The dark side of the China Story

From his perch in The City, a leading strategic analyst who prefers the pen name Samuel Pepys, looks at what’s shifting at the intersection of business, markets, economy and society. In this letter: a global supply crunch; an imploding credit-driven economic model; a new economic playbook

Samuel Pepys

[Image by Jason Goh from Pixabay]

China Behaving Badly

The world must prepare for the end of the greatest economic miracle it has ever seen

Sometime ago, I came to know of a cheeky brand called Elves Behaving Badly that sold Christmas dolls with an amusing back story. Apparently, these are naughty elves exiled from the North Pole that descend on British homes to snitch on boys and girls as naughty as themselves.

As a dad to a couple of little elves myself, I decided at once to buy those dolls this Christmas. So imagine my disappointment when told that a million eager elves wouldn't be able to make it to the UK this year as they’re stuck in China’s ports.

China? Weren't they supposed to come from the Arctic? Well, it turns out that the elves’ real home is the east, where they are birthed along vast assembly lines of the world’s manufacturing backyard. It makes no difference usually as they promptly arrive in time for Yuletide. But this time, something has gone horribly wrong and the ships can’t leave China. There are so few elves in Britain right now that doll vendors are considering the unpleasant prospect of rationing them to just two per customer. Santa Claus may receive only a thin report on British naughtiness this year, for want of enough home visits.

[Image by Photorama from Pixabay] 

I am not unique in getting my knickers twisted over a sudden shortage in things that I want to buy. Wherever you live, dear reader, you have been frustrated too. Virtually every product category and every country is suffering its own version of a global supply crunch. Volumes have been written about cancelled car orders in London, an endless armada of container ships waiting outside Los Angeles, missing iPhone 13s in India, Moscow restaurants starved of marbled beef and Australia's unbuilt homes amidst a shortage of timber and steel.

I am not going to bore you with the vagaries of just-in-time supply chains, nor am I going to dive into the underbelly of the current squeeze. But I would just like to point out a common theme occurring in most, if not all, of the shortages. Namely, China, China and China.

Surely enough, there are many reasons unrelated to the world’s most populous country that are tightening this choke. As economies reopened from Covid lockdowns, pent-up demand for goods all came out at once. Companies and commodity suppliers, which had battened down the hatches, didn’t have the surge capacity to meet the new demand. Millions of workers around the world had reassessed their life priorities and quit low-paying, hard-grinding jobs, leaving professions like truck driving severely understaffed. The world’s distribution backbone, the container shipping lines, got into a mess because they couldn’t scramble together the hundreds of thousands of boxes they had abandoned in remote corners of the world.

While all those myriad problems are true and serious, they’re also transient. The pent-up demand will be met, capacities will be restored and containers will be procured in necessary numbers. Salaries will rise in short-staffed professions and workers will return. Commodity prices will moderate and all the goods we covet now—cars to semiconductors—will once again be available on demand. 

But the China factor is a different story. It won’t vanish when this merchandise mayhem ends. And looking at the mess the Chinese are getting into, it may never go away.

The $15 trillion economy is undergoing a once-in-a-generation transformation that will recast not only the nature of its own growth and prosperity, but its role in the wider world and the rules of the game for anyone daring to do business with it. Given how far all of us have come to depend on China for our cheap phones and naughty elves, that change is going to affect all of us.

While China’s economy changes, the world’s view of it is also changing. Already, there are murmurs about the need for alternative supply lines so that our dependence on that one nation can be reduced. There are fears that everything we have gotten used to about China, from its heady growth to the ease of doing business, is gone forever. Worse, it is even possible that the next global economic crisis may not come out of New York or London, but from Beijing and Shanghai.

Perhaps, it is fitting that the elves are still in China. That’s where the most naughty are active right now.

Ticking Time Bomb

China’s credit-driven economic model is imploding

[Image by Free-Photos from Pixabay] 

One of the inconveniences of moving among London’s financial elite is that one is never beyond the earshot of some wide-eyed merchant banker or broker going on about the so-called “China Story.” With gusto and mind-numbing cliches, they lecture about the nation’s rise from an insular communist ghetto to the world’s second-biggest economic power. They can’t stop talking about how vibrant the society is, and how open the economy. They reserve their most effusive praise for the government. They call it terms like “practically a capitalist haven,” and “a one-billion BHP economic-reforms engine.”

But ask them about the dark side to the China Story and they look at you with greater abomination than if you had insulted the Queen.

