Red Flags: Why Xi's China is in Jeopardy, with George Magnus

Jan 23, 2019

China's economy has grown exponentially over the last four decades, but George Magnus, former chief economist at UBS, sees four traps that could derail its continued rise: rising debt, the struggle to keep its currency stable, aging demographics, and the challenges of changing from a low-income economy to a complex middle-income one. Will Xi Jinping be open to reform? What could be the effects of lingering U.S.-China trade tensions?

JOANNE MYERS: Good evening, everyone. I'm Joanne Myers, director of Public Affairs programs, and on behalf of the Carnegie Council I would like to thank you all for joining us.

As we try to gain a better understanding of China's impact on the world, we are very fortunate to have the wisdom of a longtime China watcher as our guest this evening, George Magnus. George is a former chief economist at UBS Investment Bank. Currently he is a research associate at Oxford University's China Centre. He will be discussing his recently published book entitled Red Flags: Why Xi's China is in Jeopardy, which was recently cited by Martin Wolf of the Financial Times as one of the best economics books of 2018.

Over the last four decades China's rapid rise from a poor country to the world's second-largest economy is one of the most remarkable stories of our time. Yet it's not only China's economy but its strengthening military and naval capacity that has also grown which has added to its stature as a world power. However, after several years of unprecedented growth, there are now warning signs that global opinion is turning against China and that its economy is suddenly sputtering.

President Xi seems to understand the need to redirect the economy. Still, there are concerns that his reforms today threaten to turn the China dream into a nightmare. As Chinese officials debate the need to further stimulate the economy, not only to keep up the high growth but to also offset Trump's toxic trade tactics, the main question is whether this remarkable journey can continue.

In Red Flags our speaker writes about the myriad ways that the Chinese economy is neither powerful nor stable. In doing so he talks about the new ideological path on which Xi's China is set, marking a break from the pragmatism that characterized China under its previous leaders. He posits that this could increase the likelihood of mishaps and even long-term instability. In raising the red flags, our speaker weaves together history, politics, and economics to give us a penetrating account of China's strengths and weaknesses. He focuses on four economic traps that could derail China as it pursues its goals of prosperity and great global influence. These are: rising debt, the struggle to keep its currency stable, aging demographics, and the challenges of changing from a low-income economy to a complex middle-income one.

With these developments taking shape the publishing of Red Flags lands with exquisite timing. For insight into the dilemmas and decisions China's leaders, notably Xi, will face in the next decades, please join me in giving a warm welcome to our guest this evening, George Magnus. Thank you so much for joining us.

GEORGE MAGNUS: That's a lovely introduction, Joanne. Thanks. We can go straight to questions.

I know people always say, "It's a pleasure to be here." It really is actually because, one, I love New York. I think it's a wonderful town. And it's a real pleasure to be not in the United Kingdom at the moment, I can tell you.For what it's—well, I don't have to tell you about pig's breakfasts and politics. Anyway, if you have penetrating and trenchant questions that can't wait about Brexit and you think I might have an answer, we can talk about it a little bit later if you wish.

But we're going to talk about Red Flags, about the book. I was kind of minded to write the book really—I've been going to China since about 1992, 1993. Often I went three or four times a year when I was at the coalface of UBS. I was minded to write it because I think something fundamentally changed in China when Xi Jinping came to power in 2012, which is basically what kind of spurred me to write about not just the economics of a rapidly growing and impressive and wow-making emerging country is facing, but the governance and political background against which these problems have to be embraced and addressed.

The book really is about the sustainability of China's model. There are two schools of thought: One is that China has the answer to most of the problems of the world because we've been exposed as being weak and without fundamental—our system was found wanting 10 years ago, and we obviously have been paying a big price for that for the past 10 years. On the other hand, there's a point of view which is that that narrative is flawed and is not least propagated by a Chinese government that wants everybody to believe that narrative, but also it has been actually undertaken and cheer-led by think tanks and academics and financial people for some time, although it's changing, as I'm sure you know.

In fact, one of the peculiar things that I think has happened so quickly in the last 12-24 months is that the pro-China lobby, as far as I can tell in this country, has pretty much evaporated. That's not as important, of course, as you can imagine in Europe but also still quite relevant, and it certainly has become a markedly different animal I think during the last year or two.

It's about the sustainability of the model. It's about the potential for political or policy instability. The subtitle of the book is Why Xi's China is in Jeopardy. I'm not making a prediction about the Communist Party disappearing from the face of the planet or the implosion of the communist system in China; my presumption is that it is going to stay pretty much as it is. Obviously, the actors may change and the emphasis of policy may shift inevitably from time to time, but I'm not making a call for democratization or regime collapse or anything like that. But I do think that the government system under Xi Jinping is more brittle than the narrative would have us believe. So that's why I'm saying it's in jeopardy. It's not because it's in danger of collapse but because it's perhaps not as robust and not quite as strong as sometimes we tend to think it is.

What I've tried to do is look in the book actually at contemporary issues that China faces, economic issues, which I call the "Four Traps" and which Joanne actually enumerated very adequately.

The most pressing of all is the debt trap. One of the things that I think a lot of people found surprising is that for a country that is supposed to think 50 steps ahead of everybody else they've repeated almost exactly the same kind of financial misbehavior that we were guilty of during the 2000s and are now having to come to terms with that.

