Dire straits

What next for China and the world?

A conversation that I have with some regularity these days begins when someone mentions China. One of us will bring it up, and we’ll both kind of let out a whistle as we mention all the things that seem...troubling about its current state and then we each shrug and, statistically, go buy stocks with tons of exposure to the Chinese economy. This insouciance is partly a product of the fact that China’s growth miracle has looked unsustainable for quite a long time now and yet it has been sustained—to such a surprising degree that it becomes hard not to attribute to Chinese leadership some remarkable, even preternatural, skill in the field of macroeconomic management. (Call it the “every little thing Xi does is magic” factor.) 

But to just assume that China will somehow defy the constraints which bind every other country is lazy analysis. Things can’t go on as they have, the end is very probably nigh, and the consequences for the world of the Chinese economic reckoning cannot help but be world historical.

Current doubts about China’s economy have of course been fed by developments in its property sector. Construction and real estate have in recent years come to account for a massive share of Chinese production. Ken Rogoff and Yuanchen Yang reckon the contribution to GDP is 29%, once connections to other sectors are taken into account, but even if that estimate is massively overstated the role of property in the economy is sufficiently large that a sharp slowdown in construction and sales must matter quite a lot. (In a very nice piece for the employer, my colleague Simon Cox explains why the actual figure is probably closer to 23%.) If a chunk of the economy that large suddenly contributes far less to GDP than it used to, then either something must be found to make use of idled resources and fill in that lost production, or else resources will remain idle and production will fall. 

How easy will it be for China to fill that hole? If China were a normal country which aspired to nothing more than being like other rich countries, the answer would be: not particularly easy, but—with sufficient commitment to reform—manageable. The government would have to do some financial-sector clean-up to address insolvencies related to the property sector. Beyond that, the policy prescriptions are mostly familiar. The economy needs to rebalance, such that it produces more goods and services for domestic consumption, and relies more on domestic demand. To get there, it needs to pull way back on state involvement in the economy while also building up its social safety net: so you get more money in the hands of households which consume more because they feel less need to engage in precautionary saving, and you have a flexible and responsive economy which caters to consumer needs. And the government should place fewer demands on foreign investors and open up the capital account more, and so on.

But China isn’t a normal country and whatever approach it takes to resolving its property problems will look almost nothing like what other economies in similar situations have done, or what the boffins at the IMF reckon is the correct course. And because China is not a normal country, the challenge that its real-estate woes pose to the system as it is currently structured is a particularly unsettling one. 

You may have read that the Chinese government is pursuing a “dual circulation” strategy, which involves something like continuing to participate fully in global supply chains while also doing more to encourage domestic demand and consumption. This seems, superficially, as though it might entail something like the reform China needs to rebalance. What it’s up to is actually considerably more disconcerting. China’s government is indeed working to build up various domestic capacities, for a few reasons. First, it is determined to become as self-sufficient as it can be, which means that it doesn’t want to rely on other economies for critical goods and inputs to production. Strengthening domestic demand is a part of this broader push, because reliance on foreign demand is a vulnerability. The other side of the coin—the international circulation—is also purely strategic. If engagement with foreign firms can help China build up its domestic capacities, through tech transfer and direct investment, then that’s great. More importantly, the more dependent foreign firms and economies are on Chinese production, the more leverage China enjoys. 

Why is China pursuing this strategy? There are more and less encouraging possibilities. On the (only relatively) benign side, China is merely reacting to hostile trade actions by other economies, especially America, and is protecting itself against future interventions by rivals which wish to interfere with China’s rise or exercise influence over its domestic matters. The meaning of this interpretation is something like: so long as other countries don’t make a fuss about Xinjiang or Hong Kong or industrial subsidies and let China do its thing, other countries have nothing to fear. This, to be clear, would not be an especially happy place to be. It means we are in a world in which the by-some-measures most important economy is moving toward self-sufficiency because it would like a freer hand to place members of ethnic minorities in camps and squash political freedoms.  

But there are also other, not-so-sunny ways to see China’s actions. Xi seems very interested in reestablishing control over Taiwan, for instance, and the more dependent China is on foreign economies, the bigger the economic cost it will pay for taking actions which are likely to result in a cessation of trade with the rich world: actions like invading Taiwan. 

Or, more broadly, China may have come to the realization (one which continues to elude much of the intelligentsia in the West) that there can be no deep economic integration between countries with wildly different political and value systems without cultural cross-contamination, and China is not interested in importing more Western values and ideas. In other words, there are three potential outcomes which may result from deep economic ties between China and rich democracies: China must become more liberal and democratic, rich democracies must become more authoritarian, or the ties must be broken. Now, a little patience on the part of the Chinese government could potentially have paid off here. America has been importing Party-friendly speech norms, and many top executives have more or less mastered the behaviors expected of the corporate brass within China. 

