Is Time Really on China's Side? What the Economic Slowdown Means for Future Chinese Power

John Lee Sunday, January 17, 2016

Editor's Note: Official estimates and popular discourse portray China as an emerging colussus whose ever-expanding economy will make it the dominant power in Asia and a peer competitor to the United States. John Lee, of the Hudson Institute and Australian National University, paints a far darker picture -- at least for China. Lee identifies a range of grave economic problems that China faces and contends that its resulting future military power is likely to be far more limited than is usually estimated.

At a recent closed-door presentation to a gathering of uniformed officers from the United States, Japan, and Australia, one Major General posed the question of whether the Chinese economic slowdown really mattered very much at all. He argued that even a serious slowing – say growth of four to five percent in 2016 and beyond – represented an enormous economic expansion for its US$10 trillion economy in absolute terms, offering Beijing a vast pool of resources with which to enhance its national power. As the officer concluded: when one is about to be run over by a Mack Truck, it becomes irrelevant whether the vehicle is travelling at 50 miles per hour or double that speed.

The line of questioning is understandable. China is already the world’s second largest economy with a formidable military force and regional presence. The Chinese Communist Party (CCP) seems determined and able to increase defense spending bydouble-digit rates irrespective of national economic performance. As one American officer who cannot be named wistfully noted during the discussion, maybe that is the authoritarian advantage available to the Chinese. The country’s economic problems may well present domestic headaches for the CCP, but nothing changes for the United States and its East Asian security allies and partners.

However, time is unlikely to be on China’s side, and current economic problems are only adding to serious problems for its leaders. There are those such as Professor Hugh White, a former senior defense official and lead author of Australia’s 2000 Defence White Paper, arguing that America should accept the likelihood, if not inevitability, of a “Chinese century,” at least in Asia. But significant constraints on Chinese power will soon become imminent, as a closer look at the mechanics of its economic growth, its political institutions and demographics, and internal competition within its security sector will reveal that the expected Chinese century is built on immensely shaky ground.

Behind the Chinese Economic Miracle

Let’s begin with the drivers of China’s economic growth across the past decade. There are only three ways to grow an economy: add more ­labor, add more capital, or use these inputs more productively (also known as total factor productivity or TFP). As economist Paul Krugman presciently pointed out 20 years ago in his observations about the economic malaise experienced by the Japanese and Soviet economies, rapid growth based on expansion of ­inputs rather than on using these inputs more productively is inev­itably subject to diminishing returns and ultimately unsustainable.

Economic axioms may seem unexciting, but they serve as a better guide for prediction than trend lines that speak to the past rather than the future. 

However, time is unlikely to be on China’s side, and current economic problems are only adding to serious problems for its leaders.

Consider China’s impressive record of growing its economy by 162 percent from 2004 to 2014. The means by which this was achieved matters greatly. Additional labor contributed about 6 percent, but an enormous 136 percent can be attributed to capital inputs in the form of fixed investment (that is, building things). This means that only 20 percent of growth has resulted from advancements in TFP.

Perhaps one’s response is “so what?” The enormous level of capital inputs needed to generate such growth has meant national debt levels have risen from 147 percent of gross domestic product (GDP) at the end of 2008 to more than 280 percent at the end of May last year. To put this in some context, the expansion of debt — which has been used primarily to finance capital inputs — from US$9-10 trillion in 2008 to US$30 trillion by the end of 2015 exceeds by one and a half times the size of the U.S. commercial banking system. This is the most rapid generation of debt in economy history, in both absolute terms and relative to the size of the Chinese economy over an eight-year period.

Yet, the result is what China’s own state-sanctioned economists lament as not just the largest national building program the world has known, but also the most wasteful: underused roads, airports that are practically empty, newly built “ghost cities” that are wholly abandoned, and enough empty units and townhouses to cater for the expected increase in urbanization for the next 20 or more years. A recent survey revealed that one in five newly built homes Chinese cities remain empty. Such activity is counted as economic growth, but it does little to actually enhance national capacity.

