China - risks to watch for in 2023 - #4
Understanding the risks associated with the Chinese economy has become paramount for investors, businesses, governments, and other stakeholders. China's rise as a global economic powerhouse that impacts international markets in every sector and industry, necessitates comprehensive ongoing risk assessment. Conducting accurate economic ‘risk assessments’ on China is notoriously challenging however due to difficulties in obtaining reliable data, vested and politicised viewpoints, and the inherent complexities of the Chinese political economy.
This series of George James Consulting (GJC) articles touches on a range of current and emerging risks to the Chinese economy that are worth watching through 2023 and beyond. It is recommended that this be used for informational purposes and that further research be undertaken as required on specific risk topics. The number of the topic # is not necessarily indicative of the likelihood or impact of the risk discussed.
#4 – Systemic risks within China
‘Systemic risks’ are those factors, conditions, or emerging challenges that may or may not be a distinct risk in and of themselves, but can initiate, contribute, or compound other risks. Many of these risks already exist and in some cases appear to be managed. Others could emerge rapidly and potentially cause a cascade of systemic risk and possibly a failure.
The systemic risks discussed can be broadly broken down into the categories of: economic, social (sociological), political (government), environmental, and technological. Many of these risks are not unique to China but may have distinct characteristics within the Chinese context and evolve differently depending upon how they are managed. The Chinese political system is a key determinant in the management of each risk and has advantages and disadvantages.
It is noted that each systemic risk is highly complicated and warrants its own deeper focused research. This article is intended as an introduction to those systemic risks that may be worth tracking as part of a wider effort to understand China’s overall risk profile.
Systemic economic risks
The rapid development of the Chinese economy has led to elements of imbalance that may create systemic risks. Contributing factors can be summarised as high indebtedness, overcapacity, oversupply, and dependence upon new investment to drive growth. The government has implemented measures to address these risks including regulation, structural reform, and deleveraging the economy.
The Chinese financial sector has been a persistent area of weakness. Despite government efforts to enhance the resilience of the sector, China has had faced persistent challenges related to shadow banking, non-performing loans, and over inflated assets. The government has consequently strengthened financial regulation and supervision and established the Financial Stability and Development Committee.
While efforts to reduce the vulnerability of the major Chinese banks has made progress, the risks within the wider banking system remains. Concentrated exposure to the same asset types and high levels of institutional interconnectivity has pushed up the risks. The implication is that even indirect losses from a smaller financial institution could create contagion in the wider system from common exposure (such as to the mortgage market). So while the stability of the major Chinese banks receives media attention the viability of the smaller Chinese banks should also be noted.
The viability of the financial institutions has been wrought by the ‘easy credit’ they have provided over recent decades to enable Chinas rapid economic growth. While this has been essential for business expansion it has also created concerning debt levels, credit dependency, and financial instability. In response, the Chinese government has tightened credit conditions and measures to control excessive borrowing. These interventions however remain challenging to balance with the flexible needs of small and medium-sized enterprises without jeopardising their viability.
The cascade effects of this easy credit can be seen within the debt sitting within government, private sector, and households. Real estate and infrastructure over development by local and regional government has emerged due to central government policy targets, easy credit, and the increased demand for real estate from internal migration. Land sales and development have resulted in some local and regional adminstrations becoming debt laden and reliant upon an unsustainable growth model.
Household debt levels have also risen rapidly as a consequence of this permissive environment. This included the accessibility of credit, the attractiveness of real estate as an asset, rising consumption levels, and general confidence in the Chinese economy. This new level of household spending propelled millions of Chinese into a growing middle class that brought with it rising confidence and expectations. The recently reduced spending power of this section of Chinese society and their pessimism about the economy will inevitably have a dampening impact.
Capital flight from China has been an issue that Beijing has been concerned with for a number of decades. It is estimated $3.8 trillion capital left China over the mid 1990’s. In response China has introduced strict oversight and capital controls to limit the outflow of funds, currency conversions, overseas investments, and foreign exchange transactions. China has also imposed stringent regulations on foreign exchange transactions to restrict the conversion of the Chinese yuan into foreign currencies.
Despite these measures, there is a risk that that further contraction of the Chinese economy motivates individuals and businesses to move capital outside China. Since the Russian invasion of Ukraine in 2022, China has been experiencing significant levels of capital flight. The recent moves by Beijing to rein in some of the mega companies (such as Alibaba and Tencent) are also thought to be pushing some Chinese companies to consider shifting operations outside China to avoid these controls and operate in more liberal markets.
Inadequately developed taxation system. China has ongoing structural challenges with its taxation system including a comparatively low tax base, inefficiencies, issues between with the central/regional/local taxation levels, and high levels of tax evasion. Ironically the inefficiency of the tax system has in many instances supported the rapid growth of businesses and a more effective system could also have a dampening effect.
