Published in 2018, Red Flags is about the four economic traps China faces according to Magnus. They are first short-term challenges: (1) the debt trap and (2) the renminbi trap. Then, over the medium-term, China faces a demographic/aging trap and the middle-income trap.
Background and History
The book begins with three chapters of background information. One covers the Chinese "Century of Humiliation," the next is the era of Communist rule, and the third is about the economic crossroads that China is at today. In these chapters, Magnus discusses how China was forced to pay massive indemnities again and again after losing wars in 1842, 1860, 1896, and 1900. Annual payments on debt in 1920 made up about 40% of GDP. A quick google search shows US federal debt service makes up 1.6% of GDP according to the CBO. In the second chapter, Magnus points out that Mao was unable, during his tenure, to stimulate strong economic growth like China had in the 1990s and 2000s, although some of the fundamentals were there early on. When the Communist Party came to power in 1949, income per head was $450, and by the time Mao died in 1979, it was $850. So better, but not by much, and Magnus says this is well behind South Korea, Taiwan, Singapore, and Hong Kong at the time. Between 1948 and 1978, Chinese proportion of world income rose to just under 5% and its share of world trade was just 1%, making it not very critical to the world economy. But even though China was not yet relevant by 1978, GDP grew at a respectable 6% annually on average until that point, and industry grew from 17.6% of GDP to 44%. Under-five mortality dropped from 205 per 1,000 live births to 73. And while 80% of China's population was illiterate in 1949, literacy was up to 80% by 1958 and then to 97% by 1975. Secondary school enrolment went from 6% to 50%, and average years of total schooling increased dramatically as well.
With those benefits laying the foundation, China struggled to build on that, as they were unable to produce large food surpluses and had insufficient employment to create sustainable consumer demand and a classic Communist neglect of efficiency and incentives. It doesn't help that China allocates government funds in a completely opaque and political manner, ignoring any conception of a popular mandate. Funds are allocated more to maintain loyalty of Party supporters than to promote economic growth based on national objectives. While the labor force grew by 200 million Chinese people, only 40% entered the "modern sector," whatever that means. The agricultural labor force was 70% bigger in 1978 than in 1952 and the agricultural laborers were worse off than urban dwellers. However, during the decade from 2003-13, when Hu Jintao and Wen Jiabao were in power, China took off, going from the world's sixth-biggest to second-biggest economy, and income per head went up from $1,293 to $7,080, or $3,940 to $12,205 in purchasing power parity terms.
In the 2000s, China's export surplus exploded, reaching 10% of GDP by 2007, and being the greatest in the world in aggregate today. However, despite being so huge, the surplus as a percentage of GDP has dropped to 1.4% as of 2017. In an aside, Magnus gives the reader some interesting information on the Chinese economy. He writes that State-Owned Enterprises account for only a fifth of output and a tenth of employment, but that doesn't mean the rest is private. Many of the rest of the firms have large or majority state owners who exercise significant control over their appointments of executives and corporate strategy, usually disguised by multiple layers of investment companies. With these included, the purely private sector of the economy is probably about 25%.
A significant issue in the Chinese economy today is that the Chinese "hukou" system doesn't allow people to move freely. 44% of Chinese people are rural, for a total of 600 million people. Many of them try to migrate to cities for better pay and public services, but they do so at their own risk. When a Chinese family lacks an urban hukou, some of them will often try to migrate to the city to work, and those migrants make up 36% of the workforce. The hukou system was created in 1958 to restrict rural migrants to Chinese systems, and although changes have been made so that migrants no longer need a permit to work and live in cities legally, they still need a permit to have access to social services and welfare. In 2014, a new reform attempted to steer migrants away from larger cities towards smaller and mid-size cities by allowing big city municipal governments to set stricter settlement criteria, and urging them to control population inflows.
China also faces a severe income inequality problem about on par with the United States. China has a Gini coefficient of .47 as of 2015, compared with .3 in the 1980s. This is considered a marker of very high inequality. 1% of Chinese households own a third of the country's wealth while just one percent of wealth is owned by the bottom 25%. These numbers were similar in the USA, which is incredibly bizarre to me since China is a "Communist" country. Obviously Communism is not "pure" in China or whatever but that's still pretty remarkable.
Debt Trap
China faces major issues with both debt owed by the government and also household debt due to years of credit-funded investment growth. It worked for a long time. During the 2008 Financial Crisis, GDP growth only dropped to a low of 4% per annum, and by 2011 China briefly returned to double-digit growth. But China borrowed its way out of the crisis, with debt as a share of GDP increasing from 135% to 170% between 2008 and 2012. By 2016, China's debt to GDP ratio rose to 255% and by the end of 2017 it was over 300%. So this indicates that China has funded a huge amount of its growth with money it didn't have, putting major stress on their banking system. About half of all new credit between 2005 and 2016 came from China. The central government is not a major borrower, with debt of just 15% of GDP, although the accounting is opaque, says Magnus. Most of the debt is owed by companies, mostly SOEs, and local and provincial governments, which together amount to about 200 percent of GDP. But I'll say this: what the fuck is he talking about? I keep seeing IMF figures and everywhere that show Chinese debt is much lower, like 60-75% of GDP. This doesn't make any sense. I can't figure out what is being included and what isn't. I don't get it.