Related to that is the quest to maintain a stable—well, they want a stable currency, and they would like it to play a much more prominent role in the global monetary system, which is another trap that I think they may fall into within the next few years.

The third is—I feel myself sort of repeating now what you just said—obviously aging. China is the most rapidly aging country on the planet. It's not the oldest, which is Japan, but the speed of aging in China I'll talk a little bit about.

Finally, the middle-income trap, which is slightly contentious in the sense that some people in my profession don't believe that it exists, but others are very fervent that it's a big problem because if you look back over the last 65-75 years, only two handfuls of countries have actually succeeded in growing out of this kind of middle-income range—whatever it happens to be over time—to join the ranks of the 33 or 34 members of the Organization for Economic Cooperation and Development (OECD) that have income per head of in excess of $40-45,000. There is a minority of countries in the world—I think there are 200-something members of the World Bank, and only about 33 or 34 of them actually are what we call "rich." So what's the key to being rich? How do you get rich if you've been poor or middle-income?

Then, on top of that, once we've gone through the domestic trap side, I enumerate and discuss in some detail both trade and Xi Jinping's Belt and Road Initiative, both of which have obviously got a lot of publicity and are very topical, and both of which have received a lot of pushback, for reasons many of which you know because it's front-page news in your media I think and also in Europe as well.

I don't think that China's problems are insuperable or necessarily unique to the country. Many countries have these issues as well. But I think the government changes that have taken place since Xi Jinping came to power make it much harder to overcome the obstacles to overcoming these issues and make it harder for China to aspire to the very ambitious goals that it has for the next 20 or 30 years.

In a sense, of course, some things don't change, and China still has very ambitious goals for its economy over the next 10-20 years: It wants to become a technological superpower. They talk about becoming a "moderately prosperous country" by the middle of the century, by which they mean a rich country. So its economic aspirations are very forward-looking.

But its political gearing as it were has done a great leap backward, if you want to put it that way, to the 1950s and 1960s, to the era of Mao Zedong, which was also a period when there was a very controlling, very authoritative leader, when the Party ruled everything. Obviously there were enormous problems associated with Mao Zedong's rule, particularly the Great Leap Forward itself and then the Cultural Revolution. I don't think Xi Jinping is inclined to try that kind of experiment in terms of society in China, but for reasons which I'll explain I think that his style of leadership and his style of government is not necessarily compatible with the economic aspirations which he has articulated for his country.

Just to give you a little bit of a throwaway of what I think about the future, and we'll come to more of this as we go through the discussion—China has been a very high-growth economy. It's unprecedented amongst emerging and developing countries. It succeeded in stringing together about 30 years of double-digit growth. No country has done that before.

It has slowed down now. The official numbers that they publish for economic activity are questionable because they look like a very smooth, flat line which has no sense of volatility or cyclicality. They are manicured, and so nobody really believes that that's really what happened in the past or even at the moment. But the likelihood is that, although official statistics say that China's economy is growing still at about 6.5 percent or a little bit less than that, I'd be very surprised if it was doing more than about 5 percent. I think—when I say "the future" I don't mean the long term, but in the next 10-20 years—the maximum that China really can grow is probably about 3 percent, maybe slightly faster than that. But I think growth will slow down.

I think that at some point the peg which the government maintains against the U.S. dollar, which is somewhere between six and three-quarters and seven renminbi to the yuan to the dollar. I think that peg is going to break, and I think the history of currency pegs, if we look at all of the emerging and developing countries since World War II, when currency pegs break, they don't break and just accidentally slip by 5 or 10 percent, they usually go down quite a lot, 20 percent, 30 percent, 40 percent. I'm not making that kind of prediction necessarily specifically tonight, but I think when the peg breaks it will be quite significant.

So, if you put these two things together, you get a slightly different interpretation of what China's relative position will look like, let's say against the United States. By some measures China is already the biggest economy in the world. There is a measure which economists use called Purchasing Power Parity (PPP), which is nice kind of academic context within which to look at relative income, and on that basis China's economy is already a little bit bigger than that of the United States. But in the kind of dollars that we spend and measure things in money, banking, finance, tourist revenues, and so on, tourist rates, so market-exchange rates, China's gross domestic product (GDP) is not as big as the United States' yet. If you believe in spreadsheets telling the future, then that point might arise in 2023, 2024, 2025, something like that.

But if you put together the combination of slower growth in China in the next 10 or 15 years and a significant depreciation of the currency, it's quite plausible that in 2030 China's GDP will still be a large fraction of the United States' but not too different from what it is today.

Again, that narrative, which is, "We have to get used to the idea that China is going to be numero uno in terms of economic power and strength"—it's not a completely pointless argument. There is sense and plausibility to it, and my predictions could, of course, we be quite wrong. It has happened before, I have to say. But I think that in this context we should also be a little bit cautious about believing the hype because stranger things have happened. For reasons that I will explain briefly—and if you're interested, obviously the book goes into them in more detail—I think both lower growth and depreciation of the currency are very likely outcomes in the future.

That's my wrap-up of the book. I'm just going to talk about a handful of things now which I hope will illustrate these perspectives. For the moment, I want to look a little bit back in time because over the last 40 years or so I think China has been through three quite remarkable transformations, which are probably unique, I would say.

The first is that many, many years ago China was a customer of the Western world. We just wanted to sell them lots of things as they were developing and starting to get their act together, obviously after relations between China and the West started to warm up and open up. So China went from being a very valued customer of Western companies to becoming a very feisty competitor in, first of all, low-value products like toys and textiles, and then in much more sophisticated products like televisions and computers and so on.

