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China’s Economic Vulnerabilities

A side-by-side look at the domestic and external picture of China’s economy reveals opportunities for the United States to exert its influence.

Derek Scissors

In consideration of The Elements of the China Challenge, Policy Planning Staff, U.S. Department of State

An economy the size of China’s has unavoidable vulnerabilities; and, perhaps surprising to some, bad policy choices over the past fifteen to twenty years have created new vulnerabilities. While China’s reliance on various imports of goods draws justifiable attention, its capital dependence, less well known, may be more dangerous to its prosperity. It may also be surprising that the United States, together with partners or even in some cases alone, has ways to exert pressure if spurred to do so by Chinese support of Russia’s invasion of Ukraine or equivalent events.

“Vulnerability” is not the same as “weakness:” The People’s Republic of China (PRC) has important economic weaknesses only indirectly related to its vulnerabilities. A shrinking and aging population, for example, reduces the PRC’s competitiveness but is not a true vulnerability. It may become a major social problem; but such problems, like the low income of rural citizens, are different from economic vulnerabilities.

A classic vulnerability is a high level of imports of goods—for example, of oil. China’s huge population leaves its natural resource base unavoidably inadequate in some ways. In addition, long-term policy choices have created additional inadequacies. China cannot avoid food imports; its land and water cannot support every major crop on a large scale. The latest available figures indicate that, in 2020, the PRC was one of the world’s five biggest importers of corn and wheat and the biggest importer of beef, pork, and rice. Its imports account for over half of the global soybean trade. The United States is the world’s leading food exporter—and is dominant when intra-EU trade is excluded. According to Chinese data, the United States accounted for about 40 percent of China’s cereal imports and 30 percent of its soybeans.

The energy import numbers are bigger, but the PRC’s vulnerability is smaller. It now imports more crude oil than the United States did at its peak in 2005; in 2021 oil and gas made up China’s second-largest import, at 15 percent of the total, or $400 billion. (Consumer electronics were first, but that is an area in which China runs a surplus.) Sources of oil and gas are apportioned broadly: In 2021, the Russian Federation was the leading supplier, at 13 percent, followed by Saudi Arabia. That order has flipped in early 2022, as buying Russian gas carries more risk. For almost two decades, Beijing has made a concerted effort to diversify its energy supply.

A third set of Chinese commodities imports gets less attention: metal ores, amounting to $275 billion in 2021. The PRC’s copper imports make up nearly half of the world’s copper trade. Iron ore is the country’s primary metals import, with the PRC typically making up more than 60 percent of all trade. Australia supplies two-fifths of China’s iron ore imports by value, with Australian ores comprising more than 4 percent of China’s total imports. Unsurprisingly, Beijing’s sanctions against Australia did not include iron.

Rising above all of these (and above proclamations of Chinese technological superiority) are imports of integrated circuits—more than $430 billion last year, almost as much as crude oil and iron ore combined. Beijing’s loud effort to become less dependent in chips has not yet worked. Further, those chips are near the start of many supply chains, from autos to telecom, putting the PRC in a broadly dependent position. This is reflected in the outsized role of Taiwan. With a population of twenty-four million, it is the leading source of all Chinese imports, at 9 percent of the total in 2021. By far the largest portion of that total was electronics.

Thus, the PRC’s current technological inadequacy is clear; its progress is largely a matter of faith. Those who tout or fear China’s technological rise point to the undeniable stress on catching and surpassing the world’s leaders. If one believes the state can properly direct broad technological progress over many years, the PRC will become formidable. But if competition and private property rights are necessities, China will falter.

Capital is harder to measure than goods, because Beijing mysteriously classifies large flows as “other investment” or “errors and omissions” in the balance of payments. Outflows in these categories touched $400 billion in both 2020 and 2021. The PRC can afford that amount because it also draws funds, both inbound investment and foreign currency earned through trade surplus. All this, however, creates a vulnerability.

