by Peter Zeihan
Which doesn’t mean it will hold. Contemporary China faces three simultaneous crises, any one of which could undo all that it has achieved since the end of its civil war in 1950.
Problem One: The Financial System
China’s regions have little in common and do not naturally cohere. Getting nationalist, security-minded northerners to cooperate with the business-savvy central Chinese as well as the occupied southerners is not an easy task. And that is before you take into account that the interior is a chunky, seething morass of dissatisfaction or that the primary hub of the south is Hong Kong, until recently part of the free world.
China needs a social binding agent. It needs to be a strong adhesive and applied in huge volumes. Without it China not only spins out into its constituent fragments, but large numbers of its citizens tend to gather into large groups and go on long walks together. None of this is a surprise to the Communist Party. After all, its founders took advantage of China’s many regional and socioeconomic cleavages in their rise to power in the first place. Rather than deny contemporary China’s origin story, they instead have used the opportunities presented by Bretton Woods to forge a solution.
It comes down to money. The Chinese government starkly limits what its citizens can do with their savings. Rather than allowing a wealth of investment options as exists in the capital-rich American or British system, private savings are instead funneled to state goals in a manner somewhat similar to the German system. Specifically, there are very few banks in China, with some three-quarters of all deposits held in four large state-owned institutions: the Agricultural Bank of China, the Bank of China, the Construction Bank of China, and the Industrial and Commercial Bank of China.
Those four banks have very clear mandates. They are to use the citizenry’s deposits to maximize bank lending to the economy as a whole. The goal of the policy is a simple one: maximum possible employment. While this is technically a lending model, it is more accurately thought of as a system of subsidization. Since Chinese citizens have so few investment options, the banks have access to their deposits at rates that are ridiculously low. Consequently, internal interest rates in China are artificially held well below global norms and are certainly far below what they would normally be in an economy at China’s level of development.
Loans are available for everything. Want to launch a new product? Take out a loan to finance the development, to pay the staff, to cover marketing expenses, to build a warehouse to store output that doesn’t sell as planned. Find yourself under the burden of too many loans? Take out another to cover the loan payments. The result is an ever-rising mountain of loans gone bad and ever less efficient firms, held together by nothing more than the system’s bottomless supply of cheap labor and cheap credit.
The distortions this system creates are ones very familiar to all of us living in the contemporary world:
• The Chinese financial system subsidizes prices for finished outputs. This drives down the price of Chinese finished goods and allows their exports to displace most global competition. Normally such price crashes would induce producers to reduce output, but in China profits and even sales are not the driving rationale for business. Employment is. And Bretton Woods, by its very design, gives the Chinese access to a bottomless global market.
• The Chinese financial system subsidizes the consumption for inputs. In effect, the Chinese system doesn’t care whether oil costs $8 a barrel or $180 a barrel. Everything is paid for with borrowed money you don’t have to pay back anyway, so demand builds upon itself. Chinese demand is the primary cause for the drastic price increases of the past fifteen years in everything from oil to copper to tin to concrete. It’s not just happening abroad, but at home as well. The Chinese property boom is ultimately caused by huge volumes of loans chasing a fixed supply of a product, in this case housing.
• When you don’t care about prices or output or debt or quality or safety or reputation, your economic growth is truly impressive. China has achieved over 9 percent economic growth annually now for thirty years, elevating it to its current status as the world’s second largest economy.
• China has expanded so much that in some sectors its demand has swallowed up all that remained of several industrial commodities in the world at large, forcing its state-owned firms to venture out and invest in projects that otherwise wouldn’t have happened—LNG in Australia, copper in Zambia, soy in Brazil. Chinese overseas investments are a who’s who of what is technically possible but economically ridiculous.
• Finally, as cheap and plentiful as Chinese capital is, it isn’t available for everyone. Because the Chinese system is ultimately managed by the Communist Party and because the leaders of localities hold so much power versus the center, there is extreme collusion between bank management and the local Communist Party leaderships. This collusion funnels capital to local state firms affiliated with friends and family of the local governing elite, often depriving smaller—and typically more efficient—firms of the loans that they need to expand. The result is a system skewed toward larger firms that, from an employment point of view, become too large to fail. Any meaningful reform of the Chinese system will not only break the links between national and local authorities, but gut the very firms that are achieving social placidity.
So how big is this problem? Pretty big. In 2007, total Chinese lending topped 3.6 trillion RMB ($600 billion). How much is that really? Well, that’s more than total lending into the U.S. economy when the U.S. subprime bubble was at its maximum inflation, and that in a year when the Chinese economy was less than one-third the size of the U.S. economy. As the 2007–9 global financial crisis bit, the Chinese government discovered that demand for goods was collapsing on a global scale, with Chinese goods being no exception. In other countries, the drop in demand for goods forced companies out of business along with the expected impact upon employment levels.
