The Four Big Structural Forces Holding Back China's Economy

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1:27Hello and welcome to another episode of the odd lots podcast i'm joe weisenthal and i'm tracy alloway tracy very weak economic data out of china lately yeah to put it mildly i'm just starting very directly no the data has been very weak i have a collection of uh paraphrased headlines here so we're recording this on august 16th and we just saw an emergency rate cut from china they also announced that they would stop publishing the urban youth unemployment rate, which is never a good sign. When you just announced that a certain data point that people have been tracking for years suddenly will not be published anymore.

2:05Yeah, exactly. And a particularly politically sensitive data point too. Retail sales are coming in extremely weak. So rising less than 3 % a year. They used to be in double digits. We have deflation setting in, which is something we spoke about on the episode we did with Richard Koo. Manufacturing is contracting. Exports are falling. The UN is dropping against the dollar. Bank loans at a 14-year low last month. You really came prepared, Tracy. I did. Yeah, I know it's surprising, but I did actually - I'm not surprised, I'm just surprised. I did actually put together the data points because they're so startling.

2:42And again, if you compare it with all the excitement from earlier in the year about China reopening, the end of COVID zero, there was this expectation that China was gonna end up being a positive catalyst for global growth this year. And instead, we are potentially seeing the exact opposite. Yeah, you bring up a good point. I think one of the theories is that there would be this big inflationary impulse globally from the China reopening, demand for steel, demand for various metals, obviously demand for oil and gasoline. And that hasn't picked, you know, there has been this pretty mild sort of mediocre reopening.

3:16It hasn't had that global shockwaves. If anything, people are talking about exporting deflation or disinflation. And then on top of all of the sort of like economic weakness that you bring up, there's also the sort of like financial market weakness. So there was just a story today about one of the companies that sell some of these wealth management products missing payments. There's obviously, I think it's a country garden, the big developer running into a lot of trouble, similar to the weakness we've seen in China Evergrande. So to your point, though, just this sort of slew of negative headlines.

3:51Well, also, I think clearly there is concern that if you get real economic weakness in China, that could lead to something bad for the global economy just in terms of real business activity. But I think there's also this financial channel that is probably the one that's likely to be the most problematic. So if you think about China as, in many ways, a giant hoarder of financial assets, the big question now is what are they going to do with those financial assets? Do they have to, for instance, start selling off some FX reserves in order to support the UN? Are they maybe going to buy fewer US treasuries?

4:29So I think that is definitely one aspect of this that is really worth exploring. So many interesting elements right now. So we have to dive deeper into what is going on right now with the Chinese economy and what types of policy responses we might get or we might not get. I always see, you know, there's like a furious debate always on Twitter. It's like, why don't they just, why doesn't the government just give more money to households? Sort of like the Richard Kuh conversation is sort of, you know, got to boost domestic demand. What's the reluctance to do that? Like all these sort of different questions.

5:02So I think we really need to dive into them further. Let's do it. Well, I'm very excited because I think we have the perfect guest to discuss this. We are going to be speaking with Songwen's Zoe Liu. She is the Maurice Greenberg Fellow for China Studies at the CFR. And she is also the author of a new book, Sovereign Funds, How the Communist Party of China Finances Its Global Ambitions. Thank you so much for coming on, Adelots. Thank you, Joe and Tracy, for having me. And I'm a big fan of the Adelots. Very, very kind of you to say. You know, why don't we just start off like super simply? In your view, why hasn't China seen a more robust recovery since the lifting of the COVID restrictions?

5:43Well, I would say that actually I have always been a contrarian. Oh, good. I like this already. You know, in November last year, I put out a piece on foreign policy, basically made the argument to say that zero COVID is the least economic challenging problem that President Xi Jinping was facing that day. And even the party, in this case, it would be the party. And even if the party decided to remove zero COVID policy the next day, the economy won't rebound, sustain a robust rebound very quickly. And the reason comes from what I characterize as the four Ds. Demand, debt, demographics, and decoupling.

6:28At that time, it was decoupling and now it's de-rescue. This is great. The four Ds. The four Ds. It's like the four D's of the apocalypse. Yeah, no, that's really I feel like if you want to like have your thing, that's like a really demand and debt demographics and decoupling. I'm writing these down. So this is exactly what I wanted to ask you, because I remember even in 2018, 2019, there were concerns and a lot of discussion about a slowdown in China's economic growth. And then COVID happened and we sort of forgot about a lot of the structural issues that we had been talking about. And then lo and behold, in 2023, it feels like a lot of these structural problems are coming back to haunt the Chinese economy.

