The Chinese Economy

On September 05 2012 21:57 Shady Sands wrote:

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My parents often liked to use an idiom called 瞎子摸象, or "a blind man touching an elephant."

The idiom basically refers to the fact that some topics of knowledge are so vast as to be essentially unknowable or unfathomable; that like blind men trying to determine the shape of an elephant by feeling only the trunk, the tail, or the legs, we may get completely wrong answers relying on our highly imperfect senses.

I had the (mis)fortune of growing up under two PhDs. They really wanted me to go into the hard sciences, so whenever I started talking about how interesting social sciences were to me, that's what they would say--"Econ is like a blind man trying to touch an elephant"; "Sociology is like..."; "Political science is like..."; "Public policy is like..." etc.

Ironically enough, I get this feeling a lot when I read Western news stories about China. Every self-respecting Western news house has released giant exposes on China in the past decade. Every news personality and academic, it seems has had something to say about the Middle Kingdom. And more often than not, they're like blind men and an elephant.

On one side, some will look at rising protests and corruption and conclude the Chinese government is unstable. Others will look at the rising military spending and conclude the Chinese government is hell-bent on pushing its boundaries with waves of cruise missiles, stealth jets, and submarines. On the other side, people will crow about the unlimited potential of the Chinese economy, and the government's insane ability to get big things done as proof positive that China will ascend toward to national greatness... or as proof that China will one day eclipse the United States and subject Americans to some unspeakable tribulations (like forcing the US to repay the debt by running a trade surplus with China. The horror!)

And they're all right, and yet all wrong.

There is one way to take off the blindfold when figuring out the elephant in the room, however. And that's with an American idiom first coined by Deep Throat--"follow the money."

In Communist China, follow the smiling Mao on the hundred-Yuan note, and everything else can be divined.

Let's start with some history though, since it's cool shit.

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In 1978, a group of eighteen Anhui farmers, led by the only one amongst them who could read, agreed to break the law by signing a secret agreement to divid the land, the local People's Commune, into family plots. Each family would turn over a portion of the produce to the government, while keeping the surplus from that plot for themselves. They also agreed that should one of them be caught and sentenced to death, the other villagers would raise their children until they were 18 years old.

That year, their village produced a harvest larger than the the past five years combined. Per capita annual income in the village went from 22 yuan to 400 yuan.

Before long, the central government found out. The villagers were fortunate that they had this man in charge and not Mao Zedong:



Deng Xiaoping decided shortly before those farmers began their experiment that being socialist did not mean being equally poor, and decided to change China by embracing capitalist reform. But before he could embark on this grand plan, he had to accomplish three things beforehand:

1) Deal with residual hard-line elements within China.

2) Gain an export market that could provide technology and a source of aggregate demand that would constantly tug Chinese companies upward to a more competitive level.

3) Scare China's neighbors so much that they wouldn't cause any trouble while China did its massive reform policy.

How to do this? With the Uriah gambit, of course.

In the morning David wrote a letter to Joab and sent it with Uriah. In it he wrote, "Put Uriah out in front where the fighting is fiercest. Then withdraw from him so he will be struck down and die."
--2 Samuel 11:14-15

And so, a mere 3 months after the farmers in Anhui decided to go capitalist, Deng executed his plan.

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On the morning of February 17, 1979, the mists of northern Vietnam were once again broken apart by airstrikes, artillery, and the sounds of men in battle. Eighteen fully equipped PLA infantry and armored divisions invaded northern Vietnam--nearly 200,000 men and hundreds of aircraft and tanks.

A curious thing happened a few days before the assaults. Normally, PLA ground offensives are conducted with little advance warning, but here, American KH-9 Big Bird satellites saw the troop buildup prior to the invasion, and in his January state visit, Deng was quizzed about the buildups. He confirmed them, in public.

Why? Because Deng wanted the war to be messy.

Let's back up for a second. Deng knows that he's sitting on a demographic surplus: China has just enacted the one-child policy; it is going to enter a huge boom period where there are a whole bunch of working adults with relatively fewer children to look after and even fewer elderly. China needs to tap into this resource and prosper, much like if it was an oil kingdom that discovered an oil field which would go away after 50 years.

