For prior posts in this series, see Whither Xi? Whither CCP? Whither China?
Whither China post #9 – Question 7 – So no democracy, no resilience; heavy challenges. Now what?
We looked at authoritarian resilience, modernization theory, the contrapositive to modernization theory, and threats to innovation, and came up short in two ways - on the need for a democratic transition and the inevitability of a growth slowdown without democracy.
This is not to say that high levels of growth can continue or that protests will cease. The question then turns to the current challenges in China – what is happening? A version of Minxin Pei’s Trapped Transition is likely, although I think there are necessary updates to his view. It is Mr. Xi who is leading China into a trap.
This is a long post. I want to talk about -
The economic traps
The geopolitical trap
The political trap
Pei’s trapped transition
The long duree of trapped transition
Challenges beyond stagnation
Watch the third tier and fourth tier cities, and young Chinese
Challenges facing all of China, not just Mr. Xi
A new post-Xi trapped transition
Durability of CCP
The economic traps
There are at least four models for an economic trap facing China. They are the middle income trap, the secular stagnation hypothesis, the impossible trinity thesis, and the extractive institutions argument. These are not mutually exclusive. None address current debt crisis issues or accounting for bad debt. All four suggest a secular slowdown.
Chinese macroeconomists worry about stagnation in the overall economy for a variety of reasons. Some have concerns of a middle income trap. CCP fears the unrest that might come from a slowdown in growth – there are still hundreds of millions of Chinese who are not middle class, or even moderately prosperous. I discussed the middle income trap here. The fear is that while China will continue to prosper, broad prosperity will not reach the majority of the population who are not yet middle class. There is good reason to think that fear is justified.
My conclusion - China will experience some version of the middle income trap, for a variety of reasons – debt overhang, far too many extractive institutions in the economy, economic reform needs frustrated by vested interests, increasing social welfare needs, export demand dropping in the rest of the world, foreign manufacturing rushing to abandon China, among others. Mr. Xi said in 2013 (Third Plenum reforms) that he wants to put the private sector in charge of the economy. Even if he was sincere about that, the existing systems of extractive institutions will resist mightily. In particular, the hukou acts as a serious constraint on the ability of farmers to improve their status, since health care, unemployment insurance, education, and living arrangements are all highly determined by one’s hukou. Middle class Chinese don't want their kid going to school with farmers, and local governments don't want to pay for education, health, and welfare for farmers. Inclusive is a long way off.
In the middle income trap, people are not starving, the world continues more or less as it has been, but the country has difficulty moving GDP per person above a middle-income level. It cannot jump into the group of high GDP per person countries. A substantial share of the population remains at a low wage status, without obvious means of improvement.
GDP growth has been the claim to legitimacy for CCP, and a middle income trap might jeopardize income growth for many Chinese who have not yet experienced the China miracle. Mr. Xi has demanded that China become a moderately prosperous society by 2020. Even if the media announce success, there will still be millions of farmers who plant and work second jobs and retain hope for their own version of the Chinese dream. At another end of the income spectrum, there will still be millions of Chinese who buy expensive cars and clothes and travel extensively. Those conditions will not change substantially – that is the essence of the middle income trap. But like the USSR, like Russia, like the US, China will retain a large segment of the population unable to advance much up the economic ladder. GDP per person will grow much more slowly, beginning about now.
Another perspective on the China economic trap is the secular stagnation hypothesis made prominent by Larry Summers. Briefly –
Secular stagnation theory refers to an economy with a chronic (secular or long-term) lack of demand. Historically, a booming economy with low unemployment and high GDP growth (i.e., an economy at or above capacity) would generate inflation in wages and products. However, an economy facing secular stagnation behaves as if it is operating below capacity, even when the economy appears to be booming; inflation does not appear. Savings by households exceeds investment by businesses, which in a healthy economy would cause interest rates to fall, stimulating spending and investment thereby bringing the two into balance. However, an economy facing secular stagnation may require an interest rate below zero to bring savings and investment into balance. The surplus of savings over investment may be generating price appreciation in financial assets or real estate.
These are characteristics of the Chinese economy. Broadly speaking, secular stagnation theory depends on two factors - too much income disparity, so aggregate demand remains lower than if income were more evenly distributed, and too much uncertainty about the future to permit more spending and more investing. Income disparity is built in for farmers and migrants who are unable to participate in the growth miracle because of their hukou status. Farmers and migrants remain uncertain of their property rights and future, and even businesspeople in the Xi era need to worry about expropriation. Both of these problems will continue in China for the foreseeable future.
Another view of constraints on China macro policy comes from the impossible trinity concept, which notes that it is impossible for a country to have all three particular economic conditions simultaneously, although every government would ideally want all three – a stable foreign exchange rate, free capital movement (absence of capital controls), and an independent monetary policy (ability to set interest rates). The US maintains free capital movement and an independent monetary policy, at the cost of a floating exchange rate. China uses capital controls and a somewhat controlled foreign exchange rate, and tries to keep an independent monetary policy, but cannot. Monetary policy – basically, the ability to control interest rates – is at risk in China. The result is that China is subject to bouts of inflation when it restricts capital flows, in and out, and also tries to keep the exchange rate within a “dirty float” band of the dollar. When money cannot flow out of China, the money bids up prices - for real estate, cars, and luxury items. Since portfolio money cannot flow in, China is left with adjustments to interest rates and the exchange rate as the two principle levers of macro policy. This becomes a delicate balancing act. When interest rates go up, the tendency is for the exchange rate to go up as well, and the float is imperiled. Now China is looking to invite portfolio money in. That will be a threat to inflation as well.
Culture and politics create economics and the institutions that govern transactions. This lesson is often lost on Americans, but it is quite obvious to anyone looking at international development. The ability of individuals to prosper, make future plans, conduct business with strangers and take risks depends on a totality of cultural and political arrangements - inheritance laws, strength of property rights, cultural acceptance of bribery, even social services like education and health care for families. The Chinese institutions that allowed some limited risk taking after 1978 worked very well for a dozen years or so, but political institutions need to keep up with changes in the economic setting. The argument, most forcefully made by Daron Acemoglu and James Robinson in Why Nations Fail, is that China retains too many extractive institutions - arrangements in practice or law that favor a ruling group over the mass of citizens. Examples are savings rates kept artificially low so that funding is available at low costs for government and manufacturers; the hukou, which keeps the majority of Chinese from relocating to urban areas with more economic potential; poor quality of schooling and health care in rural areas; restrictions on foreign business in China; controls on information, whether internal or external; or the closed nature of the financial system, controlling the value of the currency. The argument is that over time, possibly decades, such restrictions will push China's growth lower.
Whether the road ahead for the Chinese domestic economy is described as middle income trap, secular stagnation, or the seesaw result of the impossible trinity, the road will be bumpy. Chinse consumers can see that.
So can macroeconomists looking at projections from the perspective of long term world GDP. Jim O'Neill, who coined the BRIC acronym (Brazil-Russia-India-China) has done projections of world GDP for various countries. The 2021-2030 period sees substantial slowdown in China, due to ageing of the workforce and slower productivity growth than in past decades.
An economic slowdown is inevitable, and China will survive the slowdown. The question is always, how will that be managed?
The geopolitical trap
The geopolitical trap begins with the Chinese cultural mix of inferiority combined with a sense of frustration at not being acknowledged as the superior world civilization. For a thousand years, China was the dominant nation in Asia, with the largest economy in the world. Then for a hundred years it was occupied, beaten down, and disrespected. Now, China wants to reclaim its glory. CCP promotes the historical glory, helping to mask its own fragility at home while claiming to be the vanguard of the people in rejuvenation, at home and abroad.
Fragility at home is shadowed by bombastic behavior abroad. But foreigners do not have to tolerate poor behavior. Remember Bill Clinton’s comment – a tight grip is a sign of a weak hand. Mr. Xi has weakened CCP domestically, and weakened China internationally as well.
A decade ago the talk was about China joining the world as a responsible partner, a provider of international public goods. China could assist on climate change, monetary stability, peacekeeping, and internet openness. That was a decade ago. Now the world notices what the government must do to keep control internally, how it behaves internationally, and China’s international image suffers as a result.
For a long time, the international image of China was self-effacing - "China is still a developing nation" was the oft-heard refrain. Now, the world notices when the government and its representatives come in gangbusters to academic conferences, threaten foreign academics, harass students elected to student offices who dare to express their personal views, try to intervene when universities schedule speakers that CCP would not like, ignore protocol at international conferences and generally behave in the boorish manner that we think should be the sole province of Americans.
Soft power – the power of culture, of national ideals, of a positive national image – is an American advantage in the world. CCP has worked very hard on Chinese soft power in the last ten years, principally through the CCP United Front and government sponsored Confucius Institutes and Chinese Students and Scholars Associations (CSSA) on foreign university campuses.
Many CSSA get all or a good part of their annual budget from the local Chinese government consulate. United Front attempts to gain cooperation of Chinese overseas by offering inducements to return, appealing to patriotic support of the ancestral motherland, and attempting to influence overseas Chinese media. The Confucius Institutes teach Chinese language and culture, but are tainted by their funding and CCP ancestry.
The close relationship between United Front and the CSSA has put off American administrators, students, and some independent Chinese students when “spontaneous” demonstrations or protests are organized against appearance of a speaker that CCP does not like. I can tell you that Chinese New Year events organized by the CSSA in Chicago have been fascinating and engaging events, with props and costumes and dragons. Years ago, I always left wondering how such events could be organized by university students, who otherwise should be, you know, studying. Now I know.
Bethany Allen Ebrahimian has been a principal reporter on the influence of CSSA on campuses, and its relation to government propaganda. Her work demonstrates pretty clearly the insidious influence of the government in student affairs, extending inevitably to providing funds. In some cases, CSSA seem to take as their model the infiltration tactics of United Front. The organizations monitor and correct what Chinese students say on social media even when abroad. They can always be reminded of what awaits them when they return to China.
Joseph Nye, who coined the term soft power, reminds us that soft power cannot be dictated by or exported by government. It is most specifically a non-government idea. But that message can’t get through in China.
It does get through in foreign countries, despite mineral deals and oil deals and infrastructure and port deals. Those deals are contemplated and implemented leader to leader, or state to state. Private business to private business, not so much. Individuals in foreign countries do notice the difference. My African students in Hangzhou certainly did. Their presence in China was attributable to scholarships awarded as part of large trade deals in their home countries, but they had no illusions about the benefits of those deals for the home population.
China tries to promote soft power at the same time as the state advances its priorities via foreign affairs, business affairs, stories in local media, and even monitoring of thought and action of Chinese students abroad. Everyone, every business, every function, is meant to serve the state.
Geopolitically, the world has finally noticed. The bloom is well off the rose of China's peaceful rise.
Civilization-state, Leninist state, and Thucydides trap
This is where Lucian Pye’s description of China as a civilization pretending to be a state begins to make sense. There is no distinction between serving the Party and serving China, even for business interests. There is no concept of personal values not subject to review and comment by senior government officials, even outside China - Yang Shuping in 2017 and Uighur activist in 2019 and Tibetan student union president in 2019. In recent analyses, the US intelligence community has begun referring to China as a whole-of-society threat. Chinese businesses in the US, Chinese in the US and around the world, students and visitors, may be called upon to serve the state. This is the Huawei threat, but far larger than a single internet company. This is China and CCP über alles - anyone may be called upon to serve the state, to steal IP or provide information of use to someone in a provincial or central government position. This is Steve Dickinson at China Law Blog on theft from employees in China -
What can happen to the Chinese employees of your WFOE in China is exactly what allegedly happened to the Chinese employees of Huawei’s U.S. subsidiary. The local Chinese government will give your employees a detailed list of exactly what your employees must take from the WFOE and the timeframe in which they must complete the task. Though your Chinese employees may formally work for your WFOE, the Chinese government is essentially their ultimate “boss,” in the same way Huawei China is alleged to have been the ultimate boss of the employees of their U.S. subsidiary.
What though if your WFOE employee is an honest person and resists following the local government’s instructions? Or perhaps the employee is not so honest but resists simply because he or she does not want to risk losing his or her job if caught. The local government responds: your spouse works as a nurse in the local hospital and it would be too bad if she lost her job. Your father lives on a pension from the local government and it would be too bad if he lost his pension. Your daughter is applying for admission to the local high school and it would be too bad if she is denied entry. On the other hand, if you provide what we [the local government] have requested, we will ensure none of this happens. Moreover, you and your family will receive benefits. If you lose your job, we will find you another job. Don’t worry about it. Just do what you are told and help YOUR country. The pressure to comply is overwhelming and your Chinese employee complies. Your employee really has no choice.
