China and the world: Inside the dynamics of a changing relationship

The relationship between China and the world now is changing. The McKinsey Global Institute’s (MGI) new China-World Exposure Index shows that the world’s relative exposure to China has increased, while China’s to the world has fallen. Accompanying this shifting exposure are the signs of stresses in the relationship. Trade disputes are making daily headlines, new rules are emerging to evaluate technology flows, protectionism is on the rise, and geopolitical tensions are becoming more heated. The way ahead is uncertain. Could we be at peak integration between China and the world after the years of deepening ties? Conversely, what opportunities could more engagement offer? What value could be at stake for all players?

China and the world: Inside the dynamics of a changing relationship (PDF–4.2MB) examines the state of China’s integration with the world on eight dimensions, concluding that while China has achieved scale this has not always translated into global integration. The research establishes evidence of a shift in the mutual exposure of China to the rest of the world, and vice versa, and estimates the value that could be at stake from more or less engagement. Finally, the research offers thoughts about how businesses could respond to a new era of uncertainty. We note that this analysis builds on MGI’s earlier research on shifting global value chains, which discussed the “new China effect” driving global demand growth and reaching a new level of industry maturity.

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China became the world’s largest economy in purchasing-power-parity terms in 2014. In nominal terms, China’s GDP was 66 percent that of the United States in 2018, making it the second largest economy in the world. On the MGI Connectedness Index that ranks participation by flows of goods, services, finance, people, and data, China was the ninth most connected country in the world in 2017. In 2018, China accounted for 16 percent of world GDP. However, China’s journey to global prominence has been uneven. To gauge the extent of China’s integration with the world, we look at eight dimensions of China’s global scale and integration (Exhibit 1).

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1. Trade. China has without doubt become a major global player in trade as a supplier and as a market. China became the world’s largest exporter of goods in 2009, and the largest trading nation in goods in 2013. China’s share of global goods trade increased from 1.9 percent in 2000 to 11.4 percent in 2017. In an analysis of 186 countries, China is the largest export destination for 33 countries and the largest source of imports for 65. However, trade exposure to China varies substantially by region and sector. China has a disproportionately high impact on specific regions (particularly those close by) and sectors, notably those with globally integrated technology chains, and resource-exporting sectors for which China is a big market. China’s global scale in services trade is not as significant as in goods. China became the world’s fifth-largest exporter of services with $227 billion of exports in 2017, triple the value in 2005. China also imported $468 billion services in 2017, making it the second-largest services importer in the world. However, China’s share of global services trade is 6.4 percent, about half that of goods trade.
2. Firms. Many Chinese firms have attained global scale. Consider that in 2018 there were 110 firms from the mainland China and Hong Kong in the Global Fortune 500, getting toward the US tally of 126. In 2018, MGI found that China accounted for 10 percent of global firms in the top 1 percentile for economic profit in 2014 to 2016, up from less than 1 percent in 1995 to 1997. However, although the share of these firms’ revenue earned outside China has increased, less than 20 percent of revenue is made overseas even by these global firms. To put this in context, the average share of revenue earned overseas for S&P 500 companies is 44 percent. Furthermore, only one Chinese company is in the world’s 100 most valuable brands.
3. Finance. China was also the world’s the second largest source of outbound FDI and the second largest recipient of inbound FDI from 2015 to 2017. However, China’s financial system remains far from globalized. Foreign ownership accounted for only about 2 percent of the Chinese banking system, 2 percent of the Chinese bond market, and about 6 percent of China’s stock market in 2018. Furthermore, in 2017, its inbound and outbound capital flows (including FDI, loans, debt, equity, and reserve assets) were only about 30 percent those of the United States.
4. People. Flows of people between China and the world (students and tourists) are rising rapidly. China is now the largest source of outbound students (545,000 in 2017) and tourists (150 million trips in 2018). In contrast, inbound students and tourists in China account for only small shares of global totals at only 3 percent of the global overseas student population and 4 percent of overseas trips taken in 2017. Despite large outbound flows, destinations for Chinese students have been highly concentrated in the United States, Australia, and the United Kingdom, collectively accounting for about 60 percent of all outbound Chinese students. In 2017, half of the trips taken by Chinese tourists were to the Greater China area, and another 29 percent went to Asia. Migration flows have been small. Chinese emigrants accounted for 2.8 percent of the total global migrant population, and immigrants to China for 0.2 percent.
5. Technology. China’s scale in R&D expenditure has soared—spending on domestic R&D rose from about $9 billion in 2000 to $293 billion in 2018—the second-highest in the world—thereby narrowing the gap with the United States. However, China still depends on imports of some core technologies such as semiconductors and optical devices, and intellectual property (IP) from abroad. In 2017, China incurred $29 billion worth of imported IP charges, while only charging others around $5 billion in exported IP charges (17 percent of its imports). China’s technology import contracts are highly concentrated geographically, with more than half of purchases of foreign R&D coming from only three countries—31 percent from the United States, 21 percent from Japan, and 10 percent from Germany.
6. Data. China is home to the world’s largest population of internet users, with more than 800 million people connected to the web. However, despite recent growth, its cross-border data flows are still limited by restrictions. China is in the global top eight for data flows in terms of bandwidth, but these flows are still small compared with the vast size of its digital economy at only 20 percent of US data flows.
7. Environmental impact. China has been the world’s largest source of carbon emissions since 2006, and today accounts for 28 percent of the global total. It has been investing heavily in renewable energy. In 2017, it invested about $127 billion, 45 percent of the global total. As well as being motivated by its commitment as a signatory to the Paris Agreement to reduce its carbon intensity by 40 to 45 percent from 2005 to 2020—a milestone that it was able to achieve by the end of 2017—China is seeking to reduce its carbon intensity because of domestic issues including pollution.
8. Culture. China has invested heavily in building a global cultural presence. Consider that the number of Confucius Institutes around the world has expanded from 298 in 2010 to 548 in 2017. Furthermore, its financing of the global entertainment industry has led to more movies being shot in China: 12 percent of the world’s top 50 movies were shot at least partially in China in 2017, up from 2 percent in 2010. However, significant investment appears to have had yet to achieve mainstream cultural relevance globally. Chinese exports of television dramas in terms of the value of exports are only about one-third those of South Korea, and the number of subscribers to the top ten Chinese musicians on a global streaming platform are only three percent those of the top ten South Korean artists, for instance.

