Dinny McMahon on China’s Hidden Crisis

Welcome to The Puck, Venture Capital and Beyond, a show that examines the changing landscape of our world. Before we dive in, a quick word about who I am and why we're here. I'm Jim Bier, corporate lawyer and restructuring professional. I've spent the last two decades helping companies navigate their toughest transitions. And about eight years ago, I found myself having fascinating conversations with clients and friends about everything from venture capital to the broader shifts happening in our economy and society.

Those discussions were simply too good, so the puck was born. Now while we started on venture capital, hence the podcast name, the Puck Venture Capital and Beyond, We've naturally evolved to focus more on the and beyond portion of the title. Today, we explore how business intersects with the bigger forces shaping our world. I still run my restructuring practice by day, but now I get to host these conversations by night. It has become one of the most rewarding parts of my life.

Today's guest continues that tradition. The population size is about to drop off a cliff. By some estimates, the size of the Chinese population could drop by half. That is a massive evaporation of a market, which begs the question, how do you continue to grow when the size of your market just keeps shrinking and shrinking? And this is where this vision of productivity led growth comes from.

They're not interested in consumption led growth because that's just about moving the wealth around. Productivity led growth is about creating wealth. And that is why you see this razor focus out of Beijing on spending money on innovation and on industrial upgrading, and those two things kinda go hand in hand in glove. China looks unstoppable from the outside. Record exports, cutting edge EVs, robots replacing workers, but inside under the hood.

A quiet crisis most people aren't talking about. Today on the Puck, I talk with Denny McMahan, a journalist who spent six years at the Wall Street Journal in Beijing, wrote the book called China's Great Wall of Debt and has been watching this economy for over twenty years. What he sees might surprise you. There's a lot to cover, so let's get to it. Denny McMaine, welcome to the puck.

It's great to be here, Jim. So, Denny, for our listeners who may not be as familiar with your work and your background, can you just take a moment and tell us a little about yourself and and kind of how you got interested in the whole history of China and global finance? Yes. So I've been watching China's economy and financial system for a bit over twenty years now. And so I got into it because I I started learning Chinese in in primary in in elementary school, which was my dad's influence back in the day.

You know, he was a mining engineer in Australia. He's traveling around a lot. And, you know, in his experience, he was just coming across more and more Chinese buyers of commodities, and this was back in the eighties. And so he came home one day and was like, you gotta learn Chinese. And and so, yeah, I learned Chinese, you know, through elementary school, through high school, and then studied in China.

And then, I eventually got a job as a financial journalist in China for ten years. You know, started off with a newswire, spent six years at the Wall Street Journal in Beijing covering banks and finance. And then I moved to The United States, wrote a book about China's economy and sort of its its debt problems, kind of a a sort of a a ground up look at China's political economy. I spent a bunch of time at think tanks, and then these days, I I write, you know, China focused econ research for for investors. Wow.

That's a lot to get into, and I I look forward to hearing more about this. So let's set the scene. I mean, many of our listeners remember hearing about China's rise around the turn of the century, but may not understand how the Chinese economy actually evolved. So can you give us a concise twentieth century history lesson on China's economic model and how it set the stage for today? Yeah.

So it kind of bounced bounced around a lot after, you know, the, you know, the the civil war, which kinda came to an end in 1949. I I mean, the real pertinent turning point for the Chinese economy was when Mao Zedong died and Deng Xiaoping took over in 1978 and kind of set China's economy on a completely different track. I mean, during the late twentieth century, we saw sort of this unleashing of private sector forces, originally in the villages and and, agricultural sector, and then in towns where you kind of started to see, you know, manufacturing, sort of spontaneously, you know, pop up. And, sure, there was plenty of state support and whatnot, but the story of China sort of, you know, growing out of sort of the the tumultuous period that was sort of China under under Mao was really a story of unleashing private sector forces. And then that kind of led up to China joining the World Trade Organization and unleashed China's export machine.

But I think really the story of the twenty first century and kind of towards the end of the the nineties as well was less a story of private sector and it's been a lot more state led. Whereas once upon a time, it was about private sector firms moving into manufacturing and, you know, moving into exports and whatnot. Since the late nineties, it's it was really a story about investment, building houses, building infrastructure, and the state has kinda had a really hands on role in that the entire way. Now at the moment, we're at a completely different stage again because in, well, I guess you can say 2021 was the peak of China's housing market and the bubble popped. And so housing, which really had been the driver of China's economic miracle, let's call it, for about twenty, twenty something years, that wasn't driving the train anymore.

And so since 2021, we've kind of seen Beijing looking for a new model, pivoting to something else, and kind of trying to scramble to sort of adapt to, you know, sort of the the financial mess that was kind of left by a system that could no longer support itself by selling it selling more land and generating economic activity by just building more and more housing. So, yeah, we're in a very different moment at the moment, but that's kind of the broad arc from, say, Deng Xiaoping taking over to really when the the pandemic pandemic hit. So when we pivot into kind of discussing how the government is dealing with these challenges, but before we get there, can you help us understand how significant and serious the over indebtedness is and, you know, in where it's most acute whether or not it's with households, corporations, or local governments? Yeah. It's a really interesting question because the the story sort of it keeps shifting.

So when I finished up as a journalist in Beijing in 2015, I was writing a book. I thought it was pretty clear that at some point in the not so distant future, China would have a financial crisis. I mean, the the pace at which debt was accumulating and the sheer degree to which it felt as though China's authorities had lost control of their financial system. I mean, we talk about shadow banking in The United States around the time of the global financial crisis. China had its own version of that through the twenty tens.

