Executive Summary

It has been 40 years since Deng Xiaoping launched China’s Open Door Policy. By several metrics, China’s economic miracle has been extraordinary, with some 800 million people lifted out of poverty in just a few decades and the country playing a critical role in the global economy. But this growth was neither stable nor sustainable, and the country has run out of the low-hanging fruits that fueled its economic rise. 

As a result, like most developing countries, China has a fundamental problem: It wants to transition to a consumption-based economy (which is more stable than relying on exports and investment), but its domestic consumer base is not yet wealthy enough to support the level of economic productivity needed to allow that transition. 

With a trade war looming, a shift to domestic consumption is even more urgent. Throw in a restive Hong Kong, and Beijing is at a critical crossroads with no obvious path forward as it tries to conjure up another economic miracle. Emerging technologies, with blockchain at the helm, could very well be a critical part of China’s future economic strategy.

At the outset of Deng Xiaoping’s economic reforms in 1978, China was poor. It had a per capita GDP level similar to Zambia – less than half of the Asian average and lower than two-thirds of the African average. 

China experienced an average GDP growth of close to 10% per year until 2014, raising per capita GDP almost 49-fold, from $155 current USD in 1978 to $7,590 USD in 2014. 

According to the World Bank, China’s poverty rate fell from 88% in 1981 to 0.7% in 2015, as measured by the percentage of people living on the equivalent of $1.90 USD or less per day in 2011 purchasing price parity terms. In urban centers, poverty has been virtually eliminated. 

However, the country’s development has been uneven. Its per capita income is below the world average, and well below the industrialized nation average, showing the amount of work still to be done. 

Moreover, while average household incomes have been rising (up 9.1% in the first nine months of 2017), the median income hasn’t kept pace (up 7.4% over the same period). This indicates that income growth is largely concentrated among high earners.

In addition, growth has been concentrated along the coastal east, while development in the rural west lags far behind. Around 500 million people, or 40% of the population, survive on $5.50 per day or less. Most of them are in rural areas and west of the mountains that divide the interior from the coastal plain. 

Of course, the two Chinas are joined at the hip. Beijing must determine how to make the success of either dependent on the other, to have coastal capital and technology modernize the interior, and to have the interior’s mass reduce the coast’s dependency on foreign buyers and keep the Chinese labor pool competitive.

How did China get to this point? It became the world’s manufacturing hub, specializing in the labor-intensive, export-led production of cheap goods that enabled a gradual increase in product complexity. Basically, its growth strategy was to assemble and sell cheap goods to the world. However, there are two overriding problems with a dependence on cheap exports. 

First, China’s ability to sustain its economy hinged too much on economic conditions outside the country. China has been overly beholden to its customers, most of them located in distant markets, none of them immune to their own periodic downturns in consumption or protectionist social pressures. 

If the U.S. or European economies crashed, so too would China’s. Following the crash of the U.S. economy in 2008, for example, Chinese exports nosedived to a record 26% on-year in February 2009. That January, the Chinese government estimated that 20 million migrant workers had lost their jobs because of the global economic slowdown. 

Second, the wealthier China becomes, the more difficult it gets to sustain an export-heavy model. Rising standards of living push wages up, making Chinese exports less competitive and giving foreign firms in the country cause to look elsewhere for lower-cost alternatives. 

Why not just look inland to those 500 million Chinese who remain in poverty? 

Unlike the United States, which benefits from vast, easily traversable lowlands connected by a single river system, China’s internal geography is rugged and extremely diverse. 

Despite Beijing’s significant push to improve infrastructure connectivity within and between regions, the challenge of integrating and developing China’s inland provinces persists due to the region’s geographic diversity, its distance from the more prosperous coast, and its large but geographically dispersed population. 

It’s slower and more costly to ship goods from inland provinces, often to the point of negating the lower cost of inland labor.

That’s why multinational firms were already eyeing the exits in China before the election of Donald Trump, who came to office threatening the trade war with Beijing that he has since delivered. 

China’s neighbors in South and Southeast Asia have begun investing heavily in manufacturing and export infrastructure. 

Wages in these countries are much lower. Unskilled workers in Vietnam are typically paid $100-150 a month, compared to the $300 earned by their counterparts in the manufacturing clusters of southern China. As a result, foreign investment has surged in Vietnam, rising nearly 8.5% in the first half of 2018 over the same period in 2017 (itself a record year). Across Southeast Asia, net foreign direct investment inflows jumped 18% on-year during the first half of 2018 to $73 billion, according to United Nations figures. 

Still, there are ample reasons for firms in China to stay put. In addition to China being the world’s largest market, less than 19% of Chinese exports in 2017 went to the U.S. Other major consumer markets have yet to follow the U.S.’ lead in imposing tariffs on China. Many of the country’s biggest manufacturers – ones that serve consumer markets across the globe – will be reasonably well-equipped to absorb the tariff costs and keep at least some of their Asian and European operations in place. 

Considering these headwinds, Beijing has prioritized moving into high-tech, higher-value exports. However, it faces stiff competition from countries that climbed the value ladder decades ago. This is known as the middle-income trap – something China is desperate to avoid. 

This is why China wants to be a leader in blockchain. Blockchain technology saw its first official CPC mention in China in 2016, when it was written into the 13th Five-Year Plan, a roadmap for national development from 2016-2020. Blockchain was depicted as one of the major tasks and projects for the nation, along with quantum communication, AI and autonomous driving.