Focusing on three of the eight dimensions, MGI has analyzed the mutual exposure of China and the rest of the world on trade, technology, and capital. From 2000 to 2017, the world’s exposure to China has increased on all three, while China’s has fallen (Exhibit 2). MGI’s new China-World Exposure Index measures the relative importance of these economic flows for the Chinese and global economies compared with other large economies. The rest of the world’s aggregate index rose from 0.4 in 2000 to 1.2 in 2017, while China’s exposure to the world peaked at 0.9 in 2007, and has declined to 0.6 in 2017.

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China’s declining exposure partly reflects its rebalancing of the economy toward domestic consumption. In 11 of the 16 quarters since 2015, domestic consumption contributed more than 60 percent of total GDP growth. In 2017 to 2018, about 76 percent of GDP growth came from domestic consumption, while net trade made a negative contribution to GDP growth. As recently as 2008, China’s net trade surplus amounted to 8 percent of GDP; by 2018, that figure was estimated to be only 1.3 percent—less than either Germany or South Korea, where net trade surpluses amount to between 5 and 8 percent of GDP. Rising demand and the development of domestic value chains in China also partly explain the recent decline in trade intensity at the global level. China is consuming a larger share of output produced. These are significant changes that alter China’s priorities and shift the dynamics of its relationship with the world.

The decline in China’s exposure also reflects the reality that the economy is still relatively closed compared with developed economies. On trade, after joining the World Trade Organization (WTO), China cut tariffs from an average of about 16 percent in 2000 to about 9 percent in 2008. However, since then the average tariff rate has edged up to 10.6 percent in 2017 (although we note that it may come down again to 7.5 percent with the 2018 announcement of a new round of tariff cuts), according to UNCTAD. In comparison, the US and EU average tariff is around 3 to 4 percent in 2017. On capital, despite opening, barriers persist. On the Organisation for Economic Co-operation and Development’s (OECD’s) FDI Regulatory Restrictiveness Index for services, the index has come down to 0.39 from 0.74, but this is still far higher than the 0.08 OECD average. We note that there have been recent moves to ease restrictions such as progress in adopting a “negative list” approach that may not have been captured in the index yet.

