Bookended by the global financial crisis and the COVID-19 pandemic over the last 13 years, the world has been presented with a third existential shock that is the defining drama of these early decades of the 21st century: a more truculent and assertive China. Once viewed by liberal-leaning democracies simply as a formidable consumer and feisty competitor, China has also grown and changed over the last decade to become an economic and national security adversary with which the United States has locked horns in ideological and strategic competition.
Economic and financial rivalry between Beijing and Washington is now commonplace in industry, investment, information systems, and innovation, all the more so in the wake of vulnerabilities, including high levels of economic interdependence, exposed by the pandemic. These have raised anxiety about what needs to be done to strengthen America’s economic system and national security. Yet, China worries about these things too, and for good reason. Its economic outlook and prospects are not only very different from the past in this new environment, but also much more nuanced than the formal narrative suggests. Indeed, the China drama includes a major paradox. The authoritarian and rigid nature of its governance system — with no rivals to President Xi Jinping or succession plan — is simultaneously the biggest threat to the global order and China’s biggest fault line. The United States needs to be aware of and responsive to both, as President Joe Biden — like his predecessor Donald Trump — places geopolitical competition with China at the forefront of U.S. foreign policy.
Two Sides of the Same Coin
In a bipartisan manner, the United States has now embraced the interrelationship between economics and national security in its bilateral relationship with China. The Biden administration, for instance, has continued Trump-era rules that target Chinese technology firms deemed a threat to U.S. supply chain security. While Washington’s national security establishment may have opposed Trump on many policies, it would find few detractors to the administration’s 2017 National Security Strategy, especially the chapter titled “Pillar II: Promote American Prosperity,” which was subtitled “Economic security is national security.” In War on the Rocks, Eric Sayers has recently reviewed the strategic competition between the United States and China, while James Mulvenon has considered it more specifically through the lens of technological nationalism. As 2021 matures, the Biden administration will likely focus on a domestic policy agenda, spanning the economy and infrastructure, key industrial sectors, technology and innovation, education, and military preparedness. In its foreign agenda, as already promised, attention will be given to strengthening alliances, especially in Asia.
China will also be paying attention to its own security agendas. At the National People’s Congress beginning March 5, it will unveil details of the new 14th Five Year Plan (2021 to 2025), which, for the first time, will have a stand-alone section on national security. Communist Party leaders revealed late last year that the plan would span not just military but also economic, financial, and technological security. Under Xi, though, China’s concept of national security could not be more different from that of the United States and other liberal-leaning democracies.
National security is indistinguishable from the security of the Chinese Communist Party’s control and rule, and in turn, from the security of Xi. All other forms of security, which include food, jobs, technology and self-reliance, the domestic economy, social stability, and the environment, are important in their own right but are also integral to the bigger political objective. Outside of these areas, territorial integrity — covering Hong Kong, Tibet, Xinjiang, and the “renegade province” of Taiwan, is a core Communist Party interest — while Xi has stated more broadly that:
We must concentrate our efforts on bettering our own affairs, continually broadening our comprehensive national power, improving the lives of our people, building a socialism that is superior to capitalism, and laying the foundation for a future where we will win the initiative and have the dominant position.
Fusion of Economics and National Security
Globalization, high levels of economic and supply chain interdependence, and China’s economic growth have ensured that economics and national security are and will remain inextricably linked. Contemporary power relations are far more complex than we remember during the Cold War, even if the economic complexity was not as apparent at the time.
China’s relative economic size and significance far exceed the Soviet Union, which was at most about a quarter the size of the United States. According to the International Monetary Fund’s calculations, China’s gross domestic product (GDP) is already about $4 trillion larger than that of the United States in so-called purchasing power parity terms, which is a way of measuring economic welfare to take account of lower prices and sometimes undervalued exchange rates in emerging nations. Yet, this measure is of little or no relevance for the economic significance of countries in the global system or for geopolitics. No one has an account or transacts in purchasing power parity. In market terms, which is the better comparison, China’s GDP is about two-thirds that of the United States, and some economists expect it will overtake the United States by the end of this decade, though whether this amounts to more than bragging rights, if and when it happens, is a good question. Nevertheless, China’s economic heft is unquestionably the platform on which its global ambition is based.
