Cracking the China Conundrum: Why Conventional Economic Wisdom is Often Wrong

Date: 12:30-13:30, 25th September 2017

Location: The Henry Jackson Society, Millbank Tower, 21-24 Millbank, London, SW1P 4QP

Speaker: Yukon Huang – Author of ‘Cracking the China Conundrum’, Senior Fellow at the Asia Program at the Carnegie Endowment for International Peace

Event Chair: Dr. John Hemmings, Director of the Asia Studies Centre for The Henry Jackson Society

Dr John Hemmings

When it comes to studying China, the world is immediately driven by the emotional content of the question because this is about the potential replacement of one hegemonic power by another. This is not talking about Canada’s economy. So what we strive for in all pretense (inaudible) academic rigour; you have beliefs but you don’t let those colour your analysis, you don’t let them colour the actual empirical facts. Otherwise, if you go down that route, you’re lost.

So what we have here, and I have to admit I haven’t read it but I’ve gone through a number of chapters in the way that academics do. I’ve gone through it briskly to figure out what was the line going through it and have found that it’s actually extremely nuanced. I would say that you have cast your chips on either side of the great debate which makes it all the more worthy for us to give him [Yukon Huang] our complete attention for the next 20-25 minutes and then open up into a discussion and then a debate.

Yukon Huang

Few countries command the attention of the public to extent that China does with views varying to the extreme. My book is about why there are such differences and why is conventional wisdom, in my view, almost always wrong.

Next month, the 19th Party Conference is meeting in Beijing. They’ll be studying the policies for the future. If the diagnosis for the challenges that China faces is wrong, then likely so are the policies being advocated whether it’s in Washington, whether it’s here in London, whether it’s in Beijing. I’m going to give you a sense of what I mean. As you [Dr John Hemmings] said, my book is nuanced because what I am dealing with is people who are either extraordinarily pessimistic, or extraordinarily optimistic; extraordinarily supportive of China, extraordinarily critical of China. So what I’ve tried to do is in a balanced way, try to square this. By basically squaring it, I’m trying to explain what exactly is happening and then you can judge for yourself what the policy prescription should be.

This new leadership is experiencing extraordinarily negative global perceptions about China. People are becoming very critical about China and very fearful about China. In London and elsewhere they’re being driven by trade and investment tensions primarily, turning to the economic aspects and not so much the political. At home, the leaders are focusing on a debt situation that is deteriorating; growth has slowed down, a massive corruption campaign, pressures for political liberalisation. If the prognosis for the problem is wrong, the recommended solutions are likely to be wrong.

Let’s start at the very simple level. What shapes policies for a country? They begin with public perceptions. So let’s talk about public perceptions (inaudible). Who is the world’s leading economic power? So every year, PEW surveys the American public and they ask the question ‘who is the world’s leading economic power?’ Ten years ago, practically everybody in the US would say ‘America is’. China hardly registered. Today, the majority of Americans say ‘China is the world’s leading economic power’ and I minority says ‘America’. This switch is shaped by economic forces; trade, growth rates over time, there’s a global financial crisis. The wide diverges in growth between the United States and China changes American’s views about who’s the economic leading power. Now suppose you ask the Chinese, ‘who’s the world’s economic leading power?’ They will say ‘America is’, very strongly. It’s kind of odd – America thinks China is the world’s leading power and the Chinese think America is. Who’s right? The Chinese are right. America is the leading economic power in the ways that we define an economic power. So how do the Americans not realise this but the Chinese do?

Now suppose you ask the rest of the world the same question ‘who is the world’s leading economic power?’ So you ask East Asians, South Asians, the Middle East, Africa, Latin America, Europe… and you ask the question, ‘what do the various regions think – who is the world’s leading economic power?’ The answer is, and every other region in the world says this, that America is the world’s leading economic power, except for one region. One region thinks China is the world’s leading economic power. So which region is the exception? 70% of the foreign policy expects would say Africa because China pours a lot of money into Africa, South America they pour a lot of money, or they would say East Asia (their neighbours). The answer is Europe. Europe by far thinks that China is the leading economic power. Everybody else thinks the reverse and Asia is the most opposite. They mostly think that America is the leading economic power. The fact however is, is you survey policy makers and government officials, they get this totally wrong. And this is my point, why do they get it totally wrong and why is it that their countrymen think this way?