And we often look at China from the outside, see it as being communist and state led, and we assume that Beijing controls everything. But that is not the case and it certainly wasn't the case with the financial system during the the the twenty tens. I remember at the time, Beijing was doing every the regulators were doing everything it could that they could to kind of get control over this sort of runaway credit creation by sort of non bank institutions. And they'd roll out regulations to kind of try and roll things in. And I remember talking to a couple of bankers who were working for Chinese state owned banks at the time, the big banks.

And they were saying, oh, yeah. Well, look, we anticipate the changes and then we have a, you know, a couple of plans about how to get around the rules. And then once the changes come out, we just we don't break stride. We just keep doing what we were doing. And that's what was happening.

And so I thought, look, this system can't go on forever. We're gonna have a crisis. And then in about 2016, 2017, there was a real pivot and it was kind of tied to Beijing sort of cracking down on corruption because no longer did the authorities kind of try and change the rules. They tried they they changed the underlying motivation of bankers. So the best way to think of it is this, all of a sudden bankers weren't at risk of violating a rule and getting a slap on the risk.

They were at risk of being hit with corruption charges. And so overnight, you kind of went from this culture of, you know, bankers flouting the spirit of what was being asked of them, but adhering closely to the rules. And that changed to them the the rules not mattering so much, but what was essential is that they adhered to the spirit of what was being asked of them. And so in a very short period of time, around 2017, you saw the government get real control over the shadow banking system. And so those risks sort of, you know, they they managed to bring them under control.

But, of course, at this point, you'd had, you know, the accumulation of debt had just been running away for over for about a decade at this point. And so the problem wasn't getting worse, but you still had to clean up the the residual mess. And I remember talking to a senior Chinese financial regulator, 2013. Right? So the problem was just starting to build at that time, but it was pretty clear that there were more nonperforming loans in the banking system than the authorities were were were acknowledging.

And so I'm like, look. Do you really expect us to believe the official data? Right? I mean, clearly, things are far worse than than what you're saying. And his response was, well, who does it benefit if we publish a a a fair and true accounting?

Because if we came out overnight and and said the nonperforming loans were significantly higher than we had the previous day, and it's like a a true reflection. We come out it's a true reflection of the state of bad bad debts in the financial system. Well, what we'd have to do is close a whole lot of businesses, you know, and that would generate a lot of unemployment. We'd have to, you know, dump a whole lot of nonperforming loans on the you know, into the market, and that would drive down prices and banks would be able to get less residual value out of them. And then we'd have to recapitalize the banks at fire sale prices.

And he's like, well, what's the point of doing any of that? I mean, we'd effectively be bringing upon ourselves the crisis we're trying to avoid. And so what he what he said is the strategy they were pursuing was trading time for space. The idea being, okay, we're not going to acknowledge the extent of the problem now, but what that does is that buys us time to be able to or space to be able to deal with it. And when this guy told me this in 2013, I was like, that's that's all well and good.

You you buy yeah. You're buying space, but you're not doing anything with that space. But then a few years later, starting around '17 2017, they did start using that space. And so for about the last seven, eight years now, we've kind of had this constant drumbeat of reforms in China's financial system where they've been disposing of nonperforming loans, recapitalizing the banks. There's been a huge wave of bank mergers, like, you know, taking the bad banks, pairing them up with better banks.

You've had a lot of high profile criminal charges levelled against, you know, bank chairman and presidents that have kind of, you know, have been doing dodgy dealings. You've had a real sort of cleanup of of the banking system. So on one level, things have got materially better. So they've done everything kind of in their power to avoid there being a financial system. But at the end of the day, you're still dealing with these really elevated levels of debt.

And a lot of the institutions that borrowed are really struggling to pay them back because we had a a property crisis. The market peaked in 2021, and prices have plunged from their former peak. You know, investment levels in the property sector are now at, like, twenty thirteen levels. So they've they've absolutely, you know, crated. And then the other big borrowers were local governments as well.

They borrowed. They built infrastructure. They paid it back with land revenue generated from land sales. But now they can't sell land anymore because the property market's created. So you've got some real borrowing problem.

You know, a lot of the borrowers in the system really are struggling to pay back their debts. And so, you know, the system the authorities have dealt with it a bit. They've cut interest rates and they've restructured debt and all this sort of stuff. But they've managed to avoid a financial crisis because the authorities have prioritized repaying bonds at all costs. Right?

So if you've got bad loans in the banking system, you can kind of hide it a little bit. But bonds, if there's a default, it's kind of out there in the open. And so they've prioritized ensuring that any of these potentially dodgy borrowers, whether it be local governments or property developers, that, you know, you kind of in sort of if if the you kind of quickly restructure or you find the money to pay the debt or you you sort of, you know, do whatever you can to, you know, sort of prevent there sort of being a credit event. So we haven't had a financial crisis, but the thing people don't talk about or don't realize is that there are still very, very serious consequences of this debt kind of crisis bubbling underneath the surface. And it's the same consequences that the EU experienced after the eurozone crisis and Greece experienced.

Because, you know, in The UK, we they didn't really have a fine you know, you didn't have sort of a what what you had wasn't just sort of pressure on the bank. What you had was austerity. Right? And that was the same in Greece. And I don't think what most people realize is that's what you've got in China as well.

Like, local governments are paying off their debts. They have prioritized meeting their interest payments above everything else. But that means that their other obligations are going by the wayside. So whereas in Europe, austerity was top down. Right?

You could look at a national government and see they are imposing austerity policies. In China, it's a bottom up. Right? So it's provinces, it's cities, it's counties that just don't have enough money, and they're imposing austerity policies at a local level. So what that means is the first thing is they're not paying their contractors and suppliers.

So if you've done work for a local government in many parts of the country, you've been waiting on payment for a year, maybe two years. Maybe you've got partial payment. But, you know, the private sector in many parts of the country that that do business with the state are screaming because they haven't seen real money in a long time. On top of that, state employees everywhere have been getting have been subject to pay cuts. And, you know, it's it's interesting in China because even with state employees, bonuses are really important.

People often get a thirteenth month bonus around Chinese New Year. For a lot of people, that completely evaporated. You know, Social Security contributions by the state, you know, you know, state employees just discovered that they're being told, well, we're not going to make contributions for a few years. So that's kind of been happening as well. And then the other sort of manifestation of austerity has been local governments sort of desperate to raise more revenue, have been just arbitrarily imposing fees and fines on households, on the private sector.

They've been going after back taxes. In some cases, those back taxes, unpaid back taxes are real. In some cases, they're imagined. But the reality is there's kind of been this and this sort of local level austerity in China, which is going on today. It is dampening domestic demand.

It has completely destroyed both household and private sector confidence, and there doesn't seem to be any way out of it at the moment. And so, ultimately, that is the consequence of China's massive accumulation of debt over the last few years. And it's something that's typically overlooked because I think everyone was like, at some point, there will be a financial crisis. We didn't end up with a financial crisis, and it doesn't look like we're gonna have one. But instead, this is what we've got, and it's a real drag on China's economy at the moment.

So from a global perspective, what's interesting from what you're saying is that in the same way Japan had a kind of lost period of time because of its overindebtedness, there's different ways that a country's deal with these debt loads. You can inflate out of it. Right? What you're saying is because it's not a democracy and because they don't have to win elections, so to speak, at the national level, they can impose austerity just kinda like what happened during COVID. And in a sense then, like Greece, will China get to the other side of this?

You know, they've kind of and this kind of brings us to what I was sort of hinting at before, you know, my sort of opening comments about China's economic model changing with the collapse of that property market. Right? Because there is an acknowledgment that China cannot grow the way it used to. And one of the the reasons for that is clear that, you know, they invested so much in property over the last twenty years. There was a bubble.

You've got ghost cities. You've got empty apartments in, you know, small cities. Yeah. They things just couldn't keep going the way that they they were going. But the other issue here is that they needed a new growth model because China's population is shrinking.

And so this question about will they end up in Japan, are they going to end up in a deflationary funk? Well, I mean, China has been dealing with effectively deflation for the last three years. Doesn't turn up in CPI consumer prices, although they borderline deflationary. But it does turn up in producer prices, which is, you know, factory gate prices have been deflationary for the last three years. So Beijing is kind of aware that it is sort of flirting with some of the conditions which plague, you know, Japan, but it thinks it's got the solution.

And so its answer to what its new growth model should be is clearly, it can't rely on profit anymore, and it sees the solution as being productivity. Right? It will grow the economy through productivity gains. Now that's kind of interesting because I think there's a a narrative in The US, even in the EU, that when the property market collapsed, and it was always gonna be inevitable at some point, they were over investing. You you could kinda see it from a mile away.

The day was gonna come. But there was this sort of sense that when that happened, the only way China would continue to be able to grow, the only sustainable growth model would be for China to restructure its economy in a way to make it look more like ours, right, where consumption is the engine of growth. It's ordinary households spending money, and that's what creates demand. And so there's always been this story about, you know, China is is gonna it's going any day now. It's gonna restructure.

It's gonna pivot to consumption. And, oh, in some ways, you you listen to Chinese leaders and they talk about the importance of consumption all the time. And so people outside of China go, oh, yeah. They talk this is happening. They're talking about it.

But I think we're kind of talking past each other because to really build a consumption led economy in China, what what you need is large scale wealth redistribution. Right? You've got to take the wealth away from state owned enterprises and China's rich and elite and give it to ordinary households. And the only way you can really do that in a relatively short period of time is with welfare. Problem is the only way China could materially expand welfare spending is with debt at the moment.

I mean, yo, China's fiscal resources, the government's revenue is already at its outer limits. You know, it's been running 3% budget deficits for the last thirty years, I think. Last year, it finally went up to 4%, which was which was a big deal. And that's just the official budget deficit. So if it wants to spend more on welfare, it's just got to borrow and it refuses to fund welfare with debt.

Like, China's leaders say this this at every opportunity. They wanna spend more on welfare, but they're not gonna do it. They will only do it to the extent that the economy can support it. So that's sort of a a nonstarter. And the other issue here is they look at a consumption led economy and they go, that's not gonna fix our problems because they can see the big structural generational issues that they need to deal with over the next ten or twenty years.

And just shuffling money around the economy, taking it from this pocket, putting it into this pocket, it's not going to fix the problem. What they want is wealth creation. And when I talk about the challenges that they're facing, there's two in particular which get a lot of which they're really fixated on. One is this idea that Xi Jinping rolled out in 2021, I think it was, which was common prosperity. The idea that we're going to raise the living standard of the nation, better distribution of wealth.

And the vision here ultimately is the the real idea behind common prosperity is that the Chinese economy or living standards in China, Chinese income level levels will continue to converge with those in The United States and the EU, except it will be more that wealth will be more equitably distributed. Alright. So that's kind of the vision. The other thing that they worry about, the other big challenge is is something economists call the middle income trap. So countries, when they kind of get to China's level of development, they kind of stall out.

You know, rather than continuing to converge with rich countries like The US, they just hit a glass ceiling. And, you know, not all economists believe this is a real thing, but Beijing does. You know? And they've put a lot of research into this, and they're like, okay. This is something we really need to worry about.

And the solution, as they see it, is like, okay. Well, the problem with developing countries is that they use other people's technology in their factories. You know, the products that they make are other people's technology. And as long as you're using someone else's technology, you're paying fees and you're a price taker. Right?

You can you you can only compete with everybody on price. But if you develop your own technology, you get to set the price. You know? If someone else wants to make it, well, you can charge royalties. You know?

And so it's an entirely there's higher profits, there's new revenues, and that's the kind of thing that will allow you to to kind of grow into prosperity. So those are the challenges they they see. And then they also realize that they're trying to do all that in an environment where, one, the population size is about to drop off a cliff. By some estimates, the size of the Chinese population could drop by half by the end of the century. That might be a little bit aggressive, but even if we're looking at 800, 850, even 900,000,000 people, like, if China's population was 900,000,000 people by the end of the year end of the century, that sounds a lot, but that's half a billion people fewer than at the moment.

Now that sort of contraction just means there's fewer people buying stuff. That is a massive evaporation of a market, which begs the question, how do you continue to grow when the size of your market just keeps shrinking and shrinking? And so this that's part of the problem, but that population decline is only really gonna pick up momentum in another decade or so, maybe another two decades. The real problem between now and then is the population is aging. And so what that means is that the state needs to spend a lot more money on health care, and it's got to spend money on pensions.

And at the same time, the tax base, people are actually paying into the tax system, that's getting smaller and smaller. So if you have this vision of common prosperity and a world where everybody's better off, how do you spend more money on an increasing population of retirees, but still ensure that the people that you're taxing are better off even as they pay more on taxes? And this is where this vision of productivity led growth comes from. They're not interested in consumption led growth because that's just about moving the wealth around. Productivity led growth is about creating wealth.

And this kind of comes back to what you were speaking about, Jim. It's like they do have one eye on Japan and the problems of deflation. And they're like, well, look, how do we grow through this problem? And it they they think, look, the only way to grow through the problem is with real growth where the growth is generated by productivity gains. And that is why you see this razor focus out of Beijing on spending money on innovation and on industrial upgrading.

And those two things kind of go hand in hand in glove. I mean, the the innovation is pretty obvious. We've kind of yeah. It's less obvious in The United States, but you travel anywhere else in the world, and Chinese products are just popping up everywhere. I mean, you I I go back to Australia, you know, sort of once a year.

Chinese cars are everywhere, not just, you know, electric vehicles, but traditional internal combustion engine vehicles. They're cheap. They're well designed. They run incredibly well. I mean, if we're talking innovation, the whole sort of battery technology that China's developed is is kind of ahead of anywhere else in the world.

You know, the the digital innovation, like, you know, sort of incorporating, you know, digital services and, you know, new devices into the the cabin of a car, China sort of really pushing ahead with that sort of stuff. You know, but even in terms of, you know, solar battery storage, you know, flying cars, drone logistics, I mean, China is just throwing money at innovation left, right, and center, and it's it's making some real strides. And so that's part of the vision. And then the other side of the vision is that they're actively and aggressively pursuing industrial upgrading. Now what that means is that a lot of industries that would traditionally have left China by now because the cost of labor has just got too expensive, it's staying in China because they're just replacing the workers with the robots and with machinery that they're more innovative engineering companies are sort of developing.

And so you kind of great example is cigarette lighters, for example. Cigarette lighters bounced around the world looking for cheaper markets. Started off in Spain, I think it was, moved to Japan and then Korea and then Guangdong province, and now something like 90% of all cigarette lighters are produced in one town called Shaodong in Hunan province. And about 2010, labor costs started going up. The firms were like, look, we're going to have to move again or move to another country, maybe move further west in China.

And instead, they started replacing workers with machinery. And after sort of six waves of capital upgrading, the number of people employed by Shandong's cigarette lighter, you know, industry has dropped by 95%. Costs have dropped by 85%. And so it's managed to maintain an industry that traditionally, a generation ago, would have already moved to Bangladesh or it would have moved somewhere where there was cheaper labor. But that is kind of what China is trying to do.

It realizes that with a, you know, a declining population and in an environment where they can't rely on the property market to drive growth and they're not willing to rely on consumption to grow to drive growth, This is their way of creating wealth in an environment where all the other forces are sort of pushing against them. So as you outline this, I think what you're reinforcing is that it really has been working in that a trillion dollar surplus when it comes to exports. When you look at their electric cars, when you look at their robots, when you look at the increases in shipbuilding, when you look at electricity manufacturing capability, when you look at what they're doing with AI, I mean, I think people in The United States, in the EU, people are very, very aware that China is kicking their butt in a lot of areas. And I guess the question is, is there any headwinds that are going to slow this up? I know we hear about tariffs, like for instance, we've gotta build a wall against $10,000 e u you know, EV cars that are better than Tesla's.

But is there any constraints on what China's doing? Because it it does seem like they are a juggernaut at this point, and there's nothing that's gonna slow them down. Well, there's two ways to look at it. Alright? There's one way of, like, well, how do you stand in the way of this absolute export machine?

Alright? But there's another question because as you said, I mean, everything I just described looks like China has found the golden ticket. Right? It's worked this thing out. Right?

But the problem is it only looks that way if you're sitting outside of China. Right? For all the reasons you just outlined. Right? $10,000 EVs that are better than Teslas, you know, the the the next wave of humanoid robots, flying cars in The Middle East made in China.

Right? It looks like China you know, the future that we all grew up expecting, you know, what was it Peter Thiel that said we we're expecting flying cars and all we got was a 180, you know, characters. Well, all of a sudden that future that we grew up watching on the Jetsons with humanoid robots and flying cars, China is on the cusp of delivering all that. So we're here looking at China going, oh my god. They're they're eating our lunch.

But if you're in China, it doesn't feel that way. Sure. All the techno everyone's experiencing all the new technology and whatnot. Right? But all that innovation only pays off if it does three things.

Right? First, it's gotta deliver corporate profits. Right? And corporate profits are great. Higher corporate profits are great because that allows firms to pay higher wages.

Right? And that's how people experience economic growth. You know, their life gets better because the economy gets stronger and they're able to earn more than they used to. So you need corporate profit profits. You need higher wages, And those two things together feed into a bigger tax base.

So, you know, a more dynamic economy ends up in the government earning more money, which they can then spend on welfare. They can spend it on pensions. They can spend it on health care. Right? And that's ultimately what Beijing wants out of this model because, you know, it want to to converge with the EU and The United States in terms of living standards, people need to be earning more, and the state needs to be able to provide better services.

And that requires higher incomes and better taxes. The problem is in 2025, it didn't get any of that. So in the first half of the year, despite the fact that the economy was growing at 5% and the export machine was going gangbusters, government revenue from taxes declined, which is absolutely mind blowing because when tax revenue falls, that's what happens in a recession. Right. Right?

That is how the government adapts to a shrinking economy. It just takes in less tax revenue. And yet, everything seemed to be going in China's favor and tax revenue fell. Now for the full year, it was marginally positive. I think it grew by about point 6%, but that was only because China's treasury department freaked out and just started looking for wherever it could find additional tax revenue.

I mean, it started going over after rich people for, like, unpaid taxes on overseas assets. It sort of dropped certain, you know, export exercises here and there, and it look. It did everything it could to kind of extract more tax out of the system without putting more pressure on the economy. Profits. Industrial profits for large firms rose by point 6%, which, again, is in an economy where exports are going crazy and it's clearly producing all these incredibly new products, and yet the industrial sector corporate firms just weren't getting any additional profit growth out of it.

Now incomes in China are a little bit harder to to track, but if you're in China, everybody has a similar story. You know, everyone knows somebody who's taken a pay cut. Everybody is worried about job security. And so, you know, talking about is there anything that stands in the way of this, you know, Chinese industrial juggernaut, well, at the moment, you know, it's not getting any of the benefits it really needs from this system. So in some ways, the world at the moment is in the worst of all possible situations because China is eating everybody's lunch.

I mean, the EU and Japan in particular are kind of looking down the barrel of deindustrialization because China isn't buying as much of their exports before. Chinese firms are competing in their home markets. And then around the rest of the world, I mean, you look at the what what happened to Honda and Toyota last year in Southeast Asia. I mean, they've had a they've they've had those markets locked down for twenty years, maybe even longer. But, you know, they were seeing their sales in places like Thailand and Indonesia drop 18% last year, and these economies were growing strongly.

And it's because Chinese firms are competing aggressively in the rest of the world, and any advanced economy is kind of looking down the barrel of what's increasingly being called China Shop two point o. So the rest of the world is look looking at the fallout of, you know, China's, you know, aggressive innovation industrial expansion. And yet at the same time, China's not really experiencing any of the benefits that it should from this sort of thing. So is that gonna change? China is pursuing what it's calling an anti involution campaign.

It's it's a fancy word for saying that they're cracking down on industrial overcapacity. The thing is they haven't really made many strides in that direction that they they sort of, you know, slowed down investment in additional investment in manufacturing and heavy industry last year, but they haven't started closing down factories, at least not to the extent that I can see. So there is a realization that the state of affairs of, you know, rapid manufacturing expansion without profits, without taxes, without incomes is just not income growth. It's just not sustainable. But, you know, just how they're gonna kind of come out the other side of this is a is a bit of an open question at the moment.

So because they have strict controls over their population and they're not subject to the same democratic pressures that the West has. They may be able to manage this for a long period of time with with austerity. And so let's assume for sake of argument that they don't have a major social upheaval and that they continue on this pathway. When you look at the closed nature of Chinese society versus The United States, even even when you look at Japan's closed nature of its society versus The United States, I I believe at least, you know, people are still coming to The United States from all over the world for education and for creativity. I mean, people like Elon Musk came to America.

I mean, I would think over time, China is gonna have certain challenges in terms of its ability to have greater productivity to the extent that they aren't more of an open society, that that does kind of constrain creativity and so forth. So on the one hand, because they can manage their population, I can see this going on for a long period of time with this amazing automation and AI revolution that the world's going through. But how does that square with being a closed society, a little xenophobic, and and, you know, being seen as a bully in certain quarters? Yeah. I'm not sure, but I I think we're kind of in uncertain and untested territory at the moment because China has turned out to be far more innovative than we would have ever given it credit for.

So I remember I forget which presidential election it was that Carly Fiorina was running for president, and she had this famous quote. It was along the lines of, you know, the Chinese can take a test, but they can't innovate. I mean, that's a slight paraphrasing, but it's not far off. And that was only a handful of presidential cycles ago. And these days, no one would accuse the Chinese of not being able to innovate.

I mean, you go there at the moment and, you know, the the the electric cars everywhere. The the payment system is far beyond anything in The United States. You know, WeChat as a sort of a Swiss army knife of apps is far more convenient to use than sort of sort of the the the hodgepodge of various applications we have on our phones. China has been innovating aggressively in a whole lot of different ways. And we talk we I I think we still have this sense of, like, yeah, but they can't how can they keep innovating?

Can they can kind of squeeze out productivity? And I think that's kind of based on the idea that most of the innovation coming out of China is entirely and purely state driven. That is all a function of of subsidies. And, I mean, don't get me wrong. I mean, the state throws subsidies at industries that it deems important.

But that's not the only thing going on because it doesn't pick winners in the same way as I think we've all kind of grown up understanding industrial policy to be. It's not like in sort of Malaysia where that state decided to build a a car company and that car company was was deemed the champion and that they were going to support it. That's not how China builds industries. What they do is they provide subsidies for the foundational technology, and then they try not to pick individual firms as winners. Right?

They provide a supportive regulatory and research environment, and then they just let the firms loose. And the degree of competition going on in Chinese markets in new products is absolutely cutthroat. It is so intense. I mean, this is not my area, but you do hear people who who are entrepreneurs and involved in manufacturing in The US, and they go over to China and they are sort of blown away by the degree. Just how cutthroat the competition in new industries, whether it be vehicles or drones or whatever, actually is.

And so that is kind of where a lot of the the the innovation and the productivity comes from. It is firms, you know, they're sure that the state has created a supportive environment, but then they are let loose to compete against each other. And, you know, the competition isn't quite the way that you know, it isn't as necessarily as free as it would be, say, you know, in The United States because a lot of firms might have effectively a sugar daddy in the form of some local government backing them. So you look at China's auto sector at the moment. I mean, a few years ago, you had, what, two, three, 400 auto companies.

Now I think we're down to a 100. Some of those of, you know, maybe even 80 at this point. Some of those should have gone out of business a while ago, but they've had life breathed into them repeatedly by some local government, which has injected more equity or they found a partner or something like that. And so this sort of degree of this intense competition with too much capacity goes on longer than it should. The the market doesn't shake out as quickly as it would if it was purely free market.

But at the same time, the the competition that's going on between China's automakers at the moment is pushing innovation really aggressively, and and you see that in all sorts of industries. So, yeah, it's a very different ecosystem. And as I said, we were kind of in our tested to, you know, territory because you're right. It is not open in the same way as The United States is. But I think what China is been increasingly good at doing is going, okay.

We can't do things and we refuse to do things in the same way as The United States. So how can we try and get the same outcomes by trying to, you know, take the essence of what The US has, the stuff that's really important, but still and then work with that within the context of our own confines. And they've been doing that in other areas as well. I think we're seeing something like that in the stock market at the moment. So I I think it it's that's their approach.

And as I said, it's untested. Let's see how sustainable it is. But we're certainly seeing innovation out of China these days, and I I don't think we can kind of write it off. Well, so I wanna push back on that a little, but I also then wanna switch to kinda talking about currencies and what they're planning to do in terms of, you know, dedollarization and so forth. But here here's what I wanna push back on innovation.

It may be a, you know, a a difference without a a distinction in that. They are taking our technology like EVs, and they're taking our technology like AI, and they're taking our technology like COVID vaccines. And there's no question they're innovating it and improving it and changing it. But the notion of creation ex nihilo, like, you know, Steve Jobs coming up with, you know, an idea for a completely different type of computer. The, you know, the Elon Musk figuring out how to make rockets that can land themselves.

I don't I don't see Japan or China having the creativity that comes out of the West, and they're good at taking what we have and then improving it. And I think that's an amazing skill. Don't get me wrong. But one of the things that I think we get in an open society where you have cultures and people from all walks of life coming together is that you do have a certain unique creativity that I think is unique to the West. You know, that is I mean, you nailed it, Jim.

That is the question du jour. Right? Because all these innovations we're looking at at China at the moment where they've been so successful, incremental innovations on technologies developed elsewhere. You know? It doesn't take away from the amount of work and blood, you know, blood, sweat, and tears the Chinese have put into it, but they're standing on the shoulders of giants.

Yes. Now the question is, can they build their own giants? Yes. And that is I mean, we're gonna find that out in the next five to ten years, I think. Absolutely.

And that and and listen, that's why I think everyone is so existentially afraid of AI right now because there is this notion, like, in the same way we had the race to develop the atomic bomb, and the West was really in this existential race against Germany originally and then the Soviet Union. I I think there's no question that the the military industrial complex, the the deep state, whatever you wanna call it, is is now locked in an existential battle to see who can innovate faster with AI because he who wins the race, at least there's the theory, rules the world. And so I think in the next five or ten years, we're gonna see if there is one who who wins if there's a winner, or is it gonna be ubiquitous where, you know, again, with nuclear weapons, everybody got them. So it was kind of a nuclear stalemate. So I I think we're living in a really fascinating period where, as you said, we're we're gonna see.

The AI thing is really interesting because I think, certainly, when it comes to military and national part power, you're spot on. But I think when it comes to commercial AI, the race between China and The US, it's not really a race because don't get me wrong. Everybody is throwing a huge amount of resources into AI and they're trying to develop it as fast as possible. But a race suggests that they're both on the same track and they're running towards the same finish line. Whereas the Chinese are trying to get something very different out of AI than The United States is.

So the big US firms in The US, they're looking for, you know, general AI. Right. They're looking for the, you know, the God app or whatever. In China, they're not trying to replicate that. That's not the goal.

Whether there's kind of a deep seated ideological issue there that the Chinese Communist Party is wary of having of having a a superior intelligence sort of that potentially could sort of sit above the party. That's a little bit outside of my pay grade. But the other issue here is that the the Chinese aren't striving for that sort of endpoint. What they're trying to do now is incrementally develop AI in a way that they can immediately insert into their manufacturing and industrial complex. Right.

And so it is very much focused on the actual physical applications of AI in this their industrial you know, in industry now and how much that can help extract additional value, dominance, productivity gains. I think that's kind of the real difference between what's happening in China, in the AI space, and in The United States. Completely agree. And I think it's one of the terrifying things because if America doesn't have its own manufacturing base and whether or not that's based on Central And South America or however it does it, the notion that, you know, China can build a 100 ships for every one we build, or it can build a thousand robots for every one that we build, or a thousand drones for every one that we build. You know, when you when you look at World War one and World War two, when you look at America's ability to build airplanes and the industrialization that took place, we were able to hold our own.

And in a in a new world where China dominates manufacturing to the extent that it does, if there is conflict, it can be very, very treacherous. Yeah. Absolutely. No. I I think I think you got it.

So let's let's switch now a little and talk about currencies. Not an area of my expertise, but my understanding is the dollar is down some. We we know that gold's gone up a lot. But, you know, at the end of the day, my understanding is China does not have a floating currency in the same way The US does. What is going on with China's currency, and how is that gonna play out in global politics over the next ten years?

So when it comes to China's currency, there's there's a bunch of different debates. It's like, is it is it properly valued, you know, in a country that's running a 1,000,000,000,000 trade surplus? I mean, the idea that China that the renminbi is anywhere near fairly valued is is kind of moot. I mean, so it's like, well, what where should the renminbi actually be because it, you know, it feels like it's chronically undervalued at this point. But then the bigger issue here is the one that you were just talking about then, which is, well, what should we expect of China's currency relative to the dollar in a world of dedollarization?

And, certainly, China has been pushing renminbi, you know, so China's currency goes by a bunch of names. It's the yuan. It's the renminbi. I'll use them interchangeably. But, you know, the they've been pushing renminbi internationalization since, I think, 2009.

And probably for the first decade of that, maybe a little bit longer, it really didn't make any headway whatsoever. But these days, I think Beijing, their their tone has changed over the last twelve months. They think that they are in a unique position to promote renminbi internationalization. It's a opportunity they really have never had because the world is gradually falling out of love with the the dollar. And so up until this point, every incremental gain the renminbi has had internationally, every small step forward it's managed to make in terms of convincing some global constituency to buy more renminbi assets or to use the renminbi more in trade.

Every incremental gain that it's made on that front, it's kinda had to claw. Right? It's had to sort of, you know, it's been hard fought every inch of the way. And now I think there's a perception in Beijing that it doesn't have to kind of fight for it in the same way. All it's got to do is gradually continue to liberalize its capital controls and its currency regime much in the same way that it's been doing over the last few years, and the benefits will just roll to it because people are kind of looking for a way to diversify away from the US dollar and hedge against potential US dollar risks.

Now often when we're talking when people talk about the renminbi, they're like, well, you know, clearly, China eventually wants to take over from the dollar, or it wants to be a rival to the dollar. Or maybe if we're talking more conservatively, maybe one day it could kind of be, you know, an equivalent to the euro. I think what the the euro counts for maybe a quarter, 30% of all global trade transactions or, you know, maybe it's 30% of the, you know, central bank reserves or something like that. May maybe one day the renminbi could could do that. And at the moment, we're talking single digits.

It's like four or 5% of global trade or something is is in renminbi. But, ultimately, China doesn't want any of that. I mean, China's goal for the currency is a little bit more pragmatic. Ultimately, to the its its motivations behind remember internationalization have changed over time. I mean, originally, when China's central bank was pushing this back in 2009, it was really about kind of having a bit of a Trojan horse to promote domestic financial reforms.

So they kind of pitched it to the powers that be in Beijing. It's like, hey. This thing internationalization would be great for the reputation and prestige of China. And they were kind of using that as a way of, like, okay. Well, if we're trying to get this prestige, then we need to do these domestic reforms as well.

That's how it started off. These days, it's about something very different. Ultimately, renminbi internationalization is about insurance. It is about Beijing being sufficiently confident that if The US weaponizes The US Dollar against China, that it won't affect China's economy in the in the way that it did with Russia. Alright.

So Russia invades Ukraine, The US, EU, and other allies get together, say you can't use the dollar, you can't use the euro, and that clearly had significant effects on the on the, Russian economy because it made it incredibly difficult for Russia to trade with anybody. Because if you're selling something to the Russians, you don't wanna get paid in rubles. But any of the currencies that you do wanna get paid in, the Russians aren't allowed to use. So, you know, you're kind of, you know, caught in this sort of catch 22 situation. And so China wants to be in a position that if The US and the EU and other US allies turn around one day and go, you cannot use our currency, the Chinese will go, okay, we'll just use renminbi.

And peep their trade China's trading partners will go like, well, we don't really like the renminbi that much, but at the end of the day, it's not that bad. You know, we've kind of used it in small amounts before and if we hold it well, China's capital markets are more open and we can, you know, invest them in the stock market. And, you know, okay. It kinda makes sense. Sure.

It's not as easy to use as a dollar. Sure. It's not as cheap to use as a dollar. But at the end of the day, it's not really that bad. It's not like using rubles.

So I think that's kind of what China is aiming for, that they wanna get China's currency to a point that if The US weaponizes the global currency regime, the global foreign exchange regime against it, that it's effectively a a toothless tiger, that it is a weapon without impact because it has set up a global payments regime. It has set up a a track record of the renminbi being used increasingly. It is put in in place the financial infrastructure to ensure that there are sufficient sufficient volume of renminbi distributed globally so that can be used as a as as a unit of payment. So, you know, put all that stuff in place. So if the day comes, I can't use dollars anymore, it just doesn't matter.

So this isn't about renminbi becoming a global rival to the dollar or even taking over the dollar. Beijing looks at the cost that has come to The United States of having the global currency, and they're like, yeah, we we we don't want that. You know, we're we're we're more than happy to sort of you know, we don't want the exorbitant privilege. We don't want to kind of be the global unit of exchange. All we want is for our own trade to be able to trade in renminbi, which will reduce our costs and allow us a degree of independence and insurance against the weaponization of the global currency raisin global foreign exchange regime.

So I I have some follow-up questions, but I'm I'm curious. What do they see as the downside of having a world currency? In other words, what negative sides did the do they see The US has by having the fiat currency and the dollar in the position that it's in? You know, I think it's like the sheer scale of currency that needs to be generated for other countries to transact in it as their currency of choice. I mean, for, like, India to trade with, you know, Saudi Arabia and use dollars, I mean, it means that there's a huge supply of dollars sitting in bank accounts around the world over which the Federal Reserve has little to no control over.

Right. I mean, the whole euro dollar market in The US is it it sorry. In you know, outside of US borders kinda has a life of its own Absolutely. That yeah. And then The US has always struggled to be able to determine just how big it is, how it's being used to control the rates.

And at the end of the day, we're looking at a, you know, a a Leninist party in charge of Beijing in charge of China, which is very pro control of all key aspects of its economy. And to think that it would have to, you know, lose control over such or relinquish a certain degree of control over such an important lever of macroeconomic management is something that I think that I'm sure would kind of, you know, keep them up at night. When you look at the progress that they've made or or lack thereof with respect to having their currency more widely accepted, I mean, is there is there any strategy or talk about backing it with gold or a way of kind of having a, people seeing it as a more secure currency? And and, again, having the stock market so there's places people then can reinvest the money. What is China's strategy to actually build up this faith in their currency?

Yeah. The gold question is interesting, but it is well beyond my grasp. I mean, the the PBOC, the People's Bank of China, has been buying gold, you know, month on month for a long time now. So it's clearly it sees some value in it. There's also China, I think, is the biggest gold producer in the world, and yet the accounting for exactly where that gold goes, I think, is a little bit hazy.

So, yeah, China clearly has certain feelings about gold, you know, the Chinese state, but I don't really know where that fits into the big picture. When we're talking about the currency, I haven't really seen any intelligent you know, any sort of meaningful statement either from the government or government advisers or any of that sort of, like, you know, state adjacent research sort of ecosystem talking about the importance of of gold to the currency. If anything, what they're more focused on is what you were saying about the stock market, that ultimately what they want to do is create renminbi denominated assets that are readily accessible to foreign investors and are appealing to foreign investors. And so that is, of course, government bonds, but, of course, that's not they're not so appealing at the moment because the interest rates are just so low. But the stock market is is definitely something.

I mean, we're seeing really significant reforms in the Chinese stock market over the last two years, which is really oriented towards, you know, rebuilding investor trust in the institution in institution in, you know, in a way that has never really existed before, you know, institutionalizing regular dividends. So regardless of of rising stock, whether prices rise or not, that that, you know, listed companies still generate real returns. There's been a push to kind of have a greater role for pension funds and insurance funds to invest in the market, you know. And all of this is is first and foremost driven by domestic considerations. They see the stock market as being increasingly important for funding tech innovation.

They see it as important for creating a a new motor for generating middle class wealth to replace the property sector. They see it as important because you've got this rapidly aging population. People need to be able to generate better returns from their retirement savings. So it's first and foremost, it's a domestic thing, but it's also a currency thing because Beijing has been liberalizing the access of foreign investors to the domestic bond market, to the interbank market, to the stock market, to the commodities markets, to the derivatives markets. There's been a real steady drumbeat over the last few years.

They're not throwing the doors open, but they have massively liberalized the amount of money that can flow in and out of the country into all of these markets and building trust in the stock market and making it more stable and supporting longer term returns. As I said, it's mostly about domestic considerations, but they do have one eye on foreign investors and the currency because they're like, well, look, if we can, you know, convince foreigners to invest in the stock market, that provides, you know, an under another underlying source of it provides a new source of of confidence and trust and faith in the Chinese currency. So as we come to the end here, Denny, I I do have one last question, which is the rule of law. When I did business in China in the late nineteen nineties, and I read their contracts and I was involved in doing business there, it was very clear to me that there was an unwritten rule that you had to take care of the local mayor, that it didn't matter what the contract said. It was it would say two plus two is four, and then it would say two plus two is five.

I mean, it was they were written inconsistently. There was no real rule of law in the way The United States has where people can rely on a contract. Has that changed dramatically? And if it has, great. If it hasn't, isn't that a constraint on their ability to do more international business long term?

You know, things have certainly improved since the nineteen nineties, but you still listen to private Chinese private sector firms, and they still think they're getting the short end of the stick. You know, they see they're being fundamentally almost a dual system for how the state treats state firms versus private firms and that there isn't a level playing field and there's the application of laws and rules can always be very subjective. So, yeah, it's not ideal. They are constantly talking about trying to support entrepreneurs and level the playing field and create a more supportive environment, but they've been talking about this for years and years and years, and yet it always remains a problem. So what does that mean in the long term?

I really don't know. But to the best of my knowledge, things are definitely better than the nineties, but they're still not where either they should be or even what the central government says they they'd like it to be. So, yeah, it's, it's it's definitely still a problem. So this has been wonderful. I think this has been great.

And we could talk about it forever. It's gonna be I think it's gonna be a really interesting five or ten years. And, you know, the the the thing that candidly terrifies me about the West is our aging population and the welfare state and the inability of politicians to make the tough decisions on how we're gonna quote ration health care, for instance, whereas China doesn't have that problem. And and I think, you know, they've got different challenges. But if the West doesn't figure out how to deal with the fact that seven out of 10 Americans want their taxes to go down and seven out of 10 Americans want their health care to go up, it it just it's unworkable.

And you look at how we're struggling. And, again, China's had all this indebtedness to catch up to the West. But if they can keep their population less addicted to social programs in the in the West, We have a real challenge here. Yeah. Well, like, I hear you, but even if China doesn't expand its spending on welfare, I mean, just the way the demographics are moving against them, I mean, the cost is going to go up even if they're not improving the standard.

I mean, I you know, I I look at them and I'm like, I it's a similar it's a similar but different problem. I'm like, I'm not sure how they're going to thread this needle either. Yeah. Well, Denny, thank you so much for joining us today. It was a terrific conversation.

I learned a lot and we really look forward to kind of seeing how the next few years play out. Fantastic. Thanks for having me, Jim. Okay. The POC Venture Capital Beyond is produced by CMVG Advisors.

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