Deng knows that the only country that can absorb the surplus output while improving his economy is the United States. The US has all the social institutions in place to give away its aggregate demand to the rest of the world by absorbing exports; it has them in place because it used those institutions to keep Western Europe and Japan under its control. Deng now wants to plug China into those institutions, but he's gotta demonstrate good faith to the Americans.

On the home front, Deng has a whole bunch of cranky generals and party leaders who hate this idea and love autarky/engaging the rest of the world with guns and revolution.

Internationally, the Soviets look down on China, the Indians sneer at China, Japan sneers at China, and even piddly little Vietnam and Thailand brag that they could kick China's ass.

By invading Vietnam and making the war a complete mess for both sides, he gains brownie points from the US for slaughtering the guys that humiliated the Americans, while also putting the PLA in its place by showing them that their retardation regarding warfare also means those hardliners should not be given influence over domestic policy. Also, since Chinese troops were not bound the rules of engagement that US troops operated under (e.g. don't kill civilians and don't blow everything up) they could accomplish part three of their mission quite well, scaring the shit out of everyone around them. (It also helped that Deng mobilized 1.5 million more troops, daring any other country around China to intervene.)

And so 60,000 Vietnamese and Chinese troops had to die, all in the span of less than a month; by far the bloodiest war in terms of deaths/day in post-WW2 history. In addition, the Chinese flattened the city of Lang Son with fuel air explosives and incendiary artillery while their own troops and Vietnamese troops were still fighting for it, killing 10-15,000 Viet civilians too, and bombed/dismantled every railway/road bridge and industrial facility between Hanoi and the Chinese border.

It was worth it. The consensus forged here--economic growth sparked by export zones; a Western target market; the CCP in charge, with reform-minded but politically autocratic leaders--was so strong that it could withstand the dual challenge posed 10 years later by a bunch of kids who refused to eat. And no country dared take advantage of China's policy shift over the next thirty years, not even when those starving kids got run over by tanks and China's international influence was at its nadir.

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The hunger games of Beijing happened in May and June of 1989. China had finished a long period of development, but bad shit--inflation, corruption, and a population that wanted the truth rather than money--was starting to get in the way. Deng decided to do his Vietnam strategy and discredit the hardliners while scaring his domestic and foreign opponents by washing their hands in blood and blaming everybody except himself for the carnage.

When the dust cleared, Deng traveled south, in 1992, and restarted economic reform; this time, he decided to fold the hard-liners into the process by giving them all cuts of lucrative state owned enterprises, which ironically placed the new arbiters of power, the Chinese financial mandarins in the National Development and Reform Commission, and the Ministries of Commerce and Finance, in a position of influence over their old masters, since these mandarins, led by reformist premier Zhu Rongji, now could determine which enterprises lived, and which died.

The WTO ascension in 2001 threw this whole game into fast forward. Had Deng still been alive, he probably would have done a fist-pump, because with Hong Kong, and Macau integrated, and China in the WTO, China had finally emerged from the long shadow of the 1840s Opium War--and China had done it with his strategies, his ideas.

And for a time after that, all was good. The Dengist consensus stood. China would stay politically stable, and get rich via investment-driven and export-driven growth. Simple.

But now cracks began appearing in the facade.

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Here is where we talk about money. How does China make money and make its GDP?

In the beginning, development was capital intensive and capital went into productivity gains. Things like better technology, for example, or highway and rail links from manufacturing greenfields to ports. Gradually, though, China has been hitting a point of diminishing returns with this model. But the growth model still uses up capital like a Chinese girlfriend uses up toilet paper (date one and you'll know). Even though logically the system should be dispensing less capital, it still dispenses moar and moar.

Why? Because this is the root of the Dengist model. Deng wanted fast development. The only way to do this, his advisors told him, was to socialize the cost of capital, while privatizing the benefits of using it successfully.

And it's true. That's the insight they never tell you in Econ. So much of economic growth hinges on intangible input variables which boil down to a simple thing: "animal spirits". And then they tell you that human beings are risk-averse. Put two and two together, and what happens? Well when the world is full of cowards, the only way to get people pumped up enough to take a risk is to take risk out of the equation, by letting people make money with other people's money (to paraphrase two of my personal heroes, Aristotle Onassis and Adnan Khashoggi.)

When this works, you get an Asian Tiger or West Germany. When it doesn't, you get Nigeria. But China is neither. Why?

Because Deng took this one step further. In most of these "other people's money" systems, it's the merchant class that leads the way. With Deng, he made sure that the flagbearers would be merchant-bureaucracy hybrids, because this is Socialism with Chinese Characteristics we're talking here, and how long could the Revolutionary Proletarian Vanguard (tm) survive if China's best and brightest did not see it as a route to serving the people getting filthy rich and banging Zhang Ziyi in the back of your chauffered, government-issue Audi right outside the gates of a preschool? (Someone actually did that. Chauffeurs have zero practice holding their liquor, so they will spill all their secrets when they're drunk)

And what of the rewards for success? In those other systems, when you succeed in building up your chaebol/zaibatsu/GmBH, you became *oppa gangnam style*. But in China, you can't do that directly, and sometimes the rewards are different.

Quick case example: Let's say you're doing a pretty decent job in a central government institution in Beijing. You get promoted to a vice section chief in one of the ministries. So the Party Organization Bureau decides to give you a challenge--they parachute you into a party secretary seat in a midsized Chinese rust belt city.

You're young enough to be eligible for promotion to province party head. But you're not alone. Two other guys are also parachuted into other cities in the province. And the Party Organization Bureau has been careful to pick only certain guys--let's say that other dude stole your sweetheart while both of you studied at Tsinghua--that you hate, and that hate you.

Well now you and him are locked in a competition to build up your cities. Imagine this as a game of Simcity on crack, and just like in Simcity, everything takes money. So you go hat in hand to the banks.

Now begins the courtship. The banks are themselves beholden to patrons higher up, so you go and align yourself with a patron. The patron (lets say he's a politburo guy who knows your dad... or if you're lucky, who is your dad) sets up a meeting. You make the pitch.

Here's how a pitch to a Chinese bank happens. You go in, you make a presentation. Afterwards, all the poor interns and analysts, as well as your mayoral aides, get shoved off to one conference room with some cheap take-out where they hammer out the specifics of the deal and argue over numbers... or just talk about the Premier League and pretend to work.

Meanwhile, you and the big boys from the bank drink and toast to each other, and drunkenly bellow phrases like

"能做成这件事情,真亏XXXX...XXXX万岁!" (this deal owes so much to XXXX, ten thousand years to XXXX!) where XXXX is the name of your mutual patron and ten-thousand years, the honorific normally reserved for Emperors.

or the time-honored

"喝! 喝! 每杯,一百万!" (Drink! Drink! Every shot, one million!), referring to the extra loan amounts you can get by hastening the onset of liver cancer.

As you can probably guess, the pitch matters little. The whole meeting doesn't really matter. Ultimately your patron settles things, and you get the loan.

Now you have the money. Well, not only that--the system knows you have the money, so it's going to expect you to boost GDP with it. If you don't, your patron will yell at you. So you put it in the things that naturally show up on the GDP charts the fastest--investment in real estate or industry.

And voila. You win. You get your promotion. You can even skim a bit off the top and no one will notice--hey, it's expected, it's your reward for taking risks with other people's money. And what's more, if you advertise your city the most, build the most shiny (vacant) malls and beautiful (empty) apartment blocks and sprawling (idle) factory complexes, then you get promoted over your hated rival--and now, in addition to being *oppa gangnam style*, you can in watch your rival beg for mercy as you sentence him to 10 years of hard labor for embezzling money with the same methods you used... and you can look into the eyes of the woman who rejected you 20 years ago in college and say
"看来你当初选错了...可惜现在后悔也来不及了"
"guess you chose wrong back in the day. well TOO LATE BITCH" (Someone actually did this, too.)

