The Coming Chinese Crackup?

Prominent China scholar David Shambaugh has turned bearish on the Middle Kingdom, which offers us the chance to review our own thinking about China’s prospects.

Prominent China scholar David Shambaugh has turned very bearish, writing in The Wall Street Journal (WSJ) in March that “the endgame of Chinese communist rule has now begun.” This provides a good opportunity to review our thinking about China’s prospects. But in my view, Shambaugh does not make a compelling case to support his about face in perspective.

As head of the China Policy Program at The George Washington University, Shambaugh is a respected analyst of Chinese Communist Party (CCP) affairs, so his WSJ op-ed, “The Coming Chinese Crackup,” has received much attention. This op-ed is also a big departure from Shambaugh’s earlier view of China’s prospects.

In his 2008 book, “China’s Communist Party: Atrophy and Adaptation,” Shambaugh was fairly sanguine about the country’s prospects:

“The central conclusion of this study, however, is that the CCP is adapting fairly (but not entirely) effectively to meet many of these challenges, has learned the negative lessons of other failed communist party-states, and is proactively attempting to reform and rebuild itself institutionally—thereby sustaining its political legitimacy and power. Whether the CCP can continue to make the necessary reforms is, of course, an open question. So far, so good—but this is no guarantee of continued success.”

In the WSJ commentary, Shambaugh wrote “times change in China, and so must our analyses. . . We cannot predict when Chinese communism will collapse, but it is hard not to conclude that we are witnessing its final phase.”

Continued Strong Economic Growth

But Shambaugh’s argument is flawed, especially when he looks at the health of the Chinese economy, which he describes as “stuck in a series of systemic traps from which there is no easy exit.” He doesn’t elaborate, but it’s important to note that real (inflation-adjusted) income rose about 8% last year (compared to about 2% in the U.S.), while wages for migrant workers, who move from China’s countryside to staff the nation’s urban factories and construction sites, rose by almost 10%. As a result, consumer spending remained very healthy, with real retail sales up almost 11% (vs. 2% in the U.S.).

China’s GDP growth has been slowing. But because the base on which last year’s 7.4% calculation was made was more than 300% bigger than the base from a decade ago (when growth was 10.1%), the incremental increase in the size of China’s GDP last year was 100% bigger than the increase at the faster speed 10 years ago.

Shambaugh notes that economic reforms proposed by Party Chief Xi Jinping “are sputtering on the launchpad.” And he adds, “Yes, consumer spending has been rising, red tape has been reduced, and some fiscal reforms have been introduced, but overall, Mr. Xi’s ambitious goals have been stillborn.” By my reckoning, however, there appears to be more of the steady, gradual structural change that impressed Shambaugh in the past.

China continued to rebalance and restructure its economy last year. Consumption contributed more to GDP growth than did investment, as was the case in 2011 and 2012. The tertiary sector (services, retail and wholesale trade in addition to finance and real estate) was larger than the secondary sector (manufacturing and construction), as was the case in 2013.

The most important “rebalancing” is the shift toward an economy that is driven by private sector entrepreneurs, and away from the model of an economy led by state-owned enterprises. Last year, state firms accounted for 32% of total fixed asset investment, down from a 58% share in 2004. Investment by private companies has grown faster than that by state firms in 59 of the past 60 months, which should lead to far better investment decisions.

I expect this reform process to continue, in part because China’s leaders have no choice. They must continue to improve the operating environment for private firms, which account for about 80% of all urban employment and almost all new job creation. I have modest expectations, however, for further progress on the reform of state firms, as the government remains concerned about job losses.

Elite Fleeing, or Trying to Get Their Children into UC Berkeley?

Additional evidence cited by Shambaugh in support of his view is that “China’s economic elites have one foot out the door, and they are ready to flee en masse if the system really begins to crumble.” He references a Hurun Report survey that found that 64% of 393 “millionaires” polled said they were either leaving China or planned to do so. But is this evidence of an impending crisis in China?

According to the Hurun Report, those rich Chinese said, “education is their main reason for considering migrating. Fees are one factor: in many countries, tuition fees for foreign and domestic students are different; thus over a number of years, the cost of emigration evens itself out. Another factor is the rapid fall in the average age at which children go abroad to study: many parents have realized that if children leave home too early, this can have a negative impact on their development. Therefore they want the whole family, or at least the mother, to accompany their children when they go abroad.”

While this reflects significant problems with China’s education system, it does not signal that the political system is crumbling. Moreover, while I don’t have hard data, my anecdotal experience is that rich Chinese who establish a second home in the U.S. to facilitate their kids’ education have not abandoned China; they have continued to run their businesses in China while pursuing their dream of their children graduating from a prestigious American university.

And, according to the data, many of those Chinese students will eventually return home, in large part because of the job opportunities in China. In 2013, 414,000 Chinese students went abroad to study, while 354,000 returned to China. The Ministry of Education estimates that since 1978, about three-quarters of Chinese students and scholars who went abroad returned to China.

Political Repression and Corruption are Real Problems . . .

