China's Development: Assessing the Implications (2003+)

CPDS Home Contact Structural Incompatibility Puts Global Growth at Risk   Are East Asian Economic Models Sustainable?   Babes in the Asian Woods  Beyond 'The China Choice' Reading China's Mind?   Comments on Australia's Strategic Edge in 2030  Friction between China and Japan: The End of the Asian 'Century'?   Competing Thought Cultures   Factors Affecting China's Future: A Brief Overview  'Art of War' Speculations about North Korea's Threats   The Dali Lama's Search for Moral Wisdom  Parting the Bamboo Curtain ... A Bit  The End of the 'Asian Century' Seems to be Coming into View   China's Reform Map Unclear   China as a Dominant Power    Debunking One Myth about the Chinese Economy  The Problem is Financial, Not Currency, Manipulation
Introduction +

Attachment: Debating the Chinese State


China has been achieving an impressive rate of development of its economy and increase in its regional / global economic and political influence. There has been speculation about its future potential to act as a major driver of the global economy, and whether its methods will provide the model that others will now seek to emulate.

In relation to this, the present document will suggest that:

  • China's accomplishments have been remarkable over the past 2-3 decades, especially when considered in the light of its history;
  • acting as an 'engine' of the global economy would be impossible unless China fundamentally changes its primarily mercantilist goals. Economic progress has been viewed mainly as a means for increasing national power. The economic methods which have underpinned its recent progress have involved unproductive use of capital and protecting financial institutions with bad balance sheets by maintaining a current account surplus (both in China and in many of its economic 'tributaries');
  • cultural features affect China's aspirations and ability to achieve an economic transformation;
  • if China were to be the pacesetter for the future of the world, this would be a world founded on practices that are incompatible with the principles that Western societies have sought in influencing the international order in recent centuries (eg individualism, individual freedom, a rule of law, increasing citizen's welfare as the goal of economic growth, coordination of economic activities through financial outcomes, democracy, and universal ethics which value all people rather than a particular group);
  • China's rapid export / investment driven growth is likely to prove to be a 'bubble' because of its: state-driven economy reliant on administrative methods for managing economic and financial outcomes; dependence on exports and on others' ability to productively use its financial 'waste'; exposed banking institutions; environmental stresses; fast aging population; and unstable political climate;
  • changes in the international environment resulting from the global financial crisis imply that economic models like that China's rapid growth relies upon have passed their 'use by' date. Thus China's leaders, having no market-oriented way to further increase their power, may turn to assertive nationalism as an alternative though suggestions about fundamental reforms also emerge from time to time..
History and Accomplishments

China's History and Recent Accomplishments

China has achieved spectacular recent progress in the face of immense difficulties.

Some History

China has the longest continuous national history (something like 4000 years) and was politically, militarily and economically dominant in its region (and also globally significant) for most of that period.

For much of that period, this was based on a system of imperial regimes - administered by Confucian bureaucracies who sought wisdom from a study of the past.  This seems to have been based on views about the nature of knowledge, society, power, economic goals and governance that are quite different to those of Western societies (see East Asia).

In overly-simplistic terms China was apparently held together through cultural conformity (backed by force) [1]. 'Harmony' and learning were idealized under Confucian traditions and achieved through a form of centralized soft-power ('thought control'). Under the examinations system the Emperor (the 'chief examiner') determined which of the best students the education system produced he favoured to control administration, and the bureaucracy then exerted state power primarily by guiding the way ordinary people understood the world. 

China's traditional regimes seemed incapable of coping with the more decentralized initiative and empirical (ie does it actually work?) knowledge of European powers during the latter's period of economic, military and political expansion from the 15th to the 19th centuries.

In 1911, China emerged from its feudal order - and then experienced decades of instability. It was governed to 1949 mainly by the Nationalist Party in the face of conflict with: imperialist warlords; Communists (at times); and expansionist Japan. The Nationalists favoured building China on the basis of traditional values and Confucian administration but were forced out in 1949 by the Communists led by Mao Zedong - who favoured breaking down the traditional social order, abandoning some of China's cultural traditions and adoption of a Marxian version of Western methods. Mao's 'cultural revolution' then largely deprived the country of its traditional Confucian intellectual capital (and made initiative impossible for ordinary people) - resulting in widespread suffering and economic setbacks.

Recent Progress

It was only after the liberalization reforms and a neo-Confucian cultural counter-revolution in the late 1970s (under Deng Xiaoping initially and possibly / probably with assistance from Japan and the factions aligned with the former Nationalist Party), that China made appreciable progress.

A View of Confucian Revival

By the time of the Beijing Olympics in 2008 China had been been transformed from a sporting also-ran to the most powerful sporting nation. Beijing was found to be efficient - but to lack unfettered internet access, freedom of speech, concessions to human rights. The media concluded that China was hopelessly oppressive. But others (eg John Harms and Gerard Weatley) suggested that few understand China, and most tend to view the world through notions of Western superiority. There is no concept of what China has been over its long history. Harms' views are informed by Dr Gao Jia (Melbourne University) who hoped that the Beijing Olympics would mare a turning point for China from the trauma of the Opium Wars. Gao sensed the revival of Confucianism ('He') in the 1990s. The Olympics opening ceremony features the artistic expression of children painting (symbolic of the Confucian tradition). Confucian revivalism comes from the top (eg Li Ruihuan and Jiang Zemin). President Hu Jiantoa has sanctioned the return to Confucianism. Zhang Yimou, ceremonial master of One World One Dream would have required Hu's approval. Western journalists would not understand the subtlety. The political elites has used proxies such as 'Li' and Renmin University in Beijing (a centre of learning on Confucianism, which is now openly advancing its research on Confucius legacy).  'He' translates into gentle / mild kind; being harmonious and on good terms. From this derives the notion of peace / being on good terms. The world has too long seen imperial dominance. Confucian China will rid the world of a confrontationist approach to international affairs (Boey K., 'Confucius lost in the fireworks', Online Opinion, 17/9/08)

See also Competing Thought Cultures (2012); A Simple View of Confucianism and Communism Versus Confucianism: The Continuing Contest in China .

Massive external (manufacturing) investment was first attracted based on education and cheap skilled labour, while equally massive internal investment has more recently been mobilized in modern infrastructure and urban (including consumer) facilities especially in major cities. Despite China's intense population pressure, there was no shortage of land as traditional uses were simply demolished to make way - and existing residents apparently compensated with an apartment and better job prospects (though this process frequently generates dissatisfaction [1]). In China all land belongs to the state, and occupants only own the structures erected on it.

A key feature of China's rapid growth is seen to have been its ability to reform its economy very quickly to become more efficient [1]. Techniques that encourage and support policy initiative within hierarchies have been developed [1].

In China's recent progress it is possible to see lessons learned from (a) Singapore's experience in building a modern 'Chinese' city with foreign investment (b) Japan's neo-Confucian 'industry policy' methods and disregard of Western financial disciplines (c) the Nationalist Party's preferred cultural alternative to Mao's version of Communism and (d) Taiwan's adoption of some US techniques. China seems to be attempting to implement a system of socio-political economy that has been little studied and probably can't be understood in terms of Western analogies or cultural assumptions (for reasons like those outlined in Structural Obstacles).

The short-term result has been an unprecedented and impressive rate and magnitude of gains in China's real economy [1, 2, 3, 4, 5, 6, 7, 8, 9], and a perception that it has excellent future prospects - even recognizing that it suffers structural defects [1, 2, 3]. Moreover some analysts have recently seen China as a 'safe haven' for investors concerns about a US asset bubble, and the structural problems facing Japan and Europe [1].

It is also argued that that China is playing, and will continue to play, a key role in promoting regional and global collaboration [1, 2].  It is seen to be challenging Japan's status in Asia, and to be the only country able to sustain a view of the world which is different to that of the US [1].

China has also been seen as a rising power that will force others to adjust because of factors such as: its huge human resources and markets; the emergence of a high class education system; and the external resources of Greater China which will provide the skills to allow its structural problems to be overcome [1]. A China-centred 'Confucian Union', similar to the EU, has been speculated for Asia [1]. 

China-led Asia has been seen to be returning to its historical role at the centre of affairs - which has had a huge impact on the global economic system similar to the long rise of Europe (and its American offshoot) to pre-eminence 500 years ago. [1] Its emergence has (as also in the case of India) been suggested to be simply a restoration of the position which had existed for most of recorded human history [1, 2]. The take-off by these two poor countries which account for 1/3 human population will make a huge difference to the global (and especially Australia's) economy. [1]

China has shifted from a unilateral stance in opposition to global institutions to working (often with great effectiveness) within those institutions [1]. A 'Chinese consensus' has been suggested to be a better alternative to the (so called) 'Washington consensus' (free societies and free markets) for developing economies [1].   The 'Beijing consensus' is seen to be characterized by putting political stability and development before (democratic / human rights) reforms [1].

Some have even argued that China is 'the future of the world' [1] - undergoing a rapid developmental process, building infrastructure and industrial capabilities that will put it into a position of immense power in 20 years - and replace the US as the world's dominant power by 2050 [1].  It has been suggested also that China's role as an economic engine shows that the 'Asian century' has already arrived [1]. 

China is seen to have features which are quite different to earlier challenges to the US's 20th century global dominance (eg Soviet Union, Japan) and to have the potential to create a future Asia-centred economic regime which others including the US can either be part of, or be excluded from [1].

A popular image now seems to be presented within China of a trendy, super-modern consumer society that will eventually be able to satisfy every material desire.

Though there are obvious environmental and political problems behind this image and China's model for socio-political economy may prove financially / economically un-sustainable, China's leaders present a confident face to the world and to Chinese people.

Economic Engine?

China as the 'Engine' of the Global Economy

It has long been speculated that (because of accumulated debts) the United States is losing its ability to provide a strong source of demand and by doing so to support the growth of the global economy.

This is considered in Structural Incompatibility puts Global Growth at Risk, which also argues that the US current account deficits party have an external source (ie an unsustainable potential deficit in global demand now exists because of the way in which the monetary and financial systems of major East Asian economies are managed - a deficit which the US has temporarily filled by creation of credit and foreign borrowings).

It has been argued for years that East Asia, China in particular, must in future provide the demand to sustain growth in the global economy [1, 2 3,  4]. 

In relation to this, it is noted that:

  • a massive infrastructure development program (perhaps equivalent to the US New Deal in the 1930s) was undertaken in China to stimulate domestic demand in the face of the 1998 Asian financial crisis and the bursting of the dot-com' bubble in 2001 [1]. While this couldn't be sustained indefinitely, public spending could be eased as foreign investment drives growth [1];
  • China's emphasis on export-driven growth was described as self-defeating [1]. Similarly its continued growth was seen to be at risk unless domestic demand (which contributed only 26% of its overall growth) increased  [1]. After decades of export driven growth, China's next stage in development will be driven by consumer demand [1];
  • domestic demand has, in fact, been increasing in East Asia - and led investors to be more positive about the region's prospects [1];
  • China has been seen to be already playing the role of an 'economic engine' - as its trade growth has stimulated and stabilized growth elsewhere (especially in Asia) [1, 2, 3, 4, 5, 6, 7]. In particular the World Trade Organization supports such a view [1];

Furthermore the World Bank has outlined a process whereby East Asia might shift to the next stage in development (ie based on innovation) - a shift which amongst other things requires boosting demand [1]. And China has ambitions as a global leader in innovation and defining technological standards [1]

However a counter view has been that:

  • current levels of consumption in Asia are too low for this to be globally significant - so Europe will have to fill this role when US becomes incapable of doing so [1].  Poor Asia-wide outlook for demand growth has likewise been seen as a critical constraint [1];
  • China's growth has been very highly dependent on US demand growth [1];
  • 41% of China's GDP was being derived from exports in 2004 - up from 26% in 1996 [1];
  • China's domestic demand growth seems mainly to be due to massive investments in infrastructure and urban facilities by state institutions - which have been generating bad debts in the banking system [1];
  • China's investment driven growth has been too fast to be sustainable [1, 2, 3] - and a substantial economic slowdown is likely due to overcapacity [1];
  • the expectation that Asian demand could could take over from the US in driving global growth seems already to have lost credibility [1];
  • China's potential as a consumer is likely to be limited because rapid population aging (related to the one child policy) will make it 'old' before it becomes 'rich' [1].

Furthermore, despite the gains which China has achieved from opening to external market influences, there appear to be significant  political influences still favouring a closed, state-driven economic system [1]. Also China has reportedly decided to:

  • abandon its 'growth at all costs' strategy in favour of reducing internal inequalities [1, 2]; and
  • significantly slow investment and growth to avoid economic overheating [1] - an action that was needed not only in 2004 but again in 2007 [1].

More will be said about the latter (and its difficulties) below.

It has seemed that China's ability to act as a regional or global economic 'engine' depends on a strong US economy to provide export demand and on massive domestic capital spending which is ultimately likely to be unsustainable.

In 2004 there was also an expectation that Japan would be able to take the role of driving global growth because of its expansionary macro-policies [1] - a hope that clearly was not realised.

In 2007 global financial instability (which initiated in the US) was accompanied by expectations that 'decoupling' of the global economy from that of the US (with growth driven in future by emerging economies especially China - and also India) would allow strong global growth to continue [1].  However:

  • though China's dependence on exports to the US might be reducing, there are much more complex requirements for real decoupling, the most important of which relates to success in the 'symbolic' economy rather than to outcomes in the 'real' economy (see Decoupling: A New Urgency); and
  • the most likely consequence of any failure by US financial institutions would be a  failure of China's economic model (see China: Victor or Victim?)

By 2009, financial instability had translated into a global financial crisis and an economic crisis , and (as noted below) this seemed likely to have closed off market-oriented options for continuing China's economic growth and thereby increasing it's power.

Cultural / Financial Issues

Cultural and Financial System Considerations

Despite the emergence of growing consumer demand [1, 2], It seems culturally implausible that East Asia generally (or China in particular) will ever be more motivated or capable than Japan has been to develop a sufficiently strong economy to provide a primary source of support for either domestic or global demand. 

Societies in East Asia whose cultural traditions have historically been heavily influenced by China (as many have) tend have a quite different economic goals to Western societies.

An attempt to describe these critically important characteristics is presented in Competing Civilizations. This refers to a tightly linked package of traditions founded on intellectual styles quite different to those of Western societies which are the basis of economic systems which are communitarian and mercantilist (ie oriented towards building the strength of an ethnic community - and its social elites in particular [1]) rather than oriented towards earning a return on investor capital by satisfying the demands of individuals as consumers. The power-building (rather than consumer-welfare) goal of economic activities is closely linked with the fact that (because of diverse other cultural assumptions) social 'harmony' depends on the ability of elites to suppress dissent.

The way in which these characteristics have been developed in the case of Japan's more highly unified political and economic systems are explicitly outlined in Why Japan cannot deregulate its financial system.

These characteristics could be changed. However doing so would require a very long time. Thus it may be wishful thinking to expect that economically-dynamic East Asian societies might be able to quickly shift from a mercantilist focus on increasing the power of ethnic communities and their social elites to being consumer oriented (a focus which results in an unbalanced emphasis on economic production - as seems to be the case in continental Europe also for different reasons and to a much lesser degree).  

A broadly-based consumer economy might be economically advantageous in East Asia - but it would: subject the economy to the discipline of market / consumer demands rather than of nationalistic elites; and undermine the social, economic and political order (which has been based on communitarian interpersonal obligations rather than earning income).

However the most critical practical constraint on China's ability to support global demand growth involves the 'skeletons in its financial closet' which arise from its economic traditions. As noted  in Competing Civilizations, characteristics of East Asian business models tend to include:

  • an orientation to maximizing 'real' production rather than return on capital (eg to emphasize market share rather than profitability) - which thus generates financial losses in the banking system;
  • a preference for coordinating economic outcomes through social relationships rather than through financial outcomes (ie doing business depends on 'guanxi' (connections) rather than financial calculations). Moreover there seems to be no Chinese word for 'unprofitable' [1];
  • a heavy reliance on financing business through debt rather than equity (which results in only a limited 'buffer' being available in the event of economic shocks)

This model creates a predisposition towards financial crisis (as shown by Japan's stagnation in the 1990s and the 1997 Asian financial crisis).  In China's case the problem is compounded by its large and loss making state industries, and by the high levels of state-driven economic growth [1].

It used to be generally recognized that capital has been used very wastefully in China [1]. And, despite efforts to improve the situation and claims of success, the problem remained (see below).

The assumption that wasteful use of capital is a residual effect of socialist history (ie that banks fund state-owned institutions who can usually ignore profits) is an oversimplification - see Structural Incompatibility Puts Global Growth at Risk. The reality is likely to be that the banking system directs funds to well-connected projects - a category in which state industries are merely an example. Firms who are not well connected have to pay black-market interest rates [1].

The IMF has argued that China's pile-up of foreign exchange earnings reflects deep structural problems - as these lead to overinvestment, overcapacity and falling prices. [1]

Moreover where profitability is not seen as important, the economic system can only be stable if the financial system is isolated from the international financial system by holding large foreign reserves (and by strict regulation in Japan's case). Confucius' instruction to become rich by saving and avoid consumption [1] provided a means of protecting financial institutions with dubious balance sheets.

China was stable through the 1997 Asian financial crisis (despite the dubious balance sheets of its financial institutions) not because of its fixed exchange rates against the US [1], but because financial institutions were able to draw capital from China's foreign exchange reserves [1], rather than having to establish a sound international credit rating.   The same was not true of 'Asia' as a whole - which had run a current account deficit in the early 1990s, and many countries could not protect their unsound financial institutions.

China shifted into current account deficit as its economy transitioned from its solely export-driven growth phase. Furthermore by late 2004, the growth of exports (which had built up the foreign reserve buffer for China's financial system) was slowing rapidly [1].

Moreover, while foreign exchange reserves may offer protection against a financial shock in the short term, they can be of little long term value because drawing down such reserves to cover a current account deficit that had emerged would reduce the ability of other countries to purchase China's exports, and thus further increase that deficit.

Before (say) China could increase demand enough to act as a real 'engine' of the global economy:

  • it would have to increase domestic demand to the point where it has a substantial current account deficit which would steadily erode its accumulated foreign reserves; and thus
  • the balance sheets of its financial institutions would have to be sound enough to be able to borrow in international capital markets - which must be impossible if the basic mechanisms of its economic / enterprise management remain biased against achieving positive financial outcomes. 

In reality, despite efforts that have been made at reform, China appears to be at more risk of suffering a financial dislocation than it does of curing the balance sheet problems facing its institutions and driving global growth.

China's reported shift in early 2006 towards boosting consumption (rather than exports) to drive growth [1] (and the weakness of US demand associated with its 2007 financial problems) would seem likely to eventually expose China's 'skeletons'.

Looking Ahead: By 2011, little progress had been made in boosting economic reliance on domestic consumption (because the global financial crisis, which was partly a result of demand deficits in economies such as China's, had forced China to rely heavily on construction and perhaps contributed to a property bubble) - see China as a Bubble. Though ever increasing commitment to reform has been announced progress seems to face significant constraints (After the GFC especially Change Driven by China's Rising Generation and Heading for a Crash?)

Future of the World?

China as the 'Future of the World'?

An even more ambitious view has been that China is 'the future of the world', and will be the world's dominant power by 2050 - a view which parallels 1980s' expectations about Japan. Moreover a case can still be made, from the viewpoint of Asia's nationalists, that Western economic and military strength must decline.

An address by China's president Hu Jintao to Australia's parliament in October 2003 laid out what may be seen as the high-minded and constructive principles which China would support in continuing its rise. It gained many very favourable reactions [1, 2, 3, 4].

Outline: President Hu's address raised critically important issues about the future of international relationships - and did so in a generous way in relation to the specific situation of China and Australia. Amongst the significant issues raised were:

  • China's long term awareness of, and interest in Australia - and its strategic approach to developing relationships;
  • future international relationships should be based on:
    • putting aside differences, and building on points of agreement (ie respect);
    • economic complementarities - bringing in capital and know-how to exploit mutual comparative advantages;
    • cultural interchange - drawing upon the strength's of others;
    • security built on mutual trust, cooperation and equality - involving democracy in international relations (especially multilateralism through UN and Security Council)
  • China has:
    • promoted domestic democracy, rights, freedoms and a rule of law; 
    • a large stable market - which has complementarities to Australia;
    • managed the relationship amongst many different ethnic groups, benefited from interchange with the wider world and recognizes Australia's multiple cultural origins;
    • has a sound relationship with Australia - and shares an interest in regional stability and opposing terrorism;
    • an irresolvable intent to incorporate Taiwan;
  • Australia was (in effect) offered an opportunity to seek a respected status in the 'Asian' region under the patronage of China's rulers.

The address was also significant as an expression of China's recognition that humanity faces severe challenges - to which force of arms is not a viable solution (see also Risks in a Clash with Islamist Extremists, and The Second Failure of Globalization?).

However there are unstated aspects of this proposal that also need to be considered. These include: China's radically different approach to universal values and human rights; the practical consequence of cultural differences (including the unfamiliar character of China's 'market' economy); and China's efforts to re-establish its historical dominance in Asia (perhaps now including Australia?) through behind-the-scenes influence over individuals and organizations who may not understand the broader implications.

For example:

  • President Hu presented one traditional Chinese approach to the relationship between cultures. He argued for putting aside points of disagreement, and concentrating on practical (commercial) gains. This reflects (not just pragmatism but) a traditional perception that all beliefs merely reflect the particular history and circumstances of a community and that the Western goal of seeking universal 'truths' or values has been foolish. This approach (which is adopted because differences in beliefs are seen as the main cause of conflict) has advantages in promoting harmony and creates opportunities for 'learning by doing'. It also reflects the undoubted fact that all cultures have strengths. However the assumption also has disadvantages, as:
    • culture appears to be the principal determinant of peoples' ability to be materially successful (see Competing Civilizations) - and very few cultural traditions provide the necessary environment for the reliable production of goods and services, and for economic change (see Towards a Comparative Study on Development Policies: Indonesia and Australia). There are serious constraints on one's ability to help disadvantaged peoples if the effect of cultural assumptions is disregarded;
    • the search for 'truth' can also confer social and political advantages (see Competing Civilizations). For example:
      • one can not value the welfare of all people (which has been the Australian ideal) and simultaneously treat all cultural traditions as equal, because there are many cultures in which social inequalities are intrinsic;
      • where there is no search for public 'truth' there is no basis for contesting the opinions of the powerful, so autocratic government is unavoidable (as is traditional in East Asia and as has recently been recognized to be an unwanted side-effect of the spread of 'post-modern' assumptions in Western humanities faculties). And in turn autocratic government both:
        • increases the risk of disharmony through abuses of power; and
        • is seen as essential to promote harmony by suppressing dissent;
      • where there is no 'public truth' there can be no egalitarian culture (another Australian ideal) because hierarchy is vital to hold a society together.
  • the differences in cultural assumptions (which President Hu suggested putting aside to concentrate on commercial benefits [1]) have significant implications [1, 2]. For example:
    • a social, political and governance order has traditionally been supported in China which involves: prescriptive rules for interpersonal relationships; a particularistic rather than a universalist set of ethics (ie one that only values those with whom one has a direct relationship); consequent acceptance of racism as natural (and a ruthlessness towards weak outsiders); a rule of man (especially of bureaucratic elites who are the real power behind nominal rulers such as emperors, presidents or elected officials) rather than a rule of law; and a concept of human rights which values community, but not individuals; 
    • the (so called) 'Beijing consensus' about socio-economic development places emphasis on political stability before development and (democratic / human rights) reforms.  [1];
    • the preference for government by Man, or virtue, rather than by law is based on Confucius' view of a major weakness of the rule of law (Little R. The Confucian Renaissance). The Analects stated: "Lead the people by laws and regulate them by penalties and the people will try to keep out of jail but will have no sense of shame. Lead the people by virtue and restrain them by the rules of decorum, and the people will have a sense of shame and moreover, will become good". The problem with this view is that:
      • those who purport to lead others by virtue suffer human failings. Moreover the moment 'virtue' is accepted as the basis for unquestioned power, every thug and power-seeker will put on a virtuous 'face' - whilst remaining a thug or power-seeker;  
      • like legalism, virtuous leadership only creates the appearance of becoming good while others are watching - rather than affecting a person's inner being. Thick Face, Black Heart (Chu C.) discussed the consequences in terms of a willingness (behind an impenetrable 'face') to accept the necessity to do evil. The acceptance of organized crime as a element part of society reflects acceptance of the necessity to do evil. It was probably no coincidence that Japan's organized crime gangs (Yakuza) instigated the Meiji restoration to modernize Japan to resist Western influence, as a rule of law would have transformed them most specifically from 'respected' citizens into outlaws; 
      • Confucius did not recognize the revolution in the concept of a rule of law Jesus of Nazareth introduced when he prescribed adherence to the spirit (rather than the letter) of Jewish law through an internally-driven 'put-others-first' ethical ideal (see Competing Civilizations). Without this a simple rule of law must, as Confucius said, be morally inadequate (eg as illustrated by the social dysfunctions that have accompanied the widespread abandonment of that ideal in Australia);
    • China's democracy is to be subservient to the rule of the intellectual elites who make up the neo-Confucian bureaucracy (ie the so-called 'Communist' Party) - a fact which needs to be considered while noting the dysfunctions sometimes associated (a) with immature democracy and (b) with autocracy. In practice democracy has been repressed more than developed [1, 2], and proposals for creation of mechanisms which would reduce elite power are difficult to implement [1].  [One observer in Beijing suggested to the author that it is the People's Liberation Army which still ultimately holds power];
  • China's economy is not a 'socialist market' system as such words would be understood in the West - because China's 'socialism' involves: the elites comprising the most-educated (rather than collectives of ordinary people or their elected representatives) making consensual judgments about what is best for the community; and the 'market' involves networks created and managed by those elites. This arrangement:
    • is a market (rather than a planned) economy, but it is certainly not free;
    • involves corporatism (ie economic dominance by state-linked organisations) rather than capitalism (where economic control resides with those who seek profits and are independent of the state);
    • is best viewed as a neo-Confucian system - involving autocratic rule by highly educated elites even though those elites are organized under the label of a 'Communist' Party.  The 'neo' element involved the introduction of Daoist concepts about the nature of knowledge (which has links with Shinto and provided the base for learning from others as the way of achieving change) to the tradition of learning strategy mainly from the study of history - the traditional Confucian assumption which had led China to centuries of stagnation (See Transforming the Tortoise);
    • involves mercantilist goals of increasing the power of an ethnic community (and its social elites in particular [1]), because (as noted above) various cultural assumptions create a situation in which social harmony can only be assured where elites are strong enough to suppress dissent;
    • is revealed in practical terms in China's approach to support for nation building in SE Asia, which involves establishing economic capabilities and relationships with limited concern about financial outcomes [1];
    • has been described as a Confucian 'worker caste system' which is a future better alternative to the 'merchant caste system' in which capital has been the source of power. It is seen as superior because it would be run by bureaucrats / technocrats whose productivity 'merchants / capitalists' otherwise constrain  [1]; 
    • has been described as the basis for a 'Chinese consensus' about a better way of achieving economic development than the (so called) 'Washington consensus' in an analysis which entirely ignored China's poor financial institutions [1];
    • seems to have resulted in possibly the world's most unequal distribution of wealth [1] because elites have taken advantage of their positions to enrich themselves and their families [1];
    • can be viewed favourably despite the associated censorship and authoritarianism - eg on the basis of lives of ordinary people and the concern for their welfare demonstrated by authorities  [1]
  • a case for the universal relevance of Confucian traditions has been made (see The Abduction of Modernity). However as noted in comments on that article, there are aspects of that model which others need to consider. For example, Western societies are seen to be 'barbarians' because their development of advanced weapons allowed common folk to equal their aristocratic superiors;
  • China's perceived economic success leaves its elites with no pressure to transform eventually from its authoritarian political model to some form of democracy [1];
  • the market opportunities that seem to exist may well be a mirage (see below) - unless (a) the global economic system changes to a 'social market' model under which economic transactions are coordinated by relationships amongst neo-Confucian elites, and financial outcomes are treated as unimportant and (b) such an alternative system is found to be sustainable.  In this case, Australia's economic and financial system would need to be re-built from the ground up on a 'Asian' model;
  • China's Diaspora have reputedly gained significant behind-the-scenes political influence in many nations in SE Asia (eg see Seagrave S 'Lords of the Rim') - a fact which has led to friction (and even conflict at times).  The extension of those networks might constitute one of the 'strategic' elements in the development of China's relationship with Australia. In other words the 'strategic' element in the development of China's relationship with Australia is likely to involve Australians in influential positions becoming directly or indirectly dependent on patronage (eg in terms of providing information / contacts) on Chinese elites:
    • Australian leaders who are subject to such influence could be expected to have good Chinese connections and also perhaps exhibit 'Confucian' characteristics, such as: (a) intellectual elitism (and perhaps an effort to enmesh politically with intellectual elites [1]); (b) a focus on history; (c) seeking moral authority by quoting respected ancient sages (eg Christ in Australia's case); (d) an autocratic approach to using power; (e) valuing society above individuals; and (f) a concern for concrete / material (rather than abstract / spiritual) outcomes;
    • it has emerged that a Chinese businessman (Chau Chak Wing) has been the largest source of donations to political parties in Australia and has developed close and supportive relationships with aspiring Australian political leaders [1];
    • the wife of an ALP backbencher (with good connection to China and Australia's PM) established a land development company with land holding in Queensland just before a Chinese company (a subsidiary of state-owned Chinalco) announced an intention to make a $2bn investment nearby [1] ;
    • a journalist alleged in 2009 that there might be something 'fishy' about the support that 'China Inc' seemed to be providing to ALP MPs in Queensland [1]
    • in 2013 it was claimed that the political department of China's PLA conducts systematic programs to influence / deceive foreign leaders:

Tony Blair gave a feel good speech in Beijing in which he declared himself an old friend of China and expounded on how a wealthier China would ensure a society with more love and care, But his speech was hosted by front organisations for the department of the PLA that runs psychological warfare and covert influence operations against foreign leaders. This illustrates the scale and ambition of China's influence-peddling - and its willingness to deceive top decision makers in government and business to achieve its ends. Blair's host was the China Association for International Friendly Contact which Chinese-language military documents show is a tool of the general political department of the PLA and functions as a deception operation [1]

  • China has been seen to be re-establishing its ancient 'tributary' system as the basis for renewed imperial dominance of the region [1];
  • the rapid development of China's military capabilities - and its need to defend its resource supply chains - require a comprehensive reconsideration of Australia's planning  [1];
  • recognition needs to be given to the unfamiliar characteristics of East Asian 'Art of War' strategies;
  • negotiations with China about a Free Trade Agreement can not be straight forward, eg
    • Australia is entering FTA negotiations with China without understanding China's negotiating methods [1]
    • China's traditional method of dealing with conflict involves psychological weakening of perceived enemies rather than over use of force [1];
    • amongst the conditions associated with closer economic collaboration with China by Australia were:
      • applying a 'free market' label to China's economy [1] - which seems simply not true [1]  . though not all agree [1]. Ultimately such a concession had to be made simply to get negotiations started [1]
      • managed resources trade between Australia and China (ie limiting price rises, locking out China's competitors for Australia's resources) [1]. [To some extent this would transform Australia into a Chinese 'colony']
      • making concessions to 'dumping' [1];
      • acceptance of its territorial claims in Taiwan [1];
      • ignoring its dubious human rights record [1, 2];
      • making no public comment on China's human rights record [1]; and
      • suppression of political dissent [1, 2];
    • diplomatic pressure has been applied to Australia to:
      • ignore Australia's ANZUS Agreement with the US in relation to Taiwan [1];
      • suppress Falon Gong demonstrations in Australia [1] - whose significance is speculated below;
      • support China politically [1]
    • Australia has had great difficulty in dealing with application for political asylum from a Chinese diplomat - because China is a regional hegemon which defies the rules of liberal democracies [1]
    • It has been suggested that China is seeking to use economic power to force Australia to give ground on security and human rights issues [1]
    • Australia will not gain from China an agreement that economic outcomes should be determined by ability to compete. Such concessions from China would only be obtainable through the WTO which is being sidelined [1]
    • there is a critical question about whether contracts should be enforceable [1]
    • concessions in relation to upstream investment would be a condition of contracts for resources [1]
    • intrinsic difficulties in developing closer relationships with China include: its command economy (which results in wastage of resources);  governance by China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party) which allowed large scale corruption); its lack of legal infrastructure to underpin a market economy; lack of transparent codified laws [1];
    • the key issues in Australia's foreign policy environment are that China is now the gatekeeper on Australia's relationships with Asia - and is also preparing for a war with Taiwan. [1]

The suggestion that the 'Beijing consensus' (which emphasizes social / political stability enforced by autocratic elites) would be an alternative to the 'Washington consensus' (which emphasizes liberty) as the basis for a model of socioeconomic development is undoubtedly valid. However both suffer from the limitation that they can not be extended globally without transmission of the cultural characteristics which are required for them to work.

The Western model (typified by the 'Washington consensus') requires (for example) individual liberty as an essential feature because it is at the level of individuals that rationality / abstract analysis can be most effective in making economic decisions.

Similarly the 'Beijing consensus' is contingent on specific cultural features, in particular "the ancient Chinese philosophical outlook that makes little distinction between theory and practice" [1]. This is essential for the model to work, because where economic theory is separated from practice, theory oversimplifies reality (because of the huge complexity of economic reality) and thus results in poor decisions. This is the foundation of the neo-liberal view of economics - which is embodied in the 'Washington consensus' and ultimately based on Hayek's recognition that it is impossible for any central authority to assemble the information required for correct economic decisions (see 'The Use of Knowledge in Society', 1945). When there is little distinction between theory and practice (ie where elites encourage decision making by practitioners, rather than themselves making decisions on the basis of abstract analysis), this difficulty can be reduced. However in countries which lack this cultural feature, attempts by authoritarian elites to guide development must result in economic and political failure.

Outside East Asia, adoption of the 'Beijing consensus' would (as for the 'Washington consensus') only be successful if the cultural foundations on which it is based were also adopted by others;

[Note: see also Future of the World: Again? in relation to the situation in the international environment created by the GFC)

Bubble? +


China as an Economic Bubble?

As noted above, no one should doubt the spectacular progress which China has achieved in the face of immense difficulties, or the creativity and effort which that progress reflects.

But, tragically, rather than regional and global leadership in economic and political affairs, the more probable outcome is that China's future prospects will be limited by its economic, financial, environmental, demographic and political challenges.

The possibility that rapid growth could be disrupted due to economic overheating was recognised in 2004. Efforts to avert this (and seriously deal with other constraints) were redoubled, but may have been inadequate.

Global financial instability in 2007 added to China's risks despite official confidence in its invulnerability. It also made the possibility of real 'decoupling' of emerging economies (especially China's) from economic conditions in US a matter of considerable global economic importance (see Decoupling: A New Urgency - which addresses in particular the apparent dependence of East Asian economic models on strong financial institutions in other countries, eg US).

It has been the present writer's suspicion that China's rapid progress can not be sustained though when and why the economic 'bubble' would burst was unpredictable.


Economic Constraints

The Chinese economy appears to work on neo-Confucian dynamics which are a different version of the (supposedly 'non-capitalist market' economy) that Japan practiced.  Government influence is strong in all aspects of society, and this arrangement is perceived by elites to be as it should be [1].

In particular China retains a 'state-driven' economy and has experienced highly unbalanced development. For example:

  • many sectors (eg agriculture, mining, basic manufacturing) remained backward in the 'growth at all costs' emphasis on infrastructure and foreign 'high tech' investment [1] - and as this imbalance is recognized and the most obvious backward sectors / regions are addressed, new backward sectors must emerge if the economy remains state-driven;
  • serious infrastructural deficiencies have emerged [1]. Energy industries have been developed on the basis of national self-sufficiency rather than market requirements [1]. Huge losses were incurred (related to poor corporate governance) when state enterprises engaged in futures trading [1, 2]. Fuel shortages have emerged because local oil prices were not allowed to rise when global prices increased [1].
  • growth has been export dependent - because a current account surplus has been needed to protect financial institutions from the need to borrow internationally - as the latter would lead to a financial crisis because of their poor balance sheets (see above);
  • growth is overwhelmingly driven by investment, rather than consumer demand [1]. Investment has mainly been by state institutions (eg in infrastructure) and foreign investors. The former have been adding to bad debts in the banking system (see below). Very high rates of industrial investment could have created an overcapacity which could have a deflationary impact [1]. Most of that capacity has been created on the basis of expected:
    • strong export demand [1]. In practice this can not be maintained unless the growth of demand elsewhere allows the US current account deficit to be reduced. And there does not appear to be anywhere else for that demand to arise (see Structural incompatibility puts global growth at risk). Moreover, in late 2007 financial / economic difficulties facing the US economy seemed likely to reduce consumer demand for China's exports (see Financial Market Instability: Two Sides of the Story).
    • domestic consumption - which is constrained (for reasons outlined above);
  • there have been major changes in the structure of China's growth since 2000. Corporate profits were 20% of GDP in 2002 but had increased to 30% by 2007 through state manipulation (ie artificially cheap land, allowing profit reinvestment, stalling financial reforms to limit investment choices, preference for state-owned enterprises, rewarding officials on raw GDP / production numbers). Employee's share of GDP fell correspondingly - especially as non-farm job growth was only 3.4% pa from 2000-2007 [1]
  • growth has been driven by investment (funded by transfers from China's consumers;), a tactic which is both limited and difficult to change [ see outline and comments in China can't be properly understood in terms of Western economics ]

In 2004 China apparently concluded that its investment-driven economy had become overheated because of:

  • fast growth of steel, aluminium, cement and property industries; accelerated fixed investment; shortages of coal, power, oil, transport; fast money supply / credit growth; potential inflation; and the failure of banks to follow instructions to curb lending [1];
  • overcapacity which emerged in many industries [1].

Many observers suggested that government actions to slow growth would lead to a 'soft' landing [1, 2, 3, 4] - though not all agreed [1] - and in fact little slowing occurred.

'Blunt' tools are all that are available to manage economic growth. Altering interest rates will not do so as these are not main mechanism used to ration credit, and provinces (who control much infrastructure investment) apparently resist central government economic directives [1, 2]. Restraining high risk investment by state companies in the face of an uncertain economic environment seemed to remain a problem for government in 2007 [1].

Furthermore it is hard to anticipate the consequences of administrative controls on credit (eg it is easy to over-correct, while targeting specific sectors for slowdown will create unpredictable repercussions for other activities that depend on them).

Economic history does not suggest that administratively orchestrated investment is likely to be sustainable. For example:

  • the Soviet Union experienced very rapid investment-driven growth in the 1950s but subsquently stagnated economically because investments determined by socialist administrators often turned out to be in things that were not really needed
  • in the 1980s Japan's success with state orchestrated exports led to economic triumphalism and a massive investment surge overseen by neo-Confucian with little regard for profitability. This ended badly, and Japanese observers have suggested a parallel with China's current situation [1]

China's private sector (which operates in parallel with large and traditionally unprofitable state-owned-enterprise) is weak. Industrial growth has mainly been achieved on the basis of foreign investment, rather than by creating an environment which would support the initiative of indigenous firms [1, 2]. Moreover historically China's mandarins and cadres have always given low status to domestic enterprises - and favoured foreign businesses [1]. Rather than enhancing the environment for private indigenous firms, efforts in recent years to improve China's economy have focussed on raising the productivity of state enterprises and claimed achievements in this may be based (at least in part) on 'cooking the books'


  • those who have become rich in China are well connected politically. There is confusion between ownership and management. Those who control and personally gain from assets may never have paid for them - but argue that previously the assets belonged to the people, and 'we are the people' [1];
  • while foreign investment has a significant role in driving growth, it has typically been unprofitable for investors [1, 2, 3, 4]. Many firms have invested not because of current profit expectations, but because of hope for future profits [1].  China has a reputation for demanding much, and giving little - and for foreign partners gaining much less, and spending much more, than they expected [1, 2]. As this may not be a transitional situation but rather reflect the the communitarian / nationalistic nature of the business environment (featuring a preference for thin margins and accumulating wealth through savings rather than profits, as well as subsidies for those with connections [1] and a desire to make sure that foreigners do not profit), a high rate of ongoing foreign investment appears uncertain - though there are claims that this situation has started to change [1]. But, though profits have increased in recent years, profit levels remain well below those gained elsewhere [1].
  • based on slender evidence as the subject does not seem to have been studied, it seems that an industrial development system has been deployed - which has parallels with that in Japan and has mainly had the effect of accelerating (without directing) change by engaging social elites in intelligence gathering and networking through various institutional arrangements;
  • emphasis is traditionally given to 'real' production, rather than to profitability (see above), and this is reflected in the losses incurred by banking institutions;
  • there is a critical sustainability difference between economic activity which is driven by the volume of business (ie by market share, as has apparently been the motive in Japan and now China) as compared with that driven by the value-added. Profitability is a much more discriminating indicator for efficient resource allocation, than is turnover. Even though the latter initially yields impressive results through increased (low cost) inputs, growth can only be sustained in the long term if it is based on productivity (value-added) growth. Other indicators of this constraint involves a reported heavy emphasis on investing in 'things', rather than in human capital [1].
    • It has been suggested that China's growth could be surpassed by India because of the latter's emphasis on domestic businesses rather than on foreign investment, and on business profitability [1, 2]. India's balanced approach also involves greater reliance on growth of domestic demand [1], and on R&D [1]. Moreover India is globalizing in services and these offer far better margins than manufacturing, and with an effective legal system and financial system it is much easier for others to work in. [1]
  • the measurement of economic growth is subject to uncertainty [1, 2, 3] - because 'financial' statements about what is being achieved don't necessarily mean much;
  • China's competitiveness ranking is not high - given concerns about state industries and corruption [1];
  • currency controls have stabilized the exchange rate against $US and directed resources to production rather than consumption. Such controls may have been damaging [1, 2] by:
    • limiting imports which are a major part of the gains from trade - through providing (a) access to goods and services which would otherwise not be available, or be more costly; and (b) the stimulus of competition to domestic producers;
    • increasing domestic money supply (as hard currency inflows have to be exchanged for yuan or government debt) leading to inflationary pressures, and to an unsustainable expansion of public sector debt. The availability of surplus cash is seen to have created bubbles in automobile purchases, real estate and steel [1];
    • minimizing pressures on government for policy reforms;
    • increasing the risk of inflation [1] - which in 2007 was becoming a major problem.

The World Bank pointed out that China's growth pattern is based on cheap capital - and this is unsustainable. Rapid gains in manufacturing productivity and stagnant agricultural productivity drive inequality. Growth, it suggested, can't be sustained without household demand and service industries and reduced emphasis on exports and resource inputs. [1]

Other observers have noted the difficulty that emerging economies have in transition to higher income levels.