7:12Can you dive a little bit further into what those issues are? Yeah, sure. I would argue that a lot of these structural problems, exactly as what you are describing, Tracy, It seemed that during COVID, we were from both inside China and outside China, we were overwhelmed by the sudden pause of the economy because of the shutdown of factories and all that. And it seemed that temporarily, the pause of the economy covered up the structural problems that had been embedded into the Chinese economic growth model. And then once the party suddenly exit the zero COVID policy, given the consumption pattern that we have observed here in America or in Europe, people started to realize, oh, OK, so this is a$1.4 billion market and people are going to spend.

8:06And that would be powerful and inflationary. But short-term revengeful expenditure would not necessarily overcome the long-term structural problems that have dragged the Chinese economy, even just from GDP terms. If we think about the Chinese economy, there are different ways that you can argue that the Chinese economy has picked. I mean, I'm not necessarily that category. But if we just measure it from GDP perspective or in terms of export as a percentage of GDP, the Chinese economy already picked. You know, China surpassed Germany back in 2010 to become the largest trading or the largest exporting economy in the world.

8:47And it has at its height, export as a percentage of GDP was about 30 percent and has since then plateaued and decreased. Right now it's about 20 something percent. And if you think about GDP growth, the double digit growth period already ended. So from that perspective, what we actually observe goes back to the 40s. The problem with demand is not necessarily at, you know, I'm not talking about the ultimate demand. I'm specifically talking about the household consumption component of demand. For a long period of time, you know, yes, we can make the argument to say household consumption as a percentage contributing to the Chinese GDP is, you know, is about 40%.

9:30It has been low and, you know, global average. I'm not even talking about, you know, the OECD level. I'm talking about a global average. It's about 60 % of GDP, whereas China is 40%. We can make the argument to say, well, the household consumption has been a drag on the Chinese economy. However, up until 2012, by the end of 2012, actually household consumption's contribution to GDP growth at least has been an upward trajection. In other words, the growth of household consumption has been positive. positive. You know, you see Chinese people do discretionary vacations and all that. But that has changed since 2013.

10:15And if we just stretch it in between President Xi Jinping's two term, the second term was even worse than the first term. So let's go further into that. A, why has it gotten worse? And then B, you know, there's all this talk. It's like, why don't they just do household stimulus or some version of that? And people are sort of bemused, maybe is the word. It's like, oh, why isn't the Communist Party more willing to extend support directly to the people and, you know, rebalancing things? A, why did it get worse? But why is there this reluctance to do something like what we did in the US, just sort of print money and give it to people?

10:55You know, Joe, that's an excellent, excellent question. You make me think about the why aspect of it, right? So fundamentally, there are, I would argue that there are two aspects of why there has been a decrease in household consumption. The first one is, obviously, you can empirically observe from the data, there has been a decline in household income growth. And household income growth, up until President Xi Jinping, before President Xi Jinping came to power, household growth was, income growth was significantly faster than after he came to power. And again, his second term was worse on average than his first term.

11:34So that's one aspect in terms of household income growth. And then the second aspect of it would be household balance sheet deterioration. And a lot of this comes down to housing market, property value depreciation because of control on real estate policies and all that. Now, the reason why beer has been reluctant in terms of basically providing stimulus checks to a Chinese household is not that Chinese economists have not thought about that option. You actually do see people do that on Chinese social media when they realize that, oh, you know what, my cousins in America, they can just line up or wait in their house and the mail would come in and get a stimulus check.

12:20Some students were even getting stimulus check. And then the problem becomes, well, historically, there has not been this kind of precedent, but no precedent does not necessarily stop the government from inventing one, right? And the deeper problem, I would argue, is the politics. The politics simply would not necessarily work. Part of that is because empowering, this is probably deeper in the Chinese political philosophy in the sense that, well, you know, it's depending upon which political scientists or political economists you are talking to, some people would say, oh, you know, Chinese system is authoritarian capitalism or fragmented capitalism or fragmented authoritarianism and things like that.

13:05But fundamentally, what we observe is that the Chinese economic growth model has been built upon financial repression. And at the center of the financial repression are the Chinese banks. And who controls the bank is essentially the Chinese government led by the Chinese Communist Party. In other words, the Chinese Communist Party has always been at the center of capital allocation. and by empowering the household or for that matter, the private sector, it basically dilute or potentially remove their relevancy. Interesting. This is exactly what I wanted to ask you. And I just did a thread on Twitter that made a similar point.

13:47But how much of this is a political economy problem in the sense that both on the business side and the consumption side, we've seen the Communist Party be sort of, well, be controlling in many ways. So for instance, on private business, we've had the property crack down, the tech sector crack down, and that would apparently seem to perhaps make people more reluctant to do their own startups and things like that. And then on the household side, it does feel like you have a reluctance from the party to sort of empower the individual at the risk of losing some of their own power and perhaps the collective power?

