DECEMBER 2019

China’s Economic Slowdown: Root Causes, ’s Response and Strategic Implications for the US and Allies

DR. JOHN LEE SENIOR FELLOW, HUDSON INSTITUTE © 2019 Hudson Institute, Inc. All rights reserved.

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Cover: A large real estate project is under construction behind the Dongfanghong square, where a statue of Mao Zedong was erected in 1968. (Zhang Peng/LightRocket via Getty Images) DECEMBER 2019

China’s Economic Slowdown: Root Causes, Beijing’s Response and Strategic Implications for the US and Allies

DR. JOHN LEE SENIOR FELLOW, HUDSON INSTITUTE AUTHOR

John Lee is a senior fellow at Hudson Institute. He is also a His articles have been published in leading policy and academic non-resident senior fellow at the United States Studies Centre journals in the United States, Asia, and Australia. He is the in Sydney, Australia and adjunct professor at the University author of Will China Fail?, published in 2007 and updated and of Sydney. republished in 2009.

From 2016 to 2018, he was senior national security adviser to His opinions have been published in over fifty major newspapers Australian foreign minister Julie Bishop. In this role, he served and current affairs magazines around the world, including as the principal adviser on Asia and on economic, strategic, and leading broadsheets in the United States, Asia, Europe, the political affairs in the Indo-Pacific region. Middle East, and Oceania.

Lee was also appointed the foreign minister’s lead adviser on Lee received his master’s degree and doctorate in international the 2017 Foreign Policy White Paper, the first comprehensive relations from the University of Oxford and his bachelor of laws foreign affairs blueprint for Australia since 2003, which is and arts degrees (1st class, philosophy) from the University of intended to guide Australia’s external engagement for the next New South Wales. ten years and beyond. TABLE OF CONTENTS

AUTHOR’S NOTE 6

I. EXECUTIVE SUMMARY AND INTRODUCTION 8

II. CHINA RUNNING OUT OF PUFF 11 Running Out of Puff 12 Real Estate 12 Shadow Banking 13 Local-Central Government Fiscal Imbalances 14 The Foundations for a Fiscal Crisis 16 Declining Growth in Revenues 17 Rising Demands by the Chinese People 18 People’s Liberation Army Sequestration with Chinese Characteristics? 19

III. DEFERRING PROBLEMS TO STIMULATE A SECOND WIND 22 The Rise of Xi Jinping 23 The Official Numbers 25 What Has Happened to China’s Debt since 2015? 26 The Size and Nature of the Debt 26 Tactical Measures to Prevent a Financial and Fiscal Crisis 28 Kicking the Can Down the Road 35 Conclusion 40

IV. 2025 AND THE FUTURE OF CHINA’S EXPORT-ORIENTED MODEL 42 Reaching the End of the Old East Asian Export Manufacturing Model 44 China’s “New” Export-Oriented Model 46 What is MIC 2025? 46 The Chinese Game Plan 48 Conclusion 52

V. THE : TRANSFORMING DOMESTIC VULNERABILITY INTO GRAND STRATEGY 54 External Solutions to Persistent Domestic Problems 56 From Extracting Economic Rents to Grand Strategy 66 Strategic Support States 66 A New Approach to Authoritarian Promotion 67 China’s Comprehensive Approach to Pre-Determine the Rules and Outcome of Competition 69 Conclusion 72

Glossary 73

Endnotes 74

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES AUTHOR’S NOTE

This monograph, the first in a two-part series, is the result of a sailed through its difficulties, just as it did after its export markets proposal funded by the Smith Richardson Foundation. in the major advanced economies collapsed from 2007 onward. Although official indicators of Chinese growth were slower, at 6–8 The project was approved and begun in the first half of 2015. percent, than a decade before, the talk was about “successful Around that time, a bourgeoning cottage industry of experts rebalancing” and “higher-quality growth.” The layperson’s view was trying to work out what the real growth rate for the Chinese was that China had again proved that its authoritarian leaders economy might be, given the widespread skepticism about were skillful and adroit economic managers. official figures. Of greater importance were growing fears that the Chinese economy was burdened by too much debt, severe Around this time, Xi Jinping also seemingly emerged as the misallocation of capital, and the emergence of a vast and most powerful leader since Deng Xiaoping, and in the view of unregulated “shadow banking” sector that posed a systematic others, the most dominant leader since Mao Zedong. Moreover, threat to the entire Chinese financial system. under Xi, China abandoned the more cautious diplomatic and strategic approach of “hide brightness, cherish obscurity” that A growing band of pessimists pointed to the prevalence of “ghost it had taken since Deng. Xi confidently put forward visions of cities” — newly built housing that was largely unoccupied — what a Sinocentric economic and strategic region might look as just one example of economic and financial irrationality and like and left few doubts that China’s objective was to become dysfunction that was taking hold in the Chinese economy. Other the preeminent power in Asia and possibly the whole of Eurasia. traditional commercial measures such as return on assets and This was the new setting in which this project recommenced in investment, non-performing and excess capacity, and mid-2018. rocketing inventory stores suggested something very worrying about the Chinese economy. The fundamental questions I posed back in 2014, far from needing to be changed, seem even more apposite In workshops, roundtables, and individual discussions with in 2020. China’s growth has slowed moderately to around experts in New York, Washington, DC, Kong, Taipei, 6 percent per annum. Many unofficial estimates are that it Tokyo, Singapore, Canberra, and other regional capitals, the is considerably lower. Is that significant, and what are the prevailing mood was one of deep pessimism. Many were certain strategic consequences of slower Chinese growth for the US that China would experience a slowdown such as the one that and allies? Did China really sail through its difficulties leading occurred in the 1980s and 1990s in Japan, even though China up to 2015? What are the ramifications of how it managed would likely avoid the financial crash and liquidity crunch that its problems? afflicted many economies during the global financial crisis from 2007 onward. That was 2015. Have China’s difficulties made it stronger, or is overreach more likely at a time when Beijing is projecting a far more confident From 2016–18, the project was placed on hold as I entered (and assertive) image of itself with promotion and expansion of the Australian government and served as the senior national ambitious plans, such as the Belt and Road Initiative and Made security adviser to the minister for foreign affairs. in China 2025?

When I left government and recommenced work on the project, More generally, what are the strengths and vulnerabilities of the mood had changed significantly. China seemed to have the “new China” under Xi? Have these changed from several

6 | HUDSON INSTITUTE years ago? Finally, what are the points of leverage and worry I would like to thank Allan Song, program director, Smith for Washington in an era of deepening competition and rivalry Richardson Foundation, for his guidance in helping to define between the US and China? the contours of the project, as well as his patience during the two years (2016 –18) when work on it was suspended. I am In this context, the monograph is part forensic (e.g., how did also grateful to SRF for funding this project. China manage the problems it had just a few years ago to be where it is now?), part explanatory, and part analytical In addition, I thank Hudson Institute for continuing to back (i.e., what is the link between its vulnerabilities, the way my work. it has managed these, and its current policy settings?). It is also policy or action based (i.e., how should the US and Finally, I thank my wife, Dr. Lavina Lee, for her constant allies respond?). encouragement and support.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES I. EXECUTIVE SUMMARY AND INTRODUCTION

Good policies and responses depend on accurate analysis, The United States openly discusses its strengths and sound assessments of the strengths and vulnerabilities of weaknesses. The difficulty is in coming up with sensible and oneself and one’s competitor, and appreciation of structural and other trends that are difficult to shift or circumvent. Photo caption: A Chinese employee counts 100- notes and The Donald Trump administration has recognized that China US dollar bills at a bank counter in Nantong in China’s eastern Jiangsu poses the most comprehensive and formidable challenge to province on August 28, 2019. China’s slid on August 26 to its American interests and values. It is a view increasingly shared weakest point in more than 11 years as concerns over the US trade war by both major political parties, the national security community and the potential for global recession weighed on markets. (STR/AFP via and policy elites, and the general population. Getty Images)

8 | HUDSON INSTITUTE effective responses to an opaque competitor or rival that is them to a future time in ways that only its unique authoritarian increasingly adept at controlling grand narratives by trumpeting political economy is able to do. apparent strengths and concealing weaknesses. We are therefore witnessing an outwardly more confident and This monograph attempts to argue and/or demonstrate three muscular China emerging at a time when it is failing to effectively main points. tackle its domestic problems, which are getting worse. These tactical measures to put-off or ignore the consequences of First, it looks at why there were credible fears about the stability its economic and financial problems leaves Beijing in an even and viability of the Chinese economy — especially the financial poorer structural position than in 2015. and banking system — leading up to the end of the Twelfth Five Year Plan (2011–15), and what these were. To understand Third, it is clear the Communist Party is not passively awaiting why Beijing was so concerned, the monograph draws out the an unhappy economic fate in connection with its mounting serious structural problems that were leading inevitably to a imbalances and domestic economic dysfunction. In many permanent slowdown from the double-digit growth rates of the respects, its leaders have been highly creative in seeking first three decades of reform. solutions that do not entail a weakening of the party’s hold on economic power. Importantly, it is not a slowdown in and of itself that matters, but what the slowing economy represents and reveals about the On the contrary, the party has been busily shaping and pursuing Chinese political economic model. After all, when the second- grand strategic policies such as the Belt and Road Initiative largest economy in the world grows at 6 percent, this is still a (BRI) and (MIC 2025) to solve or alleviate considerable achievement. Instead of focusing on official or many of its domestic political-economic problems. estimated GDP growth rates, which are not analytically useful because they provide little indication of whether the economic This monograph argues that these and other outward-focused activity is commercially sound or sustainable, the monograph initiatives stem most fundamentally from Chinese weaknesses focuses on the cost to the regime and broader economy of and vulnerabilities but are being remade and recast into initiatives managing and stabilizing an economy that has poured far too that will strengthen the position of the CCP domestically, much national wealth into unproductive or commercially irrational ensure greater resilience for its political economy, and advance areas. This is the basis for the economic, financial, and fiscal crisis its ambitious strategic and international objectives at the that the Chinese Communist Party (CCP) desperately tried to avert. same time.

The purpose is not merely to give a descriptive or academic In summary, it is about the Communist Party cleverly transforming account of recent economic history, but to introduce the serious domestic vulnerability into grand strategy and using economic structural problems that continue to have political and strategic approaches to gain pre-eminence and “win without fighting.” policy ramifications relevant to the US and allies. Part two in the monograph series, to be published in early Second, the monograph looks at what occurred from 2015 to 2020, will examine methods of confronting, countering, or else the present, and how China apparently overcame its economic undermining these Chinese strategies and initiatives. It will do so difficulties. In fact, it has not overcome its problems, but deferred by taking seriously the challenge they present and suggesting

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES responses that take into account Chinese vulnerabilities and the • China does not need the US and other advanced points of leverage available to the US and its allies. This linking economies to achieve its objectives. It is already a of China’s vulnerabilities and weaknesses, on the one hand, and sufficiently large and sophisticated nation and is close to its ambition and purpose with respect to its outward-focused achieving a terrifying self-sufficiency. In fact, China cannot policies, on the other, is essential for effective policy responses. achieve its external objectives without the cooperation of If the domestic is not linked with the external, US policies are the US and other major advanced economies. Despite much more likely to become complacent, counterproductive, or its economic size, its economic tools and levers in the susceptible to overreaching. world are surprisingly limited in important respects. Even the resilience of its domestic economy is enormously In linking analyses of Beijing’s domestic political economy vulnerable to US policies. with its external policies, the monograph will challenge some The US and other countries have little ability to influence enduring but incorrect grand narratives that play into the hands • domestic Chinese politics, especially when it comes to of the CCP. challenging Xi’s authority. In fact, Xi’s high tolerance for risk is causing immense angst for other senior Communist Party These include: members and Chinese policy makers. The more Chinese failures and the rise in international resistance are attributed • The external policies of Xi Jinping and the Communist to Xi’s actions, the more pressure he will feel to retreat and Party begin from a position of unprecedented strength take a more cautious approach. and national resilience, with few domestic vulnerabilities. In fact, the truth is quite the opposite: Xi and the party are engaged in an approach — high risk and with a high China is the most formidable and comprehensive challenge economic cost — of pursuing growing Chinese ambitions the United States has faced since the Soviet Union. In many abroad while concealing festering internal weaknesses and respects, China is a more complex and difficult competitor vulnerabilities. and rival.

• There is a unique economic and governance competence The response to China must be based on a good understanding that must be attributed to the authoritarian Chinese of its strengths and vulnerabilities, and how these both drive the political economic framework, in contrast to the chaos and CCP’s policies and behavior. dysfunction of liberal democracies. For example, China has the proven ability to sail through economic crises. In To borrow two well-known Chinese aphorisms, we should always fact, the Communist Party and its authoritarian model are “seek truth from facts,” and “if you know your enemy and know showing an inability to learn from past errors and a stubborn yourself, you need not fear the result of one hundred battles.” unwillingness to address serious problems.

10 | HUDSON INSTITUTE II. CHINA RUNNING OUT OF PUFF

One decade ago, several authors speculated about the limits Go Wrong?,”2 “China’s Economy: Stuck in a Vicious, Stubborn of China’s authoritarian model and its capacity to lift the Cycle,”3 and “Forget Greece: China’s Economic Slowdown Is the country out of the so-called “middle-income trap.”1 The broad Biggest Problem of the Year.”4 The World Bank, normally staid argument then was that China’s authoritarian political economy and reluctant to stray from economic consensus, had released a retarded the development of institutions and economic substantial report two years earlier that largely supported those practices that were common to all high-income economies. earlier pessimistic assessments.5 Jointly produced with China’s These included institutions such as the rule of law, protection Development Research Center of the State Council, the report of intellectual property rights, and efficient and transparent predicted that growth would be halved from the double digit regimes for dispute resolution. Beijing’s political economy is rates of the 2000s to about 5 percent by 2026, before slowing characterized by massive misallocation of capital, systemic graft, and other serious forms of growth-inhibiting corruption. China was already a formidable power but could not surpass Photo caption: An abandoned construction site at Caofeidian, in the city the United States with its authoritarian model. That view was of Tangshan within China’s Hebei province in 2013. Workers deserted certainly not then the consensus one and these authors were the site at the end of 2012. The construction zone was built on reclaimed in the minority. land that was made possible through huge bank loans. After being half built, all bank loans were halted and projects suspended due to rising However, around 2015, China bears found themselves in the costs of raw materials and a lack of government support. (Gilles Sabrie/ ascendency. Headlines included “Where Did China’s Economy LightRocket via Getty Images)

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES further prior to 2030. That was the optimistic scenario. Without pertain to three specific problems: a real estate bubble, the far-reaching reforms of Chinese institutions and policies, the growth of the shadow banking system, and a highly leveraged report warned, the outlook was likely to be more dire. local government sector. All of these are intrinsically linked, and managing them successfully will absorb a significant and A common response to predictions of a Chinese economic growing share of China’s public resources (and national wealth). slowdown is, “So what?” Most governments would do anything to grow at even 4 or 5 percent, and China’s economy is already Real Estate the second largest in the world. This misses the reason that Real estate has made an increasing contribution to China’s Beijing is apprehensive about the slowdown. It is not the GDP since liberalization of the sector began in 1990. In 1997 it slowing economy per se, which is only the symptom of profound contributed about 4 percent of GDP, rising to about 9 percent problems. Rather, it is the cost to the government of managing in 2008. The Chinese government implemented stimulus the consequences of an economy that has poured far too much measures starting that year, and by 2015, real estate accounted national wealth into fixed investment and has seen debt rise to for around 16 percent of GDP.6 Indeed, it is estimated that more dangerous levels at precarious speed. than one-quarter, and perhaps a third, of all fixed investment went into real estate from 2008 onward,7 and nearly half of the This section will focus on understanding the reasons for the total national debt up to 2015 is linked to the real estate sector.8 economic slowdown that were of high concern to Beijing leading up to the end of the Twelfth Five Year Plan (2011–15). It It is often assumed that urbanization is driving this dynamic, also sets the scene for the beginning of the Thirteenth Five Year but with real urbanization advancing at a steady rate of only Plan (2016–20), which the next section will address. 1–1.5 percent each year, the massive recent increases in real estate construction have little to do with urbanization needs.9 The purpose is not merely to give a descriptive or academic Instead, local governments have long raised revenue by account of recent economic history. It is to highlight those appropriating rural land to rezone it for industrial or residential serious structural problems that have strategic and other policy construction and use. In the decade leading up to 2005, an ramifications for the US and its allies. This section explains what estimated 40–70 million farmers were forcibly evicted from their these problems are. The next two will look at how Beijing has land for this reason, often with inadequate compensation or no managed them and how its management has influenced and compensation at all.10 shaped Chinese strategic and other policies that are now of concern to the US and allies. The recent record makes clear that rezoning from rural to urban has little to do with the demand from urbanization. From 2001– The last two sections will look at how allies can more effectively 08, proceeds from land-use rights (for both industrial and real respond to take advantage of China’s weaknesses and counter estate projects) represented 40.5 percent of local government its actions by better understanding the political and structural income averaged across all localities. Within two years of factors (and vulnerabilities) driving Beijing’s behavior. the 2008 government-ordered fiscal and monetary stimulus, proceeds from rezoning land from rural to urban dramatically Running Out of Puff increased — to 61 percent of local government income, and The concerns leading up to the end of the Twelfth Five Year Plan possibly 70 percent by 2014. Such reliance on land sales (2011–15), emanating from China’s enormous expansion, was enhanced by local governments’ creating an estimated

12 | HUDSON INSTITUTE 155,000 local government financing vehicles (LGVFs) to get — interest rates, well above ceilings imposed by authorities for around restrictions on their taking on debt. LGVFs became formal bank loans. major recipients of the credit binge ordered by the central government, and many of these entities (which are effectively This also allowed to create off-balance-sheet wealth local state-owned enterprises, or SOEs) forged commercial management products (WMPs) and trust products to sell to partnerships with property developers to gain a share of real individual and groups of . These offer short-term estate sales built on rezoned land. investment returns five to fifteen times bank deposit rates, while the bank-owned entities selling these WMPs and trust The extent of the debt racked up by local governments and products can charge a high to borrowers unable to their LGFVs is not widely appreciated outside China. In two secure sufficient credit from commercial banks. For private firms years, from the beginning of 2008 to the end of 2009, the starved of formal capital, it is one way of gaining a line of credit local government balance had increased to approximately to tap into a booming economy. For SOEs and LGFVs, it is an $1.19 trillion, an increase of 70 percent.11 By mid-2013, local easy way of acquiring and doubling or tripling down on government debt had reached an estimated $2.89 trillion,12 and rapid gains from the property market. by 2015, most estimates placed such outstanding debt at $4 trillion at least, or around 40 percent of GDP and one-fifth of From 2008, shadow banking loans in China was growing at all provincial GDP.13 The French banking firm Société Générale above 30 percent each year and had more than tripled in believes local government debt is closer to $4.83 trillion.14 volume by early 2014. At that time they accounted for about Conservatively, we can say that local government debt has half the increase in overall credit in the economy since 2008 increased from around $700 billion at the end of 2007 to $4 and approached 55 percent of GDP.16 The China Banking trillion by 2015 — with much of it used for construction or to Regulatory Commission estimated WMP assets alone to be repay the interest and/or principal of existing debt. worth around $2.08 trillion as of September 2014, with trust products worth roughly the same again (even though there is If the pure size of local government debt is not worrying enough, some double counting).17 Bear in mind that a large proportion we must also understand the link between this debt and the so- of these WMPs and trust products are used as collateral to called shadow banking system, which is beyond the regulatory lend to developers, including local governments (LGVFs), to sight and reach of the government. This refers to all credit fund further property and infrastructure projects, while shadow extended outside the formal and regulated banking system, banking institutions are creating new WMPs just to pay their even though state-owned banks are generally the starting point obligations to retail investors. for shadow bank lending and reap the ultimate rewards and risks of such loans.15 It was estimated in 2013 that 30–40 percent of such unregulated lending was extended to property developers Shadow Banking and 20–30 percent to LGFVs.18 Those engaged in real estate Chinese shadow banking has grown exponentially since around were the major beneficiaries of shadow banking loans, a fact 2010 for several reasons. First, it was one way for banks to reaffirmed by figures showing that debt-to-equity ratios for real circumvent regulatory scrutiny and prudential restrictions in estate and construction firms had increased to 250 percent by the rush to maximize profits, by ramping up lending in a loose 2013, up from about 150 percent in 2008. For SOEs engaged credit environment while still charging high — even exorbitant in the property sector, including LGFVs, leverage has increased

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES similarly, from under 200 percent in 2008 to about 250 percent episodes such as this are bound to create significant fiscal as of 2015.19 problems for local governments and liquidity problems for financial institutions that are dependent on a robust property To be sure, experts disagree on whether local government market and cheap borrowings for interest obligations to be met debt is manageable (and whether the shadow banking sector and principal from maturing loans to be repaid.23 presents a systemic risk in and of itself to the entire financial system).20 But it is undeniable that evidence of fragility is Local-Central Government Fiscal Imbalances growing. For example, in 2014, the central authorities instructed The previous analysis does not predict whether a property lending institutions to roll over up to $600 billion worth of bubble will eventually trigger a serious financial and fiscal crisis maturing local-government debt for a further three years, for China, as interesting and important as this question is in meaning that an estimated $800 billion worth of debt matured and of itself. Instead, it explains how China has managed to in 2018. In that same year, investors in the $500 million China achieve rapid economic growth, especially since 2008, through Credit Trust Co., a shadow bank trust fund, were bailed out the systematic underpricing of capital, land, and labor — after government intervention, indicating that Beijing acted to pursuing a supercharged fixed-investment model where SOEs avert the possibility of a contagion effect from the failure of an have been major players and the primary beneficiaries. Slowing off-balance-sheet scheme.21 growth is unmistakable evidence that such a model is nearing exhaustion, and that more and more resources (i.e., credit) are What is certain is that when credit slows, and the cost of capital required just to stabilize the model (e.g., pay back interest and goes up markedly, a high number of LGFVs (and property principal obligations) rather than drive productive economic developers) will be unable to meet their debt obligations and expansion. The next stage of even moderate growth will prove will face a real risk of insolvency. The whole local government difficult to attain. financing and fiscal system would then be vulnerable to breakdown and grinding to a halt. Simultaneously, credit- Moreover, and as argued earlier, the challenge facing Beijing issuing institutions, including those in the formal banking sector is not slowing growth per se, but managing the imbalances and the informal shadow banking sector, would suffer a growing created by its stuttering growth model. A serious financial number of defaults by borrowers, which in turn would affect and fiscal crisis is by no means inevitable. But doing nothing their capacity to issue new loans. will only mean a harder reckoning in the future,24 as the government already knows.25 Recent examples serve as a Similarly, the eventual cooling of the real estate market, leading warning: prolonged loose in North America to a slowdown in land sales and construction, would cause and Europe led to the global financial crisis for these advanced liquidity problems for all real estate investors, including LGVFs. economies from 2007 onward. In addition, Japan’s tardiness There are enough reports of “ghost cities” and empty houses, in properly recognizing bad debts and recapitalizing its banks as well as studies of poor housing affordability, to indicate that as financial institutions — with regulators waiting in vain for a the economic fundamentals of the real estate driven model are return to stratospheric asset prices — plunged the country into questionable. For example, official figures reveal that the ratio an economic stagnation in the early 1990s, from which it is only of unsold property to annual sales reached 51.5 percent in now recovering. But successfully preventing a similar downturn 2014, up from 24.7 percent in 2011. Housing prices began to in China will involve significant actual and opportunity costs for fall for the first time this century in September 2014.22 Periodic the central government.

14 | HUDSON INSTITUTE By late 2015, there were signs that credit growth was declining This is the setting for what occurred from 2008 onward, when and growth in fixed-asset investment was being wound back the central government instructed banks to flood the economy from the heady years of 2009–13.26 In addition to declining with credit. As mentioned earlier, proceeds from land rights capital-output ratios, these were obvious reasons why (which includes land sales revenue and real estate construction) growth was slowing. These developments, part of Xi Jinping’s represented some 40.5 percent of local government income “new normal” of slower growth, were widely applauded by from 2001–08, before jumping to over 70 percent by 2014. economists.27 It is arguable whether this new normal was Whereas local government expenditure constituted between engineered by the central government or is an automatic 65–70 percent of all government expenditure from 2008–13, consequence of the laws of economic gravity. Either way, local government share of all government revenue went up from the new normal brings with it risks and costs that are directly 45 percent to over 55 percent by 2013, driven by the doubling relevant to the resources Beijing can deploy to continue China’s down on land transfers and the property market.32 From the “rejuvenation” in external affairs.28 central government’s point of view, this killed two birds with one stone: allowing local governments to take the lead hastened At the heart of the problem is the increasingly brittle and the stimulus effect while offering local governments some fiscal unsustainable central-local government fiscal setup — the relief from their burdens. driving motivation behind the seemingly irresponsible economic profligacy and recklessness by local governments. To understand Even then, this was never going to offer an adequate or this point, we must go back to the dramatic fiscal recentralization sustainable solution. By the time the central government decided that took place from 1994 onward as part of the tax-sharing to gently cool the property market in 2013, the gap between reform initiatives. Prior to 1994, approximately 78 percent of fiscal what local governments needed to spend and the share of fiscal revenues went to local government, which made 72 percent of revenues they received was still well into the double digits. The fiscal expenditures.29 After the reforms, an increasing amount fact that revenue from selling land leases to developers alone of fiscal revenue instantly went to the central government. The declined — from about 50 percent in early 2013 to about 15 initial idea was for the central government to collect 60 percent percent toward the end of 2014 — demonstrates that this model of tax revenues and make 40 percent of expenditures, with a 20 of rapid local government revenue growth is nearing its end.33 percent surplus to be deployed to less-developed regions.30 As the property market cools, and as the debt burden of LGFVs But it was not to be. In the year the reforms were enacted, local rises, the gap between expenditure commitments and available government’s share of revenue went down from 78 to 44 percent revenues will only widen. Ratings firm Moody’s and Nomura within a year, even as its expenditure rose slightly.31 By 2008, Securities estimated that half of all local Chinese governments according figures released by China’s National Bureau of Statistics, had insufficient cash flows to cover debt repayments in 2013, 55 percent of fiscal revenue went to the central government, which is one reason why the central government eventually even though it was responsible for only around one-quarter of demanded that financial institutions roll over $600 billion worth all national expenditure. In other words, local governments were of local government debts the following year.34 The point is responsible for 75 percent of fiscal expenditure but received only that the supercharged credit boom since 2008 could never 45 percent of all fiscal revenue. By 2013, local governments be a lasting solution to the central-local fiscal imbalance, received 53 percent of all fiscal revenue but were responsible for and reforms reversing the centralization of fiscal revenues 85 percent of all government expenditure. are inevitable.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 1: The Stylized Structure of Claims in the Chinese Shadow Banking System

Information Source: Torsten Ehlers, Steven Kong and Feng Zhu, “Mapping Shadow : Structure and Dynamics,” BIS Working Papers No. 701, February 2018, https://www.bis.org/publ/work701.pdf Figure Source: Torsten Ehlers, Steven Kong, and Feng Zhu, “Mapping Shadow Banking in China: Structure and Dynamics,” BIS Working Papers, No. 701, February 2018, https://www.bis.org/publ/work701.pdf.

