China’s Global Disruption

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China’s Global Disruption:
Myths and Reality

BY
CHI LO
Senior Economist and Independent Scholar, Hong Kong

United Kingdom – North America – Japan – India – Malaysia – China

Emerald Publishing Limited
Howard House, Wagon Lane, Bingley BD16 1WA, UK

First edition 2021

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British Library Cataloguing in Publication Data

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ISBN: 978-1-80043-794-4 (Online)
ISBN: 978-1-80043-796-8 (Epub)
To Margaret, Edwyn and Arthur
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Table of Contents

List of Abbreviations ix

Preface xi

Chapter 1 China’s Global Disruption: From Digital Currency to

COVID-19 1

Chapter 2 The Chinese Emperor Shock 23

Chapter 3 The China–US Tech Race 39

Chapter 4 The Sum of All Fears 53

Chapter 5 China’s Role in the Global Market Cycle 69

Chapter 6 The Debt Time Bomb 89

Chapter 7 The Crooked Debate of China’s Debt Risk 115

Chapter 8 China and the Currency War 125

Chapter 9 From Trade War to Global Disruption 147

Chapter 10 Renminbi Internationalisation 165

Chapter 11 The Disruptive Belt and Road Initiative 181

Chapter 12 Global Disruption – The New Normal 197

References 209

Index 221
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List of Abbreviations

AI Artificial Intelligence
AIIB Asian Infrastructure and Investment Bank
BIS Bank for International Settlements
BoP Balance of Payments
BRI Belt and Road Initiative
CCP Chinese Communist Party
CFETS China Foreign Exchange Trade System
CIPS Cross-border Interbank Payment System
CF Countercyclical Factor
CPI Consumer Price Index
CPTPP Comprehensive and Progressive Agreement for
Trans-Pacific Partnership
DCEP Digital Currency Electronic Payment
EBIT Earnings Before Interest and Tax Expenses
EM Emerging Markets
FDI Foreign Direct Investment
FX Foreign Exchange
G3 Europe, Japan and the United States
GDP Gross Domestic Product
GFC Global Financial Crisis
ICT Information and Communication Technology
IMF International Monetary Fund
IP Intellectual Property
IPR Intellectual Property Rights
IT Information Technology
JPY Japanese Yen
x List of Abbreviations

LGD Local Government Debt

LGFVs Local Government Financing Vehicles
MNC Multi-National Companies
MPA Macro-Prudential Assessment
NBFIs Non-Bank Financial Institutions
NEER Nominal Effective Exchange Rate
NPL Non-Performing Loans
OECD Organisation for Economic Co-operation and
Development
PBoC People’s Bank of China
PPI Producer Price Index
PPP Public–Private Partnership
P2P Peer-to-Peer Lending
RCEP Regional Comprehensive Economic Partnership
REER Real Effective Exchange Rate
SDR Special Drawing Right
SOE State-Owned Enterprise
SPV Special Purpose Vehicles
STEM Science, Technology, Engineering and
Mathematics
S.W.I.F.T. Society for Worldwide Interbank Financial
Telecommunication
TFP Total Factor Productivity
UNCTAD United Nations Conference on Trade and
Development
UNPD United Nations Population Division
WMP Wealth Management Products
WTO World Trade Organization
ZIRP Zero Interest Rate Policy
Preface

The ascent of China to the global stage is going to cause disruption to the status
quo. This is not only because China’s emergence has come under the global
scrutiny but also because its increasing weight will create ripples in the global
system whenever it moves. As an illustration, nothing is more apt than the
COVID-19 crisis that hit China first in December 2019 and then developed into a
global pandemic through 2020, causing severe disruption in every aspect of
human life across the world. We shall discuss this particular disruption in the
beginning and concluding chapters of this book.
More generally, the ‘China disruption’ is a natural phenomenon as the world
needs to accommodate a rising power while the existing ones try to defend their
positions. So, let us face it. You can run but you cannot hide from it. Under-
standing China properly is imperative to enable the world to manage the
upcoming disruption and transit to a state with a new global power. But, China
has often been misunderstood, leading to distorted business and policy decisions.
In my view, the media has played its part in creating confusion and propa-
gating distorted views on China without substantiation. For example, in reporting
on China’s COVID-19, or coronavirus, outbreak in early 2020, a major inter-
national newspaper published an opinion piece by an academic calling China ‘the
real sick man of Asia’ and accusing its government of covering up the health
crisis.1 While a healthy dose of scepticism is appreciated and there is nothing
wrong with exposing any possible wrongdoings, both the author and the publisher
provided no evidence at all to support the claim, at which Beijing took serious
offence.
Similarly, another international newspaper reported that

…the most fateful consequence of the official silence was that it

facilitated the exodus of some five million people in the weeks
before the city (of Wuhan, the epicentre of the coronavirus
outbreak in China) was quarantined on January 22, thus helping
to transport the virus all over the country and overseas

1
China is the real sick man of Asia, by Walter Russell Mead. The Wall Street Journal,
February 3, 2020.
xii Preface

to underscore their narrative of China covering up the serious state of the virus
outbreak.2 This kind of reporting was hardly intellectual or impartial, as it
showed that the journalists were either ignorant about China or distorted the
evidence to fit their narratives.
Any informed China watcher knows that most if not all of these five million
people that the report alluded to were migrant workers who always went back to
their home towns during the Chinese New Year (and other major Chinese festi-
vals) for family reunion. They left early (before the city of Wuhan was locked
down) because they had to get home before the New Year, not because the city
government ‘facilitated the exodus’ as the journalists assumed and promulgated
as a fact. China has some 280 million migrant workers, or floating population,
who travel back home from the cities where they work every Chinese New Year
for family reunion. That is why many observers call this Chinese New Year travel
the largest migration on earth.
So the problem with misreading China and, hence, the analysis about its global
disruption has a lot to do the contamination and abuse of public information,
aggravated by socio-cultural differences in doing the analysis. The latter is
highlighted by the fact that what is understood by the West of China is often not
the same understanding by China of the West. These problems have created an
expectation gap between what the world expects China to deliver and what China
can actually, and want to, deliver in terms of policy and reform actions. This gap
has become a key factor in creating geo-political tensions and market volatility,
and in hyping the fears about China’s global disruption.
All these distortions, suspicions and confusions have led to an irony of the
world’s opinion on China’s global impact. It is worried about the global
disruption that China would cause when it thrives, and it is also worried about the
disruption when it collapses. Most of the time, it does not even seem to have a
clue about whether China would thrive or collapse, and many China watchers and
experts are often wrong about their predictions on China’s development.
Underscoring the problem of misreading China is the fact that over the
decades, major speculators who bet on a China collapse sending shock waves
across the globe in the form of a banking crisis, or an asset market blow-up, or a
debt-currency crisis have all lost big money. It seems that these ‘intelligent’ money
managers have never learnt their lessons. On the other hand, optimists and
alarmists think that China would take over the world with its technological
advancement and economic clout in the not too distance future. This also creates
fears about the emergence of a dominant China disrupting the world order.
Does the world want China swim or sink? Or is it too confused about the
Middle Kingdom and does not know what to do with it? Research and media
coverage on China abound, but China-bashing is a favourite and common
approach to talk about China. This does not help to better understand this giant
country. To put it bluntly, when a lie is told a thousand times (about China in our
case here), it becomes the truth. In the public domain, guesstimates, conjectures,

2
Coronavirus: The cost of China’s public health cover-up, by James Kynge, Sun Yu and
Tom Hancock. Financial Times, February 7, 2020.
 Preface xiii

a priori reasoning from dubious assumptions and media-generated hallucinations

are reiterated so often that they are taken as facts. The demagoguery of
contemporary populism, especially in America, ensures that clamour about China
needs no evidence at all to fuel it! The two international media reports on China’s
coronavirus outbreak that I alluded to above underscore all this vividly.
To aggravate the problem of confusion and misunderstanding about China,
some observers who often disguise themselves as experts would even skillfully turn
some structural positive stories, such as Beijing’s anti-corruption campaign and
withdrawal from the distortive implicit guarantee policies, into negative horrify-
ing stories of a systemic collapse in China.3 Some had even bet on a collapsing
China based on these distorted views by short-selling Chinese assets and lost tens
of millions of dollars in the end due to these bad decisions.
Past mistakes about China abound. When it joined the World Trade Orga-
nization (WTO) in 2001, for example, many observers and analysts thought that
China would liberalise to become a democracy. This was because, the logic goes,
Japan, Taiwan and South Korea had all moved in that direction after joining the
WTO when their countries became wealthy enough to prompt their growing
middle classes to demand more say in the system. Hence, China would follow the
pattern.
That turned out to be wrong. China seems to be moving more towards political
centralisation since President Xi Jinping took office in 2013. This has led to an
emerging concern that China’s economic collapse would be inevitable because it
has defied for too long the widely held view that political openness was necessary
for sustaining economic growth. China’s exceptionalism of high growth without
political openness should be ending soon, according to this logic. So, its growth
rate would have to collapse to commensurate with its closed political system,
creating devastating effects on the global system.
A less dramatic view is that China would get stuck in the ‘middle income trap’,
just like many other emerging economies that do not make it to the rich income
country status after decades of high growth. The worry about China’s future
growth has, in turn, raised a practical concern about China disrupting the world
order by pursuing currency devaluation as an escape route to its potential growth
disaster, thus triggering future currency wars.
China’s history of surprising the world goes even earlier. Before Deng
Xiaoping’s economic liberalisation in 1978, most China watchers did not think
that China would undertake serious economic reforms and usher in the longest
period of fast economic growth in the world history. But it did. And earlier yet, it
was inconceivable that a large country like China would lose the Opium War

3
For example, see Chinese bank on verge of collapse after sudden bank run, by Tyler
Durden. Zero Hedge, January 11, 2019. Retrieved from https://www.zerohedge.com/
markets/chinese-bank-verge-collapse-after-sudden-bank-run. The Zero Hedge website was
permanently banned by Twitter for violating rules against harassment and abuse in early
2020, as reported by Bloomberg News, ‘Zero Hedge Permanently Suspended from Twitter
for “Harassment”’, by Siraj Datoo, February 1, 2020.
xiv Preface

(Yu, 2018) so decisively to a relative small British naval fleet and ended up having
to cede Hong Kong. And it did.
Amid all the China-bashing and negativity on one hand and hype and opti-
mism on the other hand about the Middle Kingdom, is the world going to get
China wrong again? This time around, may be the Middle Kingdom is not
doomed to live under the Communist Party’s ruling; may be its growth is not
collapsing; may be its demographic problem is not biting so soon as many
observers have expected; may be its banks are not crumbling; may be its debt
bomb is not going to explode; may be its technological advancement is not as
threatening as commonly perceived; may be Chinese President Xi Jinping is not
just grabbing power as seen by the West; may be China is not going to trigger
another currency war… The list can go on.
What complicates the analysis on China and what kind of disruption it will
cause to the world is the emergence of neo-conservatism, led by the United States
(Elghossain, 2019), towards the rise of China in the global stage. This attitude has
manifested itself in strategic competition between the two nations, creating biased
views on each other by each other and by the public that interfere with rational
analysis.
Ideally, the developed world in the West, led by the United States, should take
steps to engage China with mutual understanding, especially on global issues and
shocks like the COVID-19 pandemic and environment and climate changes.
Practically, the United States would have to accept China as a country with a
different political and economic model, in which the state leads the way in pur-
suing some economic and social objectives. China, on the other hand, should
accept those Western practices that could help it progress and integrate into the
world system. If both sides can accept and accommodate each other’s differences,
they can co-exist with peace and stability.
However, all these co-operation and co-existence will not be possible without
proper understanding of China’s policies, intentions, changes, risks and actions.
Blindly insisting on China to accept the Western value of democracy and socio-
economic systems will not work. China will not bow to any foreign demand to
transform its development model by weakening state-owned enterprises sub-
stantially or withdrawing the role of the state in directing strategic economic
sectors. Escalating tensions with China could push the world powers, led by the
United States, into the Thucydides Trap of disastrous war (Allison, 2017).
Furthermore, most Western players tend to misread the internal and external
pressures on China since President Xi took office by thinking that these pressures
had weakened his governance. Arguably, this misreading has emboldened the
West to force China to change and accept the Western values. But, there is a
distinct difference between how political development like the Hong Kong pro-
tests (which started in June 2019 and turned into riots that are still ongoing at the
time of writing) and the Taiwanese presidential election in 2020 are seen inside
and outside China.
In China, these chaotic incidents did not raise feelings of admiration or envy,
let alone inspiring people to challenge Beijing’s authority that the West thought
they would. Instead, they reaffirmed the belief of most ordinary Chinese in the
 Preface xv

importance of stability for delivering continued social and economic progress and
prosperity. This belief has actually helped Chinese President Xi Jinping and the
Communist Party to leverage on the Hong Kong and Taiwan issues to rally
nationalism to solidify their power as opposed to weaken the Chinese leadership
and eventually lead to the demise of the Communist regime.
Even the COVID-19 health crisis was not able to shake the Chinese leadership
power as the United States had hoped when US President Donald Trump capi-
talised on growing public distrust of China that was fanned before the outbreak
by waging a major anti-China campaign in May 2020. Leveraging on the xeno-
phobic anti-Chinese discourse in some western countries, the Chinese government
turned its political campaign to combat COVID-19 into a moral crusade involving
the whole country. As a result, Mr Trump’s strategy of ‘demonising’ China
(Froomkin, 2020) backfired by fanning nationalism in China, which Beijing had
skillfully exploited to further gain support from both the local and overseas
Chinese in an alleged united front to fight the virus. Arguably, both Washington
and Beijing had used the health crisis as a tool to engage in a new Cold War,
which we shall discuss in a subsequent chapter in this book.
Sino-US tensions are going to remain as part of every country’s life in the
future, regardless of the US presidency or party. This will be a major global
disruption. The trade war that President Trump waged against China in 2018 will
not go away as it is a manifestation of the secular Sino-US strategic competition
on technology, linking national security of the two countries in the fight. China
used to admire the United States for its dynamism, creativity, innovative capacity,
cultural influence and economic breath and opportunity. It still does and still
recognises the United States as a great power, but the level admiration has gone
down sharply since the US subprime crisis in 2008 which exposed significant
fractures in the Western capitalist/democratic system. Western, especially
American, provocations in recent years have only fuelled nationalism in China –
this is the inside view from China, which runs against the view from the West.
So it is imperative to gain better understanding about China in order to
manage the inevitable global disruption that it will bring. This book tries to serve
this prime purpose by engaging in rigorous research-driven discussions with data
and evidence, but not anecdotes, narratives and opinions out of thin air, as the
backbone for the debates and arguments. It takes a critical approach to explore
many of the may-be scenarios mentioned above by examining the changing
structure of the Chinese economy and by questioning many conventional wis-
doms about China. It combines the political and economic aspects of China and
the world to articulate the hidden, and often misunderstood, themes and trends in
China to gain better understanding of its impact on the world system.
The book starts with examining the world’s two major concerns about China’s
global disruption – China’s launching of an official digital currency in late 2019
and the COVID-19 crisis that hit China in late 2019 to early 2020 and developed
into a global outbreak with significant global ramifications. The geo-political
impact of the COVID-19 crisis leading to long-term global disruption will be
explored in the first chapter and discussed again in the last chapter. The other
chapters will examine the structural, political and economic factors that are
xvi Preface

unfolding in China and assess their impact on the global system. A critical and
research approach is used to assess conventional wisdom and distorted views and
debunk myths that underlie the confusion and fears about China’s global
disruption and to reveal hidden trends and implications that have been
overlooked.
In the case of a thriving China that creates concerns about the rise of a bully
wreaking havoc on the global system, we shall (1) discuss and question the con-
ventional wisdom of President Xi Jinping’s power-grabbing move to achieve his
‘Chinese Dream’, which has invited international criticism on him reversing
China’s governance reform and trying to export China’s autocratic model to the
world; (2) examine the fears about China’s technological advancement taking
over the world; (3) assess the concern about China’s global ambitions through the
renminbi internationalisation programme and the Belt and Road Initiative; and
(4) examine China’s role in affecting the global growth cycle.
On the concerns about the global disruption caused by a collapsing China, we
shall (1) assess the Sino-US trade war and its impact on China’s growth and the
global system; (2) debunk the myth about China’s vulnerability to financial (debt
and banking) crises sending seismic shock waves to the world; (3) examine the
debate on China’s debt problem and the flaws in analysing China’s debt risk;
(4) uncover the missing analysis on China’s long-term growth challenge with
respect to the middle income trap and demographic problems and their relevance
to the world; and (5) evaluate the risk of China using a currency war as an escape
route to solve its future growth problems.
The book concludes with some final thoughts on the serious possibility of a
global disruption brought upon by the Thucydides Trap and an inherent tendency
of the world to self-inflict systemic disruption even without China playing any role
in it. Global disruption is becoming the ‘new normal’ of the future, but instead of
being a negative force China at times can provide examples and lessons for the
global community to think about managing the disruptions due to the world’s
geo-political and economic evolution.
Chi Lo
July 2020
Chapter 1

China’s Global Disruption: From Digital

Currency to COVID-19

China’s emergence in the global stage as a new influential player has raised many
concerns about its disruption to the global order in social, economic, financial and
political aspects. The world will have to accommodate this new rising power. But
it is confused and the contaminated information used by many media and ana-
lysts is not helping to gain better understanding of China’s impact on the global
system.
Two events in late 2019 and early 2020 have heightened the China disruption. The
first is the launching of a national digital currency by the People’s Bank of China
(PBoC), the central bank, in December 2019. The move makes the world nervous
about a potential digital currency war between China and the United States rocking
the global financial system. For China, a national digital currency could help deepen
the renminbi internationalisation process and challenge the prevailing international
monetary order that the US dollar dominates. The second is the COVID-19, or
coronavirus, outbreak between December 2019 and early 2020 in China that ground
the Chinese economy to a halt and hit global growth, even before it became a
pandemic as declared by the World Health Organisation in March 2020 (BBC, 2020),
by hurting global tourism and breaking the global supply chains. This health crisis
certainly speaks volumes about the China disruption to the world economy.

The Rise of a Chinese Digital Currency

China has been working on creating a national digital currency since 2014, but
Facebook’s intention to launch a cryptocurrency, Libra,1 in 2019, seemed
to give China a push to get ahead of the competition. The PBoC launched
in December 2019 a national digital currency called the Digital Currency
Electronic Payment (DCEP), involving the Big Four State Banks2 and Big Three
Telecoms companies3 in Shenzhen and Suzhou as pilots.

1
At the time of writing, Libra is still waiting for regulatory approval.
2
The Big Four Banks are the Industrial and Commercial Bank of China, China Construction
Bank, Bank of China and Agricultural Bank of China.
3
The Big Three Telecoms companies are China Telecom, China Mobile and China Unicom.

China’s Global Disruption, 1–22

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211002
2 China’s Global Disruption

In general, cryptocurrencies have raised concerns by global regulators about

their potential risks in disrupting monetary policy and financial stability and
controlling money laundering, terrorist financing and other illicit usages (Araya,
2018). But the PBoC’s cryptocurrency is different. When it creates the DCEP, it
can see everything and anything because it is the regulator and the clearing house
for the digital currency’s transactions so that illicit usage can be properly
controlled, in principle. By jumping the gun by creating DCEP, China has
inspired many developed-world central banks to accelerate their programmes to
provide digital currencies for general usage and to strengthen their regulatory
oversight of cryptocurrencies. This competition is not simply on reaping the
seigniorage, it is also on the government’s ability to regulate and tax the economy
globally.
Arguably, the worry about China’s DCEP disrupting the global monetary
order stems from the strategic competition between China and the United States
and the lack of trust between the two countries. In the short term, the rise of a
Chinese digital currency is not going to undermine the US dollar dominance of
global trade and finance, at least the large part that is legal, regulated and taxed.
America’s deep and liquid capital markets, strong institutions and the rule of law
will trump Chinese efforts to achieve any financial dominance in the medium term
(Smart, 2018). Crucially, the fact that despite China’s rising economic clout, there
is still so little acceptance of the renminbi by the international community speaks
volumes about the renminbi’s lack of credibility.
China will have to sort out its policy for the renminbi’s convertibility first
before it can push its internationalisation ambition further. It will be a long
process for China to sort out its market distortions due to capital controls, lack of
transparency, governance problems and restrictions on foreign ownership of
Chinese assets before the renminbi could displace the US dollar as the premier
global currency. But the DCEP’s challenge to the US dollar dominance is real and
intensifying (Lo, 2020) as it may serve as a catalyst for prompting changes in
China.
However, when it comes to managing the unofficial and non-mainstream
activities, especially those that China and the United States do not share any
common interests, the threat of a widely used, state-backed, Chinese digital
currency could indeed make a big difference to the world order. For example, in
the case of a US-regulated digital currency which is traceable by US authorities, if
some countries on the US sanction list were to use it to finance illicit activities, the
US authorities could potentially block the transactions and catch offenders under
US laws.
However, if the cryptocurrency were to come out of China, the United States
would have little levers to pull. Of course, the United States and other Western
regulators could ban the use of the Chinese cryptocurrency in their respective
jurisdictions, but they would be powerless to stop it from being used/abused in
other parts of the world where US regulations do not apply or are not followed
closely. This oversight problem could even extend to underground activities in the
United States and the rest of the world (Araya, 2018).
 China’s Global Disruption: From Digital Currency to COVID-19 3

That is why global regulators have a strong incentive to rein in crypto-

currencies by prohibiting their general usage. The regulatory barriers make
existing digital currencies highly illiquid and, thus, limit their circulation. If the
United States and the West can work with China on regulating digital currencies,
the emergence of a Chinese government–backed digit currency, like DCEP, would
just be a market development under Chinese regulatory oversight. It should not
be a concern for global disruption.
But not so for China and the United States (and the West) when they do
not share the same interests. In the hypothetical case of a US-regulated digital
currency, the United States may be able to prohibit its usage to finance North
Korea’s nuclear development programme, for example, but it would not be
able to do so if the digital currency were to run out of China. An incentive
incompatibility problem arises here as China and the United States do not share
a common policy interest in dealing with North Korea and they do not trust
each other when pursuing their respective policies (Albert, 2019; Calamur,
2017a).
By jumping the gun by creating DCEP, China has inspired many developed-
world central banks to accelerate their programmes to provide digital currencies
for general usage and to strengthen their regulatory oversight of cryptocurren-
cies. This competition is not simply on reaping the seigniorage, it is also on the
government’s ability to regulate and tax the economy globally.
From the US perspective, having a cryptocurrency is also a competition with
China on boosting one’s currency as the dominant global reserve currency to
advance the country’s foreign policy claims. Just as technology has disrupted
business and finance, media and politics, a digital renminbi could disrupt
America’s ability to pursue its broader national interest by leveraging faith and
general acceptance in the US dollar. The United States certainly wants to defend
the status quo of a dominant global US dollar while China’s crypto-renminbi is
catching up fast to challenge that dominance (Lo, 2020).
Chinese President Xi Jinping’s ‘Chinese Dream’ is intended to spread China’s
global influence through his Belt and Road Initiative (BRI) that covers almost
70 countries and has extended more than USD1 trillion in foreign loans since
inception in 2013.4 The BRI is supposed to work with the renminbi internation-
alisation efforts on building an empire for a global renminbi (Lo, 2017). The
creation of DCEP is part of this grand expansion plan to facilitate the realisation

4
In this nationalistic framework, President Xi Jinping seeks to combine national and
personal aspirations in order to ‘reclaim national pride and enhance personal well-being’.
In economic terms, this amounts to creating incentive compatibility between the state and
the people to maximise national and individual interests, subject to political and resources
constraints. President Xi is in fact driving home the point of structural rebalancing from
export-led growth to consumption-led growth: In his vision, China has been manufacturing
and exporting products to meet the consumption appetite of the West for more than three
decades. Now China is ready to consume what it produces and to realise the materialistic
aspect of the Chinese Dream.
4 China’s Global Disruption

of the Chinese Dream in the long term. In other words, Beijing hopes that
launching DCEP will help boost the BRI and renminbi internationalisation
efforts simultaneously. But this has created a jittery about a new global power
shaking up the world system.

Crypto-renminbi to Challenge the US Dollar

China’s incentive to climb the global ladder is indeed strong. It overtook the
United States as the world’s largest goods trading country in 2013, and has since
been in the top two positions as the world’s largest trading nation. There is a clear
disconnect between the highest proportion of the world’s trade going through
China and the trade’s denomination in US dollar.
Back in 2009, China launched the renminbi internationalisation programme to
promote its foreign trade role. In 2010, just 1.0% of China’s foreign trade was
denominated in renminbi. That jumped to 27.8% in 2015. The PBoC even set up
China’s own international payments system, the China International Payment
Service (CIPS), in 2015, to facilitate cross-border renminbi settlements and as an
attempt to break the dominance of the US dollar–dominated payments system.
Participants in CIPS include global banks such HSBC, JP MorganChase,
Citibank, BNP Paribas and Deutsche Bank.
However, deliveries of these expansion initiatives have not been satisfactory
for China. After 2015, the renminbi’s share in foreign trade settlement has shrunk
(Fig. 1.1). Furthermore, the bulk of the renminbi trade settlement came from
Hong Kong, meaning that its usage was quite limited in other countries. On the

Fig. 1.1. Greater China* RMB Trade Settlement.

 China’s Global Disruption: From Digital Currency to COVID-19 5

Fig. 1.2. Renminbi’s Share in Global Foreign Exchange Reserves.

international payments front, compared to Society for Worldwide Interbank

Financial Telecommunication (SWIFT),5 the US-dominated messaging system
for international payments, CIPS is much smaller. It only had 900 members as of
2018, compared to SWIFT’s 10,000 membership. SWIFT data also show that
the renmimbi’s share of international payments was just 1.9% in 2019, despite
10 years of internationalisation efforts.
The International Monetary Fund (IMF) added the renminbi to its Special
Drawing Right (SDR) basket, an international reserve asset, in October 2016.
China regarded that move as an international recognition of its progress on
financial liberalisation. SDR inclusion has also made the renminbi an official
reserve currency, though a minor one, as the SDR is held by all IMF member
central banks in their foreign exchange reserves. While the renminbi’s share in
total global reserves has moved up the ranks steadily from zero percent in 2009, it
has remained tiny and stagnant under 2.0 % (Fig. 1.2).
To further push the international usage of the renminbi, China undertook
numerous financial liberalisation efforts in 2017. They included expanding the
Stock Connect scheme, which links the Hong Kong stock market with the
Shanghai stock market, to include the Shenzhen stock market for direct trading
without foreign exchange controls, reforming the renminbi–US dollar fixing
mechanism to make the renminbi–US dollar exchange rate more market-driven,

5
SWIFT provides a network that enables financial institutions worldwide to send and
receive information about financial transactions in a secure, standardised and reliable
environment.
6 China’s Global Disruption

establishing a Bond Connect scheme to allow direct bond trading between Hong
Kong and Mainland China, just to name a few (China Daily, 2017).6
Meanwhile, the BRI aims at bolstering trade and investment between China
and almost 70 countries. Under the Initiative, China would provide large loans to
fund expansion of the foreign trade network and international infrastructure
projects, such as power grids, industrial parks, railways, water works and high-
ways. Economically, the spending of huge sums of renminbi loans and invest-
ments abroad is a way to internationalise the Chinese currency. Politically, it
allows China some leverage over the recipient countries by tying their economic
being to Chinese influence.
However, despite the push of renminbi financing, there was not much accep-
tance. Only 14% of the BRI trade and investment was denominated in renminbi in
2017 (Yicai, 2017). This creates another disconnect between China’s economic
prowess and the international usage of the renminbi as a funding currency. In
most cases, the countries involved only used the US dollar as the funding currency
even though China was funding their trade and investment projects.
Despite more than a decade of internationalisation efforts, and despite
China’s rising economic and financial clout, the slow BRI development and the
renminbi’s small international role are certainly dissatisfactory and frustrating
for China’s ambitions. To accelerate and deepen these internationalisation
efforts, China needs to create a significant non-trade demand for the renminbi so
that it will be used as an investment and a funding currency by the BRI and
other countries. To create this secondary demand, China has to create the
incentive for holding and trading the renminbi, and for that to happen the
renminbi will have to be fungible, among other fundamental conditions that it
will have to fulfil (Lo, 2017, Chapter 9).
Beijing hopes that the launching of DCEP will help boost the BRI and
renminbi internationalisation efforts. By coming in as an easily accessible
exchange of value with clear international ambitions, China’s digital currency
could boost its effort to challenge the dominance of the US dollar by fulfilling the
fungibility condition (Lo, 2020). The PBoC created DCEP with the purposes of
promoting renminbi internationalisation in the BRI policy environment,
improving the convenience of renminbi cross-border payments, enhancing the
renminbi as a tool for international trade settlement and invoicing and as a store
of value.
So it is clear that DCEP was created as part of the financial infrastructure to
achieve the Chinese Dream. Arguably, the erosion of the basic functions of money
(as a unit of account, a medium of exchange and a store of value) of the G3
currencies (the US dollar, the euro and the Japanese yen) since the Global
Financial Crisis in 2008–2009 has opened up a window of opportunity for the
renminbi to rise to challenge the world monetary order (Lo, 2017, Chapter 10).

6
Every morning, the PBoC sets a so-called daily mid-point fix for the renminbi–US dollar
exchange rate, based on the renminbi’s previous day closing level and quotations taken
from interbank dealers. The exchange rate is allowed to trade within a narrow band of 2%
above or below the day’s mid-point rate (the fixing).
 China’s Global Disruption: From Digital Currency to COVID-19 7

And Facebook’s intention to launch Libra just gave China a push to jump the gun
and launch its government-back digital currency, as China was afraid that Libra
might threaten its internationalisation efforts (Huillet, 2019). The official Chinese
cryptocurrency will keep the world on its toes in the coming years.

The COVID-19 Disruption

The other event that has rocked the world with a China disruption is the
COVID-19, as the World Health Organisation officially called it, or the coro-
navirus outbreak between December 2019 and early 2020. Its devastating global
effect spoke volumes about the impact of a China shutdown when China closed
most of the country for two months to prevent the epidemic from spreading. The
health crisis tragically illustrated that economic interdependence was a double-
edged sword that could confer enormous benefits as well as exact colossal costs
to their champions.
Champions of globalisation have long preached the benign benefits of inter-
national division of labour, which amounts to economic interdependence among
nations. But such benefits can quickly turn into devastating costs when things go
wrong. This is especially so in the context of asymmetric interdependence, when a
big core economy such as China suffers a sudden calamity and sends shock waves
to peripheral economies which have become overly reliant on the core. The
COVID-19–induced disruption came in three major ways: (1) decline in tourism,
(2) contraction in international trade, which was also due to (3) disruption to the
global supply chains.
During the COVID-19 outbreak, Asia’s tourism was hit harder than many
other regions with negative implications on the region’s current account
positions.7 The impact on the global supply chains stemmed from the world’s
dependence on China both for its demand for and supply of intermediate goods.
China’s shutdown also hit countries with large direct investments and produc-
tion facilities in the country and cut off the supply of intermediate goods to
them. This risk was unprecedented and could have prompted a structural change
in the global supply chains by prompting foreign firms to reassess their China
exposure.
The far-reaching impact on the global system is still unknown at the time
of writing. Time will tell how the global supply chains will evolve after this
health crisis. What is certain is the global impact of a China disruption is much
bigger today than it was during the SARS outbreak in 2002–2003. China now
accounts for 18.7% of the global economy, 12.4% of global trade and 12.0% of

7
In economics, a country’s current account is one of the three components of its balance of
payments, with the other two being the capital account and the financial account. The
current account consists of the balance of merchandise trade, net factor income (earnings
on foreign investments minus payments to foreign investors) and net unilateral transfers
that have taken place over a given period of time.
8 China’s Global Disruption

global oil demand, compared to only 8.2%, 5.0% and 6.0%, respectively, in
2003. And the world had no idea about this global domino effect until the
COVID-19 crisis hit China.

Tourism and beyond

Tourism is perhaps the most immediate propagation channel from China to the
world, as Chinese tourists have driven a major tourism boom across the world,
especially in Asia. But China’s USD270 billion annual outbound tourism turned
from a spending boon for the recipient countries to a bane during the coronavirus
crisis with its tourists staying home. The negative impact on global tourism
had actually gone beyond the direct impact of a reduction in tourist arrivals, as
third-country tourists cancelled or postponed their trips for the fear of contagion.
The spillover effect on other sectors included transportation, accommodation,
food services, retail sales and financial services such as insurance and foreign
exchange transactions.
During the crisis, more than 130 countries imposed travel restrictions on
passengers to and from China. Asia felt most of the effects, as over 90% of Chinese
tourists travelled within the region. Those economies that received the largest
number of Chinese tourists were hit especially hard, including Hong Kong, Taiwan.
South Korea, Vietnam and Japan (Fig. 1.3). But the ultimate economic impact
depends on the share of Chinese tourist spending in the local economy (Fig. 1.4).
The impact on Hong Kong was the biggest, as Chinese tourist spending accounted
for 4.8% of its gross domestic product (GDP). Excluding this outliner, the GDP of
Thailand, Vietnam and Singapore all suffered more than average due to the loss of

Fig. 1.3. Share of Mainland Chinese Tourist Arrrivals* (2018).

 China’s Global Disruption: From Digital Currency to COVID-19 9

Fig. 1.4. Share of Mainland Chinese Tourist Spending in Local

GDP (2018).

Chinese tourist revenue. The reality might be worse as the virus scare had cut
tourist travels all over the world, thus reducing non-Chinese tourist arrivals.
Tourist revenue, including from mainland Chinese visitors, is an important
source of foreign income for many economies, contributing to their current
account balances. A sharp drop in tourist arrivals will, thus, hurt a country’s
external balance. Using data on current account tourism receipts and tourists’
origin at the time of writing, I estimated the potential impact of the disruption by
a drop in mainland Chinese tourists on a country’s current account balance.
For most of the top tourist destinations for China, a drop in Chinese arrivals
would lead to a manageable deterioration in their current account positions,
with Thailand, Taiwan, Japan and Hong Kong showing a bigger-than-average
deterioration (Figs 1.5 and 1.6). Hong Kong’s change would be dramatic as its
current account would move from a surplus to a deficit position.
From a macroeconomic risk perspective, things are not too bad as those
countries such as Indonesia and the Philippines that have weaker fundamentals,
such as twin (current account and fiscal) deficits and high foreign debt, the impact
would be relatively small. Meanwhile, countries that were estimated to be affected
more significantly had large current account surpluses to help cushion the hit by
the loss of tourist revenues.

Trade Disruption
The disruption to international trade comes from the fact that China is the top
export destination for many countries, particularly in Asia. Economies that
depended more heavily on exports to China both in terms of total value and as a
10 China’s Global Disruption

Fig. 1.5. Current Account Balances (2017–18 Average).

Fig. 1.6. Estimated Change in Current Account Balances Due to a

Loss in Chinese Tourist Revenue.

percentage of their GDP were thus affected more than average by a China closure
due to the coronavirus crisis. Most Asian economies were also affected by their
roles in the global supply chains.
China imports significantly more from South Korea, Japan, Taiwan, the
United States and Australia than other countries (Fig. 1.7). But relative to
the size of the local economy, the impact of a drop in Chinese imports was
more serious on Taiwan, Vietnam, Malaysia and South Korea as their exports
 China’s Global Disruption: From Digital Currency to COVID-19 11

Fig. 1.7. China’s Top 20 Importing Countries (2018).

Fig. 1.8. Exports to China as % of GDP* (2018).

to China accounted for an above-average share of local GDP of the other

countries (Fig. 1.8).
Commodity exporters were also hit hard as China was the biggest raw mate-
rials buyer in the world with over USD500 billion imports in 2018. The epidemic
halted all kinds of construction activities in China during the months of crisis
management. Most of the property projects suffered significant delays by as long
12 China’s Global Disruption

Fig. 1.9. China’s Top 20 Raw Material Importing Countries (2018).

as half a year. China’s energy demand also fell sharply due to a substantial
drop in traffic volume and industrial activity, and all Chinese refiners had cut
production. All this sent the oil price in early 2020 to the lowest level since 2003,
reflecting the financial disruption in the global commodity market.
In terms of value, Australia, Brazil and Russia are the top three exporters of
raw materials to China (Fig. 1.9), which account for over a third of their overall
exports. Their sales include iron ore and energy, which are exposed to China’s
construction cycle as well as overall demand. The outlook was particularly
negative for them during the COVID-19 crisis because China had pledged to buy
more energy and agricultural goods from the United States in the temporary trade
deal signed at the onset of the crisis in January 2020. That trade agreement meant
that the market shares of Australia, Brazil and Russia would be squeezed by the
Americans. In terms of the shock on GDP, the impact of this China disruption fell
more on the typical commodity-producing countries in the Middle East, Africa
and South America than on Asia (Fig. 1.10).

Supply Chain Shock

China as a Demander
The disruption to the global supply chains is complicated by the fact that China is
both a big demander and supplier of immediate goods. On the demand side,
China imported USD430 billion intermediate goods in 2018, including those for
processing trade – i.e., imports that Chinese manufacturers would process and
export again to the rest of world. The shutdown of Chinese factories due to the
 China’s Global Disruption: From Digital Currency to COVID-19 13

Fig. 1.10. Raw Materials Exports to China as % of Local GDP*

(2018).

Fig. 1.11. China’s Top 20 Intermediate Goods Importing Countries

(2018).

coronavirus crisis cut demand for intermediate goods sharply and created a
negative shock on both international trade and supply chains.
Japan, the United States, South Korea, Taiwan and Switzerland are some of
the largest immediate goods exporters to China in value terms (Fig. 1.11).
14 China’s Global Disruption

Fig. 1.12. Intermediate Goods Exports to China as % of Local GDPp

(2018).

Relative to the economy size, the impact on local GDP was the biggest in South
Korea and Taiwan, as well as in Switzerland, Chile and South Africa (Fig. 1.12).

China as a Supplier
The risk of global supply-chain disruption also stems from China’s role as a major
supplier of intermediate goods. For example, during the coronavirus outbreak,
Hyundai and Nissan had to shut down their factories in Korea and Japan,
respectively, and Apple had to delay iPhone shipments, all because their Chinese
suppliers could not deliver the parts.
Indeed, the world has become more dependent on China for its supply of
intermediate goods. According to the United Nations Conference on Trade and
Development data, China’s exports of intermediate goods that are used by other
countries as inputs for producing their exports had risen to 32% of China’s total
exports in 2018 from 24% in 2003 (Fig. 1.13). So those countries that rely more
heavily on intermediate goods supply by China are more exposed to the supply-
chain disruption risk. The data showed that Hong Kong and Vietnam stood out
as the most exposed economies, while Singapore, Malaysia, Taiwan and Thailand
were also quite exposed, due to their high dependency on China’s supply chain
(Fig. 1.14).

Changing Dynamics
Furthermore, China’s roles as a demander and a supplier of intermediate goods
have been changing, making any projections for future trends unstable. While
 China’s Global Disruption: From Digital Currency to COVID-19 15

Fig. 1.13. China’s Intermediate Goods Exports Used by Other

Countries as Inputs for Exports.

Fig. 1.14. Intermediate Goods Imports from China (% of Local

GDP).

China has increased its exports of intermediate goods over the years, it has also
reduced its imports of foreign inputs (Fig. 1.15). This changing trade dynamics
highlights the decreasing importance of China’s role as a demander and the
increasing importance of its role as a supplier in the global supply chains. This
16 China’s Global Disruption

Fig. 1.15. China’s Imports of Processing Goods* (Used as Inputs for

Exports).

development is likely to continue as Chinese domestic manufacturers use more

local components under Beijing’s self-sufficiency industrial development policy.
All this also means that Asia would have to adapt to China’s changing
international trade profile and trade dynamics, especially Asian upstream sup-
pliers of intermediate goods for China’s export-processing industries who will be
adversely affected. This is a structural change in the supply chains that will cause
relative changes rather than an absolute negative shock on the regional growth.
But it is a global supply-chain disruption, nevertheless.

Disruption to Investment
Beyond this exposure to intermediate goods imports, countries are also exposed
to a disruption risk via their direct investment in China and Southeast Asia.
In recent years, despite efforts by Japan, South Korea and Taiwan to reduce
concentration risk by diversifying their investments from China to Southeast
Asia, their stock of foreign direct investment in China remains large (Fig. 1.16).
Furthermore, Southeast Asia is also deeply integrated in the global supply chains
that are dependent on China. This has greatly eroded the diversification benefit
that these North Asian economies want to achieve.
So the shutting down of the virus-hit Chinese provinces such as Hubei (the
epicentre of the outbreak, which accounts for 4.5% of national GDP) and
restriction of activities in other major production centres in coastal China, where
most of these foreign investment and production facilities are located, hit the
North Asian production lines directly. They were also hit by their investment in
Southeast Asia that also depends on Chinese inputs for production.
 China’s Global Disruption: From Digital Currency to COVID-19 17

Fig. 1.16. Foreign Direct Investment* by Japan, South Korea and

Taiwan (2015–18).

The China Disruption

The data analysis above shows clearly that the COVID-19 crisis had far-reaching
effects on the global system by disrupting both global demand and the global
supply chains and investment. Table 1.1 summarises the countries that were
affected more than average by the various disruption channels discussed above.
The old saying of sneezing by the United States would give the rest of the world a
cold should now be changed to sneezing by China would inflect the rest of the
world with a flu.
The increasing dependency on China for intermediate goods has greatly eroded
the world’s ability to avoid any production and supply disruption by China. The
COVID-19 crisis may also prompt a structural change in the global supply chains
by increasing the incentives of multinational firms to relocate away from China
and China-dominated regions as a risk management measure. How the global
supply chains and trading system will evolve is a big uncertainty at this point and
requires further research to monitor and understand.
In particular, it is not sufficiently understood how rapid that process of supply-
chain disruption could be. The complex global supply chains are fragile precisely
for the same reasons as they are valuable – namely, their interdependency nature
that makes the whole network hard to construct and maintain. So once broken,
they will be hard to rebuild. This nature of the cross-national supply chains makes
them especially vulnerable to shocks like the coronavirus because they do not
adapt so well to complete cutoffs in materials or labour, as happened during the
China outbreak that shut down factories, workplaces and transport linkages.
An obvious case in point is the auto industry, as highlighted by production
shutdown by Hyundai and Nissan in South Korea and Japan, respectively, during
18 China’s Global Disruption

Table 1.1. Above-average Impact on GDP by Disruption Channels.

Tourism Current Trade Raw Supply Supply Investment

Account Material Chains Chains
Trade (Chinese (Chinese
Demand) Supply)
Hong U U U
Kong
Taiwan U U U U U
South U U U
Korea
Japan U U
Malaysia U U
Thailand U U U
Vietnam U U U
Singapore U U
Australia U
Russia
Brazil U
Angola U U
Congo U
Peru U
Venezuela U
Iraq U
Iran U
Chile U U
Kuwait U
South U
Africa
Switzerland U
Source: Author

the health crisis. Since closed Chinese factories cannot produce many auto parts
used by these foreign auto makers, it is not simply a question of the supply
chains losing money. It is a serious matter of missing critical pieces of the pro-
duction process that renders the cars unworkable without the Chinese inputs
(Braw, 2020).
The foreign establishments might try to source those components elsewhere,
but the increased reliance of the world on Chinese intermediate goods means that
 China’s Global Disruption: From Digital Currency to COVID-19 19

it is not easy for other suppliers to produce enough of them at sufficient scale and
quality. The foreign producers might try to bid more for the Chinese auto
components, but if the workers are prohibited from even going back to work, no
feasible market clearing price can make this arrangement work. Production just
will not be possible.
While the coronavirus crisis might be a transitory shock stemming from China
in 2020, the chance that a more prolonged China disruption in the future is rising
from other sources. This is because both the Sino–US trade war and the coro-
navirus crisis have strengthened the hand of those who advocate for dismantling
of international trade networks, i.e., de-globalisation. The more people start to
believe that long, complex global supply chains are risky, the more fragile they
will turn out to be, and the bigger will be China’s global disruption.

The Post COVID-19 Geo-political Disruption

Even after the COVID-19 crisis has passed, vaccine has been developed to treat
the disease and economies have recovered, the far-reaching geo-political disrup-
tion left by the crisis will not go away. This is because the world has lost its global
leadership, the United States, when fighting the pandemic (Bennhold, 2020) and
has to live with increasing political tension between China and the United States
after the pandemic when they compete for global influence. In essence, the
pandemic has exposed two structural flaws of the world system: the breakdown of
the global supply chains and the collapse of international order of cooperation
during a crisis period.
The coronavirus has shown immunity to all barriers – national, cultural,
ideological and individual. It has attacked humans indiscriminately, the rich, the
poor, the strong and the weak. In a crisis of such scale, the United States used to
step forward to offer leadership, using its unique convening power for mobilising
resources and rallying countries in a common direction. Such was the case
following the Southeast Asian tsunami in 2004 (Roos, 2018), the global financial
crisis in 2007–2008 (Claessens, Ayhan Kose, & Terrones, 2010) and the outbreak
of Ebola in East Africa in 2018 (US Mission to the African Union, 2019).
Over time a pattern has built up, the United States and China would set aside
their differences when the world faced a crisis and work together on coordinating
a collective response to the common cause. The United States has generally
viewed its leadership and international cooperation with key players such as
China as a positive-sum game to navigate these global challenges. But that is no
longer the case since President Trump took over the helm in 2017 and changed the
traditional ‘constructive engagement’ China policy of the past Administrations to
‘strategic competition’ (Jishi, 2020). The COVID-19 pandemic has added fire to
the strategic rivalry between the United States and China by clearly revealing the
fracture in the Sino–US relationship. Throughout the health crisis, leaders in both
countries were consumed by arguments over where the coronavirus emerged and
who was to blame for its spread, rather than on the cooperation to stop it.
20 China’s Global Disruption

The behaviour of the two powers during the COVID-19 crisis has shown that
decoupling between them would be unavoidable, especially in supply chains,
investment and trade flows (Liang, 2020). Trends are developing that the United
States and China increasingly live in their own economic ecosystems (Yang,
2020). The lockdown in China has upended supply chains and shut down factories
across the world, as discussed above. The United States has used this pandemic as
an opportunity to bring production back to the States and wean American
companies’ dependence on China. It has also restricted investments in China and
delisted Chinese stocks in the United States, while China has moved away from
dependence on US technology. All these point to upcoming long-term disruptions
resulted from a deterioration in Sino–US relationship, which will likely worsen
post COVID-19 crisis.
Since the coronavirus outbreak, many American policymakers view coordi-
nation with China as a self-harming exercise in a zero-sum competition for global
leadership. This underscores a fundamental change in the Sino–US relationship
from constructive engagement, which all pervious US administrations before
Mr Trump pursued, to strategic competition since 2017 (Jishi, 2020). This new
American foreign diplomacy also reveals an abrupt change in the US attitude
towards its global leadership role which, in turn, underlies the perpetual global
disruption involving its relationship with China in the future.
Under Mr Trump’s leadership, America seems to be moving towards
isolationism (Eichengreen, 2020) but hitherto has yet to show a conviction of
relinquishing its traditional global leadership role. This could be dangerous as
it seems to be unprepared to turn inwards and make adjustments to the new
reality of an emerging China in the global stage. China, on the other hand, is
heralding the return of its strong civilisation and seems determined to push
ahead (Lee, 2020) but hitherto has yet to show any conviction of taking on
global responsibilities. The world meanwhile has been stuck between the clashes
of these two Titians, who have wasted much time and efforts on shifting
blame on each other trying to score points over the course of the COVID-19
health crisis.
China and the United States were mired in a narrative war over the causes
of the pandemic and the apportionment of blame for the global destruction it
is causing. The downward spiral of the Sino–US relationship shows no signs
of abating at the time of writing. It is not difficult to imagine this game of
naming, blaming and shaming each other would lead to negative-sum outcomes
for the United States and China. Top US officials believe they have a moral
imperative to link China’s negligent initial response in Wuhan, the Chinese
city where the coronavirus outbreak started, and the global spread of the virus.
The more global the destruction COVID-19 unleashes, the stronger the
conviction has become for these US officials that China’s authoritarian
governance system must be challenged, and that no cooperation would be
possible in the future.
The efforts by the American hawks going against China was clearly seen in US
Secretary of State Mike Pompeo’s unsuccessful insistence on the G7 foreign
ministers to refer the coronavirus as the ‘Wuhan Virus’ in an official communique
 China’s Global Disruption: From Digital Currency to COVID-19 21

in March 2020 and in a directive for US diplomats to press host governments to

criticise Beijing’s response to the virus outbreak (Graziosi, 2020).8 Continuation
of these trends would mean that America’s foreign policy in Asia over the coming
years might likely be consumed by efforts to pin the blame on Beijing, Chinese
President Xi Jinping and the Chinese Communist regime.
Under such a backdrop, the COVID-19 crisis could not have come at a worst
time. When the crisis started, the world was at the tail-end of the longest period of
economic growth, in the middle of rising trade tensions between China and the
United States and half-a-year away from the US presidential election in
November 2020. When the pandemic started to peak in May 2020, the US
intensified its blaming and naming strategy on China to divert America’s
accountability and voters’ attention. Going forward, as the Sino–US conflict
intensifies, relations will become tense and trust will be low leading to new
conflicts and unwelcome dilemmas for neighbouring countries who are forced to
choose between the United States and China.
The point is that such a blame-shifting focus of diplomatic strategy during the
coronavirus crisis would risk alienating the United States from virtually every
country in Asia after the health crisis, sparking a potential new Cold War between
China and the US (Haltiwanger, 2020). While many countries, including those of
the US allies, will be privately sympathetic to critiques of China’s behaviour, few
will think it would be in their national interest to join a public narrative war
against China. This political dilemma has become increasingly acute because
China’s economic clout has become too large for neighbouring countries to
ignore.

