China's Democratic Future

The most pressing question about China in the 21st century is what is China’s long-run political system?  There seem to be two distinct futures.

  1. China moves to some version of Western democracy
  2. It does not.

This is a significant question because if it is the former the question then becomes will the transition to a Western democratic political system be through gradual change or through disruptive revolution? Which of these paths is taken hangs over China with great uncertainty and China’s central role in the global economy makes it impactful to all investors whether invested in China directly or not. Of course against the backdrop of short-term market movements such long-term concerns may seem unimportant and faraway but as the sub-prime mortgage crisis and the Grexit situation have shown these long-term build ups of systematic risks are worth keeping half an eye on.

‘It might seem unfair to concentrate on the ability to anticipate recessions, given that they are (thankfully) unusual events. But it is only sharp discontinuities in economic conditions that we want to know about in advance. To be informed that trade will grow roughly as it did last year is valueless as professional advice, given that our own intuition will tend to tell us that anyway.’ Dominic Lawson

This essay aims to give a tangible example of a framework (my Frodo risk idea for predicting recessions) for tracking potential long-term systemic risks against the stream of new data and events.

The widely held view on China, of course, is that it will gradually progress to a democracy with ‘Chinese characteristics’ where China’s sheer size, culture, and historical preference for ‘stability’ account for some non-democratic components of its future political structure. This view, although it may prove right, suffers from a) being very simplified and b) offers no systematic way to track this narrative against what is actually happening in China and whether events are aligning with the hypothesised future and c) perhaps most dangerously a sufficiently compelling explanation of what is going to happen that a market participant may not make the effort to dig deeper until it’s too late.

Regarding a transition to a Western-style democracy there are four scenarios that we are going to consider:

  1. Scenario 1 – Government led smooth transition
  2. Scenario 2 – Chinese middle class revolution
    • 5 worsening, 2 stable, 2 improving
  3. Scenario 3 – Chinese rural working class revolution
    • 2 worsening, 2 stable
  4. Scenario 4 – Chinese urban working class revolution
    • 1 worsening, 3 stable, 3 improving

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 1 – Government led smooth transition

If the Chinese government is to provide a smooth path to Western style democracy you would expect to see

1. A gradual introduction of the democratic process and a reduction in government autocracy.

2. Chinese government rhetoric around political reform.

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 2 – Chinese middle class revolution

There are a number of early warning signs that you might expect to see in the event of a Chinese middle class led change in government.

1. Increasing numbers of protests for democracy. ~ worsening

The 2014 student-led Hong Kong Protests, or so called Umbrella Revolution, were a reaction to the NPCSC’s proposed reforms to the Hong Kong electoral system which are widely perceived to be very restrictive in terms of the candidates that present themselves to the Hong Kong electorate. Police tactics (including the use of tear gas) triggered yet more protests. Despite this, the protests were ended without any political concessions from the government. Going forward, Hong Kong’s Western ties (with its British history) and non-Mandarin languages (English & Cantonese) may mean that it is a likely seed of future political dissension that could spread to the rest of the Mainland.

2. High government corruption ~ worsening

One of General Secretary Xi Jin Ping’s signature policies since taking power in 2012 is his anti-corruption campaign and his so-called crackdown on ‘tigers and flies’ (high level officials and civil servants respectively). There was initially much skepticism from the Chinese public however the extent and reach of the campaign has beaten expectations where there have been more than 70 provincial (or above) officials including four National Leaders including most notably Zhou Yongkang. Having said that, critics argue that the crackdown is politically rather than corruption prevention motivated. Alarmingly the 2014 Corruption Perceptions Index has found that, despite the crackdown, China’s corruption has worsened (40 in 2013 to 36 in 2014) not improved. The primary issue seems to be a lack of transparency and the ease with which officials can launder bribes offshore. If this downward trend continues this could be a potential seed for future unrest.

3. Difficult business conditions ~ stable

Chinese business sentiment has remained relatively stable over the past decade.

