Xi Jinping has maneuvered the Chinese Communist Party into welcoming him as the nation’s undisputed leader with a tenure of unspecified length. Xi achieved that goal with the precision of a watchmaker. Cheered on early in his presidency by political and business leaders around the world, he launched an “anti-corruption campaign” that masked a purge of potential opponents in the party and government. While eliminating foes, Xi placed capable allies in key roles in state-owned enterprises, local political offices, and in the operation of the machinery of government. Xi has assumed the combined role of head of state, head of government (including the role of military commander in chief), and leader of the party.
All the while, he cultivated an image of himself as enlightened leader of the third way, quoting Abraham Lincoln in Davos; seeming to embrace liberal economics, including multilateral trade and commercial pacts; mounting a massive diplomatic campaign centered in economic development in his One Belt One Road initiative to develop greater connectivity between China and the rest of Eurasia; and establishing the People’s Republic of China as the dominant military counterbalance to the U.S. and its allies in Asia.
Xi insists that the world look at him and the PRC on his terms: as a force to be reckoned with, a growing economic power not to be ignored. This is perhaps Xi’s greatest achievement. Credible economic and foreign-policy analysts have published tracts on “the Chinese Century.” According to this analysis, the Chinese economy either already has taken over as the world’s largest (according to the International Monetary Fund) or will do so soon.
And yet . . . China remains a country riven by fault lines that make all of this impossible. In fact, President Xi’s greatest achievement is his mastery not over reality but over illusion. To create the illusion, Xi forces us to observe the foreground distractions — conspicuous urban wealth, global companies dominating their sectors, the largest banks in the world, military expansion, diplomatic energy.
That’s the China Xi wants us to see. By focusing on it, the world misses the reality of the China that is in the background: runaway public and private debt fueled by both the formal and the shadow banking sectors; aging parents and grandparents who lack support because their younger family members and relatives are too few, and because the working-age, younger population is proportionately too small to fund a strong safety net; rural poverty that rivals the worst found anywhere else, at a scale found nowhere else; and a “left-behind generation,” tens of millions of children whose parents have left to seek hope in the cities.
The challenges by now are too obvious to be ignored, even given the distraction of Xi’s foreground illusions. The allure of new markets and the concern not to to miss out on potential opportunities are powerful motivations for U.S. and European manufacturers and investors to ignore what lurks behind. But the cracks are there for anyone who chooses to look.
Start with what some call China’s looming “debt bomb.” China’s debt as a percentage of GDP has nearly doubled in ten years. The central government, local governments, companies, and households are dangerously over-leveraged. There is no obvious way to stop it. Xi’s impressive economic team has begun to tighten the availability of credit through the banking system. But, by design, the shadow sector is taking up the slack, to ensure there is no liquidity/credit trap of the sort that threatened to seize Western economies in 2008.
Local governments rely on the shadow sector to extend financing to real-estate developers and other companies, contributing to the by-now familiar story of so-called ghost cities, where empty malls and condo developments are a hallmark.
The dangers of the shadow system are complex and pernicious. In its most basic form, a relatively prosperous urban middle class is drawn toward so-called wealth-management financial products with promising yields, creating liquidity for the asset managers pushing these risky products, allowing them to lend at high returns to local governments, real-estate developers, and other entities unable to secure bank financing. While this activity takes place off the balance sheet of the traditional banks, there is linkage throughout the system. Banks often generate fees for creating the products and transferring them to non-bank institutions to distribute. I don’t want to draw too tight an analogy, but think of how households, the U.S. government, the banks, and Fannie Mae and Freddie Mac combined to create the housing bubble and collapse ten years ago: inflated asset values driving exotic financial instruments linking consumers to markets in ways no one really understood. That’s the dynamic driving the PRC shadow banking system.
This has led to over-borrowing, over-lending, and over-capacity. It is well understood, but no one really knows how to stop the cycle without creating a crash: a crash for the individual investors, for the creditors, and for the end users of the financing. Many of the same investors buying the financial products to seek higher returns are the ones borrowing the money to buy second apartments or to invest in side businesses. Local governments rely on the shadow sector to extend financing to real-estate developers and other companies, contributing to the by-now familiar story of so-called ghost cities, where empty malls and condo developments are a hallmark.
