Guest Contribution: “China’s Transition: Three Scenarios”

Today, we are fortunate to have a guest contribution written by Phillip Swagel, Professor in International Economic Policy at University of Maryland’s School of Public Policy, and formerly Assistant Secretary for Economic Policy at the Treasury Department (December 2006 to January 2009).

My new book with Dan Blumenthal, An Awkward Embrace: The United States and China in the 21st Century, features three potential scenarios for the future of the Chinese economy and discusses implications for U.S.-China relations. The scenarios are:

  1. Optimistic: China becomes wealthier and gradually becomes less authoritarian and a more responsible participant in the international system.
  2. Somewhat Pessimistic: China becomes rich but stays authoritarian and increasingly challenges or even threatens the United States in economic and security spheres.
  3. Very Pessimistic: China’s economic growth derails, leading to a period of internal instability that contributes to severe global instability.

The first scenario is a benign outcome in which the bilateral economic relationship remains strong, while there is a gradual evolution within China toward political and social freedom. China addresses its current economic challenges, including normalizing monetary policy as part of a gradual shifting in the composition of Chinese growth toward domestic demand, along with liberalized trade and financial flows. This optimistic scenario involves a renewed move toward economic reform on the part of the new Chinese leadership.
As part of reform, the Chinese Communist Party eases its hold on the economy in the spheres of information, communications, capital flows, and internal migration. This moderation comes about in part out of necessity, since greater freedom contributes to long-term economic development. An economy turning toward more knowledge-intensive activities cannot prosper when knowledge is repressed. In the best case (and thus least likely or imminent), political oppression gradually eases as well. While a multiparty democracy seems quixotic, one could imagine a situation in which Chinese citizens enjoy considerable freedom in their personal affairs even if still circumscribed political liberty. While not conforming to precepts of a western democracy, this would be a huge improvement from the situation of today.
The second scenario envisions involves a modest change in trajectory from China’s current path. China’s economic growth continues but the nation remains authoritarian without meaningful change in the political and intellectual climate. Moreover, China shifts further toward a more aggressive external posture that presents economic and security challenges for the United States and other nations such as Japan.
Economic policy changes are made cautiously in this scenario, typically only as needed to defuse growing imbalances such as in the financial system. Growth is somewhat slower than in the first scenario though still fairly robust for years into the future before eventually slowing as internal migration ends. The eventual slowdown—a sort of middle income trap—manifests in part because the failure to proceed with further political and social liberalization limits the growth of knowledge-intensive sectors and thus puts a ceiling on development. Without fundamental changes, the occurrence of an economic crisis cannot be ruled out, but this possibility is reserved for the third scenario.
This second scenario in which China muddles through economically with more illiberal internal policies presents a difficult problem for the United States. China is still growing and has mounting resources at its disposal, but rejects the “liberal international order” or at least limits its participation to the benefits it can accrue from limited trade. Of particular concern in this scenario is that problems inside China might be externalized. China, for example, might seek to force Taiwan into unification and claim additional spheres of influence for itself such as the “first island chain.” Present difficulties with Japan are thus a preview of aggressive Chinese behavior in this second scenario.
In the third and most worrisome scenario, China’s growth falters and the Chinese leadership does not act in a timely or appropriate way to stave off the ensuing economic crisis. This in turn poses a political challenge to the Chinese leadership and the rule of the Communist Party, leading to an internal crackdown and an increasingly aggressive external posture as the leadership embarks on foreign “adventurism” to distract from its domestic failings.
Economic problems could arise in China through a sudden event resulting from financial imbalances and China’s dependence on export-led growth, from inflationary pressures caused by inappropriately loose monetary policy, or from slow-building demographic pressures such as the aging of the population and the unbalanced numbers of men and women. These developments already are giving way to wrenching changes, as the culmination of the one child policy is a collapse of extended networks of cousins and the family-oriented social safety net upon which Chinese society has been built for millennia. The surplus of men leads to societal pressures from millions of men who cannot marry; in response, the regime whips up anti-foreign nationalism as a replacement for the social glue lost with the demise of the traditional Chinese family. A failure of the party leadership to adapt to such societal pressures could turn a demographic shift into an acute crisis.
Such a dire scenario would threaten the stability of the regime by upending the implicit bargain under which the Chinese Communist Party rules in exchange for ensuring continued prosperity. Social pressures would have acute security implications, possibly including sparking active conflicts or grinding global tensions. As in scenario two, this could happen if Chinese political leaders use external adventures to rally domestic support. A more aggressive China would find itself increasingly distrusted by other nations and excluded from the global economic system. This in turn would affect Chinese growth and further exacerbate external tensions.
In considering these three scenarios, the key questions for U.S. policy revolve around how to achieve the first scenario and avoid the third scenario. Much of the change must take place within China, including reforms of monetary and investment policy, removal of trade barriers, and opening the nation to free flows of capital, ideas, and political debates. On the economic side, a key U.S. contribution would be to increase U.S. national saving to reduce our dependence on foreign capital and thus to narrow our trade deficit. This would both provide a market-based impetus to move China away from export-led growth and also help avoid populist responses in both countries that could spur serious problems such as a trade war.
It is less clear how to shape China’s path when there appears to be every economic incentive for China to move toward the cooperative path of the first scenario. The United States must also take into account that economic policymaking in China is mixed together with security policymaking and that policy decisions might not reflect a full understanding of any negative impacts on other nations. Chinese involvement with Iran on energy policy is irresponsible, for example, but this could reflect a lack of understanding rather than ill intent.
Even so, it would be prudent for the United States to recognize the clear possibilities of the second and third scenarios and thus prepare for continued political and strategic tensions. How the United States should prepare to deal with China in the coming decades is the central topic of the policy conclusions of our book.