Example: Many countries have achieved rapid initial growth which they failed to sustain. China has passed an important milestone with incomes averaging $US7000 pa, which has often been a turning point. Beyond this, annual growth rates have tended to slow 2.8% pa because consumption spending rises and investment falls. One country that survived this and continued growing was South Korea. Its government reduced power of chaebol - the state-linked debt-laden conglomerates that were seen to be too big to fail. This injected competition into the economy, while imports were liberalized and the financial system deregulated (Baker P. 'China: the rise before the fall', Australian Financial review,  8/12/10)

Financial Constraints

China seemed to be becoming a new economic 'bubble' at risk of bursting eventually (and creating renewed Asia-wide / global financial turmoil) because:

  • a huge fiscal stimulus (ie high public spending and deficits) was required for years to achieve a sufficient rate of growth to absorb labour force growth and workers displaced from failed state enterprises in the face of international economic weakness [1, 2].
  • investment has accounted for a very high percentage (eg > 50%) of output and mainly involved development of infrastructure and urban facilities by state institutions financed (often unprofitably) by banks drawing on local savings - and generating bad debts [1];
  • China's growth appears to be being driven largely by massive investments with limited concern for return on investment [1]
  • the banking system has been a disaster area in terms of non-performing assets, and technically insolvent institutions [1, 2, 3]. The IMF warned of the risk of a financial crisis [1]. This system transforms the savings of China's people into bad debts. As argued above this seems more likely to be a consequence of cultural traditions rather than the residual effect of a socialist history. It was not subject to internal reform pressure or to external checks because China finances itself internally (and has generated large foreign reserves) - but there are no precedents suggesting that these contradictions can be continued indefinitely.  External financial institutions have to be allowed entry by 2007 under WTO requirements [1]. The value of China's bad debts exceeds its foreign exchange holdings [1] - and some foreign exchange holdings are already committed. The possibility of a financial crisis is considered further below;
  • there is uncertainty about the financial viability of massive housing investments - as the average price / household income ratio is three times greater than normal [1]
  • China's economy has grown rapidly but not been very productive - as shown by bad debts in the banking system and huge government debts. It may be seeking to correct decades of economic mismanagement through pressures imposed by seeking WTO membership but there is little room to manoeuvre and time is running out [1]
  • emerging private areas of the economy also have limited concern for profitability - and a significant economic downturn could emerge if banks are forced to tighten up on credit conditions [1];
  • the buffer of foreign reserves which has protected China's perhaps-insolvent financial institutions started to be eroded by:
    • a current account deficit which emerged - as growth was increasingly driven by urban / infrastructure investment rather than exports, and imports of components of goods to be exported increased from elsewhere in Asia;
    • weakening of export growth [1];
    • the need for Chinese companies to make mainly-defensive foreign investments (which may result in losses because of management difficulties and paying too much in an economic / resource boom) [1];
    • drawing upon foreign reserves to recapitalize insolvent banks [1];
    • drawing upon foreign reserves in a $20bn bid by CNOOC (a state owned company) to buy Unocol to increase China's oil security [1].
  • also China's balance of payments surplus depends on continued high rates of foreign investment - given reduced current account surpluses - and this is not assured because of such investment is frequently unprofitable and would not be maintained if export demand faltered.
  • there is a further risk of very large foreign reserve losses if the US current account deficit is not reduced and financial markets devalue the $US (in which most foreign reserves are held) at some time after the Yuan is untied from the $US;
  • massive overcapacity, and a collapse in profits, have emerged in vehicle production by investment on the assumption of continued 70% pa growth in domestic demand which has not eventuated [1]. A low level of capacity utilization (around 60%) appears (in mid 2005) to have emerged in many industries - and this will increase the exposure of banks to bad debts;
  • much urban investment is simply being wasted - and there is vast industrial overcapacity and low returns [1]
  • problems that create the risk that the bubble may burst include: artificially high property prices; a weak banking system; poor corporate regulation; an immature legal system; and official corruption [1];
  • intense competition within China could lead to a classic business downturn. As margins are small and pricing power is nil, weak profits could lead to low investment / growth. [1]
  • China's economy is unbalanced - with 45% of GDP invested (suggesting over-investment). Its low interest rate policy (a bye product of $US currency peg) has led to property speculation - which could bust. High reliance on exports could halt growth as the world will not indefinitely tolerate its mercantilist exchange rate policy. China's growth has not been due to productivity improvement but to huge investments in bringing part of its rural labour surplus into a market economy - and it won't achieve high rates of productivity gain without adopting free market economic principles [1]
  • China has made significant progress since opening in 1978 - but liberalization has stopped before dealing with financial sector. Investment funds are channeled through state banks, while equity markets are dominated by state-owned enterprises. Financial repression has created a sea of bad debts; mis-allocation of capital; overinvestment in the state sector and private under-investment; politicisation of decisions; widespread corruption; poor stock-market performance; undervalued real exchange rate; and stop-go monetary policy. Financial reform is vital for development to continue [1];
  • Chinese people are seeking profits through stock market and real estate investment which is like a pyramid scheme. It seems similar to Japan's asset bubble. China like Japan at that time has a loose monetary policy - which favours asset booms. China's growth is supported by foreign investment - that assumes that the currency is undervalued. This can't be corrected without large losses in China's $1.4tr in foreign exchange reserves [1];
  • while China's share-market does not reflect the real economy, companies have come to depend on it and on property as a major source of profits - alongside their core businesses in which profits are increasingly squeezed [1];
  • economic openness has increased the potential for instability within China's financial system [1]. For example:
    • large foreign capital inflows to China [1] (by investors seeking to reduce $US exposure in 2007 [1]) was seen as a risk of further over-heating (say) property markets, and China attempted to prevent foreign investment in such sectors [1].
    • falling US interest rates, while China's rise, makes it harder in 2007 to prevent rapid growth in property / stock prices in China. Continuing international turmoil encourages capital to flow to China, and strains it financial / regulatory system [1]

Blunt tools also appear to constrain China's ability to reform its financial system. For example:

  • reforming China's financial institutions by making them act more commercially is problematical (as suggested above) if their characteristics are not (as Western observers apparently tend to believe) a product of socialism / communism but are rather a product of a communitarian / mercantilist economic regime which has deep cultural roots (eg emphasizes the 'real economy', rather than financial, outcomes - and involves economic coordination by 'connections' rather than by calculation of financial outcomes). Reform could disrupt the basic dynamic of China's rapid growth and development (as perhaps occurred in Japan); 
  • government instructions to the banking system in 1999 to behave more commercially were apparently ignored [1];
  • China's economic progress to date has been achieved by eliminating the most extreme obstacles to markets but the next stage (creating the institutions required for fair and stable markets will be much harder), and political changes needed to contain community demands for liberty could lead to instability [1]
  • China has the most restricted capital market in Asia - and this has huge costs. Development can't continue unless capital restrictions are loosened - but such liberalization would put the current governing regime at risk of losing power  [1]
  • problems in reforming China's financial institutions might be solved by privatization, and obstacles to this (eg lack of methods for setting values, and negative net worth) have been reduced by establishment of a State Asset Supervision and Administration Committee [1]. However this may not be an easy option if state ownership of banks is seen as essential for a 'socialist' economy [1] in an environment in which a (so-called) 'Chinese consensus' (a form of autocratic corporatism) is being promoted as a superior alternative to the 'Washington consensus' (free financial markets) as a path to economic development [1].

There have been ongoing financial reforms (as mentioned below), and possible progress. For example:

  • amid rising input and wage costs, China's corporates are making best gains and efficiencies in sectors with strongest wage and material-cost pressures (which have been absorbed with little price rise, and profits contribute to high levels of corporate savings). Profit growth is high (37% yoy). China is now importing less intermediate goods from elsewhere in Asia - and this could improve the profitability of Chinese companies [1]

There are also plausible suggestions that reform has often been only superficial [1, 2]. Furthermore;

  • while reform of its banking system is China's top priority because of the risk of a financial crisis, this may not be possible [1];
  • while China is striving to present a number of major financial institutions (eg Bank of China) as financially sound and worthy of foreign investment and offshore listing, this seems likely to be being achieved by 're-arranging the deck chairs' rather than by solving structural problems [1]. In particular one major bank was recapitalized by drawing upon foreign reserves which merely transferred losses to China's central bank [1]. And in attempting to write off the bad debts of banks, it appears likely that state-owned companies (under no pressure to make a profit) would out-bid foreign investors [1] - and this outcome would (of course) merely 're-arrange the deck chairs';
  • 'red chip' firms are experiencing rapid growth in China by buying up other firms - but their operating position is poor. Profits seem to come from financial engineering rather than performance [1];
  • corporate profits have been boosted at least partly by squeezing workers' share of national; income. Wages' share of GDP fell to 41% in 2005 from 53% in 1998 [1]
  • some observers have expressed concern about China 'cooking the books' in order to be able to present statistics that constrain social discontent by making performance appear much better than it is (eg present unemployment as 20m rather than 50m) [1]

Various other observers have have identified the potential for a serious China-centred financial dislocation [1] or suggested that this is inevitable in the next few years - and that this has the potential to turn an economic downturn into a global depression [1]. It can be noted that in the event of a banking crisis, it would China's government, rather than its (insolvent) banks, which would borrow heavily [1]. However China's government also has very high debt levels due to past public spending to sustain growth.

Environmental Constraints

China seems likely to follow the USSR as a place where (with the help of 'Soviet trained planners') the 'limits to growth' are transformed from an ecologist's theory into a nasty fact. For example:

  • China has a huge population. Its cities occupy 50% of the countryside in fertile areas.
  • it has immense constraints on soil and fresh water - which seem to be near their limit.  The water table drops 1.5m pa in major grain growing regions in North China [1]
  • traditional sustainable agricultural practices have been traded for 'industrialised' agriculture;
  • in 2006 China's environmental challenges (eg energy and water shortages, water and air pollution, cropland and biodiversity losses) were seen to be escalating [1].
  • industrialization adversely affects people's health (eg air pollution has a wide impact) and the environment (eg loss of vegetation causes concern about desertification [1, 2]);
  • the UNEP has argued that China could never achieve a high level of consumption due to environmental and resource constraints [1];
  • as in the USSR very real environmental hazards have been ignored by autocratic government in the push to industrialize (eg the Three Gorges Dam project [1] was driven apparently by Li Peng, an influential Soviet trained engineer). Similar (smaller) projects in China have failed to live up to expectations due to silting - while international experience and experts on the environmental and economic impact of large dams suggest a more cautious approach);
  • in the past China's motto was to 'conquer nature' in the belief that development should be emphasised with pollution cleaned up later. Though this is changing fundamental changes in development model and administrative system are urgent [1];
  • many people suffer diseases caused by pollution which have been ignored so as not to disrupt economic growth [1]
  • China's environmental problems are mounting and pose a risk to economy and to public health. The economic miracle could end due of this - officials have warned. Central government has announced measures to address these problems, but it has little influence in the provinces. Solving this problem requires revolutionary political reforms.[1]
  • the People's Republic of China traditionally neglected the environment (as well as worker safety and public health problems). Pollution leads to major health problems. Energy efficiency is low. Chinese people face obstacles to speaking out about such problems. However in recent years the situation has been improving [1];
  • Four areas have been identified by the China State Environmental Protection Agency and the ADB as requiring urgent attention: pollution of air, water, land; water shortages and land degradation; environmental accidents; energy efficiency; and GHG emissions [1]
  • while China has moved to end its previous neglect of environmental issues, it will need to review its emphasis on economic growth as the prime policy goal, and address the conflicts that emerge because government is both the main polluter and the environmental regulator [1]

Furthermore the world does not yet have (and has no guarantee of ever having) a way of meeting China's escalating energy needs. It seems inevitable that global conventional oil production will peak sometime over the next decade - leading to shortages and rapidly rising prices. Fossil fuel usage really could become problematical given the possibility that global climatic change could be more severe and rapid than traditionally assumed [1]. Alternative energy sources seem to remain unproven. China's economy uses energy very inefficiently in relation to GDP [1].

There were signs in early 2008 that the 'peak oil' phenomenon - and priority being given to the production of biofuels - could give rise to famine in vulnerable regions (and that China might be vulnerable) [1].

A radical change in China's economic model has been seen to be needed if growth is to continue [1].


China will face the most severe 'aging population' challenge in the world around 2030 because of its one child policy, and even now is suffering shortages of skilled young workers in its major cities (partly because lower educational standards in rural areas make rural migration an ineffective solution to the cities' problems) [1]

Political Constraints

China's political system is autocratic - and sits on top of a seething mass of minor potential local 'protests' - which constantly need to be suppressed [1] and which could get out of control if for some reason they were to gain critical mass [1, 2].

Moreover, the growth-at-all-costs approach has led to increasing social unrest [1] and problems in rural regions [1].

  • China is planned economy - ruled by a single party.  Since Tiananmen Square great efforts have been made to ensure that educated elites are enmeshed with party - but this is not true of the masses [1];
  • China has been seen to be close to revolt in regional areas because: population growth has reduced size of holdings; desertification has reduced arable land (just 14% of China); deforestation and pollution have reduced water available for irrigation; officials have imposed heavy taxes; and only 20% of farmers can access credit for productivity improvement - at the same time that urban middle class is entering an era of conspicuous consumption. [1]
  • potential instability across Asia as a whole is seen as possible because rapid economic growth has not been matched by jobs growth, and unemployment rates are very high [1];
  • there are now vary large numbers of affluent consumers who are not included in the one-party state [1]. In the absence of political reform economic growth can lead to instability, because of demands of rising middle class [1].
  • Traditional authority structures (based on a Confucian 'merit-aristocracy') may not be viable because:
    • to some extent power requires access to superior information to influence subordinate's thinking and this is at risk because of widespread access to the Internet - as demonstrated by heroic efforts that have been made to devise an Internet system which allows censorship of disruptive ideas [1]. Such efforts to suppress access to information must inevitably prove futile in a networked society;
    • the neo-Confucian bureaucracy's practice of making no distinction between news and propaganda in the information which is released [1] is unlikely to work if a more knowledge-based economy is eventually to emerge;
    • Japan's economy stagnated for a decade, because of its traditional 'merit-aristocracy' - whose economic leadership promotes mercantilist goals (ie excessive 'real' production without ensuring financial profitability so as to accumulate US paper assets despite the insolvency of its bureaucratically-controlled financial institutions - see Scenario).  Writing-off the bad debts that Japan's financial institutions accumulated in the 1980s' asset bubble was vital to their future financing role, but this would have required a loss of status and control of the banking system by the elites descended from the Ministry of Finance (and also by the nationalistic gangsters (yakuza) who provide the discipline in Japan's social order [1], and control the often-technically-insolvent construction industry);

China has been suggested to have had a 3000-4000 year history of repeated conflict between the commercial and materialistic cultures of South China and the rural and spiritual cultures of North China (see Seagrave S., Lords of the Rim  ). Conflict between these was suggested to have seen the merchants driven out of China in many waves - to become the offshore Chinese who are economically powerful, politically influential and supported by 'private armies' (the Triads).

Seagrave presents a version of China's history from 1100 to present - a tale of scandal, war, politics and money making. It is said that 'To be rich is good'. However his book is also an account of the enormous power wielded by 55m offshore Chinese in SE Asia (and increasingly elsewhere). They financed the boom that has made China a major economic power - and have the greatest stake in China's political directions [1]

Seagrave presents an impressive account of the Overseas Chinese who down through the ages have become a major force in SE Asia and now on West Coast of North America. This started in about 1100 when the repressive, puritanical and anti-business Chou dynasty first drove the merchant class from north China. The latter established commercial beach-heads everywhere in East Asia except Korea and Japan. The 55m offshore Chinese have enormous income and wealth. A significant proportion of their income is derived from drugs and prostitution - and they are frequently involved in bribery, partnerships with government officials and other forms of corruption. The loyalties of these groups are to their ancestral villages in China rather than to the communist Chinese Government [ 2]

If China's commercial drive falters then the 'northern' influences concerned with 'higher' values may well again mobilize to suppress the 'greedy' merchants who dominate in the 'south'.  The potential for a new civil conflict is suggested by:

  • the perceptions that public morality has collapsed in China in recent years [1, 2] and that East Asia now exhibits many of the worst elements of Western modernization [1];
  • north-east China's continued status as a huge economically under-developed region [1];
  • the emergence of Falun Gong in 1992 in the tradition of the White Lotus Society, which has been the source of earlier grassroots attempts to gain political power in China [1];
  • the apparent incompatibility between the bureaucratic neo-Confucian methods that have been used by the (so-called) 'Communist' Party (which are built on a social hierarchy) and the social equality aspirations of China's nominal communism (see Communist Communism Versus Confucianism: The Continuing Contest in China);
  • an extreme level of income inequality which is above that that can result in social unrest. Income inequality has been rising rapidly in China (according to University of Michigan study). Gini coefficient is a measure of inequality, This is now 0.55 - almost doubling from 0.3 in 1980, and above the 0.45 in US. Anything above 0.4 is seen as indicating potential social unrest. [1];
  • claims (of unknown validity) that economically-significant amounts of capital have been moved off-shore by corrupt officials

The situation is further complicated by reports of official concern in China about the extreme levels of corruption in the PLA [1]

Tensions have also grown over Taiwan [1] which could, if not resolved, have an adverse effect on foreign investment into China.

It has been suggested that China now promotes unity through a religious concept in politics. In imperial China this had involved a Confucian state - whose ideal was harmony. It presumed that conflict would disappear if people conformed to a particular set of beliefs (including moral codes). The ruled would naturally obey the ruler. Communism as an alternative was 'bookish', introduced a modern moral orthodoxy and promised harmony. The shift to market economy in 1980s created an ideological vacuum. This was filled by Chinese nationalism - under one party rule. The so-called 'Communist' Party is seen to reflect China's potential as a great power - so any dissent would be unpatriotic. Those who rule according to a shared belief can't afford to negotiate with dissidents, as this would undermine the shared belief [1


There have been indications that China has been getting serious about the constraints it faced.

Indicators include:
  • comments on China's energy and environmental challenges [1, 2, 3];
  • a peaceful transition of political power was achieved in 2004 [1];
  • courts have been used in attempts to constrain arbitrary state power [1];
  • the World Bank's positive assessment of the political and economic outlook - which also argued in 2003 that there is a very long way to go especially in relation to breaking export dependence and reforming financial practices [1];
  • the leverage which WTO membership will provide to force structural reforms - though not all agree that this can be managed [1]
  • the possibility of economic [1, 2], political [1] and social [1, 2] reforms;
  • the IMF's argument that China had a strategy to build a sound financial system [see also 1, 2,] This appears to involve an intention to make China's banks 'real' and act commercially [1] and privatize them [1]. Some of the bad debts of China's banks are to be sold to foreign institutions [1]. Rules have been tightened making transactions more transparent - resulting in a significant decline in non-performing loans [1]; 
  • efforts have been made to: boost domestic demand; use market mechanisms to manage economy [1]; and clean up the balance sheets of two major banks to attract foreign participation [1];
  • a reported decision to abandon the 'growth at all costs' strategy in favour of reducing internal inequalities [1, 2] - a decision which (as noted above) seems inconsistent with acting as a regional / global economic 'engine';
  • wages have been raised in rural regions in order to inhibit movement to the cities [1] - a strategy which will also favour economic development if the skill base is raised by discouraging investors interested only in cheap labour;
  • Government has sought to reduce taxes on farmers. Also higher spending on health, education and the environment will increase socio-political stability [1]
  • efforts have been made to boost consumption (rather than exports) to drive growth [1, 2].

Whether such reforms will prove sufficient is unknown.

Is Optimism Justified?

A case can be made that China's growth and development is assured despite the many constraints it faces. For example:

  • China has huge human resources and potential markets. It has a high class education system, and can draw on external resources (Greater China) for the skills to allow its structural problems to be overcome [1];
  • past obstacles have been successfully navigated, and (as above) this process is continuing;
  • China's response to indications of over-heating in 2004 were satisfactory because (a) the problem was addressed by administrative controls rather than raising interest rates and (b) despite the bad debts of its banking system, China has large international reserves, a more-or-less balanced current account / a modest fiscal deficit and a closed capital account which prevents capital outflows [1];
  • the 2007 credit crisis illustrates China's strength. A $1.3tr cash reserve has been built up in the 10 years since the Asian financial crisis - and the Peoples Bank of China believes that this provides insulation against crises elsewhere. Entrepreneurs have flourished in China, and the stock market has risen rapidly. There has been a flight of capital to Asia because of the credit crunch. The US / UK economies are heavily dependent on financial services - and these are in doubt [1]

There appears to be a very high level of confidence amongst China's leaders, and the message given to the people is that China's rise to world prominence / dominance is assured. The political consequences if this does not eventuate could be severe.

Crisis Scenarios

However China's prospects are uncertain because of the constraints outlined above, so its spectacular growth could be derailed at some time.

Potential sources of crises have included:

  • economic imbalances - especially:
    • very fast growth driven mainly by investment by the state and foreign investors without adequate concern for return on state capital, and limited profitability of foreign investments directed towards China's consumers;
    • dependence on strong economic conditions and financial systems elsewhere to provide demand for exports;
    • the unsatisfactory environment for domestic businesses, which seem vital to filling the economic gaps left by foreign and state investors and so creating a balanced economy;
    • overheated markets (eg an apparent property bubble) that are at further risk from capital flows as a result of global financial instability in 2007
  • the poor balance sheets of financial institutions, the dependence on strong financial markets elsewhere to productively invest the current account surpluses which are needed to protect those institutions and prevent currency appreciation; and the uncertain claims about improved productivity by state-owned enterprises;
  • the blunt 'administrative' tools that are mainly used (and are all that are really available without extensive further reforms) for managing potentially-unstable economic and financial systems;
  • environmental / resource obstacles to long term growth; and
  • potential political instability

Moreover the interactions between such risk factors make government into a difficult juggling act. For example:

  • the current account surpluses that are needed to protect financial institutions contribute to the global financial imbalances that put export demand at risk. Moreover the foreign exchange reserves that protect them are subject to other demands;
  • the dependence on export demand can't safely be overcome without improving the balance sheets of financial institutions, and the latter seems to be constrained by cultural features (see above);
  • there is a fundamental incompatibility between maintaining strict political control and reforms of financial systems to comply with internationally accepted practices;
  • seeking to create a 'private sector' to fill economic gaps while maintaining political control has resulted in 'entrepreneurs' who tend to be crony capitalists and whose 'success' breeds domestic resentment.

It has reasonably been suggested that, though China is implementing reforms that are headed in the right direction (eg reducing environmental degradation and social inequality and reigning in overheated sectors), they are too slow - and China faces huge risks because its economy is now open and exposed to external shocks [1].

For example, with an overheated economy in early 2008 which needed to be slowed by higher interest rates while others were reducing rates to stimulate growth, there was a risk of rapid revaluation of the yuan - which would erode competitiveness and lead to large losses in foreign exchange holdings (perhaps the 'financial tsunami' an Australian Treasurer warned about?).

This could arise because hot money inflows (attracted by higher interest rates and the prospects of currency appreciation) added to the already significant problem of sterilizing current account surpluses by acquiring ever more foreign exchange reserves  (see more).

The US argued that unless China implements much deeper reforms of its economy it would be unable to sustain rapid growth [1].

Because of the apparent inability of the problem solving methods that are the basis of economic 'miracles' in East Asia to ensure success in terms of financial outcomes, the control of global financial systems seems likely to be an ever more important source of international disputation (see Friction over global financial systems).

China: Impact of the GFC +


China: Impact of the GFC

In March 2009, there appeared to be uncertainty about China's response to a severe economic shock (see Global Financial Crisis: The Second Test of Globalization?).

China's economy was impacted very severely. In part this was due to a sharp fall in exports and foreign investment as a bye-product of the global financial crisis (GFC). However, as exports had only accounted for about 10% of GDP, other factors were important in China's economic slowdown and rising unemployment including:

  • a collapse in some of the investment which had accounted for 60% of GDP.  Property investment, which had enriched those with close connections to the neo-Confucian bureaucracy (ie the so-called 'Communist' Party) , had been funded by state controlled banks with limited concern for profitability - and the property bubble ultimately seemed unsustainable. Property investment thus collapsed as did industrial investment related to developing the factories needed for both exports and the materials required for property development;
  • losses on foreign investments by Chinese companies.

An Apparently Inadequate Stimulus [<]

In the December quarter of 2008, China's GDP growth was reportedly essentially zero [1]. However in March 2009, China's premier announced that his country would achieve 8% growth in 2009 because it needed, and had the ability, to do so [1]. But he did not state how this would be achieved beyond vague references to 'doing whatever was necessary' and exhortations for China to 'change its development pattern and realize structural adjustment' and 'promptly and creatively implement the policies and plans of the central government' including 'boosting domestic consumption' [1].

Another official suggested that stimulus measures announced previously were appropriate and working [1], while another source suggested that the solution lay in 'confidence' and the fact that all officials were aware of the vital need for 8% growth [1].

The World Bank suggested that China's 2009 growth would be 6.5% because of the first stimulus package and the expected property recovery in late 2009 [1]

However many economic analysts had believed that this growth goal would only be achievable with a large additional economic stimulus as China's first round stimulus of (about) 2% of GDP in November 2008 was seen to be inadequate. By early 2009 there had been a strong rise in public fixed asset investment (roads, railways, power plants, bridges and apartments) - as a result of government stimulus package. But  private property investment was stagnant, and developers were going bankrupt [1]. Moreover:

  • China's current account surplus had collapsed to $4.8bn per month in February 2009 [1] - thus raising the prospect of deficits if China's growth was faster in the face of global contraction. Deficits would create problems because of the weakness of China's financial system (see China: Victor or Victim?);
  • there was very limited prospect of significantly increasing domestic consumption because of extreme imbalances in the distribution of wealth and the limited role consumption had played in China's economy in the past.

In June 2009, it became apparent that in addition to the national stimulus program, additional stimulus measures had involved (a) reduced constraints on bank lending (see below) and (b) heavy borrowing by local governments in the expectation that tax revenues would increase with recovery to allow increased debts to be repaid [1].

While a turn-around from 0% growth to 8% would be very difficult, something like 8% is vital to keep up with the growth in China's labour force and maintain political stability.

Export-Oriented Industrialization Strategies are Now Impractical [<]

One problem is that export-oriented industrialization reliant on traditional markets (especially the US) won't be feasible as the primary driver of Asian growth and development in the post-GFC era (see  New Economic Strategies)

This problem appears to have been recognised in Asia (op cit), though initial responses seemed unlikely to produce sustainable growth. The US did little to boost its supply capability, and China's stimulus mainly increased production capacity.

In initially responding to the economic crisis, governments have done little or nothing to address the need for a more balanced international financial system.

For example, the US (and other current account deficit countries like Australia) have done nothing to promote structural economic changes - ie to boost production capacity, rather than demand, so as to reduce the global financial imbalances that were linked with the easy money policies that led to the GFC.

Likewise China's first-round fiscal stimulus package tended to go mainly into boosting production [1] (for which there is currently no assured market other than China's government itself). For example:

  • China's growth model in the face of the global financial crisis is based on government spending [1];
  • while China forecasts 8% growth in 2009, the World Bank projects 6.5%. 4.9% of this will result from a massive government stimulus package. Also though new state bank lending surged in February, as industrial growth and private investment stagnate. Also World Bank forecasts assume that China's exports will pick up as global recovery emerges in late 2009 while IMF forecasts global economic decline of over 0.5% in 2009 [1];
  • China, because of the modest size of its fiscal expansion, is clearly expecting that economic recovery will be driven by external demand [1];
  • analysts had doubted China's ability to rapidly resuscitate its economy - but this under-estimated the advantages of a semi-command economy. Banks pumped money into state controlled companies, and they expanded investment. 75% of China's expected 6.5% growth in 2009 will come from government investment and consumption. Going beyond this will be harder [1] ;
  • while private investment had provided most of China's rapid jobs' growth in the past, it is now investment by state enterprises that is driving growth. The fact that lending has exploded at the same time that market conditions are contracting suggests an increase in future non-performing loans and over-capacities [1];
  • China is 10% of global output, but suffered severe slowdown in late 2008 which may recover to 5-6% pa growth in early 2009. Better outcomes depend on US / global recovery (in 2010?). Risks include: inadequate stimulus / overcapacity. Growth is based on aggressive fiscal / monetary policy - as measures to boost domestic consumption have been slow. Government is well placed to fund deficits, but gaps between China's 8% growth goal and external weakness is large. When US recovers it will rely more on increased exports than on ongoing imports and consumption [1];
  • China 's stimulus program is to invest heavily in the development of 4G telecom technologies - and was seen as potentially setting standards in this area [1];
    • Comment: this seems potentially hazardous as, without strong consumer demand, such development would be driven (as in the former Soviet Union) by the guesses of technologists and industrialists without the ultimate direction being set by users (ie consumers) which is necessary for successful innovation.
  • China is likely to rapidly recover from its economic downturn because the official decision to launch a 4tr yuan stimulus package concentrated  leaders at all levels in China on boosting growth - so huge amounts of additional spending resulted from local governments and business who had needed nothing but a release from government controls [1];
  • China's aggressive stimulus has steadied its economy, but it has not made the deep structural changes needed for growth after available funds run out [1]
  • China is investing heavily in solar energy technologies - and achieving efficiencies that make solar energy competitive with coal. This may reflect the fact that China's coal reserves are not as large as often believed, and due to concerns about air pollution [1]

There is also concern that stimulatory spending may have mainly gone into stocks, and that excessive liquidity (credit created in the first half of 2009 equally 45% of GDP) is causing bubbles [1]. Also concern has been expressed about the effect of rescue packages on adding to already severe overcapacity [1].

Some observers further expressed concern [1] that:

  • China is 'cooking the books' in order to be able to present statistics that constrain social discontent by making performance appear much better than it is;
  • stimulus efforts through state owned banks are seen to have created bubbles in stock, real estate and commodity markets - in the expectation of recovery by export markets. If this doesn't happen China will be in serious trouble

Moreover,  in the development of a solar cell industry China seems to be applying traditional techniques (ie subsiding production in order to gain huge global market share) [1] a tactic which implies an expectation of large scale ongoing international financial imbalances.

Measures to boost domestic consumption in China were taken involving a social safety net,  consumer subsidies and dubious statistics.

Efforts are being made to promote domestic demand:
  • some indicators emerged of a shift in China's emphasis from hard to soft infrastructure (eg to health care and education); a willingness to downsize existing production capacity; and improvements in China's safety net in ways that would reduce China's high, but ultimately destabilizing, savings rate [1].  Indications have also emerged of vouchers being provided to citizens allowing them to buy appliances [1]
  • data has been presented suggesting a rapid increase in the number of cars being sold to consumers in response to a demand stimulus package (reduced taxes and subsidies). However observers have noted that other data sets suggest that this is 'happening' at the same time that the number of engines being produced is declining [1]. Other data suggested a 15% increase in retail sales in China in the first quarter of 2009 - though there may have been uncertainties about this [1].
  • China is to boost the production of electric cars, by providing large subsidies to consumers for buying them [1];
  • China's growth is increasingly self-generating and domestically-driven despite the perception that recovery has been entirely the result of government spending [1]
  • China may have scope to increase domestic demand because prior policy actions had been taken to reduce it - ie constraints could be taken off bank lending [1]
  • China's 7.9% yoy growth in the June 2009 quarter was seen to suggest that it can take the role as the customer of last resort in driving export-led growth in the rest of the world that the US took prior to the GFC [1];
  • China's spending splurge and US parsimony are a recipe for global economic stability - because in many areas demand growth in China is outstripping that in US [1]

However the effect has been modest, and huge social and political reforms would be needed to make China's economic growth sustainable through such reforms. None-the-less by August 2009 China's economy was seen to be growing from internal consumption  [1]. In early 2010 however caution was expressed about consumer-driven growth based on large subsidies (which simply transferred future consumption to the present) and the severe difficulties of generating consumer-driven growth without simply relying on subsidies (eg the need to boost private enterprises at the expense of state owned firms) [1]

In 2013 it was suggested that China will be unable to conform to the world's rebalancing expectations because of its demographics. It will become ever more dependent on exports and foreign asset income. It will be unable to run a sustainable external deficit to smooth out global imbalances. In the near term there is also a risk of a credit bubble. China's M2 money supply is 180% of GDP (about double that in the US) [1].

Economic Reforms on Western Principles were Absent [<]

There are serious structural obstacles in the economic model that China appears to have adapted on the basis of Japan's pre-19990 rapid growth to achieving the macroeconomic balance needed for growth based largely domestic demand (see Are East Asian Economic Models Sustainable?). For example, the lack of serious attention to the profitable use of capital creates the risk of financial crises if growth were based on domestic demand. Others noted that Chinese state-owned companies have high savings rates because they had no one to pay dividends to [1]

Thus China's leaders may believe that they are unable to engineer market-oriented economic changes based on Western principles that would allow continued growth in the global economic environment that must emerge as a consequence of the GFC. They do not, for example, appear to envisage Western-style reforms to China's financial systems [1] - any more than Japan did following its financial crisis in around 1990. Moreover emphasis continues to be place on state-owned-enterprises which are not noted for the profitable use of capital.

Doing China's Own Economic Thing?  [<]

One interpretation of the vagueness of China's premier about future GFC responses is that it is recognised that further economic stimulus (which mainly boosted the supply side of China's economy would be pointless), and that something radically different is intended.

One initiative suggesting this involved diversifying perhaps 50% of China's $2tr+ foreign exchange holdings away from $US - perhaps into commodities and other assets with reduced current values. While this could be rationalised as seeking protection against an expected $US collapse [1, 2, 3], it would appear to make US-led global economic recovery more difficult and thus: (a) increase the demands on China's foreign exchange reserves - and the risk of a medium term financial crisis; and (b) put at risk the value of the alternative assets that China acquired.

Implications of Diversification from $US

If correct (and other reports mention China's rush to build up coal stockpiles at almost any price) this could be taken to imply that China either expects, or  is trying to ensure, that the financial crisis will result in a crash in value of $US. However this outcome would be counter-productive.

Why: China might ensure access to the resources needed to manufacture (say) hybrid cars - but, if a general run on US Treasuries prevented the US from funding its stimulus / bank rescue packages and budget deficits without simply printing money and crashing $US value, then there would be no short term global economic recovery or much market demand for whatever China intends to manufacture - so that the value of industrial commodities purchased with proceeds of selling US Treasuries would also fall.

However China may not simply be shifting its foreign exchange holdings because of concern about the prospective collapse of $US, but because the GFC has highlighted the structural challenges facing China's own capital account that are implicit in its past strategies.

China's previously solid current account surplus had reportedly essentially disappeared in February 2009 [1]. China had record surpluses from November 2008 to January 2009 and the World Bank forecast a $400b current account surplus for 2009 (because lower commodity prices would partially offset the impact of the global demand shock) [personal communication].

However the World Bank's forecast seemed to depend on a substantial improvement in the global economic situation in late 2009, ie that the world emerges from recession even though:

  • the IMF forecast a decline of 0.5% or more in global GDP in 2009;
  • the World Bank forecast a 9% fall in world trade in 2009 [1];
  • the OECD has forecast a 4.3% contraction in developed world's economies in 2009 [1];
  • any benefits China gained from lower commodity prices would be offset to some extent by reduced capacity elsewhere to buy its products; and
  • despite the optimism US authorities express about the potential for recovery, the challenge of funding the US budget deficits this requires would seem to be severe (eg because of the risk of a post-flight-to-safety bond market crash similar to that which apparently occurred in 1931 as cashed-up investors, believing the crisis was being resolved, shifted their money in other areas).

Thus (if China is to achieve 8% growth in the face of global recession) it will probably have to finance growth by drawing down its foreign exchange reserves. However China can't safely do this for long (as its financial system is not able to cover future deficits by borrowing).

Moreover "protecting" China's now-critical foreign exchange holdings by withdrawal of capital from $US may damage the global economy and thus be counter-productive for China in particular (because global demand could further weaken, and falling exports would merely accelerate China's slide towards a financial crisis). .

For these reasons steps to attempt to avoid this constraint in the medium term  (see Creating a New 'Confucian' Economic World?), may have become urgent - even though there is no guarantee of their ultimate success.

China has also indicated a desire for radical change by expressing concern about dependence on US markets and the $US. For example, a case was made for the creation of an an international currency based on IMF Special Drawing Rights. And a Chinese analyst called for significant increases in US savings [1], a change which would severely disrupt China's export-led economic strategy.

Other Chinese economic initiatives include:

  • using foreign exchange reserves to: (a) make loans to key trade partners; (b) acquire businesses; (c) stockpile commodities; and (d) acquire future key energy / commodity inputs;
  • restricting machinery imports, and exports of rare earths that are essential to some advanced technologies;
  • seeking to upgrade established industrial regions on China's coast to succeed on the basis of independent innovation - while transferring traditional low-cost industries inland;
  • proposing the development of Shanghai as a international financial centre with 'Chinese characteristics' - perhaps including better stock market regulation
  • encouraging use of the Yuan as international trade currency ;
  • encouraging diversification of export markets away from North America and Europe;
  • officially supporting companies that refuse to honour derivatives contracts;
  • increasing emphasis on state-owned (rather than private) enterprises;
  • proposing to give preference in government purchasing contracts to products incorporating indigenous innovation;
  • attempting to make economic growth more sustainable by closing the most environmentally damaging industrial operations
Indications of other initiatives include:
  • in May 2009 it was suggested that China was seeking to become a hard-asset republic (with a preference for conducting trade in RMB; currency swaps in Asia and acquiring energy / resource assets). Walking away from $US slowly - so as not to hurt its $US holdings was seen as a way to help rebalance the world economy [1]
  • China's competitive strengths have been improved as a result of the GFC. It is using cash to acquire natural resources and friends. Its economic stimulus package will retrain workers, increase R&D and provide infrastructure which reduces transport costs. Bank lending has increased rapidly. The slowdown has also solved persistent inflation problem, reduced shipping costs and wages. China's companies are buying foreign businesses [1];
  • China provided $25bn loans to SE Asia. Industrial production rose 8.3% yoy to March 2009. Crazy amounts of iron ore are being imported and boosting stockpiles. All China's neighbours are being boosted. Most new activity comes from government stimulus [1];
  • China has made arrangements for its currency (Yuan) to be used in international trade with South Korea, Indonesia, Malaysia and Argentina (as an alternative to $US [1]. Others have suggested that China has taken many steps to promote the Yuan as an international currency and as a reserve currency [1, 2, 3].
  • China has reportedly strongly promoting its leadership in SE Asia, while (a) criticising the global dominance of developed economies (b) offering to invest in the region and to use the yuan as a trade currency (c) complaining about dependence on US markets - which is said to be needed because of $US hegemony and (d) advocating use of available resources - including China's huge foreign reserves - to promote growth [1].
  • China has reportedly envisaged that (a) it could refuse to finance US deficits (with the expectation that the $US would then collapse) without adversely affecting its own prospects and (b) its own currency could be floated as the basis for an independent market-based financial system [1];
  • China's sustained growth was seen to potentially come from: (a) economic spin offs from the government stimulus; and (b) innovation within China that significantly improves its productive strengths [1];
  • China will no longer 'hide its capability'. Using $2tr foreign exchange reserves: industrialists have locked in energy resources; infrastructure investments have been committed, as well as projects to bridge wealth gap. China's success formula is its state banking system - which has plenty of cash allowing increases in consumer / capital spending. State controlled banks take compulsory savings of all employees. Once child policy forced parents to save. China has started to internationalize its currency. China's premier argued that financial crises in recent years have resulted from clash between needs of country issuing reserve currency and international fiscal requirements - and argued for a super-sovereign reserve currency managed by a global institution. US leaders will in future need to concede that they are losing financial power to regions such as China [1];
  • China owns several large banks, all well capitalized, and has many companies that are going public on HK and Shanghai exchanges. Its growing middle class will encourage more sophisticated financial services sector. China's financial system is simpler than US / UK but this may be an advantage. China could link HK and Shanghai banks and transfer know-how from former colony. Beijing has declared Shanghai will be major global financial centre - and there is growing cooperation with HK. Common regulations could be established [1];
  • while foreign banks are frustrated about many aspects of doing business in China, they are making profits (which in one case came 80% from holdings of Chinese financial institutions, while losses were incurred on consumer banking). China is offering them room to pursue business despite tight overall restrictions. China has promised pro-market rules, new products, technological advances and lower taxes in an effort to boost Shanghai's role as a global financial centre that retains Chinese characteristics. Shanghai has been seen to face many obstacles as a financial centre because of: state involvement in everything; uncertain legal, tax and media structures; and lack of a convertible currency. On the other hand China's restrictions allow banks to charge premium fees (a form of tax on users) [1];

    • however the fact that foreign banks in China are becoming profitable seems to reflect something like the market rigging through cartels that allegedly [1] allows state-favoured enterprises to appear profitable at the expense of the economy generally.
  • as well as trying to change the international rules by blaming $US's position for global crisis, China is seeking to become a hard-asset republic (with a preference for conducting trade in RMB; currency swaps in Asia and acquiring energy / resource assets). It is seeking to walk away from $US slowly - so as not to hurt its $US holdings. This may help rebalance the world economy [1] [Comment: The short term risk with such a strategy would be a collapse in economic output]

  • China's regulators are seeking to remove scams associated with stock market in the past [1]
  • China's leaders have suggested different ways of responding to decline in exports - eg government support for cheap-labour exports or new industries Wang Yang (Communist Party Secretary, Guangdong) suggested Party was advancing with the times and can communicate with West, but West doesn't understand China and this is needed. He suggested that economic transformation and industrial restructuring must be based on 'scientific perspectives on development' (a party slogan for maximizing growth and also addressing rural-urban imbalances and environmental issues). The model used for 30 years is no longer viable - because (a) it neglects costs of resources / environment / worker health; (b) it depends on external demand. The obstacle to economic change is seen to lie in dealing with vested interests (eg those who have become wealthy through renting land). Plan is to enhance independent innovation, transform traditional industry and set up modern industrial systems. This will open wider markets. Local industry will be upgraded while low-cost manufacturing is transferred inland. Guangdong would become the shop-front for manufacturing elsewhere in China. Transformation of Guangdong into a centre for independent innovation poses risks in facing chaos of marketplace [1]
  • a new market for $US denominated bonds to be issued by non-financial firms has been announced [1];
  • though China has benefited most in recent years from trade, bans were imposed on the purchase of foreign equipment in investment projects - a more restrictive version of the US's 'Buy America' clause - which threatens to generate reactions elsewhere [1];
  • reportedly placing the Ministry for State Security in charge of economic dealings [1]

  • China has officially supported companies that refused to honour losses incurred under derivatives contracts - a move which was viewed in the West as breach of contract and increase in sovereign risk, but seen a defensible by China on the basis that the products peddled by Western banks had triggered the global financial meltdown [1];

  • there has been a shift away from private enterprise and greater emphasis on state-owned enterprises [1]. The private sector has been seen to be under attack in China. It was sidelined by massive stimulus efforts, can't get credit and faces trend towards re-nationalization by government [1]. Private operators in steel industry have been forced to sell assets below fair prices to large state operations. Renationalization is also affecting coal industry. The lesson of history is that without private enterprise past efforts to modernise China's economy went into dead ends [1]

  • China has sold first batch of sovereign bonds in yuan to foreigners [1]

  • China has made its continued growth prospects more sustainable by diversification of its exports away from US and Europe (where growth is likely to be weak) towards, Mexico, South America, Latin America and Australia [1]

  • in August 2010 it was suggested that China "is now diverting its reliance on the debt-straddled US-consumer, and focusing its future growth plans on the Chinese consumer. This is a radical change that will take years, but is already taking place. In the meantime this week's figures also pointed out that China is currently making plenty of money sending most of its exports to other emerging economies" [1].

