George Magnus, the former chief economist of UBS Investment Bank and author of the book «Red Flags», sees a deglobalisation and fragmentation of the world economy. Beijing’s support for Russia will accelerate this process.
George Magnus has followed China’s rise from an investor’s perspective for almost three decades. The former chief economist of UBS Investment Bank became increasingly pessimistic over the past years. In his book «Red Flags: Why Xi’s China is in Jeopardy», he showed how the world’s second-largest economy took a marked turn in its governance system under Xi Jinping.
In an in-depth conversation with The Market NZZ, which has been lightly edited and condensed for clarity, Magnus lays out what Beijing’s support for Russia means. He shares his views on the state of China’s economy and what the developments mean for Western businesses and investors.
«There is no liberal reform agenda in China anymore», Magnus says.
What is your assessment of China’s current stance with regards to Russia?
China likes to portray an image of itself as a neutral party. But it isn’t really. Of course, there is a latent distrust between them, there are elements of friction over the Central Asian republics and China’s commercial interests in the Russian Far East for example, but all in all, they have been cozying up for several years. Bilateral trade between them is minimal if you compare it to China’s trade with the EU or the US, but it has grown from a few billion dollars in 2010 to about 150 billion dollars in 2021. China imports Russian oil and gas, while the railway bit of the Belt and Road Initiative runs through large parts of Central Asia and Russia. Xi Jinping and Wladimir Putin have met 38 times, which is more than Xi has met any other head of state. They are bound together, in a mission to make the world safe for autocracy. The climax of this coziness was the meeting of Xi and Putin on February 4th in Beijing, before the opening of the Winter Olympics.
Where they declared that their friendship has no limits?
Yes. They released this 5500 word statement about the bond between the two countries, united against the US, NATO and the West. That geopolitical bond is important, because Xi and Putin share the view that the time is right to act in a peacock-like fashion on the world stage. They are convinced that the US is weak and will inevitably decline. In that sense, I think it’s an error to see China as a neutral party. They have repeated Russian propaganda about the war, including false assertions as far as we know about Ukraine having biochemical weapons.
So you say China has made its bet with Putin.
Yes, but obviously they find themselves in an uncomfortable position because the war has not gone as Putin would have planned. I don’t think Xi would welcome any outcome in which Putin was humiliated or was deemed to have lost in Ukraine. This would feed back negatively to Xi before the 20th Party Congress which will take place later this year.
And yet we see Chinese banks showing that they do not want to be seen as helping Russia avoid Western sanctions. Is that just lip service?
I don’t think so. There is a huge tension in China’s position, because politically, Xi is committed to Putin for as long as Putin does not become excessively toxic. At the same time, it’s in China’s economic interest to back away from Putin and to avoid all risk of being sanctioned. Don’t forget that China’s rise over the last thirty years has been heavily contingent on its access to an open global economy. China is in an awkward position. They politically need to support Putin, but economically they need to back away from him.
Don’t you think they are making a cold economic bet that they will gain Russia as a vassal state with vast reserves of commodities?
Sure, one can make the point that China is the senior partner in this relationship, where Russia, being a pariah state for the foreseeable future, will be entirely dependent on Beijing. But I don’t think this would compensate for what they put at risk in terms of their commercial and economic ties to Europe, the US, Japan, South Korea and other countries. In purely economic and reputational terms, China has little to gain and much to lose with Putin.
Were Party elites in Beijing surprised by the swiftness of the sanctions imposed by the West?
I’d say so. I mean, deep down, even we didn’t expect this kind of Western cohesion, right? So imagine how that would have been seen in Beijing. For liberal leaning democracies to be in decline, they aren’t doing a great job of proving Beijing’s case. And by the way, between the US, Japan, the EU, India, and Australia several initiatives are underway in the economic, infrastructure, finance, supply chain and technology spheres. They will have been bolstered by what we see going on now. A lot of things are in play.
What lessons will Beijing take?
