China Shock 2.0: State Capitalism at the Frontier | Dinny McMahon

25:05And so you kind of get called in and you're told, oh, guess what? You owe this in back taxes. And it's like, well, no, I don't. And it's like, well, yes, you do. So, yeah, in some ways, local government being financially overstressed is hitting the consumption side of the equation. But it's also more directly hitting private sector firms. And of course, the second order effects of that is it's hitting consumption. Because if you're working at one of those private sector firms and the local government is your major customer and it hasn't paid its bills for the last two years, well, that affects salaries, it affects bonuses.

25:39And so there is a real trickle down effect through the entire economy. So yeah, it is suppressing household consumption.

25:45Demetri Kofinas:So Michael Pettis, who's been on this podcast before and who I'm pretty sure you cited in this paper as well, is one of many economists who have argued for years, though I think he's the one who's maybe most famous for doing so, that China needs to rebalance its economy by prioritizing consumption at the expense of investment, or putting more emphasis on consumption that is currently the case. And I think you also fall in this category as well. Certainly, this is something that you've talked about in interviews and in this paper. I'm curious to understand what the perspective is in Beijing, because there does seem to be some sense of recognition that the economy is unbalanced, though maybe what they interpret as being balanced or what a balanced economy would look like is different than what Western economists think.

26:34Demetri Kofinas:So what exactly is the perspective on this particular view in Beijing, the need to emphasize consumption, how to go about rebalancing the economy, what the relationship is between investment and consumption. How would you answer that for people that want to understand the perspective of the CCP on this question? Yeah. So there are certainly senior Chinese economists who share Pettis's opinion. I mean, he's not a foreign voice siding with foreign ideas. I mean, his ideas do have some currency within the Chinese system, but it is not the approach that Beijing is pursuing. And I know this starts to get a little bit confusing for foreign observers because Beijing talks a lot these days about consumption and the importance of consumption and the need to boost domestic demand and that they're going to put domestic demand at the center of the economy.

27:26All these are sort of things they've been saying over the last few years. And so, outside of China, when people hear this, they assume, okay, the pivot is going to finally come because there has been a school of thought, particularly among Western, but also some Chinese economists, which was that when the property driven growth model hit its use by date, the only thing China could do then is pivot to a consumption led growth model, because it had already invested so heavily in property and invested so heavily in infrastructure. At this stage of economic development, and given the size of China's economy, it couldn't go back to an export led economic model.

28:03It just already exports so much, it couldn't lean any more on exports.

28:07Demetri Kofinas:What is the current percentage? Do you know off the top of your head of global exports? What percentage of those are out of China? Of global exports, I don't know, but I know that China exports about 35 % of its manufacturing by value. I know that the UN estimates that by global standards, China is responsible for about 29 % of industrial production. So, given anything produced in industry globally, China accounts for between a quarter and a third, and that number is just rising with a bullet. So, it's absolutely massive and absolutely huge. And economists said, well, look, it's already so huge, you can't expect an economy of that size to lean any more heavily into exports.

28:47And so, there was only one legitimate, feasible, viable alternative economic model. And that would be for China to lean into consumption because it's so weak. And that would be the thing that would drive the economy. And so I think there's still a sense of whenever China talks about, Beijing talks about, we're going to boost consumption. Domestic demand is very important. We need to increase household spending. People overseas hear, oh, okay, this is going to be demand side stimulus. They're going to do the sort of stuff to boost consumption that we do in the United States and we do in Europe.

29:19And that is put more money into the pockets of households so that they can spend more stuff. The thing is, that is not what China is doing at all. Because if you want to rebalance the economy and make it a consumption-led economy, that's what you need to do. It is through the welfare system. There is no other way that you can redistribute wealth on the sort of scale that can really drive consumption in a relatively short period of time in China, unless it's through the tax and the welfare system. But the thing is, Beijing isn't doing that. And there's a couple of reasons. And often what you hear is people say, well, the reason they're not doing it is because Xi Jinping himself, Xi Jinping has this sort of deeply felt aversion to welfarism.

29:59He just doesn't want to spend money on welfare, which couldn't be further from the truth. I mean, he has used that term before, but he also talks all the time about wanting to spend more on education and on pensions and on healthcare. But the reason they don't do it is, and this is the other thing that you hear all the time in the official documents, is that they want to do it, but they will only do it to the extent that it is within our means. And they use a variation on that phrasing all the time. They spend more on welfare when they can afford it. And they have this deeply ingrained fear of funding welfare from debt.

