China's People Problem
Obviously the trendiest news of the week is the TerraLuna debacle. The crypto community is in turmoil and there’s no shortage of finger pointing and post-mortems. Hopefully, at least now more people are clued in to the concept of tail risk. I will probably cover the lessons learned from this event in a future article once the dust settles. The wonderful thing about crypto is that all the details of an event is recorded on-chain for anyone to dissect and review.
For this week, I would like to cover something that got shoved beneath the mainstream radar: Just what is going on over in China? If you look at all the rhetoric coming out of China right now, nearly everything is to prove how their governance, policies, and leadership is superior to that of the West. They are laser focused on being number one, always wanting to one-up the US when it comes to GDP growth, and continuously touting that their Covid-Zero policy gives China one of the lowest Covid death rates in the entire developed world.
That last statement might be true from a pure statistical standpoint, but at what cost? Shutting down multiple Megalopolis, forcing people to submit to daily testing, and untold amounts of anguish over basic human needs like food and shelter. There were disturbing scenes of police abusing their powers in the name of maintaining order. The “Covid-volunteers”, or Big Whites, as they’re colloquially known, gives off huge stormtrooper vibes. It’s almost as if someone high up found a copy of “Nineteen Eighty-Four” and decided to use it as an instruction manual.
If you've been in the markets long enough, you’ll know that just because something has worked once, doesn’t mean that it’ll work again. The market is a complex adaptive system, and any edge that you might have exploited temporarily will eventually get arbitraged out over time. And just like the market, Covid itself is a complex adaptive system, it mutates and morphs over time to defeat or bypass our own adaptations to it. Just because China had success with Covid-Zero policy against the original strain, doesn’t mean it’ll work against the Omicron BA.2.
This presents the quagmire of Chinese governance. Because of the cultural concept of face, it’s exceedingly difficult for the leadership to pivot and adopt new strategies or even revise existing ones. Doing so is tantamount to admitting the original strategy has failed, thereby reducing the legitimacy of the CCP rule in the eyes of the people. They have little choice but to forge ahead with the decision that’s been made, as the alternatives will lead to a lot of uncomfortable questions that they do not want to answer.
This type of governance is similar to steering the Titanic using nothing but your teeth. Sure you could probably do it easily in open water, but once you starting seeing a few icebergs, things are going to get very dicey very quickly. China has numerous obstacles it needs to navigate through, from dealing with Covid to a supply chain crisis to a real-estate debt bubble. However, these are still comparatively minor problems to what looms over the horizon.
If you have not yet read Ray Dalio’s book: The Changing World Order: Why Nations Succeed and Fail, what are you waiting for? It contains a fantastic model for thinking about how empires rise and fall, spanning from the Dutch, the British, and finally to the American empire. If reading is not quite your thing, there’s an amazing companion video that will give you a great summary.
In his book. Mr. Dalio makes a strong argument that China is essentially the hegemonic heir apparent after the American dynasty concludes. There are definitely a number of assets in China’s favor: their massive population, their control over strategic resources such as rare-earth metals, and their centrally planned and managed infrastructure. However, even with these advantages, there is something that is currently undermining China’s future, and there’s very little they can do about it.
In my opinion, there are two additional important factors that Mr. Dalio should’ve also considered while developing his model, and that is population demographics and the importance of human capital.
Demographically, China is a ticking time bomb. A great way to visualize this is through a population pyramid. Here’s the current population pyramid for China. Notice the swells around the 50-54 and the 30-34 bins. These are the equivalent Baby Boomer and Echo Boomer (Millennials) generation for China. What is frightening is if you look down further, where are all the kids at?
These missing children were the direct result and legacy of the “One-child Policy”. Originally instituted by Deng Xiaopeng’s government to reduce the number of mouths to feed as China was still a largely an agrarian based economy at the time, where poverty was rampant and famines were still a major problem. The problem for China is that the policy worked well…too well. China’s total fertility rate (TFR) has been below replacement rate (generally accepted as 2.1) since the early 90s and has never recovered above it since.
In the 1960s, the CCP probably took notice of Japan’s economic miracle and was rapt with envy. China was on the winning side of WWII and somehow faring worse economically. This is when Deng Xiaopeng started to strategize and laid out the foundations for economic reform, away from a Soviet style centrally planned economy. They especially paid close attention to how Japan effectively made use of the 1964 Summer Olympics to mark their presence on the world stage, something China copied to great effect in 2008.
For most of the 1990s and the 2000s, China has reaped the rewards of this “demographic dividend”. The economic policy devised in the 1980s successfully mobilized their massive population and transformed China to becoming the industrial base for the world, lifting millions out of poverty in the process. Grand infrastructural monuments were built, from the Three Gorges Dam to the largest high-speed rail network in the world. In the midst of all this prosperity, nobody stopped to ask: “Who are we building all this stuff for?”
Even when you think about the one-child policy from a family unit level, it doesn’t make sense. You are now put in a situation where one child is responsible for two parents and four grandparents, not to mention their own children. Anytime when a pyramid gets top heavy, something is bound to come crashing down. This is partly why you see the younger 20 to 30s generation suffering through “996” work culture just to make ends meet. Consequently, this leads directly to predictable burnout and the ensuing “lying flat” movement, creating economic nomads that are greatly disillusioned by their future prospects. As if that wasn’t enough, there is also an innate rural cultural preferences for males, compounding the problem further by adding a gender imbalance on top of a shrinking population cohort that also is less willing to contribute to the economy.
