The changing economics of China

 

China’s trade is evolving and has been described as China 2.0, a shift up the value-creation ladder from labor-cost advantages to more high-tech exports. To support growth, it has targeted high-tech exports to offset overall economic slowdown still driven by repricing of property risks.

Trade surpluses have continued to grow, with EVs, solar, and batteries being key drivers. China’s export growth has created significant economies of scale that will be hard for other countries to match. It is harder to raise trade barriers when the tariffs target goods needed to meet strategic environmental goals. The strategic move to high-tech manufacturing makes it harder to disengage with China. 

One of the only solutions is to innovate faster and leapfrog China’s high-tech manufacturing lead, but this is much easier said than done, and any innovation will take years to fully implement.

Dimension	China 1.0 (c. 1990s–2010s)	China 2.0 (c. 2020s–Present)
Primary Growth Engines	Property market, massive infrastructure investment, and domestic urbanization.	High-tech manufacturing, the “New Three” (EVs, lithium batteries, solar), and green technologies.
Export Profile	“China Shock 1.0”: Low-cost, labor-intensive, low-value-added consumer goods (clothing, toys, basic electronics).	“China Shock 2.0”: High-value-added industrial capital goods, advanced vehicles, industrial robotics, and clean-tech equipment.
Corporate Dominance	Real estate developers (e.g., Evergrande, Country Garden) and traditional heavy industries.	Advanced tech & industrial giants (e.g., BYD, CATL, Huawei, SMIC).
Policy Objective	Rapid, high-volume quantitative GDP growth (“Growth at all costs”).	High-quality qualitative development, technological self-reliance, and supply chain security.
Leverage & Debt Model	Rapid local government borrowing (LGFVs) and property sector leverage.	De-leveraging property, state-directed credit toward strategic high-tech manufacturing, and managed debt restructuring.
Global Trade Impact	Absorbed foreign investment; offered cheap labor to global brands.	Unprecedented trade surpluses, global manufacturing overcapacity, and direct competition with Western industry.

The big moves in fixed income - getting to equilibrium faster

 

Call it the "Great Bond Freak-out," as long-term yields have consistently moved higher, as measured by 3-day changes. The direction has been clearly upward, and the moves have been the largest since the Liberation Day debacle. The market has repriced bond risk quickly. Inflation expectations, while seemingly well managed, are above the 2% target. Real rates have risen on higher expected growth and stronger demand for AI financing. Monetary policy is moving to a hawkish stance, which places further pressure on the front end. 

The sudden repricing of bond risk should attract attention, but it does not imply bond market irrationality. Perhaps the irrationality was with the false valuations prior to this move higher.

The AI boom in historic perspective

Several investment booms have occurred throughout economic history. These booms have not always been part of a bubble or led to a bust, yet periods of investment exhaustion have occurred in which marginal firms have failed and early high returns have reversed or, at a minimum, significantly declined. Yet the current infrastructure boom is orders of magnitude higher than what we have seen in the past.

The AI investment boom exceeds the huge investment in railroads post-Civil War and is much larger than other economically changing technological investments. This is cause for concern because today's euphoria may not match reality tomorrow.

The short-term market is telling us rates will be higher

A good indicator of rate direction is the spread between 3-month Treasury bills and 1-year rates versus the EFFR. Market rates for slightly longer maturities show that the market is willing to clear at higher rates, and implied forward rates will, by definition, be higher. The switch from falling to rising rates occurred earlier this year, with the 1-year vs. EFFR spread rising sharply in the last month. Nothing suggests rates are headed lower.