This post written by Phillip Swagel.


14 thoughts on “Guest Contribution: “China’s Transition: Three Scenarios”

  1. 2slugbaits

    Prof. Swagel a key U.S. contribution would be to increase U.S. national saving to reduce our dependence on foreign capital and thus to narrow our trade deficit.
    Are you talking about increasing national saving as a longer term objective, or are you recommending an immediate increase in national saving? Any increase in national saving must come about through less government spending (i.e., an increase in public saving or an increase in private saving. Both would be contractionary.
    And let me welcome the Terrapins to the Big Ten (now Fourteen).

  2. randomworker

    Is it not possible that the third scenario would result in (classically) liberal social change? Why would it necessarily be the most dire outcome?
    If there is unrest can we have influence like we are attempting in the ME?
    Interesting stuff for a random worker such as myself! Thanks for posting it.

  3. Bruce Carman

    Scenario #3 is the historical pattern during the Long Wave Trough phase going back to the late 18th century, including the White Lotus Rebellion, Opium Wars, Boxer Rebellion, and Mao’s revolution. We are due yet another crisis era between China and the West.
    Westerners seeking their fortunes in the Middle Kingdom eventually reaches a tipping-point series of events that culminates in descending into financial, economic, political, and social crises, xenophobia, expulsion of “western devils” and others, confiscation of foreigners’ assets, and a turning inward by the Chinese elites from the rest of the world to deal with domestic crises and instability.
    This scenario is made more likely as China reaches the so-called “middle-income trap”; China becomes a net importer of food, energy, and materials; fixed investment/GDP collapses; the banking system and corporate debt implodes; peak positive demographics roll over and become a permanent drag, resulting in China “growing old before becoming rich”; and the working masses of China experience a growing sense of betrayal and disappointment after thirty years of rising expectations.
    China is also highly vulnerable to backdoor hot money outflows by wealthy Chinese nationals and US supranational firms via Hong Kong, Singapore, Taiwan, and Caribbean banking centers. I expect eventually China in a period of financial and economic crises will impose draconian capital controls. It’s getting quite late to exit the Middle Kingdom whole.
    The impending crisis era is likely to result in a breakdown in trade and diplomatic relations between China and the West (US), making China vulnerable to US military embargoes and blockades in Asia, Africa, the Middle East, and the western hemisphere, further isolating China, reducing access to commodities and markets, placing China under the stamping imperial boot of Anglo-American empire.
    China is a four-letter word: SELL.

  4. B Turnbull

    Prof. Swagel:

    Considering your expertise in China and Economics, what are the best recent books from Western economists analyzing what works in China, why most Western economies are in such deep decline, and what can the West learn from China?

  5. Christiaan Hofman

    It seems to me that scenario 2 is not stable in the long run, and has to eventually evolve either into 1 or 3. And which one it would be would not be under control of the leadership, so it would be a real gamble. It’s really a tipping point scenario before the tipping point is reached. Unfortunately, in the medium term, scenario 2 seems to me the most probable outcome, in part from what seems to have come out of the recent change in leadership. And as you have indicated already in your description of scenario 2, the tipping point has a higher probability of leading to 3 rather than 1.

  6. randomworker

    Thank you Bruce.
    A while back I heard an interview with (I think) Barry Diller (of all people!) who said something to the effect that it would be impossible for the Chinese ruling elite to put the internet genie back in the bottle, and that western-style liberalism was inevitable. The usual tools of oppression would be less effective and the people simply would not stand for it. Maybe we will find out.
    I always thought the way out for everyone concerned was the evolution of China into a consumer economy over time. But you are saying external forces like peak oil, and water and food shortages (global climate change) make this impossible?

  7. B Turnbull

    Why do you think China is going to lose propaganda war because of Internet? So far they are doing quite well to utilize it for their own goals.

    Even in US, internet didn’t really hurt American ruling elite. In fact, they can use it for pinpointly effective propaganda of single individuals, having enormous amount of information volunteered by and accumulated thanks to FB, Google, e-mails, browsing history, etc.