The most recent turn of events in terms of that continuum is that it has also now become as you know well an adversary and a rival in important areas, particularly in trade and in technology and in terms of international relations, under which you can pigeonhole the South China Sea, Taiwan, Belt and Road, and all of the things that we now read about more and more.

That's the first kind of transformation that has taken place. This is not the Soviet Union as it was, and it's not a small but dynamic economy somewhere else in Asia or elsewhere in the world. This is a very serious country with a large population and a very robust economy in some respects.

The second transformation has been in China's economy. Over many years following the coming to power of Deng Xiaoping in 1978, China thrived under the mantra of "reform and opening up," which was the slogan that he coined and which was about the experimentation which China did to improve the lot of its people. Deng Xiaoping is widely credited with having used the phrase in front of the Party Congress before he came to power, and the expression was, "I don't care if it's a black cat or a yellow cat, so long as it's a cat that catches mice," and that was widely seen as being his exhortation to party cadres that we can't go on like this, and we have to embrace the use of market mechanisms, albeit within the context of a state-run system that was a one-party state, but embrace market mechanisms to be more efficient, to get wealthier, and to improve the lot of citizens.

This was the guiding light of not just Deng Xiaoping but also the presidents and premiers that followed him pretty much until 2012. The timing is a little bit fuzzy because in 2013, which was obviously the year after Xi Jinping came to power, there was a so-called "third plenum" of the Party. Usually on this political cycle of the Party's meetings, the third plenum is often quite an important point in the Party's five-year cycles, where initiatives for change and discussion about reform take place. And in the third plenum in 2013 there was an extensive agenda announced. From memory now, I think it covered about 64 different sectors and 380 different initiatives which were designed to basically press on with this process of reform and opening up.

But in the event nothing really has happened of great substance. In fact, most of the reforms that were announced have either withered on the vine, been diluted, forgotten about, or they've just kind of lay fallow.

The problem with reform under Xi Jinping is they talk a lot about reform, but they don't mean the kind of reform that his predecessors meant by reform and certainly not what we mean by reform. When we talk about reform, we mean that we want our institutions to be more flexible and to be more dynamic and to improve the way in which we produce things and the quality and so on, whether it's labor or whether it's companies or products or healthcare and so on. But what under Xi Jinping China calls "supply-side reforms" is not really the same kind of thing. What they mean by reform is strengthening the role of state enterprises in the economy. While they do have objectives to reduce excess capacity in things like heavy industry in coal and steel, and they do want to reduce their dependence on credit, but it's a different kind of approach to reform from what has happened before.

The reason that China's economy is now facing a difficult period I would say is because whereas before it was an economy that was very dynamic and led by private sector initiatives and reform, in recent years it has become rather different. It has become very dependent on credit. It is much more dependent on credit for generating economic growth than many Western countries were in the 2000s. This dependency actually has cost them dear because eventually you could imagine that the Chinese economy may face some kind of a crisis. We can discuss whether that's likely in an economy where the banks are all owned by the government, but that doesn't mean to say that they can escape the manifestations of this kind of dependency on credit which they, to be fair, are trying to wean themselves away from to some degree.

You don't have to take my word for this state of affairs because Wen Jiabao, who was the premier of China in the previous administration, famously said in I think 2007 before the financial crisis rolled into China and again in 2011 before he stepped down from office, that the Chinese economy had become "unsustainable, uncoordinated, and unbalanced."

In 2016 there was a now-famous article that appeared anonymously on the front page of the People's Daily. It was anonymous at the time. People speculated about who it was. Today most people think it was the man who is coming to Washington at the end of this month to continue the trade negotiations with the White House, Liu He, who is in charge of economic and financial affairs. His message in 2016 was: "We can't go on like this. If we carry on with this addiction to debt and with this dependency on credit we're going to end up in a bad place, and we have to stop this."

None other than Xi Jinping himself said in 2017 at the 19th Party Congress that China was also unbalanced and that its economy was "inadequate"—to use his words—to meet the people's needs for a better quality of life.

So there is a recognition—this is the irony in a way about China. As you can tell from what I've already been saying I am a bit of a skeptic about China, but I acknowledge that they have achieved great things and still can and could achieve great things, but there is an irony in this that the leadership in some respects knows exactly what the problems are but can't really bring themselves round to addressing them because if they did that it would threaten the integrity and the role that they reserve and believe strongly the Party should have in the country.

There's a conflict there between what you should do and what you want to do. They want to keep the Party supreme and in total control of all issues of economic and social life in China but they know that they should do things that might threaten that primacy, so they tend not to get done, as you can imagine.

The third of the three big transformations in China has been, as I said, in the political system. The Party has for long been known for its pragmatism and for its ability to manage change well. Obviously, there were some hiccups along that route including of course in 1989 with the riots and disorder in Tiananmen Square, but for the most part the Party has done a pretty good job. I think most people would say that.

But things have changed because with Xi Jinping coming to power there has been a new emphasis as I said before on authoritarianism, on control, on ideology, on the application of Marxism to aspects of public policy, and repression. The Party has to control everything.