China is the only emerging country to have materially lifted its share of world output, from about 3.5 percent in 2000 to almost 18 percent by 2020 (or by a factor of 12 in U.S. dollar terms to about $14.8 trillion). Rising GDP levels mean that current military spending at just under 2 percent of GDP — and research and development spending by the government and corporations at a little over that level — deliver a lot more quantity over time, even if the effectiveness of that spending can be judged only in the context of the quality of the spending as well as the amount.
For now, though, China’s growing economic weight in the world economy is what has propelled economic issues to the heart of geopolitics. The American thinker Edward Luttwak once alluded to America’s trade disputes with Europe and Japan in the 1970s as the “logic of conflict in the grammar of commerce,” and Sino-Western trade and commercial relations have underscored this with some serious feistiness and frisson.
Better balanced bilateral trade may have been the Trump administration’s original flawed goal back in 2017. As I explained in my book Red Flags: Why Xi’s China Is in Jeopardy, the objective was faulty because it is not possible to manage bilateral trade balances effectively, and overall trade balances are determined by savings and investment, not by tariffs. But today’s grammar of commerce is overly expansive, and embraces everything from export controls and close scrutiny over foreign direct investment, to entity lists of companies forbidden to sell or trade certain products. Moreover, disputes over industrial policies and corporate governance, different standards and protocols for advanced technologies and communications systems, internet access, data gathering, and cyber security are all up for grabs in the current Sino-American economic competition.
The U.S. government, for example, has used its own more than 300-strong entity list to restrict or ban the sale of certain types of semiconductors without a license, especially where there are links to the People’s Liberation Army or to the repression in Xinjiang. China’s biggest and most advanced semiconductor manufacturer Semiconductor Manufacturing International Corporation, the drone maker DJI, and dozens of other Chinese firms and universities are affected, including construction firms militarizing disputed islands in the South China Sea.
Moreover, it was recently reported that China was considering export controls on rare earth metals, of which it controls 80 percent of the world’s supply. Officials were examining if and how restrictions might affect the U.S. defense industry, especially the manufacture and maintenance of F-35 fighter jets and other sophisticated weaponry and their intricate electrical power systems and magnets. Lockheed Martin (maker of the F-35), Boeing, and Raytheon have all previously been in the crosshairs of China’s Foreign Ministry for selling arms to Taiwan.
There is cause for some concern that the imposition of export controls on rare earth materials would deprive buyers of important resources, but such concern is measured. China may account for the bulk of rare earth metals output, but it has only 37 percent of global reserves. The United States has its own deposits, as do Canada, India, South Africa, Japan, and Brazil. But many nations prefer to buy cheaper in China, in effect outsourcing the environmental costs of processing them. China banned rare earth exports to Japan in 2010 because of a row over disputed islands, but Tokyo was quickly able to reestablish a new supply chain, neutralizing the ban.
Finance and National Security
The U.S. dollar financial system is a big deal in geopolitics. Indeed, financial power and political power are as intertwined and significant for the United States as they were for imperial Britain and Spain and Renaissance Italy. There are both costs and benefits for the United States in having the world’s principal reserve currency, but it certainly allows Washington to run external deficits without fuss, and use leverage and sanctions in international financial transactions. The Austrian-born U.S. economist Joseph Schumpeter once wrote, “the monetary system of a people reflects all that the people wants, does, endures, is and … exercises a significant influence upon its economic activity and its destiny in general.” Seen this way, the monetary system itself is existential, and one can see why China sees it this way too, because a yuan-based system would bring status and influence.
Just over a decade ago, the financial crisis that lay waste to Wall Street and the Western economic model proved to be the catalyst to persuade Beijing that the U.S. dollar’s era of dominance was over. China has no choice but to use U.S. dollars for the bulk of its trade and investment transactions, but it doesn’t like to be subject to an effectively U.S.-controlled monetary system. Its rhetoric is therefore to move away from a U.S. dollar-centric system while being unable to do much about it. The People’s Bank of China, under the direction of the State Council, and Chinese and international banks embarked on a significant campaign to internationalize the renminbi, literally “the people’s money,” or more colloquially the “redback.” It was a feisty call, and one that has neither aged well nor had much substance.
