01_

Question Authority

Heres how we kept the economy growing: by scaling back infrastructure projects and reducing heavy industry, iron and steel production, and machinery production; by expanding light industries such as consumer products and textiles while allowing and encouraging private businesses; by developing service industries. Former Chinese Premier Zhao Ziyang, on the 1980s1 A totally laissez-faire approach will inevitably lead to economic disorder and unfair social distribution, and will eventually take its toll. A credible market-oriented reform should never set the market against government macro-regulation. The invisible hand of the market and the visible hand of government and social supervision should both act, and act vigorously. Only in this way can resources be distributed according to market rules and distributed in a reasonable, coordinated, balanced and sustainable manner. Chinese Premier Wen Jiabao, 20092

August 2010

Investors burned by bubbles are debating whether China is next. Bears point toward Chinas red-hot property markets and its rapid expansion of bank loans and warn that a correction is inevitable. Bulls insist that Chinas government will exercise its control over the economy to navigate smoothly through any storms. Chinas economy has grown about 9.8% a year since 1978; it even grew 8.7% in 2009 during the Great Recession. But even after all this growth it is still poor.The second largest economy in the world divided by 1.3 billion people yields only $3,678 per capitathat is, 98th in the world.3 Bulls and bears debate the present, but they largely agree about the past and the future. They believe that Chinas growth was enabled by poverty and policy: plenty of room to catch up with developed countries combined with a newly enlightened government. Bulls believe China can maintain the same smooth rate of growth, while bears expect severe turbulence, but both sides appear to believe it is inevitable that China will eventually catch up to the rich nations of the world. Yet what appears inevitable today often never comes to pass, and sometimes yesterday did not unfold the way people remember. Our analysis therefore aims at the consensus rather than the debate. Convergence should not be the baseline. It should be the question. Our analysis is necessarily speculative. China has been a mystery to the West for centuries, and it remains one today. Chinas lack of good data, opaqueness, and sheer vastness make it impossible to render any definite conclusions. But this uncertainty makes it all the more important to ask hard questions instead of accepting the answers given by the authorities.

1. Zhao Ziyang, Prisoner of the State: the Secret Journal of Zhao Ziyang, trans. and ed. Bao Pu, Renee Chiang, and Adi Ignatius (London: Simon & Schuster, 2009), 99.

2 . Full text of Chinese premiers speech at University of Cambridge, Xinhuanet, February 2,

2009. 3. International Monetary Fund World Economic Outlook Database, April 2010. Conversion at market exchange rates. Note that at the time China was the third largest economy.
This document is confidential, for qualified individuals only, and not for further circulation. This is not a solicitation or recommendation to buy, sell, or hold any securities or commodities. Certain statements contained herein may be forwardlooking. Information contained herein is believed to be accurate and/or derived from sources which Clarium Capital Management LLC believes to be reliable, but such information may not be independently confirmed. Graphics contained herein are purely representational and do not reflect any hypothetical retur n from an investment in the depicted instruments. 2010

02_

WHAT We HAve Here Is

A journey into the unknown must start in familiar territory. Let us therefore review the debate on China as it is currently framed. Those looking at the near future see three factors that make them bearish.
1. 2. 3. China appears to have excess capacity in multiple industries. Chinas property markets appear to be oversupplied and overvalued. Chinas lending boom suggests that many bad loans have been made.

Bears combine these points to argue that Chinas economy is in a bubble and that the bubble will burst in the next few years with very bad consequences.4 Let us briefly recapitulate the arguments for each bearish factor.

Fig. 1 Chinas Investment Boom is Unprecedented

Sources: Pivot Capital; CEIC

50%

Japan (1960-1990)

South Korea (1978-2008)

China (1981-2009E)

45% Investment as % of GDP

40%

35%

30%

25%

20% 0 5 10 15 20 25 30 Years from Start of Investment Boom

E xcess Ca pacity

Bears argue that Chinas investment boom is unprecedented in duration and intensity.5 Unless Chinas fundamentals are also unprecedented, the historical evidence suggests that Chinas capital investment has boomed too much and too long.

4. For more, see Chinas Investment Boom: the Great Leap into the Unknown (Pivot Capital Management, 2009). Jim Chanos has made a similar argument in numerous lectures and interviews, in which he heavily emphasizes Chinas property bubble. Another thoughtful analysis is Edward Chancellor, Chinas Red Flags (GMO, March 2010). Chancellors thesis is that China today exhibits many of the characteristics of great speculative manias. 5. To read about the extraordinary level of Chinas gross fixed capital formation as the main driver of its economic growth, see Tyler McClellan, Save Now, Invest Later (Clarium, August 2009), 78.

03_

Fig. 2 Interest Rates vs. Growth

Sources: CEIC; GMO (2010)

18%

Lending Rate

GDP Growth

15%

12%

9%

6%

3%

0% 1980 1987 1994 2001 2008

In addition, Chinas lending rate has been substantially lower than its economic growth rate for many years, which implies that interest rates have been held well below their natural rate. Suppressing interest rates encourages investment in riskier and more marginal projects, which leads to misallocation of resources.6 Bears are suspicious of the sanguine claim that all this investment is justified by high returns,7 and note that investments always appear to earn a high return in the midst of a bubble. They point to Japan in the 1980s, U.S. technology companies in the 1990s, and U.S. housing and financial companies in the last decade. Instead of returns that may be ephemeral, bears focus on numerous anecdotal indications of overcapacity. For example:
Chinas manufacturing capacity of industrial inputs such as cement, aluminum, and steel dwarfs the capacity of the rest of the world. These were among the industries that a recent study by the European Union Chamber of Commerce in China concluded suffered from overcapacity.8 There are numerous stories of trophy projects in China, i.e. large construction projects that do not appear to serve a reasonable economic need. The most famous of these is Ordos, an entirely new city that stands relatively empty and is intended to replace an existing city in which people currently live and work. Chinas property markets appear to be oversupplied, as explained in more detail below.

6. See Chinas Red Flags, 7 (note 4). As Chancellor notes, the natural rate of interest is not visible, but he uses the rule of thumb that prime lending rates should track economic growth over the medium term. 7. For an example of such a claim, see Kevin Daly and Ben Broadbent, The Savings Glut, the Return on Capital, and the Rise in Risk Aversion (Goldman Sachs, May 27, 2009). 8. Overcapacity in China: Causes, Impacts and Recommendations, European Chamber of Commerce in China and Roland Berger Strategy Consultants (November 2009).