Well. Anyway, Magnus says it won't be possible to grow its way out of its debt, since it's the higher creation that drives China's higher growth. Additionally, he writes that China's high savings rate can't save the country either. China's debt risk is not what many countries like Argentina or others have faced in which they owe large amounts of foreign currencies. Rather, China has to deal with high domestic debt involving Renminbi assets and liabilities. This would be more like the US situation in 2008 in which a high savings rate did not help much. I also honestly didn't understand this part too much either.
The Renminbi Trap
The next trap China faces is how to raise the value of its currency. As of 2017, renminbi made up just 1.6% of international payments. The problem that China runs into is that since it has such a massive current account surplus, countries are constantly buying goods, bringing foreign currencies into China rather than exporting renminbi to the rest of the world.
The Renminbi faced a major challenge in 2015-16 when the Chinese markets crashed, bringing the RMB down to 7 against the dollar by the end of 2016. The fall was only stabilized by China burning its foreign currency reserves by $500 billion. Luckily for them, their current account surplus from earlier years had meant that their foreign reserves increased from $400 billion in 2003 to $4 trillion in 2014. So it wasn't a huge problem for China, and they bottomed out with $3 trillion in January 2017. That's really an amazing amount considering that the USA has something like $250 billion (not that we need it since we can print dollars).
The Demographic (Aging) Trap and the Middle-Income Trap
I am combining the demographic and income traps because I took fewer notes on these, and really not that much on aging because it is so straightforward. Because of dumb One-Child Policy (OCP) and the general trend of countries' fertility rates dropping as they get richer, China's population is set to crash over the next few decades, with a way higher proportion of people being too old to work than is good for the economy. Magnus writes that the Great Leap Forward (1960-62) crushed Chinese fertility as well as killing 40-45 million Chinese people. Fertility rates dropped from 6.4 children per woman to 3.1. Numbers climbed again into the early 1970s, reaching 5.8. But then, the CCP introduced family-planning policies that brought the rate down to 2.3, and then started OCP, bringing the fertility rate down to 1.45. Although numbers picked up to about 1.5-1.6 in the 2000s, they have not reached replacement levels since then. OCP was enforced by means of pension arrangements and its effect was large, but can be underestimated. Consider the fact that many places like Singapore, Taiwan, Hong Kong, and South Korea all reached lower fertility rates without such a policy.
The other difficulty China faces is the so-called "middle-income trap." There seems to be some disagreement on whether such a "trap" exists. After all, the high-income countries deal with slow growth, and low-income countries have to deal with being poor. So everybody has problems. But the specifics of this are that countries' growth tends to slow down initially as per capita income moves into the range of about $10,000 and then again at around $15,000 (in terms of 2005 purchasing power parity to US dollars, so it would be higher now). Googling says that China's GDP per capita is about $14,000, or $21,000 PPP adjusted. The World Bank does research on this sort of thing, and of the 101 countries that were middle-income in 1960, only 13 became high-income countries (although some aren't really "countries"). In case you were wondering, the group is: Hong Kong, Japan, Singapore, South Korea, Taiwan, Equatorial Guinea, Greece, Ireland, Israel, Mauritius, Portugal, Puerto Rico, and Spain.
China was extremely impressive in the 2000s, with seven straight years of double-digit growth from 2003-10, and had also spent 23 years growing at seven percent or more. After ascending to become a low-middle-income country in 2001, China was already a high-middle-income country by 2010. but China has a lot of work to do. One problem is that a lot of the recent growth has been illusory, and due to massive real estate investment that has funded the building industries but has created too many useless buildings. Additionally, Chinese workers are under-educated. Only 17% of Chinese workers had tertiary education as of 2015, and the share of those in manufacturing was lower, at just 10%, whereas the number is 47% in the US. Moreover, China spends less money on research and development than its competitors, at just about 2% of GDP. The US spends (as of 2016) 2.7%, Germany 2.9%, Japan 3.5%, and South Korea 4.2%.
I'll conclude by saying that this was a fact-dense, but very readable book. It is short so I was able to get through it quickly. My only real complaint is that I wish there was an update to read from George Magnus written after Coronavirus, but maybe I will be able to find more from him in newer articles.
Miscellaneous Facts:
- There is an interesting passage about the importance of the Shandong Peninsula in the north of China, which is known as a "dagger pointing at the heart of China." Magnus compares it to the Chinese version of Alsace-Lorraine, giving those who controlled it geographic command over Peking, the Yellow River, and the Grand Canal. Japan managed to get it from Germany after the Treaty of Versailles. If I remember correctly from other readings, it contains a disproportionate amount of the ports of northern China.
- Before war with Japan in the 1930s, three-fifths of Chinese factory output was produced by Chinese-owned factories, but a fifth was foreign and another fifth was Japanese-owned, mostly in Manchuria.
- The working-age population of China is in such decline that the old-age dependency ratio is expected to double between 2017 and 2020.
- During the Financial Crisis, apparently people used to say, "there's nothing right on the left side of the balance sheet, and nothing left on the right."
- I know it's communism but this shocked me: in China in 2015, when their stock market crashed, their version of the SEC prevented shareholders with stakes above 5% from selling for six months and ordered executives and board members of companies who sold shares in the six months prior to buy them back.
- Chinese shipping companies carry more cargo than any other country.
- China is home to five of the world's top ten container ports, the largest maritime law enforcement fleet, and a fishing fleet of over 200,000 vessels.
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