The availability of low cost labour has undoubtedly been a core driver behind China’s rapid growth to become the ‘worlds factory’. China’s position as the most populated country was frequently cited as its key underlying resource. Access to this low cost work force was supported by waves of migration from rural China to its cities. However, as the country has developed its average wage also rose leading to a decrease in the availability of cheap labour. Arguably, other international locations offering the same or cheaper labour has also led to the loss of manufacturing competitiveness and the Chinese reliance on the lowest price strategy (note the social implications of the shift away from low cost labour are discussed elsewhere).
As noted, the systemic economic risks China faces have unique characteristics due to the CCP apparatus. This is particularly evident in the relationship between national security and the economy. Over the last decade the Chinese government has introduced a number of measures purported to be for national security reasons that may have a detrimental impact upon the Chinese economy.
These include the 2023 anti-espionage law that has caused alarm with the international business community. These laws appear to deem routine business activity of international persons or organisations as potentially ‘espionage’ and requires foreign companies to provide full access to its communications to the Chinese government. Many international companies now perceive China as an unsafe operating environment for its staff and business activities requiring elements of confidentiality.
Systemic social risks
China has a number of systemic social risks that need managing. Many of these risks are not unique to China however the Chinese government response has created different outcome pathways.
China’s aging population is decreasing the available workforce and simultaneously the levels of
dependency. By 2029, China will begin a period of ‘negative population growth’ and by 2065 the population will return to the levels of the mid-1990s. This demographic shift poses challenges for sustaining economic growth and puts pressure on healthcare, pensions, and formal and informal social systems. It can also lead a reduced consumer base and flow on effects upon other demographic groups in society.
Social inequality and urban-rural divide continues to challenge China with significant income disparities between urban and rural areas and wealth inequality. An estimated 13% of the Chinese population still live close to the poverty line. There is little doubt this has been a focus for government with policies aimed at poverty alleviation and rural development. While poverty rates have been reduced it remains a challenge. This may become more acute with rising employment rates and the loss of opportunity amongst those who moved from rural to urban areas.
Youth unemployment in China has steadily risen over the last decade to reach over 20% in 2023. This will be further exacerbated by an estimated 11.6 million college students set to graduate in 2023 and bring with them expectations of a career and prospects.
The significant risks facing the Chinese property sector (which is already covered in another article – see China risk # 1) are increasingly burdening the Chinese population. The high concentration of the populations wealth within a sector that is dangerously over leveraged has creates a systemic social risks that could rapidly unravel. There is clearly growing concern within the Chinese population around the stability of the property and this has led to protests includes the 2020 movement to stop paying mortgage payments to banks and development companies.
A possible outcome of the many social risks are increasing levels of unrest within China. This could include labor disputes and strikes, particularly in the manufacturing and industrial sectors where workers may be seeking working conditions and higher wages. As China’s economy contracts and manufacturing leaves China for alternative international locations, there may be increased tension between labour costs and the expectations of Chinese workers. A failure to find the right balance could lead to increasing levels of labour unrest and disruption.
Systemic political risks
There are longstanding questions around the Chinese one-party system and the extent it creates systemic political risks for China. Much has been written about the downsides of such a centrally controlled system and specifically the Chinese Communist Party (CCP). Despite this the CCP has defied the critics and its longevity has provided stability to China for decades.
The authoritarian nature of the CCP and the apparatus required to maintain it however does create underlying risk. The rigidity of planned economies can reduce adaptability to changing circumstances with concentration of power in a leader and/or a small group of leaders. This can lead to decision-making that is less responsive and adaptable to evolving circumstances. Rapid changes in the domestic or international landscape require flexibility and agility in decision-making, including the ability to respond to unforeseen events. A highly centralized decision-making structure may hinder the ability to promptly adjust strategies and policies.
Elements of the risks within the CCP have been addressed in different ways, such as Deng Xiaoping’s introductions of limits to presidential terms within the Chinese constitution. This was an attempt to rebalance the supremacy of the party following the Mao years and the ‘cult of personality’ that had developed. This was also seen as a means to mitigate leadership excesses that could give rise to coups by orchestrating the peaceful transfer of power from one leader to the next.
The CCP is also been highly aware of the dangers of corruption, the abuse of power, and limited political accountability. Continual efforts to address these challenges have been made through anti-corruption campaigns and by promoting rigorous intra-party supervision mechanisms. While on some level these measures may have reduced risk, they have arguably created different issues and the need for a ‘deep state’. The Chinese government has introduced stronger ‘anti-espionage’ state security laws and increased the visibility of the CCP throughout country. The effectiveness of these efforts to foster good governance and mitigate the limitations of one-party rule is cause for ongoing concern.