04_

Pr o pe r ty Ma rke ts

Even by official statistics, commercial real estate looks significantly oversupplied. Office vacancies are very high for a growing economy, with 20% in Beijing and 16% in Shanghai. (Office vacancies are also high in many OECD cities, but in contrast to China those vacancies have followed a massive recession that also shrank commercial real estate construction.) Yet the high vacancy rate has not slowed down the market: 100 million square meters are under construction, which is one 5 foot by 5 foot office cubicle each for half of Chinas 20- to 25-year-old population. The supply of residential real estate is complicated by what appears to be overbuilding of luxury housing and perhaps insufficient low-income housing. Nevertheless, prices are high and there is anecdotal evidence of speculative behavior. The price-to-rent ratio in Shanghai, for example, is greater than in Tokyo, London, and New York. What may be pushing up prices is a tendency for people to buy apartments purely as a financial store of value. One recent estimate suggests that at least 64.5 million houses in China are vacant,9 which is roughly five times the excess housing inventory in the United States. Since China has only four times the population of the U.S., the overhang of vacant housing today may be even greater in China than in the aftermath of the American housing bubble.10
Fig. 3 Price to Rent Ratio of Major Cities 11
Source: Global Property Guide

Tokyo New York

London Shanghai

10

20

30

40

9 . Yi Xianrong, an economist at the Chinese Academy of Social Sciences, based this estimate on electricity meter readings. See China: Property speculation leaves 64.5 million vacant homes in China, Asia News, July 10, 2010. 10. This comparison of Chinese and American vacant housing relative to population is from Patrick Chovanec, More Data Points on China Real Estate, An American Perspective from China, July 23, 2010. 11. In a low interest rate environment, a lower rental yield and higher price to rent ratio may be warranted. Given this context, the valuation of Tokyo real estate, in particular, is even lower relative to that of Shanghai. Data for the price to rent ratios for a 120 square meter apartment are the most recent available. For Tokyo: April 2010. For New York: July 2009. For London: June 2009. For Shanghai: February 2010.

05_

B ad Loa ns

One can usefully measure a countrys indebtedness by comparing the sum of all its nonfinancial debtgovernment, corporate, and consumerto the size of its economy.12 In the U.S., for example, the total debt/GDP ratio is roughly 240%, the highest since modern records have been kept.13 Chinas numbers are not nearly as accessible, so we must make some estimates. By official statistics, the ratio of private sector debt to GDP is approximately 110%.14 We use the official statistic of Chinas central government and external debt (RMB 6.2 trillion and $387 billion respectively), which together account for approximately 26% of GDP. Then we add the official statistic of RMB 5.6 trillion owed by local governments (another approximately 17% of GDP). Finally, we use a plug for likely under-reportingrepresenting non-bank liabilities of local governments and corporations (17%)to arrive at a total debt/GDP ratio of roughly 170%.15 Yet the quality of loans in an economy can be even more important than their quantity. In the U.S., overvalued houses and poor underwriting caused mortgage loans to go bad, fueling the recent financial crisis. By official statistics, Chinas banks are well capitalized, but this is small comfort for two reasons. First, banks often look well capitalized in a lending boom until the loans go bad, just as investment income looks robust until the investment boom ends. The problem is particularly acute in China given the lack of transparency and the heavy hand of the state. Fitch has suggested that Chinese banks have been rolling over problematic loans, and there are anecdotal reports that loan officers are strongly motivated not to report problematic debts.16 In recent history, Chinese banks have been plagued by non-performing loans. There is no obvious basis in history to trust Chinas banks any more than those in the West.17

12. Non-financial debt excludes financial contracts such as derivatives. It is very difficult to gather accurate data on the net exposure of such financial contracts even in the West; some contracts are undercounted because they are not accurately reported, while other contracts are over-counted because they offset one another. In general, taking the ratio of non-financial debt to GDP is a good measure of how leveraged an economy is, but not a good measure of how leveraged a countrys financial system is. 13. Fed Flow of Funds, Q1 2010 & Bureau of Economic Analysis. Note that this does not include entitlement program liabilities such as Medicare, Medicaid, and Social Security. It is a common conceptual error to equate such entitlement liabilities to debt. This is an error, because debt represents a legal obligation, while entitlement liabilities represent a political obligation, and one that is continually renegotiated. We do not minimize in any way the seriousness of these obligations, but they need to be treated differently from the contractual obligations represented by debt. 14 . Private sector debt is corporate and consumer debt; in China the overwhelming majority of private sector debt is in the corporate sector. Note that the official statistics do not capture offbalance-sheet issuances, which have surged in the last two years.See, for example, Charlene Chu and Chunling Wen, "Chinese BanksAnnual Review and Outlook," Fitch Ratings (December, 2009). 15. Estimates based on Arthur Kroeber and Louis-Vincent Gave, GaveKal Ad Hoc Comment (March 19, 2010). 16. See Chinas Red Flags, 910 (note 4). It is interesting to compare the incentives of Chinese loan officers with mortgage loan originators in the U.S. during the housing bubble. 17. It is also important to note that Chinas local governments have independently taken on significant liabilities, whose quantity and quality are extremely murky. See David Cui, Andy Zhao, and Tracy T ian, China: A Strategists Diary (Bank of America/Merrill Lynch, January 28, 2010).

06_

Fig. 4 Credit Growth

Sources: CEIC; GMO (2010)

40%

Year-on-Year Growth in Private Sector Credit

30%

20%

10%

0% 2001 2003 2005 2007 2009

Second, private sector credit has grown dramatically. New bank lending in 2009 increased to nearly RMB 10 trillion, or roughly 30% of GDP. The 2010 target for new bank lending is RMB 7.5 trillion. Economic research corroborates the commonsense intuition that when private credit grows substantially above trend, the financial system is substantially more vulnerable to problems in the financial sector.18 One rule of thumb suggests that loan growth faster than 20% per year for more than two years inevitably leads to a substantial number of bad loans.19 China will certainly surpass this amount by the end of 2010. For bears, such loan growth presages trouble.
A FA Ilu re TO CO m m u nIC AT e

Bulls may contest or concede different aspects of the bearish arguments above, but their eyes are fixed on a farther horizon.The bullish thesis on China is that this once-great nation, impoverished by disastrous Communist mismanagement, finally joined the modern world after the death of Mao Zedong and the reforms of Deng Xiaoping.The bullish thesis rests upon two core tenets:
1. 2. China starts from such a low base that even after more than three decades of very fast growth it still has many more years of superfast growth before it reaches its natural place. Chinas growth over the last 30+ years shows that it is pursuing the right policies to unlock its long-term potential.

18. See Claudio Borio and Philip Lowe, Asset Prices, Financial and Monetary Stability: Exploring the Nexus, BIS Working Papers, no. 114 (Bank for International Settlements, July 2002). 19. Dominic Barton, Roberto Newell, and Gregory W ilson, Dangerous Markets (Hoboken: John W iley & Sons, Inc., 2003), 80.