But the course of events seems such that patience is not an acceptable option. That is partly down to the pandemic, which appears to have accelerated China’s withdrawal from the world. The zero-Covid policy pursued by the government, and the onerous entry restrictions which have gone along with it, have made life incredibly difficult for anyone hoping to jet into and out of the country to keep an eye on critical pieces of their supply chain or other such things. But the state’s enthusiasm for insularity goes beyond what a zero-Covid strategy requires. Xi could travel abroad if he wished, but he very pointedly has not. That is legitimately quite worrying given that the state has also been cracking down on dissent within the country and making life extremely difficult for foreign news agencies. China was never free, but it is now closing itself from outside influence to an alarming degree. 

The clock is ticking in other respects as well. It is slowly dawning on a number of large, significant rich-world firms that their investments in China are highly exposed to geopolitical risks. These firms have to tread extremely carefully; they need to hedge their exposure to China, but they also have to do it very carefully and quietly lest they invite various forms of retaliation by the Chinese state. Given enough time they’ll manage it, and China will have lost a very important source of leverage over its rivals. But they haven’t yet, which means that—for now—there is a pain point China can press which stands to really hurt the American consumer, and really make the American government reflect on what an appropriately calibrated response to a Chinese provocation might be.   

But above all there is the property problem. A sharp contraction in construction and related activities cannot help but blow a large hole in the Chinese economy. The government may move more forcefully to limit the size of the contraction, by easing up on its regulatory red lines and loosening credit, but this will only do so much. At the end of the day Xi isn’t magic, we have some idea how property busts after epic booms go, and it will take a heroic effort to prevent the Chinese economy from experiencing its worst growth performance since the 1970s. The other reliable stratagem—massive infrastructure investment—cannot do much to help either. China is a really big economy now, which has already absorbed massive amounts of infrastructure investment over the past decade. It is very difficult to see how the government could spend enough on worthy projects to fill an appreciable piece of the property hole.  

There are other routes out of this mess, but they all involve movement in a direction exactly opposite the one the Party wishes to take the country. And so the place in which we find ourselves is a very uncomfortable one to contemplate. It is hard to imagine, given Xi’s ambition and the expectations he has set, that the state would simply allow the economy to limp along for a period of years. And yet we have arrived at a point where it looks as though the only alternative to that outcome is a radical leap toward liberalisation and opening up: and the complete abandonment of Xi’s major policy aims. If neither of those are acceptable to the Party leadership, then one has to wonder what it is that comes next.

It is very difficult for those of us who have grown up in rich democracies to understand quite what animates Xi and his pals. I didn’t live through the cultural revolution, I haven’t been steeped in narratives of historical grievance, and neither does it seem to me that China’s rise would have been impossible had it not been for the superior management skills of the Party leadership. I look at a country like Japan, which is rich and democratic and peaceful and innovative and influential, and I wonder why its fate wouldn’t count as a perfectly acceptable one for a country like China. Or indeed a grander one; if China were peaceful and democratic, with an income level similar to Japan’s, it would wield massive economic and cultural influence not only in Asia but all around the world. Most countries would look to China first, not America, and most of those that looked to China first would probably do it happily. But the Party stands in the way of that, and I worry that the Party must be soundly, decisively discredited before it can be displaced.

Would China really invade Taiwan, or take some equally rash and earth-shaking action? It is, honestly, hard to believe that it would. The potential pay-off seems so incredibly small given the potential costs. But there are a few reasons why a gamble like that seems a realistic possibility. One is that as China withdraws from engagement with the world, its leadership receives worse information and does a worse job analysing that information. 

Another is that you can tell a story in which it isn’t especially costly for China. Perhaps Xi believes the political payoff to successfully taking Taiwan would be enormous, and that he would earn a much freer hand to do other dramatic things as a consequence. Furthermore, it isn’t clear that threats from America and others to come to Taiwan’s aid are particularly credible. Are we really prepared to go to war with China, at simply massive cost and at the risk of triggering nuclear war, over a small island 100 miles off its coast? Are we not much more likely to hit China with heavy sanctions, which may in the end come at a bearable cost, or perhaps even less given how much we rely on Chinese production? 

But of course we’ve said we will stand with Taiwan, which provides Xi with another reason to make a go of it. The more salient that particular metric—the status of Taiwan—is as a gauge of China’s power relative to our own, the harder it may be for Xi to resist an attempt to one-up America. And which society is more fractious and less likely to hold together behind its leadership in the face of a severe trial?

Yet in the end, the most compelling reason may be, simply, that there is no safe route forward, not now. The menu of options in front of Xi does not include the status quo ante, I fear, because the property-market engine is dead and the infrastructure cannon has been fired too many times and the world has had enough of China attempting to simply export its way out of crisis (and the Chinese economy is too big for that to be an option either). And several years of limping growth, well below what the Chinese have grown used to, alongside other hardships like a loss of housing wealth, could seriously threaten what Xi has tried to accomplish over the course of his tenure: the building of a powerful China, able to command respect and bend the arc of world history to its desires.

It still seems a difficult thing to imagine. But it isn’t as difficult as I wish it were.