Decline and Fall of China?

China’s rise has awed foreign observers and inspired a stream of books, many of them excellent, recounting the Asian juggernaut’s recent history and speculating about its future. The topic is of more than casual interest. China’s rulers tout their authoritarianism as superior to the liberal tradition, are upgrading their military in ways that seem designed to drive the United States out of the Western Pacific, and after concentrating an enormous part of the world’s manufacturing capacity in their country, are now working their way up the value chain. China has set itself the goal of dominating the Artificial Intelligence industry—and by implication, all the industries likely to be transformed by that general-purpose technology—before the year 2030.

“Tell me how this ends,” the clever general used to say.

To his credit, George Magnus knows he doesn’t know how it will end. But Magnus, the British former chief economist at UBS, knows a lot. I will try to summarize Magnus’s insights while noting limitations in his perspective and registering a demurral with respect to his conclusions.

At times, this book ventures deep into the economic weeds. Magnus’s four pages on the stalling of the reform of State-Owned Enterprises between 2013 and 2018 may be more than some readers want to know about that subject. But no one can gainsay the importance of economics for understanding modern China, and often Magnus complements more familiar perspectives in valuable ways. He mentions, for example, that at the time of the 1989 Tiananmen protests, the rate of inflation was 30 percent.

The thesis of Red Flags: Why Xi’s China Is in Jeopardy is twofold: First, China has reached the “end of extrapolation” and what worked for it in the past will not continue to work. Second, what makes it doubtful that China will adapt to the challenges now facing it is the insistence of the Chinese Communist Party (CCP) (and especially of Xi Jinping, who recently made himself in effect President-for-life) on tightening control over the economy and society.

Most of the book elucidates the first proposition. Like the four Asian Tigers (Hong Kong, Singapore, South Korea, and Taiwan), China relied on cheap exports and massive infrastructure investment to work a growth miracle. It is a familiar trope in the literature of development that after succeeding in this way, countries must adopt new strategies to keep growing richer, because they need higher-value-added industries and maybe don’t need any more bridges. The goal for these nations, upon arriving at middle-income status, is often said to be a “rebalancing” under which an expanded share of output is devoted to domestic consumption.

Magnus covers this ground but in greater detail than most authors, and with some surprises. He shows, with hard data, that the most serious imbalance in the Chinese economy is no longer the trade surplus but the over-reliance on domestic investment and debt-financing, the marginal productivity of which has fallen. At the beginning of the 1980s, you could get an extra yuan of GDP from as little as two yuan of investment; in 2015, the same growth required nine yuan in investment. With figures such as these, rather than anecdotes about ghost cities, Magnus draws a picture of widespread malinvestment in an economy laboring under rising debt.

Now, China is at no risk of a meltdown such as traumatized the other countries of East Asia in 1997, since its debt is not owed to foreigners. Even after describing the highly leveraged and under-regulated shadow-banking sector, and weighing the risk of a banking crisis, Magnus suggests in the end that the debt problems, in and of themselves, are manageable. What makes them a threat to China’s stability is that they will place a drag on growth.

Dealing gracefully with a fall in growth, and a fortiori with a recession, is difficult in a country with severe income inequality. Adding to the danger is the CCP’s insistence on tightly controlling the exchange rate, which requires capital controls that are hard to maintain in times of falling confidence. The greater the quantity of domestic credit, the greater the reserves needed to “back” it in a regime of fixed exchange rates, and confidence in the currency becomes more fragile. Magnus has an excellent section on the missteps during 2014 and 2015, and the cascading panics that shook the stock market and put pressure on the Renminbi. It cost the State about $150 billion to stabilize the former, and almost $500 billion in currency reserves to support the latter.

The author suggests, without making the reference explicit, that the authorities are reenacting the movie Speed on a grand scale. GDP growth depends on increasingly inefficient credit, with a strengthening headwind of rising debt. Everyone knows that rebalancing the economy will require slowing it down, but that would stress both the financial system and the social compact, with possibly explosive results. The People’s Bank of China therefore keeps its foot on the credit accelerator, so financial leverage and the debt overhang continue to mount . . .

