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  • China’s Chickens Come Home to Roost
     
    Even if the United States continues to provide the four structural resources needed to support the post-war international order, China increasingly ap pears to be on a glidepath toward economic and geopolitical decline. In fact, there is no basis for the belief that China can reach high, politically determined growth targets in perpetuity.

    Consider the headwinds China is facing in 2022. At the annual meeting of the National People’s Congress in March, China’s leaders declared that 2022 GDP growth would be 5.5 percent.

    But where could this growth come from? There are three possible sources: business investment, trade surpluses and consumption by households and government.

    Unfortunately, there is no logical way investment can add even 1.5 points to GDP growth in 2022. In higher-tech industries, a series of unanticipated regulatory moves has frightened away investors. So, new business starts by entrepreneurs are in deeply negative territory.

    To achieve the goal, household and government consumption combined would need to add at least 3.5 percentage points in 2022 toward the 5.5 percent growth target. But with almost 100 million consumers in lockdown from COVID-19 outbreaks, retail activity is frozen.

    Promising high-tech job-creating sectors are shedding employees because of government interventions aimed at control, reducing income growth and hence consumption potential. And local governments have shrinking resource bases to support their spending, since they were ordered to stop selling land to property developers but don’t have permission to replace that lost revenue by raising taxes or imposing new ones.

    Local officials are now being told to do what was condemned not long ago: quickly issue special revenue bonds without concern for repayment. But even a municipal debt binge cannot offset the fall in the housing bubble and the consumption slowdown that resulted from COVID-19. Therefore, it looks as if it will be hard to replicate even last year’s base of consumption expenditure, let alone grow it by hundreds of billions of dollars.

    As for China’s trade surplus, there are clear reasons to be cautious about growth.

    First, with exports already at historic highs thanks to the once-in-a-century conditions produced by the pandemic, there is no likely direction but down.

    Second, China’s terms of trade (the ratio of export prices to import prices) has gotten worse owing to Russia’s invasion of Ukraine and other geopolitical tensions affecting prices, which are driving up China’s import bills. And,

    Third, elsewhere in the world, COVID-19 is receding and factories that were temporarily shuttered are coming back online, whereas export regions of China such as Shenzhen and Shanghai are facing the most acute COVID-19 crises China has experienced since the pandemic began.

    Taking all this into consideration, it will be challenging for China to achieve two percent growth this year. As Beijing continues to report results that appear much stronger than that, as it did for the first quarter of 2022, the CCP’s credibility will take a hit. Doubts about China’s numbers are already frightening domestic and foreign investors alike away from China’s markets. Accurately measured, zero growth is likely and economic contraction is possible.

    One of the CCP’s primary tools to accomplish its dual ends of rapid modernization and control has been dirt-cheap credit; this money flow enables favored companies to ignore pesky things like productivity, market forces and input costs regardless of whether that input is oil or copper or soy or cement or labor.

    Standard operating procedure says, “Just take out another loan to cover costs and expand.” Even poorly connected private companies see benefits from cheaper credit, though these companies don’t have anything like the bowling alley gutter guards of their more favored cousins.

    This credit access means they view the issue of cost as largely irrelevant; they can compete in any market on price. The Chinese can - and do - buy high and sell low because efficiency is secondary to the political needs of the Party such as maintaining high employment levels.

    Furthermore, there’s only so much you can spend on fancy equipment, automated warehouses and shiny corporate headquarters. The excess money inevitably spills out and allows Chinese firms to acquire other companies. The result since 2010 has been a massive Chinese corporate binge on foreign firms, whether it be to secure resources, eliminate competitors, or acquire technologies.

    But the Chinese development model has its downsides: risky corporate behavior brought on by a lack of consequences, bloating of expenses, and, of course, a mountain of debt that will never be repaid.

    The result is diminishing returns: Chinese GDP has expanded by a factor of 4.5 since 2000, while Chinese credit has expanded by a factor of 24. Total debt in China has ballooned to more than triple the size of the entire economy, according to Citigroup. And the Economist estimates three-quarters of the value of new loans does nothing more than pay the interest of loans issued previously.

