China’s rapid growth in manufacturing was built around a few pillars: * Low-cost labour with discipline enforced by the CCP. This is no longer the case as rapid urbanization has pushed labour costs up 5/10 times depending on location. Scalability encouraged Chinese entrepreneurs to change global practices in the sizing of projects to maximize economies of scale by free access to capital where the principal did not have to be repaid and got rolled over.
The government invested in infrastructure, ensured productivity, and delivered low logistics and transaction costs. Meanwhile, Chinese labour toiled longer hours than anywhere else in the world with no rights. * As Chinese expat industrialists now reveal in interviews, China supported a policy of technology theft, coercion of global political and business leaders as well as influencers using money and sex as tools for blackmail.
China sent its talented students to study in the best scientific universities globally and penetrated their R&D. This laid the foundation for Chinese technology upscaling domestically. The greed of the West to outsource complete manufacturing handed the Chinese their Intellectual Property Rights dirt-cheap. American think- tanks estimate that IPR theft regulated by China causes them an annual loss of $200 billion. *
The Chinese Communist Party dealt with incoming industry on a case-to-case basis. Authorised personnel made quick decisions hinging on the Central strategy. They ensured that the industry was competitive and endorsed the creation of strategic advantages. The Chinese government successfully transformed their media into an aggressive propaganda machine. They managed to penetrate, influence think-tanks globally and played the waiting game incredibly well. *
The Chinese built their financial backbone on three pillars ~ Domestic Monetary Control, Fixed Exchange Rate, and a substantial open Capital Account. They used Hong Kong as a Foreign Capital sourcing location as well as a laundry shop for mainland Chinese leadership. Nearly 70 per cent of China’s investment inflows came through Hong Kong using the Free Trade Agreement between the USA and HK. *
With foreign trade at $4 trillion plus, China had weak systems to disentangle Trade Flows from Capital Flows. Hence, the Trade Surplus need not be representative data. The recent crackdown by SAFE (China’s foreign exchange Regulator) to make exporters repatriate all export proceeds is an indicator that the dollar is in short supply. In 2016, the People’s Bank of China lost nearly $1 trillion in supporting the fixed exchange rate peg. Other Chinese banks borrowed nearly $500 billion to support the peg. It could be possible that the country’s Foreign Exchange Reserves are not $3 trillion but less than $2 trillion, of which $1.1 trillion lies in US Treasuries and balance in Euro. *
The liquid reserves comprising $2 trillion support a domestic debt of $36 trillion and foreign debt of $4 trillion. This figure is the key to understanding China’s paranoia of the trade war. The foreign capital access, which is its lifeline, is effectively being blocked. China created its entire edifice of export- led manufacturing by successfully crowding out FDI from other nations and getting a lion’s share. The foreign bondholders who invested in China are now waking up to the risk that the country may not have the currency to redeem their bonds. *
The Chinese government has been borrowing 9-11 per cent of GDP over the last 5 years, having increased from a previous 7 per cent. Government indebtedness is up to $6 trillion, with another estimated $4 trillion hidden in SPV borrowings which has not been collated. China is overloaded with weak demand for infrastructure and real estate. Economic stimulus is hence not an option. Surplus capacity released from the collapse of exports from 2018 onwards (the Trump effect) has been putting immense pressure on the viability of domestic businesses. All sectors are showing a reduced /neutral or de-growth.
The government has flooded MSMEs with liberal credit to get a short-term breather, but it is good money chasing bad. The fiscal deficit which had hit 15 per cent in 2015 has now reduced to 10 per cent of GDP, but not come down in absolute terms. There is a lack of genuine data on Chinese domestic inflation and unemployment numbers post-Covid, and the status of migrant workers. The world economy runs on market-driven demand and supply.
Russia’s centralized planning had collapsed in the 1990s and now, China’s three-pillar strategy based on Centralised Planning is beginning to unravel. The trade talks between the USA and China broke down, not because China was unwilling to concede on the $250 billion tariffs but because President Trump insisted on stringent IPR and cyber-security conditions to plug the $200 billion loss the USA suffers every year. He also wanted the agreement codified in Chinese laws, a humiliation that Xi Jinping could not digest.
The Chinese are against giving President Trump a victory before his election in November. Trump has upped the ante by blocking capital flows and may cancel the Free Trade Agreement with Hongkong as a next step. With their navies going eyeball to eyeball in Taiwan- China waters, neither country can back down. Penal provisions and attachment of US Treasuries held by China as a claim under Covid reparations is a real threat. China would have to pray for a Democrat President getting elected in November 2020, one who would compromise American interests.
China invested nearly $5 trillion in debts of 150 Sovereign borrowers. Of this, $1.5 trillion accounts for direct Government- to-Government lending for infra projects; defaults trigger repayments in commodities or asset transfers/99-year leases. The contracts are denominated in USD and carry high-interest rates, and it is for this reason that the USA has kept mum on their legality. This is China’s attempt to take control of African mining assets and land, but it needs a peaceful world for China to reach Africa.
In any case, these debts cannot be sold without massive haircuts and are the solace of borrowers. The CCP’s deepest fear is not of the world but its own people. They sold them a dream that would pull them out of poverty, and in return, the people accepted many restrictions. The CCP has been struggling to clamp down and maintain its control as well as atheistic stance. With a strong pro-democracy movement in Hong Kong, a defiant Taiwan, the revival of Buddhism and painful memories of the Tiananmen massacre being revived by Americans, the summer of discontent may have arrived for China.
The capital outflow of private money from China was considerably high between 2009 and 2017. The traditional route was through gems and jewellery bought in HK in Chinese currency using the CNY/HK dollar peg and remitting by using the HK dollar. The sale of gems in HK always peaked before a devaluation occurred in China. From 2016 this pattern switched to bitcoin and the highest settlements were in CNY, before the Chinese central bank banned it.
It is fairly evident that China’s powerful people have salted their money illegally overseas and are vulnerable under new anti-money laundering laws. They will always be influenced by funds-hosting countries. China’s new normal is a negative current account. They had built an economic juggernaut on the premise of becoming the world’s factory and, consequently a consumer of 45-50 per cent of global commodities. The country is dependent on imported goods for energy, food and commodities.
While the post Covid imports may have been inflexible to sharp contraction, exports have taken a serious hit by global supply chains moving out and the blunder of not diversifying the supply base. China cannot position itself as an alternate powerhouse to the USA with no worthwhile forex reserves. The Chinese have been buying gold and withholding the quantum that they mine domestically. They have also been experimenting with the launch of a digital currency which may be partially backed by gold.
Their desire to break the USD hegemony in the energy trade could garner support from Russia. They could treat this as the last roll of the dice to weaken the dollar and shift tangible trade to CNY which they print merrily. The country will exert pressure on its funded media cohorts to build a narrative around how the world cannot survive without a robust China, and hence it must be absolved of the Covid catastrophe. But the world will have to choose between justice and avarice, between supporting the subjugation of 1.5 billion Chinese or take the pain of relocation for a few quarters.
China will have to decide how it resolves the Covid claims that 150-plus countries may make. One thing is for certain; its dream of becoming the reserve currency of the world will remain unfulfilled, American profligacy notwithstanding. China’s damaged credibility will take a few decades to repair. This will be an eventful year in China’s and the world’s history. This will be a year of posturing, where public and private positions of nations will vary sharply. The time till 31 October 2020 will hang heavy on China’s leadership, as also the entire world.
(The writer, a veteran management professional, is Managing Partner, S&S Associates)