Figure 1 shows a stylized depiction of the structure of the ticket reforms was expected, priority was given to addressing Chinese shadow banking system, along with its relationship the misalignment between central and local fiscal budgets. This and links to the formal, regulated finance and banking system. included the central government’s taking on some spending on social services currently overseen by local governments.35 But The Foundations for a Fiscal Crisis these were not substantial reforms and will make little difference The Xi Jinping government is well aware of the central-local fiscal to local governments’ capacity to meet shortfalls. And as the problems. In the 2013 third plenary session of the Eighteenth slowdown takes hold, it will result in both worsening revenue Central Committee meeting, where the announcement of big- problems and rising expenditure obligations for Beijing.

16 | HUDSON INSTITUTE Declining Growth in Revenues government. Even the seemingly over-optimistic official forecast By the end of 2014, China’s government debt as a proportion of of about a 5.5 percent increase in total revenues in 2015 is a GDP reached a still comfortable 55 percent.36 The question is what a three-decade low that was unfathomable until just two years credit- and property-led slowdown — which is already taking place earlier. With expenditures increasing at double-digit percentage in structural terms — will do to total government revenues. At the rates for all but one of the last twenty-four years, any fiscal shock beginning of 2015, even factoring in these projected slowdowns, resulting from the current economic slowdown will not be trivial. the Ministry of Finance forecast growth of 7.3 percent in central revenues and 3 percent in local revenues. Independent financial Additionally, while local governments have extremely limited institutions such as Deutsche Bank were far more pessimistic, revenue-raising avenues outside sales of land and property, forecasting only a 4.5 percent growth in central revenues and a the central government’s revenue and tax base means that the 4.9 percent decline in local revenues. Who was right? When the slowdown will amplify the hit to the coffers. If we take the 2013 January–February 2015 figures were released, they revealed a 1.7 central government budget as an example, over 34 percent of percent decline in central revenue and a 9.1 percent decline in local the revenue comes from a domestic value added tax, or VAT (in revenues.37 This gave rise to a renewed emphasis on debt-based which producers pay at every stage of production), and 24 percent stimulus, which will be discussed in the following section. comes from corporate taxes. In contrast, only about 24 million people, or less than 1.8 percent of the population, pay income The longer-term trend that confronted CCP leaders by the end taxes, meaning only 6.5 percent of revenue came from income tax. of 2015 did not appear promising: the slowdown in revenues appeared to be amplifying. From 1993 onward (after the This very unbalanced tax base has several implications “Tiananmen Interlude” of 1989–92), growth in total government specifically relevant to a Chinese economic slowdown. One revenues averaged almost 19 percent per year, with expenditure is that the heavy reliance on corporate performance for increasing almost 20 percent per annum according to official tax revenue makes the budget exceptionally vulnerable to figures from China’s National Bureau of Statistics.38 From 2001– corporate downturns, since tax receipts are tied heavily to 06, before the monetary stimulus that began in 2008, revenue the performance and profits of corporations rather than to growth remained close to 19.5 percent and expenditure growth household or personal income. Another pertains to China’s still averaged 17 percent. In the 2007–12 period of profligacy, extremely unbalanced reliance on fixed investment to generate revenue growth still averaged 20.5 percent … before falling growth: a dramatic slowdown in fixed investment growth precipitously to 10.2 percent in 2013. Expenditure growth will disproportionately impact corporate performance, and similarly averaged 17.5 percent … before falling to 11.3 percent therefore corporate tax revenues. This problem is exacerbated in that same year. In 2014, revenue growth increased a mere 8 by the country’s SOE-dominated political economy, in which percent, while expenditure growth was about the same. For the SOEs have been the primary commercial beneficiaries of first six months of 2015, total government revenue increased growth and opportunity. As the downturn bites, and heavily 6.6 percent, even as government expenditure from April-July indebted SOEs use more capital to fund debt obligations, jumped 24.1 percent on the back of government attempts to their declining profitability will minimize the dividends the stimulate the economy.39 government can extract from them.

When offered in this context, it should be clear why the Using 2015 figures, around ten firms account for about 70 January–February 2015 preliminary revenue figures shocked the percent of all profits made by central SOEs, while up to half of all

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES SOEs do not make any profits. By any commercial measurement government revenue as the economic slowdown continues and (such as return-on-investment, return-on-assets, or total factor property markets subside. productivity), SOEs tend to be 30–50 percent less efficient than private-sector firms — even with all the capital, land, regulatory, So far, Beijing has resisted significant fiscal reform. In fact, even and taxation advantages offered to them.40 Add in an estimate as local government spending has increased from 70 percent to that some 70 percent of central SOEs have dipped their fingers 85 percent of all government expenditure (1994–2013), central in the real-estate pie.41 The bottom line is that the nature of government expenditure has been increasing at a significantly China’s fixed-investment slowdown will do sustained damage faster rate than fiscal revenue receipts since the 1994 reforms. to Beijing’s corporate tax receipts. Rather than undertaking genuine fiscal decentralization, Beijing has chosen to implement some Band-Aid solutions to relieve There are also considerable doubts as to whether proceeds from the local government’s plight. One has already been mentioned VAT can pick up the slack in the long term. Since VAT is leveled (involving forcing lenders to roll over maturing loans); another at every stage of production (even if it ultimately is passed on involves measures allowing local governments to issue bonds to the final consumer), collections depend heavily on industrial in their own right.44 Even then, demand for such bonds has production growth, which is slowing. Neither can VAT collections been adequate only because they are implicitly guaranteed from a boom in domestic consumption allow a “business as by the central government, meaning a large proportion will usual” approach. The main reason is China’s low level of domestic become a central government liability upon maturity, given the consumption, which at about 35 percent of GDP is comfortably indebtedness of local governments. the lowest of any major economy in the world. (According to World Bank figures, only Equatorial Guinea, Kuwait, and Saudi The problem for the central government is that the local Arabia have lower levels as a percentage of GDP.) Over the reform government shortfalls cannot be quarantined or ignored. While period from 1979 onward, the figure has steadily fallen from over the central government assumed primary responsibility for 50 percent in the 1980s, to over 40 percent in the 1990s, to the national external and internal defense, external diplomacy, and current figure over the past decade. It is not conceivable that any national infrastructure projects, local governments continue to increase in consumption would be sufficient to offset declining take the lead in local construction and infrastructure, education, fiscal revenues from the corporate sector.42 healthcare, and most other social and public goods. Any fiscal crunch at the local government level would therefore impact Rising Demands by the Chinese People households immediately and severely and inevitably lead to Declining revenue growth, if not contraction, for the total spikes in dissatisfaction with the government at the grassroots government budget is a virtual certainty. This is a problem level. What makes this worse is that recent well-received social because since 2007, the funding gap (between fiscal revenues schemes have been announced with little serious thought given local governments receive and what they spend) has ranged to funding. For example, the current government announced from 8–10 percent of GDP (approximately $800 billion to $1 in August that it will extend minimal public health insurance to trillion in current terms) — and most of the shortfall is made up almost 95 percent of the population by the end of 2019, with with land and property sales. With revenues from land sales local governments expected to pick up much of the expense. alone likely to fall from a high of just under $700 billion at the end of 2013 to about $400 billion toward the end of 2015,43 local Public Chinese demands on local governments are only going governments will increasingly demand a greater share of total to grow. Demographics is a compelling factor. Despite China’s

18 | HUDSON INSTITUTE aging population,45 only around one-third of all urban residents distressed and non-performing loans, it will require hundreds of and less than 5 percent of rural residents have some form of billions of dollars to rescue and recapitalize the balance sheets central, provincial, or local pension.46 Although the current of state-owned lending institutions. pension scheme covers a minority of citizens, the consensus among researchers is that the state’s pension liability still Then we must consider the expanding demand for social and amounted to about $2.9 trillion in 2013.47 Other reports estimate public goods that will come from Chinese citizens, especially that this pension liability could grow to $10.8 trillion over the those in urban areas. For China to reach a similar level to next two decades (or almost 40 percent of GDP based on a other low-middle-income countries (in terms of proportion generous assumption of 6 percent GDP growth each year).48 of government spending on social and public goods as a percentage of GDP), the government will need to find an More generally, as of 2015, China spent just over 25 percent additional $1 trillion per year. Throw in liabilities from existing (one-quarter) of its total governmental budget on social goods but unfunded pension schemes in an aging society, and we such as welfare safety nets, healthcare, and education, with local already may have fiscal pressures unprecedented for any major governments responsible for about 95 percent of spending in economy in recent times. these areas.49 This compares to an average among lower-middle- income countries of around 36 percent of their budgets spent on For a government receiving $2.26 trillion in revenue in 2014, these public and social goods. The figure is 33 percent for upper- these actual and deferred liabilities are not trivial amounts. The middle-income countries and 42 percent for OECD countries.50 Ministry of Finance estimate of a $180 billion deficit for 2015 either grossly underestimates the enormity of China’s fiscal The major problem for local governments is the gap between woes, or shows a government that is choosing to ignore the revenues from their limited taxation and transfers from Beijing, problem staring it in the face and refusing to recognize and and expenditures. This gap, estimated at $800 billion–$1 trillion, prepare for existing and future liabilities. More generally, simply has been addressed mainly through proceeds from land and relying on growth as a cure-all — China’s approach from the property sales over the past decade. But with local government 1990s onward — is no longer possible. Indeed, high growth, revenues from land-related sales likely to slow or even decline which can only be driven by even higher credit growth, lies at in absolute terms, there could well be an additional $500 billion the heart of the imbalances and will make the government’s local government fiscal gap by the end of the decade, which will fiscal position even worse in the medium term. have to be somehow narrowed, as reducing local government services is not an option. The CCP is not blind to the seriousness of fiscal and broader economic challenges. In 2017, the Nineteenth Party Congress Added to local government’s debt burden is the need to stave declared China’s most pressing challenge to be the contradiction off insolvency for its LGFVs and prevent a contagion risk to “between unbalanced and inadequate development and the the whole financial and banking system. This means many people’s ever-growing needs for a better life.”51 hundreds of billions of dollars — estimated to be around one- third of all local government borrowings — that need to be found People’s Liberation Army Sequestration each year just to tread water and contain the problem. If the with Chinese Characteristics? government takes the bull by the horns and chooses to formally As the following section will note, Beijing may well come up recognize what may be more than a trillion dollars’ worth of with clever policy responses to many of these problems and

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES shortfalls, such as deepening government and corporate for sustained fiscal deterioration already exist, meaning that bond markets to fund shortfalls; implementing reforms that local governments will come calling, and Beijing cannot afford widen the tax base to help government revenue become to ignore them. more immune to business cycles; or implementing institutional reforms that dramatically reduce corruption in the use of public Just as other countries have been forced to eventually accept monies in order to gain a greater bang for the fiscal buck.52 fiscal reality and wind back growth in military spending when Even then, none of these or other imaginable possibilities can debt-fueled economies slow, Beijing will soon have to confront alter the final conclusion: efforts to enhance national power its own economic reality and fiscal mortality. The solvency of and security cannot continue in the same way as in the local governments that are overwhelmingly responsible for previous fifteen years. providing social and public goods, and the stability as well as solvency of the entire financial system, are presumably higher Bear in mind that about 41 percent of central government priorities than even rejuvenating the Chinese nation through the expenditure (after transfers to local government) currently goes rapid advancement of military power.54 to the People’s Liberation Army (PLA) and to domestic security, which includes the People’s Armed Police (PAP), a military- The “long-standing task for China to safeguard its maritime trained force whose primary purpose is to control domestic rights and interests” is a main theme in China’s 2015 Defense unrest and serve as a fighting force within continental China White Paper, which notes that “the [United States] carries on in times of war. Local governments spend around 5-6 percent its ‘rebalancing’ strategy and enhances its military presence of their budget on the PLA and PAP. The bottom line is that and its military alliances in this region [while] Japan is sparing Chinese government spending on the PLA and domestic no effort to dodge the post-war mechanism, overhauling its security is over 11 percent of the entire budget. If one accepts military and security policies.”55 This amplified the slightly softer outside estimates, such as those by the Stockholm International line in the 2013 Defense White Paper that “China is a major Peace Research Institute (SIPRI), that the true PLA budget is 55 maritime as well as land country.”56 If the transition from land- percent higher than the official one, then more than 60 percent based to maritime-based great power continues, as is likely, of central government expenditure (not including transfers to then the CCP will be breaking with an eighty-year PLA tradition. local government) is for external and internal security, which equates to around 14 percent of total Chinese government In times of fiscal well-being and plenty, a rising tide tends to spending.53 lift all boats. Opportunity costs are minimal, and strategic and operational ambition is easily articulated and accepted. With This brings us back to central-local government issues, difficult fiscal times ahead, deciding CCP and PLA strategic which will increase pressure on Beijing’s capacity to continue and military priorities becomes far more fraught and contested. to grant the PLA rapid increases in its budget each year. The Continued government largesse to enhance the capacities of PLA’s budget has been increasing at double-digit rates that the PLA Navy (PLAN) might not prove as forthcoming, for a significantly exceed GDP growth per annum for the majority couple of major reasons. of the past fifteen years. Beijing has essentially prioritized supercharging national power and security at the expense of The first is the certainty of intensifying competition for resources transfers to local governments, which oversee the provision of between the PLA and PAP. As the 2015 Defense White Paper the vast majority of social and public goods. But the conditions and countless other documents and speeches confirm, two

20 | HUDSON INSTITUTE of the top three priorities are to prevent independence for these remains the responsibility of the PAP. By all estimates, East Turkistan (Xinjiang) and , and to deter Taiwanese the number now is regularly well over 100,000 each year. This moves toward independence — all second only to preserving guarantees rapidly increased funding for the PAP no matter the the CCP’s political power.57 Xinjiang and Tibet are regions economic or fiscal circumstances. actually controlled and administered by Beijing, and together they constitute about one-third of China’s current continental Second, the PLA, unlike its competitors with tight budgets, territory. Xinjiang also has significant oil and gas resources,58 has not had to negotiate difficult and zero-sum funding while Tibet has become a critical site for the Chinese strategic decisions. But dormant interservice rivalries within the PLA nuclear arsenal vis-à-vis Eurasia and South Asia.59 will intensify as budgetary belts tighten.62 This is as significant as weaknesses that exist (vis-à-vis the United States and While China has little direct control over what happens in Taiwan, even Japan) in almost all aspects of the PLA’s organizational, it has no tolerance for any adverse developments in Taiwan’s human capital, training, capabilities, logistical, and integrative western regions, over which Beijing has formal sovereignty and capacities across all the services.63 control. In these areas, the PAP usually responds first to any ongoing problems. Indeed, the lion’s share of the enormous Furthermore, competing priorities in what Beijing coins its “core resources allocated to the PAP is deployed in the country’s missions” will increasingly undercut each other in a tighter fiscal western inland region, and problems in Xinjiang are only environment. For example, “containing separatist forces” will worsening: repression of Uighurs has intensified, alongside require different spending priorities, as will “resisting aggression” alleged acts of Uighur terrorism.60 from China’s land-border neighbors such as Russia and India. Finally, core missions such as “safeguarding border, coastal, and Add to this the growing official instances of “mass unrest” territorial air security” require enormous and ongoing investment in China (defined as fifty or more people protesting against not just in the PLA Navy but also in cyber and space assets. This government officials), which have increased from 8,700 in 1993 is part of the “winning local wars under informatized conditions” to as high as an estimated 230,000 by 2010.61 (The government concept, which drives China’s anti-access/area-denial capabilities, has refused to release more recent estimates.) Responding to designed primarily to counter the U.S. Seventh Fleet.64

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES III. DEFERRING PROBLEMS TO STIMULATE A SECOND WIND

If the period of the Twelfth Five Year Plan (2011–15) ended with Two of these themes addressed internal reforms that had dark economic clouds looming for China, the Thirteenth Five long preoccupied Beijing in the Hu Jintao era (2003–12). They Year Plan (2016–20)65 declared strong optimism that the country emphasized the importance of “coordinated development,” will achieve its objective of “building a moderately prosperous meaning confronting problems such as the widening disparity society in all respects.”66 in regional (especially between coastal and inland provinces); the problem of inefficient industrial In some senses, this was a surprise. The Thirteenth Five Year Plan recognized that China had an “unbalanced, uncoordinated, and unsustainable growth” model. But this Photo caption: China’s Secretary General Xi Jinping is seen on a large plan, far from having China retreat into its shell in the face screen over delegates as he joins a session of the National People’s of formidable economic problems, was arguably Beijing’s Congress to vote on a constitutional amendment at The Great Hall Of The most ambitious. Rather than focusing only on addressing the People on March 11, 2018 in Beijing, China. In an historic vote, Chinese structural imbalances detailed in the previous section, the lawmakers abolished presidential term limits and paved the way for Xi plan gave the impression that it was “full steam ahead” for Jinping to rule indefinitely. Only two delegates out of 2,964 voted against the country. The blueprint based the next five years on five the controversial change that amended the constitution to allow the 64-year key themes. old Xi the possibility of being a “leader for life.” (Kevin Frayer/Getty Images)

22 | HUDSON INSTITUTE policies and practices; lack of reform of the hukou, or household As the following sections will argue, these latter two themes (and registration system, which prevented labor mobility; and the related initiatives such as MIC 2025 and BRI) have emerged lack of public services, especially in poorer areas. as major geostrategic and economic concerns for the United States and other countries. Interestingly, the problems with The Thirteenth Five Year plan also recognized the importance the Chinese political-economic model have not been resolved. of “inclusive growth.” This refers to ensuring that more Indeed, this section will show that they have worsened. citizens are given access to economic opportunity and lifestyle improvements. Toward this end, the plan set targets Moreover, in what seems at first instance to be a paradox, for alleviating poverty and providing better accessibility and the following section will make the case that Xi’s ambitious affordability for healthcare and social services. and expansive geostrategic and economic objectives are inextricably linked with China’s worsening domestic and A third theme was the importance of “green” growth to address economic imbalances. His ambitions are both driven by these the severe environmental degradation that had occurred over imbalances and weaknesses and formed to deflect from them. decades of rapid growth.67 It included targets for using energy, Not only is this important for a better understanding of the improving air quality, lowering carbon dioxide intensity, and driving forces behind Chinese policies over the past few years; reducing soil and water pollution. it will also offer valuable insight into how best to counter many of those aspects of Chinese policies that negatively impact US The other two themes are more closely associated with the interests and values. Xi Jinping era. The first was an emphasis on the importance of “innovation.” According to the plan, China would rapidly The Rise of Xi Jinping move up the global value chain and enhance its future global Domestic and economic uncertainty usually leads to the competitiveness and comprehensive economic power. The plan centralization, or else diffusion, of power. Under Hu Jintao (2003- set ambitious targets with respect to moving up the global rankings 12) and Jiang Zemin (1993-2002), the puzzle was to identify the for innovation, increasing the share of research and development various factions and other centers of power to peer inside the (R&D) as a percentage of GDP (from 2.1 to 2.5 percent), increasing black box of Chinese decision-making. In the context of foreign the number of individuals working in R&D, and almost doubling policy, a 2010 SIPRI paper entitled New Foreign Policy Actors the number of patents filed (from 6.3 to 12 per 10,000 people). in China was representative of the oft-repeated comment by Much of this was encapsulated in the MIC 2025 blueprint, formally China watchers that the Communist Party was not a monolithic released in 2015, which will be discussed in further detail shortly. entity that spoke with one voice, and that power did not only flow from the party.68 Others argued, more persuasively, that The second was summarized under the innocuous and neutral- while the CCP was not monolithic and there were other entities sounding virtue of “openness”: Exports will be increased. China with influence, the party maintained an iron grip over all the will promote outbound investment and the increased use of the institutions and levers that matter.69 (RMB). Beijing will play a larger role in global economic governance and trade, including through internal economic Much of that China-watching debate has changed since 2016. zones such as the Beijing--Hebei Integration Plan and the Power has been centralized in a manner unseen since the end Yangtze Economic Belt. Significantly, these sub-regions will be of the Mao Zedong period in 1976 and the emergence of the integrated with the expansive BRI. Deng Xiaoping era in 1978. The efforts by Xi Jinping to centralize

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES power for himself — and his apparent success in doing so — Less subtle than institutional redesign have been measures to have been as striking as they were unexpected. directly boost Xi’s personal authority and standing. Much has already been written about his unprecedented anti-corruption Over the past two years, several changes have occurred that campaign, which has snared over one million officials since it lead back to Xi.70 Central authorities have accrued political and began in 2012, including at least thirty-five Central Committee policy power at the expense of bureaucratic ministries and members — more senior figures than were disciplined by provincial and local governments. To enable this, small but all previous anti-corruption campaigns, from 1949–2012.74 powerful ad hoc groups have been empowered or else created It is also clear that from 2015 onward, the anti-corruption to guide the policy work previously performed by ministries. campaign intensified and became far more politicized in terms of advancing Xi’s personal political power. The politicized nature Since 2012, it is estimated that at least twenty-nine leading of the process, the additional resources given to the campaign, small groups (LSGs) have been created to add to the fifty-four and the lower threshold and “simplification” of evidence required in existence before the Xi era.71 Prior to that, LSGs existed to for disciplinary procedures to commence, have led to the collect information and offer guidance. Over the past few years, “considerable expansion of the CCDI’s [Central Commission for they have increasingly taken the lead in policy formulation. Xi Discipline Inspection’s] anticorruption investigative capacities and chairs at least eight LSGs — earning him the moniker “chairman a significant increase in Xi Jinping’s leverage to impose political of everything.”72 loyalty and compliance upon Party officials in the future.”75

Most of the party-led LSGs formally cover foreign policy, In this setting, there was little surprise when in March 2018, the domestic and external security, and domestic politics. Although National People’s Congress “voted” overwhelmingly — 2,958 to an estimated nineteen of the twenty LSGs on the economy are 2 — to amend the constitution to remove presidential term limits. state rather than party LSGs, it is becoming clear that the party The same gathering unanimously approved a petition to add “Xi exercises immense, if still undefined, influence over important Jinping Thought on Socialism with Chinese Characteristics for a areas of economic policy. For example, the most active LSG seems New Era” as one of the guiding principles in the constitution. “Xi to be the one on comprehensively deepening reform (LSGCDR), Jinping Thought” offered additional policy content and specificity chaired by Xi. According to some accounts, the LSGCDR acts to Xi’s earlier “China Dream”76 or “Rejuvenation of China”77 notion as a virtual state council and has issued authoritative policy by naming multiple goals, such as pioneering global influence, guidance documents on legal and public security issues, the turning the military into a “world class” force, eradicating poverty, economy, the environment, resource use, public administration, and economic reform with Chinese socialist characteristics. By science and technology, public administration, party discipline, writing himself into the constitution, Xi joins Mao Zedong, the only SOE reform, and culture and sports.73 other person to have his doctrine enshrined in the document. He also joins Mao as the only paramount leader seeking to build a The point is that these powerful entities operate opaquely but “cult of personality” and not just glory for the party.78 cut across all areas of policy-making in the Chinese system. While their interaction with formal ministries and other state The noteworthy aspects of these developments are that since entities can be unpredictable, the rise and prominence of LSGs around 2015, Xi has decisively abandoned the “hide your signals a return to a more powerful party and its control over the strength, bide your time” approach that has been in place apparatus of state. since Deng Xiaoping. Whereas Hu Jintao and his predecessors

24 | HUDSON INSTITUTE emphasized China’s many domestic challenges to reassure occurred since 2015 and how China has apparently stabilized the world that its rise would be peaceful and even inward and corrected its imbalances. looking, Xi has gone out of his way to project an image and construct a narrative of strength and confidence. Whereas his According to these official figures, the economy grew 6.66 predecessors were seemingly selling the message of building percent, 6.8 percent, and 6.4 percent in 2016, 2017, and 2018, toward something indeterminate but non-threatening, Xi is respectively. Importantly, the growth in fixed capital during those telling the world that China’s time in the sun is imminent and periods was in the single figures (between 5–9 percent), while that its ambition ought to be marveled at rather than resisted. consumption increased by between 8–11 percent. Indeed, consumption as a percentage of GDP grew from 51.8 percent At the same time, a more confident and muscular China is in 2015 to just under 54 percent by the end of 2018. emerging in a period when serious problems with its political economy have become apparent. Xi’s centralization of power The seemingly good news did not end there. Between 2017 has led some to argue that he is now better positioned to take and 2019, domestic household consumption increased on the vested interests necessary to any painful economic almost 20 percent over 2015–17, while government reform and policy tonic.79 consumption expenditure increased almost 22.5 percent. Private consumption as a percentage of overall consumption In fact, this section argues that most of what has occurred is the remained at about 73 percent, with government consumption opposite of promised reforms, and this has important strategic as a percentage of overall consumption at around 27 percent. ramifications for China and other countries. Beijing has used these figures to make the argument that the great rebalance away from fixed capital as a driver of The Official Numbers GDP growth and toward consumption has occurred to a While China’s official GDP growth figures have slowed to their significant degree. lowest levels for several decades, they display an apparently remarkable consistency and resilience in the face of more dire Perhaps more impressive are official figures suggesting fiscal predictions around the 2015 period. Nevertheless, we should resilience and recovery. From 2015–16 and then 2016–17, bear in mind that China’s official GDP numbers are unreliable public revenue grew 4.5 percent and 7.4 percent, respectively. and almost certainly overstated for political reasons.80 One This is against public expenditure growth of 6.3 percent and 7.6 recent investigation suggested that China had been overstating percent respectively in the corresponding periods, which seems its GDP by an average of 1.7 percent each year since 2008, to set China on a more sustainable fiscal path. During 2016–17, which means that the size of its economy could be 20 percent central government revenues grew over 17 percent, and local smaller than the official figure.81 If that is correct, then the size government revenues increased by 10.2 percent. of the Chinese economy was $11.1 trillion at the end of 2018, rather than the official figure of $13.4 trillion. These official figures reinforce the reality that the years when budget revenues grew at over 20 percent (which last occurred For the purposes of this monograph, it is not productive to in 2011) are long gone, while double-digit government revenue enter more deeply into China’s “true” economic size. We will growth (which last occurred in 2013) is likely also over. However, accept the official National Bureau of Statistics figures as they growth in government expenditures of over 20 percent (which are and devote effort to forensically drawing out what has last occurred in 2011) is also probably over, while central and

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES local governments seem to be tightening their belts. Have fiscal Even so, the negative fiscal ramifications of the structural slowdown recovery and stabilization genuinely been achieved? seem to be modest rather than dramatic, despite the warnings leading into 2015. In 2015 and 2016, growth in fiscal revenues What Has Happened to China’s Debt was just 1–2 percentage points below reported GDP growth, while since 2015? in 2017, fiscal revenue growth was above reported GDP growth. To many American and other analysts, China seems to be able to consistently defy the laws of economics. Its financial What has China done with SOE debt and other debts effectively system serves mainly to provide funding for a state sector even guaranteed by the government? According to one estimate, though the private sector uses capital twice as efficiently as the outstanding debt owned by LGFVs alone might well have been former.82 Its banks have impressive profits, but not, however, around $6.5 trillion by the end of 2015, which amounts to because they allocate capital efficiently. Rather, it is because about two-thirds of GDP in that year.83 Of interest is what the they have the artificial advantage of existing in a virtual oligopoly consequences might be for China’s fiscal situation and capacity and reap the benefits of heavily regulated interest rates — with to project power, given the way it has managed its debt issues. the spread between benchmark bank deposit rates and lending rates, set by the People’s , around a generous The Size and Nature of the Debt 3 percent for the past two decades. Liquidity in the system By early 2019, global research and/or ratings organizations is maintained even when return on capital is low or negative estimated that China’s total debt was approximately 300 percent because China can force financial institutions to lend to each of GDP.84 One of the estimates at the higher range was from other or to corporate firms to maintain desired levels of growth. Goldman Sachs, which had put the figure at 317 percent of GDP And even in the absence of political instruction, banks and other earlier in 2019.85 According to these and other credible sources, financial institutions will continue to lend to SOEs rather than the breakdown of debt is roughly along the lines shown in Table 1. more profitable and dynamic private firms because SOEs enjoy an implicit government guarantee, making them less of a credit Note that it is misleading to look at China’s relatively unremarkable risk than a more profitable and deserving private firm. government debt-to-GDP ratio, which is just over 50 percent, and compare it to that of other countries.86 As the previous The obvious upshot of a massive misallocation of capital is a section points out, the Chinese government offers substantial slowdown in growth. This arises from the declining returns in explicit and implicit guarantees over the liabilities of formal and economic output from each dollar of capital invested and the informal financial institutions (including shadow banking lending need to use more new capital to pay off the growing interest and WMPs), central and local state-controlled entities, and local burden from existing debt. government entities such as LGFVs.

