Monday, August 12, 2019

China’s Existential Dilemma

By Roy C. Smith

The US-China trade dispute should have been resolved a year ago, enabling both countries to get on with their growth agendas and avoid a lot of unnecessary market disruption and investment uncertainty.

Early negotiating sessions suggested that China would yield to some US demands and increase agricultural purchases to avoid any new tariffs. But Mr. Trump apparently wanted more and negotiations slid off into the political arena where both Trump and Xi Jinping risk losing face for crumbling before an adversary, which made things worse.  Now both sides are in territory in which blows may have to be struck and the time until an agreement is achieved has been delayed further. Even if the blows are more symbolic than forceful, their effect will be on slowing the growth rates in both countries and several others.

China’s official growth rate was 6.2% in the second quarter of 2019, the lowest in 27 years, and is predicted to slow further even without the trade dispute. According to local economists, China’s true growth rate is probably well less than 6% and many indicators show the turmoil over tariffs and the slowing of long-term foreign direct investment will bring it down further.

That will put pressure on China to address political dissatisfaction throughout the country that has already begun to develop over future job growth, opportunity for upward mobility, and the adequacy of pensions and health care services for an aging population.  For years China watchers have said that a minimum growth rate had to be achieved for the people to continue to allow the Chinese Communist Party to rule without elections. That assumed rate used to be around 8%. Xi Jinping knew this when he came to office, and he acted quickly to consolidate his personal power, and then to distract attention from growth to pride in China’s long history, rising global influence and power, as seen in its South China Sea activity and in expensive demonstration projects like the “Road and Belt” initiative. But the decline in growth has led to bankruptcies, increased layoffs, unemployment and public protests and demonstrations. So far, these protests have not been very disruptive, but In January 2019, Xi warned fellow party members of the rising dangers of public dissent.

Dissent has now broken out in Hongkong, where for ten consecutive weeks, more than 2 million protesters have taken to the streets and violence erupted on several occasions. The resistance is to increased grasp by China of local political power. Hongkong is much more than a returned autonomous colonial territory – it is a vital business center for the country (affecting  about 25% of China’s GDP) and key to the financial markets of Southeast Asia. Bottling up Hongkong with political and maybe military strife could be disastrous to the Chinese economy, and could include a capital flight (which may already have begun) that China would be unable to prevent without draconian measures, which could precipitate a financial crisis such as occurred in Japan 1989 and ended that country’s ambitions to being an economic superpower.

Financial crises are like avalanches, you never know in advance where they are coming from or when.  A large part of China’s securities and bank credit market activity is presently provided by non-Chinese investors that can change their minds in a flash. China is now sitting on a record level of debt (300% debt to GDP), about 60% of which is not federal, but of more unsteady corporate and municipal entities.  Declining economic conditions have caused defaults to rise, credit ratings to fall and access to credit to be constrained.  Avalanches in credit instruments begin under circumstances like theses, then accelerate and broaden to include all securities, pushing  market values well below their true value, and, because of mark-to-market accounting, requiring massive loss taking (and bailouts) within the financial system. This happened in New York in 2008, in the Euro-era in 2010. +In both cases, the velocity of market movements greatly exceeded governments ability to halt them.

China can survive a financial crash, though at great cost to the economy. But economic distress can open the doors to political risk that protests such as are occurring now in Hongkong could spread to nearby Guangzhou, Shenzhen and even to Shanghai, autonomous industrial cities in the South, distant from Beijing, where millions of migrant workers with few economic rights would be subject to a sudden increase in layoffs and economic difficulty unassisted by social safety nets.  

This could be an existential moment for Mr. Xi and his Communist Party colleagues in Beijing. It could get out of hand and require violent repression to settle, which  like Tiananmen Square in 1989, was deemed the only way to save party rule.

These circumstances give Mr. Trump the advantages in negotiating with China that he has claimed from the beginning (“We can win a trade war...”).  He may be prepared to face a Chinese existential crisis, though it would not be in the US’ interest to have one. Mr. Xi , on the other hand, may believe that Mr. Trump cannot sustain a trade war with China through an election year, and China can wait him out. Maybe, but Trump is unpredictable, changeable and seemingly very confident in his political base to support him in the election.  This could end up in a very dangerous game of "chicken." with disproportionate consequences. China would be well advised to find a way to settle the trade issues soon, even at some loss of face, to slow the growth decline but, more important, to preserve political stability. This should be obvious, but all politics are domestic in the end, making some obvious things hard to do.

Americans need to remember that the US struggled for more than 20 years to manage trade disputes with Japan, a country we wanted as an ally but many Americans believed exploited US benevolence. Then we spent another 20 years dealing with China’s rise as the next Japan. But China is not a democracy, and though it has said it has opened its markets to link with the capitalist system, it has joined the capitalist system only in part, while preserving Deng Xiaoping’s notions of “socialism with Chinese characteristics,” or capitalism with exceptions.

The Chinese characteristics, however, are seen by Mr. Trump, and many others, to include many anti-competitive measures prohibited by the World Trade Organization, such as providing large subsidies to state-owned enterprises that make up a large portion of the Chinese economy. Trump sees these as exploitative, Xi sees them as essential to keep large, unprofitable state companies from collapsing.

These issues are difficult but not unresolvable. To resolve them, both sides will have to swallow stuff they don’t want -- but  can be renegotiated in the future. That's what politicians in capitalist countries do,  Failing to do so will bring back some Cold War intransigence that we would be better off to avoid.


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