30:36And they talk about the risk of what they perceive as being Latin Americanization. They kind of see this as being the original sin of the Latin American economies in what, the 70s and the 80s, where middle income economies that were growing really aggressively, you know, they were going to become rich nations and yet they kind of hit a wall. And the way Beijing sees it is part of that wall was they started to sort of build the foundations of a European or Western style welfare system before their economies had the capability to support it. And so debt ballooned and their economic prospects went out the window.

31:10And so that's why when we hear consumption-led growth, we think redistribution and we think demand-side stimulus. The Chinese are like, no, we're not willing to do that until the tax base can support it.

31:24Demetri Kofinas:Well, so let's clarify something here. It's not that the tax base can't support it. It's that they want to maintain their current growth rates. They want to capture more export markets. They want to expand the share of exports that they currently have. They want to dominate certain industries. So the level to which they continue to prioritize investment, that is preventing them from engaging this welfare spending, because in order to do that kind of welfare spending in the context of prioritizing investment, they need to expand debt. Is that right? Is that the right way of thinking about this?

31:56I wouldn't necessarily put the cause and effect like that. I think the way that they see it is that they've got an incredibly low tax to GDP ratio at the moment, which is about 20%. Now, to increase taxation levels in this particular economy would be potentially recessionary, right? I mean, if you started taxing households, which already feel the pressures of a relatively weak post-property market, that would further suppress consumption. You can't really do it to firms at the moment because profit margins are so weak. And so you can't really expand - And why are profit margins so weak?

32:34Demetri Kofinas:I mean, obviously every firm is different, but some firms could have room to expand profit margins, couldn't they? I mean, we are also facing tariffs now and pushback. I mean, I guess what I'm trying to say is that China is a rich country in the sense that they have captured a huge portion of global production. They run a chronic trade surplus. I think that an average person listening to this would be confused by the notion that they don't have the money, that they're constrained by the income to actually support these services. The only way that and I fall in this category as well, because I've heard this for years.

33:06Demetri Kofinas:The only way that it makes sense for me, and then help me understand why I'm getting this wrong. The only way that it makes sense for me is that there's just a very high emphasis on competitiveness, on global economic competitiveness. And that is the priority. And it comes at the expense of building up domestic consumption. Because I feel like they could do it, but they would have to pull the reins a bit on investment. I don't think that's quite right in the sense that I don't think the priority is global competitiveness. I think that is a consequence, but it's not a priority. So what they want to be able to do is they want to be able to, they definitely want higher levels of consumption, right?

33:46Ultimately though, they see that as being coming at the end of this transformation project as opposed to the beginning. And so they don't want to do it through welfare and wealth redistribution. They want to raise incomes and increase consumption, not through redistribution, but through wealth creation. And that kind of speaks to what you were saying there about global competitiveness. But global competitiveness is kind of a symptom or a consequence of what they're trying to build. So, in terms of wealth creation, what they want is to develop the sort of economy that is able to deliver eventually higher corporate profits, and those more competitive companies are able to pay higher wages and greater bonuses.

34:25And once you've got a public that is earning higher incomes and hence paying higher income tax, and you've got more profitable companies, that will expand the tax base, at which point the government will be able to expand welfare payments, start to raise income levels, start to deliver on the promise of common prosperity. And that, you know, it may be part and parcel of that as well, because you've got more profitable companies, you know, stock valuations go up, which is great for China's middle class, it becomes a driver of middle class wealth to replace the property market. And you put all of that stuff together.

34:58And you have a China that is then able to support higher levels of consumption because the nation as a whole is more affluent. And that is the vision. They don't want to do wealth redistribution now, partly because they don't think the system can support it, but partly because they don't think that sort of consumption led model is kind of the road to sustainable wealth and affluence. It's redistribution as opposed to creation.

35:20Demetri Kofinas:Right. But in order to accomplish that, they need to rely on selling more to the rest of the world, which means they need to pull income from the rest of the world. They need to buy debt from the rest of the world. They need to buy assets. They need to continue this model that is at the center of the political crisis that are facing Western democracies at the moment, and that have led to the erection of trade barriers, export controls, and the like. And so again, I hear what you're saying. I think the emphasis you're making here, it sounds like is the causal dynamics. So then maybe the more practical question, Denny, is how do they square this with what's going on in the world today?

