Xi Jinping
Photo credit: Neou Vannarin / Wikimedia

Financial journalist Dinny McMahon talks about shadow banks, ghost cities, and massive loans that could end the Chinese miracle.

The Dow Jones plummeted Thursday over concerns that President Donald Trump is plunging the US in a trade war with China. Such a conflict is widely expected to harm US consumers. But what about the Asian superpower?

What if the Chinese Emperor has no clothes? Remember back in the 1970s when Americans were afraid of the Japanese economy taking over? When they bought great American assets and real estate? In fact, all that fear and anxiety were misplaced. The same may be true today with respect to China.

We hear breathtaking economic numbers coming out of Beijing. The consistent low unemployment rate and high GDP are often the envy of the world. But are those numbers real? And if not, does the Chinese government even know what the real numbers are?

In this week’s WhoWhatWhy podcast, Jeff Schechtman talks to Wall Street Journal and Dow Jones News Service journalist Dinny McMahon, who has spent more than a decade inside China, and who understands much about the mythology and challenges of the Chinese economy.

Many of these economic statistics from China are manufactured from the bottom up, as city and regional leaders puff up the numbers they send to Beijing to make themselves look good. All of this, according to McMahon creates an artificial impression of growth.

It’s the Chinese version of fake news.

These statistics encourage more borrowing by state-owned companies and local governments to build more factories, housing and public works, much of which are not needed. The overcapacity creates so-called investments that may never pay off.

McMahon also explains how China’s continued emphasis on infrastructure and heavy industry could be a disaster. And that China has to make the turn to a more consumer- driven economy if it is to join the modern world economy.

Its once endless supply of cheap labor is drying up, the move from rural areas to the cities has slowed, the population is aging, manufacturing costs are increasing and it’s very possible that China might grow old, before it grows rich. If that happens, McMahon explains, the repercussions for the world economy could be substantial.

Dinny McMahon is the author of China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle (Little, Brown Book Group, March 13, 2018).

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Full Text Transcript:

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Jeff Schechtman: Welcome to Radio WhoWhatWhy. I’m Jeff Schechtman. Many of you remember that back in the seventies, we were terrified by the power of the Japanese economy. They were buying up the great companies and the great real estate assets of America, and we thought we’d all be speaking Japanese and working for Japanese bosses. Obviously, none of that came to pass. Today, much the same fear exists about China. We fear that in technology, they’re way ahead of us, that their infrastructure and economy is booming, and that by controlling so much of America’s debt, we are beholden. But what if the emperor has no clothes? What if everything we think we know about the Chinese economy is wrong, that it is propped up on a mountain of debt, and could come crashing down, taking the world economy with it at any time? That’s the view of my guest, Dinny McMahon, in his new book, China’s Great Wall of Debt. Dinny McMahon spent more than a decade in China as a journalist covering the Chinese economy and financial systems, and he’s the author of the new book, China’s Great Wall of Debt. Dinny McMahon, thank you so much for joining us on Radio WhoWhatWhy.
Dinny McMahon: Hi Jeff, it’s great talking to you.
Jeff Schechtman: One of the things that you discuss in the book is that as big a part as China is of the geopolitical discussion, and certainly the world economic discussion, that so much of what we know in terms of numbers, statistics, information, transparency, that it’s all very sketchy. Talk about that first.
Dinny McMahon: Yeah, it’s always very difficult getting to the bottom of Chinese data and exactly just how legitimate it is. Some of the numbers that they publish, just outright, there is no legitimacy to them. For example, China’s unemployment level has been about 4.2 percent for about a decade. No matter what happens, it just doesn’t move. It’s fair to say that there’s no truth behind that particular number. The number that everyone watches is the GDP figure. China’s economy clearly is one of the fastest growing in the world, it’s probably the fastest-growing large economy, but certainly we can’t take the GDP numbers at face value either. You kind of look at the way that other nations’ GDP figures bounce all over the place. China’s numbers are amazingly smooth from one quarter to the next. They just move up and down by maybe a tenth of a percentage point or two-tenths of a percentage point. Certainly there’s enough to suggest that these figures aren’t legitimate, and that makes it incredibly difficult to actually know at any given time just how strong the Chinese economy is.
Jeff Schechtman: I guess the broader question then is the degree to which this information that is coming out to the rest of the world may not be accurate, and how much internal information that the Chinese government has is accurate, and is there something that they know that we don’t?
Dinny McMahon: Yeah, this is an age-old question is that is the data we see really for the consumption of foreigners, and do the Chinese have a parallel set of numbers which actually tell the real story? There was a quote that was released in one of the Wikileak dumps a few years ago was a big leak of American State Department cables from embassies around the world, and one of those had the report, the notes from a conversation that the US ambassador had with a senior governor at the time who would later go on to become China’s premier, and he said that no, China’s data is man-made, and that even he doesn’t trust the data. If he’s trying to get a sense of what the economy’s doing, he looks at things like freight data and energy and electricity consumption. Now, the problem is that the problem with the data isn’t simply an issue of the figures being manufactured at the very top. The issue is really that the numbers are manufactured from the very bottom, because everybody throughout the system kind of has an incentive to make what they’re doing look better or more successful to the next level of officials above them than they actually are.
For example, officials at every level of the Chinese system, they get rated on their ability to drive economic growth. More than anything else, that is the measure against which their success is judged. If they can’t generate that economic growth for real, then they often fudge the numbers. Then they fudge the numbers and they submit them to the officials above them, who might have the same pressures to do the same. By the time the numbers get to Beijing, they’re being manipulated and massaged at every level, so the guys in Beijing don’t necessarily know exactly what’s going on.
Jeff Schechtman: How much of what drives the economy than what drives public policy is the goal of actually trying to get the economy to work up to the numbers that they’ve put forth?
Dinny McMahon: That sums it up quite well. Economic growth isn’t really something that’s aspirational. It’s very much something, it’s a number that everybody is trying to achieve. That bias is baked into the system at every level. State-owned enterprises, they’re not so much driven by the motivation to earn profit, they’re more driven by this goal of growing bigger and producing more. Local government officials are exactly the same. It’s all about generating growth, and in particular, generating up to the level that Beijing says it wants to see.
Jeff Schechtman: One of the things you point out though is that a lot of this growth is artificial, whether it’s cities being built with nobody to live in them, or factories that are still sitting empty.