Future business conditions however look very uncertain with potential continuation of the recent decline. 

4. Lower economic growth rate ~ worsening

Of course a 7% growth rate is still extremely high but China’s history of decades worth of unprecedented growth rates has led to the narrative that the Chinese people will only compromise on democracy and human rights if the Chinese government continues to deliver continued economic development. For a long time growth rates of less than 8% was considered the crucial threshold but so far the Chinese government countered that perception with a ‘new normal’ rhetoric of sustainable growth.

5. Urban city problems ~  improving

There are many severe urban city problems in China and according to numbeo China has one of the lowest quality of life indexes in the world (where factors includng purchasing powers, safety, health care, consumer price, property price to income, traffic commute and pollution at just 15.99 in 2015 compared to  192.49 for the United States and 78.60 for India. However, this still makes for a significant improvement on China’s 2012 score of just -49.55.

On the pollution front in particular, in 2014 Xi Jinping has ‘declared war’ on pollution in China where new environmental laws past in April enabled environmental enforcement agencies with significant punitive powers. This law is coupled with a massive US$277 billion package with the goal to reduced air emissions by 25% by 2017(compared to 2012 levels).

Even more remarkably this March China Academy of Space Technology’s vice president Li Ming ‘China will build a space station in around 2020 which will open an opportunity to develop space solar power technology’ with the long-term view of having a commercially viable space power station by 2050. The plan would involve building a station with five to six square kilometres of solar panels (twice the size of the New York’s Central Park) and then beaming the energy back to Earth by microwaves or lasers.

Coming back down to Earth (literally), there is a worrying trend in China’s urban cities with the rise of the so called Diaosi or so called self-proclaimed ‘losers’ which a sociologist at the Chinese Academy of Social Sciences has attributed to a ‘feeling of relative deprivation is a troubling consequence of China’s growing wealth gap.’

It is also worth emphasising China’s cities suffer from a number of very significant challenges including the migrant underclass who toil in factories and menail jobs but are denied public services because of internal migration restrictions (from the household registration or hukou system). It is also concerning that farmers in China have no property rights which has left them open to exploitation by urban officials who are looking to make money through land grabs and selling the land onto developers.

6. Middle class emigrating abroad ~ worsening

According to a 2014 Barclays report which surveyed more than 2,000 wealthy individuals (>$1.5m) around the world showed that the Chinese want to emigrate more than any other any other region. The survey found 47% of rich Chinese planned to move abroad in the next half-decade compared with just 23% in Singapore, 16% in Hong Kong and only 6% of Americans and 5% of Indians.

The primary reasons cited were better children’s education and future job prospects were named as the main reason to emigrate by 78% of respondents. A better economic situation by 73%. The US and Europe were the favoured destinations.

7. Academia/public intellectuals criticizing government ~ stable

In 2008, 60 years after the UN’s original ‘Declaration of Human Rights’ 350 intellectuals and human rights activists signed ‘Charter 08’ (so named because of Czechoslovakia’s famous Charter 77). It has now has more than 10,000 signatures.

At least 70 of the original signatories have been summoned by the police and in December 2008 Charter 08’s leader Liu Xiaobo was sentenced to 11 years in prison for ‘inciting subversion of state power.’ In October 2010 he would be awarded the Nobel Peace Prize

8. Government finances are weak ~ improving

After the Financial Crisis most countries suffered a massive increase in public debt and China with it’s gargantuan stimulus package in 2009 was no different. The government since then has shown an impressive ability to bring that debt back under control.

Recent policies include this year a debt relief programme for local governments where they will be able to swap $160 billion of their high interest debts for lower costs bonds, according to the Economic Observer, a local newspaper, this may just be the first tranche with total refinancing being three times that amount.

9. Increase in Human rights/freedom of speech restrictions/violations ~ worsening

According to the Dui Hua Foundation China executed 2,400 peoplelast year this is compared to just 778 in the rest of the world combined. Nonetheless compared to in 2002 the 12,000 executions. According to Dui Hua China ‘has executed far fewer people since the power of final review of death sentences was returned to the Supreme People’s Court in 2007’, Dui Hua’s executive Director John Kamm told the Telegraph the decline was ‘the single most positive development in the field of human rights in China in decades.’