One of the people I know, a professor at Oxford, has talked about China as being a "controlocracy," a place that basically thrives on the control of the leadership and the Party, a sort of dictatorship that lacks institutions of constraint and consensus and that has roots that resonate with 50 or 60 years ago in the sense that the system embeds barriers to dissent, to civil society, and to foreign argument and foreign ideas.

You might think that this is all fine so long as everything goes well. Why would China need to be integrated or engage forcefully with the rest of the world? But of course, you can't rely on the fact that people will go through their political lives without making mistakes, sometimes egregious mistakes. If something goes wrong, then of course the blame falls fairly and squarely at one person's footsteps, which would be the president himself.

There is some evidence that his style of governance and government has already resulted in the emergence of, I wouldn't call it "dissent"—that would be a strong word—but "disquiet."

It's interesting that for four or five years there was almost nothing. There was this belief really that Xi Jinping was in total control. He was an authoritarian leader.

You may remember that last March at the National People's Congress the Party basically abandoned the term limits on the president. Deng Xiaoping introduced the system whereby there would be orderly succession, so that presidents would not stay in power or the leadership would not stay in power for more than 10 years. But last year term limits on the presidency were lifted, so potentially if he wants to and if the Party remains happy with him, he could be president for life. Who knows? He's young enough to stay in power probably for another 20 or 30 years if his health holds and if his enemies stay low. This has not always gone down well with people in China. We can't really measure public opinion in China, as you know.

The modern version of Kremlinologists or Sinologists who basically look at the body language and the actions—if somebody stands up when Xi Jinping is talking or if they don't stand up, and if they applaud or don't applaud. People put together anecdotal information like this, and they have detected that there are certainly senior members of the Party leadership that are not always completely happy with Xi Jinping's speeches when he makes them.

But more poignantly I think is the emergence of largely essays I would say but sometimes also comments on the Chinese Internet which are usually there long enough for somebody to take down and translate—they don't tend to stay there for very long—from imminent intellectuals at some of China's leading universities that basically criticize not Xi Jinping himself, which would be I think probably a bridge too far, but they criticize China for going in the wrong direction. For example, one professor has said: "It's a mistake for us to think"—"us" being China—"that our success is due to the exceptionalism of the Party, the state, and industrial policy. Our success is down to our ability to use and apply" what they call "marketization," which is the application of market mechanisms within their system, "to entrepreneurship and to learning from the rest of the world." This is a very different kind of narrative from the one that obviously you would get from Beijing.

Another professor more recently, at the end of last year, published a paper in which he stirred up what was already quite a lively debate in China. We talk about trade a lot in the West, as you know, which the Chinese do as well in the media, but actually one of the burning issues of debate in China is the role of the private sector. I mentioned before already that the private sector had been the most dynamic and explosive part of China's economic eruption. But there have been voices expressed from the Party that the private sector has "fulfilled its historic mission in bringing China's emergence about," or words to that effect, and criticisms that the private sector now needs to be put in its place and that pride of place needs to be reassigned to the state sector and to the important function which China's technology companies, private or public, will play in advancing China's prosperity.

This has had the effect of actually disincentivizing a lot of genuinely private companies and entrepreneurs. This particular professor has said: "Even though we have the capacity and the tools—we can use interest rates, we can use credit policy, we can use tax cuts, we can do all sorts of things to try to stabilize bad economic moments, but actually what we really need to do to secure our future and to ensure that we turn around from this direction in which we're heading are things which of course the government will not do," so he thinks they need to have total reform of the tax structure. He thinks there needs to be reform of state governance—which is kind of what we're talking about here this evening—and also political reform, which would include not just reform of the relationship of central government to local government and the Party's role within the country, but also aspects of private-public realignment, including transfer of wealth from the state sector to the private sector. These things are not going to happen under Xi Jinping.

It's true, of course, to say that these people do not run China. They are just intellectuals and academics and people who have points of view. So we shouldn't necessarily expect that there are going to be any major changes in China as a consequence of this. But it is interesting that this has emerged for the first time in Xi Jinping's China.

I've sort of run for about half an hour. I don't think I'm going to say very much more about the traps other than just to summarize what they are and why they are. Otherwise, the discussion could get quite nerdy. I'm quite happy to talk about them privately with you afterward if you wish, but I don't want to send you to sleep at this point of the evening.

The debt trap is really what it says it is; it's a rapid accumulation of indebtedness, mostly over the last few years by companies, state enterprises, and local and provincial governments, and more recently by households as well, so mortgage debt. The problem with the rising indebtedness, of course, is the speed with which it has arisen. It has tripled as a share of national income in the past of 10 years.

What's always the problem with debt, particularly in big economies like China as it was in the United States 10 years ago and in Japan before that, is it's not always the kinds of assets which cause the problem, it's how banks fund those assets. If banks lend money for projects or for house purchases or infrastructure or whatever it is, and they borrow money from you and me, they normally rely on the fact that we won't demand our money back tomorrow. We basically put our money in the bank and we take some out, we put it in, and basically these deposits are quite stable. But often when financial innovation gets out of control banks become heavily reliant on new sources of borrowing to fund their loans which are much less stable and much flightier. What caught out Bear Stearns, Lehmans, Northern Rock in the United Kingdom, and a lot of the banks that had huge problems 10 years ago, was illiquidity. Banks very rarely go bust because they're insolvent, but they always fail if they can't get liquidity.

