China's Great Stagnation

BY DAN BLUMENTHAL and DEREK M. SCISSORS

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China's economy is stalling. The most likely economic scenario over the course of the next decade is not high growth or an economic collapse, but stagnation. If this occurs, the Chinese Communist Party (CCP) will have difficulty sustaining its ambitious national development and strategic plans. In particular, Beijing will not be able to avoid a more serious "guns v. butter" tradeoff.

This has sharp implications for American policy. Most importantly, while the US certainly has its own structural problems, it is far wealthier and more powerful than China, and that gap may actually grow or at least hold, rather than shrink. The dominant Sino-US relations paradigm of a declining power managing a rising power is inaccurate. A truer depiction of the Sino-American relationship is that China is a capable great power seeking to compete with US primacy in Asia, much as Russia has become a US rival in Europe and the Middle East, while Iran challenges American interests in the Persian Gulf. To attribute to China the capability to "overtake" the US or compete with it globally—or to describe the power dynamics as a "power transition" from Washington to Beijing—is at best premature.

Because the bilateral relationship contains cooperative elements, it would be better for American interests for China to return to market-based reforms, both to spur global economic growth and to stabilize Sino-American relations. However, this is unlikely in the medium term. And given the combustible mix in China of less stability at home and foreign policy adventurism abroad, Washington needs to more strongly resist destabilizing Chinese actions. It should reorient US strategy based on the long-term leverage created by likely Chinese stagnation and the enduring power gap.

China's Economic Future

There are three views of China's economic trajectory: (1) it is slowing, but also transforming into a healthier and very large economy; (2) it is stagnating; or (3) a true economic crisis is inevitable in the not-too-distant future. The preponderance of evidence is for stagnation.

Both the China (still) rising and crash scenarios are fundamentally flawed. While their ranks thin and their version of success is watered down every year, there are still "bulls" who see China as a future economic success story. This view is based not on current analysis but on a combination of history—the People's Republic of China (PRC) in 1978 and 1992 did indeed rise under worse circumstances—and the ensuing faith that pro-market reform will either be chosen by the Communist Party or be forced upon it.

Reform forced on the party by some sort of crisis may indeed be the best hope, since the party voluntarily choosing pro-market reform at this point is highly unlikely. The much-hyped 2013 Third Plenary session did not in fact offer a sound set of reform proposals. For example, it promoted cooperation between the public and private sectors when the exact opposite is needed. Unsurprisingly, no net progresstoward the market has been made since. And few bulls would be able to endorse the economy purely on the basis of the present explosion of debt, weakening demographics, depleted natural resources, and other objective indicators.

The economic and financial crash argument has a more specific problem: it mistakenly treats the troubled Chinese financial system as similar to the American system. Commercial financial systems in rich countries may be only as strong as their weakest link, but Chinese finance is dominated by the state. Its primary function is to serve state interests, not to make money. Noncommercial financial systems are only as weak as their strongest link because governments can, without legal or political delay, order the strongest institutions to save the weakest. The cost, of course, is an enormous amount of waste.

Neither Preeminence nor Collapse - The Stagnation Case

To understand why stagnation is likely, first consider other countries. While the categories are not well-defined, far more economies rise out of poverty than become truly rich. This is sometimes referred to as the middle-income trap.

In the postwar era, the most impressive economic success stories are in East Asia, which bodes well. However, in comparison with the world as a whole, Japan became rich before World War II, and much of its growth during 1946–1990 was a return to the status quo. Hong Kong and Singapore are mere cities, while Taiwan's population is about the same as Shanghai's. The structure of these microeconomies is fundamentally different than China's economy, and they hardly demonstrate that the PRC can become rich.

In contrast, the middle-income trap has not been kind to large nations. Only one country with a population over 30 million has become rich for the first time in the postwar era: South Korea. A long list of countries that have not gone beyond middle-income, from Argentina to Thailand. It would not be surprising if Chinese cities the size of Singapore had income levels similar to France. It would be astonishing for the PRC as a whole to match French income, much more astonishing than what it has accomplished to date.

