The Involution Solution
The Involution Solution
China has been the key to the global economy for the past 30 years. By their willingness to accept marginal, even negative, returns on capital over the past 30 years to grow their manufacturing juggernaut, they have fueled the consumer/technological-based economy in the West.
It’s a mercantilist model that requires the yuan to be maintained at low levels, necessitating the accumulation of US dollars to pay for imported raw materials, energy and high-end manufactured goods and technology. This is what we see from the outside; the inside of China’s economy is far different.
Inside China, it’s a combination of financial repression, neo-feudalism, and widespread rent extraction by CCP elites. Chinese citizens are subject to rampant fraud of all types perpetrated by the government and fellow citizens. The banking system is a Ponzi scheme designed to funnel money to the top.
Both the external and internal models require growth to remain solvent and that’s where both are finding a brick wall. Like a company facing bankruptcy, China Inc. is running for cash in global markets, limiting imports while maximizing exports. Internally, Chinese businesses are turning to hyper-competition to remain afloat as they run the gauntlet of weak consumer spending, onerous government fees, rules, and taxes, and deflationary asset markets.
The smart Chinese have already gotten their money out, including the CCP elite. Trillions of US dollars have been squirreled away in Western asset markets, leaving an extraordinarily levered Chinese banking system devoid of equity capital. The People’s Bank of China added 20% to the money stock in 2023 without an uptick in inflation. In fact, things are so weak internally that consumer and industrial prices continue to decline.
Involution
Involution always precedes evolution – James Arthur Ray
The mathematical definition of involution is a function, transformation, or operator that is equal to its inverse. Applied to Chinese businesses, to survive, they must be equal to the inverse of the difficulties they face. In other words, the survivors must be extraordinary competitors.
Small, private businesses represent 96% of all Chinese businesses and employ over 80% of Chinese workers. They are also responsible for more than 90% of new job creation. The CCP treats them as disposable sources of cash flow.
Starting September 1st, all businesses and workers must contribute to China’s Social Security System. Until now, it has been optional, allowing workers to opt out if desired. It’s a pay-as-you-go system and it’s out of money so the CCP is now forcing 100% participation. They’re robbing Peter to pay Paul.
The result is going to be mass closures of businesses across the country because most can’t afford to pay the 1500 yuan per month for each employee. Perhaps worse, the individual portion can be as much as 40% of take-home pay which will further pressure consumer spending.
In short, it is a form of economic suicide and it reflects a financial system on the brink. Not only will it hurt consumer spending, it will make it more difficult for homeowners to continue to pay their mortgages. It marks the beginning of the end for China.
One way or another, we’re going to see the start of massive change before 2025 is over. Nobody in China believes they will ever receive Social Security benefits; instead, they are trying to stuff their bank accounts to pay for retirement. Will these payments be the straw that breaks the camel’s back?
Cash Flow is Drying Up
Never take your eyes off the cash flow – Richard Branson
Chinese state-owned enterprises are perfect for rent extraction by the CCP. Oil, chemical, tobacco, and rail companies provide numerous opportunities for CCP officials to dip their beaks. The ones that sip go unnoticed while the ones that gulp are vulnerable.
Wang Yilin is the former chairman of China National Petroleum Corporation who was convicted of bribery for accepting $2 million and sentenced to 13 years in prison. His true crime is believed to involve RMB 1.5 trillion maybe more. They found the gigantic basement of his home stuffed with cash.
Xi Jinping has been quietly floating the idea of taxing Red princelings to shore up the cash flow deficit in Beijing. It’s bad enough his policies have destroyed the Chinese economy but taxing them is going too far. Xi has reportedly lost the PLA to General Zhang Youxia, the highest-ranking princeling in the military, which effectively neutralizes Xi’s power.
Beijing is out of money. They’re attempting to claw back the most obvious excesses but without taxing the princelings, those claw backs are limited. The People’s Bank of China can print money to temporarily shore up the nation’s banking system but at some point it will bleed into consumer prices. In effect, they are holding the great deflation of the housing collapse, rail collapse, air travel collapse, consumer spending collapse, and the social security collapse at bay. The demographic collapse is happening as the real birthrate is less than half the replacement rate. The idea that China can somehow reverse this disaster is fantasy; the problems are insurmountable.
