In honor of the upcoming 19th National Congress of the Communist Party of China, I will highlight some of the significant hurdles the Communist Party faces that often go under appreciated in the western media. Like in many states - the largest risks to government rule are not external threats, but festering internal divisions. The challenges range from the financial system to geography and regional inequality.
What is largely missed in the endless discussion over the global financial crisis and its aftermath, is that it was Chinese credit expansion that fueled the global economic recovery. In the face of a cratering global financial system, and the devastation to aggregate demand that would ensue, China unleashed fiscal stimulus - especially in its housing sector. Commodities prices and emerging markets soared in the years after the crisis, providing ballast for the world. In the exuberance, many industrial sectors became plagued with overcapacity, a problem China and the world must still deal with to this day. In a state led economy like China's, the government often both implicitly and explicitly influences business activity. Chinese corporate debt has accounted for 70% of global corporate debt since 2008. Adding up both the on and off balance sheet debt equates to roughly 650% of Chinese GDP. The economy can be maintained with these levels of debt issuance while a country is growing at double digit rates as China has done, but it cannot grow at this pace forever. Since WWII the global economy has been in a long term debt super cycle. Credit expansion fueled economic growth far above natural growth rates. That cycle likely peaked in 2008, meaning low rates of growth and inflation for the foreseeable future. Arithmetic tells us that China cannot maintain its high level of growth, if the rest of the world is not growing along with it. Combine this to the hurdles regulators face with a booming shadow banking sector, and the deleveraging path looks daunting.
It is common to view China as some homogeneous economic colossus pumping out exports and building a thriving middle class for the next century in unison. This narrative underestimates the ethnic and geographical diversity in China that threaten social cohesion - a key factor for a developing country. For most of its history China was divided among its geographic regions. Regions like Xinjiang and Tibet where geopolitical gravity and historical precedent pull them away from the coast. Xinjiang is primarily inhabited by Muslims with disdain for their Han Chinese rulers in Beijing. Insurgency and terrorism is commonplace. The Party's solution thus far has been to crush any whiff of opposition or dissent. The divergences between coastal and interior China are stark. Per capita income in interior China is a round 30-50% lower than coastal China. Per the World Bank - 650 million Chinese live on under $4 a day. This divergence between coastal and interior China was palatable because coastal China could generate enough well paying jobs for the interior poor. This job development was made possible by coastal China exporting goods to the United States and other foreign markets. If developed market growth rates are indeed going to be lower in the foreseeable future, how can they afford to keep buying Chinese products at the same rate? If coastal China can't keep exporting at the same rate, how will they maintain their structural relationship with interior China? Inevitably this means coastal China must make direct fiscal transfers to interior China in order to promote economics development and jobs. Hopefully one day interior China can be a source of demand for coastal Chinese goods. This fiscal transfer project will be a massive undertaking, perhaps unprecedented in world history. When American President George W. Bush asked Chinese leader Hu Jintao "What keeps you up at night?" He quickly replied "Creating 25 million jobs a year."
An interesting observation lies within the People's Liberation Army (PLA) and its 2 million strong military force. There is no rule of law in China, there is only power. As the effective internal security apparatus for the Party, the PLA is the underwriter of the Party's rule. The PLA is a crucial institution in Chinese society not just from a security aspect, but as an important link between coastal China and interior China as well. Many of the PLA personnel are the sons of peasants from interior China. This way poor but ambitious young men have an avenue to prosperity within their nation. In 2016, Xi Jinping assumed control of the Joint Operations Command Center in part of a broad restructuring of the PLA from a old school mass mobilization force to a modern one. Another reason was for Xi to assert authority over the military as part of an effort in the Party's anti corruption purge that has whacked the wealthy business class in coastal China. The PLA officers often have intertwined business relationships to generate personal profits aside from their day job. The more private wealth accumulated in coastal China, the greater likelihood of capital outflows and the greater the likelihood that the wealthy are able to unduly influence the Party itself. This is unacceptable to the Party. For now, with Xi appearing set to become the first core party leader since Deng Xiaoping this fall, Xi and the Party may succeed in bringing the PLA to heel. But what if they push the PLA too far? The PLA view the wealth they gained as a sort of corrupt social contract the Party is now seeking to violate. Especially the men who grew up as poor peasants, and view their wealth as justly earned. After all, wasn't Deng Xiaoping's message to "enrich yourself"? A dissident PLA could turn on the party and even interior China to protect their wealth. Stifling the fiscal transfer of resources to interior China would only exacerbate regional tensions and threaten the Party's control of the country. The Party crackdown may seem a whole lot less intimidating to a group of millions of armed men. Absent the rule of law to navigate these dilemmas - only competing power spheres will regulate the path forward.
I believe people are generally willing to give up sovereignty and freedom in exchange for economic prosperity. For decades after Mao's death, the Party was able to deliver prosperity, providing justification for its rule. Now that the days of double digit growth are likely over, it will become much more difficult for the party to maintain its rule. Growth dynamics in the rest of the world make it less likely that coastal China can continue to produce the necessary jobs for interior Chinese poor who seek to move towards the coast. This means China must make fiscal transfers from wealthy coastal China into interior China for economic development in the interior itself. If the Party fails, it risks inflaming regional tensions that would threaten the Party's rule. This core realization by the Party explains its crackdown on corruption. Local officials from coastal China will not be keen to lose resources for economic development, for it stifles their own career ambitions. It also risks a backlash with the PLA, the ultimate guarantor of the Party's rule. All the while the Party must delicately balance a deleveraging of its financial sector which is at best bloated and at worst out of control. Yet so far, so good. Xi seems to have balanced competing interests while accumulating the most power of any Chinese leader in decades. However the road ahead is still fraught with difficulty, and future developments warrant monitoring.