The size of this apparatus is uncertain, but it’s large and probably growing, even as traditional bank credit is slowing. Moody’s estimates shadow lending to be more than 80 percent of China’s GDP. Other estimates suggest that more than half of all credit in China is extended by non-bank entities, with trillions of dollars in lending. In its spring 2018 report on global financial stability, the IMF warned that, although “regulators have taken a number of steps to reduce risks in the financial system, . . . vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system.”
The government’s attempt to rein this in is an example of the PRC’s triumph of illusion over reality. High-profile attention has been drawn toward the government pressure to deleverage that is being put on large companies, including the highly acquisitive HNA Group (which fancied itself a Chinese version of Warren Buffett’s Berkshire Hathaway) and Anbang Insurance. These examples have been met by analysts and others as demonstrations of the serious of purpose with which Xi is addressing the challenge. But the underlying linkage between individuals seeking higher returns on bogus products and non-bank entities lending to bogus companies and bankrupt local governments continues more or less unabated. No one wants the economy to lock up, or asset values to crash, which is what would happen if the cycle were truly interrupted.
The challenges of the shadow financial system are linked to the other crises facing the PRC. The aging population contributes potential energy to the “debt bomb.” China is growing older on average. The population’s percentage of young people is shrinking. If demography is destiny, China’s future will be significantly affected by the economic implications of this challenge. The IMF estimates that that only about a quarter of Chinese workers contribute to the pension system, which is inadequate to the task anyway. Given the aging of the Chinese population, the population over 60 will approach 360 million by 2030, while the population of those 20 to 24 years old will decline to about 70 million. This is exacerbated by the delayed effect of the one-child policy, which has led to a dearth of marriageable women. So China faces a decline in the ratio of workers to retirees, from 5–1 to 2–1, in the next 15 years. This results in what is being called a 4–2–1 social structure, with one worker supporting two parents and four grandparents, given that the social safety net is inadequate. It’s not surprising, then, to see young people invest in shadow-banking investment products, seeking outsized returns to build savings.
Another reality obscured by the illusion of urban development and modernity is China’s massive rural poverty. The World Bank estimates that more than 70 million Chinese live on a dollar a day. Lack of jobs and opportunity has created an outmigration to the cities. Among the many challenges this presents is the left-behind generation of at least 60 million children, who must fend for themselves in remote rural villages. These children face profound health, educational, and emotional challenges, with a concomitant impact expected on China’s economic growth.
Xi’s power grab has shaken the developed world from its complacency; there seems to be an emerging consensus that China is not pursuing benign socialist capitalism or some third way. That’s a start.
Stanford professor Scott Rozelle has studied China’s rural poor for decades; he associates the left-behind generation with an “education apocalypse.” Rozelle calls it “the biggest problem China is facing that nobody’s ever heard about,” estimating that as many as 400 million future working-age Chinese “are in danger of becoming cognitively handicapped.” This is driven by malnutrition on top of underlying chronic health challenges, oversized classrooms where only the most capable children — a small percentage of the total — can command the attention of overstressed teachers, and lack of reinforcement by parents incapable of buttressing classroom learning at home. More than half of rural eighth-graders have IQs lower than 90, according to a report in Science magazine. There is no real answer to this challenge. What is obvious, though, is that its social and economic impacts will be staggering.
President Xi understands all of this in the broadest terms. He ties his crackdown on excessive debt directly to national security, acknowledging that rapid economic growth in the first decade of the century created dangerous conditions. GDP growth in China is slowing down, if it is even positive at all — we can’t be sure, given how opaque official data is. A slowdown of economic growth will only feed the problem of rural-to-urban migration, intensify the pursuit of outsized returns from risky investments by the urban middle class, and steal from the resources available to the government to create a social safety net.
It is impossible to know how this will proceed, but the dangers seem obvious. As with all practiced illusionists, Xi and the PRC will continue to try to keep the world fixated on the artifice in the foreground. We should expect further military adventurism, aggressive regional diplomacy, further attempts to be seen as the counterpoint to the U.S. on the global stage, further displays of power and authority by President Xi over the party and the government, and other illusions of stability and dynamism.
Paradoxically, Xi’s power grab has shaken the developed world from its complacency; there seems to be an emerging consensus that China is not pursuing benign socialist capitalism or some third way. That’s a start. Even as President Xi strives to keep the world, including his own people, focused on the illusion of strength and influence, the U.S. and other countries must, at the very least, recognize the reality of decline and despair. Ignore the illusion. Acknowledge the reality.