By Timothy Ang

Since the onset of the reform era almost four decades ago, China has relied on heavy investment and credit expansion to achieve unparalleled economic growth as an emerging economy.

Now, as China settles in as a major economic power, pressure points are appearing that suggest it is time for the country to make its long-awaited transition to a new growth model.

Slowing demand, tariff threats and the emergence of large asset bubbles have left Beijing fighting fires on all fronts.

In his latest book, Red Flags: Why Xi’s China is in Jeopardy, veteran economist and commentator George Magnus examines the root of these structural weaknesses and argues how a failure to adequately reform could stunt China’s economic aspirations.

China Economic Review caught up with George to get his view on the current state of affairs in the Middle Kingdom.

CER: Red Flags centers around a ‘rebalancing’ in China’s economy. What do you mean by that?

GM: This is really about whether China’s growth model is sustainable, and what must be done to make it so.

The infamous anonymous article that appeared in the People’s Daily in May of 2016 carried the message: “We can’t go on like this,” referencing growing issues such as surging debt levels that cannot be maintained indefinitely. At the National People’s Congress of this year, we had clear signs of recognition by those in Beijing that economic policy has to switch to different objectives – not just narrow metrics but a more fundamental health.

In a way, this is stating the obvious. The investment-driven development model that brought China out of poverty cannot exist in perpetuity. You eventually stumble into misallocations of resources, capital inefficiencies and so on. This need to move away from reliance on investment to a consumption and services-based sector was the theme of the 13^th Five-year Plan.

By ‘rebalancing,’ economists mean moving China to a development model more in line with its current status and that facilitates its aspirations as a leading global economy. It has to be smarter, rather than just accumulating capital and labor resources, i.e. the strategy of a poor country.

CER: Where are the warning signs in China’s current debt profile?

GM: First things first. When we talk about China facing some massive financial crisis, it’s imperative to stress that there is no reason to think that it will look like anything we’ve yet seen in the Western or emerging world before.

We’re talking about a very large country with a state-owned banking system, with the associated assumption that no major financial institutions will be allowed to fail. The way in which stability, or instability, manifests itself in China is likely to be different to how it did for the West.

Indicators like China’s debt-to-GDP ratio, or the speed with which it clocked up debt, are warning signs, certainly, but there are no clear fault lines at present.

Also, the bulk of the problem is still RMB-denominated, so the risk of China undergoing some kind of Thai, Korean or Indonesian-style crisis is relatively slim. Strict controls prevent any wholesale withdrawal of capital in the same way as the Asian Financial Crisis, or more recently in Turkey or Argentina, which should give some discipline to China’s domestic markets.

CER: Should markets be worried?

GM: That’s not to say that China’s debt pile is not a problem. I see the vulnerability in two places: firstly, how the debt is funded; and secondly, how the overhang will weigh on economic growth. As for the first one, this is something the authorities have had in their cross-hairs since late 2016. We have seen a clampdown on the more egregious forms of risk-taking and a reduction in the issuance of financial products such as WMPs (wealth management products) and treasury management products, which were used to fund large-scale projects.

It’s not clear to me that deleveraging has gone far enough, however. And throughout the course of 2018, as the consequences of deleveraging have become more evident, we have seen incremental retreats from stricter controls over leveraging and lending. The government seems keen to get their hands back on the wheel, so to speak.

And of course, how do you get rid of the debt? Bad debt is bad debt, it’s not going to magically disappear. You can evergreen it, use accounting regulations that don’t recognize it, but the impact of bad debt will be a significant cap over economic growth, as we’ve seen in the rest of the world for the past 10 years.

The bottom line: what is the government’s appetite for slower growth as it pursues a deleveraging policy? Most economists will say, it’s not a choice of whether or not the government will do it, but how long it will take and what the economic growing pains of that will be.

The danger is that it is dealt with in a disorderly fashion, in a much more abrupt way. Perhaps investment drops too significantly, or property prices begin to wilt, as per the hints popping up around the economy. Then we will have to pay close attention.

CER: China has been described as suffering from ‘policy incoherence’ – trying to meet too many objectives at once. What do you think the government’s economic priorities are right now?

GM: If you have a GDP target of near 6.5% and are trying to pursue serious deleveraging of the economy, then you will hit roadblocks. These two goals are fundamentally incompatible. If, on the other hand, the government was to say that it planned to phase out GDP targets over the next few years, for example, then this would be in line with the sentiments of the NPC and tell us a lot about macroeconomic intentions.