Greater political repression by President Xi Jinping is another reason Shambaugh cites for his new pessimism, noting that “a more secure and confident government would not institute such a severe crackdown.” I agree that during his first two years as Party chief, Xi has further reduced the already very limited space for even modest political dissent, and it probably does reflect “deep anxiety and insecurity,” as Shambaugh notes. This is very troubling and, over time, must be improved, but is this a sign that China is closer to a “breaking point?”

. . . But Chinese are Fairly Content with Their Lives

Shambaugh accurately cites corruption as a major problem, which he says not only “riddles the party-state and the military” but “also pervades Chinese society as a whole.” Data from interviews of more than 3,000 Chinese in 2014 by the U.S.-based Pew Research Center, however, found people pretty content, despite strong concerns about corruption. Fifty-nine percent of respondents described themselves as highly satisfied with their lives, compared to an emerging markets median of 50%, and 65% in the U.S., 47% in South Korea and 43% in Japan. Sixty-four percent of high-income Chinese said they are happy (72% in the U.S.), while 50% of low-income Chinese agreed (56% in the U.S.).

More interesting, especially in the context of Shambaugh’s recent pessimism, the share of Chinese reporting that they are highly satisfied with their lives has risen from 23% in a 2002 Pew survey to 33% in 2007, and 59% last year. And 68% of Chinese told Pew that they are optimistic that their standards of living will improve in the coming five years.

Rule of Law is a Significant Long-term Challenge

Shambaugh accurately calls out the absence of the rule of law as a serious shortcoming. Again, the questions we should ask are, how likely is this to trigger regime collapse, and what are the prospects for change?

In a November 2014 issue of Sinology titled “A Missed Opportunity,” I explained that:

I am optimistic about China’s medium-term economic prospects, within the context of expecting gradually slower year-on-year growth rates. This optimism is based in large part on the continuing evolution of government policy designed to embrace private enterprise and markets. My biggest concern, however, is that there has been little parallel evolution in China’s governance and institutions.

China’s economy and society are increasingly based on property rights: private companies employ 80% of the workforce, create almost all new jobs and are responsible for most investment and industrial sales; entrepreneurs and artists are creating new intellectual property daily; 85% of urban families own their home; and farmers have land-use rights. Yet the country lacks the rule of law, which is needed to effectively protect these property rights and ensure a fair, rules-based commercial environment.

This is already the source of many of problems. Corruption, weakness in industries dependent on intellectual property rights and the widespread theft of land from farmers—the main cause of protests across the country—are all consequences of the lack of rule of law.

My conclusion was that:

In the near term, China can continue to thrive, as people find ways to navigate corruption and the opaque system, and as the Party works to reduce interference in the legal system by local officials. But as the pace of economic growth inevitably slows over the coming decades, China’s unique form of authoritarian capitalism is unlikely to provide the necessary institutional support for a modern, market-based society.

There are, at this moment, no signs that the Party is preparing to establish the rule of law. The Party appears to want to continue to use the legal system to exercise its political control over the population, rather than to move toward a system that is designed primarily to protect the rights of individuals by limiting the government’s power.

We do need to acknowledge, however, that back in the mid-1980s, when I first worked in China, it was not apparent that the Party was prepared to significantly relax its control over people’s daily lives. But, a decade later, the Party stopped telling its citizens where to live and what to farm. In the mid-1990s, we did not expect the Party to dramatically shrink the state sector and pave the way for private firms to become the engine of growth. Private home ownership was not on the horizon. Today, most urban Chinese work for private companies and own their homes.

During the past two decades, the Party has surprised in many ways. It has taken a path that is unique among authoritarian regimes: relaxing day-to-day control over people’s lives and commercial activities while strengthening the Party’s control over the political and legal systems. This is a key reason why the Chinese Communist Party has outlived other authoritarian regimes. Constant, pragmatic reform of economic policy is also why GDP growth averaged 10% for two decades before cooling to an average of 8% over the last four years.

Establishing the rule of law would require the Party to take another unique and dramatic step: to cede to its citizens some of the Party’s control over the political and legal systems. Failure to take this step is not a short-term risk for investors, but I believe it will be key to China’s economic prospects over the next 10 to 20 years.

In his 2008 book, Shambaugh wrote that as China becomes richer, one of the principal lessons it should learn from the USSR and Eastern Europe is that “the task of government increasingly is to provide a range of core public goods—health care, safety, education, environmental protection, social welfare, and so on—to the population.” Party leaders appear to understand this, and while public services remain very weak relative to the developed world, Beijing has directed serious money into those tasks. Over the last five years, for example, government spending on health care and education rose by more than 100%. An even faster pace of investment in hard infrastructure such as power, roads and subways is well documented.

I’m Sticking with the 2008 Version

Back in 2008, Shambaugh wrote: “One-party states can indeed remain in power for long periods of time, and they possess a variety of tools and tactics to do so. The ‘end of history’ is not inevitable.” However, in his more recent op-ed, he changed tack with: “We cannot predict when Chinese communism will collapse, but it is hard not to conclude that we are witnessing its final phase. The CCP is the world’s second-longest ruling regime (behind only North Korea), and no party can rule forever.” For me, his original arguments remain more aligned with the continued progress I see underway in China.

Andy Rothman
Investment Strategist
Matthews Asia



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