  • China ordered 2000 polluting factories to close [1]

  • In early 2011 it was suggested that China needs to move its focus from exports to domestic consumption - and that this is likely to follow from: government efforts to increase household incomes and cut the savings ratio; increasing wages (eg due to labour shortages and population aging). Government is also promoting new strategic industries to move China up the technology and service industry value chain [1]

  • enabling Renminbi held offshore to be used to buy equities in China [1]

In October 2009, China's government and financial institutions were concerns about the risk of economic overheating - and recognised the need to shift away from reliance on exports and government spending [1]. In December indications of undesirable outcomes from the way stimulus funding and credit have been used were increasing, and the difficulties of a rapid increase in domestic consumption were apparent - leading to expectations about a major reform initiative [1]

Beyond Export Dependence: Creating an 'Asian' Economic World? [<]

The steps that were being taken by China seem to make little sense within an international order based on Western political and economic practices.


Any attempt to use the Yuan as an international trade currency generally (in the way the $US is used) would result in its revaluation, and a decline in China's international competitiveness and create hazards in the longer term in the absence of significant changes to China's financial systems.

Seeking to establish Shanghai as a major global financial centre (perhaps in parallel with Hong Kong) [1] can not in itself solve the difficulties that China faces in growth based on domestic demand (ie the need to borrow in international markets to fund growth). The ability of banks in such a centre to counter-balance a substantial Chinese current account deficit depends not on the practices of those banks and their regulatory framework, but on the practices of the entities within China that they would invest in.  

Likewise seeking to reduce dependence on the $US by acquiring hard assets (which, in some ways, would reproduce the tactics of European mercantilists in the 18th century and arguably result in a collapse in global demand) would not result in the emergence of a balanced / efficient economy within China.

Stimulating growth in trading partners who lack sound domestic financial practices so that they could allow export-led growth to continue in China would also be futile.

The possibility of redirecting surplus savings (from East Asia and oil exporting nations) into investment in developing countries through international institutions created by the IMF has also been raised [1]. This could (in principle) allow China to continue with an export-led development strategy by shifting the excess demand from the US to developing countries.

However developing countries who participated in this scheme to permit export-led development in East Asia  would have to run large current account deficits, the financial institutions managing the offsetting capital flow would need to be able to guarantee sound financial outcomes - and this is not characteristic of developing economies. Moreover 'everyone' now apparently wants to copy the 'successful' export-led strategy that allowed East Asia to avoid the risk of financial crises.

Achieving profitable outcomes has been difficult / impossible within the framework of socially-coordinated East Asian economic models, Thus borrowing in international markets to fund growth has been impossible. Economic strategies have thus been dependent on large domestic demand deficits and export markets (mainly to the US). This is no longer feasible - and the problem is recognised in East Asia.

It is possible that China's leaders do not understand their medium-long term economic predicament under a Western political / financial global order (and are suffering a case of 'pride before a fall').  It is also possible (noting provocative statements about the US increasing its savings to avoid risk of a further economic crisis [1] - a step which, while necessary, will probably make past East Asian economic models unsustainable) that China expects that a catastrophic economic crisis is unavoidable and is trying to make a point about who should be blamed.

However it is more likely that there is a long-developing plan to create an international economic, political and financial system with 'Asian' characteristics (an order that Japan first sought in the 1930s). It may be hoped that a combination of innovation, growth in domestic consumption, developing non-traditional markets (eg in emerging economies whose growth might be less affected by the GFC), rigging markets through cartels to make major state-supported enterprises and banks 'profitable' at the expense of other parts of the economy, undermining international institutions operating on Western-style political principles and creating machinery to handle 'international' financial transactions under government control could overcome the growth constraint in a uniquely Chinese / Asian basis. This possibility is speculated in Creating a New 'Confucian' Economic World?.

As noted in the latter speculation this option would seem risky. It would involve a race against time (ie to create alternative markets within a China-centred trade / tribute regime before foreign exchange reserves became depleted). It would demand a great deal of ordinary Chinese people, mainly to ensure control by traditional social elites. And in the long term, the lack of enterprise whose profitability depends on meeting customer demands (ie of effective capitalism) would probably make it impossible to balance supply and demand.

The shift in export emphasis from US consumers to emerging economies is fraught with dangers as many of those economies had copied East Asian economies in seeking export led growth and maintaining current account surpluses in order to protect their financial systems from the need to borrow in international markets (see Leadership by Emerging Economies?). Given the inability of the US to perpetually remain everyone's 'consumer of last resort', China's emphasis on exports to emerging markets must put weak financial institutions in the latter at risk of financial crises.

Discord / Conflict? [<]

Thus another possible interpretation is that there is internal discord about China's future directions, and thus no current consensus.

China has faced constant internal social political unrest (with a reported 100,000 mass incidents pa) and has an extremely imbalanced income distribution. Thus despite China's overall economic growth internal political shifts are not impossible - even though they may be unlikely.

The ever-present tension (noted above) between what might simplistically be called 'north' and 'south' China could be significant - as the rural 'north' apparently favours a military approach to developing China's strength, while the commercial 'south' favours economic tactics.

'South China' has dominated in determining strategy for China's growth and development since the post-Mao economic liberalization in the late 1970s - a dominance which funded the military aspirations of the 'north'. However the 'southern' tactics may be no longer sustainable, and have caused many domestic concerns within China (eg about the distribution of wealth and abuses of power)

Thus, in an environment in which the West's strengths in financial services have been undermined, it could be that a resurgent 'north' might be gaining more influence in advocating both traditional socialism and aggressive nationalism. The potential for virulent anti-Western nationalism (based on both pride in China's achievements and resentment of its historical treatment by Western powers) was exposed by grass-roots responses to widespread Western demonstrations against China's actions in Tibet during the 2008 Olympics [1].

If maintaining GDP growth is vital, and it was believed that little could be achieved by market-oriented adjustments, at some time spending on armaments and militarily-significant infrastructure (for which the state would be the 'customer') could be emphasised to boost GDP and create jobs, while nationalistic drums were beaten to blame 'foreigners' for the economic crisis and thus divert attention from domestic defects. Needless to say such an intention would not be overtly stated - not least because such a change in tactics could generate internal conflict.

It can be noted in passing that:

  • China's military spending is reportedly to increase 14.9% in 2009 - and the details of what this involves are being kept secret [1];
  • China was seen to respond belligerently in a dispute with Japan [1];
  • China's view of history focuses on its past humiliation by foreign imperialism (rather than on its subsequent domestic difficulties, eg under Mao), and the so-called 'Communist' Party is presented as having thrown off the yoke of foreign oppressors [1] ;
  • in March 2012 it was reported that the person who is expected to be China's president next year (Xi Jinping): (a) rejected US president Obama's proposal for a serious dialogue between US and China's armed forces; (b) is seen to tougher, more nationalistic and closer to the military than his predecessor (Hu Jintao); and (c) won't resist those who press for China to be tougher as the US is seen to be heading for inexorable decline [1]

Another 'Tiananmen Square' Moment for China's Regime? [<]

In July 2009 China arrested Stern Hu, the senior executive in China of a major mining company (Rio Tinto), on changes of stealing state secrets that had damaged China's economy.

One observer suggested that China's use of what seems to be 30 year out-of-date Cold War tactics would raise concerns in the world business community about doing serious commercial deals in China [1] (noting the context of China's displeasure about Rio's rejection of a large share purchase by a state owned company (Chinalco) and the outcome of iron ore price negotiations, and indications [1] that Rio may be planning to seek $9bn compensation payments from Chinese steel mills for breach of contracts).

While it is possible that Rio Tinto may have benefited from obtaining commercially-confidential information about China's negotiating position, the fact that smart business tactics can become 'national security' questions highlights what is different about the character of China's economy. Corruption is understood to be quite common. Laws exist prohibiting this which carry severe penalties but are only enforced against those who act contrary to the wishes of the regime.

Moreover, (unless evidence can be presented to justify espionage charges against Hu) this action may be symptomatic of the fact that China's authoritarian regime is under a lot of stress and may be facing another Tiananmen Square moment (ie a threat to its existence).

The regime is under diverse internal stresses perhaps because of:
  • separatism in peripheral regions such as Tibet and Xinjiang province;
  • frequent 'mass incidents' reflecting local dissatisfaction related to corruption and abuse of power;
  • dis-satisfaction with the income inequalities that have resulted from the combined effect of economic liberalisation and crony capitalism - and continued preference by some for the equality of the Mao era;
  • spiritual movements such as Falun Gong - which were suggested to the present writer by a Chinese contact to have a political aspiration of restoring China's Imperial system;
  • advocates of democracy;
  • tension within the regime itself between the currently-dominant factions (apparently from 'southern' China, including the Diaspora) who favour commercial options for advancing China's power, and those who may favour alternative (eg Cold War style) options.

The real problem however may be that China seems to be headed for serious economic problems - and the 'legitimacy' of the present regime in the face of its domestic competitors depends on their ability to maintain economic gains.

China needs to achieve rapid economic growth (eg 8% pa) in order to prevent unemployment escalating. However, despite expectations to the contrary in mid-2009, the 'world' (and especially the US which has provided a large share of demand for China's exports) faces a lengthy period of economic stagnation because of unresolved financial system problem (see False Dawn).

While China might seem to have options for more domestically driven growth, this would require empowering China's people at the expense of China's regime. Moreover strong domestic growth in a stagnant global environment implies that China's current account surpluses would reverse and so start to run down China's accumulated $2tr foreign exchange reserves - and eventually expose China to the risk of a financial crisis because its financial system has not in the past been able to justify borrowing to cover current account deficits (see China: Victor or Victim?, and Unsustainable Economic Models).

In the post-GFC era the global financial imbalances which have been essential to the financial stability of creditor countries will no longer be able to be supported by US and other debtor countries, and massive real-economy adjustments (which have not yet really even been started) will be required before macroeconomic conditions can allow global growth to be sustained. The demand deficits that are essential to protect against currency crises in emerging economies can no longer be counter-balanced by excess demand in US and other debtor countries.

In response to this challenge it seems that China may be seeking to develop a new international 'Confucian' economic order (similar to the trade / tribute regime that prevailed under China's control prior to the arrival of European influences), as a means to avoid the breakdown of its economic model. This possibility, though anything but certain, seems compatible with China's initiatives since the global financial crisis started seriously impacting on Asian economies.

However the failure of the takeover attempt of Rio Tinto may have revealed a fundamental weakness in what might have been hoped to be China's escape route. China seems to have made determined efforts to acquire behind-the-scenes political influence in Australia. In SE Asia (where crony capitalism has been well established) political influence translates into the ability to do 'commercial' deals to suit political interests. However this did not work in Australia in the Rio Tinto case - and demonstrates a serious limitation on the notion of an international 'Confucian' economic order in true market economies.

Arresting ethnic Chinese Rio Tinto executives may be symptomatic of the need which China's regime feels to enforce 'disciple' within an intended 'Confucian' empire.

Another observer suggested that this event signals a major re-alignment of how China managed its economy - and that spy and security agencies have been promoted to top strategic positions (specifically that the Ministry for State Security had been put in charge of economic dealings [1]. If this is correct, it: (a) suggests a rising sense of fear within China's regime about the economic future; and (b) is likely to alarm trading / commercial partners, and potentially trigger a reversal of the gains China achieved as a result of its 1979 economic opening to the external world.

In mid 2011 it was noted that as China celebrates the 90th anniversary of the founding of the 'Communist' Party: (a) it has a lot to celebrate as the world's most successful 'Communist' party; (b) democracy has not come to China, and the 'Communist' Party is not interested in this; (c) the Mao cult is being revived as a sign of increasing nationalism;  (d) the Chinese state has been astonished and appalled by democratic uprisings in Middle East and elsewhere - as the leadership genuinely believes in the superiority of authoritarian government; and (e) extensive control of the internet is maintained to prevent information about developments elsewhere being disseminated [1]

Political Change and Potential Instability: The Continuing Saga   [<]   

Political instability has, and remains, a feature of China's history (see Political Constraints above). The latter referred to:

  • periodic civil wars over thousands of years perhaps between the commercially oriented south China and the more rural / spiritually / militarily oriented north. Factions from southern China have repeatedly been driven out to become the commercially oriented Chinese Diaspora across SE Asia. Though there was more involved, the 1949 Mao-led Communist victory on the Chinese mainland over the Nationalists can be seen as a continuation of this process, while China’s market liberalization in 1978 under Deng can also be seen as a resurgence of influence in mainland China (through behind-the-scenes takeover of so-called 'Communist' Party) by the commercially-oriented Diaspora;
  • relative economic under-development in NE China;
  • the need to and difficulties in enmeshing educated elites and the masses in the so-called 'Communist' Party;
  • perceptions of a collapse of morality;
  • high levels of official corruption;
  • near-revolts and the suppression of about 100,000 'mass incidents' annually;
  • constraints on China's traditional authority structures;
  • the incompatibility between the social equality aspirations of China's nominal communism and the neo-Confucian social hierarchy that has been required for its economic success.
  • attempts to promote Confucian religious concepts to ensure harmony.

In early 2010, speculations were put forward by John Lee in Australia suggesting that China's younger leaders who were just on the point of assuming power might take their country in new directions (eg away from its state-driven export-led economy and towards stronger roles in global / regional institutions).

Outline: A significant development will occur  in 2012 when a rising generation of leaders with no memory of the turmoil / hardship of Mao years starts to take power. This might allow new options to be pursued. China's leadership has focused on fine-tuning Deng's state-led development model for past 15 years. But this model is not likely to be viable much longer (because of dependence on inefficient state-led fixed investment and export-led growth rather than domestic consumption.  Progress in currency / capital account liberalization, weaning state-controlled industries off state capital has been slow. Also since mid-1990s China's foreign policy has been cautious not bold - based on Deng's 'hide capacity and nourish obscurity' idea.  Leaders fear that big-picture reforms will bring disruption and chaos (noting how Mao took China in the wrong direction, Tiananmen Square and urban labour unrest). All elites see China as Asia's natural leader with US as recent interloper - and giving US an excuse to 'contain' China causes concern. The next generation (without experience of past problems) may be more confident / assertive. Some already see reform as too slow. Many (especially those educated in Western graduate schools) are concerned about China's weak strategic position in Asia and in global / regional institutions. When new leaders take power China will be much less predictable than it is now [1]

Similar suggestions have been made by others.

China's economic growth has been driven by: (a) a huge labour force; (b) economic reform which unleashed private entrepreneurship that now accounts for 70% of China's GDP (and ICBC, Bank of China and China Construction Bank are amongst the world's best in terms of market capitalisation, while large state-owned enterprises are now profitable); (c) opening to foreign investment; and (d) natural resources. These factors will diminish in future (eg export surplus will decrease; FDI will fall; labour shortages are emerging; population is aging; resource limits are approaching; environmental damage has been high). Future gains could come from: removing discrimination against private sector;  further reform state enterprises; and promoting innovation [1] (Comment: It is noted above that market rigging may be a factor in the reported profitability of China's major banks and state owned enterprises)

Nobel peace prize winner, Liu Xiaobo, suggests that people in China are no longer willing to simply accept the 'party line', and that China's system which is run to benefit the elite is no longer acceptable  [1]

While such options are be worth consideration, they arguably face severe structural obstacles. For example,

  • shifting from state-led growth (which is ultimately dependent on maintaining current account surpluses to protect China's financial institutions) encounters the same structural obstacles that existed in East Asia generally at the time of the 1997 Asian Financial Crisis (see Understanding the Cultural Revolution - needed for success under Western-style financial regimes, 1998). The latter referred (for example) to the obstacles to shifting from 'communitarian' investment to that driven by capitalistic expectations of profit that arise from: fundamental differences in the way information is used; the need to change economic goals from economic 'power' to financial returns; the inseparability of economic issues from questions of social / political power; and the lack of appropriate legal systems: Similarly
  • China's role as Asia's 'natural leader' is based on Confucian traditions for exercising power (arational / intuitive consensus amongst the subordinates of social elites), rather than on the Western-style traditions of rational policy debate amongst elected community representatives that applies in prevailing international institutions. It is difficult to see the former simply being expanded to take a stronger role in the latter environment, or being relevant in contexts where others don't accede a dominant status to China's social elites (because of expectations about a rule of law) or expect decisions to be based on rational analysis.

In late 2010 statements by China's premier, Wen Jiabao, suggested directions for reform in China (ie to reduce the risks implicit in inflation and corruption [1] and to boost freedom of speech and democracy [1]) - at a time when trade frictions with the US were increasing so that appearing to become like a Western democratic capitalist society in future might be be hoped to result in a less antagonistic stance.

China has raised expectations of reform at 'Communist' Party summit - at a time of intense internal pressure (from intellectuals) to lift censorship and hasten reform. China's 12th five year plan will extend to administrative, political, social and cultural restructuring. China's premier laid the ground work for reform in a string of speeches [1]

Economic plans of China's Communist Party have been railroaded by forces outside its control. Agenda considered by 200 members of China's wealthy and cosseted Communist Party elite will now consider political reform - following series of speeches by China's premier [1]

[Preliminary comment]: The possibility that the political reform proposal may be a ploy is supported by the fact that: (a) Japan has put on a democratic 'face' without apparently changing the reality of government by bureaucratic elites equivalent to China's so-called 'Communist' Party; (b) change under China's system does not traditionally come from the centre, but from communitarian consensus, and tends to be announced after it has already been put in place; (c) deception and holding up a 'mirror' so that others see a reflection of themselves, is a traditional Art of War tactic; (d) controlling information flows is the essence of the way power is exerted under East Asian traditions - and while means may have been put in place to provide advantages to China's elites in achieving this (eg stronger state controlled media, Internet censorship) true democracy could unleash forces that tears China's system apart. . The present writer suspects that rather than moving in the directions suggested above (which would boost international harmony, but face severe internal structural obstacles) China's leaders, even those well-educated in Western ways, may be forced by their traditions more in the disharmonious directions speculated in Creating a New 'Confucian' Economic World?.

In March 2011, it was suggested that China's new 5 year plan incorporated elements to boost the role of consumption and reduce reliance on exports and investment. Features of the plan included: (a) a shift from manufacturing to labour intensive services; (b) boosting wages; and (c) building social safety nets (Roach S., 'Consumers key to China's brand new plan', AFR, 1/3/11)

[Preliminary Comment]: There is some complementarity within different elements of this plan - because increased wages and a social safety net would boost demand for services (or which the most labour intensive seem to be education, health and welfare). There are also precedents for increasing wages as a means for transitioning from low quality labour-intensive industries (a technique that was used by Singapore). However unless and until there are changes to the techniques for political and economic management of such changes, the financial imbalances that China's distorted financial systems require (and their adverse effect on the global economy) will not moderate (eg see comments below)

However in mid 2011 indications of pressures for political change and of radically different views of China's future were emerging:

China's Communist Party is now the world's most powerful organisation. It is an essential partner to Australia's economic prosperity. Yet it is little understood (in terms of funding / selecting leaders). The Party has given authoritarianism new currency - with Western business in particular.  But the Party (with 80m members who are the wealthiest and most powerful in China) lacks legitimacy. It's right to rule is based on victory over nationalist government worn down by fight against invading Japanese. Power comes from the barrel of a gun, according to Mao. Since Mao's death its legitimacy comes from material catch-up to others in Asia. The Party incorporates the flag, the state symbol, national heroes, public rhetoric and the PLA (which is responsible to the Party leadership). China's constitution entrenches the Party's dominant role in the state. The standing committee of the Party outranks the state council (the highest arm of executive government). The last attempt to separate the Party from the state was made by Zhao Ziyang in the 1980s - but response to 1989 protests resulted in his being placed under house arrest. No significant political reforms have been attempted since 1989. Economic reform has slowed to a crawl since premier Zhu Rongji took China into WTO a decade ago. But China's financial system is an empire in itself designed to prevent anyone taking a position opposite to that of the government (according to Carl Walter and Fraser Howie in Red Capitalism). The CCP has become the party of stability, power and tradition - tentatively embracing Confucius, denigrated by party's founders as an arch-reactionary. But though a statue of Confucius was placed in Tiananmen Square, it was later shifted to a museum. The Party has become a dynasty. Its top leaders are cut off from ordinary life. Those who founded the Communist Party would be perplexed by what has happened. The 250 year old Qing Dynasty had fallen a decade before they met, and Sun Yat-sen was seen as founder of modern China. The Russian revolution in 1917 had been a powerful catalyst. The Party initially tried to build credibility within the nationalists, but this founded as Chiang Kai-shek took over. Mao then focused on establishing soviets (communal groups) in his rural Hunan homeland - a quite different approach to that in Russia. Decades later China again set out in a new direction - engaging with global business. When nationalists encircled communists, Mao former a guerrilla force. he then purged all dissent, as the nationalists lost ground to invading Japanese. China's republican era from 1911 to 1949 brought rapid modernisation, a start to elections and engagement with the world. Many gifted people returned from overseas to help. But Mao purged them, communalised farming, seized private property and developed a class consciousness derived from Marx's European theory. Mao launched his Great leap Forward to industrialize China and 30m died, mainly of starvation. After pragmatists (Liu Shaoqi and Deng Xiaoping seized power) Mao launched cultural revolution to dislodge them. After Mao died Deng seized control, and announced the open door era. This was first restricted to economy, but has since been broadened so long as people do not challenge the party. In the first half of the Communist era, China went backwards under Mao, but in the second half China started to reclaim its role as a superpower. It retreated from reliance on charismatic leadership to governance by committeemen. Deng's 'contract' with China's people has been fulfilled (ie we will improve living standards if you let us rule). The Party is being challenged by: corruption; a wealth gap,; frustration about lack of rule of law; and a growing sense of entitlement rather than gratitude amongst the young. The Party is likely to reach its centenary. The cadres rule people whose tastes, interests and experience are changing faster than theirs [1]

 China's communist party officially held its first meeting in Shanghai in 1921. The meeting room is a shrine to Marxism, Leninism and the Great Helmsman, Mao, but is surrounded by consumerism. China's rulers take mandate from 1949 revolution, not from democracy. Party has reasons to celebrate - having overseen China's ascent. But this comes at expense of individual freedom. No dissent is allowed, but rising wealth could undo authoritarianism. Party believes the Chinese model of communism is new - and better than Western democracy - socialism with Chinese characteristics (combining freewheeling capitalism with an iron rule). The Party is enmeshed in China's society. There is little dissent, because this would lead to trouble. The Arab spring shows that the Party is in an unusual position. People don't talk of democracy - but value wealth and stability they have gained. But more now pay tax, and want a say in how it is spent. Young people have little spiritual feeling for the Party, and are more materialistic. The Communist Party changed from an underground guerrilla organisation to controlling the fastest growing economy. People join the Party to advance their careers. CEOs of most big Chinese companies are Party members, with his deputy being in charge of operations. Mao persecuted 'capitalist roaders' - but eventually entrepreneurs were allowed into the party. Online comments favour the Party - because dissent leads to trouble. 'Red tourism' is thriving - visiting sites associated with Party history. Party has ruled out anything resembling multi-party democracy. The Party ensure peaceful transfers of power - which were not usual in imperial times. People's biggest concern with Party is that some are corrupt, and the problem is getting worse. The number of 'mass incidents' resulting from abuses of power is escalating  (287,000 last year up from 85,000 in 2005). The big question is what happens when growth slows or inflation rises. Confidence in the Party is high, though it must constantly reinvent itself to keep people onside. How long it can continue doing so is the big question [1]

Communist Party 'princelings' (ie children of past Party leaders) are seeking to establish their status - but their interests are diverse. In order to establish their positions they need to cut Deng Xiaoping down to size. His 1992 'no debate' edict is being challenged (from the left, by sabre-rattling generals, and by pro-democracy advocates - ie democracy within a one-party state). The 'no debate' era is ending [1]

In particular there appeared to be tension between between the social equality aspirations of China's nominal Communism and the inequalities implicit in the neo-Confucian social hierarchy that has been the framework on which China's rapid economic modernisation has been built (see Communism Versus Confucianism: The Continuing Contest in China). 

In some respects these seemed to re-raise the motivations under-pinning the Mao-led 'cultural revolution' in the 1960 to free China of traditions that blocked the adoption of his version of Western-style socialism. Without at least 'cultural evolution' now it seems unlikely that China's international economic and political influence can continue increasing harmoniously.

These controversies were given public expression (which is unusual in China) by the efforts of Bo Xilia to promote social equality (and state economic institutions), and the efforts to block his rising influence on the basis that Bo had used dubious methods (though these seem to be typical of the methods used by the elites in China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party) generally).

It has been suggested that China's Confucian order in 2011 can in some ways be seen as like that which revolutionaries overthrew in 1911.

China's 1911 revolutionaries might recognise the system they fought as being like today's communist China.  Once celebrations of China's communist party focused on workers, peasants and soldiers. Now they refer to science, technology and modernity. However 2011 is centenary of 1911 overthrow of Qing dynasty and 2000 years of imperial tradition. This is being downplayed. It was not organised by Communist party, and lacked ideology. Some blamed Manchu emperors for China's problems, or backward looking Confucianism with its stress on social hierarchy that ended in stagnation. A democratic republic was the aspiration. Now Communist party's rule resembles the system the 1911 revolutionaries overthrew: a large privileged bureaucracy; hereditary privileges in ruling elite; a mass of toiling workers and farmers; and the embrace of Confucius. In January a large statue of Confucius appeared in Tiananmen square, but disappeared in April. Confucian influence remains. The official doctrine is now harmony, not class struggle. While the Maoist era is publicly celebrated, in the party schools it is being refashioned.  It is still a Leninist party - dedicated to perpetual rule, but one where the Party and business are closely linked. Now Confucius is embraced over both Marx and Mao [1]

Bo Xilia was Communist Party Secretary in Chongqing (the main instrument of central government control) til last week. He is one of China's princlings, and was Minister for Commerce until he conflicted with Hu Jintau. He was responsible for crackdown on corruption that netted police chief, members of the local mafia, and many officials / businessmen. He was helped in this by new police chief. Bo wanted to return to power (ie to Standing Committee). he promoted Chongqing model which featured leftist 'red' ideals - but was imposed on the population. He used the 'clean up' to get rid of factional enemies. His investigations also showed how local corruption was linked to Beijing. Bo's main rival is Guangdong leader (Wang Yang) who seeks reform, and does not favour hard-line leftist policies. Police chief sought refuge in US Consulate - and this might have been part of larger power play to damage Bo's prospects. Factional enemies in Beijing have evidence of corruption and persecution of Falun Gong by Bo and his police chief. To save himself, Bo set police chief adrift, and the latter then threatened to expose BO. The police chief then feared that he would be killed, and sought refuge. Bo was forced to resign, but will never be charged with corruption because: this level of power is never touched by corruption allegations, and the law is manipulated for people's own ends. But Bo has evidence against members of Standing Committee - in China the rot goes to the top. Thus Bo is still a player, despite his demotion. His main ally is Zhou Yangkong (head of Political and Legislative Affairs Committee), and supervisor of Falun Gong persecution. Police chief's flight has opened window on internal machinations in Communist Party. ideology is dead, all that matters is shared lust for power / enrichment in leadership group. This is likely to be the beginning of the end of totalitarian Communist Party rule in China.  [1]

The removal of Bo Xilai (who had promoted a broad 'red revival' movement) has disrupted an delayed the once-in-a-decade leadership transition in China [1]

In March 2012, Li Keqiang (who is expected to be China's next premier) highlighted the need for market-based change after sacking of an ambitious provincial leader who wanted a bigger state role in economy. Reforms would focus on: brisk / balanced growth and stable prices. Market forced would play a bigger role in resource allocation. This followed removal of Bo Xilai, who had turned Chongqing into a bastion of Communist-revolutionary inspired 'red' culture and egalitarian growth and won national attention for cracking down on organised crime. IMF has speculated about reserve currency status for yuan, given financial market liberalisation [1]

China's premier referred to serious divisions within the Communist Party, and to the 'deadly chaos of the cultural revolution and the continuing influence of feudalism'. This is most unusual, as normally differences are resolved internally and a united face presented externally. Normally the cultural revolution and Mao's distortion of reality are not mentioned. The Communist revolution was supposed to have done away with feudalism, yet Dictatorship of Proletariat is feudal in practice. The CCP and government rule like emperors they replaced. There is no equality in China. Power cascades from king / emperor / president, to provincial level barons and thence to local lords (who are the meanest and most corrupt). All others are modern day serfs. Yet China's second most important man warns of the risk of another cultural revolution, and points out that China's feudalism remains. Whichever faction gains power in China will rule for next 10 years. Moderates and reformers want a more socially fair and environmentally responsible society - or else gains of past 30 years could be lost. The radicals want to extend power of central government and its control over people's lives. This would be a great leap backwards. Bo Xilai (Party Secretary from Chongqing) has experimented with this model. China's future hangs in the balance [1]

Rumours circulated of an attempted coup in Beijing - perhaps organised by Bo Xilia's supporters in March 2012, and of uncertainties about who was actually running the country [1]

Until March 15 Bo was the top official in Chongqing, and poised to join the Politburo. Then his political fortunes vanished, and his wife was charged with murder. This is a major shift for couple seen as China's Kennedy's. Rumours have circulated in Beijing that this represents a concerted effort to halt Bo's rise based on the 'Chongqing model' - a top down push for social equality (with a strong government role and huge infrastructure projects). Many saw Bo promoting a cult of personality - and a return to the Cultural Revolution was feared. The real story is that China's political system is trapped in the past (ie in closed-door deliberations, backroom deals and purges) in the face of an internet culture that makes it impossible to control the news. Bo's situation shines a light on massive gap between the rich elite and the poor. To thrive China must now stop transferring income from households to the state - but elites may not allow this. The obstacles to reform increase the risk of a hard landing for China, and political instability [1]

China will face another cultural revolution organised by the left wing of the Communist Party if the economy stagnates [1]

This contest needs to be considered in the light of the apparently substantial grass roots support for the sort of equality (even in the absence of wealth) that China had under Mao.

When the present writer visited China in 2003 there was a constant queue of hundreds of people waiting to visit Mao’s tomb, and a guide explained that this was due to their  desire for Mao-era equality.

[She also suggested that Falun Gong is not just a spiritual movement but is vigorously suppressed because it is seeking to restore the position of China’s emperor – and thus to challenge the elites linked to the 'Communist' Party].

It was the pro-Maoist mood that Bo Xilai was building on that recently led to recognition of potential instability at top level in China (see above) – and considerable official nervousness about what side China’s army would support.

Comments (in August 2012) by a resident Western observer on changes in China in recent decades provide a view of the adjustment challenges that are faced, including:

  • indications that China's current political and economic system may have eroded the 'communalism' (ie the willingness of Chinese to put the interests of the whole community first) on which it has been critically dependent for reasons suggested below;
  • an apparent break in trust between the Communist Party and China's people, when both China's political and economic decision making is organised on an hierarchical neo-Confucian basis within the Communist Party as 'representative' of China's people generally;
  • China's traditional 'Asian' approach to education, which establishes conformity rather than an ability to 'think', and thus presumes the continuance of an economic model built around a social hierarchy centred on the Communist Party;
  • the incompatibility between the vengeful nationalism the Communist Party has engendered in China's people, and the expectation being promoted elsewhere that China will take a global leadership role in the 'Asian century';
  • the incompatibility between the neo-Confucian leadership style (which forces subordinates to decide) and the expectation of a leading Chinese role in international affairs (see also Eurocentric Aspirations in a World of Rising Asian Influence);
  • the lack of realistic investment options available to increasingly wealthy Chinese - who thus are virtually forced to invest in what seems to be a property bubble.
I have wanted to to live in  China for 16 years, but now want to leave. Despite China's progress, the dream that has existed since coming as a student in 1986 is broken.  China then was communist, and backward. It was also optimistic. A free market was emerging (with inflation which was also viewed as progress). There was a sense of social obligation - generating selfless socialism / unity. Deng Xiaoping was responsible for that optimism. He also ordered the tanks to Beijing in 1989, creating a a damaging legacy for the Communist Party. On returning to China in 1996 there was still optimism, but a whiff of commerce. Deng had offered people material wealth, providing they didn't ask for political change. If the party was trusted, everything was supposed to be all right. But now it is not. My business has encountered ongoing difficulties - due to a state owned competitor (enemy). But personal considerations are not the basis for these comments on China's problems. China is now focused only on making money. Family culture has become a 'me' culture. Communities do not act together. Social status is linked to displays of wealth. This upsets those who have little. Investment options are limited to property (or under the mattress). Stock markets are rigged, and banks are non-commercial. The powerful transfer their wealth overseas but other can only buy property - creating the biggest property bubble in history. Home ownership has become unaffordable for young urban workers, and vast residential developments continue to be built purely as investments. When the bubble bursts / deflates the Communist Party's promise of wealth to the people will have been broken. If this coincided with other social stresses, there could be real trouble. The government is now scared of the people, and doesn't lead them. Local issue passed up to Beijing, are passed back saying 'You decide'. The Party only intervenes when its power or personal wealth is affected. The country is ruled behind closed doors. The current / outgoing prime minister (Wen) is a puppet. His proposals are good, but won't be implemented. To get to the top you must be grey - with no strong ideas. Those who are supposed to control the Chinese Century are faceless. China is supposed to be merely regaining its former / rightful position. But there are two problems with this. China was only ever powerful because of its size. And the world over which China presided did not include the US or enlightened Europe. China defeated invaders from the north - because they consumed them from the inside. Believing they are unique, Chinese can't empathise. Controlled by people with conflicting interests, China's government can't make decisions about domestic or foreign issues. A world leader must offer more than supremacy (eg the end to slavery that the British Empire offered, or democracy that the US offered). A China that led the world would not offer the chance to become Chinese - because this is impossible. And China's leaders tolerate slave-like working conditions domestically. China can't lead the world because the Communist Party has encouraged anti-foreign sentiment since its inception. Fevered nationalism is a cornerstone. Chinese are regularly told to feel aggrieved at what others (ie Western societies and Japan) have done to them (over the 100 years from Opium Wars to 1949), and expect the Communist Party to extract vengeance. There is a real prospect of upheaval in China - eg sparked by a property crash. This will bring an end to China's record-breaking growth - and hopefully can be handled with generating external conflicts. Personal risks in China include: having my business taken away; unhealthy air and food; poor education for children (which does no seek to produce future leaders / innovators); and propaganda. There are many in the Communist Party who understand that there is a problem, but time to solve this is short and the challenges are immense. (Kitto M., 'You'll never be Chinese', Prospect, 8/8/12)

It can also be noted that:

  • the post GFC need to shift to domestic demand to drive future growth and the apparent decline of 'communalism' arguably make the neo-Confucian methods that have been used domestically, and might need to be used in international relations in future if China's global influence is to increase, unsustainable. For example:
    • China's economy has grown rapidly partly because of non-capitalistic financial systems associated with Neo-Confucian systems of socio-political-economy involved elites coopting national savings from state-controlled banking systems to finance state-linked businesses activities that: (a) were coordinated by social relationships (ie by connections rather than by the calculation of profitability by independent enterprises); and (b) allowed the elite (but not households) to become rich. Those systems not only depended on the willingness and ability of trading partners (especially the US) to run large current account deficits and increasing debt levels. They also depended on the willingness of ordinary Chinese to allow high rates of national savings to be achieved at the expense of consumption so that they could be invested with limited regard to profitability;
    • lack of feedback between domestic supply and demand in the absence of a profit-driven approach to investment (see Balancing Supply and Demand);
    • the most plausible model whereby China could take a significant international role would involve an arrangement similar to the 'trade-tribute system' that existed in Asia prior to the spread of Western influence (see Creating a New International 'Confucian' Political and Economic Order), and this depended critically on the willingness of ordinary Chinese to work hard for limited reward, so that net material benefits can be provided to 'tributaries' in exchange for accepting the primacy of China's social elites.  
  • this difficulty is compounded by both the need for a more highly educated workforce and the emergence of Internet-based social networking - as these make it much harder to exert control through the traditional Confucian method of controlling access to information and thus of subordinates' thinking. However, China's education system seems to be geared to producing a just-do-it society largely comprising people who are conditioned to not thinking for themselves (see Competing Thought Cultures). This has arguably been appropriate to China's past economic model but: (a) seems likely to be the reverse of what will be needed in future; and (b) will take a long time to re-engineer;
  • Bo Xilai’s rise in Chongquin could well be only the 'tip of the iceberg' in terms of a gathering reaction to the non-capitalist neo-Confucian system of socio-political-economy established through the so-called Communist Party since 1978 – because in East Asia nothing tends to be visible or announced (as Bo Xilai started to do) until a lot of ground-work has been done.

In April 2012 reports emerged of concern in China about extreme levels of corruption in the PLA [1]. The PLA is thus both: (a) apparently expected to provide support to the neo-Confucian bureaucracy (ie the so-called 'Communist' Party) as it is challenged by 'redder' elements; and (b) part of the reason that the latter would object to China's current directions.

And different / incompatible interpretations of China's political reform options were suggested, eg: a shift to democracy; renewal of Confucian virtues as a non-democratic source of legitimacy; subjecting the 'Communist' Party to the constitution, a rule of law and an independent judiciary; making the law even more firmly a tool of the 'Communist' Party; or severe crack-downs on those who protest against inequalities.

China's 'communist' party is said to face a legitimacy crisis - because of Bo Xilai scandal. In the West non-democratic regimes are seen to lack legitimacy. But China's people are not dis-satisfied with the regime. Problems are mainly seen in lower levels of government, China's regime gains legitimacy from: (a) performance (eg from reducing poverty); (b) meritocracy (ie the perception of above average ability to make morally-informed judgements - a tradition with long historical roots. China cares more about having high quality politicians than the procedural arrangements involved in their selection); and (c) ideology (especially nationalism - rather than communism which few now support). These sources of legitimacy could be lost in future. Performance will be judged in ethical / intellectual terms when poverty is eliminated. Lack of virtue (the basis of Confucian moral legitimacy) is already being lost (as Bo case highlights). China's leaders are also held responsible for moral state of the whole country - and this is in a poor state.  Nationalism is a changing goal - as the past emphasis on defence is inappropriate when fear of being bullied shifts to the possibility of being bullied. Confucian reformists argue for more human nationalism (based on benevolence harmony) [1]

Confucian Renewal in China? - email sent 27/4/12

Professor Daniel Bell

Re: Real meaning of the rot at the top of China, Financial Times, 23/4/12

I appreciated the logic of your argument about non-democratic Confucian-style legitimacy in China, and what might be required to maintain this in future.

My interpretation of your article: see above

However I should like to submit for your consideration that there are probably two significant complicating factors, related to the economic model that China has adopted.

The systems of socio-political-economy that have been developed in various ways across East Asia appear to be neo-Confucian rather than simply Confucian, with the difference involving a blending of Confucianism with Daoism – because of the latter’s parallels with Shinto and Zen which are significant in Japan from which the East Asia models were derived. This blending has permitted / required learning from others, arguably because of Daoism’s rejection of traditional Confucian certainty about the wisdom that could be gained primarily from a study of history.

While this created an economic system that works (for reasons speculated in a section on East Asia in Competing Civilizations, which was derived from an attempt to ‘reverse engineer’ the intellectual basis of Japan’s pre-1990s economic miracles), it also created two serious difficulties. In particular:

  • The methods used to mobilize resources for economic activities have been based on Confucian-style social status and connections rather than on calculations of expected profitability in the use of capital. This has:
    • required macroeconomic imbalances (ie domestic demand deficits and excess savings) to make it unnecessary to borrow in capitalistic (ie profit focused) international financial markets (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy);
    • played a significant role in the international financial imbalances that have disrupted global financial systems and economic activity in recent years (see Impacting the Global Economy); and
    • laid the foundations of likely future financial / economic crises when trading partners cease to be willing and / or able to continue increasing their debt levels, and demand has to be domestically driven (eg see Heading for a Crash?);
  • Introduced moral uncertainty, and thus undermined Confucian aspirations of virtuous leadership. Confucian leadership is not traditionally concerned primarily with economic success, but it has had to do so in recent decades, and (because of the way economic functions have been organised) this has created options for acquiring personal wealth at the same time that the traditional basis for acquiring moral certainty has been eroded.

My undoubtedly inadequate speculations about the issues involved in reforming China’s system (which tries to recognise both the East Asian cultural context and the economic context) are in Change and Potential Instability Driven by China's Rising Generation?

I would be interested in your response to my suggestions.

John Craig

Reformers in China's 'communist' Party are seeking to exploit ousting of Bo Xilai to  make constitutional and political challenges - according to party leaders. Bo had opposed reforms proposed by Wen. For the party to save itself it must make itself subject to the constitution / law. There is doubt that the party can manage another peaceful transition. Bo's allies were main opponents of Western-style democratic reforms and an independent judiciary. Wen seems increasingly convinced of the need for democratic reforms to maintain social, economic and political stability (eg by gradually expanding from village elections, and making judiciary independent). Without serious political reform, the party's grip on power will be at risk [1]

Options for a shift to democracy over 10 years were suggested by a social science professor [1]

Removal of Bo has shown how ruthless politics is in China. Such purges happen periodically. His strong ego-driven personality was seen as likely to upset the consensus model. Few 'princelings' had chosen to got into politics, many preferring to use their position / influence to get into senior positions in business. Connection between party and business was sealed when former president Jiang allowed business people into the party and its senior advisory bodies. Bo had risen through the ranks to gain senior positions in Dalian. He became minister for commerce - and he hoped to get a vice-premier job. Some (eg Chen Li at Brookings institute) see Communist Party as 'one party two factions'. But Wang Zhanyang (Beijings Central Institute of Socialism) suggests that, while there are personal relations and ideological affiliations, reformers / conservatives and those at the centre all give precedence to 'stability maintenance'. This phrase was created by Deng Xiaoping and was meant to be temporary - but has become permanent. Some suggest that Bo's fall will see new burst of Deng-like enthusiasm for opening / reform. Others suggest that his removal merely rebalanced equilibrium of Hu-Wen administration - under which reform had slowed / stopped. Some wish to use Bo's downfall to crack down on officials who move from the centre. Zhou Yangkang (China's domestic security chief) argued that the law must serve the Communist Party (ie strengthen its ruling status). Clearly some are pushing for more than a simple smackdown of adversaries. Hu and Wen's power base for reform in Communist party has never been stronger [1]

Little is really known about events in China (eg bring down of Bo Xilai and accusing his wife of murder). Nothing has been proved. Things always get interesting in China before a National People's Congress. Leadership change in most democracies is transparent - though behind the scenes deal making is also a factor (especially in Japan). But everything in China is out of sight. Public spectacles are often used to resolve political conflicts. Bo gave the appearance of a gangster boss - like most party bosses in China (corrupt, ruthless, rich, behaving as if above the law). Bo was unusual in having open ambition - where China's party bosses like Japan's politicians and mafia dons are supposed to be discrete in seeking power. This upset others - and required a public scandal. A disgraced wife is a common tactic. Sine Bo presented himself as a critic of Chinese capitalism and promoted Maoist ethics, his natural enemies would be the more 'liberal' bosses who favour free-market capitalism and perhaps political reforms. Bo's fall might lead to a more open society, or to the reverse (ie to increased crack-downs on dissidents the more protests about disparity in wealth occur). This would not be to protect communism - but rather the Communist Party's version of capitalism [1]

In May 2012 it was argued that behind the scenes struggles at top of Communist Party related to purging of Bo Xilai could delay for three months handover power at coming party congress [1]. Maoists also claimed that authorities have fabricated their case against Bo Xilia in order to suppress his political ideas [1]

In September 2012 (just before a change of leadership to create the framework for future policy was due to occur) it was clear that uncertainty remained.