Not in China. Following such a normal business cycle in China would have resulted in unemployment and social unrest (or worse). Instead of the credit crunch that the rest of the world suffered, Chinese companies were encouraged to borrow ever larger volumes, allowing them to finance their way through the downturn. Overall lending not only increased, it tripled in just two years. Normally, such a credit explosion would generate massive inefficiencies, bubbles, and other distortions that would be damning to an economy—but such problems were already embedded in the Chinese system, so the change didn’t really register.
Nevertheless, the Chinese government isn’t actively looking for problems, and it dialed back the credit expansion… or at least it tried to. Since the banks operate just like the rest of the country—on throughput rather than profit—they needed to keep forcing money through the system. The result was a proliferation of new methods of lending, ranging from bogus insurance policies to corporate bonds. None of these programs work in China the way that they do elsewhere. For example, in most countries, firms seeking to raise money issue corporate bonds that are purchased by interested investors. In China, the large banks issue bonds to each other and use the money raised to support their own phalanx of corporate customers. It is simply another means of force-feeding capital through the system to maximize short-term economic activity.
The various means of capital profusion had become so many and so lax that the government actually lost control of its own financial network. The government knew it had to somehow rein in credit, but it wanted to find a way of doing so that wouldn’t actually cause a recession, much less an economic crash and the unemployment that would go along with it. The government dared not risk changing the fundamental method of handing out credit, nor the large-scale absence of quality checks, nor the absence of due diligence. The “solution” was to issue a centrally imposed quota on bank lending every month. In most months, the quota was reached well before month’s end, causing the entire financial sector to seize up when the credit suddenly dried up.
This led to two outcomes. First, the central bank had to (repeat
edly) pump in emergency credit the day after the quota was reached, or else face the sort of systemic financial crash that U.S. subprime caused in late 2007. Second, banks, firms, and retail investors, appalled by the idea that the government might actually deny them credit because of something as silly as a lending quota, built their own financial network to run in parallel to the existing system. This shadow system includes everything from loan-sharking to financial products with even fewer quality controls than official bank lending (after all, they were formed expressly to bypass government authority). By the first quarter of 2013, China’s own central bank estimated that such shadow lending was exceeding all other forms of credit combined.
That puts total financing at around $5 trillion for an economy only worth about $8 trillion. Not only is that an absolute volume of capital more than seven times new lending in the United States, it is the equivalent of an Obama stimulus package (that’s $800 billion over two years) about every twenty-nine days.
Just as the United States meted out access to its market to bribe its way into the world’s largest ever alliance, the Chinese used finance to bribe both its often conflicting regions and ever restive populations into quiescence and even cooperation. It is a brilliant strategy, but it has limits.
Japan followed a similar system in the 1950s through the 1980s, eventually reaching a level of overextension that brought the entire system to its knees. In the quarter century since the Japanese crash, the Japanese banking sector has retreated completely from the global system, and the Japanese economy as a whole has not grown. Such stagnation is China’s best-case-scenario future. Unfortunately, it is also not a very likely one. The Japanese economy is largely domestically held and demand-driven, so while loose credit certainly helps, it is not the hedge against doomsday that it is in China. Additionally, Japan is over 98 percent ethnically Japanese, and over four-fifths of the population lives on the island of Honshu. China is considerably less unified regionally, ethnically, and spatially.
The United States even experimented with this system: the idea that growth and throughput were more important than profitability and a positive rate of return on capital. The result was a mess of graft, abuse, and unwise lending that created the failed company we knew as Enron, and the property bubble we now know as subprime. Both experiments created impressive growth for years. But such investments were geared to maximized throughput, not profits or efficiency. And so they collapsed. In essence, the entire Chinese system is subprime, in every economic sector.
Problem Two: Demography
But let’s assume for a minute that China’s remarkably unstable financial system holds together a bit longer. Something even worse is just around the corner. China’s one-child policy is often held up as the pinnacle of what can happen when a government is willing to pair demographic concerns with a complete disregard for individual rights. In a few short years, strict enforcement slashed the birth rate, preventing an estimated 200 million to 400 million births and heading off the overpopulation problem that policy makers so feared.
Now the success of that policy means the end of the Chinese system.
There are many legitimate criticisms of one-child. Forced abortions, the ability to buy government approval to flaunt the policy, the concept that the government can choose who can reproduce when, a massive sex imbalance in a culture that prefers sons to daughters—all these and more have twisted Chinese culture in awkward and painful directions.
But the real problem with one-child is that it worked. During the period from 1979 to 2003 when it was strictly enforced, the birth rate dropped by half. That slashed everything from health care to education to food costs, but it gutted the most recent generation. After three decades of the policy, there has been a European-style hollowing out of the younger segments of the population.
This presents China with three unavoidable—and system-killing—problems.