    To summarize: China is spending more and more to get less and less, and this has already resulted in the greatest debt run-up in history. The rest of the world has seen - repeatedly - where this sort of “expansion-at-all-costs development model leads: in-vestment-led bubbles that collapse into depressions.

    In 2020, Charlene Chu of Autonomous Research put the figure for Chinese loans that have gone completely bad at $8.5 trillion. For the point of First World comparison, the total value of subprime loans that went into foreclosure during America’s 2007-to–2009 financial crisis came out to just $600 billion. Put it simply today’s “China debt crisis” is nearly 15 times as big as the sub-prime crisis!

    In Japan, a similar crisis resulted in three lost decades of deflation and near-zero growth. But unlike Japan in the 1990s, which was one of the wealthiest nations in the world on a per capita basis when it downshifted to low growth, China is relatively poor.

    Per capita income in China is about one-fifth of that in the United States, at around $12,000 a year. Worse yet, nine hundred million Chinese citizens are not yet living middle class lives and are waiting for their turn. Given that unmet potential, one would expect China to return to a faster growth rate after a bad year such as 2022. However, the problems contributing to the current malaise will weigh on China’s economy for decades.

    Most striking is the country’s demographic challenge. China has seen declining population growth for decades, a trend that is not unusual as nations become wealthier. But since 2015, China’s population growth has fallen from around ten million a year to around zero, and the trend points further down.

    There are as many as 130 men for every 100 women in their prime, so naturally not everyone can marry. And many people who are married are deciding not to have children or to wait much longer to do so than earlier generations did, for a variety of reasons. In simple terms, they are anxious about their economic burdens.

    There are hundreds of millions of people who have not yet migrated into the modern urban economy, education and health levels for people in rural China are poor, and some researchers have cast doubt on their ability to fill even labor-intensive factory jobs. Fewer workers, fewer future buyers for unbuilt apartments, fewer consumers: these demographic fundamentals are impossible to hide or change in just a few years.

    Likewise, it is no longer possible for the CCP to allow a property bubble to act as a supercharger of growth; so, construction investment will certainly be subdued for years relative to the past.

    There is room to shift investment to new, unmet needs such as energy infrastructure, schools, hospitals and a myriad of other priorities. But China’s financial sector is not yet incentivized or organized to push investment toward those areas.

    A “big bang” of financial reform is first required to achieve that goal’ and such a transition would necessarily involve a period of slow-growth structural adjustment. Only then could next-generation business investment approach the levels seen in past years. And unfortunately, there is no evidence that such a transformation is on the horizon.

    Further, the most important driver of economic growth in the long term is technological innovation. China has absorbed more technology from abroad, and benefited more from it, than perhaps any country in history. But foreign firms and other countries are now taking a far less permissive stance.

    It is unclear if truly indigenous Chinese innovation can take the baton and drive future growth. Firms that have innovated have frequently been the target of reasserted state control, for fear of independent actors. Other firms are building out a massive technology base, but only with support and subsidies from the state, which calls into question how efficient they are at research and development and how much longer the state can afford to support them.

    No doubt, given the effort the CCP has put into industrial policy, there will be successes. But as a system, Chinese innovation funding is underperforming.

    These are structural problems, and they are embedded in the system. They could be remedied. And from 1978 to 2012, such structural impediments were frequently corrected, unleashing the growth and development we’ve seen over the past 35 years.

    However, such problems are not being remedied today . And, at best, it will take years to make a credible dent in the problems dragging China’s performance down.

    Given this trend, we offer the following forecasts for your consideration.

    First, over the coming decade, China can manage its decline but not reverse its trajectory.

    Unlike the United States, China is neither rich nor self-sufficient. In fact, it’s more dependent on an accommodative global system than any other major power. And its largest problems require decades to solve. Why? Repressive industrial policies stifle entrepreneurial innovation.