My book begins with economics, perceptions about trade and methods to measure how strong you are. The problem is, it’s all wrong. Trade has nothing to do with its power. Let’s change the question slightly to something more personal. Do you like or dislike China? And the question is are you favourably or unfavourably disposed toward China? Favourable or unfavourable, okay? [Referring to a projected graphic that the audience can see] Now this is the result for Americans over the last 15 years. Very few people can remember that ten years ago, the majority of Americans were favourably disposed toward China. They were not critical. Today they’re heavily critical of China and the increase is not linear, it’s actually cyclical. There are actually periods when it goes up, then it goes down, then it goes up so it’s not just one way. It is effected by economics as well as politics. China’s growth causes people to get nervous in the US. When you have a global financial crisis, China’s growth is good for the world so you begin to feel positive about China. Then more recently you have the South China Seas, North Korea. A surge of this and you get very, very negative. America is very negative right now for a whole bunch of reasons. But if you deal with policy you should understand the nature of those reasons and the origins of why. Very few people get down to this. But let’s ask the question… let’s ask the Europeans the same question – are you favourably or unfavourably disposed toward China? And let’s look at four major European countries – England, Germany, France, Spain. Which country dislikes China the most? Which country likes China the most? Which country dislikes China the most, which would you guess? [Audience say UK]. Which country likes China the most? [Audience say Germany]. The answer of course is, the exact opposite. Germany is the most unfavourably disposed and dislikes China, the UK is the most favourable.

Now you all are here because you are interested in foreign affairs, you have some knowledge, but you got it entirely wrong. My point is, if I ask the foreign policy experts [the same questions] they get exactly what you said and they’re exactly wrong. Isn’t this kind of interesting? Very basic questions which shape foreign policy, recommendations and perceptions… conventional wisdom is always wrong because your country’s policies towards China are shaped by these kinds of perceptions and the more you are an expect or policy orientated, the more likely you’re going to get it wrong and that’s where we have a problem in this world. So I start off my book in Chapter 2 with perceptions – why do people feel this way? And I explain, why are the Germans most negative? Why are the Brits most positive? Why do the policy makers not realise this? Why if you look at the BRICS, South Africa is the most negative in Africa. Brazil is the most negative in Latin America. BRICS does not help each other get along it actually makes people hate each other more. These political relationships are driven by personal ones which are unpredictable. So that’s the first point. In every chapter I say ‘here’s the conventional wisdom’, these are not esoteric questions, these are not minor things – they are major things but they are always wrong.

Now… trade. Everybody in the US thinks that America’s trade deficits (which are huge) are caused by China’s huge trade surpluses. My book then says ‘there is no relationship between America’s deficits and China’s surplus’, no relationship! But everyone thinks so. Even the Chinese think so if you ask them. They won’t admit it, but they’ll think so. So how do I explain this to people that are not confident with trade theories because it gets a little technical. I have a very technical explanation in [the book] about why, based upon economic principles but that’s not understandable to the general public. So I’m going to explain to you as the general public in very simple images [referring to a projected graphic that the audience can see].

Here is America’s trade deficit, insignificant in 1996 and ’97, it becomes really huge by 2000, stays very huge, gets a little bit better, stays at a fairly substantial level and that’s what they are today. So this is America’s trade deficit. Now let’s look at China’s trade surpluses. Notice that they don’t even matter until about 2004/05 and then they get very huge and then they moderate. Look at the relationship between China’s surpluses and America’s deficits. There is no correlation at all. America’s deficits become huge even before China generates any surpluses and then when America’s deficits start to improve, China’s surpluses get even larger – they move in the opposite direction. There’s absolutely no relationship but everyone including the White House thinks that China is the cause of America’s deficits. The question then becomes that if you get these diagnoses wrong then you get the policies wrong, totally wrong.