On theft within the US, see venture Beat on theft of Apple autonomous vehicle IP.
Remember the outcome of business negotiation in China. In a business negotiation with foreign businesses, a good outcome for the Chinese side is not seen as a victory for the company. It is seen as a victory for China.
In such an environment, distasteful assumptions are revived. As I wrote in Lie Down with Dogs, Get Up with Fleas, honest Chinese bear the burden of being marked as suspect Chinese. All individuals, businesses, organizations are expected to serve the state. To portray Huawei as an innocent private company caught in a trade spat is to misunderstand the civilization-state idea. Don Clarke, professor of law at George Washington University, comments on the innocent bystander meme – The Zhong Lun Declaration on the Obligations of Huawei and Other Chinese Companies Under Chinese Law (March 17, 2019). A Chinese law firm wrote a declaration in support of Huawei as being under no constitutional obligation to serve interests of the Chinese government. To Clarke, as well as many others, this is a laughable position.
Clarke makes the point (unaltered, by the way, by the new foreign investment law) that provinces and cities are still free to determine for themselves what actions to take to encourage or force local Chinese businesses to comply with demands, and in any case, illegal demands are no more necessary than a slight encouragement when it comes from CCP. “There’s a whole variety of pressures that the government can bring to bear on a company or individual, and they are not at all limited to criminal prosecution Clarke says. “China is a Leninist state that does not recognize any limits to government power.”
Military and economic competition with the US have ramped up significantly. Those who see competition as always benefitting the world – China as a competitive balancer in the one case, an economic rival in the other – might be advised to think again.
John Mearsheimer has warned of the potential for a Thucydides trap in the growing competition between China and the US – that it is difficult for an established power and a rising challenger to not engage in conflict over resources, control and territory. See his book, The Tragedy of Great Power Politics, and the video. Conflict is not inevitable, but it is a reasonable expected outcome. The US appears to have awakened to failure of the modernization thesis and to the harm done to American businesses via IP theft. The world, once enamored of Chinese culture and growth, is now growing fearful of Chinese lying and bullying by government and underhanded business practice. Good relations are generally gone, and a new era of raw competition seems likely. Mr. Xi has made threatening noises about reunification with Taiwan, one way or the other. Even if conflict does not come, less openness between China and the west will. The world will now begin limiting Chinese growth for the world’s own good. That is a new part of the trapped transition.
The internal political trap
Mr. Xi is attempting to change the way CCP works without changing underlying characteristics of either CCP or Chinese culture. Mr. Xi has no possibility of changing the ancient Chinese practices of rule of men, extremely disaggregated government, lack of trust, guanxi, and foreigner distrust of Chinese intentions. He inherits a CCP that has become a vehicle for private gain for some its members rather than a political ideology, and that needs to change or lose legitimacy. I say this with all due respect for the scores of Chinese government officials I know who are honest, hardworking, and only want good middle class lives for themselves and their child. CCP has no intention of giving up on power.
Governance will move toward totalitarianism rather than a more benign authoritarianism. The touch of totalitarianism can remain light in most circumstances. This is the ancient, traditional dynastic occupation of China by a ruling elite that exists to serve itself. It is Maslow made explicit – survival as the fundamental goal. Or, perhaps, the stationary bandit idea of Mancur Olson – an autocrat or authoritarian government that expects to remain in power can extract less from the population, to afford stability for heirs. That expectation of future extractions provides the limit to CCP extractions now. No need to steal too much today if you can steal more tomorrow.
Party self-preservation is a weak national goal. There is no overarching theme, no superordinate purpose, to CCP rule, other than to remain in power, and therefore to produce economic development. Marxism is no longer a motivator for cadres or the people. Religion cannot function as a source of moral authority when it is controlled by government. Economic growth is destined to slow. A “moderately prosperous society” hardly engages. As economic growth ebbs, China has turned to nationalism in concert with totalitarianism. Nationalism bonds; totalitarianism controls.
Nationalism only works as an advantage when it exerts itself internationally through threats and strident positions. At home, totalitarianism works pretty well to tamp down dissent. CCP now uses both to ensure its own survival. In one of his early 2012 or 2013 speeches, Mr. Xi might have said something like the following, paraphrasing one of those westerners out to destroy China, John Fitzgerald Kennedy -
“Let the word go forth from this time and place, to friend and foe alike, that the torch has been passed to a new generation of CCP, born in this century, tempered by Cultural Revolution, disciplined by a hard and bitter Tian’anmen, proud of our ancient heritage, and unwilling to witness or permit the slow undoing of those leadership benefits to which this party has always been committed, and to which we are committed today at home and around the world. Let every nation know, whether it wishes us well or ill, that we shall pay any price, bear any burden, meet any hardship, support any friend, oppose any foe to assure the survival and the success of CCP.”
This is not Mr. Xi’s inaugural, but it might well have been. He needs to secure the survival and success of CCP even as CCP is divided, the necessary crackdowns on corruption divide further, and the people mistrust, denigrate and ignore CCP whenever able.
Pei’s trapped transition
Minxin Pei laid out a case for stultification in his China’s Trapped Transition – The Limits of Developmental Autocracy (Harvard University Press, 2008). His case is that CCP politics will permit too much theft, too much corruption to be left unaddressed. Pei made the economic argument as well – that China’s ability to prosper will at some point be hindered by the one-party state, or by the corruption it fosters. The trap lies in the iron grip of these characteristics -
It cannot enforce accountability of its cadres without highlighting its lack of power and supervision over the hinterlands and vast bureaucracy.
It cannot wean itself from its inherently predatory behaviour because the captured money, and associated party advantage, is all that it has left to offer adherents.
It cannot address the catastrophic drop in party morale because the majority of cadres are now convinced that socialism is a lost cause. The best strategy therefore (individual and communal) is to take as much out of the system as possible before it collapses.
In some respects, this is the trap that Mr. Xi has been appointed to address.
In his latest book, China's Crony Capitalism, Pei expands on the thesis. He provides a detailed description of the corruption, collusion, and theft that is the result of two important features of the system - incomplete and often unclear property rights and inability to enforce laws in a rule of men system. He sees a predatory bureaucracy that has privatized the state’s authority. The Chinese system of governance is very decentralized, as has always been the case. But this allows for local perversion of central rules and regulations, and the central government really does not know what is happening locally until they ask. And China has always followed a “don’t ask, don’t tell” policy. And you remember the Chinese unstated cultural assumption – no questions.