Table 1: Location of Debt in the Chinese Economy

NON-FINANCIAL DEBT BREAKDOWN HOUSEHOLDS FINANCIAL ENTITIES GOVERNMENT ENTITIES

% of GDP 54 155.5 43.1 51

Sources: Institute of International Finance, BIS, Haver, National Bureau of Statistics, Bloomberg

26 | HUDSON INSTITUTE Figure 2 shows government debt as a proportion of GDP in Figure 2: Comparison of Government Debt and a selection of Asian economies, and government debt as a Types of Debt in Selected Asian Countries percentage of GDP compared to other forms of debt held in developing Asian countries.

It is impossible to determine with any accuracy what the government’s liability might actually be; because the country’s economic and financial system is opaque, there is no way to know to what extent the government will follow through on implied guarantees. We can surmise that the government would honor these guarantees if failure to do so would lead to more serious or even systemic risks to the economic and financial system. Even so, whether a default will lead to a serious or systemic risk is always dependent on context and other contiguous and contemporaneous events, which cannot be known ahead of time.

We can make the following broad but pertinent estimations. The debt owned by the government is obviously a direct liability, while the overwhelming proportion of the debt owned by Information and Figure Source: Simon Roughneen, “Public Debt in Asia financial entities is an implied liability. Most of the debt owned Creeps Past 50%,” Nikkei Asia Review, 21 January 2019, https://asia. nikkei.com/Economy/Public-debt-in-emerging-Asia-creeps-past-50-of- by households does not enjoy any explicit or implicit guarantee GDP. by the government. Household debt is mainly significant as an indicator of the extent to which households can increase consumption to help fuel economic growth. It is also one state-controlled entities had debts of around $17 trillion at the important indicator of whether households are overleveraged end of 2017.89 It is also conservatively estimated that debt when it comes to the residential property market. As explained in held by non-financial commercial entities controlled by local the previous section, this has considerable bearing on both fiscal governments has increased from around 40 percent of GDP in and the country’s financial system more generally.87 2008 to almost 75 percent.90

The great variable of high consequence is the extent to which Adding together the explicit and implicit liabilities for the there is an explicit or implicit obligation for the government to government leads to a figure of approximately 220 percent guarantee corporate debt by non-financial entities. According of GDP, or about $33 trillion.91 Note that there has been an to most credible estimates, state-controlled enterprises increase in non-financial corporate debt (of state-controlled and hold more than 80 percent of corporate debt in the Chinese private firms) from around $6 trillion in 2007 to about $30 trillion economy.88 This means that state-controlled entities hold debt currently, and that this has occurred despite an incremental that equals around 125 percent of GDP (compared to just over capital output ratio (i.e., unit of capital input required to achieve 80 percent of GDP in 2007–08.) That estimation is consistent one unit of additional output) that has deteriorated from about with official data released by the State Council, which estimated 3.5:1 in 2007 to about 6:1 in 2015 and about 7:1 currently.92

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 3: Return on Equity of Listed Chinese State Companies From 2007–17 (In Percent)

Information Source: Based on data from DZH, QUICK-FactSet Figure Source: Yusho Cho, “How China’s State-Backed Companies Fell Behind,” Nikkei Asia Review, 23 May 2018, https://asia.nikkei.com/Spotlight/Cover-Story/How-China-s-state-backed-companies-fell-behind.

Bear in mind that while state-controlled companies have It is true that profits of state-controlled firms have been incurred about 80 percent of the debt of non-financial firms in growing, which provides some measure of fiscal comfort for China, their return on investment has been halved since 2007. China. This is reflected in the reasonably stable tax revenues This means that the following has occurred: Beijing has received since 2015. However, the sustainability of this situation depends on whether the policy of prioritizing • Growth in borrowing by state-controlled firms has increased state-controlled firms at the expense of more efficient by more than twice the levels of GDP growth since 2007; private firms can continue. This in turn depends on whether it is possible for these state-controlled firms to take on and • At the same time, state-controlled firms have been using capital far more inefficiently than in 2007. (The chart below manage more and more debt for capital investment when shows only the return on equity of listed state-owned firms, economic growth is slowing and profitable investments (at which are by some distance the most efficient SOEs in least in the domestic economy) are becoming increasingly the Chinese economy. Even then, the deterioration in their difficult to locate, given the overinvestment that has already performance is considerable.) occurred. It is in this context that we turn to how China — and state-controlled firms in particular — have managed their • At the same time, the government has become more reliant ballooning debt levels. on fiscal revenues gained from the increasingly inefficient activities of state-controlled firms, which receive the lion’s Tactical Measures to Prevent a Financial share of capital in the country. and Fiscal Crisis Although Beijing’s accumulation of debt since 2008 is the most Figure 3 shows the deteriorating performance of Chinese listed rapid in recorded peacetime economic history in both absolute state-controlled companies from 2007–17, when measured by and relative terms, China enjoys a “perverse resilience” as a return on equity. result of its unique political economy.

28 | HUDSON INSTITUTE Figure 4: Year-On-Year Growth in M2 Supply in the Chinese Economy

Information and Figure Source: “In Latest Tightening Move, China to Cut Money Supply Growth to 12%,” Silveristhenew.com, http://silveristhenew. com/2017/02/28/in-latest-tightening-move-china-to-cut-money-supply-growth-to-12/.

It avoided a Lehman Brothers moment and is likely to be able Moreover, the fact that much of the debt is held by state- to continue to do so in the foreseeable future. When Lehman controlled corporate entities rather than the government Brothers collapsed, intrabanking lending ground to a halt after or households has some advantages. In China’s case, the commercial banks lost confidence in each other’s solvency. central government has ultimate control over the way debt Liquidity in the economy subsequently dried up, as banks and liquidity is managed in the macroeconomy, especially as treated each other as failing institutions and almost created a it relates to state-controlled entities. This means that Beijing self-fulfilling prophesy. can devise policies to manage the timing, pace, and process with which debts are repaid or non-performing loans are China’s financial system is very different, dominated by state- recognized and handled. owned banks that ultimately do what Beijing tells them to. This has been proven time and again, since Beijing has frequently In contrast, indebtedness in official government accounts forced banks to lend to other financial institutions and firms leaves less room for maneuver because governments have when authorities demand more liquidity in the system. less ability to quickly raise revenue or restrict spending without

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 5: Fixed Assets Investment Growth in the Figure 6: Non-Bank Lending as a Percentage of Chinese Economy (in Percent) Total Lending in China

Information and Figure Source: “Economic and Trade Information on China,” HKTDC Research, 18 October, 2019, http:// economists-pick-research.hktdc.com/business-news/article/ Facts-and-Figures/Economic-and-Trade-Information-on-China/ff/ en/1/1X32LK39/1X09PHBA.htm. Information Source: CEIC Data Figure Source: “China’s Tighter Regulation of Shadow Banks Begin to Bite,” The Economist, 6 June 2018, https://www.economist.com/finance-and- economics/2018/06/14/chinas-tighter-regulation-of-shadow-banks- immediate negative social and political consequences. It is begins-to-bite. also more difficult to conceal government fiscal problems than financial stress for corporations. With respect to households, they have fewer options when it comes to managing and convertible “near money” such as savings deposits, money repaying onerous debt and debt burdens. A household under market securities, mutual funds, and other fixed-time deposits. severe debt stress is less able to ride out tough times than is a state-controlled enterprise with the explicit or implicit backing of The fall in money supply is reflected in and consistent with the Chinese government. Figure 5, which shows the dramatic slowdown in Chinese fixed-investment growth from the highs of the previous decade, Even so, Beijing has had to find tactical ways to forestall a especially from 2015 onward. financial and economic crisis in recent times. It has achieved that in the following ways: Second, in 2017, China identified “financial risk” as one of three critical battles (along with pollution and poverty). Intent First, it has slowed the availability of credit to prevent debts from on reducing “excessive leveraging,” Beijing put much of spiraling out of control. its effort into cracking down on off-balance-sheet activities between lending institutions and from these institutions Figure 4 shows the fall in growth of M2, a measure of money to firms and individuals — that is, the so-called shadow supply that includes cash, checking deposits (i.e., M1), and banking sector.

30 | HUDSON INSTITUTE Figure 7: The Rise, Decline, Then Return of Figure 8: China’s Debt-To-GDP as Percent Shadow Bank Lending in China of GDP, 1998–2018

Information Source: People’s Bank of China Figure Source: Information Source: BIS, Haver, IIF. Figure Source: Konstantinos Issaku Harada, “Financing in China Picks Up as Shadow Banks Efstathiou, “Chinese Growth: A Balancing Act,” Brugel, 28 January Revive,” Nikkei Asia Review, 23 February, 2019, https://asia.nikkei. 2019, https://bruegel.org/2019/01/chinese-growth-a-balancing-act/. com/Economy/Financing-in-China-picks-up-as-shadow-banks- revive2.

firms held a declining share of debt as a proportion of GDP from By the end of 2017, regulators announced they had uncovered 2016 onward (even though absolute debt held by non-financial nearly 60,000 instances of wrongdoing involving about $2.5 firms continued to grow). Instead, households, government, trillion. Fines worth over $400 million were issued against almost and financial firms took on an increased share of national debt. 1,900 banks, and more than 1,500 financial employees were punished with fines and even lifetime bans.93 As a result, non- From a systemic risk point of view this was preferable, as household bank credit as a proportion of overall credit was halved from and central government debt remained manageable, while the the highs of 2013–14, and from 2018 onward, repayments of lending and borrowing activities of the formal financial sector shadow bank loans exceeded new loans issued. were more easily monitored and regulated than activities by non- financial firms. Incentives for households to take on more debt also Figure 6 shows the rapid rise up to 2013–14 of non-bank credit offered the prospect that this would fuel much-needed increases as a percentage of overall lending in the Chinese economy, in domestic private consumption to offset relative declines in fixed followed by its relative decline. investment from the corporate deleveraging process.

Figure 7 shows the rapid rise, then decline, then re-emergence Figure 8 shows the sectoral components of China’s debt-to- of shadow bank lending in China. GDP ratio from 1998–2018.

From a macro balance sheet point of view, these tactical Third, in keeping with the directives of the Thirteenth Five Year measures worked. As Figure 8 demonstrates, non-financial Plan, Beijing identified around 350 central state-controlled

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 9: The Decline in Workers in the Iron, Steel, 1990s and earlier this century, Beijing set up and funded and Coal Sectors Since 2013–14 in Workforce (m) four companies (AMCs) to inject capital into distressed banks by purchasing bad or questionable debts to offer some relief from loan sheets weighed down by non-performing loans (NPLs).95 The theory was that AMCs would specialize in the recovery of debt, ensuring that the proportion of NPLs recovered would be significantly higher than if the NPLs had remained with the banks. In return, the AMCs issued promissory notes and bonds to the banks for from 50 percent to as much as 100 percent of book value. The purpose was to lower NPLs on banks’ balance sheets. It is estimated that almost $170 billion worth of NPLs Information Source: Gavekal Data; CEIC Figure Source: Emily Feng, was taken off the books of China’s four largest banks over “China’s Laid-Off Workers Pose Daunting Challenge,” Financial Times, that period. 16 November 2017, https://www.ft.com/content/de33f222-af09- 11e7-aab9-abaa44b1e130. The expectation was that AMCs could recover 40–50 of the NPLs. Ernst & Young conservatively estimates the average cash firms that had suffered losses for three consecutive years recovery rate to be about 25 percent. Fitch Ratings estimated and did not fit in with the priorities of the country’s broader the most generous recovery rates for these to be about 30 industrial policies. Local governments were also pushed percent, meaning a loss of 70 percent — significantly worse to identify “zombie” local state-controlled firms that met than the 40–50 percent recovery rate officials reported as the those criteria. minimum. A Deutsche Bank report revealed that in 2003, the AMCs were burdened with about 19 percent of the state banks’ In practice, the plan to eliminate these zombie firms within NPLs and had liquidated about a quarter of them. The cash three years has only succeeded in modest and narrow recovery rate was only about 20 percent.96 terms. The focus has been mainly on coal and steel producers, while state-controlled firms that make profits The more recent version of the framework (from 2016 onward) only through the significant government advantages they are contained modifications, as the primary objective was to afforded (through cheap or free credit, subsidies, tax relief, assist distressed non-financial firms rather than distressed inflated invoicing, etc.) are left 94alone. Indeed, at the time banks. In fact, five of China’s biggest banks — Industrial and of writing, the plan to phase out zombie firms seemed to of China Limited, have stalled. Corporation, Agricultural Bank of China Limited, Bank of China Limited, and Co., Ltd. — became Figure 9 shows the decline in workers in heavy industries such the main executing entities driving the debt-for-equity swap as iron, steel, and coal since 2013–14. arrangements, rather than AMCs.

Fourth, China introduced a new debt-for-equity framework in Under the current scheme, the government takes less of a March 2016, though its approach was not new. In the late direct role. Instead, banks are encouraged to work with third-

32 | HUDSON INSTITUTE Figure 10: China’s Debt-To-Equity Swap Program (Billions of Renminbi)

Information Source: State Council of China; National Development and Reform Commission of China; China Banking and Insurance Regulatory Commission. Figure Source: Tianlei Huang, “Tracking China’s Debt-to-Equity Swap Program: ‘Great Cry and Little Wool,’” China Economic Watch, Peterson Institute for International Economics, 24 June, 2019, https://www.piie.com/blogs/china-economic-watch/tracking-chinas-debt- equity-swap-program-great-cry-and-little-wool.

party investors (including private entities) to set up debt-for- Figure 10 shows significant improvement in the implementation equity investment funds. These funds inject equity into heavily of China’s debt-to-equity swap program. indebted companies, which use the new capital to pay back debts to banks and other lending institutions. Fifth, as mentioned in the previous section, local governments are now permitted to issue bonds, following revision of the 1994 In 2017, China’s Ministry of Finance announced that it intended Budget Law. This was done to ensure that local fiscal budgets to swap more than $150 billion of debt for equity through this became less reliant on proceeds from land and property sales and framework.97 By late 2018, only about $22 billion worth of such LGFVs became less dependent on the shadow banking sector. swaps had occurred, despite an announcement that $157 billion worth had been agreed upon.98 Constant tinkering with In China’s bond market, which is still relatively undeveloped, the scheme to make it more attractive to state-controlled and local government bonds have been hugely successful in private entities has led to significant increases in executed debt- raising revenue for these governments. One notable scheme to-equity swap agreements. By the end of 2018, the estimated was a “debt swap” program, begun in 2015, which allowed figure was $145 billion executed.99 Even so, we know the local governments to convert the debt held by LGFVs (which amount of distressed debt held, especially by state-controlled includes bank debt, monies owed to non-bank entities, and firms, has grown exponentially. LGFV bonds) into local government bonds. About half of the

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 11: China’s Local Market Figure 12: Value, Growth, and Composition of Since 2016 China’s Local Government Bonds

Information Source: RBA; WIND Information. Figure Source: Alex Information Source: IMF; MIC; RBA; SIFMA; WIND Information. Figure Holmes and David Lancaster, “China’s Local Government Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/publications/ Source: Alex Holmes and David Lancaster, “China’s Local Government bulletin/2019/jun/chinas-local-government-bond-market.html. Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/ publications/bulletin/2019/jun/chinas-local-government-bond-market.html.

At the NPC’s most recent meeting, Chinese authorities approximately $4 trillion worth of local government bonds significantly increased the 2019 quota for local government outstanding in the Chinese economy was issued under this bond issuance. They set the quota at CNY3.1 trillion (3 per cent program.100 The central government also allowed special- of GDP, or $450 billion), almost one-third more than for 2018, purpose bonds to be issued for specific projects or specific undoubtedly to offset the general slowdown and the Trump purposes. For example, in August 2018, the Ministry of Finance economic offensive. instructed local governments to accelerate issuing of special- purpose bonds in order to meet growth targets, given the Finally, desperate local governments have used private-public ongoing economic tensions with the United States.101 partnerships (PPPs) to bypass the central government’s deleveraging instructions. This is being done by having LGFVs China’s local government bond market is now larger than that entice investors to inject capital into low-return projects by of the US in absolute terms and as a percentage of GDP. By promising them guaranteed returns on their capital, guaranteed the end of 2017, bonds issued made up about 90 percent of buybacks, or redemptions at an agreed time and price that all local government debt, compared with 7 percent when local are more generous than the market would allow. This clearly governments (and their commercial entities) relied heavily on the has the opposite of the intended deleveraging effect, as LGFVs shadow banking market.102 Quotas for local government bonds are offering even more generous terms to third-party entities are normally set during the annual National People’s Congress in their desperation to secure capital and keep their fiscal meeting in March. revenues stable.

34 | HUDSON INSTITUTE Figure 13: Performance of State-Controlled Firms Versus Private Firms in China

Information Source: China National Bureau of Statistics; People’s Bank of China; Haver Analytics; original calculations by Benn Steil and Benjamin Della Rocca Figure Source: Benn Steil and Benjamin Della Rocca, “With Growth Sagging, China Shifts Back to Socialism,” CFR Blog, 18 October 2018, https://www.cfr.org/blog/growth-sagging-china-shifts-back-socialism.

By the end of March 2019, almost 9,000 PPP projects by LGFVs liberal economic reformer that China had been waiting for since had been registered with the Ministry of Finance, worth about Deng Xiaoping.106 $1.9 trillion. The ministry, recognizing the prevalence of the practice, announced that it would assess these projects to see Those believing that the market would soon play a “decisive the extent to which they were designed to bypass regulations role” in China missed a critical part of something about which and increase the off-budget debt of local governments.103 Xi was always upfront: in the quest for greater innovation, efficiency, financial stability, and economic resilience, the party Kicking the Can Down the Road will play an even greater role in shaping the priorities and When Xi came to power in 2012, he promised to allow the policies of the economy and state-controlled firms, and hand- market to play a “decisive role in the economy.”104 As he picked “national champions” will continue to dominate leading explained later, this was necessary because China’s economy sectors of the economy. was “big but not strong” and “bloated” and “frail.” Low “innovative ability” was its “Achilles Heel.”105 This led many in In short, China will remain a Leninist political economy in that all the US and elsewhere to predict that Xi would be the great tools of economic power will be used to further the dominance

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES and objectives of the Communist Party.107 Under the coercive First, identifying zombie companies is essential for working out cover of an ongoing and unprecedened anti-corruption which firms to phase out, as these entities are the greatest drag campaign that has entrenched Xi’s personal power, cowed (or when it comes to (mis)allocation of resources. These are also jailed) his enemies, and put his rivals off-balance, China’s leader the firms that exacerbate NPL issues, as constant borrowing by has dared to advance that Leninist vision that his predecesors loss-making firms makes it less and less likely that loans will be perhaps shared but lacked the means or else resolve to advance. serviced, let alone paid back.

Figure 13 compares the increase in the profit growth of state- Furthermore, debt-to-equity swaps work only if the distressed controlled industrial firms with the decline in profitability of firm is able to return to profitability, which is necessary to allow private firms in China since 2016. it to buy back the equity from the rescuing entity or ensure that the equity taken on by the rescuing firm has future value for It is now common to describe the economic situation in China that firm. If the distressed firm does not return to profitability, as “the state advances — the private sector retreats.”108 then a debt-for-equity swap merely represents a transfer of Under Xi, the unequal treatment of the private sector has been losses from the distressed company to the rescuing company. extended further: state-controlled firms are being offered easier This is problematic, since much of China’s bad debt is held by and cheaper access to credit, privileged access to some of state-controlled firms that are fundamentally uncompetitive.111 the most lucrative sectors in the economy, and regulatory and It would obviously increase the number of NPLs in the financial legal protection from local and central governments.109 This is system and for individual lending institutions. demonstrated by data showing that private-sector profits have been generally declining since around late 2014 — and fell by One of Beijing’s stated goals is to exclude zombie companies 22 percent in 2018, the largest decline since 1978 — while from any such debt-for-equity schemes.112 However, there is profits of state-controlled firms have been increasing since late no guidance on how to identify and exclude them from either 2015. This is occurring even though private firms have a return bailouts or debt-for-equity swaps. Regulators might respond on assets around three times better than that of state-controlled that it is up to “the market” — or more precisely, individual firms, and their use of capital is twice as efficient asstate- banks and investors — to determine whether a distressed controlled firms.110 These trends are a reversal of what occurred firm is worthy of assistance. The problem is that the party-led during the three decades prior to 2014. political economy is designed to assist and protect less-efficient state-controlled firms. While zombie private firms tend notto In macroeconomic and fiscal terms, this is a problem for Beijing. exist because they have already died a natural commercial The private sector accounts for about half of the country’s tax death, it becomes very difficult to assess whether a state- revenue, about 60 percent of GDP, and 80 percent of urban controlled firm can genuinely return to profitability or whether employment. These political priorities also create serious longer- it was truly profitable in the first place, given the multiple non- term challenges for Beijing in achieving sustainable economic market measures assisting its survival. growth and managing the debt and fiscal issues in the medium- to-longer term. Additionally, a key principle of successful debt-for-equity swaps is the capacity to convert debt at fair value, and transparency Consider the tactical measures to manage debt, deleverage, about the true accounts of the distressed company.113 This is and stabilize and grow fiscal revenues above. undermined by the political and structural incentives offered

36 | HUDSON INSTITUTE to LGFVs and other state-controlled firms to underplay their Even so, this pales in comparison to the almost $21 trillion in level of distress and overvalue their debts in order to receive a outstanding non-financial corporate loans at that same time. larger-than-warranted equity injection. At the same time, state- The $131 billion in executed swaps is less than the estimated controlled rescue firms are generally happy to accept inflated $148 billion in new non-financial corporate loans in the month estimates of the distressed company’s health in order to attract of April 2019 alone.114 third-party investors to join the debt-to-equity scheme. As there is no developed framework to determine which entity bears the Similar principles apply to the PPP schemes. It is revealing that cost if the distressed company ultimately fails after the debt- perhaps as many as 75 percent of firms participating in PPP for-equity swap, the likelihood is that the local government will arrangements are state-controlled entities rather than private bear the cost or will lean on state-controlled banks to mop firms.115 One report, which is typical, suggests that most private up the spill. Indeed, the uncertain prospect of repayment firms surveyed were concerned that local governments would means that state-controlled firms such as China’s five largest not honor their agreements and would not enforce state-owned banks continue to be the major investors in the rights against local government entities.116 scheme and will most likely be forced to absorb any losses. Many banks are even forced to resort to selling WMPs (offering generous rates of return) to raise funds from private investors to participate in debt-to-equity swaps for fundamentally unsound Figure 14: Local Government Bond Pricing Versus companies. That increases systemic risk on several levels. Debt-To-Revenue Ratios of Local Government More broadly, the simple solution of a direct bailout in the first Issuers (By Province, 2018) place makes more sense and entails less unknown risk in some circumstances.

Moreover, the rescuing entities have no capacity to replace the management of the distressed firm or even influence its governance practices. Debt-to-equity schemes tend to work when they lead to plausible plans as to how distressed firms will deleverage, turn the business around, and recapitalize. In China’s case, the debt-for-equity scheme is intended primarily to rescue distressed state-controlled firms rather than change the corporate and market practices that led to the problem in the first place.

In any event, even if the distressed firm were operating soundly, debt-to-equity schemes would not make a significant impact on the deleveraging process. One study by the Peterson Institute Information Source: CEIC Data; RBA; WIND Information Figure for International Economics estimated that by the end of April Source: Alex Holmes and David Lancaster, “China’s Local Government Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/ 2019, there was just over $131 billion of executed swaps, publications/bulletin/2019/jun/chinas-local-government-bond-market. which is around a three-fold increase since the end of 2017. html.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 15 shows the difference in prices (spreads) Figure 14 shows the unusually even pricing of local government between different local government bonds. bonds in China, despite the significant differences in debt-to- revenue ratios of different local government entities.

This tends to suggest that bonds are all low risk because there is an explicit or implied government guarantee that they will be honored. This leads to a familiar moral hazard problem in which local governments can issue bonds at artificially low prices and therefore do so with little discipline. (The same logic is at play when lending institutions offer credit to state-controlled entities at substantially lower cost because they are confident that the government will bail these firms out if necessary. This encourages the firms to increase financial leverage even more).118 Conversely, those who purchase the bonds do so with little due diligence and subsequently use them as AAA-rated collateral for further borrowing.

Information Source: Bloomberg; RBA; WIND Information. Figure This increases the fragility of the financial and economic Source: Alex Holmes and David Lancaster, “China’s Local Government system and undermines the central government’s deleveraging Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/ publications/bulletin/2019/jun/chinas-local-government-bond-market. objectives. It will also inevitably lead to serious dilemmas for html. the central government. If it leans toward offering a guarantee for local government bonds, then the moral hazards described above worsen. If it allows local governments or LGFVs to default, Second, while the transition of local governments and LGFVs then panic by bond holders and entities accepting these bonds away from the shadow banking sector to greater reliance on as collateral could trigger a cascading and catastrophic crisis issuing of bonds can be more carefully monitored and regulated, for the financial system of that locality, or even the country. it does not solve the issue of overleveraging or fiscal sustainability. Issuing bonds is merely another way for local governments to In recent times, the central government has made attempts defer fiscal reckonings and continue to spend increasingly more to introduce better market-based pricing of different types of than they receive through traditional fiscal channels. bonds. For example, in 2018, it introduced a prohibition on local governments’ guaranteeing LGFV debt.119 This did lead There are other problems, which go to the heart of the nature to larger spreads between the lower-risk bonds issued by local of the Chinese political economy. Two researchers observed governments and those issued by LGFVs. that there is very little difference in the way local government bonds are priced — despite differences in the type of bonds However, the larger spread ultimately increased funding (e.g., general or special-purpose) and the issuer (e.g., different costs for local governments. As the economy slowed and local governments, which have different debt-to-revenue ratios, the increase in transfers from the central government similarly or various LGFVs).117 In fact, almost all local government bonds slowed, the pressure to lower the cost to local government of are rated AAA by domestic rating agencies. raising debt became greater. Inevitably, the pressure on Beijing

38 | HUDSON INSTITUTE Figure 16: Type of Investor in Local Government Figure 17: Bank Holdings of Local Government Bonds in China, the US, and Japan Bonds in China as Percentage Share of Bank Assets

Information Source: Bank of Japan; CEIC Data; RBA; SIFMA Figure Source: Alex Holmes and David Lancaster, “China’s Local Government Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/ publications/bulletin/2019/jun/chinas-local-government-bond-market.html. Information Source: CEIC Data; RBA. Figure Source: Alex Holmes and David Lancaster, “China’s Local Government Bond Market,” RBA Bulletin, 20 June 2019, https://www.rba.gov.au/publications/ bulletin/2019/jun/chinas-local-government-bond-market.html. to offer stronger implicit guarantees to lower bond costs for local government grew. This is what occurred from mid-2018 onward due to the sluggish economy and the ongoing effects of the trade tensions with the United States. Figure 16 shows the differences in type of investor in local government bonds between China and the US and Japan. In One possible buffer against systemic risk is that the , investors in local government bonds are dominated by government is limiting the monetary value of bonds that local state-controlled commercial banks. governments and LGFVs can issue to “safe” levels. However, if the quota is set too low, then local governments and LGFVs It is worth noting that China’s commercial banks (which make will simply revert to the shadow banking system, as they have up around half of the Chinese banking sector) purchase around done from time to time in recent years. Allowing these bonds to 80 percent of all local government bonds, which is a very be issued largely means repackaging products to permit local narrow investor base compared to other major economies. governments to spend more than they earn; it does not, in and One reason to encourage local governments and LGFVs to of itself, impose fiscal discipline or create an enduring source of transition to bonds for finance is that this spreads the risk of unencumbered fiscal revenue. default throughout the economy. In China’s case, that risk is

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 18: Relationship Between Total Social It is instructive to see what occurred when the combination of Financing and Credit Impulse the continual structural economic slowdown and the exogenous shock of economic tensions with the US caused some panic in Beijing. The credit impulse measures change in new credit as a proportion of GDP. Total social financing represents off- balance-sheet forms of financing outside the conventional banking system (shadow banking) and includes loans from trust companies and bonds.