Now today’s interesting because Europe is generating significant surpluses. America’s trade problems are more with Europe than they are with China, but why does everyone think that it is a China issue? [Referring to a projected graphic that the audience can see] Here is America’s trade deficits in manufactured goods with Asia and what’s interesting is that it hasn’t really changed in 15 years, it’s been about the same share since 1990, 2000 and 2015. The question is ‘where is it being recorded’? In 1990, China only accounted for 8% of America’s trade deficit with Asia – today it is the majority. Why is that? Because other productions share a network. All these parts and components produced in South Korea, Japan, Taiwan [are] exported to China, they end up in the US and it is recorded as a ‘China export’ but really it is an export of Japan, Korea, Taiwan.

So that iPhone that we have in the States that costs $700, $25 of that actually stays in China. $250 of that goes to Japan, Korea and Taiwan and $250 goes to Apple – it’s extraordinarily profitable. But everyone thinks that it is a China surplus. It really isn’t, it is an Asian surplus. It only shows up because it is shipped through China [whereas] before it was shipped directly from Korea, Taiwan and Japan and now it is different. The changes and the policies that you want to deal with this are completely different because no one understands what’s actually going on here.

Here is the next problem that is going to emerge (inaudible). China says that it wants to improve connectivity with the West. 65 countries are involved with potentially trillions of dollars. China sees this as an economic issue that benefits everyone and will promote more trade. Externally most countries are extremely nervous. They think that China is going to push its values on countries, it’s going to come up with lousy projects, it’s going to put countries into debt and it’s going to be a source of tension for years to come. But the basic point is no one is going to force a country to have a project. It is up to them to decide whether that project is good or bad but this is going to be a source of tension because of the geopolitical issues. So trade is a problem – tension is still there and misunderstood. But one-belt, one-road is also a big issue that’s misunderstood.

Innovation, technology transfer, theft. That’s what you read about in the West. So Germany, France or even England, people are worried about China coming in and buying technology – worried that countries will give it to China, that China will become much more innovative, that it will be able to dominate the world. Let’s look at this because in my book I have a chapter on this question. Is China trying to be more innovative? The answer is that clearly it is trying to become more innovative. So how do we know this? [Referring to a projected graphic that the audience can see]. On this axis is how rich the country is per capita GDP. On the vertical axis is (inaudible) how hard they are trying to as measured by a global innovation index which is put out by Switzerland and a group of universities. Every year they record how much a country is trying to become more innovative. They look at RND, subsidies, support for universities, promotion of technology (inaudible) and they come up with index. So every year they come up with an index and what it shows is that compared to other countries having to adjust to how wealthy they are, China tries harder than any other country. (Inaudible) development, they subsidise various industries, promotes its universities, has programmes to go with its high-tec…

So china is trying to becoming more innovative. So there is a slide that basically shows something that practically every country falls in this line – the richer you are, the more innovative you are. So the issue is, are you above the line trying harder or are you below the line trying less hard? And the answer is that almost everyone is very close to the line except for China which is way above the line. It tries harder than any country we have seen. The only other country with a similar level of effort over a sustained period is South Korea.

The second question is whether they have been able to get results? I have an index which says ‘are you producing more sophisticated products as a share of the GDP above what one would predict [to be] your income level’? China is steadily making enormous progress, faster than we have ever seen. They’re not up there at the levels of the very rich countries because they are still very poor but it’s soared. The other aspect of the question which is interesting – what about the rest of the world, particularly the G20? What happened to them during this period in which China was getting much better? [Referring to a projected graphic that the audience can see] The interesting thing to me in this diagram, and I’m writing another book on this, is every one of them gets worse. Every one. Whether you are Russia or Brazil, Germany, Japan or US, they are getting worse. That means there’s another subset of countries because these countries are all getting worse, there must be a subset of countries that is actually making progress. And there is. These countries are globally not as connected, and relatively small. But to me there’s actually a shift in the (inaudible) technological capacities of countries which is changing the growth relations of countries in a way that we have not seen. But China is going to be the focus of this. Because it is the only one, you either see it or feel it. When you read the newspaper you feel it.