07_

To a bull with this perspective, the bearish arguments are not so much right or wrong as they are a question of ones time horizon. For short-term traders, it matters greatly whether Chinas economy faces a hard landing in the short term, or whether good economic management can maintain the same steady growth that China has enjoyed for so many years, even through the crisis of 2008-09. But for long-term investors, the only way to bet is for China to keep converging with the West. Consider, for example, the bearish concern about excess capital investment in Chinas economy.
Fig. 5 Capital Stock to GDP
Sources: CEIC, Morgan Stanley, Clarium analysis

Fig. 6 Capital Stock per Capita

Sources: CEIC, Morgan Stanley, Clarium analysis

China Taiwan

Japan USA

Korea

China Taiwan

Japan USA

Korea

4 Capital per Unit of GDP

$0

$100,000

$200,000

$300,000

Dollars per Person

Capital stock divided by GDP measures capital in relation to its present use. Comparing China to other countries gives an ambiguous picture. It stands to reason that richer countries with more productive workers should need more capital than poorer countries with less productive workers. Perhaps China has more capital than a poor country generally needs, while the United States could usefully absorb more capital in relation to its economy. Furthermore, data problems abound, so perhaps with better data the relative positions of these countries would look different. Still, a bull sees nothing in this picture that obviously corroborates the bearish concerns about overcapacity. Capital stock per capita measures capital in relation to its potential future need. Here, it is apparent that over time China could absorb many times more capital per person. Of course, an attempt to close the entire gap immediately could not possibly be an efficient use of capital. (How could the money even be spent all at once?) But this is precisely the point: even if all the bearish arguments are correct over the next few years, over the long run the enormous per capita gap in capital stock implies that Chinas investments should continue to bear fruit. Nor, given the long-term demand growth they see, are bulls worried about short-term supply considerations in Chinas property markets. Before Deng Xiaopings reforms, which began in 1978, China was an outlier among the worlds large nations in the very low proportion of its population who lived in urban areas. Even after three decades of massive urban migration, Chinas projected 47% urbanization level is low compared to 6580% for developed nations like Japan, Germany, and the United States. It is Chinas official intention to increase its urbanization level to 60% by

08_

Fig. 7 Chinas Urbanization (1950-2020)

Sources: OECD Urban Trends and Policy in China; CEIC

70% 60% 50% 40% 30% 20% 10% 0% 1950

Population Living in Urban Areas

Projection by China Ministry of Construction: urbanization of 60% by 2020

11th Five Year Plan urbanization target: 47%

1960

1970

1980

1990

2000

2010

2020

2020.20 And who knows how much further urbanization will proceed after that? Bears may take issue with how China defines urban and rural areas, and indeed there are legitimate questions about the data.21 But to a bull, a fixation on such nits misses the larger point that any short-term oversupply will be absorbed by the years of urban migration that undergird Chinas growth. Finally, bulls see little reason to be worried about yet one more loan crisis in Chinaand there have been several over the last three decades22given their belief in Chinas ability to keep growing its economy. A recent, nuanced, bullish analysis of Chinas stock of non-performing loans reflected both the expectation and the necessity for China to grow its way out of its bad loans.23 It concluded that in order to absorb the current NPLs without crisis, China must stop generating new ones in 2011 and keep growing its economy over the coming decade at a nominal rate in the high single digits. Fortunately, since the author believes that Chinas structural real GDP growth rate will be roughly 8% during 20102020 (down from 10% during 19802008), he believes that the required nominal GDP growth rate is easily achievable without an inflationary crisis.

20. Lamia Kamal-Chaoui, Edward Leman, and Zhang Rufei, Urban Trends and Policy in China, OECD Regional Development WorkingPapers 2009/1 (Organisation for Economic Co-operation and Development, 2009). 21. See, for example, Urban Trends and Policy in China, 2021 (note 20) and Kam W ing Chan, Measuring the Urban Millions Chinese Economic Quarterly (March 2009): 2126. 22. Yasushi Suzuki, Dulal Miah, and Jinyi Yuan Chinas Non-Performing Bank Loan Crisis: the role of Economic Rents, Asian-Pacific Economic Literature 22, Issue 1, (May 2008): 5770. 23. See Arthur Kroeber, The Magical Debt-Shrinking Machine, (GaveKal, September 30, 2009) and Chinas NPLs: Another financial time-bomb? Financial Times, October 6, 2009.

09_

Fig. 8 Chinas History of Growth

Source: IMF

18%

Chinas Real GDP Growth

12%

6%

0% 1981 1987 1993 1999 2005

Essentially, bulls and bears occupy adjacent phases along the same long-term view of Chinas economy, where bears emphasize the near-term risks and bulls stress the longterm prospects. This is evidenced by the contained nature of the consequences bears foresee from the investment bubble they perceive in China. For example, in the first widely-read China bear essay in the summer of 2009, Pivot Capital predicted that the shift to a consumption-driven economy would leave average growth rates capped at 78%, so that the overall economy grows at 56% for the foreseeable future.24 Contrast this to the bullish forecast in the previous paragraph that Chinas structural real GDP growth rate will decline from 10% in the last decade to 8% this decade. Can the difference between bulls and bears really be only two percentage points per year of GDP growth over the next several years? Perhaps the reason that bulls and bears seem essentially to share the same long-term view on the future prospects of Chinas economy is because neither side questions Chinas past. The simple story of a disastrously inept regime being replaced by enlightened albeit authoritariangovernance is tacitly accepted on all sides. We therefore turn our investigation away from the present economic statistics and tentatively explore Chinas history to draw lessons about its economic and political prospects.
O ne CHIn A?

Westerners tend to view Chinas rapid economic growth during the last three decades as the inexorable reemergence of a great power.They believe in the ingenuity of the Chinese people because China invented printing, gunpowder, papermaking, and the compass.They respect the power of Confucian ethics. And they know that China has sustained empires for centuries over vast territories. But other than casual stereotyping, why should anyone think the last thirty years in the history of the worlds largest country could be boiled down to something half-remembered from high school? History continues after high
24. See Chinas Investment Boom: the Great Leap into the Unknown (note 4).

10_

school, and even if the textbook answers have not yet been written, the last three decades deserve serious questions. Under Mao Zedong, Chinas economy failed, and this failure culminated in the Cultural Revolution, which destroyed basic institutions, impoverished peasants working in agriculture, and left the country in shambles. China began its ascent from utter poverty in 1978 when Deng Xiaoping jettisoned the failed policies of Mao and encouraged a socialist market economy with Chinese characteristics. While Deng promoted a gradualist approach to reform, his successes are myriad. He encouraged the establishment of Township and Village Enterprises (TVEs) outside of the central plan, devalued the highly overvalued exchange rate in order to attract capital and promote trade, gave greater autonomy to industrial enterprises, and allowed rural households to sell any goods they produced over the quota demanded by the state. Chinas super-fast economic growth through the 1980s was driven by such reforms, especially in rural areas with successful non-state enterprises and in the coastal special economic zones where the export boom began.25 This economic boom coincided with freer markets and greater openness in economics and also politics. Top political leaders, like Zhao Ziyang and Hu Yaobang, encouraged discussion of political reform, including grassroots elections, a more open media and a scaling back of the role of party committees that directly managed government ministries and state businesses. Unlike todays stiffly staged photo-ops, foreign reporters were allowed to chat informally with the Politburos inner circle at a cocktail party at the conclusion
Fig. 9 Perceived Corruption
Source: Heritage Foundation

0 Freedom from Corruption Index Value*

United States

China

India

20

40

60

80

100 1997 1999 2001 2003

*100 is Low Perceived Corruption, 0 is High

2005

2007

2009

After initial signs of political improvement, perceived corruption in China has not improved over the last ten years.
25. Jeffrey Sachs and W ing Thye Woo, Structural factors in the economic reforms of China, Eastern Europe, and the Former Soviet Union (University of California Davis: Institute of Governmental Affairs, 1994).