COVID-19 Legacy
The legacy of COVID-19 is an increase in political tensions across the world, with
the developing economies shouldering the bulk of the political dilemma as
seemingly marginal issues such as terminologies for the pandemic and China’s
industrial policy, decisions on BRI projects, technical standards for 5G build-outs
or votes for candidates to head United Nations agencies become proxies for
measuring support for Washington or Beijing. Even though China and the United
States will continue their rhetoric about not forcing other countries to choose
sides, space for countries to remain neutral will shrink with each discrete decision.
Even before the coronavirus crisis, the structure of the international system
had become increasingly bipolar due to the Sino–US competition for global
leadership. The COVID-19 crisis only aggravated the strategic rivalry. The
United States has become more insulated as it has shunned cooperation across
international organisations such as the World Health Organisation. Even
America’s soft power seems to be in decline (Nye, 2019) as its policy under the
Trump Administration seems to be generating less support from stakeholders

8
The Group of Seven (or G7) countries include Canada, France, Germany, Italy, Japan,
the United Kingdom and the United States.
22 China’s Global Disruption

across the world. The rest of the world, including China, is accustomed to a rule-
based order but the United States is trying to shun its responsibility of upholding
this system. This change in the US foreign policy direction also makes it hard
for regional geo-political cooperation as China and the United States see such
platforms as a tool for fighting for influence.
While it is far from certain at this stage that Washington would persist
indefinitely in ratcheting up its rivalry with Beijing, it seems very likely that the
US Administration’s old constructive engagement foreign policy approach in
dealing with China is gone for good. It is also not certain whether China will
maintain an abrasive external posture in dealing with the United States indefi-
nitely, but Beijing has certainly grown more assertive in its demands as China
grows stronger, richer and more technologically advanced (Clover, Hornby, Ju, &
Liu, 2018).
COVID-19 crisis or not, the world has to live with this trend of global
disruption stemming from the Sino–US strategic competition. To hold the world
together, US leaders do not need to like or agree with their Chinese counterparts.
But they do need to realise that the emergence of China in the global stage is a
foregone conclusion. Hence, the United States needs to develop a relationship
with this emerging power that allows both countries to pull in the same direction
at decisive moments when it serves mutual and global interests to do so. The
prevailing trends show that this minimum standard is not being met, but it is
imperative for minimising the global disruption.
Chapter 2

The Chinese Emperor Shock

For all the lessons for President Xi Jinping to take away from China’s coronavirus
health crisis in early 2020, he seemed to have settled on one above all others, and
that is centralised control works and more is needed. For those who have followed
Mr Xi’s rise to power, the draconian measures to manage the health crisis were
seen as a new chapter in a long-term effort to remake China’s political system
rather than a temporary emergence response to a public health crisis. The western
view is that the Chinese government that emerges from the crisis will likely be
more centralised and more authoritarian (Hsu, 2020).
All this has raised the concern that President Xi would try to export his auto-
cratic model to the world. Many observers actually see this ambition in his move in
March 2018 to change the Chinese constitution to remove the presidential term
limit, making himself the new ‘Chinese emperor’. For decades, the world thought
that China would move towards more political openness as it pursues economic
liberalisation. But Mr Xi’s move has proven this conventional wisdom wrong.
Expectations on harmonising China’s ascent to the global system have turned into
fears about a China disruption. His move has also invited strong international
criticism on reversing China’s governance reform by engaging in power-grabbing to
make himself the life-time ruler of China with an international ambition.
In his anti-corruption campaign since assuming Party leadership in late 2012
that ensnared some 1.5 million officials, including a former public security czar and
former top army generals, Mr Xi has also eliminated many of his political rivals.
From the world’s business perspective, this anti-corruption campaign has invoked
fears about a disruption to the luxury goods business, as a large part of the luxury
goods demand in China came from the gift-giving habit, which often involves
bribery. Major global luxury brands, such as Louis Vuitton, Gucci, Prada, Chanel,
Hermès, Dior, Cartier, Tiffany & Co., Burberry, Rolex, Armani, Lancôme, Yves
Saint Laurent, Bulgari, etc., have been relying on the China market for the bulk of
their profitability and market expansion (McKinsey & Company, 2019).

China’s Anti-corruption War

Some market players are wondering if China’s war against corruption has gone
far enough so that its negative impact on Chinese growth, and in particular the

China’s Global Disruption, 23–37

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211003
24 China’s Global Disruption

demand for luxury goods (and, hence, the profitability of the global luxury brands
and the performance of their stocks), may have come to an end. This is essentially
a question about how long China’s disruption, via its domestic policy, to the
global luxury goods market will last?
From China’s perspective, the ultimate question is whether reducing the role of
the state in the Chinese economy, as conventional wisdom has it, will allow market
forces to clean up corruption, improve economic efficiency and, hence, smooth its
integration in the global system? Evidence argues that China’s war against
corruption is far from over (Jakhar, 2018). But the worry about a China shock on
the global luxury goods market should not be exaggerated, as Chinese demand for
luxury goods should improve in the long term by improving growth quality and
industrial upgrading, but not depend on the truce of the anti-corruption war.
Academic research has not been able to conclude with conviction a correlation
between corruption and economic performance of a country because bribery and
economic performance can feedback effect on each other through other unob-
servable factors, due mostly to the lack of data (Kochanov, 2015). However, the
consensus is that corruption obstructs the law of economics from functioning and,
hence, hurts economic growth.
World Bank data show that the average income of countries with high level
corruption is only about a third of that of countries with low level of corruption,
and the infant mortality rate in such countries is three times higher and literacy
rate is 25% lower. The theoretical justification for such evidence is that corruption
leads to dead-weight loss via collusion in the form of monopolies and/or oli-
gopolies. Corruption also has a negative effect on the quality of education and
healthcare by increasing the cost of these services, thus leading to higher illiteracy
and infant mortality rates.
In a nutshell, corruption hurts economic performance by misallocating resources
and distorting wealth distribution. President Xi Jinping is well aware of such
destructive potential, which could also undermine the legitimacy of the Communist
Party to rule the country. Hence, he has embarked on a massive anti-corruption
campaign since he came to power in late 2012 that is unprecedented in scale, scope
and depth.
Between 2013 and 2016, the campaign resulted in dismissal and different forms
of sanction (ranging from jail terms, even capital punishment, to deprivation of
political rights and expulsion from the Communist Party) of more than 440
provincial officials, 8,900 municipal officials, 63,000 county officials and 278,000
village officials. Almost 60,000 individuals have been put under criminal inves-
tigation. Overall, 1.5 million (or 1.7%) of the Communist Party’s 89 million
members (including many very senior party leaders dubbed ‘tigers’ in the Polit-
buro) were affected, according to official statistics.
Despite years of efforts, the anti-graft initiative is still ongoing. At the 19th
Communist Party Congress in December 2017, the Party created a national
Supervision Commission to consolidate and deepened the anti-corruption efforts
by expanding beyond Party members and covering all officials exercising public
power at all levels. But hitherto, Beijing’s anti-graft campaign has not yet covered
private sector to private sector dealings.
 The Chinese Emperor Shock 25

The Handicap of Market Forces

Sustaining robust anti-corruption institutions is easier said than done due to the
enduring ability of corrupt officials to capture, and meddle in, such institutions.
From this perspective, the conventional wisdom that Beijing should reduce its role
and let market forces to transform the system and to fight corruption may just be
a conventional thinking without wisdom. Corruption is not only a failure of the
state but is also closely linked to the failure of market and institutional frame-
works (witness corruption in the developed, free-market system). If the network of
economic and social power that free-market economies tend to create can be used
to capture and control political power, an effective system of checks and balances
becomes impossible.
The irony of the market’s failure to direct effective forces to fight corruption is
well illustrated by recent research which argues that those on the political right
had condemned excessive bureaucracy but yet their solution of reducing the role
of the state and allowing market forces to take over could backfire by fuelling
cumbersome bureaucratic expansion (Graeber, 2015). The so-called ‘iron law of
liberalism’ states that any government initiative to reduce red tape and promote
market forces would have the ultimate effect of increasing the total number of
regulations, the total amount of paperwork and the total number of bureaucrats
the government employs.
In other words, markets can work efficiently only with the guidance of a
competent benevolent and fair state that designs a system that protects against
abuses and graft from both the public and market sectors. But such a state is a
Utopia. That is certainly not China where the state is unfair by default. Why is
that?
Firstly, the pay of the public sector is too low to commensurate with the power
vested in the government officials so that they face very high temptation to abuse
their power to extract rents/profits from the system. Secondly, despite decades of
economic liberalisation, China still lacks modern mechanisms for resolving civil
disputes arising from unclear property rights, which is another area that needs
clarification and improvement urgently.
In economies with low level of corruption, officials not only receive much
higher pay but also subject to checks and balances that limit what they can do and
require transparency through reporting. They are also subject to legal limitations
on their private sector involvement after they leave office.
This means that China has to develop a modern institutional framework for
defining clearly property rights and for resolving disputes arising from market
transactions. It needs to raise significantly the accountability of the public sector
and prevent vested interests from capturing institutions. All these are tall orders
that involve fighting corruption and creating a system with effective checks and
balances. Market forces alone cannot do it, in my view.
26 China’s Global Disruption

No China Disruption to Luxury Demand

So China’s war against corruption still has a long way to go, and it may well be
the toughest challenge that President Xi faces in realising the ‘Chinese
Dream’.1 It is not practical to expect a truce of Beijing’s anti-corruption war
anytime soon to help revive Chinese demand for luxury goods. Does this mean
that the China shock on global luxury goods demand is here to stay? Not
necessarily because such demand is more a function of economic fundamentals
than politics, and these benign fundamentals have already unfolded, albeit
only gradually.
Even at an average growth rate of 5.0% a year, China’s annual per capita
income is expected to reach the rich-income level of USD12,000 by 2028,
according to my calculation. As the Chinese households become richer, they will
want to eat better, live better and enjoy more luxury. Furthermore, the Life Cycle
Theory (Ando & Modigliani, 1963) argues that China’s ageing population could
set off a consumption boom in the medium term. This is because, the Theory
argues, people saved when they were young as they wanted to smooth out their
life-time income volatility so that they could continue consuming after they have
retired. Most people start working, and saving, at around 20 years old and retire
at around 65. So China demographic dividend delivered a high savings rate and
high economic growth for more than 30 years. Also typically, net worth peaks in
the 55–64 age range and then falls (Fig. 2.1).

Fig. 2.1. Life Cycle Income Hypothesis.

1
See footnote 4 in Chapter 1.
 The Chinese Emperor Shock 27

Demographic changes in China imply that the share of its population aged
between 30 and 50, the typical prime age range for saving, would drop from
currently half of the population to about 40% by 2030, according to the United
Nations projection. This is negative for economic growth in the long term, ceteris
paribus. But what has been missing in the discussion about China’s long-term
growth is that its ageing population is also going to set off a consumption boom
under the Life Cycle Theory framework which can last for decades and, to some
extent, offset the drag on GDP growth by a shrinking labour force.
This argument is underscored by a statistical phenomenon of asymmetric
growth between income and income distribution, which matters a lot for the
change in demand dynamics and patterns. The crux of the argument is that the
number of affluent consumers should grow by more than proportional to income
growth so that the Chinese demand for non-essential goods and services,
including luxury goods and services and financial assets, will rise exponentially in
the coming decades.
Assume China’s per capita income follows a normal distribution, with mean
equals the average annual per capita income. Growth in per capita income (say by
17.0% from USD6,000 in 2012 to USD7,000 in 2014) is represented by the shift of
the income curve to the right (Fig. 2.2). However, growth in the number of people
with per capita income above USD12,000 would rise by more than eight times
from 1.7% to 15.0% under the bell curve.2
The reason for considering USD12,000 in our example is that empirical
evidence shows that the propensity to consume of a typical economy continues
to rise from the USD6,000 (which is the World Bank’s threshold of middle
income) to USD12,000 (a loose threshold of rich income) per capita income
levels, with the consumption pattern moving into higher value–added goods
and services, such as mobile phones, cars, tourism and personal services.
Above the USD12,000 level, consumer demand will move into even higher

2
The example is based on the statistical distribution under the bell curve:
Normal Curve
Standard Deviation

19.1% 19.1%
15.0% 15.0%
9.2% 9.2%
0.1% 0.5% 4.4% 4.4% 0.5% 0.1%
1.7% 1.7%
–3 –2.5 –2 –1.5 –1 –0.5 0 0.5 1 1.5 2 2.5 3
28 China’s Global Disruption

per capita income rises by 17%

the share of the

population with
per capita income
above $12,000
rises by more than
8 times from 1.7%

15.0%

1.7%

$6,000 $7,000 $12,000

source: author

Fig. 2.2. Demand for Luxury Goods Can Grow Exponentially Faster
than Income Growth.

value–added goods and services, including luxury goods and services and assets
(Lo, 2010).
The economic logic is clear. When per capita income is low, say at USD1,000 a
year, people typically buy basic and white goods. When the economy becomes
more affluent, with per capita income growing beyond the rich-income threshold,
overall demand for high value–added and personal goods and services, including
luxury goods and services, will increase exponentially.
As China grows old, its savings will fall as the retirees draw down their net
worth to fund consumption. Longer life expectancy and better diet and lifestyle
will also boost consumption. Japan is an example that an ageing population has
helped boost consumption. Its workforce (15- to 64-year-old cohorts) started
declining in the 1990s. But Japanese consumption had actually risen steadily since
then (Fig. 2.3). The strong negative correlation between the contraction of the
workforce and the rise in consumption speaks volumes about the Life Cycle
Theory implications. The relevance of Japan’s experience to China is that the
Middle Kingdom would be going through the Japanese demographic route in the
coming decades, suggesting a pending boost for private consumption growth in
China.
Furthermore, China’s per capita income will continue to grow (albeit at a slower
rate) alongside an ageing population. Empirical evidence shows that all countries
that have crossed the annual USD6,000 per capita income mark will experience a
surge consumer spending by an average growth of 29% within two years after the
USD6,000 mark is hit, supported by a surge in consumer credit growth by an
average of 52% within two years (Lo, 2010). Currently, average per capita income
of large Chinese cities, such as Beijing, Shanghai and Guangzhou, is significantly
higher than USD6,000 a year. Their enormous spending power is evident.
 The Chinese Emperor Shock 29

Fig. 2.3. Japan’s Consumption Rises as Its Working Population*

Contracts.
Despite an ageing population, industrial upgrading and industrial migration to
the inland provinces in China should also support consumption by creating
income growth (see below). This industrialisation trend is expected to help shift
the whole income distribution curve forward (see Fig. 2.2), augmenting the
growth of affluent consumers and, thus, benefiting the share of luxury goods
demand in total consumption.

The New Emperor

The world is more concerned about President Xi Jinping’s centralisation of
power and its disruptive impact than the effects on global luxury goods
demand. But behind this worry, in my view, little is known that Mr Xi had
changed the government’s policy objective function from maximising growth
rates to improving growth quality, subject to the reform and debt-reduction
constraints. Many players have simply assumed that China’s GDP growth
would soon fall sharply below its potential growth rate (Black & Morrison,
2019; Gorrie, 2013) to justify their concerns about a global growth disruption
by China.
Most analysts also fail to realise what is revolutionary about Mr Xi’s approach
is his forceful change of the political and economic incentives that had governed
the country for over three decades. In my view, he has a much bigger agenda than
what most analysts see as a power-grabbing move. China’s new economic model
is based on strategic usage of markets under state guidance with very limited
privatisation of state-owned assets. Signalling problem is a drawback of Mr Xi’s
30 China’s Global Disruption

new political model, while key-man risk is the ultimate China risk that the world
has to face in the future.
To ensure Mr Xi would have enough time and power to make the necessary
structural changes, the Communist Party revised the constitution to remove the
presidential term limit at the National People’s Congress in March 2018. The
move not only showed that Mr Xi had the power to break with past conventions
and change the constitution but also that he dared to challenge and alter the
unwritten rules that have long guided the Communist Party bureaucracy. For
better or for worse, he is moving China to a more centralised and top-down
system. That is true.
Two crucial questions follow immediately from these changes. Firstly, as
China’s policy moves from maximising growth rates to improving growth quality,
when will its growth rate fall below the estimated potential growth rate of 6%?
The answer will shed lights on assessing the concern about a global growth
disruption by a China growth decline. Secondly, why does President Xi want to
re-centralise power? Is this simply power-grabbing to crown himself the emperor
of modern China? The answer to this question will help understand if Mr Xi is
returning to dictatorship and trying to export his autocratic economic–political
model to the world, as many critics have argued.

Will Growth Fall Below 6% Soon?

Many players expect that China’s growth rate to fall below 6%, or even 5%, soon
because of various reasons, including capacity constraints due to economic dis-
tortions and Beijing’s desire for slower growth in exchange for structural reforms.
Indeed, at the 19th Communist Party Congress in October 2017, President Xi
announced his vision of a ‘new era’ in which China will achieve national
supremacy by pursuing high-quality growth and de-emphasising high-speed
growth. But in my view, in practice the focus on high-quality growth will not
end the pressure to deliver economic growth, nor does it mark a shift to a smaller
role of the government/Party in the economy. There was a Communist Party goal
set by the administration before Mr Xi of doubling China’s per capita real GDP
in 2020 from its 2010 level. This is a hard target for Mr Xi to deliver.
Structurally, China’s GDP growth may remain at around 6% for much longer
than most players have expected. Firstly, China is going through a creative
destruction process that will generate an inherent growth momentum.3 For
example, China’s tertiary sector, a proxy for the new economy, has grown bigger
than the secondary sector, a proxy for the old economy, since 2013 (Fig. 2.4). This
takeover by the tertiary sector of the secondary represents a continuous process of
destruction of the old growth forces making room for the emergence of the new
growth momentum.

3
Creative destruction describes the process of industrial mutation that incessantly
revolutionises the economic structure from within, constantly destroying the old one by
creating a new one.
 The Chinese Emperor Shock 31

Fig. 2.4. China’s Creative Destruction.

Secondly, there is a developing trend of industrial migration towards the

inland provinces (Fig. 2.5), leading to reverse migration of labour from the major
cities back to the towns and villages (Fig. 2.6). As economic development spreads
from large cities to small cities and towns, many older migrant workers (those
over 40) are finding work in these areas that are closer to their rural hometowns.
They prefer to move back to their hometowns after spending years working in
faraway big discriminatory cities, and now they find that many of the city ame-
nities are also available in small towns and villages close to home but at much
lower cost than in the major cities.
Rather than a negative sign for growth, this reverse migration trend reflects
progress on economic rebalancing spreading growth to small cities, towns
and villages, uncovering and employing cheaper and untapped resources,
spreading job creation, income growth and consumption to the poor parts of
the country. The combination of the growth of the new economy and industrial
migration will likely generate growth momentum to offset some of the growth
drag from structural reforms, de-leveraging efforts and even an ageing popu-
lation, and sustain China’s GDP growth at around 6% for much longer than
expected.

Is It Simply Power-grabbing?
The international media mostly framed the discussion on President Xi Jinping’s
scrapping of the presidential term limit in 2018 as a power-grabbing move to
make himself the life-time ruler of China (Buckley, 2018; Phillips, 2018; Pomfret,
2018). The move was a shock even to many mainland Chinese because he
32 China’s Global Disruption

Fig. 2.5. Industrialisation Migrating Inland*.

Fig. 2.6. Population Growth.

 The Chinese Emperor Shock 33

uprooted one of Deng Xiaoping’s most important legacies of institutionalising

leadership succession that was meant to end the political instability stemming
from chronic power struggle in the Mao Zedong era. For the West, the term limit
was a mechanism that constrained a system from moving towards dictatorship.
From Mr Xi’s perspective, the de-centralised power structure that evolved after
Deng Xiaoping had become a set of outdated political conventions that needed to be
overturned so that he could deliver his Chinese Dream because de-centralisation did
not work as intended. For the two decades before him, Beijing delegated more
autonomous power to the regional governments to encourage them to try out
economic reforms. They were given powers to run major regional affairs, including
land allocation, business development, infrastructure construction, local fiscal
policy, law making and enforcement, and allowed to own state companies.
The central government had an explicit policy of encouraging regional
competition to get rich as a reform motto. Hence, GDP growth became the
predominant political objective with appointment and promotion of government
officials being tied to local growth performance. This created an incentive scheme
of ‘chasing growth at all cost’. It also created powerful provincial officials, who
acted like regional warlords, defying the central decrees (Lo, 2015). Indeed,
Chinese bureaucrats have a long history of skillfully resisting orders from above
and abusing power. The ancient Chinese proverb of ‘the mountains are high and
the emperor is far away’ has been manifested in modern day practice of ‘whenever
there are decrees from above there are counter-measures from below’. Mr Xi
realised that he would not be able to make any changes under this old framework.
After his first term formulating growth and reform strategies, Mr Xi and the
Chinese senior leaders were poised to tackle the next phase of the reform chal-
lenge: implementation. But the regional defiance had raised the risk of reform
failure faced by Mr Xi – in terms of failing to pull China out of the middle-income
trap and risking political demise of the Communist Party if the system’s distor-
tions were not resolved.
As power de-centralisation had backfired, the implementation risk became a
mounting concern. Using corruption as a proxy to reform implementation failure,
China remained quite corrupt (Pei, 2009), according to the Transparency Inter-
national Corruption Index (which ranges from 0 or highly corrupt to 100 or very
clean) in the 20 years before Xi Jinping took office (Fig. 2.7). Its corruption index
averaged only 33 under both the Jiang Zemin and Hu Jintao administrations but
rose to 41 in 2018, reflecting the initial success of Mr Xi’s anti-corruption
campaign and structural reforms.
President Xi believes that there is a link between leadership power and reform
implementation. The need for greater leadership power, as reflected in the
elimination of the presidential term limit, has become a key element of his
implementation efforts. From the perspective of western democracies, scrapping
the presidential term limit is a disappointing governance setback by China. But
from Beijing’s perspective, it may be the only option to tackle its daunting
reform risk.
Hence, Mr Xi endeavoured to change the incentive scheme of the system
from single-mindedly maximising growth to multi-targeting different policy
34 China’s Global Disruption

Fig. 2.7. China’s Corruption Index.

goals, including maintaining GDP growth, alleviating poverty, reducing finan-

cial risk and protecting the environment (see below). By replacing the old
incentive, which was easy to pursue, with a complex set of priorities, which
makes optimising all the policy goals simultaneously impossible, Mr Xi has
created a high-pressure political environment to ensure compliance by local
officials. Since it will be so hard for local officials to know the best way to satisfy
Beijing’s multiple goals, they would just have to do what they are told rather
than be creative and defiant.
So there is a big agenda behind Mr Xi’s motive to stay on as a patriarch leader,
in my view. To realise his Chinese Dream, he needs time and power to make
changes. Eliminating the term limit makes it clear to the local officials that there
are no alternative power centres for them to appeal to, and that waiting for Xi to
pass from the scene is also not an option. To survive and thrive under this
framework thus requires pledging loyalty to Xi.

Problem with Multiple Policy Goals

But Mr Xi’s multiple policy goal framework carries a big signalling problem,
which was only tested and revealed by the coronavirus outbreak in December
2019 and early 2020. Shortly after the outbreak, Beijing removed Hubei pro-
vincial party secretary Jiang Chaoliang and Wuhan municipal party secretary Ma
Guoqiang from their offices for mishandling the crisis. The Qiushi magazine, the
most important ideological publication of the Communist Party, published an
internal speech that President Xi gave in early February 2020, quoting him saying
that he had asked local officials to deal with the coronavirus outbreak back in
 The Chinese Emperor Shock 35

January. The Qiushi report implied that the failure to tackle the outbreak early
was largely a result of the Hubei provincial leadership’s failure to follow the
President’s order.
However, it is unclear, in my view, that officials in Hubei intentionally ignored
Mr Xi’s order, given how centralised the system has become since he came to
power. It is more likely that the provincial leadership of Hubei had difficulties in
weighing the importance of the various policy goals and made the wrong policy
move in the end.
The Communist Party has committed to eliminate poverty and build a
moderately prosperous society by the end of 2020, and governments at all levels
were told to prioritise these two tasks. Stabilising growth was made more
important than de-leveraging under the Sino–US trade war, which started in
2018, and the COVID-19 crisis in 2019–20. Thus, in their year-end planning
exercise in 2019, 10 provinces, including Hubei, set higher growth targets for
2020. Hubei officials probably did not want to deviate from these goals. As a
result, they dragged their feet on implementing measures to contain the outbreak,
which required stoppage of economic activity.
However, the balance between the various goals had completely shifted, as the
epidemic spread nationwide and officials were purged for failure to contain the
outbreak. After the sacking of the Hubei provincial officials, many other officials
were under the impression that they must stop the spread of the virus at any cost,
simply in order to save their political careers. So many local government officials
went out their way to issue draconian, often unreasonable, policies such as
stopping factories from resuming production and preventing workers from
returning to work. These measures had ground China’s economic growth to a halt
in early 2020.
The shift in policy balance made President Xi worry about the economy. So he
told the country in late February 2020 to focus on stabilising the economy and
accomplishing the Communist Party’s 2020 policy goals. He also explicitly called
for local governments to expedite the resumption of business activities. Beijing
wanted to contain the outbreak and stabilise the economy at the same time. But
the two policy directives conflicted with each other, with the former requiring
stoppage of economic activity to minimise the risk of cross-infection through
human contacts but the latter calling for increase in economic activities to boost
growth.
The local officials could not reconcile the conflicting priorities and were, thus,
stuck between a rock and a hard place; they had to prioritise the policy goals at
their own risk. What happened to leaders in Hubei signalled to the officials in
other provinces that they could be removed from office or even face prosecution if
they failed to contain the outbreak, but they would not lose their jobs if people
could not return to work quickly. Thus, most local officials leaned towards the
less risky option to save their political careers by delaying resumption of eco-
nomic activities. As a result, GDP growth plunged to –6.8% on a year-on-year
basis in the first-quarter of 2020.
The dilemma of the local officials lays bare the signalling problem of a multiple
policy goal framework that creates confusion and policy dilemmas that could
36 China’s Global Disruption

backfire on policy management. But it is unclear how Mr Xi can resolve this

signalling problem, since he is determined to change the system’s incentive scheme
by pursing a multiple policy goal approach.

Changing the Incentive Scheme…

The essence of his approach to tackle incentive problems is opposite to what the
western countries do by making people, not institutions, pay the price for
excessive risk-taking and misconduct so that policy misstep and financial crisis
can be reduced. This approach is often criticised by the West as overly heavy-
handed. But this may be the price China has to pay for correcting the incentive
problem inherent in its system. Any success will go a long way to strengthen the
structural underpinning of the Chinese system by putting the country on a sus-
tainable growth path with stronger governance.
Official data show that China’s anti-graft watchdog punished almost 37,000
officials in 2018 for corruption, fund embezzlement and violating Party frugality
rules including the misuse of government-owned vehicles, the awarding of
unauthorised bonuses and the exchange of gifts. President Xi also personally led
the 25-member Politburo to investigate the vaccine scandal (first exposed in July
2018) of Changchun Changsheng Bio-technology, which made and sold nearly a
million substandard vaccines for children (Westcott & Wang, 2018). More than
40 cadres, including some ministerial level officials, were put under disciplinary
action in this investigation.
The purge of individuals for misconduct was most prominently seen in Beij-
ing’s approach to de-risk the financial system. It took the exact opposite approach
to what many Western countries did in the aftermath of the 2008 subprime crisis:
people, not the institutions they worked for, were made to pay for the price of
excessive risk-taking and misconduct. The regulatory tightening since 2017 did
not lead to the collapse of any major financial institutions, but many financial-
sector executives were jailed.
Naturally, this has raised the question of regulatory forbearance. It is clear that
Beijing did not want any major financial failures during the de-leveraging
campaign for the fear of triggering a systemic shock and, most importantly, of
losing public confidence in the Communist Party. But this does not mean regu-
latory forbearance. The Chinese way of correcting the incentive distortion is to
threaten the people who run the financial institutions with the failure of their
careers rather than threatening them with the failure of the institution they run.

… the Chinese Way

Instead of closing them down, all of these problem institutions were kept alive and
their creditors were asked to keep the funding lines open. But the key people who
ran these firms were banned from the financial industry or, more often, faced
criminal charges. In this approach, Beijing was sending a clear message to the
Chinese financial executives that they would not be treated the same way as their
 The Chinese Emperor Shock 37

Wall Street counterparts were treated after the 2008–2009 subprime crisis. Few
individuals were then prosecuted and made to pay for malpractice, but the
financial institutions and governments had to bear heavy costs.
Experience shows that incentive distortion, which is undeniably prevalent in
the Chinese system, lay in the heart of the United States subprime crisis (Lo,
2010). Distorted incentives are also intrinsic to the Chinese financial intermedi-
ation process and financial innovation which are evolving rapidly. The West
chose to deal with the financial mess by making the institutions pay for the
mistakes. China lets the financial institutions survive, but makes the people who
led the risky practices pay. The aim is the same – to correct the distorted
incentives.

The Ultimate China Risk

In a nutshell, Mr Xi has created a high-pressure political environment to break
local defiance and emphasise strict compliance of central decrees. His vision for
the future is not to reduce state intervention, but to refine the role of the state in
the economy. The new economic model will continue to be a strategic mix of
markets and state guidance. This is an important analytical point that the West
seems never understands.
Key-man risk – that the person making all policy decisions is increasingly
insulated from criticism or feedback, leading to potential bad decisions and
disastrous mistakes – is the primary China risk that the world is facing. There are
secondary risks also. Mr Xi’s high-pressure political environment may ensure
compliance, but the local knowledge and power of the regional officials may no
longer serve as a checking force on potentially ill-considered central policies. The
pressure on officials to deliver on multi policy targets has a signalling problem
that may worsen the old problem of data falsification and disrupt markets and
even social stability.
These risks have remained manageable so far because Beijing has shown
enough sensitivity to adjust policies when implementation gets off-track. A
relatively closed capital account also helps minimise the risk of potential capital
flight stemming from the loss of local confidence. But history has shown that few
authoritarian regimes could maintain power and systemic stability through
coercion alone. China’s capital account is also opening wider as economic lib-
eralisation progresses. A China disruption to the global system is indeed an
evolution that we have to face, even though many of the views on China’s risks
have either been distorted or misunderstood.
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Chapter 3

The China–US Tech Race

Technology competition lies at the heart of the trade conflict between China and
the United States, with Beijing’s industrial development policy, which used to be
called ‘Made In China 2025’, being a key focus of contention. Since the emer-
gence of trade war between the two countries in 2018, China has tried to play
down the tensions by not using this term again, but its industrial policy and global
ambition embedded in the ‘Chinese Dream’ have not changed at all. The US is
worried that lavish government aid would enable China to overtake American
technological leadership and threaten American national security (Moeller, 2019).
Meanwhile, China views Washington’s push back as hostile containment of its
global ascent (Haenle, Russel, Chen, Rothman, & Yang, 2019).
Fears and misunderstanding about this conflict have aggravated its global
disruptive impact and pose risks to both countries and the world. What the tensions
are really about is a race for ‘geo-technological’ superiority. Understandably, the
US wants to stay ahead, while China is catching up fast and reckons that it must
succeed to secure its economic growth and national unity. The rivalry appears to be
driving a tech decoupling, which is already manifesting into a global disruption in
international trade and supply chains.

The Core of the Tech Conflict

Information and communication technology (ICT) is the core of this Sino-US
tech competition. Before the trade dispute erupted, the major American firms in
the high-end ICT upstream market worked with downstream Chinese companies,
creating a stable supply chain. The United States leads the market for global
server central processing unit, the brains of a computer. American makers of
industry-leading microprocessors, such as Intel and AMD, provided licences to
Chinese firms, including Hygon and Zhaoxin. The records of patent value and
sustainability of US companies far eclipse their Chinese competitors, with Huawei
(of China) the sole possible exception. However, the world has been led to believe
that China had beaten the US and other high-tech economies such as Japan and
South Korea, in technological advancement, hyping the fears about China taking
over the world of technology (Koffman, 2019).

China’s Global Disruption, 39–51

Copyright © 2021 by Emerald Publishing Limited
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40 China’s Global Disruption

Meanwhile, China has been leveraging on its domestic market to upgrade its
ICT sector. Chinese ICT companies are competitive, particularly in wired and
wireless communication, server, cloud computing and artificial intelligence (AI).
Many global companies are also attracted by China’s huge domestic market,
which has contributed significantly to the earnings of many American companies.
But this Sino-US cooperation did not last for long. Since the trade war in 2018,
the United States has attacked the Chinese supply chain of core components and
business networks. It aims at achieving two goals: forcing the Chinese (1) to
retreat from the high-tech industries that the United States deems strategic with
national security threats and (2) pay extra political and economic costs by using
America’s dominant supply position as leverage. More Chinese companies will
likely be put on the Entity List,1 banning them from accessing American sup-
pliers. The disruption to global ICT supply chain will inevitably be manifested in
companies shifting from China to other countries.
In response, China has been deepening its domestic market and opening it up
to promote free trade arrangements, such as the Regional Comprehensive
Economic Partnership (RCEP), the ASEAN-led Asia-Pacific trade accord which
has yet to be concluded at the time of writing. China has even expressed the
intention to join the Comprehensive and Progressive Agreement for Trans-Pacific
Partnership (CPTPP), which is a trade arrangement among 11 economies in the
Asia-Pacific region. But US President Donald Trump withdrew from the original
form of the CPTPP (or the Trans-Pacific Partnership, TPP) when he took office in
2017. Chinese companies, meanwhile, have engaged actively in global mergers
and acquisitions, global talent recruitment and partnerships in third-party mar-
kets to fight back the American containment.

Is ‘Made in China’ That Formidable?

China does have a thriving digital sector with formidable smartphone producers
and giant internet companies leading a strong position in developing AI. It has
dominated the new fifth-generation (5G) mobile telephone technology, notably
with Huawei working out the technical standards for 5G and developing com-
mercial equipment to implement it at lower cost than the US firms.
Concerns about China’s tech success so far are mostly focussed on down-
stream, consumer-oriented technologies. But Beijing’s industrial policy is deep-
ening the concern by boosting the upstream sectors, such as semiconductor and

1
The Entity List is a document provided by the Bureau of Industry and Security (BIS) of the
US Department of Commerce that includes the names of foreign persons, government
organisations and companies that are subject to specific licence requirements for the export
of certain items. These specific licence requirements are in addition to those requirements
outlined in the Export Administration Regulations (EAR). The EAR contains a list of
names of certain foreign persons – including businesses, research institutions, government
and private organisations, individuals, and other types of legal persons – that are subject to
specific licence requirements for the export, re-export and/or transfer (in-country) of
specified items.
 The China–US Tech Race 41

mobile equipment, creating gigantic component suppliers to challenge the existing

industry leaders. China’s huge domestic customer base is creating a favourable
backdrop for Chinese chipmakers to develop competitive technologies which they
can export.
Add in the Chinese government’s intervention in the form of subsidies and
shutting out foreign competition, Beijing is seen as playing unfair games by aiding
Chinese technological advancement at the expense of foreign countries.2 The
violation by some Chinese tech firms of US sanctions on Iran, notably Huawei and
ZTE (another telecom equipment and system maker) has also deepened the
international mistrust in China (Katz, 2019). Thus, the potential success of China’s
long-term industrial policy is creating worries in the United States national security
community about Chinese equipment sitting at the core of the next generation of
mobile networks.
Many of the concerns are valid. But the fear about government intervention
boosting Chinese technology and threatening the US may be exaggerated. This
is because the protected environment has trapped many Chinese firms in a
‘Galapagos syndrome’ (Lo, 2017, pp. 34–35). Consider those successful Chinese
companies, such as Alibaba, Tencent, Baidu and ByteDance. The ‘great firewall’
that Beijing has built has no doubt shielded them from foreign competition.3 But
it has also deprived them of an aptitude for international competition, as the large
domestic market has created a comfortable ‘archipelagos’ for them to thrive.
This is not to say that Chinese firms cannot, and will not, challenge the world.
They have and they will (see below) but not necessarily under government
directives in the industrial development policy. Indeed, such official plans and
targets were not behind the success of China’s most innovative technology
companies. Huawei was shut out of the most lucrative government contracts for
building mobile infrastructure in its early days because it was not a state-owned-
enterprise (SOE) like ZTE and Datang. But that disadvantage did not prevent
Huawei from rising to a national champion. Neither is the success of major
Chinese smartphone companies Xiaomei and Oppo due to state support.
Their success is due to some common market factors, including availability of
a large talent pool, with over half of the eight million-strong annual university
graduates in China having science, technology, engineering and mathematics
(STEM) degrees who could quickly copy new features,4 easy access to software
licences from Android, availability of an experienced labour force for assembling
electronics and a huge domestic market.
These success stories do not support the argument that state-backing would
create competitive companies. If America wants to fear, fear China’s ‘tech animal
spirits’. With or without a government industrial policy, the world will face the

2
Notably, Beijing has driven out Facebook and Google to give local companies, such as
Baidu and ByteDance (both are among global leaders on AI research), a protected
environment to thrive in a vibrant domestic market.
3
To be fair, China is guilty of protectionism on this count.
4
This is where China’s intellectual property thief could arise.
42 China’s Global Disruption

disruptive forces brought about by the rise of the Chinese technology anyway, in
my view.

The Patents Myth

But is Chinese technology rising so fast and so prevalent to take over the world
soon as most observers fear? Ostensibly, China has claimed to have filed the
largest number of domestic patents in the world at an exponential rate, making it
one of the most innovative countries and overtaking South Korea, Japan and the
US as the largest domestic patent owner by 2011 (Fig. 3.1). These data have
prompted many observers, including many ‘smart’ money managers, to claim that
China would become a global tech giant challenging the US leadership soon. But
that could be an illusion.
There are three types of patent: invention, utility model and design. The
invention patent is the most difficult to acquire as it represents a breakthrough in
process, concept or design, and its scrutiny and approval processes are long
(18 months or more). It is protected for 20 years and accounted for just a little
over 20% of the patents granted in China in 2017.
It is the design and utility model categories, both have a 10-year legal protection,
which have boosted China headline patent numbers. But many of these filings are
not very valuable, such as a design patent for a new shape of a cup or a utility-
model patent for a playing-card dispensing machine on a casino table. These pat-
ents are not subject to rigorous examination and are granted within a few months.
Despite the huge number of patent filings, the discard rate of them is also very
high. Data in 2017 showed that more than 90% and 60% of China’s design and

Fig. 3.1. Number of Domestic Patents Filed.

 The China–US Tech Race 43

Fig. 3.2. Worthiness of China’s Design Patents*.

utility-model patents, respectively, were discarded within five years (Figs. 3.2 and
3.3), as licencees balk at their escalating fees amid doubts about their usefulness.
Meanwhile, patent fees were still paid on 86% of the US patents after five years,
according to the US Patent and Trademark Office.
This problem stems from Beijing’s push on companies, inventors and aca-
demics to climb the technology ladder quickly. Subsidies and other incentives are
geared towards making patent filings rather than making useful innovations.
Hence, soaring filing volume does not translate into quality and usage sustain-
ability. Furthermore, many people have cheated the lax approval process for the
design and utility-model patents by copying foreign patents and seeking approval
in China, and many local companies have abused the patent filings to get tax
benefits and subsidies. This phenomenon makes a mockery of China’s industrial
development policy goal to make China a technology global leader.
Chinese regulators are only just starting to notice some of these fraudulent
practices. To be sure, the government’s support for patents has bolstered some
sectors, such as AI and cloud computing. But the cheating and high disposal rates
mean that China is still a long way from becoming a genuine technologically
sophisticated nation.

What About Intellectual Property Theft?

To be fair, the increasingly accepted narrative in the West that China acquires
technology mostly through forced technology transfer from multi-national com-
panies (MNCs) investing in China and through outright theft (Wernau, 2019) has
been exaggerated. Official data show that China’s payments of licensing fees and
royalties for the usage of foreign technology have jumped four-fold in the last
44 China’s Global Disruption

Fig. 3.3. Worthiness of China’s Utility Model Patents*.

Fig. 3.4. Chinese Payments for the Use of Foreign Intellectual

Property.

decade (Fig. 3.4). International Monetary Fund data also show that China ranked
fourth globally in 2016 in the amount of licensing fees it paid to use foreign
technology (Fig. 3.5), even ahead of Japan, Singapore, Korea and other advanced
economies.
 The China–US Tech Race 45

Fig. 3.5. Top 15 IP Licensing-fee Paying Countries (2016).

It is important to note that licensing fees in Ireland and the Netherlands are
paid mostly by foreign holding companies residing there for tax reasons. This
means that domestic Irish and Dutch payments of intellectual property (IP)
licensing fees are far less than what the headline numbers show so that China’s
global ranking in licensing fees paid for technology used within national borders
should be even higher.
All this is not to deny China’s IP and technology-transfer mischievous behav-
iour. Research by the Federal Reserve Bank of Minneapolis estimated that half of
the technology possessed by Chinese companies came from foreign firms (Holmes,
McGrattan, & Prescott, 2015). But there was no proof of the amount of theft and
forced technology transfer, and it was not clear if these joint ventures were suc-
cessful in enabling Chinese firms to compete unfairly with the foreign firms.
There is also evidence showing that China is trying to strengthen its IP pro-
tection laws. An IP court was set up in December 2018, and more and more
foreign companies are starting to file patent-related cases in Chinese courts. China
may finally realise that better protection of IP, reforming the SOEs and stopping
forced technology transfer is increasingly in its self-interest. Given rapid growth of
home-grown IP products, enhancing IP protection and making the SOEs more
competitive are certainly helpful to promote local innovation and facilitate
China’s aim to become a technological powerhouse.

The Big Question

So is China closing the technology gap with the United States soon? Initial evi-
dence seems to say no. A country’s technological capability can be gauged by its
46 China’s Global Disruption

Fig. 3.6. Intellectual Property Rights Earnings.

performance in international markets, as approximated by its intellectual prop-

erty rights (IPR) earnings/payments.5
Foreign firms still produce about two-thirds of China’s high-tech exports, and
China’s largest import item is integrated circuits. Moreover, over half of its
technology imports come from just three countries – the United States (27%),
Japan (17%) and Germany (11%), despite its efforts to boost domestic innovation.6
Granted, China is an important hub for technological production, but the pro-
duction process is largely controlled by foreign firms and dependent on the imports
of high-value components.
Typically, countries with strong technology industries earn big incomes
from licensing their technology to firms in other countries. But China’s
IPR earnings are dwarfed by those of the United States’ and Japan’s (Fig. 3.6),
and it runs a chronic IPR payments deficit while the United States runs a huge
surplus (Fig. 3.7). From this perspective, it does not seem China is rapidly
closing the technological gap with the United States. Of course, China’s
industrial policy may just be aiming at being self-sufficient but not generating
IPR revenues. But the data, together with the Galapagos syndrome, do not
support the view that the United States is at imminent risk of losing a techno-
logical race to China.

5
This is available from the balance of payments data.
6
Data as of 2018.
 The China–US Tech Race 47

Fig. 3.7. IPR Payments Balance.

The Disruption Risks

All this argues that the risk of the Sino-US trade war, which started in 2018, has
mutated from the macro level (in terms of market volatility) of a trade conflict to
the micro level (in the technology sector) of tech race, and this tech competition
will last for a long time. The risk to the world is that United States technological
protectionism, manifested in an aggressive foreign policy, would prompt an
aggressive Chinese resistance that would hurt the world by disrupting the global
technology supply chain and creating a contractionary spiral in global trade and
investment dynamics.
US President Donald Trump’s ‘America First’ approach has increasingly been
seen by China as hostility to its ascent in the global system. On the one hand, this
could create a benign unintended consequence for China by rallying more
domestic support for Chinese President Xi Jinping’s structural rebalancing efforts.
On the other hand, China’s hardliners could hijack this hostility perception and
push for defending national security and reversing the opening-up policy.
Last but not least, those voices in the Trump administration calling for
decoupling and isolating China through a new Cold War (Johnson & Gramer,
2020) are risking hurting the United States more. As of 2017, 144 countries had
more trade with China than with the United States, including 50 countries in
Africa and Asia. If the United States tries to isolate China and if these trading
partners do not follow, the United States will end up isolating itself. This revives
the argument that the United States would have a better chance of changing
China’s behaviour through a multilateral mechanism, such as the CPTPP.
48 China’s Global Disruption

But Mr Trump, unfortunately, rejected this approach on day one when he

came to office.