Third point. Does China steal? The answer is that China steals technology or adapts technology from others to an extent that we have never seen before. [Referring to a projected graphic that the audience can see] So I have a diagram which shows how fast and how much compared to other countries. This adapting [of] technology can be legal – trade, foreign investment, buying it. It can also be illegal. It can also be secured through what I call ‘unfair bargaining’. The question then becomes, how do you deal with this? How long is this going to continue? So we can compare China with Taiwan, Korea etc who also stole, so how long did they steal [for]? In my book, I actually calculated the probability that a country will steal. Now the interesting thing about countries that steal – they tend to be low income, they tend to grow very rapidly and they tend to be quite skilled because there’s no point stealing something if you don’t know how to use it and most countries cannot. You can’t benefit from theft in most cases because you don’t have the institutional capacity to make use of it. China does for a variety of reasons and the question is how, why and how long is it going to be before it stops stealing? The answer is that it’s going to be a long time. That’s a subject that I want to get in to. Conventional wisdom in my view, when they look at innovation and about technology theft, they haven’t captured the guts of the issue.

I want to get down to China’s debt problem. So let’s start looking at some of the internal issues. [Referring to a projected graphic that the audience can see] So here’s China, way above normal. This is the performance/success/results for China over the last 10 years. Output from a sophisticated product line is steadily improving. Here is everybody else. They have all fallen down a little bit, a lot, or don’t change. The US doesn’t change, the UK is lower, France lower, Germany doesn’t change, Italy goes backwards, Spain… the question is why? That’s not an easy one to explain.

[Referring to a projected graphic that the audience can see] Here is theft. Theft is red. Green is [showing] that you’re no longer stealing and there are periods of time when South Korea, Japan and Taiwan all stole, and they quit. The question is when China will quit. The answer is that it will take a long time. Not until they reach a certain level of GDP, not until growth slows down. But you will eventually no longer steal but that’s going to be a major issue.

People think that China’s growth prospects are that it’s going to do well for a long period of time. The pessimists see a potential financial crisis and a crash. I think that China will continue at the [aforementioned rate] for the foreseeable future. It’s not going to crash but it won’t be as good as the optimists might say. If you are a pessimist, why do you think the economy is going to crash? The answer is debt and the financial pages will be dominated by China’s debt indicators soaring. Every country with a debt has surged by this amount has crashed. So why not China? The answer has to be that there’s some peculiar about China that does not exist for other countries. [Referring to a projected graphic that the audience can see] So here is China’s debt to GDP ratio along the horizontal axis. It’s about 250/250% of GDP. So let’s concentrate on this horizontal axis – debt to GDP ratio. This (inaudible) the hundred major economies. What you see is something very interesting. China’s debt to GDP ratio is higher than practically all the developing [countries], it tends to be among the lower values of the developed. If you think about it that’s probably what you would guess because China’s not really developing, it’s not really developed. If you have to guess, you’d put it in the middle. Yet people think this is a real problem. Where China is unusual is the vertical axis – the speed at which the ratio increased over the last ten years and that’s very high. Only a few countries has a debt ratio that has increased by that speed and many of them had trouble – Japan, Greece, Ireland. And here’s an interesting case; Singapore. Singapore doesn’t have a problem but its data indicators have increased even more rapidly than China. In my book I point out that actually, China’s debt situation has more similarity to Singapore that the countries like Japan that people tend to compare them with. Why is that? It is because both countries save a lot and the role of property plays an unusual role. Where did all this money go to in China? The surging credit levels, is it completely different to what you see in other countries? The answer is yet, actually. It largely went to property. Property and land values in China over the last ten years have gone up by 500-600%. So you’re sitting here in London. You know what a surge in property prices means – 50% increase… 100% increase… that’s large and you still have to worry about sustainability. What happens if it goes up by 500/600%? Surely it must be a crash? The answer is no, it isn’t a crash because private property didn’t exist in China fifteen years ago. This is going from a very low base to something like Asian levels.