China's political tensions - email sent 17/9/12

Ambrose Evans-Prichard

Re: The End of China's Easy Growth, Telegraph, 16/9/12

Your article drew attention to the contrast between the bullish certainties of outsiders about China’s economic prospects, and the despondency of insiders.

“I missed the World Economic Forum in Tianjin last week but Jamil Anderlini from the Financial Times reported a pervasive tone of "despondency and cynicism" from Chinese officials and economists, in marked contrast to the bullish certainties -- or naïveté? -- of foreigners at the event.”

This internal uncertainty about China’s economic future seems to be paralleled by political indecision – according to a couple of articles reproduced below.

The latter are one observers’ attempt to explain what is going on in China’s political system from his socialist perspective. In brief it seems to view:

  • the removal of Bo Xilai as pointing to political infighting in the top CCP leadership between two major factions—the Young Communist League led by President Hu and Premier Wen Jiabao, and the “Shanghai gang” headed by former President Jiang Zemin and Zhou Yongkang, the state security chief on the Politburo Standing Committee;
  • the recent disappearance of Xi Jinping (China’s vice President and expected next President) as possibly indicative of similar tensions – as he was a compromise candidate who (being acceptable to both factions) was endorsed for this role in 2007 but may have recently increasingly favoured political liberalization [which, for reasons suggested below, would disrupt China’s current economic methods].

My suspicion is that there is also a need to take account of the incompatibility between the social equality aspirations of China’s nominal ‘communism’ and the social hierarchy required by the neo-Confucian methods that have been one key to China’s rapid economic transformation in recent years (as suggested in Communism Versus Confucianism: The Continuing Contest in China). The (so-called) ‘Shanghai gang’ are likely to reflect those who (probably with Japan’s help) introduced and control neo-Confucian methods of state-orchestrated economic change. However the state can only orchestrate economic change if it focuses on market demand rather than on community needs and aspirations (for reasons suggested in Economic solutions appear to be beyond politics, 1995). However:

  • a state focus on what the community needs, rather than what markets want, appears to be high on the agenda of the New Left / Young Communist League in China; and
  • this would require parallel market liberalization (ie towards a profit-driven / capitalistic approach to economic change) and the latter would probably result in financial crises like those experienced elsewhere in Asia in 1997 – for reasons suggested in The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems (1998).

Once again bullish / naive outsiders (who hope that China will be the solution to their local economic problems) seem to ignore such questions.

John Craig

Chan J. ‘The strange absence of China’s vice president’, World Socialist Web Site, 15/9/12 [text omitted]

Chan J. ‘Open letter demands Chinese premier’s removal’, World Socialist Web Site, 8/9/12 [text omitted]

In October 2012 it was suggested that:

  •  charges against Bo Xalai would carry the death penalty because 'liberal' Communist Party leaders want him out of the way so as to make it easier for them to defeat hardline factions. Rumours had circulated that Bo had plotted with security supremo (Zhou Yongkang) to usurp power and install a government of hardliners. Reformers were concerned when anti-Japanese demonstrators in China recently held portraits of Bo alongside Mao chanting 'Bo belongs to the people' [1];
  • China's Communist Party is to move towards dropping references to Mao in party communiqués. This change (which is illustrated by the fall of Bo Xilai) implies more Dengism and less Maoism [1];
  • China's Communist Party has warned of the need for bold political and social reforms - though it offered no specifics on what this might mean. Others suggested that meaningful reform would be difficult because of the same obstacles that have existed over the past 10 years [1];
  • China's premier, Wen Jiaboa has been attacked because of the riches that his closest family members amassed over the past 10 years at the same time that his political opponent Bo Xalai has been kicked out of the party and prosecuted for corruption. Discrediting him would undermine the political reforms that he has been advocating. China's internet suggests that the Bo faction has hit back at Wen with these allegations. The left of the Communist Party and Bo have seen Wen as their main enemy and his relations wealth was a rallying point. Illicit riches have always been a tool to bring down senior politicians in China - but Wen has little to fear as China has no tradition of investigating retired politicians [1]

When details of China's new Politburo was announced, it was variously suggested that:

  •  this laid the basis of a future economic crisis because it was dominated by conservative hardliners rather than those who might have followed through on the political and economic reform agenda of China's retiring president Hu Jintao.
The influence of Jiang Zemin has thwarted reform in China. The Politburo has reportedly been packed with conservatives (as the acolytes of Jiang, who rose to influence after Tiananmen, gained positions), Hardline dominance would require rethinking China's future. Jiang instituted the Patriotic Education movement - which whipped up anti-Japanese nationalism. His new influence comes at a time when Japan and China are seen to be one error away from war - which the US could become involved in. Prospective members intended to avert China's 'middle income trap' by following through on Hu Jintao's reform proposals gained no positions. Hardliners who claim that tight party control of banks and key industries shielded China from the problems in global capitalism in 2008 - though China's continued growth reflected a large stimulus and 30% pa growth in credit. China's risk is like that Japan faced after it brushed off the US's 1987 crash with apparent ease. Wen Jiabao argued that China's economy is 'unsustainable, unbalanced, uncoordinated and unsustainable' and his allies in the China Development Research Centre with World Bank highlighted the need to move from export-led growth model. The forces that facilitated China's rapid growth are fading, and a 'middle income' trap is visible. Manufacturing wages have risen 16% pa - outstripping productivity. Gains must come from inventive dynamism - which is impossible in a top-down system / government planning. The state of official finances is not really known - but there are serious problems. There are only 10 more years before China's democratic crunch. [1]
  • this new group included five experienced individuals and two potential reformers who would learn but have little influence for the next five years, but then dominate when the older group retired [personal communication];
  • the process of selecting leaders remains complex and non-transparent [1];
  • recent events revealed the increased difficulties of maintaining China's behind-closed-doors political system [1];
  • the new group confronts the fact that its predecessors largely failed to deal with the political and economic challenges that China faces [1];
  • political reform remains the largest challenge the new group faces. Five years ago 'democracy' was being widely touted by China's then president. Though many in China have argued the need for this, those who might have advanced this were not advanced into Politburo. There have been moves towards open intra-party democracy (behind closed doors) in Vietnam and Myanmar  - and these could be a precursor to more general democracy in China also. But discussion of this has been suppressed in China. Few expect the new group to be more successful than their predecessors in dealing with China's problem [1]

In May 2013 it appeared that the 'vision' that would guide China's development for the next decade could be of a Spartan / martial society (see Does Anyone Else Support the 'China Dream'?). This suggested that: (a) China had undergone a peaceful transition from dominance by the 'commercial south' to the 'spiritual / militaristic north' (see above); and (b) that China's future was unlikely to be a continuation of its recent past.

In June 2014 it was suggested that the reforms brought in by Xi jinping had little to do with economic liberalization (as many had expected) but rather were primarily political and involved the recreation of something like China's ancient elite-dominated regimes.

The Resurgence of Ancient Authoritarianism in China - email sent 5/6/14

Rowan Callick,
The Australian

Re: Beijing Smashes Through Red Tape, The Australian, 5/6/14

The changes in China that your article describes are hardly surprising. However rather than merely seeking to find a way to participate in a new China-centred tributary regime like that which existed before Western societies’ social, economic and political liberalism disrupted Asia’s ancient order, it would be worth considering: (a) what the re-emergence of a variety of traditional Asian authoritarianism actually means; and (b) whether it is likely to work.

My interpretation of your article: Xi Jinping is not just another Chinese leader. He is very different. China’s emerging governance demands close attention. Relationships are important in Asia – but there is a sharper-brisker tone in the way things are now being done in China. Relating well with China’s top leaders is becoming essential to building economic partnerships. In China everyone looks over their shoulder to the person behind and above them – straining to see the summit. Australia’s foreign minister had a meeting with Xi for an exclusive / constructive session in March. Australia’s prime minister did the same in April. A free trade agreement could result. Respectful personal connections are crucial. Anne Stevenson-Yang (J Capital Research) and Ken DeWoskin (Conference Board) have written for Wall Street Journal on emerging governance structure in China. Those who view China in terms of step-by-step liberalization are missing the point. There is a new museum of National History near Tiananmen Square which replaced the Marxist economic evolutionary approach to history. Xi took the new Politburo Standing Committee on a high-profile tour 19 months ago. His anti-corruption and anti-pollution campaigns are seeking to strengthen and purify the Chinese Communist Party. This is not the vanguard of the international proletariat. The Party is being recast as inheritors of ancient Chinese tradition of infallibility and rectitude. This well befits the first core of elites who have ascended to top ruling positions based on hereditary rights since the fall of the Qing Dynasty. ‘Princeling’ children of venerated party leaders (led by Xi) are in the vanguard. This has eluded analysts seeking economic measures involving liberalization. Observers wanted to see economic reforms emerging from Third Plenum. However the agenda was in plain sight – it was just not what was expected. There has been a major restructuring of power – with two new super-ministerial committees (one for security and one for economic reforms) that over-ride government machinery. Both are led by Xi. Many in Beijing complain about bureaucratic interference. The new structure will cut through this. Now ‘reform’ means sidelining institutional bureaucracy and injecting personal power into a sclerotic system. It involves cutting through the red tape that invites bribery. Reform in Australia might mean new government agencies, regulations and legislation. Xi’s reforms are headed in the opposite direction – bulldozing institutional frameworks out of the way. Australia needs to find a way to fit into this fascinating and dynamic new framework.

The need to seriously consider ‘what’ Australia is dealing with in East Asia (which I had expected to be something like your article indicated) was recently suggested in Aussies Outsiders to What? .

The latter included reference to Creating a New International 'Confucian' Financial and Political Order, which speculated about the sort of elitist international structure which political and business leaders might be expected to have to deal with in Asia if something like the international tributary system through which China had ruled Asia were to be promoted (as your article implies is the case).

Aspects of the new ‘ancient’ regime in China that your article outlined need attention. For example:

  • China’s so-called ‘Communist’ Party is putting this arrangement in place out of desperation – because of the financial, economic and political difficulties that it faces (see China: Heading for a Crash or a Meltdown). China’s rapid economic advancement was achieved through a variation of the neo-Confucian non-capitalist market economy that Japan pioneered as the basis for Japan’s pre-1980s economic ‘miracles’ (and post-1990 stagnation). The non-capitalistic financial systems that this involved put China at the same risk of a financial crisis that Japan faces if its institutions were subject to international scrutiny (ie it is forced to borrow to fund current account deficits because growth is being driven primarily by internal demand). And the use of neo-Confucian methods (with the so-called ‘Communist’ Party taking the catalytic role that the bureaucracy had taken in Japan) raised massive problems because: (a) Mao’s ‘cultural revolution’ had sought to purge Confucian social elitism from China and many Chinese still aspire to social equality; and (b) those with ‘Communist’ Party connections had exploited their positions to enrich themselves and their families / friends – thereby creating the world’s most extreme imbalance of wealth;
  • It is presumably intended that power be exerted through the traditional methods used by Confucian bureaucratic elites (ie on the basis of having top-down elite status, being highly educated, having social subordinates who make decisions on their behalf and providing a sense of direction through introducing strategic information to influence others’ consensual decisions). The methods of exerting power parallel the traditional methods used in ‘education’ in East Asia (in the sense that this involves inculcating desired behaviours in students (or subordinates in the elite bureaucracies’ case) rather than enabling them to understand). The new top-level security and economic groups that over-ride existing machinery of government will co-opt bureaucratic machinery rather than pushing it out of the way. Those arrangements are in fact merely admissions of what had existed in China since the late 1970s - ie the so-called 'Communist' Party had taken on the role of a traditional Confucian bureaucratic elite. Providing ‘tribute’ to social elites (which would be viewed as bribery in a Western context) is a traditional part of such systems. It is not a simply feature of existing Chinese bureaucracies that would disappear;
  • China’s educational system has apparently already been in a process of change to be compatible with neo-Confucian bureaucratic rule. It seems to be geared to creating a compliant population rather than one that would be able to operate in a liberal economic environment (Financial and Educational Reform in China: Headed in Opposite Directions?, 2013);
  • It is not currently clear who this system of government is expected to account to? China’s traditional Confucian bureaucratic elites ruled on behalf of the Emperor, who was the recognised centre and symbol of China’s society. Does Xi see himself as the new Emperor, or does he have another candidate? Or maybe there is an existing Emperor in East Asia under whose mantel of authority Xi and the other 'princeling children of venerated party leaders' have been entrusted with the quasi-Confucian bureaucratic government of China. If China is to have such a government, it is very likely that there is an 'Emperor' somewhere;
  • A ‘free trade’ agreement within a China-centred tributary environment would not involve anything like ‘free’ trade (for reasons suggested in 'Free' Trade with China: Not Likely under a Neo-Confucian Regime);
  • Parallels can be drawn between a government by ‘princeling children of venerated party elites’ who carry forward a ‘Chinese tradition of infallibility and rectitude’ and the fascist regimes that emerged in various places in the 1930s – and were initially frequently admired for their ability to smash through red tape. Closer to home parallels can also be seen with the Bjelke Peterson Government in Queensland in the 1980s which the present writer observed from the inside. It decided (presumably with encouragement by Japanese investors connected with Ryochi Sasakawa) to facilitate projects favoured by those with top level connections – and thereby created a situation in which the fairly effective machinery of government that was being created in Queensland in the 1970s was broken down and corruption flourished because no one was ‘minding the store’.

Finally (as noted in Aussies Outsiders to What?) it is by no means certain that the financial, economic and political systems that have been developing in East Asia are even viable or sustainable. This needs to be evaluated on the basis of Asia-literate advice, rather than assumed.

John Craig

Other views of China's new regime were also expressed.

Bo Xilia's fall revealed a great deal about the distribution of power in contemporary China. It was the first leadership change without a central strongman such as Deng Xiaoping. The new elite is the first building block in an interlinked system of patronage, tribalism, factional and institutional links that reach out from Beijing into the five-levels governmental structures of China, through the 84m Communist Party and into China's society as a whole. The long term legitimacy of this is uncertain. The key question is the nature of the Communist Party. It came to power through revolution - and lives uncomfortably with its violent past. Tough questions have been asked (eg by Yang Jisheng) about how power has been exercised over the past 60 years. there was an enormous death toll from famines in the 1960 - due to blind following of destructive policies. The Cultural Revolution has become tboo - as those who cut their political teeth in this era 9eg Bo Xilia) have gained power. Xi Jinping gained power in 2012. His life during Cultural Revolution was influenced by marginalization of his father. Thus he is a member of party royaly due to his father, but also worked as a man of the people. Problems in explaining what happened before China's opening are paralled by difficulties in explaining what happened since. Mao had a utopian vision of a Socialist heaven on earth. But perhaps Party is just about pragmatic national goals - rather than about having grand ideas for the future. Perhaps it simply allows space for people to thrive and prosper. or does it have a coherent belief system. The Party seems focused and tangible - but also brittle / fragile. The only way to understand is to look at the people in it. Membership of the Politbureau has immense spiritual as well as material meaning. They not only seek to lead China but also to represent its values and identity. China can perhaps be seen as what Mikhail Bakhtin called a 'carnival' society [1]

It isn't just networking in China - email sent 3/7/14

Kerry Brown
University of Sydney

Re: China’ networked leadership, Inside Story, 2/7/14

Your useful article suggested that:

“This new elite – those who finally emerged at about noon on 15 November 2012 in the Great Hall of the People – is the first building block in a system of interlinked patronage, tribal, factional and institutional links that reaches out from Beijing into the five-level governmental structure of China, through the eighty-four million members of the CPC itself, and into Chinese society as a whole. The seven members of the new Politburo Standing Committee are the final clue to how power is evolving, developing and renegotiating its parameters in modern China”

Another view of what has been happening is in The Resurgence of Ancient Authoritarianism in China . However I should also like to suggest that what is going on should not be viewed in simply a domestic Chinese context – for reasons outlined in Creating a New International 'Confucian' Financial and Political Order.

I would be interested in your response to my speculations.

John Craig

More on: It isn't just networking in China (email sent 3/7/14)

Kerry Brown

A couple of further comments on issues raised in your article follow.

Bo Xilia fall needs to be viewed in terms of the apparently immense support that exists in China at grass-roots level for social equality like that which existed under Mao – which is incompatible with the hierarchical networks that you article described. Bo Xilia had sought popularity on the basis of restoring this (and perhaps other) features of the Mao era – which was incompatible with the way China had come to work later.

China’s history needs to be viewed in terms of the attempts (under Mao) to purge China’s traditional Confucian power structures (because they had oppressed China’s people) and their discrete resurrection in a different form apparently with Japanese encouragement in the post-Mao era when China opened its economy and adopted a variation of the neo-Confucian economic model that Japan had pioneered as the basis for its pre-1990 economic ‘miracle’. The CPC is ‘communist’ in name only – and has operated increasingly on neo-Confucian lines since the late 1970s.

It is unlikely that there was no strong man behind the scenes to endorse to recent rise to senior administrative positions of China’s current leadership. Given the apparently almost-openly neo-Confucian system that has been put into place, it is likely that the ‘strong man’ will be viewed as some sort of emperor (or perhaps be an actual emperor).

There is not considered to be any need to ‘explain’ anything. The intellectual foundations of East Asian societies with an ancient Chinese cultural heritage are radically different to those of Western societies. Explaining would imply that there is something to be gained by understanding – and that notion is not part of the region’s traditional epistemology (see East Asia in Competing Civilizations and Why Understanding is Difficult). In East Asia ‘education’ (and neo-Confucian government) is about inculcating favoured behaviours rather than about enabling others to ‘understand’. Likewise the absence of an ideology is crucial to the way power is exerted (by facilitating-without-judging whatever powerful individuals / organisations who are prepared to accept a subordinate status want) – see Acquiring 'Soft' Power.

What is going on simply can’t be understood in terms of Western concepts – and attempt s by (say) Chinese academics to explain what is happening in such terms are either naïve or intended to be deceptive.

The background to the present writer’s involvement in dealing with issues such as those outlined is available.

John Craig

The inclusion of Liu Yunshan was a surprise when China's new leadership was announced in 2012. His career had been in journalism and propaganda. He holds the ideology portfolio. Liu needs to be studied to understand modern China. He articulates a pure orthodoxy that was learned from Ding Guang'en. Managing though is seen to be increasingly difficult / dangerous in China. Liu was part of Maoist program of late 2000s to bring many statues of controversial leader into Beijing. Liu's Maoist bent is less strict than that of Bo Xilia - but it has been influential. It is revealed in Xi's strong words on Mao's 120th birthday anniversary and his drive fro a purer vision of party membership behaviour. Liu's vision is of a party that is more than a political force. Liu emphasises the 'splendid culture' of China and links this the Party's mission. The Party is seen as putting the people first - and being a cultural as well as a political entity. Liu has supported clampdowns on the media. Those who want to understand China are seen to need to come to terms with the Party - its history / mode of operation / people-focus / global role / culture. However do China's people see the Party as a quasi-religious entity supplying them both materially and spiritually. Profound cynicism across China seems to dash that hope. The biggest problem will arise if growth slows. For now it is all about control [1]

A Chinese writer (Yu Jie) sees Xi Jinping as 'China's godfather' - implying that he is a stronger more ruthless leader than China has seen since Mao. However the days when individuals could exert such control have gone - as the the institution (ie the so-called 'Communist' Party) is now all important. Perhaps the Party could be seen as China's godfather [1]

What is happening in China in October 2014 could affect China for years. Economic data is to be released showing whether China's economy is on course to normalization. Politically the Fourth plenum of the Communist Party is discussing the legal future of the country (ie discussing governing according to law'). If the economic numbers are good, the Party will allow the economy to slow as it has been. But there are indications that the numbers will be bad. This will result in economic policy responses. However there is another issue at stake - China's sense of itself. It it going to remain a country dominated by the Party elite - or even more increasingly by those connected with Xi Jinping, or is it going to legitimate an equitable rule of law. The Party has proposals for expanding the rule of law. But there have been troubling trends. One observer suggested that China is turning in on itself. The regime seems to want to change China from the top down. This would involve a shift towards China's traditional ancient legal culture. China will continue to embrace capitalism - but not foreigners or foreign ideas. New Party slogans stress 'traditional' culture and values. The language of Confucianism is being invoked to legitimize a new dynasty of red emperors. State researchers are being warned against foreign collaboration. Liberal public interest lawyers are being subjected to crackdowns. Christian churches are subject in one province to selective demolition. Pro-democracy media in Hong Kong are subject to intimidation. Xi is seeking to eliminate 'corruption' from China. But will this put the 'red emperors' on a more equal footing with others - or thin their ranks to only those who agree with Xi?  [1

Heading for a Crash or a Meltdown?



Heading for a Crash or a Meltdown? [<]

In July 2010 a Chinese ratings agency (Dagong Global Credit) gave China a higher credit rating than the US - which is the opposite of the position taken by Western-based ratings agencies [1]. This follows complaints by Beijing that Western ratings agencies fail to give China full recognition of its economic strength [1], because of an ideological bias in favour of the West [1].

However, rather than being economically strong China seems to face the short term risk of a financial crisis due to unwise investment, and in the longer term structural difficulties affecting its social, economic and political systems appear to create the risk of an implosion.

An Investment-driven Bubble?

In 2010 it was first being argued that China could be headed for trouble because of wasteful spending to counteract the effects of the GFC - which was seen to have generated a property bubble much worse than that in the US.

Disruptive events ('black swans') such as 911 and the global financial meltdown can send history in totally unforeseen directions - yet these events don't seem to have disrupted shift in locus of global wealth for Atlantic countries to Asia Pacific - noting China's ability to sustain 10% pa growth. If China's economy becomes bigger than US, because of China's large population it would still be relatively poor. However increasing wealth brings military power, political leverage and diplomatic influence - perhaps allowing China to 'rule the world'. Beijing's handling of GFC supports such projections. But some now see a 'black swan' in China's future. To avoid social unrest, China has directed a torrent of money to state owned enterprises and local governments - and used this to fund wasteful projects. This has created a real estate bubble much greater than in US. A deep and sustained recession could have severe political and strategic costs to China (Friedberg A., 'Black swan haunting China's future', The Australian, 21/7/10)

China faces major challenges in reinventing its economy. Beijing model seems to be succeeding (ie maintaining about 10% pa growth) just as policy-makers in US / Europe seem to have run out of ideas. Complacency about China's model (Beijing consensus of state-controlled capitalism versus Washington consensus of free-market capitalism). Yet China faces many constraints on sustainable growth, eg heavy local government debts; property bubbles; rising labour costs; changing demographics; high energy consumption / pollution associated with growth; a need for tax reforms. China recently noted strong growth in foreign investment - but didn't mention that domestic sharemarket is not doing well. While there are short term uncertainties facing China, it has consistently show the ability to overcome constrains. Requirements now seem to include: restructure economy to emphasise consumption; revamp social welfare; reform taxes to fund local governments; and extend private property rights (Ryan C. 'The China model gets a workout', AFR, 17-18/7/10)

China's growth could be faltering - as a result of external supply disruptions and internal tightening, though the notion of a hard landing was dismissed.  However some see China's economy as like US in 1929 (with massive wealth disparities; rapid industrialisation and displacement of labour; opaque / misleading financial / economic data; massive borrowing by rising 'middle class'; bubbles in housing / infrastructure investment; accelerating and uncontrolled rise in disintermediated credit; expected transfer of growth to domestic demand; and wage / price spiral). China is seen to have lost control - as desire to placate masses with growth has created inflation that will lead to social unrest. It risks a deflationary collapse. Others seem China and emerging economies caught in price / wage spiral that can't be controlled through traditional monetary, fiscal and legislative control - because of wage inflation. Faith in China driving growth will be lost - and the world will be left with deflationary adjustments starting in US and then Europe [1].

An asset bubble is China's main short-term obstacle to economic growth - though a hard landing may have been prevented [1]

A large bail-out local government because of bad debts incurred by provincial banks may be needed [1]

There is near universal agreement that developing economies , led by China, will growth at double the rate of developed economies. China has set the pace for the past 2 decades, and most fast-growing developing economies have adapted China's export-led development model. But China's model has meant that is a net exporter of capital, not an importer. It has funded internal investment with high savings and low household consumption. Foreign direct investment has been allowed with strict conditions involving technology transfers that allowed rapid productivity growth. Portfolio investment has been controlled and limited. Thus financial proxies have emerged as the way of riding China boom (eg Australia's financial markets). Asia's future is bright, but the no-brainer of Asian portfolio investment may be over. Controlling inflation is proving difficult. Electricity rationing was introduced, and then scrapped. China's one-child policy is rapidly reducing pool of rural labour migrating to cities - and this could shift earnings from companies to employees [1]

The bailout of local governments in China will be equivalent to 150% of the TARP program required in the US - and thus that China has 150% of the 2008 financial crisis ahead of it [1]

There are signs that China property bubble is starting to deflate. China's economic growth could slow rapidly and adversely affect global economy. Real estate is foundation of China's rapid growth for two decades, and is crucial to construction / steel / cement industries. It is also favoured investment in China, because of poor bank interest rates, and critical to local authority budgets (as property sales fund infrastructure spending). Property construction in China was 13% of GDP in 2010, twice the level of 1990s. Many other countries have come to depend on this. Some cities have 20 months inventory of unsold properties, and suffer declining prices. Ordinary citizens can no longer afford to buy properties. In 2006 average apartment cost 32 years average salaries, but this is now 57 years [1]

China's post-crisis economy is built on 10,000 local government investment platforms which are in turn based on unsustainable rivers of debt. China has had competing needs for slow credit growth to contain inflation / asset prices and resource misallocation, and short term pressure to complete infrastructure and develop real estate. New credit had to keep flowing to meet repayment obligations on old bad loans. China has responded to the need to slow credit growth by blocking credit to private sector. Municipal owned companies accumulated $2.1tr debts (35% of GDP) - with 75% of this over the past 2 years. This may be unsustainable, but not be resolved for a long time because China does not really have a banking system - as the banks that hold local government debt are just arms of Communist party enterprise - and they can be topped up by other parts of this cashed-up enterprise at any time. Also local governments are finding new ways to raise capital - through bonds.  China's local debt is however a systemic problem - as there are limits to which households can be gouged, and thus likely political constraints. Land is current constraint - as used for loan collateral and this requires ever increasing land values (and coercion to hold down compensation payments from the dispossessed). The battle for land is where China's economic and political crises intersect [1]

 Problem loans from China's 2009 stimulus are about to hit China's banking system - and could require a rescue effort (about 7% of GDP) that is bigger than US TARP program. Government encouraged banks to lead to prevent recession in 2009 and a significant percentage of this went to local government borrowers, of whom 25-30% went bad. Also China established asset management companies (AMCs) in 1999 to absorb and dispose of bank bad debts. However they have not done so quickly, and rather than winding down they have continued to carry forward bad loans. Absorbing the new bad debts would compound problems in their balance sheets. Much of China's debts are held off balance sheet - ie nominally debts are only 20% of GDP, but actual total is about 80% of GDP. A large part of China's economic miracle has been built on ill-considered lending and accounting slight-of-hand [1]

There is increasing concern about China's debt levels. Local government debts are stated to be 27% of China's GDP (but may actually be 42%), and 20-30% of these loans are at high risk of souring. Defaults are emerging. The central government will need to assume responsibility for this - and most analysts see central government debt as 70% of GDP. However if contingent liabilities are also included the figure would be 150% of GDP. The bigger problem could be high levels of debt in economy - as many SOEs are now highly diversified, especially in areas where cheap capital gives them advantages (eg real estate and high tech). Chinese companies have incentives to borrow heavily and bulk up (eg better executive remuneration and political connections). China's investment driven growth model may be leading to unsustainable increase in debt. There is now a need to reduce growth dramatically or risk even worse increases in debt levels - though at least another two years of high-investment driven growth are likely [1].

 China may need a recession - though its leaders and international investors would not want this. There has been growing concern about debts of China's local governments - that spent heavily as part of response to GFC. Borrowings were estimated at 27% of GDP - but are probably more. Few loans are reported as non-performing - but as much debt was incurred with little regard to repayment, a great deal could turn sour. China is unlikely to face a debt crisis. Most loans are owed by one state-owned entity to another - so government carries any losses.  China's eagerness to keep joblessness at bay papers over the hole in the balance sheets of local governments - and this prevents banks operating on commercial terms. Corruption and fraud is not exposed. Problems with China's high speed rail network raise questions about whether spending was prioritised over quality control. China needs a recessionary bust to clear the way for a new boom  [1]

China is facing a hard landing (because of excessive credit growth and attempts to control the consequences). Moreover, as Europe and US experience economic problems, China will not be able to again boost spending to boost its domestic economy - and demand from economies that supply it with inputs [1]

China's private sector was born in Wenzhou (and entrepreneurs flourished). But problems arise. The city spearheaded China's manufacturing. But the trust based financing structures that replaced banks and fuelled its binge are collapsing - given slowing exports. The city has many problems. The cities financial-industrial model is unravelling. Wenzhou is defined by one-industry clusters, and never depended on foreign investment (as China's other boom cities do). 2m of the cities population live offshore, and are the basis of trade links. Wenzhou capitalised on non-bank financing, where relationships matter more than collateral. Traditional methods for channelling money to friends and family were massively expanded. But lending has ceased, because of risks [1]

In late 2011 a report (whose reliability can not be confirmed) quoted a Chinese source (who appeared critical of China's regime and was supposed to be commenting in private) as suggesting that China faces very severe fiscal and economic problems (Chinese TV Host Says Regime Nearly Bankrupt)

There seems to be a discrepancy between China's official 8.9% pa growth rate in the final quarter of 2011, and other (real economy) data indicating negative growth [1]

61% of global investors surveyed in December 2011 expected that China would experience a banking crisis because of misallocation of resources (as well as serious political and economic instability) in less than 5 years. Only 10% expected that China would escape trouble [1]

China is seen as likely to be the last country to experience the effects of financial / economic crisis, because of its massive surge in investment. But it is also likely to be the last to experience recovery. The dominant role of SOE's in the post results in wastage of resources. Huge profits are earned because their monopoly power is exploited. Economic vitality is being stifled and wealth is concentrating in the hands of a few [1].

China has not rebalanced towards consumption in 2011, and debt continues to rise quickly. This will not lead to a crisis, as it would simply be rolled onto government balance sheet. Financial Times reported that China has allowed banks to roll over loans to local governments. China's response to GFC allowed banks to lend $1.7tr to local governments (25% of GDP). As principal is not repayable, banks are now extending the loan terms. China has growing amounts of unrepayable debt - and most will wind up on government's balance sheet. Some suggest that the problem is only one of structure (ie using bank loans rather than bonds), but debt is debt. The problem was not perceived because of opaque financial system. The problem can only be solved by eliminating loss-making investments, yet China's growth is kept high by borrowing, misallocating the proceeds and allowing debts to rise. Household income is too low to be used to subsidize debts - so government will need to provide the transfers (eg by privatising assets or absorbing debt). Japan chose the latter. Now its debt is escalating, and there are risks of capital flight, high borrowing costs, falling currency / stocks and central bank needing to pump cash into local banks. Japan's government borrows more than it raises in taxes and has $10+tr debts. China can choose to absorb debts, and it would take many years before doing this becomes unsustainable. China is likely to have much slower growth and rapidly rising debt for most of the next decade - because privatising assets is hard. World Bank suggestions about doing so (in the context of pointing out the difficulty of China's economic transition) have encountered resistance. Increasing SOE dividends to the state would not solve the problem, as total SOE profitability is less than 1/5 to 1/8 of direct and indirect subsidies transferred from households [1].

China's headline GDP growth has been 8-10% of GDP. However this has been driven by new lending averaging 30-40% of GDP - of which 20-25% is likely to prove to be non-performing. Thus losses of 6-10% of GDP arguably need to be deducted from China's nominal growth. So China's real growth is much lower [1]

China's economy has slowed since mid-2011 - with electricity consumption growth down; a property bubble; local government debt overhang; and eurozone crisis. Despite reported strong 2011 growth, stock-market is down - indicating waste and limited value adding. China hasn't moved from quantity expansion on supply side and government investments / exports on demand side. Waste has escalated. This increases inflation. Banks have increased liquidity to sectors other than property, which will prevent the liquidation of inventors needed for a bottom. Chinese businesses face high / arbitrary taxes - with 45% of labour costs going to government, and low employee wages. Most demand is government-driven. China needs to boost competitiveness. It has now reached average $5000 per capita income, but is one of the last Asian countries to do so. While China's growth has been strong over the past 3 decades, it has few strong companies. Competitors elsewhere in Asia do much better. Multinational companies have all structured their operation to take advantage of China's cheap labour while protecting their own technologies / know-how. No other country has developed with such dependence on foreign companies. China's industrial policy has failed [1]

Xianfang Ren (IHS Global Insight) suggests that land sales account for 30% of central government tax revenues and 70% for local government. Property construction accounts for 10% of jobs directly and 20% indirectly. Residential property investment (12% of GDP) is above to 9% usual maximum for developing economies. Though minimum down payment is 30%, house prices are 16-18 times incomes in major cities. Financial system has much greater real estate exposure than it seems (especially weak are real estate trusts and non-bank lending). Small developers are cash flow constrained and will need to reveal defaults quickly. China's demographic crunch has arrived - percentage of children and elderly has reached minimum (28%). urbanisation has passed 50% when growth in developed economies starts to slow. Edmund Phelps suggests that China can no longer increase productivity enough by importing western technology. Productivity growth will be like that in west in 10 years, but at much lower levels. China can bail out banking system (given deposits, government revenues, sale of state assets, and foreign reserves) - unless it is simultaneously hit by external shock (as Japan was). [1]

In May 2012 there were signs (especially in M1 deposits, electricity output, lack of orders in shipyards, housing starts) that China is headed for a hard landing in late 2012 [1]

China seems to be facing a deflationary collapse. Prices have been falling; China faces a fast aging population and has excess factories. Credit has grown explosively . Loans doubled to 200% of GDP between 2006 and 2011. This is double the rate of loan growth (50%) before Japanese and US problems. There is near universal assumption that China can set off fresh credit boom, but loan take-up has been falling rapidly. China has, however, a lot of scope for fiscal largess (which the West lacks). If China experiences deep downturn and seeks to flood the world with cheap goods, the world could suffer a deflationary downturn [1]

In July 2012 it was suggested that China (and surrounding economies) are facing a severe recession - and that China has abandoned plans to reform its economy (ie to switch from unsustainable investment towards domestic demand) and is preparing large stimulus measures which will create further problems for its banking system [1]

In September 2012 it was noted that funding state pensions is becoming a major challenge for China given: its fast aging population as a result of the one child policy adopted in the 1970s; a corresponding decline in the working population; reduced willingness / ability of children to support aging parents; and expectations that China's growing wealth will be more equitably shared [1]

Private sector credit was seen to be laying the groundwork for a new financial crisis in Asia (especially Hong Kong, China, Vietnam) - according to Capital Economics. The credit explosion in Hong Kong, for example, was seen to be similar to the situation in Ireland before its financial crisis. Vietnam's property bubble seems to be bursting [1]

In China's non-bank lending now exceeds that by China's banks. A 'shadow banking' system now offers high returns to investors through very risky lending - and this is again feeding a red-hot property market (and creating risks of a crisis like that in the West) despite official efforts last year to cool the property markets by tightening credit.  The government turns a blind eye to this (and merely seeks to limit risk in banks) because it is desperate for growth to be maintained [1]

GMO (Edward Chandler and Mike Monnelly) argue that China's economy depends on ever larger quantities of credit - and looks like a bubble. This is like Indonesia at end of Suharto regime and Japan in late 1980s. Markets however can't get enough of China. GMO suggests China's credit / GDP ratio rose 60% to 190% between 2007 and 2012. This is more than Japan in late 1980s and US prior to Lehrman Brothers collapse. This could be a problem if credit market freezes - eg when there is a major default in Asian high-yield bond market. This is most likely in wealth management products. This shadow banking system emerged as Chinese savers tired of negative interest rates. Dumb money chasing yield is a formula for for band investments. These funds direct investment to real estate and companies that big four banks won't touch as they are seen to be too risky. If Chinese lost confidence in the shadow banking system there could be a full blown crisis. Some defaults have already occurred, and some trusts use new money to pay out earlier investors - which chairman of the Bank of China describes as a Ponzi scheme. Many of the products resemble the collateralized debt obligations that were sold prior to GFC. Products are sold as low risk, even though components are very risky. While the Chinese government might stand behind the trust, the economic effect of a crisis could be significant [1]

China's rapid growth may have created the largest housing bubble in history. State driven growth has focused on real estate and construction - creating cities with no one in them [1]

Zhou Xiaochuan (China's central bank governor) has been one of the few voices advocating genuine economic reform in China. He has been calling for a reduction in capital and opportunities available to SOEs and warning about the threat posed by the hundreds of $bns of loans to local governments to invest in property markets since 2009 (which continue to pose a systemic threat) [1]

China's premier warned 6 years ago that its economy was unstable, unbalanced, uncoordinated and unsustainable. And since then China has continued with the economic model that led to that concern (ie heavy reliance on investment in roads, factories and infrastructure). After the GFC such investment was further stimulated by fiscal spending and credit creation (which is now 4 times greater annually than in 2007). China's public / private debt now exceeds $200% of GDP - which is unprecedented for any developing country . This is not seen as a cause for concern - though attempts to understand the origin of financial crises suggest that this is false. The rate of increase in debt (particularly private debt) matters more than total debt. BIS found that 6% pa growth in debt higher than the rate a decade earlier implies major risk. In China this difference is now 12%. IMF found that if private debt grows faster than GDP for 3-5 years financial distress is likely. China's private debt has grown faster than GDP since 2008 - and has risen to 180% of GDP. China is assumed to be immune to risk because it owes little to foreigners - yet studies of the 79 financial crises in major economies over 140 years show that crises are just as likely in countries reliant on domestic savings. Also while Asian countries with high savings and few foreign liabilities did avoid crises after credit booms, growth fell sharply. Thus China is likely to experience rapid growth slowdown. To 2007 China created $1 of growth for $1 of debt - but now requires $3 of credit - which is what happens at late stage of a credit binge. China's exports and manufacturing are slowing while money flows into real-estate speculation. A more stable growth model requires promoting consumption. However while consumption has grown at 8% pa ((faster than in other miracle economies and as fast as possible) consumption is still falling relative to GDP because investment has grown faster. Thus China must cut back investment to rebalance and accept slower growth [1]

Fears that China could experience a hard economic landing have been renewed - because of skyrocketing property prices, mounting credit and GDP growth slowdown. China's economy is seen to parallel symptoms that led to 2008 financial crisis [1]

There has been increased speculation of a financial crisis in China. Nomura has suggested that China looks like US before sub-prime mortgage meltdown. The problem is seen in massive amount of credit that is extended off bank balance sheets (by contracting with less regulated financial vehicles or by property developers raising credit through friends). Such activity is opaque and largely fuelling speculation. Most comment has focused on how exposed China's banks are and whether government can recapitalize them. But the more important point is that off-balance-sheet activity is a good thing in China - because China's banking system does its job very poorly. Savers receive negligible returns, and banks direct money to SOEs - the least efficient firms. While off-balance-sheet activity generates risks, this is part of a process for fixing defects in the existing system [1]

One of China's top auditors has stopped approving local government requests to increase their debt levels, and warns that China faces a financial crisis bigger than that in the US and Europe unless debt levels are brought under control [1]

Possible responses to these challenges have been suggested to lie in gradual appreciation of emerging economy currencies and increased reliance on domestic demand. This seems to underestimate the difficulties of achieving such as transition.

Avoiding a Hard Landing in China - email sent 20/2/12

Jerome Booth,
Ashmore Investments Management

Re: A Chinese hard landing is about as likely as a comet destroying Earth, The Telegraph¸19/2/12

Your article suggests that gradual currency appreciation (to boost domestic demand) could provide a solution to the apparently-severe economic challenges that China currently faces – difficulties that lead some observers to predict a ‘hard landing’.

My interpretation of your article: China has bubbles that can be dealt with easily, and pose no real risks – unlike the systemic risks the West faces. If banks losses on ‘social expenditure’ need to be covered by central government, that is quite affordable. And banks are rolling over loans, so nothing stops – it may only be a cost to central government. After Lehman Bros collapsed China had to boost aggregate demand, and move from export-driven growth to that driven by domestic demand. China launched a massive fiscal stimulus (unlike the West). As monetary policy loses its effectiveness (because of inflation risks), the answer will lie in currency appreciation (which will give companies the incentive to favour domestic demand). Concern that companies might send cash surpluses offshore is the reason for slow Renminbi appreciation. A 30% appreciation is needed because of imbalances dating back to 1944 Bretton Woods agreement. Imbalances built up in 1960, and the system crashed in 1971. Imbalances have re-emerged as emerging markets and commodity exporters generated large current account surpluses after the Asian financial crisis of late 1990s. This can’t go on indefinitely, and currency appreciation will occur when emerging economy central banks decide to act. China is a stabilizing influence, and is likely to move Renminbi up slowly. With large foreign exchange reserves, emerging central banks can move their exchange rates any time at will – which is opposite of the situation in the de-leveraging developed world.

However, while increasing domestic demand in such economies is undoubtedly desirable, the situation seems vastly more complex than your article suggested because:

  • The shift towards export-driven growth and the mercantilist accumulation of foreign exchange reserves started long before (not after) the Asian financial crisis of 1997 (see An Unrecognised Clash of Financial Systems which refers to an apparent contest for control of global financial systems that seems to have been under-way for decades). Both Japan and China had significant surpluses much earlier, and this was the reason that their economies (which also involved financial institutions that favoured state cronies rather than independent enterprises with proposals that focused on profit) escaped most of the effects of the Asian financial crisis. The protection that current account surpluses provided to economies with under-developed financial systems was then recognised by other emerging economies, and adopted widely (see Leadership by Emerging Economies?);
  • The suppression of domestic demand needed to achieve current account surpluses imposed a serious macroeconomic constraint on the world’s economy generally, and those demand deficits had to be compensated for by developed economies if global growth was to be maintained. The excess demand needed to offset demand-deficits was supported by easy money policies that led to ever-increasing debts offset by asset inflation, and ultimately to the global financial crisis (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Impacting the Global Economy 2009);
  • Significantly increasing reliance on domestic demand in China and other emerging economies will lead them to current account deficits in a very few years– and this will in turn lead them to financial crises unless reliable financial systems are first developed (see Emerging Market: What about the longer term and see Eyes Wide Shut at Davos?). Reforms will require a long time, and (as the latter document indicates) arguably faces extremely difficult cultural obstacles in East Asia. There would seem to be a critical need for developed economies to provide support to emerging economies such as China in reform of their financial systems if such risks are to be avoided as a consequence of the transition to significant reliance on domestic demand (see Options Available to liberal Democratic Capitalism);
  • China’s autocratic political institutions also seem to be serious obstacles to: (a) changes that would empower consumers / households economically by significantly increasing their share of national income; and (b) the increased grass roots access to information that would be needed to sustain increasingly high-income economic functions.
  • [added later] reserve banks can not always engineer currency appreciation simply because an economy has large foreign exchange holdings. Strengthening exchange rates are rather likely to reflect: (a) the levels of currency transactions at a particular time - with the demand associated with trade surpluses tending to lead to appreciation; (b) well developed financial markets; and (c) stable / reliable government;
  • increasing income levels in emerging economies will reduce the protection that cheap imports provide against inflation in developed economies - and potentially require a rapid and potentially-disruptive reversal of the quantitative easing that: (a) has provided a boost to asset values and economic activity in the post-GFC environment; and (b) would normally would not be possible because of the inflation risk.