The China Challenge and Its Limits

Aggravating the global disruption risk stemming from a Sino-US tech war is
China’s resolve to push its internet ventures abroad by trying to replicate the
success of the products and playbooks they used in their huge domestic market.
While China deems such a move commercially driven, America sees it as a direct
challenge to its global leadership.
Indeed, Chinese firms are the only credible challengers to the global hegemony
of US internet companies: essentially only American and Chinese companies
appear on lists of the world’s most valuable publicly traded internet companies
and private startups. Yet the global expansion of Chinese internet firms is often
less visible, in part because it is focussed on operating in poor or non-English-
speaking countries. While the Chinese firms are not likely to challenge Google or
Facebook seriously by gaining much market share in the United States and
Europe, they may become a formidable force in the developing world, especially
in Asia, where the problems they can solve are more like those in China than in
the West.
With per-capita GDP of around USD10,000, China’s income level is closer to
most countries in Asia, Africa, the Middle East and Latin America. Crucially,
China and these developing countries share many things in common, making
them easy to accept each other as partners. For example, fewer people have credit
cards or access to traditional financial institutions in these countries than in
America, making it easier for mobile payments to take off in the developing
world; and China’s Alibaba and Tencent are world leaders in mobile payments.
Retail networks tend to be less mature, and labour cheaper, so online retail can
easily take a higher share of the overall retail sales business; and Chinese firms are
e-commerce experts for retail. Furthermore, fewer people own computers, making
smartphone and their applications the primary way they access the internet.
Alibaba, China’s online commerce champion, is a prime success example of
infiltration in e-commerce businesses overseas. It is the most active major Chinese
internet company abroad partly because one of its earliest businesses was helping
Chinese companies find foreign customers. Its subsidiary, AliExpress, allows
overseas consumers to purchase directly and efficiently from distributors in China.
Alibaba also makes overseas investments in locally-grown companies by taking
and increasing stakes gradually, scaling up after promising results and then
engaging in full acquisition.
Indeed, most of the large Chinese internet companies (with the exception of
Baidu) have been actively making overseas acquisitions and investments funded
by their large profits from their protected domestic market in China. Their
aggressive overseas investment activity, especially in acquiring controlling foreign
stakes has often transformed what started off as acquisitions in the tech business
into Chinese-controlled diversified business companies.
 The China–US Tech Race 49

Online retail is not the only sector in which Chinese firms are directly and
increasingly challenging the US internet companies. Their footprints are seen in
travel, transportation, media and entertainment. Didi Chuxing, a ridesharing
service, ousted Uber in China in March 2018. Before that, it raised USD4 billion
in 2017 to fund its expansion under its own brand in Mexico, Australia and
Brazil. At the time of writing, it has plans to expand in Japan and Taiwan. In the
travel sector, Ctrip acquired the UK-based Skyscanner in 2016 to become an
international travel booking agency. The company leverages on its dominance in
China and the growing numbers of overseas travellers from Mainland China to
establish dominance in the global tourism market.
Chinese firms are also developing new products with which US companies do
not and cannot compete. One such notable product is the so-called content
aggregation apps, which pull together news, photos and videos that are optimised
for a particular user’s interests. ByteDance, the developer of news aggregation
app Jinri Toutiao and other social media apps, and by some accounts the world’s
most valuable startup, is a leader in this area and has vowed to generate half of its
revenues from overseas markets between 2019 and 2024.
Meanwhile, Beijing-based Newsdog has built a popular news aggregation app
in India, which is available in seven different local dialects. The app works
through algorithms that optimise for user engagement, and it does not depend on
any detailed local knowledge for operation. Chinese internet companies are also
competitive in video-focussed social media apps. Tik Tok, which is also owned by
ByteDance, and Kuaishou are short-video apps that have become enormously
popular in China and Japan. In the beginning of 2018, Tik Tok was the most
downloaded app on the iPhone and by the end of 2018 it had amassed more than
10 million active users in Japan.
The key advantage of the Chinese companies is their willingness and eagerness
to adapt to the local demand conditions by localising their products. While
American firms like Amazon and Uber offer the same branded experience and
product features across all markets globally, Chinese firms offer tailor-made what
look like home-grown products to cater for local culture and tastes and prefer-
ences. They also localise their services so intensively that the local users often do
not know that Chinese companies are behind these services. In many cases, the
Chinese firms take control of the local companies that have already developed
local products and brands. Such willingness to localise shows that Chinese
companies are more flexible to blend in with the idiosyncratic market conditions,
giving them an edge to compete with, and challenge, the American firms which
prefer the consistency of operating a standard global platform.
However, it is a different story when it comes to expansion in the developed
markets, such as Europe and the United States, due to government regulations
and branding. For example, after a great deal of fanfare around the expansion of
its cloud services, Alibaba had to halt its expansion in the United States in 2018
(Mclaughlin, 2018) because it was unable to effectively compete with Amazon
Web Services, Google Cloud and Microsoft Azure. This underscores my argu-
ment of Galapagos syndrome of Chinese companies above. To expand in other
markets, Chinese internet companies often have to come up with workarounds.
50 China’s Global Disruption

ByteDance, for instance, offers separate versions of Tik Tok in China and abroad.
The apps function identically but the Chinese version is censored to comply with
Chinese regulations.
The limits to the Chinese internet giants’ overseas expansion are seen in their
earnings, which show that international expansion only had a marginal impact on
the business of China’s three largest publicly traded internet firms – Baidu, Ali-
baba and Tencent. Market leader Alibaba had only 8.4% of its revenues gener-
ated from overseas in 2017, Tencent only had 3.4% and Baidu had zero, according
to company reports. These compared unfavourably with the 53%, 51% and 30%
overseas revenue shares by Google, Facebook and Amazon, respectively, in 2017.

The Disruption and Opportunity Cost

This evidence shows that Chinese internet companies’ expansion in the developed
world had very limited success, while their projects in the developing world were
more successful. It may be too simplistic to argue that China is posing an
imminent challenge to the United States in technology. But it may not be an
overstatement that China could create a global disruption in its technology
competition, as manifested in a trade war, with America by disrupting the global
technological landscape. This is because restrictions on technology transfers and
linkages, justified on the national security basis, will give rise to competing and
non-compatible standards, just like the GSM versus CDMA mobile-phone
network battle in the 1990s. It is possible that the internet, and technological
development as a whole, could be broken up into competing domains, giving rise
to excessive or cut-throat competition, hurting innovation and leading to higher
costs, slower adoption and even inferior products.
This risk of global disruption was echoed by Eric Schmidt, the former exec-
utive chairman of Alphabet, who argued for a ‘bifurcation’ of the global internet
into ‘a Chinese-led internet and a non-Chinese internet led by America’ (Kolodny,
2018). In such a world, American and Chinese internet companies would divide
up the technology space between them with the United States taking the devel-
oped countries and China taking the developing countries.
Only time will tell if such bifurcation of the technology space will play out in
the long-term. What seems to be certain in the medium-term are two things.
Firstly, Chinese internet companies will become established global players with
significant strengths in some services, such as online retail and mobile entertain-
ment, and will shape the internet experiences of many more people in developing
countries. But they will also have to contend with significant American influence
in those markets. Chinese firms will no doubt also try to break into the developed
markets and may probably be able to deliver on occasional success, but they will
not likely displace any of the major US incumbents for a long time to come.
Secondly, the strategic competition between China and the United States is a
global disruption that the world has to live with, and it is hard to predict the
winner of the ICT competition. Chinese ICT companies are competitive in fibre
optics and wireless communications, while the United States is more competitive
 The China–US Tech Race 51

in satellite technology since it has mature and highly cost-effective supply chains.
Despite China’s lead in the 5G development, the competitive landscape for the
development of 6G, slated for 2025 to 2030, is still highly uncertain. It is unlikely
that any one party will gain full advantage in this long-term competition.
The geo-political complications resulting from this Sino-US competition is a
matter of national interest allocation rather than a matter of right or wrong. In the
digital age, however, economies will prosper or wither depending on their capacity
to adapt to the next ICT revolution against the complicated geo-political backdrop.
Inevitably, in a world of an intensifying China-US geo-technological rivalry, no
country can play Mr Nice Guy by pleasing both countries. Every country, espe-
cially small and medium-sized economies, will be forced to take sides.
In the grand scheme of things, under such circumstances, this geo-technological
rivalry will make it more difficult for countries to tackle the substantial global
challenges such as poverty reduction, terrorism, climate change, money laundering
and digital governance. A far better result would be for the two major powers to
find ways to work together to maximise mutual benefits for themselves and their
partners and to minimise the damages of zero-sum competition. But given the lack
of trust in the two sides, the Sino-US ‘tech cold war’ is likely to get colder because
the trade war is only a manifestation of economic and political ideological differ-
ences that have threatened the national security of the two countries.
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Chapter 4

The Sum of All Fears

A collapse in Chinese growth is, arguably, the sum of all fears about a global
disruption because of China’s increasing weights in global Gross Domestic
Product (GDP), trade and markets (Fig. 4.1). The disruption will be multi-fold,
ranging from a negative shock on global demand and supply chains to financial
dislocations wreaking havoc on the global markets and triggering currency wars.
A key China growth debate is whether it would be able to escape the middle
income trap. A negative view on this is raising fears about future economic and
financial chaos caused by potential China policy actions to address its growth
woes.
Indeed, economic fault lines in the Chinese system are easy to find, leading
many observers to believe that China is heading to a growth crash sooner or
later. China’s debt build-up leading to financial implosion is one perennial
worry, despite China’s defiance in the past 20 years against all the dire pre-
dictions that it would happen. Over the past few decades, many argued,
China’s debt kept on rising. According to the International Monetary Fund
(IMF) data, Chinese corporate, government and household debt had increased
by about USD23 trillion between 2009 and 2019, and its debt-to-GDP ratio
had risen by more than 100% points to more than 250% (Badia & Dudine,
2019). That is orders of magnitude above the level at which financial crises
normally occur.
Conventional wisdom also argues that mounting domestic imbalances should
crush China’s system. For any normal country, the build-up of excess capacity
would lead to sharp decline in investment and GDP growth. And that, in turn,
would produce financial distress, leading to an economic crisis if the government
sits on its hands. But all this has not happened in China after decades of expert
warnings. Its GDP growth has indeed slowed, but investment has remained robust
and there has been no stress in its banking system.
So for decades, China has been an exception defying the practical laws of
economics. But many analysts are questioning how much longer such situation
can last. They believe that China’s apparent invulnerability was a result of its
strong financial power, in the forms of high-domestic savings, huge foreign
exchange reserves and a strong government balance sheet, managed by a highly
centralised decision-making political system that allows for swift, decisive and
concerted actions to manage any crises. However, as the domestic imbalances

China’s Global Disruption, 53–68

Copyright © 2021 by Emerald Publishing Limited
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doi:10.1108/978-1-80043-794-420211005
54 China’s Global Disruption

Fig. 4.1. China’s Increasing Global Weights.

continue to build up, this closed political system may also become China’s
Achilles heel that could crumble the giant, according to the pessimists.

The Economics-politics Marriage

There is also a long-established view that political openness is necessary for
sustaining long-term growth (Andersen & Babula, 2008). China has defied this
conventional wisdom for over four decades by having both a tightly controlled
political system and high-economic growth rates (see point A in Fig. 4.2). Since
President Xi Jinping came to power in late 2012, he has made China’s political
system even more centralised (see Chapter 2). Meanwhile, external stress, such as
trade, investment and political frictions with many foreign countries, is building
up for China in addition to its domestic imbalances, such as rising debt and
diminishing returns on investment.
Development in recent years shows that China’s strategy of fostering exports,
promoting industrial ‘national champions’ and expropriating foreign technology
had crossed the threshold of what the West, especially the United States, was
willing to tolerate. President Xi’s Belt and Road Initiative (BRI) is showing signs
of overreach. Not only does the BRI’s lending far exceed participating govern-
ments’ borrowing capacity, but its loan terms have become increasingly onerous
(Hausmann, 2019) and, thus, backfired on China by increasing the credit risk of
such loans.
The worry is that on the back of rising internal and external stresses, China’s
defiance of well-established findings in development economics is not going to last
for too long. Research has shown that long-run economic development tends to
rely on strong state institutions and open political systems (Acemoglu, Johnson, &
 The Sum of All Fears 55

Fig. 4.2. Economics and Politics.

Robinson, 2004; Acemoglu & Robinson 2010) because these are necessary to
foster efficiency, public confidence, dynamism, invention and innovation.
The positive relationship between political openness and economic develop-
ment is shown in Fig. 4.2 – more political openness is associated with more
economic growth. As the notable exception to this long-term relationship, China
has long defied the narrative of this theory – with its closed political system, it
should not be anywhere near as rich as it is.
In the 1990s and 2000s, the West put a wager on China that it would cease to
be an exception and would move towards the global norm by adopting more open
and democratic political institutions (as indicated by the up arrow in Fig. 4.2). In
essence, that bet translated into Western policies to facilitate China’s economic
ascent and decisions by many Western firms, notably Americans, to move
manufacturing capacity to China. The hope was to make China rich so that it
would open up its political system (i.e., move towards a democratic system).
However, President Xi Jinping’s leadership has proven such gamble of the
West wrong by moving China to a more closed political system by centralising
more power. The overall economic development direction has also shifted back
from a private sector-driven growth model to state capitalism (Lardy, 2019). In
other words, the political and economic changes since Mr Xi came to power are
making China even more of an exception. This has convinced many observers
that the rising odds for China’s return to normalcy will have to come in the form
56 China’s Global Disruption

of a sharp drop in economic growth (as shown by the horizontal arrow in Fig.
4.2). Nobody knows precisely when that correction will come. But according to
this logic, the more China defies the rules of economic development, the more
likely its growth will have to drop sharply to justify the lack of political openness.

How Would the Shock Unfold?

Any sharp decline in China’s economic growth would have a seismic effect on the
rest of the world because it would lead to negative demand and supply shocks (see
Chapter 1) and financial dislocations. There is also a potential risk of China
engineering a currency devaluation to find an escape route for its ailing economic
performance by boosting exports to cushion the inevitable fall in domestic
demand. Such an act would risk igniting a global currency war and creating
financial chaos. We shall assess this risk in Chapter 8.
Such a scenario would have a tsunami-like impact on global currencies,
especially Asian ones as a renminbi bloc has developed in the region over the
years that has increased significantly the correlation between the movement of the
renminbi and its Asian counterparts (Lo, 2013). Thus, major Asian countries
would respond by devaluing their currencies in response to any renminbi deval-
uation to maintain their competitiveness. This would inflict sharp deflationary
pressures in Europe and the United States as their currencies would strengthen in
kind, eventually prompting them to devalue their currencies in retaliation and,
thus, triggering a global currency war.
Making matters worse, foreign trade is much more important to the global
economy today than it was some 90 years ago when the first currency war broke
out in 1930. Merchandise exports accounted for 25% of global GDP in 2017,
compared to just 8% in 1929. That means a depreciation in Asian currencies
would have a significantly bigger global impact than the dollar/sterling devalua-
tion in the 1930s when they triggered the currency war. Thus, a China shock could
potentially dwarf the competitive currency devaluations of the early 1930s – one
of the darkest economic periods in modern economic history.

Demographic Pains – What We Know

China’s economic growth path over the years seems to vindicate that it is heading
towards a sharp growth deceleration if not yet a crash. Its annual GDP growth
has fallen from double-digit rates between 1980 and 2012 to around 7% since
President Xi Jinping officially took office in 2013 and to 6% since then. Many
observers are expecting growth to fall below 6% soon (Lee, 2019).
This declining trend also seems to vindicate warnings of the dreaded middle
income trap (Glawe & Wagner, 2016) – the tendency of fast-growing developing
economies to revert to a much weaker growth trajectory, and stagnate when per
capita income approaches the upper bound of the middle income range between
USD6,000 and USD12,000 a year, as defined by the World Bank. China’s per
capita income in 2019 was already USD10,098, as calculated by the IMF.
 The Sum of All Fears 57

When talking about growth obstacles, the first that comes to mind is China’s
demographic decline. China passed its demographic golden age, or saddle point,
in 2010 when its dependency ratio was at the lowest. It has suffered from a
‘demographic tax’ since 2014 when the working-age population (15–64 years old)
started shrinking.1 The United Nations Population Division (UNPD) projects
that China’s total population would contract by 2030.
The driving force of China’s ageing population is its low-fertility rate,2 which
has fallen well below the replacement rate of 2.1.3 At around 1.5, China’s fertility
rate is among the lowest in the world. What’s more, China’s ageing process is
happening much faster than in most other countries, despite its developing
economy status. Hence, the demographic dividend that China enjoyed for four
decades has turned into a demographic tax (Fig. 4.3) when its dependency ratios
started rising again in 2010 (Fig. 4.4).
Such a fast demographic transition from high death and birth rates to low
death and birth rates is a serious concern as the ageing population will pose a
challenge to China’s fiscal and macroeconomic stability through increased

Fig. 4.3. Growth of China’s Labour Force (15–64 years old).

1
This is the ratio of the dependent (0–14 years and 651 years) population to the total
population.
2
The fertility rate of a population is the average number of children that would be born to a
woman over her lifetime if she were to survive from birth through the end of her
reproductive life.
3
The replacement rate is the fertility rate at which a population exactly replaces itself from
one generation to the next without migration. Simply put, this is the fertility rate at which
women give birth to enough babies to sustain the size of the population. This rate is roughly
2.1 children per woman for most countries.
58 China’s Global Disruption

Fig. 4.4. China’s Dependency Ratios.

government spending on pension, healthcare and social benefits programmes for

the elderly. The negative impact on growth of a shrinking labour force is obvious.
The emerging labour shortages imply that much of China’s labour-intensive
manufacturing will either have to restructure or move out of the country to
cheaper production bases; and this is already happening. On public finance, China
faces a daunting pension burden before it can develop sufficient means to look
after the old (Wang, Beland, & Zhang, 2014)!
If the current trends continue, the UNPD projects that China’s population
would start to contract by 2030 (Fig. 4.5). Fewer people means less consumption
and, thus, slower economic growth. And despite the government’s denial, the two-
child policy that came into effect in 2016 with an aim of raising the birth rate did
not work as intended (Fig. 4.6). Official data show that the number of babies born
in 2019 fell to 14.7 million – the lowest figure since 1961 when China experienced
a devastating famine – bringing the birth rate to a record low of 1.05. The rapid
fall of the birth rate from 1990’s 2.1% will become an important drag on future
growth.
The latest UNPD projections also shows that there would be about 118 million
people in the 45–49 age cohort by 2020 and another 127 million in the same age
cohort by 2035.4 Assuming they are all working, the labour pools in this age
cohort will retire in 10 years’ time, suggesting that China would lose 245 million
workers between 2030 and 2045. China’s official estimates echo this projection.

4
As of May 2019.
 The Sum of All Fears 59

Fig. 4.5. China’s Population Will Start Shrinking after 2030.

Fig. 4.6. China’s Birth Rate.

60 China’s Global Disruption

What We Don’t Know

While the world seems to be fixated on worrying about China’s daunting
demographic problem, two issues have escaped the public eye so far – China’s
retirement system and an extra 200 million workers that China can easily find in
the next 20 years.

Early Retirement and the Incentive Problem

The retirement age of the Chinese workers, 60 for men and 50–55 for women, is
much earlier than most countries in the world. The average effective retirement
age is even younger at 54, according to the Organisation for Economic Co-
operation and Development (OECD), because of the government’s practice of
asking unwanted workers to retire earlier than the official age.5
Official data show that there were 83 million people in the 60–64 age cohort in
2018. Theoretically, they should still be in the labour force, but practically they
may have already retired. Early retirement is certainly a negative force that adds
to the economic growth drag because of the demographic tax.
If that is the case, can the government not simply extend the retirement age to
deal with the demographic tax? Actually not because of an incentive incompati-
bility problem that exists between the central and local governments. Since the
pension reform in the 1990s, the responsibility of paying the pensions has been
shifted from the central government to the local governments, which also have the
authority to approve applications for early retirement.
Here lies an incentive problem, which has become more pressing under Beij-
ing’s excess-capacity reduction and structural reform efforts. On one hand, the
central government wants to keep pension payments down as pension funding is
already strained. So it does not want to encourage early retirement. But on the
other hand, the local authorities want to approve more early retirement (thus
increasing pension payments) during the process of industrial retrenchment so as
stabilise the local labour markets and reduce the risk of social unrest.
Corruption aggravates the problem (Gong & Ren, 2012). In theory, early
retirement is only available to workers in the industries affected by industrial
retrenchment, or in certain dangerous and arduous occupations. In practice, there
are always ‘exceptions’ granted by the local officials to allow early retirement
contingent upon bribery payments.
Thus, Beijing is caught between a rock and a hard place. It knows that extending
the official retirement age and discouraging early retirement are medium-term
measures to counter the negative growth effects of the demographic tax. But it

5
Based on the 2010 census data, 10% of the retired population was below official retirement
ages. However, this figure underestimated the true early retiree group because it only
captured people who retired early at the time of survey. There were many who retired in
the previous years but had since passed retirement age at the time of the survey, and hence
were not captured by the survey. The survey data from the Ministry of Human Resources
and Social Security put the early retiree group at 56.8% of the retired population!.
 The Sum of All Fears 61

cannot implement them effectively because of resistance from the local authorities.
Nevertheless, extending the retirement age is still technically the easiest way to
encourage labour participation to counter the impact of deteriorating demographic
dynamics on GDP growth. Expect some regulatory actions on this front later.

Finding Another 200 Million Workers

The good news is that China can still find another 200 million workers quite easily
in the next two decades. Firstly, there are those ‘forgotten’ labour. There were 250
million 0–15 year-olds in 2018. If we assume the urban/rural distribution of this
age cohort follows the national distribution, where 41% of the population is rural,
in the next 16 years, these 100-million-plus (250 3 41%) people will all be in the
labour force who can be urbanised.
Further urbanisation of the adult rural population (15–64 years old), estimated
at 402 million in 2018, will also augment the labour force in the coming years.
Assuming half of this population was aged between 15 and 30 in 2018, there will
be more than 200 million of the rural working-age population that can be
urbanised in the next 20-plus years.
Secondly, raising the retirement age to 65 for both men and women will
increase the labour force by 9.1%, using the 2018 data for estimation. In addition,
if China’s 68.4% labour participation rate were to rise to match Japan’s 79%
(Fig. 4.7), China’s labour force would increase by 26% (or 162 million). Suc-
cessful industrial restructuring may lead to higher labour force participation by
increasing the incentive for people to work longer to take advantage of new
opportunities offered by the private sector.
It is also possible that industrial restructuring may create redundancies and
unemployment. This downside risk will be reduced if the labour market can be
made flexible, through the removal of institutional and other barriers to occupa-
tional and geographical mobility. In this regard, Beijing is working on relaxing the
hu kou (or household registration) restriction to increase rural-urban migration.6 It
is also increasing spending on education and research development to improve
inter-sectoral labour movement and increase industrial value-added.
Thus, apart from policies to raise productivity, there are dynamics for
expanding China’s labour force to counteract its contraction under the current
static framework. The estimated increase in the labour force can more than offset
the expected loss of 200 million plus workers between 2030 and 2045. Any change
in the population policy that could boost the birth and urbanisation rates would
add to these positive dynamics.
This analysis argues that contrary to conventional wisdom, labour per se
would not be a constraint on China’s growth in the medium-term, though cheap

6
Hu kou is a system of household registration used in mainland China, which officially
identifies a person as a resident of an area and includes identifying information such as
name, parents, spouse and date of birth. A hu kou can also refer to a family register in many
contexts since the household register is issued per family, and usually includes the births,
deaths, marriages, divorces and moves of all members in the family.
62 China’s Global Disruption

Fig. 4.7. Labour Force Participation Rate*.

labour is gone for good. Together with the ongoing trend of industrial migration
toward the inland poor provinces (as approximated by the share of the secondary
sector in the local GDP of the poor provinces, Fig. 4.8), which will employ
cheaper and untapped resources and create jobs and income, China’s annual
GDP growth may be able to sustain at an average rate of 6.0% for a much longer
period than most players have expected.7

Relaxing the Growth Constraints

Economic growth is a function of the two factors of production – labour/
population and capital – and a residual factor – productivity. When a country
grows toward its production possibility frontier (PPF),8 which defines the size of
the economy, by using up efficiently all the labour and capital inputs, diminishing
marginal returns set in (Fig. 4.9). And if there is no growth in productivity, overall
economic growth will stagnant and eventually decline.

7
The secondary sector consists of industrial, manufacturing and construction activities.
Growth in the share of this sector in an economy is a proxy to increasing industrialisation.
The other two sectors in an economy are the primary sector which consists of agriculture
(both subsistence and commercial), mining, forestry, grazing, hunting, fishing and
quarrying, and the tertiary sector which consists of services.
8
A production possibility frontier is a curve that shows all the possible combinations of
output for two products that can be produced using all factors of production, where the
given resources are fully and efficiently utilised.
 The Sum of All Fears 63

Fig. 4.8. Industrialisation Migrating Inland*.

China could avoid falling into the middle income trap if it could break the
economic constraints of population, capital and productivity on growth.
Relaxing these constraints can increase the size of the economy, i.e., push out
the PPF in Fig. 4.9. I have argued above that the ageing population problem
might not bite for another 20 years to hurt growth, what about capital and
productivity?
Evidence shows that capital also does not seem to be a growth constraint for
China in the medium-term, despite the existence of excess capacity. China only
started building up capital in the late 1980s while most of the other major
economies started in the 1950s (Fig. 4.10). Even after 40 years of catching up, its
capital stock per worker is still significantly less than the major economies and its
Asian peers (Fig. 4.11).
There is a conundrum unknown to most observers that China suffers from
under-investment as well as excess capacity. The coexistence of these two con-
flicting forces lays bare a serious structural flaw of capital misallocation. It argues
that China’s economic inefficiency was not because of too much investment but
because of the state sector’s soft budget constraint that misallocated capital to a
few giant inefficient state industries. These industries have created excess capacity
that has dominated the economy and stymied private-sector ‘animal spirits’,9
resulting in under-capitalisation in other (the efficient) parts of the system.

9
Animal spirits is the term coined by John Maynard Keynes in his 1936 book ‘The General
Theory of Employment, Interest and Money’ to describe the instincts, proclivities and
emotions that influence and guide human behaviour, including investment and spending
decisions, and which can be measured in terms of public confidence.
64 China’s Global Disruption

Fig. 4.9. Production Possibility Frontier.

Fig. 4.10. China’s Capital Stock Accumulation is Still in a Catch-up

Process.
 The Sum of All Fears 65

Fig. 4.11. China is Still Under-invested (2017).

Meanwhile, China’s total factor productivity (TFP) growth seems to be

recovering from the decline in recent years under President Xi’s ‘new normal’
policy, which aims at keeping GDP growth at a moderate 6.0%–7.0% range by
implementing structural reforms and paring down debt.10 Previous debt-fuelled
excess investment led to sluggish or decline in productivity growth. The new
normal policy has shown some initial success with rising marginal efficiency of
debt-financing (Fig. 4.12), as approximated by the ratio of change in GDP to
change in loans. An increase in the ratio means each unit of new credit is creating
more than a unit of increase in GDP, implying an improvement in the efficiency
of lending and in GDP growth quality.
The aim of the ‘Chinese Dream’ is to move the economy into high value-added
high-tech production through manufacturing and industrial upgrading. Already,
the growth of high-tech industries has out-performed overall economic growth
significantly. China’s aim to become a technology powerhouse by 2050 should
help raise productivity growth.

Escaping the Middle Income Trap

If labour will not be a growth constraint for another 20 years, capital will
continue to accumulate and productivity growth will revive under the new

10
Total-factor productivity is the amount of output produced by the combined inputs of
labour and capital. It is estimated here by dividing output (GDP) by the weighted average
of labour (including migrant workers in China) and capital inputs, with the standard
weighting of 0.7 for labour and 0.3 for capital.
66 China’s Global Disruption

Fig. 4.12. Marginal Efficiency of Debt-financing Improves.

technology-focussed development policy. China’s PPF can be pushed out, i.e., the
size of China’s economy can be expanded. Even if China’s per capita GDP grows
by an average of only 5.0% a year for the next decade, its per capita income will
breach the World Bank’s USD12,000 rich-income threshold by 2028 and make it
a high-income country.
Empirical evidence shows that the propensity to consume of a typical economy
continues to rise from the USD6,000 to USD12,000 per capita income levels, with
the consumption pattern moving into higher value-added goods and services, such
as mobile phones, cars, tourism and personal services (Jappelli & Pistaferri, 2010).
Above the USD12,000 level, consumer demand will move into even higher value-
added goods and services, including education, healthcare, financial services and
assets.
Hence, upgrading of consumption and industries will be two of the key
emerging growth themes for China’s structural change story in the post-middle
income paradigm. The next question is which industries/sectors will benefit from
this new China economy? Increase in and upgrading of Chinese demand will not
only benefit the domestic market but also the world markets in these industries/
sectors, turning a potential negative China disruption to a positive disruption, or
contribution, to the world.
Chinese consumers have been upgrading their demand for goods and services
alongside income growth since the turn of the millennium. For example, total
consumer spending on healthcare rose by 5% points to 11% between 2000 and
2014, but consumer spending on crops dropped by 9% points to only 5% in the
same period. As China moves into a rich country status, its consumption pattern
is expected to converge to that of a developed country.
 The Sum of All Fears 67

Fig. 4.13. Top 10 Industries Expected to Benefit from Consumption

Upgrading.

By comparing China’s consumption share in various goods and services with

those of the developed countries (including the United States, the United
Kingdom, France, Germany, Japan and South Korea in our study here), we
should get some clues about those industries that will play catch-up. Basically, the
larger the consumption share gap, the bigger the room for that industry to benefit
from China’s consumption upgrading (Fig. 4.13).
Meanwhile, those industries that have bigger room to climb the value chain
through technological innovation will benefit more from China’s industrial
upgrading. Thus, comparing the productivity of Chinese industries with that of
the developed countries should give some clues for that assessment. The bigger the
productivity difference, the bigger the room for that Chinese industry to gain from
industrial upgrading (Fig. 4.14).

The Real China Growth Story

Our analysis argues that China’s changing growth dynamics do not always have
to create global disruption. They can also create benign forces that contribute to
the world’s economic well-being. Consumption-led growth and industrial
upgrading will be two of the key emerging themes for China’s structural change
story in the next 30 years when President Xi Jinping’s Chinese Dream is supposed
to yield some tangible results by 2050.
Crucially, the Chinese economy is far from being mature, unlike most players
and observers believe. Structural reforms are crucial for pushing China’s long-term
growth potential beyond the current PPF. Certainly, the day of double-digit
68 China’s Global Disruption

Fig. 4.14. Top 10 Industries Expected to Benefit from Industrial

Upgrading.

Chinese growth rates is over. This is inevitable. But there are good reasons to argue
that China’s real growth story of shifting output from quantity to quality has just
begun. If China’s growth is not going to fall off the cliff, as many have feared, its
disruption to the global system should also not be exaggerated.
Chapter 5

China’s Role in the Global Market Cycle

Despite China’s closed capital account, which limits its direct financial impact on
the global markets, its indirect impact on the global market cycles via changes in
market sentiment and expectations has been increasingly crucial. Fears about a
Chinese ‘financial tsunami’ sending seismic waves to the world range from its
disruptive effects on the global trade cycle and commodity market to the global
cost of capital and currency market. We shall examine the currency market chaos
in Chapter 8.
As an emerging market, China has its share of problems for sure. But many of
the views on China’s global market role are misinformed and distorted. In many
cases, the perceived damages by China are changes in relative demand or supply
by the Chinese rather than an outright shock on the markets. What this means is
that when China’s demand for one commodity falls off sharply, for example,
while its demand for another rises significantly, net global demand may not
necessarily change so that there may not be any market shocks. So it is important
to understand not only the absolute impact of China on the world but also its
relative impact on different sectors and parts of the world to gain a holistic, and
impartial, assessment. We also need to have perspectives on the factors that make
China change to affect the world.

It Cuts Both Ways

The International Monetary Fund predicts that if the current growth trends
continue, China would overtake the United States as the world’s largest economy
(in nominal US dollar terms) by 2030 (IMF, 2018). In recent years, China’s
growth has contributed about a third of global growth, and its contribution is
expected to rise further, according to the United Nations. The increasing weight
of China in the global economy (Fig. 5.1) inevitably makes it one of the world’s
major disruptive forces at a time when the G3 (Europe, Japan and the United
States) countries’ global influence is being questioned.
While many global players fret about the potential China disruption, let us not
forget China’s global impact cuts both ways. It could also be a benign force at
times. Consider the world’s economic situation in early 2019 when the United
States Federal Reserve and the European Central Bank reversed their monetary

China’s Global Disruption, 69–88

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211006
70 China’s Global Disruption

Fig. 5.1. Share of China’s GDP* in the Global Economy.

policy course from tightening to easing and the Bank of Japan intensified its
easing policy, world liquidity improved sharply relative to 2018. All this, pre-
sumably, should be good news for the global asset markets, including Asia which
is much closer to China’s influence than the West. But cheap money is only one
positive factor for boosting the markets, they also need sustained economic
growth to perform well. This is where things get tricky.
Global growth momentum weakened sharply between 2017 and 2018. All
those monetary easing in early 2019 by the G3 central banks was not for nothing
and might not be all good news. Emerging markets, especially Asia’s open
economies, would need external demand in addition to cheap funding to sustain
economic growth. Here is where China’s role in affecting regional growth
becomes evident.
Back in the years after the global financial crisis (GFC) of 2007–08, Chinese
demand growth picked up much of the slack left behind by the weakened demand
of the West and kept the world growth going (J. Wu, 2019).1 Fast forward 10
years to 2017 and 2018, weakening developed market growth prompted the

1
The financial crisis of 2007–08, also known as the GFC, is the most severe worldwide
serious financial crisis since the Great Depression of the 1930s. The crisis began in 2007
with a collapse in the subprime mortgage market in the United States and developed into a
full-blown international banking crisis that led to the collapse of US investment bank
Lehman Brothers on 15 September 2008. Excessive risk-taking by banks such as Lehman
Brothers helped magnify the financial impact globally. Massive bail-outs of financial
institutions and other palliative monetary and fiscal policies were employed to prevent a
potential collapse of the world financial system. The crisis was nonetheless followed by a
global economic downturn, later called the Great Recession by the economics profession.
 China’s Role in the Global Market Cycle 71

authorities to ease policies in 2019. So that policy easing was in fact a symptom of
weakening world growth, which could only be sustained by a corresponding rise
in Chinese demand just like in the post-GFC years. And China just provided that
growth cushion between 2017 and most of 2018.
The importance of China’s demand was best seen in its impact on Asia’s
growth. Before mid-2018 when Asian exports to Europe and the United States
were falling amid rising US interest rate and Sino–US trade tension, China
remained a growing export market for Asia (Fig. 5.2). Arguably, that helped
sustain Asia GDP growth (Fig. 5.3) amidst a world of rising geo-political tensions
and liquidity squeeze. But when China’s growth started to decelerate in the
second-half of 2018, Asia’s exports to China also plunged, and regional growth
followed the decline (see Figs 5.2 and 5.3 together).

Things Have Changed

However, one may argue that since most of Asia’s exports to China were pro-
cessed and then re-exported to Europe and the United States, this Asian–
export–China–growth relationship would not necessarily argue for China’s
importance for the regional growth. Well, it does.
Data show that the bulk of the drop in Asia’s exports to China since mid-2018
was not due to a drop in China’s exports to Europe and the United States, but to
China’s growth deceleration. There has been a change in the structural relation-
ship since the turn of the millennium between Asian exports to China and Chinese
export to the developed markets, as represented by the United States here.
This structural change can be assessed by calculating the correlation between a
country’s exports to China and China’s exports to the United States. The data
show that the correlation has fallen over time (Fig. 5.4). This implies that the
share of China’s imports used for re-exporting to the United States had dropped.
Indeed, this is what has happened as the share of China’s processing imports (as
inputs for making exports to the developed markets) in its total imports has
declined since late 1990s (Fig. 5.5).
What all this means is that China has been retaining an increasing amount of
imports for local usage so that its demand has an increasingly direct impact on the
export growth of other countries. Therefore, slower Chinese growth means slower
regional exports, and Chinese growth did slow sharply in the second-half of 2018.
Indeed, empirical evidence has shown an increase in China’s growth impact on
the growth of its trading partners over time (Fig. 5.6). Even for a large country
like Japan, which exports a lot to China, evidence shows that a one percentage
point rise in China’s GDP growth boosted Japan’s growth by an average of 0.4
percentage points each year in the 2011–2018 period, compared to only 0.25
percentage points in the 2000–2008 period. The exceptions are India, Indonesia
and the Philippines, whose economies have seen a falling exposure to China with
growth being more domestic driven.
So when the developed market growth cycle entered a downturn in 2017,
China’s growth became all the more important for cushioning that drag on the
72 China’s Global Disruption

60.0%
China's growth
50.0%
slowdown
40.0% started in mid-
2018
30.0%
YoY growth

20.0%

10.0%

0.0%

-10.0%

-20.0%

-30.0% US EU China
-40.0%

-50.0% * data series in 3-mth moving avg sources: CEIC, author

12.0

10.0

8.0
%YoY

6.0

4.0

2.0

0.0

-2.0

-4.0

-6.0 * Average of Singapore, Malaysia, Indonesia, Japan, HK,

Philippines, S.Korea, Taiwan, Thailand sources: CEIC, author

Fig. 5.3. Asiap Real GDP Growth.

global markets. The point is clear that Chinese growth helped pick up the growth
slack left behind by the West in 2017 and 2018 just like it did post-GFC. Regional
growth and asset markets benefited from China’s growth (until late 2018 when
China’s own economic growth started to slow down). Otherwise, monetary easing
in the West, prompted by weakening demand there, would not have provided the
lift for the regional economies and financial markets in 2017 and 2018, in my
view.
 China’s Role in the Global Market Cycle 73

Fig. 5.4. Correlation between Exports to China and Chinese Exports

to the United States.

Fig. 5.5. China’s Processing Imports*.

The Capital Flight Scare

It is common that partial analysis dominates the world’s (especially the West’s)
view on China. Fears about China causing a financial tsunami wreaking havoc on
the global markets are not new (Dawkins, 2017; O’Brien, 2016). Back in 2015 and
2016, many so-called ‘China experts’ were warning about capital flight from
China caused by mounting economic ills. Some of them even predicted a currency
74 China’s Global Disruption

Fig. 5.6. Change in GDP Growth Rate Due to a One-percentage

Point Change in China’s Growth Rate.

crisis as Beijing would be forced by the capital flight pressure to massively devalue
the renminbi (Cukierman, 2015).
Hindsight has proven that these views were fundamentally flawed. The prob-
lem that caused apprehension and confusion about China’s capital outflows was
non-foreign direct investment (non-FDI) outflows, which were volatile but had
nevertheless exhibited a rising trend. They included portfolio investment (or hot
money) flows, trade credit flows, foreign lending and borrowing by Chinese
companies, interest rate arbitrage flows and illegal capital outflows.
China does face a risk of capital flight over the years, due to a combination of
socio-political and economic factors, but it is not an imminent risk that could crush
the Chinese system any time soon (Lo, 2013, pp. 27–31). Furthermore, non-FDI
inflows are not representative of the driving forces behind China’s capital outflows
over time. The problem is that estimating non-FDI outflows is tricky because there
are no official data records and no one has a clear picture about these flows.
Some observers argued that China’s foreign exchange reserves dropped sharply
between late 2015 and early 2016, despite a large trade surplus and net FDI
inflows, was an evidence for capital flight (Lockett, Hancock, & Clover, 2016).
This is not entirely correct because the valuation effect on China’s foreign reserves
(due to exchange rate changes) and other factors had distorted the picture.
China reports its foreign reserve holdings at face value in US dollar terms. So
even if it has made no changes to its portfolio holdings, but if the foreign exchange
value of the non-US dollar portion of the reserves, which is estimated at about 40%
of the total (Troutman, 2013), has fallen the headline foreign reserve value will show
a decline. This was indeed what happened between 2015 and early 2016, when the
world’s major currencies dropped sharply (by more than 20%) against the US dollar.
Research (Troutman, 2013) shows that China’s foreign reserves consist of
foreign assets denominated in seven major currencies, including the US dollar, the
 China’s Role in the Global Market Cycle 75

euro, the yen and pound sterling, with the euro accounting for two-thirds of the
non-US dollar portion. It is obvious that the sharp fall in these major currencies
against the US dollar had the effect of reducing significantly the reported dollar
value of China’s foreign reserves, all other factors remaining constant.
My estimation shows that this valuation effect reduced the value of China’s
foreign reserves by a total of USD399 billion in the second-half of 2015 (or 57% of
the USD700 billion loss in reserves estimated by the financial market for the
whole year), giving a false signal of capital flight. While the estimates of the loss in
reserves may be subject to debate, because no outsiders know the true composi-
tion of China’s foreign reserve portfolio, the rationale of the valuation effect
behind the drop in its foreign reserve value is robust.
There were other factors that also distorted China’s headline foreign reserves
value. They included the transfer of USD168 billion of funds by the central
government from its foreign reserves as a capital injection into the policy banks
between the second-quarter of 2014 and the second-quarter of 2015, a notable
decline in the fixed-income asset value in the foreign reserve portfolio due to
market conditions and the repayment of foreign debt by Chinese companies.2
According to the Bank for International Settlements, this repayment of foreign
debt amounted to USD235 billion in the third-quarter of 2015. My estimation put
the total repayment at USD330 billion in the second-half of the year. The point to
note is that this debt repayment is normal capital outflow but not capital flight.
Crucially, repayment of foreign debt reduces China’s debt vulnerability. It also
leaves the country’s net international financial position completely unchanged.
This is because the foreign currency assets of the central bank (which supplies
foreign exchange to the Chinese companies in exchange for domestic currency)
fall, but the foreign currency liabilities of the Chinese corporations are also
reduced by the same amount. At the time, most analysts and the media focussed
exclusively on the fall in the official foreign exchange reserves but had totally
ignored the identical decline in the corporate sector’s foreign liability. This lays
bare the problem of partial analysis on China.
Complicating the misunderstanding problem is the lack of accurate data for
China’s non-FDI outflows, as part of them are distorted by rent-seeking activity
and capital flight. One way to estimate China’s non-FDI flows is to subtract the
current account balance and net FDI inflows from the change in foreign reserves.
These estimated non-FDI flows have fluctuated widely over the years but have
nevertheless shown a rising trend since 2009. This is echoed by the errors and
omissions account in China’s balance of payments data (Fig. 5.7), which has been
used by some analysts as a proxy for illegal capital outflows.

2
During 2013 and the first-half of 2014, when expectation of renminbi appreciation ran
high and the onshore–offshore interest rate gap was large (with offshore rates much lower
than onshore rates), many domestic Chinese entities borrowed in foreign currency (mainly
US dollar) and swapped the proceeds into renminbi (thus increasing capital inflows). The
total amount of these foreign corporate debts was estimated at USD1 trillion in 2015. But
since renminbi expectation turned negative in mid-2014, these entities unwound their
foreign liabilities by selling renminbi for US dollar and thus increasing capital outflows.
76 China’s Global Disruption

Fig. 5.7. China’s Errors and Omissions and Estimated

/Non-FDI Flows.

Another big part of the outflows, about 30% of net financial outflows in late
2015, came from large foreign currency loans to foreign entities. These loans were
extended by the China Development Bank, the country’s main policy bank
assigned with a significant foreign lending mandate, and other state-owned banks.
Despite being part of capital outflows, these transactions should also have no
impact on China’s net international financial position because the fall in the
central bank’s foreign exchange asset should be matched by the increase in foreign
currency assets of the domestic banks by a similar amount.
All this is not to deny the trend of capital outflows in China, which many
observers have confused with capital flight. But after allowing for the valuation
effect and the special factors that had reduced the value of China’s foreign
exchange portfolio, actual capital outflows in the years of 2015 and 2016 were
likely to be much smaller than the headline estimates suggested. In any event,
non-FDI outflows will continue to rise as the Chinese investors/savers and banks
diversify their investment and lending portfolio overseas in the coming decades.

The Fuss About China’s Current Account

There is also a concern about China’s current account turning from a surplus to a
permanent deficit, creating a global disruption to the financial markets by pushing
up the global cost of capital. The prime example for this misinformed view is the
market consensus in 2018 that China’s current account surplus would turn into a
secular deficit from 2019 onwards (Setser, 2019) with negative impact on the
global borrowing costs. With hindsight, of course, this view was misplaced as
 China’s Role in the Global Market Cycle 77

China’s current account rose in 2019 and 2020 and there are no signs that it would
fall into a permanent deficit any time soon.
This example underscores the problem that many people look at China and
jump into conclusions by using partial information and analysis without taking
into account the perspectives and other relevant information. Ignorance about the
Chinese economic and political systems has added to the distorted views and
misunderstanding. In this particular case of the 2018 market consensus, the
problem was a confusion between the cyclical and structural forces that affected
China’s current account. It is true that structural forces will erode China’s current
account over time, but it does not mean that they would push the current account
into a permanent deficit soon.
As I argue below, it is more likely that China’s current account would swing
between small surpluses and deficits in the future. Nevertheless, it is undeniable
that the swing of China’s current account from a persistent surplus to even small
periodic deficits in the future will have far-reaching effects on China’s economic
policy, the renminbi exchange rate and global financing costs. But the global
impact will not be as significant and dramatic as many observers have expected,
ceteris paribus.
China’s current account surplus deteriorated steadily from a peak of 10.3% of
GDP in 2007 to only 0.4% in 2018. When it suffered a deficit in the first-quarter of
2018, the first in 17 years, the market started worrying about the emergence of a
structural deficit. Not so soon, in my view for solid reasons. The drag on China’s
current account in 2018 came from surging imports on the back of weak exports.
Exports were hurt by the Sino–US trade war but imports were not boosted by
strong growth as the market had erroneously assumed because China’s growth
was declining throughout 2018 with the pace of deceleration intensifying in the
second-half of the year. Rather they were boosted by a sharp rise in the prices of
two major imports – oil and semiconductor (Fig. 5.8).3 The market estimated that
these price hikes had pushed China’s oil and semiconductor import bills higher by
USD77 billion and USD53 billion, respectively, in 2018 from 2017, and eroded
almost half of China’s current account surplus in 2018.
However, these price hikes did not repeat in 2019 so that their erosion on
China’s current account balance was also not repeated. Crucially, China plays a
role in influencing the cyclical price adjustment. Because of its market size, China
is not simply a commodity price taker – i.e., commodity prices are also sensitive to
changes in China’s growth and policy changes so that the value of its major
imports vary with its economic cycle. This means that slower Chinese growth
would tend to drive commodity prices lower, cutting China’s import bill and,
thus, improving its trade balance, and vice versa.
This was exactly what happened in 2018 when China was in a cyclical
growth slowdown. Its weak demand for commodities had kept prices weak in

3
Oil traded between USD75 and USD80/bbl in 2018, up from the USD55 to 65 range in
2017, while semiconductor prices surged, with the DRAMeXchange index jumping to over
27,000 for most of 2018 from 15,000 at the beginning of 2017.
78 China’s Global Disruption

Fig. 5.8. Semiconductor and Oil Prices* Surge between

2017 and 2018.

2019 and 2020. Furthermore, its easing policies were much less commodity-
intensive because their focusses were on boosting private-sector spending rather
than public investment and housing construction. China’s attempt to build up
massive semiconductor production capacity had also exerted, and will continue to
exert, downward pressure on chips price. Hence, China paid much less for its
major imports in 2019 so that its current account surplus actually expanded as
opposed to the market consensus view of a deficit.

Structural Erosion but not yet Structural Deficit

Beyond the short term, China’s current account is indeed going through a
structural downward shift so that it will likely run a much smaller overall current
account surplus in the future than it did in the past 25 years. There will also be
periods of deficits, but it is too early to conclude that it is headed for a structural,
or permanent, deficit.
Firstly, China’s export capacity constraint is current account negative. Being the
largest goods exporter in the world and accounting for 13% total global exports in
2019 and 2020, China’s export sector is so big that it cannot possibly keep gaining
market share. Indeed, the size of its export sector peaked 10 years ago (Fig. 5.9).
Secondly, the biggest current account erosion force comes from the changing
structure in China’s imports. As it gets richer and rebalances towards consumption-
led growth, but with an underdeveloped domestic service sector, Chinese demand
 China’s Role in the Global Market Cycle 79

Fig. 5.9. China’s Foreign Trade as a Share of GDP.

for service imports will continue to rise. Already, China’s service trade deficit has
been growing and eroding the current account surplus steadily (Fig. 5.10).
Thirdly, China’s goods trade surplus, the largest contributing factor to the
current account surplus, has long been sustained by processing trade which
imports components to make finished products for exports. In this kind of trade,
exports determine imports so that a slowdown in export demand will automati-
cally lead to a slowdown in import demand. This simultaneous movement in
exports and imports in the same direction has helped keep China’s goods trade in
surplus through the economic cycles.
However, the importance of China’s processing trade has declined over time as
more imports are retained for local use and domestic manufacturers are using
more local components. Meanwhile, China’s imports of primary products
(including commodities) have increased steadily (Fig. 5.11). Unlike the processing
imports for re-exports, primary imports do not automatically fall as exports
weaken. Since 2011, primary imports have been larger than processing imports,
thus weakening the processing trade’s support of the current account surplus.
Finally, continued industrialisation and policy using infrastructure spending to
boost economic growth will boost imports for commodities and capital goods.
That is negative for the current account, ceteris paribus.
Despite all these negative forces, a persistent current account deficit is still not
likely because conflicting forces are at play. Rather China will likely see a mix of
small surpluses and small deficits in the future, depending on the economic cycle
and the government’s economic policies.
80 China’s Global Disruption

Fig. 5.10. A Growing Service Trade Deficit Eroding the Current

Account Balance*.

