The End of China as We Know It?

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1:07The end of China as we know it. Welcome to this Real Vision deep dive interview series. Today with a focus on global macro, with a particular focus on the developments in China. It's my great pleasure to introduce the independent economist and research associate at the China Center at Oxford University, George Magnus. George authored the book Red Flags, Why Xi's China is in Jeopardy in 2018. And he's also the former chief economist of the UBS Investment Bank. George, it's a sincere pleasure to be able to host you here at Real Vision. Thank you for joining us. Great to be back here. And thanks, Andreas.

1:47George, we have a lot to cover today because of the developments in China. I've personally struggled with getting Chinese developments right. So I really look forward to this discussion on the developments in the Chinese real estate sector, the new business model that they're trying to develop, and also the ramifications for financial markets and financial stability. But the first question I'd like to address with you is the question I started asking at the very top of the show. Is China now transforming into a new business model? So, George, is this the end of China as we know it? That's a nice dramatic way to put it.

2:34I have to start off with. I don't think there's any question, Andres, in my mind that China is in a transition. and if that means by definition that China has reached the point at which you can no longer extrapolate into the future the way it has performed and the features that accompanied it during the 80s the 90s and the 2000s on then I would say yeah China is at the end of that period, and it faces an hour transition to something else. We don't really know what that is. And I think certainly on my, I haven't been to China since before zero COVID, to be honest, but certainly up until that point, and my contacts there subsequently certainly continue to reveal that some economists in China, policymakers that I had loose contact with, certainly acknowledge that China needs to change.

3:41But politically, it's really difficult for Leninists to change the kind of model that they believe is necessary for their survival and for their raison d 'etre, which is to rule unchallenged. So we're in a very, very interesting, the 2020s are very, very interesting, and that's what really prompted the book and the title about Xi Steiner being in jeopardy because the future could no longer look like the past. George, in your words, what sort of characterized the Chinese business model or the Chinese economic model up until recently? It seems from the outside like it was very dependent on real estate and construction.

4:24Yes. So let me just kind of go back slightly in the sense that China's business model, its economic development model, was very similar in many ways to that of Japan and South Korea and a lot of Asian tiger economies. well, I say a lot, I mean the Asian tiger economies, based on high rates of savings, high rates of investment, very mercantilist in terms of its characteristics. But whereas Japan and Korea and Taiwan and Singapore, for example, made the transition from being those kinds of economies to what they are today. And that did involve both widespread economic reform, but also political reform as well.

5:20China is kind of unique in the sense that no country really has had as sustained a high level of investment as a share of its economy that compares in any material way. So China's investment rate is still about 44 % or 45 % of GDP. Nobody got near that. India's today is about 10 percentage points or more below that. So the problem is that when, obviously, we now look at real estate as well, which is a very, very particular aspect of this kind of high investment rate. And, you know, what was a housing welfare system 25, 35 years ago was transformed into a market as we know it. Very, very high and sustained rates of investment.

6:11But, of course, the government treated the property market as a sort of a one-way counter-cyclical tool, really. So whenever the economy was losing momentum, as it did, for example, during the financial crisis of 2008-9, then again in 2011, then again in 14-15, the government was continuously pumping up the real estate market, but never deflating it when the economy was doing very well. So it was a one-way bet. And I think we learned ourselves in 2008 what one-way property bets look like when they eventually give up the ghost. Yeah, we did indeed. And admittedly, I've tried to dip my toes into the long Chinese real estate bet a couple of times this year with zero luck.

6:59So I'd like to get your take, George, on the current status of the real estate sector in China. We've obviously seen the headlines with Evergrande Country Garden in trouble over the past couple of years, some of the big developers in China. So what's the status here and now? Is the real estate sector still struggling? Yeah, I think it is. I mean, it's a little bit kind of horses for courses. I mean, just like, you know, not everywhere in the United States looked like Las Vegas or Florida in 2008. Not everywhere looks like some of the kind of lower tier. so-called lower tier cities, like tier three, tier four cities.

7:39These are administrative levels of cities in China, the tier one cities that everybody knows, like Shanghai, Shenzhen, Beijing, and so on. Things are not quite as bad in the tier one cities. But the lower down in the administrative pecking order you get, the worse it is in terms of oversupply, empty apartments. There are probably something like, I don't know, the last count, maybe something like 50 million empty homes in China, which is about 12 % of the housing stock. The levels of activity in terms of transaction volumes, sales, investment are 20 % or so down on what was a weak year in 2022, down maybe 30 % or 40 % compared with pre-COVID.

