The Chinese Communist Party has lasted 100 years through one overriding philosophy, and that is that the number one goal of the Communist Party is the preservation of the Communist Party. If investors and governments were to remind themselves of this every day, a litany of policy errors and poor economic outcomes could have been avoided.
While the first sixty years of the Party could be described at the intersection of incompetent, barbaric, and tragic, from Deng Xiaoping onwards, China's economic transformation has been nothing short of remarkable. Eight hundred million people out of poverty. Urbanization rate at 64%, up from 19.4% in 1980. China has the world’s best infrastructure, is rapidly closing the military gap with the United States, spends more money on climate, AI, electric vehicles, and clean energy than any other country. While China’s rise to the world’s largest economy is due, in no small part to 1.4 billion people, its economic dominance is without question.
Yet, the western world, led by the United States, has underestimated China for forty years. Washington ignorantly assumed that China would never achieve economic prosperity without allowing political freedom. This ideological dogma gave China the upper hand, which now sees the US fighting back with policy tools more designed to hold China back rather than boost American exceptionalism. This has led many to believe Graham Allison's writing (The Thucydides Trap: Are the U.S. and China Headed for War?) I am not sure we are heading there but what is clear is that both governments and business leaders have to get their framework right about China and move away from the misconceptions that have led to flawed policy and bad investment decisions. Policies that are designed to reign in China’s rise are doom to fail.
To appreciate China, you need to understand that:
1. It can flourish without allowing people to vote
2. It can control the internet
3. The Chinese Communist Party is not China
4. If competition equals capitalism, China is Capitalist
5. Xi Jinping has inserted a structural risk factor to investing in China
6. China will not cave to international pressure
7. Chinese technology companies lead US peers
8. China is not expansionist
9. China doesn’t want the RMB to rival the USD
10. China can ban bitcoin
The investing community needs to rethink the ways that it invests in China. Traditional emerging market benchmarks are entirely out of date. Sector allocations that combine Chinese companies with global peers are problematic as they operate by different rules and cycles. Allocations to China within an Asia bucket are also imperfect, especially if China continues to look more and more inward. The only solution I see to allocate money to China as a separate strategy. Just as the United States is given its own dedicated pool of capital, China deserves the same across every asset class. The growth of dedicated China funds will be exponential in the years ahead.
Before we go there, let's deal with them is conceptions.
The one mistake that the United States has made ever since Nixon’s first meeting with Chairman Mao was the belief that China could not achieve economic supremacy without political freedom for its citizens. Every US President has made this mistake, which has led to decades of underestimating China’s potential and set in place a framework at the World Trade Organization that China abused to the detriment of tens of millions of developed marker workers. I would argue that the administration of George W. Bush, with its focus on spreading democracy to the globe, underestimated China to such an extent that it set the stage for China to come out of the 2008 global financial crisis as the world growth engine.
The United States spent four decades renouncing the involvement of the government as a source of research, development, and infrastructure. It consistently focused on how much China was wasting rather than conceding that China was building the world’s grandest infrastructure. Successive US administration dismissed the Communist Party’s efforts to be a central part of economic development through a failed Soviet lens. The result is that China’s infrastructure is lightyears ahead of the United States, and frankly, it is China’s great strategic advantage.
What Washington and laissez-faire economists failed to appreciate is the unwritten contract between Beijing and its people. The alliance between the Party and its citizens is one of providing economic prosperity and security, but political freedoms are sacrificed. This equilibrium was forged through a combination of coercion, censorship, and indoctrination, but the reality is that it works. In the past four decades, China has taken 800 million people out of poverty, allowed small businesses to flourish in arguably the most competitive (aka capitalist) environment on the planet, and has provided property rights where there were none two generations ago. The Party has kept its side of the bargain by providing the sort of economic prosperity demanded by citizens who have given up their right to participate politically.
This alliance is evolving. Xi Jinping appreciates that the stability of the Party requires not just the continuation of economic prosperity but also tackling issues such as corruption and pollution. Some of the biggest scandals in the past decade have not been driven out of a desire to exercise a voice but calling out the Party when they haven’t kept up their end of the deal regarding improving life. Mainland China has not seen a large-scale democracy protest since 1989, but public outrage of issues such as tainted milk, the Sichuan earthquake, corruption scandals involving Bo Xilai led to the Party taking steps to ensure its stability. The Party knows that its long-term survival revolves around making life better for its citizens. While we should not lose sight of the draconian actions that are omnipresent, it is telling that Mainland China could avoid democratic protests of note given moments such as the Arab spring or any fall out from the occupy/democracy movement in HongKong. While censorship plays a part, maybe the West has overestimated the importance of democracy to the average Chinese citizen.