Fig. 5.11. The Changing Structure of China’s Imports.

 China’s Role in the Global Market Cycle 81

Fig. 5.12. China’s Exports to BRI Countries* and the United States.

Continued structural rebalancing from industry-based investment-led growth

to service-based consumption-led growth makes the economy less commodity-
intensive. Meanwhile, China is diversifying its exports to new markets, notably
to countries along the Belt and Road Initiative (BRI) routes (Fig. 5.12) to reduce
its reliance on the US market. It is also boosting new industries, notably in
semiconductors, robotic, aircraft, bio-tech, Artificial Intelligence, electric
vehicles, aerospace and other technologies, as highlighted in Beijing’s new
industrial policy. All these moves will reduce long-term import demand for
capital goods and commodities and increase exports. They are, thus, current
account positive.4 The point is that there is no a priori reason to believe that
China’s current account will fall into a structural deficit any time soon.

Implications
With China’s current account more-or-less balanced since 2018, the renminbi is,
arguably, fairly valued from this perspective. As long as the capital account is not
fully opened, any exchange rate pressure would be quite manageable.
Previously, in the years of large current account surpluses and when portfolio
flows were not significant, short-term capital outflows by Chinese companies’
decisions on managing their foreign exchange exposure were not important in
affecting the foreign exchange market and China’s monetary policy. But now with
a small surplus and rising importance in portfolio flows, those decisions will have
a bigger impact on the market and foreign exchange policy.

4
Of course, if these initiatives fail, China will remain dependent on high-tech and
commodity imports and face persistent current account erosion.
82 China’s Global Disruption

Experience in recent years has shown that the People’s Bank of China (PBoC),
China’s central bank, had a policy preference to reduce control on the exchange
rate as China moves towards the ‘Impossible Trinity’ paradigm.5 This means that
there will be more two-way volatility in the renminbi exchange rate in the future
as the PBoC allows it to adjust to the current account swings.
In the long term, if China’s current account moves into a permanent deficit, the
implications on China’s policy management and global markets could be signif-
icant because the deficit will need to be financed by capital inflows. China will
have to decide how much currency depreciation it will tolerate. This will, in turn,
dictate its decision on setting the level of domestic interest rate to retain/attract
capital flows and, hence, constrain its monetary policy on managing domestic
demand growth.
For the markets, when China turns from a net capital exporter to a net capital
importer (as manifested in the current account deficit), its competition for funds
would push up the global cost of capital. However, the resultant global disruption
will depend on the size of China’s deficit. Take the market’s assumption for
China’s current account deficit of 1.0% of GDP (at the time of writing), and
assume China will grow by 6.0% a year. China would add about USD153 billion
to the world’s demand for capital. This is a big sum but not insurmountable.
Crucially, the current account deficit may not necessarily be funded completely by
foreign savings (i.e., borrowing). China could use its large (more than USD3
trillion) foreign exchange reserves to fund the deficit and, thus, easily lessen any
potential upward pressure on global funding costs.
The narrative of China wreaking havoc on the global markets because of its
current account deficit has grossly been exaggerated. Evidence and theory suggest
that China’s current account might not fall into a structural deficit so soon so that
its impact on the global cost of capital would likely be small. After all, it is
structurally a high-saving country, with a national savings rate of 46%, how can a
saving-surplus country suffer a permanent current account deficit? This is just
simple economics.

The Fear of the Commodity Market

There is another big concern about slowing Chinese growth depressing the global
commodity market. The concern is real, given the increasing weight of China’s
commodity demand in the global market. But this is more a story of change in
relative demand for various commodities than an absolute negative demand
shock, as many have mistakenly thought. Furthermore, it is important to
distinguish between the cyclical and secular China impact on commodities.

5
The Impossible Trinity paradigm states that under an open capital account, a central bank
can only control either the interest rate or the exchange rate, but not both. Hence, the
central bank faces a policy trilemma of three variables: the capital account, the exchange
rate and the interest rate.
 China’s Role in the Global Market Cycle 83

As I argued in Chapter 4, China’s GDP growth is unlikely to fall sharply below

6% a year on a sustained basis anytime soon. Beijing has been fine-tuning its
demand management policy to balance between sustaining growth and imple-
menting structural reform and de-leveraging measures. Both fiscal and monetary
policies are kept on standby modes to ease on any potential signs of significant
GDP growth deceleration.
Since the 2018 economic slowdown, monetary policy has been used to offset
the financial stress stemming from the de-leveraging and structural reform mea-
sures. Beijing’s acute sense of policy sensitivity has allowed it to implement debt-
and excess-capacity reduction without inflicting a heavy cost in the economy.
GDP growth has moderated and systemic risk has been contained.

The Cyclical Impact

China’s property market, which is one of the major drivers for investment and
growth, has been cooling but not crashing down since the economic slowdown in
2018. Housing inventories have dropped to between 10 and 18 months from over
30 months at the market trough in 2015. This has kept developers building,
despite sluggish real estate sales.
Commodities, especially iron ore and coal, are strongly influenced by China’s
construction cycle which, in turn, is affected by its property market conditions.
China’s metal imports have been dropping since 2017, underscoring a weak prop-
erty market. A weakening construction cycle in China is thus not good news for
metal prices. But Chinese domestic supply has been constrained since 2015, when
Beijing started to cut excess capacity, while metal demand has not dropped as much
as supply. This has created a bottle-neck condition in the metal sector and helped to
prevent any price collapse, despite the economic slowdown in 2018–2020.
China’s construction cycle is not only key to demand for commodity-exporting
emerging markets but also drives many developed market exports. Europe, Japan
and the United States (the G3) are important capital goods exporters to China and
their shipments closely track swings in China’s construction activity (Fig. 5.13).
However, a moderate slowing trend in China’s economy and construction activity
may not cause any major damages on developed market growth, just as the deep
decline in 2015 did not derail Europe’s economic recovery. America’s growth did
suffer in 2015 but it was mostly a result of the oil price collapse hurting its
domestic energy investment.
So the cyclical impact of China’s economic slowdown on commodity prices is
likely to be moderate. The short-term risk for the commodity market lies more in the
combination of China slowdown, oil price fluctuation and other geo-political risk
factors such as Europe’s political turmoil and US trade conflicts with its trading
partners.

Secular Impact
China’s commodity demand is undergoing a structural shift from metals to energy
and foods, reflecting the creative destruction process that is moving the economy
84 China’s Global Disruption

Fig. 5.13. G3 Exports Correlate with China’s Construction Growth.

from investment-led to consumption-led growth (Zhou, He, & Zhu, 2016).

China’s industrialisation between the 1980s and the 2000s created a huge demand
for metals and energy. But since President Xi Jinping came to power in late 2012
(officially in 2013), he changed the government’s policy objective function from
maximising growth quantity to improving growth quality through structural
reforms and debt reduction. The resultant growth moderation means that in the
future, China’s commodity demand will shift from metals to energy and high-
quality foods as income level rises.
Growth in China’s steel demand has already fallen from double-digit growth
rates in the mid-2000s to low single-digit rates in recent years, reflecting the
structural shift in the economy (Fig. 5.14) from commodity-intensive industrial-
led growth to service-based consumption-driven growth which is less commodity-
intensive. This has inevitably created a large disruption to the steel sector and to
the markets related to steel production, such as iron ore and coke. Nevertheless,
although the growth rate has and will continue to come down, the base for
China’s steel (and other commodities) demand is still very large so that the annual
demand increment in volume terms will remain large.
China’s per-capita energy consumption has also fallen but not as much as the
decline in steel demand (Fig. 5.15). The reason is that even as China’s need for
steel-intensive construction and heavy industries has dropped, energy demand
from the new industries (such as those featured in the new industrial policy under
President Xi) and the new economy characterised by household consumption,
transportation, services, information technology, computer, commerce and
finance has grown. This new energy demand will continue to rise, offsetting the
decline in demand by the old economy.
 China’s Role in the Global Market Cycle 85

Fig. 5.14. China’s Steel Demand* Growth Slows as the Economic

Structure Changes.

Fig. 5.15. China’s per-capita Electricity Demand Slows but by Less

Than the Slowdown in Steel Demand.

China’s economy mostly runs on coal, which is domestically supplied, so not

all of the new energy demand will be felt by global markets in the medium term.
But this situation will change in the longer term as China is moving away from
demand for ‘dirty’ coal to clean energy. Meanwhile, oil will be an increasingly
important energy source. China is already importing half of its oil needs and an
increasing share of natural gas supply (Fig. 5.16). The pressure that China puts on
global energy supplies will increase in the future, unless stringent energy conser-
vation policies are strictly implemented to offset that pressure. In other words,
86 China’s Global Disruption

Fig. 5.16. Share of Natural Gas Import in Total Energy Imports*.

China will be a positive force for driving prices in the global oil and gas market in
the long term.
China is also going through a structural shift in the demand for refined oil
products. It used to have huge demand for heavy distillates, such as diesel and fuel
oil, used in heavy industry and lorry transport. But as its economic structure shifts
away from industry-based investment-led growth, diesel demand has slowed
sharply since 2013 when the tertiary sector (a proxy to the service-based new
economy) started out-growing the secondary sector (a proxy to the old industrial
economy). Meanwhile, gasoline demand has soared, driven by the new economy’s
inexorably rising passenger car fleet.

A Story of Relative Changes

Overall, China’s energy and oil intensities (i.e., the amount of oil needed to
generate a unit of GDP) are set to fall due to the significant decline in heavy
industry and construction activity. This trend is a natural result of the structural
shift from capital-intensive investment-led growth to service-based consumption-
led growth.
Japan offers a pertinent precedent. Its housing starts peaked in the early 1970s
and so did per-capita steel demand. Its oil intensity fell by more than 30% in
subsequent years. China is going through a similar structural slowdown in con-
struction activity led by housing. This means the biggest drop in demand due to
this structural shift will be diesel. But the shift towards a consumption-driven
economy will create strong demand for light distillates, notably gasoline due to
increasing usage of automobiles.
 China’s Role in the Global Market Cycle 87

Fig. 5.17. Changes in Share of Consumer Spending between

2000 and 2014.

Last but not least, Chinese consumers have been upgrading their demand for
goods and services alongside income growth since the turn of the millennium, as
discussed in Chapter 4. Daily necessity and tangible items, including basic foods
and clothing, have seen demand fallen since 2000, while higher value-added and
service-based items have seen a surge in demand (Fig. 5.17). For example, the

Fig. 5.18. China Has Been a Net Importer of High-quality

Food Items*.
88 China’s Global Disruption

consumption share of total household spending on social services, vehicles, edu-

cation, premium foods and healthcare rose by an average of three percentage
points between 2000 and 2014, and their gains came at the expense of the con-
sumption shares of crops, clothing, fishing/agriculture, non-metallic mineral
products and basic furniture.
China’s demand for better quality foods, including grains, meat and dairy
products (of which China is already a net importer, Fig. 5.18), is expected to grow
sharply as the general income level continues to rise. The market estimates that, in
the coming years, China’s per-capita grain consumption growth can easily double
from the current 1.0% a year.
All this underscores my argument that the perceived China shock on the global
commodity market is more of a story about changes in relative demand rather
than an absolute negative shock. Indeed, the same logic applies to many other
types of perceived China disruption to the world. There is demand destruction in
some sectors by China due to its structural growth changes and economic reba-
lancing, but there is demand creation in other sectors. That is why it is important
to assess China’s global disruption with perspectives by taking into account all
available relevant information.
Chapter 6

The Debt Time Bomb

For a long time, China’s debt problem, which some observers refer to as a ‘ticking
time bomb’ (Canavan, 2019; Lueth, 2016; Klooster, 2017), is seen as one of the
biggest potential disruptions to the global system. Globalisation has knitted the
world into an interlocking network so that when the China part falls, it will set off a
domino effect on dragging down the whole network with no countries spared. The
concern about China’s debt includes not only its total debt level but also its banking
system (since bank loans are a large part of China’s total debt and Chinese banks
are generally seen as financially unstable), the local government debt (LGD) (as it is
a black box that no one can understand) and the household debt (which has been
rising exponentially since the 2008–09 Global Financial Crisis (GFC)).
No matter how you look at China’s debt, it seems that things are bad. And this
has raised more scepticism about the sustainability of China’s financial system and
increased fears about its potential shock on the world. In this chapter, we shall
assess each of these debt vulnerabilities by using a holistic approach. In the next
chapter, we shall follow-up with the China-debt debate to uncover the missing
pieces in the conventional approach to understand China’s financial system.

Debt Vulnerability – Déjà vu

Concern about China’s debt vulnerability arises again in recent years on the back
of weaker economic growth and a weaker renminbi exchange rate. Indeed from a
broad perspective, China’s real GDP growth fell by 4.6 percentage points between
2010 and 2019, from 10.6% a year to 6.0%, while its non-financial sector (non-
financial companies, household and government) debt rose by 70 percentage
points from 180% of GDP to 250% of GDP. Meanwhile, its consumer price index
inflation dropped from over 5% a year to less than 2% and the producer price
index went from over 6% inflation to 1.2% deflation. This is a scary debt-deflation
environment and, theoretically, should expose China to both a growth shock that
affects credit risk and a foreign funding shock when foreign creditors pull out. To
assess this systemic risk, let us compare China with its peers on some common
debt risk parameters.
Among its peers, China (and Hong Kong) recorded the biggest increase in non-
financial sector debt since 2010 (Fig. 6.1). However, over 97% of China’s debt is

China’s Global Disruption, 89–113

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211007
90 China’s Global Disruption

Fig. 6.1. Change in Asia’s Non-financial Sector Debt

(%GDP) from 2010 to 2018.

renminbi-denominated, suggesting that it is not at risk of a foreign-induced debt-

currency crisis as China can easily pay off all the foreign creditors with its huge
foreign exchange reserves. Overall, most of Asia’s debt is denominated in local
rather than foreign currency.

The Domestic Growth Shock

Slowing growth hurts debtors by squeezing corporate earnings, eroding the ability
to service debt, triggering credit-rating downgrades and widening credit spreads.
If companies respond by laying off workers, that will hurt households’ ability to
service mortgage loans. Some commonly used debt risk parameters for assessing a
country’s growth/credit risk include total non-financial sector debt and its change
over time, the interest coverage of the debt and debt–service ratio.

• Total non-financial sector debt can be divided into corporate and household
debts. It is not just the level of debt but also the rate of accumulation that
matters.
• The interest coverage is a ratio of a company’s earnings before interest and tax
expenses (or EBIT) to interest payments in a given period. It measures how
many times a company can cover its current interest payment with its earnings,
thus its margin of safety for paying interest on its debt. Generally, a ratio of 1.5
or lower is considered insufficient.
• The debt–service ratio of a country is its total interest payment plus amor-
tisation as a share of GDP. This measures the portion of income being used to
service debt.
 The Debt Time Bomb 91

In our analysis, we assess five domestic growth risk parameters for China and
compare them with nine other Asian economies:

(1) Total non-financial corporate debt as a percentage of GDP

(2) Total household debt as a percentage of GDP
(3) Change in private (non-financial) debt between 2014 and 2019
(4) Share of companies with long-term debt interest coverage ratio of less than 1.5
(5) Private non-financial debt–service ratio.

Using financial market and macroeconomic data, we can estimate these risk
parameters for each country. We first calculate the Z-score of each of these five
risk categories for each country, and sum up the country’s Z-scores of all these risk
variables and then add 100 to the total Z-score to arrive at a final risk score for
that country.1 A higher risk score means higher credit risk due to a negative
growth shock. This means that a larger debt load, faster debt accumulation, a
higher share of a country’s corporate debt with low interest coverage and a higher
debt–service ratio result in a higher risk score. On this comparison, China’s credit
risk due to a growth shock is high (Fig. 6.2).

The External Funding Shock

A sudden withdrawal of foreign creditors creates balance of payments funding
pressures on countries that rely heavily on foreign savings to fund their large
current account deficits. The commonly used parameters for assessing this risk
include the following:

• The size of non-financial sector foreign currency debt and its change over time.
• The short-term (less than a year) foreign currency debt as a share of a country’s
foreign exchange reserves; a higher share implies a higher rollover risk.
• The current account balance as a share of GDP; a large deficit hurts foreign
confidence and, hence, the foreign appetite for funding the deficit.
• The import cover, with foreign exchange reserves covering at least three
months of imports being the minimum safety standard.
• The deviation of a country’s real effective exchange rate from its long-term
(10-year) average; a large positive deviation implies an overvalued currency
hurting a country’s balance of payments and, hence, foreign creditors’ confi-
dence in the country.

1
A Z-score is the number of standard deviations below or above the mean of an observed
data series. It is calculated by subtracting the mean of the data series from an individual
reading and then dividing the difference by the standard deviation of the data series. This
process is called standardising or normalising. Calculating the Z-score requires the population
mean and the population standard deviation. When these values are unknown, the standard
score may be calculated using the sample mean and sample standard deviation as estimates of
the population values.
92 China’s Global Disruption

Fig. 6.2. China’s Relative Debt Vulnerability Due to Growth Risk.

Here, we assess six external funding risk parameters for China and compare
them with nine other Asian economies:

(1) Total non-financial corporate foreign currency debt as a percentage of GDP

(2) Change in private (non-financial) foreign currency debt (as a percentage of
GDP) between 2014 and 2019
(3) Short-term foreign debt as a share of foreign exchange reserves
(4) Import cover of foreign exchange reserves
(5) Current account as a percentage of GDP
(6) Deviation of real effective exchange rate from the long-term (10-year) average.

Like the exercise above, the risk estimates are calculated by summing a country’s
Z-score in each of these six risk variables, and then adding 100 to the sum of the
Z-scores to get a final risk score for the country. A higher risk score means higher
foreign funding risk. So a larger foreign currency debt, faster debt accumulation,
more short-term foreign currency debt, a larger current account deficit, a smaller
import cover and an overvalued currency result in a higher risk score. Relative to
its peers, China’s external risk due to foreign funding squeeze is low (Fig. 6.3).
What all these show are that China’s external funding risk is very low but its
domestic growth/credit risk is very high compared with its Asian peers (Fig. 6.4). A
blanket concern about China’s debt vulnerability is thus unwarranted. China’s state
control, closed capital account and strong fiscal position offer it more room to
manage potential domestic credit risk than many other countries with open capital
accounts and external deficits. But there are still concerns about its domestic debt
load, especially a banking crisis, which is what we are going to examine below.
 The Debt Time Bomb 93

Fig. 6.3. China’s Relative Debt Vulnerability Due to External Risk.

Fig. 6.4. China’s Overall Debt Vulnerability.

A Ticking Time Bomb…

Since China’s domestic credit risk due to slowing economic growth is quite high,
many market players have bet for many years on a banking crisis in China and
expected losses to wipe out as much as a third of the banking system’s total
equity (CNBC, 2019; Durden, 2019; Jepsen, 2019). To understand this potential
94 China’s Global Disruption

‘Armageddon’ scenario, one needs to know the biggest risk exposure of the Chinese
banks. It is not in the loans to the state-owned enterprises (SOEs) or the house-
holds. The former enjoys implicit guarantee from the government, though Beijing is
retreating from this policy selectively, and the latter still have a strong balance
sheet, despite the rapid increase in the household debt from a very low base (see
below).
The highest credit risk lies in the loans to the non-state companies and non-
bank financial institutions (NBFIs). The latter include investment companies,
brokerages, mutual funds, asset managers, trust companies, auto-financing and
financial leasing companies and private loan companies, which are players in the
shadow banking market. They do not enjoy the same degree of implicit guarantee
as the SOEs and the large banks do and are not properly regulated.
Data show that loans to all enterprises and NBFIs totalled RMB107 trillion
in 2018 (Table 6.1), accounting for 75% of total loans. Let us assume two loss
scenarios, one with a 10% loss and the other with a 15% loss on these loans.

Table 6.1. A Stylised Example of Chinese Banks’ Risk Exposure and

Potential Losses (2018).

RMB Trillion
1) Loans to enterprises 81.1
2) Loans to non-bank financial 25.9
institutions
Total (51 1 2): 107.0
3) Assumed bad debt from the
above loans
3a) Scenario 1 (with 10% loss) 10.7
3b) Scenario 2 (with 15% loss) 16.0
4) Assumed recovery rate (20%)
4a) Scenario 1 (0.2 3 3a) 2.1
4b) Scenario 2 (0.2 3 3b) 3.2
5) Loan loss provisions 3.8
6) Assumed net loss from the above
loans
6a) Scenario 1 (3a–4a–5) 4.8
6b) Scenario 2 (3b–4b–5) 9.1
7) Banks’ equity capital 21.7
8) Loss as % of equity
8a) Scenario 1 22.1%
8b) Scenario 2 41.8%
Sources: CEIC, author.
 The Debt Time Bomb 95

Given the structural down-shift in China’s growth environment, a 10%–15%

non-performing-loan scenario looks plausible. There could also be bad debt
arising from other loan categories.
There were RMB3.8 trillion loan loss provisions in the banking system in 2018.
Experience also shows that Chinese banks had an average bad debt recovery rate
of 20%. Assuming all the provisions would be used to cover the losses and the same
bad debt recovery rate going forward, the potential net loss to the banking system
would amount to RMB4.8 trillion and RMB9.1 trillion under scenarios 1 and 2,
respectively (Table 6.1). Meanwhile, Chinese banks had an aggregate equity capital
of RMB21.7 trillion. This stylised example shows that if the bad–loan ratio were to
rise to 10% or 15% (from the official 2% at the time of writing), the estimated losses
could wipe out between 22% and 42% of aggregate bank equity (Table 6.1).

… That Won’t Detonate

So the worry about a Chinese banking and currency crisis should be real. But this
view hinges upon the creditors’ behaviour. In an open and mature market, which
is how most western analysts see China, the creditors would lose faith in the banks
and cut funding, pulling the rug from under the financial system and crushing the
exchange rate due to capital flight.
However, the creditors in China are mainly the households, as banks source
over 80% of their funding from retail deposits. Since the banking system is ulti-
mately backed up by the government’s implicit guarantee policy, i.e., no banks
would be allowed to fail (at least that is what the public believes), the Chinese
people believe this public ‘put’ option will continue to support the banks.2 Hence,
China’s public confidence in the banks has remained high so that the probability
of bank runs and financial contagion is negligible. Meanwhile, China’s closed
capital account locks up domestic liquidity, providing a backstop for keeping the
banking system whole.
Even though the central government has been calling for a clean-up of ‘zombie’
companies, it has also asked banks to ensure the process would not cause any
financial instability, i.e., not to cut off funding abruptly.3 Granted, this policy of
market interference is not going to solve China’s debt and capital misallocation
problems. But it means that China could avoid a financial implosion for much
longer than most people think.

2
In finance, a put option is a financial instrument, or derivative, traded on the stock market
which gives the holder (i.e., the purchaser of the put option) the right to sell an asset (the
underlying), at a specified price (the strike), by (or at) a specified date (the expiry or maturity)
to the writer (i.e., seller) of the put. Applied to the bank bailout situation, the ‘put’ option is
essentially a guarantee by the government to buy up the failing bank(s) to guarantee its (their)
value intact.
3
Zombie companies are indebted businesses that are still generating cash, but after paying
for all variable and fixed costs only have enough funds to service the interest of their debts
but not the principal. So they generally depend on banks (or creditors) forbearance for their
continued existence.
96 China’s Global Disruption

Crucially, the Chinese banks and the government are not sitting on their hands
to wait for a crisis. They have improved risk and policy management, as reflected
by the increase in loan loss provisions by 93% and bank equity by 76% between
2014 and 2018. So long as there is no loss of public confidence and the creditors in
China do not cut off funding to the banks and NBFIs which, in turn, do not cut
off funding to the companies, there would be no financial crisis or collapse in the
renminbi exchange rate. Contrary to all the worries, there have been no signs of
capital flight; otherwise there should have been significant and persistent depletion
in domestic deposits. Obviously this has not been the case (Fig. 6.5).

The Risk Lies Somewhere Else

All this is not to deny the financial risk in China. There is indeed a rising risk of
localise financial failures, thanks to the rapid expansion of small and regional banks
(Fig. 6.6) many of which have engaged in regulatory arbitrage and illegal dealings
through opaque and complex financial activities funded by wholesale funding.4
Note that interbank borrowing by small and regional banks had risen from 12% of
their total funding sources in 2015 to a peak of 18% in 2017 before moderating to

Fig. 6.5. Saving Deposit Growth in China.

4
These banks include joint-stock banks, city commercial banks and rural commercial
banks. Joint-stock banks have mixed public–private ownership with the majority stake
still held by the (central or local) government. The city and rural commercial banks also
have mixed ownership but with only a minority stake held by the local government (the
central government is not involved).
 The Debt Time Bomb 97

Fig. 6.6. Small and Regional Banks Expansion Comes

at the Expense of Major Banks.

13% in recent years due to Beijing’s de-leveraging and anti-corruption policies.

Meanwhile, interbank funding only accounts for about 2% of the large commercial
banks’ total funding sources (Fig. 6.7).

Fig. 6.7. Source of Funding from the Interbank Market.

98 China’s Global Disruption

Understanding the banks’ funding structure is important because normally an

increase in reliance on wholesale funding raises systemic risk. During times of
financial stress when the interbank market seizes up, the interbank participating
banks would be vulnerable to funding squeeze. This would, in turn, create a
domino effect on the whole system. In the developed markets, this could lead to a
systemic collapse.
But China is different because, most importantly, the banking system does not
rely on wholesale funding. Furthermore, the People’s Bank of China (PBoC)
would most likely step in during times of financial stress either to keep funds
flowing or force the major banks to take over the small troubled ones, as it did in
1998 when it asked the Industrial and Commercial Bank of China to bailout the
Hainan Development Bank, and again between May and August 2019 to bailout
three regional banks: Baoshang Bank, Jinzhou Bank and Hengfeng Bank (see
below).

Not yet a Dire Problem

Many observers argued that China’s regulatory arbitrage activity, especially
between 2013 and 2017, funded by the wholesale market looked similar to the
situation in the United States before the subprime crisis in September 2007, and
projected a financial meltdown in China sooner or later. However, the compar-
ison with the US situation is not appropriate at this stage. This is because the
majority of the Chinese banks do not rely on wholesale funding, which is a major
determinant of bank vulnerability during the US subprime crisis (Huang &
Ratnovski, 2008). In China, wholesale funding accounts for only 14.5% of total
funding, according to the PBoC (see also Fig. 6.7), compared to 75% at the peak
in the US system.
Furthermore, virtually all banks in China are owned (directly or indirectly) by
the government. At the time of writing, there are only five private (small) banks,
and foreign banks account for less than 1% of the banking market share in China
(as of 2019). All the major NBFIs are also majority-owned by the government.
The point is that the state is behind the Chinese financial system, underscoring the
public confidence in it. The US crisis was triggered by private creditor decision to
cut off funding for over-extended firms such as Bear Sterns and Lehman Brothers.
This is not likely to happen in China.
Granted, the state ownership and implicit guarantee policy in China have
distorted rational creditor behaviour. But ironically, these policies that create
irrational creditor behaviour help preserve the system. In the event of defaults by
small institutions, the government can also order the big state-owned banks to
keep credit flowing. There is certainly risk in the Chinese financial system, but it is
not yet imminent and systemic.
The cost of sustaining the banking system under such a policy framework is
insufficient market forces to force exit of the zombie firms. This means that
China’s SOE and corporate sector reforms would only proceed in slow motion,
delivering mediocre economic efficiency in the medium term.
 The Debt Time Bomb 99

The bottom line from all this is that in the near future, an ‘Armageddon’
scenario for the Chinese banking system is not likely. The game changer will be
the opening of the capital account and scrapping of the implicit guarantee policy
quickly, as many experts have demanded. But such moves are impractical as they
would crush the Chinese system before any benefits of full convertibility, debt
reduction and structural reform can be materialised. So one can only expect a
gradual pace of financial and capital account liberalisation according to Beijing’s
discretion.

Bank Failures – A Turning Point for Reform?

But die-hard China critics argue that the defaults of some Chinese banks, espe-
cially those between May and August 2019, were signs of a systemic collapse
(Letts, 2019; Tan, 2019). This belief even prompted some speculators to bet on a
financial crisis in China forcing a sharp repricing of risk for its banking system in
late 2019. With hindsight, all these bets on a financial implosion lost big money as
no banking crisis erupted (Dulaney, 2018). Why?
The government’s takeover of Baoshang Bank in May 2019 was China’s most
high-profile bank failure in two decades. This led some speculators to declare an
economic collapse of China soon (Jepsen, 2019; Lambert, 2019). Then Bank of
Jinzhou and Hengfeng Bank failed in July and August 2019, respectively, requiring
bailouts by some large state-owned banks and the sovereign wealth fund Central
Huijin. Predictions had emerged in the following months that more bank failures
would follow, leading to a financial crisis. With hindsight, at the time of writing, of
course nothing had happened.
The failures of Baoshang Bank and Hengfeng Bank were both results of
corruption investigation in disgraced financier Xiao Jianhua’s Tomorrow Group
which owned these banks. Bank of Jinzhou was punished for regulatory viola-
tions. The problems of all three banks were known for a while as they failed to
publish financial statements for two years.
The PBoC moved decisively to inject liquidity in the system and managed to
keep the failures of these banks, which were not systemically important insti-
tutions anyway, from triggering systemic risk. Crucially, the majority of the
Chinese banks do not rely on wholesale funding (see above), which is a major
determinant of bank vulnerability in the financial system. The government used
different forms of bailout to contain the impact of the failures. Baoshang Bank
and Hengfeng Bank were nationalised through government takeovers. The Bank
of Jinzhou was rescued by state-owned strategic investors, including Industrial
and Commercial Bank of China, China Cinda Asset Management and China
Great Wall Asset Management.
The three strategic investors intend to keep the Bank of Jinzhou as an ongoing
concern as opposed to putting it into receivership. They plan to sell it to the
market once the bank is turned around. This a more market-oriented approach
than the nationalisation approach of Baoshang and Hengfeng.
100 China’s Global Disruption

Nonetheless, the Baoshang and Hengfeng takeovers might mark a turning

point for China’s banking system by breaking the implicit guarantee policy. If
implemented properly, this will go a long way to attack the moral hazard problem
when investors do not exercise prudence in making their investment decision
because they believe that the government would always come to rescue in case of
a bank failure.
Although the PBoC offered guarantee for all deposits outside the deposit
insurance RMB500,000 coverage, all wealth management products and all
corporate and other financial institutions’ claims on Baoshang under RMB50
million, it did not completely bailout Baoshang’s creditors. For those with over
RMB50 million exposure, they had to take a loss between 10% and 30% of their
investment. There is no information on Hengfeng’s bailout package at the time of
writing as the due diligence process has yet to begin.
The Baoshang case has set a precedent for subsequent bank bailouts. The
decision to offer depositors a full guarantee that went beyond deposit insurance
and force large creditors to take a loss was a carefully calibrated compromise
between preventing financial contagion by preserving public confidence and
avoiding moral hazard by injecting market discipline in the system.
The retreat from implicit guarantee for bank failures follows a landmark move
in 2016 on removing implicit guarantee from the capital market when Beijing
allowed for the first time a SOE, the Dongbei Special Steel Group, to default on
the principal of its debt (Shepherd, 2016). Dongbei’s bond investors with over
RMB500,000 exposure had to take a ‘haircut’ of 78%, though small investors
were repaid in full. Subsequent bond defaults have followed this precedent.
Since China’s excess capacity problem was due to capital misallocation
stemming from the implicit guarantee policy favouring the SOEs and their soft
budget constraints (see Chapter 4), the ending of the implicit guarantee policy is,
thus, structurally positive for Chinese asset value by addressing moral hazard and
improving credit pricing.

Unregulated Growth Is Over

Crucially, these bank failures also suggest that the era of unregulated rapid
growth for China’s small and financially unsound banks was over. Since the early
2000s, the assets of small and regional banks have grown rapidly at the expense of
the large banks (see Fig. 6.6). As argued above, many of these small financial
institutions have engaged in regulatory arbitrage through opaque and complex
financial activities funded by wholesale funding.
Allowing this rapid growth helped meet policy goals of financing local infra-
structure and improving the funding access by the private sector in the early years.
But it soon became clear that financial risk was rising rapidly at the small and
regional banks, including the shadow banks or the NBFIs, that could risk setting
off a systemic shock. So Beijing launched a de-leveraging campaign in 2017
focussing on the small banks and NBFIs and making systemic risk control the top
policy priority. Since large banks were major lenders funding the growth of these
 The Debt Time Bomb 101

small financial institutions, Beijing started the campaign by cutting off bank
funding to them (Fig. 6.8).
As it has become harder for small banks to use rapid growth to cover poor
lending decisions, their problems will continue to surface. Therefore, it is likely
that many other small banks will have to be restructured or absorbed by larger
and stronger institutions. The examples of Baoshang, Jinzhou and Hengfeng
show that China had the capacity to handle the short-term pains of financial
clean-up adequately and paved the way for more financial reforms. Far from
being an imminent sign of a financial crisis, these banks’ failures reflected Beijing’s
resolve to attack the incentive problem in the system even at the cost of slowing
economic growth.

Local Government Debt

Then there are the worries about China’s LGD, which is like a mystery inside an
enigma because no one has an accurate understanding and estimate of its size.
The different levels of the Chinese government and the market players do not
have a uniform way to define LGD, and there is a lack of comprehensive records
and data for the LGD.
The market is concerned about the LGD’s rapid growth, which has built into a
size that is much bigger than the central government debt. Ironically, Beijing’s de-
leveraging efforts since 2017 have aggravated the worries by making some local

Fig. 6.8. Bank Claims on Corporate and NBFIs.

102 China’s Global Disruption

government financing vehicles (LGFVs) miss or delay their repayments.5 LGFVs,

a large part of the LGD, are special purpose vehicles (SPVs) set up by the local
governments to eschew regulatory borrowing restrictions to raise funds for
infrastructure projects. The pace of LGFVs debt accumulation has contributed
substantially to the rise of China’s overall debt level since the 2008–09 GFC.
How big is LGD, and how did it get to such a worrying level today? Are the
LGD risks getting out of hand? What is the government position in dealing with
the problem?
Estimates for the size of the LGD are all over the place because there is no
official definition for the debt and data records have been poor. In 2017, these
estimates ranged between RMB16 trillion and RMB42 trillion, according to
different players including China’s Ministry of Finance, the Bank for International
Settlements (BIS), the International Monetary Fund (IMF), Chinese brokers and
academics such as the Chinese Academy of Social Sciences.
In 2018, some global banks estimated that the LGD amounted to between
RMB28 trillion and RMB50 trillion, representing a 20%–75% year-over-year
jump. Together with the RMB13.5 trillion central government debt, China’s
total debt was estimated at between RMB41.5 trillion and RMB63.5 trillion, or
between 51% and 76.8% of GDP.
All players agree that there are two parts of the LGD:

(1) The explicit debt which is the part of local government on-budget liabilities
that the central government recognises
(2) The implicit debt which includes the LGFV debt and the Public–Private
Partnership (PPP) debt that are off-budget borrowing that the central gov-
ernment does not recognise.

The LGD has grown much larger than the central government debt and there
is no proper and timely records for the implicit debt. The latest official estimate
for the implicit LGD was released by the National Audit Office in June 2013 at
RMB17.9 trillion. But this debt has grown sharply. The market estimated that in
2018 the explicit debt amounted to between RMB16.5 trillion and RMB18.4
trillion, and the implicit debt between RMB11.5 trillion and RMB31.6 trillion
(Fig. 6.9).

LGD Build-up and Risks

The surge in the LGD is mainly due to the accumulation of implicit (LGFV 1
PPP) debt. By law, the local governments are not allowed to borrow. But since the

5
The first LGFV bond default in China happened in August 2018 when a military-affiliated
company in Xinjiang failed to pay interest on a RMB5 million bond. The second partial
default was in December 2019 by the Hohhot Economic and Technology Development
Zone Investment Development Group’s which failed to repay 40% of its RMB1 billion
private bond issued in 2016.
 The Debt Time Bomb 103

Fig. 6.9. China’s Public Debt Structure.

late 1990s, many local governments started setting up SPVs to circumvent the
regulatory restrictions to raise funds for infrastructure projects. The implicit debt
jumped when Beijing injected RMB4 trillion into the system in 2009 to fight the
impact of the GFC, as local governments with the blessing of the central gov-
ernment set up numerous LGFVs to borrow funds from the banks and capital
market to fund the infrastructure investments approved under the stimulus
package.
To meet the central government’s growth targets, local government kept on
borrowing to fund infrastructure projects even when Beijing started to clamp
down on local borrowing in 2011 to rein in systemic risk. Beijing also introduced
in 2014 the PPP programme to bring in private investors to fund infrastructure
investment in order to reduce local government borrowing pressure. But most of
the PPP projects have been abused by the local governments by inviting fake
private investors to get approvals for borrowing. The ultimate borrowers and
stakeholders are still the local governments, and the PPP platform is effectively a
mutation of LGFV borrowing.
Ballooning LGD is creating a systemic balance sheet mismatch risk, which
underlay the 1997–98 Asian financial crisis. Most of the LGD is short term,
maturing in less than three years, but the investments it funds are long term, over
10 years. So the LGD is subject to high interest rate and rollover risks.
Ironically, Beijing’s de-leveraging efforts since 2017 have aggravated the LGD
problem by tightening domestic credit conditions, eroding the debt–service
capabilities of many of the infrastructure projects which were unsound invest-
ments to start with. Crucially, bank loans account for the biggest funding share of
104 China’s Global Disruption

the LGD, thus linking the LGD risk to the banking system.6 Furthermore, land
sales revenues, which constitute the bulk of local government fiscal revenues, have
become unstable in recent years due to Beijing’s efforts to clamp down on housing
bubbles in the large cities. Since a lot of the LGD has gone into funding property
development, deteriorating financial conditions in the real estate sector has
significantly weakened the local governments’ debt-servicing ability.

Debt Risk Is Still Manageable

The prime concern about the LGD is its sustainability. The situation is not as bad
as news headlines have it. Firstly, the LGD risk remains localised. Data show that
local debt-to-GDP ratios are the highest in Guizhou, Qinghai and Yunnan, fol-
lowed by Inner Mongolia, Liaoning and Ningxia (Fig. 6.10). This suggests that
credit risks are the highest in the western and northern provinces, though Hainan
in the far south is also high risk (Fig. 6.11).
Secondly, China’s total (central 1 local government) public debt-to-GDP ratio
is not excessive compared to many other countries (Fig. 6.12). Crucially, its public

Fig. 6.10. Provincial Government Debt-to-GDP Ratios.

6
Bank loans accounted for over half of the total LGD and almost 60% of the implicit debt
in 2018, according to market estimates. Other funding sources include special construction
funds, government guided infrastructure funds, shantytown reconstruction loans, trust
loans, leasing, PPP borrowing, LGFV bonds, build and transfer loans, etc.
 The Debt Time Bomb 105

Shaded areas = high systemic risk due

sources: CEIC, author
to high debt-to-GDP ratios

Fig. 6.11. Distribution of LGD Risk.

Fig. 6.12. Public-to-GDP Ratios (2017).

106 China’s Global Disruption

debt is funded by domestic savings and denominated in renminbi, thus ruling out
a foreign debt-currency crisis. With high domestic savings, Beijing should have no
problems in servicing the public debt.

What Matters the Most

All this is not to downplay the LGD vulnerabilities. While it is manageable today
does not mean that it will remain manageable tomorrow. In recent years, the
adjusted fiscal deficit (i.e., official deficit plus total government borrowing) has
grown at an annual rate of 10%. If Beijing cannot effectively contain the growth
of the LGD, the problem could eventually become unmanageable.
What matters the most is the government’s attitude towards the debt risk.
Beijing has so far taken a slow and progressive approach to cut debt growth. This
is quite different from the debt crisis countries which had left their debt bomb too
late to be diffused. Since 2011, Beijing has implemented regulations and measures
to cut the LGD by

• prohibiting LGFV borrowing and reining in shadow banking, which is a key

funding source for the LGFVs
• urging local governments to set up early-warning systems for their debt
• implementing a debt-swap programme (in 2015), which replaces LGFV debts
by government and municipal bonds thus improving the LGFV credit risk
and reducing their debt-servicing cost as borrowing through the government
bond market pays lower interest rates than borrowing from the shadow
banks
• implementing PPP infrastructure investment programmes to bring in private-
sector funds. Though the programme has been abused (see above), an over-
hauling process has been implemented since 2016 to scrutinise the PPP project
approvals
• including local government borrowing in the fiscal budget via legal process.
China amended the Budget Law in 2015 prohibiting LGFV borrowing and
requiring all local government borrowing to be included in the official budget
and regulated by the local People’s Congress
• retreating slowly from the implicit guarantee policy to allow LGFVs and SOEs
bankruptcies and defaults to bring in market discipline to address the moral
hazard problem

China is also changing the incentive behind local government borrowing by

deemphasising the GDP growth targets, which is the root cause for LGD build-
up. President Xi Jinping has changed the country’s policy objective from max-
imising growth to targeting multiple goals, including sustaining moderate GDP
growth, reducing poverty, reducing systemic risk and protecting the environment
(see Chapter 2). By replacing the old single-minded growth incentive by a set of
complex priorities, he has created a political environment that is conducive to
debt reduction.
 The Debt Time Bomb 107

The Household Debt Mystery

Like its LGD, China’s household debt is a mystery and another big worry of the
world. Firstly, it is a moving target as financial deepening, which is still work-in-
progress in China, is opening up more borrowing opportunities for the household
sector (see Chapter 7). Secondly, there is no accurate household debt data. Lastly,
there are idiosyncratic differences between the composition of household debt in
China and other economies. This makes international comparison and assessment
difficult.
Expansion of household debt received strong policy support in the past as part
of financial liberalisation to facilitate economic rebalancing towards more con-
sumption. But the household debt’s rapid rate of accumulation and rising debt–
service burden have become a key concern under Beijing’s de-leveraging
campaign. Both indicators have grown by an average of more than 25% a year
since 2009, according to the IMF, when nominal GDP growth has only averaged
11.4% a year. Continuing this rapid rate of expansion would create substantial
systemic risks for both China and the global system.
There are no accurate data on the size of the household debt, the actual interest
rates charged on the different types of consumer loans and the maturity of loans.
China also includes in the household debt operating loans to small businesses due
to their family-run nature. This item usually comes under business loans in other
economies. This difference complicates the international assessment of China’s
risk.
Household debt in China includes three items (Fig. 6.13):7

(1) Mortgages, including borrowing from the housing provident funds; together
they account for almost 60% of the total household debt
(2) Operating loans to small businesses
(3) Consumer loans, including credit cards, auto loans, etc.

All these totalled RMB52.8 trillion in 2018, or 57.5% of GDP, up from 17.9%
of GDP in 2008.8 But this is likely an underestimation as Chinese households also
borrow from the non-bank and unofficial channels, notably the peer-to-peer (P2P)
lending platform. P2P loans amounted to RMB789 billion at end of 2018 (after
peaking at RMB1.69 trillion in May). Including them, the household debt was
58.4% of GDP in 2018.

Is China’s Household Debt Excessive?

At close to 60% of GDP, China’s household debt is certainly not low. But it is also
not very high by international standard and is lower than many of its Asian peers’
ratios (Fig. 6.14). However, the debt-to-GDP ratio is a commonly used but

The debt composition will change over time as financial innovation in China evolves.
7
8
But the IMF calculations showed a lower (54.2% of GDP) ratio in 2018.
108 China’s Global Disruption

Fig. 6.13. China’s Household Debt Components.

Fig. 6.14. Household Debt-to-GDP Ratios (2018)

International Comparison.

inconsistent indicator as debt is a stock variable, while GDP is a flow variable. It

is more relevant to look at the household debt-service-to-income ratio, which
compares interest and principle payment flows with household income. Since both
are flow variables, the ratio better captures the impact of debt servicing on
household income and spending. China’s household debt–service ratio is also not
excessive by international comparison (Fig. 6.15).
 The Debt Time Bomb 109

Fig. 6.15. Household Debt–Service Ratios (2018)

International Comparison.

The Risks
The concerns are more about the rapid rate of growth than the debt level, as
accelerating household leverage often results in economic dislocation and painful
de-leveraging (Mian, Sufi, & Verner, 2017), as seen in Thailand in the late 1990s
and South Korea in the early 2000s. According to the IMF, China’s household
debt growth was the highest among the BIS-reporting countries since the GFC,
underscoring the worries about systemic stability (Han, Jurzyk, Guo, Yun, &
Rendak, 2019). Empirical evidence shows that while an increase in household
indebtedness could boost consumption in the short term, it would reduce con-
sumer spending and GDP growth in the medium term to long term; typically after
two years of an increase in household leverage (Jorda, Schularick, & Taylor,
2016). Furthermore, the negative long-term effect on consumption would inten-
sify when the household debt-to-GDP ratio exceeds 60% (Lombardi, Mohanty, &
Shim, 2017).
High indebtedness makes households vulnerable to adverse economic shocks
by forcing them to deleverage, leading to significant macro-financial dislocation
when they choose to cut consumption to repay debt (Baker, 2014; Nakajima,
2018). This phenomenon is more likely to happen in countries like China that do
not have a well-established household bankruptcy regime because households
could not resort to default to restart afresh.
Since almost 60% of China’s household debt are in mortgages, de-leveraging
could hurt housing demand, adversely affecting home prices and the financial
110 China’s Global Disruption

stability of property developers. This, in turn, could hurt banks’ financial health
through lower collateral valuation and raise risk aversion and reduce lending. As
argued above, China’s financial stability was vulnerable to negative growth shocks,
and high household indebtedness could amply the adverse impact of income shocks
by eroding debt repayment capacity, increasing household defaults, crimping credit
growth and constraining future consumption and investment growth.
Rising risk aversion, de-leveraging and a decline in domestic demand would
become a vicious cycle and reduce fiscal revenues, hence, the government’s ability
to pursue counter-cyclical policies. Savings would rise under these circumstances
and contribute to growing external imbalances in the form of rising current account
surplus. Ultimately, macroeconomic and financial instability ensues (Fig. 6.16).
Like the LGD, the level of household leverage and, hence, the associated risks
differ across regions in China. As of 2017, there were six provinces that recorded
household debt-to-GDP ratios above 60%. They were Shanghai, Beijing, Zhejiang,

Adverse shocks from

growth, interest rate, asset
market etc.

weak domestic deamnd:

cut consumption to repay externalimbalances:
debt, reduce asset weak growth and fiscal
demand, put pressure on position contribute to
housing prices and Financial volatility, excess savings and
financial health of growth in current account
aggravated by high surplus
developers & banks household debt

Banking sector: rise in risk

aversion due to higher Fiscal risk: rising risk
household defaults & aversion, deleveraging,
higher credit risk of domestic demand decline
developers, cuts lending; create a vicious cycle to
credit growth slows hurt fiscal revenues and
counter-cyclical ability
Asset market: lower
demand for risk assets,
hurts housing prices,
risking asset price
deflation, further hurting
domestic demand

Feedback effects among the domestic sector contributes to growing external imbalances

macroeconomic risks financial instability

source: author

Fig. 6.16. Macroeconomic and Financial Risk from High

Household Debt.
 The Debt Time Bomb 111

Guangdong, Fujian and Gansu. The first five had per-capita income levels
significantly higher than the national average.
Housing prices in these regions are quite high, so households have to take out
large mortgages to buy homes, thus driving up their debt ratios. Indeed these rich-
income regions suffer from poor housing affordability when income growth falls
short of house price inflation. China’s tier 1 cities have a chronic housing
affordability problem, but in recent years even the lower tier cities have suffered
from deteriorating affordability (Fig. 6.17), prompting households to borrow
more to buy homes and, thus, increasing their indebtedness.