8:29I would say during the winter this year and into early 2024, things may not look quite so grim because levels have fallen so far. But you can have a little bit of a cyclical lift. And the government has been taking a lot of measures to try to stabilize the housing market, abandoning restrictions on developers, those infamous three red lines that were introduced in 2020. making it easier for not only existing new mortgages, mortgagees to get financial good deals for mortgages, but also existing mortgage holders, allowing migrant workers the right to urban registration in some smaller tier cities in some provinces, not nationwide.

9:23And yeah, smaller down payments and so on and so forth. So, you know, things may not look quite as grim, but structurally and systemically, the market, the real estate market in China is going to have to shrink in the next 10, 15 years. And it will do, you know, either wildly or steadily or in some kind of shape or form. It's the only question really of how that's going to be managed. We already get a lot of questions coming in. And I'd like to bring up a question from Jordan already now because it relates to the discussion we have right now on real estate, George. He's asking for your opinion on the demographic trends in China and how related they are to these changing winds in real estate in China.

10:11What's your view on the demographic trends ahead and how they will sort of impact the Chinese business model? Yeah, that's a great question, which ties in, as the question I'm sure knows, to the real estate market. Because one of the things which I think we're kind of all a bit like kind of anxious about really is that because of the low birth rate, and, you know, it might be as low as 1.1, 1.2 children per woman. And I don't think that's probably a bit lower than the official number. But certainly there are demographers that think it may be as low as that. But what that really means is that the population or the cohort of first-time buyers, so people aged between 25 and 34, 35, something like that, that this group of people in society is going to shrink probably by orders of magnitude, maybe about a quarter between now and 2040, 2045.

11:08So the rate of household formation is going to be much lower than it has been, certainly during the years when the property market was booming. And we also see this not just in terms of low birth rate, but also low rates of marriage. So this year, there'll be fewer marriages than at any time since 1980. And property is something that is very closely associated with marriage and dowries and so on. So the demographics for China in terms of the real estate market are really, really not good. So not only do you have the oversupply problem and the fact that the sector is far too big for the economy, but you also have these adverse kind of demographic shifts as well.

11:55But that's kind of a microcosm in a way of the big picture. The big picture is shrinking working age population from now to the foreseeable future, rising old age dependency. The fact that, you know, obviously, as in other countries, China's not unique in this regard, the financial capacity of individuals and of the state to accommodate and integrate age-related costs of pensions, health care, residential care, and so on, is not great. So, it's the old mantra about getting old before you get rich. In other words, we find it difficult with our income ahead of like$40 ,000,$50 ,000,$60 ,000 in the OECD world.

12:44China's obviously not there yet by a long chalk. I mean, it's$12 ,000,$12 ,500, much inferior, a kind of social security welfare system. In fact, the government doesn't actually even believe in welfarism as we do in the West. So, yeah, these are going to be big challenges for China going forward. George, where does this leave structural growth ahead in China? We've obviously grown accustomed to these centralized growth targets. And I think for this year, they targeted 5 % initially or was it 5.5%. So where does it leave that target ahead? Should we expect that target to get continuously lower over the next 5, 10 years here?

13:24Well, just as a matter of behaviour, I mean, the government actually says it's not publishing five-year targets anymore for GDP. The 14th five-year plan, which came out for the period 2021 to 2025, I mean, it has an implicit target in the sense that they want to double GDP and per capita GDP over that period. But it doesn't actually have a formal target. But they have retained and said that they would continue to set annual growth targets. So this year's, as you say quite correctly, I think it was, quote, about 5%. And yeah, it probably will be, quote, about 5 % on official data. And the IMF has just actually revised up its expectation for this year, I think, to something like 5.3 or 5.4.

14:21But this was basically a 5 %-ish growth in China's economy on a really, really bad 2022. So whether it could grow at that sort of rate in 2023, I think is a little bit doubtful. And I think that if we look at, as economists call it, trend growth or potential growth, which is basically a product of land, labor, capital, quantity and quality, productivity, and so on. The likelihood is that China's maximum sustainable growth rate now, I think, is about half of what it was in the 2010s. It will be, I think, around 2 % to 3%. So, it's halved between now and 2010s. The 2010s was roughly half of what it was in the 2000s.

15:18So, China's really, its growth rate has really just come back down to earth. And Xi Jinping's problem is not that he caused the problem of lower growth, I mean, it was going to happen anyway, and predates his ascent to power. But he hasn't really addressed the issues and the systemic problems associated with it. If we look at the path ahead for the Chinese business model, given this issue of demographic trends being, if not outright abysmal, then at least trending in the wrong direction, paired with high debt levels and structurally lower growth. What's the plan for China here? Because I kind of get the feeling that in the Western media, there is this narrative that China is currently like a deer stuck in the headlights, right?