Even though Beijing is opening the door selectively to American financial services companies to gain access to U.S. dollars and American know-how, financial decoupling is occurring in several ways, as the integration of American and Chinese capital markets is coming under scrutiny. Financial sanctions have been implemented against Chinese officials and firms, federal pension funds have been banned from investing in Chinese stocks, Trump signed an executive order banning U.S. investments in 31 Chinese firms tied to the People’s Liberation Army, and over 200 Chinese firms listed on U.S. exchanges have been given limited time to finally comply with U.S. accounting standards or be delisted.
Washington has set up a bureaucratic infrastructure to oversee the economic decoupling with Beijing. The Commerce Department’s Bureau of Industry and Security, which oversees technology and export controls, is a key player. The Treasury’s Office of Foreign Assets Control administers sanctions, including on individuals and entities in Xinjiang and Hong Kong. The longer established interagency Committee on Foreign Investment in the United States polices foreign direct investment. Now, under the Foreign Investment Risk Review Modernization Act, it has a wider brief to review a variety of deals, especially involving high technology. Finally, the Justice Department’s National Security Division authorizes criminal prosecutions in the event of theft of trade secrets and intellectual property.
The Chinese government still holds at least $1 trillion of U.S. financial assets, and almost certainly more that is not recorded officially and held in offshore financial centers. Thankfully, this is a weapon it would be foolish to use. Wholesale liquidation of its U.S. assets would trigger staggering losses that would hit China directly and antagonize Washington. While it is sometimes argued that China holds leverage over the United States by virtue of its ownership of U.S. securities, the reality is that China is condemned to increase its Treasury securities holdings for as long as it runs balance of payments surpluses, and there is no indication these will not persist.
Beijing cannot seriously internationalize the renminbi or aspire to global reserve currency status because it doesn’t permit the only two mechanisms that can bring this about: running balance of payments deficits, or allowing open and free outward capital movements.
Further, China is also part of a Belgium-based financial entity called the Society for Worldwide Interbank Financial Telecommunication in which 11,000 financial firms in over 200 countries receive payment to settle about $5 trillion of transactions each day. Three-quarters of payments are settled equally in U.S. dollars and euros, while the renminbi accounts for around 1.5 to 2 percent. The United States has the power to exclude participants from this system simply by refusing access to dollar clearing in U.S. banks. China is trying to develop its own version of this exchange, but to little noticeable effect. It also expects progress in developing a digital currency to possibly elbow the U.S. dollar aside but this is unlikely too, as reserve currencies rely not so much on technology but openness, convertibility, transparency, sophisticated markets, the rule of law, and trusted regulation.
The U.S. dollar-based global financial system will continue to prevail for the foreseeable future.
Wuhan Was Not China’s Chernobyl
A little more than a year ago, some analysts thought China was having a “Chernobyl” moment, with the pandemic replicating in China the political consequences for the Soviet Union of the famous 1986 nuclear accident. As economic activity collapsed and unemployment surged to more than 20 percent, according to estimates made by private sector forecasters, Xi was thought to be facing the strongest challenge to his office since coming to power in 2012, endangering both his authority and the legitimacy of China’s ambition for global leadership. The Chernobyl analogy, though, couldn’t have been more wrong.
Having embraced draconian forms of pandemic suppression, the Chinese government brought COVID-19 under control, allowing the economy to turn back up, according to official data as of spring 2020. It’s been unbalanced with too much reliance on credit creation and infrastructure spending, and not enough on consumer spending and services. Nevertheless, a return to economic growth has won China bragging rights in the global system, and the economy will at least provide a favorable backdrop for the Chinese Communist Party’s centenary celebrations in July.
This year will indeed be a busy one for Xi. At the forthcoming National People’s Congress, the details of the 14th Five Year Plan (2021 to 2025) will emerge. We already know a few things. Top priority will be given to a $1.4 trillion state-led science and technology strategy, designed to make China self-reliant and a global leader in advanced technologies. Details of a Chinese version of decoupling, known as “dual circulation strategy,” will be aired explaining how China intends to rely more on domestic consumption, production, and supply chains. China watchers expect to learn more about the party’s pledge to build a modernized military by 2027, the centenary of the People’s Liberation Army, though the time frame to deliver on this goal is almost certainly much longer. Great fanfare will be given to the target year of 2035. This will be halfway between the centenaries of the founding of the Communist Party in 2021 and of the People’s Republic in 2049, at which time China is to be a “modernized socialist country” with per capita income on par with lower-level Organization for Economic Cooperation and Development states. Then, according to Chinese planners, the country will be en route to becoming a “high level socialist market economy” by midcentury, code for rivaling or overtaking the United States as the dominant global power.