11_

of the 1987 party congress.26 Our first question then is, Was China in some respects more politically open in the 1980s than it is today? With the Tiananmen Square protests and subsequent crackdown, there began a brutal reassessment of these principles of openness.27 While Deng, Zhao, Hu, and others had succeeded by pursuing openness in the face of consistent pressure from the leftist communists they had replaced, this uneasy balance began to tilt. Due to his particularly acute outspokenness against Mao, Hu became a target for the leftist communists. In order to appease them, Hu was scapegoated and eventually forced into a humiliating early resignation. Upon his death in 1989, student protests erupted, both in mourning for Hu as well as in opposition to his unfair treatment. In response, Deng declared martial law and forced the protesters into submission. Though the protests were largely quieted, the event weakened Deng. The Party repealed the policies that had promoted development in the countryside and replaced them with policies that favored the cities, the focus of political unrest and economic upheaval.28 Could the Tiananmen Square debacle have fundamentally changed the Partys view of the importance of maintaining state control? Although his power was diminished, Deng was able to implement meaningful reforms until his death in 1997. Of particular note, in 1994 the government reformed and streamlined its tax system and the Company Law allowed for the corporatizing of stateowned enterprises (SOEs)leading to privatization and the diversification of ownership.29 Nevertheless, the pace of reform appears to have slowed after Tiananmen Square. When the Asian Financial Crisis struck in 19971998, China had stricter capital controls than other Asian countries, it was far less open to foreign capital, and its very high level
Fig. 10 Composition of Funding of Fixed Asset Investment in China
Source: National Bureau of Statistics
Foreign Capital Domestic Loans State Budget

Fig. 11 International Reserves

Source: IMF 60%
Chinas International Reserves to GDP

100%

80%

40%
60%

40%

20%

20%

0%

0% 1987 1993 1999 2005 1978 1988 1998 2008

1981

Chinas capital flows suggest a distrust of foreign capital and a desire to maintain control.
26. Richard McGregor, The Party: the Secret World of Chinas Communist Rulers, (New York: HarperCollins Publishers, 2010), 36. 27. Ibid. 28. Ibid. 202. 29. Barry Naughton, The Chinese Economy: Transitions and Growth (Cambridge: The MIT Press, 2007), 301.

12_

of investment was largely funded domestically. While China had liberalized some of its state-owned enterprises, the government still owned a majority of Chinas large businesses. Before the Asian Crisis, these differences were largely seen as disadvantages. Yet it was precisely these levers of control that allowed China to avoid the contagion that spread throughout the region. It avoided a currency crisis and was able to engage in aggressive post-crisis stimulation of loan growth, especially to state-owned enterprises.30 And the Asian Crisis struck China at a deeply sensitive time: with Dengs death and the immediate experience of the Crisis fresh at hand, the Party had both the ability and the reason to pursue greater control. It may be impossible to know from the outside how profoundly China was affected by the Asian Crisis and the death of Deng, but there are telling clues. Outside perceptions of government corruption stopped improving. Foreign exchange reserves increased massively in relation to Chinas economy. Foreign capital was increasingly shunned even as investment rose to unprecedented levels in relation to Chinas economy. Could the Party have learned from the Asian Crisis that it must fuel its economic growth on its own terms? Answers to these questions about Chinas history are unclear, but what we know for certain is that the Party remains entrenched in society and in the economy. For example, following the Asian Crisis, the Party instituted a policy of grasping the large, and letting the small go. In grasping the large, policy-makers sought to focus their attention on the largest, typically centrally controlled firms, reorganize them into even largerenterprise groups, and restructure and refinance them, while keeping them under state control.31 Some part of this reorganization has involved the internationalization of various large state-owned enterprises via the issuing of stock to foreigners. However, each formerSOE/now-joint-stock company internationalized under the Company Law retains a Party committee that has the final say over the foreign corporate board.32 Thus, it is not clear that state control has waned. Companies privatized in this manner can be thought of as having issued Class A shares to the Party and Class B shares with minimal voting rights to outside investors. In one case in 2004, the Central Organization Department of China literally switched the top executives of the three largest telecom companieseven though two of them were listed on overseas exchanges and one of them (China Mobile) is one of the largest companies by market capitalization in the world. Is this free-market capitalism? As Chinas economy has become more and more the driver of global growth and China has dodged crisis after crisisincluding the Great Recession of 2008 and 2009we might wonder whether the Party has become even more enamored of its control. On the one hand, its reign has been a success; on the other hand, it may now see greater openness and globalization as more of a threat to its power than an opportunity for China. To put it another way: if one might call the era of Deng Authoritarian Capitalism with an Inferiority Complex, one could call the post-Deng era the era of Authoritarian

30. John G. Fernald & Oliver D. Babson, Why has China survived the Asian crisis so well? What risks remain? International Finance Discussion Papers, no. 633 (U.S. Board of Governors of the Federal Reserve System, February 1999). 31. See The Chinese Economy: Transitions and Growth, 301304 (note 29). 32. SOEs have declined as a proportion of the above-scale industry (those firms with annual output over $600,000) from 49.6% of industrial output in 1998 to 38% in 2004. Joint-stock companies have risen from 6.4% to 42.1%. However, SOEs that became joint-stock companies are counted in both categories, so it is hard to interpret the decline in the proportion of output attributable to SOEs. See The Chinese Economy: Transitions and Growth, 303 (note 29).

13_

Capitalism with a Superiority Complex. After all, the humiliation of the West by the Great Recession has made China even less interested in taking advice from outsiders.33 If Chinas government manifests a superiority complex, that suggests it believes it no longer needs to learn from the rest of the world. Has China really reached the end of history? Or is it still true that pride goeth before destruction, and a haughty spirit before a fall?34
nOT everYTHInG THAT rIses musT COnverGe

Chinas super-fast economic growth over the past three decades is a case of convergence.The technical definition of convergence is a reduction in the disparity of per capita incomes across countries;35 the more commonplace notion of convergence is that poor countries are able to catch up to rich countries by growing faster.What makes convergence possible? Standard models of economic growth suggest that if a country is far from the technological frontier (capital poor, low educational attainment, etc.), then it has the potential to grow rapidly. In such a case, technology transfer, increased savings, the importation of capital, and increased trade should push growth beyond what can be achieved by a rich economy. As Alexander Gerschenkron argued, there can be an advantage to backwardness.36 Yet convergence is neither easy nor inevitable. Poor countries do not usually grow faster than rich countries; indeed, for the past 200 years, convergence has been the exception and divergence the rule.37 For instance, the top half of countries in 1973 have grown their incomes on average 1.54% per year through 2008, while the bottom half has seen 1.20% growth.38 This fact may go unnoticed because of the obvious successes in East Asia, as well as the seemingly anomalous exceptions of serial underperformers. But the evidence is not merely indicative of economic basket cases throwing away their potential. Even poor countries with a recent record of fast growth fall in and out of the convergence club all

