The Illusion of the Chinese Miracle Economy and Blockchain’s Dark Side
A few months ago there was a slew of positive headlines regarding the Chinese Communist Party’s newfound appreciation of ‘blockchain’. On the 25th of October, President Xi announced that “blockchain is an important breakthrough for the independent innovation of core technologies”.
Looking more closely at the suite of blockchain-related announcements curated by the CCP, we see a mix of state conditioning, censorship, allegiance to Maoism, and a pinch of capitalism.
- China’s most downloaded app, Xuexi Qiangguo (study for becoming a powerful nation), started recommending a course for educating oneself on ‘blockchain’. The lessons cover Bitcoin and Ethereum, among other things.
- Articles denouncing blockchain or claiming that the technology is a scam were banned.
- CCP party members can now pledge their allegiance to the party and its mission on-chain. (?!)
- Huang Qifan announced that the PBoC will issue a sovereign digital currency. He claimed that the PBoC has been researching this (DCEP) for 5–6 years and that they’re poised to be the first central bank to achieve a digital sovereign issuance.
- Crypto mining is no longer “to be eliminated” in China.
Less than two weeks after the ‘Xi pump’ we saw a painful unwind, however, as the CCP launched a fresh crackdown on crypto exchanges. While the larger established exchanges were immune (as they have been in past crackdowns thanks to implicit government support), smaller, less reputable operations were investigated and shutdown.
The whole affair left many scratching their heads, bewildered by the mixed messages coming from the Chinese administration. Indeed, their insistence to draw a distinction between blockchain (good), and crypto (bad) is curious. But while the crackdown on ‘crypto’ made sense as a response to the massive PlusToken scam that took place last year, Xi’s overt praise of blockchain feels more foreboding.
I suspect Xi likes blockchain for the same reasons he likes anti-corruption measures and social credit scores. In isolation, these policies may appear to be relatively innocuous. When amalgamated, however, they clearly signal a policy drive towards greater centralization of power, more oversight over the financial system, and an ongoing decline in economic freedoms and basic privacy rights for Chinese citizens.
The need for tighter financial controls and greater oversight comes at a time when structural imbalances in the Chinese economy continue to build. Their debt problem has been well advertised for years, so much so that most macro investors are jaded with the theme.
I could argue that their debt bubble is in its eleventh inning, but the truth is they can keep printing RMB with a closed capital account as long as they maintain sufficient FX reserves to manage the soft peg. We have already seen their loose monetary policy fuel bubbles domestically in both real estate and equity markets, but it’s manageable as long as they don’t lose control of the currency.
Their export sector thus serves as the linchpin of the economy. As long as it strong enough to support a current account surplus, credit creation can steam ahead and the non-performing loan rate can be massaged as the debts of insolvent companies are selectively rolled where needed. One of the perks of central planning!
It’s a double-edged sword though. The need to maintain a healthy war chest of FX reserves renders China’s economy highly vulnerable to shocks in global demand and protectionism. And that’s before we even contemplate the potential economic fallout from the Coronavirus. But before we dive deeper into China’s economic quandary and their poor negotiating position, it’s helpful to rewind to the post-WW2 ascension of the Soviet Union and its subsequent demise to consider some of the parallels.
I can’t speak for all Millenials, but I must admit that I find the magnitude and breadth of geopolitical conflict in the 20th century hard to fully appreciate. Two World Wars, a Holocaust, civil wars in Russia, Spain, and China, plus three wars in the Balkans, just to name a few. The ideological rift between capitalism and communism manifested itself in conflicts across many fronts. Most notably in Korea, Vietnam, and of course, the Cold War.
In the context of history, it really wasn’t that long ago that the Hoff was at the Berlin Wall in 1989 singing “Looking For Freedom”, shortly after Gorbachev tore down the wall. Just two years later the Soviet Union collapsed, ushering in a period of remarkable geopolitical stability in an era of American supremacy.
In hindsight, it may seem obvious that America was destined to prevail. These days most economists agree that liberal capitalism has a tendency to outperform centrally planned economies, especially over the longer term. Yet interestingly, when the Iron Curtain was still up, fear of Soviet dominance was palpable.
Indeed, even Nobel laureate Paul Samuelson was fooled by strong topline growth numbers. Below is an excerpt from the 1961 edition of his textbook ‘Economic Principles’. He forecast that the Soviet Union would overtake the US sometime between 1984 and 1997. Of course, this never happened. In later editions, Samuelson stuck to his thesis with lines redrawn and targets pushed back.
Samuelson was considered one of the founders of ‘neo-Keynesian’ economics. While he made many brilliant contributions to the field of economics, his take on the Soviet economy was not one of them. There was too much of a focus on headline growth, and not enough attention paid to the sectoral breakdown of GDP, as well as the drag from price controls, malinvestment and corruption.