So how do we know that this increase is not excessive? Who do you compare it to? I’d compare it to India because India is a developing country and it’s very large but India’s per capita GDP is one third the size of China’s and it doesn’t grow as rapidly as China. So what does conventional wisdom tell us? Are property prices in Delhi higher or lower than in Beijing? Property prices in Bombay compared to Shanghai, which would be higher? Most people would expect Indian prices to be lower than China’s but India’s prices are twice as high as China’s even after a 600% increase. So in my chapter I show that China does not have a debt problem. What is happening in China is what we call financial deepening. Money is beginning to realise that value of an asset hidden in a socialist regime. That asset is land.

Conventional wisdom is that the more corrupt a country, the slower it goes. As a country gets richer, the less corrupt it becomes. So OEDC European countries, developed countries, are less corrupt than developing countries. Countries that are stagnant, those in the Middle East and other countries, corruption is the reason why it doesn’t grow. Why is China different as it is very corrupt and grows very quickly? The richer it gets, the more corrupt it gets. It does not fit the stereotype and Xi Jinping wants to eliminate or moderate Chinese corruption to preserve the credibility of the Chinese party. So why is corruption good for growth in China but bad for growth in every other country, without exception? The reason is something very particular to China. So some people think the answer is because these are Chinese but that doesn’t explain it. The answer is that corruption greases the wheel but why doesn’t it do that in Indonesia, why doesn’t it do that in India but only in China? The reason is that China has a mixed economy. It has a state sector and a private sector. In the state sector, the returns on capital are very low whilst in the private sector the returns on capital are very very high. But you’ve got a political problem because the ownership of land and assets rests with the state but the entrepreneurs are all in the private sector. So how do you get the use of these assets to the private sector so that China can grow very quickly? The answer is corruption.

So entrepreneurs basically strike a deal with the authorities for the use of assets in exchange for a share of the profits. China’s administrative sector is structured in a very unique way. It promotes the investment in rapid growth and this is not the same in any other country. Not in the Soviet Union, the United States, Italy or Brazil – it basically allows a very rapid growth and corruption is what does this. Now the problem is that if you eliminate corruption without changing other things, growth in China will fall. So Xi Jinping has a problem. He thinks that if he eliminates corruption, growth will increase. But in fact, elimination of corruption without other reforms will actually stifle China’s growth in the future. [Referring to a projected graphic that the audience can see] This is China’s growth model and I’m going to say this very simply. This is the existing growth model of China – it’s what I call a Chinese dining table. The Chinese dining table has GDP at the top and its growth is dependent on the party, the government, state enterprises and state banks all fused together in a very coordinated way and corruption is one of the glues that holds this system together. This is extraordinarily efficient having a coordinated system that’s been able to generate growth, but the issue is that they are trying to move towards what I call a Western dining table. The Western dining table has four legs. You split up the political parties, the government, firms, banks… you introduce accountability. This is what’s happening in China – indecision about whether you want to move or not and be stuck in the middle and there are all sorts of consequences. This is the major question facing the United 19th Party Congress (China). Do they continue moving in this direction or are they going to be stuck in the past?

I have tried to give you a sense of the issues and why it is that the people see things differently – it depends on what you see, philosophically how you feel… it’s very risky to oversimplify but people do so. There’s no suitable analytical framework in economics today that we can teach that allows people to understand what is happening in this country and that’s basically what I have in my book. [End of talk and start of Q&A].

Question One

You mentioned property prices. Wasn’t the financial crisis of 2008 caused by sub-prime mortgages in the US so couldn’t the same thing happen in China?

Answer One

The sub-prime bubble in the US is because people are giving mortgages with no down-payments to people whose salaries were never verified and then it multiplied and there was a chained-link between households, banks, insurance companies and others who basically sold off these kinds of mortgages and then the whole system got wrapped up in it.