It may be that not everyone in China is convinced that China’s current challenges can be easily resolved by increasing domestic demand. A couple of sources not only suggest why a hard-landing hypothesis is plausible (eg because dramatic political and economic changes seem to be needed almost overnight), but also contain vague indicators of the possibility of capital flight.


John Craig

Other Structural Problems

China's problems are arguably more fundamental than the immediate risks associated with wasteful spending and property bubbles in response to the GFC.

China has long had to struggle against economic, environmental, demographic and political constraints as suggested above (eg economic imbalances; wasteful investment; blunt economic management tools; pollution; limited soil and water resources; a soon-to-be rapidly aging population and need for massive state aged-care spending as a result of the 'one child' policy ; wealth imbalances; and frequent protests about official actions and corruption).

However in recent years observers have drawn attention to other structural problems, such as:

  • a fragile and distorted financial system;
  • lack of innovation / creativity;
  • the dependence of local government finance on maintaining a property bubble;
  • inflation being generated by an undervalued exchange rate;
  • failure to actually increase domestic demand though rising wages are undermining China's industrial competitiveness;
  • an inadequate education system;
  • breaks in social harmony - as income inequality was rising rapidly and was well above the level that would normally indicate a risk of social instability;
  • falling demand for construction (for which huge capacity exists) as income shifts to households;
  • over-reliance on investment;
  • the parallels between Japan's and China's property / investment bubbles;
  • a potential precipitous decline in working age population after 2020 [1] - a problem is likely to compound China's export-dependence in an environment in which the import demand from the aging populations in developed economies is likely to be weak;
  • the inability of China's political system to respond fast enough to achieve major adjustments needed to sustain growth;
  • possible capital flight.
 Observers' comments on structural problem's China faces ....

In September 2010, questions were being asked about China's financial system.

There is concern that Chinese banks may be involved in a pyramid-style capital structure after domestic arm of China's main sovereign wealth fund raised $8bn through bond sale (to recapitalise China's state owned banks) and those banks were the biggest buyers of the bonds [1]

Moody's has expressed concern that China is powering its economic growth by raising the gearing of its banking system in ways that could leave the country exposed if outlook darkens. CIC borrowed $8bn to recapitalise three state-owned banks using debt, rather than genuine equity. There is concern about the opacity of China's banks [1]

In late 2010, a prominent Chinese academic also suggested that China faced serious structural risks.

 China's growth model is unsustainable and sudden slowdown is likely without radical economic and political reform - according to prominent academic and former member of People's Bank of China's monetary policy committee (Yu Yongding) writing in state controlled China Daily. Threats were seen in: social tensions; pollution; lack of public services; over-reliance on exports and investment (particularly in real estate). This comes at a time when many expect China to overtake US eventually - though there is current concern about rising inflation.. A transition in power to younger people is likely in 2012, and Yu's article reflects debate preceding this. Yu expressed concern about lack of innovation / creativity; inefficient use of capital (with investment over 50%) resulting in too many luxurious buildings. Yu also called for political reform - to break the alliance between politics and business. China's institutions require meritocratic government, but this is being eroded by sycophancy and cynicism. If China can't end current 'capitalism of the rich and powerful', then social tensions will lead to serious backlash. This investment is about    [1]

In early 2011, it was argued that China faced great difficulties in rebalancing its economy despite the announced intention of its neo-Confucian bureaucracy (ie the so-called 'Communist' Party) to achieve this.

China's premier spoke of rebalancing China's economy. But the role of the state in China's growth is a major problem. China is too reliant on unsustainably high levels of fixed investment to maintain growth. Fixed asset investment has risen 20-40% pa for the past decade - and this is not justified by urbanisation which grows only 1-1.5% pa. Such investment is about 55% of GDP - much above the 25-30% of GDP in Japan and Korea at a similar stage in their development. Bank lending has risen rapidly, and over the past 14 months Beijing has tried to restrain this. 3/4 of credit goes to SOEs through thousands of local bank branches. This creates obstacles to rebalancing. Local governments can't borrow - so they create state-owned commercial entities which invest in property market, rezone land (often illegally) to make this profitable and then sell. 50% of local government revenues come from property - so government tax revenues depend on perpetuating property bubble. Thus officials only pay lip service to central directives to curb lending. Also local officials (who have influence in banks) favour SOE dominance as it allows them to dispense patronage. Economic and social elites are Party's main supporters. Though returns from SOEs are poor, funding them is vital. Non-performing loans on books of China's banks could be 70% of GDP. Bias towards SOEs gives them 15-20% increases in revenues annually - but means that household income only increases 1-3% pa. This is why domestic consumption is weak (30% of GDP, the smallest level in any major economy). China can't reform its unbalanced and unsustainable economic model until the Party releases its grip on economic power  (Lee J. 'Party needs to loosen its grip', AFR, 9/3/11)

Australian Treasury warned about risks to global recovery associated with inflationary pressures in emerging economies. China and others in Asia are trying to quell inflation without doing anything about the accelerant of their undervalued exchange rates. Countries that tie their currencies to $US are importing monetary policy designed for an economy with low inflation and where private demand is weak. This is creating conditions like those prior to Asian financial crisis. Inflation is significant in China despite the fact that wages incomes are still falling as a percentage of GDP [1]

China has experienced an economic miracle, but three contradictions are emerging. China's leaders hope to slow growth and thwart inflation while raising wages and benefiting the masses. However wages have falling share of overall income, and gap between rich and poor is widening. There are many retail stores, but people look without buying. Wages are rising - but this seems to be diluting the competitiveness of manufacturers. There is thus a need to migrate to more sophisticated manufacture's and services. However this requires a better education system (as current one suffers from Soviet style management of science, and is shunned by China's elites). Second, China wants to internationalize the yuan - so that in a future economic crisis it could borrow in its own currency (as US does) - but this won't be possible unless economy is subjected to global markets. Low interest rates in China are driving asset bubbles - because people have no alternative investments. Third there is distrust between people and elites (eg Internet restrictions, wealth imbalances) [1]

Social management is the new buzz phrase in China's propaganda. Increasing public protests show why this is needed. The cracks in China's economic miracle are starting to show. China's president has called for social management to ensure harmony and stability. This is a belated rationale for crackdowns on most public critics. China has a 'Great Firewall' and an army of cyber-warriors - but this threatens to be overwhelmed by a home grown system like Twitter. Social management has led to efforts to silence lawyers, agitators, writers, artists. Beijing was worried by unrest in Middle East, and reacted harshly - but this may prove counter-productive. The origin of discontent is often in injustice - yet the role of lawyers in China is limited. The Communist Party prevents some matters being considered by the courts, and prescribes findings in others. The harmony China seeks has been hard to find [1]

The Bank of China issued a secret memo tightening the way mandatory reserve requirements for banks are calculated. This is an attempt to curb run-away lending by thousands of state-owned bank branches (which has boosted investment in China and commodity prices). However it is unlikely to be effective in the short term - because local banks are hooked on such lending and (with economic weakness in developed economies) it is hard to maintain growth without high levels of investment. Because of the bias towards SOE, China's private sector has shrunk - so there is ever more reliance on SOEs to create jobs - and building things is mainly all they know how to do. China's reliance on fixed investment guarantees that it will eventually have a hard landing [1]

The President of the World Bank argued in September 2011 that there are structural problems in the world economy which make monetary and fiscal policy solutions to economic growth constraints inadequate, and that significant changes to China's economic growth model (which has been based on exports and domestic investment) would be needed as a result [1]

In late 2011, a parallel between the bursting of Japan's 1980s investment bubble and China's current situation was suggested [though without mention of the cultural features that have arguably have given rise to this].

In China, industrialization as always, combines, progress with problems - though China differs in scale and cultural and entrepreneurial history.  China has many: large cities; rich people; university graduates; mobile phones; TV stations; patent filings (though no respect for others intellectual property); declining infant mortality; high speed trains (based on others technology, now localised); and outbound tourists. China's renaissance is as much cultural as economic, Chinese people are entrepreneurial, creative, energetic - who have been contained for centuries by domestic dynasties or foreign occupation. But prosperity brings problems - such as overconfidence - and the business cycle reflects this. China is not different except in scale, Australia's dependence on it and in the source of debts. Western business-cycles are consumption led, yet China's are investment driven. There are untold projects (eg cities built for a million people) that can never earn a return. The loan for one project costing $185m was guaranteed against land valued at $1.5m acre - the same as land values in richest parts of US where household incomes are $250,000 pa though in China the average was only $2,300 pa. 10,000 special purpose vehicles have been set up by China's local governments for such projects over the past 10 years - and $US2.2tr invested in them, of which 1/3 is estimated to be unrepayable. Central authorities tried to stop this, so local authorities established corporations to handle the transactions. Two of China's largest banks are estimated to have problem local government loans that amount to 30% of their book value, as well bad debts emerging from exploding corporate bond market. Since WWII consumers have driven growth in most Western economies. China has no consumer society. Rather it is an investment society. Consumption has fallen from 50% of GDP in 1980 to 35% . Investment has taken a reverse trend (ie from 35% of GDP to 50%). US consumption / investment figures are 71% and 15% respectively. This is why coal / iron ore / concrete prices has boomed. Since 2007 67% of increase in China's GDP has come from investment (the reverse of US situation). US bailed out the banks, while China embarked on massive government-driven investment program. US GDP stagnated, while China's increased 30% over the period. Michael Pettis (Peking University) argues that high levels of municipal debt are symptoms of underlying problems (ie repressing price signals, distorted investment incentives and heavy reliance on investment to achieve growth). In history this always tend to push growth too high and become unsustainable. However China can now only get growth with ever riskier increases in debt - and this must eventually be stopped resulting in many years of poor economic performance. Developing countries can initially find many profitable investments, but this eventually becomes harder - and when momentum takes over the system loses its ability to discriminate between profitable and loss-making investments. Strong GDP growth masks this problem until the bubble bursts. Japan's experience in 1980s and since illustrates the problem. To early 1990s Japan's GDP increased rapidly as share of global GDP (from 7% in 1970, 10% in 1980 and 17% in 1990) - but since then it has reversed (to 9% of global GDP). China is more likely to experience a Japanese style lost decade than Europe of the US.  Japan produced attractive, low cost products to achieve huge trade surpluses - using cheap labour and low exchange rates. The resulting surpluses caused concern to trading partners, and were used to invest / modernise. Ordinary Japanese paid for this (via low wages; a declining GDP share; low interest rates; escalating property values; and expensive imports). This is the model, not a by-product of the model . Eventually land values collapsed. poor investment decisions were exposed, and Japanese banks faced bankruptcy - and the economy entered recession from which it has yet to fully emerge. Peter Hartcher (in The Ministry) argues that though Japanese companies understand about return on capital, they would spend cash without worrying about the return.  In 1988 Japan's real estate boom paused, and speculators who were used to ever-increasing prices felt problems. But banks continued lending - and the boom continued. China did the same in the 1990s - and offloaded bad debts into state-run asset management companies. This allowed banks to claim 1.8% bad debt ratio in 2009. In 2002 one yuan of GDP needed 0.17 yuan of debt. Now it needs 0.30 yuan. Banks are forced to fund suspect government projects at excessively low rates, so bad debts will be high. China's banks are now facing a liquidity crisis - though this is invisible because the bad stuff has been taken off balance sheets. China seems likely to follow Japan. Edward Chancellor (in China's Red Flags) argued that China had all the features common to bubbles over the past 300 years. Half of China's millionaires reportedly want to emigrate - because of fears about future stability. The crisis may be a few years away, but investment-led growth must end. Government-induced slowdown is already occurring. But a shift to consumption-led growth is not on the horizon. Property values will continue falling. China's rulers have implied social contract with people since 1989 - sacrificing political freedom in return for economic gains. This may now crack. For China to change its economy, political and economic power must be devolved, yet elites don't readily give up power. ('The Coming China Crash', Intelligent Investor, December 2011)

In early 2012 a crisis was seen to be arising because: (a) high levels of investment are needed to sustain growth, though this also generates inflation; and (b) China's political system is not able to respond rapidly to the major adjustments that are required to maintain growth.

Concerns arise about China's economy (property deflation, weaker exports to Europe, cut-back on infrastructure investment). Since GFC China's economy has been driven by investment. High capacity has been created, which external demand won't support. There is a recognised need to shift to domestic demand, but China's system is geared to direct resources away from households towards investment. This would need to reverse rapidly - but more likely outcome is fall in investment. China's official economic statistics are not reliable (as shown in 2009 when 6.5% pa growth was reported yet 'real economy' data (eg electricity consumption) was contracting). Now all sectors seem to be contracting yet this is not officially reported, Most people see 5% pa GDP growth as 'hard landing' - and it seems to be current reality. If China built again everything it did in 2011 and everything else was unchanged, its GDP would fall 2% (to about 4.5%). Fiscal / monetary policy options are constrained. There is a need to grow over bad debts. Credit in system is fully occupied on existing projects, and POBC is wary about increasing credit because of inflation risks. Money supply expanded 2/3 over recent years, and was invested. Thus fiscal policy is now being considered. But China's nominal low debts (30% of GDP) is understated because of contingent liabilities (ie for debts of state institutions). This makes debt / GDP 100-200% already. It is likely that government spending will be increased and it will be revealed that past monetary stimulus was just disguised fiscal spending - as bad debts have to be covered. Spending will increase, but investment boom can't be maintained. Bubble probably can't be re-ignited. Diverting resources to consumption might help - but there is also a possibility that money just leaves the country. Capital leaving is now tending to offset China's current account surplus. If China's growth slows, devaluation will be sought - but this could provoke international reaction. If exchange rate is not adjusted, then inflation in China will increase. If exchange rates rise then producers bear the burden, whereas inflation hits households. Exporters are now being hit by rising costs in China. Some tried to adjust by getting into financial dealings, and again got burned. China's economic pattern is unsustainable given export / investment dependence. Leadership changes at present make adjustment impossible - as no one can afford to upset powerful constituencies. New leader will then take a long time putting protégés into key positions before radical changes can be implemented. Economy will require action much faster. Elements of hard landing are already occurring. Fiscal stimulus will help for a little while. But in mid 2012 hard decisions will be needed. A lot of debt needs to be rolled over. Tension between investment driving growth and driving inflation has reached a crisis point - given problem of bad debt. Bad debt is going to absorb credit. 300-400m Chinese are on internet, and complaining. Officials are concerned about social stability. Any hint of organised protests would result in crackdown.  But social media has changed the game - as everything that happens in shared / spread. Government is struggling to cope. Some favour social media as letting government know about community concerns. (Robini N and Chovanec P., 'China: How much stress can the system take?', Economonitor, 8/2/12)

CPDS note: Both of the above sources contained hints of possible capital flight from China. Similar suggestions appeared in Cash Exiting China (Duy T., EconoMonitor, 31/5/12; Frangos A etal 'In Reversal, Cash leaks out of China', WSJ, 15/10/12), and the rapid escalation of gold purchases by individuals in China (see Lee J. China's twitchy gold bugs, BusinessSpectator, 17/2/12) might also have similar implications.

China's leadership was seen to be very worried about the future in December 2011 - even though many other countries are worried about China's competition. Their focus is on internal problems (eg dependence on high growth driven by exports to maintain social tranquillity; resistance to currency manipulation; inequality; the need for shifting to domestic demand; inflation and housing bubble; political transition in near future; pollution; aging population; protests; international isolation; [1]

Constraints are emerging on the expansion of China's international influence in support of its expanding economic roles [1]

More analysts are starting to understand constraints on China's growth model. It is predicted that: (a) China will be the last country to emerge from GFC - because those problems resulted from great trade and capital imbalances to which contributed with a massive savings rate which it has continued increasing, rather than reducing; (b) China's consumption will stagnate / decline until existing growth model (which depends on transfers from households to subsidise growth) is abandoned; (c) financial repression is the heart of China's problem; (d) investment is being misallocated on a massive scale, as a fundamental feature of the economic system; (e) debt is rising at an unsustainable pace, and this can't continue; (f) attempts to deal with debt problems will fail because the debt problem is systemic; (g) while privatisation is a forbidden topic, it will soon start to be considered; (h) a fundamental political split is likely between those demanding reform of China's growth model and those who want to maintain control of resources; (i) China's government debt will continue to escalate; (j) China's average GDP growth for 2010-20 could be 3% pa; (k) if China rebalances successfully growth in household income will be similar to GDP growth; and (l) non-food commodity prices will collapse over the next 3-4 years because these have been critically dependent on Chinese investment [1]

The IMF published Is China Over-investing and Does it Matter which argues that China is over-investing - as this accounts for over 50% of GDP and is most unusual relative to other countries. Households and SMEs have been forced to subsidise growth at a cost of 4% of GDP (or perhaps 5-9%) - and this explains collapse in household share of GDP. China has to eliminate that subsidy (and thus abandon its current growth model) if it hopes to get household / consumption shares of GDP to increase. China's investment has to fall by 10-20% of GDP, and this will adversely affect those who have benefited from over-investment. Moreover bringing the investment share of GDP down is very difficult [1

Obstacles to China's efforts to use its currency as the basis for international trade were suggested to arise because: (a) China still has a more-or-less fixed exchange rate with $US; (b) there is not much use for yuan outside China (and thus little point in holding the currency); and (c) all lucrative sectors in China are reserved for SOEs (except export-oriented manufacturing and participation in JVs to allow technology transfer into China). Until China opens its markets there is no good reason to hold yuan [1]

Japan shows the risks that China faces in shifting to a lower-growth model. China expects its growth to slow over the coming decade. This can be seen as either a reflection of the 'middle income trap' or of catching up with advanced economies. Indicators of this include: slowdown in infrastructure investment; falling returns on investment due to overcapacity; labour supply growth has fallen sharply; urbanisation is decelerating; and risks are growing in local government / real estate finance. A case can also be made for a more optimistic view - because China's income levels are currently much lower than when such transitions occurred elsewhere. However China is much bigger than other economies, so the world can provide it with relatively less opportunities, and its growth has often been seen as 'unbalanced, unco-ordinated and unsustainable'. High dependence on investment creates the biggest problem. A growth slowdown could be associated with a collapse of investment from 50% of GDP to 30% - and, if rapid, this would lead to depression. Real estate investment has led to a large rise in credit - and in risks of bad debts (leading to a more fragile financial system - especially because of growth of 'shadow banking' system). There may not be a decline in household savings to accompany falling investment. China hopes to manage the transition smoothly - but Japan showed that it may not succeed [1]

China's claims of strong export-led economic recovery (ie 19.8% year on year to the end of February 2013) appear dubious because of a discrepancy between China's claims of exports to Hong Kong (($US94.9bn) and Hong Kong's data on imports from China ($US58.7bn) [1]

China's 30 year economic miracle may be near exhaustion.  China's prime minister has asked the State Council to clamp down on excesses of the regions - as local government finances are out of control. China's growth could be at a safe 7%. Vested interests in state industries are seeking to prevent this. Catchup growth in the western hinterland has more years to run, but overall growth may be below 7%. There has been doubt about China's statistics. National Bureau of Statistics now says that regional data overstates GDP by 10% - because of growth-claim incentives facing officials. Some expect China's future growth to be much lower - eg because of population aging - and perhaps not much more than renewed US. Thus charts showing China tearing past US may be wrong. The 2008 banking crash was a nasty shock to US financial system but not to its creative enterprise. It was however a crippling blow to Europe and a subtle blow to China in many ways. US Council of Foreign relations (Richard Haass) sees US as doing well in many areas. It has a large debt hangover - but so does as state banks let rip during downturn. Total credit has jumped from $9tr to $23tr over the past 4 years. US has moved in the opposite direction with loan-to-deposit ratio around 0.7 - the biggest safety margin in 30 years. US Treasury debt has jumped - in ways normally seen in wars from which recovery has been possible in the past. China is facing 'middle income trap' which have affected many rising economies. China needs to shift from state-driven industrialization and cheap exports to free markets. Innovation at the technological frontier is incompatible with government planning.  However even if this change is made, population aging will significantly reduce China's growth. Surplus workers will be replaced by a shortage - as happened to Japan 20 years ago. More credit can keep the game going for a time - but this just increases the risks. The 'China Dream' of a post-American empire has a dated feel  [1]

Rather than reducing China's reliance on investment, detailed figures for last year show that investment increased as a percentage of China's economy in 2012 [1]

A credit rating agency suggests that China's shadow banking system is out of control as borrowers struggle to roll over short term debts. The scale of credit was so great that China could struggle to grow its way out of these excesses as it had been able to do in the past. Credit-driven growth is falling apart - and could feed into aver-capacity and potentially a Japanese-style deflation. The shadow banking system lacks transparency (in terms of who borrowers / lenders are, and quality of assets). The official non-performing loan rate of 1% means nothing as irregular lending makes up half of new credit and bad assets can be offloaded through the system [1]

There seems to be a contradiction between China's intention in November 2013 to announce sweeping economic reforms at Party's Third Plenum (involving an assault on SOEs and Party patronage machinery) and simultaneous reinforcement of a one-party, one-ideology authoritarian state. This contradicts core finding of DRC- World Bank report which suggested that China could not jump to next stage of economic development (and would languish in 'middle income trap' unless it embraced modern 'free thinking. Countries need to increase productivity through innovation. China is running out of cheap labour, faces severe demographic change, has picked easy economic options (cheap labour / investment led growth / catch-up growth) [1]

China is facing a new economic crisis - namely family business succession. China's economy is not dominated by SOEs as many believ. Private enterprise accounts for about 2/3 of China's economy - up from zero decades ago when private business was outlawed. Most such enterprises started 3 decades ago - and now simultaneously face succession issues. This is happening at the same time that China's privately controlled manufacturing has to move away from its low-wage labour intensive methods. Also there are major cultural differences between first generation business owners and their children. The first generation had little and limited education. 88% of their children have degrees and 52%studied overseas. The latter often clash with their parents over corporate management. The children favour advanced Western management systems - and parents believe that this is incompatible with the reality of doing business in China. Western educated children don't like dealing with government officials, which is vital in the Chinese business world. There is concern that they have been influenced by foreign culture / beliefs. In the US people have beliefs (eg in Christianity). While China has Buddhism, few people really believe it in their heart [1

In 2015 it was noted that the richest man in US politics (with almost $500m in family wealth) would only rank 166th in China [1]

Moreover the limitations that Western observers perceive in China's political and economic systems are only part of the story (eg see China can't be properly understood in terms of Western economics). The structural problems that China faces are escalating because of factors that require reasonable Asia-literacy to appreciate. For example: 

  • East Asian systems of socio-political-economy have created and depended on favourable international financial imbalances (ie on the willingness and ability of trading partners to sustain ongoing current account deficits and ever rising debts) - see China may not have the solution, but it seems to have a problem.

Similar points are explored in China can't fix the global currency crisis without economic disaster (and in Another 'sting' driving Japan's urgency?). China lacks the ability to sufficiently reduce these imbalances that: (a) played, and continue to play, a central role in global financial instabilities; and (b) if uncorrected must eventually make global economic growth unsustainable. Those imbalance will soon lead to a decline in external demand and thus create crises for non-capitalistic financial systems when / if reliance on domestic demand creates a requirement to borrow externally.   The possibility of total failure of China's financial system is explored below (see China's Super-Ponzi-like Financial System and Preparing for a Con?);

  • assumptions that seem to be made by China about the economic benefits of large scale industrial / infrastructure investment with limited regard to profitable use of capital in specific investments (ie benefits associated with synergies and side effects) appear likely to be false - and likely to generate a financial crisis because of the massive levels of sovereign debt that that assumption has apparently caused to be accumulated .
A source which the present writer suspects is based on realistic briefings about China's economic tactics suggests that there is an assumption underpinning large scale investment with limited regard to profitability in specific projects can have net overall benefits eg because:
  • those investments can generate synergies / side effects; and
  • providing cheap capital facilitates the rapid growth of capital-intensive production.

Synergies / side effects can be real and economically valuable. The present writer's 'take' on this is outlined in Fixing Economics (2012) and A Case for Innovative Leadership (2009+). These suggest that accelerating the development of industry clusters / economic systems as a whole can generate additional economic benefits - while Developing a Regional Industry Cluster (2000) suggests methods whereby this could be achieved in a democratic / capitalistic environment without eliminating the need for productive use of capital in relation to specific investments).

However without the latter constraint there is doubt that the economic benefits will compensate for the steady build-up of debts / bad bank balance sheets that is likely to occur in parallel because:

  • it is difficult to know the productive value of such potential synergies / side effects - and thus how much build up of bad debts this may justify;
  • where nationalistic / mercantilist goals (eg building economic / military power) are a significant element in any process, the costs could well greatly exceed any economic spin-offs;
  • the individual interests of those participating in a process intended to promote community-level overall benefit cannot be entirely excluded - so the process can not be guaranteed to be unbiased - no matter how much 'self-criticism' the neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  may try to impose on its members;
  • there is a limit to which any organisation / organism can deal with complex issues. There are in nature many large organisms and many complex organisms. But there do not seem to be very large / very complex organisms - because the problem of managing complexity becomes overwhelming.

Furthermore while a high savings rate and abundant capital can achieve rapid growth in the production of capital intensive goods, most growth in developed economies comes from the deployment of knowledge. There are limits to growth merely from increasing inputs of labour and capital - and unless those limits can be passed an economy risks being caught in the (so called) 'low income trap. And the reported shift in China's education system towards encouraging just-do-it compliance (rather than abstract understanding) through starting with rote learning of Chinese classics strongly suggests that knowledge intensive economic development is not envisaged (see Competing Thought Cultures).

  • there is an incompatibility between the social equality aspirations of China's nominal Communism and the Confucian-style social-hierarchy that was vital for the methods for rapid economic modernisation that Japan had demonstrated and which it has been suggested: (a) were pioneered by Japan's military in Manchuria in the 1930s; and (b) China's post-Mao leaders were persuaded to adapt as 'socialism with Chinese characteristics' in the late 1970s. That incompatibility has the potential to lead to serious political tensions and perhaps even to a civil war.

China's history has been littered with civil wars. As noted above it has been argued that these civil wars featured contests between 'commercial factions' in southern China and rural / spiritual / militaristic factions that dominate in northern China – which resulted usually in the southern ‘commercial’ interests being driven out to become the Chinese Diaspora across SE Asia.

Tensions between such factions can be seen to have played a role in China's more recent history. 

Confucian-style hierarchy had been targeted for elimination by Mao's cultural revolution as Chinese 'Communism' favoured social equality, but was (apparently secretly) reintroduced after Mao's death by factions whose power base was southern China (Shanghai) who have arguably been the architects of China's modernisation using a variety of the neo-Confucian systems that were the basis of Japan's post-WWII economic miracle - see also Communism versus Confucianism: The Continuing Contest in China). The role that an elite neo-Confucian bureaucracy had taken in Japan was taken by the so-called 'Communist' Party itself - presumably because under Mao the Confucian bureaucracy had been successfully demonised as oppressing the masses.

Tensions were exacerbated by the massive personal wealth that many at the top of the socio-political hierarchy took the opportunity to acquire for themselves and their families (noting that the average wealth of the top 60 (2%) of the National People's Congress is reportedly $US1.4bn [1]).

This ultimately produced deep divisions within China's so-called Communist Party (illustrated by the Bo Xilia case mentioned above) apparently between: (a) the south China / commercial neo-Confucian factions who have provided the engine of China's rapid modernisation through a non-capitalistic / mercantilist / financially-repressive market economy built on relationships within an hierarchical and autocratic social elite; and (b) the 'redder' elements who favour social equality, but would not seek or be able to maintain a market economy (Political Change and Potential Instability: The Continuing Saga ).

In this context it is worth noting that (after China's system had been seen to be unbalanced and unsustainable) China was promoting both: (a) economic / financial liberalisation; and (b) potentially incompatible changes in China’s education system which would create a community that complies with social elites but would not be successful in a liberalized economic environment (see Financial and Educational Reform in China: Headed in Opposite Directions?).

Given China’s likely financial, economic, social, environmental and political tensions another revolution in China (revolting against the so-called-Communist-but-actually-Confucian factions in power) is neither impossible nor certain.

Even if the immediate threats to China’s political and economic stability are suppressed, these issues won’t go away, and anything that disrupts the social inequalities that have been essential to China’s post-1970s' neo-Confucian system of socio-political-economy is likely to disrupt China's ability to have a competitive market-oriented economy. Thus the vague 'China dream' endorsed in 2013 by the secretary of China's so-called Communist Party (Xi Jinping), which apparently included reducing the extremes of wealth that those with so-called Communist Party connections had achieved probably has major economic implication;

  • the China-centred neo-Confucian international order that seems likely to be envisaged (which could from one viewpoint be viewed as a realization of Japan's 1930's aspirations for a 'Greater East Asian Co-prosperity Sphere') is incompatible with the demands now being placed on China to take the prominent role in global leadership within prevailing Western-style international institutions that is needed because East Asia's economic methods have partly incapacitated traditional global leadership. The Chinese state (which seems to be geared to mobilizing China's people for nationalistic endeavours to obtain vengeance for what China suffered from the time of the Opium Wars in the mid-19th century and as a result of Japan's actions from late-19th to mid-20th centuries) is structurally limited in its ability to operate in a Western-style international arena. The purpose of providing information under Confucian traditions is to induce others (eg students, subordinates, outsiders) to do things that would benefit one's ethnic community, rather than to enable them to understand. Thus diplomatic dialogue can not involve a serious attempt to resolve problems (see The Limits to Dialogue and Time May not be on China's Side). The latter also notes the difficulties being experienced in promoting ethical behaviour, and the uncertainty of resolving such problems by re-emphasising Confucianism;
  • various other structural arrangements seem incompatible with the competing pressures that China is facing from the external world, and from its own people (eg apparent erosion of grass roots confidence in China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  and of the willingness of China's people to sacrifice for national gains; an education system that primarily prepares people to operate within a social hierarchy rather than to take independent initiative; poor domestic investment options; and vengeful domestic nationalism that is incompatible with providing the constructive international leadership that others now hope to see).  Many owners of China's 'private' businesses are retiring, and their university / overseas educated children have been influenced by foreign ideas - including doing business in ways that are incompatible with the state-orchestrated way in which business has been done in China (see above)

These structural difficulties are primarily a by-product of the neo-Confucian methods that were used to accelerate economic modernisation in China (as in Japan and elsewhere in East Asia) - and it is not at all clear that those problems can be resolved by the continued use of the methods that gave rise to them.

The supportive reactions of a Chinese American to suggestions similar to those outlined above may be noted.

Proposals for Reform in 2012 / Financial Obstacles / Increasing Aggressiveness

Proposals for fundamental economic and political reform that were being advanced to China's leadership from late 2012 in relations to these challenges included:

  • curbing the power of state firms; increased emphasis on market in setting interest and exchange rates; and tax reforms (as local governments do most spending while central government gains most revenue. Emphasis is being placed on developing a national consensus on reforms, rather than reliance on Beijing sources [1];
  • political reform and a greater emphasis on law-based governance without adopting a Western-style democratic style of government. Greater emphasis would be placed on 'how the Communist Party exercises leadership and governance to ensure that it leads the people in effectively governing the country' [This constituted an endorsement of neo-Confucian style leadership / governance]. Emphasis was also given to boosting China's: maritime power; social ethics; socialist market economy; and domestic demand within a framework of 'socialism with Chinese characteristics' [ie a neo-Confucian system of socio-political economy]  [1].
  • proposals from a Central Economic Work Conference for short and long term measures to enable stable growth. Continued socialist market reforms were indicated and (for the first time) clearly stated plans for reform, to overcome suspicions that government was not serious about reform. [1]
  • proposals for sweeping reforms to avert an economic crisis were being prepared for consideration by the Communist Party Congress by Liu He (Central Leading Group on Financial and Economic Affairs). This included proposals for: changes to financial system that directs cheap finance to SOEs but not to households; financial deregulation; fiscal reforms (related to central government transfers and effective property and consumption taxes); land transfer / usage systems; urbanisation; reducing income inequality; cutting red tape; and imposing market prices on coal, oil and other resources. No consideration was however being given to the sorts of institutions needed for transparent markets [1]

However, as the rest of the world stagnates economically because of failure to deal with international financial imbalances (see Too Hard for the G20?), China (like Japan) has seemed likely to lose the strong cash flows from exports that are needed to allow strong domestic growth without having to borrow in international financial markets. If this happened the balance sheet of its institutions would be called into question - and this could expose the 'Ponzi-like' character of its economy.

Diverting China's exports to emerging economies (as China has seemed to be seeking to do since late 2010) can not avoid this problem as many emerging economies (like China) can apparently only avoid financial crises by preventing current account deficits through export-led growth dependent on (mainly) US consumers (see Leadership by Emerging Economies?).

China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  has perhaps created an economy on the basis of a financial system that has many of the characteristics of a Ponzi scheme (ie one dependent on ongoing injection of new cash to delay exposure of problems in an undertaking's balance sheet that result from not earning enough to cover the ever increasing amounts owed to those whose savings were invested).

Comment: China's Super-Ponzi-like Financial System

Western ratings agencies work in terms of balance sheets, whereas China's claims to financial strength are based on the mercantilist accumulation of a stock of 'treasure' (eg foreign exchange reserves and domestic capital assets) through organising production capabilities and building up savings by suppressing consumption. A large stock of 'treasure' can be accumulated by a high rate of savings, even if those savings are used wastefully so that the balance sheets of China's banks and state enterprises may be weak because the neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  uses national savings to create economic activity / jobs / capital assets or mandate desired policy changes without taking profitability seriously (see more general comments in Understanding East Asia's Ststems of Socio-political-economy). Indicators of the emergence of problems and the increasing potential in 2012 for China's financial system to implode are outlined above and in Profitability?

China's economic growth has largely been based on investment funded by transfers from households (via low interest rates on savings, repressed wages and a depressed exchange rate) [1]

As a result of those transfers China's state enterprises generate huge cash flows and save a great deal of this. This saving increases the size of their balance sheets and provides funds for further investment, but does not necessarily prove that operations have been 'profitable' (ie increased the amount of capital made available to enterprises both: (a) in establishing them; and (b) through retained earnings).

China's credit rating claims (see above) seem to be based on something that could over-simplistically be said to be like a 'super' Ponzi scheme.

In brief: A Ponzi scheme involves attracting investment by paying high interest rates, and defrauding investors because the scheme does not actually earn enough to cover the interest it promises but pays investors by continually attracting new capital. Providing the promoter of a Ponzi scheme can maintain investor confidence, and thus a strong flow of new cash, the scheme can potentially remain in operation for a long time.  However, once confidence is lost, the Ponzi scheme quickly runs out of cash and investors realize that their capital has been frittered away.

China, and other countries that have adopted variations on the neo-Confucian  system of socio-politiocal-economy that Japan pioneered, arrange capital inflow into what seems to be a Ponzi-like financial system through organising production that generates huge cash flows, substantial amounts of which are saved and then invested with little regard to profitability. It arguably constitutes a super-Ponzi' scheme, because new cash flows are required not only to fund new investment and pay (tiny) interest rates on capital, but also to continue topping up capital which is being eroded by losses on investments that are perceived to be be in China's national interests by social elites and their subordinates.

In November 2011, Standard and Poors produced an assessment of the risks associated with banking systems in various countries worldwide [1]. This assessment (written from the perspective of Western approaches to economics) tended to support the view that  there were significant  risks associated with China's banking system, and that access to a very high rate of domestic savings was the reason that crises could be avoided. There was not, however, any comment on what would be likely to happen when the international financial imbalances that permit a high rate of domestic savings were reversed, as they must be because trading partners simply can't maintain strong demand if this required continually increasing their debt levels.

"  Although in terms of economic risk, Vietnam is in the "highest risk" category, we believe China represents the most significant future risk in Asia-Pacific. This is owing to the combination of China's "high risk" of "economic imbalances" and "high risk" of "credit risk in the economy", given its sizable economy and connections within the region and the globe.

The distribution of industry risk scores in Asia-Pacific is broadly similar to that for economic risk. Our assessment  of "institutional framework" reflects a regional dichotomy. On the one hand, systems like Australia, Hong Kong, nd Singapore are among a handful of systems to be classified as "very low risk". ....  On the other hand, half of the systems in the region have classifications of "high risk" or worse for "institutional framework", reflecting our assessment of insufficiently robust regulatory frameworks, weak regulatory track records, or limited governance and transparency standards.

Our assessment of "competitive dynamics" in Asia-Pacific shows a concentration toward the higher risk categories.

Eight of the 16 systems reviewed show "very high risk" or "extremely high risk", taking into account important government ownership, significant directed lending, or administrative controls in countries such as China, India, Indonesia, Thailand, and Vietnam. Although we observe a minimal amount of targeted high-risk lending, we believe periods of rapid credit expansion could cause moderate to aggressive risk appetites. ....

We believe "system-wide funding" is an area of relative strength for the region, and we assess 10 of the 16 systems as "very low risk" or "low risk". One reason for this is the region's high domestic savings rate, which exceeds 30% of GDP in a number of countries. This is an important contributor to the relatively stable deposit bases that reduce the need for external funding."  " (p13)

Ponzi-like financial systems can presumably be continuing indefinitely so long as the flow of new cash is maintained, and enterprises that are directly or indirectly state controlled generate most of the savings that are unprofitably invested, so that no one questions what is happening to the enterprises' balance sheet.  However in the event of a serious global slowdown, cash flows to feed into this system would be reduced and the balance sheets of China's institutions would be called into question - because they would require external capital if growth were not to fall below the levels at which political instability would be a serious risk.

China's financial situation may usefully also be likened to that of the 'entrepreneurs' who built large business empires in Australia following financial deregulation in the 1980s. Money moved around so fast that it was impossible for anyone to realistically assess their balance sheets. But when the economy stagnated, and the financial shuffling stopped, they were found to have serious balance sheet problems.

China's only prospect of avoiding crisis might be to try to create an environment in which its institutions / economy would not be evaluated against prevailing international financial criteria.

It is possible (though not certain) that the increased aggressiveness that China displayed from late 2012 was a reaction to the difficulties of its situation (as suggested in Friction between China and Japan: The End of the Asian 'Century'?). And, though the situation is anything but transparent, other late 2012 indicators of China's intentions included:

  • the lack of any clear intentions to implement political / economic reform in the membership of the new Politburo;
  • the apparent intent of China's education system to produce a just-do-it population that would be compliant with elite guidance in matters of politics and the economy (see Competing Thought Cultures) - a goal that suited China's past economic tactics, but would be incompatible with significant political and economic reforms;  and
  • early indications [1] of an intention to continue China's GFC era economic tactics (ie an emphasis on property development and infrastructure investment).

Arguably China's wild (and desperate?) spending and credit creation in response to the GFC merely amplified a fundamental feature in non-capitalistic neo-Confucian East Asian systems of socio-political-economy generally (ie the lack of attention to profitability in the use of savings) - and thus increased the risk of a financial crisis when trading partners find or decide that they can no longer continue increasing their debt levels indefinitely.

Preparing for a 'Con'? [<]

As observers have long pointed out, China seems to face increasingly severe debt problems.

Brief outline of earlier examples (drawn from Investment Driven Bubble above).