There are laws and rules and regulations, both in government and in CCP. The intricacies of factions and collusion networks and guanxi can defeat those laws and rules. The whole point of rule of men at this stage of development is to defeat standard rules and procedures. Pei sees these as clear signs of a system in decay.
Mr. Xi is making valiant attempts to reign in the moral decay, but he is running against the wind. By virtue of the decentralization of governance and no rule of law, local elites spring up in order to accomplish development. Those local loyalties remain strong, and will not reduce with advancing modernism.
The long duree of trapped transition
Pei’s case for regime dissolution in the next decade or two is that political decay will cause economic catastrophe as well. But in the absence of an extreme political event, I fail to see the economic stagnation Pei foresees from the trapped transition. Pei been proclaiming regime decay accompanied by economic problems for well over a decade, and so far economic decay is not yet visible.
The economic decay may not come. Corruption does not always hinder development, even if it detracts from public welfare and spreads moral decay. One of the arguments made in support of localized trust, or rule of men, is that it can cut through cultural norms and oppressive regulations that stifle growth. This was no doubt the case in China with early development, as with the township-village enterprises of the 1980s. Sometimes, corruption to get around the rules is necessary for growth. I am not suggesting that is the case now.
China is far past that early stage in which getting around The Man could be a positive contribution to growth. Pei’s point about incomplete property rights is strong. One has only to consider Wu Fulong’s Urban Development in Post-Reform China (Routledge, 2007) which documents in numbing detail the variety of different mechanisms necessary to transfer land use rights among the variety of actors in real estate development – central government, provincial government, local government, counties, SOE (central, provincial, or municipal), villages, real actual private parties as we would define in the west, different use types (government, party, industrial or manufacturing, office and residential) and the nature of the change in land use (farmland to industrial, farmland to residential, residential to office, farmland to infrastructure, residential to infrastructure …).
Each variation on the above categories can have a different required transfer process – not to mention Party influence locally and from above. The central government owns all land that is not farmer land, but also transfers to cities the right to supervise and allocate that land. In a decentralized system without much real oversight, that is nearly a license to steal. One should remember Willie Sutton and his rationale for robbing banks.
In any case, the new Chinese economy is past the stage of depending on real estate and infrastructure for growth. Now, growth will come from the science and engineering of pharmaceuticals and internet related businesses, which in their creation and technical performance are far less susceptible to manipulation by government officials. I think this is where Pei has not updated his predictions of economic decline. In a review of the Trapped Transition thesis, Barry Naughton argues that Pei mischaracterizes China’s economic policy and its ability to create a more sophisticated economy. I agree.
Pei’s argument about economic stagnation is unclear. In China’s Crony Capitalism, he describes how government, and individuals in government, extract benefits for themselves to China’s detriment. But this corruption is necessarily a declining share of the overall economy. The “middle income trap,” would be a form of stagnation, but even if that slowdown does come, it need not be a major political crisis for China. No definition of the trap prohibits government transfers to adjust income shares between classes or ongoing improvements in the lives of farmers. Farmers’ lives can be improved with better health care, better schools, some form of social security for retirees. Improvement in the lives of millions more of farmers will go a long way toward pacification of the masses, without democracy, without China becoming a high-income country, without complete modernization.
Pei was looking for economic stagnation more than a decade ago, when development was significantly less complex what we see today. His idea - that the inefficiencies of corruption will doom the economy - does appear mistaken. His idea was an economy stymied by the predator state, a China that failed to democratize and a China that failed to live up to the expectations of eager western business interests. He saw an incapacitated state, one unable to perform its required functions environmentally, or control poverty and disease. In this, his prediction is also just wrong. But perhaps Pei was just a bit too soon. Now, in 2019, Mr. Xi has reversed many of the benefits to which Pei’s critics pointed in 2007. No one commenting in 2007 could see the China of 2019.
Certainly, the big national SOE are sources of inefficiency. These companies are overstaffed, which is part of their role as SOE, and they don’t allocate capital well. The government has committed – more than once – to reducing the impact of the big SOE, but Mr. Xi seems inclined to let them merge to become national champions, perhaps international champions. But I don’t think the SOE problem will significantly harm the economy. Normal budget constraints coming in the next decade will force a greater transfer of SOE profits in the form of taxes to the government, the shrinking labor force will reduce some demand for jobs for cadre kids, and pressures on banks will force a bit more fiscal discipline on big SOE. These big companies are becoming a smaller and smaller share of GDP, now.
Challenges beyond political and economic traps
There is a twenty-year-old idea – that China will get old before it gets rich, and that the problems of an ageing population, combined with other great social problems, will be enough to cause political change. CCP will never be able to take sufficient political and economic reforms to permit growth to a high income nation.
There is merit in the “getting old before getting rich” observation. This is happening now. The working age population is decreasing by more than three million per year – admittedly, a drop in the bucket in China, but those drops add up over a decade or two. Perhaps a good part of China can become at least “moderately prosperous” in the next five years, but the getting old is happening right now.
At the same time, young Chinese face terrible prospects (as do young Americans now). Jobs are contingent – a project here, a project there. Gig jobs are a norm, as are jobs for which university graduates would seem overqualified. The means by which the central government controls the economy also limits job prospects for college graduates. Think of the kinds of jobs college graduates seek. They are service jobs in service industries – some part of law, medicine, marketing, advertising, insurance, banking, finance, architecture, engineering and construction management. These jobs are precisely those that are not open to foreign businesses. The government has been saying it will open some of these to foreign businesses, and there is in fact some small movement in that direction now. China has just permitted Allianz, a German insurance company, to open shop. But progress is very slow, and for a good reason. To open these industries would risk losing control of the currency and business practices. Money in services moves across borders more easily than trade in hard goods. Guanxi-type relations between business and government are illegal in the US.
What jobs are available for many young Chinese are outside the social security system – meaning that jobs are hourly, off the books, cash only, and no paying into the housing fund or health care or pension system. This is not so unlike many American jobs now, but the US may be better at forcing those workers into the formal economy sooner rather than later.
Macroeconomic data gives us the broad perspective on the jobs issue for college graduates. Services are about 50% of the Chinese economy. (The “services” category includes real estate and finance and banking, along with marketing and advertising, education and health care, legal and leisure. The US Bureau of Labor Statistics definition is here and here. China uses the same definition). In the US, services account for about 70% of GDP. The two economies are now comparable in complexity, though the US is still larger.
