Newsletter 132 - Why the Chinese economy is in trouble?

How bad is the economy

Since CCP took power in China in 1949, Chinese economy as under total control of the government. It was in stagnation in the 1970s.

In 1978, Deng decided to start the economic reforms.

First reform:

The first thing they did was to allow rural residents (farmers who did not own any land) to be in charge of their production, called “decollectivizing”. It was Mao who started collectivizing agriculture to ensure resources for his Korean war effort. The infamous three years of famine that killed tens of millions of people was a legacy of this policy, while most of those starved to death lived in rural villages.

Second reform:

Deng also reformed state-owned enterprises to improve the urban economy and finally allowed private companies to exist. A market-driven economy was born.

Third reform:

Deng opened up China to the world, to attract investment and technology transfer. This turned out to be the main driver of the growth of Chinese productivity.

And decentralization:

Politically, Deng also loosened central government holds on local government, allowing many different “experiments” as people started to learn to live in a new way of governing.

And the results were… stunning.

It allowed Chinese people to freely trade their hard work and talent in the market and with the world, and unleashed a period of high growth. Of course, we also need to consider that the starting point was very low, thanks to the first thirty years of brutal totalitarian ruling. Still, millions of people benefited from Deng’s “reform and open up” policy. At some point, everyone was talking about China taking over the USA to be the biggest economy in the world.

Back in 2015, Professor Joseph Stiglitz claimed that China was already the largest economy in the world by many measures. He was welcoming a new world order in which a China led the effort to tilt the rules of play to favour developing countries.

However, a few people insisted that the underlying problem of China would lead to an economic collapse. We discussed the debt crisis of local governments in newsletter 127, which was called “The Biggest Ponzi Scheme The World Has Ever Seen” by people in the West who know the Chinese system very well, as far back as 2018. To people like that, today is what they have been “seeing”.

The Economist just published an article: China’s economy is in desperate need of rescue (alt version not paywalled): so, instead of assembling the bad news from social media, I am summarizing the bad news from that article:

1. The economy grew at an annualised rate of just 3.2% in the second quarter —- below the 5% expectation, which is much lower than the double-digit growth rate China has enjoyed in the past. In comparison, the USA is expected to grow at 6%. If this new trend holds (very likely), there will be no talk anymore of China passing USA to be the number one economy of the world.

2. House prices have fallen and property developers, who tend to sell houses before they are built, have hit the wall, scaring off buyers. —- Real Estate, the number one driver of GDP growth and the cash cow for local government revenue, is in deep trouble.

3. China is suffering from deflation: consumer prices fell in the year to July. —- Zero COVID policy has ruined many businesses, so when the zero policy was abandoned, many predicted a consumption rebound, but it did not happen. Many people are saving for worse times and spending went down. As a result, domestic investment and loans are falling to the ground.

4. High unemployment rate for the youth (not covered by the Economist): in June, official statistics reported a 21% unemployment rate among urban youth (there are no such stats on rural youth, if you wonder why, consult our previous newsletter). This was before university graduates ended their student lives. The number in July must be terrible, but we will never know because the government has decided not to publish it.

5. America is shunning exports from the country and restricting investment in it. Chinese exports shrank by 15% in July compared to one year ago.

6. Foreign direct investment all but vanished in the second quarter, falling by 87% year-on-year to 4.9bn USD, as multinationals repatriated their earnings rather than reinvesting them. Overseas funds have been fleeing the mainland market : offloading the equivalent of 10.7 billion USD in a thirteen-day run of withdrawals through Wednesday, the longest since Bloomberg began tracking the data in 2016.

You might have read about Evergrande seeking bankruptcy protection in the USA, and Country Garden (a real estate developer larger than Evergrande) failing to pay its workers, after defaulting on its debt. Or big Chinese trust funds failed to pay interest to its investors.

Other news on Chinese social media that you might have heard about: a prominent company that helps rich Chinese to get investment visas in the USA is under investigation, its founder arrested and its client data taken by the government.

The government is also cracking down on corruption in the medical sector, forcing doctors to give back bribery money to the government going back 20 years. According to Chinese social media rumour, one province just ordered each ordinary doctor to give back 200,000 RMB (around 24k USD)to the government, while each senior doctor must give back 500,000 RMB (around 68k USD). The provincial government collected tens of billions of RMB this way, without any legal procedure. Nation-wide, according to Singapore media, 168 chiefs of hospitals have been taken away for investigation of corruption. The scope and intensity of this anti-corruption campaign is unprecedented and shocking.

According to Lilaoshi, the best hospitals in some big cities have reduced operations so that doctors can avoid the very strict scrutiny from government officials, just as expected. While some public welcomed the government’s effort to crack down on corruptions, many consider it as yet another way for the government to collect money from society.

How the Chinese system works

There is one characteristic of the Chinese system that determines everything else in the economy: all of the land in China is owned by the government. There is no private land. When people buy a home in the city, they buy 70 years of right to use it. They don’t own the land. What happens when the right expires? No one knows, since private home ownership only started in the 1990s.

