China's Economic Transition

China is one of the 21st century's most consequential nations. It has never been more important to understand how the country is governed and what its leaders and its people actually want and believe. Welcome to Pekingology, the podcast that unpecks China's evolving political system and the trajectory of China's domestic and foreign policy. I'm your host, Henrietta Levin, Senior Fellow with the Freeman Chair in China Studies at CSIS. This is Pekingology. I am very pleased to be joined today by Dini McMahon and Andrew Polk from Trivium China. Andrew is also a non-resident senior associate here at CSIS, and Dini and Andrew recently published a fantastic report called China's Economic Transition. Debt Demography, De-globalization and Scenarios for 2035. And I am very excited to discuss their findings on today's show. Dini and Andrew, it is great to see you. Fantastic to be here. Yeah, thank you for having us. So we'd like to start all of our episodes with a personal question to both of you. How did you become interested originally in China and its economy? My story goes back to my father, actually. My dad worked for big Australian mining companies, and when I was about 11 or 12, I think, he started me learning Chinese because his take at the time was, at least in Australia, to the extent that anyone was learning as Asian languages, they were learning Japanese. But in his experience, wherever he was travelling, he was seeing Chinese officials turning up in more greater and greater numbers, buying ore and metals around the world. So his sense was, China is the future, and you're going to learn the language. So that's kind of where it started. And then, you know, since then, I spent a few years after I finished high school during university studying in China, and then eventually found a job as a financial journalist. I worked in Shanghai and Beijing for 10 years. And Andrew, how about you? My story, I guess, is a little bit more classic China Watcher, which is I went to go teach in Asia and Hong Kong. I think we have had a few of those on the show. Yeah, yeah, yeah. And just caught the China bug. I remember it was 2006, 2007. It was the first Focac meeting, which is where China meets with the heads of state of most of the countries in Africa. And just the idea of kind of China as the leader of the global south at that time was really interesting. So I went to grad school here in D.C. at Seis. Probably had a few of those people on here as well. Had planned to sort of do more of the political approach, but the first class was global monetary. And I was like, no, this China's role in the global monetary system is what I want to do. Here we are 20 years later-ish, still doing the same thing somewhere along the way Dini and I met in Beijing 2012, 2013. So over a decade, we've been trying to figure this stuff out together. The rest was history. Exactly. Well, we're all very lucky that you're both doing this work. And so to turn to the report itself, let's start with the increasingly stark challenges facing the Chinese economy across debt, demography, and de-globalization, these three areas you focus on in the report. How do decision makers in Beijing conceptualize the problem they're trying to solve when it comes to the future of the Chinese economy? There's a lot going on. So the way that they approach this is that they kind of have a list of things that they kind of want from the economy, just in terms of the stuff that they talk about regularly in the press, in the think tanks, the officials themselves. They're worried about China sliding into the middle income trap. They're focused on trying to achieve common prosperity, which was Xi Jinping introduced that idea in 2021, this idea of sort of creating a richer, more equitable China. They're definitely concerned about the fallout from a rapidly aging population and a shrinking population. And then layered on top of that, they're certainly aware of the risks that are presented by the sheer mountain of debt that's accumulated over the last 20 years because of the old growth model. So in terms of addressing what they want out of the economy, how they want the system to change, those are kind of the four things as they kind of line up. The idea of the middle income trap, economists around the world don't even agree. They sort of agree to disagree whether it even exists. But within China, there is a consensus that there is such thing as the middle income trap that countries, when they get to a certain level of development, they face almost an invisible glass ceiling at the point where they become advanced economies. And that's where China is at the moment, that if they don't transition to being an advanced economy at this particular moment in time, then they'll kind of get stuck in this purgatory of being a developing economy forever. And so they're very mindful of that, that they've got to be able to transition, structurally change their economy in such a way that they don't remain a developing economy and become an advanced rich nation sometime in the next few years, otherwise it might never happen. And then of course, as I mentioned, the common prosperity issue, which I think often outside of China isn't properly understood. I think when she first introduced the idea of common prosperity, it was widely regarded overseas as almost kind of being like, OK, well, we're going to see more welfare. That this is just a straight up redistributionist policy. Yeah, we understand what this is. But the reality is they've always been extremely reluctant to expand the welfare system. And even you listen to Xi Jinping speaking back in 2021 and even consequently, incredibly reluctant to expand welfare unless they're actually in a position to be able to financially sustain it, which they're very mindful at the moment that they can't given the sort of the dire state of their tax base. So instead, common prosperity is ultimately about developing a richer, fast growing economy that then kind of redistributes wealth as it kind of changes in nature. So it's an idea of like, you have more entrepreneurs and the middle class is able to build their wealth through the stock market. And through these sorts of mechanisms, you redistribute wealth such that the country becomes richer and that's how