    At the end of the day it is broken economy that is likely to put a major strain on stability, and for the last 30 years Chinese GDP per person has grown remarkably, while in US it has recently started to contract, with median household income dropping at least 8% in the last four years.

  8. Carol

    Here is another scenario, Professor: China hits crisis, desintegrates, breaks into smaller states and destructive civil war.

  9. Bruce Carman

    “But you are saying external forces like peak oil, and water and food shortages (global climate change) make this impossible?”
    randomworker, in a word, yes. China’s growth boom is done. Demographics and global resource constraints mean China will grow old before growing rich.
    China’s wealth and income concentration is not unlike that of the US, UK, Russia, the Middle East, and many African dictatorships. Social instability are virtually assured. Betting against it is betting against the forces of thermodynamics and human nature. Bad bet.

  10. DOR

    I think we’re missing the mainstream scenario:
    * Chinese incomes rise slightly faster than inflation, and faster in the cities than in the rural areas;
    * Environmental damage forces water rationing in much of the north and west;
    * Corruption moderates somewhat; and
    * The leadership continues to exercise autocratic powers.
    In other words, “present trends continue.”

  11. Bruce Carman

    As in the case of Japan, EU, and the US, China’s total domestic debt (provincial, central gov’t, and private debt) to GDP has effectively reached the so-called Jubilee cycle threshold after which debt to GDP must contract 50%.
    Moreover, China’s money supply is now 80% larger than GDP (velocity of 0.55), owing primarily to US supranational firms’ MASSIVE investment flows since the ’90s, as well as HUGE gov’t “stimulus” and investment for the Olympic games since the early ’00s. At some point, perhaps soon, China risks a dramatic contraction in FDI/net capital flows and in money supply as a result of US firms’ attempts to repatriate US dollars via Chinese banks and US Treasuries holdings in China’s central bank’s custodial account. This is the primary reason US firms are so insistent (desperate) to force China to float the Yuan. US firms are dying to pull their money from China directly out the front door instead of being forced out the back door, as it were, via Hong Kong, Taiwan, Singapore, Australia, and Caribbean banking centers.
    Moreover, because of the large net flows as a share of GDP and money supply to GDP, net outflows of just 1-1.5% equivalent of GDP in China risks a Great Depression-like contraction in money supply, fixed investment, production, asset prices, and real GDP per capita.
    Don’t walk, run from China.

  12. Phillip Swagel

    Thanks to all for the comments. Here are a few notes in response:
    On increase US nation saving: I have in mind over time, putting in place a gradual but credible approach to tackle the fiscal imbalance. Whatever the mix of spending and revenue in the adjustment, this means addressing the imbalances in Medicare, Medicaid, and Social Security.
    Yes, I agree that our third pessimistic scenario could end up with classical liberal social change. This looks messy in the ME so far (Morsi looks to be a PR genius to launch his sorta-coup on a US holiday). My sense is that the consequent struggle in China would be more disruptive than what we see in the ME, and US policy levers limited — witness the reluctance to engage in Syria. But yes, the ending could be better if cataclysm leads to liberal rebirth. That seems like a big if and at the end of a long and disruptive process after lots of aggravation.
    I also agree that one could say our scenario two will inevitably evolve toward one or three (get better or worse). But that could be a matter of decades, so it feels to me like a scenario worthy of analysis on its own. That timing of decades in a muddle along situation is based on the sense that China still has plenty of room for growth, even with the recent slowing. From the Chinese perspective, six percent growth will feel like a middle-income trap, but that’s still plenty to keep them out of the third scenario in which things go bad. A key question in my mind is the extent to which the Party lets go of control over knowledge flows — seems like a strong connectoin between that liberalization and their ability to sustain growth.
    My sense is that it’s way too soon to say “sell.” China has so much potential yet — has come so far and still has room to do even better on the economy, liberty, and so many dimensions. Will be fascinating to watch the new leadership figure out their steps.
    I thought Raghu Rajan’s book was excellent looking at the US and other western economies.
    And thanks on the welcome to the Big 10!

  13. Bruce Carman
    See “dark matter” above.
    Also, China’s FDI/net capital investment to GDP is set to reverse along with trade, China’s growing deficit for food, energy, and materials, and US firms’ attempts to repatriate Yuan deposits from Chinese banks via China’s central bank (and Fed, primary dealers, Eurodollars, and Caribbean banking centers).
    Economists and financial media influentials won’t see it coming because they don’t understand (misinformed) about the relationship between US (and Japanese) supranational firms’ investment and deposits in China, the net effects on the current account balance, trade flows, and the larger implications hereafter.
    Prepare for the “giant sucking sound” of net capital outflows from China coincident with another deflationary contraction in global trade. The PBoC and Fed are about to be overwhelmed by a big liquidity demand from US supranational firms, including the TBTE banks and their largest borrowers (collateral holders).

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