"I do think 'crisis' is a reasonable description today": Daniel H. Rosen on China's Economy

Economics researcher Daniel H. Rosen talks to CACR about China's current economic concerns, risks, and policy options. This interview is edited for clarity and length. (November 10, 2022)

Daniel H. Rosen is the co-founder of Rhodium Group, an independent economic research partnership, and leads the firm’s work on China. Mr. Rosen has worked professionally on China’s domestic economy and global commercial relations since 1992. He is widely recognized for his research on US-China relations and Asian commercial dynamics. He is affiliated with numerous think tanks focused on international economics and is an Adjunct Associate Professor at Columbia University. From 2000-2001, Mr. Rosen was Senior Adviser for International Economic Policy at the White House National Economic Council and National Security Council. He is a member of the Council on Foreign Relations, and board member of the National Committee on US-China Relations. A native of New York City, Dan graduated with distinction from the graduate School of Foreign Service of Georgetown University (MSFS) and with honors in Asian Studies and Economics from the University of Texas, Austin (BA).

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I want to start with a question about your latest quarterly report on the Chinese economy on the Rhodium group website. It said that the outlook for economic liberalization seems very mixed. There seem to be certain measures that the government is taking that are helpful, but there are other things that they’re doing that seem to indicate that relations between government and businesses are still going to be dominated by political considerations. What is your view on the likelihood of there being the sort of liberalization that you think is needed in the foreseeable future?

There is a complicated set of challenges for Beijing. There are two impediments to getting a rationalization of the economy on track. One is of course that there’s much mixed sentiment in the leadership about the role of market forces as opposed to just Party control over the commanding heights of the economy, and that is diluting the urgency around needed market reforms. Second, even if there weren't misgivings about liberal market systems, the reform backlog is so severe that the process is going to be painful and somewhat destabilizing now. That’s not a uniquely Chinese problem; virtually every economy that’s gone past the early development era and made it to higher income level has gone through financial distress. Banking crises are common on the journey past middle income levels, so this is going to be difficult.

Given the mix of social and political tensions and development risks facing Beijing it’s daunting to plow ahead on needed economic policy reforms, such as fixing the fiscal system by implementing property taxes to end the need to sell land assets to property developers just to fund local expenditure requirements. This presents a serious impediment to reform. On the flip side, Beijing is aware that without reform potential growth will be greatly diminished -- to the point of not allowing China to achieve its great power aspirations.

For non-economists, could you explain a little bit about how these liberalizing reforms that are so necessary would be destabilizing? What exactly is it that the government is afraid of as a consequence of these reforms, if they recognize that they’re necessary?

In order to achieve high growth Beijing has encouraged overinvestment in some sectors for the past two decades. First and foremost the property sector. There was awareness even ten years ago that property sector debt was ultimately problematic, but with GDP growth a fixation, misinvestment was allowed to persist.

Once you have overinvested so much, you have vested interests at stake. In the case of the property sector, it’s not just a handful of state enterprises that have skin in the game, but hundreds of millions of middle-class citizens who have put their life savings into property. These assets are not going to hold their value through the reform process. Fixing over-deployment of capital into this one gargantuan sector, property, is going to mean hundreds of millions of middle-class urban Chinese seeing a loss of net worth. That’s going to have political and sociological consequences: people who put their faith in the Party to chart the right course will find be surprised by this instability.

There will be bankruptcies and renegotiated business obligations, and balance sheets will be impaired by reform. This means a large bite out of the existing value of the Chinese economy. It also means property can no longer be the source of growth it has been. Whatever the hit on asset values today, there is no good answer to the question of GDP growth tomorrow: China needs to content itself with slower growth until new drivers are identified.

Your latest quarterly report also talked about rising unemployment, which may be higher than is being reported because it’s a politically sensitive issue. One of Beijing’s solutions is to try to get more young graduates into state-owned enterprises. Does that feed the beast, so to speak, because bloated SOEs are traditionally regarded as an obstacle to liberalizing reform?

State enterprises are not the solution to unemployment. State enterprises are most common in heavy industrial sectors that are not labor-intensive. There are not many people working at a modern steel mill, for example; it’s technicians and capital equipment. The sectors that create more employment are service sectors like delivery, education services, and health care services. These are the sectors with potential to generate employment in China, both new graduates and existing people who don’t have a lot of skills. These aren’t the sectors getting the best access to bank credit, and their ability to hire people is in doubt.