you do it. You don't do it through welfare programs. And then the other part, of course, is the population piece of the puzzle. Now, I think China's shrinking population is the part of the puzzle that kind of gets the most attention. I think the population peaked in 2021, but at least for the next decade or so, probably the bigger burden or bigger stress on the economy will be the sort of the rapidly aging population because China at the moment, the balance between retirees to the working age population is pretty reasonable, but it is fast deteriorating. I think by about 2080, there'll be more retirees and there will be working age people. And so over that next 60 years, things are just going to get progressively worse and that's going to put a huge burden on the state's financial resources, whether it be just from pensions or from health care. And so you kind of put all this together and these kind of line up as the government's priorities when it comes to the economy. How do we ensure we don't get mired or stuck permanently as a developing economy? How do we ensure that at the same time we manage to deliver to the public sort of this vision of a more equitable, more well off population or better income distribution? How do we do both of those things in the face of a rapidly souring demographic profile? And then on top of that, how do we do that without ramping up debt beyond its current levels? Because China's debt to GDP ratio is incredibly high by the standard of almost any country other than Japan. But ideally Beijing would like that to fall, that ratio to fall in the next few years, because you would imagine sometime in the not so distant future as the population ages, Beijing's going to have to borrow a lot more to make up any pension shortfalls to be able to make up for any shortfalls in the need to sort of fund health care system. And so to be able to do that in the future, what they really need to do now is to get onto a much better footing when it comes to debt. So you kind of take all that into account, the middle income trap, common prosperity, the population issues. And at the same time, they want to be able to deal with those issues without building more and more debt. That is the challenge that Beijing is facing at the moment to come up with a new economic model or a new economic system that allows them to do all those things at the same time. And how does the housing sector fit into those challenges? You mentioned in the report, the property sector alone was responsible for 25 to 30% of all economic activity in China at its peak, and it's not at its peak. So how does that fit in? The impact that the sort of collapse of the housing market has had on the economy. There is so many different ways. So on one level, yeah, there's just the economic growth driver as investment in property continues to slow year on year. I mean, we're in what year number five since the market peaked and it's still continuing to slow. That's a drag on economic growth. The other impact it's having here is it's having an impact on people's willingness to spend. I mean, so much of middle class wealth in China was tied up in the property sector. And, you know, people who own property in China have seen the value of their homes significantly eroded over the last four years. I mean, the whole driver of middle class wealth in China has been completely tipped on its head for years. The thing that made people more and more wealthy were kind of the unrealised capital gains in their apartments and their homes. And now that's just heading in the other direction. So that kind of has a drag on consumption and it's also having an impact on people's financial wellbeing. And then the other way that this is affecting the economy and this is perhaps in some ways it might be kind of the biggest and most destructive is that local governments were so dependent on land sales, not just to service the debt that they were borrowing for infrastructure projects, but also revenue from land sales went in significant volumes to supplement local government's ordinary budgets. You know, that's the money that they spend on education or health care or whatever. And so now that land sales have absolutely plummeted to a fraction of their former levels because I mean, no, property developers don't want to buy land because, you know, they can barely shift the units in the apartments that they've already built. And so this incredibly important source of local government revenue, which in some ways had kind of allowed the government to keep tax levels lower than they otherwise would be because they could just keep selling land. That source of revenue doesn't exist anymore and it's left the local governments in a budgetary black hole. There's not as much money there anymore to supplement their budgets. They're left dealing with not having enough money to deal with the debt repayments. And so, you know, you kind of have these multiple impacts of the property market. Yes. Firstly, it's an ongoing drag on growth and will continue to be until really property prices stop falling. Secondly, it's a drag on household wealth. And again, it will continue to be so until prices start rising again. And then thirdly, it's effectively created a situation where local governments in China are pursuing a policy of austerity. They just don't have the financial resources that they used to. There's no way that the central government can really plug that hole, or at least the central government could plug the hole if they massively ramped up borrowing, but they've decided not to do that. And so the consequences of all that is at a local level, you have austerity policies whereby local governments aren't paying their staff the way that they used to. Maybe they're not getting paid on time. Maybe they're forced employees to take a pay cut. They're not paying the contractors and suppliers that have done business for the local governments on time or in full. They're pursuing additional sources of revenue by going after unpaid back taxes, both real and imagined, and they're sort of imposing arbitrary fees and fines on both the public and firms just to kind of top up their revenue. And all of that stuff is having an impact on the economy that undermines both business and consumer confidence and is an additional