Offshore investors who have become enamored of the illusion of economic growth and political stability in China may want to recalibrate the reality gauge in 2019.

The western view of China’s political economy is driven partly by anecdote, partly by accepting Beijing’s propaganda/economic data as fact. Foreign investors have convinced themselves that the Chinese Communist Party (CCP) is superior in terms of economic management, this despite ample evidence to the contrary, thus accepting the official view is easy but also increasingly risky.

In a December 15 speech, Renmin University’s Xiang Songzuo warned that Chinese stock market conditions resemble those during the 1929 Wall Street Crash. He also suggested that the Chinese economy is actually shrinking. But this apostate view was quickly rejected by legions of captive western economists and investment analysts whose livelihood depends upon “selling China” to credulous foreign audiences.

Facts aside, the perception of China is what matters to global investors, part of a larger pathology of hope-based investment allocation that eschews those rare bits of hard data that disagree with the positive narrative. China growth, Tesla profitability, or the mystical blockchain all require more credulity than ever before.

For example, in the first half of 2016 global capital markets stopped due to fear of a Chinese recession. Credit spreads soared and deal flows disappeared. But was this really a surprise? In fact, the Chinese government had accelerated official stimulus in 2015 and 2016 to counter a possible slowdown and, particularly, ensure a quiet domestic scene as paramount leader Xi Jinping was enshrined into the Chinese constitution.

Today western audiences are again said to be concerned about China’s economy and this concern is justified, but perhaps not for the reasons touted in the financial media. The China Beige Book (CBB) fourth-quarter preview, released December 27, reports that sales volumes, output, domestic and export orders, investment, and hiring fell on a year-over-year and quarter-over-quarter basis. Headed by Leland Miller, CBB is a research service that surveys thousands of companies and bankers on the ground in China every quarter.

Contrary to the positive foreign narrative about “growth” in China, CBB contends that deflation is the bigger threat compared to inflation. “Because of China’s structural problems, deflation has very clearly emerged as the bigger threat in a slowing economy than inflation. Consumer demand has weakened, and you see that reflected in retail and services prices,” CBB Managing Director Shehzad Qazi said in an interview.

In fact the Bank of China has been cutting reserve requirements for Chinese banks since the start of 2018, another example of how long it took for Wall Street to get the joke on China. Of course the real driver of the economic tightness in China is the same as in the United States and Europe, namely the voracious appetite that the U.S. Treasury has for cash. The Federal Open Market Committee talks about interest rates, but the debt issuance of the Treasury is the doggie, the Fed is the tail. And the actions of the Treasury, combined with the runoff of the FOMC’s bond portfolio (aka quantitative tightening or “QT”) is constricting credit markets from Paris all the way to Beijing and back again.

The continuing unwind of the shadowy and likely insolvent Chinese conglomerate HNA is a useful metaphor for the Chinese economy more broadly. Lots of debt, but no visible equity in a corporate organization chart that defies understanding. Offshore holdings in companies or real estate are being liquidated as fast as they were accumulated. During the third quarter of last year, Chinese conglomerates sold off more than $1 billion worth of commercial real estate in the United States, while purchasing only $231 million, according to the Wall Street Journal. The retreat from offshore investments came after restrictions were imposed by the Chinese government on foreign investments.

Because of the slowing internal economy, there is every indication that Xi intends to increase restrictions on offshore holdings, especially those involving debt, to help maximize liquidity at home. What does this suggest? Chinese companies all clear their currency and securities through Bank of China; thus, the Chinese central bank has a comprehensive view of and risk to offshore flows for investments and debt service. A single point of failure: to borrow from the world of enterprise risk. The forced liquidation of HNA and insurer Anbang suggests a degree of urgency to pairing back the huge amounts of debt leverage used by many Chinese companies and the attendant cost of funding these obligations.