That difference between 50% and 70% is the millions of jobs that do not exist in China. In recent years, there has been substantial growth in the service sector of the economy, as reported in GDP numbers. But if one subtracts finance and real estate from the services data, the sector is actually a smaller proportion of GDP than was the case five years ago. Service industries like transportation, communications, real estate, health care, legal, education, finance and banking are also those in which SOE or direct government have the greatest stake, and will prove most difficult to open to foreign investment and increased competition. Finance and banking are still focused on providing liquidity to the large old SOE rather than young, small or private businesses.
Watch the third tier and fourth tier cities, and young Chinese
The important action in watching the Chinese economy in the next decade will take place outside the glittering cities that we all know – Beijing, Hangzhou, Ningbo, Wenzhou, Suzhou, Shanghai, Dalian, Shenzhen and Guangzhou. Those are international cities, and although each still has a substantial rural population, these and a dozen others contain the bulk of the Chinese middle class. The middle class has multiple apartments and at least one car and is able to travel abroad and shop at the extravagant malls that boggle the minds of people from Chicago. Their consumption habits are not going to drive the Chinese economy in the future. They just can’t buy that much more stuff, and the crackdown on luxury from CCP makes gifts and ostentatious display of luxury watches and clothes and cars no longer de rigueur, and is, in fact, n’est pas approprie. Middle class families and their kids are paying down debt from purchasing the apartment. The second and third apartment may have no debt, but the apartments are not finished, not decorated. This is an investment that is earning no return for its owners. Data from electric meters shows about 50 million, roughly 22% of China’s urban housing stock, with no use of power. You see the evidence driving anywhere at night. The share of apartments with lights on, tv on, is surprisingly small. Many of those apartments are empty. That is trillions of yuan invested on the come, the come of rising property values.
The children of this middle class - now in their twenties and thirties - are tapped out paying on the mortgage that allowed them to marry. The one child gets extra special attention, which means spending less on big-ticket items for themselves. Salaries for this age group will rise, but not at the rate of the first part of this century. Young Americans are not buying cars as their parents did; neither will young Chinese. On-demand services like didi in China are quite prevalent, easy, and fast. This saves money, or allows it to be spent on other things, but can also be a drag on GDP growth. When interest rates go up, the mortgage payments go up, and young Chinese need to think about that as well. There are no 30-year fixed mortgages. Interest rate adjustments are frequent.
Government control of the service industries means that the middle class – already quite large, with a little room to grow – is unable to grow much. From a consumption perspective, current middle class Chinese are already living about as well as they can.
Whether China can become the moderately prosperous society that Mr. Xi envisions will depend upon the ability to transform the lives for more of the hundreds of millions, in small towns and rural areas, who have not yet grabbed a bite of the golden apple. This will be tough. Factory jobs don’t pay that well, and they will not be growing in any case. The service sector jobs that college students want are not in great supply. The demographic collapse will help employment for those in their twenties, but just the number of college graduates is still much greater than the number by which the employment base falls each year. No increase in net exports is going to be available to offer jobs in logistics and transportation. Shopping malls are hurting, as in the US, from online sales. The hukou still restricts rural people from the big cities where they want to go to find work. Being young in China right now is a tough gig.
Being a young woman in China is a tougher gig. There is intense pressure to be married by about age 27, even though millions of Chinese women want to be independent and live their own modern lives. When they do have a child, they are caught between the two sets of grandparents who want to dominate on the one hand and themselves be taken care of on the other. Young Chinese men have it a bit easier, but there is still the pressure to marry, and the culture now demands a house, a car, and money in the bank before a girl will commit (same viral video, with English subtitles, last in series). “Leftover women” who demand proof of assets over proof of love, who don’t need a man to provide, are a phenomenon. That, plus the phenomenon of 30,000,000 extra men from selective abortion of female fetuses and the one-child policy, means that many men will not be able to produce offspring for their ancestors.
Andrew Batson of Gavekal Dragonomics has made the argument that it may be too late to reverse the over-concentration of elite education in China. Beijing, Hubei, and seven coastal provinces overwhelmingly dominate top tier university education in China. It is not so easy to go to a school outside one’s home province. It can be done, but not so customary. Batson argues that it might be better to focus on improving schools in much of rural China, rather than infrastructure, which is already pretty good. But as an economic development tool for the Xi program, improving schools is far too late. That is a couple-of-generations project. Think of this as having to improve schools in rural America, or even schools in poor neighborhoods in New York or Chicago. It is not just access to expressways and airports, and not just access to jobs. It is a cultural makeover.
A related piece by Andrew Batson recounts data from 2010 showing that secondary education in China runs far behind the OECD average. Scott Rozelle, co-director of the Rural Education Action Project (REAP) in China, has written extensively on rural health and education. His 2014 series Inequality 2030 documents the health, education, and welfare for rural children in poor provinces in China. Rozelle reported on families in one village that would not change their feeding of rice tainted with heavy metals to their kids – “we ate rice from the same fields … no need to change now.” Not a hopeful series, despite huge government spending on food and health care. Sounds a bit like eradicating urban and rural poverty in America. And as China transitions to a tertiary sector economy in services, the millions of farmers and rural factor workers will be left behind. Not much opportunity for them to upgrade skills.
Challenges facing all of China, not just Mr. Xi
What are other political challenges facing China now - apart from the debt overhang, which is real and very worrying for the elite, and environmental problems, and lack of generalized trust in society and lack of a defining national sense of the Chinese dream – Marxism no longer works, getting rich is passe, religion is forbidden, even cultural belief in the wisdom of leaders – aside from all these, what else is there?