The increasing exposure of the rest of the world to China reflects China’s increasing importance as a market, a supplier, and a provider of capital. China accounts for 35 percent of global manufacturing output. Although it only accounts for 10 percent of global household consumption, China was the source of 38 percent of global household consumption growth from 2010 to 2016, according to World Bank data. Moreover, in some categories including automobiles and mobile phones, China’s share of global consumption is 30 percent or more. It is, as we have noted the world’s second largest source of FDI and its second largest recipient between 2015 and 2017. However, the exposure to China varies among sectors and countries, according to our analysis of 73 economies and 20 sectors.

China has made huge strides in innovation in recent years. China is a global force in the world’s digital economy and artificial intelligence (AI) technologies. In many types of technology, it is already the largest consumer (for example, China accounted for 40 percent of global mobile phone sales in 2017, 64 percent of sales of battery electric vehicles sales, and 46 percent of semiconductors consumption). Access to the Chinese market has provided many high-tech players with significant growth opportunities. According to an MSCI index, the US information technology sector makes 14 percent of its revenue in China.

Because technology value chains are some of the most complex, they require the most collaboration, and, indeed, China is highly integrated in these value chains with a large share of technology global exports and imports. Consider, for instance, that in the case of integrated circuits and optical devices, Chinese imports outstrip domestic production by a factor of five.

Technology is arguably at the center of the changing relationship between China and the world. Because China is highly exposed to foreign technology flows, it needs continued—if not enhanced—access to technologies to fuel its innovation and enhance productivity. The rest of the world—notably advanced economies—have begun to pay increasing attention to China’s rapid technological development. New legislation has been put in place that more closely evaluates Chinese investment that accesses foreign technology. Close attention has been paid to whether China’s technology value chains are becoming decoupled from global value chains, and to China’s stated aims to localize technology sectors. China’s Made in China 2025 plan sets targets for local players’ market share of 40 to 90 percent in 11 of 23 subsectors prioritized by the government.

In many respects, China’s technology markets already appear to be localized, but the degree of localization varies. In the case of solar panels, high-speed rail, digital-payment systems, and EVs, Chinese players account for more than 90 percent of the domestic market. In other segments including semiconductors and aircraft manufacturing, Chinese players still have a very small market share both at home and internationally, and depend heavily on foreign technology. In the majority of value chains we studied, China still has huge room to improve its global presence. At the high end, China has up to 50 percent of the rest of world market (in the case of solar panels); at the low end, its market share abroad is less than 1 percent (in the case of aircraft manufacturing) (Exhibit 3).

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To gauge China’s integration with the world in technology value chains, MGI studied 81 technologies in 11 areas and found that China uses global standards for more than 90 percent of them. In the minority of sectors where China’s standards have diverged from global ones, economic drivers can explain the shift. For example, in polyvinyl chloride (PVC) manufacturing, the costs associated with adopting a coal-based process versus an ethylene-based process that is more common outside China are lower because China has an abundance of coal. We also found that Chinese suppliers are able to provide 60 to 80 percent of the technologies studied, which means that China still uses inputs from multinational corporations in at least 20 to 40 percent of cases.

Experience from around the world suggests that four elements need to be in place to move up the technology value chain: (1) investment at scale; (2) channels through which to acquire technology and know-how; (3) access to large markets; and (4) an effective system to encourage competition and innovation. Looking at the four elements across China’s technological sectors, we find that China has substantial scale in terms of investment (the first element) and market (the third element). China has capacity to support a great deal of investment into technological R&D and also create new markets to commercialize the technologies. Therefore, the critical ways for China to move up the value chain are to make progress on developing and acquiring core technology and know-how (the second element) and designing an effective system to ensure that its ecosystem has the competitive dynamics to fuel innovation (the fourth element). In both cases, participation in global value chains and stronger flows of capital, knowledge, and talent could arguably accelerate China’s move up the value chain.