It cannot happen in China because there is no mortgage market selling these things off. It cannot happen in China because you have 40% down-payment requirements. Property has gone up by 600% so the amount of equity that most Chinese people have in their homes now is incredible and I’ll give you an example. I bought two apartments in China in 2006 for $400,000. At that time I couldn’t get a mortgage – I had to pay it all before they even dug the hole. I sold one of them last year for $2.4million. The person who bought my apartment, he had to put down $1million down-payment and he had a mortgage for $1.4million. If this property crashes it has to fall dramatically because he’s put $1million down. But here’s the point – debt. Debt goes up by $1.4million in the system because of the credit/mortgage. What happened to GDP in the transaction? The answer is that GDP didn’t change because the transfer of land value or the depreciation of land value doesn’t count in GDP because what most people are saying is that the debt to GDP ratio has soared. But no, it hasn’t – the value of your assets has increased in multiples, faster than the debt has. That’s a great thing. The analysis however says that it is a bad thing. Then the question is whether it is sustainable. Affordability for housing in China has actually improved however. The inventory of unsold housing has been cup in half over the last eight years. The stock of unsold housing has actually fallen. There’s actually going to be a supply problem in China. The pressure is for it [prices] to go up rather than come down. In a nutshell, and as I say in my book, the property market is not the problem. There are some really big problems in the financial sector. There is a budget problem in China but you rarely see that in the newspapers. They always focus on banks. So when I talk about conventional wisdom being wrong – the point I say is that conventional wisdom thinks that there is a banking problem in China, but there isn’t – there is actually a budget problem in China at the local government level that is never fully recognised.

Question 2

When you go out to more rural cities, it appears that they are building houses way beyond the demand level. It is fair to say that there are a huge number of people that could relocate but is it possible that the reinvestment of money obtained through connections into China is going to go elsewhere or do you think it will remain within the circle and that there’s enough demand to sustain it? 

Question 3

To what extent is the anti-corruption campaign a sham? Or put a different way, how wide are the limits, or perhaps more accurately, the off-limits to that? And do you have any comments to make about the role of Macau, Hong Kong and Singapore and maybe Kuala Lumpur as the equivalents of the Channel Islands for China? (By that I mean not just tax havens and corruption).


Answer 2

If you go out to places like Chengdu, there are a number of things going on in China that are not obvious. You see, in some cases, excess surplus housing or building occurring… more so than you see in Beijing and Shanghai. The over building in China is in the outer provinces and the smaller places. Why do you see this? I told you China has a budget problem, not a banking problem. Those local authorities don’t have sufficient tax revenues so the only way that they can finance their needs, whatever the needs are (roads, highways, social security…) is to become commercial entities and they develop commercial land developments. They use the land they have, they pair it with banks and entrepreneurs and they over build. In some cases they don’t over build, but they build. If they are successful they will generate a lot of profits and use that to fund local government expenditures. In the West, that would be done through revenues or bonds. In China it’s done through this kind of land development, linked with banks – that’s why you have a banking over-building problem. So the question is, is there overbuilding? Are these ‘ghost towns’ getting better or worse? The answer is that they are slowly getting better. Why? Because China is starting to move into some of these areas, the inventory in these cities has fallen dramatically.

Answer 3

Is there corruption? There is corruption everywhere but in a different form. What is the form of corruption in Chengdu? The primary form of corruption is either provincial authorities – I control the land, the right to produce, I can even get access to preferential financing but I do a terrible job of using these resources myself so if you’ve got a good deal and you can try to generate growth or jobs or something, I will give you access to these resources, and let’s share. We will both benefit if we are successful. If we are not successful, then neither one of us will benefit. In India, if you have a local authority in somebody, first of all that person already has the land – he is trying to operate. The local government official can only make money by ‘holding him up’. He has no motivation to produce – his motivation is to slow down to get a pay-off and then the guy can go off on his way. In China, the motivation is ‘the more we produce, the more we can share’. Now going back to the problem of Xijing Ping’s corruption campaign, he wants to eliminate corruption because he realises that it is weakening the authority of the state and the Communist Party is losing prestige. But the other major concern in China is that they must grow rapidly. This system allows a mixed economy to invest and grow rapidly in the absence of the rule of law and in the absence of strong institutions. Now normally in the text books we would say ‘proceed with the rule of law, proceed with institutions, get it right and you will be able to flourish’. So this is what I call the pragmatic way to deal with the chaos in a way that does not allow for your economy to collapse but it’s not sustainable. At some point in time these issues have to be addressed and this is what I’m talking about in terms of the challenges facing the next generation. These issues are left in the middle – it doesn’t work.

