On China’s Economic growth – an interview with Perry Jones, Investment Advisor and Chief Analyst, Kearsedge Boston Group

What are the factors that contributed to the rapid development of the Chinese economy?

A member of the Chinese leadership reported that in the early 1980’s, he was touring several rural areas of China. According to Marxist theory, after nearly 40 years of socialism, the countryside should have been blooming with wealth. What he observed instead was just the opposite. The people lived in dire poverty. With this insight, official government policy of China adopted a more capitalist position in their approach to the economy. By freeing up rural residents to grow food and produce and then profit by selling that food on an open market, China’s leadership observed that this produced a rapid rise in living standards in the region.The government realized that this phenomenon could be extended throughout the economy. Citizens were allowed to profit from their own labor and businessmen were permitted to profit from their own capitalist undertakings. The People’s Liberation Army – as an arm of the government – sought to take advantage of this policy and desiring to bring more cash into its coffers, adopted its own policy of capitalistic growth, – thereby, as a byproduct (perhaps intentional by the military leadership), extending the influence of the military over official affairs of China – a policy which is only now (2013-2014) bearing fruition (with China’s more assertive actions in the western Pacific region).

To complete the reorganization of China’s economic base, government enterprises themselves adopted a more capitalistic stance and – with government money – began building empires of their own. By creating corporations and flooding these with money, state enterprises realized rapid growth and enhanced their influence. A byproduct of this rapid growth was an extreme increase in state corruption.

China recognized that economic infrastructure was the key to growth. By building modern highways and ports, building and expanding an industrial base, building urban infrastructure, upgrading agriculture and modernizing its communications network, China laid the foundation upon which to build what is today the world’s largest economy as measured by purchasing power parity (PPP).

Can we trust China’s official GDP statistics?

I am not certain if any government can be trusted to provide 100% accurate statements regarding almost any segment of policy. As an insider, I was privy to how gauges were structured and how input was weighted to reflect a particular policy position. Having said that, from my understanding of the Chinese mindset when it comes to this particular assessment of the state of China’s growth, I would guess that the official Chinese statements and statistics are fairly accurate.

During my fact-finding tour of southern China in 2006, I realized that the statements regarding China’s economic rise were, if anything, understated.

The Chinese Communist Party and the PLA – as two separate entities – need accurate reporting in this area in order to accurately assess where they have been, how well their goals are being met and that economic growth will be great enough to attain the aims (sometimes competing) that they seek. The PLA wants a more powerful military which requires extraordinary sums of money. The Communist Party wants to remain in power and in order to accomplish that, they need a tranquil populace which can be placated (so they believe) only by a rising standard of living.

With these very strong positions, I would suggest that the official statements and figures released by the Chinese authorities have a high degree of accuracy and may in fact remain today somewhat understated.

Can China maintain its current high growth rates?

Not at all. Official Chinese policy has worked against high growth rates. As one example, China’s one-child policy has worked against the economy. China’s population is aging. Much of China’s young adults are already at work in China’s densely populated urban areas in factories and offices. Rural areas remain – for the large part – the domain of the elderly. Although the leadership has recently relaxed the one-child policy, it has not come soon enough to affect the eventual decay in the labor class who will have to support the increasing numbers of the elderly that have stopped working.

Economically, investment has been far too focused in state enterprises, real estate, corporate bonds and municipal debt. As the economy cools, the state may seek to bolster the slowing rate of increase with initiatives designed to enhance investment, but these are likely to be short lived and essentially ineffective as the economy matures.

China’s economy is maturing. As China enters the next phase of economic development in its growth cycle, focus will naturally shift from the industrial sector to a more service sector orientation. Services represent a “softer” footprint and thus less economic growth can be released from a service oriented economy. A maturing economy also causes the population to focus more on spending and consumption rather than on savings and investment. Savings and investments produce higher growth rates. Although a rebalance in this aspect is necessary and even healthy for an economy because it diversifies the economic base, this rebalance engenders a lower growth rate.

To a large degree, China’s infrastructure is complete and in place. The bridges have been raised, the highways have been laid down, the airports and seaports expanded and modernized, the dams have been built, agriculture upgraded, the skyscrapers erected and the factories established and are now churning out goods that are shipped to every corner of the world. This construction forced a high annual GDP. But with all the work that has been done, and with little more to do in this regard, the economy must soften in reflection of the pace of development which is weakening. Already whole Chinese cities lay uninhabited, factories dormant and office buildings in even the coastal cities have many empty cubicles. China is overbuilt, it has reached the “bamboo ceiling” in which the past high rate of growth cannot be sustained. As the pace of infrastructure development declines, GDP growth rate must also decline.

The PLA siphons off a portion of GDP. Although there is not any accurate hard measure of the affect of military spending and how it impacts the GDP in my opinion, it certainly must have some impact and because it does not contribute directly to the production of goods and services in the economy, it is only reasonable to expect that this impact must be negative in nature.The PLA is now expanding its spending above the annual rate of growth in the GDP. This can only detrimentally impact the economy as more and more of the production of the state and its labor force is diverted to the military sector.

Has China sacrificed too much at the altar of GDP?