Outlook and Policy

As the households in the rich regions are reaching a debt-ceiling (60% of income),
limiting the amount of debt they can take on further, the growth of overall
household leverage should slow down from the prevailing 25%, unless other
regions rapidly catch up. The slowdown seems to be happening. A market study
(UBS, 2020), which surveyed 3,100 users of consumer credit between October and
November 2019, showed that China’s household-debt growth and debt–service
burden eased sharply between 2018 and 2019 (Figs. 6.18 and 6.19).
Even a moderate slowdown, to say 15% (which is the average household-debt
growth rate in 2008–09), would have important economic consequences. Firstly,
China’s housing market will not see another boom as borrowing declines, and
house price inflation, especially in the rich cities, will slowdown. Secondly, a
constrained housing market will crimp economic growth due to the housing sec-
tor’s large multiplier effect on economic activities. But this slower growth outlook

Fig. 6.17. China’s Housing Affordability.

112 China’s Global Disruption

Fig. 6.18. Debt-to-Income Ratios of Different Credit Product Users.

Fig. 6.19. Median Debt-Service-Payment-to-Income Ratios of

Mortgage and Non-mortgage Users.

should fit Beijing’s ‘new normal’ economic policy which aims at sustaining only
moderate GDP growth and implementing debt-reduction and structural reforms.
Beijing has changed its policy stance since 2018 on household leverage from
encouraging to discouraging its growth. The banking regulators have asked banks
to cut lending to households since 2018. This is a policy reversal from the PBoC’s
encouragement to boost household lending, especially in mortgages, in 2016. The
 The Debt Time Bomb 113

tough crackdown on P2P lending in 2018 as part of the de-leveraging and

financial de-risking campaign was a key effort to pare household debt.
Cross-country studies have shown that macro-prudent policies, such as mea-
sures to limit the loan-to-value and debt-repayment-to-disposable income ratios
and credit growth and to boost loan loss provisions, can effectively reduce the
adverse effects of high household debt on consumption and growth. Setting up
credit registries can also reduce risk by enhancing overall financial sector trans-
parency and allowing for early detection of problems (IMF, 2017).
Beijing has indeed been implementing many of these policies, including
limiting banks’ mortgage lending and total credit growth, increasing bank capi-
talisation, raising loan loss provisions, implementing restrictive measures to curb
housing speculation through very high (50%1) down payments and caps on debt-
service-to-income ratio to less than 50% to discourage household borrowing.
More needs to be done though, notably in the areas of setting up credit registries
and putting in place capital requirements of different risk weights on household
debt.
The point is that China’s household debt does not point to a crisis anytime
soon. Market evidence of no systemic shocks despite decades of dire expert
warnings suggests that the risks are being contained as Beijing is not sitting on its
hands to wait for a household debt crisis to erupt.
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Chapter 7

The Crooked Debate of China’s Debt Risk

Before we move onto discussing the currency war disruption by China, I want to
follow-up with our discussion in Chapter 6 on China’s debt risk. There are a lot of
misinformed views leading to crooked analysis and debate on China’s debt risk
that have led to bad investment decisions and policy reactions around the world
on how to position for the coming China disruption. It is imperative to clear up
these distortions before moving on to the important topic of China’s role in the
currency war (both in the past and in the future).
Contrary to those critics’ belief that China’s ‘debt bomb’ would go off anytime
soon, China has started tackling its debt problem through practical means since
President Xi Jinping took over the helm in 2013. However, a policy to cut
the country’s debt-to-GDP ratio swiftly, as many of them have urged, would be
impractical as it could backfire on China by crushing the economy before the
benefits of debt reduction could even emerge. This is a crucial point that many so-
called China experts and advisors fail to realise.
China’s debt risk lies in its rapid rate of accumulation. The debate on the
problem has predominately focussed on the liability side of the economic balance
sheet. But it totally misses the asset side of the balance sheet that has growth
implications from the debt accumulation. The coexistence of excess capacity and
underinvestment in China is clouding the analysis of its debt as there is a lack of
under-standing of this conundrum (see Chapter 4). Headline data give an incom-
plete picture of China’s debt risk and, hence, have distorted its strategic outlook.
The amount of China’s debt (which is predominately bank loans) is not as
excessive as the news headlines have painted (see Chapter 6). Contrary to the
conventional wisdom, China’s debt is also structurally stable as it is funded by
domestic savings and managed under an implicit guarantee policy (from which
Beijing is retreating only slowly) and a closed capital account. The risk stems from
its rapid rate of accumulation in recent years (Fig. 7.1), which raises the alarm of
capital misallocation leading to a financial crisis eventually.

De-leveraging Cannot Go Fast

Beijing is not in denial of the country’s debt risk, though it has been criticised for
moving too slowly to cut debt. To be fair, a policy to cut China’s debt-to-GDP

China’s Global Disruption, 115–123

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116 China’s Global Disruption

Fig. 7.1. China’s Non-financial Sector Debt.

ratio swiftly, as many players have urged, would be implausible. This is because
aggregate financing growth has outpaced nominal GDP growth by an average of
six percentage points since 2012 (Fig. 7.2). To cut the debt-to-GDP ratio abruptly
would mean slowing credit growth by more than six percentage points below the
nominal GDP growth rate. This could crush the economy before the benefits of
de-leveraging could even emerge.
The government has taken a practical approach to deleverage. It started a debt-
swap programme in 2015 to pare the debt burden of the local government
financing vehicles, implemented a debt-equity scheme to deal with non-performing
bank loans and set up provincial asset management companies to absorb regional
bank loan losses. Despite the stock market’s volatility, it has also encouraged
equity financing to channel domestic savings into the economy to reduce its
reliance on debt for growth, though evidence of success has yet to emerge.
Furthermore, the People’s Bank of China (PBoC) has implemented a Macro
Prudential Assessment (MPA) framework since early 2017, which has resulted in
some initial debt reduction.
The MPA is a framework introduced in early 2016 that sets parameters such as
capital adequacy ratios and lending standards for assessing banks’ total credit
growth, including their off–balance sheet activities such as wealth management
products (WMPs) and lending to non-bank financial institutions (NBFIs) or
shadow banks. Banks that fail the quarterly MPA test will be disqualified from
using the PBoC’s lending facilities or be hit with significantly higher interest rates
from such facilities.
Hence, many banks have scaled back lending to the NFBIs in order to comply,
leading to a liquidity squeeze in the wholesale funding market and a reduction in
 The Crooked Debate of China’s Debt Risk 117

Fig. 7.2. Total Social Financing Minus Nominal GDP

Growth Rates.

overall credit growth. Nevertheless, the authorities have set a directive of not
allowing any credit squeeze to get out of hand and create credit default events that
could destabilise the system. They have pursued a stop-go approach to balance its
dual policy objectives of supporting GDP growth and managing systemic risk via
de-leveraging. However, such a balancing act has been the focus of criticism by
many observers for lacking debt-reduction progress (Rothman, 2019; Wei, 2017).

The Partial Debt Debate

The ongoing debate on China’s debt risk has focussed predominately on the
liability side of the economic balance sheet (Shen, 2020; Springfield, 2019). But it
misses the asset side that has growth implications from the debt accumulation.
Equity financing aside, debt arises when an economy transforms savings into
investment. By design, China is a debt-financed system (mainly through bank
loans), which accounts for over 90% of its total financing. The rapid increase in
debt reflects the sharp rise in China’s capital spending that makes the economy
more capital intensive. Capital broadening and capital deepening are the ultimate
ways for a country to improve productivity and living standard.1,2
China has directed massive financial resources to infrastructure investment
largely by state-owned enterprises after the 2007–08 Global Financial Crisis

1
Capital broadening refers to increasing the capital stock at the same rate as the labour
force so that labour productivity is kept constant by using existing technology.
2
Capital deepening refers to increasing output through better/new technology so that
labour, and even capital, productivity increases.
118 China’s Global Disruption

(GFC) to boost growth. Arguably, this debt-financed investment is equivalent to

the massive increase in fiscal deficits in other countries to finance social welfare
spending to support demand after the GFC. The difference is that China’s state-
led infrastructure spending boosts demand through capital accumulation, which
will raise future output, while the developed world’s fiscal spending boosts
demand via consumption, which does not increase future income. Can one really
argue that China’s rapid rate of debt accumulation is more dangerous than the
developed countries’ burgeoning fiscal deficit?
One may argue that China’s excess capacity is making its debt risk worse. But
things are not that simple. The truth is that China suffers from excess capacity
and under-investment simultaneously, as discussed in Chapter 4. The coexistence
of these two conflicting forces lays bare a more serious structural flaw in the
Chinese system – capital misallocation – than its debt accumulation.
The culprit of China’s excess capacity is not too much investment but the state
sector’s soft budget constraint under the old development model that focusses on
misallocating capital to a few giant inefficient state-dominated industries. The
state-sector’s excess capacity dominates the system and stymies ‘animal spirits’ of
the private sector which remains under-capitalised. Now the old model of debt-
financed investment-driven growth is broken. Genuine supply-side reform, not the
shallow ones that have been implemented by the government to-date, is the only
way out of this conundrum.
Under such circumstances, debt reduction only will not solve the problem of
capital misallocation in China. It could even hurt future growth since China’s
debt supports investment, not consumption. Beijing will have to resolve this
conundrum by a combination of de-leveraging in the excess-capacity sectors and
supply-side reforms to improve capital allocation to the under-capitalised new
economy. In its current form, the Chinese-style supply-side reform aims at
improving operational efficiency of the state sector with minimal impact on
employment and bankruptcy. This can only contain the flow of the structural
problem under the weight of capital misallocation. It cannot solve the stock of the
problem.
Beijing is facing significant headwinds in implementing structural reforms and
debt reduction, but eventually it still needs to allow liquidation, reform the state
sector, encourage bad debt write-offs by the banks and truly liberalise interest
rates in conjunction with other structural reform measures. It also needs to
honour its pledge to give the market a bigger role in the economy to solve the
capital misallocation problem. If it allows more equity financing and diverts
borrowing to the under-invested areas, China’s debt risk will be a much less
concern than it is perceived today.

The Financial Deepening Conundrum

The other problem with the debate on China’s debt risk lies in the ignorance
about China’s financial innovation process. Conventional analysis only focusses
on the problem of diminishing marginal efficiency of credit in China; meaning
 The Crooked Debate of China’s Debt Risk 119

that each unit of credit increment produces a less-than-proportionate increase in

output. It has totally missed the impact of financial deepening on boosting the
system’s debt-to-GDP ratio but not necessarily making credit more unproductive.
Despite years of financial reform, China is still going through financial deepening.
The sharp rise in mortgage debt, which is seen by many observers as the next debt
time bomb, is a result of this process. Concluding that all the increase in China’s
debt-to-GDP ratio reflects worsening credit quality overstates the true debt risk
and, thus, elicits the wrong business and political reactions.
Financial deepening refers to a process that increases the provision of financial
services to economic agents in the system at any given level of GDP. It includes the
development of financial markets and an increase in the number of financial
institutions providing diversity in financial instruments. Theoretically, a rapid
increase in debt relative to GDP growth leads to diminishing marginal efficiency of
credit. Much of this unproductive credit will eventually turn into non-performing
loans (NPLs) when borrowers cannot generate enough revenues to service their
debt. The NPL problem may be hidden when GDP growth is strong, but will
emerge and inflict losses in the system as growth slows.
Furthermore, as in China, when fast debt accumulation is accompanied by
financial innovation, which includes a proliferation of new financial players and
instruments creating multilayer lending and regulatory arbitrage, systemic risk
becomes bigger and harder to regulate. This was what happened in the United
States in the years before the subprime crisis broke out in 2007, with the rise of
poorly understood securitised loans spawning into a diversity of leveraged
products. Arguably, something similar is happening in China, with the rise of
shadow banks (including NBFIs) as conduits for disguising loans as ‘investments’
that require less capital backing and are exempt from NPL provisions.
These worries and arguments about China’s situation are all valid, but they
only describe a partial picture in China. A rise in the debt-to-GDP ratio does not
necessarily indicate that credit is becoming unproductive or more risky, causing
efficiency losses in output. It could also be a result of financial deepening when
households and companies have more access to credit for financing their expen-
ditures. Since one person’s debt is another person’s asset, this means that on the
other side of the balance sheet, economic agents also hold more financial assets as
investment. This point also reinforces our argument in the discussion above that
the China debt debate had focussed predominately on the liability of the eco-
nomic balance and totally ignored the asset side.
Financial deepening transforms a cash-based system into a credit-based one,
allowing the expansion of spending power. Europe and the United States went
through this process in the 1960s through the 1990s (Sahay et al., 2015), when
their average private-sector credit-to-GDP ratio went up from less 50% to over
100%. But no one argued during that time, as they do about China today, that
financial disaster was imminent as the incremental credit was generating less and
less GDP growth. Instead, analysts at that time praised the rise of consumer
finance and financial innovation as new growth catalysts, allowing people to buy
more and companies to produce more, despite the ostensible decline in the
marginal efficiency of credit.
120 China’s Global Disruption

China is undergoing financial deepening. Banks dominated China’s financial

system a decade ago, and they only lent to state-owned enterprises. Since then,
deregulation has improved access to credit for households and non-state com-
panies via various channels, including shadow banking, WMPs and Internet
finance. This credit expansion has its most obvious link to the mortgage debt
build-up.

Mortgages not a New Debt Bomb

Since the mid-2000s, mortgage loans in China went from a little over 8% of total
loans to about 20% (Fig. 7.3), which is still low by international standard, and
they account for almost 80% of all consumer loans (Fig. 7.4). Crucially mortgage
loans have often grown significantly faster than nominal GDP (Fig. 7.5),
reflecting the rapid rise in urban land values prompting households to borrow to
fund purchases. Not surprisingly, the bulk of the mortgage lending is concen-
trated in the major cities where land prices have gone up most rapidly.
To the extent that the increase in mortgage debt is reflecting the rapid rise in
land values prompting households to fund home purchase through mortgages, it
is entirely possible for debt associated with the property market to rise faster than
nominal income growth. As long as households have enough income to service
their debt, and housing prices are not out of line with economic reality, the debt
build-up is normal and should be manageable.
Contrary to the conventional wisdom of mortgage debt danger, these seem to
be the conditions in China’s property market. The household sector is a net
creditor in the system (Fig. 7.6), housing affordability (as approximated by the
ratio of cost per-capita-living-space to per-capita-income) has worsened mostly
for the Tier-1 cities but improved for the smaller cities until 2017 (Fig. 7.7, see also

Fig. 7.3. Mortgage Loans (% Total Loans).

 The Crooked Debate of China’s Debt Risk 121

Fig. 7.4. China’s Bank Loan Distribution.

Fig. 7.5. Nominal GDP vs Mortgage Loan Growth.

Chapter 6). But even the deterioration of the smaller cities’ housing affordability
was not serious to put these cities’ property market out of economic reality.
This is not to deny the existence of unproductive credit in China, which
certainly has a lot of it. The point is that the rise in the debt-to-GDP ratio has also
122 China’s Global Disruption

Fig. 7.6. China’s Household Sector is a Net Creditor.

Fig. 7.7. Housing Affordability.

imbedded a significant element of financial deepening resulted from deregulation.

The process has not only created more ways for SOEs and local governments to
finance dubious projects but also enabled non-state firms and individuals previ-
ously starved of credit to get financing.
 The Crooked Debate of China’s Debt Risk 123

Financial deepening means that more firms and people have access to credit
now, and they have more options for how to finance investment and spending.
Thus, concluding that the entire increase in China’s debt-to-GDP ratio was a
reflection of deterioration in underlying credit quality overstates the true debt risk
of China.
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Chapter 8

China and the Currency War

History has shown that high debt and domestic economic woes were the causes for
currency wars, where one country tried to devalue its way out but other countries
joined in and resulted in competitive devaluations. Viewed from this perspective,
China has all the ingredients for starting a currency war by devaluing its currency.
Indeed, this is a global disruption (Rickards, 2012) that many observers believe
China would cause sooner or later. Some even said China triggered the last cur-
rency war back in 2014 and again in 2016. Did it? More importantly, will China
trigger a currency war in the future? The possibility is certainly there, but the
world’s opinion on this subject has been distorted by misinformation and partial
analysis, leading to misunderstanding of this China risk.
Currency war is an act of competitive devaluation by different countries at
different time horizons to achieve a lower exchange rate for their own currency.
As the price to buy a particular currency falls, so too does the price of exports
from the devaluing country. So currency devaluation helps boost growth via
boosting exports. But its imports become dearer too. So domestic industry, and
thus employment, receives a boost in demand from the domestic market through
import substitution (International Relations, 2015) and export expansion. How-
ever, it has long been established that the increase in import prices could, in turn,
harm domestic purchasing power by boosting inflation (Wilson, 1976).
The first currency war broke out in the 1930s (Dadush and Eidelman, 2011).
When countries abandoned the Gold Standard during the Great Depression, they
used currency devaluation to stimulate their economies. But devaluation by one
country pushed up unemployment of the other, so trading partners retaliated by
engaging in devaluation also; hence, the term competitive devaluation. Contrary to
the common belief that devaluation would boost growth, such development actually
adversely affected all countries because competitive currency devaluation acted to
reduce overall international trade and, thus, the ‘cake’ of global economic growth.
The term currency war was coined by Guido Mantega, the Brazilian Minister
of Finance in 2010 when countries engaged in competitive devaluations after the
2008–09 Global Financial Crisis. There has been no agreement on when the
currency war ended, or even if it had ended. Even some analysts argued that it
ended in 2012 (but without conviction), the global market still saw evidence on
competitive devaluation and dwelled on fears that China would be the next
country to trigger another global currency war (Palmer, 2019).

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126 China’s Global Disruption

Countries engaging in competitive devaluation since 2010 have used a mix of

policy tools, including direct and verbal government intervention and quantitative
easing (QE) to drive down their currencies. While countries on the other side of
the currency war experienced undesirable upward pressure on their exchange rates
and took part in the ongoing arguments, the most notable dimension of the
2010–12 currency war conflict was the rhetorical conflict between the United
States and China over the valuation of the renminbi (Wall Street Journal, 2016).
In January 2013, when Japan announced monetary expansion measures to
boost its moribund economy, it sparked concern about another round of currency
war; this time with the principal source of tension being not China versus the
United States, but Japan versus the Eurozone (Thorbecke, 2013). By late
February, concerns about a new round of currency war was allayed after state-
ments from the G7 and G20 group of nations made commitments to avoid
competitive devaluation actions. But the worry about China’s currency war
disruption never really went away.

Currency Wars and Causes

Domestic Economic Woes
The backdrop for the currency war in the 1930s was the Gold Standard and Great
Depression, with the former hindering economic adjustment that eventually led to
the latter. By fixing the value of the currency to the price of gold, the Gold
Standard prevented a country from printing too much money causing inflation. If
it did, people would simply exchange fiat money for gold, or for other currencies
pegged to gold. This rigid rule denied policy makers any flexibility to deal with
shocks to their economies.
Domestic economic woes, thus, became the cause of competitive devaluation as
governments could not, and did not want to, stand the economic pains under the
Gold Standard anymore. The United Kingdom became the first country to abandon
this regime, setting off a volatile chain of events (the first currency war). In
September 1931, Britain took the pound sterling off the Gold standard by devaluing
it against gold and, hence, against the ‘gold bloc’ currencies (i.e., currencies that
remained pegged to gold). Then Norway, Sweden and Denmark followed suit
shortly and de-pegged from gold.
The United States suffered a big loss in export competitiveness to Britain by
holding steady the US dollar price of gold. In January 1934, US Congress passed the
Gold Reserve Act to nationalise gold held by banks by giving them gold certificates
that they could use as reserves at the Federal Reserve. The US government also
forced a devaluation of the US dollar against gold. Like the United States, the
remaining gold bloc countries (Germany, France and some smaller European
countries) also suffered a loss of competitiveness, leading to contraction in exports
and industrial output growth. By 1936, they also abandoned the Gold Standard.
The lessons learnt from the 1930 currency war are that (1) deteriorating
domestic conditions triggered competitive devaluation, (2) financial contagion
arose swiftly as investors looked for countries with poor economic fundamentals
 China and the Currency War 127

and took bets against those countries’ markets and (3) early movers of compet-
itive devaluation benefited the most from this so-called beggar-thy-neighbour
policy.1

Debt
When there was a massive private and public sector debt build-up leading to an
economic bubble which burst later, the post-bubble effort to pare down the debt
would be deflationary. Policy measures to boost aggregate demand and generate
inflation (known as measures to ‘inflate the way out’ of the problem) to reduce the
real debt burden would likely fail as households and firms would attempt to pay
down debt and increase savings, rather than starting a new round of debt-financed
spending.
In addition, financial institutions would only be willing to lend to the strongest
borrowers. Such an extreme risk aversion attitude is an important factor limiting
credit expansion in a post-bubble environment. It is, thus, very difficult to
generate growth and inflation under high risk aversion. Any economy-wide efforts
to cut down on debt significantly and quickly could easily lead to an economic
collapse and depression.
Hence, to prevent such a dire economic situation from unfolding in the United
States after the 2007–2008 subprime crisis, then Federal Reserve chairman Ben
Bernanke implemented QE for the United States to prevent a debt-deflation
spiral. In general, the purpose of QE is to flood the domestic financial system
with a huge amount liquidity, which will also keep interest rate at or close to zero,
which hopefully will find its way into consumption and investment to boost
economic growth.
However, QE’s impact on aggregate demand growth is uncertain, especially in
the presence of risk aversion. QE’s main channel to boost growth is through asset
price inflation. By boosting asset prices (including real estate, stocks and bonds),
QE hopes to stimulate consumption and investment through a wealth effect.
While most people still believe that inflation would follow the enormous monetary
expansion of QE, more than a decade after the subprime crisis and the
implementation of QE (by various central banks), inflation today has remained
absent in the developed world. The reason is simple: risk aversion and the lack of
confidence have crimped consumption and investment appetite. Hence, the
liquidity released by QE has remained in the financial system without being spent
– a situation called the ‘liquidity trap’ (Lhuissier, Mojon, & Ramirez, 2020).
When the QE effect fades, or becomes unstable, the monetary authorities will
launch another round of QE. Exchange rate depreciation becomes a natural result
of QE – if the government concerned aims at pushing down its currency by using
QE, the resulting drop in the exchange rate is called devaluation, but not

1
In economics, a beggar-thy-neighbour policy is an economic policy through which one
country attempts to remedy its economic problems by implementing policies that tend to
weaken the economies of other countries or worsen their economic problems.
128 China’s Global Disruption

depreciation. Currency depreciation is driven by market forces, but devaluation is

driven by policy intention. When different economies pursue QE, a currency war
ensues. This was what happened in the post-subprime-crisis years.
In other words, the main driver of currency movements (war) in recent years
has been the various monetary policies of the world’s major central banks. The
US Federal Reserve, the Bank of England , the Bank of Japan (BoJ) and the
European Central Bank were all trying to grow their economies out of the
problems by QE, thus also pushing down their currencies to generate growth
momentum from exports. These were just the major central banks. By the mar-
ket’s estimates, there were 38 central bankers around the world engaging in
money printing during the currency war episodes between 2010 and 2013, thus,
contributing to intensifying and sustaining the currency war.
A currency war leads to higher foreign exchange (FX) volatility, thus increasing
FX risk and the cost of cross-border transactions. Higher hedging costs, plus the
negative impact of a strong currency, will squeeze the profit margins of exporters
in the non-devaluing countries, prompting companies to focus on their home
markets at the expense of international markets, thus dampening global trade. It
will also discourage foreign direct investment (FDI) flows and strengthen the home
bias for capital flows, increasing the cost of capital in countries that run current
account deficits. In the end, a currency war only leads to heightened FX volatility
exacting a toll on international trade and capital flows. The more intense the
competitive devaluation, the higher is the cost in terms of hedging and trade
contraction and slower economic growth. It is a negative sum game.

The Currency War Game

So why do governments still engage in currency wars? Was China dragged into
the battlefield, and will it play the currency war game in the future? The ‘pris-
oner’s dilemma’ framework of Game Theory (Bonanno, 2018) helps us analyse
FX policy decisions and sheds some light on China’s strategic decision in the
currency war. Those who are familiar with the prisoner’s dilemma theory may
skip the following digression and jump directly to the currency war game section.

Prisoner’s Dilemma – A Digression

The prisoner’s dilemma is the best-known game of strategy in social science. It
helps understand what governs the balance between cooperation and competition
in business and finance, in politics and in social settings. The theory shows why
even rational economic agents might not cooperate, even if it appears that it is in
their best interests to do so.
Let us assume there are two members of a criminal gang, A and B. They are
arrested and locked up in separate rooms so that they cannot communicate with
each other. The prosecutors do not have enough evidence to convict the pair on
the principal charge. But they hope to lure them to tell the truth and give each
prisoner a choice.
 China and the Currency War 129

Each prisoner is given the opportunity either to betray the other by testifying
that the other committed the crime or to remain silent. Here is the offer:

• If A betrays B, but B remains silent, A goes free and B gets three years in jail.
• On the contrary, if A remains silent and B betrays him, A gets three years,
while B goes free.
• If A and B betray each other, each of them gets two years in jail. For A, this is
still better than staying silent and getting three years alone when B betrays him;
the same incentive goes for B.
• If A and B both remain silent, each of them gets 1 year in prison.

The dilemma can be depicted by the following matrix:

The Prisoner’s Dilemma

Prisoner B betrays Prisoner B stays silent

Prisoner A betrays Each gets 2 years Prisoner B get 3 years

Prisoner A goes free

Prisoner A stays silent Prisoner A gets 3 years Each gets 1 year

Prisoner B goes free

The crux of this dilemma is that neither prisoner knows what the other will do.
So no matter what the other decides, each prisoner gets a higher pay-off by
betraying the other. It is obvious that among the choices, betrayal is the best
strategy for both A and B. So both prisoners should opt for betraying each other
and would get 2 years in jail each, even if staying silent would yield a better
outcome of only 1 year in jail each.
The prisoners’ dilemma has applications to economics, business and politics.
Arms races between superpowers or local rival nations offer another example of
the dilemma. Both countries are better off when they cooperate (stay silent, in our
example above) and avoid an arms race (betrayal, in our example above). Yet the
dominant strategy is for each to arm itself heavily.

The Currency War Game

This certainly has relevance to analysing the currency war. Let us assume two
countries, Europe and Japan, do not communicate with each other on their FX
policy moves. Each has the option to either devalue its currency or stay put. Let
us further assume the game delivers the pay-offs depicted in Table 8.1.
• If Europe devalues but Japan stays put, Europe gets 1% growth and Japan
contracts by 2%, as Europe will be better off by attracting FDI and boosting
exports and, thus, GDP growth at the expense of Japan.
130 China’s Global Disruption

Table 8.1. The Prisoner’s Dilemma of Currency War.

Europe devalues Europe stay put

Japan devalues 21 for Europe 22 for Europe

21 for Japan 1 for Japan
Japan stays put 1 for Europe 0 for Europe
22 for Japan 0 for Japan
Source: author

• For the same reasoning, if Europe stays put and Japan devalues, its growth
shrinks by 2%, while Japan gains 1%.
• If both devalue together, each country’s growth shrinks by 1% because any
gains in competitiveness will be offset by higher FX risk, which will reduce
FDI, trade and economic growth for both countries. For Europe, this is still a
better outcome than staying put and getting -2% growth alone if Japan
devalues. The same incentive goes for Japan.
• If both stay put, there is 0% growth impact for both.

The crux of this dilemma is that neither country knows what the other will do.
Hence, no matter what the other decides, each country gets a higher pay-off by
devaluing its currency to play safe. Strategically, devaluation is the best choice for
both Europe and Japan. So both countries have a strong incentive to devalue,
even though that would make them both suffer 1% growth contraction, and even
though staying put would yield a better outcome of 0% growth for each. When
more than two countries are playing this game, the increase in FX volatility, risk
and hence cost on capital flows and economic growth is much higher.

China’s Devaluation Choice

The last episode of the currency war around 2013–14 was fought between the US
dollar and the renminbi. The renminbi’s trade-weighted exchange rates had been
rising sharply, and China’s weak growth in 2015 and intensifying deflationary
pressures were creating concerns among senior Chinese officials about the strong
renminbi damaging the local economy. Indeed, both of China’s nominal and real
effective exchange rates had risen for more than a decade, but the rate of
appreciation had sped up since the global currency war started in 2010. Hence,
some market players were predicting that China would join the currency war by
devaluing the renminbi to find an escape route for its weak growth (Taylor, 2019).
According to the prisoner’s dilemma analysis, China should have all the strategic
incentives, reinforced by its weak economy, to play the currency war game. Evidence
also shows that the People’s Bank of China (PBoC) intervened to push down the
renminbi exchange rate, as seen in the sharp rise in the PBoC’s foreign asset accu-
mulation without sterilisation, before it widened the renminbi’s trading band in mid-
 China and the Currency War 131

Fig. 8.1. Growth Contribution of China’s GDP Components.

March 2014.2 This had led many observers jumped to the conclusion that the PBoC
had changed its FX policy to devalue the RMB as a way to boost growth. But as we
shall explain below, the renminbi band-widening move was not a devaluation move;
it was a currency reform move taking advantage of the currency war. In fact, China
resisted to devalue the renminbi in those currency war years, and it is still sticking
with the no-devaluation policy today. Why?
Here is where rational decision meets strategic consideration. Rationally, Bei-
jing should resist the devaluation temptation (and it did) because it would not
significantly help Chinese exports and economic growth, as the external sector has
not contributed to China’s GDP growth since 2009 (Fig. 8.1). Any devaluation
benefits would thus be small. China’s economy has already moved from export-led
growth to domestic-led growth since 2009. Structural reforms and financial lib-
eralisation are meant to improve resources allocation within the domestic sector so
that it can transit from investment-led growth to consumption-led growth.

2
Sterilisation, in macroeconomics, is an action taken by a country’s central bank to counter
the effects on domestic money supply caused by capital inflows (or outflows) due to a
balance of payments surplus (or deficit). This commonly involves open market operations
by the central bank to neutralise the impact of FX intervention on domestic money supply.
For example, when massive capital inflows are pushing up the exchange rate, but the
central bank wants to keep the exchange rate stable, it can intervene in the market by
buying FX with the local currency, thus accumulating foreign assets. But this action
increases domestic money supply, which will threaten to boost inflation. So the central
can sterilise its intervention effect by selling enough financial securities (typically
government notes and bills) to absorb the excess money supply resulted from the FX
intervention.
132 China’s Global Disruption

Furthermore, the renminbi had risen by more than 30% against the US dollar
and 40% in real effective exchange rate terms between 2005 and 2014. Meanwhile,
wages had soared, while productivity growth had slowed. A small devaluation
would not make any difference to China’s export competitiveness, while a large
devaluation, say more than 20%, would not be tolerated by the international
community. Any devaluation move could also accelerate capital outflows due to
expectations of further devaluation, and exacerbate the financial burden of those
Chinese companies with large and unhedged foreign currency (mainly US dollar-
denominated) debt.
One might argue that China needed a weak currency to combat the defla-
tionary forces that had plagued the economy. This argument made no sense.
China has experienced periodic deflation since the early 2000s (Fig. 8.2), but the
renminbi has kept appreciating, while economic growth kept humming along. The
evidence argues that exchange rate was not a necessary tool for combating
deflationary pressure in China’s case.
Since President Xi came to power in 2013, China has chosen to engineer a
growth slowdown to force through some structural reforms. It has other policy
options to boost growth, and renminbi devaluation is not key among these
options because of the greater domestic bias in the new Chinese economy.
Granted, the exchange rate could be an auxiliary tool to strike a balance between
growth and structural reforms. Under a balance of payments surplus, as is the case in
China, FX intervention to keep the renminbi from rising, including to force a
temporary renminbi devaluation, due to the external accounts surplus would boost
growth in the near term via the liquidity spillover from the FX intervention to the
domestic system but not so much through the devaluation effect on exports.

Fig. 8.2. China’s Inflation.

 China and the Currency War 133

However, this was (and still is) not enough a big incentive for China to pursue a
devaluation policy. From a reform perspective, a strong renminbi is a macroeco-
nomic policy tool for Beijing to push through structural reforms in one stroke,
effectively riding roughshod over detailed microeconomic measures that are facing
strong resistance from the country’s reactionary forces. From a market perspective,
if we consider Beijing’s FX policy in the context of the prison’s dilemma that it is
facing in the currency war environment, a policy shift to devalue the renminbi, and
triggering a currency war, would only be a tail risk with a low probability of
materialising.3

Risk Implications
If China were to join the currency war at that time, it could have triggered
competitive devaluation in Asia (but evidence showed that no such competitive
devaluation happened, implying that China did not play any currency war) due to
the increasing number of Asian currencies that had been closely tracking the
movement of the renminbi. Technically, this situation is equivalent to the emer-
gence of a renminbi bloc in Asia.
Before 2016, China had two periods of renminbi flexibility when Beijing
allowed the currency to ‘float’ within a wider trading band against the US dollar:
the first ran from June 2005 to June 2008, the second was between June 2010 and
2015 (Fig. 8.3). In the second period of flexibility, empirical evidence shows that
the number of Asian currencies tracking the renminbi movement had increased
compared to the first period of flexibility. Meanwhile, the number of Asian cur-
rencies tracking the movement of the US dollar and the euro had fallen.
Crucially, the correlations between the movement of the renminbi and major
Asian currencies had also increased between mid-2010 and 2015 compared with the
first period of flexibility, with eight out of the nine Asian currencies in my analysis
here seeing increased correlation (Fig. 8.4). This implied that the Asian major
currencies had been tracking the renminbi’s movement more closely than before.
The rise of a renminbi bloc in Asia is a natural result of China’s increasing
economic ties with the region. Countries that trade with China or are part of the
supply chains centred on China have a strong incentive to minimise exchange rate
volatility against the renminbi than against the US dollar and/or the euro.
Market forces drove down the renminbi exchange rate before the PBoC’s
band-widening move in 2014, as the market turned bearish against the renminbi
due to a dimming China’s growth outlook. The PBoC reduced its intervention in
the FX market to allow more market forces to play in determining the exchange
rate. This was not a devaluation move, but part of the reform efforts to liberalise
the exchange rate regime by making renminbi trading ore flexible.

3
Technically, a tail risk is a form of portfolio risk that arises when the possibility that an
investment will move more than three standard deviations from the mean is greater than
what is shown by a normal distribution. In general, tail risks refer to events that have a
small probability of occurring, and occur at both ends of a normal distribution curve.
134 China’s Global Disruption

Fig. 8.3. Renminbi–US Dollar Exchange Rate.

Fig. 8.4. Change in Correlations of Asian Currencies with Renminbi,

US Dollar and Euro between Period 1 and 2 of Renminbi Flexibility.

Did China Join the Currency War After 2015?

The worry about China devaluation intensified again in 2016 when the renminbi
dropped the most against the US dollar among its Asian peers, aggravating Asia’s
economic challenges in the face of a strong US dollar at the time. This led many
 China and the Currency War 135

market players wondered if China had finally joined the currency war (Gillespie,
2016).
The US dollar had risen steadily since the US Federal Reserve started to scale
back its QE in late-2013. Subsequent Fed rate hikes and the victory of Donald
Trump in the US presidential elections had accentuated the US dollar bull-run
(Fig. 8.5). As a result, most Asian currencies fell against the US dollar in 2015 and
2016, with the renminbi dropping the most (Fig. 8.6).
In the past when the renminbi was held steady against a strong US dollar,
Asia’s currency depreciation provided a competitive boost to the regional econ-
omies. We can see this from three episodes. Since the 1998–99 Asian Financial
Crisis, there have been three periods of sharp Asian currency depreciation: the
bursting of the US high-tech bubble in the early 2000s, the US subprime crisis in
2007–08 and the sell-off around the 2013–14 when the United States started
talking about reversing QE. In each of these cases, the renminbi either stayed put
or continued to rise when the Asian currencies fell sharply against the US dollar
(Fig. 8.7).
However, in the 2016 round of US dollar strength, the renminbi led the cur-
rency sell-off in Asia and, thus, squeezed the competitiveness of Asian exporters.
The rule of the game seemed to have changed, prompting suspicion that China
might have finally succumbed to the pressure of currency devaluation after
holding out for so long.

Fig. 8.5. USD Trade-weighted Exchange Rate.

136 China’s Global Disruption

Fig. 8.6. Annual Change of Exchange Rates against the US Dollar in

2016.

Fig. 8.7. Asian and Renminbi Exchange Rates against the US Dollar.

Devaluation Will Backfire on China

Arguably, despite the changes in the capital flow dynamics in China’s capital
account over the years, renminbi devaluation is still not in China’s best interest.
Devaluation could backfire on China, which is the world’s second largest econ-
omy that runs one of the world’s largest trade surpluses. Developing economies
that devalued successfully were much smaller in size, so the global system could
 China and the Currency War 137

easily absorb the increase in their exports. They also devalued after their over-
valued currencies had caused persistent large current account deficits.
But China was too big to be absorbed. There was also no evidence for an over-
valued renminbi. Those who argued that the renminbi was overvalued and, thus,
needed a devaluation were being ignorant because with a closed capital account,
there is no way to estimate the renminbi’s fair value and compare it with the market
exchange rate to gauge the renminbi’s over-valuation or under-valuation.
From the current account’s perspective, a renminbi devaluation would not
work as intended because China is a surplus country. Rather than boosting
growth, a weak currency makes a current account surplus country more precar-
ious. This is because in deficit countries where the shortage of domestic savings
forces them to fund domestic investment by foreign savings, slowing growth
destroys confidence and scares off foreign capital. This contraction in foreign
funding, in turn, forces domestic investment to fall. Currency devaluation may
help offset or cushion this negative impact on growth in deficit countries by
increasing savings.
Devaluation reduces real household disposable income and, hence, consump-
tion, so that its share of GDP falls. By the definition of national income
accounting, the share of household savings should rise when the share of con-
sumption falls at a given level of GDP. Typically, this happens when the deval-
uation increases the profitability of the tradable goods sector (i.e., exports), which
increases the saving of this sector, in addition to the increase in household saving
due to the fall in consumption. In other words, currency devaluation redirects
income from consumption to savings. The rise in domestic savings reduces the
country’s dependence on foreign capital and, thus, boosts investment even when
foreign inflows decline.
However, devaluation does not work for surplus countries the same way
because they do not suffer from saving deficiency; and China’s national savings
were excessive at 50% of GDP in 2016. Devaluing the renminbi would thus
depress the already-low domestic consumption and increase the country’s already-
excessive investment and reliance on exports to release the excess capacity.
The point is that for surplus countries, devaluation replaces consumption
demand with investment demand and trade surpluses. If exports are constrained
by weak global demand, as is the case since the 2007–08 subprime crisis, deval-
uation will not help boost economic growth but only make the country’s
consumption–investment imbalance more serious.
From China’s perspective, this result would certainly go against the purpose of
its economic rebalancing from investment-led to consumption-led. So Beijing was
right to resist renminbi devaluation. But keeping a stable, and dear, renminbi also
means pains for China’s export and manufacturing sectors, especially when it is
losing the comparative advantage of cheap labour to its Asian neighbours. Well,
this is typically the cost of structural rebalancing, and a bullet that Beijing has to
bite.
From the global perspective, in a world with growing trade tensions and
persistent weak demand, if Beijing were to pursue a devaluation policy, it would
likely ignite more currency wars, encourage trade protectionism and risk turning
138 China’s Global Disruption

back the process of globalisation. Hence, even though strategic positioning (as per
prisoner’s dilemma analysis) argues that Beijing would choose to join the currency
war, practically it had not.
Evidence also does not support the devaluation view. It was market forces that
pushed down the renminbi, not a policy move. The most important driver for the
decline in the renminbi exchange rate in 2015 and 2016 was capital outflows from
China (see Chapter 5). There were not a lot of foreign portfolio outflows from
China, but domestic outflows were large.
These were driven by several factors: (1) Chinese households and companies
starting to diversify their assets offshore, especially amid concerns about a
domestic asset bubble and diminishing marginal returns on investment, (2) Beijing
pushing for renminbi internationalisation and a ‘going out’ investment strategy
(but that had also prompted unwanted (illegal) capital outflows), (3) Chinese
companies repaying foreign liabilities since mid-2016 and (4) market players
expecting further renminbi depreciation.

Currency War Prompts Renminbi Reform

Arguably, China has used the competitive devaluation environment to reform its
FX regime – to make the renminbi exchange rate more flexible and closer to the
influence of market forces. But many market players have taken China’s reform
incentive as a clue for joining the currency war. This is wrong, as there has been
no proof of policy shift to devaluation by Beijing so far, as we shall discuss in the
next chapter, but the incentive to reform the renminbi exchange rate regime, to
make it more market-driven, has grown over time.
Until 2015, Beijing persistently targeted a stable renminbi–US dollar exchange
rate to help keep Chinese export competitive. Meanwhile, the renminbi’s nominal
effective exchange rate (NEER) was volatile and bore a strong negative corre-
lation (20.65) with Chinese export growth.4 Targeting the US dollar made sense
during those early years because the United States and US dollar–bloc countries
were China’s largest export markets, and the dollar had the biggest weight in the
renminbi’s trade-weighted FX basket.5
Between 2013 and 2015, Chinese companies also increased significantly their
foreign borrowing, mainly in US dollar. An estimated 80% (or USD9.5 trillion)
of China’s corporate foreign debt (almost 130% of GDP in 2014) was denomi-
nated in US dollar. That meant that any wide fluctuations of the renminbi–US
dollar exchange rate would increase the FX risk/burden of these Chinese com-
panies that had accumulated unhedged US dollar–denominated debt. So a stable

4
The NEER is an unadjusted weighted average rate at which one country’s currency
exchanges for a basket of multiple foreign currencies. The NEER is an indicator of a
country’s international competitiveness. FX traders sometimes refer to the NEER as the
trade-weighted currency index.
5
US dollar–bloc countries refer to those countries that use US dollar to settle their
international transactions.
 China and the Currency War 139

renminbi–US dollar exchange rate was important for preserving China’s finan-
cial stability.
However, things have changed since 2015 and rendered this stable renminbi–
US dollar FX policy obsolete. China’s trade with the United States and US
dollar–bloc economies have dropped steadily, albeit slowly, from over 82% of its
total foreign trade in the mid-1990s to about 74%, eroding the importance of the
US dollar in the renminbi’s trade-weighted FX basket. Beijing has also been
pushing for using the renminbi as an international trade settlement currency since
mid-2009, and the renminbi derivatives market has also started to take shape. All
this has eroded the importance of the US dollar for China.
Over time, the diminishing significance of the dollar in China’s foreign trade
argues for an end to targeting the renminbi–US dollar exchange rate and a policy
shift towards targeting the renminbi’s NEER (due to its strong negative corre-
lation with Chinese export growth). Indeed, Beijing took a step to de-linking the
renminbi from the US dollar by announcing in 2016 that it would use the trade-
weighted renminbi index, the China Foreign Exchange Trade System (CFETS)
index, as a reference for conducting its FX policy. In other words, since 2016,
Beijing has not solely targeted a stable renminbi–US dollar exchange rate as it did
in the past; it has shifted to a duel-targeting policy of both the US dollar and the
trade-weighted exchange rate.

Japan Aggravating the Currency War…

Back in April 2013, the BoJ added fuel to the currency war by announcing that it
would inject the equivalent of USD1.4 trillion into the Japanese system in two
years. That is, it would expand its balance sheet from 35% of GDP in 2012 to 60%
by the end of 2014. The policy caused the Japanese yen to depreciate sharply,
including against the renminbi.
The irony was that Japan was launching a new round of QE when the United
States was ending its QE. This created a policy divergence which Japan was
loosening up monetary policy significantly, while the United States was starting to
tighten up. From an FX perspective, this divergence was positive for the US
dollar (i.e., it would cause the US dollar to rise against the yen and, hence, against
other currencies also) and negative for the yen (i.e., it would cause the yen to fall
against the dollar and other currencies).
In the wake of QE, Japanese capital flowed abroad in search of higher returns.
Evidence suggested that the key destinations for Japanese capital outflow were the
emerging Asian economies, including China. Experience also suggested that the
BoJ’s monetary easing was more powerful in affecting Asian liquidity than the
Federal Reserve’s policy tightening. This was manifested in Asia’s soaring debt
growth in the 1990s and 2000s when the BoJ was expanding money supply
earnestly. After Japan’s asset bubble burst in 1990, the BoJ resorted to zero
interest rates to save its economy. At the time, the Federal Reserve also engaged
in significant monetary easing to soothe the economic pains in the United States
140 China’s Global Disruption

Fig. 8.8. US vs Japanese QE Impact.

after its Savings & Loans Crisis. These aggressive monetary actions prompted
capital flows to Asia looking for better returns.
Then the Federal Reserve started a two-year rate hike cycle in 1994 to rein in
the risk of an economic bubble. Global liquidity contracted. However, thanks
largely to the sustained monetary easing by Japan that triggered massive Japanese
capital outflows to Asia in search for better investment opportunities, Asia’s credit
growth continued to soar in the face of United States’ policy tightening (Fig. 8.8).
The same thing happened in the 2000s. To fight deflation, the BoJ expanded its
balance sheet significantly between 2001 and 2006, adding liquidity pressure on
the BoJ’s zero-interest-rate-policy that was already in effect since 1998. The wall
of money flooded the Japanese system, crushing Japanese borrowing cost towards
zero and forcing a large amount of global (including Japanese) capital into Asia
through the yen carry trade activity. Interest rate hikes by the Fed, which totalled
4.25 percentage points between 2004 and 2006, only aggravated the carry trades
and pumped more liquidity into Asia, boosting regional credit growth in the face
of higher US interest rates (see Fig. 8.8).

… Opening a Window for Renminbi Reform

The point of all this is that the Japanese QE action aggravated the upward
pressure on the renminbi trade-weighted exchange rate, which was already rising
rapidly since the United States started its QE in 2008 (Fig. 8.9). Owing partly to a
concern that FX intervention to weaken the renminbi would boost domestic
inflation and partly to a willingness to tolerate a stronger renminbi to force
economic restructuring from export-led to domestic-led growth, China’s PBoC
 China and the Currency War 141

Fig. 8.9. Renminbi Trade-weighted Exchange Rates.

reduced its market intervention and allowed the renminbi to appreciate under
market forces, albeit still within the trading band around the PBoC’s daily
fixing.6,7 This was seen in the sharp decline in the growth of the central bank’s
assets accumulation after 2008 (Fig. 8.10).
As a result, the onshore renminbi spot rate appreciated under market forces to
the ceiling of the official trading band (Fig. 8.11). In other words, the PBoC was
allowing market forces to drive up its daily fixing, since the fixing was calculated
as the average of the past 10 trading days’ closing rates.8 This was a fundamental
departure from the PBoC’s past policy practice when it tightly controlled the
onshore renminbi spot rate and prevented it from deviating from the fixing. Since
2012, both the frequency and the extent of deviation from the fixing have greatly
increased (Fig. 8.12). The increase in the renminbi’s flexibility is a structurally
positive sign for China’s FX reform, moving it a step towards market-determined
exchange rate.
But what happened in August 2015, when the PBoC allowed the renminbi to
drop unexpectedly more than 3% drop against the US dollar in just one day? That
move had again led many market players to argue that the PBoC had shifted to a

6
The trading band was expanded in March 2015 to 1/-2% around the PBoC’s daily fixing.
7
Every morning before the FX market opens, the PBoC sets a so-called daily mid-point
fixing, based on the renminbi’s previous day closing rate against the US dollar plus other
market factors considerations and quotations taken from interbank dealers. The market
then starts trading the renminbi–US dollar pair based on the fixing rate, and the day’s
trading is allowed to fluctuate within the official trading range, which has been set at 2%
above and below the fixing since March 2015.
8
The PBoC changed the calculation of the renminbi–US dollar fixing in August 2015 to
make it based on the market closing exchange rate of the previous trading day plus some
other market factors considerations.
142 China’s Global Disruption

Fig. 8.10. Growth in the PBoC’s Assest.

Fig. 8.11. Renminbi Reform Process.

devaluation policy that would ignite another round of currency war. With
hindsight, no current war was triggered. More importantly and contrary to
conventional wisdom at that time, it was not a devaluation move by the PBoC.
The change was a policy shift in breaking the renminbi away from the US dollar’s
 China and the Currency War 143

Fig. 8.12. Deviation of Onshore Renminbi Spot Rate from PBoC

Daily Fixing.

dominance by making the renminbi more market-driven. This was part of China’s
capital account reform efforts to force a major overhaul of the FX regime.
The PBoC surprised the markets on 11 August 2015 by changing its daily
fixing mechanism suddenly, and that led to a more than 3% decline in the
renminbi exchange rate against the US dollar (see Fig. 8.11). The fixing has since
been based on the previous day’s average market closing rate quoted from the
CFETS, instead of on the moving average closing rates of the past 10 trading
days, as in the old system.9 But the PBoC has retained the discretion to adjust the
ultimate fixing according to market demand and supply conditions.
The conventional wisdom at that time for such a move was devaluation, under
the guise of FX reform, to boost exports and, hence, economic growth. This was
unlikely, in my view. Firstly, China’s economic weakness was not as dire as many
observers thought. China’s growth started slowing down in 2013, and if the
growth situation was so dire, why did Beijing wait until late 2015 to make the FX
policy shift, and why did it not devalue the renminbi by much more than a paltry
3%? The fact was that China was making a transition to a new growth model,
with the tertiary sector growing faster and larger than the secondary sector since
2013 (Fig. 8.13).
This economic restructuring process is inherently contractionary in the
medium term as the growth of the new economic activities in the tertiary sector is
typically not strong enough to completely offset the decline in the traditional
industrial and manufacturing sectors. Expanding demand for services, such as

9
The onshore FX market made up by 35 large banks designated by the monetary
authorities.
144 China’s Global Disruption

Fig. 8.13. China’s Economic Restructuring.

health care, education, tourism, entertainment and financial products, is less

dependent on expanding industrial output, investment and exports, and less
demanding for power consumption, raw materials and freight. Hence, the decline
in traditional macroeconomic output indicators that many observers focussed on
reading was giving a distorted picture of China’s growth and, thus, misled the
conventional wisdom.
Secondly, and more crucially, devaluation is not an effective tool for boosting
Chinese exports and, hence, GDP growth (as I argued above and see Fig. 8.1). I
ran a regression on China’s export growth using the renminbi exchange rate and
global demand (as approximated by European and the US industrial output
growth) as the explanatory variables (see Box 8.1).
The evidence shows that the predominant factor affecting Chinese export
growth was global demand, not the exchange rate. Furthermore, the impact of
global demand on Chinese export growth was 20 times bigger than the exchange
rate impact. In other words, China’s exports did not really need a cheap renminbi.
If devaluation were to give Chinese exports a competitive boost, my estimate
shows that the renminbi would have to be devalued against the US dollar on a
sustained basis by 20% to 40%, depending on the currency-weight assumptions
used. This would potentially create an unacceptable global financial shock.

It’s all About Reform

Rather, the move to change the daily fixing mechanism was a step towards
renminbi liberalisation as China moves towards the ‘Impossible Trinity’ para-
digm, where the opening of China’s capital account was forcing it to choose
 China and the Currency War 145

Box 8.1 Impact of Renminbi Exchange Rate and G2 Demand Growth on

Chinese Exports

Xt ¼ b0 1 b1 RMBt 1 b2 IPt 1 et

where Xt 5 China’s export growth.

RMBt 5 RMB/USD exchange rate %YoY change.
IPt 5 US and EU’s industrial output growth.

OLS Regression Results:

Coefficient t-stats
Intercept (ß0) 14.83 15.26 Adjusted R-squared:
0.52
RMB/USD %YoY(ß1) 20.11 20.37 Observations: 179
(from 1999 to 2014)
EU 1 US IP growth (ß2) 2.13 13.83

Experiment with different (2–3 month) lags yielded similar results, but with
the wrong signs for the renminbi coefficient. Data Sources: CEIC, IMF,
author.

between retaining monetary autonomy (or controlling the interest rate) and
controlling the exchange rate. The evidence we have seen so far shows that Beijing
was choosing to retain monetary autonomy by letting go of the exchange rate.
Rationally, this is the preferred choice because China’s large continental economy
will allow it to conduct more effective monetary policy in managing domestic
demand than small open economies, such as Hong Kong and Singapore, where
international factors often overwhelm the influence of monetary policy on the
domestic economy.
This means that opening the capital account, or the advent of Impossible
Trinity, is forcing China to pursue a major overhaul of its economic, financial and
policy frameworks. Beijing’s move to reform the fixing mechanism was another
step to making that change. In the currency war episodes since 2014, most
observers have got it all wrong in looking at China’s currency reform and its
impact on the world.
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Chapter 9

From Trade War to Global Disruption

The Sino–US trade war that started in 2018, which is still ongoing at the time of
writing, is one of the largest disruptions that has both short- and long-term
implications on the global system. It will not go away because this trade con-
flict is not just about economics but also about strategic competition between the
two global powers fought over technology and national security grounds. From
this perspective, the United States is also creating global disruptive forces notably
through President Donald Trump’s mercurial policy approach (Bauer, 2017).
While conventional wisdom sees his erratic policies as un-systematic and as acts
without thorough strategic considerations, I beg to disagree.
In the trade war environment, both China and the United States could be the
culprit for triggering a currency war among other economic and financial disrup-
tions. There will be collateral damages on other ‘innocent by-stander’ economies as
well as on the United States, despite the US Administration’s perception that China
would be the biggest loser. However, there is no evidence on China shifting to a
currency devaluation policy (see below).
In the longer term, both China and the United States seem to be striving for
on-shoring the globalised production chains built over the past three decades, with
China doing it through import substitution (Long, 2010; Poon, 2014) to minimise
the foreign share of its industrial base and the US via America-first policies
(Calamur, 2017b). Even partial success of these initiatives could be damaging.
Firstly, the breaking up of the global supply chains will likely bring back
inflation by reversing the disinflationary forces brought about by globalisation.
Secondly, and arguably, cross-border production chains are a force for peace and
stability as they raise the cost of armed conflicts. Reverting back to national
production structures raises the possibility that big countries would try to settle
their differences by force. At this point, it may be too early to be alarmed but the
direction is worrying.

From Global Imbalance…

The Sino–US trade war is a global economic imbalance problem that cannot be
resolved by imposition of tariffs alone, as US President Trump incorrectly

China’s Global Disruption, 147–163

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211010
148 China’s Global Disruption

believes (McBride & Chatzky, 2019). It is an imbalance between China which

suffers from excess savings and the United States which suffers from excess
consumption. In other words, these individual disequilibria have kept the world
economic system in an unstable equilibrium for more than two decades with
China supplying the United States with surplus savings to support America’s
excess consumption. The fundamental solution to this problem is for China to
reduce savings and increase consumption and for the United States to increase
savings and reduce consumption. China is working on its economic restructuring,
but what about the United States?
The irony is that China’s economic rebalancing per se is a disruption to the
global status quo. China was an export-led economy, reflecting its excess savings
problem, while the American consumer was its largest customer, reflecting the
United States’ savings deficiency problem. However, China has moved away from
its export-led growth to domestic-led growth since 2009, as seen in the net exports’
negative contribution1 to China’s GDP growth (Fig. 9.1).
In this process of growth rebalancing, China has moved up the value-add
ladder, shed processing trade and low-value exports and become the centre of the
global supply chains by supplying an increasing amount of intermediate goods to
the world. This means that China is reducing its role as an intermediate goods

Fig. 9.1. Growth Contribution of China’s GDP Components.

1
GDP, by definition, is the sum of private consumption, government spending, investment
and net exports. A negative contribution of net exports to GDP growth means they are
dragging on growth instead of boosting it.
 From Trade War to Global Disruption 149

demander and increasing its role as an input supplier (see Chapter 1). This
structural change dynamics inevitably disrupts the global trade structure but in a
benign way that it encourages international trade growth and division of labour.
Meanwhile, the United States has remained the world’s largest consumer. It still
depends heavily on China (and other emerging markets (EMs)) to provide low-cost
goods to Americans to help them live within their means. From a macroeconomic
perspective, this means America still depends heavily on China to fund its twin
(current account and fiscal) deficit through heavy buying of US assets. Mr Trump
disrupted this global relationship by waging a trade war with China in 2018.

… To Currency War
Trade conflicts are risking another round of currency war. Suspicion about
China’s central bank shifting to a currency devaluation policy to fight the trade
war with the United States intensified in mid-2018 when the Sino–US trade
tension escalated. Indeed, when President Trump criticised China (and Europe)
on 19 and 20 July 2018 for manipulating their currencies to gain competitive
advantages (Cox, 2018), the People’s Bank of China (PBoC) set the renminbi–US
dollar fixing2 on 20 July almost one percent weaker than the previous closing.
This led many market players argued that Beijing had shifted to a currency
devaluation policy to fight the trade war.
But this devaluation narrative does not stand up to scrutiny. Let us test it by
examining the PBoC’s action through the fixing. There are three parts to the
renminbi fixing:

(1) The renminbi–US dollar spot closing rate as of 4:30p.m. of the previous
trading day.
(2) The average of the 24-hour daily changes in the US dollar against the cur-
rencies in the CFETS basket, the BIS renminbi basket and the IMF SDR
basket.
(3) A ‘Countercyclical Factor (CF)’ which represents the PBoC’s discretion in
adjusting the fixing based on its judgement on the foreign exchange (FX)
market’s demand and supply conditions, risk appetite and international
developments.

The third part of the fixing was always there but was formalised as the CF in
May 2017 for Beijing to manage FX volatility that is not reflected by economic
fundamentals. The first two parts of the fixing represent the renminbi’s movement
that is driven by market forces. The CF is a policy factor that holds the clue to
assessing whether the PBoC engages in devaluation or not.
The first two parts of the fixing are observable, but the CF is not because the
PBoC has never disclosed its calculation. But we can estimate the CF by making
the following observations and assumptions:

For explanation of the fixing, see footnote 7 in Chapter 8.

2
150 China’s Global Disruption

The fixing is determined by market forces plus the policy factor CF, as
reflected by

(1) the previous day’s (denoted as ‘t-1’ below) closing of the renminbi–US dollar
cross-rate, represented by DoD% of (renminbi–US dollar)t-1 in the equation
below
(2) the previous day’s average change of the three currency baskets monitored
by the PBoC, represented by average DoD% of (CFETS, BIS, SDR)t-1 in the
equation below
(3) the CF on the day (denoted as ‘t’ below) when the fixing is set, represented by
CFt below.

If we assume that the first two factors carry equal weights in the fixing
calculation, this implies
PBoC Fixingt ¼ DoD% of ðrenminbi 2 U:S: dollarÞt 2 1
1 average DoD% of ðCFETS; BIS; SDRÞt 2 1 1 CFt

The only unknown here is the CF.

We can do a back-calculation to estimate the CF by subtracting the
renminbi–US dollar exchange rate implied by market forces (which is calculated
from the previous day’s closing of renminbi–US dollar rate and the average
change of the currency baskets) from the PBoC’s fixing, i.e.,
CFt ¼ PBoC Fixingt
2 faverage DoD% of ðCNY 2 USDÞt 2 1 1 ðCFETS; BIS; SDRÞt 2 1 g
|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}
Implied market forces

When the renminbi is weakening and if the CF is negative, it means that the
PBoC is using the CF to force the fixing to go against the market trend, though not
necessarily overwhelming and reversing it, to make fixing stronger. For example,
according to the data, market forces implied a renminbi–US dollar cross-rate of
6.855 on 20 July 2018, but the PBoC set the fixing at 6.759 that morning, or 0.095
stronger than what market forces would warrant (6.759–6.855 5 20.095).
Conversely, if the CF is positive when the renminbi is weakening, the PBoC is
using it to lead market forces, thus discerning a policy of pushing the currency
along the market direction to a weaker level than market forces would imply.
On the contrary, when the renminbi is strengthening and if the CF is positive,
it means that the PBoC is using the CF to set the fixing weaker to prevent the
renminbi from rising as strongly as market forces would warrant. And if the CF is
negative when the renminbi is strengthening, the PBoC is using it to lead market
forces to push the currency stronger than market forces would imply.

No Proof of Devaluation
In terms of a devaluation policy, we should see positive CF values as the PBoC
would have set the fixing higher (i.e., pushing the renminbi weaker) against the
 From Trade War to Global Disruption 151

US dollar than what market forces would imply. A one-off devaluation should be
reflected by a big positive jump in the CF value. But my estimation shows clearly
that in the second-half of 2018 when speculation of devaluation was rampant
when the renminbi was weakening, the PBoC used the CF to lean against the
market depreciation trend (Fig. 9.2), as the estimated CF had developed a
negative trend since June; i.e., the PBoC was trying to slow down the pace of
renminbi depreciation by supporting it instead of pushing it lower.
On the other hand, when the renminbi was rising strongly against the US dollar
between late 2017 and May 2018, the CF was also rising sharply, indicating that the
PBoC was trying to slow the pace of appreciation by setting the fixing higher
(i.e., pushing the renminbi weaker) than the rates implied by market forces. The CF
was indeed doing the job that lives up to its name as a ‘Countercyclical Factor’.
Hence, there was no proof of the PBoC shifting to devaluation in 2018. But it
seemed to use the sharp drop in the fixing on 20 July to send a message to the
markets (and to Mr Trump) that implicit in its no-devaluation pledge was its
ability to do so if it so desired – if it had stepped back from the market, the
renminbi would have fallen even more.
China has chosen a no-devaluation policy so far because devaluation would
not be in its best interest (see Chapter 8). In a nutshell, by bolstering exports,
renminbi devaluation would undermine Beijing’s goal of shifting the economic
structure away from export-led investment-driven growth to consumption-led
service-based growth. Furthermore, any devaluation move would run the risk
of massive capital outflows, echoing the nightmare in 2015–16 when massive
capital outflows put significant downward pressure on the renminbi and wreak
havoc on the global asset markets.

Fig. 9.2. Renminbi–US Dollar Cross-Rate and

Countercyclical Factor*.
152 China’s Global Disruption

However, a persistent US campaign of economic pressure on China has

bolstered the possibility that the United States is on a long-term fight to reduce its
trade deficit possibly using a weak US dollar as a tool. US Treasury Secretary
Steven Mnuchin raised exactly this fear in January 2018 by commenting on the
benefits of a weak dollar (Domm, 2018). Though senior US officials hastily reaf-
firmed a strong dollar policy afterwards, the market had grown sceptical because
cutting the trade deficit was a stated policy goal of the Trump Administration and
cutting the US current account deficit from 4% to 2–3% of GDP would require a
10% decline in the US real exchange rate (Institute of International Finance, 2018).

The Trump Disruption

The much feared global disruption by China has a connection with the United
States’ own role in creating disruptive forces via President Trump’s ‘will-they-or-
won’t-they’ policy uncertainty in driving American foreign and trade policies
(Davis, 2019). His global policy confusion has manifested most clearly in his
dealing with North Korea on the denuclearisation talks in 2017 and in the
Sino–US trade negotiations between 2018 and 2020, when both events created
significant volatility to global markets. While many observers say that he has no
strategic framework for formulating his policies (Yglesias, 2019; Park, 2020), I
think there is much more to the fickle and unpredictable pattern in Mr Trump’s
negotiation tactics that meets the eye.
The Game Theory in economics provides insights into his behaviour and helps
deduce policy and market implications. Let us examine the denuclearisation talks
because it carries important implications for understanding the disruption of the
Sino–US trade conflict. Those who are familiar with the Nash equilibrium
concept can skip the following digression and jump directly to the ‘Why Are We
Confused?’ section.

Nash Equilibrium – A Digression

In game theory, the Nash equilibrium is a solution concept of a non-cooperative
game involving two or more players in which each player is assumed to know the
equilibrium strategies of the other players, and no player has anything to gain by
changing only their own strategy. If each player has chosen a strategy and no
player can benefit by changing strategies while the other players keep theirs
unchanged, then the current set of strategy choices and the corresponding payoffs
constitutes a Nash equilibrium.
Stated simply, A and B are in Nash equilibrium if A is making the best decision
she can, taking into account B’s decision while B’s decision remains unchanged,
and B is making the best decision he can, taking into account A’s decision while A’s
decision remains unchanged. Likewise, a group of players are in Nash equilibrium
if each one is making the best decision possible, taking into account the decisions of
the others in the game as long as the other parties’ decisions remain unchanged.
Informally, a strategy profile is a Nash equilibrium if no player can do better
by unilaterally changing his or her strategy. To see what this means, imagine that
 From Trade War to Global Disruption 153

each player is told the strategies of the others. By knowing the strategies of the
other players, and treating the strategies of the other players as constant, if any
player can benefit by changing his/her strategy, then that set of strategies is not a
Nash equilibrium. But if every player does not want to change strategies, or is
indifferent between changing and not, then that strategy profile is a Nash equi-
librium. In other words, each strategy in a Nash equilibrium is a best response to
all other strategies in that equilibrium.
An example
Consider the following coordination game with two players, two strategies and
a payoff matrix shown as below.

• If player 1 chooses strategy A and player 2 also chooses strategy A, they both
get 4 credits.
• If player 1 chooses strategy B and player 2 also chooses strategy B, they both
get 2 credits.
• If player 1 chooses strategy A and player 2 chooses strategy B, player 1 will
only get 1 credit but player 2 will get 3 credits.
• If player 1 chooses strategy B and player 2 chooses strategy A, player 1 will get
3 credits but player 2 will only get 1 credit.

In both of these cases, the two players should cooperate and choose strategy A,
and they should have no incentive to change their strategies because if both
choose strategy B, each one will be worse off as their payoff will drop from 4 to 2.
It is also obvious that if they do not cooperate and each chooses a strategy
different from the other, one of them will be much worse off (by getting a payoff
of only 1 credit) than if they cooperate and choose the same strategy (both of
them will at least get 2 credits).
So the cooperation between the two players to choose strategy A is a Nash
equilibrium as both players have no incentive to change strategies, given the other
player does not change. However, if both players choose strategy B though, this is
still a Nash equilibrium, even though each player gets less than the (4-credit)
optimal payoff, because neither player has an incentive to change strategy due to
a reduction in the immediate payoff from 2 to 1 if they do not cooperate.
So we have two Nash equilibria in this game, both players cooperate with each
other and choose either strategy A (optimal) or strategy B (sub-optimal):

Player 2 Player 2 adopts Player 2 adopts

strategy A strategy B
Player 1

Player 1 adopts strategy A Player 1 gets 4 credits, Player 1 gets 1 credit,

player 2 gets 4 credits player 2 gets 3 credits

Player 1 adopts strategy B Player 1 gets 3 credits, Player 1 gets 2 credits,

player 2 gets 1 credit player 2 gets 2 credits
154 China’s Global Disruption

Corner Solution (Winner Takes All)

Technically, a corner solution is a special solution to an agent’s maximisation
problem in which the quantity of one of the arguments in the maximised function is
zero. In non-technical terms, a corner solution is when the player is either unwilling
or unable to make a tradeoff. In economics when someone says ‘I wouldn’t buy
that at any price’ or ‘I will do this no matter what’, those are corner solutions. The
word ‘corner’ refers to the fact that if one graphs the maximisation problem, the
optimal point will occur at the ‘corner’ created by the budget constraint and
one axis.
Practically, a corner solution is an instance where the best solution for a
problem, such as maximising profit or utility, or winning a war, or whatever value
is sought, is achieved based not on market-efficient actions to maximise the tar-
geted goals/quantities, but rather based on brute-force boundary conditions.
For example, if the maximum utility of two goods is achieved when the quantity
of goods X and Y are (X 5 22, Y 5 5), and the utility function is subject to the
constraint that X and Y must be non-negative, i.e., X and Y must be greater than
or equal to 0 (one cannot consume a negative quantity of good or sell the good),
then the actual solution to the problem would be a corner solution where X 5 0.

Why Are We Confused?

The trouble with understanding Mr Trump’s erratic behaviour is that we tend to
think rationally about his negotiations with his counterparts reaching a Nash
equilibrium (in the North Korea denuclearisation talks, for example). In Game
Theory, a Nash equilibrium is a solution concept of a competitive game involving
two or more players in which each player is assumed to know the best strategies of
the other players when he/she picks his/her strategy. This also implies an assump-
tion of perfect information in the game. If each player has chosen a strategy and no
player can make further gains by changing strategies while the other players keep
theirs unchanged, then the prevailing set of strategy choices and the corresponding
payoffs constitutes a Nash equilibrium.
Consider two countries, A and B trying to engage each other in denuclear-
isation talks. Their moves are in Nash equilibrium if A is making the best decision
it can, taking into account B’s decision while B’s decision remains unchanged; and
B is making the best decision it can, taking into account A’s decision while A’s
decision remains unchanged. In other words, a strategy profile is a Nash equi-
librium if no player can do better by unilaterally changing his/her strategy.
We tend to think in a Nash equilibrium framework for working out a solution
for the North Korea crisis because there are visible goals for Trump, Kim Jong-un
of North Korea and others (Gearan, 2018; Gordon and Salama, 2019; Kim, 2019;
Masterson, 2020):

• All parties want to reduce tensions and avoid a nuclear war.

• Seoul wants to normalise relations with Pyongyang.
• Mr Trump wants to secure a foreign policy win for his administration.
 From Trade War to Global Disruption 155

• Mr Kim has multiple goals including relief from Washington’s economic

sanctions, security guarantees of no attack and an international recognition of
its nuclear power status.
• Beijing wants to avoid the prospect of North/South Korean unification under
the US umbrella.
• Russia wants to leverage on this political chaos to increase its influence in
North Asia.

So analysts rationally assume each party, knowing the other party’s strategy to
get what it wants, would work towards a Nash equilibrium outcome – denucle-
arisation through political dialogue.
However, what they have missed when thinking in such a way is that these
goals may have changed or been misunderstood, thus introducing imperfect
information to the game, so that the initial strategies chosen to achieve them have
also changed. There are two cases in point: One is the implicit strategic alliance,
which was built since early 2018, between Beijing/Seoul and Pyongyang (Albert,
2019), which has emboldened North Korea’s Mr Kim to become more defiant
against the United States, and two is the difference in the definition of denucle-
arisation between Washington and Pyongyang3 (Chandran, 2018).

Trump’s Optimal Strategy

In engaging denuclearisation talks with North Korea, Mr Trump was, in my view,
pursuing an optimal (but not commonly understood) strategy in driving for a
corner solution for the benefit of the United States. Theoretically, a corner solution
is a special solution to one’s maximisation problem in which the quantity of one of
the arguments in the maximised function is zero. This occurs when the player is
either unwilling or unable to make a tradeoff. For example, when someone says ‘I
won’t buy that at any price’ or ‘I will do this at any cost’, these are corner solutions.
The word ‘corner’ refers to the fact that if one graphs the maximisation problem,
the optimal point will occur at the ‘corner’ created by the budget constraint and one
axis.
From Mr Trump’s perspective, given the past Presidents’ failure in their
approaches to deal with North Korea’s nuclear programme (Goodby, 2003), he
was unwilling to make the same mistakes. So, in my view, he tried to shift North
Korea’s behaviour away from a predictable Nash equilibrium, which is disad-
vantageous to the United States in political and military terms (due to the past
failures). He introduced ‘noises or imperfect information’ to the game in order to
reach his undisclosed corner solution of gaining full control of the denuclear-
isation talks and stress-testing Pyongyang’s behaviour.

3
Washington demanded the complete, verifiable and irreversible dismantlement of North
Korea’s nuclear weapons programme. Pyongyang said it could consider giving up its
nuclear arsenal if Washington withdrew its nuclear umbrella of deterrence from South
Korea and Japan and withdrew all its troops from South Korea.
156 China’s Global Disruption

Of course, a non-Nash game is unfamiliar, and uncomfortable, to the world’s

sedated bureaucrats and political observers. But it is familiar to the seasoned
military generals in the United States, China, Russia and North Korea.
Mr Kim’s best generals should also be familiar with such seemingly irrational
antics, unless he has killed them all to reduce any threats to him (Jeong &
Martin, 2019).
In a non-Nash game, there are many undisclosed objectives from the propo-
nent (or the driver of the game, or the United States in our case), i.e., there is
imperfect information. Other nations should not lock themselves into commit-
ments with the United States and with one another on the basis of the seeming
obvious goals (e.g., denuclearisation, peace in Asia, US military withdrawal,
trade war, etc.). This also means that at any point in time, anything that seems
obvious could be wrong in such a game. And because of this confusion, global
markets would be wacked with volatility and disruptions from time to time.

Relevance to China
President Trump has been playing a similar non-Nash game with China in his trade
negotiations, in my view, hence his unpredictable policy behaviour. One may
wonder what would be his next, unpredictable, move in shocking the trade nego-
tiation framework to get what he wants. What about an attack on the renminbi,
i.e., a currency war alongside a trade war with China?
Before Mr Trump became President, US policy for maintaining the dollar’s
primacy was largely passive, if not conciliatory. Even when it was clear that China
was promoting the renminbi as an alternative to the dollar (despite the technical
implausibility in the medium term), the Obama administration did nothing to
push back on the Chinese effort (Gagnon & Troutman, 2014). That was because
the players were expecting a Nash equilibrium outcome in which China and the
United States would employ their best strategies to achieve their goals, given their
knowledge of the other’s strategy.
But then came Mr Trump and all bets on a Nash equilibrium were off, as he had
gone on the offensive by introducing ‘imperfect information’ to the game through
erratic policies and conflicting messages (i.e., making the game non-Nash). The
United States has a great incentive to play more non-Nash games with China in its
attempt to contain China’s potential challenge to its global supremacy status in the
future. From this perspective, Mr Trump’s policies and future policy direction will
play a crucial role in creating global disruption.

Damage on the United States

The trade war disruption does not only hurt China but also hurts the United
States and other regional economies. China has potential ‘nuclear options’ to hit
the US companies operating in China by using regulatory and non-trade barriers.
This would be very damaging for the United States because it has a lot more
investment in China than China has in the United States (Fig. 9.3). The total sales
 From Trade War to Global Disruption 157

Fig. 9.3. Cumulative Foreign Direct Investment (FDI).

of US-invested companies in China were estimated at about USD480 billion in

2015 and are now likely much more than USD500 billion. Essentially, no US
product sold in China, or US company invested in China, would be considered
safe from Beijing’s retaliation.
Since the trade war started in 2018, Beijing has been identifying non-tariff
measures that could limit investment or market access by US firms (Mitchell &
Donnan, 2018; W. Wu, 2019). There are a large number of regulatory tools it
could deploy. Evidence from previous economic conflicts shows that the measures
on restricting trade and/or tourist flows with Japan, South Korea, Norway, the
Philippines, Taiwan and Mongolia had inflicted economic damages in these
economies at little costs to China. But the US economy is much bigger and has
deeper ties with the Chinese economy, so the potential economic damage from
the trade conflict on China would also be larger. Thus, the first targets of Chinese
retaliation would likely to be on US products that are less consequential and more
replaceable.
US airplanes are a large target. But since redoing multi-year contracts with
Boeing would be costly and disruptive and may affect China’s bargaining power
with Airbus, Beijing is likely to tread carefully with this sector (Odell & Samson,
2018). Hollywood is a much easier target, as earnings from the massive Chinese
market are increasingly important for American movie makers. Beijing can easily
instruct the two state-owned movie distributors to halt or delay distribution of
American films, or tell video-on-demand companies to reduce the number of US
TV shows they stream. It could also tighten censorship requirements, delay films’
release dates in China, shorten theatrical release periods or keep movies off screens
during lucrative holiday seasons. These latter non-trade barriers have already been
put in place for a while and have been a chief compliant by American movie
producers (Zeitchik, 2019).
158 China’s Global Disruption

American pharmaceutical companies are also an easy target. Beijing can

easily use targeted regulations to slow approval of foreign drug applications by
US companies, hurting their market share in China (Hancock, 2017). Agri-
culture is another sector where Chinese authorities have enormous regulatory
discretion. Issues such as health and sanitation concerns have already been
used to prolong customs checks and quarantine periods to restrict many
agricultural imports from America. The regulatory barrier (Zhang, 2014) can
easily be raised and extend to include US genetically modified crops sold in
China, which have been facing delays in the approval process that is already
taking years.
The market is also concerned about American automakers being targeted in
Chinese retaliation (Howlett, 2019). China’s car market is now the world’s largest
and one of the most competitive. American brands accounted for only 9% of
passenger-car sales in China in 219, down from 11% in 2018 when the trade war
started. Since substitutes from both domestic and foreign cars are readily avail-
able and auto brands are usually tied to national identity, cars have been a
favourite target in previous disputes.
South Korean and Japanese automakers saw their sales and market share drop
sharply in China when their relations with China turned sour in 2017 and 2012,
respectively. In both cases, Beijing said consumer outrage, not government action,
was the cause for boycotting the foreign cars (Automotive News China, 2012;
Murphy, 2013). But who really knew. Beijing could also easily limit the growth of
US automakers by withholding or slowing approvals for new factories or models
or distribution licences.
Technology companies are also potential targets for regulatory retaliation.
Take Apple Inc., which has USD40 billion in sales in China (Leswing, 2019).
Beijing could delay issuing network licence for the iPhones and, thus, hurt Apple’s
launches of new iPhones and sales revenues. Although such action would also
hurt the revenue of Chinese suppliers and mobile carriers, Beijing may see that as
a price worth paying since it would help Chinese smartphone makers.
If China were to weaponise the tech guidelines to hit American companies,
they could easily cause significant difficulties for operating in China and even
shutdowns. The Center for Strategic and International Studies argues that the
cybersecurity standards purposely use vague language around testing and verifi-
cation so that Beijing has broad discretion in assessing and, hence, taking actions
against, foreign firms (Sacks & Li, 2018). These standards could affect not only
tech firms and social media but all businesses that rely on information and
communications technology, including retail, fashion, e-commerce, services and
manufacturing, etc.
The point is that the destructive power of China’s regulatory and non-trade
barriers largely operates free of constraints and could virtually hit any sector and
any company according to Beijing’s discretion. Chinese officials would be happy
to comply with Beijing’s implicit requests to carry out the retaliation as they see it
as their patriotic duty to make life hard for American companies. If China
deploys such ‘nuclear options’, no one will benefit and market risk aversion will
soar and the global disruption will be significant.
 From Trade War to Global Disruption 159

Collateral Damage
Although the focal point for trade conflict is between China and the United
States, there is collateral damage on the regional economies too. In particular,
Asia’s export-oriented economies are not immune to tighter US dollar liquidity
stemming from risk aversion resulted from the Sino–US trade war. This financial
disruption is seen in the sharp fall in Asian currencies against the US dollar when
the trade war started (Fig. 9.4). The collateral damage of the Sino–US trade
friction clearly has risk implications on regional growth and asset allocation.
A slowdown in global growth due to the Sino–US trade war will lead to a loss
of demand for EM exports. Empirical evidence shows that in Asia, GDP growth
of Singapore, Malaysia and Thailand is the most sensitive to shifts in G3 growth
(Europe, Japan and the United States). China is not sensitive due to its large
continental economy and the availability of domestic stimulus tools.
However, just the bilateral trade dispute between China and the United States
could have significant effects on the regional economies through the global supply-
chain disruption. The potential collateral damage can be estimated by stripping out
the foreign value-added content (averaging about 40%) in China’s gross exports
and reassigning them back to its original source countries to assess these countries’
ultimate export exposure to the United States.
This means that when China’s exports to the United States drop due to the trade
war, exports from these countries will also fall. My estimation shows that six of
the top 10 most-exposed countries to the Sino–US trade war shock are in Asia
(Fig. 9.5). The damage on China would be rather limited. From the asset allocation
and risk management perspectives, ceteris paribus, markets with the highest US–
China exposure tend to be hurt the most. Furthermore, in those Asian countries
that have the most US exposure, the industries that could be hit hard are textiles,

Fig. 9.4. Change in Nominal Exchange Rates Against the

US Dollar (2018).
160 China’s Global Disruption

Fig. 9.5. Final Export Exposure to the United States Compared to

Direct Export to the United States.

leather and footwear in Vietnam, computers and electronics in Taiwan and

Malaysia and chemicals and petroleum products from Singapore (Nomura, 2018).

Impact from Contagion

The trade conflict between China and the United States has also raised risk
aversion, as investors reassess the economic fundamentals of EM and ponder who
might be susceptible to financial contagion as the trade shock unfolds. The key
economic fault lines under scrutiny include a country’s current account balance,
fiscal balance, external debt and inflation. When a negative shock hits, a country
will likely fall into a crisis or suffer from financial contagion when it has a
combination of a twin (current account and fiscal) deficit, a large foreign debt and
high inflation triggering a loss of confidence.
China has none of these macroeconomic problems, as it has a current account
surplus, subdue inflation and a small fiscal deficit and a small foreign debt. Most
importantly, the renminbi is not convertible so that its financial contagion risk is
very small as speculators cannot sell the currency short in the FX market. In
Asia, there are three major Asian economies that are vulnerable to financial
contagion stemming from escalation of Sino–US trade tension. They are India,
Indonesia and the Philippines due to their twin deficits and relatively high
inflation. But their foreign debts are still small (Fig. 9.6 and Table 9.1). While
Malaysia has a large foreign debt, it runs a sizable current account surplus and
has low inflation.
Overall, Asia Pacific economies have more solid fundamentals than many
other EM countries, though they are still susceptible to selling pressures from a
rise in risk aversion. Every Asian currency in our analysis fell against the US
dollar in 2018 (see Fig. 9.4), with the three twin-deficit countries (India, Indonesia
 From Trade War to Global Disruption 161

Fig. 9.6. APAC EM Macro-stress Indicators (2018).

Table 9.1. APAC EM Macro-stress Indicators (2018).

Current a/c Fiscal Bal Gross Foreign CPI Twin
(%GDP) (%GDP) Debt (%GDP) Inflation Deficit
(%YoY)
China 1.3 23.7 14.0 1.6 No
India 21.9 23.5 20.0 3.6 Yes
Indonesia 22.3 22.6 35.0 3.8 Yes
Malaysia 3.7 22.9 69.0 3.8 No
Philippines 20.5 22.2 23.0 2.9 Yes
Thailand 11.2 23.5 33.0 0.7 No
Vietnam 4.1 24.7 45.0 4.2 No
Sources: CEIC, UBS, author.

and the Philippines) falling the most, followed by China (which saw a one-time
current account deficit in the first-quarter of 2018).
Crucially, as discussed in Chapter 8, the correlations of the movements
between the renminbi and major Asian currencies have increased at the expense of
their correlations with the US dollar and the euro in recent years. This suggests
that whenever the trade conflict exerts downward pressure on the renminbi, Asia’s
currencies will also face more depreciation pressure, creating more disruptive
forces in the global FX market than they used to.
162 China’s Global Disruption

From Trade War to Cold War to Global Disruption

An increasing worry that is creeping onto the global radar screen is the risk of the
Sino–US trade war escalating to a new cold war, which could potentially cost
dearly not only China and the United States but also the world economy. If the
end of the last Cold War fostered global economic integration, the beginning of the
next cold war between China and the United States will produce fragmentation,
with long-term impact on even technological innovation and climate change.
Rising Sino–US trade tension is already contributing to an economic decoupling
that is reverberating across the global system. The breaking up of the global
supply chains will be extremely disruptive to the world’s production ecosystem by
destroying the comparative advantages of different economies and international
division of labour. Under these circumstances, it is conceivable that the world could
be divided into two trading blocs, with each centring on a global power – China
and the United States. Intra-bloc trade may still thrive, but there might be no close
links between them. This scenario will be bad enough to unwind many of the
globalisation benefits that the world has enjoyed for over two decades.
An increase in Sino–US rivalry could unravel the global system. The Trump
administration has shown its ability to hurt its targeted countries by using sanc-
tions to deny them access to the US dollar–denominated international payment
system. To hedge against this liquidity risk, America’s strategic rivals, China and
Russia, and even its ally, the European Union, are trying to establish alternative
payment systems (notably the China Cross-border Interbank Payment System or
CIPS (Blair, 2016), which uses S.W.I.F.T. messages and S.W.I.F.T. standards and
modelled after the US FedWire).
Such financial fragmentation will disrupt the global technological landscape.
This is because restrictions on technology transfers and linkages, justified on the
national security basis, will give rise to competing and non-compatible standards,
just like the VHS versus Betamax battle in the consumer video market in the late
1970s and 1980s, or more recently like the GSM versus CDMA mobile phone
network battle in the 1990s. It is conceivable that today’s Internet would break up
into competing domains, giving rise to excessive or cut-throat competition, hurting
innovation and leading to higher costs, slower adoption and even inferior products.
A more imminent concern will be the disruption to the global supply chains.
To avoid being hit by US tariffs, firms producing or assembling from China and
exporting to the United States will be forced to move their production facilities to
other unaffected countries. With China standing at the centre of the global supply
chains, such a wave of relocation will be very disruptive. The broken supply
chains will be inefficient as the benefits of the other countries leveraging on
China’s industrial infrastructure, technology and the size and skill of its labour
force will be gone.

Impact on Climate Change

Another potential consequence of economic fragmentation will be a lack of
coherent action to combat climate change. China and the United States are the
 From Trade War to Global Disruption 163

world’s two largest carbon dioxide emitters (Frohlich & Blossom, 2019). Together
they account for about 38% of annual global carbon dioxide emission. If they fail
to work together on combating climate change, there is little hope for concerted
global action against global warming. A Sino–US Cold War (Gallagher, 2020)
will make this outcome very likely because neither country will be willing to cave
in to the other side’s demand. International climate-change negotiations, already
stuck with challenges, will end in deadlock. Without the cooperation between
China and the United States, any agreements struck by other countries will be
insufficient to produce any meaningful impact.
A related disruption will be on technological innovation that enables progress
in renewable energy development. Such progress depends crucially on the rela-
tively free flow of technology across borders with China as the driver for econ-
omies of scale and cost reduction. Cold War inflicted economic fragmentation
and restrictions on technology transfers will make the much-needed innovations
and breakthroughs much more difficult to achieve.

Disruption to Stay!
If the United States and China are to work together, both US President Donald
Trump (and his successors and the White House) and Chinese President Xi
Jinping will have to broaden their focusses from national interests and personal
political aspirations to global cooperation. This is a tall order, given the rivalry
approach pursued by both countries (Hurlburt, 2020).
Together with other geo-political risks, all this suggests that global disruptions
of various sorts are here to stay, and they are not just of China’s creation. The
ability of the world’s central banks to soothe the resultant economic pains may be
limited due to political pressure on their moves. With the world’s two largest
economies at loggerheads, any agreements on tackling climate change seem
unlikely in the short term. Even if the world somehow manages to achieve the
goal of capping global warming to less than 1.5 degrees Celsius, global growth is
set to slow as a result. The consequences will be dire if the world fails to tackle
climate with political and economic disruptions aggravating the resultant prob-
lems by creating global fragmentation.
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Chapter 10

Renminbi Internationalisation

China’s renminbi internationalisation programme, which started in 2009, has

been seen as a move to challenge the US dollar’s global supremacy and, thus,
shake up the global monetary system. Some cynics even argued that by inter-
nationalising the renminbi, Beijing was preparing for future currency wars by
making the renminbi more convertible and more readily available in the foreign
exchange (FX) market.
By internationalising the renminbi even before its capital account is fully
opened, China is indeed showing its ambition of using the renminbi to foster a
new monetary order. The erosion of the basic money functions of the three major
global currencies (yen, euro and US dollar) since the 2008–09 Global Financial
Crisis (GFC) has given the renminbi a window of opportunity to increase its
influence in the global markets. However, the pace of progress and delivery of
internationalisation results are not in Beijing’s control. Indeed, it had to slow
down the process since 2016 because of changes in the global economic
environment.
Contrary to the common belief, renminbi internationalisation is never a top
policy priority on Beijing’s agenda (Windsor & Halperin, 2018), though it is an
important policy goal. Arguably, renminbi internationalisation is still stuck in
first gear with no depth in the process even after more than a decade of pro-
motion by the Chinese government. While China has strong motives for inter-
nationalising the renminbi, how fast and effective it can deliver tangible results is
a totally different matter. It will take a lot more efforts than what China has
done so far to make the renminbi a global currency and challenge the US dollar.
In fact, it will take a mindset, or even a regime, change for China to do that. But
this is not practical in the foreseeable future. This means that the disruption of
the renminbi to the world’s monetary order is not as serious as most observers
have feared.

The Motives
Theoretically, currency internationalisation is a market-driven response to regu-
latory constraints and evolvement of the international monetary system that make
the status of the existing international currencies unstable. There is no historical

China’s Global Disruption, 165–180

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211011
166 China’s Global Disruption

precedent for the Chinese government taking the lead in internationalising its
currency (McCauley, 2011). Its move to do so has been prompted by both
international trade and financial management initiatives. Reducing currency risk
is the most obvious trade-related motive to internationalise the renminbi. Using
the US dollar for trade exposes China’s producers, its financial institutions and
the official sector to currency risk. Chinese exporters typically incur production
costs in renminbi but receive payments in US dollar. Meanwhile, importers
buying from overseas pay for their goods in US dollar but sell them in the
domestic market for renminbi. This payable-receivable currency mismatch is a
FX risk to both Chinese exporters and importers because of currency fluctuations.
Such risk is costly and difficult to hedge under China’s still underdeveloped
capital markets (Huang & Ge, 2019). Hence, settling foreign trade in renminbi
would benefit Chinese companies by reducing their exchange rate risk as well as
eliminating the cost of FX transactions.
More renminbi-denominated assets will also reduce Chinese financial institu-
tions’ exposure to FX risk. This will help reduce the volatility of their capital
base,1 and contribute to strengthening of their competitiveness by improving their
funding opportunities through increased accessibility to a larger pool of renminbi-
denominated assets (Gao & Yu, 2009).
China runs a balance of payments (BoP) surplus. It uses this surplus to finance
countries with BoP deficits, notably the United States. The Chinese surplus has
gone into building up the country’s FX reserves which, in turn, have accumulated
assets denominated in foreign currencies (mostly US dollar) through lending to
these foreign deficit countries. If these debts of the deficit world that China holds
were denominated in renminbi, then China would eliminate a major source of risk
stemming from FX fluctuations, notably depreciation of the foreign currency, on
its national balance sheet.
From a foreign trade perspective, making the renminbi an international
settlement currency will help keep trade financing normal under adverse condi-
tions. During crisis periods, there is typically a strong demand for the US dollar,
which is seen as a safe-haven currency. Since everyone hoards US dollar, this
excess demand for dollar creates a liquidity squeeze on trade financing. The
shortage of trade financing was prominently evident in the 2008–09 GFC, with
the shortage of US dollar aggravating the negative demand shock of GFC and
inflicting a detrimental effect on China’s exports.
Chinese financial institutions, whose funding base is in renminbi, only have a
limited ability to provide US dollar trade financing. However, if foreign trade
could be settled in renminbi, the trade financing ability of the Chinese institutions
would increase significantly. This would not only allow them to stabilise trade and
production domestically, it would also help sustain global, or at least regional,
trade by providing renminbi financing when the US dollar is in short supply.

1
If the capital base consists of assets denominated in different currencies, regular valuation
of the assets in terms of the home currency will create an inherent volatility of asset values
because of exchange rate fluctuations, even though underlying asset prices may have not
changed in their original currency terms.
 Renminbi Internationalisation 167

Dollar shortages are usually most acute in the emerging market (EM) econ-
omies. If China trades with EM countries in renminbi, it could continue to pro-
vide them with financing when dollar liquidity dries up during a crisis. This could,
in turn, sustain or increase the demand for Chinese products as well as financial
services from Chinese banks (Otero-Iglesias, 2010), thus helping to cushion the
damages of the crisis on China also.
Domestically, internationalising the renminbi will require deepening of the
Chinese financial reforms, improving the process of using Chinese financial
markets as a platform for lending to and borrowing from the rest of the world and
improving the sophistication of Chinese capital markets. All this fits well in
China’s structural reform programme for upgrading the Chinese economy and
creating high value-added service jobs in the financial sector.
In the long term, it is also about prestige and influence. The use of the renminbi
as a global currency will strengthen China’s influence in the world, a condition
that will commensurate with the rising Chinese economic power in the global
economy. An internationalised renminbi will also contribute to increasing China’s
clout in international institutions, such as the World Trade Organisation, Inter-
national Monetary Fund (IMF) and World Bank, and allows it to play a bigger
role in the global financial order.
These motivations have gained increasing credibility following the financial
crises (first the 2007–08 US subprime crisis, then the 2011–12 European debt
crisis2) set off by the collapse of the US investment bank Lehman Brothers in
2008. The uncertainty and damages of financial crises made Beijing realise that
China could not be too dependent on foreign currencies, notably the US dollar.
Arguably, the subprime crisis has acted as a trigger for Beijing to internationalise
the renminbi, and the subsequent global development has prompted it to accel-
erate the process until 2016 (see below).

A Portfolio Perspective
There are two, more intriguing, financial management initiatives behind Beijing’s
push for renminbi internationalisation. The first is the need for diversification in
the country’s growing net positive foreign investment position. China is the
world’s third largest creditor nation after Japan and Germany, although much of
its wealth is held in the form of FX reserves as opposed to foreign direct
investment (FDI) like the other two creditor nations.
Diversifying China’s massive FX holdings (over USD3.0 trillion at the time of
writing) away from the US dollar and the euro appears to be virtually impossible,
given the limited market size of other currencies and the very limited roles that
they play in the international monetary system. So internationalising the renminbi
and then increasing the renminbi-denominated assets in its FX reserves would be
the easiest way to limit the FX risk for China.

2
According to the Organisation for Economic Cooperation and Development, the Eurozone
debt crisis was the world’s greatest threat in 2011, and in 2012, things only got worse. The
crisis started in 2009 when the world first realised that Greece could not repay its debt.
168 China’s Global Disruption

Japan indeed adopted this approach when it softly promoted the internation-
alisation of the yen in the 1970s. The best example of this strategy is the offshore
yen-denominated (samurai) bonds that foreign borrowers issued in major financial
centres with the samurai bonds bought by Japanese investors, among others. This
way, Japan increased the share of yen-denominated assets in its wealth pool and
reduced its overall FX risk exposure in the country’s balance sheet.
The other, far reaching, initiative to internationalise the renminbi is that
Beijing might want to prepare for the time when China becomes a net debtor in
the global system, like the United States. This argument may not sound that
remote because China’s BoP surplus has declined steadily from a peak of 12% of
GDP in 2010 to about 2%. Its current account surplus has followed the same
declining pattern and is projected to post periodic deficits in the future.
China’s finances are currently sound and its external positions robust. But this
situation may change in the longer-term, notably when its current account turns
into a deficit. So it would make sense to start preparing for being a debtor nation
with renminbi liabilities in the long term, and the renminbi needs to be an
internationalised currency to facilitate international debt issuance. To be a debtor
in your own currency has tremendous advantages. Just look at the United States,
which is the world’s too-big-to-fail nation. Since America’s foreign debts are
predominantly denominated in US dollars, its foreign creditors have no choice
but to keep funding the US deficits even at very low cost and put blind faith in its
sustainability despite its broken finances (Gabler, 2016).
So is China following the US example and preparing for becoming a net debtor
nation in the future? Looking at the structure of the ‘dim sum’ (offshore renminbi)
bond market in Hong Kong, the very important role that Chinese firms play
in issuing renminbi-denominated bonds hints a tentative yes. Ever since the
establishment of the offshore renminbi, or CNH3, market in Hong Kong, Chinese
borrowers have dominated the issuance of offshore renminbi bonds with a total
issuance market share of more than 50% by all Chinese entities.
China’s borrowing needs will continue to rise, as the country’s industrialisation
process still has some way to go (see Chapter 4). As the Chinese economic and
financial systems continue to open up, domestic credit demand and funding cost
structure will become increasingly sensitive to international market conditions,
and Chinese entities will likely take advantage of financial liberalisation to
diversify their funding sources to eschew domestic financial repression by tapping
the foreign capital markets. This will, in turn, pave the way for China to become a
borrowing nation in the long-term.

