China’s alarming lack of freshwater resources is perhaps the single most mispriced macroeconomic risk in the world today. Hard times for China investors are set to get even harder.
China is in the throes of an acute water scarcity crisis, exacerbated by a heat wave of unprecedented severity. The drought has been catastrophic for industries in China. Water is critical to power generation, industry, agriculture, and manufacturing, meaning water scarcity is not only limiting agricultural production in China but also exacerbating an acute domestic energy crisis that mirrors Europe’s, affecting virtually every economic sector, particularly manufacturing. As the rest of the world still imports roughly $3.36 trillion of Chinese economic output a year, few sectors are unexposed to supply-chain shocks emanating from China.
As this dual water and energy crisis has unfolded over the last few months, the Chinese Communist Party has been prioritizing water and electricity for households over industry, virtually ensuring further—and substantial—curtailment of industrial production. These supply shocks will reverberate through global supply chains and financial markets, with frightening and unpredictable consequences for the global economy.
Despite the water crisis, as well as Beijing and Washington’s mutual desire to reduce their economic interdependence, China’s hold on key energy supply chains will likely increase. China’s share of the global polysilicon market—the crucial input to photovoltaic solar panels—recently hit 80%, and may grow even higher. China dominates the supply chain for lithium-ion batteries, graphite, nickel, and most rare-earth minerals used in clean energy, electronics, and defense manufacturing. Polysilicon market prices have nearly quadrupled since January 2021 while lithium metal prices have quintupled, indicating how little slack there is in the market, even prior to the recent heightening of the Chinese water crisis. As Covid-related and other market bottlenecks eased in spring 2022, lithium battery pack prices moderated—but market deliveries have more than doubled year on year—keeping supply quite tight and subject to disruption.
Climate change has almost certainly exacerbated both the drought and heat wave. Ironically, this threatens some of the highly capitalized firms that are darlings of environmental, social, and governance investors and the sustainability crowd. In 2019 Apple had 380 suppliers in mainland China, representing a stunning 46% of its total supply chain. The company has gone to great lengths recently to reduce its supply dependence on China. But Covid-related supply-chain issues in China have caused significant production disruptions because “the vast majority of Apple devices” are still assembled there, highlighting lingering exposure. Tesla, a poster child for the clean-energy economy, in July signed long-term supply deals with two Chinese companies. The effect is to further concentrate its China supply chain for its Shanghai “gigafactory,” as Tesla calls its plant, further increasing its vulnerability to China’s drought. Tesla’s facilities have substantial water demands. Inadequate water availability delayed the opening of Tesla’s Berlin gigafactory.
Indeed, China’s widespread water shortages are already affecting its supply-chain resilience, with industrial users facing severe power cuts in both 2021 and 2022. This leaves China’s economy in a perilous position, forcing the CCP to choose between continued economic growth and depleting water resources. As a result, the implicit assumption that drove much of the global economy for decades—that China can continue to manufacture low-cost goods—is more in doubt than ever. Capital markets face a painful adjustment period as the new reality gets priced in.
Beijing does have options to decrease water consumption or boost supplies, but all carry heavy political costs for the CCP. These include forcing consumption changes, like reduced meat eating, onto Chinese consumers; significantly raising the price of water for farmers and industry; or securing water resources from rivers that cross into neighboring countries. All would be controversial. Beijing is deploying atmospheric interventions. Techniques like cloud seeding boost rainfall, but also likely exacerbate extreme weather patterns. Beijing has long relied on transfers of water from wetter to drier regions. But signs of severe water stress in regions previously considered water abundant, like the Pearl River Delta, suggest that these transfers may soon be infeasible. Large-scale desalination is also not viable, given the massive power consumption required, and the lack of distribution networks to bring water from the coast to China’s interior.
That leaves Chinese policymakers in a difficult place.