I am not being dismissive of the abuses we are witnessing in Xinjiang. However, most Chinese residents have prioritized economic well-being over political choice.
Controlling the internet is like nailing Jello to a wall.
US President Bill Clinton’s observation is the second biggest misconception that the United States made towards China. The rise of the internet age, especially during the administration of George W. Bush, ultimately reinforced the flawed notion that the Chinese people will eventually demand the right to vote. The thinking was that the internet would expose democratic values to so-called repressed people all across the globe. Information could never be controlled, and the voices of freedom and democracy would fill the computer screens of every household on the planet. This simply reinforced how little the United States Government knew about China’s intentions and capabilities.
Enter the Great Fire Wall.
China’s ability to not only control the internet but to manipulate it to its advantage has been one of the crowning achievements of the Party and its effort to solidify control. The ability for the Chinese to ban bitcoin (more later) and build out a blockchain protocol that can run entirely within the confines of the Great Firewalls is a testament to how far the Chinese are ahead of the rest of the world where it comes to innovation infrastructure. While the United States has the great strategic advantage of American Universities, China is leapfrogging the world through its use of capital, a risk-taking mentality where failure is encouraged, and a leader in Xi Jinping who has made Chinese technological dominance a priority.
The Party has taken a systemic threat in the form of the internet and turned it into an essential tool for its longevity.
Journalist Isaac Stone Fish is one of the more hawkish contributors to the US-China Series. His criticism of the Party for human rights abuses, Hong Kong, and anti-democratic values are articulate and incredibly valid. However, he believes we often cloud the debate by not making a fundamental distinction. The Chinese Communist Party is not the Chinese people.
The Chinese people are not so different from citizens in any society. They work, they shop, family and friends influence them. They have hobbies, read the news, and faith may play a part in their lives. Western consumers are not defined by their governments, yet we often make assumptions about the values of Chinese consumers based on the attitudes of the Party. We assume Chinese consumers don’t care about online privacy, and nothing could be further from the truth. Chinese consumer privacy laws are some of the toughest on the planet, and many of the online provisions stem from GDPR.
So when making an investment decision, remember that customers are not the Party. They are aspirational consumers like any burgeoning economy. They are users of social media, are influenced by cultural issues that are regional, national, and come from abroad. Companies are notselling to 1.4bn Xi Jinpings. They are selling to people just like you and me.
If you are sitting on the fence about whether you think China is a capitalist economy, think about 996. It is a reference to work 9 am to 9 pm, six days per week. I am not saying that this is exclusive to China as many entrepreneurs in the west work crazy hours, but hard work and competition is the bedrock of entrepreneurial China.
We have to move away from the labels of communists and capitalists. The Chinese Communist Party espouses Mao and Lenin and yet has overseen the greatest four-decade expansion of any economy in human history. The US has slightly more billionaires than China, but given that China has only had property rights for less than four decades, it is safe to say where the momentum lies. China is communist in name only.
Allow me to take it a step further. I wrote the following back on June 6th
The United States will espouse its free-market values and lambast the EU, Japan, and China for their corporate welfare state, the hypocrisy of this thinking should not be lost on anyone. Is there a difference between a loan guarantee in Europe, preferential lending in China, or corporate bond-buying programs by the Federal Reserve? The results are identical, and that is to provide preferential liquidity conditions to strategically essential companies. Industrial policy is a four-letter word in Washington circles, yet; it has told the markets that its biggest companies would never be allowed to fail. Is it any wonder that the value of these companies continues to rise when, in the face of a financial shock that comes along every decade, that Washington, Brussels, Tokyo, and Beijing are prepared to nationalize losses and privatize gains. At least the Chinese government gets dividends from their investment.
There is a natural assumption that the return on capital will be more significant in the private sector versus the public sector. That may be true for many industries, but optimizing ROI should not be the role of the government. Maximizing outcomes should be the objective, and this requires capital to be spent on innovation and not bailouts. Is there anything more “socialist” than bailing out strategically important companies twice in one decade and getting absolutely nothing in return? You may not like how China runs its economy, but it is clearly working.
China continues to vault ahead of the rest of the world because it is prepared to fail. I was discussing China’s semiconductor ambitions with a Chinese venture capitalist. We were debating how much money would need to be spent on developing semiconductor self-sufficiency. He responded by saying that if they spend $250 billion but waste $100 billion, they still have $150 billion of productive long-term investment to provide the foundation for chip security for decades to come. What could be more capitalist than being prepared to fail?
