In February 2023, the world was abuzz with the now-infamous “Chinese spy balloon” incident, which quickly dominated the news cycle. At the time, I lightly remarked on one of my social platforms that this might be more spectacle than substance. I even half-jokingly came up with an economic model where one player had the option to “spy” or “not spy” and the other had the option to “shoot” or “not shoot”. Both the Nash equilibrium in the static game and the subgame perfect equilibrium in the sequential game pointed to the outcome “not spy, shoot”.
Fast forward seven months to a recent revelation by Gen. Mark Milley, the chairman of the Joint Chiefs of Staff. Speaking to CBS News, Milley explained that the balloon was unintentionally diverted from its original route by winds and ended up drifting over the continental United States. The device, it turns out, did not collect any intelligence or transmit any data to the PRC.
Regular readers of this blog are well aware of my views on China. While I’ve always maintained a nuanced perspective on the challenges posed by the PRC to the U.S. and the Western world at large, this balloon episode stands out as an interesting example of how narratives, once established, can overshadow reality. Ironically, the media’s uncritical role in the entire scenario bears a striking resemblance to China’s state-sanctioned propaganda within the Great Firewall.
The “Chinese spy balloon” downfall (pun intended) serves as a stark reminder of two things: the importance of evidence-based judgment and the need for cool heads to shape our perceptions. As people navigate this complex geopolitical landscape in this era of constant (mis)information, they should remain discerning and deliberate in their responses. When the stakes are so high, clear-headedness is not only a virtue, it’s a necessity.
This post is not intended to discuss the general topic of foreigners investing in China but rather to provide my thoughts on the recent news report that billionaire investor Mark Mobius was unable to take his money out of China. While the PRC has long restricted the free exchange of foreign currencies for its citizens, the repatriation of profits for foreign investors has typically not been a big issue when the Chinese economy is strong.
In light of this incident, I think it might be helpful to use a simple economic model to explore the factors that influence a foreign investor’s decision to invest in China, as well as how the PRC government would respond to such investment in different economic scenarios.
The Model
First, consider an outside rate of return, denoted as \(r_{0}>0\), such as that offered by Treasuries. Within the country, there are two rates of return: one under weak economic conditions, denoted as \(r_{1}>0\), and another under strong economic conditions, denoted as \(r_{2}>0\). The government levies taxes on the return earned by the investor at a rate of \(t\in(0,1)\). A one-shot strategic interaction between a foreign investor and the country’s government can be modeled using the simple Bayesian game below.
Nature moves first, with probability \(p\in(0,1)\) of a weak economy and probability \(1-p\) of a strong economy. The government is faced with two possible courses of action: “exploit” or “support.” “Exploit” involves taking over the entire investment and return of the foreign investor. This is relevant in the context mentioned above, as extreme measures to prevent foreign investors from withdrawing their money from the country can be seen as a form of nationalization. “Support,” on the other hand, involves allowing the foreign investor to retain full control over their investment and continue their business as usual. When the government observes a strong economy, it only opts for “support,” which can help establish a positive reputation and attract more foreign investment. However, when the government observes a weak economy, it may consider “exploit” instead of “support” for corporate control, revenue maintenance, and the control of capital outflows.
The foreign investor does not know the actual state of the economy—due, for example, to delayed reporting and/or the outright suppression and manipulation of data—or the government’s action beforehand. However, the investor has access to other information that is common knowledge, including the probability of a strong vs. weak economy, the returns under each scenario, the tax rate, and the potential payoffs. The investor moves simultaneously with the government and has two options: “in” or “out.” Choosing “in” signifies the foreign investor’s decision to invest in the country, while opting for “out” means staying out of the country and earning the external return \(r_{0}\).
Without loss of generality, suppose the foreign investor’s initial capital is one. The structure of the game and the payoffs are shown in the graph below.
Observations
Consider the foreign investor’s options and the government’s best responses. If they play “in,” then the government has a higher payoff by playing \(E^{W}S^{S}\) (“exploit” when the economy is weak; “support” when the economy is strong). If they play “out,” then the government is indifferent regarding its strategies. Hence, the strategy profile \((In, E^{W}S^{S})\) can be a unique pure-strategy Bayesian Nash equilibrium if and only if the investor’s expected payoff of playing “in” is larger than their expected payoff of playing “out”: \(-p+(1-p)(1-t)r_{2}>r_{0}\), which implies \(r_{2}>\frac{r_{0}+p}{(1-p)(1-t)}\). That the right-hand side is increasing in \(p\) suggests that as the risk of a weak economy increases, the investor demands a higher return when the economy is strong, or else they will walk away.
Perhaps the most interesting observation, given my simple model, is that playing “in” at the equilibrium point has nothing to do with the rate of return when the economy is weak. The foreign investor already takes into account the contingency that the government will “exploit” if the economy turns out to be weak. This may provide a partial explanation for why there are far fewer “bears” relative to “bulls” among Wall Street professionals who talk about projects in China (see, for example, here), as it is not \(r_{1}\), but \(r_{2}\) that really matters when it comes to making investment decisions. It remains to be seen how the absolute number of those “China bulls” will change as the longer-term growth outlook in the PRC turns dimmer and more uncertain (i.e., an adequate \(r_{2}\) becomes harder to find).
What is going on with the Chinese economy? The headline figures have painted a rather bleak picture. Just last month, industrial production was down 2.9% year-over-year, retail sales down 9.7%, food catering revenues down 22.7%, et cetera, et cetera. This has prompted one of the CCP’s top leaders this week to chair a teleconference on “stabilizing the economy” with 100,000 or so cadres in attendance. Meanwhile, it has been reported that the US may outpace China in economic growth for the first time since 1976.
Mainstream narratives have mostly blamed the current economic situation in China on the so-called “dynamic zero-COVID policy” (动态清零政策), which not long ago, as I noted in my previous posts, was cheered in the PRC and by some “China experts” in the West as a “victory” of the CCP-led “Chinese model” in contrast to the ostensibly more chaotic responses in the West, especially in the US.
Yet, behind the periodicity of the zero-COVID disruptions is a more sinister trend that is more or less beyond the control of PRC officials: de-globalization. So far, this has been overlooked by many China-focused journalists and analysts. Ironically, the backdrop of this macro trend was the US-led hyper-globalization in the last 30 years, which, in the case of China, played out in a doubly ironic way consisting of free rides. As Professor Dani Rodrik of the Harvard Kennedy School of Government said in a recent podcast interview:
The greatest beneficiary of hyper-globalization was clearly China, but there’s an interesting paradox there. On the one hand, you can say that, look, you might feel bad for the lower-middle classes or workers in regions left behind, in Europe or in the United States. On the other hand, you had a billion people lifted out of extreme poverty, in part because of the ability of China to leverage the world economy.
But the paradox here is that China played the globalization game not by hyper-globalization rules, so it’s precisely by pursuing this set of policies that were contradictory to the spirit of hyper-globalization that paid them so well.
What do I mean by this? China had extensive industrial policies and subsidies to their infant industries, and you were not supposed to do that under the WTO rules. They managed the exchange rate – well, you were not supposed to do that under the rules of financial globalization. They had controls on capital movements across the border, when you were not supposed to do that under the rules of financial globalization. They violated intellectual property rights and many of the other rules of the WTO in spirit, if not exactly in letter.
So the paradox is that China did so well not because it followed the tenets of the hyper-globalization period, but precisely because it was essentially free-riding on the openness of other countries.
The ongoing trend of de-globalization, however, is effectively ending the PRC’s free ride, as the “globalization bus” is heading elsewhere, figuratively speaking. Factories are re-shoring, and economies are de-coupling. China can get off and find another bus to free-ride on, or it can build one of its own, or—to follow in the footsteps of its good friend Russia—it can try to take off the steering wheel. But this old bus will no longer take China where it likes to go, as it once did.
Compound that with the PRC’s increasingly restrictive domestic economic policy, its long-accumulated debt problem and low productivity growth, as well as its worsening birth rate and labor shortage. What we are seeing in the Chinese economy today may just be a harbinger of a much more challenging situation that could occur in the coming decade and beyond.
As I alluded to several times in my previousposts, China has something called “democracy with Chinese characteristics.” On the one hand, for those who grew up in the PRC and went through “patriotic education,” the phrase has always been there, but its meaning has never been apparent. On the other hand, a shadow of a doubt—or should I say, conspiracy—has constantly been cast on the version of democracy that is without Chinese characteristics whenever an average Chinese person wants to learn something about the latter from party-approved sources, which are virtually all they can get if they do not speak another language or use a VPN.
Most recently, this phenomenon has been manifest in the curious effort by the CCP leadership to “redefine” democracy. For instance, and I quote the always-loyal party tabloid the Global Times (环球时报):
Jiang Jinquan, director of the Policy Research Office of the Communist Party of China Central Committee, made the remarks at Friday’s press conference on the sixth plenary session of the 19th Central Committee of the Communist Party of China.
He said democracy is not a patent of the West, nor can it be defined by the West. Western democracy is a democracy dominated by capital, a democracy of the rich, not true democracy.
…
Color revolutions in recent years have resulted in disasters to local people, which the people of the world have become increasingly aware of, Jiang said in response to a question on comparison between China’s whole-process people’s democracy and Western democracy.
Usually, I am sort of cagey when it comes to domestic politics in the US. Still, as someone who spent his first two decades of life in the PRC and who unavoidably had his perception of the world geared toward the possibility of a “Western conspiracy,” I do have an interest in giving my two cents on the issue of “true democracy.”
The “stupid wokeness,” or “‘defund the police’ lunacy,” as Democratic strategist James Carville calls it, seems to show that “Western democracy” is real and extends beyond the “bourgeoisie.” I tend to view “wokeness” as not being “stupid” or “lunatic,” but as the rise—within the democratic system—of a radical and powerful ideology and political movement, as well as a way of “brainwashing” the next generation, that is arguably revolutionary/destructive to the very foundation and upkeep of the prevailing social contract in the world’s most successful capitalist society.
As reflected in the latest election results, the current backlash against “wokeness” and “critical race theory” appears to be part of the re-adjustment process and negative feedback loop that is also a typical feature of “Western democracy.” But can those in the PRC say in any meaningful way that their “whole-process democracy” has the same level of openness and tolerance toward endogenous changes in political and social institutions (regardless of the direction of change) and even the “overthrow” thereof?
All in all, despite my pre-existing bias, “Western democracy” feels very true to me. To what extent it “works” is a topic for another day.
The recent crackdown by Chinese authorities on their largely foreign-listed education and tech companies has caused much chaos among Western investors.
As I hinted last year, the CCP leadership’s vision for China’s future appears to be a sophisticated version of high-tech big-data authoritarianism that advances the interest of the party-state. While “authoritarianism” and “big data” are the inherent political and demographic characteristics of China, “high tech” is, to a great extent, an imported good. Given that foreign investment and know-how in technology are still relatively scarce, it is indeed puzzling to see the PRC killing the goose that lays the golden eggs at such an early stage of its “technology struggle,” to the point where it appeared to be helping its adversaries in achieving their goals.
Unless “we must have missed something”—as the “conventional wisdom” goes when it comes to the “mysterious ancient nation that reads Sun Tzu and plays Go”—
They must have been playing 4D chess, or for that matter, Go, as the saying goes… https://t.co/CahdMz14ci
So is China playing Go? I don’t know. What I do know is that an enormous bet is being placed: if successful, it could make George Orwell blush for his lack of imagination, but if it goes south, one can only hope that things would end up peacefully.