It is clear that the only reliable way Beijing has of maintaining adequate growth — needed for fiscal stability — is to increase credit in the system. China cannot significantly deleverage and resolve its debt issues without wholesale changes to its political economy, which would be fundamentally incompatible with the Information Source: CEIC; UBS estimates. Figure Source: Orchard Leninist mindset on which Xi is doubling down. Research, “China: Examining Chinese Equity Exposure,” Seeking Alpha, 2 May 2019, https://seekingalpha.com/article/4259227-china- examining-chinese-equity-exposure. Moreover, due to state-controlled enterprises’ privileged access to formal finance, such as standard bank loans, the private sector is heavily reliant on the shadow banking sector. The crackdown on shadow banking has been disproportionately disruptive for merely passed on to banks that are explicitly guaranteed by private firms.120 Given that these firms pay around half of all the government. taxes, the government is being forced to relax controls on the shadow banking sector as the economy slows further. This all but Third, measures to deleverage by slowing the flow of credit guarantees a rerun of the risk and systemic concerns of 2015. by formal lending institutions and/or the shadow banking network can endure only if total factor productivity goes up Conclusion (ensuring more tax receipts without further indebtedness to Economic reformers such as Zhou Xiaochuan, governor of the force-feed growth) or if government spending increases more People’s Bank of China from 2002–18, might have preferred the slowly than tax receipts (reducing the need to increasingly path of gradual corporate deleveraging, coupled with structural grow tax revenues). If these conditions are not met, reforms that better allocated resources and opportunity to more governments and firms will need to borrow exponentially more deserving private and state-controlled firms. A more efficient and to generate adequate growth and ensure fiscal requirements effective use of capital would likely have restricted the growth of are met. corporate and government debt, supported a more rapid increase in household income (rather than state-controlled corporate Figure 18 shows the complementary relationship between total revenues), and achieved moderate growth at the same time. social financing (TSF) — off-balance-sheet lending — and the increase in “credit impulse” (which measures change in credit as The alternative growth model favored by Xi sees the continual a percentage of GDP). buildup of investment and credit and little progress on structural

40 | HUDSON INSTITUTE reforms. Under this current model, less deserving companies The Communist Party under Xi believes that this scenario continue to receive the lion’s share of opportunity and credit, offers the best prospect for it to retain its hold over the levers and the enormous misallocation of capital will likely worsen. An of economic power and opportunity, and therefore, political increasing amount and proportion of credit will go to inefficient, power and control. This is the model on which China is betting over-capacity, and even loss-making sectors. The private its future in the Xi era. sector and household income will remain artificially suppressed.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES IV. MADE IN CHINA 2025 AND THE FUTURE OF CHINA’S EXPORT-ORIENTED MODEL

At the time of writing, Chinese banking authorities had lowered pace of defaults is concerning, the absolute amount is relatively the reserve ratio requirements for the nation’s commercial banks modest. Bear in mind, however, that formal defaults record only more than half a dozen times over the previous twelve months. those bonds that were not refinanced (as there were not sufficient State-controlled companies continued to receive most of the profits or cash flow to honor them from existing balance sheets) formal finance, which led to Beijing’s urging lending institutions or bonds that were repackaged by state entities to prevent — and in some instances, pressuring them — to offer more any default. finance to private firms.121

There were 35 cases of bond default in 2017, rising to 119 in Photo caption: A light installation commissioned by Huawei mimics the 2018.122 Companies formally defaulted on around $6 billion of Aurora Borealis above the Tower of London, to promote the launch of domestic bonds from January–April 2019, which was about 3.4 the Huawei P30 Pro phone, on April 4, 2019 in London, England. (Joe times the total for the same period in 2018.123 While the increased Pepler/PinPep via Getty Images)

42 | HUDSON INSTITUTE Figure 19: Purpose of Bonds Newly Issued by LGFVS, January 2013 to April 2019

Information Source: Eastmoney. Figure Source: Bart Carfago, Allen Feng, and Logan Wright, “Local Government Debt: Running Faster Just to Stand Still,” Rhodium Group, 15 May 2019, https://rhg.com/research/local-government-debt-lgfv-running-faster-just-to-stand-still/.

More broadly, the pattern of additional borrowing to In the first quarter of 2019, almost 79 percent of LGFV bonds manage existing debt is clear, strengthening, and seemingly were used to repay or refinance maturing debt or to swap debt unchangeable. Given the fundamental unreliability of Chinese for other instruments. The figure was just over 19 percent in macrostatistics, better insights are usually gained from 2013. In Figure 19, the majority of “unexplained use” bonds are extensive bottom-up analyses. also likely for this same purpose.

One recent and compelling analysis was performed by the We could also put this another way. In the first quarter of Rhodium Group, which looked at the bond prospectus 2013, almost 81 percent of bonds were issued for capital documents of almost 2,500 LGFVs.124 Its investigation showed projects. By the first quarter of 2019, the figure was just over that the problem discussed in Chapter II — using new credit to 21 percent. help manage existing debt rather than for new projects — has worsened considerably. Furthermore, all components of growth are clearly slowing or

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 20: Trends in Chinese Growth and Credit stagnating in structural terms. It is obvious that overinvestment Metrics: Reform vs. No Reform has led to overcapacity and overleverage, while it is unlikely domestic consumption will be able to underpin the next phase of growth envisaged by the Thirteenth Five Year Plan and beyond. Figure 20 shows the trends and expectations of Chinese growth and credit metrics up to 2025 with and without reform.

The orthodox consensus is that China needs liberal and market- based political-economic reform,125 but Xi is committing to other approaches. This chapter looks at how MIC 2025 and the philosophy behind it are related to the economic vulnerabilities described above.

Reaching the End of the Old East Asian Export Manufacturing Model Since the Second World War, rapidly developing East Asian economies — Japan, South Korea, Taiwan, Singapore, Malaysia, Thailand, and, most recently, China — have all relied upon a remarkably similar export-manufacturing model. They seek to grow by making exported products for consumers in advanced economies more cheaply, quickly, and reliably than other countries or regions can.

At the heart of the so-called East Asian model of rapid economic development and industrialization is the emphasis on developing a strong export-manufacturing domestic sector that is bolted onto a highly protected domestic consumption market. The countries using this model have a natural advantage in being able to offer a cheap and plentiful supply of low-cost labor, and they have also implemented state interventionist policies to attract foreign firms and capital into the export-manufacturing sectors. These include tax concessions and subsidies to domestic and foreign firms to locate manufacturing plants in Information Source: BlackRock Investment Institute; IMF; Bank for the country. Export-enhancing policies also include currency International Settlements, February 2017. Figure Source: “China’s regimes that artificially suppress the value of the domestic Tricky Transition: Signposts to Watch in Its Economic Evolution,” Global Insights, Blackrock Investment Institute, February 2017, currency relative to Western , making it cheaper for https://www.blackrock.com/corporate/literature/whitepaper/bii-china- Western firms to inject capital and for Western consumers to tricky-transition-2017-international.pdf. purchase the exported goods. The export-oriented model has

44 | HUDSON INSTITUTE Figure 21: Chinese Trade as a Percentage Figure 22: Components of Chinese Share of GDP GDP growth, 2000–18

Information and Figure Source: Brad Setser, CFR Blog, 4 February Information Source: CEIC Data; RBA. Figure Source: “The Australian 2019, https://twitter.com/brad_setser/status/1092531177569820672. Economy and Financial Markets,” Reserve Bank of Australia Chart Pack, October 2019, https://www.rba.gov.au/chart-pack/pdf/chart- pack.pdf?v=2019-11-05-20-11-36. also been aided by advances in logistics and transportation that allow goods to be transported ever more economically. For example, transportation networks are now so efficient that, if However, there is a structural problem. The combined a T-shirt is carried on the largest modern cargo ships, it costs population of Japan, South Korea, and Taiwan in 1970 — about two cents to ship it from Asia to America. when these countries were in the midst of pioneering the export-manufacturing path — was only about 150 million. The Export manufacturing was and remains at the heart of combined population of the industrialized economies in North East Asia’s rise. The East Asian manufacturing trade as a America and Western Europe, their main markets, was around proportion of global manufacturing trade has increased from 400 million at that time. But this balance will be reversed for the about 12 percent in 1970 to 26 percent in 1990 to over 35 next generation of ambitious exporters. There are one billion or percent today.126 The share of global export manufacturing of so consumers in the handful of advanced economies, while there the Association of Southeast Asian Nations increased from a are now some two billion people living in developing countries in miniscule 0.3 percent in 1970 to about 6 percent currently. In East Asia. Sluggish growth in the advanced economies means 1990, at the peak of Japan’s economic rise, its share of global those scales will not tip soon, even if we add in the fifty to one export manufacturing exceeded 12 percent. China has become hundred million consumers in China with similar buying power to the outstanding individual performer, increasing its share of their counterparts in advanced economies. This does not even global export manufacturing from 0.5 percent in 1970 to about allow for the very real possibility that other low-wage countries 13.5 percent currently. with large populations, like Mexico, Ethiopia, or Nigeria, will also try to break into the export-manufacturing game.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 23: Domestic Value Added in Chinese Figure 24: Sectors Targeted by Made In China 2025 Exports and Type of Traded Good

Figure Source: Asia Briefing, Ltd.; Melissa Cyrill, “What Is Made in China 2025 and Why Has It Made the World So Nervous?” Dezan Shira & Associates Briefing, 28 December 2018, https://www.china- briefing.com/news/made-in-china-2025-explained/.

Figure 23 shows the components of Chinese exports, broken down by ordinary exports (finished goods) and processing exports (intermediate parts of an unfinished good), as a percentage of total trade, along with the domestic value added Information Source: Macrobond, 2019. Figure Source: Niloofar of exports, from 2005– 2017. Rafiel, “How Trade Made China Great: Past, Present and Future,” Sarasin Report, 16 July 2019, http://www.sarasinassetmanagement. com/Insights/Article/article-537-jul19-how-trade-made-china-great. China’s “New” Export-Oriented Model In May 2015, the State Council launched MIC 2025 to guide the upgrading of Chinese industry, production, and innovation over the next ten years. The blueprint identified the sectors below as In China’s case, merchandise trade as a share of GDP is essential. falling, even though in absolute terms, trade and services and trade volumes are still rising, albeit slowly. From a GDP growth MIC 2025 did not arise in a vacuum. In 2006, the Hu Jintao perspective, net exports are no longer a significant contributor, regime issued a Fifteen Year Plan to enhance “indigenous as they were in the mid-2000s. innovation”127 and subsequently identified seven strategic emerging industries (SEI) that were essential for China if it What is significant is that the share of processing (intermediate was to evolve into an “advanced economy.”128 That plan set a parts) trade of exports from China is falling while the domestic target for SEI-related industries to account for 8 percent of the value-added component of China’s exports is increasing. This economy by 2015 and 15 percent by 2020. means it is transitioning from a low-cost assembler of exported products toward an exporter of domestically generated value. What is MIC 2025? In other words, China is increasingly capturing more of the value MIC 2025 pursues the same central planning and target-setting of a traded product. approach in seeking to implement an industrial policy that

46 | HUDSON INSTITUTE Figure 25: Chinese Companies’ Domestic Market- However, MIC 2025 is far more extensive and significant for Share Target for Made In China 2025 Sectors several important reasons. First, the program seeks control over, and dominance of, entire manufacturing processes, supply chains, and associated services for the sectors identified in the MIC 2025 plan. For example, it specifies targets for the domestic content of core components and materials: 40 percent by 2020 and 70 percent by 2025 (a violation of World Trade Organization rules). It makes explicit reference to how much of China’s technology markets in various sectors should be controlled by Chinese companies and how many component parts in various relevant products need to be “Made in China.” It sets out industry-specific and tech-specific targets in detail. These include market share targets for Chinese technology, quotas for smart machinery use, targets for the number of patents per RMB 100 million in revenue, and details about the development of world-class brands in these selected industries.

Moreover, while the state and state-controlled sectors will still lead, MIC 2025 will co-opt and use indigenous private firms to ensure that value creation is created in and retained within China. All state-controlled and private indigenous firms are potential partners and participants in MIC 2025, and Information Source: Mercator Institute for China Studies. Figure those advancing the blueprint’s objectives will be offered Source: “China Sets Its Sights on Dominating Sunrise Industries,” financial, commercial, regulatory, legal, and political support Economist, 23 September 2017, https://www.economist.com/finance- and-economics/2017/09/23/china-sets-its-sights-on-dominating- and assistance. sunrise-industries. Additionally, MIC 2025 reads like a comprehensive blueprint for domestic reform to “upgrade” the entire Chinese economy. improves capital allocation, policy coordination, and innovation For example, its stated goals are linked, and one follows from throughout the entire political economy and in accordance with the other: improving manufacturing innovation, integrating strategic objectives. The MIC 2025 blueprint is also largely information technology and industry, bolstering the industrial driven by China’s desire to avoid the so-called middle-income base, fostering world-class Chinese brands, enforcing green trap. This occurs when rising but still developing economies technologies, promoting breakthroughs in ten key sectors, lose their competitive advantage due to factors such as rising restructuring the country’s entire manufacturing base, wages, a declining supply of cheap labor, and less favorable promoting service-oriented manufacturing, and having Chinese demographics, and are unable to compete with more innovative firms globalize manufacturing. Performance indicators are given and productive advanced economies. and taken seriously.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 26: Key Performance Indicators for Made in China 2025

CATEGORY MANUFACTURING TRANSFORMATION KPI 2015 2025

1. R&D cost/revenue/($) 0.95 1.68 Innovation Capability 2. Patents/billion RMB of revenue (#) 0.44 1.10

3. Manufacturing quality competitiveness (index) 83.5 85.5

Quality and Value 4. Manufacturing value-added increase over 2015 (%) - 4 5. Average annual labor productivity growth (%) - 6.5

6. Broadband penetration (%) 50 82

IT and Industry Integration 7. Digital R&D and design tool penetration (%) 58 84 8. Key process control rate (%) 33 64

9. Energy decrease over 2015/industrial value add (%) - 34

10, CO2 decrease over 2015/industrial value add (%) - 40 Green Industry 11. Water use decrease over 2015/industrial value add (%) - 41

12. Industrial solid wastes utilization ratio (%) 65 79

Information and Figure Source: “Made in China 2025,” Institute for Security and Development Policy Backgrounder, June 2018, http://isdp.eu/ content/uploads/2018/06/Made-in-China-Backgrounder.pdf.

In this sense, it is a whole-of-government and whole-of- For these reasons, it is superficial to compare MIC 2025 to economy plan intended not just to reform and enhance China’s Germany’s 2013 Industry 4.0 plan. MIC 2025 might have been capabilities in these vital sectors, but to hit defined benchmarks inspired by the German blueprint, but Industry 4.0 merely seeks indicating ultimate success. It is a far more elaborate blueprint to consolidate German leadership in mechanical engineering to update “capitalism with Chinese characteristics” for the first in a world of increased digitization and the Internet of Things. half of this century. MIC 2025’s objectives of global dominance are not mirrored in the German plan. Importantly, as argued below, the means Finally, MIC 2025 is much more ambitious and muscular by which China will seek to achieve MIC 2025’s goals are in a in its outward-focused end goals than previous blueprints. different league altogether. Its objective is not simply to ensure China becomes an advanced and competitive economy; the internal measures The Chinese Game Plan are explicitly designed to create the foundation for Chinese The public pronouncements and implementation of MIC 2025 firms to dominate these sectors in global markets. China gathered pace from about 2017 onward due to the urgency to is also to become a global hub for firms in these sectors. combat China’s structural slowdown. Increasingly, Beijing put MIC This will allow its economy to host, absorb, and localize 2025 forward as an industrial plan that would help China escape entire supply chains, intellectual property, and related from the “middle-income trap,” and party officials and the state- services. sanctioned press even linked it to Xi’s “great rejuvenation” or

48 | HUDSON INSTITUTE “China dream.”129 Although in recent times China has downplayed Party direction. Beijing is producing state-directed economic MIC 2025 to remove it as a lightning rod and appease the Trump goals and blueprints for both the private and state-controlled administration, it remains a primary industrial blueprint for Beijing.130 sectors in industries and sectors that will create and store an increasingly large proportion of economic value into the future. Indeed, by the end of 2018, the government had issued around This is a strong signal of its intention to strengthen its grip on the 450 authoritative documents detailing MIC 2025 implementation political economy rather than loosen it. measures. In that year, the Ministry of Industry and Information Technology identified five focal points: establishing indigenous It is also a firm indication that the more important and potentially specialization in MIC 2025 national demonstration zones; lucrative a sector is in the future, the more China will retreat establishing world-class industry clusters in industrial internet into an economically nationalistic mindset. The country’s and emerging industries; introducing innovations in basic quest to escape from the “middle-income trap” is leading to general technologies; establishing manufacturing innovation a strengthening and deepening of economic nationalism and centers; and reorganizing fiscal support frameworks to mercantilism in China. advance these objectives.131 Of the approximately 4,000 projects linked to MIC 2025, around 3,600 were announced Moreover, this is occurring at a time when repression, from 2017 onward. At least thirty MIC 2025 pilot cities have surveillance, and coercion in China are gathering pace, when Xi is been established, and each is tasked with developing specific centralizing power for himself and reviving the cult of personality MIC 2025 sectors. These comprise over 50 sub-industries and — all aided by the use of advanced technology.133 For example, 115 industrial sub-fields.132 the so-called Integrated Joint Operations Platform is being used for mass surveillance in Xinjiang, tracking people’s movement Importantly, indigenous private firms, motivated by a lighter by monitoring their phones, vehicles, and identification cards.134 regulatory touch and commercial and other incentives, have When “irregular” movements are detected or they are outside been strong supporters of MIC 2025. This is evident in fields police-designated areas, police and/or security forces are such as artificial intelligence, electric vehicles, facial recognition immediately alerted, and an investigation is launched. technology, big data, 5G, and advanced communication systems. At the same time, state-controlled firms continue to China’s use of technology for repression is being complemented play an outsized role in the manufacturing component of these by advances in big-data gathering and analysis and facial and sectors, complementing the strength of private firms in driving speech recognition applications — all relevant to MIC 2025. commercialization and service-related aspects. Given this Beijing appears to be creating and advancing a “Leninist dynamic, Beijing is increasingly looking to fuse state-controlled technonationalism” in which economic entities and technological and private firms through PPPs, or else mergers and acquisitions. progress are deployed to enhance the coercive, repressive, and surveillance capabilities of the state, and therefore the The United States and other advanced economies are deeply uncontested power of the party. The evolving “social credit” concerned about several aspects of the purposes and system is perhaps the manifestation of the “brave new world” implementation of MIC 2025. that China envisages under Communist Party rule. This system uses various technological advances to monitor, rate, and First, the plan represents a considerable evolution in the rise of regulate the financial, social, moral, and political behavior of “China Inc.,” or the Chinese corporate state under Communist China’s citizens and companies. It achieves this through a

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES system of punishments and rewards seeking to “provide the Figure 27: China’s Trade Balance in High-Tech trustworthy with benefits and discipline the untrustworthy.”135 Components (in BN USD)

Second, MIC 2025 can be treated as a blueprint to build the early foundations of a future mercantilist export-oriented approach to growing the economy. As previous chapters argue, the era of export-oriented growth in traditional merchandise trade will not drive the next phase of Chinese growth. There is a general problem of overcapacity in the production of traditional merchandise goods. In addition to the rise of manufacturing technologies such as automation and robotics, which lower the costs of production and reduce the importance of low labor costs, traditional merchandise goods are suffering from oversupply, and there is insufficient net Information Source: NBS. Figure Source: Max J. Zenglein and Anna demand in the world to absorb surplus production. Holzmann, “Evolving Made in China 2025: China’s Industrial Policy in the Quest for Global Tech Leadership,” MERICS Papers on China, no. 8, July 2019, https://www.merics.org/sites/default/files/2019-07/ Additionally, the production and supply chains for traditional MPOC_8_MadeinChina_2025_final.pdf. merchandise goods are becoming more local or regional, meaning they are being produced closer to the end consumer. This makes it more difficult — not easier — for Chinese exporters to target the industries. This would then allow the Chinese political economy still vast consumer economies of North America and Europe.136 to absorb and localize entire value chains.137

The reverse is occurring with trade in high-end professional There is also growing appreciation in the United States and services and high-tech products and services, where trade is other economic partners that China is playing a zero-sum, becoming more global — helped along by technologies such even illegitimate game in pursuing MIC 2025 goals. In seeking as cloud computing, artificial intelligence, and the Internet of to create and entrench new export markets and other external Things. These are precisely the sectors that MIC 2025 is seeking opportunities, Beijing’s goal is to capture and localize high-tech to target. It is becoming clear that the plan is not about creating value and supply chains. At present, China still relies heavily win-win economic relationships with trading partners, but about on import of high-tech components, machinery, know-how, dominating the sectors that China identifies as being of high and intellectual property. Using its National Bureau of Statistics economic value into the future. Beijing will continue to export definition of “high-tech,” which correlates closely with MIC its way to further growth at the expense of trading partners, 2025 sectors, China has an account deficit once computers including the United States. and telecommunications equipment are excluded.138 The other high-tech sectors include biotechnology and life-sciences, It is worth noting that in practice, MIC 2025 sets specific market- opto-electronics, electronics, computer-integrated machinery, share targets and defines strategic priorities for Chinese firms and aerospace materials and applications.139 that extend beyond the ten core industries identified. The MIC 2025 industries are only the foundation for a strategy that seeks Beijing seeks to make up this shortfall by offering privileged market to transform China into the primary global hub for high-tech access to foreign firms with these technologies, or access to the

50 | HUDSON INSTITUTE Chinese market through more favorable joint-venture agreements. Further analysis reveals that around two-thirds of these industries’ Other methods include acquiring foreign firms through foreign products imported from China to the US are produced by direct investment channels and eventually absorbing and foreign-invested firms based in China. This is significant because repatriating their technology and know-how.140 More egregious those firms do not have to base operations there. Not only does is China’s industrial cyber-theft, committed against foreign firms doing so mean that they face concerns about IP transfers and inside or outside the country to secure these technologies.141 theft, but also, when the next destination or end destination for their product is the US, the tariffs levied on them make China- Figure 27 shows China’s trade deficit in high-tech products and based operations commercially less attractive. components (excluding computers and telecommunications), which suggests that China relies heavily on foreign components Third, Beijing’s plans for the new export-oriented phase of and know-how. growth are not just about economics and the desire to grow fiscal revenues through success in future external markets. Indeed, an analysis of tariffs levied by the White House against As the 2017 National Security Strategy puts it, “a geopolitical Chinese goods under section 301 of the Trade Act of 1974 competition between free and repressive visions of world order revealed that of the targeted trade with China, 80 percent is taking place in the Indo-Pacific region.”145 (by value) was in industries identified as “patent-intensive” by the Department of Commerce.142 These include computer/ China’s exporting of its technology is not value-neutral. Adam Segal electronic products and machinery/equipment. Those sectors from the Council on Foreign Relations notes that “in Xi’s words, constitute about 30 percent and 22 percent of Chinese exports cyber-sovereignty represents ‘the right of individual countries to to the US, respectively.143 independently choose their own path of cyber development, model of cyber regulation and Internet public policies, and participate in One of the justifications the United States offers is that these international cyberspace governance on an equal footing.’”146 are the industries heavily targeted by Chinese efforts at forced transfers and IP theft. The US is also clearly seeking to weaken The emerging fragmentation of cyber into “two internets,” one the foundations for China’s indigenous and export dominance led by the United States and the other by China — as predicted of MIC 2025 sectors into the future. The tariffs seem designed by Google’s Eric Schmidt147 and others — is based on both not only to “target” Chinese-based firms in these high-value- the deepening strategic rivalry between the two countries and creating and patent-intensive industries; they also appear aimed the widening differences in political and moral values. Ongoing at making it less commercially attractive for foreign firms to invest efforts by the US and allies such as Australia to ban Chinese or engage in joint or cooperative ventures with local firms to firms from participating in future 5G rollouts are largely driven produce high-value-creating intermediate parts in China. These by these differences. Suspicions of the innocuous-sounding two sectors (computer/electronic products and machinery/ “Huawei cities,” which seek to offer other governments equipment) are prominent in integrated regional and global tools similar to those Beijing uses to keep the Uighurs under supply chains. Moreover, approximately one-third of all Chinese surveillance and control, are further evidence of the exporting of exports of these products to the United States is directly related Chinese values and standards — not just goods and services.148 to the business operations of US-based firms.144 In other words, around one-third of these Chinese products imported into the It is highly significant that Huawei — a Chinese “national US form part of the supply chain for US-based firms. champion” and critical firm for MIC 2025 — is leading the

