Streetwise Professor

Evidence abounds that the Chinese economy is in the midst of a fundamental structural crisis. To which I respond: “It’s about time!”

I say this because I have written for over a decade that the Chinese development model is fundamentally flawed, and that signs of its distress have been emerging for years. My main surprise is that it has taken so long.

Signs abound of fundamental structural defects that cannot be addressed using the means that the CCP has used to extend and pretend for the past decade or so. The Chinese economy did not rebound robustly from the lockdown. Indeed, “flaccid” is a good descriptor of the economic performance in the last year. Despite reported growth estimates of 5 pct annually, it is virtually impossible to reconcile these official figures with more granular measures of economic performance (many of which are less subject to manipulation than top line growth numbers). For example, imports and exports have fallen–a troubling development for a trade-heavy economy.

Other indicators include widespread youth unemployment–especially among urban, educated young adults. A real estate collapse, with property development firms falling like dominoes and property turnover approaching zero. Accelerating debt-to-GDP ratios. Reduced marginal productivity of investment, as proxied by increasing debt per unit of GDP growth. Financial distress among local governments. This is another symptom of the real estate problem, as local revenues are significantly dependent on land sales. The local government troubles really represent a national fiscal crisis because local governments account for a disproportionate share of total government expenditure (and debt) in China. Banks are increasingly shaky due to a deterioration of the credit quality of their loan portfolios.

In the past China has responded to growth recessions with increased stimulus. But the government apparently increasingly realizes that the issues are structural, and that if anything increased stimulus will exacerbate rather than mitigate these problems.

Inside and outside China, there is a growing realization of the deep structural imbalances within China–something that has been obvious (and which I have written about for years) but which are now receiving attention. In particular, the investment intensity of Chinese economic activity, and the concomitant enervation of private consumption is the focus of most post-COVID analyses of the Chinese economy.

These diagnoses are fine as far as they go, but all too often those offering cures for the disease are slaves to economic aggregates and the hydraulic model of how economies work. Aggregate investment too high? Aggregate consumption too low? Well, just shut this valve and open that one and the economic shmoo will flow from investment to consumption. Problem solved! Easy peasy!

No, actually. The imbalances in the Chinese economy are the product of its very structure and most importantly its policy and political infrastructure. There are no valves to open or close, no dials to twiddle, that can alter these imbalances. Change would require a fundamental reordering of the entire Chinese system. Moreover, any fundamental adjustment in the allocation of resources would entail substantial adjustment costs, including the junking of much existing capital and widespread unemployment as people lose jobs in contracting sectors before they can find employment in new ones–not to mention that the human capital accumulated in the present structure is likely to be less than ideally suited for employment in the new consumer sector.

Low consumption and investment intensity are built into the existing system by design, and many of the problems that are metastasizing now are manifestations of this structure. The near absence of a social safety net encourages high savings and low consumption–a phenomenon that is deepened by the since discarded but still relevant One Child Policy that deprived the elderly of their traditional support, namely their children. Moreover, myriad policies have distorted relative prices to favor investment in infrastructure and state-owned enterprises (SOEs).

A salient example is “financial repression” which reduces returns to savings–and interest costs to borrowers, especially capital intensive industries, thereby channeling wealth to them. So what is a middle-aged Chinese person to do when he or she wants to save for old age, but can’t achieve high returns through traditional investments? Well, buy real estate for one–the massive overbuilding of apartments in China (illustrated by the many “ghost cities”) is emblematic of this malinvestment. The periodic proliferation of “wealth management” products offered by banks and other financial intermediaries desperate to secure funding for dodgy loan portfolios is another. I could go on.

These various policies are deeply embedded. They cannot be changed at a whim. And perhaps most crucially, they have created powerful political constituencies who are dependent upon their continuation: think of how many businesses (banks most notably) that would collapse during a fundamental rebalancing. And news flash: individual Chinese citizens/consumers are not a powerful political constituency.