“Contrary to what many skeptics had earlier believed, the Soviet economy is proof that… a socialist, command economy can function and even thrive.”
- Paul Samuelson, 1989Soviet growth was investment heavy, and that investment was funded by fleecing the pockets of the proletariat via wealth transfers from the private sector to the government. This dynamic can be realized in various ways. The Soviets opted for underpaying workers in relation to output, the illusion of property rights, and when desperate, the outright confiscation of property.
Proceeds were ploughed into all sorts of harebrained schemes that taken collectively, did little to improve the debt servicing capacity of the economy. You could erect a statue of the great Vladimir Lenin in the middle of Siberia, only to remove it at a later date. Both the construction and removal of the monument would count towards ‘GDP’ in the relevant calendar, but in reality, the end result would be nothing but an increased national debt burden without a commensurate gain in productivity and debt servicing capacity.
Reliable Soviet economic statistics are understandably hard to come by, so we have to rely on US research to try and grasp the nature of their predicament mid-way through the 1980s. Below is an excerpt from a 1985 CIA report investigating the relative economic performance of the US vs. the USSR. Note the USSR’s reliance on labour-intensive agriculture as well an increasing reliance on investment over time.
High investment levels in of themselves are not a harbinger of economic crises. Investment led growth can be extremely successful, especially for developing countries still riding the wave of industrialization. So it is no surprise that Soviet growth was on a tear throughout the 1950s and 1960s. As the tailwind from the initial pulse of industrialization subsided, however, their economy faded into stagnation. To compensate, the government began to rely more on external debt to fuel growth via investment.
Things may have turned out differently if they rebalanced the economy by investing the spoils of commodity exports on education, medicine and services for the betterment of society. Instead, the Politburo chose to research and manufacture guns, radios and space gadgets in an attempt to retain power by projecting military strength.
The Union was in shambles by the time Gorbachev came to power in 1985, but he too was no stranger to ill-conceived economic policy. In a push to improve productivity he banned the retailing of hard liquor, which was only to be permitted in restaurants. As you might have guessed, the Russians didn’t stop drinking vodka. It just resulted in the rise of a gangster class peddling black market moonshine, while government tax revenues fell, further weighing on an already bloated fiscal deficit.
Cue Chernobyl 1986, Baltic uprisings throughout 1988 plus the Hoff’s triumphant performance on the Wall at the end of 1989, and it’s fair to say Gorbachev was taking on water while still in dry dock. On the 26th of December 1991, he announced that “we are living in a new world”, and the Union was officially dissolved.
At the time of dissolution, the Soviet Union held just a few billion dollars worth of gold and FX reserves against a growing pile of $66 billion in external debt.
Turning to China, I by no means contend that it is a carbon copy of the Soviet Union. Aside from the plethora of cultural, political and geographic differences, there are some glaring structural economic differences, too.
For instance, the composition and size of international trade are markedly different in the case of China. While the USSR exported raw commodities in modest amounts, China imports them in droves and sells manufactured goods back to the world at competitive prices. China is such an important player in international trade that these supply chain dynamics have contributed to dampening inflation in manufactured goods all around the world.
Secondly, the USSR was a command economy. Price controls were imposed and they chose to be quite insular in an attempt to be self-sufficient. In 1985 the USSR’s trade-to-GDP ratio ([exports + imports] / GDP) was just 8% . In China’s state-capitalist system, the trade-to-GDP ratio has been as high as 65% in 2006 and has tracked a little under 40% in recent years. A steady trade surplus has allowed China to stockpile trillions in FX reserves, but at the same time means their export sector is heavily reliant on Western demand, and as mentioned earlier, exposed to changes in the global order.
One could expand on the many differences, but it’s important to note some key similarities. Consider the following:
- Like the USSR before its collapse, China has fallen into the trap of severe overinvestment. To give you some perspective, statistics from the US Geological Survey and the Mineral Industry of China indicate that in just 3 years China consumed more concrete than the US did over the entire 20th century.
- There is likely a huge amount of malinvestment. Without the free market as an arbiter for debt issuance, a decent portion of centrally planned investment risks being misplaced. We define malinvestment as a capital allocation that fails to produce sufficient revenue to cover debt servicing costs. The cost of malinvestment is ultimately be borne by households, either via lower incomes, higher taxes or fewer social benefits.
- Lastly, workers are underpaid relative to output in China, as evidenced by a very low household income share of GDP (which by definition results in a high savings rate for the country). The consumption rate is falling not because they are frugal, but because they are getting poorer relative to total output.
