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As the Chinese Communist Party (CCP) turns 100, the late Milton Friedman is trending in cyberspace. The reason: the spectacular ways in which the Nobel laureate had Asia’s now biggest economy wrong.
In particular, his strong belief that capitalism would give China no choice but to go the way of Western democracies was dead wrong. Here’s how Friedman put it in 2003, less than two years after Beijing entered the World Trade Organization (WTO): “I predict that China will move increasingly toward political freedom if it continues its successful move to economic freedom.”
The exact opposite has happened. Rather than WTO rules changing China, the nation bent global trade to its own will. Ditto for the internet, which Friedman and his ilk argued would put the CCP out of favor.
On Thursday, President Xi Jinping reminded the globe in dramatic terms of the party’s indisputable role in China’s success – and in continuing its trajectory toward the ranks of advanced world powers. Speaking from Tiananmen Square before thousands of party officials, Xi struck a defiant tone about China’s broader ambitions.
“Nobody should underestimate the staunch determination, firm will and powerful capacity of the Chinese people to defend national sovereignty and territorial integrity,” Xi said. The Chinese people, he added, “will never allow foreign forces to bully, oppress or enslave us. Whoever nurses delusions of doing that will crack their heads and spill blood on the Great Wall of steel built from the flesh and blood of 1.4 billion Chinese people.”
But as Xi’s China takes a victory lap, it’s important to highlight what was not in his big speech: a recognition that the really hard part is only just beginning and details on where his economic reform team plans to go from here.
For all China’s success in reviving the economy, China still has yet to convince the globe of two things. One, that efforts to build a solid, innovative and transparent financial system are keeping pace with the rapid internationalization of China Inc. Two, that the so-called “Beijing consensus” model is worth emulating.
Who has the best approach?
Xi’s comments, remember, come against the backdrop of US President Joe Biden working to tweak the “Washington consensus” that long won this argument before China upended the WTO-centric global trade system.
Ironically, Biden’s predecessor Donald Trump was more of a Beijing man than a protector of Washington’s preferred policies. The Washington consensus of democracy, free markets, financial openness and transparency was the antithesis of Trumpism.
Trump’s Washington veered far more in the Beijing direction of authoritarian rule, quasi-open markets and censorship. Though he didn’t close newspapers, Trump’s daily assault on the free press probably made even Russian leader Vladimir Putin blush.
Yet the ball is now in China’s court to demonstrate to Asia that its approach is preferable to America’s. And thanks to Trump’s epic failures, the wind is at Beijing’s back.
Granted, the US has often been a poor shepherd of its ideals. A case in point was the 2008 crash that Wall Street shared with the globe. Trump’s chaotic trade wars, his banning of mainland tech giants and his disastrous handling of Covid-19 squandered US soft power.
Friedman, who died in 2006, didn’t live to see Trump break the cardinal rule of laissez-faire economics: when trying to beat mercantilist China, it’s best not to turn your nation Chinese.
Trump’s attacks on Huawei Technologies, TikTok, WeChat and mainland 5G were far more Mao Zedong than Adam Smith.
The same with Trump’s broadsides against US institutions: the press, the judiciary and the legislature. He even installed a non-economist, Jerome Powell, as Federal Reserve chairman with one directive: flood the globe with dollars to weaken the exchange rate to increase America’s trade advantage.
That set the stage for a fascinating role reversal: the Fed arguably acting less independently than the People’s Bank of China. Even before Covid-19 hit, Trump was browbeating Powell to slash short-term interests rates back to zero and beyond. Trump even threatened to fire his hand-picked Fed chief.
Contrast that with PBOC Governor Yi Gang and predecessor Zhou Xiaochuan, who ran the central bank from 2002 to 2018. Even at the darkest moments of the trade war in 2017 and 2018 or Covid-19 in 2020, the PBOC never came close to heading down the quantitative easing rabbit hole.
Setting the stage
Zhou gets big credit for shepherding the yuan into the International Monetary Fund’s special-drawing rights orbit. Having it grouped with the globe’s most liquid currencies sent a signal that, while it’s doing things its own way, China is committed to opening its financial system and winning overseas capital flows.
That set the stage for top global indices like MSCI to include China stocks. And for global benchmarks to incorporate China’s US$18 trillion government bond market, including the Bloomberg Barclays and FTSE Russell indexes.
As the CCP turns 100, though, the real issue is where Xi’s team takes things next. In particular, where China’s most powerful leader since Mao, arguably, takes Beijing policy over the next five to 10 years.
Exhibit A: efforts to deleverage China’s financial system. Before Xi took power in 2012, the government of predecessor Hu Jintao tossed trillions of dollars of stimulus at an economy reeling from the 2008-2009 global financial crisis.
Local government debt levels soared, the shadow banking industry exploded and Beijing built considerably more skyscrapers, six-lane roadways, bridges, international airports and stadiums than the economy needed.
In 2015, Xi’s team added to the problem. As Shanghai stocks plummeted in the summer of 2015 – falling 30% in only a few weeks – Xi’s government shifted stimulus into an even higher gear. That pushed China toward what economists call the point of “diminishing returns,” whereby gross domestic product (GDP) gets less of a boost from aggressive public borrowing.
“Today, containing its leverage ratio is one of China’s greatest economic challenges,” says economist Gene Ma at the Institute of International Finance.