Jude Blanchette is the Freeman Chair and Head of the China Program at CSIS. I would be doing you all a disservice to talk about the Party's sustainability without going to the source of the best Western intelligence on this topic. The following is from Jude’s article in Foreign Affairs Magazine released on June 22nd titled Xi’s Gamble: The race to consolidate power and stave off disaster.
Next fall, the 20th Party Congress will be held, and normally, a leader who has been in charge as long as Xi has would step aside. To date, however, there is no expectation that Xi will do so. This is an extraordinarily risky move, not just for the CCP itself but also for the future of China. With no successor in sight, if Xi dies unexpectedly in the next decade, the country could be thrown into chaos.
Even assuming that Xi remains healthy while in power, the longer his tenure persists, the more the CCP will resemble a cult of personality, as it did under Mao. Elements of this are already evident, with visible sycophancy among China’s political class now the norm. Paeans to the greatness of “Xi Jinping Thought” may strike outsiders as merely curious or even comical, but they have a genuinely deleterious effect on the quality of decision-making and information flows within the party.
It would be ironic, and tragic, if Xi, a leader with a mission to save the party and the country, instead imperiled both. His current course threatens to undo the great progress China has made over the past four decades. In the end, Xi may be correct that the next decade will determine China’s long-term success. What he likely does not understand is that he himself may be the biggest obstacle.
The great risk to global financial security in the decade ahead is a political vacuum in China due to Xi Jinping removing term limits. The consolidation of power undermines the check and balances that are inherent within the Party itself. This is an unhedgeable risk to an investor but needs to be front and center
When US Trade Representative Robert Lighthizer first visited Beijing in 2018 as the lead negotiator of the Trump administration, he brought with him a list of 147 demands. This wish list was all the concession stipulated as essential to redefine the economic relationship between the United States and China. By the time the Phase One trade deal was signed, only seven of those demands were in the final agreement. One of them related to banning the exportation of Fentanyl.
For all the noise and insults from the Trump administration, for all the Biden administration's diplomatic efforts to unite the democratic world against human rights abuses in Xinjiang, Hong Kong’s lost identity and fears over Taiwan, China has not budged. I challenge all of you to name three significant concessions that the Chinese have made in the last decade that resulted from international action. The Chinese now allow foreign ownership of financial institutions, yet American Express still doesn’t have a license to operate in China after twenty years of trying. There is no Google or Facebook, and for few success stories such as Tesla, there are hundreds of companies that struggle.
Whether commercial or moral, China determines its course. China has effectively ripped up the Joint Declaration that legally determines Hong Kong’s fate until 2047. The recent closure of the Apple Daily, the imprisonment of pro-democracy advocates, and the path towards the eradication of Hong Kong’s voice have been met with waves of international condemnation. It won't change a thing. Canadian calls for observers in Xinjiang will be rejected, and complaints about unfair trade practices will be ignored. Even the most wide-ranging anti-China legislative agenda, the centerpiece of which is the Strategic Competition Act, will not see China concede on anything. The Party and the dominant philosophy of Xi Jinping have decided what is in its own best interest, and foreign pressure plays no part.
China will act but not by concession. The perception of outside meddling only reinforces the idea of isolationism and self-reliance. The most successful anti-China policy from the Trump administration was the semiconductor embargo that exposed an over-reliance on imports of chips, especially from the likes of TSMC. The result has been the fast-tracking of investment to build out a domestic chip capability to ensure domestic security in the precious resource. Just as China focused on energy, food, and water security, the next decade will see China aim to ensure strategic domestic access to chips and other vital components in the technology supply chain. This will be a world where China has its standards and protocols. At the same time, Chinese firms with global aspirations will require western software to be compatible all across the globe. That said, the future is bleak for US tech companies operating in China, just as the future for Alibaba, Tencent, and AntGroup will be in their home market.
On June 22nd, Amazon had Prime Day. This annual orgy of shopping came with some news. Amazon provided some live streaming with partners promoting particular products. US analysts loved it. It’s a shame that Alibaba has been doing this for some seven years.
The birth of tech venture capital in China was straightforward. The model was one where young entrepreneurs, many of whom worked at Google or Microsoft, blatantly ripped off ideas from Silicon Valley. As soon as they came to market, copycat companies sprung up, replicating what they were doing. In the daily warfare that was tech investing, plagiarism was a standard business model.
