 Welcome to Think Tech on OC16, Hawaii's weekly newscast on things that matter to tech and to Hawaii. I'm Raya Salter. And I'm Nicole Horie. In our show this week, we'll cover a talk by international journalist Richard Hornick at the China Seminar of the Friends of the East-West Center. The subject was the challenge of Xi Jinping. Can China avoid economic stagnation, an important and provocative topic in the age of Trump? The China Seminar, an educational nonprofit founded by Danny Kwok, is now in its 38th year. It's known for its role as a forum of the Friends of the East-West Center. In his talk, Richard Hornick focused on the notion that all rapidly developing countries eventually face what economists call a middle-income trap when they try to move from resource driven growth dependent on cheap labor and capital to growth based on high productivity and innovation. Two countries have made that transition, and China's chances have been heavily compromised by the unprecedented growth of private and public sector debt over the past eight years. The question now is whether dynamic zonguo will become the muddled kingdom we need to know. Richard is a lecturer and the director of overseas partnership programs at the Center for News Literacy at the School of Journalism at Stony Brook University. He is a journalist with 30 years of global experience. He is executive editor of AsiaWeek, deputy chief of correspondence and news service director of Time in New York, and served as Times bureau chief in Warsaw, Boston, Beijing and Hong Kong, and as national economics correspondent in Washington D.C. and Europe business editor in London. Richard co-authored Massacre in Beijing, China's Struggle for Democracy with Donald Morrison and has written for Foreign Affairs, Fortune, Smithsonian, The New York Times and The Wall Street Journal. He has an M.A. in Russian studies from George Washington University and a B.A. in political science from Brown University. He is a member of the Council on Foreign Relations and has been a journalist in residence at the East-West Center. He was the visiting lecturer at the University of Hong Kong in 2012 and at UH Manoa in 2015. Richard is also an editorial consultant who has designed and implemented editorial reorganizations at Reuters and the Harvard Business Review. In 2011, he served as the Harvard Business Review's interim editor. With all that in mind, let's take a look at some of the remarks he made at January's China seminar. Can China move from being an upper middle income country to an upper income country? And that challenge, so a middle income country by the World Bank's definition is one where the gross national income, which is a measure of economic activity, is roughly 12 to a maximum of $12,000 or $13,000 per capita. And the challenge is that it's very, very difficult to move from what they call a resource driven economy, one that relies heavily on lots of labor, lots of capital, to one that more is based on innovation and high productivity. So if you ask somebody from the World Bank, they'll tell you that the way you have to do it is you try to get authentic innovation. That is innovation that's actually creating something new and not just an incremental change or improvement and not something that's been copied from someone else. Requires new processes and new markets. And one of the key elements is to get domestic demand up enough so that your country is not reliant on exports. Most of the countries that have gone, economies that have grown over the last 20 or 30 or 40 years, have been driven by, have had export-led growth. At some point, you have to then rely on your own economy. The requirements are pretty straightforward. You have to invest in education and infrastructure. If you're going to raise productivity, you have to have a better educated workforce. You have to be able to move products and goods. You need an atmosphere that's conducive to innovation. That is you need people who are willing to take risks. People who will try crazy things. People who will think outside of the box. And because most rapidly industrialized countries have built up large debts, you have to figure out ways to pay those off. So I think we all know the Asian success stories, Japan, Taiwan, South Korea, Singapore, Hong Kong. This actually provides you with a very misleading view of what it takes to get out of the middle income zone. Because although there are those success stories, there are many, many more failures. The blue countries are the ones who have gotten out of the middle income classification. All the others are stuck or on the verge of getting out. And by the way, as it says there, all but one of the infamous or famous BRICS is still a middle income country. Only Russia has gotten out, and that's purely based on its raw materials, its resources. As is Saudi Arabia. China is facing a ticking clock, if you will. As you can see, it was one of the great growth stories of the 20th century. But in the 21st century, beginning in 2008, it's had a very, very rapid drop off from 15% annual growth down to six and a half. And most people who follow these things don't actually believe any of those figures, sorry. But they're rough approximations, and so they're measures within broadband. Regardless of what you think the actual number is, everybody agrees that it's a lot less than it used to be. Now part of the reason for that, and this is another problem with being a middle income country as you're trying to get bigger, is something called the law of large numbers. So if you have $100, and you increase that by $10, that's a 10% increase. But if you've got $1,000, and you increase it by $10, that's a 1% increase. As your economy gets bigger, it gets harder to get those high percentages. And China has been facing this problem for quite a while. It's somebody who's covered it for a long time and often been called a China skeptic. I've always enjoyed the sort of straight line projections that the China optimists like to use. Well, if it continues growing at 15% a year for the next 20, well, it's not