The problem is there isn’t clarity of what they’re trying to do over the next 5-10 years. This is somewhat disconcerting. While the rhetoric of reform and opening up is still quite loud, in practice I don’t see much evidence of China moving in that direction. If anything, the reaffirmation of role and primacy of the party in commerce and industry goes against the fabric of what’s being touted.

CER: What do you make of the recent wave of measures to shore up the financial sector and private business? Could we see more stimulus on the way?

GM: I think you can take Liu He at his word, that among him and other senior economic officials, there is a visceral distaste about repeating what happened in 2015. They don’t want that level of intervention again.

How far that feeling goes, I’m not entirely sure. It depends on just how effective their alternatives are. If the policy easing and expeditional controls which have been implemented this year result in a stable economy in two years, then I imagine a slower growth rate will be tolerated. I can’t foresee Beijing toying with credit expansion of the scale we saw three years ago.

This reiterates the same principle as before: how much growth are they willing to lose to form a healthy, sustainable economy. Does China have the nerve to take a hit, then get back up with a reform package to take the economy on a different path for next five years? We don’t know.

CER: How will US pressure compound the problems raised in the book?

GM: The impact on China so far is basically a rounding error. It’s already offset by the easing measures put in place for domestic reasons.

If the tariffs go up to 25% as the Americans intend, and extend them to all Chinese goods, then we’ll see a significant effect on China. The 2018 effect is around 0.25% of GDP, but this could widen to 1% or more by the end of 2019 – not an insignificant hit to growth.

The trade war is not a make or break issue for China in itself, but it’s an untimely affair. It certainly has the potential to amplify existing headaches, such as the weakness of the yuan and capital flows.

But most of all it risks diverting global supply chains. Foreign firms will be looking at their long-term relationship with China and how they do business there, compared with surrounding regional alternatives. The disputes with the US, after all, are likely to be a long-standing affair.

CER: What changes must China make to avoid falling into the middle-income trap?

GM: What economists focus on is total factor productivity (TFP) – the amount of a country’s output not caused by traditionally measured inputs of labor and capital. All economies tend to come to rely on TFP for economic growth as they mature, since there are limits on how much capital you can accumulate and how much the labor force can grow, particularly in an aging economy like China’s.

The result is you have to get smarter. You have to deploy labor and capital to get quality rather than quantity.

Most Western countries, and China since 2008, have succumbed to a period where TFP growth has slowed down. Crucially, the periods where TFP has been on fire in China coincide, not by chance, with the periods of greatest reform and opening up, i.e. the early 1980s, ‘90s and following entry to the World Trade Organization. Therefore, it is a concern that the future of reform has had this question-mark placed over it.

The key to getting TFP lively again is whether an economy has institutions that create the competitive and regulatory environment in which incentives are rewarded and private initiative is encouraged. If you took a snapshot of China in 2018 and asked whether it looked like a country trying to foster this – probably not.

George Magnus is an independent economist and commentator, and research associate at the China Centre, Oxford University.

Since the arrival of Xi Jinping to the presidency, the path of Chinese policy seems to have taken a U-turn. Markers of liberalisation seen in China over the past 30 years are slipping away as the party reinforces its centrality in business, media and the everyday lives of individuals.

According to Fordham University academic Carl Minzner, the authoritarian turn in Beijing not only has enormous political implications, but will also have far-reaching, long-term effects on China’s economy. In his latest book, End of an Era, he argues that abandoning the policy consensus set in place by former leader Deng Xiaoping risks harming China’s prosperity and derailing the country’s rise as the world’s superpower-in-waiting.

In a conversation with China Economic Review, Minzner lays out why he thinks the growing role of Beijing in the economic and political spheres could mark a turning point in the country’s history.

CER: In End of an Era, you write that in recent years China has been “closing down.” What do you mean by this?

CM: Ironically, we are at a time when China’s impact on the outside world is possibly the greatest it has ever been. However, I do think that China is closing itself from outside influences.

While on the one hand it’s certainly true that the party has become more sensitive to outside, particularly Western influence, this isn’t solely the state’s policy. There is also a considerable motivation from Chinese citizens away from the 1990s mentality where everything foreign was golden – international schools, American brands – towards a greater satisfaction with life in modern-day China. We see this in TV shows, domestic box office numbers, even in academic standards and attitudes towards learning English.

But the government’s stance is without a doubt more inwards looking. Thinking back to the 1990s, in the run-up to China joining the WTO, there was this big hang-up on meeting international standards, which filtered down all the way through society. At this time, foreign ideas acted as both a stamp of quality and a useful way to address latent problems in Chinese government like monitoring local officials and tackling corruption. Now, on the flipside, there is a little bit of a suspicion attached to what is ‘foreign.’