What is largely missed in the endless discussion over the global financial crisis and its aftermath, is that it was Chinese credit expansion that fueled the global economic recovery. In the face of a cratering global financial system, and the devastation to aggregate demand that would ensue, China unleashed fiscal stimulus - especially in its housing sector. Commodities prices and emerging markets soared in the years after the crisis, providing ballast for the world. In the exuberance, many industrial sectors became plagued with overcapacity, a problem China and the world must still deal with to this day. In a state led economy like China's, the government often both implicitly and explicitly influences business activity. Chinese corporate debt has accounted for 70% of global corporate debt since 2008. Adding up both the on and off balance sheet debt equates to roughly 650% of Chinese GDP. The economy can be maintained with these levels of debt issuance while a country is growing at double digit rates as China has done, but it cannot grow at this pace forever. Since WWII the global economy has been in a long term debt super cycle. Credit expansion fueled economic growth far above natural growth rates. That cycle likely peaked in 2008, meaning low rates of growth and inflation for the foreseeable future. Arithmetic tells us that China cannot maintain its high level of growth, if the rest of the world is not growing along with it. Combine this to the hurdles regulators face with a booming shadow banking sector, and the deleveraging path looks daunting.
It is common to view China as some homogeneous economic colossus pumping out exports and building a thriving middle class for the next century in unison. This narrative underestimates the ethnic and geographical diversity in China that threaten social cohesion - a key factor for a developing country. For most of its history China was divided among its geographic regions. Regions like Xinjiang and Tibet where geopolitical gravity and historical precedent pull them away from the coast. Xinjiang is primarily inhabited by Muslims with disdain for their Han Chinese rulers in Beijing. Insurgency and terrorism is commonplace. The Party's solution thus far has been to crush any whiff of opposition or dissent. The divergences between coastal and interior China are stark. Per capita income in interior China is a round 30-50% lower than coastal China. Per the World Bank - 650 million Chinese live on under $4 a day. This divergence between coastal and interior China was palatable because coastal China could generate enough well paying jobs for the interior poor. This job development was made possible by coastal China exporting goods to the United States and other foreign markets. If developed market growth rates are indeed going to be lower in the foreseeable future, how can they afford to keep buying Chinese products at the same rate? If coastal China can't keep exporting at the same rate, how will they maintain their structural relationship with interior China? Inevitably this means coastal China must make direct fiscal transfers to interior China in order to promote economics development and jobs. Hopefully one day interior China can be a source of demand for coastal Chinese goods. This fiscal transfer project will be a massive undertaking, perhaps unprecedented in world history. When American President George W. Bush asked Chinese leader Hu Jintao "What keeps you up at night?" He quickly replied "Creating 25 million jobs a year."
An interesting observation lies within the People's Liberation Army (PLA) and its 2 million strong military force. There is no rule of law in China, there is only power. As the effective internal security apparatus for the Party, the PLA is the underwriter of the Party's rule. The PLA is a crucial institution in Chinese society not just from a security aspect, but as an important link between coastal China and interior China as well. Many of the PLA personnel are the sons of peasants from interior China. This way poor but ambitious young men have an avenue to prosperity within their nation. In 2016, Xi Jinping assumed control of the Joint Operations Command Center in part of a broad restructuring of the PLA from a old school mass mobilization force to a modern one. Another reason was for Xi to assert authority over the military as part of an effort in the Party's anti corruption purge that has whacked the wealthy business class in coastal China. The PLA officers often have intertwined business relationships to generate personal profits aside from their day job. The more private wealth accumulated in coastal China, the greater likelihood of capital outflows and the greater the likelihood that the wealthy are able to unduly influence the Party itself. This is unacceptable to the Party. For now, with Xi appearing set to become the first core party leader since Deng Xiaoping this fall, Xi and the Party may succeed in bringing the PLA to heel. But what if they push the PLA too far? The PLA view the wealth they gained as a sort of corrupt social contract the Party is now seeking to violate. Especially the men who grew up as poor peasants, and view their wealth as justly earned. After all, wasn't Deng Xiaoping's message to "enrich yourself"? A dissident PLA could turn on the party and even interior China to protect their wealth. Stifling the fiscal transfer of resources to interior China would only exacerbate regional tensions and threaten the Party's control of the country. The Party crackdown may seem a whole lot less intimidating to a group of millions of armed men. Absent the rule of law to navigate these dilemmas - only competing power spheres will regulate the path forward.
I believe people are generally willing to give up sovereignty and freedom in exchange for economic prosperity. For decades after Mao's death, the Party was able to deliver prosperity, providing justification for its rule. Now that the days of double digit growth are likely over, it will become much more difficult for the party to maintain its rule. Growth dynamics in the rest of the world make it less likely that coastal China can continue to produce the necessary jobs for interior Chinese poor who seek to move towards the coast. This means China must make fiscal transfers from wealthy coastal China into interior China for economic development in the interior itself. If the Party fails, it risks inflaming regional tensions that would threaten the Party's rule. This core realization by the Party explains its crackdown on corruption. Local officials from coastal China will not be keen to lose resources for economic development, for it stifles their own career ambitions. It also risks a backlash with the PLA, the ultimate guarantor of the Party's rule. All the while the Party must delicately balance a deleveraging of its financial sector which is at best bloated and at worst out of control. Yet so far, so good. Xi seems to have balanced competing interests while accumulating the most power of any Chinese leader in decades. However the road ahead is still fraught with difficulty, and future developments warrant monitoring.
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