2010 and Beyond - China

Strategic Update

On February 14th, as China prepared to welcome in the Chinese New Year, their Year of the Tiger, Chinese Premier Wen Jiabao warned of the challenges that lay ahead in 2010. Key points from his address include:

• In 2010, China will face a more complicated situation, both at home and abroad.

• People must keep a sober mind and an enhanced sense of anxiety about lagging behind.

• Priority should be given to persistence in taking economic development as the central task; forcefully promoting reform and opening up; and doing a better job responding to the global financial crisis in order to keep steady and relatively fast economic development.

These are indeed the challenges that lay ahead for the Chinese leadership as they look into 2010 and beyond to the appointment of a new Chinese President in 2012.

China’s Challenge in the Global Economic Crisis

While the world looked to the stability of the Chinese economy to help maintain the recovery efforts from a global financial meltdown, cracks began to appear in the veneer of China’s economic health.

China’s dramatic growth rates in the years since 1980 cannot maintain themselves in perpetuity. In fact, the notable growth during China’s period of economic liberalization is based upon the same economic model that raised and then dropped the economies of Japan in 1990 and other East Asian countries in 1997.

The lesson learned from the Asian crises of the 1990s was that economies could not maintain stellar growth without maintaining free capital markets to ride out economic storms. Countries can manage capital to keep costs artificially low, giving them an advantage over countries where capital is rationally priced. However, the strains of the market will eventually catch up. China has begun to feel those strains.

The Chinese government has been able to capture nearly all of China’s government, corporate, and personal savings. According to one study completed for the International Monetary Fund in January, the savings rate in China currently hovers around 50% of GDP. This enormous reserve capital is funneled into state banks to state-linked firms at below-market rates. Businesses are created with essentially free loans from the savings of nearly a billion workers.

This scheme works on a mass production scale – create businesses with cheap money to hire people to produce products for export. Everyone is happy until the customer is no longer available. Then the back end of the production line runs into a wall and the economic model begins to fracture.

For China, this problem moves from one of pure economics to one of keeping the central government in control. Social stability becomes the primary focus when work is not available for the Chinese people. In times of social instability, the diversity between China’s 1.3 billion people becomes more pronounced. China’s large urban centers are located in the coastal regions where some 600 million citizens live on an average of $7 per day; while 700 million farmers and laborers reside in the inland rural regions and live on an average of $2 per day.

Finding a solution to their current predicament is paramount to the Chinese central government to keep China from following the same path as Japan and the other East Asian countries.

China, the U.S., and Bretton Woods

To keep their current economic system afloat, China needs an endless demand for the products it is producing. The United States provided that demand until the 2008 financial crisis. In fact, the global recession reduced Chinese exports by nearly one fifth and there is no one picking up the slack. Additionally, financial reports coming out of China show they now fear the demand for exports will not make a sustainable return to previous levels until 2012.

The outlook may be worse than China expects; and they may not be able to depend upon the United States as their future “consumer of choice.” Under President Barack Obama, the U.S. is considering fundamental changes to the Bretton Woods arrangements as outlined in the National Export Initiative (NEI). Presumably, the NEI was intended to update the global financial system and reduce the chances of future financial crises. For China, it means a new trade expectation.

The Bretton Woods Agreement was created in the aftermath of World War II when Germany and Japan had been defeated and most of Western Europe lay destitute. Essentially, a portion of Bretton Woods laid out an agreement between the United States and the Western allies stating the allies would be able to export at near-duty-free rates to the U.S. market to boost their economies. In return, the U.S. would be granted wide latitude in determining the security and foreign policy stances of the rebuilding states.

The plan was so successful in the rebuilding processes it was extended to Germany and Japan. Eventually, as the Cold War progressed between Russia and the U.S., this trade policy proved militarily and economically advantageous to the U.S. and was extended to Korea, Singapore, Taiwan, and others—including China.

It was this open door to the U.S. market that is uniquely responsible for China’s economic success in the last thirty years. As part of Bretton Woods, U.S. markets were opened and its “protectionist policies” were discarded. The Chinese were allowed to produce whatever they wanted and they had a willing supply of consumers to sell to.

However, Obama’s NEI plan calls for U.S. exports to double within five years, specifically by targeting additional sales to large “developing” states, of which China is at the top of the list. Tensions in this regard have already begun to surface, as the World Trade Organization (WTO) is reviewing U.S.-China trade disputes on tires, steel products, poultry, Chinese tariffs on raw materials exports, and product quality and safety.

The shift in tone in U.S. trade policy is being felt as the U.S. plans to compete with the rest of the world in exports. How China will respond will most likely be determined by the administration of China’s incoming president in 2012.

New President, New Perspective

Chinese President Hu Jintao took office eight years ago with an ambitious plan to close the wealth gap and economic growth between the rural interior regions and the coastal cities. To bridge this gap, Hu and his supporters have pursued a multi-phased plan. The first step was to rein in the most independent coastal areas of burgeoning influence—Shanghai in particular. The second step was to consolidate redundancies in China’s economy and shift light- and low-skilled industry inland. By increasing wages in the key coastal export manufacturing areas, reduced competitiveness would drive industry westward.

