Communist China’s Rise Sowed the Seeds for Its Fall

Security personnel stand guard at Zhongnanhai near Tiananmen Square ahead of China's 20th Communist Party Congress in Beijing on Oct. 13, 2022. Noel Celis/AFP via Getty Images

Commentary

China’s meteoric rise to a global economic powerhouse appeared unstoppable until it stopped. Now, with deflation looming and an economy in shambles, other asset managers are scrambling for an explanation of these newly discovered China risks—risks that we at Strive Asset Management have been alert to since our founding.

Prevailing market theories attribute the recent decline to an overleveraged, too-big-to-fail real estate sector and a Chinese Communist Party-based cultural stranglehold that prevented China from transitioning to a consumer-based economy.

All that may be true enough. But it misses the bigger picture: The same macroeconomic factors that led to China’s rise are now the cause of its fall. U.S. investors should consider portfolios that appropriately mitigate the risk of Chinese investments.

According to the Cobb-Douglas production function, economic output comes from three inputs: labor, capital, and what economists call total factor productivity (TFP). TFP can be thought of as how efficiently labor and capital can be utilized, usually through technological innovation. TFP is what sets countries apart. While labor and capital are relatively commoditized, TFP is often considered the primary contributor to gross domestic product (GDP) growth. It’s what allows countries such as the United States, which has never been more than a 10th of the world’s population, to consistently contribute upward of one-third of global GDP.

This model explains China’s ascent to become the world’s second-largest economy over the past 70 years. For centuries, China had the world’s largest population, allowing it to enjoy an abundance of labor. And its one-child policy temporarily bolstered its labor force. Women, previously confined to a decade or more of childrearing, were now free to work. Female participation in the labor force surged, increasing production and household income.

China’s rising prosperity, in turn, fueled investment. Western societies and their often state-backed pension systems began to supply billions of dollars in investor capital.

Since the Cultural Revolution, China has been unable to develop technological advancements on its own but has supercharged its raw production potential by imitation or, in many cases, outright intellectual property theft. Most of China’s largest businesses—such as Tencent, Alibaba, Baidu, and Luckin Coffee—are knockoffs of innovations developed elsewhere. These Chinese businesses only exist because of Western capital, Chinese Communist Party (CCP) protectionism, and internet censorship, which shields these imitators from their more nimble international competitors.

However, the same central planning policies that led to China’s success now spell doom. The CCP’s one-child policy—though officially abolished in 2016—set in motion generational and cultural shifts, with millions fewer women of childbearing age every year, and the fertility rate is less than half of the replacement rate.

In 2023, China’s population dropped below that of India, meaning it is no longer the world’s most populous country—a title that it is unlikely to regain. The declining labor force threatens China’s position not only as a global producer but also as a global consumer. Multinational companies will no longer be lusting over China’s consumer base, willing to set common sense and business judgment aside for a chance to open shop.

Capital is fleeing, too. China’s State Administration of Foreign Exchange reported last month that foreign direct investment into China collapsed by 82 percent to a 30-year low. This sudden change highlights how foreign companies are pulling money out of the country. If a Chinese government agency is reporting poor numbers, you can bet the actual numbers are likely much worse.

Multinational companies are not alone. Investors from all over the world have been switching their emerging markets (EM) exposure to EM ex-China funds as a way to manage China risk separately or eliminate it altogether. In 2023, EM ex-China funds took in $5.6 billion as China had one of the worst-performing equity markets, with losses for the year exceeding 10 percent.

Then there’s TFP. China’s aggressive intellectual property theft has become so bold that Western governments and companies have begun to take note. The Biden administration is restricting our most advanced artificial intelligence hardware exports to China. A diminished Chinese economy also means less leverage to demand that U.S. companies form joint ventures or hand over technical information as a condition for doing business there. A mass exodus of Western companies means less technology to steal.

China cannot replace the stolen innovation on its own. By design, the country lacks the individual liberty, economic freedom, and profit incentive required to create the innovation that has driven most of the economic growth in the modern world.

The result is a self-perpetuating downward spiral. The more foreign capital flees, the more countries and companies are emboldened to safeguard themselves from Chinese theft, and the more the CCP tries to tighten its grip on whatever it believes is within its control, further scaring off foreign investment. In the Chinese view, the only remedy to a failure of central planning is more central planning. But you cannot innovate through force, and, as China is learning the hard way, you cannot dictate children into existence or regulate your way to prosperity.

China’s rise to become the second-largest economy over the past roughly half-century is an impressive accomplishment and a testament to the power of even the smallest improvements in economic freedom. However, the CCP’s tight grip on the factors of production is increasing the risk of China’s investment while also sowing the seeds for its economic decline. U.S. investors should take note.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.