So what the Chinese banks have done is not dissimilar from what our banks did, too, which was to basically become much more vulnerable to flighty sources of deposits that could vanish very, very quickly. Partly to address that, the Chinese have been clamping down on egregious forms of financial behavior for the last couple of years. The problem is that they don't like—it's kind of what I said before about what they want to do and what they tend to brush under the carpet because they can't contemplate it. They would like to de-leverage the system. They know they can't rely on debt forever because it leads you down a very slippery slope, but they can't wean themselves of this determination to continue to have elevated rates of growth.

You can't do both. You can't take debt out of your economy and not have a slowdown in growth. What's happening now is the slowdown, which they're very reluctant to allow to persist, so we are seeing the beginnings of a little bit of pushback against some of this financial discipline. One of the interesting issues for 2019 is how far they will let that go, but one way or the other the debt won't go away. So the debt has to be paid for; it always has to be paid for. Anyway, this is one of the most urgent issues they have to deal with.

The renminbi trap is very closely related to that. I talked before about the likelihood of a depreciation. Essentially, it's related to the overhang of too much liquidity at home. You have to have a stable relationship between what goes on in the domestic financial system and your reserves if you're going to have a pegged exchange rate. If you have a floating exchange rate, it doesn't matter, but if you want to have a pegged exchange rate, which China still seems to want to have, then the weight of liquidity is too high for the limited levels of reserves that they have, big though they are.

The aging trap is really very familiar to the one that we have. It's about fertility, essentially. Part of the problem with aging societies is who's going to look after us when we get old, but that's a very personal view about aging. The economic problem is that when you don't have enough children to replace the older people who are retiring in droves and becoming either inactive or less active than they were and certainly more dependent on spending money for health care and pensions and so on, then you have a problem because the labor force is shrinking or stagnating, and you have to find ways to compensate for that.

In China's case, for example, there are now six or seven workers per retiree, but in 25 or 35 years' time there will only be about two and a quarter. That dependency shift has very obvious economic costs which are difficult enough for us. You have an income per capita of about $60,000 in this country. In lots of European countries, leaving aside Switzerland and Lichtenstein, it's about $40,000, $45,000, $55,000. We have much higher levels of income per head and much more sophisticated levels of social security than China does, and we think it's a big problem to deal with aging societies.

So the problem with China is that they will age as much in the next 20 years as we have done in about 70 years. So it's the speed of aging. I don't think it's anything to do with the one-child policy by the way, which is more about chronic gender imbalance, but it's the weakness of fertility and the speed with which China's "boomers" as it were are retiring. And they retire quite early. Men retire at 60, and women retire at 55 or 50, depending on what kind of work they do. Although the Chinese government keeps saying, "We're going to change it," it hasn't been changed, and there are no plans to do so.

How do you fund an aging society when you're already relatively poor and when you're not willing to commit the money to those social and health care-related areas?

Finally, the middle-income trap. As I said right at the beginning, it's about how you basically—you can grow out of poverty to become a middle-income country, which is what China has done extremely successfully, but how do you grow out of middle-income status to become rich? Very complicated topic, but fundamentally it boils down to productivity, and productivity boils down to whether you have robust institutions—competitive institutions, regulatory institutions, legal institutions, educational institutions, and technological institutions—which allow people to be creative and to do great and wonderful things which will have productivity benefits that trickle down to the rest of the society.

So if it's about institutions, then my judgment is that in Xi Jinping's China they have shortcomings, because the questions that I ask really about whether in an authoritarian society you can spur people to be productive—nobody told Thomas Edison to invent the light bulb; he kind of did it. I'm being slightly facetious, but we think about innovation and we think about creativity as being something that happens bottom-up. We learn to fail, we learn from our mistakes, we think that creative destruction is actually a good thing, and openness, sharing of information, and learning from another's successes and failures and so on is something that basically creates a common good.

In a top-down system where you dictate or determine which companies will do what by 2025 or 2027 or 2028, we can be skeptical about it, but we don't know whether this is going to be a successful way of addressing issues that we all want to overcome. We all want to be technological top dogs within the next 10 or 15 years.

Myself, I still believe that our system, flawed as it is, with all the problems that it has, is still more likely to generate broader commercial benefits than China. Which is not to say that they can't achieve great things in landing on the far side of the moon, quantum computing, big data, medical technology, and gene sequencing. They are very good at doing these things. But they're also not very good at doing a lot of other things, and the book tries to look at the balance between them.

I haven't spoken much about trade because I'm sure you read about it and come across it all day long every week. We can talk about it because obviously we're in this truce period at the moment. There were stories going around this evening that Steve Mnuchin has offered—I don't know how people find this out, but some journalist basically claims that he has offered to lift the tariffs on Chinese products as a way of encouraging good or better long-term behavior. We don't know how much truth there is in this story. It may or may not be true. But obviously there is a lot at stake that has to be decided by the first or second of March. China will be very keen I think to have a deal because I think they need it quite a lot. But you could argue that President Trump may want something to crow about as well under current circumstances, so lots of things to play for.

In conclusion, I would say we can think about all of these economic issues. As I said before, they're not necessarily deeply original issues, and they're not necessarily exceptional to China, but I think they are exceptional in China under the governance system and the political system that China has because I don't think it's best suited to solving the problems which they'll have.


QUESTION: Don Simmons. Thanks for a very interesting discussion.

How does the desire of the Chinese government to build itself up militarily intersect with the economic problems or the debt problem?

