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on geopolitics

Feb 14, 2019 | 23:07 GMT

11 mins read

The End of Strategic Luxury for China

Senior East Asia Analyst, Stratfor
Zhixing Zhang
Senior East Asia Analyst, Stratfor
As its economy matures, China has attempted to move up the value chain in manufacturing, beyond industries such as textiles and into high-tech development.
(STR/AFP/Getty Images)
Highlights
  • Signs of China's economic maturation, such as decreased reliance on exports and reduced returns on government-led investments, have promised an era of slowed Chinese economic growth since the years after the global financial crisis.
  • China needs more time and space to facilitate its domestic socio-economic transformation and upgrade its value chain, but it is losing the "strategic luxury" of a  relatively stable external environment.
  • Beijing will reverse infrastructure spending and credit expansion and try to use financial incentives to stimulate domestic consumption where it can, but it is likely to face greater economic pain, at least in the short term.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Second-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.

When Chinese President Xi Jinping declared his country's "era of national rejuvenation" at the 19th Communist Party Congress in 2017, he saw a historical mission awaiting him. China had gone from a "century of humiliation" into seven decades of rehabilitation through internal reconsolidation and economic growth. The country had developed a massive economy and was halfway to its goal of ascending into a global power; Xi saw it as his job to take it the rest of the way. But though Xi may have had a clear mission informed by his predecessors, the fact is that he presides over a China that sits at a major crossroads domestically, politically, economically and globally.

China has hit the point in its economic transition where it must adapt to slower growth and adjust to a rockier economic situation. Chinese leaders are finally facing the constrictions stemming from the end of the country's previously near-unrestrained expansion at the same time that China is facing active challenges from the United States in the form of an aggressive trade war, a tech competition and challenges to Chinese territorial claims. For the next several years, almost none of China's existing internal and external challenges will face, and some will possibly even escalate, marking the final years of the decade as the end of "easy times" for China.

The Big Picture

Over the past two decades, China's emergence as the world's second-largest economy, coupled with its growing capacity to turn wealth into military power, has remade the geopolitical landscape, both regionally and globally. But its economic boom years have passed, and as its economy matures, China faces pressure to transform its structure and climb the value chain. It must figure out how to do so, however, without the strategic luxury that its astronomical growth spurt afforded to it.

China's Economy, the Origins

To understand the complex challenges that Xi's China faces today, it is helpful to examine their origins. While the historical perspective will not answer the question of what China will do next, it does illuminate the country's priorities, and, in turn, help explain its behaviors. While China's actions are inherently driven by the country's economic path, the interplay of geopolitics and the global power competition exudes a strong pull on them.

Even before Xi took his place as the Communist Party's general secretary in 2012, the economic and political order that guided China in the post-reform era had been rapidly evolving.

In 1978, China opened its economy to the world and started down a path to economic success and, by extension, military and global ascendance. Over 40 years into the process, China's economy is finally stumbling, but the country's main challenges have not arisen simply because of its cooling growth. Investment returns and external trade were once the core pillars of the Chinese economic miracle, but both have been losing potency, promising a somewhat slower "new normal." Continued weak domestic consumption, a struggling private economy and high debt loads provide a limited buffer for externally driven financial crises like a recession or the current U.S.-China trade war, while China's aggressive pursuit of technological development is facing increasing international scrutiny.

Stratfor has long argued that the 2008-09 global financial crisis and its aftermath had profound implications on China's domestic environment, resonating in the policy priorities and challenges that China's government faces today. In short, the financial crisis exposed the fundamental vulnerabilities of the export-oriented growth model that sustained China's decades of extraordinary growth and its employment of some 300 million people — the majority of whom were low-end manufacturing workers migrating from the impoverished countryside.

When the recession hit China's coastal economy and 40 million laborers found themselves unemployed, the government had few options other than drastically pivoting away from the export sector. But to do so, it had to implement a massive financial stopgap of 4 trillion yuan ($591 billion) for government-directed investments into development of roads, railways and, most importantly, real estate to mitigate economic and employment stress. In a post-crisis world, China continued to rely on credit expansion to sustain its economic transition, resulting in substantial industrial overcapacity and outstanding debt; indeed, debt currently sits at almost 260 percent of gross domestic product (GDP), spanning local government, state-owned enterprises and the household sector (the latter in part due to soaring real estate mortgages).

It was only a matter of time before China entered a lasting era of slow growth. As its economy matured and government-led investments expanded, returns naturally diminished. And regardless of Beijing's willingness to spur China's real estate market, whatever stimulus it could provide could not maintain the pace of growth it experienced before 2015, resulting in limited domestic consumption and suggesting that boosting the real estate market is losing its efficacy as a key policy tool. Added to all this is China's rapid shift away from export reliance — the export sector went from accounting for 36 percent of GDP in 2007 to just 22 percent in 2013.

The fact that domestic consumption has not grown as expected, private investments grew tighter and debt got larger pointed to one of two core problems facing the Chinese government: short of broad liberalization reforms, the strategies available to the government to quickly respond to unexpected shocks — and by extension, to continue to deliver wealth and mitigate social consequences — have been stretched to their limits, and using them will come with increasing costs.

 

China's economy also faced a second maturation challenge in the years after the recession. Although its export sector continued to grow in dollar value following the crisis and has served as a key buffer for the country's economic transition, rising costs of living and rapid urbanization, coinciding with inevitable shrinking demographic dividends would eventually undermine China's competitiveness in the face of emerging economies in Southeast Asia or East Africa. And for the sake of avoiding the dreaded middle-income trap, China must aggressively accelerate the pace of development of its technology sector to make the country's economy a more value-added and innovative one.