First, China is aging far more quickly than it is getting rich. At the beginning of China’s international resurgence in 1990, the average Chinese citizen was only 24.9 years old, and the country boasted some 350 million citizens aged fifteen to twenty-nine. It was this simple circumstance that allowed for China’s massive manufacturing boom in the 1990s and 2000s: China was the world’s ultimate source of cheap labor and no other developing country could compete with the Chinese on price.
Fast-forward to the present and, courtesy of one-child, the average Chinese is now 37.0, just a shade younger than Americans, who are currently 37.3 years old. The Chinese will pass the Americans in average age in 2019 and by 2030 will be 42.9 years old versus 39.6 for the Americans. The Chinese call it the 4:2:1 problem: four grandparents to two parents to one child. China is not yet wealthy enough to be able to try to afford a pension system like the advanced democracies, which places the onus of caring for the elderly on their descendants, of whom there are precious few. In terms of relative numbers, the financial cost of the one-child policy is more than double the comparative costs that the Americans face from the Boomer retirement, and the Americans already have a social security system in place to absorb some of the cost. The burden of having to financially support their elderly has a catastrophic impact on young workers’ professional and financial development, reducing educational opportunities, gutting consumption, and all but making savings impossible. In China’s specific situation, not only will this factor alone freeze in place China’s efforts to switch its economy from exports to internal consumption and stymie its efforts to move up the value-added scale, but it will also prevent the sort of savings that makes the force-fed-finance model possible in the first place.
Second, China will never be able to move away from its current export-driven model. Recall what roles each age group carries out in society from an economic point of view: Young workers do the consuming that generates economic growth. The last baby boom that China experienced was in the 1980s just as one-child was picking up, and China has suffered from an intentional baby bust ever since. Those boom babies are now aged twenty-five to twenty-nine and are very visible as a bulge in China’s population pyramid. It may be only a five-year increment, but it represents about 125 million people. This group’s consumption is the primary reason why China appears to be succeeding somewhat in its current efforts to switch from an export-led to a consumption-led economy. But—again, courtesy of one-child—their successors are ever smaller population cohorts. So congratulations are due to China for having impressive consumption growth in recent years, but that consumption growth has never beat out investment/loan-driven activity, and is now nearly played out.
Third, so too is the Chinese development model. Simple aging has already reduced China’s pool of young, mobile workers by over 40 million during the past decade. And because of the baby bust, that decline is about to accelerate greatly. Put simply, China has run out of surplus labor; its presence on the low-cost side of global manufacturing has run its course. This is already reflected in Chinese labor costs, which have sextupled since 2002.
Looking forward just twenty-five years, China faces a far darker financial future than Europe and a far darker demographic future than Japan.
I normally caution people I speak with about drawing forward linear trends—for example, the idea that China, or before it the Soviet Union or Japan, will soon rule the world. But demography is different. Young workers simply do not magically appear. They have to be born and raised. It takes twenty years to grow a twenty-year-old.3 Changing a demography requires a broad-scale shifting of cultural and economic trends, and then holding the change for decades. Simply abolishing one-child is only one step of the process. China would then need to encourage the young workers who are crammed into apartment housing to produce multiple children while still working and taking care of their parents (and grandparents). It would have to build out an entirely new series of social services in health and child care whose absence provided the spare capital that helped make China’s manufacturing boom possible.
Even if we
assume that China can pull this off and an immediate abolition of the one-child policy leads to an immediate doubling of birth rates—which would be unprecedented in human history—it would still be two decades before China would begin to benefit from an expansion of the labor pool in any significant manner. That’s two decades during which the rest of the Chinese population would still be aging toward retirement. Two decades during which China won’t have much internal consumption going on. Two decades during which the low-cost, export-led model would still not work.
Problem Three: Dependency on America
And of course, even if China could somehow survive that, it would still remain locked into a system whose very survival is simply beyond Beijing’s control. The Bretton Woods network is what made everything about China—its unification, its existence as a modern state, its manufacturing base, its export-led economy, its military strength—possible. There are any number of reasons how the Americans backing away from Bretton Woods would be disastrous for the Chinese. Here are four:
As with many other countries in the Bretton Woods world, the Chinese have purposefully adjusted their system to maximize the role that exports play, so the largest and most dynamic portion of the Chinese economic system has been and remains export-driven. Roughly 10 percent of China’s GDP depends upon direct exports to the United States.4 Another 5 percent of GDP is locked up in supply chains whose ultimate destination is the American market. Should American trade access be revoked it would be as if China suffered from an equivalent of three American Great Recessions all at once. And even that “rosy” scenario assumes that all of China’s other export markets remain open. All told, about one-third of Chinese economic activity is directly involved in exports, and that does not include the raft of affiliated sectors—from ports to refineries—that while technically “domestic” are largely dependent upon international links. As one would expect, the Chinese regions with more mercantile histories—most notably the greater Shanghai and greater Hong Kong regions—would suffer more.