GEORGE MAGNUS: One of the things which—I'm just going to backtrack very briefly. There's an interesting story about how Xi Jinping came to power in 2012. By all accounts, there was a lot of factional strife going on at the time. You may remember that one of the governors of one of the big provinces, Bo Xilai, was dismissed from his office and eventually ended up in prison. He was one of the rivals to Xi Jinping.

Before the 18th Party Congress in October of 2012 Xi Jinping disappeared for two weeks, and to this day nobody really knows why. The official reason was that he had a backache, but the Sinologists speculate that he basically went out to do a deal with the Party, the internal security apparatus, and the People's Liberation Army (PLA), without whose support he would not have been able to become president.

So he has spent quite a lot of the last five years reasserting discipline and control over all of these three agencies, including the army. The army has lost quite a lot of its senior brass to the anti-corruption campaign and has been replaced obviously with his people. There is quite a strong commitment to the PLA, and obviously the bigger China's GDP is, the bigger—whatever the defense budget is, the share of GDP obviously gets bigger and bigger as China's GDP gets bigger.

The question really is whether we think that China is primarily focused on being the dominant and unchallenged power within Asia or whether it has larger, more ubiquitous designs geographically.

As far as I can tell in the military and intelligence communities most people seem to think that China's principal focus is Asia rather than the world as such and that its military buildup will continue insofar as it can. As you know probably better than I do since it's your navy that's out in the Pacific, apart from the odd British frigate that joins in from time to, there is a tension in the South China Sea about the islands and about freedom of navigation and so on. Obviously, there are no contiguous borders between the United States and China, so the likelihood of land war is obviously very slim except possibly if things should go awry in Taiwan.

I think the military angle is an important one, but there is an infrastructure of dialogue which is good. Obviously, nobody wants a problem. The fact that there is a dialogue to resolve issues hopefully will be good. I don't think anybody can say more than that at this point.

QUESTION: Hi. My name is Bill Rabin.

If China has a big debt problem, and they own so much of our debt and that creates more of a problem in the future, what's the impact on us in the West with their debt problem?

GEORGE MAGNUS: In the industry I spent my career, this issue about the Chinese selling U.S. bonds actually was an old chestnut that cropped up very regularly. I don't think they're actually going to do that.

If relationships between the United States and China broke down completely, dialogue stopped, and the Chinese wanted to basically just send a message that they didn't care anymore, they could out of pique sell their U.S. assets. They may hang onto the dollars but not have the securities, or they might try to buy more euros or whatever. But there are practical limitations to what the Chinese could do because the dollar is the dollar is the dollar, and I think it would be so aggressive a gesture that it would send out, A, the wrong signal altogether, and B, it's an act of self-harm because the more dollars they want to sell, the more the price of their assets goes down, so they basically kick themselves in the backside in doing that.

I wouldn't worry too much about that, actually. There are other things that we could worry about in terms of U.S.-Sino relations, but a breakdown of that kind of financial dependency I think is only a risk if things really get out of hand.

QUESTION: Hi. Thanks for your comments. My name is Charlie Wang. I'm an investment analyst.

I'm trying to reconcile what you mentioned before about the strengthening of state-owned enterprises versus the private sector. I think the government has admitted that the private sector was the majority of economic growth, job growth, and innovation growth, but then they're putting the state in front of the private sector? How do you think they're reconciling what appears to be a contradiction?

GEORGE MAGNUS: It is a contradiction. Late last year, for example, Xi Jinping invited—I should say, again I just want to backtrack for the sake of full disclosure.

What the Chinese call "private" companies is not always what we would call private companies for a couple of reasons really. First of all, the ownership structure of corporations in China can sometimes be quite opaque, and if you follow the money, you can sometimes find a state holding company or an industrial holding company owned by the government or that the government has a big stake in that is somewhere in the chain, actually part of the structure of ownership.

The second reason is that particularly in the tech companies—you're all kind of aware of the problems that the company Huawei has run into, not just in this country but also in the United Kingdom, Germany, Australia, New Zealand, Canada, and goodness knows where else. As a consequence of the national intelligence law that was passed in 2018 all companies and citizens are obligated to assist the government in national intelligence gathering and dissemination.

The third thing that's kind of a complication is that, again because of the emphasis on the Party, every company where there are more than three Communist Party members has to have a Party structure in the operational management, which obviously holds sway over the board of directors.

So when we talk about private companies, we have to be careful who we're talking about. Mostly what we're talking about are smaller and medium-sized enterprises which are mostly below the radar screen.

So why the contradiction? I don't know is the answer to the question except that when Xi Jinping came to power he and certainly his colleagues were very mindful of the fact in their view that they needed to be the new leadership because the old leadership had basically allowed the Party to become fat and lazy and cut off from the people.

During the first years of their period in office, so in 2012, 2013, and 2014, they often spoke about, "We will never become like the Soviet Communist Party," because when push came to shove nobody stood up for the Party. I don't know whether they actually talked about Gorbachev by name, but they were certainly very critical of him and of what they regarded as the betrayal actually of the Party that started with Khrushchev. They went all the way back to that. For them the purity of the Party was the Party that Stalin basically presided over. I'm not saying that they want to be Stalinists in the sense that he was but simply in terms of the structure of the Party.

There is this firm belief really that the Party had lost its way, they had to reaffirm its primacy, and now I suppose particularly with the tensions that existed between China and the United States and the West in many respects there has been almost this kind of pullback really to behind the Party structure, which is "We have to look after ourselves, we have to be self-reliant, we can trust no"—I don't mean this really, but it's almost like they're saying, "We can't trust anybody but the Party."