Do note that these problems are not emergent, but have been compounding for decades. That’s the nature of demographics, they shift around like tectonic plates. The changes day-to-day or even year-to-year are imperceptible. But over a long enough time horizon they can have empire altering ramifications. The Chinese baby boomer cohort that built China to where it is today is on the verge of retirement, and their echo boomer children need to work at least twice as hard to maintain the same standard of living and fulfill their filial piety duties, leaving little precious time for raising the next generation.
As much as the CCP wishes that they can, they cannot flip a switch and magically get a cohort of people in exactly the right age bracket to slot into the gaps of the pyramid to fix their demographics. You cannot force people to have babies, and even if you can, all babies would start at age zero, so a massive baby boom would represent a drag on the economy as resources get diverted to focus on child-rearing. China introduced a two-child policy in 2015 and a three-child policy in 2021, but the cultural norms have already been so ingrained in the populace and the impact these policies on TFR thus far has been minimal.
Oh what about immigration you may ask? Well the Han Chinese are very much a homogeneous group. This group generally see themselves as above all the other ethnic groups in China and are often harbor a degree of xenophobia, thereby making integration from a non-Han Chinese person into their culture very difficult. If a significant population of foreigners were introduced in China, it’s very likely racial tensions and cultural clashes would become an even bigger problem than demographics itself, risking the very stability that the CCP tries so hard to maintain.
So demographically China has already shot itself in the foot, but what about the other one? Even if you have only one working foot you can still limp along right? What about getting other brilliant and talented people to work for China? With the proliferation of remote work in the wake of Covid, you don’t have to be in China to work for China. I’m sure more than a few global entrepreneurs view China as the market grand prize, dreaming of endless floating dollar signs from the prospect of servicing a market that is more than a billion strong.
Business school 101 will teach you that continuity and predictability are the key pillars for providing a fertile environment for business activity. Businesses can take on greater risks when markets are stable and regulations are anchored. When there are multiple shocks to the system, the instinctual reaction is for preservation, as business itself is an infinite game. There’s no winning in the game of business, your main goal is just to stay in the game for as long as you can.
This is why the brutal lockdowns in Shanghai have been so jarring. There are already signs of human capital flight. At this point, anyone who has the means to escape already has. The people with the means represent important cogs in the economic engine: Business owners, expats, diplomats, and executives. And now they all have to perform the mental calculus of determining if the risk of returning to Shanghai is too great compared to the risk of rebuilding elsewhere. For the younger capitalists out there, imagine what happens when all the fun extraverts leave a party. My summary for what I see happening in Shanghai is: “The Reverse Singapore”.
The importance of human capital cannot be understated. Hell, Singapore was able to transform itself from a swampy marshland into a first-world country by embracing human capital; enticing the best and brightest to build their dreams and giving them the appropriate infrastructure to do so. It is so goddamn impressive that I’ll probably have to write a follow-on article about how exactly Lee Kuan Yew accomplished this herculean feat.
To some extent, human capital flight is worse than capital flight itself. Capital has a tendency to follow capable people around, as talent knows how to transform capital into more capital via providing goods and services to an audience that needs them. Without humans, capital is about as useful as all the gold that’s purported to be in Fort Knox. China can manipulate capital controls to their hearts desire, but they have no means to convince the best and brightest to build out their dreams in China, especially if they continuously interject themselves into the economy. Some recent examples that come to mind are the after school tutoring crackdown, big-tech fines, and most recently the Covid lockdowns, all of which shatters any remaining semblance of business confidence.
For human capital, the jury is still out on whether this is only a flesh wound or this problem is more permanent. Most major multinationals are already acutely aware of the impact these disruptions are causing on their supply chains and are actively looking to re-shore their operations either domestically or to another nearby country like Vietnam or Indonesia. As opportunities move away from China, jobs will be lost and this will have ripple effects on their economy and eventually on their GDP for which they are so protective of.
When you mess with biology, expect to get a bunch of unintended consequences. China borrowed heavily from its own future and now has an insurmountable amount of demographic debt it needs to pay back. And just like student loans, you can’t discharge this debt through bankruptcy. China has a relatively short timing window of about 10-20 years before their demographics completely take over and this problem becomes unaddressable and presents a massive tail risk for China. For a sneak preview, just look at what’s happening over in Japan.
This is a lesson that took me far too long to learn, but never forget why we partake in the game of life, it’s all about the people. When the economy is good, it’s the people that prosper, when the economy is bad, it’s the people that suffer. New technologies and services have to benefit people in order to have value. When you don’t take care of the people, everything will quickly start to fall apart, whether it’s a business or an empire. This is the basis why demographics is such a powerful mental model.
I’m a big fan of Jim O'Shaughnessy’s podcast Infinite Loops. He has a saying that I’m extremely fond of which is (paraphrasing): “We’re all deterministic thinkers living in a probabilistic world. Either tragedy or hilarity will often ensue”. The most applicable model for what China is going through is a probabilistic one. There is definitely a non-zero chance that they make the miraculous trench run and navigate through their multitudes of problems unscathed, but those probabilities are shrinking day-by-day, year-by-year. China got so caught up trying to play the finite game of beating the United States, that they neglected to play the infinite game of staying in the game itself.
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A bit less jokier than usual due to the serious tone that is necessitated for an article like this. Hopefully I’ll indulge you in more laughs in next week’s article, where we see how one man basically speedrun any% nation building.
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