As the trade war between the U.S. and China continues with negotiations and an unclear outcome, questions are being asked in certain business circles as to whether China is still a good place to do business. While Western companies have been doing business in China for 40-plus years, the price of doing business has often been Chinese copying of technology and intellectual property. For decades, this was seen as an acceptable cost of doing business, given the size of the Chinese market and apparently stable political-economic system. However, China presents some long-term challenges that makes it advisable for certain businesses to reanalyze their strategic position in regard to whether the risk/reward trade-off is still the same as it has been in the past. This is not to say that a business should necessarily be out of China; only that certain challenges mean that the old risk/reward paradigm may no longer be valid.
In looking at China, it is important to bear in mind a couple of things. The first is that the Chinese government doesn’t see business and economic growth as something worth pursuing for its own sake as do many Western governments or cultures. For China, the growth is seen as a source of political legitimacy and national power. The second, related to the first, is that the fundamental social contract between the Chinese people and the governing Communist Party is that in exchange for submitting to autocratic rule, the party will provide prosperity. This makes a massive, sustained economic downturn extremely dangerous for the stability of the governing system.
In the West when there is an economic downturn, there is an election, often the old government is tossed out, a new one elected, and life goes on. In China, there is currently no mechanism for a peaceful transfer of power. This means that if the system ever loses legitimacy to the point that the Communist Party can no longer coerce compliance, China is likely to experience a violent uprising/revolution of some sort. Regimes that lose legitimacy to this point can experience instability ranging from massive strikes and protests until the government steps down all the way up to armed uprising. It is virtually impossible to tell in advance what path things will take, as much of it depends on actions taken by multiple actors under multiple constantly changing conditions. Suffice it to say that a country going through a wrenching upheaval is not one that is conducive to business-as-usual.
Given this, the primary question is, how likely is it that the political legitimacy of the Communist Party of China (CPC) will deteriorate to a level that would trigger massive civil unrest? There are several indications that the legitimacy of the CPC is on the decline, as well as some challenges in the future that are likely to further erode the autocracy-in-exchange-for-prosperity bargain.
(Note that the recent unrest in Hong Kong indicates a low level of governmental legitimacy. However, Hong Kong has a unique political history, which means that conditions there are not necessarily indicative of conditions throughout the rest of China. The danger for the regime is that the protests would spread to other cities, which could put the party control of the country into serious jeopardy. However, at the time of this writing, this does not appear to be happening.)
The first indication that things might not be well in China is there is some reason to believe that the economic growth numbers that the Chinese government has been presenting to the world are not completely accurate. Starting from 1989-2018 (according to Wikipedia), the average annual growth rate that the Chinese government has put out is 9.25 percent. Put another way, the Chinese economy is said to be more than 14 times as large as it was in 1989.
For comparison, the U.S. economy is only 3.6 times as large on a nominal basis than it was in 1989. While this by itself is not necessarily cause for skepticism, the fact is that China appears to have a system in which leaders at various levels are judged on the economic numbers that their regions produce. (1) This produces an incentive to get the “right” numbers and further incentivizes numbers falsification when the true numbers come in low. This virtually guarantees distortion of the final economic numbers in a positive direction. Even overstating the number by 1 percentage point over 30 years can have the effect of implying that the size of the Chinese economy is nearly a third larger than it actually is.
Earlier this year, several academics (Wei Chen, Xilu Chen and Michael Song of the University of Hong Kong, and Chang-Tai Hsieh of the University of Chicago) looked into additional (aka, harder to fake) data such as tax receipts, nighttime light intensity from satellites, electricity generation, railway cargo and merchandise exports to name a few. They estimate that China has been overstating its GDP growth rate by 1.7 percentage point since 2008. (2) Even assuming that the 2008 GDP numbers were accurate, this would imply that China’s GDP is roughly 20 percent smaller than what the Chinese government is saying it is.
Whatever the true size of China’s economy, it is clearly smaller than what is being portrayed by the government and the popular press. For a system whose entire legitimacy depends on providing prosperity, high published growth rates can for a time satisfy a population that has been promised prosperity with the image of that prosperity being visible in the near future, even if it isn’t currently here in the present. However, that game can only go on so long. When the people lose faith, the legitimacy of the entire system can be called into question, with resulting civil unrest.
One concern is that credit allocation in China is more politically influenced than in the West. This is not to imply that politics is the only factor governing the allocation of credit in China, but it is not an insignificant factor when viewed on an economy-wide basis. It is important to understand that the Chinese government views bank lending as a tool to attain the government’s political goals. Historically, whenever political rationality and economic rationality collide, political rationality virtually always wins in the short run and virtually always loses in the long run. Although the banking sector can, in theory, give loans to anyone, in practice roughly 75 percent of the lending goes to State-Owned-Enterprises (SOEs). (3) These enterprises tend to run in line with the state’s political goals, rather than what business/economic rationality would perhaps dictate. This implies that economically inefficient loans (i.e., bad or troubled loans), are much higher than would be the case in a relatively free and efficient capital market.