    The rapidly aging population will soon result in too many dependent seniors, too few productive workers and no children to replace them; and even if fertility incentives suddenly bore fruit, it would be 20 years before the pay-off arrived. More urgently, China’s twenty-somethings are disproportionately part of the “lying flat” generation.

    China lacks access to the food and energy resources needed to be self-sufficient. The people of China have their wealth tied up in real estate which is so dramatically over-priced that a crash seems inevitable. More importantly, the CCP’s bad behavior has “burned bridges” with potential allies both regionally and globally; this means that China has few real “friends” willing to help it recover.

    Second, as confidence in China’s ability to achieve consistent growth evaporates, this will impact valuations of companies with business connections to China.

    Until recently, there has been a widespread belief that Chinese economic growth was unstoppable. Investors in many companies have assumed they will generate big future profits from China-related businesses; but as China’s growth slows, their valuations are likely to fall.

    On the other hand, the stock prices of other companies have been depressed because of concerns about Chinese competition; so, their valuations could rise. Similar ripple-effects will influence the long-term valuations of commodities and other assets that are based on expectations of another decade of relatively fast Chinese growth.

    Third, investors will exit China at an accelerating pace through at least 2025.

    Since the 1990s, whether buying bonds or building factories, foreign investors have appreciated China for its political predictability and associated growth. Now, with greater uncertainty about the outlook, those investors will require higher profit premiums to justify the risks they are taking. In recent years, strategists in democratic countries have tried to discourage their firms from going to China or to put pressure on those already there to leave.

    But now, it is the market itself, that is compelling those decisions. Western authorities don’t need to pressure firms to curtail their China ambitions: increasing transparency about the extent of China’s macroeconomic stress will do that job naturally. The result will be elective decoupling, even without political arm-twisting.

    Fourth, less Chinese growth means less for companies to fight over and fewer reasons to risk reputations and compromise on values.

    For example, if China accounted for 30 percent of marginal growth in global demand for luxury vehicles, U.S.-EU alignment on trade policy would be more stressed than if China only accounted for five percent.

    Fifth, for countries that see China as an engine of their own growth, a diminished Chinese outlook will mean a weaker outlook for them, too.

    This applies to the 55 nations that have a trade surplus with China, the 139 countries that have signed up for the Belt and Road Initiative, and others that benefit from other China-related growth drivers. The weakest of these countries may have trouble servicing debt burdens they took on in anticipation of sustained Chinese demand growth or encounter political upheavals if it turns out they erred by deciding to align themselves with Beijing. And,

    Sixth, a slower Chinese economy means the CCP will have less room to maneuver at home.

    Fiscal promises which were made assuming five percent or higher GDP growth will have to be scaled back.

    Support for industrial policy, especially for technology development, runs to hundreds of billions of dollars a year, while these numbers pale in comparison to the growing perennial expenditures on education, health care, infrastructure, government salaries, government debt service, and other obligations.

    Less fiscal capacity will mean fewer resources for outbound investment and official development assistance. Choices about public expenditure priorities will become more difficult. Beijing can’t do everything it hoped. And with less spending power, Chinese leaders will have to worry more about social stability. The party has built authoritarian tools to suppress discontent, but these have been tested only during the long period of high growth.

    Officially, in 2019, China’s $261 billion in military spending represented 1.4 percent of GDP and was growing at around six percent annually, but many observers think that spending is higher and growing faster; notably, slower growth means China will have to make some tough “guns and butter decisions.” On balance, this is probably good news for the United States and many of China’s neighbors.

    Resource List
    1. Foreign Affairs. April 15, 2022. Daniel H. Rosen. The Age of Slow Growth in China And What It Means for America and the Global Economy.

    2. Foreign Affairs. May 3, 2022. Carl Minzner. China’s Doomed Fight Against Demographic Decline: Beijing’s Efforts to Boost Fertility Are Making the Problem Worse.

    3. Zeihan.com. May 10, 2022. Peter Zeihan. Credit, and the End of the World.

    4. Foreign Affairs. November 5, 2021. Daniel H. Rosen. Xi Is Running Out of Time: China’s Economy Heads for a Hard Landing.