Rhetoric aside, China has long struggled with the things that fully modernized economies like the U.S., Japan and Germany have mastered, particularly the development of core technologies and native innovation. 

High-end products like cars and electronics require high-end industrial robotics, and Chinese progress has been mixed. In 2017, for example, China had 138,000 industrial robots installed – three times the number of any other country and an increase of more than 120,000 over a decade earlier, according to the International Federation of Robotics. But the bulk are owned by foreign firms.

Moreover, this amounted to just 68 robots per 10,000 industrial workers. The United States, by comparison, had 189 per 10,000 workers and the global leader, South Korea, had 631. Sophisticated robots also require sophisticated software — another point of Chinese dependence on foreign IP — and artificial intelligence applications.

One factor has been the breakneck development of China’s manufacturing sector, which means that many workers are relatively new to the job. Many frontline managers lack the experience to identify the problems associated with new plants and new ventures, and react to problems rather than look for their root causes. 

As a result, companies don’t get the full benefit of productivity improvements. McKinsey studied one typical auto-assembly and body-shop operation where team leaders spent as little as 5% of their time on coaching and problem solving (McKinsey says industrial world best practice is about 30%).

The trade war with Trump’s America is another ferocious headwind. China holds the weak economic hand in this dispute. Its export-dependent economy depends on overseas sales, which comprise one-fifth of its gross domestic product (GDP). One-fifth of those exports go to the United States, meaning that fully 5% of China’s economy is exposed in this trade dispute. By contrast, the United States counts on exports for about 12% of its GDP, and barely 8% of its total exports go to China—leaving just 1% of the U.S. economy exposed to retaliatory Chinese tariffs. Moreover, some 30% of U.S. goods sold in China are off-limits to tariffs, as they constitute components, mostly to computer and iPhone assemblies, that support Chinese exports.

These relative disadvantages showed themselves early in the dispute. U.S. firms began moving their operations elsewhere, while many Chinese firms have decamped to other Asian countries, in large part to avoid U.S. taxes. Even the perennially upbeat (and suspect) official Chinese government statistics show the economy is suffering: China’s real GDP during the third quarter grew at its slowest rate since 1992. 

Export volumes appear to have dropped more than 4% in the past year. Imports have also declined by more than 5%, indicating a drop in employment and consumer spending. 

While official figures still suggest a robust Chinese jobs market with unemployment just below 5%, surveys of Chinese media show a marked drop in help-wanted advertising, with ads for technology jobs down more than 20%. 

So why doesn’t China simply give in to U.S. demands?

The U.S. insists that concessions be explicit and quantifiable. That creates two problems for Beijing: One, the Chinese system is exceedingly opaque, especially given the dominance of state-owned enterprises. Two, implementation of the biggest issues – forced technological transfers and cyber theft, for example – can’t easily be quantified or monitored. 

That is problematic because the U.S. also demands to independently assess whether China is living up to the spirit of the deal – and tariffs won’t be removed until it concludes Beijing has.

The worst of all worlds for China is if it agrees to painful changes, and then the Trump administration drags its heels on removing the tariffs. 

In addition, China’s state-led industrial and technology policies and tightly controlled market are critical to the Communist Party’s power and overseas ambitions.

Of the 40 million people who work for China’s state-owned industrial behemoths, more than 10 million are Chinese Communist Party members. A party boss tends to be the board chairman. In addition, these enterprises contain more than 800,000 party committees.

While the 102 enterprises are big – with assets of 50 trillion yuan ($7.3 trillion USD) including state oil companies, telecom operators, power generators and weapons manufacturers – their profits are weak. 

For example, Sinosteel has failed to repay bondholders on time since 2014. China Cosco has racked up losses of about 10 billion yuan a year.

Political loyalty, not profitability, is the priority for state enterprises. Since Xi Jinping took over, he has stressed China’s biggest state-owned enterprises must answer the party’s every call.

Thus, SOEs are a critical part of China’s foreign trade and infrastructure strategy, known as the Belt and Road. The 102 SOEs have made 60% of China’s Belt and Road investments, a series of infrastructure development and investment initiatives stretching from East Asia to Europe. 

The plan extends to 65 countries with a combined GDP of $23 trillion and includes some 4.4 billion people.

Then there are high tech firms like Huawei and ZTE. Beijing wants to dominate the next generation of technology and both companies have been pushed by the central government to take key roles. Their opaque structures and party ties mean Western governments suspect they will build backdoors through which Beijing can exploit. 

While the companies deny they are explicitly tied to Beijing, they certainly have a far tighter relationship with their government than Google or Apple (which see themselves as global rather than American companies and are outright hostile to Trump).

Ultimately, Beijing is playing for time. Trump’s favorability ratings are low and he may well lose the next presidential election in November 2020. Historically, Beijing plays a long game — so 14 months is nothing. 

Above all, the Communist Party of China deeply fears social unrest and thus cannot tolerate the kind of spike in unemployment that would accompany short-term periods of economic disruption. More than 200 million Chinese people work in manufacturing. It’s bad for China if firms hit by tariffs have to start downsizing. It’s a whole lot worse if firms begin abandoning the country altogether and new foreign investment simply dries up. Throw a restive Hong Kong into the mix, and Beijing has entered a crucial 18-month period in keeping its economic miracle on track.