  • to avoid social unrest China has directed a torrent of money to fund wasteful projects ;
  • China's economy is like US in 1929. China has lost control. A desire to placate masses with growth has created inflation that will lead to social unrest;
  • China faces an asset bubble and a need to bail out provincial banks' bad debts;
  • the future bail-out of China's local governments will have 150% of the effect of post-2008 TARP bailouts in US;
  • China's property bubble has been critical to economic growth (and to others' ability to share the benefits), but is starting to deflate;
  • China's post-GFC economy is built on 10,000 local government investment platforms - and these rest on unsustainable debts. New credit has to be created to meet repayment obligations on old bad loans. China does not have a real banking system - as 'banks' are just arms of the neo-Confucian bureaucracy (ie the so-called 'Communist' Party) ;
  • Local government debts are 27-42% of China's GDP - and 20-30% are at risk. Central government debts are 70% of GDP - 150% if contingent liabilities are considered, Chinese companies also have incentives to borrow heavily. Investment driven growth is leading to unsustainable debt levels;
  • Local government debts cause increased concern. Few non-performing loans are reported, but loans were often taken without intent to repay. Most debts are owed between state-owned entities - so government carries losses;
  • China won't be able to ease problems associated with excessive credit growth - because US / Europe also face problems and can't boost China's economy
  • in 2011 it was suggested (with unknown reliability) that China is nearly bankrupt;
  • 60% of global investors surveyed expected China to face a banking crisis due to misallocated resources;
  • China is likely to be the last country to experience the effects of GFC - and the last to recover. Dominance of SOEs results in wasted resources. Huge profits are earned by exploiting monopoly power;
  • China has not rebalanced towards consumption. China's GFC response involved allowing banks to lend 25% of GDP to local governments. Principle was not repayable. Banks are now extending loan terms. Opaque financial system conceals but does not eliminate the problem. Government needs to absorb losses by privatising assets or increasing debt. Japan did the latter - and is now in serious trouble;
  • China's 8-10% GDP growth has been driven by new lending of 30-40% of GDP - of which 20-25% is likely to be non-performing.
  • Loans in China doubled to 200% of GDP between 2006 and 2011 - double the rate of loan growth before Japanese and US problems;
  • Private sector credit was seen in 2012 to be laying the basis for a new financial crisis in Asia (including China);
  • non-bank lending now exceeds that by China's banks. This offers high returns through very risky loans - which feed a likely property bubble;
  • China's economy depends on ever large quantities of credit - and looks like a bubble. Shadow banking system is causing problems. It directs loans to real estate that major banks find too risky. Some defaults have occurred with new money being used to pay this out - officially described as a Ponzi scheme;
  • China's central bank governor has warned about systemic threats;
  • China's premier warned some years ago that China's model was unsustainable - yet that model remains;
  • One of China's top auditors warned that China faces bigger financial crisis than US unless debt levels are brought under control
Late 2013 examples

In September 2013 China showed improved economic growth - reversing a politically serious mid-year slowdown. This was the result of reverting to infrastructure led investment. Net asset investment was 56% of GDP. Many observers have been concerned about China's dependence on investment. China is repressing domestic demand to build state-directed infrastructure - much of which does not produce economic returns. Bad debts are being avoided only by taking on more debt to pay interest bills. In September 2013 China's total system credit growth was $230bn ($2.3tr for the year to date). This massive credit growth is causing an asset price boom. It has not deflated yet because of ever increasing credit growth. This is a Ponzi scheme. In 2013 China's credit growth is likely to be 35% of GDP - leading to mal-investment. There is no certainty when this will end, but problems are likely eventually. The price of money has been faked globally by reserve banks, and the $US-renminbi exchange rate manipulation has led to excessive construction and manufacturing capacity in China. [1]

Borrowing by all government levels in China is unprecedented and one of the world's highest. Overall government budget deficits were 9.7% of GDP last year. But despite this massive stimulus growth has slowed. China's loan growth has taken total to 200% of GDP - leaving little scope for further budget stimulus. Recent growth has been driven by heavy state-led industry. But money growth is now lagging indicating problems in 6 months time. China bought $70bn of foreign bonds last month to hold down the yuan. China does not seem to be able to overcome dependence on export-led growth promoted by artificially cheap currency [1]

A few years ago it was suggested that the credit dynamics of China's growth involved an unsustainable increase in debt - which would ultimately undermine the banking system. This was disputed on the grounds that: (a) debt was directed to investment - and was thus not necessarily rising faster than debt service capacity (a view that few now support); (b) China's debt doesn't matter (being funded domestically / guaranteed by government - and China dealt with debt problems successfully before); and because foreign exchange reserves are available to recapitalize banks. A recent article noted that China credit situation has parallels with US before GFC. However it then suggests that there is no problem because of China's massive savings rate and foreign reserves (which would allow government to recapitalize the banks). Because banks are government guaranteed and people have no savings options apart from banks, China won't face a system-wide bank run as long as guarantee remains credible. There thus won't be a Lehman-style crisis. But neither will there be the advantages of such a crisis (ie quick resolution of the problem - that is possible in countries with sound financial / political institutions).  Rather there could be a Japanese style rebalancing which has much higher economic cost. Foreign exchange reserves can't be source of refinancing for banks - because there are merely assets on a ledger that are balanced by liabilities (ie the renminbi that the China's government had to borrow locally to borrow foreign reserves - in order to prevent currency appreciation). It has long been rumoured that PBoC would be insolvent if its liabilities were correctly marked. If foreign exchange reserves were used to recapitalise banks, PBoC's assets would thus be reduced, while its liabilities remained unchanged. Bailing out banks is no different to transferring their debt to central government. Some have suggested that because China's debts are hidden - those debts don't matter. But hidden debt eventually matters (as Greek and Italian situations have recently shown). This is because those debts must continue to be serviced.  If the assets funded by debt don't create enough wealth and borrower does not default, then there must have been a transfer from some other entity. In China this has typically been the household sector - eg via very low interest rates. But such transfers are China's problem. If any entity covered by central government can't service its debt - the difference must be paid by someone else, and this reduces demand and thus slows economy. If such transfers continue to come from households, then households' ability to increase consumer demand will be low. However if the state seeks to cover the difference in other ways then it creates difficult political problems - in assigning costs to influential interest groups. Debt must be paid by someone - and China's rapidly rising credit implies that growth must be slower in future - and that rebalancing will be increasingly difficult [1]

China's banks are amongst the world's healthiest and most profitable according to their financial statements. But investors are not convinced. Bad debts account for less than 1% of loans - but price-to-book values have been falling reflecting concerns about declining credit quality. Credit quality trends are not trusted. Banks tend to extend, restructure or sell loans to borrowers - rather than admit that they have gone bad [1]

There has been concern about China's local debt problem - and China's National Audit Office has recently reported on this (though the results are not public). Local governments have used innovative financial structures to raise debt. Auditors have clashed with local governments about debt classification. China's local debt problem is guessed to be between 10-50 tr yuan. The last official pronouncement was 10.7 tr in 2010 before explosive growth of shadow banking system. Total lent to local financing vehicles is about 10tr (in early 2013). This is 30% up from end of 2009 - reflecting 4tr fiscal stimulus package. Much of this was funded by debt from China's banks to local governments. 36 provincial capitals were surveyed. They have 3.85tr collective debt - and for about 1/3 debt-to-GDP ratios are over 100%.  There are problems in that a lot of local debt will be due in 2014. China's local debt problem (40-60% of GDP) is serious - but won't cause a crisis because governments have adequate financial resources (given large foreign exchange reserves, income tax of 10 tr yuan pa (which increases rapidly), and domestic financing of China's debt [1]

China's local government debt reportedly reached 20 tr yuan ($US3.7tr) in late 2012 - having almost doubled over two years - and has kept rising. Beijing is increasingly concerned with such liabilities - and this has driven a credit crunch. Total debt (consumers, companies, governments) has reached $20.8 tr - more than double GDP. Local government accounts for 80% of all government spending - yet only receives 40% of revenues. Debts of central and local governments had totalled $4.5tr at the end of 2010. Some local governments have been found to be taking on new debts to repay old ones. Incomes for such bodies are below their debt service obligations - and they hope to cover the difference with land sales.  (Callick R., 'Mixed messages on mountain of debt confuse China's markets', Australian, 30/12/13)

A blast of money from China's central banks has not stemmed growing cash crunch - as liquidity dries up and struggling lenders hoard funds. One-week borrowing costs rose over 1%, and the crucial 3 months rate rose 80 points. Fitch ratings argues that China's wealth management products (a hidden second balance sheet of banks worth $2tr) is the biggest risk . 50% of all liabilities have to be rolled over every 3 months - and a further 25% every 6 months. If rates remain at current levels, weak funds could be caught as Lehman Bros was. Central bank is also trying to rein in dangerous credit surge. Hot money has been pouring into China following optimistic response to reforms promised in November [1]

In October 2013 it seemed possible that China was hoping to 'con' the world in relation to its financial position. For example, there were suggestions that:

  •  financial liberalization in China would significantly boost the global economy because a 'wall of money' from wealthy Chinese would be available for external investment [1];
  • China's banking system was being cleaned up in October 2013 by 'huge' (ie a total of $4bn) write offs [1].

This seemed like a potential 'con' because (for example):

  • the 'wealth' of elites connected to China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party) is simply a component of the 'wealth' of the Chinese state; and
  • the 'huge' write offs by the China's major banks involved about $US4bn relative to the claimed increase in credit in China (a significant fraction of which was perceived to be suspect) of $US2300bn to that point in 2013. It was estimated  in 2011 that the rescue effort that China's banking system required would be about 7% of GDP [1]. In October 2013 China's GDP was estimated to be about $US8,000bn. If the time discrepancy is ignored this implies that China's banking system (effectively a branch of the so-called 'Communist' Party) requires something of the order of a $US560 bn  rescue package (not a $4bn write-off).

In October 2013 China's people were reported to be wondering why China had acquired so much US debt - a question that pointed directly towards the need for reform of China's financial system

Why China had to Buy US Debt - email sent 11/10/13

Eunice Yoon

Re: China wonders: Why do we own so much U.S. debt?, CNBC, 10/10/13

It is interesting that people in China are starting to wonder about why China owns so much US debt. This could lead to real reform of China’s financial system – and thus help reduce one of the fundamental constraints on global economic growth.      

China’s economic ‘miracle’ (ie rapid economic development), like that of Japan, depended partly on using national savings with little regard to profitability. China’s savings were made available by state-linked banks to state-linked enterprises with little regard to return on national savings. Because the Chinese people’s savings were being run down by the (so called) ‘Communist’ Party, the poor balance sheets of China’s banks required that the people’s incomes and consumption be suppressed to the point that it was not necessary to borrow in international (profit-oriented) financial markets. The result (as for Japan) was a large current account surplus which had to be balanced by exporting capital (eg through buying US Treasury Bonds) - see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy (2009).

The resulting demand deficits in countries such as Japan and China involved a macroeconomic imbalance that had the potential to stall global growth altogether (see Structural Incompatibility Puts Global Growth at Risk, 2003). However the US (primarily) provided the excess demand needed to compensate for the demand deficits in East Asia – presumably because its post WWII efforts to promote economic globalization within a liberal market framework had required it to accept the role of ‘consumer of last resort’. However compensating for East Asian demand deficits with consumer consumption built on a shaky foundation of ever-rising household debt was risky – and eventually this led to a financial crisis (see Impacting the Global Economy). Following the 2008 crisis, the US’s ability to provide the excess demand to sustain growth in countries with poorly developed financial systems (such as Japan and China) came to depend increasingly on rapidly rising US government debts – a process that is clearly nearly at an end.  

  If China’s people’s interest in why China has so much US debt leads to domestic pressure for genuine reform of China’s financial system – so that China can build domestic demand and borrow safely in international markets through solvent financial institutions – then one of the major obstacles to sustainable global economic growth of the last few decades will have been eliminated.

John Craig

Or Maybe There is No Real Problem  [<]

On the other hand it has also been suggested that China has no real problem:

  •  China does not really need to change because a lack of attention to profit in the use of capital confers economic advantages because: investment makes the economy more productive and thus generates positive side effects (including taxes); a broader view of the economy is taken which sees capital as only one component; and there are more protections than are generally understood.

China: Sustaining Growth by Neglecting Profitability? - email sent 14/7/12

James White and Stephanie Cain
Colonial First State

I should like to comment on your suggestions that China will be able to sustain growth because it is a ‘post capital economy’ (in The Rise of the Ferro Dollar - of which relevant extracts are on my web-site).

As I understand it you are suggesting that:

  • China’s rise has been driven by government infrastructure investment for which limited return is expected, because this makes the economy more productive and government can capture positive side effects through tax revenues;
  • In the developed world, economic progress is viewed in terms of return on capital. However in China capital is seen as just one element in the economy, where the goal is to raise the living standards of households. Capital is treated much differently. Investment comprises 45% of GDP, and this is leading to sustainably higher growth, though return on capital is poor (relative to other BRICs). Strong investment improves labour productivity and allows wages to rise faster than in other BRICs;
  • Capital and intellectual property rights are well protected in Western markets, but not in China – where scale and productivity growth are the only way to sustain profitable businesses. China improves the allocation of capital in its economy, by not using capital returns as a scorecard. A broader view is taken of the role of capital, and there is more protection than global markets seem to understand because: (a) government can fund losses through accumulated financial reserves; (b) government can recoup returns through positive externalities; (c) failure by individual projects does not mean that economy as a whole has not benefited; and (d) government can continue to invest through the business cycle. This has resulted in an economy that produced both rapid growth and low inflation.

It is submitted for your consideration that, while you have presented a reasonable view of China’s economy from one perspective, there is a great deal more to the story. For example:

  • The lack of concern for profitability in the use of capital in major East Asian economies such as Japan and China has been obvious to Asia-literate observers for many years;
  • This arguably has cultural roots in societies that lack the West’s classical Greek heritage, and thus have no tradition of (or institutional) reliance on such abstract concepts as law and profit;
  • International financial imbalances have emerged from these non-capitalistic practices which have put global growth at risk, and played a major role in the world’s ongoing financial crisis;
  • China’s main economic goal is more likely to be mercantilist (ie to boost national power) than to raise the living standards of households;
  • Economic growth driven by massive investment is not necessarily sustainable;
  • The rest of the world will eventually have to get to grips with the threat to growth posed by non-capitalistic practices that require trading partners to be willing and able to indefinitely increase their debt levels;
  • Australia needs to take a more Asia-literate view of the challenges and opportunities posed by Asia’s rising influence.

The above comments are presented in more detail on my web-site.

I would be interested in your response to my speculations.

John Craig

Detailed Comments

It has been increasingly obvious for many years that (as was suggested in relation to China) the financial systems in major East Asian economies are not ‘capitalistic’ in the sense that capitalism involves a profit-focused approach to investment (eg see Profitability in Competing Civilizations). As the latter notes Japan’s economy is similar in this respect (and was said to be a ‘non capitalistic’ market economy in 1993 by Sakikabara, a senior Ministry of Finance official).

Arguably this practice has constituted a generally unrecognised source of industrial protectionism (see Resist Protectionism: A Call That is Decades Too Late , 2010).

Limited regard for ‘abstract’ concepts (such as profitability and intellectual property) and a primary concern for ‘real’ economic variables (eg production / market share / cash flow) is a by-product of cultural traditions in East Asian societies which have an ancient Chinese cultural heritage (rather than the West’s classical Greek heritage, that gave rise to the notion that abstracts / ideas usefully model reality) – see East Asia for an outline of the origins and practical consequences of this fundamental difference.

Capitalism (profit focused investment) is one of the methods that Western societies invented to allow individuals to make decisions ‘rationally’ (ie on the basis of abstract concepts such as profitability) – see Cultural Foundations of Western Strengths). Investment by Japan and China is far more market-directed than would apply under the centrally-planned Communist regime that China used to be, because the influence of social elites (ie operating on variations of traditional Confucian methods) force market reality to be considered by their subordinates in reaching consensus (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009). It is unrealistic to view China’s rapid development since the 1980s as owing much to its nominal Communism (eg see Communism Versus Confucianism: The Continuing Contest in China, 2011).

The absence of real concern for profit in the use of capital in East Asia has been a growing threat to the global economy (eg see Structural Incompatibility Puts Global Growth at Risk, 2003).

Where (as in Japan and China) national savings are captured through state-linked banking systems and directed to state-linked undertakings with limited regard to profitability even when they are market-oriented, a financial crisis can be expected if there is any need to borrow in capitalistic (ie profit focused) international financial markets. Thus it has been necessary in such economies to suppress domestic demand to ensure that a current account surplus results in an opportunity to export capital (rather than a need to import capital through banking institutions with poor balance sheets). The resulting domestic demand deficits would have made global economic growth unsustainable – unless their trading partners (especially those in North America and Europe) had been willing and able to maintain current account deficits, and increasing debt levels, indefinitely.

The associated financial imbalances were one of the major factors giving rise to the global financial crisis (GFC), because rapidly rising overall debt levels were only tolerable so long as overall asset values were stimulated to rise faster by easy monetary policies – see Financial Imbalances (2007) and Impacting the Global Economy (2009).

The risks to the global economy associated with the financial imbalances needed to protect economies that encourage investment with limited regard to profitability have expanded beyond Japan and China. The Asian Financial Crisis in the late 1990s affected countries with similar crony-ist financial systems but which lacked the protection of current account surpluses that Japan and China had. Though the IMF sought to encourage affected countries to reform their financial systems in terms of Western methods, many apparently chose to reduce their risk in another way because of The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems (1998). Similar options were at times taken by emerging economies elsewhere (see Leadership by Emerging Economies?).

It is most unlikely that China’s economic goal is to improve the living standards of households. The People’s Liberation Army has been proportionately the largest beneficiary of China’s rapid growth, followed by ‘Communist Party’ insiders with households very much is last place (see Coalitions of Interests?). And the China-centred trade / tribute system that existed in Asia prior to Western expansion required China’s people to work very hard for limited reward so that China’s elites could exert their regional influence (see Creating a New International 'Confucian' Political and Economic Order ).

Economic growth driven by massive investment is not necessarily sustainable - because investment may not raise productivity enough to generate increased revenues or other benefits to offset its costs (eg consider the rapid growth achieved by the Soviet Union in the 1950s on the basis of investment in things for which there was no market, and Queensland’s debt-driven investment binge of the past decade which appeared to involve accounting practices as reliable as those in China). And there seem to be fundamental constraints on balancing supply and demand in any economy where return on capital is not considered important (see Balancing Supply and Demand)

The international community has proven unable (so far) to get to grips with the threat to global growth posed by the financial imbalances needed to protect countries such as China that seek to have ‘post capital economies' (eg see G20 in Washington: Waiting for Hell to Freeze Over?). However eventually the rest of the world will probably realize that there is a need to do something about this (eg steps along the lines suggested in China may not have the solution, but it seems to have a problem).

Australia needs to take a more Asia-literate view of the challenges and opportunities posed by Asia’s rising influence (eg as suggested in Babes in the Asian Woods, 2009+ and Autocratic Asian States and Australia's Economic Options, 2012). The systems of socio-political-economy that have been the basis of economic miracles in East Asia, by (for example) enabling investment to be somewhat divorced from considerations of profitability not only result in macroeconomic obstacles to sustainable global growth (eg see Economic Recovery is Constrained by Dead Weight Economies) but are also incompatible with Australia's liberal egalitarian social traditions.

There is no doubt that the profitability of individual undertakings has limitations as a way of driving economic change (eg for reasons suggested in The Advantages and Limitations of Financial Criteria and Restricting the Role of Financial Services). However methods of achieving this that are compatible with liberal egalitarian democratic capitalist societies are available (eg see Lifting Productivity: Considering the Bigger Picture View).

Outline of The Travelling Economist: Rise of the Ferro Dollar, Global First State

China’s rise confounds economic history, but not necessarily economic theory. A focus on capital investment in infrastructure is at the heart of growth (to create more productive lives) funded by a government which may bear losses but captures the still positive side-effects (externalities) from rising tax revenues. The government also promotes a competitive industrial landscape to lower the cost of living for households. These foundations seem brittle to those used to judging an economy by on capital. But China is comfortable with low capital returns if the pay-off is a stronger economy.

The Chinese don’t play chess. They play wei qi a game of strategy played on a larger board with black and white pieces each of equal value2. The Chinese government views the economy as though it’s wei qi. Each piece has its own economic role, but each is no more important than another.

In the developed world, the stronger the outcome for capital the stronger the perception of the entire economy. Low returns on capital show economic weakness reflecting over-investment, which is naturally followed by under-investment. This is the business cycle.

In China, capital is just one factor in raising living standards, and is used differently.  Government’s role is paramount. Despite claims of imbalances (investment spending has made up to 45% of GDP in recent years) investment is driving sustainably higher economic growth.

The higher allocation of capital has led to falling profit growth and lower returns for capital. Compared to its BRIC counterparts the Shanghai Composite has been bad. And there have been stories of large capital losses (eg by local government financing vehicles under the Great Stimulus of 2009, property developers and informal lenders in the coastal cities).

But, strong investment improves labour productivity and allows wages to rise. Chinese wage growth out-strips wage gains in other BRIC markets. Since 2005, Chinese wages have doubled - reflecting  productivity improvements and improving income equality (more than falling competitiveness).

Capital is often very well protected in Western markets. Property rights are important in capitalism. Property rights are evolving in China - but are less protected where this may discourage competition. Competition is seen as a way of raising living standards by lowering the cost of goods and services. This drives innovation through the threat of failure; there is no carrot for innovation. Achieving scale and productivity growth is the only way to sustain a profitable business.

By not using capital returns to assess economic progress, China improves the allocation of capital (ie it takes a broader perspective to the value of capital). This has dangers - but there is more protection than global markets understand.

First government can fund losses from financial reserves (> $3.2 tr). Second, and most important, the government (the ultimate capital allocator) can recoup returns from positive externalities in the form of higher tax revenues created by higher levels of activity. Third, the failure of individual projects does not discourage investment elsewhere if other projects can still add value to the economy as a whole. The government can continue to invest through the business cycle - and this has driven stable economic growth.

Government tax revenues have risen as a share of nominal GDP; 11% in 1992 to 20% in 2011.

China can get returns from individual projects. The Great Stimulus should perhaps have been smaller and  better regulated. But that investment will provide dividends for years and be a foundation for future growth.

China’s economic performance in the last 20 years has been remarkable; with very strong growth and low inflation. This is particularly the case when compared with other developed, BRIC and Asian nations. India has similar opportunities - but India’s government is not capable of undertaking this investment. Instead, capital investment generally falls to the private sector, which focuses on the returns specific to an investment rather than the good of the wider economy. Thus the economy suffers from under-investment and an unstable mix of growth and inflation.

Infrastructure investment creates economy wide positive externalities and a competitive economy improves living standards. These two drivers stand in contrast and so highlight the nuanced role of government. Government must build infrastructure as only it can capture the returns from the investment. Conversely, government removes itself from consumer industries where the private sector is willing to invest. The risk , is property which sits between infrastructure investment and a competitive private industrial economy.

The development of infrastructure promotes growth and price stability by improving productivity. Productivity and supply management (increasing the supply of goods and services), rather than demand management, is at the core of successful emerging markets.

The lack of simple infrastructure comes at a cost - the time people take at unproductive tasks. Building infrastructure brings short-term jobs - but its long-term impact (creating time for more productive activities) is much more important.

Urbanisation is at the pinnacle of this process. By moving to a city, a family immediately increases its productivity and living standards (eg by access to better jobs and providing access to economies of scale in the provision of (say) social, health and education services.

China does not allow the ad hoc urbanisation. Most emerging economy cities have large slums with new migrants from rural areas. China limits migration by a licensing system or hukou (which ensures culturally similar people). The urban hukou provides considerable privileges / allows households to lower their precautionary savings - thus increasing consumption of goods and services that further increase living standards and productivity. The hukou helps manage urbanisation. Cities are being built prior to settlement to limit the extent of incremental urbanisation.

China currently has relatively high costs of transport. Only more infrastructure, including the high speed rail network, can lower these costs.

The second plank in China’s bid to lower the cost of living has been the creation of a super competitive industry structure. The industrial structure of China adds to the economy’s growth - but remains a constraint on capital returns.

China’s industrial structure emerged with manufacturing economy after the Cultural Revolution. Each province established its own factories for the manufacture of a variety of goods *rather than following USSR with national champions). This created inefficiencies with the non-performing loan crisis at the turn of the 21st century. China then denied bank funding to companies that were not cash flow positive - allowing only the strong to survive and creating hyper-competitive companies.

The impact of competition is negative for capital returns. Many manufacturers operate at a loss or only small profit. But what’s negative for capital is not necessarily negative for the economy.

The aggressive use of capital reflects its relative abundance due to a closed capital account and high savings by firms and households. The resulting low interest rates provide an incentive for business investment by lowering the required return. Low interest rates lead to the creation of new capital rather than asset bubbles (with the potential exception of property). Businesses start again, rather than bid up the price of assets. Rates of return are low because of fierce competition.

China has the capacity to grow. Economies with less competitive industrial structures tend to have more limited capacity that allows incumbent firms to earn higher profit margins. More profitable firms come at an economic cost as production is not maximised and growth is contained. China's steel industry operates at a very small profit, but high state ownership allows the government to benefit through positive externalities such as lower infrastructure costs because of abundant cheap steel. Unprofitable steel mills lower the cost for other, valuable activities, such as road-building.

Property is China’s Achilles’ heel. It sits between the government-led infrastructure building and a hyper-competitive consumer economy. Each apartment, office, shopping centre or factory is in its own way unique. Location and design play a role in determining the value of property. China knows it must shift to a system of individual property rights, particularly for residential property. It is difficult for the market to be truly competitive; as excess returns exist and it’s not possible for the government to capture them.

This makes property policy extremely difficult. The value of property closer to the city centre, jobs and other facilities rises. Private ownership of property excludes the government from capturing the appreciation - and leaves some households out. Households bid up house prices. This  creates risks of price bubbles / inequalities / unaffordable housing.

Through the prism of financial markets China is not a welcoming economy for capital. Capital returns are low because of competition, a closed capital account that makes capital abundant and companies that have more than just financial motives in mind when they invest. It takes skill to identify opportunities that can offer a sustainable long- term return above the cost of capital.

But this is positive for the broader economy. The aggressive use of capital is lowering the cost of living by raising the productivity of firms and individuals and cutting the prices households pay for the goods and services they need and want. The government, as the largest capital allocator, can both manage losses from individual projects and capture the benefits of loss-making projects through its tax-collecting authorities.

  • China's financial system is sufficiently protected from the risk of crises because: (a) its banks are being used to fund what elsewhere would be government spending; and (b) any potential problems in its banks can be covered by the government which has low debt levels and large foreign exchange reserves

[Comment: this involves claiming that a poor balance sheet for a country as a whole can be ignored by claiming that this is a matter of sovereign risk, and that sovereign risk is not an issue for a country with large foreign exchange reserves. This certainly seems to be what has been assumed - yet: (a) this protection can only be available so long as it is not necessary to borrow in international markets - which requires trading partners who are willing and able to continue indefinitely with current account deficits and rising debt levels; and (b) poor balance sheets are likely to be a symptom of badly directed investment].

China's financial challenges are not limited to its banks - email sent 31/1/13

Yukon Huang
Carnegie Endowment for International Peace

Re: China’s banks are too big to manage’, Business Spectator, 30/1/13

Your article suggested various problems with China’s banks that might be remedied by break-up and competition. However I would like to suggest that there seems to be a more fundamental problem, namely the limited concern for profitability by business enterprises under the neo-Confucian systems of socio-political-economy that have been the basis of ‘economic miracles’ in Japan and elsewhere in East Asia (including China).

My interpretation of your article: China's big four state banks make large profits. Though many see them as the source of problems in China's economy, they merely reflect problems elsewhere. China's banks are too secure – and their performance could be improved by break-up. Critics cite: inflexible / low interest rates; government interventions such as encouraging property bubble; and huge deposits which raise the risk of misuse (given lax governance). But China's interest rates are relatively high in real terms. Capital markets lack the depth needed for flexible interest rates. The property bubble is more due to capital controls that discourage investors moving funds offshore (thus encouraging domestic property speculation). And the huge deposits are the consequence of economy with limited investment options. The emergence of wealth management products / a shadow banking system allow higher returns, but at the cost of introducing risky financial instruments. But this diversification is useful. Though there will be problems, this is the cost of learning in a regimented system. There is no basis for a banking crisis in China. The big four banks pay high dividends; non-performing loan ratios are low (though flawed); their volume of deposits is immense; mortgage lending is not highly leveraged; and most lending goes to state entities - so the ultimate risk is of state creditworthiness. The main problem in China's banks is a lack of incentive for prudent risk-taking and commercial objectives in state-dominated activity. The main need is to introduce more competition into a system that will continue to be dominated by the state and vested interests. Increased entry of foreign banks could help. Breaking up the big four into regional banks would also help - as HQs away from Beijing would reduce the pressure to respond to political goals.

Your article suggests that China’s banks make large profits and that China’s financial problems lie elsewhere. In relation to this I should like to point to indicators that profit has not been a serious consideration in the use of national savings in either China or Japan (who allegedly had a role in the 1970s in introducing the economic methods that were the basis of China’s subsequent rapid development).

Those neo-Confucian methods appear to involve state-led orchestration of economic activity financed by state-owned banks, rather than profit-focused decisions by independent enterprises. And while this is effective in creating production capabilities, it is not geared towards getting a return on national savings. And this system is likely to have very serious domestic and international consequences namely:

  • consuming the community’s savings, and in the process providing an undisclosed subsidy for producers;
  • requiring that enterprises, state-owned banks and regulatory regimes tolerate poor and / or misrepresented balance sheets;
  • creating a risk of financial crises, which require suppressing domestic demand to achieve sufficient savings to avoid the need to borrow in profit-focused international capital markets; and thus
  • making global growth dependent on the willingness and ability of trading partners (especially the US) to continue tolerating large current account deficits and escalating public and private debts – a fact which appears to have played a significant role in the international financial crisis.

Your article suggests that there is no sign of an imminent banking crisis in China.

However the situation in Japan (whose economic / financial methods are similar despite its apparently different political arrangements) is becoming serious – noting that:

  • important trading partners increasingly appear to be unable to continue tolerating large current account deficits , and are forced to rely on risky monetary policy options to promote economic recovery;
  • government debt amounts to some 200% of GDP – which suggests that a limit to government borrowing is possible;
  • the Bank of Japan is being pressured to boost money supplies, which will presumably ease government borrowing constraints while encouraging a resumption of the carry-trades that had a role in creating asset bubbles elsewhere prior to start of the international financial crisis;
  • substantial current account deficits are now being incurred (eg Obe M. Japan post deep current account deficit, Wall Street Journal, 11/1/13), and this implies a need to either: (a) draw down foreign exchange reserves thereby increasing the current account deficit constraints facing trading partners; or (b) risk borrowing in international markets with still-suspect financial practices.

And if Japan experiences another financial crisis, it is very likely that this time there might be significant and Asia-literate international attention to the nature of its problem – which could also lead to recognition that competition and break-ups may not be sufficient to strengthen China’s banking system if its major enterprises (like Japan’s) remain state-orchestrated with limited regard to return on capital. My speculations about the possibility of a financial crisis facing China eventually are in A 'Super-Ponzi' Financial System.

I would be interested in your response to my speculations.

John Craig

Resulting Interchange with Yukon Huang Regarding China's Financial Challenges

Initial Response from Yukon Huang - 31 /1/13

China's banking system is different because the big four are state owned.  With interest margins controlled they are guaranteed profits.  As long as the public debt levels are low - which they are - any financial risks are sovereign risks and not banking risk.  As an added measure, China's huge reserves are used to protect the system against NPLs being much higher than they are officially state.  Thus the issue is more about getting the banks to serve the real needs of the private sector rather than just rely on easy lending and implicit government guarantees.

Reply to Yukon Huang - 31/1/13

Thanks for your response. I would appreciate your permission to include it with the copy of China's financial challenges are not limited to its banks on my web-site.

An aside: A subsequent brief discussion about reproducing this interchange has been omitted from this record. Conditional permission was granted

You again pointed out various reasons to believe that China’s banking system is not at risk. However you did not comment on concerns expressed in my email, ie that China’s state-funded public and supposedly-private major enterprises (like Japan’s) do not seem to be required to take profitability seriously, and that this practice has serious domestic and international repercussions.

Poor balance sheets can be disguised as your email suggested (ie by ensuring that China’s major banks are (artificially) profitable; considering the financial risk of investing / NPLs to be sovereign risks; and pointing to the protection apparently provided to China’s sovereign credit rating by large foreign exchange reserves). However the fact that this arrangement is non-transparent (both in relation to the lack of serious emphasis on profitability in the use of national savings, and to the actual state of corporate and national balance sheets) is: (a) incompatible with prevailing international financial practices and systems; and (b) likely to increase the risk of domestic and / or international financial / economic crises.

Three Responses from Yulon Huang - 1/2/13

China’s banks do not take profitability as seriously as others because at state-owned banks a large portion of their lending are actually quasi-fiscal expenditures – typical of socialist systems. There is less expectation that these loans will be profitable. Nevertheless they are relatively profitable as evidence by the dividend stream and the huge capital gains that outside investors such as Goldman and Temasek have made on their investment shares purchases years ago.

China’s government expenditures to GDP ratio is unusually low – around 28% compared with 40% in OECD countries. They fund what would be normally included in government budgets through bank loans. Thus trying to think of them in normal banking terms does not make sense. Thus China’s banking problems stem actually from a failure to use the budget properly. It is a fiscal rather than banking problem.

Japan’s banks are completely different – they are not state owned.

Attaching another article of mine on China’s banks

Outline of attached article: There is increased scrutiny of China's banking system - and concern about negative interest rates, repressed consumption and excessive investment. Premier Wen Jiabao said the big four have monopoly position, earn excessive profits was catering for large state enterprises and neglecting small private companies. However there are myths involved. Negative interest rates are a global phenomenon - and more of an issue in US than in China. China's financial repression does not result from negative interest rates, but from capital controls - which lead to restricted investment choices so that government can capture savings easily for its own spending. Decline in consumption relative to GDP results from shift from agriculture to industrialized economy - and also arose in Japan, South Korea and Taiwan. Consumption spending has grown 8% pa over 2 decades. Big 4 banks have only 45% of bank assets now compared with 75% 2 decades ago. And while they have large profits they will face big write-offs from 2008 stimulus program. The real problem is limited role of other financial intermediaries and rudimentary bond / equity markets. Excessive investment is not the result of low interest rates. Given savings of 50% of GDP, rates might fall if financial system was liberalised - without government driving investment. Build up of heavy industry reflected an overly ambitious effort to rebuild capital stock after Mao era. And despite this China's capital stock remains low relative to others, and to its needs to support rapid urbanisation. Reform would not allow the banking sector to play a bigger role in economy, as its existing role has been huge because government has used credit expansion to drive demand and households have limited investment options. Suggestions that reform of banking system requires improved governance / regulatory framework misses the point that banking weaknesses are less important than inadequacies of fiscal system - where expenditures account for only 27% of GDP compared with 35% in other middle income countries, and 40% in OECD. When reforms started decades ago government revenue and state enterprise profits had collapsed - and the only way to mobilize resources for investment was to tap household savings. Now China needs to move away from having banks as the main instrument for funding public spending. Thus fiscal system needs to take on its normal responsibilities. This would be more accountable and transparent. (Tall Tales about China's Banks hide Economy's Problems, Bloomberg, 5/6/12)

One last point. Yes China’s banks do not fit the mode other global banks but this is not a systemic risk for the global financial system for many reasons.

Working Draft Reply to Yukon Huang RE: China's financial challenges are not limited to its banks -

As I understand it your conclusion, is that China’s major financial problems are largely outside its banking system – related to the way banks have been used by the state - and that the goal should be to: (a) normalize China’s fiscal arrangements; and (b) find ways to mobilize funds for private business;

While this is reasonable, I submit that:

  • there is a need to consider cultural features as these impact on both current arrangements of which China’s banking system is part, and on realistic options for reform. What has been called ‘Socialism with Chinese characteristics’ appears to involve the same sort of neo-Confucian (ie bureaucratically –orchestrated ) approach to economic development that Japan used, and to involve a similar approach to the use of national savings (ie limited regard for profit in the use of capital and a consequent need to rely on the accumulation of foreign exchange reserves to protect against the resulting ‘sovereign risks’);
  • while China’s major banks (like Japan’s) do not in themselves constitute a risk to the global financial system because they are artificially made to seem profitable, the neo-Confucian system of socio-political-economy of which China’s banks are part is the source of very severe risks to the global financial system and to countries such as China in particular.

My reasons for these suggestions are developed further on my web-site.


The responses to my earlier email and the other article that was referenced (Tall Tales about China's Banks hide Economy's Problems which is outlined above) suggests that:

Socialism with 'Chinese Characteristics'

It was suggested above that China uses banks to fund what should be state fiscal expenditure – and that this is typical of socialist countries. However ‘socialist’ countries usually can’t invest to meet market demand – because collectivist politics over-ride market considerations.

China is not ‘socialist’ in anything like a traditional form. There is frequent reference to ‘socialism with Chinese characteristics’. And those ‘Chinese’ characteristics seem to involve neo-Confucian methods for accelerating economic development (ie stimulation of market-oriented learning by their connections / subordinates within enterprises and whole industry clusters by social elites within the neo-Confucian bureaucracy - ie the so-called 'Communist' Party) rather than the central ‘planning’ that is typical of socialist economies.

My speculations about the methods being used are in Understanding East Asia's Neo-Confucian Systems of Socio-political-economy. This suggests that those economic methods: (a) are similar to those that were the basis of earlier ‘economic miracles’ in Japan and elsewhere in East Asia; (b) are effective in orchestrating the development of potentially-market-oriented production capacity by the use of the ‘real-world-education’ methods like those that Confucian bureaucracies traditionally used in governing countries such as China and Japan; and (c) don’t involve making investments on the basis of the expected profitability of independent / truly-private enterprises. And, as noted above, those methods have generated serious political tensions within China because they required the reintroduction of a social hierarchy, whose elimination had been the primary goal of Mao's cultural revolution, and also into gross inequalities in the distribution of wealth.

However as far as China's financial system is the concerned the result is that investment has been funded by state-controlled banks to which national savings are channelled by various methods of 'financial repression' and which make these available to state-linked (sometimes-nominally-private) organisations with limited regard to the profitability and balance sheets of borrowing organisations.

'Socialism' with Japanese Characteristics?

The suggestion that "Japan’s banks are completely different – they are not state owned" appears suspect.

While Japan's banks are nominally 'private' they were controlled by Japan's Ministry of Finance (MOF) during Japan's period of rapid industrialization (eg noting the 'descent from heaven' system whereby former MOF officials gained the senior roles in those banks). Moreover Japan's system was like China's also in that it involved:

  • 'financial repression' to direct national savings to state-linked investments; limited regard for profitability in the use of national savings; and government-driven investment to build up the capital stock (see Why Japan's Can't Deregulate its Financial System). Thus in Japan also there was a need to accumulate foreign exchange reserves in order to provide protection against 'sovereign risk'.
  • apparent state endorsement (via the LDP and the so-called 'Communist' Party respectively) of  a neo-Confucian catalytic role in controlling the government / economy / society (by the bureaucracy in Japan and by the s-called 'Communist' Party itself in China) on the assumption that this would both build economic capacity - and benefit the connections of those in the political system. 

A prominent 'Asia watcher' has also argued (with unknown validity) that a variation on Japan's system was transmitted from Japan to China in the late 1970s.


While China’s major banks (like Japan's) do not in themselves appear to create a risk to the global financial system, the neo-Confucian systems of socio-political-economy of which those banks are components does pose such a risk – and also poses a particular risk to countries in East Asia such as China.

In relation to the global risk it is noted that:

  • neo-Confucian systems of socio-political-economy have required that the countries involved accumulate large foreign exchange reserves to protect the state against ‘sovereign risk’. The ‘financial repression’ needed to achieve this has created demand deficits that would make global growth unsustainable unless their trading partners had been willing and able to tolerate large and persistent current account deficits and increasing debts so as to provide the demand in excess of their national incomes that was needed to prevent global economic stagnation (see Structural Incompatibility Puts Global Growth at Risk, 2003). And trading partners' current account deficits require that they have domestic demand that exceeds domestic production, which (a) was stimulated by excessively easy monetary policies that contributed to the asset bubbles that ultimately led to a global financial crisis; and (b) affected the US in particular because of its post-WWII ‘mission’ of encouraging the global spread of democratic capitalism by acting as a 'consumer of last resort' (see Impacting the Global Economy);
  • accumulating foreign exchange reserves to protect poorly developed financial systems is incompatible with international financial practices. Moreover this arrangement :
    • is not the basis of an alternative global system, because not all countries can adopt this practice;
    • has not been transparent. For example, the 1985 Plaza Accord, which involved attempts to reduce the US’s persistent current account deficits by devaluing the $US against the Japanese Yen, did not reduce US trade deficits with Japan because controls on capital flows in Japan (which were not apparently disclosed) directed national income to increasing production. Thus trade imbalances could not be corrected no matter what was done to exchange rates (see Inadequacy of Currency Re-alignment);
    • has spread to many other Asian countries who had suffered from ‘crony capitalism’ at the time of the Asian Financial Crisis, and to emerging economies elsewhere who had reason to fear financial crises (see Leadership by Emerging Economies?);
  • the creation by reserve banks of huge quantities of credit at very low interest rates in a last-ditch attempt to maintain global economic growth in the face of the large public and private debts in countries that don’t practice ‘financial repression’:
    • has resulted in a so-called ‘currency war’ involving quantitative easing by reserve banks mainly through monetising government debts (which generated ultra-low interest rates). This can be viewed variously as: (a) a means to stimulate domestic economies; (b) a tactic to devalue national currencies to boost competitiveness; or (c) a way to encourage carry trades from current-account-deficit economies in order to boost asset values / economic demand in 'surplus' economies;
    • is very likely to merely stimulate asset bubbles like those that preceded the global financial crisis, if the international financial balances liked to ‘financial repression’ have not been corrected. And this is not likely to happen until reasons for such repression are disclosed and adequately understood so that the problem can be addressed. Another global financial crisis that will leave that of 2008 in the shade seems quite likely (see Debt Denial: Stage 3 of the GFC).

In relation to the risk that this poses to countries such as China, it is noted that:

  • national savings have been eroded and the balance sheet of the whole community is weak even though this does not show up in the accounts of major banks because their 'profitability' has been artificially boosted at the expense of the community. Thus the community has notional financial assets / savings that are not actually available, and there is a need for an ongoing process to continue attracting savings. This has the character of a 'Ponzi scheme' (ie if anything goes wrong, and it proves impossible to continue attracting enough new savings, the problem could become apparent);
  • foreign exchange reserves are not necessarily a reliable means for guarding against 'sovereign risk'. If significant current account deficits start to be experienced (because trading partners face austerity), drawing on those reserves will exacerbate the debt constraints on trading partners' demand. It will also require converting those reserves back to yuan - thus causing the currency to appreciate and undermining industrial competitiveness [1];
  • the need to create a sustainable global economic system must eventually force trading partners, either unilaterally of through international institutions to recognise that counter-cyclical or stimulatory policies can not be effective in the face of structural financial imbalances and thus force change (eg as suggested in China may not have the solution, but it seems to have a problem, 2010). The G20 has been chronically unable to deal with the problem of financial imbalances - even though some observers are clearly aware of its implications;
  • a 'capitalistic' (ie profit focused) economic structure that is able to effectively balance domestic supply and demand has historically proved superior to the mercantilist acquisition of a 'stock of treasure' (equivalent to the accumulation of foreign exchange reserves) - see Balancing Supply and Demand;
  • frictions between Japan and China that have their origin in history make China's apparent reliance on the adoption of a Japan-facilitated system of socio-political-economy very difficult for China's people to accept - and this compounds the many domestic challenges that China faces
  • the creation of ways to provide finance for truly-private enterprise requires radical changes to the methods that have been the basis of early-stage industrialization and: (a) the necessary changes involve significant cultural obstacles; and (b) external help in making those changes can't be provided unless outsiders are assisted to understand those obstacles. Japan was exposed to a need to adjust its methods in about 1990, yet found the adjustment to be immensely difficult (impossible?). There has been no such thing as truly ‘private’ enterprise (see In East Asia Deals always Involves ‘politics’) - a constraint that seems to apply even in Singapore which might otherwise be seen as a model for China to emulate.

The biggest ultimate losers from the imbalances build into East Asia's neo-Confucian systems of socio-political-economy are likely to be in East Asia.

Japan's position already appears to be extremely difficult - even to those who do not take account of the lack of serious attention to profitability in the use of national savings and thus can't see how desperately Japan probably needs to avoid current account deficits and the ultimate need to borrow in international financial markets (see Japan's Predicament).  The latter also points to the effect that rapid population aging (which Japan currently experiences and China will experience after 2020) has on increasing dependence on exports in an environment in which the aging populations of developed economies reduce their import demands and also increase their dependence on exports to sustain growth.

  • major reforms may be made to align China's financial system with the liberal international financial system [Comment: such a move would seem to face serious obstacles]

Financial and Educational Reform in China: Headed in Opposite Directions? - email sent 4/6/13

Peter Drysdale
Australian National University

Re: China’s Next Big Round of Economic Reform, EconoMonitor, 3/6/13

While there can be no certainty about how China hopes to overcome the serious imbalances in its economy, I should like to point to changes that seem to be occurring in another arena (education) that point in a direction that is incompatible with the suggestion in your article (ie that China’s financial system should be aligned with the liberal international financial system).

My interpretation of your article: China may attempt a major round of economic reforms - like that on entering WTO. As China's markets were opened traders became more confident in exchanging commodities with China. It also affected the way China's economy / markets / institutions operated. Prices had previously differed from international prices. Now China's economy is integrated into international economy. China's commitment to liberal international trading system was a major triumph. The focus is now on structural imbalances in Chinese and global economies - especially in financial and capital markets. There is no certainty about what is now intended, but financial and capital market reform must be central - to integrate these with international capital and financial markets. This basically requires liberalization of China's international capital account - so firms / individuals can buy international assets with minimal controls. Liberalization of China's capital account is now a focus for China's leadership. This is needed if RMB is to become an international currency. Progress requires liberalization of interest rates / government bonds / entry of foreign financial institutions, and reducing inward / outward capital flow controls. A pilot program has been set up for open financial zone between Qianhai and Hong Kong

As has been the case in Japan it seems that China’s financial system has been incompatible with the global financial system – in the sense that investment has not been based on calculations of expected return on capital (eg see Evidence, Why Japan can't deregulate its financial system and Comments by a Former World Bank China Expert). Rather it seems likely that the neo-Confucian systems in countries such as Japan and China have directed national savings through state-linked financial institutions into state-linked (even when nominally ‘privately’ owned) enterprises on the basis of consensus about maximizing market share. And the imbalances that those systems have required, have adversely affected the international financial system (see Impacting the Global Economy).

In considering China’s options for financial system reform it is necessary to recognise that the neo-Confucian systems are not based on Western-style systems of rational / abstract thought – see Competing Thought Cultures. The latter includes comments on observations about the differences between Confucian and Western thought by Reg Little (a former China specialist with Australia’s Department of Foreign Affairs and Trade, who in 1976 was arguably the first Western analyst to predict China’s subsequent rapid economic advancement). The difference is significant because the use of profit-focused accounting principles is one of the ways in which Western societies have facilitated independent economic decision making by individuals and enterprises. Those methods have not been used in Japan and China because the emphasis under Confucian traditions is on boosting the position of the ethnic nation as a whole, rather than the position of individuals or independent enterprises.