Despite China’s increasing global presence, there has been a heightened sensitivity since the end of the reform era towards what comes in. China wants to export itself, its culture, its brands, its governing style, to other countries, but the internal setup needs to remain Chinese. This is one of the big shifts we’re seeing take place at the minute.

CER: What were the economic/political conditions that led to this retreat from liberal reform?

CM: The first thing to clarify is that the title of the book is ‘End of the Reform Era,’ not ‘End of Reform.’ So, if we talk about the reform era, the post-1978 society which clearly demarcates itself from the Maoist period that preceded it, there were three defining characteristics: economically – rapid growth; ideologically – a certain degree of openness to the outside world; and politically – a relative degree of stability marked by partial political institutionalisation. This is not the same thing as liberalisation, just that the rules of the political game post-78 became much clearer and organised from what had existed before. This included no cult of personality, decentralisation of power to a wider group of individuals, clearer rules of succession, and the lack of basically anything that resembled a mass movement.

If you compare all three factors with today’s China, it’s clear that such a period is coming to an end. China’s economy is slowing down, the party has changed its tone towards foreign ideas and influences inside the borders, particularly in business and academia, and of course those partially-institutionalised rules of the game are coming undone.

CER: How did the reform era shape China’s economic development?

CM: If you’re describing the full sweep of the reform era in China, one of the big events has been the re-emergence of deep inequality. From the pre-reform era society where inequality was high but China was universally poor, through the mid-1980s when China had a much more equal society under Deng Xiaopeng and was getting richer, until the 1990s when we see almost US-level inequality arise.

Take Shanghai, for example. Thirty years ago, anyone who was an average state employee would have received some sort of government-sponsored housing as part of their compensation package. Fast-forward to the “privatisation” of land by the end of the decade, and these workers, in essence, own their own apartment. When the property prices in a place like Shanghai triple, quadruple, quintuple in the early 2000s, anyone on the property ladder was at an enormous advantage and could sit back while their net worth kept going up and they were free to think about second properties and other investments.

Migrant workers from rural areas, however, had a different experience. Yes, during the agricultural reforms of the 1980s they saw their wealth improve somewhat, but by the 1990s more and more of China’s growth is being channelled and enjoyed by a narrower slice of the population. And what do you see going on in your daily life? School fees for your children are increasing, rural healthcare had pretty much fallen apart by the 1990s, the hukou system prevents you from sending your child to a school in another region, and so we begin to see the phenomenon of the ‘left-behind’ children. All these multiple, very real impacts on the lives of individuals are a direct consequence of a movement away from economic and social policy reforms over the course of the last three decades.

CER: How does the party reconcile this skyrocketing inequality with its Marxist roots?

CM: Since 1978, Beijing has jettisoned many of its earlier socialist practices. In 1980s and 1990s, rural communes were abandoned, market pricing introduced, and negotiations opened to facilitate China’s entry into the global free trade club of the World Trade Organization.  But one of the biggest shifts away from anything resembling Marxism is best embodied by the party’s adoption of the theory of the ‘Three Represents’ in the late 1990s – essentially redefining the Communist Party itself as a vehicle to represent the newly emergent capitalist class. So, in a society where the divide between rich and poor – even if you believe the official statistics – has surged over the course of the reform era to levels resembling those in Mexico, Peru and the United States, and where 1% of the population owns one-third of the wealth, Beijing’s nominally socialist ruling authorities have aligned their interests with the wealthy and middle-class urbanites over those of the migrant workers and rural poor. 

That being said, this doesn’t mean that there has been an abandonment of the classic socialist goals of, say, providing social welfare. This goes back before Xi Jinping, to Hu Jintao and beyond. Leaders are very aware of the looming gaps that were left in society during the 1990s and know that this has to be addressed through active means, such as the removal of school fees or improvement in access to healthcare.

The problem that repeatedly arises for policymakers, however, is an inextricable tension between the urban middle classes and the rural populations when you have to ask one group to sacrifice some of its wealth to benefit the other. Shanghai and Beijing benefit from extreme preferential treatment compared to the poorer provinces, because they are willing to resist when social welfare picks at their pocket in some way. This is well demonstrated by university places. Residents of these two cities enjoy very high quotas for entrants into the best schools, disproportionate to their populations, as there is pressure on the government to keep it this way.