See what I mean about Simcity on crack? And once the promotion happens, it repeats; you're now playing Civilization 5 on crack with the province you just inherited.

Now, for a while, this method actually generated a lot of real improvement, because China was so underdeveloped that you could throw real estate, infrastructure, or industry anywhere and it would help out--and China had that "demographic dividend" from the one-child policy restricting its giant working age population from having kids to supercharge the "build it and they will come" approach. But now there's enough of it. China needs to change its growth model.

But change ain't easy; while some rare people lead by example, everyone follows by example, and the people at the top, nowadays, got there by walking this route (Xi Jinping in Fuzhou, Li Keqiang in Henan and Liaoning). But these new leaders aren't dumb. They know that the jig is up. China's almost out of cash, and that fact becomes more and more apparent each day in spite of all the made-up statistics. How to tell all the underlings below them though, without leaving the blood on their hands? Who do they find to make an example of?

Enter Bo Xilai. This is where we go back to history again.

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In March, Bo Xilai, hotshot and rising star of Chinese politics, was sacked from his position as the Party Chief of Chongqing, a megacity of over 100 million people and the land area of Austria. (China places its four megacities--Shanghai, Beijing, Tianjin, and Chongqing--on a political level equal to provinces.)

On the surface, Secretary Bo was sacked because of a scandal.

The quick details: his wife was involved with some British dude named Neil Heywood (whether sexually or just financially, no one knows.) Neil helped Mrs. Bo shift cash out of the country for safekeeping, and also helped Bo Junior get admitted into Harrow and later Oxford. Well, they had a falling out over the size of the fees Neil got for doing this, so Neil was murdered. Then the police chief of Chongqing, Wang Lijun, supposedly Bo's right-hand man ever since his days as a mere mayor of Dalian, was told to cover things up, but instead told Bo that he was uncomfortable doing this. Bo vaccilated a few days between tossing his wife under the bus or covering it up, and instead decided to do a full on cover-up, which included placing his right hand man in a soft form of house arrest. Wang Lijun says "fuck this shit", and decides to escape to the US Consulate, where he eventually walks out a day later into the hands of the Chinese central government to testify against his former provincial boss. Mrs. Bo is convicted, as is some random flunkey from the Bo circle, and everyone goes home.

Peel back a layer, and you might see a different story.

2012/2013 is when China changes its highest leadership. Bo's predecessor in the Chongqing party seat was Wang Yang, now the head of Guangdong Province, the richest province in China (right next door to Hong Kong) and himself a rising star for the highest levels of Chinese government. Wang's predecessor was He Guoqiang, who now sits in that highest level of leadership, running that very same Party Organization Bureau that maintains promotion files for high-level Chinese officials, CEOs of Chinese megacorps, and the high command of the PLA.

When Bo took office, he decides to embark on a "Strike Black" campaign to boost his popularity for the 2012/2013 intra-party elections. From 2007 to 2011, Bo arrests and executes many former officials who served Messrs. Wang and He loyally, including the former police chief in Chongqing (who got replaced by Wang Lijun.) In doing so, he likely accumulated a dossier of dirt on those two other heavyweights, and probably pissed them off, or worse yet, scared them. In Chinese politics, nothing is worse than scaring someone who has more power than you, and that was why Bo had to go.

Peel back a third layer, though, and we get a different story. This one touches on ancient Chinese history. (Well, relatively ancient.)

When Wen Jiabao (China's current No.2 leader) was gently questioned about Chongqing shortly after the scandal broke, his answer was pretty goddamn extreme. He not only foreshadowed Bo's political execution, but defined Bo as the man who wanted to turn back the clock on China's decades-long effort to modernize. To paraphrase John Garnaut,





In this story, then, the reason Bo is getting punished is because of what Bo did in the Cultural Revolution, as well as what he did to boost civic spirit in Chongqing; order citizens to re-embrace the Cultural Revolution.