33. Chinas vice-premier in charge of the financial sector, Wang Qishan, met with several foreigners in 2008 to discuss financial advice for China. Wang said This is what you do, and this is what we do which is what the Chinese always say, one of the participants recalled. But his message was different. It was: You have your way. We have our way. And our way is right! Richard McGregor, The Party (New York: HarperCollins Publishers, 2010), ix. 34. Proverbs 16:18. 35. J. Bradford DeLong, The Convergence Club. 36. Alexander Gerschenkron, Economic Backwardness in Historical Perspective: A Book of Essays (Cambridge, MA: Belknap Press, 1962). 37. Lant Pritchett demonstrated this empirical fact in Divergence, Big T ime. Pritchett showed that even with poor income data history for most countries, it is possible to test the convergence hypothesis. First, assume that in 1870 developing countries must have at least earned a level of real income necessary for subsistence. Second, use contemporary income data (at the time of his writing, 1990). Third, assume that there has been convergence over time (so that poor countries have grown their incomes faster than rich countries). Given the data, we end up contradicting our first premise, because for convergence to have happened, poor countries must have started growing at a much lower base than subsistence level. Pritchetts analysis jibed with other similar studies, and we now know that instances of absolute convergence (where poor countries grow faster than rich ones) are anomalous. Lant Pritchett, Divergence, Big T ime, Journal of Economic Perspectives 11, no. 3 (Summer 1997): 317. 38. Analysis excludes OPEC. Data come from Prof. Angus Maddison, Statistics on World GDP and Per Capita GDP, 1-2008 AD, University of Gronigen.

14_

the time.39 For example, much of Latin America, post-colonial Africa, and the communist world fell out of the convergence club over the past 50 years, after being members for the early part of the twentieth century. Consider what was, in the worlds first great wave of modern globalization (from 18701913), the vanguard of the convergence club: Argentina. Boosted by investment from Great Britain and driven by the productivity of enterprising ranchers in the Pampa, Argentina was able to develop into one of the worlds key commodity exporters.40 Like China today, Argentina then had the fastest growing major economy in the world. In Europe, a common expression was as rich as an Argentine.41 Success bred overconfidence in the sustainability and reliability of Argentinas regime. Norman Angell argued in 1911 that:
The Argentinehas been drawn into the circle of international trade, exchange, and finance. Their economic relationships have become sufficiently extensive and complex to make repudiation [of their debts] the least profitable form of theftIt is only where a community has nothing to losethat the government can afford to repudiate its obligationsThis was the case with Argentinaa generation ago[T]he public credit has improvedbecause they [now] know that trade and finance are built upon credit and that if credit is profoundly touched, there is not a section of the elaborate fabric which is not affected.42

Like several of Angells predictions,43 this conjecture missed the mark. Following the global crisis of the 1930s, political disorder set in leading to the establishment of a rightwing civilian-military dictatorship.44 And, with the rise of Peron by 1945, the potential for both integration and liberalization was shelved in favor of autarky, unionization, and nationalization. Argentina is better managed today than it was then, but it has never approached its former heights. Of course China is not Argentina. But then, every country is unique.We must understand the common factors that cause and sustain convergence. One obvious answer is globalization, and we agree that globalization is necessary to achieve convergence. The spread of ideas and technology, the application of capital, and the benefits of trade all require the integration and openness that flow from globalization.45 But globalization is
39. The convergence club is a term used to describe that set of economies where the forces of technology transfer, increased international trade and investment, and the spread of education [are] powerful enough to drive productivity levelstowardthose of the industrial core. See The Convergence Club (note 35). 40. Julio Godio, The Argentine Anomaly: From Wealth through Collapse Developmentalism, Internationale Politik and Gesellshaft, no. 2 (2004): 129133. 41. Ibid. 42. Norman Angell, The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, 3rd ed. (New York: G.P. Putnams Sons, 1911), 7475. 43. The thesis of The Great Illusion was that globalization, and in particular the economic integration and interdependence of the European states, rendered armed conflict mutually destructive and thus obsolete. World War I began four years after the books first edition was published. 44. See The Argentine Anomaly: From Wealth through Collapse to Neo-Developmentalism, 135 (note 40). 45. Jeffrey Sachs and Andrew Warner, Economic Reform and the Process of Global Integration, Brookings Papers on Economic Activity 26, Issue 1995-1: 1118. to Neo-

15_

not sufficient for convergence to take root and endure. If it were, then in periods of greater globalization we should observe all emerging country economies rising faster together. Yet while the last 35+ years are generally considered a period of increasing globalization, we know they are also a period during which we have generally seen divergence rather than convergence. A critical explanation is policy reform. Poorer countries must reform their domestic institutions and pursue responsible economic policies to take advantage of the potential for higher growth. Experience shows that such long-lasting reform is hard rather than easy. If we take the degree of backwardness and the level of globalization as fixed, we can develop a spectrum for classifying the capability of countries to converge by the amount and kind of policy reform enacted. Four broad categories emerge:
1. The first category is a country recovering from a disaster. Here we have an otherwise more highly functioning economy devastated by a war or similar catastrophe. Once the cause of the catastrophe is removed, so long as the basic society remains intact, both the return on investment and the amount of investment surge to super-normal levels as the economy returns to its natural state. This kind of convergence can be thought of as a country returning to its more normal (and more highly functioning) level. The second category is political and economic reform of domestic institutions. Such reform increases the return on capital for an extended period, which attracts foreign investment chasing higher returns. This is the ideal economic model of how poorer countries are supposed to converge towards richer countries:46 structural change produces higher returns and leads to a sustainably more highly functioning economy. Eventually, as the economy reaches its now higher potential, both the return on investment and the rate of economic growth fall to normal levels as the economy reaches a per capita level commensurate with developed peers. The third category is super-normal domestic capital deepening. In this model, the government pursues policies to enrich the country by bringing about very high domestic investment. However, unlike the second category, domestic institutions are not fundamentally reformed. Politically, the government refuses to devolve control to the people and to promote transparency and the rule of law. Economically, therefore, the rate of return on investment across the economy is not raisedeconomic growth is fueled by the quantity of forced investment rather than its quality. This strategy risks a catastrophic failure from either mal-investment or political crisis. The fourth category is political dysfunction. There is no meaningful reform; nothing removes the impediments that keep the returns on capital low and that stunt needed investment. If such a country has nothing to offer the world, it will stagnate. If it owns a precious commodity, then during periods where the world desires that commodity and if the country has the military might to stave off de facto colonizationit may prosper for awhile. This temporary prosperity can serve as a catalyst for either domestic reform or increased domestic investment. Alternatively, if the government simply takes the money, then once the bull market ends the economy will stagnate again. Sadly, many countries have fallen into this category over the years, and many continue to do so. Indeed, many countries that were in one of the higher categoriesparticularly the second or thirdhave fallen back into this category.

2.

3.

4.

46. The fact that many emerging markets have not attracted capital from foreign investors was discussed by Robert Lucas in Why Doesnt Capital Flow from Rich to Poor Countries? American Economic Review 80, Issue 2 (May 1990): 9296. Lucas noted that if the developing world is to converge by raising its capital per capita relative to the developed world, one would naturally expect the developing world to import capital from the developed world.