Essentially, when Xi took power, the country was caught between two types of economies: eager emerging markets were waiting for China's low-end manufacturing windfall, but at the same time, China also retained a heavy dependence on Western markets for cutting-edge technologies such as semiconductors. Chinese leaders knew their options were limited, and so was time.

A Sense of Economic Urgency

Xi has always known he was racing against time, which explains the spate of reform initiatives since 2015 (around the time when he consolidated political power) and his clear belief that the country needs to slow its growth rates to make way for these reforms. Over the past three years, Xi's government has ruthlessly eliminated excess capacity and improved efficiency in state-owned sectors, and it removed so-called "zombie" corporations owned by the state that produce no returns and carry high debt. It has limited credit generation, cracked down on informal lending in local governments and the private sector, and restricted property markets in large cities.

A sense of urgency also explains Xi's desire to rapidly ramp up China's technology industry and reduce external dependency on cutting-edge technologies — a plan outlined in the state-led Made in China 2025 industrial initiative. And it informs the country's aggressive overseas tech investments and acquisitions and its hunt for technological know-how, which has also included illicit means such as espionage and cybersecurity.

 

The Communist Party itself will struggle to maintain the sort of legitimacy that high growth and substantial wealth once helped to provide.

 

None of these measures are without casualties. The credit crunch, liquidity stress and property restrictions, for instance, have hit hard, affecting both private companies that have rising defaults or bankruptcies and debt-laden local governments over the past two years. It also risks bringing rising unemployment and financial stress to individuals who have experienced negative consequences from reforms. And amid China's aggressive pursuit for tech development, many Western companies and governments have found themselves directly exposed to growing Chinese competition and national security threats. Even within China's domestic political environment, the Communist Party itself will struggle to maintain the sort of legitimacy that high growth and substantial wealth once helped to provide. But despite the limitations, Chinese leaders are convinced they can buy China enough time to quickly upgrade the country's value chain, advance its technology capabilities, prevent potential supply chain disruption, and ensure China is in a better position to withstand another internal or external economic crisis than it was a decade ago.

The Dawn of the U.S.-China Rivalry

Another global economic crisis has yet to manifest. But something more profound has arrived, long overdue: the emergence of a strategic rivalry between China and the United States. The two are engaged in competition over technological supremacy, conflict over China's territorial and infrastructure expansion and a massive trade war, both reflecting and increasing the global ambivalence to China's rise.

Just a year after its economic opening, China normalized its relationship with the United States, a key element of ensuring a stable strategic global environment in which China could grow and develop. After decades of ebbs and flows from its Cold War peak, the state of the U.S.-China relationship has hit an all-time low — and it's poised to grow worse.

This eventuality is hardly surprising to Beijing. The prospect of the U.S.-China relationship morphing from positive to competitive has haunted Chinese leaders since the collapse of the Soviet Union neutralized their mutual adversary. Indeed, the administration of U.S. President George W. Bush entertained the idea of labeling China as a strategic competitor in early 2001 — right before the 9/11 attacks urgently redirected U.S. attention toward a global war on terrorism (for which it conveniently needed strong allies like China) for nearly two decades.

Now, almost 20 years later, the United States is working to disengage from overseas conflicts in Afghanistan, Iraq and Syria, and it has finally begun amassing resources to engage with China in a strategic rivalry. In late 2017, the administration of U.S. President Donald Trump released a policy paper officially classifying China as a strategic competitor of the United States. But China has not wasted the past two decades. Building on its economic heft, China has largely established dominance as a regional economic and political powerhouse. Beijing has also accrued diplomatic influence, infrastructure capability and military power on a global scale.

At this point in the great power competition, China is acknowledging the blessings and curses it has observed in other rising powers. Specifically, as China's economic growth slows and as it increasingly challenges U.S. technology supremacy in areas such as artificial intelligence and robotic and other high-end manufactured goods, China has found itself limited in ways similar to those that Japan faced three decades ago. Back then, Washington challenged Tokyo's protectionist policies, currency management and economic model, much like the United States is doing to China today. However, unlike Japan in the 1990s, which relied on the U.S. security umbrella, China's security independence allows it to approach any negotiations with its strategic competitor from a stronger position.

Likewise, as China assertively engages in eastward maritime expansion to secure vital access to overseas markets and moves westward to develop its desolate inland regions, it finds itself with the same geographic limiters that Germany confronted nearly a century ago. Like pre-World War I Germany, China sees its expansion as defensive in nature, but that inevitably exposes China both to skeptical and competing neighbors and to conflicts with the United States over its imperative to secure maritime dominance. If China's expansion makes it a target for containment by U.S-led allies, then its critical supply lines would be vulnerable to disruptions.

The End of Easy Times

China still would benefit from more time and space to facilitate its domestic socio-economic transformation, but the strategic luxury that once supported the country's four-decades of near unrestrained rise is evaporating. It is coming to the global great power competition from a position of much greater strength than it would have two decades ago. However, it also has found itself with fewer domestic policy options and less strategic flexibility for withstanding external shocks.

In the long run, China's global ambitions will oblige it to continue updating its supply chains and restructuring its economy while continuing its fierce economic competition with the United States. At the same time, Beijing cannot ignore domestic economic issues, such as maintaining employment levels and minimizing supply chain disruptions. It will do that by seeking to expand and deepen export markets and continuing its push to build out infrastructure, a strategy that will drive it, when it can, to continue expanding its economic, political and military influence. This process will inevitably create points of conflict with other powers and require a reluctant Beijing to continue to adapt to international norms.

Without question, China is entering a new period in its ascendancy, and the way it handles the international conflicts and economic challenges ahead will shape the country's trajectory for many years to come.

 

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