Which brings us to the biggest bull in the China shop: supreme leader Xi Jinping. Xi is a devoted communist ideologue with a cult of personality. Basically Mao with a better haberdasher and hairline.

Xi’s overriding–not to say obsessive–ambition is extending, deepening, and strengthening the control of the CCP over every aspect of Chinese society. A fundamental reordering of the Chinese economy to correct the increasingly unsustainable structural imbalances would require massive decentralization, and a grant of considerable autonomy to Chinese individuals as consumers, investors, and entrepreneurs.

And that is an anathema to Xi.

Add to this Xi’s reading of the history of the Soviet Union. He–not wrongly–attributes the collapse of the USSR to Gorbachev’s attempt to loosen the grip of the state and the party over the economy. Xi is hell-bent on avoiding the same mistake. As a result he is consciously adopting an anti-Gorbachev strategy, and increasing centralization, and the power of the party over the economy. And since he has basically declared le Parti, c’est moi, increasing his power over the economy (not to mention virtually every other aspect of Chinese social life).

This foreshadows a fundamental conflict between economic and political realities. Xi’s political agenda will only exacerbate China’s current structural problems. His “solution” is a version-on-steroids of the source of the problems.

Unlike those who screech “OMG China’s slowdown will reduce world GDP growth,” in some respects (economic respects in particular) I don’t care much one way or the other: I don’t consume Chinese GDP growth (and especially not the official statistics on that growth), and the indirect effects on the US economy don’t trouble me that much.

The reason that I do care is the nexus between the Chinese economy and its foreign policy. I can see this cutting in at least a couple of ways.

On the one had, an economically hobbled and distracted China could turn inward and be more focused on foreign domestic issues than foreign adventurism and dreams of reordering the world to be subservient to Chinese domination and a desire to take revenge on centuries of alleged humiliation by foreigners.

On the other hand, intractable domestic problems can lead a personalist system–and China is clearly that now, in contrast to the more collectivist leadership of the post-Mao, pre-Xi era–to ramp up the foreign adventurism. This is particularly true when the personalist person is a seventy-something guy who wants to cement his place in history by, say, “liberating” Taiwan.

Prudence and an objective reading of Xi leads me to place greater weight on the latter possibility. Prudence, because it is the alternative that poses the greatest threat to the United States. Objective reading because of the Xi-as-anti-Gorbachev phenomenon discussed above. Gorbachev’s rapprochement to the United States was driven in large part by his recognition of the strategic and geopolitical ramifications of the USSR’s deep structural economic problems. A player of the Gorbachev Opposite Game–a fair characterization of Xi–would ramp up tension, rather than attempt to ameliorate it.

Xi is clearly ascendent in China now, but there are palimpsests that suggest discontent beneath the propaganda facade. What does an autocrat facing internal opposition do? He removes them. Note that the recently appointed Chinese foreign minister disappeared–and had much of the evidence of his existence erased: perhaps he’s exploring exciting new opportunities in organ donation! Further, commanders of the People Liberation Army’s strategic rocket forces were also recently replaced. Thus, these moves by Xi could be evidence of a dark star of opposition to Xi’s sun.

Intra-CCP politics were always highly factionalized. Xi has apparently triumphed over all of these factions. But short of Stalinist methods–which Xi has not employed–oppressed factions do not disappear, but take cover and can reemerge given the opportunity.

Alas, Chinese is the riddle, mystery, enigma on steroids–it puts even Russia in the shade in this regard. The United States, and the West generally, have very little insight on what is going on in China. Meaning that economic dislocation in a personalist system ruled by a Han exceptionalist, communism with Chinese characteristics autocrat creates extreme risks for the US and the rest of the non-Chinese world. But to compound the angst, the governing “elite” in the US and its allies is clearly not up to the challenge–and indeed may not even recognize its existence, and/or may be personally compromised in their ability to respond.

Meaning that economic tumult in the Middle Kingdom is fraught with risk for you and me. But China is where it is, and the tumult is inevitable.