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES export of this kind of technology and command systems under political economies such as those of the US and the EU, what it markets as “safe cities” platforms, ostensibly as a tool standards are usually influenced by industry bodies and of law enforcement but with obvious uses for authoritarian leading firms. regimes. The first buyers of Huawei’s safe cities products and services were authoritarian regimes including Russia, Pakistan, Note that it is not a like-for-like choice. The consequences of Venezuela, Laos, Angola, and Ethiopia.149 buying into the technological ecosystem of an authoritarian state like Xi’s China are very different from those that flow from It is important to note that technological bifurcation is both participating in the technological ecosystem of the United a driver and a consequence of supply chain and value States and other democratic partners. chain competition. The United States and China will place increasing pressure on other countries to adopt their preferred Conclusion infrastructure, platform, software, supply chain, etc., even if the There are already many precedents to indicate China’s game economic and/or transactional costs of doing so are higher. plan. In the well-known case of solar panels, government The purpose is to lock other countries into their preferred support for Chinese firms, combined with state-backed theft technological ecosystem or operating system and prevent their of intellectual property, allowed these firms to dominate global rivals from doing the same. exports at the expense of US and European firms. MIC 2025 follows the same approach: localize and indigenize R&D and This principle also applies to the setting of “standards,” which control key segments of the global supply chain; proceed have been described as the “‘connective tissue’ between with domestic substitution after reducing dependence on technology and [its use in] the market, providing specifications foreign technology; and capture dominant global market share for products, services and systems.”150 Standards can also after Chinese technology and brands are developed and be defined as the voluntary specifications that enable the entrenched.153 interoperability of products and technologies. These can be simple, such as the size of rail gauges, or complex, such as The US concern is reflected elsewhere. The European Union, those relating to the interoperability of technologies such as though reluctant to take bolder action, has similarly taken aim 5G networks. With respect to the latter, complex technical at “distortions in China’s economic system.” These include standards can involve patented technologies and the use of a Beijing’s state-driven policies like MIC 2025, preservation of company’s intellectual property, which entrenches privileges for domestic Chinese markets for “national champions,” and the firm holding the rights.151 shielding of those entities from legitimate competition. As the EU sees it, this is achieved China has taken a state-led, strategic approach in order to privilege its own firms and domestic practices, becoming through selective market opening; licensing and an increasingly effective participant in international other investment restrictions; heavy subsidies to standards-setting organizations.152 This applies to emerging both state-owned and private sector companies; technologies such as 5G and artificial intelligence. Indeed, closure of its procurement market; localisation Beijing has identified the setting of standards as a critical requirements, including for data; the favouring battleground for political and commercial advantage over of domestic operators in the protection and other advanced economies. In contrast, in liberal democratic enforcement of intellectual property rights and other

52 | HUDSON INSTITUTE domestic laws; and limiting access to government- As Beijing looks outward for new economic opportunities, funded programs for foreign companies.154 it increasingly exports its political values and standards. This is very different from the previous few decades, when buying The EU estimates these subsidies to be in the hundreds of “Made in China” did not entail the same political and moral billions of dollars.155 It also chides Beijing for creating an unlevel compromises that it does now. playing field in common export markets by offering Chinese companies “access to state backed loans and export From a global economic point of view, Chinese approaches at preferential terms and applying different corporate and labor inherently undermine what globalization and interdependence standards.” In addition, it calls out China for investments in are designed to facilitate and enhance: the maximization of many countries that efficiency and creation of new opportunity for participants based on market forces. China’s approach in the global economy frequently neglect socioeconomic and financial reflects its own political-economic setup, which is designed sustainability [and produce] high-level indebtedness to ensure that the party retains the levers of economic power and transfer of control over strategic assets and and relevance. While all governments intervene in the domestic resources. This compromises efforts to promote and global economy to some degree, the nature, scale, and good social and economic governance and, most extent of intervention by the party and Chinese state mean that fundamentally, the rule of law and human rights.156 authoritarian China plays a vastly different game from other major economies in the global system. In September 2018, trade ministers from the US, the EU, and Japan issued a joint statement criticizing such practices.157 This is the paradox of MIC 2025 and the Xi era more generally. Domestic weaknesses and vulnerabilities have caused Xi to The ramifications are immense. China is seeking to find new increase his outward ambitions. MIC 2025 is both the product of ways to grow its economy while increasing the power of the domestic Chinese economic and technological vulnerability and party and its control over the Chinese economy and society. the expression of an aspiration to future economic dominance.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES V. THE BELT AND ROAD INITIATIVE: TRANSFORMING DOMESTIC VULNERABILITY INTO GRAND STRATEGY

The Belt and Road Initiative is accurately and widely described Africa, and the Mediterranean. With respect to Europe, the as President Xi Jinping’s flagship policy and even China’s most plan is to link China with railways that go through Central Asia, ambitious comprehensive strategic and economic strategy Russia, Eastern Europe, and Spain. The Maritime Silk Road since the Deng Xiaoping period, which began in 1979. Some extends from China to Southeast Asia, the Indian Ocean, the commentators have even called it China’s version of the post– east coast of Africa, through the Suez Canal, and into the East World War Two Marshall Plan for Eurasia and the Indo-Pacific.158

Promoted to the world in economic rather than strategic terms, Photo caption: Alibaba Chairman Jack Ma and Hong Kong Chief and formally introduced by Xi in 2013, the BRI encompasses Executive Carrie Lam pose during the inauguration of the Belt and Road the “Silk Road Economic Belt” through the Eurasian continent Cross-Professional Advancement Programme on December 12, 2018 and the “Twenty-first Century Maritime Silk Road,” which links in Hong Kong. (Zhang Wei/China News Service/Visual China Group via China with Southeast Asia, Oceania, the Indian Ocean rim, Getty Images)

54 | HUDSON INSTITUTE Mediterranean Sea. Figure 28 shows the overland and maritime Figure 28: BRI Overland and Maritime Routes routes of the BRI.

In a March 2015 Chinese white paper, “Vision and Actions on Jointly Building Silk Road Economic Belt and 21st Century Maritime Silk Road,” the most comprehensive official document issued on the BRI, Beijing described the plan’s five goals as policy coordination, facilities connectivity, unimpeded trade, financial integration, and people-to-people connections.159

In practice, the BRI has no formal institutional structure or set of guidelines. In contrast to the situation with the Asian Information and Figure Source: Severine Renard, “BRI Explainer: What Infrastructure Investment Bank, a multilateral entity with is Belt and Road?” Transnational, 30 July 2019, https://transnational. live/2019/07/30/bri-explainer-what-is-the-belt-and-road/. established rules and processes, with the BRI, terms for countries and individual firms are negotiated directedly with the Chinese government, state-owned firms, or state-sanctioned firms. Memoranda of understanding between China and other Road Fund. Joint ventures with Chinese firms under the BRI countries and commercial terms between firms under the BRI banner can open up funding from Chinese financial entities banner are not generally available to the public. such as the , the , the Export-Import Bank of China, and the China Moreover, many projects involving Chinese firms in the sixty- Investment Corporation sovereign wealth fund. Funding from five or more countries within the geography of the BRIare these sources for BRI projects is frequently less restrictive in counted as BRI projects even if they were not conceived with initial phases of investment and is given on non-commercial the BRI in mind or preceded the BRI’s formal announcement. terms. Chinese firms can also gain fast-tracked financial and Claims that the project could be a $4 trillion scheme should be regulatory approvals from domestic authorities when partnering understood with the previous caveat in mind. Banks such as with foreign firms on BRI-designated projects. Morgan Stanley believe the BRI is so far a $200 billion initiative and is likely to entail investment of $1.2–$1.3 trillion by 2027.160 For our purposes, it is important to recognize that the BRI If we count all known projects that appear to be part of the BRI began as a way for China to find solutions for many of the the figure could be above $600 billion.161 In this sense, the BRI economic problems described in earlier sections. From that is both a hugely ambitious and consequential concept but a attempt to address vulnerabilities, the BRI has morphed into significantly inflated one. a grand strategic plan, but one that seeks to make a virtue out of necessity. The initiative is ambitious but also dangerously Even so, an investment gaining designation as a BRI project optimistic, based on domestic weaknesses and limitations that can be meaningful. The Chinese government has established are severely underappreciated by outsiders, and perhaps by funding mechanisms for BRI projects, including the Asian many Chinese officials as well. From this perspective, we should Infrastructure Investment Bank and the $40 billion New Silk not be blown away162 or dismissive163 of the BRI.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES External Solutions to Persistent It was only several years later that Xi latched on to the Domestic Problems BRI as his flagship foreign policy initiative, referring to itas Prima facie, there are sound economic reasons for the BRI the “Project of the Century.”165 The point is that while the that are strategically neutral or else benign. In reality, they are BRI has some genuinely profound strategic objectives largely the result of the persistent lack of reform in the Chinese and ramifications, it began as a policy framework to relieve domestic political economy, and the BRI’s origins are better pressure resulting from some serious domestic economic understood as a creative way for China to find external avenues problems. of economic growth and opportunity while resisting reforms that would lessen the party’s role and that of state-controlled firms in First, China’s model of capital-intensive growth, which the domestic economy. accelerated after 2008, was becoming more and more inefficient with rising domestic intolerance toward effects such When the BRI was launched in 2013, it described as pollution. There was worsening overcapacity in all major cooperation in five areas: 1. coordinating development hard industrial products and commodities, such as steel, policies, 2. forging infrastructure and facilities networks, 3. cement, and industrial glass. Beijing needed to locate or create strengthening investment and trade relations, 4. enhancing external markets in these capital-intensive sectors for Chinese financial cooperation, and 5. deepening social and cultural firms, many of which were state controlled. The higher priority exchanges. That same year, the party’s Central Economic was to ensure the medium-term viability of struggling or loss- Work Conference treated it as a platform for new thinking on making state-controlled firms through other means and not Chinese development and outbound investment.164 simply to close them.

Figure 29: Fixed-Asset Chinese Investment by Firm Type in Select Industries

Information Source: National Bureau of Statistics; The Economist Intelligence Unit. Figure Source: “Are State-Owned Enterprises Reformable?” Economist, 18 December 2018, http://country.eiu.com/article.aspx?articleid=1697451553&Country=China&topic=Economy.

56 | HUDSON INSTITUTE Figure 30: Percentage of Chinese Exports to BRI Partners

Information and Figure Source: C. Constantinescu and M. Ruta, “How Old Is the Belt and Road Initiative? Long-Term Patterns of Chinese Exports to BRI Economies,” World Bank MTI Practice Note 6, 2018, http://documents.worldbank.org/curated/en/984921545241288569/How-Old-is-the- Belt-and-Road-Initiative-Long-Term-Patterns-of-Chinese-Exports-to-BRI-Economies.

Figure 29 shows the share of fixed-asset investment by state- The leading sectors for BRI-denominated projects include owned, private, and foreign entities in a selection of industries transportation, energy, shipping, mining and minerals, in 2017. petrochemicals, real estate, telecommunications, and agriculture.166 These are All sectors with a dominant or heavy In this sense, the much-talked-about “rebalancing” of state-controlled element with respect to Chinese firms. the Chinese economy was not just a domestic economic matter. Domestically, the rebalancing was about greater Second, and this is related to the first point, Chinese industry reliance on consumption over fixed investment (and and manufacturing are still suffering from a confluence of several net exports). Externally, the emphasis came to be on negative trends. The so-called demographic dividend is well outbound investment as a source of revenue, profits, and past. This refers to the tens of low paid but hard-working millions growth. This could be achieved only through increasing of rural workers moving into urban regions with many of them aggregate demand in investment and export markets that benefitting from the export-manufacturing sector.167 That dynamic suited China’s state-controlled firms. Figure 30 shows the led to gains in productivity without rapid increases in wages and percentage of Chinese exports going to the economies of BRI gave China a huge advantage in labour-intensive industries such partners. as traditional manufacturing. China’s comparative advantage in labour-intensive production peaked in the middle of the previous In 2015, outbound investment exceeded inbound investment decade.168Additionally, China’s aging demographics mean that into China for the first time since the reform period in 1978. the working population has been growing at ever-decreasing

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 31: Source of Electronic Exports within the Asia 16

Information Source: International Trade Centre. Figure Source: “Rapid Development of Asia’s Electronics Supply Chain,” HKTDC Research, 10 October 2017, https://hkmb.hktdc.com/en/1X0ABJSN/hktdc-research/Rapid-Development-of-Asia%E2%80%99s-Electronics-Supply-Chain.

rates, with 2015 marking the year when more workers were Note that China was already capturing a significant share of leaving the workforce than entering it. This scarcity of labor regional supply chains in the production of exported goods. placed further upward pressure on wages.169 The case of electronics, the single biggest category in regional trade, is instructive. By 2015, the value of Chinese electronics The point is that China needed a new model for export-led output was over $700 billion, about 38 percent of global output. growth to drive industrial activity and growth that was not based Beijing’s aim is to extend its dominance at medium- and high- on comparatively low labor costs. MIC 2025 identifies the high- value-added levels in the supply chain of exported goods, from value industries that will become more important in the future. contemporary electronics to the MIC 2025 industries. BRI complements this by providing the infrastructure, finance, logistics, and agreements required between China and regional Figure 31 shows the percentage of exports of electronics within trading partners to lay the foundations for industrial activity and the Asia 16 economies: 10 ASEAN countries, China, Hong a new era of export-led growth. Kong, Japan, Taiwan, South Korea, and India, 2001–16.

58 | HUDSON INSTITUTE Figure 32: Share of Chinese Goods in Trade with BRI Economies

Information Source: IMF Direction of Trade Statistics. Figure Source: China’s Belt and Road Initiative in the Global Trade, Investment and Finance Landscape (Paris: OECD Business and Finance Outlook, 2018), https://www.oecd.org/finance/Chinas-Belt-and-Road-Initiative-in-the-global-trade- investment-and-finance-landscape.pdf.

Note: For each region, the rest (up to 100 percent) is accounted for by non-Belt and Road corridor economies. Corridor economies in Sub- Saharan Africa include only Kenya and Tanzania.

While the BRI does not include the United States, it does extend In fact, China’s trade balance with BRI countries has been as far as Europe. Beijing intends to create and capture dominant in surplus since 2014. It is early days, and the results could shares of the export markets in low-, medium-, and high- be as much about Chinese success in vertical integration of value-added export sectors based on the economic needs of manufacturing supply chains as they are about the success countries along the BRI: from developing economies in Central of specific BRI policies. Nevertheless, Chinese exports to and Southeast Asia and Africa to the advanced economies in the overwhelming majority of BRI countries have increased Western Europe. significantly since around the time the initiative became policy.170

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 33: China’s Trade Balance entities impartially chasing more profits and better returns. with BRI Economies, 2010–18 Instead, it believes that Chinese financial institutions ought to Billion USD advance national objectives even as they seek out opportunities. The BRI allows these institutions to offer development finance options that are negotiated with individual BRI countries and participating firms. From that perspective, Beijing retains a degree of control even as Chinese financial institutions gradually creep outwards into foreign markets.

With respect to the RMB, it is neither free-floating nor freely convertible. This continues to place severe limits on the extent to which it can become a “store of value” and therefore a genuine reserve international currency.171 The latter allows countries Information Source: State Information Centre, Standard Chartered such as the United States the “exorbitant privilege” of reduced Research. Figure Source: Colby Smith, “Pakistan’s IMF Bailout Adds borrowing costs, given the enduring demand for US dollars. to Belt and Road Woes,” Financial Times Alphaville, 12 October 2018, https://ftalphaville.ft.com/2018/10/12/1539316801000/Pakistan-s- Moreover, although commitment to a “managed currency” IMF-bailout-adds-to-Belt-and-Road-woes/. offers China some measure of currency stability and protection against the destabilizing effects of “currency speculators,” it also means Beijing effectively outsources the value of its currency to Figure 32 shows the share of Chinese goods in overall trade other countries—and to the US most of all. figures for BRI economies in 2000, compared to 2017. Given that Beijing will continue to resist opening its capital Figure 33 shows China’s trade balance with BRI countries, account and freely floating the RMB, there are limitations which has been in surplus since 2014. to how much it can be internationalized, even though internationalization would bring considerable benefits to China: Third, the BRI allows China to bilaterally adjust its financial reduced transaction costs if trade is performed in RMB rather interactions with BRI countries in a manner and at a pace that than US dollars or another currency; greater control over the suit it. This Beijing achieves by negotiating financing terms on value of the currency; and greater leverage over and relevance a project-by-project basis, without having to meet the normal to foreign entities and governments holding RMB as a “store standards demanded by institutions and governments from of value.”172 particularly advanced economies. However, the BRI will promote greater use of RMB for various The financing of BRI projects also allows China to oversee the purposes: for settling trade, conducting investment within the gradual internationalization of its financial sector and the RMB BRI platform or agreement, and for RMB-denominated bonds without excessive exposure to open financial and currency issued as part of BRI financing packages.173 These include markets that could create the instability and unpredictability it BRI-specific domestic bonds; “Panda” bonds in RMB, issued loathes. Beijing rejects the model that its financial institutions by international companies inside BRI corridors or by foreign ought to participate in the global economy as independent firms for specific BRI projects and sold to the domestic market;

60 | HUDSON INSTITUTE Figure 34: Income Spread between Chinese Provinces and Regions

Information and Figure Source: Salvatore Babones, “China Quietly Releases 2017 Provincial GDP Figures,” Forbes, 12 February 2018, https:// www.forbes.com/sites/salvatorebabones/2018/02/12/china-quietly-releases-2017-provincial-gdp-figures/#1df16b4420dc.

and “dim sum” bonds, issued by Chinese and international swap agreements, which in turn helped to deepen trade and companies in Hong Kong but denominated in RMB. economic integration between them and China by a statistically significant 30 percent.174 This is already occurring with numerous developing countries participating in the BRI. For example, China’s banks have It is worth noting that investment by Chinese entities in the become important foreign creditors for many countries in BRI offers the prospect of better return for passive or “parked” Southeast Asia and Africa. In April 2017, the RMB was used for Chinese capital compared to bonds with yields that are the first time as a currency of bond issuance in Africa. In that low or negative (in real terms), such as US Treasury bonds. same year, more than one-third of BRI countries signed bilateral Additionally, framing BRI projects as being between China and

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 35: BRI Land Corridors

Information Source: Hong Kong Trade Development Council, Nomura Global Economics. Figure Source: “The Belt and Road Initiative: Globalization, Chinese Style,” Nomura Report, April 2018, https://www.nomuraconnects.com/focused-thinking-posts/the-belt-and-road-initiative- globalisation-china-style/.

the partner country will create new opportunities for Chinese and the Baltic Sea”; investing in cross-border transportation firms engaged in related services such as cross-border infrastructure and a transportation network connecting East Asia, e-commerce, real estate, tourism, banking, and legal and other West Asia, and South Asia; and promoting “unimpeded trade” professional services. by removing trade barriers and reducing the costs of inter-border trade. Figure 34 shows the income spread or disparity between Fourth, it is highly significant that the contemporary roots of the different provinces and regions in China. BRI can be traced to a September 2013 speech by Xi delivered at Nazarbayev University in Astana, Kazakhstan.175 In that speech, The issue is the persistent disparity in wealth (absolute and per Xi mentioned the “ancient Silk Road” and the singular importance capita) between the eastern coastal provinces and the central, of Central Asian countries to China, arguing that China and these southwestern, and western regions. Beijing has had a “western countries, to lay the foundations for a “new golden age,” should development strategy” since 1999, aimed at invigorating the “take an innovative approach and jointly build an ‘economic belt economies in the dozen or so provinces that did not benefit along the Silk Road.’” This entailed improving road connections from the era of opening up and export-oriented growth and have to create a “major transportation route connecting the Pacific been left behind economically.176 Despite massive injections

62 | HUDSON INSTITUTE of funds into the fiscal budgets of these regions’ provincial of oil while avoiding the Malacca Straits and the maritime governments, enormous capital made available to mainly state- routes in Southeast Asia. However, it must still successfully controlled entities in these regions, and other preferential tax negotiate a path through disputed territory between India and regulatory policies, the results have been disappointing. and Pakistan. In fact, these state-directed policies have tended to crowd out the private sector even more than in other parts of China, with The New Eurasia Land Bridge consists mainly of an extensive Xinjiang, Tibet, Qinghai, and Gansu scoring particularly poorly railway line from Lianyungang in Jiangsu Province through on measures of private sector activity.177 Alashankou in Xinjiang to Rotterdam in Holland. The sections in China include the Lanzhou-Lianyungang railway and the In this context, the BRI was initially seen as one way to create Lanzhou-Xinjiang railway, which passes through eastern, bourgeoning, self-sustaining opportunities for these provinces central, and . From there, the railway line passes through economic partnerships with countries in Central and through Kazakhstan, Russia, Belarus, and Poland and into Southeast Asia. The idea was to build platforms, regimes, and coastal ports in Europe. To enable China’s western regions infrastructure that will facilitate trade, investment, and other to benefit from the New Eurasia Land Bridge, Beijing has economically beneficial exchanges between the poorer Chinese invested in an international freight rail route linking provinces and countries such as Kazakhstan, Pakistan, to Duisburg (Germany); a direct freight train running between and Myanmar.178 and Pardubice (Czech Republic); a freight rail route from to Lodz (Poland); and a freight rail route from This largely explains the thinking behind the formation of various Zhengzhou in Henan province to Hamburg (Germany). All these BRI “economic corridors” in the region. Examples include rail routes offer rail-to-rail freight transport as well as expedited the China-Pakistan Economic Corridor (CPEC), Bangladesh- cargo inspection processes. China-India-Myanmar Economic Corridor (BCIMEC), China- Indo-China Economic Corridor, and New Eurasia Land Bridge The China-Indo-China Economic Corridor connects Southeast Economic Corridor. Asian capitals such as Singapore, Kuala Lumpur, Bangkok, Phnom Penh, Ho Chi Minh City, Vientiane, and Hanoi with Most of the Chinese funds invested in CPEC—over $50 Nanning in the Guangxi region. The network is not new; it is billion—are being spent on building and updating the overland an enhancement of networks developed as part of the earlier connections between Xinjiang and the Arabian Sea across Greater Mekong Sub-region initiatives. the Himalayas. This includes a road network extending about 3,000 kilometers, the port of Gwandar in Pakistan, and a The proposed BCIMEC has been hobbled by persistent rail and oil pipeline between China and Pakistan. CPEC is objections from India.179 It is envisaged as an expressway and complemented by a substantial bilateral trade agreement high-speed rail links between Kunming in Yunnan Province between the two countries. and Kolkata in India via Mandalay in Myanmar and Dhaka in Bangladesh. Meanwhile, China, India, Myanmar, and This corridor is part of a vision to enhance connectivity Bangladesh have also agreed to build airways and waterways between China’s western regions and countries such as Iran, connecting each other as well as power transmission lines Afghanistan, and the Central Asia Republics (India is not a and oil pipelines. A combined market of over 400 million BRI partner). CPEC is designed to enable Chinese imports people has encouraged Chinese manufacturing firms to

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES move further west in attempts to access the Indian and Figure 36: Expected Loss in Net Profit Myanmar consumer markets.180 from Social Insurance Collection

Previously, a high percentage of goods produced in China for export left the country through ports on the eastern coast. The corridors described above are designed to create the infrastructure and markets to export Chinese goods through road and rail networks in central and western China. The vision is twofold: 1. to create new hubs of export-manufacturing and export services in central and western China, and 2. to Information Source: Credit Lyonnais Securities Asia. Figure Source: develop, grow, and capture new consumer markets in Central Anjani Trivedi, “China’s Racing to the Top in Income Inequality,” Bloomberg, 23 September, 2018, https://www.bloomberg.com/ Asia and Southeast Asia for Chinese firms. The success of that opinion/articles/2018-09-23/china-s-racing-to-the-top-in-income- vision also depends on the rapid liberalization of labor mobility, inequality. as much of the current expertise in export manufacturing and services remains in the eastern provinces.181 This liberalization has yet to occur. Indeed, if the investment going into BRI offering largesse and privileges to these firms is only making the infrastructure within China fails, then the efforts could resemble situation worse. previous extravagant capital expenditure programs in central and western China, which worsened the debt situation without All companies are also obligated to contribute to social adequate countervailing benefits. insurance, which covers employee pensions, medical funds, unemployment safety nets, maternity leave, and work injuries. Finally, there are enormous fiscal impacts riding on blueprints The idea is to offer relief from the inadequate fiscal budgets of such as the BRI and MIC 2025. Under a series of reforms since local governments. In practice, compliance is piecemeal and 2007, state-controlled firms are required to transfer profits (in unpredictable due to poor enforcement and/or companies’ the form of dividends) into a state capital management budget inability to meet these obligations.184 Beijing is determined to (SCMP) account, which will eventually be integrated into the lower social insurance obligations but ensure much more strict general central government budget. Although the government and thorough enforcement. Firms in sectors such as telecoms, passed a directive in 2013 stating that a dividend ratio of 30 machinery production, computers, military applications, and percent was to be paid into the SCMP, the figure has remained electronic equipment will likely suffer the biggest hit to their a little over 20 percent.182 The economic slowdown has profits if these reforms occur.185 made Beijing reluctant to lean too heavily on state-controlled enterprises. These are the same sectors highly valued by Beijing for reasons of strategic and national interest. The only solution is to seek In this context, stable and growing profits for state-controlled new avenues for increased profit outside China. firms are essential, particularly in the poorer western regions. Firms in the three poorer provinces—Xinjiang, Shanxi, and Figure 36 shows the expected loss in net profit for firms in Qinghai—rank among the top five in the three indicators of debt select industries from planned social insurance collection to revenues, leverage, and debt service burden.183 Continually in China.