Competing Thought Cultures also highlights an apparently significant change in the direction of education in China – towards starting education with the rote learning of Chinese classics. The point is that this would condition students to: (a) distrust the use of abstract concepts (including profit-focused accounting principles); and (b) be willing to act as compliant / just-do-it ciphers in a ‘family state’ (which would be a shift somewhat in the direction of North Korea). It can also be noted that the willingness of China’s people to accept brain-washing and compliance within a ‘family state’ dominated by a Confucian elite was critical to the China-centred international economic order that existed in Asia prior to Western expansion (see Creating a New International 'Confucian' Political and Economic Order).

It may be that China intends to try to align its financial system with the liberal international financial system. However this would run into massive cultural obstacles (eg see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems). And the direction apparently being taken by China’s education system suggests that a return to a pre-Western international economic order might be what China actually hopes to engineer.

I would be interested in your response to my speculations.

John Craig

  • China's economic reform agendas will create a basis for sustainable growth
An economy that starts process of modern economic growth can never stand still. China has been undergoing change since 1978 decision to pursue market-oriented reform and integrate into international economy. Changes, that amount to a new growth model, are now being forced by labour scarcity; rising wages; changes in resource allocation / income distribution / environmental impacts; and rates of growth / savings / investment / international capital flows. From 2004 China's old model suffered from wages rising above productivity and from decline in working age population from 2012. The old model's involvement with large current account surpluses was of concern because of its possible role in 2008 GFC. Uninhibited investment growth was also approaching limits. income inequality was becoming a source of social tension. There was international concern about China's contribution to greenhouse gases buildup. Corruption was also seen as a source of instability. Thus China entered transition to advanced modern economy - with a declining share of GDP associated with investment; heavy investment in education; higher quality education; expansion of consumption / services; reforms needed for legal and institutional basis for advanced market economy; structural change to technologically sophisticated industry. These changes reduced the contribution to growth by labour and capital - and increased the effect of institutional improvements. this requires less use of fiscal and monetary expansion - and acceptance of moderate slowdown without Keynesian response. Higher priority is attached to environmental amenity; energy savings; reduced carbon intensity. Rising wages are reducing income inequality. Government payments for rural education, health, transport, communication and an income safety net have increased. Measured inequality has started to fall.  [1]

The reforms announced by China' Third Plenum involved: (a) top level backing; and (b) a full market system. Reform would rely on top-level design rather than 'crossing the river by feeling the stones'. The most important statement is tht wherever market mechanisms work to allocate resources government should not intervene. This transition is leading to slower growth and rebalancing. Higher wages cut into profit margins, investment returns and export competitiveness - but increase household income. External surpluses decline. But there were also proposals for financial liberalization. The effect on rest of world will be to reduce China's contribution to external growth and perhaps increase risk of inflation. Expectation of a China collapse should be viewed with caution. China's outward foreign investment will provide opportunities. The privileged position of monopoly SOEs is coming to an end. China will remain a strong market for food and resources - and increasingly for consumer goods. China will rise up economic ladder with increasing innovation.  By 2020 China should be a market economy, a high income economy, the world's biggest economy and a vibrant consumer market [1]

  • while there is concern about possible defaults in China's bond market, this risk is minimized by the ownership structure of the companies that issued the bond (ie many are owned by the Chinese government) [1] [CPDS Comment: All segments of China are ultimately subsets of the Chinese state. The question that needs to be asked concerns the financial viability of the whole system. The Chinese state ultimately inherits bad debts associated with the banking system, local government and SOEs all of whom have problems]

Or Maybe There IS a real Problem  [<]

At the start of 2014 the prospect of a financial crisis in China (a consequence of the escalating debt problems outlined above) was finally gaining observers' attention as an economic threat.

China's local government debt ($3tr) is now seen as the biggest 'known unknown' threat to global financial markets. China's spiralling credit addiction is a major problem as it struggles to maintain growth and avoid a financial crisis. Local government debt has risen 70%. Local governments borrowed heavily to maintain China's growth after GFC by spending on special projects. They were unable to borrow from banks - so special investment vehicles were established. Many investments may not produce enough return to pay interest / principal. Local government debt is now about half of China's total $5tr public debt. Cutting lending would have severe economic impacts - but QE could be used to deal with the problem. US government debts are about $17tr. China's government needs to relax their grip on liquidity, tighten control on state banks and control shadow banking sector. China's biggest advantage is that US is now growing 4% pa [1]

China's financial system is in danger of being too big to bail out. Official bank lending has more than doubled since the GFC - growing twice as fast as economy. The shadow banking system is a bigger problem -as it allowed companies / individuals (often with political connections) to borrow from state-controlled banks at low interest rates and re-lend at higher rates to private businesses desperate for credit. Now Communist Party has sought sweeping financial reforms. Markets will play major role in directing economy. Interest rates will be liberalised, cross border investment welcomed and regional / bureaucratic protectionism curtailed. Modest changes are already causing turbulence. Central bank had to back off to avoid stress on banking system as vested interests objected to paying more for what had been cheap loans. Efforts are being made to raise interest rates to reduce credit expansion. Market-driven interest rates have soared twice - though not for long. Tightening will induce de-leveraging. A complex / loosely regulated network of financial go-betweens has sprung up to profit from repackaging / reselling China's new mountain of debt. These investment products (which pay higher interest rates) have become popular with ordinary investors. But such products can be risky. The final users of the money will not be able to earn enough in slowing economy to repay loans. There is an expectation that Chinese people could withdraw money from banks - out of concern for stability - and thus make it impossible for them to continue funding SOEs and politically connected individuals (even where such loans are to repay existing loans). China's banks have been profitable despite lending at low rates, because they paid even lower rates on deposits - and savers had few alternatives until recently.. Real estate prices are now stratospheric relative to incomes; sharemarkets are distrusted; and shadow banking businesses require periodic intervention. Total credit in China (though growing fast) remains slightly below that in the West relative to GDP - though the percentage of non-performing loans could be higher and China's poorly regulated financial system may be harder to bail out than others  [1]

China's banks are now set to seek overseas bond buyers to provide cash. They need to raise $370bn from share / bond sales over 5 years. With growing levels of bad debts they can no longer rely on share issues to raise capital [1] [Comment: Avoiding the need to borrow in international profit-focused seems vital to protecting against financial crises where profitability is not sought in the use of capital];

Soros argues that China has become the major source of global economic uncertainty. Its past growth model is unsustainable - and current policies contain profound contradictions. It has been necessary to emphasise growth over structural reforms - to avoid a deflationary downturn, Growth has been highly dependent on expanding credit. There will be a need for political reforms to overcome China's problems. There is a strong parallel between China's situation now and the US in 2007 - though a big difference is that in China the state has control over the financial and economic systems, while in the US financial markets are independent [1]

China's national audit office has released results of country-wide survey of government debts. Local government debt growth has averaged 20%. Total debts rose 3.9tr yuan ($US720bn) to 10.6tr yuan over past 3 years. . They also guaranteed 2.7tr in others debt, and must cover 4.3 tr yuan in other liabilities. Total local government liabilities are 19.6tr yuan - about 1/3 of GDP. Central government debt is 9.7tr yuan. Total government debt is about 54% of GDP. This total debt level is concerning - but not an immediate risk. The biggest problem is the rate of debt growth while China's growth slowed. Also some areas face much greater debt risks than others. Moreover  history shows that in a crisis current government debt levels can escalate rapidly [1]

[CPDS Comment: It is unrealistic not to include the liabilities of China's banking system and shadow banking system - which are extensions of the neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  - as part of China's government debt. It has been noted that China's banks are used to undertake quasi-fiscal expenditure (ie undertake spending that elsewhere might be funded by government) and that the associated losses are not seen as a risk to the banks because government will cover the cost. Credit creation by the shadow banking system has also grown rapidly - and apparently often been associated with dubious investments.]

The rise in shadow banking has been a major reason that China's debt has soared at a pace similar to the US and European nations before they crashed. Since 2008 domestic debt has ballooned to 216% of GDP from 128% and could climb to 271% by 2017 if not corrected - according to Fitch Ratings. 34% of local governments' debts came from non-bank sources [China to rain in shadow banking', The Australian, 8/1/14]

China has set up arrangements to address the bad debts of its financial institutions [1]

China does not really know the extent of local government debt - according to China Beige Book International. China's state auditor came out with a figure - but this could only have been a wild guess - as the data is simply not available [1]

China faces major problems with debt. A cash crunch is looming. Affordable credit is being rationed. Foreign buyers are obtaining nearly completed buildings at severe discounts from distressed developers. Shadow banking system rose from 20% to 30% of all lending over past year (though some say it could be 50%). Growth generated from each extra yuan of credit has collapsed from 1 to 0.25 over past 5 years. China is now trying to deleverage without economic collapse. Money supply is 120tr Yuan - but inadequate as velocity of money is very slow and interest rates are rising. China might manage the problem because all contracts can be re-negotiated. Stock market is not a real market - as it is wholly government controlled. But efforts to limit speculation cause more speculation. When China opens its capital account, there will be a rush of money offshore - and perhaps trigger disorderly fall in real estate prices. defaults by financial institutions are looming. China is riding a $24tr debt tiger that it can't control. Loans have risen from 120% of GDP to about 220-250% since GFC. This is unprecedented for a large state. There will not be a banking crash as financial system is an arm of the state. Its ending will be quite different [1]

[CPDS Comment: The 'difference' in the ending of China's debt crisis could be that it beings down the whole Chinese state, not just the financial system]

 Most analysts expect China's economy to continue to grow - but China has had rapidly rising debts. Only 5 developing countries have had similar credit booms and all have suffered credit crises and economic slowdowns. China's 'credit gap' - increase in private sector credit as proportion of economic output - has risen 71% to 240% over past 5 years. Over the past 50 years 33 countries with the top credit gaps (42% or more) - and 22 of these suffered severe credit crisis. Many believe China will be different. Rate of credit growth (not total level of debt) seems most significant - because this increases risk of wasteful investment. This seems to be China's problem. Five years ago $1 of debt generated $1 of economic growth - now this requires $4. One third of new debt goes to pay off old debt. China is seen to have protection against a debt crisis in the form of foreign exchange reserves and a current account surplus - but this is no protection against a domestic credit crisis.  Other countries with large reserves and current account surpluses (eg Taiwan and Japan) have suffered crises. China may avoid a credit crisis - but this is unlikely [1]

Trust and bond defaults are expected in China in 2014 given the number of debt-plagued companies near the edge. 1/3 of outstanding ($836bn) trust loans mature in 2014 - which many struggling firms rely on for capital. Construction / property companies are heavily dependent on debt-laden local governments. About half of local government debts ($17.9tr yuan in mid 2013 up 67% since 2010) comes due in 2014. Maintaining China's growth will be increasingly difficult. Other countries reliant on supplying inputs to China are feeling difficulties also ['China's leaders signal growing unease as overseas producers feel the pain', The Australian, 6/3/14]

China's exports fell 18% in February 2014 (rather than increasing 7.5% as expected) while imports rose more than expected. This led to expectations that China will be unable to achieve planned growth rate and to iron ore price falls. New bank loans in China fell by 50% in February [1]. It is possible that this fall in exports might reflect the ending of previously inflated data - as capital was slipped into China disguised as exports [1]

Very weak data from China and Japan led to a sharp sell-off in Asian markets and a significant decline in iron ore prices in March 2014. Lending through China's shadow banking system had ground to a halt in February 2014 (down from $160bn in January) - at about the same time that China experienced its first corporate default. It is very hard to engineer a soft landing for China as it accounts for half of the $30 tr increase in world debt over the past 5 years [1];

Falls in copper / iron ore / and China's currency values reflect more than poor trade numbers. The issues go to heart of China's banking system and the activities of hedge funds. Copper is more than a simple commodity for China's banks. It has been used as collaterale for bank loans to property developers - and thus became part of the banking system. China's banking system is stressed. Credit increase by $13tr to $15tr over past 5 years. Much of the funds (especially recently) have been borrowed in $us - - to take advantage of US QE. But this now gives Chinese banks exposure to falling yuan. Declining yuan thus has negatives for China rather than simply increasing trade competitiveness. Rapidly rising lending has been accompanied by strange bank lending deals (eg like copper based real estate funding). China's steel mills are under pressure because of falling steel prices - but were given letters of credit to fund iron ore purchases and this assisted in getting bank loans to keep steel mills afloat. This created artificial demand that boosted iron ore prices. Now falling iron ore prices place huge pressures on China's steel mills and banks. Hedge fund shorting has compounded the problem - by targeting copper and iron ore to further force prices down. This accentuates the problems facing those exposed to those commodities. China's government or central bank will need to fix this problem [1]

China's present government inherited a dangerously unbalanced economy - which had been sustained by government-sanctioned spending on construction. AS this starts to be unwound, cracks are appearing (eg in steel sector where loss-making producers had long been supported by government subsidies). Some are now likely to default - and government expects that such failures can be localised and not have system-wide consequences. But China's economy has been accustomed for years to huge quantities of government cash which have funded massive projects (eg empty cities and over-capacity property development). Without this stimulus, and given necessary tightening, bank lending will slow and substantial segments of real economy will be in difficulties. In some regions entire towns depend on industries that are no longer needed [1] -

China faces the biggest ever property default as credit curbs threaten to break the property boom and leave a string of ghost towns (now likely at 10 sites, not just the 2 previously well recognised). Developers are running out of cash. This is undermining land sales needed to provide local government revenues. China's residential property investment to GDP ratio reached 9.5% in 2012 higher than peaks in Japan and Korea and much higher than during sub-prime bubble in US [1]

Devaluation of the yuan threatens a wave of forced selling and increasing problems for those with $US debts. There is a fire sale of Hong Kong real estate by those desperate to raise cash in the face of liquidity squeeze in mainland China. The losses on structured products as yuan devalues could force further devaluation and losses [1]. Alternately devaluation of the yuan can be viewed as part of deliberate Chinese strategy to stem hot money flows into China which had over-heated property markets [1]

China seems to be headed for a 'hard landing'. It has had 30 years of strong growth. Until 2007 this was driven by exports and investment. Imbalances both external (current account surplus) and internal (high investment-GDP ratio and low consumption to GDP) have increased. These are seen as inherent feature of China's growth model related to three price distortions (ie for exchange rates, wages and interest rates). Great Recession of 2008-09 made export reliance harder because of weaker demand growth elsewhere and yuan appreciation / increasing wages which impeded competitiveness. Thus growth depended even more o investment - and external imbalances reduced sharply while internal imbalances worsened. The fall in China's trade surplus reflected commodity imports - usually at high prices - because investment surge was commodity intensive. Though government has committed to rebalancing, this has not yet occurred - perhaps because of insufficient effective reform. Fundamental features of China;'s growth model (eg financial repression) remain uncorrected. That model has reached its limits - as shown by China's steady slowdown since early 2001. This could lead to a Japanese-style 'hard landing'. Reasons for suspecting this are: historical rebalancing precedents (most countries with similar model to China's experienced sharp growth slowdown; China's characteristics are those of other countries that experienced slowdowns); overinvestment (some see 12-20% of GDP being over-investment; capacity utilization fell from 80% before crisis to 60% in 2012); unsustainable debt trends (investment surge was largely financed by debt); and a real estate bubble (situation is like Japan at start of 1990s, and investment option in China are limited to real estate). [1]

Is China different, or must its debt binge end in tears. While China won't have a meltdown, growth will slow. China's net exports fell from 8.8% of GDP in 2007 to 2.6% in 2011. This was offset by sharp rise in investment. The latter was associated with explosion of credit and debt. Social financing rose to 200% of GDP (up from 125% before GFC). Most increase has been outside traditional banking. Private sector credit is now as large (relative to GDP) as in US in 2007. China's growth has slowed to 7% pa. If this data applied to a company a bad outcome would be expected. However it has been argued that: China borrowed to fund investment; companies are the main borrowers; and China does not depend on foreign lenders; and yuan is not freely convertible. However others have had problems with excessive corporate investment, and a substantial amount of investment (eg 12-20% of GDP) may have been squandered. The other points are stronger. Yet credit can't grow faster that GDP in China forever. Debt accumulation is likely to end with a wimper, not a bang. Households and smaller enterprises have subsidised SOEs. These subsidies will have to increase - harming the economy, if growth is to continue. China faces major difficulties in arranging a transition [1]

China has the greatest construction boom / credit bubble in history. China's development since Deng has been based on monetary and credit inflation. In 2000 US had $27tr credit - and this rose to $59tr (ie at 7% pa). In 2000 China had $1tr credit but now it has $25tr. There is no real banking system in China - just bureaux that distribute credit from the top. There has never been any real pricing or honest accounting. There is no financial discipline based on contract law. China's GDP grew $10tr after 2000 - without anyone ever apparently making mistake / loss. China had 1.5 bn tons of steel capacity - but use for only half of that. This is also true for cement, ship-building, solar power, aluminium. It also has 70m empty apartments. Local governments have little income, but large debts supported by inflated land values. Coal mines face collapsing prices / revenues - but double digit interest rates on shadow banking loans collateralised by overvalued coal reserves. Shipyards have no orders, but vast debts collateralized by their idle construction bays. Speculators have collateralised massive copper / iron ore stockpiles at outdated prices. Onece asset values start falling, its pyramids of debt will stand exposed. Zhejiang Xingrun Real Estate may be the catalyst for collapse - though there are thousands of other possibilities.  It borrowed $562m of which $112m was at 30% interest. It proposed a redevelopment project - but was unable to proceed because it was bogged down in a lawsuit with residents. It continued rolling over loans. But private lenders no longer want such risky projects. There are calling in loans. And real estate values are declining . Its default will add to local government debts and thus to provincial debts [1]

Major Chinese banks claim admirably low non-performing loan levels - but no one takes the official figures seriously. A mini bank run in Zheijiang could be a sign of things to come [1]

Many observers now believe that China's property bubble is like Japan's in 1990 and that it is only a matter of time before it bursts [1]

Turnover in China's property market fell 45% year on year to May 2016 and 19% over the previous month. A fall in property turnover has often been an indicator of recession. There are 53m unoccupied properties in China. Property development has accounted for 16-25% of China's GDP [1] - as compared with 6% of the US's GDP prior to the GFC [1]

China has backed away from long term structural reform because of the need to respond to its slowing economy [1]

China has suffered from a debt addicted economic growth. Other countries who have had a rapid rise in credit (eg a 40-50% increase) over 5 years have suffered serious financial crises (eg Japan to 1990, Korea to 1998, US and UK to 2007). China's debt-expansion (at 87% since 2009) has been much greater. Corporate debt in China is now greater than in US. The average Chinese company has been seen to have worse cash flow and more debt that firms anywhere else. Other countries also have accumulated debt problems (eg Japan, US, various European countries). It is only a question of who will hit the wall first  [1].

The state-owned Bank of China has been accused of money laundering and not complying with foreign exchange controls. Clients allegedly were helped to 'launder money' (eg illicit money gained by corrupt officials and businesspeople). There is a dilemma facing China regulators. They are seeking to promote financial liberalization and outward investment. But at the same time there is an unprecedented crackdown on corruption - and many officials are fleeing China. China could be preparing to clamp down on the illegal outflow of capital [1]

Debt plays a major role in recent evolution of China's economy. Investors take debt issues more seriously than economists, Many analysts get China wrong because they fail to understand the distortions driving the economy (especially the creation of debt). Unbalanced growth may make sense initially - but this has to change at some point. Eventually the imbalances must be reversed - and in countries with centrally managed economies like China the imbalances can have become extreme. There are various ways in which China could rebalance away from reliance on rapidly rising debt - but they perhaps require 4-5% of national wealth being transferred from state to household sector annually and growth rates on 3-4% (not 7-8% as at present). Everyone now recognises China's debt as a problem. However some see that this is merely a matter of administrative changes to eliminate the distortions in shadow banking system. But the reality is that escalating debt has been a fundamental part of the way the economy worked. There has to be a massive transfer of wealth from state sector to households to change this. Some believe that China's debt problem can be solved by socializing it - ie transferring it from banks to state - and that as China's total is less than in Japan (where high debt levels have been managed) this should not be a fundamental problem. But Japan's government debt has been sustainable so far only because GDP growth and thus interest rates have been close to zero. Socializing China's debt (or transferring local government debt to central government) would reduce the risk of legal defaults - but do noting to resolve the actual problem of resolving the debt problem which requires assigning the costs. China has been misallocating investment for years (ie generating returns on investments much less than debt service costs) and, because there have been no debt write-off these implicit losses remain on balance sheets of China's banks. GDP has thus been over-estimated (perhaps by 20-30%) by not writing down these losses. Productivity numbers have also been biased upwards. Losses that are rolled over do not disappear - but has an adverse economic effect in some way. GDP growth only increases while increasing amounts of losses are being rolled over, and is reduced when they eventually are written off. The difference can be very significant in terms of reported GDP growth (eg increasing a desired 7% pa growth to a reports 10% pa while losses are rolled over, and reducing it to 4% pa when they are being written off). The problem would be worsened by distress costs during the write-off phase. Debt can only be resolved by assigning the losses. China has hidden losses in its banking system - and China's government has to decide how to assign them. China can't assign losses to households as it did previously by financial repression without suppressing domestic demand, generating social unrest and creating an escalating requirement for increases in debt. If losses are assigned to SMEs then the engine of China's future growth will be affected. Assigning losses to state sector would be difficult as China's elites profit from control of state sector assets - and will thus resist attempts to assign them losses. The losses in the balance sheets of China's institutions can't simply be ignored. They have to have an effect somewhere [1]

Chinese property buyers are not concerned about a property bubble. But prices are falling and some see major problem. The risk that China's banks / shadow banks face is not the same as in the US. Rather the risk is that property is used as collateral for everything else - as applied in Japan before its 1980s' boom collapsed. Property is 15% of China's GDP. Authorities have sought to constrain China's property boom - and the effects are now becoming obvious. Credit drives expansion of China's property market - and when this fades property is directly affected. Since 2008 China's money supply expanded three fold - with most going into property. Constraints on credit to developers requires then to cut prices which discourages buyers. Developers are seen as the weakest link in China's property market. The market could be supported by: easing of government restrictions; relatively low level of household debt; requirements for large deposits mean that loan / valuation ratios are low [1]

China is seen as likely to experience a full blown banking crisis. Authorities are understating the extent of bad loans on their books - and will face difficult choices when bank failures start . 20 years ago authorities responsibility for 30% of bad loans in the system - but now claim this is 1%. A Chinese 'Lehman Brothers effect' could result if small banks are allowed to fail [1]

In China almost all debt is government debt - and bankruptcies / corporate failures are rare. Will Beijing step away from this practice, or might it face a situation where government is unable to prevent a broad unraveling? A $500m investment vehicle recently faced default. China's government its four pillar banks to have a massive borrowing-lending spread. Private borrowers can't usually get funds from them - but must rely on alternative vehicles (the 'shadow banking' system). The investment vehicle had been set up by one of the giant state banks - and a 'white night' rescued it. This was an entity that had been set up as a 'bad bank' to hold the assets of the major bank in 1999. Authors of red Capitalism argue that this is a shell game - where assets move around as Beijing maintains a fiction that NPLs are 1%. Now the AMCs are being listed as the communist party struggles against financial losses of all kinds. Since 201 China's banking assets have grown to double those in US. To postpone NPL time Beijing can print money. This casts a shadow over the prospects of real financial reform. 15 years ago the prospects of reform seemed better. It is now necessary to belatedly build on that start [1]

China risks heading in the direction of Japan - a nation synonymous with decaying first world economies. Urgent action is needed by authorities to prevent economic stagnation. China's problems are more serious than those in Japan. There are strong signs that the housing cycle is tipping over. Japan experienced rapid growth in second half of 20th century to become world's second largest economy - but was derailed in early 1990s - and is now mired in high inflation, low growth and high government debt. China's government debt problem is even worse. China may go the way of Japan as bad debt accumulates rapidly and assets deflate in value. China's problems are similar to Japan's - ie unbalanced growth; government stimulus; over-capacity; and overwrought housing market and an under-capitalized financial system. However there are steps that China to take to improve its position [1

The People's Bank of China will inject liquidity into the five largest banks in what is seen as as a form of quantitative easing [1]

China's attempt to achieve financial reform is running up against the pressing need to maintain growth. Growth has slowed. Beijing has tried to avoid short term stimulus measures at the expense of longer term reform -- as banks, companies and local governments carry huge debts, China's central bank has long sought competition between state owned banks and to get more money into consumers' hands. People's Bank of China offered money to banks at discounted rate - so that it could go to commercial enterprises - but political connections still proved dominant. Unlike US Federal Reserve, China's central bank is not independent and for decades directed banks to provide politically approved activities. With growth stalled China's leaders have made it clear that priority should be given to stimulating growth - and it is hard to also seen financial market reforms. The central bank is concerned that new funds made available could stimulate demand for loans to support real estate. Policy makers are now trying to prevent property market becoming an economy-wide crisis [1]

China's financial sector was reasonably sound prior to GFC - but since then its has become the biggest threat to China and perhaps to the world economy. The cause of the problem was probably the adoption of rigid economic growth targets and incentives that encouraged over-performance [1]

China's industrial production has fallen to lowest level since 2008. Retail, investment and housing all point to a slowdown. Government has given $81bn to 5 major banks - but this will make little difference, Corporates (especially in mining, property and industrials) face grim future. China's corporates took on 5.4 times more leverage in first half of 2014 than they had before - restoring levels like those in 2006. This has largely been unintentional - as debt growth has been decelerating. Situation is unsustainable - and government insists it won't provide rescue with big stimulus. Chinese companies seem to be in terrible position as in 2008 and 2011 - and on both occasions growth decelerated. Defaults, credit events and failure by weak companies should be expected [1]

There is a need for close attention to China's banks, China has to cope with a slowing economy and cooling real estate markets. Government has made it easier for households / business to borrow. This won't address growing pile of bad debts. Debt can still be increased at the moment - but the rate of debt increase since GFC is alarming. Since GFC over half of China's GDP has been from debt financed investment. This led to historic rise in property values which is now slowing. If this reverses significantly China economy could be badly damaged [1]

Despite this other observers have argued that problems facing China can be ignored because China has demonstrated a superior ability to avoid the effects of potential financial / economic crises in the past.

This might however be invalid. China's society and economy had responded to centralized coordination through a quasi-bureaucratic neo-Confucian hierarchy centered on the so-called 'Communist' Party - just as Japan's had done at least until the 1980s (though in Japan's case it was the actual bureaucracy that had provided that coordination) - see Understanding East Asia's Neo-Confucian Systems of Socio-political Economy

However this was not a sustainable arrangement because centralised coordination through an elite hierarchy that is able to create credit for 'desirable' investments with limited or no regard for return on capital (see Evidence) is a formula for escalating and unserviceable debts. Japan grew rapidly in the second half of 20th century but then became mired in low inflation, low growth and significant government debt. China now has an even bigger debt problem

Moreover for such systems unsustainable debt levels create the risk of political collapse (not just a financial / economic crisis) because it is the governing elites themselves (eg the so-called 'Communist' Party or Japan's bureaucracy) rather than private entities that would lose control if huge quantities of debts have to be written off. When Japan's financial crisis followed the excess credit creation of the 1980s, bad debts were concealed to be written off slowly so that Japan's governing elites would not lose power. The result was decades of economic stagnation.

To minimize the risk of either economic stagnation or political collapse China arguably needs to reduce the role that affiliates of the neo-Confucian bureaucracy - the so-called 'Communist' Party (ie state banks and politically connected individuals) play in allocating / using capital and place greater reliance on independent profit-oriented decisions in a market context. Another justification for doing this would be to reduce the wealth inequalities that have resulted in China as many have exploited their positions in the economic hierarchy. The (possible) extent of the corruption (and its adverse economic effects) can be seen in 2014 suggestions (of unknown validity) that up to $4tr (almost half of China's 2014 $9tr GDP) have been corruptly moved offshore by Chinese officials since 2000.

However, if this were done, the view that China will successfully manage its current challenges because it has done well in the past would be invalid (because the key to moving forward would be to demolish past machinery)

Though not all are convinced (see indications), the possibility that real market reform was intended was supported by:

  • suggestions by Chinese analysts (see above);
  • a perception that China's president (Xi Jinping) has orchestrated an anti-corruption campaign across China. This has consolidated his power and resulted in jail sentences for his former political rival, Bo Xilia and for many other prominent officials [1] [CPDS Comment: another interpretation of these purges is that they have had the effect of eliminating those who might have sought a more truly 'communist' China - in which social elitism and gross wealth inequality is reduced. This certainly seemed to be the basis of Bo Xilia's populist campaigns - which appeared to favour a return to a variant of the Mao era and a primarily state-owned economy]
  •  the reported flight from China by rich Chinese (most of whom presumably gained their wealth from connections with the Chinese state) in order to get their wealth out of the reach of a reformist Chinese state. One third of China's 'super-rich' were reported to have already left, while another 1/3 were said to be considering leaving [1] [CPDS Comment: another interpretation of a large-scale shift offshore by China's economic elite would be that this is intended to provide a means to orchestrating a global, rather than a purely domestic, Chinese economic empire];
  • lending through China's shadow banking system ground to a halt in February 2014 (down from $160bn in January) - at about the same time that China experienced its first corporate default [1] an indication that government would no longer automatically bail out failed ventures;
  • a China Development Forum in March 2014 heard acknowledgement of China's economic challenges (which included demographic constraints on labour force; rising financial risks; pollution; and water-availability constraints on resource-intensive growth) and proposed liberalizing reforms to provide a basis for China's future political and economic success (see details below).  [1] [CPDS Comment: The problem with such proposals is the same as it has always been - ie that 'liberal' arrangements seen incompatible with China's traditional culture]

China's Credibility Problem - email sent 26/3/14

Martin Wolf
Financial Times

Re: ‘China’s struggle for a new economy’, Financial Times, 25/3/14

Your article provided a useful account of the profound implications of the reforms that China has announced to respond to its currently unsustainable economy.

An extract: “The ‘Decision on Major Issues Concerning Comprehensively Deepening Reforms’ agreed last November is the response. It is the blueprint for the next round of reforms. It proposes, notably, substantial institutional and political reform, including a transformation of “imperative and administrative governance” to “governance by law”. The market is to play a “decisive” role in resource allocation. The government is, in turn, to be responsible for “macroeconomic regulation, market regulation, public service, social administration and environmental protection”. Westerners would recognise all that.

This implies changes in the role of state-owned enterprises. It also implies a shift from positive to negative lists of what new entrants are allowed to do: instead of needing approvals, businesses should be able to do whatever is not prohibited. This might prove revolutionary. Also important are proposed changes to the system of residence permits, which should allow 100m migrants to become permanent urban residents."

However China has a credibility problem in putting forward such proposals at its reform agenda because:

  • Such liberal market options are incompatible with China’s cultural traditions (eg see The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems, 1998). The latter referred, for example, to: fundamental differences in the way information is used; the need to change economic goals from economic 'power' to financial returns; the inseparability of economic issues from questions of social / political power; and the lack of appropriate legal systems. Thus the announced reforms would require a complete change in the cultural practices that have been the basis of its rapid economic modernisation in recent decades. Such profound change would require decades and have many unforeseeable consequences;
  • China’s education system seems to be being changed to create an increasingly compliant population rather than one that could succeed in a more liberal economic environment (see Financial and Educational Reform in China: Headed in Opposite Directions?, 2013). [Note added later: A 'liberal' environment (ie one involving a rule of law and profit-focused resource allocation) requires 'responsible individualism' amongst the general community - because the individual rationality that 'liberal' institutions require can't work where individual decisions are constrained by communal pressures). Building 'education' on rote learning of the Chinese classics (as seems to be intended) will create a sense of communal obligation and a distrust of individual rationality. Christianity is being increasingly accepted by Chinese people (and would provide a foundation for 'responsible individualism'). But it would take several decades for its impact to be sufficient for 'liberal' institutions to work]; and
  • While Westerners would indeed recognise, and generally endorse, such reform proposals, it should be noted that East Asian cultural traditions do not involve leaders making rational decisions which become the basis of a ‘blueprint’ for change. Rather their role is: (a) to provide a framework within which their subordinates can decide on and make changes; and (b) to present a face to the external world that is expected to induce others to do things that would advantage that community (see Why Understanding is Difficult). 

Looking closely at what is actually happening – rather than what is being said – is necessary for real understanding.

John Craig

  • there is a perception that China's efforts to promote the role of the yuan as a international / reserve currency is a sign of serous intent to establish a free-market financial system [1]. However this is not necessarily so.

Are Yuan Reforms an Alternative to Market Liberalization? - email sent 27/3/14

Geoff Weir and Kathleen Walsh
Australian Centre for International Finance and Regulation

Re: Casey M J., China markets to take off with yuan reforms, The Australian, 27/3/14

There are possible problems with the suggestions ascribed to you in the above article:

“CHINA is poised to accelerate liberalisation of its capital and foreign exchange markets, a move that will turn the yuan into a major reserve currency within 10 years and catapult Chinese stock and bond markets into the ranks of the world’s two biggest, according to researchers from an Australian government-sponsored think tank.

A comprehensive report by Geoff Weir and Kathleen Walsh from Australia’s Centre for International Finance and Regulation argues that if new experiments with free-market finance in the Shanghai Free Trade Zone succeed, Beijing will expedite the opening up of China’s capital account.

Such a move, which would allow more or less unrestricted exchange of yuan for other currencies, has been flagged as a five-year goal by the Chinese Communist Party’s Central Committee.”

While there is little doubt that China would like to see the yuan become a recognised ‘reserve currency’ this would probably be regarded as an alternative to the adoption of a true free-market financial system because there are massive cultural obstacles to the adoption of such a system within China itself (see China's Credibility Problem). Moreover China is arguably facing a financial, economic and political meltdown unless it can convince the world that yuan are worth having irrespective of the true balance sheet of China’s banks and government. Where financial institutions do not take profitability seriously (see Evidence) the need to borrow internationally (which China’s declining current account surpluses suggest is imminent) is a formula for financial crises – unless one can borrow in a ‘reserve currency’ that one manufactures oneself.

The view of an experienced ‘China-watcher’ about one of the issues you reportedly mentioned is referenced in Not Everyone is Convinced that the Shanghai free-trade zone is serious.

I would be interested in your response to my speculations.

John Craig

Observers had both positive and negative perceptions of China's economic reform agenda.

China's premier presented his annual Work Report in March 2014. It referred to maintaining 7.5% pa growth and free trade negotiations with Australia. It also targeted international audiences with references to pollution / corruption reduction - and targeted China's political business elite in warning of break-up of government monopolies and corporatising financial services. In relation to concerns about a 'hard landing', China's government committed to reducing its deficit, spending cuts and a wider trading band for renminbi. Foreign trade would be increased, conditions for foreign investors improved and outbound investment streamlined. There was a wider blueprint for wide-ranging market and fiscal reforms as the foundation of deregulated and liberalised economy. Reforms related to marketisation, entrepreneurship and public finance were outlined at Third Plenum. These were converted to deregulation agenda involving abolition of government monopolies, opening state-controlled industries to private capital and banking sector corporatisation. private entrepreneurship is recognised as contributing to innovation / job creation. Private sector would gain better access to bank finance and protection of intellectual property. Markets for services and other areas would be opened to foreign participants. Most reforms are just on paper - though some are being trialled locally. They would be complemented by social welfare reforms (eg extending the right to live in cities). The problems of reform in China have long been known - but now there is a government plan that permits private entrepreneurship and a market-based fiscal system. This is like deregulation in Australia during Hawke / Keating years. However implementation is likely to be gradual. Chinese government's desire for a better market economy and better system of governance is now indicated. [1]

Everyone wants to hear of 'reform' in China. Those who rejected criticism of China's system now say that its system needs 'reform'. China's premier recently spoke more about maintaining growth than about 'reform'. Reforms mentioned included: closing idle factories; encouraging private investment; cutting red tape; encouraging consumption, rather than investment, driven growth. But these are not real reforms. What is the  'market-based reform' to which Chinese leaders are committed? Real reform requires: (a) encouraging real competition between firms / individuals; and (b) building institutions needed for fair and even transactions between economic entities and for 'creative destruction' of undeserving entities. One requirement to achieve merit-based competition would be winding back the special position of SOEs. However at present all that is being done is apply band-aids to problems created by SOE dominance. Raising the social safety net can not significantly encourage consumption. Rather this requires enabling millions of private firms to seek opportunities by reducing SOE role. However SOEs continue to be subsidies at expense of consumption. Interest rates are kept low to give SOEs cheap finance. Investment options are limited to state-owned banks. Creating private banks won't overcome the bias to financing SOEs which is implicit in their government guarantee. Profit is not the way market-worthiness of firms is judged in China. Many SOEs are profitable because of advantages given them - not because they are more efficient or provide better products. Also the advantages given SOEs mean that they can ignore measures intended to improve environmental situation. Chinese officials claim that institutional support for fair competition is proceeding. And urban residents now have more secure long-term lease rights. Contract law is generally enforced. However in important ways reform has ground to a halt.  When the state or SOEs are involved in disputes, problems arise because the state controls courts and tribunals. Millions of rural residents have had property siezed to allow developers to profit in property market. Land rights would be the best way to remedy rural poverty in China - yet government has to pour in huge subsidies to compensate for lack of land rights. To avoid the 'middle income trap' China needs real reform [1]

Japan was seen to be likely to overtake US economically in 1980s - but asset bubble burst. Plunging share / land prices led to banking crisis (with $US 950bn banking losses from 1992 to 2007). Japanese government spent $500bn on non-performing loans. China could be going the same way with non-performing loans. NPLs of 12 listed Chinese banks are (officially) $A67bn. China's banking regulator has demanded better performance. China seems better prepared than Japan to now avoid a crisis. Corporate debt is likely to fall over coming years, and credit growth has been constrained. Rate of private debt growth / GDP in China is below that in US, UK, Spain.  China's banks have strong balance sheets to withstand losses. In 1980s Japan's banking regulator did not take pre-emptive steps to curb credit expansion. China's homebuyers need to find 30% deposit (or 60% for second homes). Banking reguator has implemented Basel III capital framework. In early 2000s banks had 40% NPL rations - so government injected a lot of capital. This could happen again. Japan's government could not do this in 1980s. China's rapid growth rate is higher than in Japan - and this provides a buffer. None-the-less China's banking system will come under stress. [1]

China skeptics used to be regarded as curiosities even as late as 2010 -but since 2011 this view has been more widely considered. The focus is now less on China's double-digit growth model and more on what level of chronic slowdown it will suffer. Intellectuals can tend to get things wrong because they are 'slaves to fashion'. Hype about the China model has been led by: (a) those who could profit from that hype; (b) those who advocate engagement with China to ensure its peaceful rise; (c) intellectuals / malcontents who were seeking an alternative to Western-style capitalism - and hoped that the Beijing consensus would avoid the chaos, corruption and indecision that can affect developing countries. Those with no experience of China's system fantasized that an all-knowing / all-powerful political party can avoid short-termism, political disputes, factionalism and other democratic features; and (d) the Communist Party - which needed to have a good story to tell to attract foreign capital and resist pressure for property / intellectual property rights and a rule of law [1]

 'New normal' is used to describe China's slower (ie about 7% pa) annual growth. However there are significant structural change. China long pursued a mercantilist model that prized production over consumption. But consumption is now seen to exceed investment. Services now account for 46.7% of GDP growth. Ryan Rutkowski (Peterson institute for International Economics) cast doubt on these nominal Chinese figures. He suggests that rebalancing is occurring but more slowly than claimed.  [1

China's anti-corruption efforts have been seen to be directed against opponents of the ruling regime, and suspicions exist about those in senior roles in the regime (see below)

One possibility that occurred to the present writer was that reform could ultimately involve a break-up of SOE's enterprises (ie to bring to an end the Mao-era economic arrangements that Bo Xilia and his supporters seemed to have favoured) and to replace this with a 'market' economy driven by businesses with social links to the state rather than one driven by independent initiative - thus creating a 'non-capitalistic market economy' somewhat like that in Japan..

However if genuinely market-based methods of setting economic directions are required in future (ie those based on independent / private enterprise), China's economy will lack the discipline it has had in responding to the fairly-well-informed consensus developed by the quasi-bureaucratic economic hierarchy. Moreover:

  • massive cultural changes would be required to enable a more liberalised financial system to operate - for reasons suggested (in the context of the 1997 Asia Financial Crisis) in The Cultural Revolution needed in 'Asia' to Adapt to Western Financial Systems (1998) and in Understanding East Asia's Neo-Confucian Systems of Socio-political Economy (2009+);
  • China's education system does not seem to be geared to creating a population with the cultural characteristics required to operate in a liberalised financial / economic environment (see Financial and Educational Reform in China: Headed in Opposite Directions?, 2013);
  • the creation of a market economy does not necessarily indicate the end of internationally disruptive financial distortions. Japan was said in the 1990s to have a 'non-capitalistic' market economy (ie one in which capital was allocated to a 'market' involving state-linked enterprises with limited regard to financial returns, so that current account surpluses - and trading partners willing to sustain ever rising debts - were vital to avoid a financial crisis). Having a 'market economy' has not meant that those distortions have been eliminated in Japan's case (see evidence).

Structural Problems (above) draws attention to underlying obstacles to reforms to ease these outlined difficulties including: dependence on unsustainable international financial imbalances; over-optimistic assumptions about the economic benefits of large scale capital spending; and incompatibility between Chinese people's desire for social equality (which China had in the Mao era) and the neo-Confucian social hierarchy (centred on the so-called 'Communist' Party) that has been the basis of its centrally orchestrated economic 'miracle' since the late 1970s (and incompatibility that could even lead to another civil war).

An aside on QE: It can also be noted that quantitative easing (QE) to compensate for any decline in the availability of credit as financial institutions suffer the effects of widespread bad debts could be quite risky for China.  Under some circumstances 'printing money' to support state spending can generate hyper-inflation. One factor in containing this risk is presumably ensuring that QE merely compensates for declining credit from other sources. However another factor that has limited the potential for an inflationary outcome from QE in the US / Europe / Japan is that the pricing power of producers (and thus the potential for wage / price spirals like those that resulted from oil price shocks in the 1970s) has been contained by competition from cheap imports (especially from China). This obstacle to an inflationary outcome from QE would not apply to China. It can also be noted that QE does not provide a solution to structural problems in the financial system (eg the effect of international financial imbalances on the requirements for some countries to be willing and able to perpetually increase their debt levels in order to prevent global economic growth from stalling in the face of 'savings gluts' elsewhere). It merely allows debt levels to rise for longer without an immediate crisis, but is likely to lead to severe problems when interest rates subsequently rise to market levels.

Ongoing Uncertainty

In mid 2014 it was argued that observers expecting China to liberalize economically or politically were misguided as what seemed to have been put in place by president Xi Jinping was a reversion to an ancient Chinese elite-guided style of regime (see The Resurgence of Ancient Authoritarianism in China).