Yet, the result is what China’s own state-sanctioned economists lament as not just the largest national building program the world has known, but also the most wasteful

Why Time is Not on China’s Side

In short, China has doubled down on Japanese errors from several decades ago. Unlike Japan, authoritarian China lacks the institutions – such as the rule of law and adequate intellectual property rights – needed to join the 30 or so countries that have escaped the dreaded middle-income trap to become advanced economies, a phenomenon referring to rapidly rising developing economies stagnating and unable to take the next step in attaining high per-capita income levels and living standards characteristic of fully industrialized economies. Dismantling China’s state-dominated political economy and winding back the power and privileges of the CCP— even if it is in the country’s long-term economic interest — will be fraught politically and highly disruptive to an already fragile economy.

With more people leaving the workforce than entering it this year, China will be the first large country to grow old before it grows even moderately rich. Up to a quarter of its growth from 1980 to 2005 can be attributed to a “demographic dividend:” the massive increase in productivity generated by a combination of declining fertility levels and a mass of young workers entering the workforce with limited familial responsibilities.

Such good fortune has passed. By 2035, China will have the same demographics as aging societies in Western Europe today without the degree of preparedness of these advanced economies. For example, unfunded pension liabilities for state-owned workers (which only cover less than one quarter of the population) could amount to US$10.8 trillion in the next two decades, or 40 percent of GDP, and this is generously assuming growth does not slow from present levels.

Strategic Implications: Increasing Chinese National Power is Not Cost-Free

For a central government that already spends at least 20 percent of its budget (after transfers to local government) on national security (more than 40 percent if we include the military-trained People’s Armed Police, or PAP, used to control unrest within China) according to National Bureau of Statistic data, continual double-digit increases for the People’s Liberation Army (PLA) and PAP will be increasingly difficult to achieve or justify. This will make the task of catching up to U.S. military might much more difficult to achieve for the untested PLA. And still, China confronts an external environment in which it has not been able to change the strategic orientation of a single major power and in which it remains a strategically isolated rising power.

In the immediate term, the general economic slowdown is already having a negative effect on CCP coffers. Fiscal revenue growth in 2014 was less than half the average fiscal revenue growth from 1993-2013, even as fiscal expenditure has been growing at a pace 3-4 times faster than fiscal expenditure growth in Beijing’s attempts to stimulate the economy.

In the immediate term, the general economic slowdown is already having a negative effect on CCP coffers.

Additionally, current official government debt might be a seemingly manageable 55 to 60 percent of GDP. But the figure was zero less than five years ago, and the official figure is almost certainly understated. It also does not include the government’s liabilities from hundreds of billions, if not trillions, of dollars of bad debt hidden in the books of state-owned banks. Should bad debts be recognized – as they eventually must be – an enormous financial sector bailout is in the cards since the CCP cannot afford the entire banking system to fail. 

Any widespread banking or financial crisis might well be averted with great skill and at great cost. But as fiscal pressures inevitably grow, one can also be sure that we will see increased funding competition and even cannibalization between the PLA and PAP. In any competition between the two, the PAP will tend to get its way simply because it is in charge of keeping unrest in Xinjiang and Tibet under control, as well as other parts of the country. In short, double-digit budget increases for the PLA cannot occur for too much longer.

One should also expect increased funding competition and even cannibalization within the PLA itself. Take the 2015 Defence White Paper, which states for the first time that “the sea is as important as the land.” But transformation from a continental to a naval power (and enhancing the PLA’s anti-access/area- denial capabilities) requires money, and a lot of it.

In the past, rapidly rising fiscal revenue lifted all boats (pun intended). With fiscal revenue growth in 2014 and 2015 at the lowest levels since the early 1980s, and with government liabilities and expenditure mounting, a successful transition from land to maritime power becomes that much more difficult.

Indeed, contemporary rapid Chinese expansion of military capabilities and the country’s more assertive behavior in the East and South China Seas may well be evidence of the CCP knowing its window of opportunity is fading, rather than evidence of a rising power feeling increasingly confident about its future, as most assume. 

Finally, news of the demise of China’s primary competitor, America, is clearly greatly exaggerated, and the United States remains far superior in virtually every factor that matters to the economy and national power more broadly: proven institutions, innovation, age demographics and resource security to name just a few. Bad strategic and/or political decisions may well cause Washington to shoot itself in the foot – as will a reluctance to accept the reality of strategic competition with China and all that entails, or else to compete ineffectively despite having a stronger hand. But that is Washington's decision to make, and the ball is in its court. 

As we head toward an increasingly contested Asia, Americas should see a future tilted more, rather than less, in favor of the United States and its allies as time passes.