There are a lot of divisions, deep and acute. Divisions are provincial – half a dozen wealthy east coast provinces (and Chongqing) and almost everyone else - similar to US east and west coast (and Chicago) and the rest. Divisions are local - wealthy cities and impoverished rural. Divisions will be environmental – when the glaciers begin to feed less water to the Yellow and Yangtze, and the water starved north demands even more from water-abundant south - not so different from the Colorado River impasse, but with far greater portent. Divisions are on industrial safety – there are deadly chemical explosions every year. They are ethnic and religious – Buddhist Tibet and Muslim Xinjiang, mountain people in the southwest, Christianity and Han Chinese and avowedly atheist Marxism. They are political Confucianism and family-values Confucianism. They are traditional – personal autonomy in the context of family and modern personal autonomy to the point of personal sovereignty. They are moral freedom – ability to say and speak what one thinks and the real fear of demotion, loss of job, arrest, disappearance, or threats to one’s parents while you are studying in the US. The divisions might even become generational – as Barry Naughton said, China will grow old before it grows rich. Pensions and health care for the fast emerging masses of elderly will sap huge shares of Chinese government spending, forcing taxes up. China could have a “takers v makers” moment. Divisions may be between citizen and peasant – urban hukou and non-urban – over social support and health care for elderly in rural areas always outside of the government social payment system. As noted above, rural workers and migrants will not have much chance to move up the economic ladder.
The demographic boon of 1980 to 2010 has become the demographic bust, weighing down on economic growth. For at least the next twenty years, the Chinese workforce will be decreasing in size. Each year, that is millions of fewer people to buy cars, apartments, washing machines and all consumer products. Many of those empty apartments, bought on the come, will remain unoccupied, and provide little or no return on the investment. This, at a time when the government is seeking to increase consumption as the remaining stimulus to GDP.
Are there ameliorating circumstances?
In the Great Famine, 40,000,000 Chinese starved or were killed, and no organized revolution took place. That was a different time, without social media. But peasants in France and in Russia managed to organize revolutions without social media.
Culture is important. China has always been a rebellious society, but it has not been a revolutionary society. At every rebellion – save the Nationalist one circa 1912 – the new rulers always returned to the model of a single paramount leader, with an educated bureaucracy, and substantial local control. Even the foreign conquerors Yuan and Qing dynasties quickly adopted the traditional Chinese practices of public administration. The stability meme is as important in China as freedom might be for Americans. That works to the favor of CCP. No one wants instability or uncertainty. What change would be for the better?
The restive provinces – Xinjiang, Tibet, parts of Ningxia and Gansu; and of course, Hong Kong and Taiwan – present much danger to CCP. Draconian crackdowns do work, and threats of violence and control of communication put local disruptions out of mind for those outside. Simon Leys (Pierre Ryckmans) reminded us that no one living in a free society can reasonably understand what it is like to live in a repressive society. Threats can come from who you work for, or don’t work for. Or who are your friends and relatives. Now, threats to persons and their families in China are greater than at any time in the last forty years, and likely to continue. Threats continue because they work. By way of example, nine protesters in the nonviolent 2014 Hong Kong Umbrella protests have been sentenced - https://www.hongkongfp.com/2019/04/09/altruistic-selfless-motivation-hong-kong-court-hears-sentencing-arguments-umbrella-movement-9/ They face sentences of up to seven years for creating a public disturbance.
Religious and ethnic uprisings are tough to beat down in the long term. They linger, and unrest pops up in unexpected places – a bombing in Beijing, a stabbing spree in Kunming.
Most Chinese do not know of anything that is happening in Xinjiang now. The information blackout works pretty well. But when there are two or more substantial disturbances in different places – Xinjiang and Tibet, or Xinjiang and Hong Kong – it will become harder to muffle the news.
The story of Chinese exceptionalism works pretty well to establish a narrative of Han Chinese educating and lifting up the minorities, and punch down on ungrateful Chinese who refuse to be part of the mainland. The reeducation camps in Xinjiang and infrastructure investment in Tibet are not likely to warm those populations to Chinese rule, and further pacification efforts might become necessary at some point. The Belt and Road projects are also not likely to improve relations with Beijing very much, except at the leader-to-leader level.
Xinjiang, Tibet and Hong Kong might need additional Chinese troops to quell unrest. I am not sure how that would be received. Memories of Tian’anmen, long tamped down, will rise again. Chinese troop violence on Chinese citizens is anathema, but minority populations and Hong Kongers are now considered only ungrateful Chinese. China’s Muslim neighbors have said nothing to date in support of Uighurs in Xinjiang and the world seems to have accommodated to erasure of Tibetan culture.
Shanghai and Zhoushan, the island city adjacent to Shanghai, are building what is expected to be a world investment hub. Will that development replace elements of Hong Kong so that the “one country, two systems” is no longer necessary? Seems right to me. Direct action in any of these three areas – as we are seeing now in Xinjiang – severely damages China’s image in the world. Direct action on Taiwan, now threatened by Xi, would be worse.
The new technologies will not save the Chinese economy any more than they would save the US economy. The employment potential from the new internet companies is modest, and the industries appear to be mostly about oligopoly or monopoly rather than a competitive marketplace. The new technologies are mostly about services in an economy in which a lot of people are still employed making things or growing things.
The social credit score and related intrusions are accepted by most Chinese - again, along the lines of, “if you’ve done nothing wrong, no need to fear.” But these new measures do not improve trust in government. Nor do they improve prospects for most Chinese. Middle class Chinese are able to invest in themselves via higher education, travel abroad, broader relationships, investment in business or securities. The majority of Chinese are still unable to do that very well. Their investment choices are limited to bank deposits.
Pei suggests that the time for easy systemic or institutional change has passed and China entered the trapped transition a decade ago. Although China has ostensibly maintained a reasonable growth rate, it has done so mainly by increasing debt or leverage. A decade ago is when the great Chinese stimulus began, larger than the $800,000,000 American stimulus in the same year. A good deal of that stimulus ended up as debt owed for infrastructure, Party facilities, factories, malls and residential development that can not be repaid. You know the stories about ghost cities and shopping malls. I have been to several of them myself, in Shanghai and Shenyang. Banks hold the debt, rolling it over every couple of years, and wait. This debt is itself a drag on the economy, since it is money that cannot be returned to the bank and relent, and it is a drag in another way in that much of this debt will at some point need to be written off, which will show up as a subtraction from GDP.
This debt problem is real, but there is no reason to think it will cause any sort of market crash or tight money problem. It needs to be addressed, but it will not bring down the economy. Xi has promised radical reforms in finance and banking but has not delivered on his promise. The prospect of a Japanese-like stagnation is real. But because the party’s legitimacy depends on prosperity, such a scenario would be fatal to its survival.