Truth is, China’s growth is partly organic and partly stage-managed. To power extraordinary rates of GDP expansion, and keep them going year after year, its nominally communist leaders took some extraordinary risks along the way. After the disruption wrought by the global financial crisis, they opted to boost growth artificially with excess credit. The floodgates opened on borrowing to drive excessive investments. As a young population swarmed into the cities for jobs that didn’t exist before, the ranks of the middle class ballooned. They not only toiled on the factory floors to keep the world supplied with cheap goods, but they also turned into domestic consumers for everything from burgers to cars and condominiums. The economy was finely, if perilously, balanced. Expanding credit was matched by expanding demand, which in turn was fuelled by expanding jobs that the credit created in the first place. 

But the pillar of this growth model, credit, was not without its risks. As time passed, it started becoming less effective in producing economic growth. The International Monetary Fund estimated that in 2008, China needed 6.5 trillion yuan of additional debt to boost its gross domestic product by 5 trillion yuan. To achieve the same growth in 2016, the nation needed as much as 20 billion yuan. In other words, the marginal utility of credit is diminishing.

The IMF has called China’s economic strategy “dangerous with increasing risks of a disruptive adjustment and/or a marked growth slowdown.” Its research shows that China’s annual growth in recent years would have been smaller by about 2 percentage points without the excessive debt. 

There is hardly any room to borrow more. The domestic credit-to-GDP ratio, which had been stable at 170% before the 2008 crisis, ballooned to 335% last year. That’s a debt trap. The companies and even local governments that carry these borrowings can’t afford to see even a small deceleration in their revenues, which could severely reduce their capacity to repay.

China needs to deleverage, and do it fast. But Covid-19 has come in the way. The economic slump brought on by the pandemic has forced the government to loosen its purse strings and pump even more money into the system. Debt has been rising once more to rescue growth from the depths of the lockdowns.

For China today, debt isn’t merely a trap but a ticking time bomb. It can either reduce debt—which will inevitably slow the economy down—or continue to pursue credit-driven growth and risk financial instability. And the latter will also end in a sharp slowdown eventually.

Nowhere else is this Catch-22 more visible than in China’s property sector. After years of a booming market, real estate accounts for 16% of the GDP and 27% of all lending. About 70% of household wealth is locked up in the sector. Any shake-up in the property business, therefore, would severely affect national growth, spark a credit crisis and shrink consumer confidence. 

As if on cue, the natural levers of the economy are weakening. Its once-young population is ageing, changing consumption patterns. The Chinese Academy of Social Sciences forecasts the population will plateau at 1.44 billion by 2029 and then enter an “unstoppable” decline. The waves of internal migration are slowing as most people who needed to move from the villages to the cities have done so. Manufacturing is already the weaker part of the economy, taking up 50% of the debt but producing only 20% of the GDP. It may slow further with the loss of cheap labour. The changing demographics are also stalling the nation’s planned shift from a low-cost manufacturing hub to a high-tech and consumer-driven economy. The China Association of Policy Science estimates the phase of rapid increase in consumption is already over in China.

It is in this fragile environment that a debt crisis is brewing. Giant developer Evergrande Group hangs perilously on the cliff of a $305 billion debt pile and is almost sure to default without a government bailout. It is laden with thousands of unbuilt homes for which it has taken payments, and isn’t able to find new buyers that could fund their construction. It’s not an isolated case. Other developers like Fantasia, Sinic, Modern Land and Xinyuan are all close to default. China’s developers are the single biggest group of distressed borrowers in the global bond market today. 

China’s government will probably prioritize the welfare of homebuyers over the financial survival of these debt-ridden companies or their lenders. In managing the coming meltdown, it may accept its effect on growth and consumer demand. It may even make an example of Evergrande by allowing it to fail, and calling curtains on the phase of credit-driven growth.

On the brighter side, I hope, some of those pub-front storytelling by Cheapside China bulls may finally fall silent.

Crafting a New China

President Xi is throwing away the old economic playbook and writing a new one

[Image by Gerd Altmann from Pixabay]

I can plausibly argue that London, where I dodge life, has more at stake than any other world city in the continued success of China’s economic model. It is the home of the internationalization of the yuan, the crossroads where global equity investors meet Chinese companies via stock-connect systems, and the capital bazaar for its borrowers. It is also where Chinese money flows into to buy everything from local property to pizza shops and even our yacht brands.

Given that interdependence, a stalling of the Chinese economy is sure to send shivers down the collective spine of the city fathers. An end to the fabled “China Story” would have positively ghastly effects.