One example of this is in an effort to jump start their economies after the financial crisis, many regions in China turned to debt and started building infrastructure. There have been many stories in the West of “ghost cities” in China—vast urban areas that have been built up with no one living in them. This phenomenon has been somewhat over-hyped in that the Chinese have had a tendency to overbuild and then let the new “city” be inhabited over time. In some cases, a ghost city today may be a normal metropolis 10 or 20 years from now. That being said, some ghost cities are likely to remain that way, as a central planner doesn’t always get things right. In both cases, these developments represent loans that either won’t be repaid for many years or won’t be repaid ever. Consequently, these loans represent nonperforming assets that will act as a drag on bank balance sheets. At best, this can reduce lending capacity economy-wide, and at worst can cause the collapse of banks.
There is some indication that nonperforming loans may be reaching dangerous levels. While the government may downplay nonperforming loans as low, some of this this has to do with the differences in Chinese and Western accounting systems. Adjusting for this gives rates of nonperforming loans that can be three times (or more) as high as the official figures. (4) Some believe that the rates could be as high as 10 percent to 15 percent. If true, this would wipe out the capital base of the entire Chinese banking sector.
While some of this is pure speculation, the fact is that the structure of the Chinese political-economy is geared toward high levels of political lending. Some of the SOEs, well known for inefficiency, are kept afloat by loans that are likely to never be repaid. Because of the political incentive of keeping bad news hidden, the amount of bad lending currently in the Chinese financial systems is almost certainly much higher than the official numbers indicate. A collapse of the Chinese banking system would have global financial implications and would most certainly result in social unrest and the likely overthrow of the CPC. How close we are to this scenario is difficult to say, but it is probable that the system is closer than the government would like to admit.
While the preceding two highlighted challenges deal with more immediate issues, China is also facing a longer-term challenge with demography. Decades of China’s one-child policy have produced two challenges. The first is that China’s population is expected to peak in the early part of the next decade (some are arguing that it has already peaked) and decline from there. The second is that the cultural preference for male children has produced roughly 34 million more men than women in the country. (5)
China’s well-known one-child policy (since changed to a two-child policy in 2015) did accomplish its aim in slowing China’s population growth. However, what it also did was artificially create a “baby bust” (instead of a baby boom) that has resulted in a rapidly aging population as life expectancy has increased over the last 40 years. The effect of not having enough workers to fund the retirement system of the aging population, so well-documented in Western countries, is even more acute in China. Fertility rates in the U.S., Germany and France (three examples often cited to illustrate the challenges of an aging population) are 1.88, 1.43 and 1.98 per woman, respectively. China effectively had a fertility rate of 1.0 for 35-plus years. Furthermore, the U.S., France and Germany have at least some experience with migration that augments the population; an experience that China doesn’t share. In other words, as disruptive as aging populations are/will be to Western countries, it will be even more challenging to China.
In the case of China, the effects are likely to be even more acute than they might be otherwise, as China’s governing system is not as flexible as Western democracies. Whereas electoral fallout in democracies can result in policy shifts relatively quickly, changing fundamental policy shifts in autocratic regimes often only occurs after many years, and often only after the need for the shift is blindly obvious to even the most uninformed person. This means that potential problems are allowed to fester until they become acute, making a positive resolution difficult to impossible.
A further effect of a declining population can be that consumer spending slows as a population ages. Some have blamed Japan’s lost decades on a baby bust that started at the end of the 1980s/early 1990s. For a country where the legitimacy of the entire governing structure rests on economic growth/prosperity, this may be fatal.
No Girls Allowed
The cultural preference for male children has also had socially destabilizing effects. The first is that women born in the years immediately following the imposition of the one-child policy in 1979 are now reaching or have passed peak fertility years. This has means that any effort to boost the birth rate to offset demographic consequences are not likely to have the desired effect as there are simply not enough women to counteract it. Even China’s shift to a two-child policy in 2015 hasn’t significantly boosted the birth rate, and it is below the population replacement rate of 2.1 children per woman. In any case, Chinese society, culture and economy have shifted to the expectation and reality of one child over the last generation and a half. Societies, cultures and economies don’t shift suddenly simply because the government flipped a switch to a two-child policy.