16_

Fig. 12 Convergence Capability Spectrum, 19502010

JAPAN

Recovery from Disaster

Reform of Domestic Institutions

Domestic Capital Deepening

TAIWAN

SOVIET UNION

Political Dysfunction

CHINA

RUSSIA

1950

1960

1970

1980

1990

2000

2010+

This diagram tracks the convergence potential of four countries starting in 1950.

Although we delineate categories to fix ideas, we emphasize that this should be thought of as a continuum. A country may exhibit elements of adjacent categories at the same time, and its position along the spectrum may shift as time passes. Consider Japan after World War II, for example. For some years Japan was in some combination of the first and second categories as it recovered from war and reformed its institutions. During the 1970s and 1980s it shifted more towards the third category. In the 1990s Japans economy entered a new phase of stagnation. In one sense, Japans convergence was an economic success, as it is now one of the richest economies in the world. But the final stage of its path to convergence extracted a terrible price, as its economic and political potential has been stunted ever since. One must also note that while a country is growing quickly it can be hard to distinguish among categories, particularly when the society in question is opaque. A salient example from recent history is the Soviet Union. In the 1950s and 1960s, many people in the West saw the economic growth of the Soviet Union as a case of sustainable convergence that might fall somewhere between the first and second categories.47 (Khrushchevs famous threat We will bury you expressed his belief about the Soviet Unions economic prospects.) As time passed, it became clear that much of the economic activity was a form of forced mal-investment, with oil profits playing an increasingly important role after U.S. production peaked in the early 1970s. Indeed, the Soviet Union stopped converging and actually started to diverge. In the late 1980s, plunging oil prices collided with political crisis and the country broke apart. Although Russias economy has done better during the last decade than in the 1990s, Russia has regressed politically, and the resurgence has been fueled by oil money that the government is not reinvesting into the economy.

47. Paul Krugman, The Myth of Asias Miracle, Foreign Affairs 73, Issue 6 (November 1994): 6278.

17_

In other cases, though, particularly where there is a credible commitment to sustained political reform, optimism can be warranted. Consider Taiwan. After Japan relinquished Taiwan as a colony in the aftermath of World War II, it was unclear whether Taiwan would continue its progress in industrialization and modernization. Indeed, just months later, the Chinese civil war resumed, with the Communists ultimately forcing the existing government to evacuate to Taiwan. Though not as egregious as the rule of the Communist Party on the mainland, the imposition of martial law by the Nationalists in Taiwan was certainly authoritarian. Combined with economic mismanagement that led to hyperinflation in the six years after World War II ended, it would not have been surprising if Taiwan had fallen with China into the fourth, dysfunctional category. Fortunately, although the Taiwanese used import substitution and other policies to force investment and growth, they also maintained a commitment to liberalization and openness. By 1965, Taiwan had established the first export processing zone (EPZ) in Asia.48 In this way, Taiwans economic openness in the 1960s and 1970s allowed it to progress more and more towards economic liberalization, even as its politics remained a closed, one-party, authoritarian system. Political liberalization soon followed with the lifting of martial law in 1987, the first multi-party election in 1996, and the governments sustained democracy thereafter. Taiwan now ranks only a few notches below countries such as France and Italy on a per capita GDP basis. It continues to grow its economy quickly and seems poised to converge further as time progresses. Taiwan has benefited from several factors. It was able to modernize under Japans colonization, yet it was able to free itself from Japans rule. It was sheltered from the Chinese Communist Party and the postwar geopolitical configuration has allowed it to maintain its independence. And its small size is also a benefit in two regards. From a domestic perspective, the much smaller population is relatively easy to manage politically and economically; from an external perspective, it is able to pursue a heavily subsidized export policy without angering its much larger trade partners. What about China? Throughout Deng Xiaopings regime, and particularly before Tiananmen Square, we would place China in some combination of the first and second categories. After decades of being torn by civil wars and disastrous campaigns such as the Great Leap Forward, simply creating stability probably allowed China to rebuild and return to a more normal and more highly functioning level (albeit one still very far below developed countries). At the same time, as noted earlier, there were important domestic reforms that raised Chinas sustainable level of economic activity. We suggest that in the last dozen years since the death of Deng and after the Asian Crisis, China may have moved closer to the third category than the second. The economic statistics suggest a greater emphasis on domestic savings and a turning away from foreign capital, and while some domestic reform has continued, in many ways it has stagnated. If this is correct, then the threat to Chinas economy is not that its journey may become bumpier than anticipated as it continues along the same road it has traveled since 1978. Rather, the danger is that Chinas journey on this new road may be nearing its end. How can we tell whether this danger is clear and present? Simply noting that China is poor and therefore has so much farther to converge is no more useful than noting that Chinas investment boom has been going on for many years and thus may peter out soon. Both observations merely assume their conclusion. Our analysis suggests that the key to
48. A region in which foreign investment was encouraged by lower tax[es]simplified procedures, andduty-free import of components and supplies. See The Chinese Economy: Transitions and Growth, 406410 (note 29).

18_

understanding the sustainability of Chinas convergence is to understand the degree to which political reform is either progressing or stagnating.
(nO) POW er TO T H e PeO Pl e

As an authoritarian country, China is controlled for the benefit of insiders,49 and this control creates external and internal conflicts. The external conflicts arise because the governments corruption and control of markets are hostile to foreign investment; the internal conflicts arise because the government resists reforms that would promote political fairness and transparency. Only rapid economic growth keeps these conflicts in check. Foreigners will tolerate Chinas hostile environment as long as the promise of growth remains alluring; citizens will tolerate Chinas authoritarianism and corruption as long as living standards keep rising for all. Chinas growing sense of superiority suggests it will resist political reform. Yet without political reform stability is at risk. If growth slows, the internal and external conflicts noted above will eventually emerge and reinforce one another. The more barriers to foreign investment, the more difficult it will be for China to import foreign intellectual, human, and financial capital, and therefore the lower Chinas attainable standard of living once the investment boom wanes. Lower living standards would threaten to undermine domestic stability, which in turn could provoke the insider class to tighten control further, exacerbating the environment for foreign investment. Start with the longstanding difficulty for foreigners to make money in China. In a popular book, Mr. China,50 one man details his adventures trying to invest Western capital profitably in Chinese businesses in the 1990s; in the end the author is lucky to escape in one piece, while his investors are even less fortunate. As China grows, its investment environment must improve commensurately to continue to attract foreign investment in proportion to its larger economy. China loses opportunities when Western investors feel the need to route investment through other Asian economies such as Japan, Taiwan, Singapore, and Hong Kong. What is the cost to China when a network of guanxi (personal connections) is particularly critical in China, where the judicial process is slow, expensive, and plagued by corruption and [r]ather than relying on legal safeguards, American companies need to ensure that their Chinese counterparts in any contract have their own motivation for fulfilling the contract?51 And, indeed, large multi-national companies encounter substantial challenges in China. Consider the success of BYD and Chery, two of the fastest growing automobile manufacturers in the world, who copy the designs of foreign car companies and even the exact logos of BMW and Chevy respectively. GM sued Chery in 2005, to little avail.52
49. Clarium has argued for some time that it is not accidental that China is controlled for the benefit of insiders. See Peter Thiel, The Optimistic Thought Experiment (Clarium, May 2007). 50. T im Clissold, Mr. China: A Memoir (New York: HarperCollins Publishers, 2005). 51. U.S. Commercial Service Beijing and Rosemary Gallant, Essential Advice for Doing Business in China, U.S. Department of Commerce. 52. End of the road for GM and Chery Dispute, Managing Intellectual Property, November 21, 2005. Although the results of the settlement were not disclosed, the stance of the Chinese government suggests the terms may have been less than favorable for GM. Wen Xikai of the State Intellectual Property Office argued, Sparks company did not make any patent application for their designs for Spark in China. But now they want to sue the Chery factory in Anhui for infringement. But since they did not apply for any patent they cannot sue them for patent infringement. So they seek to sue them over loss of trade secrets. But evidence is very important for that.