64 | HUDSON INSTITUTE If there are any doubts that the BRI is a Chinese-centered plan Furthermore, with respect to BRI activities in Europe, it is clear to export excess capacity and capture export markets, let us that the MIC 2025 blueprint (and other industrial policies) are look at the numbers. According to the CSIS Reconnecting Asia fundamentally mercantilist, designed to enhance Chinese self- database, 89 percent of contractors participating in Chinese- sufficiency in important strategic sectors and secure Chinese funded projects are Chinese. 186 Only 7.6 percent are from export dominance in international markets in these sectors. BRI the country where the project is taking place, and 3.4 percent corridors and networks promise to enhance the flow of goods, are non-Chinese foreign companies. In projects funded by services, and information between China and BRI countries multilateral development banks, 29 percent of contractors are and in doing so, facilitate Chinese economic and industrial Chinese, 41 percent are local firms, and 30 percent are non- dominance. It is significant that China is promoting increased Chinese foreign firms. Port investments and upgrades involve connectivity without undertaking significant domestic measures finance, design, construction, and servicing, all activities that to remove what the EU terms “significant market distortions.” Chinese firms provide at lower prices, given the domestic This includes CCP control over the financial system and policies advantages and assistance Beijing provides them. Indeed, offering preferential treatment for domestic companies. Chinese infrastructure financing for BRI projects offered by China businesses in BRI-related sectors receive land at artificially low is frequently tied to exclusive procurement agreements for prices, access to cheap energy, preferential access to capital, Chinese firms.187 suppressed borrowing costs, and beneficial pricing for raw materials and commodities. There is also growing discomfort within host countries with the close connection between the funding arrangements of Chinese Foreign investment in the most important and lucrative sectors firms and government-controlled financial entities. A case in of the Chinese economy is heavily restricted, and entry is via point is China COSCO Shipping Corporation, which in 2017 joint ventures—which leads to the new problem of large-scale, received over $26 billion from the China Development Bank to state-sponsored theft of intellectual property and trade secrets. In invest in BRI-sanctioned projects. These firms are given loose addition to China’s still-closed capital account and discriminatory lines of credit to advance government policies and not just to regulatory and antitrust laws, it is extremely difficult for foreign firms maximize their commercial success. A counter-argument is that to gain permanent and meaningful footholds to thrive in Chinese well-regulated economies such as those in Europe can dictate industrial and consumption sectors—while China is laying the the laws and regulations that apply to assets in their sovereign groundwork for even greater access to European markets. territories, but such assets can likely be used to benefit the Chinese economy disproportionately. Indeed, Beijing has not made a convincing case that improved networks throughout Eurasia exist to spread the opportunity of For example, COSCO Shipping’s investment in, and control of, globalization and share the spoils of greater economic integration the Greek mean the port will cooperate with evenly.188 The BRI and Beijing’s interest in assets such as ports Chinese ports to boost synergies. This is evidenced by a June remain China-centric. China is paving the way to sell and buy what 2017 agreement with Shanghai International Port Group to it wants according to economic and strategic policies produced by cooperate in project planning, staff training, and information the CCP. When Chinese firms negotiate opaque deals with Asian, exchange. As a complement to the Chinese purchase of Piraeus, African, and European countries, they begin with the largesse and Chinese banks provided loans to Greek shipping companies to non-commercial advantages that come from state assistance. In build additional commercial vessels in Chinese shipyards. other words, the exchange is rigged from the start.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES From Extracting Economic Rents to Port have forced the country into a $1.1 billion debt-for-equity Grand Strategy swap with China, giving Beijing long-term control of a military- China’s official Blue Book of Non-Traditional Security (2014–15) capable port and considerable leverage over Colombo’s foreign states that two of the purposes of the BRI are to mitigate US- policy. Over the past five years, China has invested over $5 led geopolitical machinations and ideas and promote a new billion in Cambodia, a sum equivalent to about one-quarter of international system of discourse and order that enhances the country’s GDP, in return for Phnom Penh’s pushing Chinese China’s national and soft power. While the BRI came about interests in organizations such as the Association of Southeast largely as a result of domestic vulnerabilities and is implemented Asian Nations. This investment includes 100 percent ownership opportunistically by many domestic entities (with disparate of the Koh Kong New Port in Cambodia, and according to media objectives) and in a fragmented manner, it is also clear that reports, Beijing has signed a secret agreement to construct a Xi has seized on it as a framework for an outward-focused military port there.191 Like Pakistan and Sri Lanka, Cambodia “grand strategy.” That must be taken seriously and has several cannot change course while it is caught in a Chinese-created manifestations and approaches. “debt trap.”192 A similar dynamic is occurring in the South Pacific.193

Strategic Support States It is more difficult for China to purchase direct influence in Investment in BRI projects should be considered in the context economies such as those in the EU, given that many European of the concept of ‘strategic support states’ which came to countries are better able to access diverse sources of capital prominence amongst Chinese strategists earlier this decade. In and economic opportunity, and given the presence of robust a 2015 consensus of fifty Chinese scholars on China’s ‘periphery liberal-democratic institutions that are more difficult to corrupt. diplomacy in the Xi Jinping era’, a ‘strategic support states’ is Even so, there have been opportunities. Greece, unlike other achieved through regional cooperation and providing economic Western European countries, has openly welcomed Chinese and public goods as China expands westward. According to investment, and in 2017 then prime minister Alexis Tsipras one extensive analysis, one of the principles of cultivating a boasted of China’s investment in the port of Piraeus as the ‘strategic support state’ is ensuring “China has the ability and opening for “China’s gateway into Europe.” In 2017, Greece resources to guide the actions of the country so that they fit into blocked an EU statement to the UN Human Rights Council on [China’s] strategic needs.”189 Chinese human rights violations, which a Greek official called “unconstructive criticism of China.” This marked the first time There is ample evidence to suggest that this is not abstract the EU has failed to make a statement to the UNHRC.194 strategizing by academic thinkers. Another case is that of Hungary, which is seeking to position itself A study published in March 2018 found that one-third of sixty- as Eastern Europe’s “gateway to China”—and receiving Chinese eight economies receiving BRI loans are “significantly or highly BRI-linked investment, including for the $3 billion Hungary-Serbia vulnerable to debt distress.”190 In Pakistan, enormous Chinese railway project, which would connect the Chinese-run port of investments, like those in the Port of Gwandar, have given the Piraeus with the European heartland. Realizing that political economy an instant sugar hit but have burdened the country with obeisance is one pathway to receiving immediate financial debt that it cannot repay and turned it into a long-term Chinese largesse, Hungary has emerged as China’s most enthusiastic client state. A similar situation is occurring in Sri Lanka, where spokesperson in Eastern Europe. For example, Budapest has unprofitable and debt-heavy projects such as the Hambantota strongly argued that the EU should grant China’s economy

66 | HUDSON INSTITUTE “market status.” In 2017, Hungary derailed an EU consensus nine-year lease of the Port of Koper. In 2018, in spite of raised when it refused to sign a joint letter denouncing China’s torture eyebrows in Western European countries, China and Slovenia of detained lawyers. Both Hungary and Greece remain unwilling signed a memorandum of understanding on cooperation in to criticize Chinese actions in the Sea, thereby transport and infrastructure that focused on integrating sea preventing the EU from presenting a unified voice on this issue. transport with the development of railways, motorways, and logistics as part of the BRI concept. This includes a cooperative The point here is not Chinese investments per se, which are of agreement between the Port of Koper and China’s Port of concern, but China’s tendency to link investment with political Ningbo-Zhoushan to increase trade between China and the demands and expectations. This applies regardless of whether CEE economies. such investment is BRI designated or not. However, BRI projects have become the sweetener for countries desperately Although the CEE Fund is underperforming because of a needing an injection of capital and economic activity when they lack of confirmed funding and agreed projects, it indicates are not pouring in from other sources. For this reason, Italy’s China’s intention to circumvent EU rules and standards or March 2019 signing of a memorandum of understanding with undermine broad support for these rules and standards by China to officially join the BRI is cause for concern.195 For less getting potentially recalcitrant EU members such as Greece economically competitive and less commercially attractive and Hungary on side. Serbia, a likely future EU member, has European countries like Greece and Hungary, dependence on accepted large amounts of Chinese capital, and in return is Chinese capital can be subsequently used to create significant supportive of China’s stance on issues such as Taiwan, the pressure on governments to alter policies so that they favor South China Sea, and human rights in Tibet and Xinjiang. Chinese interests. Once again, in this context, it is not the investment in port or other facilities per se that is of concern, but China’s use Europe is also instructive in that China has used the lure of of big spending promises to alter established EU norms and enormous infrastructure investments, including development of commercial standards for investment. Greek ports, as an economic development gateway into the Balkans to divide and conquer the EU. The main mechanism A New Approach to Authoritarian Promotion is the China-initiated 16+1 grouping, which includes sixteen When it comes to authoritarian strategic objectives and Central and Eastern European states, eleven of which are EU policy implementation, the BRI fuses economic partnership members, plus China. In late 2016, China announced it had and opportunity with developmental assistance and political established a $11.1 billion Central and Eastern European (CEE) support: BRI countries and projects are inherently drawn into a Fund to finance projects in the group-of-sixteen economies to world of Beijing’s desire and making. support the BRI. An ulterior motive is to create an economic investment zone that will decide on investments according to The previous section looked at China’s use of BRI to create China’s rules and processes, rather than the more stringent and nurture strategic support states. That must be considered and transparent EU standards preferred by Western European alongside China’s emergence as a major provider of states such as France and Germany. development assistance and non-concessional loans, to the tune of almost $230 billion between 2009–14,196 compared Consider the case of Slovenia, which was promised a $1.5 to just under $69 billion from 2000–08.197 It is obvious that billion financing package for a railway in exchange for a ninety- autocratic regimes are overrepresented. For example,

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES from 2009–14, six of the top ten recipients of development Importantly, China has abandoned the model in use since Deng assistance were dictatorships, and three were countries Xiaoping of “hiding strength and biding time.” According to Xi, where authoritarian regimes controlled and dominated formal as China becomes a leading global power from 2035 onward, electoral processes and outcomes.198 With respect to the top the Chinese people will enjoy the “common property” of the ten recipients of concessional loans, half were dictatorships international system. Xi has also stated that “the Chinese nation and three were dominant authoritarian regimes thriving will stand with a more high-spirited image in the family of nations” in countries with formal electoral institutions. Only two — and “socialism with Chinese characteristics” is a “new choice” Ecuador and Brazil — were democracies.199 for other developing nations seeking to grow economically while maintaining their independence.”203 Bear in mind that Chinese economic assistance usually does not include demands for good governance, respect for human As the previous section argues, China is not just promoting rights, and relevant economic reforms, which are characteristic authoritarian values, but teaching tactics for repression and of assistance by organizations such as the International exporting apparatuses used for domestic coercion to willing Monetary Fund and World Bank. Beijing justifies this as being authoritarian clients.204 It has gone beyond forcing foreign firms consistent with its stated principle of “non-interference in the to agree to its restrictive internet and social media standards internal affairs of other states.” Instead, it offers support and to championing its standard of “internet sovereignty,” which cover for regimes to insulate themselves from reform pressures. gives every government the right to regulate online information Examples of this have been documented with Chinese and rejects a universal freedom of information standard.205 In investment and assistance to countries in Asia, Africa, and the the United Nations, China promotes the innocuous-sounding Middle East.200 “community of shared future for human beings” or “community of common destiny” as an alternative to the notion of universal This must be placed in the broader context of a Chinese-led human rights. The former concept is based on the right of each authoritarian revival and promotion currently taking place. On country to interpret what “human rights” actually means, and the day of President Trump’s inauguration, the Chinese state- insists that other countries should respect and accept that owned newspaper People’s Daily devoted an entire page human rights will have different meanings for each country.206 to editorials criticizing Western democracies as chaotic and Perhaps most concerning is China’s increased willingness suffering from “social crises.” They claimed that democracy had to interfere in, and covertly influence, the domestic decision- “reached its limits” and contrasted it unfavorably with China’s making institutions and debates in democratic nations. This one-party system, which, they said, offered stability, social includes the promotion of Chinese authoritarian values.207 harmony, competent policymaking and implementation, and economic progress.201 Xi, in announcing that he had abolished Proponents of this model in China and elsewhere begin from presidential term limits during the Nineteenth Congress of the position that any political system ought to be assessed the CCP in October 2017, declared that China is moving to according to practical outcomes, and that there is no intrinsic “center stage” and that its authoritarian model “offers an option value to liberal-democratic systems that emphasize individual for other countries and nations who want to speed up their rights and freedoms without regard to the consequences. China development while preserving their independence; and it offers argues that it has resolved the alleged contradiction between Chinese wisdom and a Chinese approach to solving problems the subordination of individual rights and freedoms to one- facing mankind.”202 party rule, on the one hand, and positive social and economic

68 | HUDSON INSTITUTE outcomes, on the other—a contradiction the Communist China’s Comprehensive Approach to Pre-Determine regimes of the Cold War failed to address. As Xi argues, the the Rules and Outcome of Competition CCP is meeting the basic needs of over one billion people, and While the BRI is as much a vision or aspiration for what China its authoritarian system has made it possible for people to live wants to create as a framework for policy and action, we dismiss fulfilling and materially better lives.208 it at our peril. It might have arisen out of a desire to adapt to domestic vulnerabilities without the need for genuine reform. This is a compelling message in an Indo-Pacific region But it represents a fusing of strategic, political, economic, and where the overwhelming majority of countries are developing diplomatic goals throughout Eurasia and the Indo-Pacific on a economies that have yet to fully industrialize. Only Japan, South grand scale. It supports and integrates the Communist Party’s Korea, Singapore, Taiwan, Australia, and New Zealand can be objectives in the following ways. considered fully industrialized. The rest are straining to become middle-income economies, while only a small number of the First, it dilutes even further the distinction between public and others, such as Malaysia and Thailand, are seeking to break out private economic activity and enterprises. Chinese public and of the so-called middle-income trap. private firms are obligated to advance the objectives of the Communist Party and Chinese state. They do that through It is also true that authoritarian systems such as China’s acquiring and/or developing innovations and technologies have demonstrated an impressive capacity to generate rapid using legitimate and illegitimate means, assisting each economic growth through the forced mobilization of capital, land, other to crowd out and prevail over foreign competition, and even labor—if only at the earlier stages of development. This creating markets and infrastructure that privilege Chinese leads to the narrative that autocratic competence is outstripping firms and the Chinese market, and assisting each other to democratic dysfunction. An editorial in China’s state-owned prevail over foreign competition. The framework allows (or Xinhua argues that “endless political backbiting, bickering and in some instances forces) Chinese firms to coordinate and/ policy reversals, which make the hallmarks of liberal democracy, or merge their R&D resources to advance state objectives. have retarded economic and social progress and ignored the This takes the long-standing “going out” or “going global” interests of most citizens,” and that they constitute the “crisis directive to a different level, with profound strategic and chaos swamp[ing] Western liberal democracy.”209 In consequences.211 contrast, China actively promotes its authoritarian model as one that is politically stable, technically superior, and better able to These approaches inherently undermine what globalization pursue sensible policies in a consistent manner.210 and interdependence are designed to facilitate and enhance: the maximization of efficiency and creation of new opportunity These messages are effective because achieving “order” for participants based on market forces. China’s BRI blueprint and “development” rather than guaranteeing “justice” for the reflects its own political-economic setup, which is designed individual remains highly valued in the region. In this context, the to ensure that the party retains the levers of economic power BRI is promoted as China’s grand plan for the region—not just and relevance. While all governments intervene in the domestic to advance economic development, but to reframe and reset and global economy to some degree, the nature, scale, and objectives, policies, and standards in a manner that places extent of intervention by the party and Chinese state mean that China as primary creator and guardian of progress in a non-US- authoritarian China plays a vastly different game from other centric Indo-Pacific region. major economies in the global system.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES Figure 37: China Global Investment by Sector, BRI framework. Chinese firms have installed significant mobile 2005–13 versus 2014–18 and digital networks in around forty countries, most of which are BRI countries.217 Vertically integrated companies such as Huawei are able to deliver far more complete “packages” that bundle together hardware and software for the entire platform or facility; all relevant standards (which suit Huawei and other Chinese firms); the labor and expertise to build and sustain these platforms; and even relevant regulations and legislation for the foreign client nation to get the platform up and running in a manner that suits the authoritarian tendencies of client regimes.218 Where the Chinese firm does not have the expertise or capability, Beijing will ensure that other Chinese firms are included in the package if this advances the objectives of the BRI.

Information Source: American Enterprise Institute, China Global Figure 37 shows changes in China’s global investment in Investment Tracker Database. Figure Source: OECD Business and different sectors from 2005–13 versus 2014–18. Finance Outlook 2018 (Paris: OECD, 2018), https://www.oecd-ilibrary. org/finance-and-investment/oecd-business-and-finance-outlook- 2018_9789264298828-en. The greater prominence of MIC 2025 in achieving broader objectives is clear when we look at the changes in foreign direct investment (FDI) by Chinese firms. Roughly two-thirds of For example, a recent survey of the largest ninety-eight companies Chinese FDI is taken by state-controlled firms or else “national in China revealed that fewer than one-quarter were privately champions” such as Huawei.219 From 2018 onwards, there have owned.212 In all state-owned firms, the CCP has a significant, if not been significant increases in FDI (mainly by state-controlled decisive, say in major corporate decisions and senior managerial firms and “national champions”) in the technology, healthcare, appointments.213 Even for private firms, the Company Law of the agriculture, and logistics sectors. People’s Republic of China stipulates the establishment of party committees in all commercial entities “to carry out the activities In the chart above, many of the sectors in the increase in the of the party in accordance with the charter of the Communist “Other” category coincide with MIC 2025. This is consistent Party of China.”214 Similarly, the 2017 National Intelligence Law with both MIC 2025 goals and broader BRI objectives using demands that “any organization and citizen shall … support, well-practiced comprehensive approaches: offering favorable provide assistance, and cooperate in national intelligence work, access to capital for acquisitions in technology; investing and guard the secrecy of any national intelligence work that they in joint ventures and/or buying companies in advanced are aware of.”215 The poor separation of political and economic economies; giving preferential treatment for high-technology agencies allows the party-state to blatantly manipulate markets imports (while protecting local innovation); helping facilitate and distort competition to achieve the party’s goals.216 lower technology and spare capacity transfer to BRI- participating economies; and promoting Chinese technology Second, it is important to understand the implications of standards within the BRI-participating economies to help blueprints such as MIC 2025 being integrated into the broader open up markets for China’s products.220

70 | HUDSON INSTITUTE At this point, it is instructive to contrast the original Trans- on Chinese takeovers of German firms or on German firms Pacific Partnership (now the Comprehensive and Progressive engaging in joint ventures with Chinese firms even when there Agreement for Trans-Pacific Partnership, which excludes the US) are strategic consequences in doing so.223 with the BRI. The CPTPP, which is based largely on the TPP, is designed to shape the rules and standards for how nations and It is this lack of policy agreement and the slowness of European firms compete.221 This applies to at-the-border and behind-the- countries in coming to agreement that Beijing will seek to exploit. border barriers as well as labor and environmental standards, While there is a lack of coordination between the US and allies investment rules, the role of state-controlled enterprises, and on industrial policy, China will continue to benefit from foreign intellectual property rights. The idea behind the TPP was to use technologies in dual-used sectors such as semiconductors, the size and attractiveness of the US domestic market especially artificial intelligence, quantum applications, and biotech. to persuade members to sign on and abide by these rules, and eventually to persuade non-members such as China to agree to Moreover, the digital silk road has direct military implications. the provisions in order to join the economic regime. Chinese-led submarine cable projects, which were 20 percent of global undersea cable projects between 2016–19, compared From this perspective, it was not about privileging US firms or to 7 percent from 2012–15, are directly boosting Beijing’s allowing them to extract economic rents from their position of intelligence and anti-submarine capabilities. BRI projects power. Instead, it was an attempt to define “fair” competition are increasing the export and upgrade of BeiDou, a satellite and economic activity rather than a plan to permanently exclude navigation system, which allows a shift away from reliance on China from the economic grouping. US GPS capability.224

This is unlike the BRI and MIC 2025, which are inherently China- Bear in mind that MIC 2025 and aspects of the BRI are merely centric blueprints designed to ensure Chinese entities remain the the outward-facing or export-oriented part of broader plans to primary and permanent beneficiaries. In that sense, it is about upgrade China’s domestic industrial base, including for military China seeking to build a hierarchical economic order, with Beijing purposes. China’s earlier National Medium- and Long-Term able to arbitrarily offer and retract opportunity for political and Plan for the Development of Science and Technology (2006–20) strategic reasons. This should not be surprising, as that is simply directs the domestic private and state-controlled industrial base the regional vision based on the domestic setup within China. to “digest and absorb advanced technology, conquer critical technologies bearing on the national strategic interest, [and] Third, the BRI (and blueprints such as MIC 2025 and Internet develop major equipment and critical products that harness Plus) have significant implications for the enhancement of China’s independent knowledge,” while urging the economy to expand military-industrial capabilities. For a start, the BRI has been used as international R&D cooperation.225 a carrot to persuade the EU to lift its post-Tiananmen embargo on exports of military hardware—so far with little success. While the The process to fast-track innovation is to ‘introduce, digest, absorb EU is beginning to view China as an authoritarian “technological and re-innovate’ (IDAR). The success of the IDAR process, which competitor,” there is little policy agreement between EU countries uses foreign markets and expertise to enhance the domestic on what that ought to mean in practice.222 For example, Germany base, will largely determine the success of the MIC 2025 and acknowledges China’s desire to emulate and overtake Western digital silk arm parts of the BRI. But IDAR (and therefore MIC 2025 technological leadership. But there are relatively few restrictions and the BRI) must also be understood in the context of China’s

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES military-civilian fusion (MCF) domestic initiative, which creates successful a scheme in practice as admirers might suggest. It incentives for domestic firms to sell or share their technology is a plan to create and capture new opportunities for China’s with the PLA. According to the Thirteenth Five-Year Special Plan economic growth without the need for greater reform of its for the Development of MCF in Science and Technology, MCF political economy. It is also a plan to ease out and exclude the in science and technology is a crucial domestic strategy to US from the broader region in economic and technological ensure that resources are shared between domestic civilian and terms to “win without fighting,” as Sun Tzu would military entities in order to build an advanced defense-industrial have advised. complex. This includes “mutual open sharing of basic science and technology resources” and “two-way technology transfer.”226 Although it is clear that China will be the primary beneficiary of the BRI, the initiative is at present a more meaningful “brand” In short, free and open economies should not take comfort to the BRI’s dozens of partner countries than the US Free and in the argument that they are more innovative and creative Open Indo-Pacific. A plan originally formulated to address at the fundamental levels than China’s authoritarian model. Chinese weaknesses and vulnerabilities, the BRI now feeds the From Beijing’s perspective, it does not matter that its political narrative of Chinese strength, relevance, and future dominance. economy has not produced pioneers such as IBM, Google, and In contrast, the Free and Open Indo-Pacific has been explicitly Microsoft. Its still inefficient and largely unreformed authoritarian endorsed only by Japan and Australia (and to some extent model is better at IDAR and MCF, which will give it the economic India). Southeast Asian nations have only just begun to engage and military edge in the future. with the US concept.227 Likewise, attempts by the United States and other countries to counter the BRI are at an early stage. Conclusion For most countries in the region, China is more determined, The BRI is both more and less than it appears: it is a plan creative, and proactive. These are dangerous times for the US of immense grandeur and significance, but not as vast and and its standing in the region.

72 | HUDSON INSTITUTE GLOSSARY

asset management companies (AMCs) Bangladesh-China-India-Myanmar Economic Corridor (BCIMEC) Belt and Road Initiative (BRI) CCDI (Central Commission for Discipline Inspection) Central and Eastern European (CEE) Fund China-Pakistan Economic Corridor (CPEC) Comprehensive and Progressive Agreement for Trans-Pacific Partnership(CPTPP) (confirmation) foreign direct investment (FDI) introducing, digesting, absorbing, and re-innovating (IDAR) Leading Small Group for Comprehensively Deepening Reform (LSGCDR) leading small groups (LSGs) local government financing vehicles (LGVFs) Made in China 2025 (MIC 2025) military-civilian fusion (MCF) (confirmation) non-performing loans (NPLs) People’s Armed Police (PAP) People’s Liberation Army (PLA) PLA Navy (PLAN) private-public partnerships (PPPs) renminbi (RMB) state capital management budget (SCMP) state-owned enterprise (SOE) Stockholm International Peace Research Institute (SIPRI) strategic emerging industries (SEI) Chinese Communist Party (CCP) total social financing (TSF) Trans-Pacific Partnership (TPP) wealth management products (WMPs)

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES ENDNOTES

1 For example, see Minxin Pei, China’s Trapped Transition: The 11 See Feng Xiyuan, “Features, Problems and Reform of County and Limits of Developmental Autocracy (Cambridge, MA: Harvard Township Fiscal Administration System in China,” Lincoln Institute University Press, 2006); John Lee, Will China Fail? (Sydney: CIS of Land Policy Working Paper, 2012, https://www.lincolninst.edu/ Press, 2007); Yasheng Huang, Capitalism with Chinese Charac- pubs/dl/2262_1601_Xingyuan_WP13FX1.pdf. teristics (Cambridge: Cambridge University Press, 2008). 12 See “China Beefs Up Plan to Tackle Local Government Debt,” 2 David Denoon, “Where Did China’s Economy Go Wrong?” Wall Street Journal, 13 May 2015, http://www.wsj.com/ Foreign Policy, 15 September 2015, https://foreignpolicy. articles/chinas-jiangsu-province-to-relaunch-bond-sale-on- com/2015/09/15/where-did-chinas-economy-go-wrong-bub- may-18-1431486373. bles-politicized-banking-industry/. 13 See “Defusing a Bomb,” Economist, 11 March 2015, http://www. 3 Minxin Pei, “China’s Economy: Caught in a Vicious, Stubborn economist.com/blogs/freeexchange/2015/03/china-s-local-gov- Cycle,” Fortune, 13 March 2015, http://fortune.com/2015/03/13/ ernment-debt. china-economic-problems/. 14 See Wei Yao, “China Takes Big Step Toward Debt Restructuring,” 4 Elliot Wilson, “Forget Greece: China’s Economic Slowdown Is the Barron’s Asia, 10 March 2015, http://online.barrons.com/articles/ Biggest Problem of the Year,” Spectator, 15 August 2015, https:// SB52018153252431963983004580509312006148670. www.spectator.co.uk/2015/08/chinas-long-boom-is-finally-falter- ing-and-well-all-feel-the-crunch/. 15 See Douglas Elliott, Arthur Kroeber, and Yu Qiao, Shadow Banking in China: A Primer, Brookings Institution, March 5 World Bank and Development Research Center of the State 2015, http://www.brookings.edu/~/media/research/files/pa- Council, China 2030: Building a Modern, Harmonious and Cre- pers/2015/04/01-shadow-banking-china-primer/shadow_bank- ative Society (Washington, DC: World Bank, 2013), http://doc- ing_china_elliott_kroeber_yu.pdf. uments.worldbank.org/curated/en/781101468239669951/pdf/ China-2030-building-a-modern-harmonious-and-creative-society. 16 International Monetary Fund, IMF Country Report, no. 14/235, pdf. 2014, https://www.imf.org/external/pubs/ft/scr/2014/cr14235. pdf. 6 International Monetary Fund, IMF Country Report, no. 14/235, 2014, https://www.imf.org/external/pubs/ft/scr/2014/cr14235. 17 See Sara Hsu and Jianjun Li, “The Rise and Fall of Shadow pdf. Banking in China,” PERI Working Paper Series, no. 375, February 2015, http://www.peri.umass.edu/fileadmin/pdf/working_papers/ 7 Ashvin Ahuja and Alla Myrvoda, “The Spillover Effects of a working_papers_351-400/WP375.pdf; Yukon Huang and Canyon Downturn in China’s Real Estate Investment,” IMF Working Paper Bosler, China’s Debt Dilemma: Deleveraging While Generating WP/12/266, 2012, http://www.imf.org/external/pubs/ft/wp/2012/ Growth (Washington, DC: Carnegie Endowment for International wp12266.pdf; Mylène Gaulard, “Changes in the Chinese Peace, September 2014), http://carnegieendowment.org/files/ Property Market: An Indicator of the Difficulties Faced by Local china_debt_dilemma.pdf. Authorities,” China Perspectives, no. 2 (2013), http://www.cefc. com.hk/download.php?file=659835c61e7197487b38175c8e- 18 See Andrew Sheng and Xiao Geng, “Lending in the Dark,” Project b6e350&id=100044483. Syndicate, 22 April 2013, http://www.project-syndicate.org/ commentary/the-risk-profile-of-chinese-shadow-banking-by-an- 8 Data is from People’s Bank of China and the National Audit drew-sheng-and-geng-xiao. Office, with analysis by McKinsey Global Institute. See Pedro Nicolaca Da Costa, “China’s Debt Load Equals 282% of GDP, 19 International Monetary Fund, IMF Country Report, no. 14/235, Raising Economic Risks,” Wall Street Journal, 4 February 2015, 2014, https://www.imf.org/external/pubs/ft/scr/2014/cr14235. http://blogs.wsj.com/economics/2015/02/04/chinas-total-debt- pdf. load-equals-282-of-gdp-raising-its-economic-risks/. 20 See Huang and Bosler, China’s Debt Dilemma. 9 This is urbanization excluding the hundreds of millions of itinerant and seasonal migrant workers who have no land ownership rights 21 See “China Credit Repays Principal to Bailed-Out Trust Holders,” in urban areas, do not contribute significantly to infrastructure and Bloomberg, 30 January 2014, http://www.bloomberg.com/news/ construction demand in cities, and do not stay permanently in articles/2014-01-29/china-credit-repays-principal-to-investors-of- cities. bailed-out-trust.