CER: In the book, you compare China today with other East Asian nations a generation ago. What are the structural differences between the Chinese mainland and Taiwan that have restricted it from making the same transition to a liberal market economy?

CM: The short answer is that the CCP authorities in Beijing have a much greater dominance over all sectors of life in mainland China than the Nationalist Party (Kuomintang – KMT) ever did in Taiwan.

Even at its most authoritarian, the Nationalist grip over Taiwanese society was subject to important limits. Taiwan’s post-World War Two economic boom years saw the emergence of entrepreneurs and firms with but loose ties to the ruling KMT apparatus. A range of religious groups, particularly the Presbyterians, escaped its full control. Such things created important constraints on the KMT’s controls and helped contribute to a rebalancing of economic and political actors in society. So, for example, Nationalist Party-owned enterprises and their role in the economy are steadily marginalized as Taiwan undergoes transition in the 1980s, 1990s and early 2000s.

In contrast, on the mainland, the CCP’s grip has been much stronger – largely because the pre-1978 period witnessed the eradication of all organized national social and economic structures outside of its own walls. This means that the party power structure ends up generating a much stronger gravitational attraction vis-a-vis all of the resources and entities that develop in the reform era boom that follows after 1978. Sure, it doesn’t look that way initially in the 1980s and 1990s. Indeed, that’s the period where observers start to imagine that various pieces of mainland Chinese society, whether civil society groups or private firms, might somehow attain escape velocity and exit the party’s orbit. But by the late 1990s, you see pretty clearly with the development of the ‘Three Represents’ that the party intends to co-opt and absorb private entrepreneurs.

And by the early 2000s (as mentioned above), you see the revival of state-owned enterprises and the role of party committees in private enterprises and society at large, and the increasing difficulties of private firms in terms of getting access to loans. That’s the inverse of the Taiwan example – it’s how the political controls start to steadily reabsorb the space for markets and private enterprise, as state corporatist models and Leninist party controls increasingly balloon within the mainland Chinese economy. 

A few things to watch will be the functioning of the real estate market and the space available for private tech companies to see how far these trends continue. Overwhelming short-term demands for maintaining social stability are steadily forcing Party authorities to extend their controls back into areas from which they had partially stepped back in the late 20th century.

CER: What do you think about the recent promises from Chinese policymakers regarding greater reforms?

CM: For market reforms, I don’t think this round of pledges will be any different from those made in previous years. The government considers state control, social stability and the state economy as paramount, so this really reduces its margin of manoeuvrability when it comes to market liberalisation. How do you reconcile the desire to bolster the role of a communist party in the economy with looser regulation and openness to foreign multinationals?

There are some very interesting governmental reforms going on, though, such as the mass restructuring we saw back in March. This was essentially ‘re-partyisation’ of the bureaucracy – a merger of party and state institutions that gives the new body a wider remit with a much stronger party presence, reversing the norms set in the early 1980s when the party decided to grant more management freedom to the state bureaus.

In their new book, “China and Global Value Chains”, Yutao Sun and Seamus Grimes provide a forensic analysis of China’s participation in Global Value Chains (GVCs), which has been a crucial driving force behind China’s spectacular development.  GVCs enabled China to average annual economic growth rates of 10 percent over three decades, and the still very respectable 6-7 percent of recent years.  As Sun and Grimes argue, China is now faced with new challenges, as it seeks to extract greater benefits from GVCs, and also as it must deal with the threat of US President Donald Trump to bring back home America’s offshored manufacturing production.

A key element of China’s development process was the gradual opening to foreign direct investment (FDI) and trade from 1978, something which accelerated following the country’s membership of the World Trade Organisation (WTO) in 2001, as the authors document.  China received vast inflows of FDI, notably from technology companies — the GVCs for Apple’s products are very much the focus of the study.  Such companies were motivated by China’s low cost structures, as well as the many incentives offered.

Apple’s production line ultimately became highly fragmented, with most low value-added assembly operations taking place in China, conducted by Foxconn, a Taiwanese company, which is now the world’s largest electronics contract manufacturer.  High value-added components are mainly sourced from Korea’s Samsung, and Japanese and Western companies.  The centre of gravity of both Apple’s and information and communications technology (ICT) GVCs more generally has shifted to China in recent years, as Sun and Grimes document.