The issue with Xijing Ping’s corruption campaign is that he targets his foes and so on. For all the people that have been jailed and prosecuted, there’s a huge number of people that are just ‘corrupt’ and that’s because people are nominating others, throwing people’s names into the basket. So you have both political opponents being persecuted as well as corrupt officials. The problem is that there is no one in China who has been in business long enough to be totally free [from corruption]. At some point there is going to have to be an amnesty. At some point you have to basically quit doing this.

In terms of Macau and gambling centres, they have all suffered a lot with the corruption campaign as people cannot bring out their money. There are tax havens but the tax havens in the world are the same for everybody else. They’re in the islands, various other places, there’s areas in Europe. Somebody mentioned the question of taking money out. There was a time in China… why did I sell my apartment a year ago? I sold it because I could take out my money instantaneously. Before that I worried about it so when I sold my apartment, within two hours I had wired $2.4million to my bank in the United States. Here’s the strange thing – when I asked the Bank of America to wire money to the Bank of China in Beijing and I want to wire more than $5000 I can’t do it because China bars the inflow of money without prior approval. So for a long time China had this strange situation where it was easier for people to get their money out than to bring it in because you’re mentioning that it was hard to get your money out. Now, China has basically clamped down and now people are having a hard time getting their money out. The consequence of that is that people are now more prepared to buy in China. That’s what I saw in the last six months.

So you either let people come out and they buy property in London or if you don’t let them out they buy property in China. Now, either way, the problem is actually something quite different. It’s not so much property or corruption or capital flows but the really strange thing in China is that so many people have so much cash and they aren’t all big business people in China. I used to have a secretary in China who, with her husband, earnt $15000 a (inaudible), which is comparatively less than what you could earn in London. But she had six houses. One was given when housing was privatised and so did her husband. Her parents both worked, they both had two. His parents also got two – they passed away. She has six houses now all paid up. They’re worth about $4million on a $30000 salary. It’s about recognising the monetary value of assets in China which are not clear in the social system. A tremendous wealth effect – people actually missed that – a tremendous wealth effect that’s given this current generation has given an enormous amount of assets on top of their savings which we have never seen.

Question 4 – (From a Member of the Chinese Embassy)

Recently Moody’s downgraded China’s [economic] ratings and I don’t know whether you agree with their decision and how do you look at this prospect for the Chinese economy?

Question 5

Will China grow old before it gets rich?

Question 6

What do you see as the major future constraints on Chinese growth? Environmental, running out of cheap skilled labour, running out of skilled management…?

Answer 4

All [economic rating services] have downgraded China, spread over different periods of time. The downgrade of ratings is strange because China’s financial ratings have improved. I would have said if you want to downgrade it, it would have made sense a year or two ago as things were getting much worse. The economy has actually bottomed-out, the debt situation isn’t actually such a big issue. Right now, after you read the papers (the Financial Times, the Wall Street Journal…), there are articles which are basically saying ‘the economy seems to be doing really well. There aren’t problems and people aren’t worried anymore’. I think frankly they are going a little too overboard – just like they were a little too optimistic before, they’re a little too pessimistic now – but this is a funny time to downgrade. I also don’t think that they downgrade for the right reasons. They think it’s a debt problem and these kinds of issues. I’d say China’s issue is more of a fiscal budget issue. It’s a long term structure issue. It will not make the economy collapse, but it will make it very difficult to allocate the resources and the kinds of things necessary to make sure things get done. And this is a struggle. But a budget problem is a problem in Europe, the United States… it’s not something that will go away.