drag on the economy. One thing to maybe tie all this together in a way, your first question, your second question through Denny's comments is Denny runs through the list of challenges that policymakers are looking at and we play this out in the report. It sort of feels like it's this smorgasbord of different challenges, but the one thing that sort of brings them all together coherently is and not to get ahead of ourselves in terms of the discussion, but how China thinks about the solutions. The solutions to all the problems Denny ran through are technological innovation or productivity, as we put it in economic terms. Right. So if you're trying to burst through the middle income trap, you need an economy that's moving up the value chain. In their conception of achieving common prosperity, you need higher wages so that it's easier to distribute wealth to the lower income part of the society. And similarly with demographics, you need more technological solutions so you can produce economic output with fewer people. And I would even just say with the property market, even though that's a current drag on growth, I think one thing that's critical here is if the solution, the way out of China's economic problems is to have a much more innovative, technologically capable and productive economy. You cannot do that when you have 25 to 30% of your GDP going into property. In a way, you can almost see it as like property was crowding out the rest of the economy, soaking up so much resources, so much investment that there was no reason for people to put that money into more productive uses. Normally we talk about the public sector crowding out investment in Western economies, but I think that's sort of how in a way the property realignment factors into me as well is they are thinking, there's no way we're going to be able to innovate and drive the economy we want with property being such a big suck of resources. And that's obviously a dramatic and chaotic transition, but I think that's one of the reasons that they were willing to let the property sector go. And when it comes to all of these challenges, the looming middle income trap, you said the party sees this next few years, the period between now and 2035 as a critical window for breaking out. Why is this the moment where these problems need to be addressed in a way that's perhaps more structural than what we've seen in the past? More than anything, it comes down to population. It's those three things that you mentioned as yes, the globalization, its debt, its population and demography. It's this moment more than any, it comes down to population because China's demographic profile is souring so quickly. It's quite interesting. It was in 2015 that a former finance minister, Loji Wei, said that he thought that China only had five to 10 years to be able to deal with the middle income trap to sort of escape the trap because of souring demographics. He thought things were already so far gone that the ability of China to kind of pivot and deal with the problems were already, I mean, the bill was sort of near to sort of ringing on sort of China's future economic prospects. And his take was like, we've got to act now, we've got to liberalize the economy, you know, get rid of the hookhole, that sort of thing. That will deliver the productivity gains that will kind of help us get through this thing. So certainly for a while now, there have been sort of reservations and concerns in Beijing that something needs to be done soon, sooner than better because of the population pressures. And yet, of course, things only really started to change in about 2020 because that's when they finally managed to reign in the property market. But I think for years now, people have kind of seen this moment in time coming. I mean, for as long as I was in China, there was always the idiom floating around that, you know, China runs the risk of growing old before it grows rich. And people could see that coming from near the turn of the century because of the one child policy. China's rapid aging was always baked into the system because we were always going to get to a point where the population of retiree started really accelerating and they weren't going to the size of the working age population coming up behind them was going to get smaller and smaller. And we're kind of now at that point. So I think by 2035, the ratio of retirees to working age people in China, according to the official data, will be at a comparable level to the United States. So the United States' ratio is getting worse at the moment as well. By 2035, the two will kind of meet. And then a few years, you know, decade after that, China will be as bad as the EU. But that's also based on official data. But of course, there's a whole lot of questions out there about just how right China's official population data is. I mean, there's plenty of speculation out there that Beijing has consistently over counted births over the last 30 years. And that actually that profile of retirees to working age people is far worse already than the official data would suggest. So even though it's officially it's not until 2035 that the, you know, China and the US converge, it could actually be well before that. Now, of course, as that ratio changes, the costs to the state sort of rise and become, you know, worse the relative size of the working age population and their contribution of taxes gets smaller, you have potential deflationary forces at work, because if they're a few working age people, well, all the factories that you built previously and all the housing, I mean, do you really need that anymore? Do you kind of need to start shutting down factories because there just isn't so much demand? The more people that you have who retire, who sort of hit the age of 60 or 65, I mean, once you enter retirement, you just don't spend as much as you used to. So there's less domestic demand. And so you kind of add up all these forces of population, these demographic forces. And as things gradually turn against China's interest, then there's all these different impacts that it's having on the economy. And as I said, I mean, Chinese officials were worrying about this vocally 10 years ago, and yet they did nothing about it until probably about 2020. So we're kind of now at that point where if they don't move now to overhaul the economy, then their ability to avoid the middle income trap, to be able to deliver common prosperity in the face of declining demographics, and to able to do all that without massively ramping up debt, is just going to become harder and harder every year that it gets put off. I agree with you that the demographics is driving the situation or the decision making from a domestic standpoint, but the demographic crunch is sort of reaching its peak at the exact same time that we're going through this moment of deglobalization, fracturing of the global economy. So the convergence of those two factors and then the inability to address it through debt, they're all just converging at the same time. So there's nothing about, say, 2025 that makes this... It's not on the mind calendar. Exactly right. Perfect. It just so happens that right now all of these things are converging at the same time to really make like force a change in how Beijing manages the economy. And before we get to those changes, you assess in the report that notwithstanding all of these very significant escalating challenges, the likelihood of a more profound economic crisis over the next decade is actually quite low. So I'm hoping you could also talk about the sources of resilience in the Chinese economy or society that are helping to maintain overall stability, even while these structural tensions continue to mount. It's always difficult to compare what's happening in the Chinese financial system to those of more open societies, right? Because we look at the disclosures of Chinese banks about non-performing loans and it's consistently low, right? I mean, we've seen NPL ratios, non-performing loan ratios in Chinese banks sort of get lower and lower despite the fact clearly there's no way that could be happening, right? I mean, the economy is slowing. We've had a property crisis. The local governments can't pay their debts. And yet the quality of the bank's assets officially are getting better. And so you can't really approach the financial system in the same way. The way that we've kind of looked at it is if we can't look at their data and sort of determine just how safe they are or unsafe they are, perhaps we can look at how the banks perceive the risk of lending to each other, which is clearly that's something that works in every other financial system that banks lend money to each other and the interest rate at which they're willing to lend reflects the perceived risk of the borrower. And traditionally, that's not something you've been able to do in China because all the banks are pretty much state owned. And there was a belief at least that no bank would be allowed to go belly up because at least some level of government was always standing behind every financial institution. And so borrowing from any given bank wasn't a particularly risky prospect. But that all changed in 2019 when the banking regulator took over Baoshang Bank. And not only did they do that, but they imposed haircuts on all the banks that had lent to it. So any bank that had lent to Baoshang Bank could not expect to get all of that money back in full. They might get 90 percent. They might get 85 percent. The exact size of the losses for each individual bank was never fully disclosed, but we have enough information to know that, OK, the banks were not just put on notice. They did not get back everything that they lent to Baoshang. And so after that point, you saw a real divergence in the interbank lending market between the banks. And all of a sudden, banks started pricing in the risk of lending to each other. And for the most part, for most ordinary banks in China, you know, in robust, financially robust provinces like Guangdong and Shandong and Zhejiang and Jiangsu to lend to that triple A rated banks, city commercial banks, rural commercial banks for the last few years in all of those places. The price didn't change. The risk of lending to one bank was no different from lending to another. But at the same time, the banking system did recognize that among their peers, there were some banks which were significantly more risky than others. And it was reflected in the premium that they demanded for lending them credit. So we're looking at banks like Bank of Dalian, Harbin Bank, Guangxi, Beihai Gulf. You know, there's probably a list of 14 of them around the country, relatively large banks that kind of ranked in the top 100 or so. And so you saw this huge blowout, divergence in the interest rates that these banks had to pay if they wanted to borrow from their peers. Now, the reason we think the financial system is probably relatively in relatively good shape at the moment is that those interest rates sort of blew out in 2020, 2021. But since then, they've been gradually getting narrower and narrower and narrower. You've seen a real convergence again among the premium that the riskiest banks have to pay and the premium that all the other banks have to pay. And that's partly because you've really seen this very dedicated campaign among the authorities to recapitalize the risky banks, get rid of their management, bring new people in, get rid of their non-performing loans. In some cases, pursue mergers. All of it's been on the down low, but it has been this sustained policy and ongoing efforts for what, five or six years now. And it seems that the consequences of that is that the banks, they look around and they look at their peers and they go, you know, this isn't as risky as it used to be a few years ago. So that's why we think the financial system is in better shape and far less risky than it was probably even a decade ago. And although we can't look at their balance sheets and look at their non-performing loans and their provisions and their profits and all that, and kind of based on that go, well, things are better, things are worse. But based purely on the degree to which the banks perceive risk in the system themselves, we think that's improved incredibly over the last five years. And so even despite the fact that we're dealing with a property crisis and austerity policies from local governments, overall, the banking system is probably in far better shape than it has been in a long time. And I'll just say, I think that's a counterintuitive point or maybe a point you don't hear very often is that actually China's financial system is quite sound. And that provides a huge amount of economic stability, right? Because most people think if China is going to have a crisis, this is going to happen through the financial system. And we would say actually at this point, it's quite the opposite of that. The financial system provides a lot of stability for the reasons didn't laid out. And then of course, there are many other sort of real economy advantages that China has. The work that it's done to in Scots and self and global supply chains, very sticky. And we always have the conversation about, can China innovate? There remains to be seen on some of these cutting edge technologies, but they're incredibly good at process innovation, which means that foreign companies, domestic companies are getting better and better and better at producing goods. They may not be innovating at the cutting edge of some of those goods in some places they are, but just getting better and better and better and better at process also means that those supply chains again become very sticky. So they've got some foundational financial and real economy economic strengths that we think really kind of are ballast against a major crisis. So in this complex economic environment, Beijing is attempting to pivot towards a new growth model. What is it? OK, well, Xi Jinping refers to it as new quality productive forces. But I mean, frankly, that doesn't tell anyone anything. So if you kind of break it down and the kind of how that's being applied to the real economy, the way that we see it is that it comes down to this, that what they're trying to achieve is productivity led growth, which is driven through sort of a perpetual innovation and sort of a process of constant industrial upgrading. And so when we're talking about innovation, I mean, this is kind of what Andrew was just talking about then. It's this idea that on one level, they keep coming up with new products that the rest of the world is willing to buy. In some ways, they're kind of creating new markets or they're getting in on the ground floor of new markets, such as electric vehicles and batteries. And then you kind of look at the shopping list of priorities that Beijing is throwing resources at. Probably the next cap off the rank is flying cars or what they call the low altitude economy. And then, of course, humanoid robots. I mean, the Chinese press is constantly talking about strides being made in humanoid robots. Then there's sort of biotech and there's marine. There's such a long list of areas that they're throwing money into. And so the hope is that firstly, that they can innovate in these areas and then be able to commercialize those innovations in a way that they'll be able to create profits. And then on the other side of the equation is industrial upgrading. And that's kind of interesting as well, because I think there was always a sense that China at some point would get to a level of development where it would be moving on from the middle income trap and it'd be moving into new industries like it is. And it would leave behind all those lower end industries that had earlier stage of the economic miracle was built on. Much in the same way as Japan and South Korea. Yeah, they started off. They were making textiles and shoes and toys and certain chemicals. And once they became developed enough, they left those behind. I mean, it was the old flying geese formation of the East Asian economies. As each economy took another step up the rung, they jettison certain industries because it just wasn't cost effective for them to make them any more. And some other country that was still developing would sort of come up from behind and pick them up. That would be their next step on the rung to higher incomes and greater development. Whereas in China is not doing that. It is very actively trying to preserve all the industries it currently has. I think to the extent that it is shedding industries at the moment, it's been more a reflection of US trade policies rather than a real concern about the rising costs. So the aim is industries that have traditionally been very labor intensive. Well, we bring in more capital. And then a few years later, we bring in more capital with new machines of greater technology and more sensors. And then we do it again and then we do it again. And so ultimately, you're replacing blue collar workers with far fewer purple collar workers. Robots and machines play a far greater role in these industries. And what you end up with is a situation where you have a whole lot of industries that we've traditionally regarded as being low end, but not only has China managed to sustain them and hold on to them, but has made them more profitable by driving costs down. And so the firms that are in these industries, whether it be spinning yarn or making cigarette lighters, they're a lot more profitable when they used to be. And of course, at the high end with innovation, that's exactly the same goal here as well, is that through innovation and through China developing its own proprietary technology, you end up with companies that are able to generate far higher profits than would otherwise be possible. And that kind of gets to the heart of the new model. Why are they seeking productivity gains through innovation and through industrial upgrading? The end goal is they want companies that can do two things. One, they want companies to be far more profitable because profitable companies can pay far more in taxes. Second thing is they want companies that can pay far more in wages. They want companies paying higher wages to purple-collar employees rather than blue-collar employees. And they want companies that are capable to kind of expand their white-collar workforce, I mean, which is what you have when you start building your own car brands, for example, all of a sudden, your successful car brands need marketers and people collecting data and salespeople and R&D people and engineers. When you kind of move into this higher end of manufacturing, the potential for creating far more higher paying jobs is kind of built into the system. And so this is what China wants from this new model. It's more profitable companies, individuals getting paid higher salaries. Those two things will