Xi’s Big Mistake
July 16, 2021
Selling the Rope
“Prepare for War”
Sleepwalking to Confrontation
China Problems and Big Brother
Washington DC, Maine, and Colorado
I have mixed feelings about China. On the plus side, I think
the country’s massive economic transformation may be one of the most impressive
events in human history. Bringing hundreds of millions from primitive rural
lives into relatively prosperous cities within a few years was awe-inspiring. I
greatly admire the millions of Chinese entrepreneurs worldwide who create jobs
and technology. They’ve helped the entire world in countless ways.
And yet, I can’t forget that China’s leaders are devoted,
ideologically centralist communists. Americans sometimes apply that term
casually to our political opponents. Xi Jinping is an actual communist. His
regime permits some limited market-like activity, but only to help achieve the
government’s goals, which remain communist.
When the West first began engaging with China in the 1980s
and then allowed it into the World Trade Organization in 2001, many hoped
exposure to our ways would tug China toward capitalism. It seemed to be
happening for the first few decades, too. But the hope is fading.
In a 2015 letter
(When China Stopped Acting Chinese), I said this:
Beijing’s stimulus efforts
created the stock market bubble; now their unsuccessful efforts to keep it from
bursting are shaking my confidence in their desire to allow market forces to
play a greater role in the transition from a top-down society to a
consumer-driven, bottom-up society.
Still, I’ve learned not to
underestimate the Chinese leadership. They make mistakes but usually
recognize them and change course quickly. We’ll see what they learn from
their current misadventures in stimulus and their attempts at top-down control
of an essentially uncontrollable market. If they don’t learn the right lessons,
China will face an even harder lesson in the future.
Six years later, it looks like Chinese leaders didn’t learn
the right lessons. Xi has been trying to balance
economic freedom and authoritarian control and it’s not working like it used to.
Today we’ll review some recent events that illustrate where Xi went wrong. Then we’ll
think about whether the Xi government can change course, whether it wants to…
and whether it will survive.
Selling the Rope
Chinese ride-hailing company Didi Chuxing had its US initial “public offering” (I’ll explain
those quote marks in a minute) last month, raising $4.4 billion. The shares
plunged a few days later. Why? Widely called the “Uber of China,” Didi seems to
have good prospects. The problems came from outside.
For one, the Chinese government decided to investigate
whether Didi presented a “cybersecurity threat.” The company was ordered not to
accept new users and its mobile apps were taken down from online app stores.
But audits, or lack thereof, may be a bigger problem, and not just for Didi. My
friend Mark Grant explains in one of his letters this week:
The core of the issue is that the
Chinese government will no longer give US market regulators, any of the
regulating bodies, the power to inspect the audits of Chinese companies listed
on US exchanges. There are at least 248 Chinese companies, listed on three
major US exchanges, with a total market capitalization of $2.1 trillion,
according to the US-China Economic and Security Review Commission.
Earlier this year the Securities
and Exchange Commission began rolling out rules threatening to delist foreign
companies from American exchanges if they do not meet US auditing standards for
three years. The Chinese response was that Chinese regulators will conduct the audit
inspections and deliver their conclusions to the US Public Company Accounting
Oversight Board. This was soundly rejected, as it should have been, by the
SEC. (emphasis mine)
In the press, recently, there have
been all kinds of talk about the Didi IPO fiasco and the effect on Chinese tech
companies and on new Chinese listings. This is all fine, but it does not go
nearly far enough. The issues are much,
much bigger.
On the equity side, how can you invest in a Chinese company, any Chinese company, regardless of size, or theoretical revenues or profits, without audited financials? There will be no way to know if any of it is accurate and foreign assertations will have all of the reliability of a drop of water purportedly not dripping down the Great Wall, because of the Chinese sunlight. No one will have any reliable knowledge of what is actually going on. No one, in his right mind, would invest in any company, domiciled anywhere, on this basis.
Mark is right; investors shouldn’t throw money at companies
based on financial statements that don’t have some kind of trusted
third-party verification.
But there’s a bigger problem here. The Didi IPO was not a
normal IPO, at least as we think of them in the West. US investors who bought
these “shares” don’t actually own equity. They own pieces of a Caymans
“variable interest entity,” (VIE) which has a contract with the parent company.
This structure is necessary because under Chinese law foreigners can’t own
Chinese shares directly.
Didi duly warned
investors in its US offering (see risk factors in their registration
statement) that they had no shareholder rights and the Chinese government had
final control. This isn’t new. US-listed Chinese companies since at least
Alibaba in 2014 have used the VIE structure. It’s one of those things that
works great until it doesn’t.
This arrangement did have a key advantage, though, at least
for the Chinese. It let Chinese enterprises rake in foreign capital while
giving up no ownership and reserving the right to leave their own “investors”
high and dry. This method may now be approaching its expiration date but it worked
well for a long time.
That’s how Xi and the
Chinese Communist Party operate. They do things that look capitalist but
really aren’t, lacing them with unnoticed poison pills for later use.
It’s similar to their appropriation of US technology, trademarks, and other
intellectual property. We are literally selling them the rope.
“Prepare for War”
We should distinguish
between Chinese business leaders and the Chinese government. I think the
former are mostly just trying to run their companies the right way. They are
like entrepreneurs everywhere, trying to grow their businesses to the best of
their ability. The latter group makes it difficult and sometimes impossible.
This can be hard to grasp. Xi and the other communists
really believe they can have it both ways, conducting “business” while
also maintaining iron-like control over everything. They may not exercise their control, but they
want to have it.
Those VIE companies are a good example. Some experts say the
whole structure is illegal under Chinese law, yet it is widely used. The
government looks the other way. But by doing so, the authorities give
themselves a giant weapon they can use any time. The business executives are
aware of this and modify their behavior accordingly. (Note that verb “modify.”)
In theory, this could still end well. Having successfully
allowed people a taste of capitalism and its benefits, the government might
think it can continue. Meanwhile those capitalist benefits might gradually
usurp the Communist ideology.
Recent events say that’s unlikely, though. Beijing
appears to be concluding it has squeezed all the advantage it can from
capitalism. Is Didi any more a technological risk than scores of other
companies? Not really. Sometimes you have to create object lessons to keep everyone in line.
In hindsight, things seem to have gone wrong after the 2008
financial crisis. Facing potential social unrest, China responded with
massive debt-financed investment in infrastructure, housing, and other
projects. Some were needed, others were make-work distractions. But all the
debt was real. And over time, it has become a heavier burden.
Xi Jinping inherited this situation when he took power in
2013. What is his plan? According to Cai
Xia, a Chinese
professor and high-level CCP member and now expatriate dissident living in the
US, Chinese Communism hasn’t changed. She wrote a lengthy paper under
the auspices of the Hoover Institution. She maintains Xi is merely dropping the
pretense.
Here’s Ambrose
Evans-Prichard in a recent Telegraph column, writing a useful summary.
Like many amateur observers of
China, I had assumed that Xi Jinping’s iron-fist policies at home and abroad
were a break with the more emollient approach from Deng to Hu Jintao (if you
can call the Tiananmen Square massacre emollient), when China seemed to be
softening from a totalitarian to an authoritarian regime. Cai Xia makes clear that the
fundamental character of the CCP has been unchanging.
The party has merely dropped the
facade and dispensed with Deng Xiaoping’s tactical dictum: “bide your time, and
hide your strength” (韬光养晦). It has also acquired the means of totalitarian control
that Hitler and Stalin could only dream of, whether face recognition technology
or digital tracking through the Social Credit System.
The long list of Xi’s affronts,
from the Nine Dash Line to the South China Sea, to the pitiless asphyxiation of
Hong Kong, to the intimidation of Australia, to the Uighur camps, are by now
well-known, culminating in wolf warrior diplomacy and state-sponsored
disinformation on Covid-19.
We are so inured to it that
President Xi’s “wall of steel” speech at the 100th birthday party almost seems
banal. We know what the party thinks. The Fifth Plenum text setting out China’s
strategy until 2035 revives the term “prepare for war” (备战), not used for over half a
century.
“Prepare for War” is an exaggeration, at least I hope, but
it is growing less unthinkable. When you have two great powers whose systems
are irreconcilable, and neither is willing to change, the options list shrinks.
Sleepwalking to
Confrontation
Not everyone thinks disengagement and confrontation is
inevitable. Ian Bremmer outlined the issues in his last letter, reaching a
different conclusion.
Ian pointed out that unlike the US-USSR Cold War, the US and
China are highly interdependent. He broke it down into three components:
Hostility (where both countries want the other
to fail): This includes mostly the national security issues like Taiwan and the
South China Sea, plus issues both countries see as core principles, like
China’s treatment of Hong Kong, the Uighurs, and Tibet.
Competition (each wants to outperform, but not
destroy the other): These are the economic issues, like international trade and
investment, technology, and domestic political stability. Both countries are
the other’s supplier as well as customer. Each wants to win, but also needs the
other.
Cooperation (both want to work together for
mutual gain): This includes the global challenges like climate change,
terrorism, etc. They agree on the goals but lack of trust makes cooperation
difficult.
We naturally focus on the areas of conflict, but Ian
thinks the full US-China relationship is actually working pretty well. It changes with time, of course. Ian rates
the relationship as currently 20% hostility, 70% competition, and 10%
cooperation. But he also says much of the competition is becoming
hostility.
Ian takes as given that neither country will do anything
that would be perceived as “weakness.” But if no one will blink, how do you
avoid coming to blows? Ian thinks it is possible.
More likely, a change in policy comes from internal failures
of the present trajectory. How would that happen?
In China: Xi leans into more state control of strategic
sectors, high-performing talent starts to leave, productivity dives, and growth
stalls and debt spirals… giving technocratic Chinese political leaders more
space to nudge Beijing policymaking back towards more interdependence.
In the United States: Domestic divisions make industrial
policy half-hearted, the private sector retains capture of the regulatory
environment, the post-Biden administration renders strategic reorientation of
the US economy incoherent and affords allies more space to direct their own
course.
Historians tell us the dangers of sleepwalking into
confrontation. But in the US-China relationship, domestic incoherence and lack
of ability to effectively implement long-term strategy makes cold war less
likely… precisely because it allows existing forces of interdependence to
persist unmolested.
I hope Ian is right. From my perch, I’m not sure much of
this is feasible. I think Xi has made a giant mistake with recent business
crackdowns. He may have calculated he
can do without Western companies. But without them, what will happen to
the Chinese businesses that still turn to the US and Europe for capital,
customers, expertise, and technology?
Moreover, can the Chinese miracle continue if millions of
small entrepreneurs stop believing the government will let them succeed? I
don’t mean big companies. I’m talking about restaurant owners, drivers,
shopkeepers—all those who keep the economy moving.
Cai Xia, who was in a position to know, has an even more
chilling outlook.
Cai
Xia’s contention is that the Communist regime is more brittle than it looks, like the Soviet regime before the end.
“I recommend that the US
be fully prepared for the possible sudden disintegration of the [Chinese
Communist Party],” she said.
Imagining what such a “sudden disintegration” would look
like, I suspect it wouldn’t be pretty, even if good in the long run.
Economically, it could make 2008 or even the COVID pandemic look mild.
China Problems and Big Brother
China is facing large problems, some obvious and others more
subtle. But I think problem number one is Xi has made a giant mistake with
recent business crackdowns.
China is the ultimate
Orwellian Big Brother state. Especially within the cities, the government
can literally watch everything you do and track everything you buy, from your
noodles to your clothes, who you talk to, what websites you visit. All of the
data Chinese corporations gather is available to the CCP, who use it to create
China’s “social credit system.” If you Google that, the first thing that pops
up says this:
The China social
credit system is a broad regulatory framework, intended to report on the
“trustworthiness” of individuals, corporations, and governmental entities
across China.
The consequences of a poor social credit score can be
serious. It affects travel prospects, employment, banking access, and ability
to enter contracts. On the other hand, a positive credit score can make a range
of business transactions easier for both individuals and corporations. Foreign
businesses have to work with consultants to make sure they have good social
credit scores, and the CCP dictates what that means. It is the ultimate
top-down centralist panopticon.