However general human rights abuses are worsening. According to a Hubei based Civil Rights and Livelihood Watch China is ‘worsening and regressive human rights situation… the stability maintenance regime is getting stricter and stricter, you could say it’s getting more and more brutal and more inhuman….[Last year – 2014] was the cruelest we have [seen] since 1989 which is cause for extreme concern.’

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 3 – Chinese rural working class revolution

1. Increasing urban-rural inequality ~ stable

Urban rural inequality has been fairly stable over the past decade although the residency permit or hukou system which prevents rural Chinese moving to the more prosperous cities may be an eventual seed of future dissension.

2. Cost of living/food/fuel rising ~ stable

According to Brien Chua a Singaporean job recruiter rural people in modern China told the Strait Times ‘With lodging expensive and food costing more than double the price than back home, no one wants to move to the big cities anymore.’

3. Rural unemployment ~ worsening

According to a 2014 report from the Chinese Academy of Social Sciences estimated that the rural area unemployment rate among college graduates could be as high as 30.5% which when coupled with the strict rural-urban migration laws would suggest a worsening situation. Unemployment statistics in China however are notoriously bad especially as the 274m migrant workers are completely ignored in the datasets.

Thus the implausibly stable official unemployment figures (in a range from 4.0% to 4.3% over thirteen years) despite drastic fluctuations in GDP/growth rate over that same period are given very little credence by most economic observers.

4. Increased rural-urban migration ~ worsening

China has a strict household registration system which is meant to limit internal migration (particularly rural to urban) within the country. Nonetheless there is a huge migration population of workers, estimates number at more than 250 million with that number expected to double by 2025.

TRANSITION TO WESTERN-STYLE DEMOCRACY

Scenario 4 – Chinese urban working class revolution

1. Increasing inequality ~ stable

Inequality in China increased significantly throughout the 90’s although it has stabilized since at a high Gini coefficient of ~0.47. In urban areas specifically Gini has risen significantly from 0.15 (1981) to 0.36 (2011).

2. Increased cost of living/food/fuel ~ stable

Against a back drop of a decade worth of 7%+ growth cost of living has remained relatively stable where according to numbeo data China’s cost of living index was 43.47 in 2009 and just 48.89 in 2015 still well below advanced developed Europe countries who are in the 90s and the United States which is in the mid-70s.

3. Increased housing costs ~ improving

In 2014 the Chinese government has cooled its effort to tighten lending and cool the housing market through a rate reduction on loans longer than five years by 40 basis points in November and 25 basis points in the following February. This explains the spike in real house prices in 2014 you can see below. However, since then the market has remained bearish where the latest tally by the Survey and Research Centre for China Household Finance of 28,000 households in 29 provinces indicated 22% of urban homes were vacant in 2013.

Generally, the interpretation is of the oversupply of housing and weak demand has been negative but for our purposes this is unequivocally good thing as it only makes housing more affordable for the urban working class.

4. Urban unemployment ~ stable

China’s economy job creation numbers remain strong such that rather incredibly there are more job offers than seekers.

Whilst unemployment number have stayed relatively stable.

There is much concern about the reliability of the data however.

5. Increased urban protests/meetings ~ improving

As you can see this is a definite uptick in strikes since 2011 although recently they have fallen dramatically in line with Xi Jin Ping’s recent crackdowns.

Of course it is worth noting that the crackdowns may have exactly the opposite effect, denying people a channel to express their views and led to a bubbling of dissent that may burst. This issue is worth watching very closely.

6. Worsening social mobility ~ worsening

Social mobility in China is very low where if one father earns 2x that of another than how much more on average will his children earn relative to the other father’s children (this is a calculation of the elasticity of inter-generational income) is 60%. This is in comparison to 47% in the US and just 15% in Denmark.

However, research from Yi Chen of Nanjing Audit University and Frank Cowell of the London School of Economics have found that since 2000 people at the bottom of society are more likely to stay there then in the 1990s ‘China has become more rigid.’

7. Culture ~ improving

Despite all the problems, China’s return to an elite place in global politics and the rise of Chinese both culturally with an increasing number of Chinese actors in Hollywood (e.g. Fan Bingbing) and the prominence of its business leaders, most notably Jack Ma of Alibaba. Jack Ma, the second richest man in China, has inspired an almost cult like following where he tours the country giving inspirational speeches saying that ‘if Jack Ma can be successful 90% of Chinese people can be successful.’ This could be dismissed as mere rhetoric but even the most cynical would have to admit that Jack Ma has succeeded against all the odds. For the young Chinese the most important thing is passing the gaokao (or university entrance exams) – Jack Ma failed three times. In China the ideal man is ‘Gao Fu Shuai’ (literally tall, rich and handsome) and the overwhelming profile of most romantic tv drama leads, is a cold, efficient Fu Er Dai (literally second-generation rich) or Guan Er Dai (son of a senior government official) who treats the poor, plain looking but positive female lead badly before slowly warming to her. The importance of a powerful father is especially true because of the importance of guanxi (or connections) in China. Jack Ma has succeeded (sensationally) despite none of these advantages which has only endeared him more to the Chinese people.

OR SOMETHING ELSE

Many of the indicators point to the fact that China requires drastic change. Interestingly though, according to a fascinating study by the Chinese Academy of Social Sciences found that there is a startling trend that young people in China are much less in favour of democracy than older generations.

Anecdotally, one of my teachers at Tsinghua University explained her indifference to the Government, ‘politics is like celebrities relationships, it’s got no impact on how I live my life.’ The best analogy I can come up with for a Western person to understand the Chinese mindsight is how for a European who the President of the United States is and which political party he belongs to actually has a significant impact on their lives but of course despite this no one in Europe is protesting for the right to vote in American elections. It is worth remembering of course that the combined populations of Europe and China is still several hundred million short of China’s which speaks to just how massive China really is and maybe explains the feeling that most Chinese people have which is of great distance and disconnect to government that most Europeans in states of just tens of millions can find it hard to relate to.

Finally, I think it is worth pointing out that post the Financial Crisis there has been more soul-searching in Western politics about the form and structure of government than in China.

And he [Lee Kuan Yew] was not only just thoughtful, just the very idea that he would take parts of the Western system and say ‘Oh this part is good, this part may not apply everywhere,’ this part he disagreed with. It was kind of bold because of course the Western system was succeeding, you know, basically all the rich countries in the world had followed the Western system, and so the idea that he thought he would do it slightly differently was a huge contribution. And so Singapore’s a city state, so you do things in terms of paying government salaries and excellence there that may not scale up but what he did was very incredible. What we really want is this mix of democracy and expertise and no country has that balance right. If you err on the side of democracy there are certain extreme thing about the wrong person getting in power and if you kick them out then how do you get new people? So a democracy they have some huge advantages that helped the US quite a bit. It is a little scary now when we have complex problems like how do you run a healthcare system efficiently. Why is the US paying so much? And there really isn’t at this time any elected representative who can have a good discussion about the dynamics of the system and why it’s different from other countries and how we might change that. So government has to deal with very complex issues and the Chinese government although I’d say the trend is a tiny bit away from it has had engineers and scientists in a lot of key positions and a willingness to look at what other countries do and also this notion that if you’re going to have a new policy you can often try it out in part of the country see if it works and tune the policy before you try to scale it up in a really broad way. So the Chinese government is a student of policy more than just a, say, the UK Parliament or the US Congress where people are kind of yelling at each other like ‘I’m right’, ‘No you’re right’ It’s not like ‘oh we’re going to do an experiment.’ I’ve never sat in the US Congress and had them say ‘Oh let’s try yours out in one state and we’ll try out mine and we’ll come together and let’s combine the best features.’ That’s not a typical electoral dialogue that we’re having right now. So it’s a work in progress. There are things like how you run your universities where the US model – you know other people should just adopt it. Then there’s things like health systems and governance where they should take some aspects that try out variation. So we get the benefit of 192 countries slightly different experience including at the sub-national level.’ Bill Gates