Notwithstanding Western military and intelligence information about the People’s Liberation Army’s capabilities, China’s economic and technology goals are ambitious but by no means all realizable. As Yogi Berra famously quipped, “The future ain’t what it used to be.” Less colorfully, China is at a stage now that can be called “the end of extrapolation.”
In other words, things that worked in the past, like transferring workers from farms to factories or joining the World Trade Organization, can’t be repeated. The pragmatism and reform-minded attitudes with which China’s former leaders nurtured the economy and private enterprise and presided over high productivity growth have been replaced by a vigorous authoritarian and controlling party-state culture under Xi. The renewed emphasis on state enterprises and the role of party organizations in the economy and in companies have elbowed aside private enterprises and entrepreneurs, the backbone of China’s economic eruption. As Xi has stated, “Government, the military, society and schools, north, south, east and west — the party leads them all.”
Moreover, it’s been a very long time since China faced such a hostile external environment as it does now. China was a major beneficiary of unprecedented globalization and openness on the part of the rest of the world, but how will it fare as these circumstances go into at least partial reverse?
Economic Outlook More Nuanced Than Known
I agree with Andrew Scobell, who uses China’s pandemic experience to argue that as good as China’s leaders are in addressing crises, they are much less capable of really resolving them. He rightly argues that clear-eyed analysis of China is necessary to avoid being pulled into a sort of siege mentality on the one hand and excessive overconfidence on the other. Behind the façade of “win-win” and “inevitable rise,” for example — terms that appear frequently in the rhetoric of Chinese leaders — he sees insecurity, political uncertainty, and even significant questions about Xi’s longevity and succession.
The pandemic and China’s behavior from the discovery of the first cases of COVID-19 in November 2019 to the present time reveal an interesting contradiction. Authoritarian control, the demand for compliance, and the suppression of debate certainly helped China manage a grave public health crisis quite effectively. But they also constitute substantial sand deposits in the gears of successful economic development for a country in China’s position. If economic security is national security, then China’s prospects are much less well known, and much more nuanced.
History also advises such caution. Within the last century, there have been three occasions to fear that a country’s quest for dominance would succeed: Germany from the 1930s to 1941, the Soviet Union in the late 1950s and 1960s, and Japan in the 1980s. None of the angst these countries generated in international relations and national security was validated. While the circumstances differed considerably, each country was characterized by a flawed development model with some combination of authoritarian government, single-party dominance, and weak economic, social, and legal institutions.
It is important to focus on the role that strong or robust institutions play not only in bringing countries out of poverty, but even more importantly as they realize more sophisticated levels of development and have to rely more on smarter ways of generating productivity than simple physical exploitation of labor and capital. As leading China economist Michael Pettis has pointed out, authoritarian governments are good at building national champions to keep foreign competition at bay, but not at promoting competition and dynamism at home. They are adept at building infrastructure but they don’t pay attention to quality or commercial judgment. They emphasize scientific and technological accomplishment but what is important is the commercial application and branding of technology and its diffusion from the technology creators into the many boring, technology-using bits of the economy. That in turn requires an efficient financial system that allocates capital well. All of these things need robust, inclusive, and adaptive institutions (legal, competition, regulatory, educational, and so on) that allow societies to extract value from investment and workers to operate at higher levels of efficiency and productivity. You can see here how and why China’s development model resonates.
In Red Flags, I examined a growing list of drags on China’s growth potential, which a more authoritarian and ideological leadership in China is not so well equipped to address. While China’s goals imply roughly 5 percent growth in the next 20 to 30 years, I think it will be lucky to get a little more than half of that, and this poses risks to both internal economic and financial instability and job creation, both of which are important politically. In addition, this would have huge implications for China’s defense budget and military posture. As the U.S. Department of Defense has pointed out, China aims to have a military that is the equal of or better than the United States by the middle of the century, notwithstanding numerous gaps and shortcomings that may be addressed. That objective becomes harder to achieve with slower economic growth, but it is also easy to imagine China struggling for resources much more ruthlessly if the economic pie is growing much more slowly.
