Commentary on Political Economy

Monday 11 October 2021

 A crisis at a property company exposes deep, dangerous, and often unrecognized weaknesses in the Chinese economy.

2:00 AM ET

Evergrande Group, one of China’s largest property developers, is tottering on the brink of bankruptcy. Its founder, Hui Ka Yan, is scrounging to find the cash to meet payments on the $300 billion his company owes. Beijing has warned local officials to prepare for possible fallout if the gargantuan firm collapses. Around the world, financial analysts are wondering if Evergrande is China’s “Lehman moment,” the starting gun for a destructive wave of defaults that could take down the nation’s banks and set back the country’s—and the world’s—already shaky recovery from the pandemic-induced economic downturn.

All of that is reason enough to care about what’s happening at this otherwise little-known Shenzhen-based real-estate company. But Evergrande and the problems it faces tell an even more important and fundamental story about China and its future. The crisis exposes the deep, dangerous, and often unrecognized weaknesses in the Chinese economy that could derail its advance and, with it, Beijing’s quest to challenge American primacy on the world stage.

That may seem like far too much to hoist onto the shoulders of a troubled company that builds apartments. Officials in Washington, and Americans more generally, tend to think that China’s economic progress rests on 5G mobile technology and artificial intelligence. But in reality, Evergrande is just as core to the future global balance of power, because it represents just how broken China’s economic model really is.

This isn’t nearly as controversial a statement as it sounds. Chinese policy makers have acknowledged the need to recalibrate the economy’s engines for more than a decade. Their system generates high rates of growth, but also large amounts of waste, inefficiency, debt, and financial losses. And, in the process, it creates Evergrandes—companies that know no limits, gorge on easy money, and build their way into financial ruin.

In fact, the Evergrandes of China—Evergrande itself is a headline-grabbing, but not the sole, example of such largesse—are just one reason to fret about the economy’s direction. A demographic disaster, a widening confrontation with the U.S., and, most important, a change in economic policy that favors the state over private enterprise all seem destined to suppress the growth, vibrancy, and innovation that the Chinese economy so badly requires.

For some, this argument induces eye-rolling. Many experts have long predicted China’s economic doom, and those experts have been dead wrong. China’s leaders, as well as its people, have consistently defied their naysayers and the odds.

Red FlagsGeorge Magnus, Yale University Press

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Still, those odds are indisputably stacked against them, perhaps more than ever before. China’s economy may have reached a point at which the easy gains are spent, the margin for policy errors has narrowed, the economy has lost some of its spirited momentum, and the leadership must garner renewed will to make tough and unpopular choices to push forward.

The growing consensus in Washington, spanning the Trump and Biden administrations, is that China must be contained because it will otherwise continue its inexorable rise, eventually eclipsing America as a superpower and imposing its will on the world order in the process. Yet what Evergrande shows us is that this is far from a fait accompli. However things play out, China has entered a new phase of its development, the outcome of which isn’t at all certain.

As far as Beijing is concerned, the 21st century belongs to China, and policy makers around the world had better adjust their priorities and loyalties to a global system with China as the lone superpower. Those world leaders still clinging to the idea of a U.S.-led liberal order are on the wrong side of history. “China’s national rejuvenation has become a historical inevitability,” its top leader, Xi Jinping, proclaimed in a July speech.

This notion has taken hold in Washington as well. America’s two parties don’t agree on much of anything, but there is broad bipartisan agreement that China presents an existential threat to the U.S., its global primacy, and democracy itself. That threat runs the gamut—economic, technological, ideological, military, and diplomatic. This belief is shaping much of Washington’s view of the world and where the U.S. stands within it. Its foreign and economic policies are being redesigned based on the perceived China threat. The Biden administration was willing to risk a break with France, one of Washington’s closest allies, to seal a defense pact that upgraded Australia’s naval capabilities and thus the power of a key U.S. partner in the Pacific to take on China. Congress’s $250 billion bill to beef up the U.S. chip sector and scientific research broke with decades of economic orthodoxy that opposed direct government support of industry in order to fight off China’s challenge to American technological leadership.

Policy makers’ job is to prepare for the worst, of course. But what if the threat from China is overblown, or not as all-encompassing as Washington seems to expect? What if China’s rise is not inevitable? Then, by extension, the American strategy is wrong too. The U.S., in this scenario, is refashioning its economic priorities and its relations with allies to protect itself from a threat that will never materialize.

Whether that threat does come to pass depends on what happens to China’s economy. Beijing’s political and military strength can continue to build only if its economic resources and technological prowess continue to advance. If China’s policy makers can successfully pivot their economy to be a more productive and dynamic one, the risk to Washington is real. If, however, it turns out that China is more like Evergrande—a glossy growth story with a rotten core—then Beijing’s ambitions will unravel, much like the property company’s.

“If China was no more economically capable than the Soviet Union was at its peak, we wouldn’t worry about it that much,” George Magnus, a research associate at the China Centre at Oxford University and the author of Red Flags: Why Xi’s China Is in Jeopardy, told me. “Its economic heft is precisely what we find rather threatening right now, because it is the basis upon which China is projecting a much more truculent and virulent attitude towards its own aspirations for what the world should look like.

“Anything that undermines its economic heft,” he continued, “is of huge consequence.”

Modern history tells us that economic development is no sure thing. In particular, many poorer countries that grow richer face a phenomenon known as the “middle-income trap,” in which they reach a certain, moderate level of wealth, and then get stuck, unable to progress much further. Only a select handful have been able to transition from an emerging to an advanced economy—South Korea offers a rare example. The problem is often an inability to change: Policies that lift nations out of poverty don’t necessarily work when tackling the next, more difficult step—becoming more productive and innovative, the crucial ingredients to reaching the ranks of the rich.

China is following this unfortunate pattern. The basic problem is that China’s growth is overly dependent on building things, such as highways, factories, and Evergrande apartment towers. All of that construction keeps economic-growth rates elevated, workers employed, and the country’s gross domestic product steadily marching up the list of the world’s largest. But not all growth is created equal. If investment flows into companies and projects that aren’t needed or wanted, and thus doesn’t offer a return, it pumps up national output in the short term but weighs on the economy in the long run.

Enter Evergrande—and for that matter, China’s entire real-estate industry. These firms have kept building, and building, and building some more, but the country doesn’t need everything that they build. Rhodium Group, a research firm, estimates that China has enough unsold property to house 90 million people, equivalent to the entire population of Germany, and then some. And property is only one sector that suffers from this kind of excessive exuberance: According to the data provider Qichacha, China has more than 300,000 companies engaged in the new energy-vehicle industry, some of which are propped up by the state, and which in any case number far too many to survive. This recurring overinvestment has helped fuel a potentially destabilizing surge of debt. Data from the Bank for International Settlements show that debt in China has increased 13-fold in the past 15 years, and is now almost three times the size of the entire economy. A significant chunk of those loans—perhaps a quarter—are unlikely to ever get repaid, because the underlying investments have gone sour.

One doesn’t need a Nobel Prize in economics to recognize that this is unsustainable. Eventually, the bills come due, and companies like Evergrande can’t pay. China’s policy makers, fully aware of the danger, have pledged to reform the economy so that consumer spending plays a larger role, much like in the United States. But they’ve dragged their feet. Mostly, this has been for political reasons: The Communist Party has marketed the country’s lofty growth rates as evidence of its competency—and, even more, its right to rule—and insists on meeting targets set far too high. “When you have what looks like a winning strategy, you never change your strategy,” Michael Pettis, a professor of finance at Peking University’s Guanghua School of Management, in Beijing, told me. “It’s very hard to switch that model until it becomes incredibly clear how unhealthy it has become.”

Perhaps the Evergrande crisis will shake China’s leaders out of their complacency. Yet even if that happens, they’re unlikely to choose the right solution—deeper economic liberalization. When freer markets are allowed to direct capital to worthy investments, rather than state priorities, and boost the productive powers of industry and workers, growth will return to a healthier trajectory.