35:58Demetri Kofinas:One, how do they square it with some of the just the drag that happens, the diminishing law of return for raising the percentage of exports that your economy depends on, just the saturation amount that the rest of the world can absorb, but also the policy pushback and backlash from the rest world, the rise of nativism and protectionism. How are they adjusting or thinking about this commitment to export-led growth, to continuing to grow investment in order to get the economy to a certain place where then they can redistribute wealth and engage in transfers that can create a flywheel of domestic consumption?

36:41Demetri Kofinas:Is the focus then to shift from the developed world to the developing world? What is the idea there to make this viable? Yeah. I think to the extent that they've certainly thought about the new model, and I think that the domestic side of things, they've clearly put a lot of thought into, right? We need higher productivity. We're going to do it through innovation and industrial upgrading. And that will extend into, we'll need greater exports. But I think they've focused a lot on the domestic side of the equation. But I think the international side of things, they're kind of dealing with a little bit more on the fly.

37:12Now, that said, I think they've certainly built up a toolbox of ways to kind of push back against the US when the US and the EU, when they're like, hey, we're not happy with this situation anymore. Both the EU and the US have kind of found it difficult to kind of rein in Chinese exports because Beijing has been so willing to push back with its own trade barriers, whether it's been with the US not buying soybeans, with Canada, not buying canola, with Europe, not buying pork. I mean, Beijing kind of knows where those pressure points are to push back. But I think what you were saying about the developing world was incredibly important as well, because I think we're going to find with China Shock 2.0, I mean, David Orta a few months back sort of, you know, rebranded what's happening now as kind of the second chapter of the China Shock.

38:01I think this one is first and foremost, it's affecting countries with advanced manufacturing. So that's the United States, EU, Canada, Japan, South Korea. But for the rest of the world, and it's not just the developing world, it's pretty much other countries that don't have advanced manufacturing, like rich nations in the Middle East, even like Australia. I mean, I go home to Australia and it's like in the US, you don't see Chinese vehicles on the road. You get off the plane in Sydney and half the rentals that are available to you at Sydney Airport are Chinese vehicles. And there's no real debate about it.

38:34There's no sort of backlash about it because, you know, Australia doesn't have a car manufacturing industry. You know, the government stopped providing subsidies in 2017. So, you know, Chinese vehicles coming in, it's not challenging jobs. It's not challenging brands or industries. And so, I think you're finding that in the developing world. I mean, what in Mexico, I think 20 % of all new cars sold in Mexico are Chinese. In Israel, I think the percentage is similar. In Australia, it's a little bit lower. So I think the degree to which the rest of the world, the non-advanced economies are willing to accept this expansion of Chinese manufacturers, I think they're going to be relatively open because they stand to lose far less from it.

39:14I mean, there's going to be certain points like steel exports, which are increasingly becoming a point of tension in developed and developing countries alike. But when it comes to China's advanced manufacturers, I think there's going to be far less sensitivity to it in the developing world.

39:29Demetri Kofinas:So is the vision for this to be... Because what this seems to appear to be like is somewhat of a colonial model or a model, maybe the word colonial is not quite right, but when the British approach to industrialization during the first industrial revolution was to focus on high end manufacturing domestically, export those goods to the colonies and to the periphery, and in return, take agricultural goods, commodities, and things like this, so that it It maintained all the advanced manufacturing know-how, all the high value was stuff that was done in the UK, and the easy stuff was done out in the sort of quote, in this case, developing world.

40:05Demetri Kofinas:Is that the vision for China? Is that also the vision through the one belt, one road? Yeah. To be honest, that's what it looks like, Dimitri. I think you nailed it. You look at what China is doing with its manufacturing machine, right? It's doing three things. One, it's moving aggressively into advanced manufactured goods. So we're talking, you know, batteries, cars, flying cars, drones, biotech. I mean, you know, the sort of increasingly the bleeding edge of manufacturing. But the other thing is, which I think is generally overlooked, is that it is hanging on to traditional industries. I mean, it's been very explicit like this.

40:39So, you know, the old flying geese model of East Asian development, right? It's like Japan was the first country to develop. And then as wages went up, certain industries like textiles or shoe manufacturing became too expensive to continue to manufacture in Japan. So those factories moved to South Korea and Taiwan. Those places went through the same process. Manufacturing then moved to Malaysia and Thailand and then to China. And China, you know, I think we all assumed that at some point these low-end factories would move elsewhere. And we've seen a degree of that happening with, you know, factories moving to Bangladesh and Vietnam.