allow the state to generate far higher revenue and taxes. And once they have higher revenue and taxes, then you'll be able to have a state capable of spending far more on welfare. And of course, the missing piece here as well is once you've got far more profitable companies, then their stock prices will rise as well, which will create wealth for the middle class and create a replacement for the property sector. And so the significance of all this, well, one, this focus on innovation and industrial upgrading allows China to move beyond the middle income trap. Secondly, by increasing incomes and expanding the tax base so that the state can spend more on welfare, all of a sudden, that is how you realize common prosperity. And that is how you kind of realize an expansion of household consumption. This is all really important to China's shrinking and aging population as well, because ultimately the state wants to be able to spend more on pensions and health care, as I said, but you could do that by just arbitrarily increasing taxes. But the amount of pressure that would put on the public would be huge. On one hand, people have to take care of their parents and now they've got greater taxes so that the state can spend more. What you really need is a system that is capable of doing two things at the same time, a, being able to spend more on pensions and b, being able to tax the public more and yet the public is still better off. And so this sort of system where people are getting paid more because of purple and white color job expansion, that gives them the potential to be better off even as the state starts spending more to realize common prosperity. And then of course, you put all that together in this in a perfect world. This model creates wealth because people are buying stuff that they want. It shouldn't be a debt heavy model if done right. And so if it all comes together, then the debt to GDP ratio should be able to decline if it's done properly. So that's the model and that's kind of how it helps them achieve that sort of shopping list of things they're trying to deal with. When President Xi talks about the idea of welfare and why he doesn't want more of it, it's generally not framed in the sense of, well, we can't afford it. It seems like it's more often takes on a political valence of the idea of wealth terrorism being somehow corrosive to the society. But you do see this more as a question of available resources. Can you talk about that? Yeah, absolutely. I think that Xi's position is pretty widely misunderstood. He did give a speech, I think again, it was 2021 or 2020 in which he talked about welfareism and we don't want people getting money who aren't entitled to it. But at the same time, Xi talks all the time about wanting to expand spending on health care and pensions and the public, not just in his statements about common prosperity. He talks about it all the time. Other government officials as well turns up in the people's daily. This is kind of a constant drumbeat. If they could spend more, they would. But the barrier to spending more, because there's kind of a difference between like spending money on what we call dole bludges in Australia or I think what the US used to call welfare queens. There's a really big gap between that and the amount that China is spending on welfare at the moment. China's health care system is chronically underfunded. They would be really happy to put far more money into things like child care or education. The whole system is underfunded. So there's a big gap between where they are at the moment and being in a situation where Xi would sort of genuinely start to worry that people are getting something for nothing. So they talk all the time about wanting to spend more, but they always say the constraint is that we don't want to do it if we can't afford it. And this is kind of baked into the system, this idea that they are not willing to spend on welfare out of debt. So if the state has the financial resources to expand welfare, they would do it in heartbeat. But until the day that they do, they are not going to borrow to be able to expand welfare. I mean, that's something that Xi Jinping said as well back in that same speech in which he talked about welfareism. He said, the problem with funding welfare from debt is that it's not like a one off investment in a bridge. You know, we borrow for a bridge today, we build the bridge, the bridge is done. Great. But welfare, if you spend it on more and welfare today, then you've got to do it again in a year. And then you've got to do it the year after that. And then you've got to do it the year after that. And so it becomes a permanent expense. And so it just means more and more debt at Infernaetum and they're not willing to do that. And so they talk about wanting to spend more, but they're only going to do it if the tax system has the capacity to do it. And China's tax to GDP levels are chronically low and they've been falling, I think, since 2020 at least. And so they kind of really need to change the system in a way that the tax hall expands really fast and then the economy does. And what are the scenarios that you envision for the Chinese economy in 2035 if Beijing pursues this approach more successfully, less successfully? What do you think we'll see? Well, I think the way that we have to look at it is first, how do we determine whether this approach is being successful or not? And I think up until now, when we look at Chinese data, the most important thing has always been GDP growth. Now, regardless of how legitimate that data is or not, that's always kind of been the barometer for how well China is doing, how fast is the economy doing the nature of the growth never mattered. It was always a question of pace because China had to create new jobs. It had to absorb people laid off from the state own sector. It had to deliver on its social contract to raise incomes. I mean, for whatever it was, growth in and of itself was enough. But growth isn't enough anymore for all those reasons that I outlined. Growth is still important, right? But the stuff that we need to look at is one, are corporate profits rising? Because that would be a sign that this innovation and industrial upgrading process, that's working. Secondly, we also need to look at how fast the