19_

The success of copycats such as BYD and Chery has been treated as almost comical. One observer laughs at the rise of Wumart, which promises Every Day Low Price.53 Before China became the second-largest economy in the world, such anecdotes could be treated as nuisances or jokes. Not anymore. For instance, Google recently threatened to withdraw substantially from China, officially because of state censorship and intense piracy attacks, but perhaps at least as much because Google has been unable to make money in China. As of this writing, an uneasy truce has been reached between Google and the Chinese government to allow Google to continue to operate within China, but it seems likely more problems will arise. Nor is this merely an Internet issue. I really worry about China, Mr [Jeffrey] Immelt [CEO of General Electric] told an audience of top Italian executives in Rome, accusing the Chinese government of becoming increasingly protectionist. I am not sure that in the end they want any of us to win, or any of us to be successful.54 A related challenge is export subsidies. An Asian tiger might subsidize exports without attracting attention in the industry. But China is too big to escape notice and complaints. The more general form of this debate concerns Chinas currency policy, which is an integral part of Chinas tight control of capital markets. Chinas policy of subsidizing its exports increasingly angers its trading partners such as the U.S. For example, Senator Charles Schumer recently called for retaliation with these words: Billions and billions
Fig. 13 Chinas Size: Exports as a Share of World Exports
Source: IMF

12%

Korea Taiwan

Singapore China

10%

8%

6%

4%

2%

0%
1978

1988

1998

2008

Chinas size puts it in a different category from other Asian Tigers.

53. Similar to Wal-Marts Always Low Prices. See Joseph Weisenthal, Chery Sounds Like Chevy In Chinese, The Stalwart, September 29, 2006. 54. Guy Dinmore and Geoff Dyer, Immelt hits out at China and Obama, Financial Times, July 1, 2010.

20_

of dollars, millions and millions of jobs flow to China simply because their currency is manipulatedChinas mercantilist policies continue to undermine the health of U.S. industries, so this is fair warningdespite the administration asking us not to do it, we are going to move forward with our bipartisan legislation [that would penalize China and other countries that maintain artificially low currencies].55 Because Chinas latest decision to tinker with its currency does not genuinely relinquish any control, we doubt it will change the structural basis of the hostility that its control engenders. Rising tensions due to China over-extending its control are mirrored at home. From the outside, Chinas government appears to provide enlightened stewardship of its economyso long as you do not try to do business there. Inside China, it has always been known that much of the benefit of Chinas growth is accrued by the top. As Victor Shih illustrates in Factions and Finance in China, political factions are entrenched around the continuation of the countrys investment-led growth engine. Shih describes his cultivation by a local Chinese official who ran an asset management company.56 The official was charged with meeting a certain cash recovery on NPLs right away. To meet this objective, he sold the collateral tied to the NPLs, without regard for how removing the collateral would affect the ability to collect on the loans in the future. In essence, the official violated his professional duty and stole from the economys future income in order to advance his career. Shih makes clear this was not an exceptional case, noting that bank deposits are viewed by officials, including state bankers, as an amply supplied public good that can and should be exploited at will to fulfill a host of policy, political, and private ends.

Fig. 14 Subsidizing Capital at the Expense of Labor

Source: IMF

14 12 10

Lending Rate

Deposit Rate

Interest Rate

8 6 4 2 0 1980 1984 1988 1992 1996 2000 2004 2008

The disparity between the rate earned on Chinese deposits vs. that paid on Chinese loans represents one dimension along which China suppresses labor in favor of subsidizing capital.

55. Ian Talley and Tom Barkley, US Lawmakers Press Geithner On China Currency, Trade Policies, Dow Jones Newswires, June 10, 2010. 56. Victor Shih, Factions and Finance in China (Cambridge University Press, 2008), 12.

21_

This situation encapsulates the more general state of theft and misappropriation, especially by local officials who are subject to little accountability. As the Peterson Institute for International Economics explains, the intensity of the problem is magnified in the context of a rapidly growing economyas there is more wealth to be captured. [Chinas cadres] are skimming off a percentage of the governments investment in new infrastructure, taking a cut from windfall profits from land transfers to private developers, and illegally lending public funds to cash-hungry investors. In addition, expropriation of farmland by local officials with little or no compensation to the displaced, often in collusion with developers may be the most widespread cause of social unrest and anger. In 2008, 2,700 officials were referred for prosecution on such charges and more than 31,000 instances were under investigation.57 Though corruption has been severe all along, the Chinese populace has tolerated forced savings because those savings have driven economic growth. Should growth slow and poor peoples income stagnate, how will they react? As Andy Xie observes, recent incidentsthe wave of suicides at electronics manufacturer Foxconn and strikes at Honda in particular are just the tip of the iceberg.58 Todays youth in China are born into a relatively richer society, with greater ambition and opportunity, than their parents. Is it reasonable to expect this new generation to accept meager wages and isolation from modern-day living? In Xies view, Chinese leaders consistently underestimate the potential for unrest driven by the generation gap: Business leaders and government officialsgrew up in poverty and rule the country with a view that marginal economic improvement is the purpose of life. Moreover, because so many members of the Party benefit from the existing structure, it is hard to believe that true reform is around the corner. [Local] governments have few
Fig. 15 Chinas Declining Demographic Tailwind
Source: United Nations, World Population Prospects: 2008 Revision

80%

Child Population (0-14)

Working-Age Population (15-64)

Elderly Population (65+)

60% Percent of Population

40%

20%

0% 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

57. C. Fred Bergsten, Charles Freeman, Nicholas R. Lardy, and Derek J. Mitchell, Chinas Rise: Challenges and Opportunities (Washington, D.C.: Peterson Institute for International Economics and Center for Strategic and International Studies, 2008), 91104. 58. Andy Xie, Dismantling Factories in a Dreamweaver Nation, Caixin online, June 7, 2010.

