Sentiment Makes Reality

Perceptions matter

I’m always struck by the often-effusive lamentations among crestfallen policy wonks on their disappointment, and sudden, awakening disillusionment, that China has not become a liberalized political economy. Hindsight is twenty-twenty, but some of these expectations, at least when they were formed (leading up to WTO accession, or in the halcyon days before 2008?) seemed seduced by the promise of economic inter-dependencies and mutual wealth creation in the wake of the Cold War. Remember the now loathsome catch phrase “Chimerica”? Perhaps it was a sloppy misspelling of “chimera.”

America First, Trade War, Hong Kong, Xinjiang, Ukraine, etc.… a flurry of newsworthy events has helped usher—as collective force function—us into an updated period of regrets, remorse, and self-questioning on America’s policy decisions over the past 20 plus years. Was supporting China’s entry to the WTO an unforced error? Were we, collectively (sans a few sober, clairvoyant voices) too rosy in our optimism, and for the role of trade as a driver of much broader, and deeper, economic (and political reforms)? Did we move those figurative goal posts too far back? In this first in a series of intermittent—and unscheduled, ill-planned, and likely sporadic—entries, we look what the United States got wrong about China, whether the doom and gloom that’s become the collective sentiment of most (but not all) policymakers and commentators is founded, and whether the future is truly a path dependent function of our perceived past. But let’s start with an opening foray into one—albeit extensive and overarching topic—that being sentiment.

Sentiment: from exuberance to cautious enthusiasm to downright…cynicism.

Several key moments helped erode investor and business enthusiasm. These include the Global Financial Crisis (GFC), Xi Jinping’s ascension, and the series of far more statist policies in the years to follow.

In the first decade after China’s accession to the World Trade Organization (WTO), China’s economy experienced an unprecedented boom, with real growth—adjusted for inflation—in one year alone (2007) surging more than 14% and sustaining levels unimaginable among developed economies. As of 2021, China’s economy in real terms has grown 400% since 2001, and exports nearly 900%, based on exchange rates.

Even during those post-WTO accession early boom year, there were rumblings among foreign enterprises invested in China about lax or woeful enforcement of China’s own intellectual property rights (IPR) protections and trade secrets. News was replete with stories of intellectual property and trade secrets theft and limited market access to many of China’s emerging sectors, such as finance. Policymakers continued to call attention, and raise grievances, over China’s interventionist currency policy that held the RMB artificially cheap relative to the dollar, altering the terms of trade in China’s favor and making Chinese exports to the U.S. much cheaper relative to U.S. goods by virtue of its cheaper currency.

The business community, from articles in Harvard Business Review and other outlets that extolled the rapid, ineluctable rise of the Chinese consumer. Sure, China’s GDP was muddled in historically low levels of household consumption as a share of GDP, and the state sector, after a long bout of painful restructuring in the 90s, was gaining a new foothold in the economy (and a large share of credit), but China’s sheer size and inevitable growth ineluctable to anyone involved in consumer goods, supply chains, or even—increasingly—recruitment of Chinese foreign direct investment.

But that all changed, as we now see, with the crash of 2008. We’ll outline some of the key changes in China’s economy since then, but here we’ll just enumerate some central themes: China’s economy is increasingly bridled with unproductive debt; labor costs are rising (since at least 2010); declining population growth, as an echo effect of the One-Child Policy; and declining productivity. In truth, these factors are all interrelated. But for now, suffice to say many of the issues only academics and experts in the field were calling attention to are now wide in the open, with the most explicit expressions of these issues coming in the form real estate solvency crises (e.g., Evergrande). The durable façade of China’s economic ascent is now showing some signs of concern.

China’s turn towards a more statist, centralized growth model, coupled with the ascent of Xi Jinping has further undercut the optimism of many in the business and policy communities. “Yes, China has some issues, from human rights to economic regulation and governance, that we find problematic. But it’s moving in the right direction.” While I’m paraphrasing, I do believe—as do many others—that this rosy assessment of China’s direction has been undercut, and in many areas completed undermined, in recent years. Let’s start with economic policy.

What’s amiss in many such appraisals of the China’s economy is the longer arc of the Reform Era, and the common misreading of the Chinese economy as moving towards a much more liberalized, market-driven system. To be caught flat-footed by these changes in policy implies a prior belief that China was on one trajectory, one that further divorced state objectives and statist, industrial policy preferences, from the operating of the economy.