government tax revenue is expanding as well. Is tax revenue growing at least as fast as the economy and ideally faster than that? And then, thirdly, we have to look at whether the debt to GDP ratio is falling, particularly when it comes to government borrowing. Of course, those last two things are related, government tax revenue and government debt. But they are kind of different as well, because when it comes to debt, the state, both local and central collectively, are kind of in a bit of a funding fiscal hole to start with, because they can't rely on land sales anymore. And so they kind of need to claw themselves out of that fiscal hole before we can kind of see any sort of real progress. But those are the three things you need to look at. And of course, additionally, the fourth one is, are incomes rising? But that's kind of more difficult to pin down. I don't think we kind of have the same sort of data set where we can kind of point to it and go, oh, yeah, consistently incomes are rising across the board. But we can look at things like rising stock market. And, you know, are we starting to see that there's a transfer of savings that used to be put into the banks in anticipation of buying a home? Is that starting to transition into the stock market and sort of supporting wealth as well? So those are the sorts of things we need to look at. And once you kind of take that into account, you can kind of see why at this particular point at your time, the model isn't working. And it's kind of strange to say that because, as I said, we're all we've traditionally cared about is the pace of GDP growth. And if you're outside of China at the moment and you've seen China's economy growing at 5.4 percent in the first quarter, 5.2 percent in the second quarter, it delivered 5 percent growth last year, despite, you know, it was going to be touching go. China still seems to be growing quite aggressively. And from outside of China, you see the strength of the exports and you see the emergence of these new Chinese brands and batteries and, you know, electric vehicle companies and yet inside of China, no one's really feeling the benefits of all that. Corporate profits have been incredibly weak. Tax revenue for almost the whole year this year has been flat or actually falling. I mean, which is mind blowing that an economy can be growing at 5 percent a year. And yet the government's tax hall is declining. Is the economy growing at 5 percent per year? Well, you look at certain things like net exports, for example, not just exports, but import substitution as well. And those sales are incredible, really. And the answer is no, it's not growing a 5 percent. But that's hardly. But the point is it is still growing. Yeah, it's growing. Yes. Whatever the number is. It's not what it used to be, but it's still growing. And so if we're looking at falling tax revenue, that's not because the economy is contracting. It's, you know, because something else is going on. And so, yeah, that's you could kind of take all that together and we've got this situation where it's like, you know, inside of China, people don't feel good about the economic outlook. They're worried about their job security. Companies aren't generating profits. The government is generating tax revenue. And yet externally, China looks like this exporting industrial powerhouse. I know we're going a bit long, but I think an early test on whether or not the new model is moving towards success or not is the recent anti-involution push that some of your listeners may be familiar with, which is basically Beijing's approach to try to reverse or at least stop this sort of value destroying competition among a bunch of different industries, everything from internet service providers to EVs to steel and aluminum. Last time around when they addressed something like this, it was all about pausing the expansion of capacity or even reducing capacity. And obviously a lot of US policymakers and other policymakers complain about Chinese overcapacity, but this time around in the early signs that we're seeing, they've put out three new plans on kind of the 2025, 2026 plan for certain industries to address the evolution challenge. And it's all about having these industries, very specific industries, building materials, copper, aluminum grow their value added more quickly than they're growing their overall output. And so Beijing isn't saying, we're going to make you shut capacity. What we are going to try to do is make you grow in a more innovative way to do the industrial upgrading that Danny talked about to move up the value chain in various ways. And so if that is successful on sort of an industry by industry basis, then it'll be an early test of this new model. And I would just lastly want to say point out that I think something that may be elided to this point is if Beijing is successful in this pivot, and not only do they sort of win some of the innovative technologies and industries of the future, but they don't let go of the sort of legacy industries and they become more productive there, it will be monumentally challenging for the global economy, right? Because that flying geese model that Danny talked about doesn't emerge. The countries around China don't benefit from China moving up as much China gains more and more of the benefits. And so we think the challenges and the trade tensions that we're seeing now are historic. They will only become more so if China does succeed on this path. That's quite audacious. The ramifications for other countries, if China is creating 50% of the world's manufacturing products in all these industries, is just hollows out other industrial manufacturing bases. So there's going to be massive geopolitical implications and also geopolitical pushback, right? We're already seeing that from especially the Western countries, but increasingly developing countries as well. So it's not just whether China can pull it off on its own. It's also what are other countries going to do about it, right? Kind of remains to be seen on that front. I think we have time for maybe one more question. And I'd like to turn towards the process of decision making. So when Beijing is deciding how if to pivot the economy, who actually matters in those deliberation, who's calling the shots, at least on a day to day