The local governments have the power to sell the usage of land, and since they are the only owners of this commodity, they can dictate the price. During economic booms, many developer companies seek to buy land in the jurisdiction of the city governments. For every local government, selling land is their main source of revenue. In 2021, at the peak of the real estate market, 60% of local government revenue came from direct land sale or taxation on land.

This revenue is also the financial source of infrastructure building in China in the past 30 years that, in turn, fuelled more economic growth. Local government officials engaged in a positive feedback loop of Economic growth, which makes land attractive to developers, which means more government revenue, it then builds better infrastructure to attract business investment, and that results in more economic growth…

This is why the crisis of the real estate market is very fundamental to the economic crisis. But why the real estate market is in trouble now?

Two reasons: low fertility rate (we have discussed the issue in newsletter 127, where estimated births for 2023 are to be half of the births of 2016), and the scar of Zero COVID policy (not only business suffered from the policy, but individuals felt insecure and less likely to make big investments, like buying homes).

When the government only cares about the home buyers paying their mortgage, but ignores their grievance when the developers do not deliver the completed buildings, consumer faith in the real estate sector is at all-time low.

With the housing price going down, consumers have more reason to wait and see. No matter how the government tried to stop the price from going down, by explicitly forbidding the developers to lower sale prices, no one is buying. As a result, developers could not pay their debt.

As big as the Chinese economy looks, inequality in China is also very big. Li Keqiang, the former prime minister, once stated in public that there are 600 million Chinese whose monthly income is less than 1000 RMB (137 USD). COVID plunged more Chinese into poverty, and Xi Jinping never give out any money to help people during the COVID crisis, unlike Western countries. High youth unemployment rate shows that young people will definitely do worse than their parents.

When local governments were making massive amounts of money selling lands, they spent some of the money on infrastructure building, some to build luxurious government facilities, and some went to overseas bank accounts for their families. Local governments also accrued massive debt (using land as collateral), a legacy from the 2008 fiscal stimulus package. While the Chinese central government has very little government debt, local governments are all deep in debt, so they have no money to hand out to help their residents.

Why Xi has no interest in helping the economy

Xi is loaded. He spent huge amount in military building: an estimated 700 billion USD for 2022 (the USA military budget was 876 billion USD in 2022). And he also just pledged 10 billion USD at the BRICS summit for global development. (Although, this is just a pledge).

Many people think he should help the Chinese economy. Ray Dalio wants the central government to help with the local government debt. Wall Street Journal gives out a whole package::

The most obvious solution, economists say, would be for China to shift toward promoting consumer spending and service industries, which would help create a more balanced economy that more resembles those of the U.S. and Western Europe. Household consumption makes up only about 38% of GDP in China, relatively unchanged in recent years, compared with around 68% in the U.S., according to the World Bank.

Changing that would require China’s government to undertake measures aimed at encouraging people to spend more and save less. That could include expanding China’s relatively meager social safety net with greater health and unemployment benefits.

But, WSJ continues, Xi hates this:

Xi and some of his lieutenants remain suspicious of U.S.-style consumption, which they see as wasteful at a time when China’s focus should be on bolstering its industrial capabilities and girding for potential conflict with the West, people with knowledge of Beijing’s decision-making say.

The leadership also worries that empowering individuals to make more decisions over how they spend their money could undermine state authority, without generating the kind of growth Beijing desires.

Another reason that Xi won’t help the economy is that he detests the welfare system. He, like most Chinese elites, believes in the “Welfare makes people lazy” doctrine.

Look at him, all hard working, nothing else, and surely nothing from his father and from the fact that he is a princeling.

Reagan’s trickle-down theory is still very fashionable in China. The government will give loans to big companies to generate jobs, but will not help the health insurance system and pension fund, both are just ticking bombs. But with consumer demands so weak, most of the company will put the money in the bank.

That is why people see no hope in China’s economy.

What will happen

The most likely scenario for China is economic stagnation like it had experienced in the 1970s. Ordinary people will suffer, already, young people are doing much worse than their parents.

China will almost surely attack Taiwan, one of Xi’s ambitions, which will prompt Western countries to close their doors to further technology transfer, economic cooperation (see the sanctions on Russia after it invaded Ukraine). Xi has prepared himself for the coming conflicts with the West. Many people with means are trying to flee the country. But still, many more are happy to stay. Whether China is in imminent danger of shutting its door to the world again (see newsletter 88), people have different opinions.

This makes me want to tell you the story of a famous Chinese writer, Eileen Chang, who fled China in 1952. Like many writers in China in 1949, she was courted by the CCP officials. She was invited to visit the countryside and see the land reform first-hand. Many of her fellow writers churned out propaganda essays, that became famous works I learned while growing up in China. Eileen Chang, instead, decided to make an excuse and ran away to Hong Kong, then moved to the USA.

She did turn her observations of the land reform into novels, The Rice Sprout Song, and Naked Earth. In these works, she describes the hunger the farmers suffered at the hands of the local government. Yes, unlike other writers, she saw the hunger of the people.

Most of the other writers were later severely humiliated and punished during the Cultural Revolution, some committed suicide in the 1960s. Ms. Chang lived until 1995, almost 30 more years of life of freedom.

You might not have heard of her name, but you might have seen a movie based on her novel, Lust, Caution. If you have not seen the movie, lucky you, you are in for a treat!