Ma’s recent study on China’s last few notable deleveraging efforts found “mixed results,” at best. As Ma sees it, China’s worrisomely high debt-to-GDP ratio is the result of four phases of leveraging: 2009 when leverage ratios jumped by 30 percentage points amid the Lehman Brothers crisis; 2010-2011 amid Europe’s debt troubles; 2012-2016, when debt ratios surged amid growing shadow banking activity; and 2019-2020 amid the trade war and Covid-19 pandemic.
The ‘beautiful’ route
Since then, there have been three significant efforts to deleverage the system. The 2010-2011 effort was subsumed by what’s happened since. The 2014-2014 episode didn’t pan out as total leverage ended up increasing by 15.5 percentage points. Finally, there was the somewhat more successful 2017-2018 period, which helped cap leverage ratios.
Ma thinks the best way forward is “beautiful deleveraging.” Going the “ugly deleveraging” route with austerity, harsh restructuring and a series of defaults “would damage growth and exacerbate economic imbalances,” Ma says.
The “beautiful” route – the one Xi’s team is pursuing – balances reducing financial excesses with targeted moves to support growth.
“Deleveraging through inflation or debt write-offs cannot be too aggressive,” Ma explains. “This is because sustained inflation will fuel expectations and lead to an upward wage-inflation spiral.
“Since banks themselves are leveraged, overly aggressive asset write-offs will cause a self-enforcing downward spiral of debt, economic growth, and asset prices, pushing the economy into a balance-sheet recession.”
As 2022 approaches, Xi’s team must be more creative and nimbler about capping credit in over-leveraged sectors like housing and making it more accessible for small businesses. Policymakers also must act faster to shift debt from weaker hands to stronger ones, from, say, overindebted local government to central-government entities.
The good news is that China’s economy is having the most robust post-Covid-19 recovery among the majors, giving Xi’s team’s latitude to act.
“When I look at the economy, the growth engines are still there,” says economist Iris Pang of ING Bank. “Consumption is moderately strong and is improving. For example, Covid in June affected consumption services in shops and restaurants but boosted online activities. External demand has yet to peak, and therefore China’s exports could be stronger when Covid subsides elsewhere in the world.”
Next, Xi’s government needs to raise its soft power game. The defiant tone that Xi struck in Thursday’s speech marking the CCP’s 100-year anniversary may strike many as tone-deaf.
His focus on a “historic mission” to gain control of Taiwan and “resolute action to utterly defeat any attempt toward Taiwan independence” reminds us how bad Xi can be at reading the room globally.
The intent was probably to push back on last month’s Group of Seven nations summit. Biden’s first G-7 as president called out Beijing on everything from Taiwan to neutering Hong Kong’s autonomy to human-rights abuses to socioeconomic fallout from its Belt and Road infrastructure initiative.
The chaotic Trump years were Xi’s once-in-lifetime opportunity to grow Beijing’s soft power at America’s expense. He’s largely squandered it. Sure, China stepped into the Trumpian void with the 15-nation Regional Comprehensive Economic Partnership. And Xi is selling China’s 2021 recovery as an unbridled global good.
Yet earlier this month, Xi urged Communist Party bigwigs to cultivate a more “trustworthy, lovable and respectable” image globally. It’s the clearest indication yet that the “wolf warrior” ethos was backfiring and that a more productive tack was needed.
A recalibration, though, may be wishful thinking. “Xi,” says analyst Michael Hirson at Eurasia Group, “has no inclination to respond to US pressure by moderating key policies.”
Finally, what does Xi do with China’s censorship-industrial complex? Beijing’s crackdown on Jack Ma’s Ant Group since late 2020 has had quite a chilling effect on China’s Big Tech players. But there are rays of light.
Ma’s Alibaba Group internet empire seems on the verge of its first major deal since having to pay a record antitrust fine. Successfully grabbing a stake in the retail unit of billionaire Zhang Jindong’s Suning conglomerate could allay fears of a broader tech crackdown.
Still, Xi’s CCP has yet to explain how new generations of tech disruptors are supposed to thrive in an economy that bans Twitter, Google, Facebook and censors myriad news outlets. The greatest irony of Xi thundering away about China’s omnipotence this week is how it lacks the confidence to let its innovators join the global marketplace of ideas.
On Xi’s watch, China is becoming more of a black box. As Chinese stocks and bonds go global, Beijing should be increasing transparency and easing press freedom and internet curbs. Instead of learning from Hong Kong, Xi’s government is exporting Beijing’s opacity to a city Freidman once celebrated as the world’s freest economy. Singapore now has that title.
These are not the actions of the confident, outward-facing government team Xi likes to project. “One lesson from 100 years of CCP history is that paranoia and insecurity are part of the party’s DNA, and it will never look like it feels secure,” says Bill Bishop, editor of the widely read Sinocism China newsletter.
Adds Maya Wang, a senior researcher at Human Rights Watch: “The Chinese Communist Party promised people press freedom before it came to power. Where is it now?”
There’s no mistaking, though, that Xi’s CCP is having a moment – and is keen to show it off to an often skeptical world. Yet the real question is China’s next 100 years. And the answers depend on the moves Xi’s team makes over the next 10. All global investors can do is hope China moves wisely.