Fostering a New Monetary Order

Even before opening up its capital account, China has been moving to build
financial infrastructure to foster the role of the renminbi in foreign countries by

3
CNH is the acronym for Chinese Yuan in Hong Kong, which is the largest offshore
renminbi (or yuan) market in the world.
 Renminbi Internationalisation 169

designating clearing banks in offshore markets. Foreign firms and individuals in

many economies can already buy renminbi with their home currencies, and
various financial institutions can already offer renminbi-denominated fund
management and FX services. But having a clearing bank locally makes a dif-
ference in terms of renminbi liquidity and funding cost.
The clearing banks in the offshore renminbi centres can access their renminbi
funds in China within the quotas granted by People’s Bank of China (PBoC) to
cater for demand from their foreign customers in these offshore centres. These
quotas represent additional liquidity that the clearing banks bring to their
respective offshore markets. Other non-clearing banks are limited to bidding for
the existing supply of offshore renminbi, and are thus more likely to suffer from
liquidity constraint and higher renminbi funding cost than the clearing banks.
This situation should change over time when China starts to allow free capital
flows and offer more renminbi-denominated assets. This would attract more
players to use the renminbi, thereby increasing liquidity and reducing transaction
costs. When that time comes, the renminbi, along with other major currencies
such as the euro, pound sterling and Japanese yen, will all play bigger interna-
tional roles, eroding the US dollar’s exorbitant privilege. This will inflict
disruption in the prevailing monetary system that is dominated by the US dollar.
But before China fully liberalises its capital account (and I have reservation
about the view that China would fully open its capital account even in the long-
term), the clearing banks serve as an extension of the PBoC’s control of
renminbi liquidity overseas. In essence, they are a gateway for renminbi outflows
before full capital account convertibility. Hence, Beijing’s move to designate
renminbi clearing banks in the offshore centres is, in effect, a step towards
fostering a new international monetary order by challenging the US dollar at the
margin together with several global currencies. This is, arguably, a step towards
creating a better match between a multipolar global economy and its financial
system. The role of the clearing banks will disappear when China allows full
capital account convertibility.
However, deep and liquid markets are not built in a day. The renminbi will
eventually erode the US dollar’s global dominance, but not just yet. Beijing is not
waiting though. It has been deepening its renminbi internationalisation effort,
albeit slowly, by sanctioning a ‘full’ onshore derivatives market for renminbi,
granting full access to the onshore interbank bond market by foreign investors,
opening up the onshore repo market to designated offshore renminbi clearing
banks and reforming the renminbi daily fixing mechanism by making it more
market-driven (see Chapter 8). The list of liberalisation measures will grow as the
effort to internationalise the renminbi continues.

The Failure of the G3 Currencies

Aiding China’s internationalisation push in its early years is the failure of the
three major global currencies (or G3 currencies – the yen, euro and US dollar) in
performing the basic functions of money in the global markets. Some powerful
170 China’s Global Disruption

structural shifts have been unfolding behind the G3 currencies and the EMs since
the GFC that have given rise to some distinctive trends that were conducive to the
rise of the renminbi (Lo, 2013). These trends include the weakening of the US
dollar’s global influence, the uncertainty of the euro and the structural decline of
the yen. Meanwhile, even with a largely closed capital account, the global market
influence of the renminbi has increased substantially.
Economic development since the GFC suggests that the basic functions of
money (as a unit of account, a medium of exchange and a store of value) of the
G3 currencies might have been eroded. Firstly, while the US dollar always
dominates as a unit of account, the outlook for this dominance is likely to change,
underscoring the weakening trend of the dollar’s influence.
Of the five most actively used international payments currencies in the
S.W.I.F.T. system – the US dollar, euro, pound sterling, yen and renminbi – only
the renminbi stands out as the one that will most likely experience an increase in
international usage in the coming years (Windsor & Halperin, 2018). Being a new
component currency of the Special Drawing Rights (SDR)4 (since October 2016)
and with Beijing continuing the liberalisation of the country’s capital account, the
renminbi is becoming a growing part of the global financial infrastructure.
Notably, China’s creation of the Asian Infrastructure Investment Bank, the Silk
Road Fund, the New Development Banks and the usage of its domestic policy
banks for international lending are all instrumental in boosting the role of the
renminbi under the Belt and Road Initiative (BRI) that spans from China through
Asia to Europe.
Secondly, most of the world’s major currencies are failing to serve as a store of
value by not being able to deliver stable positive return both in nominal and real
terms. Since the currency war5 in 2010, global currency market volatility has risen
sharply. The Swiss franc and the Japanese yen have become negative yielding
currencies since 2015. The euro, the Swedish krona and the Danish krone also do
not provide any reasonable stable non-zero returns. The Canadian, Australian
and Kiwi dollars, Norwegian krone, Brazilian real and South African rand have
been stuck with volatile trends that are influenced by commodity prices.
Although the US dollar and the pound sterling are still providing the store of
value function (at the time of writing, that is), their returns are not much higher

4
The Special Drawing Rights, or SDR, is an international reserve asset created by the
International Monetary Fund in 1969 to supplement official reserves in its member
countries. SDRs are allocated to members and can be exchanged for freely useable
currencies. The value of the SDR is currently based on a basket of five major currencies:
the US dollar, euro, yen, pound sterling and renminbi (the latter was included in the basket
in October 2016).
5
Currency war is, in essence, rounds of competitive devaluation when a country seeks to
gain a competitive advantage over other countries by devaluing the exchange rate of its
currency against other currencies. The term was coined by former Brazilian Finance
Minister Guido Mantega in 2010, when he opined that a currency war broke out in the
aftermath of the US subprime crisis. This view has since been echoed by many other
government officials, analysts and the financial media from around the world.
 Renminbi Internationalisation 171

than zero. Indeed, the dollar and the sterling have been more volatile, and
providing lower yields, than the Chinese renminbi. Under these circumstances,
could the renminbi emerge as an alternative over time in a world of financial
instability? Granted, there are structural problems behind the renminbi and it is
not fully convertible on the capital account yet. But who else do not have
structural problems?
China differs from most other countries in that it has a stronger resolve to
reform. It is, arguably, the biggest country implementing the largest amount of
structural reforms since President Xi Jinping came to power. Beijing’s ambition to
make the renminbi a global reserve currency is compatible with its incentive to
keep the renminbi strong and stable over time, despite all the short-term noises
about devaluation.
Finally, on the medium of exchange function, the US dollar’s global domi-
nance has been shaken in recent years as more international payments are settled
in non-US dollar currencies. A strong challenger to the US dollar seemed once to
be the euro. The European integration project in the 1990s and 2000s raised the
expectation that Brussels might be able to attract an ever-increasing number of
countries into the euro zone system. That would mean an ever-increasing demand
for the euro as a medium of exchange in the global markets.
Unfortunately, the ‘European dream’ has been disrupted as the expansion path
of the euro system appears to be challenged by the geo-political conflict in
countries in emerging Europe and by the upheavals across the Arab world.
Britain’s vote on 23 June 2016 to exit from the European Union, an event that
financial market dubbed as ‘Brexit’, was the latest blow to global confidence in the
European dream and the euro (Kirkegaard, 2016).
In the 2000s, there was also the commodity boom that increased the demand
for US dollar and, hence, further strengthened the dollar’s role as a global
medium of exchange, as nearly all commodities are priced in US dollar. However,
that demand for dollar has abated following the commodity bust since 2013. The
table will turn in favour of the US dollar only when global trade and the
commodity cycle reaccelerate markedly again. But when global trade accelerates
again, where would the biggest momentum come from?
Given the difference in growth dynamics between the developed and emerging
worlds, long-term global trade growth is likely to take place mostly in the EM.
With China’s rising economic influence, time will tell how much of this trade
growth will be denominated in renminbi. What seems likely is that in relative
terms, the share of renminbi-denominated trade will rise at the expense of the G3
currencies, especially when one takes into account China’s ambitious BRI
programme.

The Role of the ‘Chinese Dream’

Just when the European dream is being disrupted, the ‘Chinese Dream’ is being
consolidated by Chinese President Xi Jinping earnestly. Indeed, the Chinese
Dream plays a central role in fostering the rise of the renminbi amid all this
172 China’s Global Disruption

global crosscurrents. It aims at building a moderately well-off Chinese society

by 2020 and a strong and prosperous nation by 2049 so that China could
become the dominant power in Asia again with global influence like the United
States by 2050.
The economics of the Chinese Dream is crystallised by the renminbi inter-
nationalisation programme (Lo, 2013) and the BRI. The latter aims at creating
new trade and investment networks, opening-up transit routes for Chinese exports
and developing China’s poor border regions by pushing for the usage of the
renminbi as the settlement and investment currency. By financing infrastructure
projects in developing Asia, the BRI essentially draws China’s neighbours closer
to its economic embrace.
China’s geo-political strategy of integrating its neighbours via the BRI to its
domestic economy reinforces a strong currency policy. Joining the currency war,
as some critics have argued, will only undermine this strategy and the vision of
making China the great power in Asia. A stable and strong renminbi will, in turn,
reinforce its money functions in the global markets when the major currencies are
starting to fail in these functions.

Internationalisations Slows Down

However, the reality for the renminbi internationalisation programme is not fully
under Beijing’s control, despite its incentive to do so. Renminbi internationali-
sation indicators (Fig. 10.1 and 10.2), including foreign trade settlement and the
Renminbi Global Index, show that the process slowed down sharply in 2016 and
2017 because of changes in economic and political conditions in China and
abroad. It has recovered only gradually since 2018 as China opens up the onshore

Fig. 10.1. Greater China * Renminbi Trade Settlement.

 Renminbi Internationalisation 173

Fig. 10.2. Renminbi Global Index*.

capital markets further to foreign investors and renminbi assets are being included
in the international benchmarks, but the robust momentum has been lost.
Renminbi internationalisation, in conjunction with a strong FX policy bias,
was once a high policy priority in facilitating China’s financial liberalisation.
However, several developments since 2014 have caused Beijing to stall the
internationalisation strategy.
Firstly, changing global growth and interest rate dynamics has dented Beijing’s
strong renminbi policy stance. When China’s economic growth was strong and
American growth was weak before 2014, it was easy for China to defend a strong
currency bias and push for currency internationalisation. But the situation
changed between late 2014 and 2015 when US growth recovered, the US dollar
rose by 20% against all major currencies and the US raised interest rate in
December 2015 for the first time since the GFC. On the other hand, China’s
growth weakened and the PBoC cut interest rates six times during that period.
Growth trends in China and the United States has continued to diverge since
2016, with the Sino-US trade war further denting China’s growth since 2018.
Secondly, from Beijing’s perspectives, the role of renminbi internationalisation
as a force to push through financial deregulation had largely been completed by
2016. Hence, its official importance had diminished. To see this, consider the
renminbi’s entry to the SDR basket. To gain entry, Beijing did a series of financial
liberalisation, including scrapping the deposit interest rate cap (in July 2015) and
shifting its exchange rate mechanism from a de facto US dollar peg to a more
flexible one (in August 2015), thus allowing more market forces to drive the
renminbi-US dollar cross rate with two-way volatility. It also implemented a
series of other opening-up measures to increase foreign access to China’s onshore
174 China’s Global Disruption

markets. Finally, the IMF admitted the renminbi into the SDR basket in October
2016. This was seen by Beijing as an international recognition of China’s
achievement in financial liberalisation.
Thirdly, renminbi internationalisation has turned from a political boon to a
bane for Beijing since 2016. The success of the offshore CNH market in making
the renminbi more widely used has allowed offshore players to sell short the
Chinese currency. This has created unwelcome volatility in the internationalisa-
tion process just when the pressures from structural rebalancing, and later the
trade war, on China’s domestic economy are also intensifying.
All this is not to say that the internationalisation initiatives have failed. They
are just being slowed down.

Speculative Demand Not Good for Internationalisation

Despite a decade of internationalisation effort, the renminbi still accounts for less
than 2% of global payments, according to S.W.I.F.T. data, and less than 2% of
global FX reserves. The key reason for this slow performance, in my view, is
because the internationalisation process has been stuck in first gear – namely the
usage of the renminbi as a trade settlement currency.
Using renminbi for foreign trade settlement is the first step of internationali-
sation. The next step is to deepen the process by creating non-trade transactions
for the currency to capture the demand for renminbi from the foreign official
sector as one of its reserve currencies and from the foreign private sector both as a
form of foreign currency saving and as an investment currency in an international
portfolio. This second step will involve creating more renminbi-denominated
assets and hedging tools through financial liberalisation.
Evidence shows this next step is still in its infancy, despite more than a decade
of internationalisation efforts. Even the expansion of offshore renminbi financial
transactions in recent years has remained trade-driven and speculative. The latter
can be seen in the sharp rise in renminbi deposits in the Hong Kong banking
system which came mostly at the expense of the share of other foreign currency
deposits (Fig. 10.3) when investors speculated on renminbi appreciation in the
early years of renminbi internationalisation.
But when the market started betting on renminbi depreciation in the second
half of 2011 and again in late 2014 and early 2015, renminbi deposits in Hong
Kong dropped (Fig. 10.3). Granted, as Beijing gradually liberalises capital
inflows, more avenues for offshore renminbi to flow back to China have also
prompted the decline. But speculation on renminbi depreciation was the major
reason for investors abandoning it between 2011 and 2002 and in late 2014 to
early 2015.
The fact that the rise in the share of renminbi deposits in Hong Kong came at
the expense of other foreign currency deposits, especially in the ‘go-go’ months
between 2009 and 2011, reflected investors’ portfolio reallocation within their
foreign currency holding. There was no long-term demand for renminbi by
switching out of the Hong Kong dollar. As soon as market expectations turned
 Renminbi Internationalisation 175

Fig. 10.3. HK Foreign Currency Deposit (% of Total).

towards renminbi depreciation (see Fig. 10.3), deposits flowed out of renminbi
and back into other foreign currency and Hong Kong dollar deposits. Such erratic
behaviour in renminbi deposit growth is not sustainable for internationalising the
currency. To deepen internationalisation, Beijing must create an incentive for
foreigners to use and hold renminbi other than for trading goods and services and
for speculation.

Stuck in First Gear

Furthermore, most of the increase in offshore renminbi financial transactions in
Hong Kong, the largest offshore renminbi centre, is still driven by international
trade activity, in my view. In other words, renminbi internationalisation remains a
function of foreign trade, and offshore financial transactions are only a derivative
of it even after more than 10 years of internationalisation efforts.
Free convertibility of offshore renminbi, or CNH, in Hong Kong has caused
its exchange rate to deviate from the onshore rate, or CNY.6 When foreigners are
bullish on the renminbi, they push up CNH so that it trades at a premium to
CNY. This gives Chinese importers an incentive to pay for their imports offshore
by transferring renminbi from China to Hong Kong and convert CNY into CNH
at par because CNH buys more FX in Hong Kong. Thus, CNH supply/deposits
increases in Hong Kong.
On the other hand, when foreigners are bearish on the renminbi, they sell CNH
and depress its exchange rate so that CNH trades at a discount to CNY. This

6
CNY is the acronym for Chinese Yuan in the onshore market.
176 China’s Global Disruption

Fig. 10.4. CNH-CNY Premium Drives Renminbi

Deposite Growth in HK.

gives Chinese exporters an incentive to accept payment in renminbi offshore since

they get more CNH for any given amount of FX in Hong Kong and can convert
CNH into CNY at par and transfer back to China. Thus, CNH supply/deposits in
Hong Kong falls. But this phenomenon was not common before 2015 because of
the persistent strength of the renminbi, CNH seldom traded at a discount to CNY
(Fig. 10.4).
Thus, there was mostly an excess of CNH settlement in imports over exports in
response to the prevalent CNH premium before 2015. The excess CNH import
settlement was the main driver of offshore renminbi-supply growth. But when the
CNH-CNY discount becomes prevalent after 2015, renminbi deposits in Hong
Kong drop precipitously (Fig. 10.4).
Empirical evidence supports this phenomenon, where a sustained one
percentage-point premium will boost CNH deposits by RMB8.2 billion a month
in Hong Kong (Gagnon & Troutman, 2014). Since China has yet to deepen the
second step for renminbi internationalisation, there remains much potential for
financial activity to develop in the offshore market.

Trade Is Not Enough – The Japanese Experience

Ask the Japanese, they will tell you trade is not a sufficient condition for currency
internationalisation. The yen (or JPY7) has never been a major currency for trade
settlement, but it is a global currency with a reserve currency status. Why is that?

7
JPY is the acronym for Japanese Yen.
 Renminbi Internationalisation 177

From a macro currency perspective, a weak US dollar which has lost some
45% against the JPY since the 1980s has made it a sticky currency serving as an
international medium of exchange. The incentive for the world (and Japan) to
stick with the US dollar for trade settlement stems from the import side as a
falling dollar cheapens import cost. And from a currency internationalisation
perspective, imports (not exports) are the key driver for the process. That is
because the domestic currency is sent out of the country through imports, while
exports absorb the domestic currency back to the country.
A weak US dollar implies that the cost of trade settlement for the Japanese
importers using US dollar is lower (as one yen buys more dollars) than using JPY.
So from a cost basis, Japanese importers have a strong preference to settle in US
dollars. The fact that the weak or depreciating dollar has kept its position as the
key international trade settlement currency argues that its function as a medium
of exchange has overwhelmed its function as a store of value.
There are many other issues behind the US dollar that make it the sticky
global payments currency in the world for so many decades. These underlying
conditions include, but not limited to, policy, institutions, legal and liquidity
that aggregate together to build the credibility of the dollar. The relevance of all
this to the JPY’s internationalisation is that because of the inertia of the US
dollar as the world’s medium of exchange, the yen cannot compete with the
dollar on this count. Consequently, the JPY competes with the US dollar as a
global currency on the store of value function front. It does that through
exporting capital, including foreign direct investment, portfolio investment and
international loans.
Being one of the largest creditors to the world, Japan exports massive amount
of capital in Japanese yen. This is an effective way for internationalising the yen
by increasing its offshore circulation. On the other hand, Japan’s chronic current
account surplus is a handicap to yen internationalisation as more yen flows back
to Japan than flowing out through the current account. Japan has offset this
drawback by exporting capita/liquidity through the financial account.
Meanwhile, the structure of the Japanese imports has also impaired yen
internationalisation efforts through the medium of exchange role. Imports of raw
materials, foodstuff and fuels account for over half of Japan’s imports. Since the
US dollar is always used as the medium of exchange in international trade of
commodities, the yen plays little role in settling these import bills. Furthermore,
many exports depend on commodity imports. Therefore, Japanese exporters are
inclined to settle in US dollar also to avoid FX risk.
China has a similar situation in this aspect. Firstly, China’s chronic current
account surplus is not conducive to internationalising the renminbi. On the import
side, commodity imports account for over 40% of its total imports; among these,
about a quarter was agricultural imports. China’s demand for raw materials,
fuels, foodstuff and other commodities are expected to continue to rise, though
not as robustly as before, because of continued industrialisation. However,
domestic supply of commodities is projected to shrink because of continued
urbanisation and depletion of arable land.
178 China’s Global Disruption

So even increasing Chinese imports may not be effective in increasing the

renminbi’s offshore circulation (i.e., deepening the renminbi internationalisation
process), as commodity imports are priced in US dollar. Like Japan, many
Chinese exports depend on commodity imports so that the renminbi’s role as a
settlement currency is also constrained. Finally, China is not as big as an inter-
national creditor as Japan, so the internationalisation via capital outflow is
constrained, at least until China liberalise the capital account further.

Internationalisation the Japanese Way

Failed to internationalise through trade expansion, Japan pushed yen inter-
nationalisation through the financial accounts. The JPY’s role in the global
financial markets rose rapidly in the 1970s and 1980s. Yen bonds were issued
abroad, medium- and long-term yen loans were made extensively abroad and
foreign investors were allowed in the stock market in Japan. All these helped
deepen the yen internationalisation process by exporting capital to the rest of the
world and improving the two-way capital flows mechanism and finally elevated
the yen to a global reserve currency status.
Before 2015, Beijing seemed to be following this Japanese footstep. But this
effort was stalled between 2015 and 2016 when massive capital outflows prompted
Beijing to reinstall capital controls. Nevertheless, the way that the yen ascents to a
global reserve currency may not be an appropriate way for China to follow
because it lacks a robust demand foundation.
Since the yen has never been a major international settlement currency, it lacks
the fundamental support of transactional demand. As a result, its role as a store of
value also lacks the support of the fundamental need for hedging transactional
demand risks (i.e., economic shocks). It can be argued that the internationalisa-
tion of the yen was mostly derived from the market’s speculative motive on the
yen’s exchange rate movement. When the JPY exchange rate was appreciating,
the internationalisation process advanced rapidly and smoothly as foreign
demand for yen expanded. But during periods of yen depreciation, the demand
for yen faded, slowing down its internationalisation process.
The lack of fundamental transactional demand support for the yen means
that its internationalisation process was constrained or even undermined by the
market’s changing speculative motive. As discussed above, this also happens to
the renminbi internationalisation process. To avoid falling into a similar situ-
ation, China should focus its currency internationalisation efforts on strength-
ening the role of the renminbi as a medium of exchange. It is crucial to export
renminbi through the current account. This means that China’s current account
will eventually have to turn into deficit to induce renminbi demand for financial
transactions based on trade expansion (or the real sector).
Meanwhile, Beijing should encourage imports that are not commodity-
related. This relates back to the need for China to rebalance its economy by
switching from investment-driven growth and to consumption-led growth. Such
expenditure-switching which will enlarge the offshore renminbi pool by
 Renminbi Internationalisation 179

increasing non-commodity, consumption goods imports that are not necessarily

priced in US dollars. In other words, China’s structural reform to rebalance the
economy is also a necessary step for deepening renminbi internationalisation.
Finally, financial liberalisation should keep up with the progress in the trade
sector so as to create demand for renminbi for non-trade purposes. This means
creating a big offshore renminbi market.
What all this analysis says is that the much feared, or hyped, about renminbi
internationalisation wreaking havoc on the global system by upsetting the status
quo will remain a remote fear for a long time. Despite a gradual pick up in the
pace of the internationalisation process since 2018, the share of renminbi in
China’s foreign trade settlement has been stuck in less than half of what it was in
2015. Meanwhile, the stock of offshore renminbi deposits (mostly in Hong Kong)
has fallen to about RMB600 billion at the time of writing from over a trillion in
2015, and ‘dim sum’ (or offshore renminbi) bond issuance was down to USD1
billion per month in 2018 from USD10 billion a month in 2015.
All this speaks volumes about the unsustainability of renminbi international-
isation via speculation that we discussed above – internationalisation accelerates
when speculative positions rise on expectation of renminbi appreciation and
subsides on expectation of renminbi depreciation. Currency demand driven by
speculation is hardly the hallmark of a global reserve currency. Global players
want to own US dollars or euros or yen because they offer legal security, liquidity
and full convertibility, but not only because of appreciation expectations. Doubts
about the renminbi’s full convertibility will continue to constrain its growth as a
global currency for a long time.

Not a Top Policy Priority

Contrary to many analysts’ belief, renminbi internationalisation has never been a
top policy goal on Beijing’s agenda (Windsor & Halperin, 2018). Although in
2012 Beijing did state a goal of gradual capital account convertibility at the 18th
Chinese Communist Party Congress, it had never made any strong commitment
to it. Then at the 19th Party Congress in 2017, it had totally dropped any
reference to capital account opening in its policy agenda. Indeed, former PBoC
governor Zhou Xiaochuan said openly in 2015 that the capital account
convertibility that China is seeking to achieve is not based on the traditional
concept of being fully or freely convertible. Instead, China would adopt a concept
of ‘managed convertibility’ (Zhou, 2015).
By managed convertibility, China means it has the right to decide on which
kinds of capital flows (both in- and out-flows) are ‘good’ and which kinds are
‘bad’ and has the discretion to control them. The use of such discretion was fully
manifested in late 2015 and 2016 when Beijing imposed capital controls to stem
the rampant capital outflow from China. So it is clear that while China is inter-
ested in internationalising the renminbi, full liberalisation has never been a top
policy priority.
180 China’s Global Disruption

All those efforts made to open up China’s onshore capital markets in recent
years will not do much to change the picture for full convertibility. Even if the
inclusion of Chinese bonds in the key global benchmark indices, including
Bloomberg-Barclays, J.P. Morgan, HSBC and FTSE Russell, brings in billions
more of portfolio inflows in the future, this does not necessary have any real
bearing on the renminbi’s future as a global reserve currency if it remains
inconvertible and if foreign ownership restrictions on renminbi assets also
remains. Just look at Indonesia, where foreigners own some 40% of its rupiah-
denominated government debt. Would anyone claim that the rupiah is on course
for any global significance?
All this is not to deny the rising influence and importance of the renminbi in
the global stage. With the Chinese Dream driving a strong structural reform
incentive to put the country on a long-term sustainable growth path, it may be
conceivable that one day the renminbi will become a global currency and yet for
China to retain a discretionary approach to managing its capital account. But that
will probably take some renegotiation of the global monetary system to get there,
and a Bretton-Woods-like system may be a way to go because it had capital
controls at its very centre, with the United Kingdom and France keeping capital
controls until way after the system was scrapped.
History shows that the emergence of a new global currency would take decades
to materialise after economic dominance. The United States overtook the United
Kingdom as the world’s largest economy sometime around the mid-1850s
(Krugman, 2000). Although the dollar became an increasingly important global
funding currency after World War I, the pound sterling still accounted for 87% of
global FX reserves as late as 1947. In other words, once a global currency, inertia
will keep its place for a very long time before a new currency can take over (Eiji &
Makoto, 2016).
The international use of the renminbi will certainly rise in the future, especially
in Asia, where supply-chain integration with China has increased the correlation
of movement between the renminbi and the regional currencies (see Chapter 8).
The greater that currency correlation becomes, the more natural for the renminbi
to become the currency choice for trade settlement. Add in the BRI countries
(there almost 70 of them at the time of writing), the renminbi bloc will grow much
larger than it is today when these countries start using more renminbi in their
trade and investment transactions with China.
However, it also seems quite likely that China will remain attached to its
preference for discretion in its management of the capital account over the free
market principle that pretty much allows everyone to do anything with a reserve
currency. After all, control is the principle of the communist party and as long as
it is running China, full marketisation of the Chinese system is not a practical
expectation. As long as that is the case, the much feared global disruption
stemming renminbi internationalisation will remain manageable.
Chapter 11

The Disruptive Belt and Road Initiative

China’s Belt and Road Initiative (BRI), launched by President Xi Jinping in late
2013 when he visited Central Asia and Southeast Asia, has generated a lot of
suspicion and criticism about the geo-political and economic impact of this
ambitious project on the world’s balance of economic and political powers.
However, the far-reaching impact of BRI on the global economy has not been
fully understood, with mostly hype and sometimes exaggerated fears over-
whelming rational analysis. In particular, most observers and analysts assume
that BRI was a well-planned strategy by Beijing to accelerate the rise of China in
the global stage (Djankov & Miner, 2016), challenging the developed world led by
the United States.
From a political economy perspective, the BRI is indeed a new kind of Chinese
diplomacy – one shifting from a defensive stance to a proactive strategy focussed
on enhancing national security by countering American containment. However,
like the renminbi internationalisation project (see Chapter 10), Beijing faces
constraints on the delivery of the BRI results despite a strong incentive to make it
work. A derived problem of the BRI is the so-called ‘debt trap’ diplomacy
(Brautigam, 2019) that has ignited fears about Beijing wreaking havoc on the
global system by stirring political and financial storms. The worry is valid, but its
ultimate global impact may not turn out as most observers and critics have
expected. China would get hurt too if it pushes such money politics too far.
A crucial point that conventional wisdom has missed about China’s BRI
global impact is the reaction of global powers, particularly that of the United
States, which have every incentive to prevent Beijing from realising its objective.
Many of China’s Eurasian neighbours, especially the democratic ones, also realise
(and fear) that their interest could be compromised if China were to achieve
primacy. This global reaction constitutes a strong constraint on Beijing’s efforts to
push the BRI programme. A corollary is that the United States’ foreign policy
plays a very important role in contributing to disrupting the global system in
counteracting China’s BRI.
By pursuing foreign and trade policies that hurt friends as well as competitors
(Cassidy, 2018), the United States is creating precisely the political-economic
running room China needs for advancing its interests via the BRI. For
example, by squandering its influence in the Middle East and Asia, it is opening
the door to greater Chinese influence in these regions. Arguably, Washington

China’s Global Disruption, 181–196

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211012
182 China’s Global Disruption

could have some material influence on many parts of Beijing’s BRI project but
only if it first manages to stop self-destructing (Zakaria, 2019). In any event, the
BRI is a big deal when it comes to global disruption, not only because of the huge
network of influence that Beijing aims at building but, more importantly, also
because of the clash between China and the United States.

The Strategic Importance for China

The BRI aims at achieving long-term economic and political objectives. It is,
arguably, a ‘one stone kills three birds’ strategy that will help China achieve
international, domestic and political objectives in the long-term by opening up
new trade and investment opportunities that will reshape the global balance of
economic power (Lo, 2017, Chapter 8). It has a land route called the Silk Road
Economic Belt that includes countries on the ancient Silk Road through Central
and West Asia, the Middle East and Europe, and a sea route called the twenty-
first century Maritime Silk Road that links China’s port facilities with the African
coast through South and Southeast Asia, moving up through the Suez Canal to
the Mediterranean.
Domestically, the BRI aims at exporting China’s excess capacity by creating
new markets for Chinese manufacturers, construction firms, capital goods makers
and manufacturers. This should enhance domestic investment returns and stabi-
lise GDP growth over the longer-term. The project envisages building roads,
railways, pipelines and industrial corridors across almost 70 countries (and the list
of countries will grow over time), requiring billions of tonnes of steel and cement,
hundreds of thousands of workers, tens of thousands of cranes and diggers, and
dozens of new dams, power stations and power grids. It also aims at connecting
all BRI countries by internet networks driven by Chinese technology.
Internationally, it should unleash an infrastructure boom by connecting China
with Asia, Europe and Africa by land and by sea and boost renminbi inter-
nationalisation by encouraging its usage in both trade and financial transactions.
Politically, Beijing hopes to use BRI to secure foreign trade relationships to
counteract major trade pacts that have excluded China and to breakout of the US
foreign policy that blocks China’s expansion eastward.
The whole BRI vision aims at building a massive network of trade, investment
(especially in infrastructure) and technology for China to expand into countries in
Asia, Central Asia, the Middle East, Europe, Africa, America and even Latin
America (Map 11.1). It should also go a long way to deepen renminbi inter-
nationalisation when the Chinese currency is used for payments. The oil-
producing Middle East region, which lies on the east-west land route of BRI, is
of particular strategic importance to China due to its linkage with the major oil-
consuming regions. Establishing a major influence in the oil-producing Middle
East will enable China to also exert influence on trading with the major energy-
consumption regions.
The geo-political aspect of BRI is an especially important strategic vision of
Beijing. The Chinese Communist Party (CCP) has started changing its foreign
 The Disruptive Belt and Road Initiative 183

Map 11.1. Belt and Road Network.

policy stance from defensive to proactive since President Xi Jinping came to power
in 2013. The new Chinese foreign policy is dubbed ‘wolf-warrior’ diplomacy, which
features an assertive, and at times aggressive, stance (Lucas, 2020; Zhu, 2020) The
policy shift aims at making China an independent politico-economic pole in the
world, which is reflected in President Xi’s ‘Chinese Dream’ that tries to transform
China from a regional power into a global geo-political power eventually to give it
the opportunities to strengthen its security and stimulate economic development.
However, before China can become an influential global player, it must first solve
its internal socio-economic problems.
For this reason, according to the senior leaders’ policy roadmap, by the time
when the CCP celebrates its centenary in 2021, China must turn into a modern
and moderately wealthy socialist country. When the People’s Republic of China
marks its centennial by 2049, the Party aims at having rejuvenated the nation,
created favorable external conditions for the country’s reform and development,
safeguarded the country’s sovereignty, security and development interests, and
maintained world peace and stability to promote common development. All these
are areas of achievement included in the Chinese Dream vision, and the BRI is a
major policy pillar for crystalising these initiatives.

It’s a Sino-US Disruption

However, America’s ‘Asia pivot’ policy (Davidson, 2014) to deter China from
becoming a dominant power in the region is a threat to China’s ambition and
184 China’s Global Disruption

national security. A map of the US treaty allies in Asia Pacific shows this clearly.
The distribution of American allies in the region spans from north to south of the
Pacific Ocean, from Japan and South Korea through South and Southeast Asia to
Australia (Map 11.2), forming an invisible shield that blocks China’s expansion to
the east.
Hence, the BRI expands to the west from China. However, such expansion
clashes with the US ‘Silk Road’ project (Laruelle, 2015), which Washington
launched in 2011 and aims at building connections between Afghanistan and
Central Asia, South Asia and the Middle East. So the United States sees China’s
BRI as a threat to its national security. Washington hopes to enlist India and

Map 11.2. The Invisible American Shield.

 The Disruptive Belt and Road Initiative 185

Japan in its effort to counter China and the influence that Beijing is gaining across
the world through the BRI.
Meanwhile, China is also trying to involve Japan and India in its BRI. By
persuading them into collaborating on BRI projects and deepening economic
relations with these two countries, Beijing aims at gaining their trust gradually by
trying to convince Delhi to strengthen cooperation in the Bangladesh-China-
India-Myanmar Economic Corridor, a plan which the four nations drew up in
2013. China reckons that pursuing this economic project would help ease tensions
between Beijing and Delhi and lead to significant bilateral trade and strategic
benefits (Lo, 2017, Chapter 8). By enlisting Japan in the BRI plan, China hopes to
secure influence in Northeast Asia by breaking the United States’ strategic alli-
ance in the region and gain a strategic leverage on managing the Korean
Peninsula.
In the grand scheme of things, China is using the BRI to mitigate territorial
and regional disputes. At the same time, it is deepening its military and political
cooperation with Russia to counterbalance the United States’ influence in the
Asia Pacific region and Central Asia. Moscow and Beijing have agreed to link the
BRI with the Russian-led Eurasian Economic Union,1 an economic union of
states that also includes Armenia, Belarus, Kazakhstan and Kyrgyzstan, which
lies along the BRI route (Lo, 2017, Chapter 8).
Thus, to blame China on upsetting the global balance of power is myopic.
Sino-US tensions lie at the heart of this disruption which, arguably, is inevitable
due to the rising influence of China challenging the global supremacy of the United
States. Through the BRI, Beijing is creating deeper economic and political inte-
gration with its neighbouring countries and beyond, stretching to Africa, Europe
and Latin America, so that it will not be isolated in case of a Sino-US confrontation
and will still be able to pursue its geo-political and geo-economic agendas. Beijing is
also using the BRI to strengthen its national security by improving relations with
countries with which it has territorial disputes or political tensions.

The Hype About the BRI

When China held the two-day BRI forum in Beijing in May 2017 and outlined
action plans for building new trade and investment global networks, the world
was left with an impression that China had an integrated implementation strategy
to expand its global influence. Optimists argued that the BRI would bring sig-
nificant economic benefits to the global economy through China’s financial sup-
port for, and enhanced policy coordination with, the BRI countries. But critics
fear that it would just be a ruse for China’s self-economic and political interests.

1
The Eurasian Economic Union (EEU) is an economic union of states located primarily in
northern Eurasia. A treaty establishing the EEU was signed in 2014 by the leaders of
Armenia, Belarus, Kazakhstan, Kyrgyzstan and Russia, and came into force on 1 January
2015.
186 China’s Global Disruption

The truth is that there is no implementation plan and no official BRI projects
as such! The May-2017 forum explained, for the first time, President Xi’s vision
and intentions of his BRI idea, but it provided no details of any strategy or project
list. The BRI is not a coherent trade and investment plan but a series of wide-
ranging projects that serve Beijing’s economic and political aspirations (whatever
they may be), in my view.
Meanwhile, different levels of the Chinese government have used the initiative
as an excuse to launch investment projects. The media and many analysts have
assumed that all these were BRI projects, even though they may not have any
official BRI status. Many of these projects were planned and initiated before
President Xi took office but have been folded into the grand narrative of the BRI.
Beijing has talked about 67 or so countries would be included in the BRI, and the
country list has been growing, but it has also said that there would be no
geographical restrictions. What actually gets built will depend on individual deals
struck between Chinese and foreign firms, subject to diplomatic negotiations
between the governments.
The reality is that the BRI is a vision based on an evolving concept. For
example, the initial BRI policy document called for building six economic link-
ages across the Eurasian landmass, but it did not specify the routes of connection
or target any specific industries and infrastructure projects. This left open the
possibility of any projects any routes depending on the evolvement of the political
objectives and environment.

The Commercial Reality

Critics often doubt the commercial viability of many of the so-called BRI pro-
jects, and there is no lack of examples of failure. China’s data seem to show that
the BRI projects do have difficulties in generating revenues. Chinese foreign
(engineering and construction) projects, which are a proxy for capturing BRI
investments, enjoyed a decade of steady revenue growth until 2015 shortly after
Beijing prioritised the BRI. Their revenue growth has slowed to a trickle since
then, even though the number of new contracts signed has kept growing strongly
(Fig. 11.1).
A macroeconomic explanation for the slowdown in this foreign income is the
fall in commodity prices in 2014 and 2015. Since most of China’s foreign projects
were focussed on resource extraction, income from these projects was hit hard by
the decline in commodity prices. The question was whether BRI could reignite
revenue growth in the foreign projects?
Subsequent data show that there was a sharp increase in the newly-signed
foreign contracts and some recovery in their revenues between late-2017 and early
2019.2 However, after early 2019, revenues dropped again. More importantly, the

2
Although there was no evidence that all of these projects were related to the BRI
infrastructure push and not all signed contracts would be realised, this data is
nonetheless the closest proxy for BRI projects.
 The Disruptive Belt and Road Initiative 187

Fig. 11.1. China’s Foreign Contracted and Completed Projects*.

rising gap between the contracted projects and realised revenues (see Fig. 11.1)
raises the suspicion that many Chinese firms were probably responding to political
pressure by rushing to sign all sorts of phony deals and then letting them quietly
rot away. Indeed, many provinces and cities have sent overseas delegations to find
projects and signed MOUs to satisfy the political directive, regardless of the
viability of the projects. When there was no follow-up of implementation on the
projects, there were of course no revenues generated.
To be fair, it is still too early to judge whether the BRI will succeed or fail
because building new trade networks and infrastructure will take a long time.3
Meanwhile, BRI enthusiasts have overstated the ability of China’s new financing
channels, notably the Asian Infrastructure and Investment Bank (AIIB), to fund
infrastructure investment in the economies along the BRI routes.

The Suspicion
Development-finance bankers have argued that Asia’s infrastructure deficit is not
a result of a lack of funding but of viable projects. So critics have opined that
while China had money it might still struggle to find profitable projects to invest
in. But it would still channel funds into commercially nonviable strategic projects

3
There is no lack of casual views on judging China’s BRI. For example, see “Why China’s
One Belt One Road Plan Is Doomed To Fail”, SCMP, 8 August 2016 http://www.scmp.com/
week-asia/opinion/article/1999544/why-chinas-one-belt-one-road-plan-doomed-fail.
188 China’s Global Disruption

to bolster its economic security or boost growth in its impoverished regions and to
establish political influence in the recipient countries.
India, in particular, has been very critical of China’s BRI, criticising its con-
nectivity projects for ‘overriding sovereignty’ of other nations (Krishnan, 2017)
and seeing China’s port-building exercise in the Indian Ocean, notably in Sri
Lanka and Pakistan, as a platform for military expansion. In general, many
countries suspect that China’s BRI diplomacy is just a ruse for advancing its
economic and geo-political interests, despite Beijing’s assurance of its purpose of
building a community of common interest (Brown, 2019).
The truth is probably a bit of both. China wants to boost its economy and
create a regional production chain centred on its manufacturing power which, in
my view, is a way of building an ‘empire’ for expanding its economic and political
influence (Lo, 2017, Chapter 10). So the BRI initiative is about exporting Chinese
technology and industrial capacity to emerging markets.
Chinese banks and the AIIB will finance infrastructure projects in building
highways, railways, ports, airports, power grids, oil and gas pipelines, telecom
networks etc. in the BRI countries. They will create demand for Chinese capital
and industrial goods and services in the recipient countries and generate income
for them to trade with China and pay for the Chinese loans and investments.
Ideally, when these trade, investment and financing deals are settled in and funded
by renminbi, the BRI will become a powerful tool for internationalising the
renminbi.
So it is a win-win outcome, from China’s perspective that is. Undoubtedly,
China is putting its interests first, but there are also benefits for the BRI countries.
China’s economic and political leverage will inevitably grow but that might be a
trade-off for countries anxiously seeking economic development but are ignored
by the multinational development banks.

Abide by International Norms

Relating to the political suspicion are concerns that Beijing would use the AIIB as
a tool to reshape the global economic architecture by bypassing the global
standards established by the existing world order. But evidence shows that the
AIIB has been just another multilateral development bank led by a team of
foreign officials and former bankers who come from global institutions. This
development is important because it counters the spirit of the AIIB’s founding
document that states that it would be a financing tool for Beijing’s BRI.4 It also
shows that the concerns about the AIIB upsetting the global governance structure
have so far been exaggerated.
In my view, the shift in the AIIB’s focus was a result of its own success. Beijing
might originally want to create an institution that would be a quasi-Chinese
government fund for financing Chinese industries to export their excess

4
Asian Infrastructure Investment Bank, Articles of Agreement: https://www.aiib.org/en/
about-aiib/basic-documents/articles-of-agreement/index.html.
 The Disruptive Belt and Road Initiative 189

capacity. However, within 18 months of China’s proposal to set up the Bank in

October 2013, 57 countries signed up to become founding members, including
many European countries that have high governance standards. The resultant
AIIB is simply too big and too diverse to function as a unilateral tool of China’s
money politics.
The AIIB’s first moves were cooperation with the existing order rather than
confrontation or competition. In all of its nine projects in the BRI countries
between 2014 and 2016, it complemented efforts of the World Bank, the Asian
Development Bank and the European Bank of Reconstruction and Development
by contributing USD1.73 billion to their projects. Most importantly, none of
these loans were made in renminbi. Hitherto, there have yet been any loans made
in renminbi by the AIIB. The AIIB also lends in local currencies, including Indian
rupee, Indonesian rupiah, Thai baht, Turkish lira and Russian ruble, but not
renminbi, according to the AIIB Treasury data.5 All this evidence counters the
world’s concern about Beijing’s ambition of using the AIIB to push renminbi
internationalisation.
These signs should serve to allay fears that China is building its own institution
to challenge the existing world order of development finance. The evidence so far
seems to suggest that the AIIB represents an evolution rather than a revolution in
development finance. Together with the AIIB, BRI is a bold strategy that must be
taken seriously. It may prove to be a long-term stimulus not only for China’s
growth but also for the growth of the developing world, as the latter badly needs
infrastructure investment. The investment opportunities will likely outweigh the
risks if China goes by its words in encouraging free trade and abides by inter-
national norms and market rules. But if the BRI is a smokescreen for China to
advance its self-interest at the expense of the others, it could be a disruption for
markets. At this point, the BRI plan deserves the benefit of the doubt to be a
positive force for the global system.

The Invisible BRI

If new technologies are a disruptive force, then the BRI certainly plays a role in
it. While China’s stated objectives of the BRI look west by connecting its old
economy to other developing countries in Central and Southeast Asia, Africa,
Europe and Latin America, its most powerful growth centres are looking east –
to the United States. China’s ‘netware’ companies are driving technological
innovation to propel future economic growth as envisioned by Beijing’s new
industrial policy, formerly dubbed the ‘Made in China 2025’ industrial policy.6

5
See https://www.aiib.org/en/treasury/_other_content/faq/index.html.
6
Due to the trade war with the United States, which started in 2018 and is still on-going at
the time of writing, China has stopped using this term “Made in China 2025” to describe its
industrial policy since 2019 in order to soothe political tensions. However, dropping the
name has changed nothing in the underlying industrial policy, which still focusses on
developing China’s high-tech industries and computer and artificial intelligence powers
with the aim of making China a global high-tech power by 2025.
190 China’s Global Disruption

This development connects with the BRI via infrastructure investment by China,
which includes building information technology (IT) networks in the BRI
countries.
However, the world’s netware champions are all built on American operating
platforms. As China wants to be a leading global technological centre of the
twenty-first century, it will have to climb the netware value chain that connects it
to the United States. This is indeed an invisible global BRI route outside con-
ventional thinking because China’s future technology growth centres (Shanghai,
Beijing, Shenzhen, and the list will grow) are looking east to the US (notably the
west coast). While the Sino-US trade war that started in 2018 may disrupt that
trend as the US is trying to cut China off from American technology transfer, it is
too early to conclude if the Americans can really do that (Goldman, 2020;
Johnson & Gramer, 2020; Swanson & McCabe, 2020). This is because the US
tech sector will also be hurt badly without the Chinese technological innovation
that helps build American tech products.
Online netware companies in eastern China are driving technological innova-
tion in the country. Beijing’s modern industrial policy has emphasised the tech-
nology sector as the future of economic growth. Netware represents a wide-range
of technologies, including social networks, online market platforms, e-payment
and investment platforms, ride-hailing services such as Uber-equivalent Didi
in China, shared bicycles, online hospitality service such as Airbnb and even
computer games.
China’s two most profitable new-economy companies are Alibaba (the
Amazon-equivalent) and Tencent (the Facebook-equivalent). The former runs
Taobao and Tmall e-commerce sites which are the number one and two,
respectively, online marketplaces in the world, while the latter runs the ubiquitous
WeChat social network and many other online services, including payments and
games. They even have online financial platforms that engage in financial and
investment services and selling of financial products.
These netware giants, and many others like them, are quite profitable, repre-
senting the success stories of China’s new economy. Unlike hardware companies,
such as Lenovo, ZTE and Huawei, which compete fiercely in individual unit sales,
they make money not by selling tangible products but by selling services that help
people to sell to each other. They are also leaders in new technologies such as
artificial intelligence and virtual reality by leveraging on their online networks.
Most crucially, they are all built on American platforms.

The Close Linkage with the US

Beneath the threat of a Sino-US trade war lies an inseparable economic tie
between the two economic giants via trans-Pacific technological networks. Net-
ware development is heavily concentrated in the Pacific Basin, with the leading
netware applications coming overwhelmingly from Chinese and Americans.
Companies such as Didi, Baidu, Alibaba, Tencent, Shanda Interactive Enter-
tainment, Mobike Technology, NetEase, Apple, Amazon, Google, Facebook,
 The Disruptive Belt and Road Initiative 191

Uber, Airbnb and Activision all share a Pacific netware ecosystem. European
companies barely register on the radar.
The business model of these online businesses is created by the United States
and represents the success of Silicon Valley which has evolved from hardware
incubation and development to software and netware manufacturing. For
example, Apple may design its iPhones in Cupertino, California, but it does not
manufacture any units. Apple makes money by putting users into an online ser-
vices ecosystem based around iTunes and the App Store.
China’s high-tech cities are going the same way. Apple’s iPhones, once made in
Shenzhen, are now mostly made in the poorer and cheaper city of Zhengzhou in
the Henan province in China. Huawei and ZTE, which are both Shenzhen-based,
have also moved their manufacturing lines to inner and cheaper provinces. All
this underscores my argument that industrial migration to the inner provinces
would help sustain China’s economic growth at an average of 6% for a much
longer period than most observers have expected (see Chapter 4). Shenzhen,
China’s Silicon Valley, like California in the United States, has evolved
into focussing on IT and AI development, social networks, online marketplaces,
e-ecommerce and sharing apps.
China basically imported all the successful netware business models from the
west coast of the United States. Tencent was founded in 1999 as a clone of AOL’s
ICQ service. Jack Ma founded Alibaba in 2000 with Silicon Valley venture capital
and expanded it by merging with Yahoo in China. Robin Li, the CEO of Baidu,
worked at Silicon Valley search engine pioneer Infoseek before co-founding Baidu
in 2000. These firms have come a long way but their close connections with Sil-
icon Valley remain.
Whether they are Chinese or American firms, the common thread among them
is that they are all built on American operating platforms (Android, Windows,
iOS or macOS) and programmed in American languages (Java, JavaScript, PHP,
Python, Perl and SQL). China is aiming at becoming a leading global techno-
logical centre in the twenty-first century. To do so, it will have to connect closely
with Silicon Valley and other US technology hubs to be part of the value chain as
the US–China technology ecosystem that links champion companies on both
sides of the Pacific Ocean is the key to their shared economic future.