So there is that tension. It doesn't sit comfortably with what a lot of other people in China believe about the role of the private sector, so it's not a kind of universally shared sentiment, but obviously the people in control are the ones who call the shots.

QUESTION: Congratulations on the book. I'm about halfway through it. It's very interesting.

The challenges they face now are interesting insofar as the external environment is going to be much more difficult for them than it has been in the past. I think the past there has always been this sense that, well, as they got better integrated with the global economy they would become more like us, their values would be more like ours, they would believe in these things that we believe in. Now Xi Jinping has really ripped the scab off recently and said no, that's not the case.

What is it like for them now with the external environment, and what possible incentive is there for the West not to say: "Wait a minute. This is a real competitor. We shouldn't be trading with them the same way. We certainly shouldn't be integrating the supply chain in the same way given the spying and the other things that have gone on"? It seems that would strongly factor in to how they grow going forward as well.

GEORGE MAGNUS: Yes, good point. If you think about the environment in which China did erupt into the world system, it couldn't have been more benign. It was the heyday of globalization, world trade was growing like billy-o, and they genuinely benefited from this.

The good news I think in a way is that unlike the Soviet Union, which I think did want to try to upend the world—I don't think China wants to do that. I think they are rule-based. They want to play by rules, and they do think that the global system suits them.It's just that they think we're big enough now to have an influence on the way those rules are framed.

By the way, they're not always the same as what you in the West have determined should be the rules. That's the nature of the tension.

In a way I'm slightly optimistic in the sense that I think that there is a basis for engagement. We aren't going to agree about everything, and I think we have to learn—I was listening to a podcast on the plane coming over here last week in which some professor from Yale or Harvard or something—he cited words that were uttered by John Kennedy after the Cuban Missile Crisis, in which he talked about a building a world that's "safe for diversity," which I thought was kind of a good phrase because we have to do that, too, as they do.

Nobody wants to go to war, for heaven's sake. We have to find a way of exploiting the economic interdependency that we have, even if it means agreeing to disagree about certain things that we can't agree about because we have different ways of looking at it.

At the moment, I think it's really difficult to see how that's going to work out because these are very early days now. The trade war only kicked off last year, and both sides are feeling their way around how to come to some sort of agreement about trade even though we know in the background there are very significant areas where it's almost impossible to agree. We will not agree about technology transfer, we will not agree about intellectual property infringement, we will not agree about the role that companies like ZTE or Huawei play, which is now being frozen out of 5G contracts and so on.

It's difficult. Because of the economic interdependency, I think there is a basis for thinking about—I'm not saying that the two presidents who are now in control are best suited to do this thing, but actually I do think that national interests could contrive to come to some sort of what we call in economics a "stable disequilibrium." It's not ideal, but it's not dangerous as such. I'm feeling that at this point.

QUESTION: Hi, I'm Paul Waters.

My question is, if they have a large debt, why would they be lending us money for our debt? Wouldn't it make sense for them not to do that?

GEORGE MAGNUS: It seems like an oddity. The debt that they have is like the debt the Japanese had in the 1980s and 1990s. They haven't borrowed it from the rest of the world. It's domestically driven debt. It's denominated in their own currency. It's the debt which banks and what we call "shadow banks," which are financial institutions—they're not strictly speaking banks, but they act like banks. It's the credit that these institutions have lent at home in their own currency to domestic borrowers. That's in the blue corner.

In the red corner, so to speak, they also had—at least until this year or last year—run balance of payment surpluses, so they run trade surpluses, the excess money which they have from selling more abroad than they have by importing. That's why we call it the balance of payments because it has to balance.

If you have a surplus on your trade, that money basically goes back out again as capital exports to somebody else. Because obviously U.S.-dollar financial markets are the biggest in the world and the most useful for China, that's why they own a lot of U.S. Treasury Bonds. They own a lot of Euro stuff as well, but mostly U.S. Treasury Bills and bonds.

So it's not incompatible. On the one hand, you've got a domestic debt problem. On the other hand, you've got a balance of payments surplus, so they do that as well, which has involved them buying U.S. bonds.

As it happens, during the last 12-18 months that balance of trade surplus has diminished quite substantially, and the Chinese spent a lot of money on tourism and commodities and so on. So, the Chinese buying of U.S. bonds has been much, much smaller in recent times. It seems like an anomaly, but it isn't really. You have to take my word for it.

QUESTION: You mentioned a number of things comparing democracy to communism, and you mentioned that they might not want to follow the path of Russia. All these things in balance, you mentioned there were about 40 countries that were rich. I think most of those are democracies. Do you think this is pressing China to be more of a democracy?

GEORGE MAGNUS: No, I don't. In fact, I think it's very—a lot of people talk about China. It's 5,000 years old, and it has had dynasties and a very brief experimentation with vaguely democratic government under Chiang Kai-shek and so on. Its experience with democracy you could write on a line basically.

I think it's very unlikely. Certainly, as we look at China today it's almost impossible to imagine that democratization is something that they actually think is a good idea. They don't.