10 See Willy Wo-Lap Lam, Chinese Politics in the Hu Jintao Era: 22 See Jun Nie and Guangye Cao, “China’s Slowing Housing New Leaders, New Challenges (New York: East Gate Publishing, Market and GDP Growth,” Macro Bulletin, 25 August 2014, 2006), pp. 99–102; Stephany Wong, “Land Acquisition in China,” https://www.kansascityfed.org/publicat/research/macrobulletins/ ECRAN Short Term Policy Brief 60, July 2012, http://eeas.europa. mb14Nie-Cao0825.pdf. Even then, and according to National eu/china/docs/division_ecran/ecran_is66_policy_brief_60_land_ Bureau of Statistics Figures, real estate investment continues to acquisition_in_china_staphany_wong_en.pdf. grow at above 10 percent each year, while real estate floor area sold has been declining by 10 percent each year since 2013.

74 | HUDSON INSTITUTE 23 See Li-Gang Liu, “Is China’s Property Market Heading toward 36 This does not include the debt held by financial institutions and Collapse?” Policy Brief, no. PB14-21, Peterson Institute for non-financial firms of 65 percent and 125 percent of GDP, re- International Economics August 2014, http://www.iie.com/publi- spectively — a large number of which are SOEs and enjoy formal cations/pb/pb14-21.pdf or informal government guarantees for paying back their loans. McKinsey Global Institute country debt database figures, found at 24 See Michael Pettis, “What Does a ‘Good’ Chinese Adjustment http://www.mckinsey.com/~/media/McKinsey/dotcom/Insights/ Look Like?” Global Financial Markets, 1 September 2014, http:// Economic%20Studies/Debt%20and%20not%20much%20de- blog.mpettis.com/2014/09/what-does-a-good-chinese-adjust- leveraging/MGI%20Debt%20and%20not%20much%20delever- ment-look-like/. agingFullreportFebruary2015.ashx.

25 See “China’s Central Economic Work Conference,” 37 See Heather Timmons, “China’s Slowdown Has Suddenly Crienglish.com, 16 December 2014, http://english.cri. Become a ‘Fiscal Shock,’” Quartz, 17 March 2015, http:// cn/7146/2014/12/16/3621s856762.htm; see also Yasheng qz.com/363855/chinas-slowdown-has-suddenly-become-a-fis- Huang, “China’s Great Rebalancing: Promise and Peril,” McK- cal-shock/. insey Quarterly, June 2013, http://www.mckinsey.com/insights/ asia-pacific/chinas_great_rebalancing_promise_and_peril; David 38 National Bureau of Statistics, China Statistical Yearbook (Beijing: Parker and Amy Jean Studdart, “Reading China’s Reforms One China Statistics Press, 2014), http://www.stats.gov.cn/tjsj/ Year On,” CSIS, Global Economics Monthly 3, 2 (November ndsj/2014/indexeh.htm. 2014), http://csis.org/files/publication/141124_Global_Econom- ics_Monthly_Vol_3.pdf. 39 See “China July Fiscal Spending Jumps 24 Percent to Three- Month High,” Reuters, 12 August 2015, http://www.reuters.com/ 26 See Henry H. McVey, “China’s Rebalancing Effort: Will It Be article/2015/08/12/us-china-economy-fiscal-revenue-idUSKCN- Enough?” KKR Global Macro Insights 5, no. 2 (February 2015), 0QH09120150812. http://www.kkr.com/sites/default/files/KKR_Insights_28-150223. pdf. 40 See John Lee, “China’s Corporate Leninism,” American Interest 7, no. 5 (2012). 27 See “Xi Says China Must Adapt To ‘New Normal’ of Slower Growth,” Bloomberg, 12 May 2014, http://www.bloomberg.com/ 41 See Hong Sheng and Zhao Nong, China’s State-owned En- news/articles/2014-05-11/xi-says-china-must-adapt-to-new-nor- terprises: Nature, Performance and Reform (Singapore: World mal-of-slower-growth. Scientific Publishing, 2013), pp. 160–65.

28 See Zheng Wang, “The from Mao to Xi,” Diplo- 42 See “New Banks Feel Squeeze,” Wall Street Journal, 13 June mat, 20 September 2013, http://thediplomat.com/2013/09/the- 2012, http://www.wsj.com/articles/SB10001424052702303822 chinese-dream-from-mao-to-xi/. 204577463973667809082; Michael Pettis, “China Has a Choice — Short Term Growth or Sustainability,” Financial Times, 2 Sep- 29 See Shaoguang Wang and Hu Angang, The Chinese Economy tember 2013, http://www.ft.com/intl/cms/s/0/18446f64-11a7- in Crisis: State Capacity and Tax Reform (London: Routledge, 11e3-8321-00144feabdc0.html#axzz3gKuOlGwL; Michael Pettis, 2001). “Rebalancing and Long-Term Growth,” China Financial Markets Blog, 3 September 2013, http://blog.mpettis.com/2013/09/rebal- 30 See Ehtisham Ahmad, Li Keping, and Thomas Richardson, Re- ancing-and-long-term-growth/; John Lee, The Fail of China (Hong centralization in China? (Washington, DC: IMF, November 2000), Kong: Asianomics, May 2011). https://www.imf.org/external/pubs/ft/seminar/2000/fiscal/ahmad. pdf. 43 Hong Sheng and Zhao Nong, China’s State-owned Enterprises: Nature, Performance and Reform 31 China National Bureau of Statistics 44 See Gabriel Wildau, “China Shifts Focus from Monetary to Fiscal 32 See John Lee, “China’s Economic Slowdown: what are the Policy,” Financial Times, 10 March 2015, http://www.ft.com/intl/ Strategic Implications”,” Washington Quarterly 38:3 2015, pp. cms/s/0/3d7c9d06-c6eb-11e4-9e34-00144feab7de.html#ax- 123-42. zz3gmoMhNsh.

33 See China Economic Update — Special Topic: An Update of Chi- 45 See John Lee, “Pitfalls of an Aging China,” National Interest (Jan- na’s Fiscal and Tax Reforms (Beijing: World Bank Office, October uary/February 2013), http://nationalinterest.org/article/pitfalls-ag- 2014), p. 9. ing-china-7886.

34 Huang and Bosler, China’s Debt Dilemma, p. 16. 46 China’s National Bureau of Statistics figures for 2010. See also Robert C. Pozen, “Tackling the Chinese Pension System,” Paul- 35 See “The Decision on Major Issues Concerning Comprehen- son Institute, July 2013, https://www.brookings.edu/wp-content/ sively Deepening Reforms in Brief,” China Daily, 16 November uploads/2016/06/31-reforming-chinese-pension-system-pozen. 2013, http://www.china.org.cn/china/third_plenary_ses- pdf. sion/2013-11/16/content_30620736.htm.

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES 47 See “Pension Gap to Hit $2.87 Trillion,” China Daily, June 14, China Sees Jihad Risk,” Wall Street Journal, 1 February 2012, http://www.chinadaily.com.cn/china/2012-06/14/con- 2015, http://www.wsj.com/articles/as-muslim-uighurs-flee- tent_15503342.htm. china-sees-jihad-risk-1422666280; “Spreading the Net,” Economist, 9 August 2014, http://www.economist.com/ 48 For example, see reports by Aileen Wang and Koh Gui Qing, news/china/21611110-new-episodes-violence-and-repres- “Analysis — China Slides Faster into Pensions Black Hole,” sion-have-heightened-tensions-xinjiang-spreading-net; Kilic Reuters, September 30, 2012, http://www.reuters.com/arti- Kanat, “Repression in China and Its Consequences,” Current cle/2012/10/01/us-china-pensions-idUSBRE88T0JP20121001; Trends in Islamic Ideology, 28 July 2014, http://www.hudson. “China Pension Shortfall to be CNY18.3 Trl in 2013: Report,” org/research/10480-repression-in-china-and-its-consequenc- Caijing, June 14, 2012, http://english.caijing.com.cn/2012-06- es-in-xinjiang. 14/111894179.html. 61 See Christian Gobel and Lynette H. Ong, Social Unrest in China 49 National Bureau of Statistics, China Statistical Yearbook (Beijing: (London: ECRAN, 2012), http://www.chathamhouse.org/sites/ China Statistics Press, 2014), http://www.stats.gov.cn/tjsj/ files/chathamhouse/public/Research/Asia/1012ecran_gobelong. ndsj/2014/indexeh.htm. pdf; Murray Scot Tanner, “China’s Social Unrest Problem,” Testi- mony, U.S.–China Economic and Security Review Commission, 50 See Moreno Bertoldi and Annika Melander, “China’s Reforms: 15 May 2014, http://www.uscc.gov/sites/default/files/Tanner_ Time to Walk the Talk,” ECFIN Economic Brief, no. 41 (April Written%20Testimony.pdf. 2015), http://ec.europa.eu/economy_finance/publications/eco- nomic_briefs/2015/pdf/eb41_en.pdf. 62 See Andrew S. Erickson and Adam P. Liff, “Lifting the Shroud on China’s Defense Spending: Trends, Drivers, and Implications,” 51 Quoted in Timothy R. Heath, Testimony Before the U.S.-China National Bureau of Asian Research, Policy Q&A, 16 May 2013, Economic and Security Review Commission, 7 February 2019, http://nbr.org/research/activity.aspx?id=340. https://www.rand.org/pubs/testimonies/CT503.html. 63 See Michael S. Chase et al., China’s Incomplete Military Trans- 52 See reforms flagged in Ministry of Finance, Report on the Imple- formation: Assessing the Weaknesses of the People’s Liberation mentation of the Central and Local Budgets for 2014 and on the Army (PLA) (Santa Monica, CA: RAND Corporation, 2015), http:// Draft Central and Local Budgets for 2015, 5 March 2015, http:// www.rand.org/content/dam/rand/pubs/research_reports/RR800/ news.xinhuanet.com/english/china/2015-03/17/c_134074808. RR893/RAND_RR893.pdf. htm. 64 As above, pp. 23−28. 53 See Sam Perlo-Freeman, “Deciphering China’s Latest Defence Budget Figures,” SIPRI, March 2013, http://www.sipri.org/media/ 65 The 13th Five Year Plan For Economic and Social Development newsletter/essay/perlo-freeman-mar-2013. of the People’s Republic of China 2016-2020 (Beijing: Central Compilation and Translation Press, 2016), http://en.ndrc.gov.cn/ 54 See Elizabeth Economy, “China’s Imperial President,” Foreign newsrelease/201612/P020161207645765233498.pdf. Affairs (November/December 2014). 66 As above, p. 6. 55 China’s Military Strategy (Beijing: The State Council Information Office of the PRC, May 2015), http://www.china.org.cn/chi- 67 See Eleanor Albert and Beina Xu, “China’s Environmental Crisis,” na/2015-05/26/content_35661433.htm. Council on Foreign Relations, 18 January 2016, https://www.cfr. org/backgrounder/chinas-environmental-crisis. 56 The Diversified Employment of China’s Armed Forces (Beijing: The State Council Information Office of the PRC, April 2013), http:// 68 Linda Jakobson and Dean Knox, New Foreign Policy Actors news.xinhuanet.com/english/china/2013-04/16/c_132312681.htm. in China, SIPRI Policy Paper 26, September 2010, http:// lindajakobson.com/wp-content/uploads/2014/12/Jakob- 57 See Liselotte Odgaard and Thomas Galasz Nielsen, “China’s son-Knox-New-Foreign-Policy-Actors-in-China-SIPRIPP26.pdf. Counterinsurgency Strategy in Tibet and Xinjiang,” Journal of Contemporary China 23, no. 87 (2014): 535−55. 69 For example, see Richard McGregor, The Party: The Secret World of China’s Communist Rulers (London: Harper Collins, 2010). 58 See Shaoying Zhang and Derek McGhee, Social Policies and Ethnic Conflict in China (London: Palgrave Macmillan, October 70 The following summary is taken from Timothy R. Heath, Tes- 2014), pp. 68−69. timony Before the U.S.-China Economic and Security Review Commission, 7 February 2019, https://www.rand.org/pubs/testi- 59 See Hans Kristensen, “Extensive Nuclear Missile Deployment monies/CT503.html. Area Discovered in Central China,” Federation of American Scientists, 15 May 2008, http://fas.org/blogs/security/2008/05/ 71 Christopher K. Johnson and Scott Kennedy, “Xi’s Signature Gov- extensive-nuclear-deployment-area-discovered-in-central-china/. ernance Innovation: The Rise of Leading Small Groups,” CSIS, 17 October 2017, https://www.csis.org/analysis/xis-signature-gover- 60 See Jeremy Page and Emre Peker, “As Muslim Uighurs Flee, nance-innovation-rise-leading-small-groups.

76 | HUDSON INSTITUTE 72 See Javier C. Hernandez, “China’s ‘Chairman of Everything’: Be- tio Is Growing as Its Economy Loses Steam,” Bloomberg, 16 July hind Xi Jinping’s Many Titles,” New York Times, 25 October 2017, 2019, https://www.bloomberg.com/news/articles/2019-07-16/ https://www.nytimes.com/2017/10/25/world/asia/china-xi-jin- china-s-debt-growth-keeps-marching-on-as-economy-loses- ping-titles-chairman.html. pace; Cary Springfield, “How Much of a Concern Is China’s Debt Problem?” International Banker, 29 April 2019, https://internation- 73 Ibid. albanker.com/banking/how-much-of-a-concern-is-chinas-debt- problem/. 74 See “Charting China’s ‘Great Purge’ under Xi,” BBC, 23 October 2017, https://www.bbc.com/news/world-asia-china-41670162. 85 China Credit Conundrum: Mapping China’s Credit, vol. 2 (New York: Goldman Sachs, 2 February 2018.) 75 Ling li, “The Politics of Anticorruption in China: Paradigm Change of the Party’s Disciplinary Regime 2012–2017,” Journal of Con- 86 For example, see Andy Rothman, “China’s Debt Problems,” temporary China 28, no. 115 (2019): 47–63 at 47. Matthews Asia Advisor Perspectives, 21 March 2019, https:// www.advisorperspectives.com/commentaries/2019/03/21/chi- 76 Robert Lawrence Kuhn, “Xi Jinping’s China Dream,” New York nas-debt-problem. Times, 4 June 2013, https://www.nytimes.com/2013/06/05/opin- ion/global/xi-jinpings-chinese-dream.html. 87 See also Martin Eftimoski and Kate McLoughlin, “Housing Policy and Economic Growth in China,” Reserve Bank of Australia 77 Rush Doshi, “Xi Jinping Just Made It Clear Where China’s Foreign Bulletin, March 2019, https://www.rba.gov.au/publications/bulle- Policy Is Headed,” Washington Post, 25 October 2017, https:// tin/2019/mar/pdf/housing-policy-and-economic-growth-in-china. www.washingtonpost.com/news/monkey-cage/wp/2017/10/25/ pdf. xi-jinping-just-made-it-clear-where-chinas-foreign-policy-is-head- ed/?utm_term=.878ded66ea39. 88 For example, see Margit Molnar and Jiangyuan Lu, “State-Owned Firms Behind China’s Corporate Debt,” OECD Economics De- 78 See Jiayang Fan, Taisu Zhang, and Ying Zhu, “Behind the Per- partment Working Paper, no. 1536, 7 February 2019, http://www. sonality Cult of Xi Jinping,” Foreign Policy, 8 March 2016, https:// oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=E- foreignpolicy.com/2016/03/08/the-personality-cult-of-xi-jin- CO/WKP(2019)5&docLanguage=En. ping-china-leader-communist-party/. 89 Margit Molnar and Jiangyuan Lu, “State-Owned Firms Behind 79 For example, see Peter Martin and David Cohen, “Inside Xi China’s Corporate Debt,” , at p. 17. Jinping’s Reform Strategy,” National Interest, 20 March 2014, https://nationalinterest.org/commentary/inside-xi-jinpings-re- 90 Margit Molnar and Jiangyuan Lu, “State-Owned Firms Behind form-strategy-10087; Sangkuk Lee, “An Institutional Analysis of Xi China’s Corporate Debt,”. Jinping’s Centralization of Power,” Journal of Contemporary China 26, no. 105 (2017): 325−36. 91 For a typology of government debts in various forms, see Meng- zhong Zhang and Youwei Qi, “Grand Strategies for Dealing with 80 See John Lee, “The Truth about China’s Lies and Statistics,” Aus- Chinese Local Government Debts,” Management Studies 5, no. 2 tralian, 2 July 2014, https://www.theaustralian.com.au/business/ (March-April 2017): 91–107 at 95–96. business-spectator/news-story/the-truth-about-chinas-lies-and- statistics/f35d0926163356485bc1c15d8fc0c726. 92 See Yiping Huang and Tingting Ge, “Assessing China’s Financial Reform: Changing Roles of the Repressive Financial Policies,” 81 Wei Chen et al., “A Forensic Examination of China’s National Cato Journal (Winter 2019), https://www.cato.org/cato-journal/ Accounts,” Brooking’s Papers on Economic Activity: BPEA winter-2019/assessing-chinas-financial-reform-changing-roles-re- Conference Drafts, 7–8 March 2019, https://www.brookings.edu/ pressive-financial. wp-content/uploads/2019/03/bpea_2019_conference-1.pdf. 93 See Xie Yu, “Xi Jinping’s War on Shadow Banking Spills Over, 82 See C. T. Hsieh and Z. Song, “Grasp the Large, Let Go of the Rocking China’s Wider Financial World,” South China Morning Small: The Transformation of the State Sector in China,” Brook- Post, 10 February 2018, https://www.scmp.com/business/ ings Papers on Economic Activity, 2015: https://www.brookings. companies/article/2132721/xis-war-shadow-banking-spills-over- edu/bpea-articles/grasp-the-large-let-go-of-the-small-the-trans- threatens-stability-chinas. formation-of-the-state-sector-in-china/. 94 See Wojciech Maliszewski et al., “Resolving China’s Corporate 83 C. E. Bai, C. T. Hsieh, and Z. Song, “The Long Shadow of China’s Debt Problem,” IMF Working Paper WP/16/203, 2016, https:// Fiscal Expansion,” Brookings Papers on Economic Activity, 2016, www.imf.org/external/pubs/ft/wp/2016/wp16203.pdf. https://www.brookings.edu/wp-content/uploads/2017/02/baitex- tfall16bpea.pdf. 95 See John Lee, Will China Fail? (Sydney: CIS, 2007), pp. 54−56, https://www.cis.org.au/app/uploads/2015/07/pm77.pdf. 84 See “China’s Debt and Shadow Banking at a Glance,” UOB Group, 8 August 2018, https://www.uobgroup.com/web-resourc- 96 As above. es/uobgroup/pdf/research/MIR-20180808.pdf; “China’s Debt Ra-

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES 97 See Don Weiland and Gabriel Wildau, “China’s 150b Debt-for-Eq- 110 Hsieh and Song, “Grasp the Large, Let Go of the Small, https:// uity Swap Shows Signs of Fizzling,” Financial Times, 19 October www.brookings.edu/wp-content/uploads/2016/07/2015a_hsieh. 2017, https://app.ft.com/content/74db0692-b2f8-11e7-aa26-bb- pdf. 002965bce8?sectionid=topics/authors/Don_Weinland. 111 See “Dept-to-Equity Swaps Won’t Resolve China’s Debt Woes,” 98 As above. Capital Economics China Watch, 27 October 2016, https:// research.cdn.capitaleconomics.com/3da6a6/debt-to-equity- 99 See “Chinese Will Deepen Debt-for-Equity Swap Reform — Cab- swaps-won-t-resolve-china-s-debt-woes.pdf?i=eyJ1c2VyIjowL- inet,” Reuters, 22 May 2019, https://www.reuters.com/article/ CJ0aW1lIjoxNTY2NjAzNTg4LCJwb3MiOiJwdWIifQ%3D%3D; china-finance-cabinet/china-will-deepen-debt-for-equity-swap- “China’s Hidden Subnational Debts Suggest More LGFV Defaults reform-cabinet-idUSB9N21K00G. Are Likely,” S& P Global Ratings - Ratings Direct.

100 See Alex Holmes and David Lancaster, “China’s Local Govern- 112 “Beijing Accelerates Deleveraging of State Owned Enterprises ment Bond Market,” Reserve Bank of Australia Bulletin, June with Debt-Equity Swaps,” China Banking News, 24 July 2017, 2019, p. 182, https://www.rba.gov.au/publications/bulletin/2019/ http://www.chinabankingnews.com/2017/07/24/beijing-acceler- jun/pdf/chinas-local-government-bond-market.pdf. ates-deleveraging-state-owned-enterprises-debt-equity-swaps/.

101 See “China’s Hidden Subnational Debts Suggest More LGFV 113 See Alessandro Nolet and Camilla Wong, “Debt for Equity Defaults Are Likely,” S&P Global Ratings - Ratings Direct, 15 Swaps, a Solution to China’s NPL Problems?” Emerging Markets October 2018, https://www.spratings.com/documents/20184/0/ Restructuring Journal, no. 4 (Fall 2017), https://www.clearygottli- ChinasHiddenSubnationalDebtsSuggestMoreLGFVDefaultsAre- eb.com/-/media/organize-archive/cgsh/files/2017/publications/ Likely.pdf/00c1bdd1-70c0-9240-12df-850df192c602. emrj-summer-2017-issue-4/debt-for-equity-swaps--a-solution-to- chinas-npl-problems.pdf. 102 W. Lam and J. Wang, “China’s Local Government Bond Market,” International Monetary Fund Working Paper, no. 18/219, 2018, 114 See Tianlei Huang, “Tracking China’s Debt-to-Equity Swap https://www.imf.org/~/media/Files/Publications/WP/2018/ Program: ‘Great Cry and Little Wool,’” China Economic Watch, wp18219.ashx. Peterson Institute for International Economics, 24 June 2019, https://www.piie.com/blogs/china-economic-watch/tracking-chi- 103 See Chen Jian, “Ministry Tightens Scrutiny of PPP Projects to nas-debt-equity-swap-program-great-cry-and-little-wool. Curb Risk,” China Daily, 24 May 2019, http://www.chinadaily. com.cn/a/201905/24/WS5ce74372a3104842260bd839.html. 115 See Andreas Kern, “China’s ‘Great Wall’ of Debt: Chinese Debts and Their Macroeconomic Implications,” Global Economic 104 “Market to Play ‘Decisive Role’ in Allocating Resources,” Xinhua, Dynamics, 2018, https://www.bertelsmann-stiftung.de/fileadmin/ 12 November 2013, http://www.china.org.cn/china/third_plena- files/BSt/Publikationen/GrauePublikationen/MT_China_Great_ ry_session/2013-11/12/content_30577689.htm. Wall_of_Debt.pdf.

105 See “Lack of Innovation Is ‘Achilles Heel’ for China’s Economy, Xi 116 See Spencer Sheehan, “What China’s PPP-Fuelled Investment Says,” Reuters, 16 May 2019, https://www.reuters.com/article/ Boom Means for the Economy: Public-Private Partnership us-china-politics-xi/lack-of-innovation-is-achilles-heel-for-chinas- Infrastructure Spending Will Boost China’s Economy but Increase economy-xi-says-idUSKCN1SM08G. Local Government Debt,” The Diplomat, 21 March 2017: https:// thediplomat.com/2017/03/what-chinas-ppp-fueled-investment- 106 See Richard McGregor, Xi Jinping: The Backlash (Melbourne: boom-means-for-the-economy/. Penguin Random House 2019), pp. 13–15. 117 See Holmes and Lancaster, “China’s Local Government Bond 107 See John Lee, “China’s Corporate Leninism,” American In- Market.” terest 7, no. 5 (2012), https://www.the-american-interest. com/2012/04/10/chinas-corporate-leninism/. 118 See Zheng Song and Wei Xiong, “Risks in China’s Financial System,” Working Paper 24230, National Bureau of Economic 108 See Ben Hillman, “The State Advances, the Private Sector Research, January 2018, https://www.nber.org/papers/w24230. Retreats,” in China Story Yearbook 2018, ed. Jane Golley et al. pdf. (Canberra: ANU Press, 2019), pp. 295–307. See also Nicholas R. Lardy, The State Strikes Back: The End of Economic Reform 119 Ministry of Finance, “Notice on Printing and Distributing the Mea- in China? (Washington, DC: Peterson Institute for International sures for the Disclosure of Local Government Debt Information,” Economics, 2019). 29 December 2018.

109 See “Caixin Explains: Why Some Fear China’s Private Sector Is 120 See “Crackdown on Shadow Banking to Moderate, but the Retreating,” Caixin, 29 November 2018, https://www.caixinglobal. Sector Will not Rebound Strongly,” Moody’s Investor Service, com/2018-11-29/caixin-explains-why-some-fear-chinas-private- 18 March 2019, https://www.moodys.com/research/Moodys- sector-is-retreating-101353607.html. Crackdown-on-China-shadow-banking-to-moderate-but-the-- PBC_1166071.