An Invisible Global BRI

The strategic objective of the BRI aims at building a massive network of trade
and infrastructure by China in Central and Southeast Asia, the Middle East,
Eastern Europe, Africa and even Latin America. Obviously, this initiative is
crucial for China’s traditional exporters of cheap manufactured goods and for the
state-owned heavy industries that build infrastructure projects.
However, when it comes to China’s economic future, it is pushing hard to
develop twenty-first century technologies, such as blockchain, big data, virtual
reality, artificial intelligence and the Internet of Things And within the BRI
framework, building IT networks in the BRI countries is part of the infrastructure
192 China’s Global Disruption

investment objective.7 This linkage between China’s high-tech economic future

that looks east and the BRI’s expansion that looks west is indeed an invisible Belt
and Road Initiative beyond conventional thinking. Putting them together, the
BRI is indeed a global framework that could make revolutionary changes to the
world’s trade, investment and technology development in the future.

The Reality of ‘Debt-trap’ Finance

The world is also worried about China shaking up development finance, which is
an area of economic prowess dominated by the developed world institutions,
including the World Bank, the Asia Development Bank and the European Bank
for Reconstruction and Development. Notably, there is a suspicion that China is
using ‘debt-trap’ finance through its BRI to mire developing-country partners in
unsustainable debt-based relationship to advance its economic and geo-political
ambitions (Brautigam, 2019).
This view assumes that China could maximise its economic and geo-political
interests by ensnaring its BRI partners in debt distress. But evidence shows that
China has not always been able to reap the alleged economic benefits and that it
has even been a victim of its lending missteps. Pushback from BRI recipient
countries is increasing, leading to a decline in BRI investment already. More
importantly, domestic criticism on the BRI has emerged, which will scale back,
though not stop, President Xi’s BRI ambition.
China’s increasingly assertive foreign economic policy through its BRI has
been criticised as a practice of neo-mercantilism (Blackwell & Tellis, 2015) and,
more recently, as ‘debt-trap diplomacy’ (Chellaney, 2017). These views argue
that China had sought to advance its economic and geo-political influence by
purposely ensnaring some of the developing countries in unsustainable loans-
for-infrastructure deals.
The conventional wisdom is that the heavier the debt burden on the recipient
country, the greater China’s leverage becomes when the country is being forced
to sell to China stakes in Chinese-financed projects or hand over management
to Chinese state-owned investors. Concerns about China’s debt-trap finance
have found their way into some countries’ foreign policy circle, aggravating the
geo-political tensions (Hurley, Scott, & Portelance, 2018 and The White House,
2018). Critics of China’s BRI assume that its economic interests are maximised
when its lending partners are in financial distress. However, there is no proof
for this claim.
There is no reliable data for tracking the profit and loss of China’s BRI pro-
jects. But as I argued above, we can use data on the difference between China’s

7
The Internet of Things is the network of physical devices, vehicles, home appliances and
other items embedded with electronics, software, sensors, actuators, and connectivity which
enables these things to connect and exchange data, creating opportunities for more direct
integration of the physical world into computer-based systems. The purpose is to increase
economic efficiency and benefits with less human intervention.
 The Disruptive Belt and Road Initiative 193

new foreign contracts (as a proxy to BRI projects) and completed foreign projects
(as a proxy to realised foreign revenues) to gauge the performance of the BRI
projects. These data show that the BRI projects do have difficulties in generating
revenues (see Fig. 11.1 above). The rising gap between the contracted projects and
realised revenues raises the suspicion that the newly signed projects just failed to
bring in revenues and, more crucially, casts doubt on the alleged profitability of
the BRI projects.

Risks for China

Anecdotally, China’s lending to Venezuela has been the single most important
evidence of its debt-trap finance backfired. Venezuela is the largest recipient of
Chinese official finance, with the China Development Bank lending the bulk of
more than USD60 billion since 2007.8 Since China is the world’s biggest oil
importer and Venezuela has the world’s largest oil reserves, the commercial
rationale for the loans was strong for financing long-term oil partnership between
the two countries.
Yet, with Venezuela in the depths of economic and political crises since 2013,
the China–Venezuela loans-for-oil relationship has gone badly wrong. The
collapse of Venezuela’s economy means that it has not been able to make loan
repayments and even oil shipment to China. In a nutshell, Venezuela has gone
from being a geo-political asset for China in Latin America to being a liability.
Some other BRI projects have also gone wrong. For example, Sri Lanka’s
Mattala Rajapaksa International Airport, which opened near Hambantota in
2013, is dubbed the emptiest airport in the world. Hambantota’s Magampura
Mahinda Rajapaksa Port is largely idle, as is the multibillion-dollar Gwadar Port
in Pakistan. Chinese lending and investment in other BRI countries, including
Afghanistan, South Sudan and Angola have also reportedly gone wrong.
All this shows that China debt-trap finance has not achieved its intended
purpose of gaining economic and geo-political benefits through the BRI. China
might just be following the footsteps of the Western governments, businesses and
multilateral development finance institutions in the 1930s and 1970s when they
found themselves in unsustainable debt relationships that hurt debtors and
creditors alike.
Resistance to BRI investment has also been rising. Notably, Malaysia sus-
pended all foreign direct investment projects, most of which (USD23 billion) were
BRI-related, when Dr Mahathir took over as Prime Minister in May 2018. He
then renegotiated in 2019 all the projects signed by former PM Najib (Bowie,
2019).
According to the US political risk consultant RWR Advisory Group, some
14% of BRI-related investment has hit trouble since 2013 (Kynge, 2018), mostly
due to public opposition to projects, objections over labour policies and envi-
ronmental damages, and concerns about national security. Chinese-financed

8
According to data from the Carnegie-Tsinghua Centre for Global Policy as of 2017.
194 China’s Global Disruption

projects often go ahead in spite of local opposition. The USD4 billion Ituango
Dam in Colombia, which was partly funded by China, is a case in point. Despite a
well-known propensity to landslides that was highlighted in the dam’s environ-
mental impact report, repeated warnings of local activists since 2010 have been
ignored. Heavy rain finally triggered a landslide in June 2018, putting the dam in
imminent danger of collapse and forcing the evacuation of 26,000 inhabitants
(Lo, 2017, pp. 172–175).
The BRI problems have also caught domestic attention in China. Since June
2018, there have been signs of discontent from policy advisors, academics and
even government officials with President Xi’s ambitious policy agenda. One of the
criticisms focusses on his excessive ‘foreign aid’ to countries in Africa and the
Middle East with obvious reference to his BRI projects.
The public airing of such a criticism may indicate the emergence of a consensus
that Beijing should scale back its BRI ambition. RWR Advisory Group’s data
show that BRI investment and lending had started to decline, with lending by the
Chinese policy banks falling by more than 80% from 2015 and lending by Chinese
commercial banks dropping to almost nil in 2017. While the RWR data may be
anecdotal, as there are no publicly available and systematic data to track the BRI
activities, the point is that with criticism and resistance on the BRI policy on the
rise, forces may have emerged to slowdown, though not stop, the BRI
development.
In the face of international and domestic criticisms about its debt-trap finance
approach to push the BRI, senior Chinese leaders seem to want to change to a
more judicious lending approach since 2019. Indeed, with debt distress in
borrower countries on the rise due to overly ambitious investments and poor
project planning, they have little choice. More than two dozen countries owed at
least 10% of their GDP to the Chinese government, with emerging economies
owing a total of USD380 billion to China at the end of 2017 (Horn, Reinhart, &
Trebesch, 2019). The data imply that there is a limit to how indebted countries are
willing or able to become before a financial crisis emerge.
When the debtors struggle to repay, the loans have to be renegotiated. While
this puts the debtors in a vulnerable political position susceptible to China’s
pressure/influence, it can also prove costly for the Chinese creditors. China’s state
banks typically extend loan terms or repayment deadlines, and sometimes have
little option but to refinance loans at reduced rates or even to forgive debts under
Beijing’s instruction. Hence, many Chinese officials have signalled a desire to
reduce policy loans and foster alternative modes of financing. In particular, the
PBoC has pledged to ‘build an open, market-oriented financing and investment
system’ for the BRI (Bloomberg, 2019) by encouraging private lending as the
mainstay (Wong and Areddy, 2019).

BRI Ambition Scaled Back

Macroeconomic forces are also prompting President Xi to scale back his BRI
ambition. When the BRI was launched in September 2013, China enjoyed a
 The Disruptive Belt and Road Initiative 195

current-account surplus with huge foreign exchange reserves close to USD4 tril-
lion. Its steel, cement and construction industries were plagued by excess capacity
with ‘hungry’ engineering firms looking for new markets. Such a macroeconomic
backdrop justified lavish lending to foreign governments in exchange for lucrative
construction and engineering contracts. But in 2019, China’s current-account
surplus had almost disappeared, and its foreign exchange reserves had shrunk
to USD3 trillion. Greater regulatory scrutiny of BRI projects and more caution
on overseas lending have naturally become an economic necessity.
As a result, the BRI has slimmed down indeed, even if it retrains political
importance. This can be seen in the sharp drop in China’s foreign loan data. The
growth of China’s external loans rose sharply after the BRI was launched in late
2013 (Fig. 11.2). It dropped between late 2015 and 2016 when Beijing tightened
up on capital controls to stem rampant capital outflows during the market chaos
but jumped again in 2017 and 2018. Between 2014 and 2016, China’s foreign
lending growth rate averaged more than 20% a year, but slowed to about 10% in
2017–2018, and started to contract in the second half of 2019 (see Fig. 11.2). This
declining growth trend underscores a slowdown in the BRI funding expansion
(ambition).
But note that these numbers have limitations. China does not report any
details on foreign lending flows, such as the loans’ destinations, purposes and
recipients, or any breakdowns between its official lending and private-sector
lending. So it is tricky to draw conclusions from the aggregate data. A lot of
loans to foreign engineering and construction projects are hidden in the form of
Chinese bank lending to state-owned contractors in the domestic system. While
the Chinese government may have tighter scrutiny of these loans and, thus, makes
it harder for the recipient countries to abuse the Chinese loans, it also means that

Fig. 11.2. China’s Lending Abroad*.

196 China’s Global Disruption

there are no details on cross-border transactions for monitoring and analysis. So

the actual foreign lending is almost certainly higher than the official data suggests,
though the growth trends should not differ much.
In a nutshell, the BRI faces constraints on both the supply side and the demand
side. On one hand, tighter financing and more stringent project controls are
forcing Chinese engineering and construction firms to be more vigilant. On the
other hand, the recipient countries are becoming more careful about agreeing to
Chinese-funded projects, as they seek to avoid becoming financially trapped by
Beijing.
From the political perspective, the BRI is still moving forward and China is
still signing more countries into the network, with Italy, Luxembourg and
Switzerland being the most recent examples (at the time of writing) of countries
signing BRI cooperation agreements in 2019. In a way, Beijing’s attempts to reset
the BRI’s direction as a multilateral endeavour that respects international norms
are making an impact – even if many European Union members remain wary of
China’s influence. But the economic, regulatory and political constraints on the
BRI’s expansion and ambition mean that the concern about its disruption to
the global balance of power should not be exaggerated. There are benefits that the
BRI will bring to the global system, and if that is seen as a disruption because it
forces the existing powers to rethink their international policies and contribution
to the world, it would be a benign disruption.
Chapter 12

Global Disruption – The New Normal

The emergence of China is an inevitable disruptive force in the global system, for
good or bad, as the world has to accommodate a new global power. This is a
natural geo-political and economic evolution from which one can run but cannot
hide. From a risk diversification perspective, global players will be thinking
seriously about moving away from China to hedge against future supply-chain
disruption, like the 2020 COVID-19 crisis that we discussed in Chapter 1. But this
is easier said than done, as the global system is mired deeply in the China-centred
global supply chains.
From a political perspective, the ascent of China to the global stage chal-
lenging the United States’ predominance lies in the heart of a major global
disruption, among many others, that the world is facing. It does not matter if
global players want to move away from China, either politically, or socially, or
culturally, or economically, or in all of these aspects, China is a force to be
reckoned with. It is better to understand China properly so that we can manage its
inevitable disruption than to blindly resist this global force. Otherwise, the world
could fall into what Graham Allison called the Thucydides Trap – a theory that
argues that war would be inevitable between a rising power and an established
power.
Furthermore, with or without China, from an economic perspective, the global
system has become inherently disruptive by itself due to the evolution of global
monetary policy in handling financial crises. The COVID-19 crisis in 2020 is the
most recent case in point revealing the unintended consequences of modern
monetary policy fighting negative exogenous shocks leading to long-term global
disruption, the effects of which is not yet clear and visible at the time of writing.
The only way to minimise the impact of any global disruption that involves China
is to work with this emerging giant, which at times provides food for global policy
and business thoughts. While this is easier said than done, it does not mean that it
cannot be done.

The Geo-strategic Disruption

As China challenges America’s global supremacy, misunderstanding about each
other’s intentions and actions could lead them into a dangerous and deadly trap

China’s Global Disruption, 197–207

Copyright © 2021 by Emerald Publishing Limited
All rights of reproduction in any form reserved
doi:10.1108/978-1-80043-794-420211013
198 China’s Global Disruption

first identified by the Greek historian Thucydides. His metaphor refers to the
dangers when an emerging power rivals an incumbent power, as Athens chal-
lenged Sparta in ancient Greece more than 2,400 years ago. History shows that
over the past 500 years, 12 of the 16 cases of those power contests ended in wars
(Allison, 2017). In the cases which the parties avoided war, they required signif-
icant and painful adjustments in actions and attitudes on both the parts of the
challenger and the challenged.
The point is that war or not, the results will be significant disruption. The
prevailing underestimations and misapprehensions of the dangers inherent in
the Sino-US relationship contribute greatly to those hazards. According to the
Thucydides thesis, this means the world is in a precarious balance that could
easily tip over to a major war. Even a business-as-usual attitude may not avoid
the potential clash between two titans because when a rising power (China)
is threatening to displace a ruling power (the United States), accidents in any
crises that would otherwise be contained could lead to unintended consequences
that produce disastrous outcomes that none of the powers would have otherwise
foreseen and chosen.
Thucydides’ powerful insight stemmed from two key drivers of the clash
dynamics: the emerging power’s growing entitlement and ego, which translate
into its demand for recognition and decision-making on sovereign and strategic
matters, clash with the existing power’s fear, insecurity and determination to
defend the status quo. In the case of the Peloponnese war in the fifth century BC,
Athens had emerged over 50 years as a steeple of civilisation, yielding advances in
philosophy, drama, history, architecture, democracy and naval and military
prowess. This shocked and threatened Sparta, which for more than 100 years had
been the ruling power on the Peloponnese peninsula.
As Athens’ power and influence grew, so too did its ego and persistent demand
for recognition and changes to the system’s arrangements to reflect new realities
of its emerging power. The Spartans saw the Athenian posture as unreasonable,
ungrateful, instigating and threatening to the system it had built and within which
Athens had thrived. The parallel of this historical precedent points right to
China’s global ascent challenging the US-led international order which has, until
recently, provided leadership and global peace and prosperity for more than seven
decades.

COVID-19 Awakes the Wolf Warrior

The rise of China has upset the world’s balance of power because never before in
history has a nation risen so quickly and on so many dimensions of power. In a
single generation, China has emerged from being an unknown that did not matter
to the top ranks in many aspects, including economic, investment, foreign trade
and technology. In 1980 when China started to open up to the world, its economy
was smaller than that of the Netherlands. But within 20 years, it vaulted to
become the second largest economy in the world by beating Japan in 2010. It is
now projected to become the largest economy in the world by 2030 or sooner.
 Global Disruption – The New Normal 199

More crucially, like Athens back in the ancient Greece, as China’s clout
grows, its leaders have become more confident and assertive and want interna-
tional recognition. The arrival of President Xi Jinping as China’s new paramount
leader in 2013 marked the watershed of the change in China’s attitude towards
itself and the world, as summarised by his ‘Chinese Dream’ policy (The
Diplomat, 2012). When Deng Xiaoping started China’s economic liberalisation
in 1978, he pursued a policy of ‘hide and bide’. He wanted China to lie low in its
foreign relations to achieve and preserve stability and gain access to overseas
markets. Under Mr Deng’s leadership, the Chinese would bide their time and
hide their capabilities.
But Mr Xi ended the hide and bide era by transforming China’s growth engine
from export-led (i.e. Mr Deng’s foreign market access policy direction) to domestic-
driven (i.e. a self-confident and self-reliant policy) and by pursuing a more active
foreign policy that is increasingly assertive in advancing China’s interests. This new
foreign policy is dubbed as ‘wolf warrior’ diplomacy.1 The Belt and Road Initiative
is a crystalisation of Mr Xi’s change in attitude, in my view, which lays bare the
essence of his Chinese Dream ambition – the rise of a 5,000-year-old civilisation
with over 1.3 billion people is not a problem to be fixed; it is an emerging and a
secular force to be reckoned with by the world.
What is important to note from the global disruption perspective is that the rise
of China’s wolf warrior diplomacy under President Xi is clashing directly with the
change in the United States’ China foreign policy from constructive engagement
to strategic competition under President Trump. China’s wolf warrior diplomacy
is a fairly recent development, only emerged in 2017, and research on this subject
is still at its nascent stage (Zhu, 2020). But this new diplomacy reflects a total
change in China’s vision for a new regional and global order and its international
relations (Rolland, 2020).
The COVID-19 crisis has pushed the Chinese combative tactics to the centre of
Beijing’s foreign policy approach. China now believes that its decades-long effort to
engage with the West had run its course (Osnos, 2020). The wolf warrior diplomacy
mindset is to coerce counterparts to respect China’s interests because, according to
the Chinese view, cooperative security has been ineffective. Watching Europe and
the US struggle to contain the pandemic had helped convinced Beijing that it could
eclipse the American-led western world as a global power.
At this stage, it is still uncertain if China’s wolf warrior diplomacy will become
the ‘new normal’ of its foreign policy. Its aggressive application to manage the
COVID-19 international pressure in 2020 triggered a backlash (Dettmer, 2020)
that had prompted fierce debate in China over how aggressive its foreign policy

1
‘Wolf Warrior’ is actually the title of a hugely-successful series of patriotic action films in
China, featuring Rambo-like warriors who fight enemies at home and abroad to defend
Chinese interests. The first film was released in 2015 and made more than RMB545
million (USD76 million) at the box office. It quickly spawned a sequel, ‘Wolf Warrior 2’,
which became China’s highest grossing film at the time when it was released in 2017. The
film’s tagline was, ‘Even though a thousand miles away, anyone who affronts China will
pay.’
200 China’s Global Disruption

should be. But the underlying clash between the economic and political ideologies
in China and the US, as manifested in the Sino-US tech competition, is certainly
a latent force in creating global disruption in the future.

Inherent Global Disruption

Meanwhile, even without China, the world has developed a self-inflicting force to
create systemic disruption. In fighting the deflationary impact of the COVID-19
crisis in 2020, global central banks coordinated efforts by pulling out the massive
monetary-easing gun – quantitative easing (QE). However, the coronavirus crisis
was an exogenous shock that monetary easing alone could not resolve effectively.
While necessary, cheap money was not sufficient to resolve the economic
disruption due to collapse in confidence, deterioration in health conditions and
restriction on the mobility of the factors of production resulted from city- and
country-lockdown measures implemented by the global authorities to contain
the virus outbreak. Fiscal expansion would be needed to fill the void left by
monetary policy in dealing with the physical supply disruption. Monetising the
resultant fiscal deficit might not be such an evil in the short-term for resolving
the COVID-19 crisis, but it sowed the seed for long-term disruption to the global
financial system.
In the aftermath of the health crisis, the massive monetary-easing measures will
have the unintended consequences of encouraging moral hazard, worsening
uneven distribution of wealth and fuelling anti-globalisation sentiment, all of
which are global disruptive forces already unfolding. In recent years, rising
inequality in income and wealth distribution has resulted in public discontent that
has driven populist politics around the world. As I argue below, central banks’
drastic monetary action, which has taken the extreme form of QE, to fight negative
shocks like the COVID-19 pandemic will aggravate these hazards over the long-
term.
Meanwhile, complications arise from the short-term need for fiscal expansion
to augment the monetary-easing effort to counter such shocks. The main
problem with monetising fiscal deficit to fight exogenous shocks like the
COVID-19 outbreak lies in countries like the United States, which was leading
the QE effort during the coronavirus crisis. The US was more fiscally con-
strained due to its high debt and low savings than saving-surplus regions like
Asia and Europe. Monetisation of its fiscal deficit would create a bigger global
systemic disruption than other countries that have stronger macroeconomic
balance sheets would.

Central Bank ‘Put’ and Moral Hazard

Monetary intervention to bailout financial markets started in October 1987, when
the US stock market, as represented by the Dow Jones Industrial Average, lost
22.6% in one single day. The market crash prompted the then Federal Reserve
Chairman Alan Greenspan to cut interest rates and inject massive liquidity to prop
 Global Disruption – The New Normal 201

up the market. The intervention was dubbed ‘Greenspan put’,2 which some argued
had sown the seed for future asset bubbles (Fleckenstein & Sheehan, 2008). Since
then, the Federal Reserve has used similar monetary policy strategy to counter
market declines due to negative shocks, including the Savings and Loan crisis of
the late 1980s and early 1990s, the first Gulf War between late 1990 and early 1991,
the 1997–1998 Asian financial crisis, the 1998 Long-Term Capital Management
failure, the 9/11 attacks in 2001 and the 2007–2008 global financial crisis (GFC).
In dealing with these financial shocks, the Federal Reserve embraced a drastic
monetary-easing policy that boosted asset price inflation and then bailed out
investors when the resultant asset bubbles burst. For two decades, the Fed acted
alone. But the ‘Greenspan put’ has gone global since 2008 when all major central
banks coordinated their massive easing efforts to counter the deflationary impact
of the GFC.
Coordinated monetary policy action has since become a routine, justified as a
necessary unconventional policy stance for fighting macroeconomic shocks at
unconventional times. However, the global ‘central bank put’ has also created
moral hazard by eroding investor prudence and making financial market players
overly reliant on the support not just from the US Federal Reserve but also from
all major countries. In other words, collective central bank bailout efforts have
encouraged more risk-taking and market distortions (Bernstein, 2009). The
extreme form of the ‘central bank put’ is QE, which creates an even bigger global
problem than conventional wisdom recognises (see below).
Generally, QE’s effect on boosting economic growth works through a financial
wealth effect on spending via asset price inflation. Practically, in a heavily
indebted world, QE’s effect also depends on public confidence in the monetary
authorities and free mobility of economic players to facilitate the delivery of the
policy impact. But the QE effect is uncertain because the multiplier of the wealth
effect is uncertain. It is definitely less than 1 and could be zero depending on the
saving behaviour and public confidence. Furthermore, the confidence and
mobility factors are uncertain. The health hazard of the COVID-19 crisis and

2
The ‘Greenspan put’ refers to the monetary policy approach that Alan Greenspan, the
former Chairman of the United States Federal Reserve Board, and other Federal Reserve
members exercised from late 1987 to 2000. The term ‘put’ refers to a put option, a contractual
obligation giving its holder the right to sell an asset at a specified (or strike) price to a
counterparty. The put option can be exercised if the underlying asset’s price falls below the
strike price, thus protecting the holder from further losses. During Greenspan’s chairmanship,
when a crisis arose and the stock market fell sharply, typically more than 20%, the Federal
Reserve would cut interest rate sharply and inject massive liquidity to encouraged risk-taking
in the financial markets to avert further declines. The Federal Reserve’s pattern of providing
ample liquidity resulted in increasing investors’ belief that in a crisis, the Federal Reserve
would always step in and bail out the market players. Invariably, the Federal Reserve did so
each time, and the perception became firmly embedded in asset pricing in the form of higher
valuation, narrower credit spreads, and excessive risk-taking. Many economist have criticised
the put as privatising profits and socialising losses, and implicated it in inflating a speculative
bubble in the lead-up to the 2008 GFC.
202 China’s Global Disruption

resultant government lockdown measures to prohibit movement and gathering in

order to control the pandemic had destroyed public confidence and mobility. QE
is not effective under these circumstances.
The following fictional narrative illustrates these points. It is a slow day in the
town afflicted by the coronavirus outbreak. Times are tough, everybody is in debt,
and everybody is living on credit. Joshua visits the depressed town and drives
through the area looking for a suitable place away from his home, in order to
‘work from home’ as required by one of the government’s virus-fighting guide-
lines. He stops at a small local hotel and puts a USD100 bill on the desk, saying
he wants to inspect the rooms upstairs to pick one for the day.
As soon as he walks upstairs, the hotel owner grabs the bill and runs next door
to pay his debt to the butcher. The butcher takes the USD100 and runs down the
street to retire his debt to the pig farmer. The pig farmer takes the hundred dollar
bill and heads off to pay his bill to his supplier at the Co-op. The wife of the Co-op
owner then takes the USD100 and runs to pay her debt to the spa operating at the
hotel. The spa owner, who has also been facing hard times and has had to offer spa
services on credit, rushes to the hotel owner and pays off her rent that she owes the
hotel. The hotel proprietor then puts the USD100 back on the counter so the
potential customer will not suspect anything.
At that moment Joshua comes down the stairs, states that the rooms are not
satisfactory, picks up the USD100 bill and leaves. Note that no one produces
anything in this whole process. No one also earns anything. But the whole town is
now out of debt and now looks to the future with a lot more optimism.
This is how the QE is supposed to work to save the economy. Joshua is the
central bank dropping ‘helicopter money’ the USD100 bill to the economy. The
people in the town all have confidence in Joshua that he will not take the money
back before he finishes inspecting the rooms. So through government helicopter
money, or QE, the private sector’s economic confidence picks up, and everyone
moves around quickly to spend the money so that everything gets back to normal.
But if public confidence is destroyed and economic mobility is restricted, as was
the case during the COVID-19 crisis, QE would not work as the narrative had it.

Unintended Consequences
A bigger problem of QE is the uneven distribution of its benefits. When the
immediate purpose of QE is to boost financial asset prices, it benefits asset owners
most immediately while leaving out non-asset owners. Thus, QE widens the
wealth gap between the rich and the poor. Furthermore, rich people typically
have a lower marginal propensity to consume (or a higher marginal propensity to
save); this skewed benefit towards the rich limits QE’s growth-boosting effects.3

3
The marginal propensity to consume (MPC) refers to an increase in consumption by an
individual due to an increase in his/her disposable income by one additional unit. By contrast,
the marginal propensity to save (MPS) refers to an increase in saving by an individual due to
an increase in his/her disposable income by one additional unit. Both MPC and MPS are
fractions of the individual’s additional income and, thus, add up to 1 so that MPC 5 1 - MPS.
 Global Disruption – The New Normal 203

This is because for each unit of income increased, the rich will spend less than the
poor out of that additional income.
Before QE was invented, bursting of financial bubbles used to teach investors
lessons and served to shrink wealth inequality by reducing the wealth of asset
owners and income inequality. But now with global coordinated QE, the ‘central
bank put’ has transformed financial turbulence into opportunities for the rich to
increase their wealth by upping their wagers in the markets as they know the
central banks will always bail them out. So this creates a twin problem of moral-
hazard-and-income-inequality.
No doubt the COVID-19 shock has inflicted significant economic damages in
the global economy by disrupting supply chains, upending travel plans and pre-
venting people from moving around. But interest-rate cuts and even QE cannot
effectively address the destruction of health, confidence and mobility of the fac-
tors of production. Monetary easing serves mainly to prop up financial markets,
and the virus-induced physical supply and mobility restriction severely limits the
spillover effect of monetary easing on the real economy. Yes, more liquidity and
cheaper money will lessen financial burden but will not necessarily motivate
companies and consumers to invest/spend more because they just will not and
cannot.
If central banks keep bailing out investors by their aggressive monetary policy
‘put’ or QE measures, financial markets will at some point regain their footing
and rebound in a big way. But that will also create more moral hazard and more
wealth inequality between the haves and have-nots and add more fuel to populist
politics and anti-globalisation sentiment. All this will further destabilise the
already fragile international order and result in more long-term global disruption.

The Fiscal Complication

Keynesian policy prescription argues if the market fails, the government needs to
step in to stabilise the system. From the COVID-19 crisis perspective, when
monetary policy cannot effectively revive private-sector ‘animal spirits’,4 fiscal
policy needs to come in. Granted, global debt is already very high, blunting the
fiscal tool. Data from the International Institute of Finance show that total global
debt in the third quarter of 2019 reached USD253 trillion (the latest data available
at the time of writing), with the global debt-to-GDP ratio at a record 322%,
significantly higher than the pre-2008 level of about 200% (Ergocun, 2020).
However, when push comes to shove, monetising the fiscal deficit may not be
such an evil under the COVID-19 crisis emergency, especially when the author-
ities are implementing QE anyway. America, which was leading the ‘helicopter

4
Animal spirits is the term coined by John Maynard Keynes in his 1936 book The General
Theory of Employment, Interest and Money to describe the instincts, proclivities and
emotions that influence and guide human behaviour, and which can be measured in
terms of consumer/investor confidence or preference. Some have also argued that trust
should be part of animal spirits.
204 China’s Global Disruption

money’ effort in fighting the COVID-19 shock, was more fiscally constrained than
Asia and Europe, as seen in their fiscal and current account balances (Fig. 12.1).
The US had (and still has) a twin (current and fiscal) deficit, which made its
economic challenges more difficult to resolve after the crisis. Meanwhile, all Asian
governments were boosting sharply their fiscal impulse, as estimated by the
change in cyclically adjusted primary budget spending, to fight the COVID-19
deflationary shock. The ASEAN-5 countries were boosting budgetary spending
by an average of 3.6% of GDP, with Singapore and Thailand leading the pack (at
the time of writing) with increases amounting to 8% and 5% of their GDP,
respectively, compared to the estimated global average of 3% of GDP (Fig. 12.2).5
Due to its dominant economic influence as the world’s biggest debtor nation,
the resultant global disruption stemming from the US post-crisis economic
adjustment, which has yet to start at the time of writing and will be manifested in
the structural rebalancing between the savings surplus countries (led by China) and
savings deficit countries (led by the US), will be very large. This also means that
economies with weaker fundamentals, such as India, Indonesia and the Philippines
in Asia which all have twin deficits, will suffer bigger shocks from the disruption.

China Offers Food for Thought

Managing the emergence of China to the global stage is not easy, as it is the
largest country implementing the largest amount of structural changes that will

Fig. 12.1. Fiscal and Current Account Balances (2019, % of GDP).

5
Indonesia, Malaysia, Philippines, Singapore and Thailand.
 Global Disruption – The New Normal 205

Fig. 12.2. Fiscal Impulse (2020, Implied by Budgetary Spending).

inevitably create systemic disruption to the world. The business community is well
aware of China’s role in leading the way in global business disruption and
innovation by being fast and first, global and local, and by investing in big data
and artificial intelligence with applications to broad range of business and con-
sumption activities. But the macroeconomic disruption, for good or bad, is still
under-appreciated by the global community due to the lack of proper under-
standing about China’s macro risks and changes.
China is a force to be reckoned with, but it does not have to be always a
negative force as many public (uninformed or distorted) opinions have it. The
COVID-19 crisis is a case in point. The crisis has created a global disruption with
both short- and long-term dimensions. In the short-term, the crisis-inflicted
growth damages have prompted governments into massive policy stimulus,
including using QE. But this massive bailout approach is creating a long-term
problem of more wealth inequality that threatens to disrupt globalisation. The
biggest challenge for the world’s policymakers is to resolve these short- and long-
term problems simultaneously at the least cost.
China’s policy easing approach may offer some food for global policy thoughts.
Since 2018, Beijing has been implementing targeted monetary and fiscal easing to
balance the needs for stabilising growth (a short-term objective) and reducing debt
and excess capacity (a long-term objective). Whether it is liquidity injection, via
interest rate or bank reserve requirement ratio cuts, or fiscal expansion, via gov-
ernment spending/investment or subsidies or tax cuts, the easing measures have
been implemented selectively, with liquidity and fiscal spending being channelled to
the targeted sectors without wholesale bailout. This is intended to avoid the
developed world’s QE approach deepening income inequality and, thus, the cor-
responding hazards to globalisation.
206 China’s Global Disruption

The primary policy objective of China’s approach is not to boost growth, but
only to stabilise growth, and not to ignite any asset bubble price inflation in the
process of policy easing. Granted, this approach carries a policy risk of insuffi-
cient stimulus for sustaining growth. But it is a cost that China is willing to pay to
simultaneously address the short-term cyclical problems and long-term structural
woes. No one expects the Chinese system to be replicated by other countries.
Even without China, global disruption seems to be the ‘new normal’ of the
future. But the spirit of China’s targeted easing approach may offer some thoughts
on policy design for addressing short-term (cyclical) and long-term (structural)
disruptions at a lower cost to income distribution and globalisation than the
blanket QE approach. Understanding China better, as this book tries to do and
show, will help the world manage the China risk and lower the cost of managing
and living with the new normal of disruption.
Finally, regarding the Sino-US tension, it is arguably the epicentre of a
disastrous crisis that could potentially erupt in the not too distance future,
according to Graham Allison’s Thucydides Trap hypothesis. Bilateral relations
were already worsening rapidly even before the coronavirus outbreak. US Pres-
ident Donald Trump’s 2017 National Security Strategy focussed on strategic
competition with China. Many Americans agree with him on punishing China for
unfair trade practices, such as subsidised credit to state-owned enterprises, and
cyber-theft of intellectual property and forced technology transfer.
While reciprocity does need to be enforced from the American perspective,6 the
COVID-19 crisis also teaches us that this competitive approach to national
security is not a good approach. And COVID-19 is not the only example. The
information revolution and globalisation are changing world politics dramati-
cally. While trade wars have set back economic globalisation, environmental
globalisation (reflected in pandemics and climate change) obeys the laws of
biology and science, not politics. In a world of porous borders to everything from
drugs and illicit financial flows to infectious diseases and cyber terrorism, coun-
tries should use their soft power to develop networks and institutions that address
the new threats but not to engage in destructive competition.
On transnational issues like COVID-19 and climate change, the combination
of power and cooperation becomes a positive-sum game. A country should not
only think of power over others; it must also consider power with others.
Empowering other countries in dealing with transnational issues produces
externalities that help the host country accomplish its own goals. For example,
everybody can benefit if others improve their energy efficiency or public health
systems.
Granted, all leaders have a responsibility to put their country’s interests first,
but the crux of the strategic question is how broadly or narrowly they choose to
define those interests. Cooperation is possible even between geo-political and
ideological rivals. For example, during the Cold War, the United States and the

6
If China can ban Facebook and Google from its market for security reasons, the argument
goes, the United States can retaliate by taking steps against Huawei and ZTE.
 Global Disruption – The New Normal 207

Soviet Union supported a United Nations programme that eradicated smallpox.

After the 2002–2003 SARS epidemic, the United States and China established a
web of cooperative relations between national health authorities and worked
together to fight the 2014 Ebola outbreak in West Africa before another outbreak
in East Africa four years later.
As far as the potential Sino-US military confrontation is concerned, the
disastrous disruption of war is not inevitable. Four out of the 16 cases in Graham
Allison’s study of the Thucydides Trap did not end in bloodshed (Allison, 2017).
Those successes, and the failures, offer pertinent lessons for global leaders. Mini-
mising the inevitable global disruption due to the emergence of China requires
tremendous efforts and understanding China better and properly is an imperative
step.
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Index

Alibaba, 190 Capital

AliExpress, 48 accumulation, 117–118
Animal spirits, 63, 203 base, 165–166
Artificial intelligence (AI), 40 broadening, 117
Asian Infrastructure and Investment deepening, 117
Bank (AIIB), 187, 189 flight scare, 73–76
Changchun Changsheng
Balance of payments (BoP), 165–166 Biotechnology, 36
Bank failures, 99–100 China
Bank for International Settlements ageing process, 57
(BIS), 102 anticorruption war, 23–24
Bank of Japan (BoJ), 128 current account, 76–78
Baoshang Bank, 98–99 as demander, 12–14
Beggar-thy-neighbour policy, 126–127 devaluation choice, 130–133
Beijing-based Newsdog, 49 experts, 73–74
Beijing’s industrial development household debt, 107–108
policy, 39 property market, 83
Belt and Road Initiative (BRI), 3–4, 6, relevance to, 156
54, 81, 170, 181, 199 strategic importance for,
abide by international norms, 182–183
188–189 as supplier, 14
ambition scaled back, 194–196 China Foreign Exchange Trade System
commercial reality, 186–187 (CFETS), 139
debt-trap finance, 192–193 China International Payment Service
hype about, 185–186 (CIPS), 4
invisible, 189–190 China’s debt risk, 115
invisible global, 191–192 deleveraging, 115–117
linkage with US, 190–191 financial deepening conundrum,
risks for China, 193–194 118–120
Sino-US disruption, 183–185 mortgages, 120–123
strategic importance for China, partial debt debate, 117–118
182–183 China’s global disruption, 1, 17–19
suspicion, 187–188 Chinese digital currency, 1–4
Big Four State Banks, 1 COVID-19 disruption, 7–8
Big Three Telecoms companies, 1 COVID-19 legacy, 21–22
Bureau of Industry and Security (BIS), crypto-renminbi to challenging US
40–41 dollar, 4–7
ByteDance, 49 disruption to investment, 16
222 Index

post COVID-19 geopolitical Comprehensive and Progressive

disruption, 19–21 Agreement for Trans-Pacific
supply chain shock, 12–16 Partnership (CPTPP), 40
tourism, 8–9 Contagion, impact from, 160–161
trade disruption, 9–12 Content aggregation apps, 49
China–US Tech Race Corner solution, 154
big question, 45–46 Corruption, 25, 60
China challenge and limits, 48–50 Countercyclical factor (CF), 149, 151
core of tech conflict, 39–40 COVID-19
disruption and opportunity cost, awakening wolf warrior, 198–200
50–51 crisis in 2020, 197
disruption risks, 46–48 disruption, 7–8
intellectual property theft, 43–45 legacy, 21–22
‘Made in China’, 40–41 Creative destruction, 30
patents myth, 42–43 Cross-country studies, 113
Chinese Communist Party (CCP), Crypto-renminbi to challenging US
182–183 dollar, 4–7
Chinese digital currency, 1–4 Cryptocurrency, 2, 3
Chinese Dream, 3–4, 39, 65, 171–172 Currency internationalisation, 165–166
Chinese emperor shock Currency war (see also Trade war),
China risk, 37 125, 149–150
China’s anticorruption war, 23–24 and causes, 126–128
Chinese way, 36–37 China’s devaluation choice,
growth fall, 30–31 130–133
handicap of market forces, 25 devaluation backfire on China,
incentive scheme, 36 135–138
new emperor, 29–30 game, 128–130, 129–130
no china disruption to luxury Japan aggravating, 139–140
demand, 25–29 opening window for Renminbi
power-grabbing, 31–34 reform, 140–144
problem with multiple policy goals, reform, 144–145
34–36 Renminbi reform, 138–139
Chinese firms, 49 risk implications, 133
Chinese foreign projects, 186
Chinese way, 36–37 Datang, 41
Chinese Yuan in Hong Kong (CNH), Debt, 127–128
168 debt-to-GDP ratio, 115–116
City commercial banks, 96–97 debt-trap finance, 192–193
Climate change, impact on, 162–163 Debt time bomb, 89
Collateral damage, 159–160 bank failures, 99–100
Commodity, 83 China’s household debt, 107–108
exporters, 11–12 debt risk, 104–106
fear of commodity market, 82–86 debt vulnerability, 89–92
Communist Party, 24, 35 dire problem, 98–99
 Index 223

household debt mystery, 107 Foreign direct investment (FDI), 128,

LGD, 101–102 167
LGD build-up and risks, 102–104 Foreign exchange (FX), 128, 149,
policy, 111–113 165
risks, 96–98, 109–111 Foreign firms, 46
ticking time bomb, 93–95
unregulated growth, 100–101 G3 currencies, failure of, 169–171
‘Debt trap’ diplomacy, 181 Galapagos syndrome, 41
Demographic pains, 56–58 Game Theory in economics, 152
Design patent, 42 Geo-strategic disruption, 197–198
Devaluation, 127–128 Global disruption, 200
backfire on China, 135–138 central bank ‘put’ and moral
Didi Chuxing (ridesharing service), 49 hazard, 200–202
Digital Currency Electronic Payment COVID-19 awakening
(DCEP), 1, 2 Wolf Warrior, 198–200
Disruption, 50–51 fiscal complication, 203–204
to investment, 16 food for thought, 204–207
risks, 46–48 geo-strategic disruption, 197–198
to stay, 163 unintended consequences, 202–203
Domestic economic woes, 126–127 Global financial crisis (GFC),
Domestic growth shock, 90–91 70–71, 89, 117–118, 165,
200–201
Early retirement, 60–61 Global market cycle
Economic(s) capital flight scare, 73–76
development, 55 China’s current account, 76–78
economics-politics marriage, 54–56 China’s role in, 69
growth, 62 cyclical impact, 83
Emerging markets (EMs), 149, 166 fear of commodity market, 82–86
Entity List, 40–41 implications, 81–82
Eurasian Economic Union (EEU), secular impact, 83–86
185 story of relative changes, 86–88
European dream, 171 structural erosion, 78–81
Exchange rate depreciation, 127–128 things, 71–72
Export Administration Regulations Gold Reserve Act, 126
(EAR), 40–41 Greenspan put, 200–201
External funding shock, 91–92 Gross domestic product (GDP), 8–9,
53
Federal Reserve, 201 growth targets, 106
Fertility rate of population, 57–58 Group of Seven countries (G7
Fifth-generation mobile telephone countries), 21–22
technology (5G mobile Growth constraints, 62–65
telephone technology), 40
Financial deepening conundrum, Hengfeng Bank, 98
118–120 Hollywood, 157
224 Index

Household Macro Prudential Assessment (MPA),

debt mystery, 107 116
debt-service-to-income ratio, ‘Made In China 2025’, 39–41
107–108 Marginal propensity to consume
sector, 120–121 (MPC), 202–203
Hu kou, 61 Marginal propensity to save (MPS),
Huawei, 41, 190–191 202–203
Maritime Silk Road, 182
Implicit strategic alliance, 155 Market forces, handicap of, 25
‘Impossible Trinity’ paradigm, 82, Middle income trap, 65–67
144–145 Million workers, 61–62
Incentive Mortgage(s), 120–123
distortion, 37 debt, 118–119
problem, 60–61 Multi-national companies (MNCs),
scheme, 36 43–44
Information and communication
technology (ICT), 39 Nash equilibrium, 152–155
Information technology (IT), Netware, 190
189–190 New emperor, 29–30
Intellectual property (IP), 45 New monetary order, 168–169
theft, 43–45 Nominal effective exchange rate
Intellectual property rights (IPR), (NEER), 138
45–46 Nonbank financial institutions
International Monetary Fund (IMF), (NBFIs), 94, 100–101, 116
5, 53, 69, 102, 167 Non–foreign direct investment
Internet of Things, 192–193 (Non-FDI), 74
Invention patent, 42 Nonperforming loans (NPLs), 119
Iron law of liberalism, 25 Normalising, 91

Japanese experience, 176–178 One-off devaluation, 150–151

Jinzhou Bank, 98 Onshore FX market, 143–144
Joint-stock banks, 96–97 Opportunity cost, 50–51
Organisation for Economic
Kuaishou, 49 Cooperation and
Development (OECD), 60
Land sales revenues, 103–104
Lenovo, 190 Patents myth, 42–43
Life Cycle Theory framework, 27 Payable-receivable currency mismatch,
Liquidity trap, 127 165–166
Local government debt (LGD), 89, Peer-to-peer (P2P), 107
101–102 People’s Bank of China (PBoC), 1, 2,
build-up and risks, 102–104 4, 82, 98–100, 116, 130–131,
Local government financing vehicles 149, 169
(LGFVs), 101–102 Political openness, 55
 Index 225

Post COVID-19 geopolitical relationship, 20

disruption, 19–21 trade war, 35, 47, 147–148
Power-grabbing, 31–34 Society for Worldwide Interbank
Prisoner’s dilemma, 128–129 Financial
Production possibility frontier (PPF), Telecommunication
62 (SWIFT), 4–5
Public–Private Partnership debt Special Drawing Rights (SDR), 5, 170
(PPP debt), 102 Special purpose vehicles (SPVs),
Put option, 95 101–102
Sri Lanka’s Mattala Rajapaksa
Qiushi magazine, 34–35 International Airport, 193
Quantitative easing (QE), 126, 200–202 Standardising, 91
State-owned-enterprises (SOE), 41,
Real China growth story, 67–68 93–94
Regional Comprehensive Economic Sterilisation in macroeconomics, 131
Partnership (RCEP), 40 Stock Connect scheme, 5
Renminbi, 135 Structural erosion, 78–81
opening window for, 140–144 Supply chain shock, 12–16
reform, 138–139 changing dynamics, 14–16
Renminbi internationalisation, 165, China as demander, 12–14
172–174 China as supplier, 14
Chinese Dream, 171–172
failure of G3 currencies, 169–171 Tail risk, 133
Japanese experience, 176–178 Take Apple Inc., 158
Japanese way, 178–179 Tech conflict, core of, 39–40
motives, 165–167 Tech decoupling, 39
new monetary order, 168–169 Technology companies, 158
policy priority, 179–180 Tencent, 190
portfolio perspective, 167–168 Thucydides
speculative demand, 174–175 thesis, 198
stuck in first gear, 175–176 trap, 197
Replacement rate, 57–58 Tik Tok, 49
Risks, 96–98, 109–111 Total factor productivity (TFP), 65
for China, 193–194 Tourism, 8–9
implications, 133 Trade disruption, 9–12
Rural commercial banks, 96–97 Trade war (see also Currency war)
to cold war to global disruption,
Science, technology, engineering and 162
mathematics (STEM), 41 collateral damage, 159–160
Shadow banks, 116 corner solution, 154
Shock, 56 currency war, 149–150
Silk Road Economic Belt, 182 damage on United States, 156–158
Sino-US disruption to stay, 163
disruption, 183–185 global imbalance, 147–149
226 Index

growth contribution of China’s US ‘Silk Road’ project, 184–185

GDP components, 148 US dollar, 166
impact from contagion, 160–161 US dollar–bloc countries, 138
impact on climate change, 162–163 USD4 billion Ituango Dam in
no proof of devaluation, 150–152 Colombia, 193–194
relevance to China, 156 Utility model patent, 42
Trump disruption, 152–154
Trump’s optimal strategy, 155–156 Venezuela, 193
Trans-Pacific Partnership (TPP), 40
Transparency International Wealth management products
Corruption Index, 33 (WMPs), 116
Trump disruption, 152–154 ‘Will-they-or-won’t-they’ policy, 152
Nash equilibrium, 152–153 Wolf Warrior, 199–200
Trump’s optimal strategy, 155–156 World Bank, 167
World Trade Organisation, 167
United Nations Population Division
(UNPD), 57 Z-score, 91, 92
United States, damage on, 156–158 Zombie companies, 95
Unproductive credit in China, 121–122 ZTE, 41, 190–191
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