Hu’s overall economic policy was an attempt to re-centralize economic control and allow the central government to weed out redundancies in industry. His goal was to create a more balanced economy that emphasized domestic consumption over exports. The road to Hu’s “harmonious society” has not been smooth and its successes have been limited at best.

With only two years left in his term as President, Hu is now looking to his legacy as he weighs the risks and rewards between promoting long-term economic sustainability or short-term economic survival. Waiting in the wings is Hu’s successor, Xi Jinping (preappointed by Hu’s predecessor Jiang Zemin).

Vice President Xi does not support Hu’s economic centralization plan. Instead, he favors returning to the model of regionalized semi-independence and strong coastal growth. Xi and his supporters assume a strong coastalled economy will provide more immediate rewards for themselves and strengthen China’s international position and its national defense.

While the end goals of both Hu and Xi are to maintain a strong central government and build a strong China, their avenues to get there are completely different. With social pressures rising amid economic uncertainties, managing the transition to new leadership may not be smooth. The consensus regarding the upcoming change in leadership is: the only thing that is certain about the next two years is that nothing is certain.

China, Iran, and Israel

In the meantime, China faces growing resistance to its policy of controlling the value of its currency, the yuan or renminbi (RMB). Just one day after being appointed to the People’s Bank of China (China’s central bank), Li Daokui said China would adjust its exchange rate on its “own initiative” before September—hinting the increased pressure is related to mid-term elections in the U.S.

However, President Barack Obama met with China’s new ambassador to the United States and called for a “positive relationship” with China, only alluding to the underlying economic strains by saying the two countries would work together on sustainable and balanced global economic growth.

Behind the scenes, Obama was lobbying for China’s support for increased sanctions against Iran for its unabated continuance of its nuclear program. The sudden change in tone regarding China’s currency policies caused speculation of Obama negotiating U.S. economic patience for Iranian hardball.

U.S. Treasury Secretary Timothy Geithner added fuel to the speculations when he announced he would postpone the scheduled April 15th report to Congress on the international economic and exchange rate policies of our major trading partners. His anticipated report would have labeled China as “currency manipulators” and some members of Congress were ready to push political and legal actions against them.

Instead, Geithner announced:

There are a series of very important high-level meetings over the next three months that will be critical to bringing about policies that will help create a stronger, more sustainable, and more balanced global economy. Those meetings include a G-20 [Group of 20] Finance Ministers and Central Bank Governors meeting in Washington later this month [April], the Strategic and Economic Dialogue (S&ED) with China in May, and the G-20 Finance Ministers and Leaders meetings in June. I believe these meetings are the best avenue for advancing U.S. interests at this time.

Similar meetings held in 2009 did not significantly change China’s economic policies. Given the current mood in China, whatever changes are instituted will most likely occur very slowly. While he denied it repeatedly, Geithner did not quell the suspicions that his delayed report was tied directly to the appearance of China’s President Hu at Obama’s Nuclear Security Summit in which the Iranian nuclear threat is a hot topic.

Israel also made a political move that was intended to sway China’s cooperation with Obama’s push for Iranian sanctions. In March, Major-General Amos Yadlin, head of Israeli military intelligence, was sent to Beijing with the latest information about Iran’s progress toward testing nuclear warheads, enriching uranium, and adopting their Shahab missiles to carry nuclear warheads. In what was described as an “incredibly rare” move, China then sent a general to Tel Aviv to inspect the Israeli Air Force’s strike capabilities.

The result thus far is that China appears to be leaning toward Iranian sanctions. However, those negotiations are only nods, smiles, and handshakes at this point in time. Hu may simply be stalling for time on economic issues.

Future Options for China and the U.S.

The global economic crisis exposed the inefficiencies of China’s export-dependent economic model. The government had to pump money into a major investment stimulus package to make up for the net drain from the export sector.

Most of the investment came from bank loans that need to be repaid. If China succumbs to U.S. pressure and tries to slow economic growth by allowing its currency valuation to rise, the risk of companies defaulting on their loans increases. The domino effect then threatens to burst China’s current real estate bubble which further compounds failure of related industry sectors. All of this could trigger massive social uprising, which is not an option in the eyes of the central government.

Should the U.S. continue pressuring for monetary policy change, China’s logical recourse would be to stop purchasing U.S. government debt. Dumping the debt outright could not be done without a monumental loss to China because every seller requires a buyer—not always an easy find for U.S. debt these days.

While the threat of continued U.S. debt support may sound ominous, it may simply be just that—a threat. The Chinese currency reserves exist because China does not want to invest all of its income in itself. Their underdeveloped capital markets cannot absorb that size investment. Additionally, the debt purchases fuel the U.S. consumers’ ability to buy Chinese products. From the U.S. perspective, if China shut the door to excessive U.S. debt, it may force the U.S. administration to balance its budget, however painful that might be.

China is watching U.S. preparations for mid-term elections in 2010 closely. Their concern is that the current “mood” will make Chinese trade issues the campaign target, further stirring contentions between the two countries. Presidential administrations and possible change in policies also loom large in 2012 as Obama faces re-election and Hu’s successor takes the reins.

Chinese Premier Wen Jiabao’s warnings sounded dire in his address to the Chinese people in anticipation of their New Year celebrations. However, given the current state of uncertainties in China, his advice was well-founded. While we will be updating the status of global events throughout the year, this concludes the 2010 and Beyond series.