Big Problems Forming in the Middle Kingdom

Big Problems Forming in the Middle Kingdom

Most of us are busy counting virus numbers and chewing on headlines that give us clues on when we will get more and more freedoms back.

Don’t get me wrong, while these are really important…constantly seeing the same headlines means we are missing important movements in the background.

Just last week I wrote there are sleight of hand moves happening in mainland China. It appears that the Chinese government is encouraging state-owned companies to de-list from a major international stock exchange.

Which reduces the transparency for outsiders…

However, as Jim points out today, there are bigger problems forming in the Middle Kingdom. One is the ever-increasing pile of debt required to encourage economic growth.

The other, is making sure the population remains appeased, so that the Chinese Communist Party doesn’t lose their grip on the population…

As Jim says, that may be more difficult then it seems.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia


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Market expert Shae Russell predicts five knock-on effects of the recent market crash that could be even bigger threats to the average investor’s wealth than the crash itself. Click here to learn more.

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China: More Bark than Bite

Shae Russell

Jim
Rickards

I’ve made many visits to China over the past 30 years and have been careful to move beyond Beijing (the political capital) and Shanghai (the financial capital) on these trips.

My visits have included Chongqing, Wuhan (the origin of the coronavirus outbreak), Xian, Nanjing, new construction sites to visit ‘ghost cities’, and trips to the agrarian countryside.

My trips included meetings with government and Communist Party officials, and numerous conversations with everyday Chinese people.

In short, my experience with China goes well beyond media outlets and talking heads. In my extensive trips around the world, I have consistently found that first-hand visits and conversations provide insights that no amount of expert analysis can supply.

These trips have been supplemented by reading an extensive number of books on the history, culture, and politics of China from 3000 BC to the present. This background gives me a much broader perspective on current developments in China…

China stuck in the middle income trap

An objective analysis of China must begin with its enormous strengths. China has the third largest territory in the world, with the world’s largest population (although soon to be overtaken by India).

China also has the fifth largest nuclear arsenal in the world with 280 nuclear warheads, about the same as the UK and France, but well behind Russia (6,490) and the US (6,450). China is the largest gold producer in the world at about 500 metric tonnes per year.

Its economy is the second largest economy in the world, behind only the US, China’s foreign exchange reserves (including gold) are the largest in the world.

By these diverse measures of population, territory, military strength, and economic output, China is clearly a global superpower and the dominant presence in East Asia.

Yet, these blockbuster statistics hide as much as they reveal.

China’s per capita income is only US$11,000 per person, compared to per capita income of US$65,000 in the US.

Put differently, the US is only 38% richer than China on a gross basis, but it is 500% richer than China on a per capita basis (of course, the massive economic fallout from the coronavirus will have an impact).

China’s military is growing stronger and more sophisticated, but it still bears no comparison to the US military when it comes to aircraft carriers, nuclear warheads, submarines, fighter aircraft, and strategic bombers.

Most importantly, at US$11,000 per capita GDP, China is stuck squarely in the ‘middle income trap’ as defined by development economists.

The path from low income (about $5,000 per capita) to middle income (about $10,000 per capita) is fairly straightforward and mostly involves reduced corruption, direct foreign investment, and migration from the countryside to cities to pursue assembly-style jobs.

The path from middle income to high income (about US$20,000 per capita) is much more difficult and involves creation and deployment of high-technology goods and manufacture of high-value-added goods.

Among developing economies (excluding oil producers), only Taiwan, Hong Kong, Singapore, and South Korea have successfully made this transition since the Second World War. All other developing economies in Latin America, Africa, South Asia, and the Middle East — including giants such as Brazil and Turkey — remain stuck in the middle income ranks.

China remains reliant on assembly-style jobs and has shown no promise of breaking into the high income ranks.

To escape the middle income trap requires more than cheap labour and infrastructure investment. It requires applied technology to produce high-value-added products. This explains why China has been so focused on stealing US intellectual property.

China has not shown much capacity for developing high-technology goods on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and ‘national champions’, such as Huawei in the telecommunications sector.

But now the US and other countries are cracking down on China’s technology theft and China cannot generate the needed technology through its own R&D.

In short, and despite enormous annual growth in the past 20 years, China remains fundamentally a poor country with limited ability to improve the well-being of its citizens much beyond what has already been achieved.

And that has serious implications for China’s leadership…

Critical for the Chinese Communist Party to survive

China’s economy is not just about providing jobs, goods, and services. It is about regime survival for a Chinese Communist Party (CCP) that faces an existential crisis if it fails to deliver.

It is an illegitimate regime that will remain in power only so long as it provides jobs and a rising living standard for the Chinese people. The overriding imperative of the Chinese leadership is to avoid societal unrest.

If China’s job machine seizes, as parts of it did during the coronavirus outbreak, Beijing fears that popular unrest could emerge on a potentially much greater scale than the 1989 Tiananmen Square protests. This is an existential threat to Communist power.

President Xi Jinping could quickly lose what the Chinese call, ‘The Mandate of Heaven’.

That’s a term that describes the intangible goodwill and popular support needed by emperors to rule China for the past 3,000 years. If the Mandate of Heaven is lost, a ruler can fall quickly.

Even before the crisis, China has had serious structural economic problems that are finally catching up with it.

China is so heavily indebted that it is now at the point where more debt does not produce growth. Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.

Meanwhile, China’s real year-over-year growth tumbled 6.8% in the first quarter.

Besides the slowdown from the pandemic, China confronts an insolvent banking system and a real estate bubble.

Up to half of China’s investment is a complete waste.

It does produce jobs and utilise inputs like cement, steel, copper, and glass. But the finished product — whether a city, train station, or sports arena — is often a white elephant that will remain unused. The Chinese landscape is littered with ghost cities that have resulted from China’s wasted investment and flawed development model.

Chinese growth has been reported in recent years as 6.5–10%, but is actually closer to 5% or lower once an adjustment is made for the waste. Again, that was before the crisis.

Essentially, China is on the horns of a dilemma with no good way out. China has driven growth for the past eight years with excessive credit, wasted infrastructure investment, and Ponzi schemes.

The Chinese leadership know this, but they had to keep the growth machine in high gear to create jobs for millions of migrants coming from the countryside to the city, and to maintain jobs for the millions more already in the cities.

The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies, and unemployment) or inflation (which results in theft of purchasing power, similar to a tax increase).

Both alternatives are unacceptable to the Communists because they lack the political legitimacy to endure either unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.

The question is, will China pursue an aggressive posture against the US to distract the people?

China does not want war at this time, but diverting the people’s attention away from domestic problems toward a foreign foe is an old trick leaders use to unite the people in times of uncertainty.

If China’s leadership decides that the risk of losing legitimacy at home outweighs the risk of conflict with the US, the likelihood of war rises dramatically.

I’m not making a specific prediction, but wars have started over less.

This is a very dangerous time.

All the best,

Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia