China’s Economy Is Heading Toward Stagnation, Not Collapse

Beijing will soon break another record, when the 2008 Summer Games host becomes the first city ever to hold the Winter Games as well. The lack of natural snow at this month’s Winter Olympics will present no hurdle for China’s Communist Party, which will literally move mountains to get the job done. But a much harder task than weather control confronts President Xi Jinping: delivering on his pledge for a fairer distribution of China’s wealth while maintaining stable growth.

Talk about China’s economy and growth model, ever since it became the 143rd member of the World Trade Organization (WTO) in 2001, always seems to swing between a Panglossian view of unbridled success and the doomsayers’ expectation that a crisis, spelling the end of Communist Party rule, is imminent. As China’s property woes deepened over the past year, examples of these extremes were on display with Jim Chanos saying yet again “it’s worse than you think,” while Ray Dalio was once more expressing confidence in China’s model. 

The reality is far more complex, and the stakes are growing ever higher. China’s success over the past 40 years—rising to become the world’s second largest economy, and top trading partner of multiple nations—should not be belittled. But nor can it be taken for granted that Beijing will continue delivering the stellar economic performance its citizens now expect, and the growth that foreign investors and governments have come to reply on.

Since the last time the Olympic flame burned in China’s capital, when Xi was in charge of final preparations, he has overseen major economic and political changes that now threaten to undermine the key drivers behind China’s success during Deng Xiaoping’s era of reform and opening up. Over the past 40 years, betting against the Communist Party has been a fool’s game, but China’s development model is now facing its sternest test.

Under Deng, the Communist Party that Mao Zedong mobilized to transform China underwent its own dramatic change. To allow the private sector to flourish, Deng accepted the capitalist class with a pragmatism that can only be marveled at, both then and now, in contrast to the Soviet bloc. Deng’s two successors kept up Olympian standards of ideological gymnastics to marry Marxism with materialism.

Xi, a red princeling spawned from the Communist Party elite, came to power in 2012 steeped in traditions and contradictions. His father Xi Zhongxun fought with Mao to establish the People’s Republic of China, was purged by Mao, then rehabilitated under Deng, and played a leading role in opening China’s doors. Yet his son has proved closer to Mao the strongman than Deng the pragmatist, in his strategy to underpin the Communist Party’s long-term legitimacy.

Xi looks to national security and ideology, not growth and pragmatism, to realize his “China dream” of national rejuvenation. And in a watershed moment last year, he added the goal of “common prosperity,” updating a Maoist concept from the 1950s to put reduction of inequalities, expansion of the middle class, and encouragement of entrepreneurship among smaller companies at the heart of China’s economic policies.

While fighting income and wealth inequality is a noble task, the way Xi has gone about it undermines two of the most important dynamos of China’s development model over the past 40 years: private enterprise and the authorities’ trial and error approach to policy change.

Xi only tolerates the private sector as long as it serves the interest of the state.

As entrepreneurs like Alibaba’s Jack Ma and others have long feared, Xi only tolerates the private sector as long as it serves the interest of the state, and large private firms too easily stray from that path. Over the past year, Xi has clamped down on big private sector companies that he regards as a potential threat to the Communist Party’s monopoly on power.

His ideological goal is to strengthen Communist Party power in state-owned as well as strategically important private enterprises, and to subordinate business decisions to the needs of the Communist Party. He has thereby changed for the worse the incentives driving China’s innovative and entrepreneurial behavior.

At the heart of “common prosperity,” as described by China, is to create space for small and medium size enterprises, which account for 80 percent of urban employment, and encourage getting rich through hard work and innovation. “Common prosperity” is nominally in supportive of the private sector. While large private firms present a problem, smaller firms, often treated as second class citizens, should be encouraged.

Ultimately, Xi might be striving for a private sector that looks similar to that of Germany’s Mittelstand, a large stable of small private firms that are innovative, generate high-paying jobs and produce technologically-advanced manufactured goods. However, making such a transformation will prove a real challenge when Xi’s mantra is frugality and redistribution.

From the onset of his rule, Xi has singled out lavish lifestyles and ostentatious spending as targets for criticisms, and the Communist Party’s top anti-graft body has punished close to one million officials since the eight-point frugality rules came in effect in 2012.

Why bother to succeed when spending your hard-earned gains however you want will be frowned upon or taken away to serve the needs of the Communist Party? Few people will strive to win the gold medal if they won’t get the ultimate credit for it.

Another of the most successful aspects of China’s development model has been formulating policy by trial and error or, in Deng’s phrase, “crossing the river by feeling the stones.” Once broad agreement is reached about the objectives of a particular reform, China’s “suck it and see” approach has created space for initiative and innovation.

Running local pilot schemes, encouraging experimentation, and exploring solutions tailored to specific circumstances—before rolling policies up to the provincial level and then nationwide—allowed China to find the best path forward. To succeed in the future in an ever more complex environment and under conditions of increasing uncertainty, Beijing must not compromise on this aspect of its development model.

Yet Xi’s centralization of power and determination to enforce state control has led to a swing toward top-down directives. Local experimentation is largely off the table with a few limited exceptions. The mood of political paranoia as a result of rolling purges has left local officials terrified of pushing the envelope, lest rivals use it as an excuse to end their careers.

And with the Sino-American geopolitical confrontation in full swing, Beijing feels it does not have the luxury of time to continue with experimentation. The paralysis of local leaders under Xi’s relentless anticorruption campaign and aggressive American efforts to contain China’s rise have combined to derail the trial and error method.

“A more open China welcomes you!” read an early Olympic slogan for 2008. A key official promised in 2001, the year of the country’s entry into the WTO, that the Olympics would also change China for the better, help establish “a more just and harmonious society, a more democratic society, and help integrate China into the world.”

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In the Communist Party’s eyes, all those goals were met, and continue to be met, as it deploys alternative definitions of democracy and human rights that put the best spin on China’s authoritarian turn under a decade of Xi.

As for a more welcoming West, China benefited tremendously from the West throwing open the doors of its industrial and financial sectors to China on the expectation that its economy would become fully market-driven over time. Eventually, many Western politicians hoped, China might even become a democracy they could recognize.

But Beijing had no intention of converging on the Western economic and political model. Xi, ditching another of Deng’s beliefs, has raised China’s head and made it crystal clear that it would follow its own path. The United States and other like-minded countries have finally woken up to this reality. And the international environment has turned much more restrictive for China, hurting its growth potential.

“Together for a shared future” says the 2022 Olympic slogan. Yet the diplomatic boycott by the United States will spotlight the competing ideological visions of the world’s two superpowers. To showcase the superiority of Chinese communism, the choreography will be perfect, both for the Winter Games and the National Congress this autumn, when Xi is likely to extend his rule.

Now a proud centenarian, the Communist Party he leads still appears to enjoy strong public support as it strives to deliver a better life for ordinary Chinese. But as Beijing moves further along the road to socialism and eventually, in theory, to communism under the deeply ideological slogan of “common prosperity,” it could well begin to squander the tremendous economic gains it has made during the past 40 years with a more pragmatic, experimental, and open approach to development. Economic stagnation could well threaten the Communist Party’s survival, but it has managed to pull from the brink of collapse before.