimately harm all producers along the chip supply chain.
Spence:
Also, the rise in chip prices will significantly impact low income countries. Decoupling ultimately harms the open spirit of technology among countries.
Q:
Professor Spencer, you mentioned that the balance sheets of Chinese households have been damaged due to the real estate industry crisis. Many people are discussing that the savings rate of Chinese residents is too high, and that household borrowing should increase. Some have also suggested that the government should raise its deficit. Do you think increasing the deficit is the solution to the current deflationary pressure? Is it the only solution?
Spence:
I’m not entirely certain; it might have some marginal effects on stabilizing the real estate industry.
It’s important to note that China is a notable outlier in terms of consumption as a fraction of aggregate demand. China is transitioning from a high investment-led model to a more balanced approach, as the extreme investment model simply won’t be sustainable.
The quickest way to boost consumption is to increase household incomes, which currently represent a low fraction of total national income. This low share is primarily due to the significant state-owned enterprise sector, where the government controls a large portion of income distribution. Therefore, regardless of what stimulus measures are taken, the key is to transfer purchasing power to the residents.
Fred:
The proportion of consumption to GDP in China is not only lower than in Europe and the United States but also lower than that in India. Therefore, it is essential to enhance social security in areas such as healthcare, elderly care, and education to boost consumer confidence. Additionally, compared to other regions globally, China’s tax burden is relatively high, while public services are insufficient. It is vital to boost Chinese households’ after tax disposable income.
We must acknowledge that there are significant short-term challenges facing the Chinese economy; however, its growth resilience remains, and policy adjustments are underway. Primavera Capital is committed to leveraging its professional capabilities and experience to collaborate with our partners, uncovering more investment opportunities while managing risks.
Many thanks to Professor Spence for sharing his insights.