Answer 5

The demographic problem in China, as you well know the One Child Policy… it’s getting old. Will it get old before it gets rich? Yes, it will get old before it gets rich. Then the question is more of a debatable question. Is the absence of surplus workers getting older detrimental to growth? We all assume that’s the case. We assume that if you have fewer workers and fewer young workers, that your growth rate will fall. The answer in economic literature however is that it isn’t. India has tons of young people and doesn’t grow – Latin America has tons of young people and doesn’t grow. The issue is what you do with them. The burden on these countries, even India, in trying to deal with people who are not well fed, well-nourished or well educated – the cost of trying to do this actually decreases your growth rates for a while. So China had to go through a huge effort to educate and do everything to its people so that they can be productive. The cost is doing that is very very large. So how did China do this? It did this because there are few savings for the households that it can tap – India does not. The problem in India in trying to get its labour force who are young to be competitive in a fiscal sense is a huge problem nationally that can’t be resolved easily. But here’s the kicker. If you run out of surplus workers and young workers and cheap workers, how do you compensate? One answer is you become more innovative – robotics, artificial intelligence, different ways of operating… the literature shows that in ageing societies, it turns out that they’re more innovative and they’re better off. There are also countries that don’t do this and their systems are not compensating for the problem of ageing and they’re worse off. The bottom line is that this can actually be a surge of innovation growth or it can be damaging sin growth – it is up to the state to decide to figure it out.

Answer 6

I say most people focus on the wrong ones. Innovation is one of them. The more innovative you are, the faster you grow – that’s conventional wisdom. In my book I say conventional wisdom is always wrong basically because I say it turns out that the more innovative you are, the slower your country grows. People never realise that.

The next question – is this true for companies? The answer is no – the more innovative you are as a company, the more profits and value you gain, it’s not clear. The US and Japan are very innovative but it doesn’t translate more rapid growth in terms of more widespread ranges and GDP increases. There is a very complicated reason but in my next book I will be showing why innovation at a national level discourages growth. Productivity increases, demand for labour falls… all sorts of things happen, but profits of companies surge. Why is it that over time, wealth concentrates but general wages stagnate?

The next issue is what’s the growth driver? Innovation, if you do it at a reasonable level or in a particular way is very supportive and helpful but it’s not the growth driver in China actually. Urbanisation is the growth driver in China. It’s a growth driver in China whereas in some other countries it’s a drag – your cities are not productive but in China it is a positive force because the ratio of urban productivity, labour productivity to rural productivity in China is 3 – it’s the highest in the world. So workers in the cities are three times as productive as in the rural areas. We have never seen a country where that difference is so wide. To give you some examples, in most developing countries, that ratio is about 2.2. The urban area is about twice as productive as rural. In developed countries that ratio is about 1.4/1.5. In a mature economy the productivity is not very different in rural or urban areas. Now here’s the real kicker. Do you want big cities or small cities in order to be productive and grow faster? China basically does the following – it says you can move to small cities in the far-out provinces like the Chengdu area but we don’t want you in the big cities like Beijing and Shanghai. So China is stopping people from going to the big cities so it is completely different from any other country in the following way: its small cities are more densely inhabited than small cities globally whereas its big cities are less densely inhabited than big cities globally. Yet you would never believe this. If you went to Beijing or Shanghai you’d say there’s too many people here! But no one realises that in the core centres of Beijing and Shanghai, there are 20% fewer people there today than there were ten years ago. They have moved out. That’s what’s happening. As a consequence, Beijing’s urbanisation programme is becoming less efficient because bigger cities are more productive than smaller cities. So in my book I basically highlight that the key possibility for China to grow at 6% or 7% a year is that it makes its urbanisation project more efficient and rational because it’s a very powerful force for pushing up investment, consumption and demand. If you don’t get it right you’re going to have a problem, but if you get it right, China could grow at a very strong rate for the foreseeable future.

John Hemmings

I think what we saw was the gates of conventional wisdom being blown open by what I thought was incredibly nuanced analysis. You have a grasp of the figures at your fingertips. The Oxford University Press, probably the best publisher in the world thinks very highly of this book and so should you. Thank you very much.


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