The way the West has sanctioned Russia, including its central bank, sends out a strong message to China that they must sanction-proof their economy and their financial system – if indeed they can, which is questionable. Heaven forbid at some stage in the future if China were to threaten Taiwan: China would not want to be in a position where it had three trillion dollars worth of foreign exchange reserves frozen. Of course, it’s a bit of an Armageddon story because we would all lose, it would be a terrible situation for the world economy. China’s economic ambition would be crippled.
You point out how important it is for China to keep its access to an open global economy. Yet at the same time, Beijing strongly believes in the narrative that the West is in decline. Is Xi overplaying his hand?
There is a domestic and an external angle to that question. At heart, China is facing a big contradiction between its politics and its economics. They have this huge economic ambition, they want to be a rich country by 2035 and the dominant economy in the world by 2049. Yet under Xi and in the past three to four years in particular, there has been a marked leftward shift in China’s governance system which I think is not compatible with its economic ambition. It’s not just the regulatory blizzard that was launched against the likes of Alibaba; there were numerous things on various levels that the government has done to bring private entrepreneurs to heel to the political directives from the Party. The system under Xi has created this situation where the politics and the economics are in conflict. If you want to have a dynamic economy, you have to liberate the energy of the private sector. It’s possible that China is going to show the world that state-directed innovation beats everything. Maybe. But there is no empirical historical evidence to suggest that this will succeed.
What’s the external angle?
China historically has always fared well when it was open to the world and vice versa. But in dynastic times as well as under the Communist Party rule, foreign influence often clashed with nationalistic influences at home. This is happening now. China wants to de-americanize its supply chains, just as the Americans want to de-sinify theirs. In the end, this pulling away of China from the global system is not something that will work in China’s interests.
Do you subscribe to the view that the world is deglobalising?
I keep bumping into people who say it can't happen because the level of interdependence between Western economies and China is so high. But it is happening. Look at the self-reliance strategies in China, look at the regulatory and legal systems, the laws that are being passed to promote state-owned enterprises. Or take data management, the bifurcation of digital standards, which means European and American firms in China have to develop separate systems, one that works in China and one they are more comfortable with. The same is true in innovation, research collaboration, as well as in aspects of trade. I think that the war in Ukraine is going to make more of that come even more alive. It’s quite blasé for people to say that we can carry on like before because business is business. That won’t work. Of course there is political risk everywhere, but here we are talking about ideological, adversarial risk, where two very different systems are trying to set out their own standards. National security is at the heart of it. This alignment of corporate and national interests, which was so much part of the China mission for the last thirty years, is breaking down.
Until recently, it looked like European companies could try to straddle that divide. Has the war in Ukraine changed that?
It’s changing. I don’t expect a revolution in companies’ views. It’s not that long ago that the CEO of Volkswagen, for example, has said some rather strange things about Volkswagen’s operations in Xinjiang province. Many companies have made their bets in China, which has become an important part of their revenues. And many of these companies thought that even with all the difficulties of doing business in China, the size of the market and its rising middle class would compensate for it. Going forward, there are many companies in the business of advanced technology products that will be much more drawn into the crosshairs where they could be at risk of having to satisfy two masters and they cannot predict how their supply chains will be impacted even if one component is affected somewhere in the supply chain. It could have dramatic effects on their manufacturing capabilities. So I think the drive to de-sinify or at the very least to diversify supply chains, will be much stronger in years to come.
What’s your assessment of the economy in China today?
It’s not in great shape. There are a number of issues which weigh on its performance. One is the deadweight of excessive debt. Second is the glacial problem of a rapidly aging population and declining workforce, coupled with quite low levels of educational attainment. We have this image that everyone in China goes to Shanghai super schools and is top of the class in maths and science. That’s not really true. Only about 30% of Chinese workers have high school educational qualifications or better, and only about 15% have degrees. There are serious issues with the Chinese labor force to do with aging and education. And then productivity is a huge issue, not uniquely in China of course, but productivity growth has stalled. Add to that the harsh external environment plus China’s governance system, which is not good for the economy. At this point in its development what China would need is not more debt-financed capital investment, which is already being misallocated. What they need is better productivity, and that is about better institutions, which create and nurture the kind of changes that allow people to be more productive. This is something that the Party is opposed to, because they want to paddle their own canoe towards their Party state image which they think will work in the future. My belief is that they will find the going to get very tough.