Not now. While competition is ripe, China has unlimited human capital with infinite potential and almost universal access to capital. The venture capital arms of Alibaba, Tencent, and Baidu, to name but three, dwarfs what you see from the likes of SoftBank and have been exponentially more successful. The true innovation in fin-tech, e-commerce, and AI are coming out of China. Where it comes to e-commerce, I argue that Alibaba is three to five years ahead of Amazon.
An era is coming where US tech firms will start copying the development of the tech behemoths in China. Suppose you want to know what Stripe or JP Morgan will do next; look at Ant Group. Amazon will replicate the innovation of JD.com, and if Facebook wants WhatsApp to thrive, it needs to focus on WeChat.
With the Olympic games just around the corner, ads are everywhere for Visa. Olympic Gymnast Simone Biles is promoting a tap and pay product. That ad doesn’t work in China because credit cards barely exist. They just use phones.
China appreciates that it can control all domestic threats. The Party, internal surveillance, and security led by an effective paramilitary force, the Chinese People's Armed Police Force (PAP), and financially through the ever-growing importance of the PBOC, Beijing has the ability to crush every domestic threat, political, financial, or health-related. The Party’s bloody past has shown its citizens that dissent will not be tolerated. The Party has shown time and time again that it can meet any domestic challenge to ensure its longevity.
China’s most significant existential threat in the past 100 years came via the Japanese occupation from 1937-1945. It remains the overriding driver of thinking towards Japan, is constantly used as a galvanizing force by the Propaganda Department, and its lessons are at the center of economic policy and national security. In short, if the Party can prevent systemic risk through an iron-clad control of domestic issues, then the only genuine threat to the sustainability of the Party is foreign. This thinking influences China’s attitude towards enhancing defense capabilities in the South China Sea, military restructurings during the early stages of Xi Jinping's reign, and the rigid capital account rules that continue to make it very difficult for money to leave the country. Is the upcoming ban on bitcoin making more sense in this context?
It is a cliché, but Communist Party Leadership are students of history. If there was one-factor influencing Chinese thinking towards its role in the world, it has been when great powers overstretch on the global stage. China doesn’t engage in foreign wars as this led to the demise of Germany, Japan, and many in China believe that an expansionist United States has structurally weakened Washington. The last military incursion of note for the Chinese was 43 years ago in Vietnam. Despite China's economic stature and a permanent seat on the United Nations Security Council, China rarely engages in peacekeeping missions. China has preferred to use its most powerful tool, its capital, to invest in countries across the globe regardless of ideology.
The key lesson from the past 100 years is that China is an inward-looking country and that national security remains of paramount importance. While all countries could say this, China’s definition of national security never involves over-stretching itself to ensure foreign influences can never derail the Party as the centerpiece of Chinese society.
This is why Taiwan and China’s long-term goals of unification are so problematic. There is an assumption that has been elevated in importance by the Biden administration that efforts to bring Taiwan under the realm of China forcibly could be accelerating. While the reality is that we have no evidence of this, Washington is extrapolating that China’s efforts to bridge the gap between itself and the United States militarily do make the prospect of conflict in the South China Sea more likely. I would think about it differently. If China’s overriding priority is domestic stability, I struggle to see a time, outside of a colossal miscalculation, that China attempts to take Taiwan by force without complete confidence that it could do so without risking a catastrophic defeat by the United States. As we stand today, and I would argue that China has no overwhelming strategic advantage for at least a decade to come. In the context of this, why would the Party take the risk?
In the context of China not wanting to expose itself internationally comes the notion of RMB internationalization. Ironically, this is where another lesson from Japan comes to mind. Despite the long-lasting animosity towards Tokyo, Japan is the economic model that looks most similar to China’s. Democratic by name only, Japan is effectively a one-party state that grew to a significant economic power through a wide-ranging industrial policy, government support, and preferential lending to prioritized economic sectors. Japan has been debt ladened since the bursting of the equity and property bubble In 1989. It has awful demographics and a structural disinflation problem. Japan has been destined for an economic crisis for thirty years, and it never happened. What lessons can China learn from Japan to avoid a crisis of its own?
Japan’s economic message to China is the reinforcement of isolationism. A commonly used and justifiable explanation of why Japan avoided an economic crisis despite the largest bad debt problem the world has witnessed was the domestic ownership of bonds. In the modern age, debt crises rarely accelerate domestically. Or, more specifically, debt crises from Mexico to Indonesia and Russia are often amplified by the foreign holders of assets dumping securities. While governments can often coerce domestic asset managers, local banks, and corporates to work together, foreigners work on a different set of incentives which is nothing more than capital preservation. Running for the exits has been the modus operandi in many crises, and while there are always foreign asset holders who will buy dips or underestimate the risk, foreign liquidations and negative speculation often make a bad situation so much worse. Declining foreign exchange reserves, leading to a weaker currency, begetting more selling and this spiral eventually lead to local corporate and bank balance sheet destruction and potentially default.