But free-market reform stalled long ago. If anything, Xi is shifting policy in the exact opposite direction—toward a heavier role for the state and the party. ”Xi knows that [economic liberalization] would require him to relinquish control in ways that he is not remotely prepared or willing to do,” Matt Pottinger, a former Trump-era deputy national security adviser who is now chair of the China program at the Foundation for Defense of Democracies, told me. “He is preparing the economy for a new phase of slower growth where the party asserts greater and greater control over the economy. It’s all about politics before growth.”

Just in recent months, Xi’s administration has curbed the influence of prominent entrepreneurs—most notably, the billionaire founder of Alibaba, Jack Ma; slathered regulation on the technology, education, fintech, and entertainment sectors; curtailed the ability of Chinese start-ups to raise funds overseas; cracked down on cryptocurrencies; and launched a campaign for “common prosperity” aimed at income inequality that so far looks like a state shakedown of the wealthy.

We already know from China’s own experience that such policies don’t work. The great myth of China’s economic miracle is that its special brand of “state capitalism” was the secret to its historic success, when in fact it was primarily just the “capitalism” part. China’s economy achieved hypersonic growth only when the overbearing state of the revolutionary Mao years receded and allowed private enterprise, foreign investment, and trade to flourish. The market-reform movement launched in the 1980s was to a great degree an antidote to Mao’s intrusive politics that left China destitute, isolated, and technologically archaic.

Xi may think he can outdo Mao and micromanage the economy to achieve better results than entrepreneurs and foreign investors. Private business, though, is the true source of innovation in China, and by sidelining it in favor of the dysfunctional state sector, he’s running the risk of worsening the economy’s most damaging problems—wasteful investment and feeble productivity. Xi’s state-led programs already have a record of encouraging bloat. The excessive investment in the electric-vehicle sector is a result of Xi’s promotion of the industry through state subsidies and other supportive policies.

China can ill afford such missteps. The populace is still relatively poor—per capita income, at $10,550, is a mere one-sixth that of the U.S.—and worse still, it’s aging rapidly. The declining workforce automatically detracts from the economy’s growth potential. (Hoping, probably vainly, to reverse the trend, Xi’s government is moving to limit abortions, a typically heavy-handed approach to the country’s demographics.)

Xi’s foreign policy isn’t helping either. As relations with the U.S. deteriorate, Washington has curtailed Chinese access to vital technology. For instance, U.S. export restrictions are hampering the development of China’s homegrown commercial jetliner as its state-owned manufacturer has had trouble securing parts. Xi’s response has been to turn inward and reduce China’s vulnerabilities to outside pressure. His highly promoted “self-sufficiency” campaign hopes to replace foreign technology with homemade alternatives. But that, too, could drag on the economy. A recent paper by the European Union Chamber of Commerce in China contends that the potential costs of the initiative “will be extensive and have a long-term, negative impact,” including a decrease in foreign investment and further resources misallocated to state-directed programs.

Predicting with any certainty how all this plays out is impossible. Still, as Oxford’s Magnus put it, “there is a plausible case that right now China has reached a kind of plateau in terms of its economic dynamism.” If that is indeed true, and Beijing fails to alter its economic policies in response, China may never overtake the U.S. as the world’s indispensable economy, nor will it amass the wealth to sustain a buildup of military capacity or continue its bold diplomatic offensives, such as its expensive infrastructure-building program, the Belt and Road Initiative.

The implications for Washington are huge. No longer would containing China be the primary focus of U.S. foreign policy, or the dominant theme of its relations with allies in Europe and Asia. It would require a different approach to a different China with a different future.

Another, darker possibility, exists: What if China recedes as an economic competitor but rises as a political one? Fearing his country will be weaker in the future than in the present, and needing a new source of legitimacy to replace economic performance, Xi might turn to nationalist causes and become more aggressive, perhaps making a grab for Taiwan. In this scenario, a China that is more like Evergrande—bloated and flailing—is scarier than a China that isn’t like Evergrande at all.

“There’s a good argument to be made that we’ve seen peak China economically, but we haven’t seen peak China politically or militarily,” Pottinger told me. “It’s one of the reasons that China is becoming more dangerous now.”

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