At its recent Twin Sessions, the government announced a 5.5% growth target for 2022. Is that realistic?
5.5% is the lowest in years, but it’s quite high relative to what China’s potential growth actually is. I think 5.5% can be achieved because for one, they can always manipulate it, and two, they will probably inject more stimulus into the economy in order to hit the target. When they discussed this target in Beijing at the beginning of March, there were very few mentions about the resurgence of Covid. But now, with Shanghai in lockdown, Omicron threatens to overwhelm China’s Zero Covid policy and its hospital system. That’s a drag on the economy. Also, there was no mention at all about the impact of the war, which through higher import costs will crimp income and shave roughly one percentage point off GDP growth in 2022. So 5.5% is an ambitious target, but they can print success if they want to.
Beijing has tried to cool down the property market, which led to the Evergrande crisis last year. How will that play out?
It’s important to understand the significance of the real estate market for the economy in China. Many people are now familiar with the paper by Rogoff and Yang, where they estimate that the real estate market, in its very broad definition, accounts for about 29% of GDP. There is probably some double counting in that, but even so, we are still talking about 22 to 23% of GDP. You can’t just replace that. You could replace it over time if you had a productive program to redistribute income, promote private consumption, open service producing industries and so on. But nothing like that is happening. So I think that there will be controlled bankruptcies, a number of property developers are de facto bankrupt. It’s just a question of how they will be restructured.
Can the banking system handle that?
The banking system in China can carry much higher levels of bad debt for much longer than they could in other economies where banks have to mark to market much more quickly. They can evergreen a lot of this stuff. But the more you do this, and the more you don’t recognize the costs of this misallocation of capital, the greater is the impact down the road. The cost will be stagnant growth going forward.
It’s been at least ten years since we heard warnings that this debt-fuelled bubble will blow up. It hasn’t happened so far.
There was a time when I flirted with the idea that there would be a Lehman type bust in China, but today I think the probability of that happening is pretty small. The state has a lot of levers in the economy, with which it can manage the assets and liabilities of financial institutions. By managing that process, passing losses around, having a word with the top managers of major banks, China can contain the worst of the kind of financial eruptions that we have experienced in 2008. But that does not mean it’s costless. It’s just different.
There are basically two ways to deal with a mountain of bad debt: One is to let it deflate, which means bankruptcies, and the other is allowing inflation. Which one will it be?
The Party leadership is probably more spooked by the prospect of inflation than deflation. They have had very traumatic experiences from inflation in the past, most notably in the run-up to Tiananmen in 1989. They also have something like a Maastricht-type constraint on budgetary policy, at least on the level of the central government. So deep down, they are quite conservative economic managers. They had this flirtation with credit creation after 2008, but they didn’t like the consequences, because it caused them a lot of grief in the crisis in 2015/16. So I think they genuinely want to deleverage the financial system. Yet at the same time, they feel the need to meet their own growth targets. I think the bias of their fiscal and monetary policy is to stimulate the economy to the extent that they feel it safe to do so, but not to overstimulate and not to create inflation.
The People’s Bank of China likes to portray itself as the last of the responsible central banks out there.
Like so many things, there is a lot of nuance involved. If you look at the PBoC’s policy and rhetoric, they come across as quite conservative, they incrementally fine-tune changes in interest rates and interbank rates. They are not opening the money tap to flood the economy. But they are always quite generous with liquidity, they are conscious about the linkages in the Chinese financial system between the big banks – which they generally think are doing okay – and the thousands of smaller-sized regional banks, many of which have rather unstable balance sheets. So their behaviour is conscious and controlled. On the other hand they still preside over a financial system which grows credit faster than GDP, so the debt to GDP ratio keeps growing year after year. They are still presiding over a significant expansion of renminbi assets and liabilities which are out of proportion to their currency reserves.
Why is that relationship important?
When you have a carefully controlled exchange rate, like the renminbi is, you have to keep an eye on the relationship between the stock of domestic assets and the stock of external currency reserves. Given that, the renminbi is vulnerable to a depreciation, particularly if the PBoC were to renege on its cautious stance, suppose they got worried about jobs or GDP growth or about property.
The renminbi has appreciated over the past couple of years. Why should it now be vulnerable to depreciation?
The renminbi goes through cycles, like all currencies. Obviously it’s not totally free to fluctuate, it’s protected against outflows by capital controls. Over the past two years, a number of factors have combined to strengthen the renminbi through China’s current account. You see, in normal times, Chinese tourists spend much more money abroad than foreign tourists spend in China. But this has collapsed because of Covid. China’s trade position has also been strong because with the bounce-back of the global economy and the demand for masks and protection equipment, China has seen a boost in exports. But I don’t think there is a trend appreciation of the renminbi going on. And yes, in the medium term I think the renminbi is much more likely to go down than up.
From the point of view of an international investor: Is China still investable?
Data by the International Institute of Finance show that global investors have been selling quite significant positions in China lately. Whether that is a knee jerk reaction because of uncertainty about Putin’s war, or whether it reflects a change of view about investing in China, we shall have to see. One thing I have been adamant about for a long time: Many people kept saying that investors had to increase their portfolio weight in China to something like 10 or 15%, close to China’s weight in the world economy. I was always sceptical about that. And I am more convinced now that it won’t happen. You can still take positions in Chinese financial assets, but you have to be very sure about the risks that you want to take, and whether you can get out of that position quickly if need be. Nobody can say what will be if something were to happen with Taiwan – mind you, I don’t think this is a near term risk, because the lesson from Ukraine for Beijing would be any intervention in Taiwan is likely to be later rather than sooner. So maybe you don’t have to take a view about that right now. But the ability to get out quickly if needed is crucial.
Until a few years ago, the optimistic view on China was always that there is a reform agenda, slowly moving forward. Do you see anything of that left?
Unlike my other answers, this one is short: No. Of course, reform is happening in China, it’s just not the market oriented reform that we would think would promote efficiency, productivity, innovation, and a dynamic private sector. So although they still talk about reform and opening up, which was the mantra launched by Deng Xiaoping forty years ago, there is not much substance to it anymore. Everything that I see in terms of government regulation is the antithesis of reform and opening up. There is no liberal reform agenda in China anymore.
But some of the reformers, like Liu He, are still rather close to Xi, aren’t they?
Liu He will be stepping down this year, Wang Qishan as well. Some of the older guard who might have been in the more liberal reform camp, will all be stepping down due to their age. New faces will come through the 20th Party Congress. We can't yet predict whether they will all be Xi Jinping Yes Men, or whether the gathering problems in the economy lead to some tensions that end up with Xi not getting his way. The exchange of personnel going on, not only at the top, but at multiple levels in the local and provincial cadres, does not signal to me that China is going to make a turn towards liberal reforms again. You never say never, and it’s possible that at some stage Xi will lose power, or something will happen and new people will press for a change of direction, but we should be sceptical about China returning to the path it was on twenty or even ten years ago.
So that would be your expectation for the 20th Party Congress, a cementing of Xi’s position?
It’s possible, albeit unlikely, that he will find himself in a terrible position ahead of the Congress, depending on how things pan out with Ukraine. But let’s say that’s not the major likelihood at this stage. So my expectation, with a caveat about whether Xi gets his way on everything, is that he will be crowned for a third term or for life and he will consolidate his position. That said, there is an element of uncertainty here that didn’t exist before February’s tumultuous events.