China has sacrificed far too much to expand its economy. Pollution in Beijing and other coastal cities is sometimes so deleterious that residents are warned not to go outside unless they must and if they must, they are cautioned to wear protective face masks. In the interior and downriver from the factories, rivers are so polluted that they change color as waste products and chemicals are dumped into the water. During my 2006 fact-finding tour, I traveled by train across southern China. At several points along my travels, the air would take on a very unpleasant aroma which, I was informed, was due to the proximity of some factory which we were then passing. Cancer and health issues are on the rise among China’s citizens and much of this can be attributed to the lack of environmental controls across a wide sector of the economy.

Imbalances also exist in the Chinese economy. As investment surged in one sector, investment in another declined or was overlooked. Infrastructure was built in one region at the expense of infrastructure in another region. Shortages in the supply of goods and raw materials also exist which would not exist in a purely capitalistic economy. These imbalances and shortages will all take time to work out and these issues will also have a dampening effect on the GDP growthrate.

At what point might China overtake the U.S GDP in nominal terms?

It is difficult to assess when China’s GDP in nominal terms will surpass that of the United States. I sense both strength and weakness in the U.S. economy and it is impossible to determine which direction the economy will take as domestic issues and international challenges affect the psychology of the market. Barring an unforeseen event that causes a trauma in the U.S. and/or world market, and if China can sustain a 6.9% annual increase in its GDP (from the current 7.6%), China’s GDP will surpass that of the USA in 2020, perhaps a year or two earlier or later (2018-2022).

China’s GDP is largely dependent upon the U.S. therefore any decline in the United States will negatively impact the Chinese economy. Because the United States has such a huge impact in the world economy, any sizable depreciation in the U.S. market will cast ripples across the globe forcing a worldwide economic decline. With this, China will not be able to make up for any lost production caused by the U.S. decline by going to another nation or market. Should this occur, China may be able to sustain some rate of growth but will not surpass the USA until after 2030.

Even with a lower nominal GDP than that of the U.S, China does more international trade than any other country, and is the largest trading partner of Japan, South Korea, Russia, India, and many other countries. What are the strategic implications of China’s economic rise?Can Beijing leverage economic might into geopolitical advantage?

As Mao Zedong observed, “military influence is based on economic power,” and “political power grows from the barrel of a gun.” While the West has forgotten these insights of Mao Zedong, the Chinese have not. The rapid expansion of the Chinese economy over the last 30 years has generated great pride in the Chinese psyche. This increase in monetary muscle has translated into military might. Under current leadership headed by President Xi Jinping, who also just happens to be General Secretary of the Communist Party of China and Chairman of the Central Military Commission, China has been keen to flex its muscle and assert influence, ifnot dominance, over waters it has traditionally claimed as its own.

Chinese national pride combined with the military power to assert that pride have merged to create a dangerous situation in the western Pacific. This wouldn’t have been possible without the economic power that supports the military and Chinese territorial ambitions.

Although China has sought to enhance its influence by presenting a more assertive role in the western Pacific, these actions are backfiring as more nations react by seeking closer relations with the United States and regional powers expand their own militaries to offset the dominance of the Chinese military. In recent days, China’s leadership has been backpedaling from its more assertive posture as it sees its policies working in opposition to China’s goals.

China’s generals and admirals are itching to use their new toys and they would like nothing more than a confrontation with the United States. The political leadership will likely curtail this action for the foreseeable future as being too dangerous and perhaps appease the military by allowing a confrontation with the Philippines, Vietnam or Japan.

China’s military leadership is very confident of their abilities but they remain untried in combat. Having lost face in a war they lost with Vietnam in 1979, the military may seek to recover lost pride by putting Vietnam “in its place.” China can leverage its capability in this arena by restricting hostilities to a naval confrontation in which China bears a distinct advantage over Vietnam. Only now is Vietnam building its naval force to counter the rising maritime threat from China.

China views the Philippines as a potential target and a confrontation with the Philippines could also embarrass the United States. By attacking a Filipino naval force in a short, sharp assault and then declaring peace in some manner, China can bruise the Philippines militarily and weaken the United States’ influence in the region.

Some analysts expect that China will target Japan in a short, violent conflict. Rhetoric coming from China’s military expresses confidence that China is more than capable of winning any war with Japan, but the political leadership seems uncertain of this and they are well aware of the repercussions any such confrontation would produce. As a result, I am not really expecting China to launch any hostile action against Japan. Japan has a powerful military and recent Japanese wargames have concluded with Japan victorious against China. This cannot have gone unnoticed by the Communist Party of China. In addition, with the United States positioning additional air and naval assets in Japan, any move China seeks to make against Japan will pose a much greater risk. I am not forecasting that China will attack Japan any time soon, but the confluence of political and military pressures within China could force it into avenues it may very well regret.

The “cabbage strategy” is a policy adopted by the Chinese leadership in which a multitude of small actions can eventually yield large gains. Moving assets, such as fishing boats into an area is very innocuous and in no way can be considered an act of aggression by any power. This is followed by additional fishing boats and then trawlers and both in increasing number. Next a small coast guard boat or patrol boat will visit the area, merely on patrol. Then, large naval vessels and aircraft patrol the area and this could be followed by the construction of some permanent facility such as an airfield, hospital, school or resupply station. With this strategy, China has claimed an area by slowly encompassing it in layers of “cabbage leaves.” In the initial stages, no action by itself is large enough or bold enough to elicit a hostile response by an opposing power, but when considered together, China has captured a location by slowly swallowing it. This is the most likely course of action we can expect from China in the near term, and with the rise in opposition by neighboring states to overt Chinese actions, the military may stand down allowing the political leadership to assert influence through the cabbage strategy.


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