Japan avoided such a cycle because, at any stage, domestic institutions owned between 90% and 95% of both the JGB and corporate bond markets. As such, the influence of foreigners was always tangential, and therefore, liquidity crises never developed. This is a leading reason why China, for all the talk of a desire for the RMB to play a more prominent role in global transactions, central bank FX reserves, and the RMB to rival the USD, often falls flat.
While China could assume the mantle of global leadership, evidence points that it will not. Talk of the Renminbi replacing the dollar as the global reserve currency misses the point that there is no domestic stability reason for this to happen. While any country would enjoy the benefits of near-perpetual demand for the sovereign bonds of the country that is the global reserve currency, China has shown little interest in wanting its bonds to be readily bought and sold offshore. After years of watching Japan avoid economic crisis as its debt has been held firmly in local hands, China knows the advantages of keeping the offshore supply of bonds limited.
China has an interest in settling global commodity transactions in RMB because a) it avoids U.S. legal jurisdiction when dealing with countries that have been sanctioned by the U.S., and b) the only place you can spend RMB is back in China. The digital RMB and global payments could be another area where the CCP could see a strategic advantage. That said, the Chinese are showing minimal inclination in the RMB rivaling the dollar.
I have been told by some of the smartest investors on the planet that China cannot ban Bitcoin. The people will not stand for it. This ultimate store of value, this libertarian ideal, will be forced upon the Communist Party, whose senior members are making far too much money out of it. I feel that cryptocurrencies run counter to the ethos of the Party because they cannot control it. China is embracing blockchain and digital currency like no other nation, but strict capital account controls, environmental priorities, and anti-corruption have been a hallmark of Xi Jinping, and wide adoption of cryptocurrency makes this more difficult. I am not sure if it will be banned, but I am confident it will be strictly regulated over time.
The Chinese Communist Party may not ban cryptocurrency, but to believe that they can't is arrogance of the highest order. To not have the legitimate concern that China prevents its citizens from dealing in bitcoin is reckless and shows a complete misunderstanding of how China operates. Any ban may not influence prices, it is a global phenomenon, and the underlying demand for bitcoin, in particular, is growing exponentially but do not think for a second that China cannot prevent its use in the mainland with the stroke of a pen.
Bitcoin is no different from any transformative asset that has come before it. No asset has ever been bigger than sovereign governments. While governments adapt to the demands of their people, no asset will be permitted to undermine government policy, democratic or otherwise. When the "otherwise" is the Chinese Communist Party, those assets or people who fly against policy will be reined in. If it can happen to Jack Ma, it can happen to bitcoin.
On the centennial of the Chinese Communist Party, I would ask that you ditch the labels. Labels such as communist, industrial policy, and democratic have created a slew of misconceptions that have led to investors and government underestimating China for four decades. The result is that western governments are addressing China’s human rights record, its actions in Hong Kong, and the ever-present concern over Taiwan when China has never been more economically powerful. The United States is being forced to adopt policies reminiscent of the Trump Administration and are designed to hold China back rather than push itself forward.
Outside of the systemic risk of the premature death of Xi Jinping leaving a leadership vacuum in China, the presence of the Party has never been stronger. While freedom advocates will look at this unholy alliance between the Chinese people and the Party (economic security versus the one-party state) as unsustainable, this equilibrium works. It will require the continuation of robust growth, avoidance of offshore conflicts, and the continuation of trillions of dollars of capital being funneled into all areas of innovation and development. It will require relentless efforts to clean the environment, eliminate corruption but also expand the health and social safety net, which is something that should have been done a decade ago.
The Party faces challenges. Taiwan is an ever-present issue but can be ignored as international conflict is somethingChina has chosen to avoid. Demographic challenges will only get worse, and current birth rates are a concern. Carbon neutrality targets must be adhered to, and the relentless innovation drive must be maintained.
Overall, the Party must continue to listen to the people and support their wishes. This may not be democracy, but the goals of the people must be taken into account.
As for investment, you have to treat China as an entirely separate allocation of capital. An allocation of capital that appreciates the nuances I have outlined above. Capital that appreciates a country that is run with a priority of domestic security where its focus will be inward-looking via the development of indigenous technologies. An appreciation that China is its own separate model that requires its own unique investment framework.
China will soon be the world’s largest economy. While no one expects allocations to China to be larger than the United States, all investors must improve their knowledge of the dominant country for the next decade.