But in truth, what might have changed is not the direction of reform, but the speed we became so familiar with. And this can significantly shape how we interpret the recent past. Were Zhu Rongji’s policies of the late 1990s an effort to reduce the role of state enterprises and an open embrace of market principles? Or were these efforts guided by the need to streamline and strengthen the state sector so they can serve a more important and relevant role in national policy in the future? I lean towards the latter, at least with the vantage of post hoc retrospect. Likewise, were the series of IPOs of state-owned banks, e.g., ICBC, illustrative of the same market embrace, or were markets merely the instrument to reform the practices of these banks, bringing them more in line with global institutions, while also raising significant capital AND retaining controlling stakes? Local governments were able to find their fiscal footing, after losing access to the lion’s share of the value-added tax (VAT) since 1994, by tapping into the rapidly growing real estate market. Reliance on land transfers that fed into China’s frenetic property market became sine qua non of local government finance. And it has not showed signs of kicking this addiction.

So, delusions and misreading of China’s economic reforms help put us on the path of cynicism. And then came the Indigenous Innovation policies, first under the Hu-Wen Administration, then the rise of Xi and, under his administration, China 2025, the continued expansion of the state sector’s share of private credit, and the unyielding whack-a-mole efforts to clamp down on unregulated credit markets. And then China’s foreign policies, including its disregard for the 2016 Arbitral Tribunal Ruling on the South China Sea and building of artificial terrain to solidify its dubious claims. China’s policy in Hong Kong has essentially made it impossible to be trusted on the issue of Taiwan, the meticulous documentation of its ethnic-based forced labor camps in Xinjiang have rightly drawn internal condemnation, and its more recent prevarications on Russia’s invasion of Ukraine—to list just a select set of policies—have all served to foster deep resentment and distrust in the United States and among our allies. One can also easily throw in China’s ongoing row with Australia, sparked by the latter’s call for an independent investigation into the origins of Covid-19 and China’s spat with the EU over its policies in Xinjiang.

But even before the Trade War, these tensions were rising to the surface. If nothing else, the Trade War (and the broader set of punitive policies, including export controls and sanctions) served as a collective expression of our unease over China’s rise and the perceived threat to the status quo in international relations. (And it may have even created the conditions amendable to zero-covid policy in China, and possibly longer-term closure to the outside, but that’s for a future post.)

Cynicism is not just a feeling. It’s the zeitgeist sentiment of the moment in DC, along with fear and deep-seated suspicion (and antagonism). There is now a thriving cottage industry of publications calling attention to the “China threat,” and efforts to divine the myopic, singular objectives of the Chinese Communist Part (CCP) to undermine the existing international order (whatever that really is, and if there’s just one) and replace with one more agreeable and conducive to China’s continued ascendancy as a global hegemon. I think these arguments, ranging widely in quality of scholarship, are dubious in their assumptions and claims to understand the intentions of Chinese leaders, as a monolithic class. (Do Chinese leaders, unlike politicians across near all types of political systems—from democracies to theocracies to autocracies—really have a long-term strategy they stay focused and true to? That would be a historic first, no?)

That zeitgeist isn’t just the murmurings of DC policy wonks—although they are a large, loud, and highly productive contingent, in news, articles, and books—but the very real frustrations of the American worker. Yes, this has been an overwrought topic, one extensively covered, in its own cottage industry of sorts, since at least the rise of Trump. But manufacturing jobs—and much of our manufacturing base—has gone away. This isn’t necessarily a bad thing—much of this manufacturing was of the lower productivity, lower valued-added type that is best suited, according to the law of comparative advantage, to places like China, Vietnam, etc. But the rapidity of these losses, which began in the late 1970s and early 1980s, but accelerated since China’s entry into the WTO, cannot be ignored.. We’ll also dig into this topic on its own—"where did those manufacturing jobs go?”—but for we leave that for a deeper entry.

For now, we close with a simple framing comment. The title of this Substack, “Decoupling,” is in part facetious, but in part trying to tap into something very real, very palpable, and very threatening to the long-term economic integration that has made the costs of conflict so great that both sides have real incentives to exhaust all available options to avoid.