This participation in ICT GVCs has been hugely beneficial to China in terms of boosting the economy and reducing poverty.  There can also be passive knowledge and technology transfer, especially through Chinese workers based in Foxconn’s factories.  But as Sun and Grimes highlight, China finds itself in a subordinate position in these ICT GVCs which are led by foreign investment enterprises.  And China is extracting very low value out of the GVCs.  Despite locating much of their production activity in China, foreign investment enterprises have succeeded in avoiding any major leakage of intellectual property to local competitors.

China’s rapid development has been very different from that of Japan in the 1980s, according to the authors.  More than 80 per cent of the top exporters from China to the US are foreign investment companies.  In contrast, most of Japan’s big exporters in the 1980s were Japanese, and Japan added most of the value to exported products.  China’s development is driven by inward FDI and being an export platform for foreign companies, whereas Japan’s resulted from exporting products based on licensed technology.

It has long been China’s goal to improve its technological capacities and intellectual property, as it seeks to climb the development ladder.  The Chinese government is also concerned about the national security dangers associated with high levels of dependence on foreign technology sources.  But as Sun and Grimes note “China failed to achieve significant technological transfer from foreign companies through insisting on the establishment of joint ventures with Chinese companies”.

However, “Despite its ongoing dependence on foreign technology, China is determined to transition to an innovation-oriented development model”, the authors argue.  So to avoid falling into a “low value-added trap”, the Chinese authorities are promoting “indigenous innovation”.  This is a new kind of protectionism which seeks to assist local industry climb the value chain and improve technological capacities.  It also involves strong-arming foreign investment companies to share technology, and set up China-based research and development centers.  The attraction of China’s large and emerging middle class market gives it a big pot of honey which can be used to attempt to subjugate multinational enterprises.

Sun and Grimes do not seem fully convinced of the merits of this approach.  “There are signs”, they say, “that China’s progress could be slowed down by its opting for a more inward model of technology autonomy within a relatively protected large domestic market”.  They do recognise, however, that a small number of Chinese companies, like Huawei and Tencent, have become highly successful global brands.

The authors also pour cold water on Donald Trump’s vision to bring outsourced manufacturing back to America.  In their quest for higher dividend payments, shareholders of companies like Apple pressure management to find the best locations for each production phase of the GVC, even though that may result in their fellow citizens losing their employment.  And with rising costs, China is no longer competing on the basis of its low cost location alone, but also its high quality workforce and its large domestic market.  But the burgeoning protectionism in Western markets could pose a great challenge to China, as a latecomer country.

Sun and Grimes analysis is excellent in that it is based on the sound theoretical framework of GVCs, extensive data, and many interviews with corporate executives.  It may be a bit heavy going to read in parts.  But it is most certainly worth the effort.

John West is Adjunct Professor at Sophia University, Tokyo.  He is the author of the recently published “Asian Century … on a Knife-edge — A 360 Degree Analysis of Asia’s Recent Economic Development.”  

By Seamus Grimes

In a wide-ranging analysis of all the countries of Asia, John West explores in his new book “Asian Century…on a Knife-edge” seven major challenges facing Asia, arriving at a somewhat negative conclusion of this region’s ability to overcome them. Compared with the OECD’s 18%, Asia accounts for 55% of the world’s population and while containing huge differences in terms of country size, composition and economic circumstances, Asia is nevertheless characterized by many similarities. The key challenges identified include (1) obtaining better value from participation in global value chains, (2) reaping the benefits of urbanization, (3) achieving higher levels of equality, (4) resolving demographic issues, (5) dealing with deficiencies of political institutions, (6) combating economic crime and (7) achieving peace and harmony.

West explores these challenges in detail in the 12 chapters of the book, providing a wealth of empirical data to support his analysis. While the book has a clearly developed framework for assessing Asia’s likelihood of overcoming major challenges, the approach is not built on any particular theoretical school of thought and the bibliography consists mainly of reports from global institutions such as the OECD, the World Bank and Human Rights Watch. The author, however, clearly has an encyclopedic knowledge of a wide range of fundamental issues affecting all countries in Asia and his analysis focuses effectively on drawing out the significance of interconnections between the various countries. Not only is it an impressive comparative analysis, but it also provides a very valuable context for understanding the nature of development in any of the particular countries examined. Because of this it is essential reading for policymakers with exposure to the region.

Although much of the book will present few surprises to those watching Asia, the voluminous data is woven into a coherent synopsis of major trends in the region. While the book provides an impressive analysis of the key economic, social and political issues facing Asian countries, the author’s central concern with the widespread abuse of large sections of populations in many countries is quite striking. There is an in-depth analysis of why some countries in the region have performed more effectively than others in terms of economic development, suggesting that only a small number of countries like Taiwan, Singapore, Hong Kong, and Korea have succeeded in catching up with the more advanced regions of the world.

While many parts of Asia and particularly China have been poised to make significant strides in recent times, West argues that both internal obstacles and global forces are coinciding to make further significant progress such as moving up value chains and not falling into the middle income trap increasingly difficult. The global forces such as the growing anti-globalisation sentiment associated with Trump’s emergence and Brexit are likely to close off further global integration of Asian countries with the advanced world, according to West. Meanwhile, China’s increased confidence on the global stage, and its significant international leadership in major projects such the One Belt One Road initiative is casting a very negative shadow on the potential for positive contributions from the US. The absence of trust between these two major economic powers will make it difficult to bring forward a more positive approach towards policymaking for the greater good of humanity.

Many of the internal obstacles within Asia stem from individual states’ lack of willingness to implement the necessary changes to provide greater social justice and equity for their populations. In China’s case, the Communist Party’s fear social unrest if major market constraints were to be eliminated. While China has made enormous strides in moving its economic activity into innovative, higher value-added sectors, the continuation of this will prove demanding so long as the state exercises such binding control over education and creativity. West, on the other hand holds out significant prospects for India, although it too must overcome huge limitations in its educational system. Japan, however, which was one of the first Asian nations to make enormous progress has now been in the economic doldrums for many years, and with its population in decline and a low marriage rate, the outlook is not optimistic.

West rightly pays considerable attention to the nation’s demography. Japan’s population has been in decline since 2010, while Korea has the fastest ageing population in the OECD, with both countries being affected by slower economic growth. Labour productivity in China is only around 15-30% of the OECD level, while its labour force has also begun to fall. Unlike Japan, Hong Kong, Singapore and Taiwan, which successfully went through their Lewis turning points, Malaysia and Thailand have already fallen into the middle-income trap, which may also be the fate of China. China has the additional problem whereby 19% of its population constitute ‘floating’ rural migrants with few rights to basic social services. West rightly questions Chinese policy priorities which allocate enormous funding in projects such as the Asian Infrastructure Investment Bank, while neglecting the basic needs of large sections of its population.

In his characteristic forthright manner, West highlights the widespread abuse of human rights in Asia and argues that perhaps one of the most extreme examples is that of depriving possibly 117-163 million women of the right to life because of prenatal gender selection, with 57% attributable to China, and exacerbated with its one-child policy, and 30% to India. A serious consequence of this is that after 2030, the number of single men seeking a wife in China and India could exceed the available unmarried women by 50-60%. Other countries in Asia such as Singapore have also followed eugenics-like policies of fertility control and are now finding it difficult to reverse the trend. While a more liberal immigration policy might alleviate the major differences between Asian regions in terms of population surpluses and deficits, Japan in particular is most reluctant to open its borders to immigrants.

In highlighting the many policy challenges facing Asian countries, West provides important insights into failed economic and social policies and very strong arguments for the need to learn the lessons of such failures. His conclusion, however, suggests that the many of the various negative social and cultural practices which results in the undervaluing of large sections of populations in Asian countries are likely to continue to hinder major improvements.

Seamus Grimes is Emeritus Professor at the Whitaker Institute for Innovation and Social Change, National University of Ireland, Galway. He is the co-author of the recently published “China and Global Value Chains: Globalization and the Information and Communications Technology Sector”.

We’re often told that mixing business and politics brings nothing but trouble. But in today’s China, business leaders ignore the ebbs and flows of Chinese political sentiment at their peril.

That is the core argument of The War for China’s Wallet, the latest work by leading China expert and Director of the China Market Research Group, Shaun Rein.

In this exclusive interview with China Economic Review, Rein explains why brands need to be more politically savvy than ever before to succeed in China, which economic trends we should watch out for in 2018, and why US President Donald Trump is actually handling the Chinese rather well.

Q: The overriding message of The War for China’s Wallet is that brands need to have a real understanding of Chinese politics to succeed in today’s China. Why is that?

A: China’s market has always been big for multinationals. But a lot of brands haven’t thought about the political risk implications of doing business in China, and that’s why I wrote the book. What we’ve seen in the last three to five years is that the Chinese government is using economic carrots and sticks to punish and rewards countries, and increasingly companies. For instance, in the last month you’ve seen how Marriott called Taiwan a separate country [on its website], and what did China’s government do? They handed out punishment, with a massive hammer. They blocked all of Marriot’s websites in China for one week. That’s a massive amount of loss of revenue.

So, the thrust of the book is: China is increasingly using economic punishments and rewards, and how do companies adjust to that? Do you kiss ass, like Cambodia has done? Do you go completely against China, like India has done? Or do you go somewhere in the middle, somewhere I like to call the ‘warm partner’ category? That’s countries like Canada, the UK and France. Those countries will be nice to China, but they’ll also stand up to it, and that’s probably where you want to be.

Q: How can companies avoid being caught up in a political furore in China?

A: It’s not easy, frankly. Your employees, from the top to the bottom, now have to become political, almost State Department-like analysts. You can’t just rely on PR people to deflect anger. You have to start at the very beginning, understanding that China wants to be a superpower—you have to listen to what it wants or be punished.

It’s not an easy thing, because if you take the example of Cambridge University Press from the UK, they bowed down to China and blocked a lot of articles and books on their websites at the government’s request. But then the backlash came in the West, with people saying that CUP was censoring its content. So, you kind of have to play that middle line. You have to weigh money vs. morality.

Some companies, like Apple, are shameless. Tim Cook stands up at the World Internet Conference in Wuzhen and says that China has a flowering internet ecosystem, and doesn’t even mention censorship. That’s mealy-mouthed and pathetic. But he does that because Apple makes so much money in China and they have their entire supply chain here.

If multinationals are going to hedge, you can’t invest too much in China. You can’t have your entire growth strategy in China only. You can’t have your sales and your production in China. And this is bad, this is killing me because I’m a China consultant who doesn’t have operations elsewhere, but that’s what you need to do.

Q: And if the Chinese government does decide to punish a company, what would be your advice for them? How can they deal with that situation?

A: Well, in the recent hubbub with Marriott, the CEO Arne Sorenson said, “We’re so sorry, we didn’t mean to upset the Chinese people.” He went out there and kissed ass, and he looked weak. I didn’t like that.

But look at a company like Zara, which also got caught up in [the same controversy over Taiwan references]. They apologised immediately and said, “We like China, we were wrong and are going to fix the situation.” But this was done through their China team. The global CEO didn’t apologise, and I think that’s the way to do it. Because once the global CEO apologises it becomes a bigger issue, the Western media starts to cover it. Did you know that Zara was hit? Probably not, but everyone knows that Marriott was hit. So, apologize, and then go slowly, wait a little bit, and see if everyday consumers are really angry at you. You always want to keep a low profile here.

Now, if you start to get a lot of anger from the Chinese consumer base, then you might need the global CEO to come in, but as much as you can you want to localise, and not go too far. I think Craig Smith from Marriott also went too far. He called it the “worst, most egregious mistake of his career.” I mean, come on! In my mind, the Chinese government knows that whatever it wants, Marriott will now do. And that’s a very dangerous situation. The Chinese government respects you if you’re respectful, but strong.

Now, this might sound kind of crazy, but Donald Trump, I think, has played China extremely well. I think on China-US relations, he has played that relationship better than any of the last three or four presidents. He comes in, has his goddaughter sing Chinese and tells Xi Jinping that he’s great. But then he also criticises at the same time, and says, “It’s unfair that you’re extracting so many business deals from us due to protectionism, and this needs to change.” Strong, but respectful.

Q: Do you think that Trump’s stance will actually help US companies do business in China?

A: Absolutely. I also think that he’s going to get a lot stricter this year, tensions are going to rise. I think his first priority was the tax cuts. Now that he’s gotten those down, he’s going to focus on trade. What’s smart is that he doesn’t attack human rights, he doesn’t attack democracy… Those are things that piss off Chinese leaders and also piss off a lot of the Chinese population, because they’re going to say: “What, you think we’re evil?”

Because when you say that you have human rights abuses, you’re basically saying to Xi Jinping that you’re an evil person. But he’s not an evil person. He’s just acting in a way that he thinks is good for himself, like all political leaders, and good for the country.

So, Trump is going to go after the economic issues, and he’s going to bang hard against protectionism, bang hard about opening up the auto market, financial services. This is what he should be doing, and its going to benefit the US business community.

Q: Do you think we will see significant action from China to open up its market more to foreign businesses this year?

A: I think there will be more. I think that China’s government will be willing to give up more market access to the US and Europe, but especially to the US, because they won’t feel like they’re being pressured into it, and being called a bad person. They’re going to feel that it’s a partnership, and they’ll be looking for ways to improve. And for them, opening up auto is not a big issue. Opening up financial services? That might actually benefit China, not just for increased competition but it might reduce some systemic risk here, because the domestic banks have been handing out too much and have too many non-performing loans.