‘We have a very strong government and they have very strong execution capabilities when it comes to infrastructure, like high-speed rail or highways. We have massive constructions and now is probably the largest infrastructure in terms of transportation in the world. But when you have a strong government are you concerned about innovation?’ Robin Li, Baidu

‘…in terms of things like, how do you make energy the state policy’s not holding back somebody figuring out some big invention. In fact, I have a nuclear power company called Terra Power. That really, China’s the most natural partner for us with the breakthrough generation of nuclear. Because China’s a lot like the United States was in the 1960s, where the idea you want to go forward and do new things, it’s very clear. The idea that the status quo isn’t where you want to be. The US today is very careful that they were pretty happy with the current conditions, so if somebody wants to build a new building or take some new approach, there’s a lot of ‘Hmm, maybe no.’ There’s like five levels you go through, maybe no, maybe no. Whereas the bias towards moving and doing new things which has a small downside but a huge upside as well. I’d say in terms of breakthroughs in some areas, like nuclear, it’s more likely to come out of China than almost any other place because of this bias towards doing big projects. And 1950s, 1960s that was the US and the 70s it started to be Japan. Korea took on that role, that big engineering bias is great for the world.’ Bill Gates

‘It’s a very interesting problem, that our founders coped with which is just how democratic you wanted the system… I don’t think it is a pure democracy… I took political science… and everybody teaches the more people that vote the better systems will work and having a contrarian streak I am not so damn sure! That the civilization doesn’t work better when a lot of people don’t vote.’ Charlie Munger

‘I think the biggest blow to our relationships is the Chinese interpretation of the financial crisis. That we did not look at political matters in an identical way that was apparent after years of the relationship. And they sort of understood that this was the case but they did think that we had a magic formula for economic progress from which they could learn. (And they had in fact with Deng Xiao Ping). That’s right and basically when Deng Xiao Ping said reform which was his basic slogan he really meant learn from the Americans. And he sent tens of thousands of students abroad. And it suddenly turns out that the American financial model that they had really tried to copy in some respects started disintegrating in some of its assumptions and that has not only made them lose confidence that we knew what we were doing but those people inside the Chinese system who leaned towards the United States had a lot of explaining to do. And we still suffer from it, I saw some Chinese commentary on the Chinese 5 year plan, and I don’t pretend to be an economist but that commentary said ‘Don’t let the Americans seeming recovery fool you because the West is trying to solve the current Economic crisis by exactly the same methods that got them into the crisis. Although I’m not saying that they’re right there is some merit in it.’ Henry Kissinger

CONCLUSION

This piece represents my first serious attempt to flesh out my ‘Frodo Risk’ approach to systematic risks with respect to a specific problem. It is truly unbelievable the extent to which financial market participants are overwhelmed with information and having now seen it up front I’m starting to understand why even the smartest people can fold under the sheer weight of information overload. What I hope this approach represents is a structured filter for monitoring information about long-term threats/risks. Any one of the news stories above e.g. a 5% decrease in business confidence taken in isolation would justifiably be considered insignificant but if that 5% decrease coincided with all the other potential revolutionary factors moving in the same negative direction it might speak to a much larger truth.

Most market participants have a short-term focus of, at most, just a couple of years but having reports like this around specific systemic threats might be a useful and time efficient way to keep an eye on these long-build ups so that situations like in Greece and the housing market in the United States don’t come as such a surprise.

Feedback on the report and structure is, as always, most welcome especially as in writing this I have wrestled with how much information should be included. Should it be primarily links to other peoples research and datasets with just one sentence summaries or should the report (if it’s only going to be read once a quarter/half year say) be more comprehensive?