level? And who does President Xi actually listen to when it comes to economic policy? The real answer is, you know, this is the black box part of the Chinese system and or at least all appropriate caveat. Exactly. We'll call it maybe a gray box. You can see through some of the smoke. You know, obviously at the end of the day, Xi Jinping is calling the shots. That's I don't think a question. What I'm trying to do is provide some frameworks for how we think about this. So she's obviously calling the shots. I think basically when you ask that question, one of the underlying assumptions or drivers of that question is, is she getting good information? Are people bringing Xi Jinping things to think about and policy options? And another way to say it is she becoming Vladimir Putin. Are we seeing key man risk evolve in real time so that Xi Jinping is isolated? Making bad decisions? No one can give bad news to the leader. We don't see that right now because we see the system being able to course correct in different ways. This anti-involution push would be one of those that pivot on covid would be another. There's been various pivots in the past few years on certain climate goals, obviously related to the economy. So we think there is a deliberative process that we see from the outside. In terms of inside the government, he is delegating quite a bit to Li Cheng, the premier and Holi Feng, who he's very close with, who is the vice premier in charge of the economy. And so those are going to be the two obvious people who are going to be dialoguing with him on key economic issues. There's a little bit of a debate as to how much Holi Feng is an implementer rather than a, you know, shape of policy. But I think it's quite clear that he has Xi Jinping's trust. So, I mean, those are two obvious ones that stand out to us, but there's definitely a dialogue there happening. But what we also look at that people don't often look at, and I'll bring Denny on to talk about is there are plenty of policy advisors outside of the government system that really matter as well. And we track those really closely. In fact, there's sort of a deliberative system where outside advisors will be brought in to speak to the Politburo, to speak to a Politburo study session. So we track when these individuals are doing presentations to the state council, to different party bodies. We track the top 20 advisors. You want to go over two or three of kind of the ones of note. We keep an eye on who's talking to the Premier, who's talking to Xi, who's turning up to the study sections of various government agencies. And then based on that, get a sense of who's in favour and who's not. People like Liu Shang Xi, who is one of China's big think tanks, who does a lot of work on fiscal issues, who sort of turns up regularly to talk to government officials. Always you've got three academic members of the PBOC's Monetary Policy Committee, who always seem to be very quite active in policy debates. You have Taifeng, who is China's leading demographer, who has a very high profile in China, particularly when it comes to not just talking about China's population problems, but specifically from an economic perspective. You know, not in terms of like, well, how do we get up birth rates, but like talking about the economic consequences and what can be done about them in the short term. So there is a whole ecosystem of government advisors. It's not necessarily that what they recommend ends up as policy verbatim. But what it does speak to is that there is a vibrant ecosystem of different voices out there that the government does listen to when they're trying to put together policy. They don't necessarily have authority in of themselves, but they do feed into a fairly vibrant deliberative process. And I would say one kind of example of this, just to give a little bit of a concrete example is that you see these advisors starting to make sort of creative suggestions or creative arguments out in the public sphere about economic policies that could be put forth. And one that we've seen recently, as it's become more obvious because of all the challenges that Dain has talked about, while they want to contain the overall macro-debt load of the economy, it is clear that the central government is going to have to borrow and spend more and likely at some point going to have to bail out some local governments, either give them increased transfers on an ongoing basis or outright bail them out. And we've seen several of these economists make the argument, you know, we won't bail out the local governments, but what we could do is have the central government pay back these local governments for all the COVID era policies that they had to enact because they weren't doing that on their own. They were doing that as a mandate from the central government. And the suggestion there being like, what if we made these local governments whole through central government coffers, but we don't call it a bailout. It's just we're paying them a rears for the policies that they carried out on our behalf. Now, we're not seeing any real movement on that front at this moment, but that's an interesting, I think, example of how the system tries to make these politically correct arguments that try to sort of influence policy at the margins to try to sway Xi Jinping one way or the other. There's a ton of other examples of that, but I thought it was maybe particularly concrete. We'll have to leave it there. Andrew and Denny, thank you so much for coming on the show. Thanks for having us. Absolutely. To learn more about their thinking on the future of the Chinese economy, I hope you'll read their recent report, China's Economic Transition, Debt Demography, De-Globalization and Scenarios for 2035, which you can find on the CSIS Freeman Chairs website. You can also tune in to their podcast, Trivium China Podcast. It's great. It is almost as good as peckingology, not quite, but a distant second. It is close. It is close. And to our listeners here, we'd love to hear what you thought of the show and which guests you'd like to see on peckingology in the future. You can send your ideas to peckingology at CSIS.org. And if you're new here, we hope you'll subscribe. We'll be back in your feed in two weeks. 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