Second, evaluate Chinese growth. The government continues to report comparatively rapid gains in gross domestic product (GDP) and will do so indefinitely. But official statistics are not a reliable indicator of how the economy is doing. Information control is a vital tool for the party, and economic information is obviously a sensitive component. Purported GDP receives the most attention but is wildly overrated as a measure of success. GDP per person is close to meaningless; it is purely an accounting device that cannot be spent or invested. In terms of what people actually have in their pockets, China reported disposable income per person equivalent to $3,400 at the end of 2015, less than one-tenth of the US.

China "bulls" typically claim that, while the PRC is poorer than the US, it continues to catch up—yet possibly not, according to Credit Suisse, which reports net private wealth figures for all major economies. From the end of 2011 to the middle of 2015, Chinese net private wealth grew 19 percent. American net private wealth grew 43 percent. The two countries' public sectors are harder to measure, but China's debt performance over this period is atrocious, approximately 40 percent is attributable to state corporates, and their share is rising.

Beijing's Blues

Nor is all of this a blip. The PRC's economic weakness did not appear in 2015, as some seem to think. It did even not begin with the 2008 financial crisis. It began in 2003. From 1978 to 2002, several waves of partial pro-market reform created a new economic powerhouse. In 2003, the new government under Hu Jintao decided state-owned banks lending to state-owned enterprises (SOEs) should continue to constitute the core of the economy, employing large numbers of people and otherwise serving the party's aims. Fresh market-oriented reforms were soon displaced by soaring publicly directed investment.

The National Bureau of Statistics reported investment growth jumped from 12 percent in 2001 to more than 26 percent in 2003, more than four-fifths by state-controlled enterprises. Investment growth then exceeded 25 percent annually for the next nine years, doubling the pace of official GDP—the huge imbalance between investment and consumption is not endemic but rather was created starting in late 2002. After a four-year boom, the economy began to hiccup. It was no longer greater productivity from market reform driving the numbers but increasing dependence on foreign consumption to buy the goods ultimately produced.

The global financial crisis was a double blow. Foreign demand plummeted. And on top of the previous public investment surge, Beijing conducted arguably history's biggest stimulus through state-run banks. Loans grew 32 percent in 2009 alone, even as profit opportunities vanished. At this point the stagnation path became clearly visible.

Since then, credit expansion has slowed but remains staggering. In a smaller economy, China's broad money supply is 75 percent larger than America's. The inevitable outcome of such leveraging is overcapacity and debt. In 2003, the government identified three industries suffering from overcapacity; in 2013, that number had ballooned to 19. Sustained overinvestment and overproduction have badly damaged the environment, exacerbated income inequality, and, most important, created a crippling debt burden.

The PRC's national debt is in excess of $25 trillion and climbing. Roughly two-thirds has been accumulated in the past nine years. In 2015, total debt rose four times as fast as nominal GDP, mocking the idea that China continues to enjoy comparatively rapid economic growth. When a country has already spent so much, the return on yet more spending is low. This is the main reason growth has slowed. A related point is that, when a country's debt is so large, a large amount of capital is spent paying it back. This is the main reason growth will slow further.

Additional Challenges

Demography also portends stagnation. Demography can cause social and political crisis when there are too many young people and not enough jobs. China is instead rapidly aging (by demographic standards), heading toward a situation of hundreds of millions of elderly requiring support and not enough workers to support them and expand economic activity.

The government reports the number of working-age people started to inch downward in 2012 and has fallen progressively more sharply each year through 2015. These numbers may not be entirely accurate, but the work force will certainly shrink before this decade ends and continue to shrink throughout the next decade. The contribution of labor to growth will fade until labor actually detracts from growth, as it does in Japan and parts of Europe. Older countries tend to stagnate.

In addition, growth based on natural resources has disappeared. In the 1980s, farm productivity soared, permitting those who had become unnecessary farmers to become manufacturing workers and helping create the world's new factory. Land and natural resources will not spur economic growth again for the foreseeable future because the PRC has significantly depleted its resource endowment.

Illustrations of this range from arable land to zinc deposits, but the clearest is water. The World Bank cites water stress starting at 1,000 cubic meters of water per person per year; northern China offers one-fifth of that. Three-fifths of monitored national groundwater sites are rated by Beijing as unfit for drinking. Just as hefty payments are due on financial debt, they are also due on environmental debt, making growth even more difficult.

Weakness in other sources of growth means increasing reliance on something that is hard to measure: innovation. The PRC has successfully imported foreign technology, legally and through the theft of intellectual property. As countries climb the technological ladder, however, they no longer benefit greatly from merely absorbing what others offer, and innovation becomes more challenging.

The government's response is exactly wrong. Sustained, broad innovation that drives growth must be bottom-up while the infamous indigenous innovation program is top-down. It is highly unlikely the government will be able to anticipate years of change in computing, telecom, energy, and elsewhere. Moreover, intellectual property is still not well protected, reducing the incentive to innovate. Continued regulatory protection of SOEs means the private sector cannot succeed beyond a certain point in the two dozen industries that SOEs dominate, sharply curbing innovation in those industries.

Reform Prospects Dim

State action brought China to this point. More state action—such as credit provision or infrastructure spending—cannot reverse it. A return to a healthy economic trajectory will require resuming pro-market reform. The party seemed to recognize this under Xi Jinping when the November 2013 plenary meetings promised to give the market a "decisive" role. Premier Li Keqiang has said reforms will be as painful as cutting one's own flesh. This was certainly better than the public investment boom inaugurating the Hu Jintao government. However, the reform restart praised by many was badly designed from the outset.

Greater labor mobility could mitigate aging by letting workers move freely to desired jobs. The PRC still discourages mobility by denying pension and other benefits to those working in the "wrong" area. Pledged changes keep the most popular urban centers cordoned off and retain most barriers between rural and urban areas at least until 2020—important lost years. If this is due to continued fear of migration breeding social instability, the party will restrict workers indefinitely.

Reform could also sharply increase the value of natural resources, along the lines of the American shale boom. This would require China to mimic at least parts of the American model, featuring private ownership of rural land, open competition among energy firms, and legal protection of innovators. The policy platform and actions to date show no progress in any of these areas. Notably, outright environmental damage is being reduced. But this means less harm to future growth, not a boost.

Finance has seen reform, most importantly in bank licenses for private entities. While interest rate liberalization wins headlines, it has little value when the vast bulk of the financial system must follow party orders. What is needed is the commercial—not political—lending, which can only come from independent institutions. The private licenses will bolster the return on capital, and thus growth, eventually. But it could take decades for private banks to substantially erode the state's 90+ percent share of banking assets, even while unsound lending adds to the debt pile. Much more radical steps are needed.

The best solution is to fix the SOEs that state banks are required to lend to. Regrettably, there has been no pro-market reform in the state sector—quite the opposite. The party's original pledges went the wrong direction:  rather than shrinking SOEs to make space for private competition, they call for private cooperation with the state. This is essentially an attempt at private bailout of public-sector errors. Further, rather than being sold or allowed to fail, SOEs are being merged to become even bigger.

This also affects innovation. Beijing sees super-large SOEs winning global competitions, but faced with no competition at home, these firms have considerably less reason to innovate. Chinese consumers will continue to be offered inferior products, and many state giants will eventually lose ground overseas, no matter their size. Only private firms, forced to compete at home and overseas, can succeed fully.

Global Economic Implications

Absent powerful pro-market reform that is nowhere in sight, true economic growth will halt by the end of this decade, no matter what the government claims. The most important implication concerns the dollar: the RMB will fall well short of challenging the dollar, and the future of the world's reserve currency will depend almost entirely on American choices.

Otherwise, for the US in particular, a stalled China will be primarily a lost economic opportunity. Financial exposure to the PRC is minor in comparison with the size of the American financial system. The PRC's trade role as a gigantic low-margin manufacturer has brought benefits but is certainly not a necessity; other countries played this role before and will again. China's economy will still have nearly bottomless needs for elderly care and environmental technology, for example, but the enormous opportunities that many American companies anticipated will not materialize.

Other economies, though, are not as large or as self-sufficient and thus more vulnerable to Chinese weakness. Energy and metals exporters from Brazil to Zimbabwe already have suffered greatly. Chinese weakness will more subtly continue to affect key trade partners such as South Korea, exerting downward pressure on their growth. On the more positive side, stagnation may already be inducing heavier Chinese outward investment. Fewer opportunities at home push Chinese firms to seek greener pastures elsewhere, at least benefiting foreign asset holders.

A central question is where to find global growth going forward. A rebalancing PRC was supposed to be a boon, as rapidly rising Chinese consumption would mean far more imports (ex-commodities). It is not reasonable to expect an economy with the PRC's debt trajectory to be an important and durable source of net global growth. Indeed, there are intensifying complaints that Beijing is attempting to finesse its debt situation by dumping excess production overseas and stealing its partners' growth.

Japan previously succumbed to debt-induced paralysis, Europe may be in the process of succumbing, and the US faces an attenuated version of the problem that will intensify as entitlement spending expands next decade. India is not large enough, much less reliable enough, as a source of global expansion at this point. In this context, Chinese stagnation is especially unwelcome. In addition to its direct impacts, it raises the likelihood that the world as a whole faces a period of economic weakness.

A stagnant China will still be large and important. It will certainly be one of the world's very top manufacturers and traders, and quite possibly the leader in absolute size in these areas. It will be a major global investor. At home, it will offer huge markets for real estate and public health, among other things. While the PRC's growth is vanishing, its size and economic stability remain. There are important security implications of all these characteristics.

The Politics of Stagnation

Xi Jinping inherited a debt-plagued economy that had abandoned reform. If that wasn't enough, Xi also had to contend with the exposure of high-level CCP corruption prompted by the Bo Xilai case. Bo was a charismatic party leader of Chongqing province who built his reputation as being "tough on crime and corruption" and his legacy as the son of a prominent Mao contemporary. But his family's corruption was exposed when his wife was arrested for the murder of a British fixer, who had helped the family launder money. Bo's public fall from grace not only raised uncomfortable questions among ordinary people about the magnitude of the corruption among the CCP elite, it exposed a rift in the upper echelons of the CCP over who would succeed Hu Jintao.

As a result, Xi's first order of business was to gain control over a fractious party leadership. To consolidate control, he has pursued a threefold political strategy. First, he has largely tossed out Deng's post-Mao model of consensus-driven leadership. To the extent possible under a dictatorship, Deng had put in place decision-making checks and balances and a relatively stable succession process. Deng was trying to ensure both that Maoist-style totalitarians would not reemerge and that his ambitious reform plans would be enacted.

Shortly after taking power, Xi began to undo the CCP's collective leadership structure and consolidated power for himself. Xi now holds 10 government and party titles, including "not only head of state and head of the military but also leader of the Party's most powerful committees." As of 2014, Xi chaired six of the CCP's 11 "leading small groups," informal committees that direct policy. In terms of the formal exercise of power, Xi may be the strongest Chinese leader since Mao.

The second element of Xi's political strategy has been a high-profile crackdown on corruption, an area in which previous leaders looked the other way, at best. Thus far, the campaign has indicted thousands of officials, ranging from former politburo members to provincial apparatchiks. Absent very high levels of economic growth, Xi has to demonstrate to the people that the CCP still deserves the "mandate of heaven"—a legitimacy that always relies on the perception that the government is a virtuous one. The anti-corruption campaign thus serves two purposes: it is a both a demonstration that Xi is removing the rot inside the government and a strategy for neutralizing potentially powerful opponents. According to Minxin Pei, "although Xi's signature campaign appears to be popular, it has almost overnight dismantled the system the ruling elites painstakingly constructed in the post-Tiananmen era to maintain their unity." Corruption, which in essence was a guarantee to party elites that they would get rich, and consensus-based leadership are no longer the glue holding the party together.

The third element of his political strategy is the escalation of CCP repression of civil society, including foreign media, nonprofits, human rights activities, and religious groups. This crackdown is also meant to expunge China of Western "spiritual pollution." Xi has stated that "all news media run by the Party must work to speak for the Party's will and its propositions, and protect the Party's authority and unity" and acted accordingly. In February 2016, the Ministry of Industry and Information Technology released new rules stating that foreign media outlets were prohibited from publishing online in China without explicit government approval. China has passed a law severely limiting the activities of nongovernmental organizations (NGOs) and attempted to purge the teaching of "harmful" Western ideas from educational curricula. In January 2015, the minister of education stated that schools should limit use of Western educational materials in higher education in order to avoid undermining the party. The CCP has also continued to brazenly arrest its political enemies. Just last year mainland authorities abducted five booksellers from Hong Kong who published material critical of the party.

All this means that Xi has eschewed another political strategy available to him: restarting Deng-style reforms. While market-driven reforms would have been politically painful, Xi's strategy carries serious risks as well. It is now probable that a powerful enemy, harmed by Xi, will emerge to try to undermine him. Elites marginalized from decision making and exposed to corruption investigations are doubtless waiting for the opportunity to strike back. For example, there was already open discontent over Xi's handling of the July 2015 stock market crash, leaving elites wondering if Xi knows how to manage the economy. It is now possible to imagine a coalition of disgruntled party leaders, members of the business class, and embittered reformers emerging to pose a real threat to Xi.

This development ought to be worrisome for a CCP that has survived post-Tiananmen by remaining more or less unified at the top. The CCP is no longer upholding its end of the social bargain with the people: economic growth in exchange for political quiescence. So now the two pillars of CCP survival—elite unity and economic growth—are crumbling.

As the promise of a rapidly increasing quality of life diminishes for many Chinese, incidents of protest against the regime's many injustices will also increase. CCP leaders have always worried that "external influences" are working with Chinese citizens to "subvert" Communist rule, whether they are Uighurs influenced by international Islamic movements or lawyers who get support from foreign NGOs. Under Xi this concern has intensified.

Perhaps because of the fractures caused by his anticorruption campaign, his takedown of powerful internal security czar Zhou Yongkang, the fallen Bo Xilai's ties to the security services, and growing sources of unrest throughout China, Xi has reemphasized to the security services their allegiance to him and the party. As Murray Tanner argues, "Beginning soon after coming to office, Xi made inspection visits to People's Armed Police units, issued numerous important security policy directives, and made major speeches to national meetings of police and judicial officials." In 2014, Xi gave a high-profile counterterror speech titled "Safeguard National Security and Social Stability," stating that Chinese people must be vigilant against both internal and external threats.

All this comes with increased financial costs. According to Cheng Li,

The cost of ‘maintaining social stability' (weiwen), primarily through the police force, has become astonishingly high. The Chinese government's official budget for national defense in 2012 was 670.3 billion renminbi (about $109 billion), while the budget for police and public security was 701.8 billion renminbi (more than $114 billion).

Notwithstanding China's notorious budgetary opacity, there is reason to believe that maintaining a surveillance state costs as much as maintaining the People's Liberation Army.

Increasing social welfare costs should be counted as internal security expenses, since an aging population that is uncared for would undoubtedly cause enormous social dissension. China has not had a real social safety net since the dismantling of the Communist work unit, and its pension and "social security" systems are grossly underfunded. Greater Pacific Capital reports:

China, due to its historic one-child policy, has a fertility rate of 1.6 (below replacement levels) and a well-documented looming demographic cliff with its old-age dependency ratio set to increase to close to by almost 4x between 2010 and 2050. . . . Pension expenditure is already the single largest expense of the Chinese government, at US$200bn annually, higher than infrastructure, healthcare or defence, almost 20% of its total budget, (but still only totaling 2.7% of annual GDP), with coverage provided to less than half of the population above the age of sixty.

These numbers will only rise.

These are only rough estimates, and retirees will certainly not be funded at the same level as their counterparts in Western countries. But the financial liabilities are large nonetheless and will far exceed spending on foreign and internal security policy. Given the levels of debt, China will have difficulty funding obligations to its elderly. It seems almost unimaginable that it can sustain rapid growth in security spending as well. Xi's only political option given these circumstances is to create and sustain a new elite coalition around his nationalist program of "national rejuvenation" and the "China dream." Given slow economic growth and unfunded promises to seniors, Xi like Mao before him will have to ready his people for "sacrifices" in furtherance of China's return to greatness.

Xi's Foreign Policy in the Era of Stagnation

Even as he faces greater financial strain, thus far Xi's national security approach has been to centralize control over security policy, to expand internal security, and most importantly to continue with Hu's more muscular stand on territorial claims in the South and East China Seas. In addition to these efforts, Xi has also put forth an ambitious development and strategic plan called One Belt One Road (OBOR), in which China will create a network of infrastructure projects linking itself with over 60 Central Asian, Middle Eastern, and European countries.

Just as Hu halted economic reform, he also initiated a more assertive foreign policy. For example, Hu had to respond to a commodities shock (with high growth, China's commodities demand rocketed higher), so he encouraged state companies to scour the earth for resources. He followed this "going out" strategy with a call for the People's Liberation Navy to undertake "New Historic Missions" to protect China's newfound overseas interests in the Gulf and Africa.

As Chinese entities went overseas to find resources, security leaders feared that the US and its allies could cut off supply in the event of a downturn in Sino-American relations. To expand its maritime presence, China has deployed a naval task force in the Gulf of Aden since 2008, developed military forces able to project power into both the South China Sea and Indian Ocean, and built diplomatic and military logistics relationships through port calls in the Persian Gulf and Africa. Plans are on track to build China's first overseas base in Djibouti, as well. Hu also began to press maritime claims in the East and South China seas and demonstrated a dangerous capability with a high-profile anti-satellite weapons test in 2007.

While Hu began to demonstrate Chinese power, Xi has taken the approach one step further. Under Xi, China has more decisively shifted the balance of power in East Asia's littoral seas. In the South China Sea, China has constructed over 3,000 acres of manmade military outposts and begun forward deploying missiles batteries, drones, and fighter aircraft to these new bases. All the while, Chinese coast guard and fishing fleets continue to harass Filipino, Vietnamese, and Indonesian fishing and coast guard vessels. In the East China Sea, Chinese maritime militias and fishing fleets maintain a regular presence around the Senkaku islands, which Beijing disputes with Tokyo. Chinese air force activity in Japanese airspace has increased dramatically in the past five years. In 2015 alone, Japan scrambled jets a record 571 times to escort intruding Chinese fighters.

If Beijing's maritime ambitions were not enough, Xi has also turned west with OBOR. The grandiose hope is to link Asia with Europe, a plan so ambitious it leaves Xi enough room for variegated assessments of success or failure. If OBOR is mostly a way to rid China of excess capacity and purchase more influence in neighboring countries, it may well "succeed." But if the strategy is meant to reshuffle Eurasian geopolitics by creating a "New Silk Road" linking East and West, with China at the heart, it will almost surely fail.

The biggest stumbling block is the long-term ability to fund such an endeavor, let alone protect it. For now, Chinese overseas direct investment to wealthy locales, such as the US and Australia, is increasing faster than investment to high-risk OBOR nations in continental Asia. OBOR funding must compete for state resources with PLA modernization, internal security budgets, a rising pension burden, and environmental remediation projects that are unprecedented in size and duration.

The risks of Xi's foreign policy approach are twofold. First, as Xi acquires a base in an unstable region, devotes more resources to Central Asia, and pushes contested maritime claims, the chances of a foreign policy failure have grown. China has little experience managing a high-stakes competition with a set of capable rivals such as the US and Japan, or countries willing to stand up to it under certain conditions such as Vietnam. Eventually, one of its rivals may push back hard (e.g., demonstrating that the militarized new "islands" are indefensible or placing US and allied exercises closer and closer to its shores), leaving Beijing with few palatable options. This scenario could be highly embarrassing to Xi who has cultivated a strong-man image. Part of the party's claim to the mandate of heaven is that it is reversing centuries of foreign humiliation. No CCP leader can be seen creating new humiliations.

Second, his ambitions may be unaffordable under conditions of economic stagnation. Xi himself hinted at these realities this spring, "In the face of mounting pressure resulting from the economic downturn, with a slowdown in budgetary income and growing expenditure, it is not easy to secure a normal rise in the military budget anymore." A PLA with budget increasing at "only" 5 percent a year will still be a formidable fighting force in East Asia, but overseas basing, far seas missions, and infrastructure protection on the Asian continent are expensive endeavors. And 5 percent increases will become an increasing strain on China's economy.

A stagnating China's best analogue is not the stagnant Japan of the past two decades. Because of Beijing's geopolitical ambitions, the better comparison is to Putin's Russia, albeit with a much larger economy and thus more durable power. Despite already poor demographic conditions and a shrinking economy, Putin continues to exert Russian power abroad. He remains a popular leader and therefore can sustain these ambitions for a strategically relevant period of time. Similar to Russia, China is discontent with an American-dominated geopolitical order and has a strong sense that it should be the leading power in its region. Political power will likely remain centralized, and opposition will be put down ruthlessly. Xi will walk a tightrope on foreign policy adventurism. Right now his activities in the South China Sea serve both strategic goals and his nationalist domestic policy goals. The risk of this approach has been, and will remain, low as long as the US continues its tepid response. Going forward, he will calibrate assertiveness based on how much he needs to fuel nationalism and how great the strategic payoff China receives, measured against the risk of a real or perceived failure (e.g., the US effectively stops China from creating new manmade islands).

US Policy Implications

China's stagnation has two broad implications for US strategy. First, Washington has more strategic leverage in the bilateral relationship than it imagines. Since the 2008 financial crisis, the central organizing ideas driving Washington's China policy are that the US is in relative decline and that economic "interdependence" limits more assertive US options to challenge China's aggression. Both of these ideas are inaccurate.

While the US has serious long-term fiscal problems, it is far more powerful and wealthy than China. According to net private wealth statistics and other data relevant to national economic capabilities, the economic gap between the US and China is vast and may continue to grow. The US can choose to put itself on a better fiscal course and translate more of its wealth into geopolitical and military power in ways that China would be hard pressed to challenge.

And "interdependence" does not quite describe the bilateral relationship. China depends on the US for secure sea lines of communication needed to import commodities, for contributions to its food supply ranging from soybeans to pork, and as a safe repository for its finances—for example the US has become China's preferred choice for discretionary overseas investment. Most important, the US continues to provide stewardship over the international economic system, and its willingness to run by far the world's largest trade deficit drives global growth in a way China never has.

In contrast, although the US has benefited from Chinese investment and the import of low-cost consumer goods assembled in China, these goods are already starting to be sourced from other locales, and falling Chinese reserves have already started to limit investment potential. If relations deteriorated, the US can inflict far more economic harm on China than the reverse. This is not interdependence.

Strategic Leverage

In short, the US will retain the clear upper hand in a relationship that is growing more competitive. Washington should reorient its strategy based on its strategic leverage. The huge gap between the two country's private sectors and deterioration in the economic position of the Chinese state leave the US a budget deal and entitlement reform plan away from translating economic advantage into even greater strategic advantage.