16:06So where does it leave, Jan, and how do you think that they will sort of develop the business model from here? Yeah, good question. And we thought we might get an inkling of an answer waiting for the Politburo to announce what we thought was going to be the third plenum of the 20th Party Congress. So the third plenum is not always, but typically the event, the party event at which the government speaks about and discusses the long term kind of economic strategy. Many people will remember that 10 years ago in 2013, there was huge excitement about the third plenum and about the 364 reform measures that were announced, split between 60 odd sectors.

16:58And, you know, it included things like elevating the role of the market from supporting economic development to being a pillar of economic development, which was the official language at the time. And most of what happened at the third plenum in 2013 basically got ditched pretty soon. And certainly by the time China went through its financial crisis in 2015-16, most of the third plenum reform measures were really underwater and forgotten. And the government obviously has switched directions since then, or basically emphasised a change of direction towards more repression and control. So, we were awaiting announcement of a third plan, and it hasn't happened.

17:43It might happen in December, it might not. If not, it'll probably happen next year. But I'm not really very optimistic that the government is going to announce the kind of changes to the structure of China's economy that we would necessarily think are appropriate. And I say that not just kind of with a Western economist hat on, which, of course, I wear by definition, but also there are many Chinese economists who actually are saying, you know, we have to do more about consumption. We have to do more about opening up. We have to reform our service producing industries. But these are not things that come naturally to Leninists.

18:25And it certainly doesn't fit very well with the overall ambition and goals that the party has, in which it believes that the party leads everything, quote unquote, which is everything from the economy and commerce to society and social intercourse and so on and so forth. So what can they do? Well, Xi Jinping obviously lays a lot of belief and stresses all the time something that he calls new productive forces, which are really the industries and the sectors that are at the cutting edge of science and technology. So electric vehicles, batteries, climate change mitigation, green economy, artificial intelligence, quantum computing, semiconductors, for heaven's sake, is something which the Chinese are absolutely desperate to be able to do on their own without having to rely on, you know, Korea, Japan, the United States, Netherlands, and so on.

19:20So, yeah, that's the goal. And they want to have global brands in these industries, and they want to be able to bring prosperity to the country and to citizens through developing these sectors, for example. But like in most countries, they're pretty small relative to the boring bits of the economy like wholesaling, retailing, distribution, transportation, and many of the things that never reach beyond somewhere very, very low down on your online version of the New York Times or Financial Times or whatever. So really what's the key is you have to develop these new technologies and you have to have the kind of diffusion mechanisms in your society and in your institutions which allow these to reach the boring bits that are essential to what we do and how we live.

20:17And that's the problem, I think, is A, the new productive forces side of the economy in China is too small to compensate for real estate and everything else. And there are genuine questions about the institutional mechanisms that allow the diffusion and transfer of technology to other places. We're going to take a quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing.

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21:48Speaking of financial times, I think probably a month or two ago, they published a chart on the export trends of cars from various large car manufacturing countries around the world. And all of a sudden, China is now placed as number one in car exports globally. likely basically driven by the move to electric vehicles globally. But what do you make of that trend, China now suddenly being a large car exporter? We also see the same trend within solar panels and stuff like that. Is that a core component of the new strategy of the CCP? I think it certainly is. I mean, and, you know, there's no question that China has succeeded in this area, you know, perhaps beyond certainly the expectations of automobile companies in the United States and Europe and elsewhere, and started earlier and put more money into it.

22:47And they are now where they are. So I think for the United States, it maybe isn't such a problem because of tariffs and restrictions on entry to the US market as it is for the moment, at least for the moment in the EU, where I would think that the big automobile companies are having a bit of a panic, really, about how they're going to cope with the competition from China. and why I imagine that the lobbying of the commission, for example, for protection is probably going to heat up quite a lot. But yeah, I mean, obviously, there are technical issues and technological issues and national security issues, which probably aren't really within my competence.

23:36So I don't really know whether it makes a big difference whether we open our markets up to Chinese EVs or not. And certainly in batteries, you know, it may not be the end of the story. I mean, people are already starting to talk about solid-state batteries as the successor or the next generation of batteries after lithium. And Japanese car companies are allegedly supposed to be quite far advanced in this research. So that's kind of an evolving story of competition, really, between China and other countries. But I think for the time being, the automobile firms are going to have to deal with the problem of having an outsized and very, very efficient competitor in terms of Chinese EVs.

