Will the China Bubble Ever Pop?

W estern China-watchers like to joke that there are more Marxists on the Harvard faculty than in the central committee of the Chinese Communist Party (CCP). After Deng Xiaoping’s “reform and opening up” in the 1980s, the CCP gradually put aside the heady theories of Marx and Engels in favor of practical, growth-oriented policies.

The departure from Communism ushered in an economic miracle: decades of GDP growth exceeding 10 percent annually, driven by low-cost exports and supported by state investments in industry and infrastructure. Adopting the model pioneered by Japan and later borrowed by the so-called Asian tigers, China increased its per capita GDP fiftyfold between 1979 and 2019.

But the road to prosperity is slippery. In the late 1980s, a credit binge induced by banking-sector liberalization led to inflation rates of more than 25 percent. Chinese authorities responded by reimposing price controls and credit quotas, pushing the economy into recession. The Tiananmen Square protests in 1989 displayed the dangers of concurrent political discontent and economic instability. For the Party hardliners who took the reins from Deng in the early ’90s, Tiananmen was evidence that Mao could not be entirely dispensed with: Economic liberalization had to be paired with political repression.

China now ranks among the world’s great powers but still stands on precarious footing: an unbalanced economy, a vast system of censorship and surveillance, and an antagonistic geopolitical landscape. For Westerners, this dual nature can be puzzling. Tom Orlik, Bloomberg Economics’ chief economist, calls it Sinophrenia: “the simultaneous belief that China is about to collapse and about to take over the world.” It is this paradox that underpins Orlik’s new book, China: The Bubble that Never Pops, which excavates the shaky foundation of the Chinese economy, finding as many sources of strength as causes of concern.

The most glaring challenge: mounting debt at the national, local, corporate, and household levels. While China’s national debt stands at roughly 40 percent of GDP, the Party ultimately holds the bag not only for sovereign debt but also for the sprawling liabilities of local party cadres, state-owned enterprises (SOEs), and financial institutions. A total debt-to-GDP ratio of 260 percent — as high as in the United States — more accurately reflects Beijing’s fiscal situation. Bad loans abound — some accounted for, others hidden off the balance sheet.

And debt isn’t doing what it used to. The state investments that fueled China’s rise now yield steadily lower returns: In the decade before the 2008 financial crisis, each 100 yuan of new lending would add 90 yuan to the GDP. Now, the figure is below 30 yuan. Party bosses throw low-cost loans into inefficient factories or vanity property developments — anything to create a semblance of growth. In an amusing passage, Orlik quotes the manager of a provincial power plant as saying, “We’re state-owned so it doesn’t matter if we make money.” Indeed, SOEs return a paltry 3.9 percent on assets, compared with nearly 10 percent for private firms.

Meanwhile, an inadequate social-welfare system, exacerbated by the social-engineering policies of the Communist era (the one-child policy and the hukou system regulating internal migration), holds down consumer spending despite rising incomes. Small Chinese families spend little on health care and education — big-ticket items in advanced economies — and, unlike Western pensioners, they must store a large portion of income away for retirement. The domestic savings rate of nearly 50 percent has thus far thwarted Beijing’s attempt to transition the economy from exports and investment to consumption.

The world’s largest Communist state thus faces the conditions of a classic Marxist crisis. Marx held that economic crises were an inevitable byproduct of the “contradictions” between capital and labor: The accumulation of capital spurs production, but perennially low wages mean that consumer spending lags output. Simultaneous overproduction and underconsumption steadily shrink corporate profits and GDP growth, eventually triggering a collapse. It goes without saying that Marx’s theory proves faulty in market economies, where firms eschew unprofitable investment. In fact, capitalist instability more often results from overconsumption (see 2008). Not so in China, where party bosses allocate capital in lieu of firms. Chinese president Xi Jinping, who enrolled in Mao’s Red Guard as a teenager, channeled Marx in identifying the principal contradiction of Chinese life as that “between unbalanced and inadequate development and the people’s ever-growing needs for a better life.”