An Aging System
While there is no scientific expiration date on any form of government or regimes, systems do historically tend to lose legitimacy with age. While a comprehensive description of why this is the case and how it happens is far beyond the scope of this article, systems in place for about 70 to 80 years start to show signs of instability, if they haven’t before. The Soviet Union lasted for roughly 70 years. China under its current regime is showing strains at 70. Even a country like the U.S., which is 243 years old, is home to the world’s oldest currently active political party (the Democratic Party) has had three periods of about 70 years each that were in many ways very different from each other. The period from the Constitution (1790) through the beginning of the Civil War (1861), the period from the end of the Civil War until the New Deal (1865-1935), and the post-war U.S. to today. At the end of each of these periods, the U.S. system was/is facing challenges to its legitimacy and/or loss of confidence within large segments of its population.
In China’s case, we are dealing with an authoritarian regime, and authoritarian regimes tend to be rather inflexible. In some ways, we likely only think of China as a flexible system because we are comparing it to the Soviet Union, which was extraordinarily inflexible. As the world changes and governing challenges change, authoritarian regimes (and even democratic regimes sometimes) find it challenging to react to them adequately. A regime that has been in place for decades owns whatever problems a country has. Whereas the Republicans and Democrats in the U.S. have alternated power over the last decades and can credibly blame each other for various problems that the U.S. has, the CPC has difficulty credibly blaming anyone else for its problems. It can point to malign foreign influences including the current U.S./China trade war. But many of China’s problems preceded Donald Trump, and many Chinese are likely to understand this.
Becoming More Autocratic
Since Xi Jinping was elected to the post of General Secretary of the Communist Party and Chairman of the CPC Central Military Commission in 2012, he has gradually been consolidating more and more authority in himself. Perhaps the most consequential of these was the elimination of the two-term limit for president, which would allow Xi to be president for the rest of his life. Other concerning actions include building a personality cult around himself in the manner of Vladimir Putin, Kim Jong Un and other dictators from history. Although no one would confuse China with having been a Western-style democracy before Xi, many in the West have assumed over the last 40 years that economic growth, prosperity and engagement with the international trading system would make China more politically liberal. This has not happened. And now, it appears that China is becoming more repressive.
In addition to consolidating power, China has expanded its surveillance state. Facial recognition software and surveillance cameras have become more widespread since Xi came to power. According to Wikipedia, by 2018 the Chinese government had installed over 200 million surveillance cameras across the country, which is 1 for every 7 citizens. It has expanded its already tight control over the internet. Users of China’s most popular message app WeChat can have their chats handed over to the government upon request (even if the chat has been deleted). The government requires users of the blogging site Sina Weibo to register with real names and identity numbers to use the site (or they won’t be allowed to post, repost or comment). Virtual Private Networks (VPNs) must be approved by state regulators and use state network infrastructure. Finally, China is developing a social credit system that combines capturing people’s activities and identifying them through facial recognition software. This information is linked to a personal credit rating so that the information is stored in a measurable and quantifiable way. Currently, participation in this system is supposed to become mandatory in 2020.
While there are many other examples that can be used, the government is tightening rather than loosening control. Thanks to technological advances, the Chinese state appears to be exerting maximum control on as many aspects of its citizens’ lives as possible. While there is a natural bias in most governments toward greater control, the extent to which China appears to be going betrays a regime that is feeling insecure in its position. A regime that is feeling insecure, especially one with as much information as China’s has, is indicative of a deterioration in the level of legitimacy.
For a company that is looking for a place to do business such as building a production facility, the size and permanency of the investment requires one to look and the long-term political, legal and social stability of the host country, in addition to the usual business metrics. Doing business in China over the last 40 years has always required the trade-off between cheap labor, political stability and a potentially large market on one side, and having trade secrets, technology, etc., copied on the other side. For countries as a whole, doing business with China has also often meant subjecting oneself to unfair trading practices, and in some cases, opaque accounting practices, to the detriment of its own citizens. While some of these factors were decried in many cases, overall the world (and the West in particular) has been willing to accept this trade-off.
However, it may be time to re-evaluate whether the trade-off still makes sense, particularly whether the Chinese system will be as stable over the next 10 to 20 years. The challenges that have been illustrated in this article have been festering for a while and point to a regime that is losing credibility and legitimacy. Regimes that lose legitimacy face unrest of some sort, although how serious the unrest is depends on many factors. One need only look at the Arab Spring revolutions a few years ago to see how things can play out differently. Tunisia transitioned relatively peacefully after 28 days of protest to more or less a democracy. Libya blew up, executed its leader, and is effectively in a civil war between two competing governments. Egypt deposed its dictator and held an election, the winner of which was later deposed by Egyptian military. And Syria has been involved in a bloody civil war that has completely destroyed it as a country.
The point is not to predict that China will undergo a civil war leading to the ousting of the Communist Party. But rather it is to point out that there is a wide range of possible outcomes when a government suffers a sufficient loss of legitimacy. These outcomes are virtually impossible to predict in advance, and that is the underlying problem. Making decisions regarding China is not a safe as it once was. Businesses should bear this in mind when analyzing their business options in China.