24:25I think this is sort of the perfect bridge building to the next topic, namely trade patterns between the Chinese mainland and the West. The Donald Trump administration, in this trade case led by Peter Navarro, inaugurated this trade war against China during Trump's reign. And if we look at trade data right now, it's pretty clear that it had an impact. So what are your takes when watching trade patterns between China and the U.S. and China and the West in general right now? Will we ever get to trade with China in the way that we did before the trade war was started? Well, I think it's, I mean, forgive me and certainly correct me if I've misinterpreted your question, but if in your question there was somewhere embedded in there was the word decoupling or de-risking, then my view is yes, I think we are going to see over time a kind of a continuous recalibration of the way in which trade happens and with whom.

25:31So, for example, and I'm not even anticipating or allowing at this stage for what might happen if, for example, Donald Trump were to go back to the White House in 2024. He's already said that he's going to introduce a 10 % tariff across the board on imports into the United States, which certainly would have a significant effect, I think, in changing trade patterns. But leaving that to one side for the time being, I mean, what's quite interesting is how the US-China trade relationship has changed. I don't think it was ever going to be the case that tariffs were going to really change the drivers of trade surpluses and trade deficits, which is really about domestic savings and domestic investment.

26:23But the tariffs certainly did result in extra costs for consumers. And they certainly have changed some aspects of the pattern of trade. But I think that the bigger effect, if I may say so, has been the recalibration of supply chains, which has started, partly as a result of the tariff war, but more specifically because of things that have happened under the budget. Biden administration, and more recently in China and Europe itself, and other countries, which is really to become less dependent on one another. And in this sense, we can see broad stability in sort of levels of imports and exports from China to the United States, or even actually some kind of decline at the margin.

27:15But that's because a lot of exports and imports have been redirected in a way to countries like Mexico or to Central and Eastern Europe, in Europe's case, or to other Asian economies as this kind of diversification is taking place either to avoid or evade, I should say, export controls or restrictions on who you can buy products from and sell them to and so on. And that goes for both sides, really, because the United States and China are both doing this kind of thing. So there are costs, of course, involved in recalibration of supply chains, but also beneficiaries. So those countries with smaller GDPs that actually are the beneficiaries of new investment or new production facilities, India is a case in point as well, they will show or experience quite significant benefits, which I think will not be lost on investors either.

28:12George, we've obviously also seen these trade trends impacting Chinese geopolitical opinions. Was it this spring we had a load of headlines around the BRICS club, basically trying to form a new currency that should compete with the US dollar? Those were these sort of the early headlines ahead of those BRICS meetings. So given these trade trends where we trade less with China, what are the geopolitical plans from the Chinese administration here in terms of securing trade partners around the world? Well, I think just for the sake of purity, shall we say, I think it'll be some time before we trade materially less with China because China is obviously, it's like a third of global manufacturing value added.

29:03So that role in the global trading system is pretty secure for a little while. It'll take time, and I think it'll be over an elongated period of time that these changes will take place. But having said that, I think, yes, I was quite amused really in a way by some of the hype that accompanied the meeting of the BRICS and the addition of new countries, including Argentina, I think Saudi Arabia, Ethiopia, Egypt, for example, UAE. Yeah, this is a kind of a governance vehicle, I think, for China. I mean, I have absolutely zero confidence that there's going to be a viable BRICS currency any time that we could look into the future.

29:57And I think that the idea that this kind of disparate group of countries could ever have what we call kind of an optimal currency area, which would be the basis on which you would have a single currency, they might want to use the yuan more intensively than it is for trading and invoicing purposes. And that may indeed happen to some degree if, for example, oil trade or fossil fuel trade gets repriced in yuan rather than in US dollars, or if China manages to kind of re-denominate a lot of its trade, as it has done with Russia, into its own currency. Having said that, I think one of the things that is also important to remember is that from a kind of global currency perspective, what really matters isn't the currency that you invoice somebody in or receive payment in, but how you accumulate your balances.

31:00So if you're running surpluses and somebody pays you, I mean, the Chinese obviously don't need any yuan because they can print as many as they like. But do the Saudis need lots of Chinese currency when they peg their currency to the dollar? No, of course not. Do other countries like Brazil or even South Africa, do they want to have basically substitute dollar liquidity for the more limited liquidity you get in RMB or yuan? I think that's very kind of doubtful. So I'm not really, I think there is a lot of hype about this. I think, you know, as a governance tool or organization, I think BRICS really fits into China's plans pretty well.

31:44But I don't think it really has the kind of financial sector implications which many people were inclined to think it did. It leads me to discuss the ramifications for global financial markets of these trends seen in China, George. And one thing that we get a lot of questions around is the development in the Chinese yuan. You've already touched upon the yuan's role in the global payment system and in the global financial infrastructure. when the Chinese yuan was included in the special drawing rights from the IMF. It seemed like a step forward for the Chinese in terms of including yuan more in global trade.