China’s rapidly expanding consumer market—confident, gradually richer, increasingly sophisticated, and willing to experiment—offers a strong link between China and the world. It is not only the prime engine for economic growth but is a huge opportunity for international businesses. By 2030, 58 percent of Chinese households are likely to be in the mass-affluent category or above (defined as household disposable income being 18,000 renminbi or more a month), surpassing today’s South Korean share of 55 percent. The spending profile of urban Chinese consumers is converging with that of their counterparts in cities around the world.

China’s consumer markets are already heavily integrated with the world and penetration by multinational corporations is considerable. Across the ten large consumer categories, their average penetration was 40 percent in 2017, compared with just 26 percent in the United States. In some categories, penetration is even higher; for instance, in beauty and personal care, multinationals’ penetration is as high as 73 percent (Exhibit 4).

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However, as more MNCs have entered the Chinese market they have catalyzed the development of homegrown companies and brands. In our study of 30 categories of consumer goods, foreign brands have lost share in 11 categories in the past few years.

We highlight two trends that offer significant business opportunities to both domestic and foreign players:

• Chinese consumers demand more and better choices in goods and services. As incomes rise, consumers want more choice, and, despite discussion about a “consumption downgrade,” we find that there is still evidence of a broad trading-up trend. McKinsey’s 2018 Global Consumer Sentiment Survey showed that 26 percent of Chinese respondents were trading up overall, compared with 17 percent in ten other top economies. In some cases, Chinese consumers are not satisfied with domestic brands alone partly because of perceived quality issues, and because of a lack of choice—attitudes that prevail in both goods and services. A fast-growing channel for Chinese consumers to access goods from overseas is cross-border e-commerce. From 2015 to 2017, cross-border e-commerce retail imports almost doubled to 111 billion renminbi according to iResearch data. Services are the next frontier for competition leading to higher quality. Chinese service sectors still lag behind other countries with productivity of only 20 to 50 percent of the OECD average.
• A rising number of Chinese people go abroad and spend more. China’s increasing flows of people—particularly students and tourists—is an expanding business opportunity for businesses in destination countries. China is already the largest source of outbound tourists in the world. Their spending can be equivalent to 7 to 9 percent of domestic private consumption in the case of Singapore and Thailand, respectively. China’s outbound students can have a significant impact on other economies, too. Australian education exports to China amounted to 10 billion Australian dollars in 2017 (not including additional spending of Chinese students for day-to-day living). Companies can take advantage of these trends by adapting to Chinese tastes and tailoring offerings.

The relationship between China and the world appears to be entering a new phase. In the rest of the world—particularly in advanced economies—there are discussions about the unintended consequences of globalization and unequal distribution of benefits, and—in the United States—concerns about the “China shock” displacing manufacturing jobs. Several major economies are putting in place legislation making foreign investment deals—particularly where technology deemed to be strategically important is involved—subject to stricter review. These developments could presage lessening engagement between China and the world. However, disengagement is not inevitable.

We highlight five choices for China and the world that could lead to more or less engagement, and simulated the potential economic value that could be created or lost depending on these choices. The five areas where China could be more (and conversely less) engaged: (1) growth as an import destination; (2) liberalization of services; (3) globalization of financial markets; (4) collaboration on global public goods; and (5) flows of technology and innovation.

The results of our simulation, which uses McKinsey’s Global Growth Model and calibrates its findings with external research, suggest that more or less engagement between China and the world in these five areas could potentially drive economic value for the world of $22 trillion to $37 trillion by 2040—equivalent to 15 to 26 percent of GDP. We note that our estimates of the value at stake are the result of a simulation based on a specific set of conditions and assumptions, and they should not be taken as forecasts (Exhibit 5).

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In both scenarios of more and less engagement, there will be upsides and downsides created for different stakeholders. For example, less engagement between China and the world could benefit countries in Southeast Asia through greater demand for their exports. Conversely, more engagement between China and the world could create short-term shocks for Chinese workers and firms in certain sectors as the country imports more from the rest of the world.