This contradiction manifests in periodic emergencies. After the 2008 financial crisis, a collapse in global demand ground exports to a halt. For the trade-dependent Chinese economy, the crisis in the West posed an existential threat, pushing GDP down by 6 percent in the first quarter of 2009. China’s government enacted a 4-trillion-yuan stimulus program — dwarfing Western stimulus bills at 15 percent of GDP — most of which went to infrastructure and industrial investment. The spending program buoyed the economy, but at the expense of further entrenching economic imbalances and “opening a Pandora’s box of financial risks,” as Orlik puts it.

In 2015, the Shanghai stock market collapsed, erasing $1.6 trillion in wealth in a matter of days. With investment options limited by a closed capital account and heavily regulated capital markets, Chinese savers had resorted to speculating on equities, fueling a bubble that saw the Shanghai exchange more than double in a single year. When the Chinese securities regulator capped margin lending by stock brokers, the market went into free fall. Authorities halted trading in more than a thousand stocks before engineering a bailout. Thanks in large part to the CCP’s total control of the economy, the stock-market crisis, as well as similar meltdowns in Chinese money and foreign-exchange markets, proved manageable. But the Party’s interventions in financial markets postponed necessary structural reforms.

For Japan, which China displaced as Asia’s great power, a financial meltdown led to a spectacular decline. The collapse of Japan’s stock and property markets in the early 1990s set off a recession that permanently hindered its economy, leading to three “lost decades” of anemic growth. For China, no crisis has proven seriously damaging, but the memory of Japan looms large.

Orlik gives three broad reasons for China’s resiliency. First, it has significant room for “catch-up” growth. Unlike Japan, which stalled after reaching the living standards of the Western world, China remains a middle-income country with a per capita GDP on par with Mexico’s. Economic weaknesses, such as low consumption and a subpar social-safety net, represent potential “low-hanging fruit” for Chinese policymakers.

On the other hand, reforms would bring short-term pains that the CCP seems unwilling to withstand. Meaningfully pulling back investment and credit would bring down the high growth rates that Party leaders see as the basis of social stability. That Chinese steel producers boosted output during the coronavirus pandemic, just as demand plummeted, accentuates the difficulty of long-term restructuring.

But it also highlights Orlik’s second reason for China’s resiliency: the one-party state. Authoritarian rule allows Chinese leaders to stabilize the economy with relative ease, boosting investment and credit in bad times and closing the spigots of capital in good times. Zealous regulation has succeeded in bringing down debt levels and reducing “shadow lending” by non-bank financial institutions. Beijing’s industrial policy also enables it to support so-called national champions, such as the telecommunications giant Huawei, with subsidies and protective measures that give them a leg up in the global market.

And Beijing’s policymakers are gifted — the third reason for Beijing’s resiliency. The CCP has a clear long-term vision to move the economy up the value chain and increase domestic living standards. In pursuit of world leadership in technological innovation, Beijing pours nearly half a trillion dollars into research and development annually. With the help of technology transfers from the West, China stands on the cutting edge of technological development. The Chinese government now intends to develop its own “indigenous innovation,” as outlined in the Party’s blueprint for technological supremacy, Made in China 2025.

For all China’s strengths, successfully transitioning to a productive, demand-driven economy relies on the world’s willingness to tolerate authoritarianism. In the wake of the coronavirus outbreak, China’s trading partners have shown increasing hesitation to carry on relations as usual. The Japanese are paying businesses to leave China, and Washington has reached a belated consensus on the need to confront China. The technology transfer that long fueled Chinese growth will be more difficult to pull off as the world grows wary of China’s business practices. Huawei has already been cut off from U.S. technology, and many U.S. allies are blocking Huawei’s entry into their domestic infrastructure.

Orlik is right that Beijing can overcome its domestic weaknesses. But its increasing international belligerence, both economic and military, could unravel attempts to rebalance the economy. The guiding philosophy of the CCP since 1989 — that economic liberalization required the consolidation of Party power — may be its undoing.