Key to the transformation of the economy is to reduce reliance on investment, particularly infrastructure investment, to drive growth. China has been trying to boost consumption spending, the services sector, to allow reduction in investment spending for growth. It has worked a bit, but not nearly as much as desired. The services sector includes finance and real estate, and if you subtract those from the services sector, there has been no growth. And investment spending is becoming more and more like pushing on a string – the capital-output ratio has been falling for a decade or more. More and more investment leads to less and less growth in GDP, symptomatic of wasted investment. The useful projects – the expressways and airports and train stations and water transfers and dams - are mostly done. Household consumption, rather than savings, requires that households have trust in the future. Those middle class households, many of them CCP, most certainly are not feeling comfortable now. Michael Pettis has been writing on this topic for a decade now. Every post at his blog is useful reading. This one from 2016 explains some of the policy conundrums in detail.
There is another element of economic reform that cuts to cultural reform as well, and that is mistrust of outsiders and mistrust of investment in intangibles. We know about the mistrust of outsiders, thousands of years in the making. Stock market investments are intangible, but marketing and advertising and architectural services and mental health care and financial advice and a good part of a modern economy are intangible services. Many an American architect refuses to do deals in China anymore, having been burned on payment for fees. I tried for months to recruit an American architectural firm to join in a venture with a colleague of mine. The contract was already secured. No bidding required, just perform. I could not get any firm to express interest, and I tried five or six. The Chinese reputation for non-payment on services with foreigners was well established. What are you going to do, sue in a Chinese court? Hahaha.
The economy can continue to grow, but faces hard headwinds on IP and AI issues. China will have much success in converting the world to Chinese internet infrastructure that can be used for nefarious government purposes. For many foreign country leaders, that is a feature, not a bug.
A belligerent China faces hard headwinds from use of threats and economic power to force conciliation in Asian neighbors. Every Asian country, including Australia and New Zealand, has to decide how to respond to demands for Chinese access, including the AI and G5 issues. These are tough issues for all, and appear to demand choosing sides – us or them. Even for Australia and New Zealand, these are “should I stay, or should I go?” issues for western facing. And Chinese diplomats, using diversionary aggression, are promoting nationalism at home with their strident demands and outrageous behavior in international forums. The performance is for the home audience, to stir nationalist sentiment, but it is also as off-turning as anything from our own American dear leader. As a result, Chinese soft power makes no headway. Erin Baggott Carter, Professor at the University of Southern California, suggests that extra-aggressive behavior abroad is an indication of severe high level tension at home between Xi and the ruling elite.
Aggressive policy abroad is an opportunity for the elite to show loyalty to Xi at the same time as it stirs popular nationalism. Nationalism is the remaining outlet for political loyalty, and is now raised in every venue, schoolchildren in China and Chinese college students in the US. John Mearsheimer reminds us that nationalism is the strongest force operating in the world today.
Loyalties to an authoritarian leader are not deep. In my mind, Xi is not building a Xi faction with any durability. At some point, he may choose to designate a successor-in-waiting, as has been the case for transitions since Mao. But my idea is Xi’s successor will have as much power as Hua Guofeng, who took charge after death of Mao. Hua’s policy framework – whatever Mao said, whatever Mao did – did not last long. The long knives came for him within months, and his power was restricted in just over two years after Mao’s death. Deng, the architect of reform, gradually took power.
The post-Xi crisis will not be due to policy differences – greater social service spending in rural provinces versus tighter police and military crackdowns - but changes in personal and family economics due to Xi policies. The networks that control industries like oil and gas, or the criminal gangs said to be very influential in Chongqing or Jingzhou – will join together to prevent further destruction of wealth. A more intense crackdown on moving money and family out of China will suddenly lose effect, and a flood will resume. Of course, no one knows what will be the spark. But it will be personal, not political. At some point, peasants or minority populations in Tibet or Xinjiang will rush in to claim greater power. This will be the existential crisis.
The Chinese people are inventive, resourceful, and perfectly content to live their lives below the level of concern about middle income traps and national policy and politics. As long as life is getting better – even marginally better – CCP need not worry about growth of 8% or 6% or 3%. Much government attention will be paid in the next five years to improving conditions in the west, in rural areas of China. Improvements in health care, health insurance, school quality, and pensions for farmers will go a long way toward improving lives even if it does not improve incomes. I don’t know how much “success” that can have – even what success would mean. But attention alone is palliative. A lesson from history is that rebellions in China come from the peasants, not from the literati. Research on the Chinese middle class shows that while they might express some favoritism toward the vague concept of “democracy,” they know little of what that means and are manifestly unwilling to push efforts to achieve the inchoate idea.
A new post-Xi trapped transition
I disagree with Pei on part of the trapped transition as he has defined it. I see no reason for economic growth to be substantially limited by lack of democracy. Debt and social service needs and environmental concerns will slow growth, but that does not mean progress will stop.
Macroeconomist Wu Jinglian sees a transition to some form of democracy as necessary to future growth. I don’t see how that works. If anything, the disruption from a democratic transition would be devastating to the economy for a decade – as it was in Russia.
The official GDP statistic now hovers around 6.5%. Astute observers like Michael Pettis and George Magnus think the real number is about half that. A recent paper by Wei Chen, Xilu Chen, Chang-Tai Hsieh, and Zheng (Michael) Song, published in the Brookings Papers on Economic Activity, says that GDP has been overstated in the NBS figures by about 1.7% per year since 2008. We should keep in mind that if the real number is closer to 3% than to 6%, the economy is still chugging along, some damaged profits this year (2018 and 2019) and tariffs are an issue. There are deep concerns in Beijing, but no one is panicked just yet.
It has been understood for twenty years that the official GDP number is cooked. Li Keqiang said in 2010 that GDP numbers were man-made and unreliable. Sophisticated observers believe him. The GDP number is an input in China, not an output. Notice that the official numbers mirabile dictu match precisely the desired numbers in the five year projections from the Development and Reform Commission. Then think of how impossible it is for the best business forecasters in the US to come up with a projection one quarter ahead.
The use of cooked numbers is not the only GDP problem. All that bad debt that is never written down, but rolled over again and again, will someday be a real negative for GDP when finally accounted for. Think of the results when a large segment of the population stops smoking- people go for a walk instead of lighting up, GDP falls, but health outcomes improve. Fixes to water, air, and land pollution problems will be money not spent on infrastructure and debt rollovers, but will improve long term economic health. The point to remember is that GDP data from China is not only manipulated, it does not account for the excess investment and bad debt.