In 2018, a significant constitutional amendment was enacted to remove the 10-year limit on Presidential terms. This change allowed President Xi Jinping to hold the preeminent leadership position indefinitely. While the CCP apparatus may have adopted this change based upon their confidence in Xi and the perceived necessity for political stability – it does heighten particular risks.
The concentration of power within a ‘great leader’ inevitably brings with it the strengths and weaknesses of the said leader. Decision-making processes can become heavily dependent on the leader's judgments and preferences. This can lead to a lack of institutional checks and balances, reduce the diversity of perspectives and potentially stifle alternative voices even if they are objectively better. Officials providing advice can become less ‘free and frank’ and instead provide upwards reporting that conforms to the views of the leader rather than reality. This can lend itself to uninformed decision-making and an unrealistic expectations of the leader to make sound choices.
The great leader model can also limit international bi-lateral relationships with its greater emphasis on the leaders personality and reflecting the leaders preferences and comfort levels. Whereas transitory national leaders can provide an opportunity for a re-set of international relationships, an enduring leader may fixate on the same view and inhibit the opportunities for dynamic policy shifts. Some may argue that continuity of leadership provides stability and the ability to pursue long term objectives better, however, this may ignore the rapidly changing complexity and possibility that a different strategy may be required.
Over reliance upon a single leader also creates longer term challenges in terms of succession planning and institutional continuity. If the leader's authority is not effectively transferred or if succession processes are not well-established, it can lead to instability and power struggles. This could rapidly lead to wider instability and a loss of confidence in the government more generally.
Systemic environmental challenges
With rapid industrialisation, China has suffered from significant environmental degradation. This includes air and water pollution, deforestation, and soil degradation. The government has acknowledged these challenges and launched a number of initiatives to address them. Progress has been made but more efforts are needed to tackle long-term environmental sustainability.
While environmental challenges have long term impacts they can also create short to medium term risks that can exacerbate other systemic risks. These can be seen with many of the areas of environmental risk.
Air and water pollution: A number of Chinese cities have severe air pollution particularly where coal is used for energy and emissions from vehicles, construction, and industry. China's water resources have suffered from pollution caused by industrial waste, agricultural runoff, and inadequate wastewater treatment. This pollution affects both surface water and groundwater and may lead to water quantity and quality issues. Beyond the environmental cost, this pollution can directly impact economic conditions (i.e. some reports estimating around 19,000 deaths in Beijing alone and costing US $9 Billion in 2023). These impacts and the reputational damage incurred by the CCP for failing to manage these issues in turn create political risks.
Land and soil Degradation. The pollution and degradation of soil are major concerns due to industrial activities, excessive fertilizer use, improper waste disposal, and contaminated irrigation systems. Erosion, desertification, and loss of arable land are growing problems and have links to the economic use of the land and population health. The annual costs to rehabilitate degraded land is estimated to be in the tens of $US Billions a year.
Waste Management. With its significant population and manufacturing base, China generates vast amounts of waste. Improper waste management, recycling, and disposal may create environmental and health risks.
Climate Change. Compounding all of the environmental challenges, climate change will increase the frequency and intensity of extreme weather events and natural disasters. Some estimates suggest the impact of climate change upon China could be in the order of nearly 4% of GDP by 2050.
Systemic technological challenges
China has been historically very reliant upon foreign technology and has consequently made considerable effort to reduce this technological dependence. Despite this, China's economy still relies heavily on foreign research and technology and remains vulnerable to changes in the policies of international competitors. The US-China trade war which began in 2019, led to the US restricting the export of key strategic technologies such as semi-conductors. This had an immediate impact upon Chinese technology companies supply chains, their ability to meet market demands, and consequently their appeal to international technology manufacturers.
The policies of the US and others also however accelerated efforts to develop Chinese versions of key technology and develop a higher level of self reliance. On one hand this move away from international supply chains could support local businesses, produce innovation, and strengthen national resilience. On the other hand, however, there is the risk that China loses its connectivity with international research, develops technology that is not aligned with international standards, is inferior, and is simply not attractive to the international market. This could have a profound impact on the value of Chinese exports and undermine its efforts to move up the manufacturing value chain.
Recent efforts by Beijing to rein in its technological firms including the likes of Alibaba, Tencent, and other significant companies are also notable from a technological risk perspective. Beijing has apparently assessed that some of these companies were becoming ‘too big’, overleveraged, and possibly, too powerful within China. The Chinese government efforts to rein these companies in may however have gone too far. By reducing the level of support for international Chinese tech companies, China may be inhibiting its ability to keep abreast with its technological competitors and shape international standards and markets.
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