As mentioned at the beginning, many Chinese are quite entrepreneurial, given the opportunity. That
being said, entrepreneurialism is not a racial characteristic. There is
something in an entrepreneur that makes them want to start their own business
or enterprise. A willingness to take risk is obviously part of that DNA. The
United States is extraordinarily lucky in that we attracted people who were
willing to take risks simply to come here.
I may not understand the Chinese mindset, but I think I have
a pretty good grasp of the entrepreneurial mindset. Successful entrepreneurs
don’t fit into a mold. You can see why some entrepreneurs thrive and you have to scratch your head to figure
out how others did it. Some work well within their system. Others simply create
new territory and methods.
Xi is going to deprive China of that second set of
entrepreneurs, those willing to create something entirely new that might not
fit well within the current social credit system. I think the growing Big
Brother state will stifle innovation. Who wants to risk their social credit
score? It is one thing to risk your reputation and capital, and another to risk
your ability to live and work.
China’s panopticon
blocks that risk-taking impulse. The consequences will accumulate and
reduce growth. And with over half the country still living in extreme poverty,
that doesn’t bode well for the future.
Further, China has a serious demographic problem. The one-child policy instituted in 1980 really kicked in around 1990, as you can see in the population pyramid below.
Source: Index Mundi
Normally, population pyramids are actual pyramids. Let’s look at India as an example. This is a population pyramid.
Source: Index Mundi
While we are on this, let’s look at Japan:
Source: Index Mundi
Japan has similar demographic characteristics to China, but with one huge difference. Japan grew rich while it grew older. China has grown older before growing rich.
All countries have problems,
but even with all its impressive growth and infrastructure, China has more. Which to me makes it more
dangerous.
The SEC is correctly insisting on audits for Chinese
companies listed on US exchanges. I personally think we should ban new Chinese
listings unless they agree to US audit standards. Kicking out currently-listed
Chinese companies will be trickier, as US investors don’t actually own the
shares many think they do. We don’t want to blow a $2 trillion hole into US
investor assets.
US corporations need
to rethink how they approach China. For some, there will be few issues.
For others? Real problems.
This week the Biden administration warned US companies about
doing business in Hong Kong. China has essentially removed the rule of law that
enabled Hong Kong’s financial activity. The US advisory reportedly
cites the risks of electronic
surveillance and having to surrender corporate and customer data to the
government.
.
Xi apparently
thinks that it is time to forgo access
to the US markets. Maybe he thinks Chinese
companies can list in Hong Kong and Westerners will still invest. Maybe. Then
again, maybe not.
Rule of law should be critical to any right-thinking
investor. When the CCP can nudge an auditor to give a thumbs-up or thumbs-down
based on some concept of social credit, how can you trust their assurances?
Will that happen often? We don’t know. But we know it’s possible.
I’m not saying avoid China entirely, as there are still
opportunities. But you should have your eyes wide open and understand the
risks. I would prefer China-exposed US
or other Western companies that give you real audits and normal shareholder
rights.
China is going to be a massive headache for the world
over the next few decades.
Washington DC, Maine,
and Colorado
I plan to go to Washington DC for a few days before heading
out to Bangor, Maine, and then Grand Lake Stream for Camp Kotok, the annual
fishing and economic fest. This year my youngest son Trey (who is now 26) will
once again accompany me, which he has done for most years since he was 12. Then
I will go to Steamboat, Colorado, for a speaking engagement before heading
home.
The problems in Cuba are a topic of interest here in Puerto
Rico. Interesting conversations. People ask why the US turns away Cubans
fleeing political unrest and persecution but accepts those fleeing Central
America for similar reasons? I don’t have a good answer, at least one that is
politically correct.
We also talked about entrepreneurs. The Cuban community in
Florida is nothing if not entrepreneurial. They have been a huge plus to the
local and national culture. Growing up with immigrants (legal and illegal) from
mostly Mexico, I would argue that they have also contributed to a vibrant
culture within Texas and the border states. I have consistently been
pro-immigration for 40 years. I want risk-takers and freedom-lovers from all
over the world, especially those with education and talent, to share in the
American experiment.
And with that, I will hit the send button. Have a great week
and remember where your ancestors came from. Most of us came from risk-taking
immigrants.
Your needing more space to talk about China analyst,
John Mauldin Thoughts from the Frontline
John Mauldin
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