I am not arguing that an economic miracle nurtured over 42 years could be blown off by a mere debt crisis or an ageing population. Many have perished underestimating China. But the real concern is that a much bigger and far-reaching change has appeared on the horizon, with the potential to recast the country in a new mould not seen in our lifetimes. It will penetrate every sector of the economy, affect everyone’s life and change all the rules of the game. Its effects will be permanent, unlike the transitory turbulence of a debt crisis. It will change China forever.

Take it seriously, for it has been set in motion from the desk of President Xi Jinping himself.

Depending on whom you ask, Xi is creating a nation of his dreams, or his fears. In that utopia/dystopia, the State will control everything. The wealth of the rich will be taken and distributed to the poor. Every arm of the economy will work towards a “common prosperity,” brushing aside lesser motives such as profit and personal choice. People’s lives will be guided by communist principles. Television, sports, cinema, art, philosophy and even mundane things like how long children can play video games each day will be determined by the Party. Private entrepreneurship will be banned in some sectors like education. Foreigners will be allowed to bring capital, but only if they keep their means of production at the disposal of the State.

At this point, I have to pause and assure you that I am not writing futuristic fiction here. Neither am I imitating George Orwell. I am just collating reported facts on China’s changing vision under President Xi. 

The BBC called this putting “communist” back in the Communist Party.

Why is Xi doing this? After all, it is the economic policies of the past four decades that made China what it is today and promises to make it even more powerful over the next decade. Why should he kill the golden goose?

Theories vary, but my money is on Xi’s Supreme-Leader aspirations. He is already the most powerful man in China, but it is still a Party-dominated system. The president wants to change it to the Cult of Xi. He isn’t doing this to build any legacy for himself, but as a practical solution to his immediate problem. There’s a strong and active opposition that works against him within the Party and is looking for an opportunity to overthrow him. He needs to build a loyal following like the admiring multitudes that a Trump or a Modi enjoys. And to do that, he needs a powerful narrative he can sell. The possibility of a debt shock or an economic slowdown has only added to its urgency.

Combine this with the growing belligerence of China on the international arena and you can see Xi is preparing his country for a new Cold War. I see the recent decision by US multinational LinkedIn to shut operations in China as a sign foreign companies will gradually withdraw as they are choked by socialist prescriptions. An Iron Curtain could fall along the Himalayas, not just in geopolitical terms, but in business and trade terms. Countries that participate in China’s Belt-and-Road mega project or borrow money from it (like the African governments do) will have to pick a side. Us and Them. Perhaps that’s Xi’s design. 

Changes have already begun. Sector by sector, Xi and his comrades are issuing new regulations to change the way business is done. Technology has been the first victim. Alibaba, Tencent and others are waking up to the idea that Xi doesn’t want businesses to focus on consumer internet (with its obvious implications for information and free speech), but more “strategic” sectors like semiconductors. They have already committed tens of billions of dollars to the common-prosperity programme. That might delay, but not avoid, a fundamental change in their business models.

Such restrictions are spreading to more industries. China’s coal-dependent electricity producers are reeling under a price surge for the raw material on the one hand, and trying to adhere to the government curbs on user prices. The result, inevitably, is an expanding power crisis.

In a cruel irony, Tesla Inc., the corporation that’s ushering in an electric revolution in the automobile industry, was told a few weeks ago its own factory in China may face a power cut and may have to shut down for a while. One can safely say that founder Elon Musk wouldn’t have anticipated such a fate when he first decided to set up a plant in the country.

In real estate, house prices have been capped and strict limits imposed on how much debt developers can carry. “Houses are for living, not speculating,” the authorities say. But for companies like Evergrande that had built their empires on credit and a state-sponsored housing boom, it is nigh impossible to abandon that business model. Evergrande’s attempt to reduce debt by selling some assets only sparked panic among investors, who dumped its bonds and ran. 

These changes will eventually have ripple effects beyond China’s borders. A communist China is not one where Fortune 500 companies can operate freely in or Wall Street moneybags dabble in securities speculation. It’s not a country that will reliably supply cheaply manufactured goods at throwaway prices to our supermarkets. We will have difficulty selling anything to the Chinese too.

Perhaps this is an oversimplification of the conundrum that lies ahead. But China’s drift into communism is unmistakable and worthy of the world’s contingency planning. 

Meanwhile, back in London, the foreign-office mavens have been jolted by another shortage: that of President Xi himself. He won’t be attending the COP 26 Climate Summit due to start in two weeks at Glasgow. When the world’s biggest meeting on environmental action takes place, one-fifth of its population won’t be represented.

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