41:14but Beijing has been very explicit that it wants to hang on to what it's got. And a great example is cigarette lighters, right?

41:21Demetri Kofinas:Cigarette lighters. That's an amazing example. Look at the company in the town of Shandong in Hunan province, right? Yeah. What an amazing story. Yeah. Tell our listeners about that one. So cigarette lighting manufacturing, they were made in Europe originally. I think they started off in Spain. And then in the what, 70s and 80s, I think they moved to South Korea and Japan. Then in the 90s and early 2000s, they moved to Zhejiang and Guangdong province, and then they moved to Xiaodong and Hunan. And then I think about 10 years ago, labor costs were going up and it was becoming increasingly difficult to find workers in these factories.

41:54And so, you would then assume one of two things would happen. Either these factories would move to Bangladesh, Vietnam, Laos perhaps, or they'd move further west into China, where there was cheaper labor. But instead, what happened is the factory owners started teaming up with local engineering and design companies to come up with machines that could start to replace some of the workers. And over the last 10 years, I think what there's been three, four different rounds of capital upgrading and the price of cigarette lighters have absolutely plunged to make it, to make them as plunged and the number of workers have plunged.

42:30I think the biggest firm in the area, Dongyi Electric has reduced its workforce by, I think, 85 % and it's reduced its costs to manufacture a lighter by 95%. And that's the model. That's what they're trying to do throughout the economy. You're seeing this in other industries as well. I mean, I think pen manufacturing, the volume of pens that China's exporting is going up rather than down, where it's exactly the sort of thing that should be moving overseas. So, Beijing wants to hold onto it because they see it as being part and parcel of their efforts to move higher up the value-added chain. So, you know, it creates demand for these engineering firms to put the R &D into coming up with into machinery that can help improve these efficiencies.

43:14So, that's the second thing. One level, they're moving into advanced manufacturing. Two, they're hanging on to what they've already got. And the third thing is import substitution. That they are, partly this is a national security issue. Beijing, as a matter of principle, does not want to be dependent on having to import industrial goods from anywhere, which is part of the reason why they kind of have established this almost monopolistic control over rare earths and magnets. But it's also why they're investing heavily in semiconductors because they don't want the US to be able to shut off the supply.

43:44But it's also why they're heavily investing in machine tools and precision instruments, which they've traditionally got from, I think, the Dutch, the Germans and the Japanese. Same sort of thing. They don't want to be cut off. And so, this import substitution thing is having a huge impact, particularly on the Germans, because the Germans have made absolute hay out of China's industrialization over the last 20 years because China needed more factories, it needed to upgrade its factories, and that's what the Germans did. And now the Chinese are making that sort of capital equipment, the machine tools, the precision instruments, the machines that run the factories.

44:22They're making the stuff that the Germans have made to a comparable level of quality and at much lower prices. And the German economy is increasingly starting to strain under it. So yeah, going back to what you were saying, Dimitri, this is why that kind of what you described as a colonial allocation of almost resources. There's maybe an element of truth to that because China's manufacturing sector is increasingly set up in a way where it exports industrial goods. It has less and less reason to import industrial and manufactured goods from elsewhere. And so ultimately what it needs is it needs food, it needs minerals, it needs energy, but increasing to not as much as it used to because of its increasing reliance on renewables.

45:06And I think also then you have the other thing that it would buy from overseas is tourism, people going abroad to, you know, on beach holidays to Thailand. And then the last thing I think they're also more than happy to import is luxury goods from places like France. But I think that is the economy that they envision. Manufacturing, they do all themselves. Industrial production, they do all themselves. But it's tourism, it's primary industries, and it's high-end luxury goods, which they're happy to import.

45:35Demetri Kofinas:So the kinds of technology-driven productivity gains that you described with the case of this lighter company, and that they're seeking to employ across all sorts of legacy industries, leads to labor displacement. government. Those workers need to find jobs higher up the value chain. How does the leadership in Beijing think about facilitating that process and how does that show up in the way that they run the education system? So are they thinking, I mean, I imagine they are, about how to use public education and other state services to accelerate the movement up the value chain for their workforce or is this primarily thought about in terms of solving the demographic problem?

46:22Demetri Kofinas:Since people are going to be getting older, we need technology-driven productivity gains anyway. We're not going to need as many workers or is it something in between? Oddly enough, it's all of those things. So you are seeing shifts in the education system to prioritize more vocational training because there is this awareness that they're going to need fewer blue-collar workers and more purple-collar workers, technicians. And so we're seeing shifts in the education system. But to the extent that Beijing is sort of vexed and stressed about employment issues, it's less the blue collar issue and more the white collar issue.

46:55Because the degree to which the universities have expanded enrollment over the last decade has been massive. I mean, every year you have millions of young Chinese graduating from the universities and the jobs aren't there or specifically the jobs that they had expected to graduate into just aren't there and they're white collar jobs. And I think that's perhaps the most interesting thing about this push into advanced manufacturing because it's not just advanced, you know, advanced manufacturing needs to be supported by advanced business services. And so, this is one of the things that just turned up in the proposals for the next five-year plan.

47:38And you're kind of seeing government and next government officials increasingly talk about the importance of business services as a source of employment and a source of growth. So, to give you some context, if you take a company like Apple, right? Apple doesn't actually make anything. It's all outsourced. And it certainly doesn't make anything in the United States. And yet it employs 90 ,000 people in America. And most of those jobs are white collar jobs, right? They're software engineers or they're coders or they're business development people or they're supply chain managers. They've got lawyers protecting IP.

48:11They've got human resources people. They've got, you know, there's a huge army of people in the services industry and they're all in white collar jobs. And I think that's what Beijing envisions as well, that the push into advanced manufacturing isn't just about reallocating workers. We don't need as many workers. This is going to improve efficiency. There's going to be more people freed up to sort of help the elderly. Maybe there's an element of that. But I think the bigger issue here is that all these army of university grads who kind of don't have anything to do at the moment, I think the vision is this is how you develop the economy.

48:51So it starts to look more like that of Europe or the United States, where you have this huge bulk of white collar jobs that are created in support of an expansion into industry. And I think that's the really big trend that they're hoping to push for. And again, that comes back to what I was saying before. They want an economy in which you have broader corporate profits, great. But what they really want is to push people's incomes higher. And the way to do that isn't really by moving blue collar jobs into purple collar technical jobs, because as you said, there's just going to be far fewer of them.

49:24The real trick is creating white collar jobs. And that's what they kind of see as being the real magic source, special source behind advanced manufacturing.

49:34Demetri Kofinas:And what are we talking about when we say white collar jobs? So this is everything from - Okay. So we're talking about research. So you've got PhDs doing the R &D work. You've got on the less technical side, you've got more and more people in sales. In between, you've got marketing and design and industrial processes and engineering of supply chains. It really is the whole gamut. So you do have your lawyers and you've got your accountants, but you've also got your technical people as well. So I'm going to move to the second hour, Denny. There are three sections that I really want to cover from my outline here.

50:13Demetri Kofinas:One is I want to dig into what the export strategy is for China now, because again, this is a much more complicated environment than it was 20 years ago. The rest of the world is erecting trade barriers. They're trying to, quote, de-signify or de-globalize or de-risk their supply chains. China has employed some very clever and thoughtful ways to get around that. One of them has been the focus on creating intermediary goods so that they can still be a critical part of those supply chains, but in a way that still evades the tariffs. I want to look at worst, best, and most likely case scenarios, which is something that you explore in the book to understand what we can expect or what the likely paths are heading out to 2035.

50:55Demetri Kofinas:And then I would like to devote the rest of the conversation to the policy implications for Western policymakers, as well as for investors. And I think there's also something to talk about here, which is the trade-off when thinking about climate and the energy transition. Because the Chinese are the leaders now in renewables, whether we're talking about solar, especially battery technology, they've built what, like hundreds of new nuclear plants. How many nuclear plants are currently under commission? Again, probably not a question you can answer, but it's a lot. It is a lot. So there are a lot of huge implications here for US policymakers and Western policymakers writ large that there are a lot of costs and benefits associated with these decisions.

51:42Demetri Kofinas:So I want to explore that, all of those things in the second hour, Denny. For anyone new to the program, Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Denny, head over to hiddenforces.io slash subscribe and sign up to one of our three content tiers. All subscribers gain access to our premium feed, which you can use to listen to the rest of today's conversation on your mobile device, using your favorite podcast app, just like you're listening to this episode right now.

52:16Demetri Kofinas:Denny, stick around. We're going to move the rest of our conversation onto the premium feed. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io slash subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius Community, you can also do that through our subscriber page. Today's episode was produced by me, and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter at Kofinas, and you can email me at info at hiddenforces.io.

52:55Demetri Kofinas:As always, thanks for listening. We'll see you next time.