People often think of the state sector as a sponge that can absorb out-of-work people, but that’s not the case. The state sector has been shedding employment in China for decades.

Your report also mentioned two primary issues with the economy right now: coronavirus restrictions and the property bubble. How much of China’s current economic woes, including low growth, is attributable to these self-inflicted coronavirus measures and could be expected to go away once those restrictions end, and how much of it is the result of long-term systemic issues like the property bubble that cannot be simply removed?

I think that’s the right question, and one that’s starting to get proper attention. Beijing has tried– and in previous years, would have succeeded– to use more property stimulus to smooth the COVID downturn. But property is so saturated with debt that it is no longer available as a panacea for what ails the economy. Beijing chose lockdowns over vaccination or living with COVID in 2022 in faith that they could offset the cost; they discovered the hard way that they no longer can. The structural limits to growth are no longer deferrable with debt. They are sticking, they are hard constraints, and they are not going to go away once the virus has subsided.

While preventing the spread of COVID was a laudable priority for Beijing, mRNA vaccine technology is mature and available. It is being deployed in other economies, permitting them to get back to a healthy economic balance. Between now and 1Q23 I think we’ll see mRNA vaccines used in China. It’ll be a rough winter as the era of zero-Covid as we’ve known it starts to close down and localities are permitted to balance differently between virology and economic necessity.

Regarding the accuracy of different figures, as an economist, do you think that China’s GDP figures and other economic indicators are generally accurate, or do you think that they’re likely to be significantly lower?

This is one of the eternal topics of China economic discussion, and from work that we’ve done at Rhodium in recent years, I can say a few things. Number one, there has always been some amount of distortion in Chinese data, and questions have gotten more serious over the past couple of years. It’s become more difficult to have an objective discussion of what’s going on in the economy. Second, there is more independent data available today than there was in the past. Many investors now use commercial imagery to second-guessing official data. At the product level, there is independent research on how many cans of soup there are on the shelves, so to speak, or how many cars are leaving the lot at dealerships. These windows on the economy are reliable.

We also see a tendency to smooth growth numbers to make it appear as though things are less volatile than they are. In a study called Broken Abacus we did a few years ago, we looked at the reported level of GDP. Surprisingly we found was that the economy was being understated in official data. Our guess is that this was to avoid admitting the extent of the property bubble. Urban Chinese who were piling into real estate actually were amassing even more of a share of the nation’s wealth, so income inequality, wealth inequality, was somewhat worse. That means that there’s even more risk of recession if that property bubble deflates, which is what’s happening right now. That speaks again to that smoothing phenomenon in the officially reported numbers.

You mentioned that the property bubble is deflating right now. Do you feel that there’s a greater likelihood than there was in the past of there being a hard landing or some sort of economic crisis?

We see current circumstances as a slow-moving financial crisis. I do think “crisis” is a reasonable description today. Activity is down so much more than policymakers intended, and they have not been able to alter that. This is not under their control. The sectors that are slowing are central to the economy as we’ve known it.

The probability of a hard landing is higher now than in the past. Beijing used to be able to smooth over contractions, provided it was willing to expose itself to even more debt risk in the future. Current conditions can probably be described as a hard landing. We have essentially 0% growth this year, which is unknown in the Chinese context. Should we be concerned that it might not land at all, but it might be a crash, followed by a lost decade or something like that? I think those are possibilities, and they’re being considered. Are there things that Beijing can do that would stabilize the outlook? Yes, there are, although I don’t think you can both stabilize the outlook and have a rebound in 2023 at the same time. They’re going to have to accept a couple fallow years in order to get things back on track. And they’d have to accept political reforms which to date have been a bridge too far.

What are those political reforms that you think are necessary? As far as the government under Xi is concerned, it seems that it’s had a very clear pattern of increasing the Party’s control over every facet of society and cracking down hard on any challenges to the primacy of the party. Are the political reforms that should happen contrary to those goals and that pattern of leadership?