Continuing his tour of the “traps” in which he thinks the Chinese leadership finds itself, Magnus provides a helpful overview of demographics. Terms like “demographic dividend” are lucidly explained, as is the history of migration from the countryside to the cities.

The author points out that China’s growth in the last three decades received an impetus from several events that were “one-offs”—by their nature, they can’t happen again. Bringing previously unproductive peasants by the hundreds of millions to work in urban factories, that’s over. Joining the World Trade Organization, that’s over. Enjoying a huge working-age population with few children to raise thanks to the One-Child Policy—not only is that over, it has left a demographic hangover in the form of a gender-skewed citizenry whose median age is rising rapidly, straining the nation’s minimal social security system.

The Need for Institutions

The second part of his thesis cites the finding of developmental economics that, to rise out of the “middle-income” bracket, a nation needs not merely more of the ingredients of prosperity: it needs those ingredients to combine more efficiently amid evolving challenges. What this comes down to, in Magnus’s view, is largely a matter of institutions. Trust in courts and contracts; mobility of labor and capital; accepted mechanisms to balance competing interests; an educational system not limited to the urban centers—all of these requirements of a modern economy are lacking. (We read herein the remarkable statistic that only 24 percent of the working-age population has completed high school.) Lacking, as well, is the freedom that people need to try new things even when (especially when), if successful, they will disrupt the industrial status quo.

No economy, he says, can remain dynamic and vigorous without these conditions. Magnus eloquently describes what is working against China here: the CCP’s fixation on control, a fixation that has intensified under President Xi. Xi appears to be bypassing much of the apparatus of the state in favor of new “leading groups” directly controlled by the CCP, and in many cases personally chaired by himself. Control of private enterprises is being tightened by means of Party cells and Party secretaries placed within them.

The Great Leap Forward, when no one dared challenge the crack-brained directives coming down from the top, offers a warning of what can happen in this kind of environment. But Magnus does not predict disaster. He suggests only that the CCP will never allow the kind of free-wheeling flexibility that would bring China into the top tier of economies. And he offers a pithy insight concerning Chinese business, which is notorious for conflicts of interest. President Xi’s anti-corruption drive purportedly aims to reduce them. But as Magnus points out, the most fundamental conflict of interest is the CCP’s own, since it acts at the same time as the owner, the manager, and the regulator of economic enterprise.

Similar arguments have been made elsewhere (even by your humble reviewer), usually emphasizing the role of civil society rather than economic efficiency. Some dismiss this critique as an attempt to impose Western values on an Eastern reality. Time will tell. More troubling is the fact that much of what threatens China is also happening in America: rising debt, pervasive propaganda and surveillance (though not necessarily by the government), and a widening gulf between classes. We are even trying out our own version of the Red Guards, struggle sessions, and officially sanctioned infanticide. Not long ago, Americans dared to hope that trade and the Internet would bring about a “convergence” in which China would become more like us. It seems instead that we are becoming more like China.

As a bonus, Red Flags includes a discussion of the One Belt, One Road initiative, which Magnus tries to consider fairly without uncritically accepting its advertising. But there are indications—which came out, I believe, after the book went to press—that this ambitious project is even more self-serving and exploitative than the author indicates.

The Limits of Expertise

It’s a useful and interesting book, but it is not wholly satisfactory. For someone so well-informed, Magnus makes curious mistakes.

After accurately describing “China’s looming water crisis,” he writes: “Yet water figures almost nowhere in the policy and political rhetoric of Chinese leaders.” In fact, as long ago as 1999, Wen Jiabao, then Deputy Prime Minister, described the water crisis as a threat to national survival. An enormous infrastructure project has been under way to divert billions of cubic meters of water each year from the South to the North. As of 2018, more than 400,000 people had been relocated and almost $50 billion had been spent on this project, which is functioning but unfinished and continues to prompt debate within officialdom as well as among citizens and environmentalists. (There are other examples that suggest caveat lector. I will put two somewhat technical ones in an end note.[1])

A certain worldview suffuses the work. Magnus finds President Trump deplorable and rarely misses a chance to say so. As a former chief economist for one of the world’s largest banks, he is a distinguished member of the global elite that has managed the Western world into its present condition. Experience has not dimmed his confidence in free trade with mercantilist counterparties, or made him less sanguine about the alignment of interests among social classes and among Western nations. Although his book conveys many a sign that China has adopted an aggressive intransigence, his recommendations imply that all we need is more of the same policies that have brought us to this pass, except perhaps now implemented with greater refinement.