78 | HUDSON INSTITUTE 121 See “China Defaults Hit Record in 2018. 2019 Pace Is Triple 133 See Jonathan Tepperman, “China’s Great Leap Backward,” That,” Bloomberg, 7 May 2019, https://www.bloomberg.com/ Foreign Policy, 15 October 2018, https://foreignpolicy. news/articles/2019-05-07/china-defaults-hit-record-in-2018-the- com/2018/10/15/chinas-great-leap-backward-xi-jinping/. 2019-pace-is-triple-that. 134 See “China’s Algorithms of Repression: Reverse Engineering a 122 See Karen Yeung, “China Bond Defaults Tripled in 2018 — The Xinjiang Police Mass Surveillance App,” Human Rights Watch Case of One Property Developer Shows Why,” South China Report, 1 May 2019, https://www.hrw.org/report/2019/05/01/ Morning Post, 31 December 2018, https://www.scmp.com/ chinas-algorithms-repression/reverse-engineering-xinjiang-po- economy/china-economy/article/2180122/china-bond-de- lice-mass-surveillance. faults-tripled-2018-case-one-property-developer. 135 See “The Global Age of the Algorithm Manifested in Commu- 123 “China Defaults Hit Record in 2018,” Bloomberg, https://www. nist China’s Dystopian Social Credit System,” Conversation, 15 bloomberg.com/news/articles/2019-05-07/china-defaults-hit-re- January 2018, https://www.science20.com/the_conversation/ cord-in-2018-the-2019-pace-is-triple-that. the_global_age_of_the_algorithm_manifested_in_communist_chi- nas_dystopian_social_credit_system-229793. 124 Bart Carfago, Allen Feng, and Logan Wright, “Local Government Debt: Running Faster Just to Stand Still,” Rhodium Group, 15 136 See Susan Lund et al., Globalization in Transition: The Future May 2019, https://rhg.com/research/local-government-debt-lgfv- of Trade and Value Chains (Washington, DC: McKinsey Global running-faster-just-to-stand-still/. Institute, January 2019), https://www.mckinsey.com/featured-in- sights/innovation-and-growth/globalization-in-transition-the-fu- 125 See China 2030: Building a Modern, Harmonious and Creative ture-of-trade-and-value-chains#part1. Society, https://www.worldbank.org/content/dam/Worldbank/ document/China-2030-complete.pdf; “China’s Tricky Transition: 137 See Zenglein and Holzmann, “Evolving Made in China 2025,” Signposts to Watch In Its Economic Evolution,” Blackrock, Global pp. 19–20, https://www.merics.org/sites/default/files/2019-07/ Insights, February 2017, https://www.blackrock.com/corporate/ MPOC_8_MadeinChina_2025_final.pdf. literature/whitepaper/bii-china-tricky-transition-2017-international. pdf. 138 Computers and telecommunications equipment are excluded be- cause China is merely the primary assembler of imported compo- 126 United Nations trade statistics figures. nents and materials in the world. For this reason, China accounts for nearly half of global exports of electronic devices, and approx- 127 The National Medium- and Long-Term Program for Science and imately 70 percent of electronic devices imported to the United Technology Development (2006-2020) (Beijing: State Council, States are assembled in China. The next three-largest suppliers 2006), https://www.itu.int/en/ITU-D/Cybersecurity/Documents/ — Mexico, South Korea, and Vietnam — account for about 19 National_Strategies_Repository/China_2006.pdf. percent combined. China is the primary “assembler” of devices, and thus much of the value of each device is not produced or 128 See “China’s Strategic Emerging Industries: Policy, Implementa- captured there. For example, China adds from 4–20 percent tion, Challenges and Recommendations,” U.S.-China Business of the value of each iPhone, even though most of the phone is Council, March 2013, https://www.uschina.org/sites/default/files/ assembled in China. Since assembly of today’s computers and sei-report.pdf. electronics is not where value will be created in the future, if these categories were included, this would give a misleading impression 129 See Laura Zhou and Orange Wang, “How ‘Made in China 2025’ that China’s high-tech deficit vis-à-vis advanced economies is became a Lightning Rod in ‘War over China’s National Destiny,’” smaller than it is. See Enrique Duarte Melo et al., “Unpacking the South China Morning Post, 18 January 2019, https://www.scmp. US-China Tech Trade War,” BCG, 5 June 2019, https://www.bcg. com/news/china/diplomacy/article/2182441/how-made-china- com/en-au/publications/2019/us-china-tech-trade-war.aspx. 2025-became-lightning-rod-war-over-chinas. 139 Zenglein and Holzmann, “Evolving Made in China 2025,” pp. 130 See Orange Wang, “Beijing no Longer Requires Local Govern- 23–24. ments to Work On ‘Made in China 2025,’ but Hi-Tech Ambitions Remain,” South China Morning Post, 13 December 2018, https:// 140 Above, p. 13. www.scmp.com/economy/china-economy/article/2177856/bei- jing-no-longer-requires-local-governments-work-made-china. 141 See How China’s Economic Aggression Threatens the Tech- nologies and Intellectual Properties of the US and the World 131 See Max J. Zenglein and Anna Holzmann, “Evolving Made in (Washington, DC: White House Office of Trade and Manufacturing China 2025: China’s Industrial Policy in the Quest for Global Tech Policy, June 2018), https://www.whitehouse.gov/wp-content/ Leadership,” MERICS Papers on China, no. 8 (July 2019): 11, uploads/2018/06/FINAL-China-Technology-Report-6.18.18-PDF. https://www.merics.org/sites/default/files/2019-07/MPOC_8_ pdf. MadeinChina_2025_final.pdf. 142 See Mary E. Lovely and Yang Liang, “Trump Tariffs Primarily Hit 132 As above. Multinational Supply Chains, Harm US Technology Competitive- ness,” Policy Brief, Peterson Institute for International Economics,

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES May 2018, pp. 4–5, https://www.piie.com/system/files/docu- 154 European Commission, High Representative for the Union for For- ments/pb18-12.pdf. eign and Security Policy, Joint Communication to the European Parliament, the European Council and the Council: EU-China — A 143 China Customs Administration figures. Strategic Outlook, 12 March 2019, pp. 5–6, https://ec.europa. eu/commission/sites/beta-political/files/communication-eu-chi- 144 Analysis in Lovely & Yang Liang, “Trump Tariffs,” pp. 4–5. na-a-strategic-outlook.pdf.

145 The White House, National Security Strategy of the United States, 155 See “China Manufacturing 2025: Putting Industrial Policy Ahead December 2017, p. 45, https://www.whitehouse.gov/wp-con- of Market Forces,” European Union Chamber of Commerce in tent/uploads/2017/12/NSS-Final-12-18-2017-0905.pdf. China, 2017, https://www.europeanchamber.com.cn/en/chi- na-manufacturing-2025 146 Adam Segal, “When China Rules the Web: Technology in Service of the State,” Foreign Affairs, September/October 2018, https:// 156 European Commission, Joint Communication to the European www.foreignaffairs.com/articles/china/2018-08-13/when-china- Parliament, pp. 4, 6, https://ec.europa.eu/commission/sites/be- rules-web. ta-political/files/communication-eu-china-a-strategic-outlook.pdf.

147 See Lora Kolodny, “Former Google CEO Predicts the Internet 157 Office of the United States radeT Representative, “Joint State- will Split in Two — And One Part Will Be Led by China,” CNBC, ment on Trilateral Meeting of the Trade Ministers of the United 20 September 2018, https://www.cnbc.com/2018/09/20/eric- States, Japan, and the European Union,” 25 September 2018, schmidt-ex-google-ceo-predicts-internet-split-china.html. https://ustr.gov/about-us/policy-offices/press-office/press-releas- es/2018/september/joint-statement-trilateral. 148 See Joseph Marks, “The Cyber-security 202: How Huawei Helped Extend China’s Repressive View of Internet Freedom to 158 See Simon Shen and Wilson Chan, “A Comparative Study of the African Nations,” Washington Post, 15 August 2019, https:// Belt and Road Initiative and the Marshall Plan,” Palgrave Com- www.washingtonpost.com/news/powerpost/paloma/the-cy- munications 4, no. 43 (2018), https://www.nature.com/articles/ bersecurity-202/2019/08/15/the-cybersecurity-202-how-hua- s41599-018-0077-9; Peter Sabine, “Belt and Road Is ‘Marshall wei-helped-extend-china-s-repressive-view-of-internet-free- Plan without a War,’ Analysts Say, as Beijing and Banks Woo dom-to-african-nations/5d547a72602ff15f906576c3/; Zak Private-Sector Analysts,” South China Morning Post, 28 March Doffman, “Beyond 5G: Huawei’s Links to Xinjiang and China’s 2017, https://www.scmp.com/special-reports/business/topics/ Surveillance State,” Forbes, 25 April 2019, https://www.forbes. one-belt-one-road/article/2082733/belt-and-road-marshall-plan; com/sites/zakdoffman/2019/04/25/huawei-xinjiang-and-chinas- “Will China’s Belt and Road Outdo the Marshall Plan, Economist, high-tech-surveillance-state-joining-the-dots/#40b63e80cd52. 8 March 2018, https://www.economist.com/finance-and-eco- nomics/2018/03/08/will-chinas-belt-and-road-initiative-outdo- 149 See Lavina Lee, “Democracy Promotion: ANZUS and the Free the-marshall-plan. and Open Indo-Pacific Strategy,” Analysis Paper, United States Studies Centre at University of Sydney, 9 July 2019, https:// 159 Vision for Maritime Cooperation Under the Belt and Road (Beijing: united-states-studies-centre.s3.amazonaws.com/uploads/036/ The State Council of the People’s Republic of China 2015). The dc6/7f1/036dc67f12bef1a48031c405e872cdbc2ecd7867/De- document was updated in 2017, http://english.www.gov.cn/ mocracy-promotion-ANZUS-and-the-Free-and-Open-Indo-Pacif- archive/publications/2017/06/20/content_281475691873460. ic-strategy.pdf. htm

150 See Hilary McGeachy, “US-China Technology Competition: 160 “Inside China’s Plan to Create a Modern Silk Road,” Morgan Impacting a Rules-Based Order,” United States Studies Cen- Stanley Research, 14 March 2018, https://www.morganstanley. tre at University of Sydney, May 2019, p. 2, https://www.ussc. com/ideas/china-belt-and-road. edu.au/analysis/us-china-technology-competition-impact- ing-a-rules-based-order. 161 See China Global Investment Tracker, the American Enterprise Institute, and the Heritage Foundation, http://www.aei.org/chi- 151 See Bjorn Fagersten and Tim Ruhlig, “China’s Standard Power na-global-investment-tracker/. and Its Geopolitical Implications for Europe,” Brief no. 2, 2019, Swedish Institute of International Affairs, https://www.ui.se/ 162 For example, see Peter Hartcher, “Donald Trump’s Tough Guy globalassets/ui.se-eng/publications/ui-publications/2019/ui-brief- Theatrics No Match for China’s Economic Weapons,” Sydney no.-2-2019.pdf. Morning Herald, 12 March 2018, https://www.smh.com.au/ opinion/donald-trumps-tough-guy-theatrics-no-match-for-chinas- 152 As above. economic-weapons-20180312-h0xdib.html.

153 See Bonnie Glasser, Made in China 2025 and the Future of Amer- 163 For example, see Tom Holland, “Why China’s ‘One Belt, One ican Industry (statement before the Senate Small Business and Road’ Plan Is Doomed to Fail,” South China Morning Post, 6 Entrepreneurship Committee), CSIS, 27 February 2019, https:// August 2016, https://www.scmp.com/week-asia/opinion/arti- csis-prod.s3.amazonaws.com/s3fs-public/congressional_testi- cle/1999544/why-chinas-one-belt-one-road-plan-doomed-fail; mony/190226_Glaser_Testimony.pdf. Tanner Greer, “One Belt, One Road, One Big Mistake,” Foreign

80 | HUDSON INSTITUTE Policy, 6 December 2018, https://foreignpolicy.com/2018/12/06/ 7 September 2013, https://www.fmprc.gov.cn/mfa_eng/top- bri-china-belt-road-initiative-blunder. ics_665678/xjpfwzysiesgjtfhshzzfh_665686/t1076334.shtml.

164 See W. Liu and M. Dunford, “Inclusive Globalization: Unpacking 176 See Lee Jones and Jinghan Zeng, “Understanding China’s ‘Belt China’s Belt and Road Initiative,” Area Development and Policy 1, and Road Initiative’: Beyond ‘Grand Strategy’ to State Transfor- no. 3 (2016): pp. 323–40. mation Analysis,” Third World Quarterly (February 2019), https:// www.researchgate.net/publication/331237441_Understand- 165 “Xi Opens ‘Project of the Century’ with Keynote Speech,” Xinhua, ing_China’s_’Belt_and_Road_Initiative’_beyond_’grand_strate- 14 May 2017, http://www.chinadaily.com.cn/beltandroadinitia- gy’_to_a_state_transformation_analysis. tive/2017-05/14/content_29337406.htm. 177 See Peter Cai, “Understanding the Belt and Road Initiative,” Lowy 166 See China’s Belt and Road Initiative in the Global Trade, Invest- Institute Analysis, 22 March 2017, https://www.lowyinstitute.org/ ment and Finance Landscape (Paris: OECD 2018), pp. 5–7, publications/understanding-belt-and-road-initiative. https://www.oecd.org/finance/Chinas-Belt-and-Road-Initia- tive-in-the-global-trade-investment-and-finance-landscape.pdf; 178 See Hui Lu et al., China’s Belt and Road Initiative: Measuring the “The Belt and Road Initiative – Six Years On,” Moody Analytics Impact of Improving Transport Connectivity on International Trade Analysis, June 2019: https://www.moodysanalytics.com/-/media/ in the Region – A Proof Of Concept Study (Santa Monica, CA: article/2019/belt-and-road-initiative.pdf. RAND Corporation, 2018), https://www.rand.org/content/dam/ rand/pubs/research_reports/RR2600/RR2625/RAND_RR2625. 167 See “Population Trends in China and India: Demographic pdf. Dividend or Demographic Drag?” in China and India, 2025, ed. Charles Wolf Jr. et al. (Santa Monica, CA: RAND Corporation, 179 See Huma Siddiqui, “Win for Indian Diplomacy: BCIMEC Project 2011), pp. 7–35. Is Not Part of BRI Anymore, Says Expert,” Financial Express, 29 April 2019, https://www.financialexpress.com/defence/win-for-in- 168 See R. Garnaut, F. Cai, and L. Song, “Reform and China’s Long- dian-diplomacy-bcimec-project-is-not-part-of-bri-anymore-says- Term Growth and Development,” in Deepening Reform for China’s expert /1562688/. Long-Term Growth and Development, ed. R. Garnaut, F. Cai, and L. Song, (Canberra: ANU Press, 2014). 180 See Ben Derudder, Xingjian Liu, and Charles Kunaka, “Connectiv- ity along Overland Corridors of the Belt and Road Initiative,” MTI 169 See John Lee, “Pitfalls of an Aging China,” National Interest (Jan./ Global Practice Discussion Paper No. 6, 2018, http://documents. Feb. 2013): 54–63. worldbank.org/curated/en/264651538637972468/pdf/Connec- tivity-Along-Overland-Corridors-of-the-Belt-and-Road-Initiative. 170 See “Casting an Eye on the Belt and Road Initiative,” Stratfor pdf. Worldview, 28 August 2019, https://worldview.stratfor.com/arti- cle/casting-eye-belt-and-road-initiative-china-infrastructure. 181 See Indermitt Gill, Somik V. Lall, and Mathilde Lebrand, “Winners and Losers along China’s Belt and Road,” Brookings Institution 171 See John Lee, “Why the Almighty Dollar Will Remain the Currency Analysis, 21 June 2019, https://www.brookings.edu/blog/fu- of Choice,” Australian Financial Review, 26 June 2019, https:// ture-development/2019/06/21/winners-and-losers-along-chinas- www.afr.com/markets/currencies/why-the-almighty-us-dollar-will- belt-and-road/. remain-the-world-s-currency-of-choice-20190625-p5211n. 182 See Chunlin Zhang, “The World Bank in China’s State-Owned 172 See Yukon Huang and Clare Lynch, “Does Internationalizing the Enterprise Reform Since the 1980s,” World Bank Working Paper, RMB Make Sense for China?” Cato Journal 33, no. 3 (2013): 9 February 2019, http://documents.worldbank.org/curated/ 571–85, https://carnegieendowment.org/files/Internationaliz- en/828251550586271970/pdf/134778-World-Bank-in-China- ing_the_RMB.pdf; Callan Windsor and David Halperin, “RMB SOE-reform-final-Feb-09-2019-En.pdf. Internationalisation: Where to Next?” Reserve Bank of Australia Bulletin, September 2018, https://www.rba.gov.au/publications/ 183 See Margit Molnar and Jiangyuan Lu, “State-Owned Firms bulletin/2018/sep/pdf/rmb-internationalisation-where-to-next.pdf. Behind China’s Corporate Debt,” OECD Economics Department Working Papers No. 1536, 7 February 2019, http://www.oecd. 173 See Barry Eichengreen and Masahiro Kawai, “Issues for Renminbi org/officialdocuments/publicdisplaydocumentpdf/?cote=ECO/ Internationalization: An Overview,” ADBI Working Paper Series WKP(2019)5&docLanguage=En. No. 454, 2014, https://www.adb.org/sites/default/files/publica- tion/156309/adbi-wp454.pdf. 184 See “China’s Tax Bureau to Collect Social Insurance,” China Brief- ing, 18 September 2018, https://www.china-briefing.com/news/ 174 See Lauren A. Johnston, “The Belt and Road Initiative: What Is in chinas-tax-bureau-to-collect-social-insurance/. It for China?” Asia and the Pacific Policy Studies 6 (2019): 40–58. 185 See Anjani Trivedi, “China’s Racing to the Top in Income Inequal- 175 Ministry of Foreign Affairs of the People’s Republic of China, ity,” Bloomberg, 23 September 2018, https://www.bloomberg. “President Xi Jinping Delivers Important Speech and Proposes to com/opinion/articles/2018-09-23/china-s-racing-to-the-top-in- Build a Silk Road Economic Belt with Central Asian Countries,” income-inequality

CHINA’S ECONOMIC SLOWDOWN: ROOT CAUSES, BEIJING’S RESPONSE AND STRATEGIC IMPLICATIONS FOR THE US AND ALLIES 186 CSIS Reconnecting Asia database, https://reconnectingasia.csis. 198 The top ten in order were Russia, Pakistan, Angola, Laos, Vene- org/database/initiatives/one-belt-one-road/fb5c5a09-2dba-48b9- zuela, Turkmenistan, Ecuador, Brazil, Sri Lanka, and Kazakhstan. 9c2d-4434511893c8/. 199 See Minxin Pei, “A Play for Global Leadership,” Journal of De- 187 See M. Makocki, “China’s Road: Into Eastern Europe,” European mocracy 29, no. 2 (2018), pp. 37–51. Union Institute for Security Studies Issue Brief 4, 2017, https:// www.iss.europa.eu/sites/default/files/EUISSFiles/Brief_4_Chi- 200 See Lavina Lee, “Democracy Promotion: ANZUS and the Free na_Eastern_Europe_0.pdf. and Open Indo-Pacific Strategy,” United States Studies Centre Analysis Paper, 9 July 2019, https://www.ussc.edu.au/analysis/ 188 See John Lee, “China’s Trojan Ports,” American Interest (Jan./ democracy-promotion-anzus-and-the-free-and-open-indo-pacif- Feb. 2019), https://www.the-american-interest.com/2018/11/29/ ic-strategy. chinas-trojan-ports/. 201 See Rosalind Mathieson and Keith Zhai, “China Slams Western 189 Devin Thorne and Ben Spevack, Harbored Ambitions: How Chi- Democracy as Flawed,” Bloomberg, 3 January 2017, https:// na’s Port Investments Are Strategically Reshaping the Indo-Pacific www.bloomberg.com/news/articles/2017-01-22/china-slams- (Washington, DC: C4ADS, 2017), p. 20, https://static1.square- western-democracy-as-flawed-as-trump-takes-office and Ben space.com/static/566ef8b4d8af107232d5358a/t/5ad5e20ef- Blanchard, “‘Crises and Chaos’: China’s State Media Slams 950b777a94b55c3/1523966489456/Harbored+Ambitions.pdf. Western Democracy ahead of Communist Party Congress,” Reuters, 17 October 2017, http://www.businessinsider.com/r-chi- 190 John Hurley, Scott Morris, and Gailyn Portelance, “Examining the na-state-media-attacks-western-democracy-ahead-of-congress- Debt Implications of the Belt and Road Initiative from a Policy Per- 2017-10?IR=T. spective,” Center for Global Development Policy Paper no. 121, March 2018, https://www.cgdev.org/sites/default/files/examin- 202 Liangyu, “Socialism with Chinese Characteristics Enters New ing-debt-implications-belt-and-road-initiative-policy-perspective. Era: Xi,” Xinhua, 18 October 2017, http://www.xinhuanet.com/ pdf. english/2017-10/18/c_136688475.htm.

191 Jeremy Page, Gordon Lubold, and Rob Taylor, “Deal for Naval 203 Zheping Huang, “Your Five-Minute Summary of Xi Jinping’s Outpost in Cambodia Furthers China’s Quest for Military Net- Three-Hour Communist Party Congress Speech,” Quartz, 18 work,” Wall Street Journal, 22 July 2019, https://www.wsj.com/ October 2017, https://qz.com/1105337/chinas-19th-party- articles/secret-deal-for-chinese-naval-outpost-in-cambodia-rais- congress-your-five-minute-summary-of-xi-jinpings-three-hour- es-u-s-fears-of--ambitions-11563732482. speech.

192 See Thomas J. Shattuck, How China Dictates the Rules of the 204 See “China’s Trade in Tools of Torture and Repression,” Ome- Game (Washington, DC: Foreign Policy Research Initiative, 2018), ga Research Foundation, Amnesty International Report, 2014, https://www.fpri.org/wp-content/uploads/2018/07/howchinadic- https://www.amnestyusa.org/wp-content/uploads/2017/04/ tatesthegame.pdf. asa170422014en.pdf.

193 See John Lee, “The Use of Aid to Counter China’s ‘Djibouti Strat- 205 Lucy Hornby, “China Defends State Control over Internet at Tech- egy’ in the South Pacific,” Hudson Institute, March 2019, https:// nology Forum,” Financial Times, 3 December 2017, https://www. www.hudson.org/research/14892-the-use-of-aid-to-counter-chi- ft.com/content/dad122c8-d7e8-11e7-a039-c64b1c09b482; and na-s-djibouti-strategy-in-the-south-pacific. Jinghan Zeng, Tim Stevens, and Yaru Chen, “China’s Solution to Global Cyber Governance: Unpacking the Domestic Discourse of 194 See Robin Emmott and Angeliki Koutantou, “Greece Blocks EU ‘Internet Sovereignty,’” Politics and Policy 43, no. 3 (2017). Statement on China at U.N.,” Reuters, 18 June 2018, https:// www.reuters.com/article/us-eu-un-rights/greece-blocks-eu-state- 206 H. E. Wang Yi, “Advance the Global Human Rights Cause ment-on-china-human-rights-at-u-n-idUSKBN1990FP. and Build a Community with a Shared Future for Mankind,” remarks at the opening ceremony of the first South-South 195 See Ali Salman Andani, “As BRI Enters Italy, Whom Should EU Human Rights Forum, 7 December 2017, http://www.fmprc. Blame?” South China Morning Post, 2 April 2019, https://www. gov.cn/mfa_eng/wjb_663304/wjbz_663308/2461_663310/ asiatimes.com/2019/04/opinion/as-bri-enters-italy-whom-should- P020171211565335323921.pdf. eu-blame/. 207 See Christopher Walker, Shanthi Kalathil, and Jessica Ludwig, 196 These are the latest reliable figures available. “How Democracies Can Fight Authoritarian Sharp Power,” Foreign Affairs, 16 August 2018, https://www.foreignaffairs.com/ 197 AidData refers to non-concessional loans as Other Official Flows articles/china/2018-08-16/how-democracies-can-fight-author- (OOF), which are defined as transfers where the grant component itarian-sharp-power; John Garnaut, “Australia’s China Reset,” comprises less than 25 percent of the total and the primary pur- Monthly, August 2018, https://www.themonthly.com.au/is- pose of the transfer is commercial or representational in nature. sue/2018/august/1533045600/john-garnaut/australia-s-china-re- See AidData, www.aiddata.org/china. set; and Anne-Marie Brady, “Magic Weapons: China’s Political Influence Activities under Xi Jinping,” paper presented at a confer-

82 | HUDSON INSTITUTE ence hosted by the Taiwan Foundation for Democracy, Arlington, 219 See Madeleine McCowage, “Trends in China’s Capital Account,” VA, 16–17 September 2017, https://www.wilsoncenter.org/sites/ Reserve Bank of Australia Bulletin, 21 June 2018, https://www. default/files/magicweaponsanne-mariebradyseptember162017. rba.gov.au/publications/bulletin/2018/jun/trends-in-chinas-capi- pdf. tal-account.html.

208 “China Focus: Principle Contradiction Facing Chinese Society 220 China’s Belt and Road Initiative in the Global Trade, Investment Has Evolved in New Era: Xi,” Xinhua, 18 October 2017, http:// and Finance Landscape (Paris: OECD Business and Finance www.xinhuanet.com/english/2017-10/18/c_136688643.htm. Outlook, 2018), p. 25, https://www.oecd.org/finance/Chinas- Belt-and-Road-Initiative-in-the-global-trade-investment-and-fi- 209 Li Laifang, “Commentary: Enlightened Chinese Democracy Puts nance-landscape.pdf. the West in the Shade,” Xinhua, 17 October 2018, http://www. xinhuanet.com/english/2017-10/17/c_136685546.htm. 221 Australian Government, Department of Foreign Affairs and Trade, “Trans-Pacific Partnership Agreement, TPP Text and Associated 210 See Stephan Ortmann and Mark R. Thompson, “China and the Documents,” 6 October 2015, https://dfat.gov.au/trade/agree- ‘Singapore Model,’” Journal of Democracy 27, no. 1 (2016), ments/not-yet-in-force/tpp/Pages/tpp-text-and-associated-docu- 39–48. ments.aspx.

211 See China Go Abroad: Belt and Road—Exploring a Blueprint for 222 See Andrew Small, “Why Europe Is Getting Tough on China—And Steady Growth in Overseas Investment (Hong Kong: EY, 2018), What It Means for Washington,” Foreign Affairs, 3 April 2019, https://www.ey.com/Publication/vwLUAssets/ey-china-over- https://www.foreignaffairs.com/articles/china/2019-04-03/why- seas-investment-report-issue-7-en/$FILE/ey-china-overseas-in- europe-getting-tough-china. vestment-report-issue-7-en.pdf. 223 See Esme Nicholson and Soraya Sarhaddi Nelson, “Chi- 212 See Scott Cendrowski, “China’s Global 500 Are Bigger than nese Companies Get Tech Savvy Gobbling Up Ger- Ever—And Mostly State-Owned,” Fortune, 22 July 2015, https:// man Factories,” NPR, 3 October 2018: https://www.npr. fortune.com/2015/07/22/china-global-500-government-owned/. org/2018/10/03/639636532/chinese-companies-get-tech-sav- vy-gobbling-up-germanys-factories 213 See Alexandra Stevenson, “China’s Communists Rewrite the Rules for Foreign Business,” New York Times, 13 April 2018, 224 Thomas P. Cavanna, “Unlocking the Gates of Eurasia: China’s https://www.nytimes.com/2018/04/13/business/china-commu- Belt and Road Initiative and Its Implications for U.S. Grand Strate- nist-party-foreign-businesses.html. gy,” Texas National Security Review 2, no. 3 (2019): 11–37 at 27, https://tnsr.org/2019/07/unlocking-the-gates-of-eurasia-chinas- 214 Article 19 of the Company Law of the People’s Re- belt-and-road-initiative-and-its-implications-for-u-s-grand-strate- public of China (revised in 2013), http://www.fdi.gov. gy/. cn/1800000121_39_4814_0_7.html. 225 Marcel Angliviel, Benjamin Spevack, and Devin Thorne, Open 215 Article 7 of the National Intelligence Law (2017), http://cs.brown. Arms: Evaluating Global Exposure to China’s Defense-Industrial edu/courses/csci1800/sources/2017_PRC_NationalIntelli- Base (Washington, DC: C4ADS, 2019), p. 9, https://static1. genceLaw.pdf. squarespace.com/static/566ef8b4d8af107232d5358a/t/5d8b- 17f10603222cff9d416e/1569396764749/Open+Arms.pdf. 216 For detailed findings and criticisms of Chinese political economy in this context, see Office of the US radeT Representative, Find- 226 As above. ings of the Investigation into China’s Acts, Policies, and Prac- tices Related to Technology Transfer, Intellectual Property, and 227 See Premesha Saha, “ASEAN’s Indo-Pacific Outlook: An Innovation under Section 301 of the Trade Act of 1974, https:// Analysis,” ORF Raisina Debates, 28 June 2019, https://www. ustr.gov/sites/default/files/Section%20301%20FINAL.PDF; Office orfonline.org/expert-speak/aseans-indo-pacific-outlook-an-analy- of the US Trade Representative, Update concerning China’s Acts, sis-52542/. Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation, https://ustr.gov/sites/default/files/en- forcement/301Investigations/301%20Report%20Update.pdf.

217 See “Freedom on the Net: The Rise of Digital Authoritarianism,” Freedom House, October 2018, p. 8, https://freedomhouse.org/ report/freedom-net/freedom-net-2018/rise-digital-authoritarian- ism.

218 See Sheridan Prasso, “China’s Digital Silk Road Is Looking More Like an Iron Curtin,” Bloomberg, 10 January 2019, https://www. bloomberg.com/news/features/2019-01-10/china-s-digital-silk- road-is-looking-more-like-an-iron-curtain.

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