Dinny McMahon: That’s right. When we talk about China’s debt levels, I guess when we talk about debt in any nation, we typically first think that  maybe it’s a [inaudible 00:06:28] issue, but it’s not. China’s not facing a situation like Greece. The borrowing hasn’t been done by the central government. It’s also not in a situation like in the United States prior to the sub-prime crisis. All this debt we’re talking about, it’s not mortgages. What it is is it’s borrowing by companies, mainly state-owned companies and local governments, and what they’ve spent it on is things like factories and housing and public works. Those things in and of themselves don’t sound so bad. It may sound like they’re making a contribution to real growth, to the real economy, but so much money has been borrowed that the sort of investments that are being made have been hugely excessive and wasteful. You get the situation where you’ve got factories that are capable of producing far more stuff than the Chinese economy will ever use. We see that in industries like steel, like aluminum, like ship building, like plate glass, paper.
There’s a huge list that the government keeps of industries that are suffering from gross over-capacity because just too much has been invested in building factories. You have the same problem with housing. There’s way too many apartment buildings in parts of the country where it will never be needed, and public works as well. Around the country you’ve got eight lane highways that hardly support more than a handful of cars, or you have airports that might only have a couple of planes arrive every week. You’ve had all this investment by local governments in projects that aren’t really generating any economic support once they’re built, any economic growth once they’re built, but the local governments will have to pay off the cost of building them for years to come.
Jeff Schechtman: Will those investments, particularly the infrastructure projects you talk about, will they help in fact encourage more investment? Will they in fact pay for themselves over time, although a much longer period of time than originally was anticipated?
Dinny McMahon: Some will, a lot won’t. When we’re talking about government spending, the best way to think about it is not in terms of infrastructure, it’s best thought of in terms of public works. Yeah, China has made some amazing strides in infrastructure over the last decade. I remember when they first started building their high-speed rail network, there was a lot of talk at the time that this was a white elephant, that this was a boondoggle. In hindsight, it has been an incredible investment in efficiency, it has made the country smaller. It’s often difficult to get a ticket on one of these trains because they’re so popular. It has been an incredibly far-sighted investment. At the same time, a lot of what the government builds can’t really be put in the same category. I talked about airports a minute ago, and they’re kind of in-between. Maybe they only have a couple of flights today, but maybe in the future, there’s an airport, you have a distant town with an airport, maybe it will create new economic opportunities.
So much of what the money is being spent on is grossly wasteful. You see a lot of new government buildings being created, often with more offices than people to put in them, and you see things like ornamental lakes and man-made mountains. You see newly built industrial parks with roads out there and sewage and electricity and new power plants to support them, and they just don’t attract any businesses. You see that sort of waste over and over again everywhere, particularly as you hit the city limits of cities and towns all over the country, where all this new construction really kicks in and you visually can see the waste.
Jeff Schechtman: All of that money that is going into these projects, what is the cost of that? What else could that money be used for if it were not channeled into these projects?
Dinny McMahon: You know, that’s an incredibly important question, because it’s often been said that the way the Chinese economy needs to change is that it needs to redirect the resources that currently go towards the state and give them to ordinary people and houses. At the moment, the state companies and local governments benefit hugely from the privileged position they have in the economy. It’s not just that they can borrow a lot of money, it’s that they can borrow money fairly cheaply, because the banks see them as being a low credit risk, because hey, they’re backed by the government, what could go wrong? At the same time, state firms get a lot of subsidy, so one of the reasons that they can build wasteful factories is because they’re getting cash subsidies from the government, they’re getting tax perks. They’re getting low rent on the land, they’re getting subsidized energy and subsidized water. You can see that the state’s resources get channeled towards the state.
The idea is look, if you took those resources, we would be much better off channeling them to ordinary people. Let’s improve the healthcare system, so that people don’t have to save as much money anymore in case they need an operation or they have a health emergency. They don’t have to save as much, they’ll be more willing to spend. Or China can bolster its pension system, same sort of thing. People won’t have to save as much for retirement because the government will help. The idea is if you can do that, then you can actually change the way the economy works. Rather than being dependent on construction and on heavy industry, you can change the economy so that people consume more and the economy can be more oriented towards consumption. Now, that’s something that economists have been arguing for years, that if China wants to become a long-term sustainable economy, kind of one that looks more like the rich countries of the world, then it needs to be less focused on shoveling resources into heavy industry and making it possible for ordinary people to consume. However, that isn’t really the direction that this government is taking. Although it is really something that will genuinely contribute to the quality of people’s lives.
Jeff Schechtman: The other part of that equation seems to be that if you bring down the savings rate in China by doing that, it imperils China’s ability to invest the way it has, and that changes its geopolitical position.
Dinny McMahon: It certainly affects its way to invest. The question whether it imperils its geopolitical position is slightly more complicated, because certainly a lot of the influence China has today globally comes from its ability to spread its largess around the globe, to be able to go to Africa, go to Central Asia, go to Southeast Asia, and build the infrastructure that those countries have always struggled to get built themselves. If you take the scale of the projects and the scale of the investment that China is doing overseas, it’s tiny in comparison to what China is actually doing domestically. In fact, it’s tiny in comparison to what its biggest provinces are doing. Even if you do see China’s savings rate drop, if this sort of investment is still hugely important to China, then it could potentially still prioritize that sort of investment. We’re not quite there yet, so it’s certainly a few years down the track before these sorts of questions will have to be answered. I think certainly in the short term, China is still sort of doubling down on its outward investment strategies as being an integral part of foreign policy.
Jeff Schechtman: Where does technology fit into this, and China’s efforts in and investment in technology, things like AI, solar, etc., that seem cutting edge and would seem to be ways in which it’s moving a little bit away from that kind of heavy industry laden economy.
Dinny McMahon: Right. I can’t speak to AI, although from everything I’ve read, China does seem to be really developing cutting edge indigenous technology in that space. China is also expanding into a whole lot of other industries as well, things like robotics and electric vehicles and semi-conductors. In fact, the government’s vision for how it’s going to drive the economy in the future is about moving up the value chain. If the industries that were so integral for the last decade are things like steel and aluminium and ship building and things like that is the future, is China being able to manufacture more of these, getting involved in these high tech industries. That produces, sort of generates its own problems, and that’s because China’s kind of using the same techniques with which it’s developed the steel industry and the aluminium industry, that is subsidies, protectionism, to develop these more cutting edge technologies.
Also what it’s doing is it’s providing state resources for Chinese firms to be able to go overseas and buy up the companies with the technology that China’s been incapable of developing itself. The reason that this a challenge is because places like the United States and Europe and Japan see their own economic futures, their own future prosperity as being closely tied with these more advanced types of industries, and they’re not willing to see China use the same subsidies and protectionist techniques on these industries to lock them out of their development, allow China to unopposed become a global leader in these industries by using these techniques I was talking about, because they see them as a challenge to their own economic future. I think this is really, the first round of significant tariffs that we saw from the Trump administration were about aluminium and steel. I think the real hot-button issues going forward, the industries where we’re going to see the most tension are over these more technologically advanced industries that China intends to expand into.
Jeff Schechtman: Mm-hmm (affirmative). I mean, in many ways, imposing tariffs against aluminum, steel, and these other things, it’s going against the industries China’s trying to get out of. They’re beginning to outsource those industries.
Dinny McMahon: Steel in particular is an interesting one. No doubt tariffs will help the American steel industry, but it’s not necessarily going to China. The reason for that is, well firstly, China does export an incredible amount of steel. It exports more steel than the United States actually produces, but very very little of that goes to the United States. This has been a problem for years, and the US government has been pushing back against it for years as well. The real issue is that China exports to other countries, and those are the countries, because they can’t compete with cheap Chinese steel, they then export their own steel to the United States, so that’s kind of how that works.
Yeah, the issue here is that the reason China produces and exports so much steel in the first place is that it just invested way too much in its own steel-producing capacity. It really, if it wants to deal with its own economic problems, it needs to start shutting down a lot of that capacity, irrespective of what the United States wants. Towards the benefits for its own economic interests, it needs to start cleaning up the excess capacity in industries like steel.
Jeff Schechtman: Talk a little bit about the biggest concerns among the Chinese leaders about the economy, even without the accuracy of the numbers, as we talked about at the outset. Where do they see the concerns?
Dinny McMahon: The thing that Beijing worries about more than anything else, and we’re going to get economic here for a minute. What they worry about is something called the middle income trap. Now, this is an idea that World Bank economists came up with a few years ago. What they did is they looked at the hundred countries that in 1960 could fairly be called middle income. That’s countries that weren’t rich nations, but they weren’t dirt poor nations, they were developing countries that were in the middle. There were about 100 of them, middle income nations in 1960. They then had a look at how many of those had become rich nations 40 years later, and there were only 11. There was a group of Singapore, South Korea, Israel. What they discovered is that a lot of nations got to the point where they’re within striking distance of becoming a rich nation, and we’ve seen this time and time again. We saw this in the 1990s in southeast Asia with Thailand and Malaysia. We’ve seen this at various times with Mexico and Argentina. Various times, developing economies have been growing extremely quickly, and they’ve kind of got to a point where it looks like they might be able to join the ranks of rich nations, and then at the last minute, they stumbled.
This is the thing that worries the Chinese leaders more than anything else, that they’re not going to be able to make this transition from a developing nation to a rich nation. The thing that really has to change is that developing countries can develop very quickly up to a certain point usually because they have, that they’re capable of making stuff cheaply. They’ve got a whole lot of people who probably traditionally were working in the agricultural sector, and they’re in a position to move into factories where they’ll get paid more, but they’ll still be able to produce things extremely cheaply. The country will be able to buy the machines to put in the factories from overseas, and then they’ll use cheap labor to become competitive. There comes a point where that dynamic starts to break down because they run out of cheap labor. At that point, they’ve got to start innovating, they’ve got to start becoming more efficient. The actual nature of the economy has to become a higher quality economy, and that’s kind of the point that China is at the moment.
I know journalists like myself for years used to write about how China had this endless supply of cheap labor. As it turns out, it wasn’t endless at all. It has ended. The flow of people moving from the countryside to the cities has been slowing year on year, and so the cost of manufacturing in China is going up significantly. One of the reasons behind that, other than this flow of migration is drastically slowing, is China’s working age population is shrinking. Now, that’s a direct fallout from the one child policy. What that means is since 2012, the working age population in China has been getting smaller and smaller. Over the next decade, it will shrink by tens of millions of people. That has two effects. It means that wages will go up, making China less competitive, and it means the government is going to have to spend more and more money on healthcare and pensions for retirees. I think China’s finance minister summed this up extremely well a couple of years ago. He said this was his biggest worry, and he was worried that China would grow old before it grew rich, because the sheer process of becoming old would make it so much more difficult to become a rich nation.
Jeff Schechtman: What is the Chinese plan at the moment to try and make this turn, or is there one?
Dinny McMahon: No, it’s what I was getting at before, it’s that China needs to move into more technologically advanced industries, so it’s this whole idea that rich nations innovate and they produced more high-quality manufactured goods, and so China, their government is trying to force-march its industry into these more highly technologically advanced businesses. Lord knows it might actually work, but there’s a whole lot of other moving parts to what makes a successful developed economy, and they’re things like efficiency and competition, and they’re not the sort of reforms that China is making at the moment. Actually, the finance minister a couple of years ago explicitly said the reason he worries about the middle income trap is because China needs to become a more efficient economy. The reforms that will take, the reforms necessary for that are going to take years, and he doesn’t think that China has that window of opportunity.
Jeff Schechtman: What are the things that could happen that could stall this and really cause the whole economy to start to unravel?
Dinny McMahon: See, this is the hardest thing to say, to work out. Certainly I think potentially a heightened trade conflict with the United States or with developing nations generally speaking, that could be it, because at the moment, China is trying to wean itself away from this investment-heavy, construction-focused model of growth. It would like to be able to export more high technologically advanced goods. The thing is, if foreign nations become less willing to take Chinese exports, then in order to maintain growth, I could imagine Beijing would have no option to double down on this debt-led, investment-driven model. We’re already at levels where debt is so high and the waste is so excessive that you’d imagine that sort of situation wouldn’t really end well. In terms of other than that, a one particular moment that might cause things to unravel, it’s very difficult to say, because the Chinese government has proven itself extremely good at being able to paper over the problems and kick the can down the road, whereas a more market-based, competition-based system would be more fragile to various economic shocks. The Chinese government has proven itself more than capable of being able to hold things steady when there are potential shocks and external crises.
Jeff Schechtman: How are the changes that are taking place in Europe right now in the EU, how is that impacting China, or potentially might impact China?
Dinny McMahon: Right. That’s a very interesting question, because it comes at the same time that China is becoming more globally assertive. For a very long time, China’s foreign policy was very low-key. Its priority was very much about developing the economy, but under Xi Jinping, that has very much started to change. In some ways, it’s opening up a space for China to become more globally assertive. Certainly here, I think we’re in this moment where China being so strong, people tend to assume that it’s set to become one of the two global powers, even challenge the US global primacy. I think we’re so ready to think in those terms because in particular, Europe has perhaps politically been at its weakest it has in a very long time.
Jeff Schechtman: The other part of that equation is what the US should be doing, one, in terms of asserting its own economic concerns vis-a-vis China, but also not doing things that will be really dangerous in terms of the Chinese economy, which could have a deleterious effect on the world economy, as you talk about.
Dinny McMahon: Yeah, Jeff, how you balance that equation, I really don’t know. We are at a point where the US really does have to rebalance the trade relationship it has with China. So much of, China has traditionally had a lot of its natural advantages. It has been a cheap place to manufacture because of its labor force, but the reason that China has become so dominant globally as a manufacturer isn’t solely because of its cheap labor, it’s because of the subsidies of the government, not just the central government, but every level of government has been willing to give to industry. For the US, it’s really at a moment where it’s like, we can’t allow that sort of balance in the economic relationship to continue as it is, and particularly with China now planning to move into more technologically advanced industries as well, it really has to come up with a way to balance the playing field. Now, how exactly to do that is going to be a very complicated and drawn-out process that’s going to take a lot of trial and error, and how you do it without exacerbating some of the problems underlying China’s economy as well, that’s well above my pay grade.
Jeff Schechtman: Finally, talk a little bit about how the global banking system sees all of this at this point and how it views China.
Dinny McMahon: I think China isn’t as integrated into the global financial crisis, sorry, the financial system as you might assume that a country of its size and its importance might actually be. If you go back to the late 1990s, the lesson that China took away from the Asian financial crisis is that if you break down capital controls, if you let foreign money flow easily into the economy and then allow it to easily flow out again, then you expose yourself to real risks, because if foreign capital decides to leave in a hurry, there’s not much you can do about it. In some ways, China has ring-fenced its financial system from the rest of the world. Yeah, there’s leakage points and crossovers, but for the most part, what happens in China’s financial system stays there. Now, perhaps the one exception to that, and I think this is probably what you were getting at is the issue of US treasuries, because China holds a massive amount of US treasuries. For a period of time, it held more than any other country in the world, but my understanding is that these days, Japan now holds the number one position.
There’s always been this theory that perhaps China could weaponize them, that the US is vulnerable because China might one day sell them all off. The problem is that there’s a reason why China holds that many US treasuries. It doesn’t want to. It’s been trying to diversify for years and years, and that diversification has resulted in things like China doesn’t have one sovereign wealth fund, it has two. They’ve diversified into everything from buying more gold to buying warehouses in Sydney and office towers in London. The problem is, no other financial market is big enough to hold China’s foreign exchange reserves, so they need to hold US treasuries, and the other thing is it needs somewhere liquid, because if it needs to cash in those US treasuries for being in a hurry, it needs liquidity. We saw that a couple of years ago when China’s foreign exchange reserves declined by about a trillion dollars in the course of a year. That’s a lot of money. It’s actually in China’s interest to be able to hold something like US treasuries, which it can cash in quickly if its own domestic economic situation demands it. Certainly in the last couple of years, China seems to have got under control the outward flow of capital, but if it happens again, it needs to be able to cash in its foreign exchange reserves quickly, and that’s why it needs to hold US treasuries.
Jeff Schechtman: Dinny McMahon. He has spent over a decade inside China. He’s the author of the book China’s Great Wall of Debt, and Dinny, I thank you so much for spending time with us here on Radio WhoWhatWhy.
Dinny McMahon: Not at all, Jeff, it’s been great talking with you.
Jeff Schechtman: Thank you for listening and for joining us here on Radio WhoWhatWhy. I hope you join us next week for another Radio WhoWhatWhy podcast. I’m Jeff Schechtman. If you liked this podcast, please feel free to share and help others find it by rating and reviewing it on iTunes. You can also support this podcast and all the work we do by going to

Related front page panorama photo credit: Adapted by WhoWhatWhy from China flag (Unknown / Wikimedia) and China’s Great Wall of Debt (Houghton Mifflin Harcourt).

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