14:29I am a political economist, so I would argue... The answer is yes. Yes, you are right, Tracy. And from an intellectual perspective, I do think this is a political economy problem, because if you look at the history of the Chinese economic growth since 1949, it's not that the economy has never experienced shocks. Actually, the Chinese system experienced a lot of shocks from even in the 1950s. You experience, the Chinese economy experienced the great leap forward. And when the communists took over, they also destroyed a lot of the banking systems in Shanghai and elsewhere established by the imperialists, right?

15:14So, and then there was also cultural revolution and all that. But then there is also the sudden stop of the cultural revolution. In other words, the Chinese economic, political economic system, A, is not short of crisis, or for that matter, man-made crisis. And secondly, the Chinese political economic system was also not unfamiliar with sudden reverse or sudden policy corrections. And what that means for today, that basically means the rapid growth of the Chinese economy has fundamentally been led by the government and the party. And it's just a degree of party state involvement. Now, if we think about the rise of Deng Xiaoping, he corresponded to the rapid rise of China and all that.

16:07But if we remember, what actually made China, the starting point of China's rapid growth was not necessary. Yes, it was 1978, the clear signal that China is reforming and open up. But then there was Tiananmen and China was put under sanctions and all that. And then 1992, he made this famous southern tour. He toured Shenzhen and all those places and he gave a clear signal during his speech when he was touring the southern part of China. And I was just recently revisiting his speech, so I remember this is something that I learned very recently, despite I read his speech so many times. So he cited this one example.

16:50This rich person, apparently he was one of the, if not the earliest, he was one of the earliest Chinese entrepreneurs to make 100 million yuan. He was the founder of this sunflower seed company called Sha Ziguazi, or Idiot Sunflower Seed. We had an idiot sunflower seeds, yes. Or Fu Sunflower Seas, Sha Ziguazzi. What a name. What a name. So at that time, out of jealousy or other reasons, there were some voices among Chinese people or policymakers to say, this guy becomes so rich, we need to take him down. And in his speech, Deng Xiaoping said, I'm aware of this kind of recommendations, But we cannot do that.

17:36He striked it down. And the reason, he also explained why the party cannot do that. He said if we punished him, that would send a terrible signal. It would make people think that we changed our policy of reform and open up. And there are so many instances that we can do things and make people think we changed our policies. And we cannot do that. So from his perspective, you know, the part, the big risk, as he characterized it, is to make mistakes, to make people think that we changed our policy.

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19:36step of the supplier life cycle, helping you deepen merchant relationships. Start fast, grow strategically, and scale at your pace with a modular toolkit you can flexibly deploy. Discover how at MasterCard.com slash commercial acceptance. Can I ask sort of, I don't know, maybe it's a devil's advocate question or I don't know how to characterize it, but obviously there's this big household debt overhang that you're talking about. It seems from the outside and it seems from many commenters like a pretty unhealthy real estate market in terms of the level of speculation, the level of cost, etc. It also seems as though the government would like to sort of find a way to get out of that trap where it's not all about, you know, not everything revolves around the cost of housing or buying a new apartment.

20:28Is there an argument to be made that stimulus direct to households today under the current economic structure would just sort of further fuel a real estate bubble or real estate demand? And that until the sort of domestic economy has shifted in some way more such that it's not out of that dynamic, that it doesn't make sense to boost demand for those reasons? First of all, I would say household demand for properties or for housing in China is on a perpetual decline for two reasons. The first reason is that from empirical data, we can observe that China's urbanization rate has peaked. And secondly, this goes back to one of the four Ds.

21:13Oh, the third D, demographics. Demographics. As of last year, Chinese population growth for the first time declined. And there are some numbers saying that actually now India's population is more than Chinese population. So it's not just the population decline on its own. is not necessarily causing an immediate shock or negative shock on housing demand, but it's actually the lower family formation rate. And the idea that people for whatever, for cultural reasons, it's very expensive to get married for fancy, you know, banquet and all that. But, you know, it's also very expensive to raise kids in China, especially in big cities.

21:52So from that, Those are the two structural reasons why demand for housing is on a perpetual decline in China. Even if the government gives stimulus checks to the Chinese household, in the current mix of policy environment, I would not necessarily be confident that the Chinese household are going to, A, be incentivized to spend or B, think that this is a good time to buy a house. And the reason, there are two reasons. The first reason is negative confidence shock. And the second is a deflationary policy environment. And the negative confidence, part of that comes from, you know, people's material feeling that their household balance sheet deteriorated as being felt by the Chinese people as, well, you know, I can empirically, observe the value of my house went lower, and yet I am still paying a lot of mortgage.

22:58So you see, well, there is early mortgage payment, which the banks are not happy about it. And then on the other hand, as the Chinese GDP growth slows down, you know, 3 % last year, despite record high export last year. And then on top of that, we see the move out or the redistribution of global supply Chi-chains and international multinationals become less bullish about the Chinese market, there are less high-paying jobs being created. So Chinese people become like, well, wait a moment. I don't think I'm going to make more money. Therefore, they are not going to be incentivized to spend. They are going to be more incentivized to save, not because of good environment, but because of lack of confidence.

23:50And the deflationary policy environment is because people are waiting. Well, it seems that from the beginning of this year, the government has put out so many policies to incentivize people to spend or, for that matter, support the housing market. And there is this popular saying, if you don't buy, if I don't buy, the housing price per square meter next week is going to be cheaper by 200 yuan. So everyone goes on strike, right, to try to get a lower price. I think this is such a good point because historically, a lot of Chinese growth has been driven by infrastructure investment and housing. And it feels like infrastructure has kind of run its course.

24:31China does have a lot of great infrastructure right now. And at the same time, housing, the other sort of twin engine of growth, there are a lot of doubts about it, as you just laid out perfectly. I want to go back to something you said earlier. I've never heard anyone phrase it quite like this, but I think it's absolutely correct. The idea that the Chinese economy is sort of predicated on financial repression and that introduces inherent limitations in a situation like this. Can you talk a little bit more about how you see that working? Sure. There are so many people talk about financial repressions and obviously people, you know, Tracy, you are absolutely right.

25:11A lot of infrastructure and housing have been the twine growth engine for the Chinese economy because they drive up aggregate demand and they also drive up global commodity prices. I would say that it's not that China built too much infrastructure or, for that matter, too much housing. It's that they overbuilt it to the extent that if population keep growing or more international companies move into China or there are more demand for factories because of entrepreneurs and all that, But growing supply, growing demand, the whole idea is this is the Chinese policymakers' mentality. As long as I build it, as long as I provide it, the infrastructure, they will come.

26:00But now the problem is international companies are not coming for a variety of reasons. And a lot of the reasons goes back to my quote about Deng Xiaoping. reason the Chinese leaders have simply made policy choices and policy decisions, created a huge uncertainty and a signal, even if they did not have the intention, but at least from our observation, they created the signal that perhaps the Chinese government or the party changed their policies with regard to reform and open up. So a lot of this boil down to, Yes, you know, the party is still very much at the center of capital allocation in this whole idea of financial repression.

26:48This whole idea is to use high savings that Chinese people tend to save. And this high savings is being channeled through Chinese banking system. And, you know, the four biggest banks are state-owned. And through lower depositors saving rate, lower depositors rate, they are able, the banks are able to lend cheaply to support state-owned enterprises or channel credit to sectors that are prioritized by the government. And many people who follow China, especially state-owned enterprises, they are familiar with this idea of the government has these guidelines or government guidelines for prioritized sectors.

27:34Every five years or so, they would update it. Right. You know, so we've talked about household demand. We've talked about debt. We've talked about demographics. There was actually a headline just yesterday in Reuters, China's fertility rate drops to a record low 1.09 in 2022. The one headline I left off my list, Joe. You found it. You had to save one for me. I appreciate that. Which is so obviously still going, you know, in the wrong direction. And I want to talk about, you know, the actual topic of your book. But I think maybe there's the fourth D in your 4D framework, the decoupling. And so obviously, I mean, I think there's some like sort of intuitions like, OK, like U.S.

28:12or global multinationals may be like less inclined to invest in China. Obviously, the sort of growing trade tensions that started under Trump and really have continued or maybe even ratcheted higher under Biden. But how do you think that we're decoupling? What does it mean to you? Like, how do you how would you define it? Honestly, I felt decoupling at the individual. First of all, Joe, I appreciate that you asked me how I feel about it because people are very confused about what is decoupling or what are we talking about? And there is actually no formal definition about what they are. At a personal level, the moment during COVID, the moment I realized I cannot get a plan from New York to go back to Shanghai or Beijing, for me, that is a sign of decoupling.

29:00And right now, if I am correct, there is still no direct flight between New York and Beijing or Shanghai. I didn't realize that. And the flight, right now, I think there are concrete policies that, you know, concrete initiatives in the aviation industry between U.S. and China to increase the flight, but it's still way below pre-pandemic level. So what we are, we can concretely observe less and less people-to-people communication. And from economic sense, obviously, or political economy sense, decoupling obviously means, or for that, you know, right now we're talking about de-risk, is very much a Western term if we view it from China or Chinese policymakers' perspective, because this is a term that they condemn a lot.