Another key source of American leverage is CCP insecurity. Xi needs to inspire nationalism and demonstrate that he is leading the process of national rejuvenation, but he cannot risk a foreign policy failure that would make him look weak at home. That means he will press on contentious issues until it becomes too risky to continue. For example, his South China Sea aggression has worked. He has paid no real cost and can credibly claim to his people that he is retaking lost territory and gaining control over China's historic seas. But if the US took action to stop China from dredging new "islands" in such places as the Scarborough Shoal, Xi would not have many responses. If the US began to convoy fishermen to waters they can legally fish, Xi would be left with a host of bad options. If the US began an active diplomatic initiative with maritime claimants in Southeast Asia to resolve conflicting issues of maritime rights and territories without China, Beijing would be isolated. These strategic initiatives should be accompanied by a renewed US informational campaign emphasizing how Xi is isolating China when there are many other options to integrate the country with the international community.

The US should make it clear that it is not seeking confrontation with China. Indeed, Washington has done much to welcome China as a great power. Rather, US strategy should be aimed at demonstrating that a policy of aggression and assertion will not end well for Xi and the CCP and that there are better options. Indeed, exercising strategic leverage could enforce a second American goal: China's return to Deng-like reforms. China's troubles are not cause for unbridled celebration. Yes, they provide the US with the opportunity to push back against China's aggression. But in the longer term, a stagnating China constitutes a far more unpredictable geopolitical rival. The brief history of the PRC offers examples of foreign policy adventures used to sway the people to support grand, transformational political initiatives. Domestic radicalization has caused problems for the US in particular (e.g., the Great Leap Forward and the Taiwan Strait crisis).

On the other hand, relations with China improved substantially when Deng Xiaoping started economic reform. Bilateral ties were also more stable during Jiang's and Zhu's reforms of the mid- and late-1990s as Beijing developed much more interest in a stable international financial system. Admittedly, China was less capable of pushing its security interests at that time. American strategic objectives should be to deter highly aggressive moves by Xi to clearly show that the US will take advantage of the risks he has taken, while using high-level diplomacy and economic carrots to further market-based cooperation.

Conclusion

China appears to be headed toward a period of sustained economic stagnation. For now Xi has demurred from returning to the market reform of Deng and Jiang. His country faces crippling debt levels, in excess of $25 trillion and climbing, the main cause of slowing growth as increasing amounts of capital are devoted to debt service. Adding to this is an aging population, whose pensions are grossly underfunded, and the long-term misuse of natural resources.

Politically, Xi has responded by centralizing power, trying to reclaim the CCP's mandate of heaven by demonstrating to the people that he will rid the country of corruption while increasing the internal security services' ability to head off unrest. In addition, Xi has pushed forward a muscular foreign policy to show the people that the CCP is the vessel through which China can attain its historical place in Asia. This amounts to a high-risk gambit. Xi has exposed himself to the ire of victims of his anticorruption campaign, and the US and its allies could hand him a foreign policy setback that would weaken him at home. Finally, Xi simply cannot pay for all the foreign policy ambitions he has announced. Tradeoffs will become inescapable.

The US will most likely face something akin to an economically larger version of Putin's Russia—powerful enough to cause great instability but still highly vulnerable. The US can choose to use its enduring strategic leverage over China to make Xi more risk averse. Beyond that, a stagnant China could radicalize domestically and become less predictable on the world stage. Alongside the use of strategic leverage, the US should therefore do what it can to encourage China to return to the path of economic reform. This dual-track approach is predicated on the realization by a new American administration that stagnation is the most plausible path for China and that the sizable gap in wealth and power will endure.

Dan Blumenthal is the director of Asian Studies at the American Enterprise Institute, where he focuses on East Asian security issues and Sino-American relations.

Derek M. Scissors is a resident scholar at the American Enterprise Institute (AEI), where he studies Asian economic issues and trends. In particular, he focuses on the Chinese and Indian economies and US economic relations with China and India.

This essay was originally published by The National Interest


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