HNA, lest we forget, was once touted as a Chinese champion. HNA officials paid for assets, threw lavish events, and pasted the company’s name on the sides of building around the world. That’s a bit flashy. Also, HNA was seen as a savior for Germany’s Deutsche Bank AG, but now the company has begun to unwind its debt financed position in the bank’s common stock. Incredibly, U.S. and EU bank regulators still have no idea as to the true beneficial ownership of HNA.

Meanwhile, HNA also is in talks to sell its Ingram Micro business to Apollo Global. The Chinese conglomerate reportedly seeks $7.5 billion, including debt, for Ingram Micro, one of America's largest distributors of personal computers and electronic equipment. But why did HNA buy Ingram in the first instance? Nobody knows. And virtually everyone on Wall Street, including the credit-rating agencies, was—and is—happy to do business with HNA.

It is telling that China Development Bank (CDB) is leading a team to supervise HNA Group's asset disposals. Watching the liquidation of the HNA Group, you begin to appreciate just how fragile Beijing’s control is over the economy. CDB, of course, is HNA’s biggest creditor, and it in turn is an appendage of the Bank of China. The financial disarray seen among some once high-flying Chinese companies suggests a major turnabout from the years when offshore investments were encouraged.

Western analysts tend to think about China in terms of economic risk, but internal stability may be a more pressing issue—both because of the growing potential for violent change and because western audiences are completely unprepared for this eventuality. These are the key risks facing the Chinese economy: mountains of debt, no real equity leverage in the economy, and a payments system that is entirely focused through the Bank of China.

But the most troubling development are the growing signs that the CCP and paramount leader Xi Jinping feel compelled to take more and more authoritarian measures to retain political control. Credulous western observers talk about the “long term” perspective of the CCP, but in fact this gang of “running dogs,” to borrow the Marxist terminology, is no different than western politicians. The CCP is no more able to manage a complex modern economy than is President Donald Trump. Thomas Sowell argues that American liberals are authoritarians with a human face. China, on the other hand, is brutally and unapologetically authoritarian.

The rise of Xi Jinping to sole power in China is nothing if not a display of massive insecurity and power, starting with the elimination of all rivals and ending with the dissolution of collective leadership. Revelations that Beijing expects to imprison over a million Muslim Uighurs in work camps, a mere 10 percent of the eleven million population of Xinjiang, also suggests a very direct and present fear of instability. But it is difficult to look at China today and not be reminded of some unfortunate historical parallels. Mao Tse-tung wrote in World Marxist Review in 1961:

A potential revolutionary situation exists in any country where the government consistently fails in its obligation to ensure a least a minimally decent standard of life for the great majority of its citizens. If there also exists even the nucleus of a revolutionary party able to supply doctrine and organization, only one ingredient is needed: the instrument for revolutionary action.

Today the revolutionary party is radical Islam, spilling across China’s western and southern borders. The CCP well recognizes the parallels with Chinese history. And it has happened before. Just as the Chinese nationalists and communist forces defeated the Japanese in World War II after decades of cruel occupation by Tokyo’s fascist rulers, the CCP is now in the position of the oppressor and the Islamist “terrorists” are the liberators. No member of the CCP who understands China’s political and military past could fail to be impressed by this parallel.

When Wang Jian, the co-chairman and a co-founder of HNA Group, “accidentally” fell off a wall in Provence, France, he atoned for creating a scheme so gigantically absurd and so heavily leveraged that it actually threatened the CCP. The CCP is happy to tolerate or even encourage wealth creation, but only so long as it does not become a problem. The so-called “spending spree” by HNA was in fact a reply of the exuberant behavior of cash flush Japanese investors in the 1980s, but with lots more debt.

HNA’s $50 billion debt-fueled investment binge was and is still a problem for China in 2019, but it also only illustrates a larger issue of national economic solidity and financial cohesion. Westerners may need to consider the possibility of political change in China driven by economic factors. Historically, political change in China has come from the periphery and moved to the center in Beijing. Communist Party doctrine is especially constructed to forestall such an event, but perhaps financial stress may be a catalyst. Offshore investors who have become enamored of the illusion of economic growth and political stability in China may want to recalibrate the reality gauge in 2019.