So, I think the Chinese government will cede. They’ll say, ‘Let’s give Trump these things.” Trump will then be able to tout his success in the US press, saying that he’s “opening up China.” And Trump, wisely, will not criticise China on sovereignty issues, human rights, and the things that China’s government really holds dear.

Q: What do you think about the recent rise in tensions over trade between the US and China, with both countries imposing new tariffs on imports?

A: They’re fencing, pairing off against each other. The US recently put up new tariffs on solar panels and washing machines, but it was actually a lot less than what insiders expected. You could see that washing machine companies like Haier were thinking, this isn’t actually that bad, this is only going to impact us a little bit. It was a strong thrust that Trump could put in the US press, but it was sort of toothless.

Q: You recently said that you are no longer one of the “big bulls” on China. What did you mean by that?

A: I think for the last 20 years, I’ve called China better than pretty much any other analyst. When I came here in the mid-1990s and put my whole career here, everybody said I was crazy. Literally everyone. I don’t think anyone supported me coming here except maybe my father. But my father is a ballet dancer, so he didn’t care what I did as long as I was happy.

Over the past 20 years, I’ve been very vocal that there is booming business, that it’s a place all companies need to be, or at least think about coming to, because this is the real market. Now, I still think there is going to be strong growth, there are going to be very good opportunities for some companies, and some sectors. Honeywell and General Electric, for example, will benefit from the Belt and Road Initiative. They’re going to make billions of dollars from this. Some other companies like Yum!, Starbucks and Nike will continue to do well here.

But the reality is that the economy is slowing, so it’s not going to be as easy to make money. The cost of doing business is also a lot higher than everyone except Shaun predicted. Real estate costs are very high; salaries are extremely high. We’ve thought about opening up an office in NYC to save costs, because a good Chinese person with many years of experience has to get paid a lot of money.

You also have the political system. It’s a rough time, politically, with the Chinese government more focused on rejuvenating the Communist Party ideologically than pushing the economy. So, a lot of foreign companies are going to ask, ‘Is it worth it?’ If you’re going to invest $5 billion dollars, like Mercedes might have done 5 years ago, is China still the place you want to invest?  If I was 20 years old and single, I wouldn’t come to China as a foreigner. I would go to Africa. I don’t know where, but I would look around.

And besides that, Chinese businesses are strong. These companies are well-capitalised, well-run, aggressive and they’re taking market share like crazy. Companies like Bright Food or Mengniu are kicking the ass of Nestle, kicking the ass of Unilever. It’s a tough place. Nestle might be better off investing in Indonesia or India, where you don’t have the same homegrown talent.

Q: So, it’s more the case that you’re no longer bullish on foreign brands investing in China, rather than the Chinese economy itself?

A: The economy is okay, but it’s slow growth. We’re not seeing the 8-10% that we had before. I’m a little different than other people, in that when the economy was growing 8-10%, I actually felt like it was growing 12-13%.

Twenty years ago especially, so much of the economy was underground. A lot of economists said that China’s economy was maybe 30% underground, and that was similar to Russia in the 90s before its economy collapsed. I always pegged it at 50%.

But it’s getting harder to cheat because of WeChat Pay, Alipay; it’s not as much of a cash business anymore. And that’s actually one of the reasons I think that the economy is slowing down. Because if you think about it, going from 10% to 6.5% GDP growth – it’s not that big, right? Over 6% is still amazing, but it feels cold, because before it felt like 15%. That’s a huge difference.

Q: What do you expect to happen with the Chinese economy this year? Do you expect the financial and environmental tightening to impact on growth?

A: No. The environmental tightening won’t have a major impact, because that’s already been tight since 2014. Q4 2013 is when the pollution went out of control, and anger went out of control. The reason for that is that in that quarter Chinese smartphone makers started coming out with affordable handsets that everyday Chinese could buy, with pollution apps.

So, it was really in 2014 when the government started cracking down on pollution. It’s much better now. It’s not great, but its not something I talk about every day like I used to.

I’m actually somewhat bullish this year. The main reason for this is that no business could be done last year because of the jockeying for power [in the run-up to the 19^th Party Congress]. Once you have that leadership switch, its going to be a hell of a lot easier.

The only way the economy is going to slow down is if they cut back on the credit, which might happen. But generally, I think that it’s going to be a more pleasant business environment this year, that’s how I would word it. Even if growth is not great it’s going to be a nicer lifestyle. It was very frustrating last year.