In 2013, at the beginning of the Xi Jinping era, an economic reform program called the 60 Decisions was enacted. It included standard nostrums, but also new language on removing the state from industries better served by private competitive dynamics. There was language saying the market must be the decisive force determining the allocation of factors. From 2013 until about 2016 a dozen elements of this reform were started. The breadth of effort to try to move market mechanisms ahead was striking.

Leaders surely intended that the party would retain whatever levers of influence were needed at the end of the day to set the overall pace of economic growth and activity. When I say that leadership hasn’t come to grips with the necessity of letting go of some political control, that’s what I’m talking about. For instance, advanced economies worldwide recognize the necessity of political independence for central bank and monetary authorities. That has not been achieved in China. There was effort to let the People’s Bank (China’s central bank) have a greater degree of independence to manage monetary conditions until recent years, but real autonomy from political control is distant.

That’s true of everything– the judiciary as well as every branch of society and the governing apparatus.

There have been steps, and experiments (for instance) with a more independent judiciary in special economic zones to handle intellectual property cases. There were test cases over the years that suggested leadership was at least thinking through a degree of independence for the judiciary, but that’s never been consolidated, and it’s absolutely fair to say that the prevailing incentive structure and way the system works is that the judiciary has no independence whatsoever from the political authorities.

The trend is clearly away from market liberalism these days. At the start of the Xi years there was an authentic internal debate about constitutionalism and separation of powers and the need for political reform. That was part of the conversation in Beijing. Powerful people in leadership, including some who went to the upper echelons under Xi, were having a different conversation. To look back and think we were hoodwinked by Beijing is absurd. The search for a different way forward was real less than a decade ago. And that search is likely to come back. My bet is that confronted with the choice between marketization on the one hand and living very low GDP growth like a Venezuela or a North Korea on the other hand, China is going to choose the former. As impossible as that seems, it’s even less possible to imagine China trying to meet its own needs and maintain social stability at 1% GDP growth.

Even with Xi in charge?

At the beginning he signed-off on an economic modernization agenda to be laid down in the 60 Decisions. He chose Liu He as the block captain to frame that program, and he approved central local fiscal reform, capital account liberalization, renminbi internationalization, interbank market reform, and requiring the introduction of independent boards of directors, including at state-owned enterprises. That broke down when the political compromises required to follow-through became clear. That was a rude awakening that Beijing has not figured out how to transcend. But there is this revealed willingness to admit the problems and try to address them. Xi may be more complicated than many think.

You co-wrote something in February of 2021 on the Rhodium website talking about the damage that decoupling in the semiconductor sector would do to the US. Given everything that has happened since then, how do you feel about the decoupling that has happened? How do you think the United States government has done in balancing security concerns with the consequences of veering in this more protectionist direction on semiconductors in particular?

The most breathless concerns about the risks from US decoupling efforts have not proven correct. But the policies that have been enacted are also scaled back from the most draconian initial proposals. Still, we are at a primitive stage of doing cost-benefit analysis in this area effectively.

Economists need a better estimate of the value of national security. We’re told that we need to take national security into consideration, and I’m on board with that, but we need to price it. Government agencies impute “shadow” prices to the worth of citizens, soldiers or species; I’m not yet sure how to value the intangible worth of an additional quantum of national security. We can’t do everything; we must make economic choices. At Rhodium we hope to find ways to push further on that analysis, so we can answer questions like yours.

Based on your experience doing Track II dialogue, what are the sticking points in US - China trade negotiations right now? What’s the holdup, and where is the disconnect between what our side wants and what their side wants?

The disconnect is that both sides want capitulation from the other side for domestic political reasons. On the US side, our domestic politics are so irresponsibly polarized by politicians trying to use China as a wedge issue: the national interest is being neglected. The White House has almost no room to talk to China, even if that would benefit the United States, our defense industrial capabilities, and our national security. We have such an absurd domestic conversation going on that’s been radicalized by irresponsible people, who have made it difficult for leaders to lead because whatever they say will be weaponized against them in the next election. Participating in Track IIs has allowed me to see that this problem exists on the Chinese side as well, with variations. Economists who are not politically palatable get sidelined or worse. American economists share this concern. It is too easy to be branded soft on China. It’s an anti-intellectual climate that is bad for all sides.