Some recent data supports this view. Refined gasoline demand is down 4.8% year-over-year. Electric vehicles are partly to blame but so too is the economy. Diesel production is down 17.2% year-over-year due to weakness in logistics and construction. Nobody knows the true specifics of the Chinese economy but these are two incontrovertible pieces of data.
Over the long term, cash flow ALWAYS tells the story whether it’s consumers, corporations, banks, or governments. The Chinese economy is so FULL of non-performing loans that the central bank will not be able to hide the deflation for much longer.
Those who make peaceful revolution impossible will make violent revolution inevitable – John F. Kennedy
Xi Jinping’s fate will be decided by October when the Fourth Plenum takes place. This is where CCP leaders make decisions as an assembled body and where the party’s elite finish the horse trading in back rooms that ultimately produces a consensus. It’s going to be VERY interesting this year.
I don’t believe China will experience a revolution because the CCP will brutally suppress those who revolt. But I do believe we’re going to get reform that returns power to regional governments and perhaps a move closer to democratic reforms. Furthermore, I believe the ill-timed Social Security rule-change will be the catalyst for weakening the Maoists.
Everyday life is difficult for the average Chinese citizen. Involution is akin to steel sharpening steel. Young people need to work long hours with little hope for a better life; it’s making them hard and dangerous. This is what the CCP leaders need to contend with at the Fourth Plenum – and the smart ones know it.
From the standpoint of industrial policy, Xi directed massive investment into electric vehicles, green energy, and the extraordinarily misguided Belt & Road Initiative that effectively destroyed more than $1 trillion in trivial, inconsequential, and downright foolish projects in the hope of making China the epicenter of a host of low-value nations. EV’s and green energy are in decline in the West even as China has built grotesque excess capacity. He’s also responsible for shutting the whole country down during Covid, destroying immeasurable amounts of economic potential.
From the standpoint of international relations, Xi rushed the CCP’s plan, started with Deng, that hoped to supplant the US as global hegemon. China wasn’t ready for such an undertaking but Xi introduced “wolf warrior diplomacy” to use a stick against potential partners instead of a carrot. In addition, he started a military build-up with the express intent of invading Taiwan by 2027. The world took notice. Now he’s backed into a corner. If he invades Taiwan, China becomes a global pariah like Russia.
Mao was terrible but at least he had very little to work with whereas Xi inherited a situation that had potential and squandered it all and then some. The yuan has been flat for the past two years with a few narrow escapes from collapse. The collapse is coming, perhaps later this year.
China’s military is not monolithic. Each theater command and each branch of the PLA – army, navy, air force, and rocket force – have different allegiances within the CCP. Zhang Youxia controls the forces in and around Beijing as well as having close relationships with army commanders around the country but he’s not universally revered in the PLA, particularly outside the army.
The worst-case scenario would be a fracturing of the nation into regional strongholds like it was prior to 1947, perhaps even a civil war between regional theater commands. This isn’t as far-fetched as it reads. The best-case scenario is that Wen Jiabao prevails in the Fourth Plenum and ushers in economic and political reform. Even this scenario won’t be enough to save China; they have wasted too much time and capital on redundancy and uneconomic pursuits even as the demographic window has closed.
Conclusion
The least movement is of importance to all of nature. The entire ocean is affected by a pebble – Blaise Pascal
I consider China to be the most critical variable in understanding the global economy and the US economy, in particular. Without China’s willingness to sell at a miniscule profit, even at loss, many layers of marginal transactions in our consumer economy get rolled backwards. People would need to cut consumption on a unit basis with the attendant decline in standard of living.
The same goes for technology. China has thousands of little companies that make the necessary inputs into chip production and other electronic media that would be inordinately expensive to produce elsewhere. The result would be price increases for technology across the spectrum, resulting in longer payback cycles and slower uptake in new technologies. This makes AI uniquely vulnerable to problems in China.
China is at an important crossroads, even leaving out the impact of US tariff policy. Xi has made a mess of things such that China will be severely hampered for at least the next 30 years. Demographics are unforgiving.
Pray that Chinese leaders choose to reverse the Maoist course during the Fourth Plenum and adopt a less belligerent and more conciliatory stance when they choose their next leader. It is critically important for our economic well-being that China remains an important trade partner.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA