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China’s “Dangerous Storm” Coming: The Eight Big Challenges Facing China and the People Chosen to Deal with Them

By Ray Dalio Founder, CIO Mentor, and Member of the Bridgewater Board

(As usual, if you want just the highlights, read only what’s in bold.)

The leadership changes in China and the speeches and writings of Xi Jinping make clear that the policies and the leaders in China are changing in important ways in preparation for the approaching “dangerous storm.”

In President Xi’s opening speech at the 20th Party Congress and in his writings around the Party Congress, President Xi made clear that China will a) have to face a “dangerous storm” that lies ahead, b) pursue the goal of becoming a regional and global power by mid-century, and c) continue to shift the economic-policy determination more to the state and less to the market. Said differently, the changes in the path and the leadership team are 1) from being more diverse in views to being more unified under Xi’s leadership, 2) from hiding power to showing it, and 3) from being more supportive to free market economics in pursuit of prosperity to being more supportive of state-controlled economics in pursuit of security and common prosperity.

So far, this appears to be more like a 45-degree shift from the policies that we have seen Xi pursue over the last 10 years than a 180-degree turnaround, though how far it will go will depend on how bad the storm is. To help convey what this shift means for capital markets, I attached Xi Jinping’s speech (link) about the capital markets. It was recently released by the Central Committee’s to convey his intentions. I encourage you to read it to get a feel for both his thinking and to anticipate his shift in direction.

Before going into the particulars, I will 1) restate how things typically transpire when the changing world order enters this stage of the Big Cycle, 2) describe what I have seen up until this point, 3) describe the eight big challenges China is facing that are leading to the dangerous storm on the horizon, and 4) describe the changes in the leadership and the approaches being used to deal with this impending storm.

1) How Things Transpire at This Stage in the Big Cycle (i.e., in late Stage 5)

For reasons I’ve explained in previous writings, it appears to me that the world order is changing in a classic Big Cycle way due to intensifying 1) financial and economic problems, 2) internal conflicts, and 3) external conflicts. At such times there is typically more fighting within countries and between countries about what needs to be done. During this stage (Stage 5), moderates who value compromising, personal freedom, and profit-motivated resource allocations typically lose out to those who are more autocratic and run a command economy. This transition from collective moderation and compromising to united, strong assertiveness without compromise happens both because of the necessity of it and the desire of each of the sides to have strong leaders who will fight for them. Regardless of which side wins, the necessity for strong unified leadership and more of a command control over the economy exists because fragmented leadership and profit-motivated resource allocation systems (i.e., that allocate resources and power based on the desires of those who have the most money) don’t work during times of economic crisis and war. During times of economic crisis and war, strong leadership generally gains control of the people and the resources to effectively deal with the bad economics and overcome domestic and foreign opposition in order to win. Even the most democratic and capitalist countries move toward more command-and-control leadership during such times.

So what are the sides and who wins?

Regarding internal issues, the ideological fight is typically about 1) how to divide the pie, so the populist sides in this heated struggle are those of the left and those of the right, and 2) social values, with the two sides being those who are more socially liberal and those who are more socially conservative.

Regarding international issues, the two sides are 1) the globalists, who believe global harmony is good, people on the other side aren’t bad just because they have different approaches to life, and issues should be worked out through compromise, and 2) the nationalists, who believe that fighting for their interests and ideological beliefs is essential because the other sides will beat their side if they don’t fight and beat them first.

Virtually all sides in all countries can be categorized by assessing which of these four types they are and in what degrees. Think about it. Pick any political leader in any country and ask yourself which of each of these they are and in what degrees and you will have a good picture of which side they are on and how strongly they will fight for that side.

Inevitably, during these classic big storms when economic conditions are bad and there is a lot of internal and external fighting over wealth and values, countries end up with more autocratic and nationalistic leaders of either the left or the right.

That is now happening in varying ways and varying degrees in the United States, Russia, and China, and a number of other countries, due to the way the world order is changing. These things are top of mind for President Biden and President Xi as it relates to their own circumstances and the other’s circumstances.

2) What I Have Seen over the Years in China

My thoughts about what is now happening in China come from the intimate contacts I have had over the last 38 years and the research I have done about its history, starting before the founding of the Qin Dynasty in 221 BCE. For me what is now happening is just the most recent unfolding episode of a story that will continue into eternity. I will very briefly share my view of the most recent episodes within the context of my experiences.

I started going to China in 1984 near the beginning of the Deng Xiaoping’s term and his big shift from very closed-door, government-directed hardline communist policies to open-door, economic-reform free market policies. I won’t recount all the details of my contacts and involvements until up to now, but if you are interested in learning a bit about them, you can read about them in pages 406 to 422 in my book Principles for Dealing with the Changing World Order. The main thing to know is that I got immersed in what was happening economically and in markets in China, and in the process of doing so I developed close relationships with many people who shaped these changes from then up until now. In the process I came to understand their issues, what they were trying to achieve, and what they were like, and I had the pleasure of helping in my small ways.

When the Xi government came to power 10 years ago, we talked about the problems that had existed at the time and the changes that needed to be made to fix them. The two most important problems were corruption (which Wang Qishan took the lead on) and the lack of economic and market reforms, which Li Keqiang (who was and is of a different faction from Xi) and Liu He (who was very close to Xi and of the same faction) took responsibility for, though more Liu than Li drove the changes.

Back then five major banks carelessly lent money to state-owned enterprises and local governments with implied government guarantees, and there were no well-developed capital markets for savers and investors to put money and credit into and for small- and medium-size businesses and entrepreneurs to get money and credit out of. Stock and bond markets existed but were nascent.

Over the 10 years that followed, great progress was made in reducing corruption and reforming the financial economy to develop these markets. At the same time debts continued to grow faster than incomes (albeit at a slower pace than before) and bubbles in some markets developed while good regulations lagged the development of these markets. Naturally, real estate investment increasingly financed by debt created a classic real estate bubble that grew unsustainably large in the classic way real estate debt bubbles do. At the same time, the free market development of the capital markets occurred via the shadow banking development that also hadn’t yet been adequately regulated, so the usual bad practices developed and had to be dealt with via regulations that hadn’t previously been developed. Both of these bubbles were dealt with by regulators via the establishment of sensible “red lines,” which consisted of financial ratios that financial intermediaries in these areas had to adhere to. At first these red lines were applied to the shadow banking institutions, which deflated that bubble. A couple of years later—which was about 18 months ago—they were applied to the real estate industry and deflated the real estate bubble and industry.

In my opinion, the real estate bubble’s deflation was allowed to go too far, meaning it went from being contained to passing into the bones of the economy. Of course, offering critical thoughts is much easier than actually managing things well, especially for someone (me) who does not know all the constraints, especially the political ones, on the actions one can take. The choices were difficult. When the bubble burst with the help of red lines that enforced financial prudence, the Chinese economic leaders who were responsible for managing this (most importantly Liu He) were in the classic position of having to decide how to balance the trade-off between a) the moral hazard risk that leads to bad lending because lenders and borrowers are bailed out rather than having to pay the price of their bad lending and bad borrowing and b) the systemic risk of allowing the pain and financial damage to pass into the financial system and economy in a way that creates systemic risk.

Over my many years of being a global macro investor, I have been immersed in and studied many such debt-financed bubbles and busts. In fact I did a study that ended up becoming a book about this called Principles for Navigating Big Debt Crises, which looked at all the big debt crises in the world over the last 100 years, showed how they transpired, and explained how they could be handled. (You can read it here (link) if you like.) For the reasons explained in that book, I believe that the debt problems in the China case were allowed to spread too far but are still manageable, and it probably will take two or three years to successfully manage and get past them. Unfortunately, they occurred at the same time that a number of other problems emerged, which brings me to the eight big challenges that are coming together to create China’s dangerous impending storm.

3) The Eight Big Challenges of China That Are Coming Together to Make the Big Impending Storm

They are:

1) The passing of the real estate and debt problems through the financial system and into the bones of the economy. Real estate accounts for about 25% of the economy [1] and 70% of wealth [2] so the direct effects of it going down are large. So are the indirect effects such as those on local government financing, lenders, and businesses, which I won’t digress into. The upshot is that this problem hasn’t, in my opinion, been dealt with early enough, so these debt problems have been allowed to spread and will be difficult to root out. Because almost all the debts are denominated in China’s own currency and because of their extensive debt restructuring experience from the late 1990s and beyond, I have no doubt that they can handle this (e.g., the newly announced supports are a first step) but I expect that it will take time—two or three years if handled well—to clean this up. Even then, it will leave some scars, which will likely be more good than bad in the long run because the lessons will stick.

2) COVID and COVID policies have weakened the economy and in some cases have led to some discontent. To me, non-Chinese people typically oversimply the COVID issue and criticize it as being needlessly troublesome because they tend to just look at one side of the issue. To them, more COVID controls equals a weaker economy, and that’s it, so they believe that China should have fewer controls to get a stronger economy. However, there are a lot of older people in China (something like 175 million who are over 65[3]) and most aren’t vaccinated and don’t want to get vaccinated. That’s because very few people have died from the disease and they worry that the vaccine will do more harm than good. I’m also told that China’s medical system, hospitals, and so on don’t have the capacity to handle large numbers of people. Because the old people are vulnerable and not protected and because the medical system is not prepared to adequately handle lots of old people with COVID, this is not an easy problem to solve, though it can be handled in a more targeted way, which is in the works. I’m told that they have a vaccine that they need to produce and administer, which, I gather, will take something like six months, and that it has good efficacy rates for preventing death (~92%). I’m not an expert on such things, but I gather from those who are that this COVID problem is likely to have a gradually diminishing effect over the next couple of years.

I haven’t yet heard a good answer to the question of how COVID could more easily be dealt with.

3) What Chinese policy makers are doing with capitalism, tech companies, and common prosperity is having both direct and indirect adverse effects on markets and the economy. The direct adverse effects are on the performance of companies and their markets, due to their changing fundamentals that are the result of the government’s policy changes. These can be objectively seen in financial statements and in markets, though right now prices are very cheap if Chinese policy makers do what they say they will do and the impending storm on the horizon doesn’t include a major worsening of tensions with the US. The indirect effects come from the worry that these policy shifts are a 180-degree reversal of reform and opening-up policies. Because there is a lot of talk by Xi about Marxist-Leninist thinking that he would like to follow, that understandably sounds to Westerners like a return to the sort of economic and market policies that existed under Mao. So the big question that’s being asked by business people and investors is “Will China remain a capitalist friendly environment that is open to foreigners?” While important changes are in the works to get the balance between capitalism and communism right, many people who aren’t informed mistakenly view this move as an abandonment of capital markets and entrepreneurship. That couldn’t be farther from the truth. It is now well-accepted among Chinese leaders that entrepreneurship and efficient capital markets are good for China. Still, the perception of the risk for capitalists and capital markets is having a negative effect on markets.

As for common prosperity, I think that it’s a good thing if done well because more equal opportunity will raise productivity and enhance stability, though it will be less good financially for the very big and rich. The question is how this move to common prosperity will work. For example, right now China doesn’t have capital gains taxes or inheritance taxes, and its income tax system, the social support systems, and the regulatory systems aren’t adequately advanced. Chinese policy makers can and should develop a system for creating “common prosperity” that its people and the world understands. That is because the ambiguity and abruptness of policy shifts cause big problems. Right now, there is more of a concept than a clear plan for common prosperity, so many people are imagining the worst-case scenario for it.

4) The wars with the United States are having a negative effect on economic activity. The United States and China are now in a trade war, a technology war, a geopolitical influence war, and a capital/economic war, and they are now dangerously close to a military war. This is scaring just about everyone, which is paralyzing activity, leading to the inefficient building of self-sufficiency in many ways, which is economically costly. Foreigner fears of what China, or more likely the United States, might do are adversely affecting investing and producing in China.

Just the possibility of more intense war with the United States is having detrimental effects on the world. Imagine if investing or producing in China or buying Chinese goods became politically like it is for doing these things with Russia. No one should doubt that that’s a possibility, even if the US government doesn’t make it happen. Because of this possibility companies are shifting production to other countries like India, Vietnam, and Mexico and investors are doing the same. Also, as previously said, the possibility of war is leading Chinese leadership to prioritize self-sufficiency over cost-efficiency, which is also happening in the United States, which is not good for real growth. Even more worrying, I have heard that in a new Republican-controlled House there is some possibility there will be a bill passed supporting the independence of Taiwan, which would be for the Chinese tantamount to a declaration of war and would very likely lead to some sort of military conflict with China. The fact that this is a possibility, whether or not it materializes, is leading to damaging consequences. The 2024 elections in the United States and in Taiwan, Japanese rearmament, and the likelihood of worse global economic conditions around that time make 2024-25 an especially risky period. The mere perception that military war is a possibility has a negative effect on markets and economic activity. Obviously the reality of it would be disastrous. The good thing is that sensible people, who are still most people in power, understand that this would be terrible.

5) The world economy is getting worse and inflation and tight monetary policies to fight it are bad for Chinese exports and Chinese capital inflows.

6) This environment of great controls and great risks is leading decision makers in all areas to be more inclined to not make decisions than to make decisions that could be perceived as bad ones. This is negative for growth and improvement. People are walking on eggshells, which has made political and private sector decisions very difficult.

7) Demographics are an exceptionally big financial and economic issue in China that is hurting growth in China—more so than in most countries—because of China’s culture in which adult children take care of their old parents. Because there is not an adequate healthcare and pension system in place, this creates a large economic and time burden on those in their 40s and 50s.

8) As has been true throughout the thousands of years of Chinese civilization, acts of nature—droughts, floods, and pandemics—are a major concern. One of the things that I learned in studying the rises and declines of dynasties is that floods and droughts toppled more dynasties than just about anything. Weather issues and climate issues lie beneath the surface and are now seemingly a greater factor.

Those are the main challenges that I see China facing.

Now let’s looks at what the leadership team that will face these and other challenges is beginning to look like.

4) The Leadership Team Chosen to Deal with China’s Challenges

I don’t know the new leaders, so I am now passing along what those who do know them say. As mentioned, when the Xi government first came to power, I personally knew most of those who ran the economy under Xi well enough to know what they wanted and what they were like. I discussed their problems with them and exchanged thoughts about how to deal with those problems. Over the years I came to admire where they intended to take China, their thinking, their character, and their accomplishments. They were the reformists and globalists who extended President Xi’s version of the opening up and market reform path that was initiated by Deng in 1978. Now, with the announced leadership changes, most of the people I know who are reformist-globalists are being replaced.

Because I haven’t been to China since prior to COVID, and because conversations over devices are not as valuable as conversations in person, I now don’t have the intimacy of contact that I once had with the senior policy makers to know what those running policy are really like and what they really want. I have spoken to knowledgeable others about them and I plan to visit early next year, at which time it will be enjoyable to see my old friends and interesting to see which of the new leaders want to see me—and if they see me, to start to learn what they are like and what they really want. In any case, since I haven’t had the intimacy of contact with the new leaders to confidently say what they are like, take what I have to say with a grain of salt.

Let’s look at the leadership changes.

The opposition is done. Premier Li Keqiang and Vice Premier Wang Yang, who are both 67 so young enough to be reappointed to the Politburo Standing Committee and members of the Communist Youth League faction, were removed from the wider Central Committee. Vice Premier Hu Chunhua, another Youth League member, who is 59, and had been seen as a rising star and a candidate for premier—possibly even future president—didn’t make it onto the 24-member Politburo. Also Hu Jintao, who was Xi’s predecessor who was unexpectedly escorted out of the Party Congress closing ceremony and was the leading veteran of the Youth League is out. In the past, when there was collective leadership, some of the opposition faction would have been put on the Standing Committee. Instead, they are out and replaced by Xi loyalists, so collective leadership has ended. So, people in the opposition are headed for retirement.

Reformist-globalists who were close to Xi are also out. Liu He (vice premier and economic czar), Yi Gang (head of the central bank), Liu Kun (minister of finance), Guo Shuqing (chairman of the China Banking and Insurance Regulatory Commission) are no longer part of the Central Committee so they are out. So in addition to President Xi eliminating opposition, he appears to be eliminating the reformist-globalists and is replacing them with conservative-nationalists who are loyal to him.

The people being added are loyal strongmen who appear to be capable and have demonstrated track records of being willing to do the unpopular things. The pending advancement of Li Qiang to premier from his job as the Communist Party Secretary of Shanghai is the appointment of a strongman who is loyal to Xi and was unpopular in some circles because he was blamed by Shanghai residents for harsh treatment and the lockdown to contain the spreading of COVID in Shanghai. I am told that he is very capable and pro-business, but I don’t know him personally so I don’t feel confident enough to say anything valuable about what he is like or what he wants.

I am told that Cai Qi (Party Secretary of Beijing and CCP’s Central Secretariat) is very capable. I am told that He Lifeng will likely be Liu He’s replacement and is likely to be less austere, as his track record is in building infrastructure financed by debt. There are people on the Central Committee who I have had some contact with and who I respect that I won’t name so I am not indiscreet.

I want to emphasize that none of the new people appear to be extremists and I do think that their concerns about both 1) the large powerful companies and the very wealthy throwing around their power and 2) the great power conflict with the US are understandable. I believe that they believe that companies need to work for the country’s overall well-being more than have exorbitant profits converted into huge personal gains while people are suffering. I believe that they also believe that large/concentrated companies can create unfair competition. I also believe that these new leaders don’t want to kill the goose that’s laying the golden eggs, which will require them to keep the market economy and entrepreneurial economy to deliver the advances and efficiencies that the leaders want. I have seen Xi support entrepreneurs in many ways, including creating the “Little Giants” program and opening the Beijing stock exchange to help them go public. The abruptness and seeming arbitrariness of the changes, and not knowing where policies are heading, have been shockingly negative for perceptions and the markets. How these policy makers will balance the trade-offs and regulate is now unknown and probably imagined to be more dangerous than whatever they will actually do.

In my opinion, China would benefit from developing clarity and good regulations ahead of the problems rather than in reaction to them. Historically the way the Chinese have regulated is to first encounter the problems and then put in the regulations to fix them—e.g., the shadow banking system and real estate bubbles were allowed to go wild and were followed by the regulators putting in the red lines that companies and markets react to. Doing these sorts of things very abruptly has been harmful for the economy and markets. In my opinion they would be better served to study best practices in other countries and sort out their versions of them and modify from there.

Of course, their beliefs of how things should be are very different from the democratic and capitalist beliefs of the United States. For example, just as they didn’t tolerate Jack Ma and his ways, they wouldn’t tolerate Elon Musk and his ways so there will be no Elon Musks and what he produces. While the United States thrives on this way of being, the Chinese leaders can’t stand it. Many other aspects of the two countries’ systems and values are different.

These sorts of different approaches make for the great competition of systems that we are now seeing. My hope and expectation remain that these competitions will play out without military war that would lead to great destruction for both countries and others affected by the fighting. In any case I expect that the Big Cycle drama and the competition that comes with it will continue. Stay tuned for the next episodes.

You can find the full post on LinkedIn here.

In the direction of optimism, I really like Dalio’s thought leadership in his other post that follows. Click on the photo to link to the post.

As an aside, I’m a big believer in the power of prayer. When we walk into a room and talk with our loved ones, our friends, our co-workers, and our clients, we bring our energy with us. Whatever the energy happens to be at that time. A bright light, kind, love-based energy is a powerful force. I believe people do feel it, and it can be uplifting. If you are up for it, join me for a few minutes each day, pause for just a second, and send some bright light into the world. If I’m wrong, at least I’m happy. If I’m right, maybe we can collectively shift the world and avoid war. We may just need it now more than ever. I believe we are more powerful together. Please know this is my view, and I in no way wish to push my view on you or others.

Click on the link to read more from Ray.

Barry Habib, MBS Highway: On Inflation and The Direction of Mortgage Rates

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My good friend Michael Gale recently turned me on to Field Notes from Admired Leadership. Every day they send a leadership-oriented note, and I enjoy most of them. This one from November 13 particularly caught my eye:

Some words never lose their impact for teaching leaders how to lead.

A case in point is a quotation from more than 700 years ago by the 13th-century Persian poet Rumi. He wrote, “Be a lamp, or a lifeboat, or a ladder. Help someone’s soul heal. Walk out of your house like a shepherd.”

While he wasn’t speaking directly to leaders, he might as well have been. Leaders who mentor, coach, and develop others need to be a lamp, lifeboat, or ladder at different times.

The ability to shine a light on an idea or issue and offer crucial insight is a sign that a leader knows how to teach others to see what they need to see.

By becoming a rock of support when team members falter, a leader demonstrates strength exactly when others most need it. Leaders who understand they are first and foremost a resource for others make others better through their feedback, instruction, and example.

Becoming a lamp, lifeboat, or ladder is what leadership is all about. 

Those of us who excel at one of these roles need to push ourselves to get better at all three. Different people need different things from leaders. If all a leader does is shine a light on issues, they miss the opportunity to provide the sustenance and tools others need to succeed. Similarly, those compassionate leaders who primarily lead by supporting others must push themselves to become better teachers and coaches.

“Walk out of your house as a shepherd” is a reminder to know those around us and to be willing to engage in the actions that will help them succeed, even if those actions make us feel uncomfortable or vulnerable.

In the end, leadership is about making people and situations better through our actions, behaviors, decisions, and choices. We can all be better lamps, lifeboats, and ladders. 

Each day is a chance to make some progress as a leader. People need your light, your support, and your ingenuity.

You can subscribe for free to receive the daily Admired Leadership Field Notes here.

Dallas and SBF

I was in Dallas for a dinner meeting on Wednesday with my partner John Mauldin and flew home late Thursday. My plan was to write about SBF and the Crypto mess this week; however, John is writing about it in his Thoughts From the Frontline letter tomorrow. So, I’m going to pass on it this week and share his missive with you next week. In the meantime, you’ll be able to find his post here on Saturday morning. His weekly letters are free, and he is, in my biased-yet-humble view, the best financial writer in the business.

For now, a quick look at SBF fraud from Andrew Ross Sorkin:

The FTX contagion spreads

 The breadth of the global fallout from FTX’s collapse has continued to emerge. Temasek, Singapore’s state-backed fund, said on Thursday that it had fully written down its $275 million investment in the crypto exchange, joining the Silicon Valley firm Sequoia Capital and SoftBank, the Japanese tech conglomerate, in declaring their stakes worthless.

The development comes as Sam Bankman-Fried, FTX’s founder, delivered a series of bombshell admissions in a candid direct-message exchange with Vox’s Kelsey Piper. Among them: S.B.F., as Bankman-Fried is known, blamed “messy accounting” for the company’s losses, which could run into the billions. (Source: The New York Times)

This is a wild and deepening story. Stay tuned.

2022 World Cup and Thanksgiving

The World Cup starts next week. The USA plays Wales on Tuesday, November 22, at 2:30 pm ET. The team is young, and I’m optimistic about our chances of advancing out of the group stage. The top two teams from each of the groups below advance to the knockout round. From there, it’s single elimination. We’ll need a lot of luck.

The current odds of winning the 2022 World Cup follow. It will likely be Lionel Messi’s last World Cup. He is the greatest soccer player to ever play. I have to admit, a bit of me is rooting for Messi and his home country, Argentina. If you’re familiar with soccer, tune in and watch one of his games. He’s magical!

After the Wales game, the USA plays England, on Friday, November 25, at 1 pm ET. A win would be epic for us.

A quick story: My college soccer coach, Walter Bahr, captained the USA team to a 1-0 win over England in the 1950 World Cup. Coach told us a story about how the English captain roasted the U.S. players at a pre-tournament dinner. Holding his glass high and looking at Walter, he told him to be prepared for an 8-0 thrashing. He poked the wrong guy. Coach assisted on the U.S. goal. A fun and humble man, in his later years, Walter was the U.S. Soccer Ambassador. In 2018, Coach passed away at the age of 91. I’ll be thinking about him, sending him some love, and hoping for a similar outcome against England next Friday. If you’re interested in the story of the 1950 win, check out the movie The Game of Their Lives.

The kids fly home early next week. We’re doing Thanksgiving dinner with close friends, and it’ll be the first time in quite a while that we’ll all be together. As I write this, I see a major scheduling conflict in our future as Brianna, Matthew, Kyle, and I are playing in the annual Stonewall Black Friday golf scramble tournament. We tee off at 10 am, and the USA game against England is at 1 pm. Small problems are better than big problems. I asked the kids what they want to do, and it was unanimous: “Let’s golf!” I quietly smiled. Go, team Blumenthal, and LET’S GO, USA!

Wishing you great joy and a warm and wonderful Thanksgiving holiday!

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