1. Growth as an import destination. China could develop itself as a major destination for imports from emerging and advanced economies; with less engagement, global trade flows could contract. We simulate that the value at stake related to trade could be $3 trillion to $6 trillion.
2. Liberalization of services. China—and foreign players—could benefit from liberalization of services; if services remained restricted, China would continue to operate at a productivity gap with developed economies. Our simulation suggests that $3 trillion to $5 trillion could be at stake from more or less global engagement in Chinese services.
3. Globalization of financial markets. Further globalizing and modernizing China’s financial system could broaden choice and allocate capital more efficiently; choosing not to do so could risk more volatility and low productivity growth. Overall, we simulate that $5 trillion to $8 trillion of value could be at stake.
4. Collaboration on global public goods. China could increase its contribution to solving global challenges. In a scenario of less engagement, leadership and collaboration would be weaker. We simulate that $3 trillion to $6 trillion could be at stake from more or less global engagement with China and as a result broader global collaboration on topics related to global public goods such as the climate change and infrastructure.
5. Flows of technology and innovation. Global flows of technology between China and the world could increase, supporting the development of globally competitive, productivity-enhancing solutions; alternatively, reduced technology flows could undermine global productivity. We simulate $8 trillion to $12 trillion could be at stake, depending on how technology flows unleash innovation and productivity growth.

We note that these choices and scenarios—and the resulting outcomes—reflect not only actions and reactions by China but also the rest of the world. Reforming aspects of the global trading system to make it more effective at resolving disputes and more inclusive so that benefits from any further opening up of its economy by China can be captured and shared broadly is a collective task. If and when China globalizes its financial sector, the rest of the world would need to be more open to Chinese investment. On tackling climate change, all countries need to commit to specific goals and milestones to avoid a situation in which some countries pursue self-interest to the detriment of the world as a whole. The magnitude of technology and IP flows between China and the rest of the world is subject to the stance taken by each country involved in these flows on technology-related investment and national security.

Given the uncertainty and potential risk of the changing relationship between China and the world, businesses may need to adjust their approach. There are four areas for consideration:

• Assess short- and long-term exposure to the China-world relationship. To understand the likely impact of changing relations between China and the world, companies should first assess their level of exposure to China-world relationship. Exposure can take many forms. Across the eight dimensions of Chinese scale and integration, there are specific metrics that businesses could examine and track. Depending on their exposure, companies can assess risks and benefits to the business depending on different engagement scenarios. Even in the face of short-term volatility and uncertainty, companies should also incorporate a view on China’s long-term fundamentals. What long-term trends—including rising incomes, technology flows, and intensifying local competition—may have an impact on the business?
• Determine investment and value chain posture. Given the scenarios and value at stake for every company, executives should determine their China strategy in terms of investment commitment compared with other countries, and the role that China should play in the company’s global value chains. They should define and be clear about their aspirations for China—do they want to make China their key growth engine, or do they want to play only in niche areas, for instance? They could for example, optimize investment as part of a long-term strategy, potentially investing more and doubling down on core value creation activities by, for instance, driving innovation and R&D, if China remains an important source of growth and innovation. If not, shifting business activities and investment to other geographies could also be considered.
• Develop operational excellence needed to manage risks and uncertainty. Given increased regulatory and economic uncertainty, companies need to be much more agile in delivering their value proposition. Governments around the world are playing an increasingly important role in cross-border investment, M&A, and flows of technology and people. Businesses need to pay attention to the local context in which they are operating as it can change quickly, sensitivities can grow, and operational mistakes can be made that in the past could be fixed easily and contained, but may, in this new era, quickly escalate, drawing the attention of stakeholders. They may think about adjusting their operational footprint, and need to be agile when making shifts, and they need to devote more resources to risk management.
• Adopt and maintain a survivor’s mind-set. Companies that have thrived despite recession and crises in the past have tended to maintain a healthy balance sheet, take care to ensure access to finance, and have a broad range of businesses to insulate them from downturns in particular sectors. However, crises and uncertainty also bring opportunity; the pressure they bring can be a catalyst to reorganization that improves the long-term health of a company, and they can bring new opportunities to expand footprint or market position through business development and inorganic growth.