If you’d like to get into the more technical details around overinvestment, here’s an IMF paper which outlines some of the dynamics and the sheer size of the issue.
Note that was written in 2012! Since then, they have continued to power ahead at breakneck speed. Let’s examine how they achieve such high levels of investment in more detail. Below you can see the breakdown of both US and Chinese GDP by component.
Investment has been the biggest component of headline growth in China for nearly two decades now. Of course, all investments need to be funded somehow, and in China, the funding mechanism is far more subtle than it was in Soviet Russia.
In addition to workers being generally underpaid, a hidden tax is imposed on net savers by setting the lending rate below inflation. The GDP deflator is recommended for estimating Chinese inflation. By setting the lending rate below medium-term inflation, net borrowers (largely corporates and local governments) can fund at negative real rates. In the below chart the IMF estimates how big the wealth transfer from households to state-owned enterprises was over the first decade of the century. It has been an incredibly large transfer.
As Stanley Druckenmiller has said for years, low rates are a problem because they incentivize malinvestment and lead to economic bubbles. We should be less concerned with obsessively tweaking interest rates to meet inflation targets in an era of technological disruption, and more worried about low rates fueling financial bubbles.
Despite all of the warning signs credit continues to surge. We are at a strange juncture now as the CCP is running out of things to build. Meeting high growth targets remains a matter of policy but they can’t rely on investment indefinitely. As of February 2019, the Nikkei Asian Review reported that over a fifth of all apartments in Tier 2 and Tier 3 cities are empty, and importantly, this comes mid-way through a 35-year-long demographic drag from the one-child policy, which ran from roughly 1980 to 2015.
So where to from here? We know that China still has the ability to keep goosing credit given their stockpile of FX reserves. The phase one trade deal with the US takes some pressure of their export sector — at least for the time being — and they welcome Fed balance sheet expansion with open arms.
Having said that, M3 in China is already about 1.75x M3 in the US despite their economy being only two thirds the size. Ghost cities and the demographic drag from the one-child policy imply a pressing need for rebalancing.
Michael Pettis (Professor of Finance at Peking University) offers a relatively sanguine view on China’s prospects. In his view, there are two key things they need to do in order to rebalance the economy.
- China must deleverage.
- China must reverse the huge wealth transfers to revitalize household wealth and support consumption.
The first point may seem obvious, but it’s important to note that a debt adjustment can be achieved in various ways.
"No country in history that I've ever found that had an excessive debt burden has ever been able to grow its way out of the debt. It doesn't grow until it starts paying down the debt... and it can do so by defaulting and restructuring with a haircut like Mexico did in 1982, or inflating it away like Germany did after the First World War, or through financial repression, or squeezing workers then using the proceeds to pay down the debt, which is what Ceaușescu did in Romania in the 1980s."- Michael Pettis, 2018
In the case of China, he believes there’s a chance they can rebalance in a non-disruptive manner if they succeed in doing the following:
- Assign debt servicing costs to local governments.
- Increase household income both directly and indirectly (higher salaries, more unemployment benefits, improved medical care, stronger social security net — these are all wealth transfers).
The issue is that a lot of the reforms designed to drive deleveraging which appear obvious at a national level face stiff resistance at a provincial level. It is precisely the groups that have been enriched by the reckless debt-fueled investment-driven growth that now stand in firm opposition to the model being dismantled.
The Chinese Communist Party has a long history of battling vested interests, with seemingly little success. The anti-corruption campaign kicked off by Xi shortly after he came to power in 2012 marked the 6th major anti-corruption campaign in the Post-Mao era. It feels like no matter how many “tigers and flies” the Party neuters, there are yet more pests sitting in the wings ready to take their place.
Some commentators painted Xi as a power-hungry strong man after he changed the constitution to abolish the 10-year term limit. A more forgiving view is that he realized how difficult it is to overcome the entrenched interests and implement the necessary reforms. So we saw anti-corruption measures, centralization of power, a cleansing of the political ranks, and now an embrace of ‘blockchain’.
It remains to be seen whether the application of a state-run blockchain will be successful in its attempt to stamp out graft and weaken existing power structures throughout China’s state-owned enterprises. Throughout history, corruption appears to be an unintended but core feature of centrally planned economies, so it will be a heroic achievement if Xi is able to execute on the desired reforms.
Regardless of whether he is successful, China’s blockchain will likely also be harnessed to surveil the proletariat. After so many years of financial repression, social credit scores coupled with blockchain-enabled personal financial histories look poised to be effective in quashing dissidents. Xi may indeed be able to maintain the social stability he seeks, but the introduction of a state blockchain represents a further erosion in Chinese civil liberties.