Beijing controls money flowing in and, especially, out of the country. The capital account is partly closed, separating money used internally from money used externally. The PRC’s external financial situation is simple: a huge pile of foreign exchange reserves is maintained through trade surpluses, especially with the United States. China’s official foreign exchange reserves were $3.25 trillion at the end of 2021, plus roughly $1 trillion that is held outside official reserves but at state institutions.

Yet China’s trade surplus stood at $676 billion in 2021 and its holdings of foreign exchange rose by less than half that amount. The trade surplus is needed to offset capital loss elsewhere, and the extravagant size of the surplus depends on just one country: The 2021 bilateral goods and services imbalance with America accounted for about half of what Beijing reported as its total surplus. That imbalance from 2007 to 2021 exceeded China’s total holdings of foreign exchange. The PRC’s external finances rely on the United States.

The country’s domestic financial situation is more important, but murkier. Inbound investment is clouded by the presence of “overseas investors,” including money from Hong Kong. This can consist of returning Chinese funds and the ultimate sources are, in any case, unclear. China’s Ministry of Commerce reported 70 percent of the country’s 2020 inbound direct investment as being from Hong Kong. Capital thus introduces an element that goods do not: Does Beijing know exactly what’s going on?

China is unquestionably attractive to foreign funds; but, as with trade surpluses, inbound investment must help carry a heavy load. Here the load is domestic indebtedness. At the start of the global crisis in late 2008, the PRC’s outstanding credit burden was comparable to that of the United States a generation before, which was easily bearable even for a much poorer country. At the end of 2020, the PRC’s outstanding credit burden was comparable to that of the United States in … mid-2020. China reports per capita personal income of about one-tenth the American level. This weight of debt will prevent the Chinese from catching up, unless there is a domestic reversal or more funds pour in.

From 2017 through 2020, gross inbound investment in the PRC approached $1.8 trillion. Annual inflows rose over that period and appear to have risen sharply in 2021. The role of Hong Kong makes it difficult to determine the sources of the inflows; but, switching to U.S. data, American investment in the PRC rose by more than $800 billion during those years, pouring into Chinese stocks and bonds. Foreign capital is clearly less important than China’s domestic policies but plays a growing role and appears to be led by the United States.

China has multiple economic vulnerabilities. To a considerable extent, they are chosen. Resources are owned by the state. Agricultural production is below par because farmers still cannot own their land. Large state monopolies dominate energy and metals, discouraging innovation. The PRC has benefited from emphasizing industry over services, but this choice requires vast amounts of raw materials not available at home. Private firms have recently been assaulted by the Communist Party, discouraging both innovation and wealth creation. These and other policies, like state dominance of finance, motivate capital flight, while Beijing’s panicked reaction to the 2008 global crisis ran up debt.

General Secretary Xi has been in charge for nearly a decade and intends to be in charge for at least another decade; these vulnerabilities will persist. The door is thus open to coercive policy by America and perhaps its allies. It is nearly impossible for the United States to organize major energy exporters to condition trade on Chinese behavior—Russia is hardly the only one that would balk at this. Metals would also be difficult—though Australia and Brazil would make up a good start in both metals and agriculture, where they could be joined by Canada and the EU to round out major farm exporters. But actions along these lines would require considerable provocation from the PRC to be politically feasible, because they would not cripple China and would harm influential groups in exporting countries.

Monetary coercion would be somewhat easier, though the United States has been moving in the opposite direction. The United States can by itself force changes in the PRC’s external economic policies if it is willing to reduce imports of Chinese goods drastically (including those through third parties) for a sustained period, thereby pressuring China’s balance of payments and the value of its currency. There would be domestic opposition to this, of course, but also considerable support.

In terms of internal Chinese finance, the United States cannot force any sort of crisis; but it can force some spending trade-offs by halting the flow of capital that has taken place since 2016. If Japan and the richer parts of the EU were to join in restricting investment in China, Beijing’s past and current choices to accumulate debt and suppress private wealth creation would come home to roost, threatening the funds otherwise available for military and security forces, industrial subsidies, technology development, and elder care.

Derek Scissors is senior fellow at the American Enterprise Institute, chief economist at the China Beige Book, a member of the congressionally mandated U.S.-China Economic and Security Review Commission, and frequently tired.

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