China faces a substantial debt mountain, which a reliance on credit creation is perpetuating, and which will result in years of lower growth while it tries to unwind misallocated capital. Broadly defined, debt as a share of GDP is now well over 300 percent, most of which has been incurred by state enterprises and local governments, but rising household debt, now higher as a proportion of disposable income than in the United States, is quickly becoming a constraint on the economy, too. Bad debts, uncommercial investment and infrastructure, and vulnerable banks are not just going to disappear, and will all have to be paid for somehow in years to come.
An additional growth constraint is rapid aging. China is the fastest aging country on Earth and will, on many demographic metrics, be a far older country than the United States by midcentury. According to U.N. Population Division data, it will have a much higher dependency ratio of older citizens on a declining working-age population by 2050, and has a bare-bones social security system that is not up to the task of tending to an aging population, except at significant and unfunded cost to the state.
China also faces the prospect of what economists call the middle income trap. That is to say that while GDP might still grow, income per head might get stuck at well below the levels achieved by the select group of advanced economies comprising the Organization for Economic Cooperation and Development. This is a phenomenon experienced by the overwhelming majority of emerging and developing countries since the 1960s, in which rapid growth peters out as countries become “middle income.” Only about a dozen or so have actually managed to continue along a development path in which income per head has risen to levels associated with countries in the Organization for Economic Cooperation and Development. Getting trapped is attributed largely to the failure to develop the robust and inclusive institutions needed to sustain development once the exploitation of physical labor and capital has been exhausted. China is now at this point.
No one knows for sure whether a data-driven and surveillance party-state will be able to deliver its technology goals, but we do know China is giving advanced technology a status that was once reserved for the development of the atomic bomb. That said, China’s experience with semiconductors — the heart of advanced technologies — and its continued dependence on imports, the value of which exceeds those of crude oil, is sobering. Many years of priority treatment along with over $50 billion of subsidies have not yet allowed China to match the experience, talent, and know-how in which the United States, Taiwan, Germany, South Korea, and Japan still excel.
Over many years, China has used a blend of state-directed policies and selected market mechanisms to build an economic platform that has allowed it to consolidate its national security at home and, over the last decade, project geopolitical expansion abroad. Officials in Washington increasingly view this as a threat to vital U.S. interests. China’s economic, industrial, and technological policies have always been of the “China First” variety, designed to favor domestic firms and producers. However, while globalization and political pragmatism also enabled it to construct that platform, the former has stalled or gone into reverse, and the latter has been overtaken by a more ideological and authoritarian governance system. Economic development, moreover, isn’t a linear path, and China’s highly centralized power structure now faces growing economic headwinds and an overreliance on key individuals and top down decision-making rather than institutional and market structures. In short, China’s economic security is not assured.
Moreover, as China expert Rana Mitter has pointed out, China’s growing security presence abroad, fueled by its economic, trading, shipping, and supply chain logistics, is also having a perverse effect on its popularity. Indeed, Chinese authoritarianism, policies of repression, and coercive diplomacy in the wake of the pandemic have contributed to a growing backlash of resentment and suspicion not just among developed market economies but also nations in the Belt and Road universe.
The United States should take note because many constituencies and countries will be trying to pull the Biden administration in different ways that may be inadvertently prejudicial to either economic or national security. Strengthening economic and trade arrangements with other countries, especially in Asia for example, is viewed as an important goal. All the more so, perhaps, because China’s own behavior and actions are a major impediment to its already limited soft power. Yet, Washington should be careful not to compromise domestic economic interests too much because in the longer term, these constitute the core of American national security and global leadership. Its economic security derives from the strength and structure of its own economy and financial system, and the dynamism of its enterprises and culture. Put another way, in its thinking about competition with China, the Biden team working on China at the White House, Defense Department, and State Department should focus on the strength of Detroit, Disney, and the dollar.
George Magnus, formerly the chief economist of UBS, is a research associate at Oxford University’s China Centre and at the School of Oriental and African Studies in London. He is the author of Red Flags: Why Xi’s China Is in Jeopardy.