going to continue growing. It's not going to grow at 10%. It can't. The law of large numbers says it can't. China's drive for indigenous innovation. We could have a whole separate talk about that. We'll skip over it right now. But China, I think about 10 years ago, seven years ago, launched an indigenous innovation effort. And these were the industries that China decided they were going to invest in to make that happen. Well, anybody who's ever covered economics knows there's this expression about picking winners. And is it possible for bureaucrats to actually pick future industries? And although meaty is always held up as the great example of that in Japan, eventually meaty's luck ran out. And in fact, meaty had quite a few misfires. I don't know if any of you know this. But meaty did not want Sony to import a line to make transistors back in the early 50s. They didn't want Honda to make cars. So when you have bureaucrats deciding what are going to be the industries of the future, they'll be right and they'll be wrong. Our economy is based on the belief that it should be done by the market. OK, so China's specific challenges. First of all, they have to build human capital because growth, the demographics, the one-child policy has meant that they have this ticking time bomb of people who are going to be, well, they're just not as many young people. They've just gotten rid of the two-child policy, a one-child policy. But that won't have any impact for 15 to 20 years. Restructuring state-owned enterprises. This is perhaps the most obvious issue. It's the one that has been talked about probably more than any other by their public officials. And it's the one where, unfortunately, in the last five years, the least progress has been made. And in fact, they probably went backwards. And then reducing public and private leverage while maintaining healthy economic growth. And that is the dilemma. Cutting the debt but keeping the economy going. And you've got an economy that's very, very dependent on debt. So on human capital, this is from the OECD. These are just some ideas of things that they should be doing. China has been increasing its spending on basic education, but it still ranks 109th in the world in terms of a percent of GDP. So evaluate university and university staff more on the quality of academic output. Anybody who heard my talk last year about academic freedom in China knows what's going on there. And promote research autonomy, merit-based promotion, and stronger intellectual property rights. And again, these are all things that are great on paper but are very, very difficult to get to in practice. Because, again, this idea of being able to pick winners, China is investing a lot of money in R&D, but it's almost all going through government agencies. And the process of applying for these funds is highly, highly political. So the state-owned enterprise issue is, again, it's a dilemma and it's unfortunately one that I think has gotten worse in the last five or six years. So you can see from this chart the orange is the percent of total industrial assets in the country, which have gone down considerably, but the percent of total urban employment has gone down even more. So basically, state-owned enterprises are eating up a huge amount of China's assets and employing very, very few people. But the people they do employ are important. They're like auto workers in Detroit. These are people who China is quite afraid of them becoming disaffected by taking their jobs away. And this share of profits, private companies, skyrocketing, state-controlled companies dropping like a stone. Assets for state enterprises versus private enterprises, 2.8% versus 10.6%. All of you who have funds to invest tell me where you would put your money. Unfortunately, where do you think all the money is going right now? It's going to the 2.8%. It's going to the state-owned enterprises because they are so heavily in debt that the government has to keep propping them up because they don't want them to go bankrupt because they don't want to put all those people out on the street. This is not something that's new, by the way. Japan went through a very similar thing in the 80s and 90s. This is not special to China. Every middle-income country that's gone through this has gone through some elements of this. And as I was saying, state-owned enterprises have twice the debt as private companies. That's the debt-to-asset ratio is 60% for the state-owned enterprises. And it's somewhere under 50 something percent for private. So therefore, China's debt is growing. You will see in the next couple of charts that 2008 is a very important date. Look at the bend of the curve to 2007. They were getting debt under control. In 2008, what happened in 2008? The financial crisis. And the financial crisis hit China in an indirect but very important way because it reduced the demand for their exports. And so the government needed to generate economic activity. And they did it largely by investing in infrastructure. Household debt has never been a problem in China. People buy their apartments or have bought their apartments for cash up until recently. But again, in the last few years, they've more and more have been allowed to mortgage. And household debt is beginning to climb, which depresses demand for domestically made goods. But the real time bomb in China, in the debt, is the local government debt, which has been growing by leaps and bounds and which is being hidden in any number of ways. Again, trust me, it's not good. And this is one of the ways it's been hidden. There's this thing called shadow banking. So these are assets that are not directly on the books of state-owned banks. They're in finance companies, broker asset management, the trust loans. There's a whole thing called a wealth management product in China. The Chinese banking system in the last five years has doubled in its size. It has effectively added the United States banking system to its size because it is now twice the size of the American banking system, even though the American economy is still about 80% larger than the Chinese economy. So we do pretty well with a banking system that's got about $15, $17 trillion in it. The Chinese banking system has $35 trillion in it. So everybody's, well, but they've got the $4 trillion that they loaned us to cover all of this, right? Oh, wait. So in the last two years, they've lost $1 trillion of their foreign exchange reserves. There are a bunch of reasons why the reserves are declining. The biggest one is probably the decline of the renmin b, which is actually, this is one of the ironies. I said I wasn't going to talk about Mr. Trump, but he is right. The Chinese are manipulating their currency. They're keeping it from falling even faster. It should be easily over $7 to the dollar. But again, they're not going to let that happen at least for a while. Well, the reason is capital flight. So if you're running a country that has a fairly close financial system, but you allow people to get money out, and it turns out that the assets seem to be depreciating, they are going to get the money out. And the Chinese have proved incredibly creative in getting money out. Mostly it's done by double invoicing. But one of my favorite anecdotes was being in Hong Kong a couple of years ago. Maybe you saw this as well. There are these Gucci stores in Causeway Bay. And you go into that store with a Chinese credit card that bills you in renmin b. You buy a Gucci bag for $1,000. You take it next door to a shop that will give you $700 in cash. The other weird thing about capital flight is that the more you try to stop it, the more people are going to be convinced that they better get the hell out today. And so in the last couple of weeks, months, they've downed a whole bunch of new efforts to they call it throwing sand in the gears just to slow things down. Apparently, Western companies now are finding it difficult to get some repatriate, some of their profits. Bankers in China have been told that they are not allowed to tell people that their request to move money has been disallowed because of a government policy. They have to make up some other reason. Increased reporting. So as a private citizen, you can take $50,000 a year out. So everybody is expecting it all to go out in the next month or so. But they're going to have increased reporting requirements. Anyway, they're trying very hard, but it's not going to stop it. So time to panic. And I've made a few of them myself. Predictions of China's economic demise are greatly exaggerated. I should have started my talk by reminding you of my very often referenced piece in Foreign Affairs in 1994 when I was at the East West Center entitled Bursting China's Bubble, in which I predicted the demise of the Chinese financial system because of a whole bunch of these same problems. So why am I always wrong? And why don't I think something bad's going to happen now? Because I've learned my lesson. They know how to reflate. The economy is not going to come to a screeching home. They won't let it. The taps are going to stay open. And they're going to try on the edges to try to change things. But they're going to keep the economy going. And especially with Xi Jinping coming up for, we're re-election later this year, perhaps even getting himself a third term or laying the groundwork for a third term, they're not going to run any risks. So the debt will continue to grow. But because of that, this was in 2015, Finance Minister Lu Wei said that China has a greater than 50% chance of falling into the middle income trap in the next five to 10 years. And I think if you asked him today, he might say that chance is even greater. And this is the only chart you need to remember from this whole talk. This is, if you look again, look at 2008, and then that rate up. The way economies work is we print money, we loan money, then there is a multiplier effect. It creates a certain amount of economic activity. In the good old days, even for less than $1, you got more than $1 worth of economic activity. Today, it takes $8 to get you one point of GDP growth. And this, again, not the first time. This is what happened in Japan in the lost decade. They kept building all these bridges to nowhere, and the bullet trains, and all this other stuff. Eventually, you run out of impact from loans. So the loans simply serve to keep things ticking over. And in that case, you're not going to have this progress. So is this horrible? Well, no, China will have gross national income of $15, maybe $20,000 over the next some years. But the idea that somehow it's going to make that leap that economists think is important to a wealthy economy, not a middle income economy, I think I'll be right about that one anyway. Thank you. Are increasing levels and proportions of debt a fatal flaw in the growth of China's remarkable economy? The rise of China has been of increasing interest and concern over the past 15 or 20 years. But now, in the heat of the isolation and contention created by the Trump administration, it becomes all the more important for us to understand and follow what's going on. ThinkTech, from its inception, has followed China on a regular basis with extended coverage of talks by journalists like Richard Hornick. And we'll, of course, continue to do so, so stay tuned for more. Want to know more about Richard Hornick? Google him and check out his link at Stony Brook. Want to know more about the China Seminar? Check it out at the Friends of the East-West Center. And now, let's take a look at our ThinkTech calendar of events going forward. There's so much happening in Hawaii. Sometimes things happen under the radar, and we don't hear much about them. But ThinkTech will take you there. Remember, you can watch ThinkTech on OC16 several times every week to stay current on what's happening in government, industry, academia, and communities around the islands and the world. 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You can watch this show throughout the week and tune in next Sunday evening for our next important weekly episode. I'm Raya Salter. And I'm Nicole Horry. Aloha, everyone.