The Cultural Revolution was a shitty time for China. The whole country engaged in open warfare on any sort of class hiearchy, which meant the country, led by a bunch of teenagers (really, just teenagers) engaged in open warfare against all government officials and men of learning except those that aligned closest with Mao. Bo Xilai's own father, Bo Yibo, was swept up in this too--he was cast out, disgraced. Bo's mother committed suicide (or was murdered, no one really knows.) And what did Bo do?

He engaged in struggle sessions against his own parents to avoid getting politically hurt. Basically he would go up to his own dad, and in public, yell at him and humiliate him and hit him. In any culture, this would be regarded as spineless behavior; in Chinese culture, with its emphasis on the family, this was regarded as the lowest of the low. And guess what? People remembered this shit, remembered Bo Xilai as that little kid who couldn't stand up straight for his own dad, remembered Bo as the kid who would say anything to get ahead, remembered Bo as the spineless one who, in the words of Wen Jiabao and Hu Yaobang, was "less than human" (不是人). These criticisms stick, because most of China's current leadership came of age in the Cultural Revolution, and they all got promoted by their predecessors, who (including Hu Yaobang, and Deng Xiaoping himself) were often the ones getting humiliated by those teenaged Red Guards.

In this regard, then, Wen is the primary repudiator of Bo, and he does it because Bo is bringing back terrible memories and threatening to lead China down that road again.

But not even this is the deepest layer. At the core of the onion lies the old idiom: "follow the money."

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When Bo became Chongqing's party chief in 2007, Chongqing had about 25 billion dollars in debt. When he left, in 2011, he added on 50 billion more in debt, as well as another 70-80 billion more outside official balance sheets.

Bo took the whole "splurge and get promoted" mentality and took it to an extreme level. He spent a billion dollars planting trees, for example--trees that experts say will die in 10 years from the shitty air quality, but that look good right now. And he used more billions to puff up Chongqing's state owned companies, at the expense of private interests.

So he had to go. Why? Privatization plans, baby. The top leaders know there's a giant debt bubble coming--they know that they're stuck in the same debt trap the Japanese were in the late 80s--and they're going to solve it with a wave of privatizations. The idea is--offload all the crap to foreigners and Chinese private citizens who don't know better, recapitalize the system, and also permanently change the "reward metric" while they're at it to something more closely aligned with popularity, like elections.

It's a good idea. It's what many top Chinese leaders have spent years prepping themselves for--just look at Wen Jiabao's own son, who has set up a private equity fund, New Horizon, itching to take stakes in newly formed ex-State-Owned Enterprises, or Zhu Rongji's son's investment bank, CICC, and their 资本运作 (capital operations) plans for the 100 biggest Chinese public companies (drafted with the expertise of Goldman Sachs and JP Morgan). The idea? Toss the baby out with the bathwater, but make sure that the baby lands with the connected and loyal Party functionaries. This way, China still remains owned by the same people, even if politicians are now elected. It's grand. I tip my hat in respect, good sirs.

How will they sell it? By giving the Chinese people more freedom--by finally giving in to those demands of the Tiananmen protestors, to the legacy of Hu Yaobang. Such sweet irony. To those who died in 1989, I thank you--your slogans are about to make some people very, very rich. (Remember those informal stakes in SOEs I mentioned earlier? Well, now they're all about to become legal.)

But Bo's methods are a throwback, an anachorism, an ugly wart--Bo wants the resources to remain in State hands. And so Bo has to go, because he did the only thing that's worse than making someone more powerful scared of him: he stepped between power and money, and in China (or anywhere, for that matter), if you do that, you die.

So there you have it. The true shape.

And the best part about it?

After all is said and done, the West will welcome China to the table as a modern economy, a prosperous democracy, as a nation just like them, yet another Elephant.

In the runup to China’s Third Plenum, the excitement among reform advocates is palpable. Likely to open in early November, the key Communist Party meeting is expected to launch sweeping changes to the Chinese economy, say economists, officials, and local media. There is a precedent after all: At the best-known Third Plenum in 1978, paramount leader Deng Xiaoping announced gaige kaifang, or “reform and opening up,” ending the autarchic period of the Cultural Revolution and earlier decades, and throwing open China’s economy to market forces.

“Thirty-five years after the Communist Party of China (CPC) lifted the country out of 10 years of chaos and started economic reform and opening up, analysts say that the Third Plenary Session of the 18th Central Committee of CPC has the potential to be a landmark event,” said the official Xinhua News Agency on Oct. 9. “It can chart out a comprehensive plan to propel the world’s second-largest economy on a more sustainable growth path.”

But what if the plenum doesn’t deliver? Given the lofty hopes, that is a real possibility. And it’s a prospect that some are starting to consider. “High expectations about reforms to rebalance growth are likely to be disappointed by the outcome of the November plenum,” write economists Louis Kuijs (formerly based in Beijing with the World Bank) and Tiffany Qiu at the Royal Bank of Scotland in Hong Kong, in an Oct. 9 note.

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So what is likely to come out of the party meeting? There will probably be few specifics about what shape individual policies may take. But there will be no dearth of broad statements by top leaders, including Party Secretary Xi Jinping and Premier Li Keqiang, laying out long-term goals for the country. Of course, that will include the now familiar refrain that China must transform its economy to one driven much more by consumption and services and less by investment. We will also hear that China intends to upgrade its industries to produce higher-value, technology-oriented products, while stepping away from its labor-intensive, energy-wasting, and polluting role as factory to the world—so serving less and less as a maker of shoes, toys, textiles, and cheap electronics.

Yet among the many reform hopes bruited about in recent months, some have a much better shot at getting a push forward at the plenum. “Surveying key reform areas, we expect reasonably concrete principles and directions on how to move forward in November, and measures in the coming two years, in areas where there is not much resistance and thus a mandate for reform, such as financial and monetary reform, pricing and taxation of raw resources and more government spending on health, education and social security,” write Kuijs and Qiu.

Others areas, however—many of which are widely seen as key to China achieving its move to a more sustainable development—have much less chance of really making progress. Prime example: dealing with the outsize role that powerful state enterprises play in the Chinese economy. “We expect little clarity on objectives in November, and not many measures in the coming 2 years, in areas where the political economy is an obstacle and that have not been emphasized by senior leaders, such as leveling the playing field between SOEs” and private enterprise, write the Royal Bank of Scotland economists.

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“The benefits preferential policies bring to state-owned companies every year are huge,” points out Sheng Hong, director of the Beijing-based market reform-oriented Unirule Institute of Economics. “Taking them away is very difficult.”

Then there is another category: reforms cited by the Chinese leadership and economists as very important but that are also deeply complicated to carry out, not to mention controversial. Official statements emanating from the Third Plenum will likely talk in general about the desirability of pushing household registration and land ownership reforms—both key to giving rural Chinese and migrant workers more consumption power—and may announce limited pilot programs in both, but don’t expect nationwide policy breakthroughs.

That’s because everyone from urban residents who don’t want to share limited educational and health-care resources to local governments hooked on land revenues are powerful opponents to change. “If an official wants to develop his city, then the land surrounding it can be forcibly taken from farmers at a very low price, and the farmers cleared off,” says Unirule’s Sheng. “We call it land finance. Every local government relies on it.”

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While slower progress on reforms won’t likely lead to economic collapse—despite what some China bears believe—foot-dragging nevertheless could create serious problems down the road. “China’s overall reform process could become skewed,” write Kuijs and Qiu. “If China maintains decent progress with necessary, politically easy ‘welfare state’ types of reforms, but cannot make progress with the politically difficult but essential growth and productivity-enhancing rebalancing reforms, the country could end up with a rebalanced but slower growing economy.”

Meanwhile, if China’s leaders don’t adopt reforms to make a more market-oriented economic and financial system, including by ending the serious favoritism shown to state-owned companies and allowing banks to make more commercially based lending decisions, risks could rise further. “If the reforms to adjust the economic structure and the domestic financial system cannot be implemented but the government presses ahead with capital account opening, the risks of financial instability would rise while misallocation of capital may actually also increase,” the RBS economists write.