The United States “should look to persuade China,” he writes. “The US should seek a dialogue with China . . . The Comprehensive Economic Dialogue is an appropriate forum . . . If calmer heads prevailed, the US would sit down with allies and try to work out a collective approach.” He doesn’t seem to realize that U.S. voters chose Trump’s confrontational style because they judged the modulated counsels of the experts to have failed; or probably he dismisses their views, like Trump’s, as “petty and misinformed.” After all, this British economist knows America. He describes towns near “Fort Meyers” in Florida (p. 112). Yet some of us believe that Trump, rather than turning away from the rest of the world, is negotiating with it—and not ineffectually.

Of Gold and Steel

Yet even though his globalist certitudes had me rolling my eyes, Magnus has written an astute and nuanced assessment of the economic challenges facing the Chinese dictatorship. I think he is right that, while there is no reason to anticipate collapse, the regime’s leadership style will compound the difficulties and ensure that stress will rise.

Early on, he weighs a basic question, namely why is it that China is so actively stepping up its centralization of power at this time: “Centralization of power can speak to pressing demands in the face of perceived threats for either military preparedness or economic reorganization. The latter seems overwhelmingly likely, and so it is plausible that China’s main purpose is economic transformation.”

That word—“overwhelmingly”—seems like a bit of hand-waving. Isn’t it remarkable that he raises two possibilities, at the highest level of strategic thought, and dismisses one of them in five words? Should we not consider the possibility that centralization was undertaken to facilitate both economic transformation and military adventures?

He writes more soberly near the end of the book:

China’s military might and naval build-up, along with the militarization of reefs and atolls in the South China Sea, are not hidden, and nothing would please China more than to drive the US Seventh Fleet away from the island chains off China’s coast and back across the Pacific. . . . [Xi Jinping] has pledged to return Taiwan to the Motherland during his rule, and we are left to wonder how China might contrive to make this occur.

And wonder, we do. Yet the author envisions only two ways the story might end: China bestriding the world as an economic colossus, or China entering a phase of slow growth, maladroit administration, and economic instability. He leans toward the second outcome.

Your reviewer considers it likely that economic developments, about which Magnus has written a fine book, will be overtaken by military ones that he doesn’t want to think about. If the Editor permits, I hope to address this question with you in a future essay.


[1] Magnus says the U.S. tax cut of 2017 worked at cross-purposes to professed concerns about the trade deficit: “Since the Trump administration and congress agreed to substantial cuts in taxation in 2018 and 2019, a much wider fiscal deficit will emerge. This is the equivalent of a fall in US savings, and since the external deficit is the outcome of the relationship between savings and investment, it follows that the wider fiscal deficit will simply expand the external or trade deficit.”

Not so fast. The national-income accounting identity [Y = C + I + G + (X-M)] , which Magnus relies on here and elsewhere, applies to a static snapshot of economic activity. To predict an economy’s changing behavior over time, we need a causal model, which the identity itself doesn’t provide.

To be sure, there is a classical, causal explanation which supports the view expounded above, but it depends on feedback loops involving both the interest rate and the exchange rate, which must be free to vary in response to market forces. (See a good discussion here.) But in fact the interest rate in the United States has been kept near zero by means of those policies known colloquially as “financial repression,” and the exchange rate can’t play its natural role if significant trading partners such as China peg their currencies to the dollar.

I mention these facts not to impute all our troubles to them, but to explain my skepticism toward macroeconomic axioms that derive from an idealized model of reality.

A third example of his occasional imprecision: The author distinguishes between utility patents and design patents (p. 152), terms of art in intellectual property law, but the definition he offers for design patents is actually the definition of utility patents, and his explanation of design patents relies on the wrong meaning of “design.”