I'm not saying that the political system will stay intact as it is forever because we don't know what the impact of artificial intelligence and data empowerment—we know that it's going to empower the government, but data also can empower people as all technologies do. We wouldn't have had trade unions if it wasn't for the Industrial Revolution. We wouldn't have had the social movements that we had after the Second World War had it not been for a lot of technological change as well. So we have no idea really where this new technological revolution will lead the way that people think and what they do and how they want to express themselves.

But I assume that for the foreseeable future and for as long as Xi Jinping is in power and probably beyond that that democracy is just not on the agenda.

Your point is absolutely spot-on. We have no empirical evidence that controlling, authoritarian countries have been able to break the mold and get rich. There just aren't any. So maybe China will be the first. That's obviously an experiment that they think they can be. We in the West obviously look at China's civilization and we think there are certain things going on here that we think just don't compute, to answer that question. We won't be around long enough to figure it out anyway. Some of you will.

QUESTION: Hello, professor. My name is Kevin McMullen.

What if anything can the United States do to make the situation in Red China worse, given that the ultimate objective is to have China fracture the way the Soviet Union did? I know that Reagan and the pope aren't responsible for the whole thing and that maybe there isn't anything that we can do, but is there something?

QUESTION: Hi, my name is Ofir Zigelman.

For countries that are still industrializing and a part of the Road and Belt Initiative, how do you think the borrowing relationship with China is going to impact their internal economics and politics?

QUESTION: My name is Mark Reedy. I work for Grey G Capital Research, and I used to be a diplomat in China.

My question is asking you to take a contrarian perspective. Some of your theses in terms of instabilities and vulnerabilities build upon the idea that China is basically committed to accepting the rules, accepting free capital, accepting how banking systems work.

I wonder sometimes if there's not a marginal thought that we've basically witnessed the biggest con in the history of mankind in terms of the Chinese Communist Party. It's only 6 percent of the Chinese population, but we've always assumed that the hardline was surrendering whenever they were opening up, that it was going to move—at least we have until recently. We're starting to come to different conclusions.

In reality, what do you think about the idea that there was never a commitment of the hardline ideologues to accept those rules, that the opening up was a way to accumulate capital, accumulate technology, and the tightening that we've seen in political control recently is actually that hardline exerting itself, preparing for times of instability as has come to the fore in the past?

GEORGE MAGNUS: It may be a matter of opinion. My perception is not that the United States actually seeks to fracture China or to lead to—I think "containment" is the word that normally runs off international relations people's lips. Because China is too big. It's geographically a totally different kettle of fish from the old Soviet Union. So I think containment is the word. It seems to me that the United States, the Western world, would be content if China just went about its business without encroaching on what we regard as our national interests. Of course, some of those interests they believe encroach on theirs. They think the law of the sea, borders, and maritime regulations actually were drawn up by anybody but them, and they want redress.

I think trying to rebalance the kind of relationship but within the context of containment is something that probably is different from trying to bring about the demise or the disruption of China, which I think is an impossible thing to do, really. It may be that China will do this to itself if it goes through some kind of Tiananmen kind of problem again, but I'm not predicting that that will happen.

The role of China in the Belt and Road is increasingly interesting. It would be churlish for us to think that countries basically don't want roads, airports, high-speed rail links, and all the kinds of infrastructure that Chinese banks want to help them build. On the other hand, as you know there has been a considerable amount of pushback from Malaysia, Sri Lanka, Nepal, Myanmar, Ethiopia, and increasingly, of course, from Pakistan, which is the centerpiece of the Belt and Road Initiative. People complain about unsustainability and opaque forms of governance and clauses in agreements which have penal implications, the use of Chinese laborers, the use of Chinese managers, and what Mahathir Mohamad actually said in Malaysia are aspects of neocolonialism. So there's a tension there which has resulted in China actually toning down its Belt-and-Road rhetoric during the last several months.

But it is enshrined in the Constitution, the Belt and Road, and it is his signature foreign policy. So I don't expect China to back off, but I do expect them to try to I think be a little bit more sensitive in some respects, particularly because now the so-called "Quad," which is the United States, India, Japan, and Australia, are actually belatedly starting to try to compete with China in terms of making infrastructure loans available to countries in Asia and Africa.

The last question was about—they didn't want to accept the rules in the first place. I'm not sure that's true, to be honest. I think if you look through the approach that was taken by Chinese governments under Deng and then under Jiang Zemin and then Hu Jintao, I think something did start to change before Xi Jinping came to power.

I think we can trace the beginnings of a much more truculent China in Asia to probably around 2011-2012, which is not coincidentally in the wake of the financial crisis. The lesson the Chinese took from that is that this is a system that's deeply flawed and can't be trusted, and we told you so. That's the attitude they have. But I think before that there was a genuine "There's a lot we can learn from the outside world," and they did engage in constructive ways with businesses and academics and so on. They had privileges and enjoyed very favorable treatment in the World Trade Organization (WTO) and so on.

My own view is that I think Deng's mantra about "Hide your capabilities and be modest and don't actually annoy people in the rest of the world, but learn and be smart" was a genuine feature and characteristic of China's foreign policy. It's not my expertise, but that's kind of how I perceived it.

But I do think that has changed. Maybe that's what size does for you. You get bigger, you get wealthier, you see that the rival economic system in the world has gone through purgatory, and you say, "Well, we must be doing something right." So you have self-confidence, and you start to project yourself a little bit more assertively, which is I think what's happened.

JOANNE MYERS: I thank you so much. You gave us a wonderful introduction to China. George's book is available for you to purchase.

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