22_

ties to workers, but they are very connected to factory owners through tax revenues and other benefits.59 As labor gains bargaining power, we believe this arrangement will become strained. Such expressions of worker discontent will only become more exaggerated, as Chinas rising generation becomes empowered by profound demographic changes that are just beginning to occur and will accelerate throughout this decade and beyond. From 1980 to 2010, the proportion of Chinas population that is working age rose from 60% to 72%. Over the next 30 years, this ratio is projected to fall back to 63%. Demographers and intuition agree that such a shift in the composition of the workforce tends to affect substantially the productivity and output of the economy.60 But such an analysis underestimates the potential effect on China because it ignores political consequences. It is not simply that Chinas workers have been in an age cohort where they add to the worker pool as well as the total pool of domestic savings available to invest. It is also a shift in power. As long as the pool of workers has been expanding, they have had no bargaining leverage. This decade will see these dynamics reverse. Workers will demand higher wages just as the economy will have a more slowly growing pool of savings to invest. Rising inequality and persistent inequity are more easily endured as long as everyone gains. If growth slows, more people will fall behind, and the risk of a backlash will grow. Hence, Chinas stability is not so much leveraged to growth as to marginal growth. When the rate of growth wanes, the fragility of Chinas system will come into sharper relief. Perhaps it is well to close these political observations by reminding ourselves that China is the last remaining major communist country. Is it really prudent to place faith in a political structure that has deservedly lost the confidence of citizens and businesses over and over again? Or is it more likely that the two groups who are most confident in Chinas prospectsthe Communist Party (the ultimate insiders) and financial investors (the ultimate outsiders)are the last two groups to see the gathering storm?
l e T A T HOusA n d mIl lIO n FlOW er s B lO O m

The fact that China can so quickly react to things, right, its not a democracy, they dont have to pass anythingI mean, the government has the ability to react quickly Is this a compelling argument for why the bubble wont burst? Question from moderator Deborah Kan, from the interview Dr. Doom and Dragonomics Lock Horns over China Growth, June 3, 201061

Ms. Kan is a television presenter who appears to be in her mid-thirties. Many women in her mothers generation had to struggle to have the same career opportunities now more easily available to their daughters. Many women in her grandmothers generation had no choices at all. Such struggles were allowed in democratic societies, and we are all better for their success. That China has not, to put it delicately, been known to pursue progressive policies towards women makes it all the more striking how easily the question was asked and how seriously its central premise is taken. Is Chinas authoritarian, undemocratic government a competitive advantage?
59. Ibid. 60. Demographers use regression analysis to estimate how a change in the percentage of a countrys working age population will affect real GDP growth. Such models estimate that China could see a 2.1% decrease in its real GDP growth rate over the next three decades compared to the last three decades based purely on the projected changes in its population demographics. David E. Bloom and Jeffrey G. W illiamson, Demographic Transitions And Economic Miracles in Emerging Asia, NBER Working Paper, no. W6268 (National Bureau of Economic Research, 1997) and David E. Bloom, David Canning, and Jaypee Sevilla, Economic Growth and the Demographic Transition, NBER Working Paper, no. W8685 (National Bureau of Economic Research, December 2001). 61. Reuters Insider Roadshow, Is China in a Bubble? (Thomson Reuters, 2010).

23_

There is a sense in which one could say that the economies of the world are in a government bubble.We do not mean here to recycle debates between Keynesian, Austrian, Monetarist, or even Marxist economic theories. Rather, the point is that financial markets now crave government actions to an unprecedented degree. For the West, financial markets desire monetary and fiscal stimulusbut because financial participants can understand the challenges faced by Western economies, they also desire structural reform and fiscal sustainability. For China, financial markets also desire monetary and fiscal stimulusbut because China is too opaque to understand, they place blind faith in Chinas government. Just do more of the same to promote growth, one can imagine the markets saying to China, it has worked so far, so you must know what you are doing. In the aftermath of the financial crisis of 2008, financial markets reliance on government intervention is understandable. Perhaps it is even necessary for a while longer. But should we really lose our faith in the primacy of economic and political liberties? This is one question we will answer directly: no, we should not. Even setting aside the moral imperative for freedom, there is a compelling case to be made purely on economic grounds. One way to compare economic liberty across nations is by using the Economic Freedom Index calculated by the Heritage Foundation.62 Figure 16 shows a strong correlation between economic freedom and (logged) GDP per capita across a number of countries. Indeed, on this measure, China does not appear particularly underdeveloped at allor to put it another way, significant convergence from this point would be remarkable without greater economic liberalization.
Fig. 16 Economic Freedom vs. Income (G20) 63
Sources: IMF; Heritage Foundation

12

11 Log GDP per Capita (PPP; 2009)

10

CHINA

US

50

55

60

65

70

75

80

85

Economic Freedom Index, 2010

Relative to its political institutions, China is not especially poor or underdeveloped.

62. For information on the Indexs method, see 2010 Index of Economic Freedom, Heritage Foundation. 63 . For more on this relationship, see Scott Sumner, The Unacknowledged Success of Neoliberalism, Library of Economics and Liberty, July 5, 2010; and Jeff Lonsdale, Guessing at Chinas Steady State, Unpleasant Facts, July 28, 2010.

24_

The relationship between political liberty and GDP per capita is more nuanced. Until recently,Western political economists believed that higher income per capita caused more libertythat as people got richer, they demanded and brought about political liberalization. This seemed to be the best way to explain the strong correlation across countries between greater democratization and higher per capita income.64 A recent study has challenged this relationship by reversing the causation and lengthening the time horizon.65 The authors find strong evidence of omitted variable bias, which is to say that the same factors that cause higher income also cause greater democratization. The implication is profound. Optimistic Westerners had believed that you could cause democracy to flower by enriching the people. The truth is more sobering: a country must choose political liberalization for itself, and this choice will also lay the foundation for greater prosperity. China surely has the potential to choose freedom. Its population is rapidly becoming more educated, and the proliferation of twenty-first century media will only accelerate. But choice implies uncertainty, which is the opposite of what financial markets crave. Those whose portfolios depend both on Chinas economy continuing to converge rapidly and on Chinas government maintaining its iron control may find themselves on the wrong side of the tradeand the wrong side of history.

Fig. 17 US & Chinese University Graduates 66

Source: National Center for Education Statistics; National Bureau of Statistics

US Soft Fields China Soft Fields

China Hard Fields US Hard Fields

Millions of Graduates

0 1996 2000 2004 2008

Chinas populace is becoming more and more educated.

64. Note that here we are discussing political liberty (democracy) rather than economic liberty (as measured in the previous paragraph using the Economic Freedom Index). 65. Daron Acemoglu, Simon Johnson, James A. Robinson, and Pierre Yared, Income and Democracy, CEPR Discussion Papers, no. 5273 (Centre for Economic Policy Research, February 2005). 66. Hard fields include science, engineering, computer science, and medicine. Soft fields include philosophy, economics, history, literature, and others.

25_

Westerners will continue to examine Chinas history for clues to its future. Some still debate whether Admiral Zheng He, the fifteenth-century explorer of Southeast Asia and East Africa, did in fact reach the Atlantic Ocean and perhaps even the American continents. What is known for certain, however, is that after his journeys, the empire abandoned its policy of exploration and diverted resources into expanding the Great Wall. Today China seems more open in terms of foreign trade and travel. But no one would call it transparent. In some ways, China is as opaque as it was before Marco Polo, and investors grope about like children playing his game. Investment is separated from demand, capital from markets, and subjects from their rulers. Exploration and the Wall now exist at the same time.

PATrICK WOlFF managing director

AndreW GArvIn Principal