Another piece of fallout from the Xi era is the exit of foreign businesses from China. Manufacturing, in particular, seems to be fleeing. Jobs and exports will be lost, but the major effect will be to increase insecurity among workers across China.
The phenomenon of job loss is something relatively new. I recall the second international beer festival in Dalian, in 2008. There were tens, perhaps hundreds, of thousands of people in Xinghai Square, larger than People’s Square in Beijing, with beer tents and games and music. In the main tent, with a couple of thousand people, all drinking, listening and dancing to a German oom-pah band playing Beach Boys. (You can imagine how surreal this all is – “Little Old Lady from Pasadena” by guys in lederhosen and hundreds of Chinese dancing). Everyone was in a good mood, strangers dancing with strangers, girls dancing with boys not their boyfriend, beer flowing like water. Amidst all the frivolity, and disorder of such an event, I reflected on how this differed from what I think would have been the feeling of a similar event in Milwaukee or Chicago – lots of police presence, and there would be some altercation in the stands or on the floor, or tension from the motorcycle gang that took over a couple of the tables. I saw no police at the Dalian event, just happy people. It occurred to me that no one that day lost their job or got evicted, background that would not have been the case in the US. Now that feeling has come to China.
Now, with Minxin Pei, I see a trapped transition, but with a different set of characteristics. Mr. Xi has created a trap for CCP. He has created a tragedy of great Chinese internal power politics. He cannibalized the reforms of the last forty years in search of sufficient stability for CCP, and simultaneously poured gasoline on the fire of instability he sought to control. Succession rules are destroyed. Factions remain but are submerged. The only loyalty is to the core of the Party, Xi himself. In April, 2019, Xi dismissed Lou Jiwei, the highly respected macroeconomist who was head of the national security fund. It appears that Lou's misstep was to denigrate Xi's Made in China 2025 initiative. As Minxin Pei pointed out in Project Syndicate, a lack of experienced voices to express alternative views is dangerous in a strongman state.
Someday, post-Xi politics will come. The fear is that it will not come easily. The trap is how CCP will reorganize, reform itself when it faces cadres and citizens squirming under years of repression, during a time of slower growth and societal damage. Rebellion is a distinct possibility in the factional conflicts of succession.
It is now more difficult to imagine a stable CCP without Xi than it will be to imagine American politics post-Trump. Every year in China, the social difficulties and economic difficulties become more salient. The local fixes no longer work, as discipline comes to those who made the system work before. The country is becoming a cauldron. With repression and jackboot tactics, Xi is the plug holding back the open hearth furnace full of molten steel, ready to pour. When the plug is pulled, the hot metal will pour out. The heat suffocates. The sparks and flying ash are dangerous. There is no good place to stand within 100 feet. This might well be the CCP that pours out when Xi leaves.
Pei has outlined several theoretical transitions for CCP to democracy. Now, those seem as far off as ever. Francis Fukuyama sees the principal flaw in the Chinese system of governance s the “bad emperor” problem – without democracy, there is no defined way to replace a leader. This will also define the end of Xi.
Mao was the last strongman prior to Xi. The transition when Mao died was not violent, other than for the Gang of Four business, but there was no clear path and China had just come through three decades of famine, mass murder, and the Cultural Revolution. It was a time for harmony and coming together. And the stakes for leaders in 1976 were far lower than they are today, with enormously wealthy vested interests, strong factions that arise from conditions of geography and economics. Bloodlines and old village ties and Long March ancestors are things of the past. Modern factional interests are about money and power.
There will remain factions in CCP, even as Xi has tried to destroy them. (Dangers of factions to Xi are not dissimilar to the danger of factions to James Madison). But political parties are not the same as factions, and CCP must remain a united party. Evolution to a single CCP with well-defined politically approved factions seems not a possibility. CCP remains a Leninist party, in which leaders have the single truth for public policy. It would be bizarre, not to say, suicidal, to permit publicly visible dissension over policy.
Lucian Pye on Chinese culture, again – “… some political cultures are built upon traditional ideals that are disdainful of the spirit of competition and compromise basic to real politics. In some cases it is a problem of … an elitism based on presumptions of virtue and self-righteousness (as with the former Confucian cultures).” Pye says that the cultural concepts are obstacles to the ethic of responsibility that Max Weber identified as real politics, politics as a vocation – that is, in the ironic phrase from Mao, “serve the people.”
Xi has determined to create the moderately prosperous by 2020. This is meant to give peasants in isolated rural villages reasons for hope in becoming part of the China miracle. The timing reflects concerns about the rate of GDP growth, inequality, and corruption. All were reasons for failure of the Guomindang, the nationalist party defeated by CCP. In ancient terms, the Guomindang – which contained a commitment to democracy, by the way – lost the mandate of heaven by not serving the people. Like the Zhou replacing the Shang circa 1046 BCE, CCP remembers how they came to power.
Durability of CCP
Some insist with some justification that the Chinese people have resigned themselves to authoritarian rule. In the popular media, phrases like the “China Model” and the “Beijing Consensus” are used liberally to construct a seductive narrative of a developmental success story under authoritarian rule. If that meme were accurate, all it would indicate is that the Chinese people are resilient, not necessarily CCP. A better model for CCP is what I term a political Dorian Gray. Understanding that his beauty will fade, Dorian expresses the desire to sell his soul, to ensure that the picture, rather than he, will age and fade. The wish is granted, and Dorian pursues a libertine life of varied amoral experiences while staying young and beautiful; all the while, his portrait ages and records every sin.
Deciding that only full confession will absolve him of wrongdoing, Dorian decides to destroy the last vestige of his conscience and the only piece of evidence remaining of his crimes—the picture. In a rage, he takes a knife with which he murdered Basil Hallward and stabs the picture. The servants of the house awaken on hearing a cry from the locked room; on the street, passerby who also heard the cry call the police. On entering the locked room, the servants find an unknown old man stabbed in the heart, his figure withered and decrepit. The servants identify the disfigured corpse by the rings on its fingers, which belonged to Dorian Gray. Beside him, the portrait is now restored to its former appearance of beauty.
Obviously no one knows the end of the Chinese political Dorian Gray story. The beginning fits quite well. China looks prosperous, fit, energetic and powerful. The pictures below the surface tell different stories. Carl Minzner says China is now cannibalizing reforms taken over the last forty years. The picture will not get better if factions within CCP and divisions within China begin to eat deeper into the muscle of stability. Like with Dorian Gray, the rot eventually emerges.