In the latter the present writer argued that introducing this reform reflects the very weak position in which China and its leadership found themselves. China's economy was messy (property bubble, shadow banking) and highly dependent on nothing going wrong with a highly-uncertain global economy. The (so-called) 'Communist' Party confirmed its status as the top level coordinators in a (neo-Confucian) bureaucratic state - and sought to promote virtue to overcome problems associated with a past lack of ethical behaviour by 'Communist' Party elites. Anything that goes wrong is now clearly their fault. Many of the people who orchestrated the economy in the past (and who have vital knowledge) have been marginalized by anti-corruption push. The Bo Xilai challenge was the face of a growing reaction against the currently-dominant factions – who presumably have their power-base in the commercial south (Shanghai) and amongst the Chinese Diaspora. Opposition to this is significant (as much of China puts communal before commercial values – and a desire for social equality is strong). Regime is tolerated so long as economy advances. Opposition is underground / invisible – but could have unexpected manifestation at any time. China’s history is littered with civil wars – which have often seen the predecessors of current dominant factions thrown out of China. Maintaining domestic security is a major challenge.

In August 2014 it was argued (on the basis of research by US Conference Board) that China's recent reform agenda had not put it on a sustainable growth path and that it seemed to be headed for the 'middle income trap' that had affected economies such as Brazil and Malaysia. Productivity growth had gone into reverse for the first time since the end of the Cultural Revolution - a classic sign of the 'middle income trap'. Over-building / over-capacity / the advance of less efficient SOEs into private sector markets have been a drag on China's economy. Growth has relied increasingly on state-directed investment - which the incremental approach to reform had failed to achieve the necessary changes [1]. [CPDS Comment: This conclusion is possible (eg because efforts to eliminate corruption from China's government have probably also eliminated many who with the best understanding of China's economy). However it also needs to be recognized that the criteria for economic 'success' that the US Conference Board perceives may not be the same as China's criteria]

In September 2014 there were indications that China's administrators might have recognized the true difficulties China faced and intended to confront them - even though this would involve immediate pain. The actual implications of that 'solution' were not immediately obvious. Panic might be imminent.

China's leaders have ignored warnings of an incipient credit crunch - and seem determined to purge excesses from the financial system despite falling house prices and a deep industrial slowdown. Industrial production fell in August. Fixed asset investment fell to record lows. Despite a sharp deceleration Beijing seems calm. New credit has fallen 40% - and there has been a shadow banking system clampdown, A 'credit crunch' is being engineered by regulators. Nominal GDP now grows faster than credit. The property market suffers. Washing machine production has fallen 7.5% over the past year. China's central bank may have to step in to prevent over-kill. Premier Li Keqiang seems determined to implement deep reforms and wean economy off very high debt levels. The money supply was said to be being restructured rather than expanded. Reform will continue so long as growth is strong and unemployment low. China's workforce is shrinking and rural-urban migration is slowing rapidly. Catch-up growth options may be exhausted. Until recently each slowdown was met with fresh blast of new loans - creating increasing problems. Credit / GDP ratio has doubled over 5 years to 200-250%. The economic benefit of new credit has collapsed - and creating new credit was becoming dangerous. Communist Party's decision to constrain credit has global implications - as its $25tr banking system was already as big as US / Japanese banking systems combined. China's industrial slowdown explains why iron ore prices have crashed - and oil demand is below expectations. China's new discipline may not last. The problems in the construction industry are disguised by advance payments that are treated as cash flow. China may find it as hard to deflate a housing bubble as Japan and US did [1].

In October 2014 it seemed possible (though not certain) that protests in Hong Kong about the erosion of political liberty associated with truly becoming just another part of China might be a 'canary on the coal mine' in relation to political stresses in China more widely.

China: No Turning Back Now???? - email sent 7/10/14

Ken Wangdong
Emerging Markets Analyst, New Frontier Investor

Re: Hong Kong, No Turning Back Now, Morning Money, 7/10/14

Your article highlights the fact that protests in Hong Kong are a reflection of the massive difference between what Hong Kong has been (which protestors seek to perpetuate) and what it is likely to become as simply part of China.

It also suggested that ‘nationalism’ in China (which the protestors are now being required to sign up to) is like ‘nationalism’ everywhere. However this is anything but the case. Nationalism in liberal societies involves a commitment to nations who value individuals. Nationalism under China’s current authoritarian neo-Confucian regime involves individuals submitting to a regime that seeks to boost the power of the nation that has little concern for their individual welfare or capabilities – and this has many parallels with the fascist regimes that emerged around the world in the 1930s (eg see explanation in Creating a New International 'Confucian' Financial and Political Order).

As I understand it the protestors in Hong Kong are not without supporters in mainland China itself who look with regret at China’s loss of social equality (eg see Communism Versus Confucianism: The Continuing Contest in China). For this and many other reasons (eg see Heading for a Crash or a Meltdown) it may well be that China’s autocratic regime might not ultimately win in the long-term ‘struggle’ that your article suggested that the protestors in Hong Kong now recognise that they will face.

John Craig

In October 2014 also an attempt was made to solve the problems associated with China's local government debts - a move that would both:(a) improve future financial transparency; and (b) pass losses associated with poor investments by financial institutions, which had been seen as implicitely subject to some sort of government support, on to those who deposited funds with, or loaned money to, the financial institutions).

China's State Council issued directives to improve transparency, clarify debtors' responsibilities and reduce overall debt. China's local governments have direct debts, debt guarantees and partial responsibility for other liabilities that are about 1/3 of China's GDP - though some are concerned that these figures are understated. Reforms include: (a) allowing local governments to raise their own debt - rather than turning to local financing vehicles - and limiting this to funding infrastructure; (b) reducing moral hazard by making it clear that central government would not bail out local governments; and (c) clarification of who is responsible for debts (to clarify the blurred lines between government debt and corporate loans). Local governments will be unable to raise debt through corporate platforms - and companies can't shift debts to local government. Local governments must withdraw from all commercial real estate projects - and liquidate assets through market mechanisms [1]

CPDS Comment: What has been announced seems to involve the ultimate 'bail in' (ie passing losses associated with poor investments by financial institutions on to those who deposited funds with, or loaned money to, the financial institutions). It seems very likely that these measures will: (a) inflict substantial losses mainly on Chinese savers and companies (given the likely massive level of bad debts that will be written off and the refusal of China's government to accept any responsibility for what local authorities were encouraged to do to sustain China's post-GFC growth); (b) be possible only because of the repressive control that the Chinese state exerts over its people; (c) have the perhaps-serious impact on China's financial system / economy that has long seemed imminent; and (d) provide China's regime with an ability to blame  the adoption of liberal Western style financial reforms for triggering that outcome.

In late 2014

  • it was suggested that China's risks of a financial crisis seemed to exceed that in the US that led to the GFC, and argued that, though Chinese leaders were smarter, China still faced a major challenge. [CPDS Comment: China's prospects can't realistically be understood without consideration of what is different about ways of thinking and doing things in East Asia].

Assessing China's Prospects - email sent 11/11/14

Steve Keen
University of Western Sydney

Re: Sizing Up the Threat of China’s Debt Pile, China Spectator, 10/11/14

You article provided useful comments on the current situation. However I should like to suggest that China can’t be properly understood in terms of Western analogies.

My Interpretation of your article: Data on China’s debts may be unreliable, but China’s leadership seems trustworthy. China’s data have improved from the days when it was a centrally planned economy. But the Communist Party remains the only power structure and data is produced that tends to tell leaders what they want to hear. But China’s leadership is better than that elsewhere – at least in terms of education. Thus, while China might face a bigger crisis than those in the West its reaction to it will be better. China faces a bigger crisis than the US did in 2007. BIS and OECD data (which understate the problem because they exclude the shadow banking system) show that there is a big problem. China’s debts are now 176% of GDP – the peak that the US reached (or perhaps more based on revised Federal reserve figures). China’s debt has risen much faster than in US (ie up 80% over 6 years as compared with rising 60% over 10 years). China’s bubble has been bigger and faster growing. China’s bubble was engineered by Chinese authorities in response to the US crisis. In US banks tell governments what to do. The reverse applies in China. After 2009 China’s banks lent like crazy (eg increasing China’s debt by 35% of GDP in one year). The US private sector has now returned to leveraging – and this might help boost China’s exports. But a huge increase in exports would be needed to compensate for stabilization of China’s debt / GDP ratio (as the latter is still growing over 25% pa – while nominal GDP growth is less than 10%). Stabilizing the debt / GDP ration could leave a 15% of GDP hole in demand. Economic activity must slow as unemployment rises. But China has a unique difference related to businesses started by local governments which sell land to developers (whose output rather than sales are included in GDP). Slowing of credit growth in China will put an end to the financing of these local government businesses. China’s credit growth is decelerating – so China may be approaching its first home-grown financial crisis. A prior example of a financial crisis in an ex-command economy was that in Russia in 1998 – though there the state was not so strong. In the US the ‘politico-financial complex’ distorted the response to its crisis – with an emphasis on rescuing the financial sector rather than the real economy. In China the government may be stronger and: put failed institutions into receivership; sack managers and bolster the real economy with government money injections. China’s leaders coped with the 2007-08 crisis but at a cost of making China’s economy as ‘financialised’ as the US had been then. The credit slowdown had a massive impact in the US. That in China will be greater.

China’s economic data are unreliable (as your article noted) because they are not the basis on which decisions are made. Major economic decisions (like those in Japan) tend to be made through a power-focused quasi-bureaucratic network of state-linked financial institutions and businesses rather than by independent profit-focused enterprises (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, and Meeting the Challenge of China's Rise). Another reason that Western parallels are not enough is that claims about debt levels are no more likely to be reliable than are economic statistics generally. Calculations of profit and loss are not the foundations of decision making by banks / businesses – so accounting standards are weak (see Evidence). My suspicion is that an independent audit would show that China’s financial institutions are in much worse condition that is officially acknowledged (eg see China's Predicament).

And, while the people who try to run these systems have to be incredibly smart / well educated, there is considerable doubt about the viability of centralized orchestration of what could ultimately become an incredibly complex system. Western governments are not so ‘smart’ but they don’t try to control everything. There are many different independent (eg economic) responses to any given situation - some of which will be right while others are wrong. The East Asian systems do spectacularly well when the ‘system’ get it right, but experience disaster when they get it wrong (eg as Japan did in the 1980s). Sir William Slim concluded that his forces in Burma in WWII could defeat Japanese forces because they could take diverse independent initiatives quickly in the field, whereas the Japanese forces would hold regular consultations and produce a superior understanding of the situation but much too late for this to be of any use in the field. Fuzzy logic (involving highly simplified variables) is now recognised to be superior in control systems to reliance on more precise calculations – because the latter respond too slowly due to the time taken to get the ‘superior’ answer. Having ‘very smart’ governments is not always the best option.

You suggested that China might now clean up its financial system in ways that were not done in the US because of the influence of a ‘politico-financial complex’. However the social-political-financial-economic-military-criminal complex that exists in countries like China (and Japan) would put anything in the US to shame. Japan’s ‘system’ ran off the rails in the 1980s with debt-driven over-investment. But in the 1990s after its financial crisis, Japan did not clean up its financial system – because doing so would have eliminated the cronies who helped run the social-political-financial-economic-military-criminal complex. China’s problem now seems similar in that respect – though even more difficult in other ways.

The US went a long way in cleaning up its financial system (by getting GFC losses written off) – much further than Europe did. As your article noted the US took actions that had the effect of minimizing failures in the financial system. One thing this required was expanding the money supply to compensate for the loss of the (about 50% of) credit-creation that had been taking place through CDOs prior to the GFC. In assessing post 2008 responses it needs to be recognized that:

  • the US Federal Reserve had found at the time of the stock market crash in 1987 that it could limited booms and busts in the real economy by providing liquidity to financial institutions – and this became the basis of a system of counter-cyclical economic management for the next 20 years (though it was one that led to all sort of unforeseen and ultimately dangerous side-effects – see Impacting the Global Economy – and has thus now probably reached its ‘use-by’ date);
  • what was done after the GFC arguably has to be viewed in a terms of a geo-political context rather than simply in terms of its effectiveness in economic management (see The 'game is rigged' for geo-political rather than 'commercial' reasons).

The fact that China’s leadership seems trustworthy arguably reflects the fact that it has to seem that way if it is to succeed (as it seems to be doing) in enticing others into something like the trade / tribute system by which Asia was administered from China prior to Western expansion (see Creating a New International 'Confucian' Financial and Political Order). However in relation to trustworthiness it is worth noting that China’s regime seems to have decided quite recently that it should not take responsibility for China’s local government / shadow-banking losses (ie for the consequences of the bad debts that others were encouraged to incur to sustain growth from 2008). It is apparently transferring these likely-massive losses to households and independent businesses. I have some sympathy for those in Hong Kong who are concerned about the implications of becoming totally subject to China’s so-called Communist Party (see China: No Turning Back Now????). The system that now rules China has been likened to that which ruled China under the last emperor in 1911. And eliminating those influences on the grounds that they oppressed China’s people was apparently the goal of Mao’s ‘cultural revolution’ (see Communism Versus Confucianism: The Continuing Contest in China).

I would be interested in your response to my speculations

John Craig

  • China's transition from its past growth drivers is likely to be very difficult, and that indicators of its actual economic growth suggested that this has fallen far more than official GDP data would indicated.

Germany and China are at the center of regional trade blocs. They both trade globally but also depend on their regions. German exports are 50% of GDP, compared with 24% for China (14% for US and 20% for Australia). Germany's primary market is Europe - and it has problems because European economies are struggling to grow. China has much more regional demand - but much of it is from people who lack the purchasing power to buy the goods China produces for export markets. China's reliance on low-cost exports and state-led infrastructure / housing investment are no longer viable. Domestic consumption / high value-added manufacturing / services are not yet of sufficient scale to offset risks of social and economic dislocation (as political legitimacy depends on creating jobs and rising material prosperity). Both Germany and China depend on sustaining strong exports. The Communist Party was shaped by rising unemployment in Shanghai in 1927. The GFC decimated China's low-end export sector - which had been maintained for too long by low wages and subsidies. Exports fell suddenly from 38% of GDP to 24% - and reliance had to be placed on state-led housing / infrastructure investment. The housing boom is now ending. China hopes to expand exports of higher value goods. China's real growth has slowed - and there are deflationary risks in housing / shadow banking system and overcapacity. China's official GDP figures are unreliable. An alternative (China Momentum Indicator) suggests that China's growth is now well below what GDP data suggests. [1]

  • China was seen to be seeking to undermine G20 proposals for international cooperation in reducing corruption despite supporting such a proposal of it own, because the latter is part of a process of purging political opponents in China, while the global initiative would also make those associated with China's current regime exposed. It has been claimed (with unknown validity) that up to $4tr (ie almost half China's $9tr annual GDP in 2014) has been moved offshore by corrupt Chinese officials since 2000.

Global anti-corruption efforts have been dealt a blow as a hoped-for agreement through G20 is likely to be torpedoed by China. Proposal involved establishing a public ownership register to prevent people hiding their financial affairs. China's likely disruption of this is peculiar as it proposed the issue at the recent APEC summit. China's corruption busters have been applying pressure on countries such as US, Canada and Australia to help repatriate corrupt officials and their loot. China argues that 19,000 officials have made off with $123bn since mid 1990s. Global Financial Integrity (US-based) argues that $2.8tr was siphoned out between 2005 and 2011. AT APEC China got member states to agree to ACT-NET initiative to facilitate information sharing on corruption. This network would be headquartered in CCDI - the discipline watchdog of Communist Party (whose methods are notorious for involving torture and abuse). However the most favoured destination for corrupt officials (US, Canada and Australia) have no extradition treaties with China because its legal system is not trusted. While Australia should cooperate in anti-corruption measures, in China there is very fine line between anti-graft campaigns and political purges. China's anti-corruption campaign since late 2012 has been as much about preserving single-party rule as about eliminating corruption. All of the 48 most senior 'tigers' who have been caught in the anti-corruption process have humble backgrounds - none are 'princelings' (sons of senior party officials). Thus Xi Jinping's own faction has been spared, while rivals have been vanquished. The G20 proposals would help China's program. But it is believed that relatives of China's political elite have been stashing huge quantities of cash offshore. As much as $4tr may have left China since 2000 - mainly through opaque corporate methods. A corporate transparency regime would put China's top leaders at risk. [1]

  • China seemed to be unable to escape from its dependence on a extraordinarily high rate of credit creation despite the declining economic impact of that credit.

China seems to have abandoned its policy of monetary tightening. It has cut interest rates to head off corporate crunch and increasing dangers of deflation. This seems like a return to old ways of credit-driven growth - a tactic that has passed its sell-by date. Falling inflation has caused the real cost of borrowing to rise from zero to 5.5% since 2011 (while non-financial companies face interest costs of 15% of GDP - up from 7.5%). Cutting rates is significant change from recent piecemeal injections of liquidity. It is being forced - but China won't be safe until its dependence on credit creation is constrained. Cuts were needed because of $250bn tightening associated with clampdown on shadow banking system over past 2 months. China is close to deflation - made worse by fall in Japanese Yen and quasi-peg to $US. It is importing contractionary forces when its housing boom is wilting. China requires 20% loan growth to keep economy going - but it has fallen to 15% and this is strangling economy. There is less GDP growth out of increasing credit - which says that loss-making assets are being rolled over. Bad loans are rising 50% p. The biggest problem lies with SOEs whose debts are about 100% of GDP - as compared with 50% of GDP for private corporate borrowing. Central bank has been trying to wean China off credit, but it may have been overruled by state council. China's debts are 250% of GDP which is unprecedented for a large developing economy. Some observers see the problems as manageable with no signs yet of real distress. The cuts to interest rates may not be as significant as some have suggested. China's labour force is declining by 3m pa (due to one-child policy) and this automatically tightens the labour market [1]

  • China faced significant limitations on its ambition to become the dominant power in Asia. [CPDS Comment: China seemed to have ambitions that went well beyond becoming Asia's dominant power - see China as a Dominant Power )

China may be Asia's economic powerhouse but a report by Paul Dibb and John Lee suggest that it won't become the region's dominant power. The factors that contribute to China's national power would be unlikely to provide it with an ability to become a region-dominating superpower. Problems arise from the nature of China's economy; a lack of close bilateral relationships; and weak military capacity. China has the economic hardware in place (and is an economic / military power).  China's economic growth rate is 7% pa - but declining productivity suggests that this rate of growth can't be maintained. In 2012 $5.50 of capital input produced only $1 of output. Experience shows that such low levels reflect massive inefficiency and are unsustainable. Also China can't shift from middle-income to high-income status (which a dominant state requires) unless it improves citizens' living standards. This would require much more government spending on social security / unemployment benefits / health care. Defense receives a large share of government spending (15% in 2014) but China can't be a super-power until it can take global-scale action. As a result of territorial disputes China has few friends in Asia. This limits its ability to wield influence / power in the region. China does not have the charismatic soft power that Asia dominant power would need [1]

  • China's economic dream is at an end

Economists suggest that China will become the world's largest economy. China's president has launched a 60 point plan to remake China's economy - and campaigned to cleanse the Communist Party of corruption. However in 2009 China's economy was growing 10% pa- but is now 7%. GDP statistics are only accurate in terms of direction - and this is now clearly down. China's economic miracle is ending. Success has depended on debt-powered housing bubble and corruption-laced spending. Many Chinese cities are surrounded by vast, empty apartment complexes. Real estate has been the main driver of China's growth for 20 years. Debt paid for the boom - with borrowings by governments, developers and many industries. The IMF has pointed out that only four countries have had as rapid a debt build-up as China (Brazil, Ireland, Spain and Sweden) - and all had debt crises in 3 years. China followed Japan and Korea in using exports to pull its people out of poverty - but China's immense scale is now its problem. It is the world's largest exporter - but can't get much more growth from this. Shifting to innovation will be hard - as its competitor nations encourage free thought and idiosyncratic beliefs.  Few engineering students in China seek to become entrepreneurs - about 1/7 the percentage in Stanford. Xi's reform agenda is standard fr China. But it is hard to make it happen. The government wants to reduce steel production in the province surrounding Beijing (where twice the steel production in US is located). It was decided to destroy blast furnaces - and this was publicly done. But those facilities has had long been out of production. China's steel production is on track for record this year [1]

  • it was noted that debt guarantees between companies had been very useful in allowing small firms with limited collateral to borrow and fuel China's rapid debt expansion in recent years. But as China's economy slows this is now leading to cascading problems and potential regional crises - because some firms are failing and their guarantors are actually having to pay up at the same time that they themselves come under financial strain. China's reserve bank reduced interest rates to take pressure off SMEs [1]
  • it appeared that China had wasted $US6.8tr over past four years (invested this amount ineffectively according the China's National Development and Reform Commission). This amounts to about half of all 2010-1013 investment. Low interest rates and government stimulus measures are seen to be the problem. China's deserted ghost-cities are a major manifestation of this. The problem is likely to continue as the PBoC has slashed interest rates. It is exacerbated by corruption amongst the countries autocratic elite [1]
  • despite China's anti-corruption programs, China was assessed to be more corrupt in 2014 than in 2013 - under criteria used by Transparency International [1] [CPDS Comment: Those criteria seem to include a 'rule of law' which is not the way China is governed]
  • China is experiencing a stock market boom despite having excess capacity in 'everything'. Authorities are striving to contain it, but China's excess savings have nowhere else to go [1];
  • China is likely to experience recession in the next year or so

China is struggling to maintain growth - given shadow banking, ghost cities, slumping property prices, a manufacturing slowdown and debt defaults. Home prices have fallen 7 months in a row. China's property market is the biggest domestic economic threat (and perhaps a global threat). A growing middle class is nice, but China needs strong export growth which is hard with a now expensive currency. China buys most of the world's iron ore - but now has huge stockpiles. China's efforts to rebalance its economy towards domestic consumption seems like a 'hard landing' from Australia's viewpoint. Jobs growth is the main driver of consumption - and this has been weak. Shadow banking has been a necessary part of China's growth (because the banking system is not working well) - but is weakening. In China, companies, individuals and government continue to leverage up to an extent never seen before - creating a massive credit bubble. A recession seems likely over the next year or two. China's housing bubble is unsustainable [1]

In early 2015:

  • China's situation was referred to using the slogan: the 'New Normal'.

After the China Dream of a new dynasty, the Fox Hunt for corrupt cadres, the New Silk Road to connect China to the world comes the New Normal. This refers to persistence of leader Xi and his economic team. Slumping commodity prices are a major boost for China. The New Normal is also seen to apply to: refraining from criticizing Communist Party; a new basis for university education - which involves more emphasis on ideological guidance; and China's shift towards consumption and services [1]

  • US analysts suggested that China was at risk of a financial crisis.

Bank of America warns that China faces the risk of a financial crisis associated with slowing growth and deflationary pressure to to defaults. A credit crunch is seen to be probable. Highly-leveraged companies are at risk form President Xi's attempt to eliminate moral hazard and reduce dependence on credit growth. Slow growth and excess debt could damage financial system. Few countries escape financial crises after after such rapid credit growth. Likely scenario involves: bad debt surge as growth slows; credit crunch in shadow banking system; and major bank recapitalization. Rescuing lenders cost China 15% of GDP in late 1990s. The problem is harder now. Loans have increased 100% of GDP over 5 years - which is twice the rate before Nikkei bubble burst in 1990. Total credit exceeds 250% of GDP (once shadow banking and offshore lending are included) - which is high for emerging economy without mature markets or layers of accumulated wealth. Explosive growth on Shanghai markets (up 350% in 3 months) is unrealistic. China has seen factory gate deflation for 33 months, and this is deepening. When producer price deflation last occurred, it took 6 years to reverse. And now there is nothing like China's access to WTO in 2001 to boost demand. Falling inflation reduces the real cost of borrowing. There has been a rapid increase since 2011. Hot money outflows raised the risk of devaluation - and will drain money from stock market and increase problems for those with $US debts. China's firms have borrowed $.12tr in external currencies. Rising $US has pulled yuan higher (because of soft peg) and it has revalued 60% against yen over two years. This reduces China's competitiveness. Hot money is now likely to leave China - perhaps leading to something like Asian financial crisis of 1997. China's capital account has been in deficit for last two quarters. China has a great deal of economic depth and is likely to muddle through [1

  • options were suggested to deal with China's financial system problems by reform of its fiscal systems. In the past expenditure that should have been by government were funded inappropriately through bank lending to provincial and local government.

Banks are not the source of China's economic problems. The real problem is fiscal system. Local governments have 45% of tax revenues, but 85% of state spending. They have had to obtain funding (for social / infrastructure spending) through off-balance sheet sources (eg land sales / shadow banking). This results in bank lending that does not generate commercial returns. Such spending should have been funded by state budgets. Such debt piles up and is written off with other non-performing loans. China has plenty of productive capacity to grow over 7% pa, but there is inadequate demand to sustain this (eg because of Europe's weakness and the US's import-weak recovery). China's rate of investment will fall because of low returns and the need to deleverage. Household consumption won't increase much because its growth will be hampered by slowing wage rises. China needs to fix its fiscal system - and a plan to do this exists. This involves expanding tax revenues, and restructuring local government debts into long term bonds and eliminating loans related to land. Incentives for seeking off-budget revenue will fall.  State budget expenditures (which have been very low) will rise. This will allow government to be more transparent. Few outside China have recognized its ambitious fiscal agenda. Success is not assured [1]

  • it was suggested (based on a parallel with what had happened in Switzerland) that China might be forced to abandon its currency's peg against the $US - and that the results could be disruptive

Currency pegs cause problems when they are out of kilter with economic reality. China announced that it would restrict margin lending to stop market speculation. The stock market fell significantly. China has problems because it linked its currency to $US since 1994. This accounts for China's trade surplus and $tr foreign exchange reserves. However to maintain pegged currency China needs to print yuan to swap for $USs. If this was not done, exporters would lose competitiveness. Thus there has been a huge amount of liquidity flowing into economy which can be inflationary. China sought to stifle this by issuing notes and bonds of varying maturities and increased bank's lending margins to restrict credit growth. But the 2008 crisis forced China to get banks to lend aggressively - thus creating a credit bubble.  China's new leadership in 2012 started trying to curb this - including purging many corrupt officials who had been profiting. The main effect of credit bubble as land boom - which is deflating. The stock market was an alternative - but now government is trying to stifle this. China might need to end currency peg to solve this problem. It is uncertain then whether yuan would go up and down. Because China has long sought to keep yuan down, revaluation seemed likely. But the damage done by the credit bubble could have the reverse effect [1]

  • China was seen to be finding (as others had previously found) that it is impossible to deflate a credit bubble safely.

Money has been tightened for a year and there has been a shadow banking crackdown. China is headed for a debt-deflation crisis. It will be hard to overcome the effects of its $26tr credit boom. Factory gate inflation is -3.3%. China debt rose from 10% of GDP to $250% in 8 years - as compared with 50% of GDP debt growth in Japan prior to its lost decade. The unemployment situation is increasingly unhealthy. Home prices fell 4.3% in December. New committed construction is down 30% over 3 months. Property investment in China rose from 4% to 15% of GDP - the same as in Spain at the peak. Inventory overhang is 18 months. Property slump is turning into fiscal squeeze as land sales are 25% of local government revenue. Fiscal deficit would be 10% of GDP without land sales revenue. China is not alone in facing such problems as 15 central banks have eased money policy in 2015. China's link to $US is eroding thin profits of Chinese companies. A significant yuan devaluation would have big deflationary impact worldwide. China has been trying for two years to wean itself off credit. Yet this is proving hard to achieve [1]

  • there was interest in the Chinese government's role in ensuring desired behavior by Chinese people. This was significant because: (a) the traditional role of Confucian bureaucracies in governing China on behalf of emperors included promoting appropriate behaviour in accordance with Confucian virtues; and (b) the authority of the state traditionally depended on the perception of a 'mantle of heaven' (ie that it would act virtuously) and this had been anything but China's recent experience (see The Dali Lam's Search for Moral Wisdom). For example:
    •  it was reported that China's education minister has vowed that 'western values' would never be allowed into that country's classrooms;
China's education minister has vowed that 'western values' will not be allowed into classrooms - as Communist Party seeks to consolidate its autocratic rule and resist demands for democracy and human rights. Anything that defames leaders or smears socialism should not be in universities. China has clamped down since President Xi took over in 2012. Many people have been detained / imprisoned for expressing views contrary to Party.  Teachers and professors in Beijing have been order to toe the Party line on history / geography / etc and not discuss democracy / human rights. Academic discussion of press freedom, civil society; elected government and constitutionalism is forbidden. President XI has sought more ideological guidance in schools / universities, and study of Marxism. Nationalism has been emphasised as a way for academics to keep themselves safe.  Even before this China's education system was highly ideological. The 'patriot education' curricular adopted after 1989 Tiananmen Square student uprising is still the basis of curricula. Paramilitary troops have been garrisoned on campuses since then. Internet censorship is now being tightened [1]
    • the rule of China's Communist Party was seen to be at risk because the crackdown that President Xi had put in place had made all Chinese people fearful [1]
    • China seemed to be seeking to establish a religious / moral basis for state authority, eg
      • China's president Xi had endorsed Confucian virtues as the foundation of his approach to life, and those virtues were described as providing the social stability required for East Asia's past economic and political progress [1] - a view that seemed somewhat simplistic for reasons outlined below

Merging Political Power and Religion Can Create Problems - email sent 11/2/15

Robert D Kaplan,
Centre for a New American Security.

Re: Asia’s Rise is Rooted in Confucian Values, Business Spectator, Feb 10 2015

Your article outlined some features of Confucian traditions, and suggested that these have been foundational to the development of East Asia in recent decades because the stability they provided allowed the emergence of capitalistic economies and often (except in China) of a form of parliamentary democracy. However it needs to be remembered that for many centuries Confucianism was also the method of autocratic government on behalf of emperors by highly-educated bureaucratic elites. Also those features continue in modern East Asian governments. Current efforts by President Xi to promote Confucian ‘virtue’ in China would involve combining the role of ‘church’ and ‘state’, and this has the potential to result in damaging oppression.

My Interpretation of your article: A feature of a book published by China’s president (‘The Governance of China’) was its emphasis in the ‘brilliant insights’ of Confucius as an explanation of his own political and economic philosophy. While Mr Xi’s sincerity in proclaiming these non-communist ideas is uncertain, there is no doubt that Confucian values have been the foundation of one of the great social, cultural and economic success stories of recent decades. The rise of the Pacific Tigers in the 1970s (and the ability of China and Vietnam to discard communism in all but name in favour of a form of capitalism) would have been impossible without the tolerance, respect for authority, hierarchy and social order embodied in Confucianism. Confucianism is best seen as a philosophy rather than as a religion – and complements Asian religions like Buddhism and Taoism. Asia’s rise has had a great deal to do with the interaction between Confucian social stability and modern capitalism. Dynamic and enlightened authoritarianism has arisen in China, South Korea, Taiwan and Singapore – and all except China evolved into parliamentary systems. China might also be forced to change also. The founders of the most robust modern Asian states were all consciously Confucian. And China’s transition from corruption and inefficiency will require (amongst other things) reinvigoration of Confucian ethos. Confucius is seen to have presented is followers with ‘seminal expressions’ of Chinese civilization (especially in the Analects – which particularly emphasises humanness and virtue). Everyone must be held to a high standard – based on respect for the experience of previous generations. In Confucianism the past is the record of human experience, rather than something primitive. In times of change, the best insurance against chaos is seen to lie in loyalty and filial piety. Postmodern western life can be seen as decadent because of its worship of youth. Confucianism encourages tolerance and discourages insubordination. It seeks to preserve the equilibrium within social and political organisations. A gentleman is seen to have universal sympathies and not be partisan. This seems like Edmund Burke’s conservatism – which focused on gradual improvement and was horrified by the French Revolution. The whole world is in tumultuous transition. Social and political survival in this environment requires preserving time-tested ethical foundations against destructive change. East Asia has been a major success story over the past 4 decades. Even though its rapid growth phase is over, the Confucian influence will remain.

Confucianism is not just a religion / philosophy that provides a basis for traditional virtues and thus for social stability (see A Simple View of Confucianism).

To understand its implications, Confucianism needs to be considered in the broad context of what is different about East Asian traditions relative to Western societies. For example the East Asian notion of ‘education’ traditionally involved inculcating behaviours that historical experience suggested were desirable (rather than as enabling students to understand as a basis for making independent decisions). And, as a means of government, Confucianism involved an extension of that notion of ‘education’ into the inculcation of presumably-desirable social, economic and political ‘behaviours’ within society by elite bureaucrats as agents for Asia’s emperors.

Traditional Confucianism involved elite study of history as the basis for ‘educating’ their social subordinates about how to behave. This failed catastrophically when East Asia was faced with Western expansion because Western traditions were so different and much more effective. It was a modified form of Confucianism (so-called neo-Confucianism) that apparently became the foundation of post-WWII progress in East Asia (see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy, 2009). The feature that was added to Confucianism was probably Daoism (China’s traditional religion). Daoism’s primary implication is that it is impossible to be sure what is good and what is evil. Neo-Confucianism allowed study of Western practices as well as East Asian history as the basis for inculcating desired (eg economic) behaviours in the community. Fairly rapid economic progress was thus able to be orchestrated by neo-Confucian bureaucratic elites (a role which in China’s case was taken from the late 1970s by the so-called ‘Communist Party’). Also, in China’s case, this seemed to undermine tradition notions of ‘virtue’ as many in key official positions took advantage of the opportunities for personal / family gain that this created.

However economic progress was not based on anything like ‘capitalism’ (in the sense that the latter involves independent profit-focused investment) – see Evidence. Rather than capitalism, national savings were mobilized through state-linked banks and provided to state-linked enterprises to achieve nationalistic / mercantilist goals. And this gave rise to: (a) rapid growth of market-oriented production capacity; (b) the international financial imbalances that have proven highly disruptive globally (see Structural Incompatibility Puts Global Growth at Risk, 2003 and Impacting the Global Economy, 2009); and (c) ever-rising risks of financial, economic and political crises in East Asia (eg see Japan's Predicament and China: Heading for a Crash or a Meltdown).

China’s President Xi has been seeking to promote ‘virtue’ / self-discipline quite generally in China through: (a) launching a crackdown on official corruption; (b) endorsing Confucianism as a religion / philosophy as your article noted; (c) requiring ‘self-criticism’ by Party cadres; and (d) supporting investigations / arrests of those perceived to lack ‘discipline’. And this poses risks. Western societies have gained enormously from the separation of ‘church’ (ie the source of religious authority about the nature of ‘virtue’) and state (see Why the separation of Church and State Allowed Government to be More Effective). Efforts by the so-called Islamic State to base government on religious authority would seem very likely to further compound the obstacles to rapid progress that have led Muslim-dominated societies to relative backwardness in recent centuries (see Challenging the Idea of an Islamic State). The crackdown that President Xi launched was recently suggested to be making ‘everyone fearful’ – and thus to be putting government stability in China at risk (see The Twilight of China’s Communist Party, Business Spectator, 3/2/15). And the Confucianism that President Xi is endorsing as the criterion for ‘virtue’ has been a very touchy subject in China because Mao’s Cultural Revolution had specifically sought to purge Confucian influences from China as they were perceived to have oppressed China’s people (see Communism Versus Confucianism: The Continuing Contest in China, 2010). Though neo-Confucianism was officially accepted in the 1970s as necessary to achieve (what nationalists apparently refer to as) China’s Hundred Year Marathon (to achieve a dominant geo-political status), this could not be mentioned in that era. And even now many Chinese still resent the Confucian social hierarchy that re-emerged to control them after the social-equality aspirations of the Communist era. And this remains the source of potential political instability in China.

I would be interested in your response to my suggestions about the apparent complexities involved in Confucianism’s past and current role in East Asia.

John Craig

  • The Dali Lama suggested that his soul may not be reborn (as has been the Dali Lama tradition for hundreds of years) - while the Chinese Communist Party leaderships insists that it will. In 2011 the Dali Lama had ended the era in which Dali Lama's were both political and spiritual leaders in Tibet. He had also expressed fears that vested political interests could misuse the reincarnation system [1];
  • China's goal of boosting domestic consumption is limited by the lack of a large middle class that is capable of high levels of consumer spending [1]
  • China is facing a major fiscal contraction

China's Politbureau is attacking the country's credit-driven growth. Real interest rates have increased. The Yuan has appreciated. Fiscal policy is tightening as big-spending local governments are constrained. This is leading to sliding global prices for commodities. China is seen to be facing a fiscal cliff. Budget deficits exceeded 10% of GDP. A budget squeeze has emerged as property slump continues - as revenues relate to property cycle. Property bubbles in China (and elsewhere in Asia) exceed those in US before 2008. There is a reliance on government bail-outs. Local governments have been prevented from raising money off balance sheet - potentially tightening fiscal policy 5.5% of GDP (similar to fiscal contraction imposed on Greece). Monetary policy can't be used to compensate for fiscal expansion - as its economic impact has collapsed. New lending now only rolls over existing debt. Total credit rose from 100% to 250% of GDP over 8 years. China is close to a deflationary trap.  Apparent monetary stimulus is merely offsetting the effect of tightening as central bank dips into foreign exchange reserves to strengthen currency. China's capital deficit in fourth quarter was $91bn. It is now a net seller of US Treasury securities. The PBOC is now in the reverse of its boom years position. Then it bought foreign assets and caused liquidity in China to surge. Now liquidity is draining away. China's shift from buying to selling bonds has been $40bn per month - outweighing the $15bn per month that Japan is buying. Asia is tapering $25bn per month - offsetting the effect of prospective QE in Europe. China needs devaluation - yet yuan is tied to soaring $US. China real growth rate is now less than 2% pa. Boosting growth requires devaluation. If half the big central banks resort to currency combat the world's deflationary impetus will escalate at a time when there is no monetary ammunition left to counter it [1]

  • China's autocratic political system was seen to be in danger of collapse in the much same way that this happened in the USSR

China's National People's Congress can be seen as either sign of strength or a theatrical veneer. China's political system is badly broken. President Xi's crackdown on corruption is supposed to end this problem. But his despotism is severely stressing China. It is hard to predict the end of authoritarian regimes. The endgame has however started. This is indicated by: (a) China's economic elites are poised to flee; (b) political repression has been severely increased in recent years; (c) loyalists are only going through the motions in defending the system - without conviction; (d) the corruption that pervades China's society / military also pervades the whole society. The problem is rooted in China's system - and can't be eliminated by an anti-corruption campaign; and *e) China's economy is stuck in a series of traps - because necessary reforms challenge entrenched interests [1].

  • a new source of financial instability was seen to have been introduced through the development of asset-based securities [1]
  • China sought advice from Japan about avoiding the sort of economic stagnation which Japan had suffered from 1990 because their economic systems were very similar

Chinese regulators are turning to Japan for lessons - to avoid taking the same path of recession / deflation that blighted Japan for the past 20 years. Tokyo's handling of the liberalization of capital flows over part 30 years is seen by China as leading to the bust of Japan's asset bubble in the early 1990s. Japan's and China's economies share similarities - so lessons should be valuable. Communication about this continued despite the chill in diplomatic ties from 2012. China is undertaking three reforms that Japan did (ie liberalizing interest rates / internationalizing currency / opening capital account). China sees Plaza Accord which approved a stronger yen and opened capital account in leading the Japan's lost decades. The stronger yen hit exports and prompter BoJ to ease monetary policy. However money from this and foreign capital flowed into stocks / property and other assets. China is applying these lessons. China is not taking measures that could heighten imbalances even when growth is slowing. Japan was said to have been unable to tighten monetary policy when bubbles were forming because of the effect this would have on US. Domestic policy considerations should dominate over international considerations. China has other problems that mirror Japan's (cooling property market / rising bad debts). China is like Japan in corporate reliance on bank loans / heavy banking regulation. China may copy Japan in bank consolidation. Exchanges between Japan and China on this are often informal. [1]

  • China sought to make the yuan a global reserve currency - as one of the foundations of the IMF's SDRs [1] [ See CPDS comments in China Does not have a Normal 'Currency' ];
  • Japan had grown at 10% pa for two decades in the 1980s - but since then has stagnated. China faces a similar risk. Economic growth is only possible by adding more labour, capital, productivity. Russia and Japan suffered malaise because growth had been driven because of expansion of inputs, rather than lifting productivity . China grew 162% from 2004 to 2014 - but 136% of this was due to more capital inputs. National corporate debt has risen from 147% of GDP to 250%. China's building programs have been wasteful. China doubled-down on Japan's strategy - and lacks means to escape middle-income trap. Dismantling China's state-dominated political economy is needed but difficult. China now has more people leaving than entering workforce - because of demographic issues. China's concealed bad debts are estimated as 70-140% of GDP. Unfunded pension liabilities could be 40% of GDP. [1]
  • There has long been debate about the relevance of Singapore's model of authoritarian capitalism for China [1]


Future of the World: Again? (Ending the West's Global Predominance?   +  Its serious for China + Comments on 'China wants a new international order but won't sacrifice national interests')

Future of the World: Again?

Prior to the GFC some observers had suggested, in effect, that China's rapid development would lead it to a position of global dominance in the reasonably near future. Comments on China as the Future of the World above speculated about the 'future' that this hypothesis implied.

In the face of severe difficulties facing both Europe and the USA as a consequence of the GFC, one observer speculated in 2010 that those difficulties marked the end of 500 years of Western global predominance. However the issues involved in postulating China's future global predominance seem more complex than that analyst had indicated.

Ending the West's Global Predominance? (email sent 18/12/10)

Professor Niall Ferguson,
Harvard University

Re: ‘Middle Kingdom re-emerges to claim its place on global stage’, The Australian, 18-19/12/10 (= In China’s Orbit, Wall Street Journal, 18/11/10)

Your article (which has been outlined below) speculated about whether China’s rise presages the end of 500 years of Western global predominance.

For reasons outlined further below, I should like to suggest that the issues are more complex than your article indicated. Specifically:

  • Western societies’ strengths resulted from more fundamental features than you suggested (eg from enabling rationality to be effective in problem solving);
  • the West’s consumer society ‘app’ was not one of those copied in ‘Asia’, and economies without that ‘app’ may have reached their ‘use by’ date;
  • China indeed seems to be trying to re-establish itself as a ‘tributary state’, but this is incompatible with a consumer society – because a key feature was that outsiders who provided symbolic ‘tribute’ to China’s elites received greater benefits in return because ordinary Chinese worked hard but received little reward;
  • economies without reliable profit signals to producers from consumers are likely to experience long term problems in balancing supply and demand;
  • quantitative easing by the US Federal Reserve is likely to be seeking to reduce international imbalances by stimulating external demand (rather than by devaluing the $US), and is only one of the many tactics that could be used to counter mercantilist economic strategies that depend on such imbalances;
  • the potential civilizational crisis, that your article implies, suggests that the humanities’ faculties in Western universities have been ‘asleep at the wheel’.

John Craig

Outline of Article and Detailed Comments

My interpretation of your article: China’s leaders see themselves as masters now – and rejected recent US calls for capping imbalances in global capital accounts and criticising Fed Quantitative easing. Confident Chinese economists explained China’s goal of becoming a leader in green energy and the need for privatisation. Western domination of China and the world for five centuries after Forbidden City was built was discussed with them – as was question of possible end of western dominance. One paper argues that China was not up to West’s GDP until as recently as 1800 – because of stagnation in Ming era (1402-1626). China’s economy remained mainly agricultural with negative savings rate. The ‘great divergence’ between East and West began early. By 1600 GDP / capita in UK was 60% above China. China then stagnated while West surged ahead. In mid-20th century China suffered Japanese invasion, revolution, man-made famine and ‘cultural’ revolution. In 1968 US citizens were 33 times richer than Chinese. West’s advantages came from: competition; scientific revolution; rule of law and representative government; modern medicine; consumer society and work ethic. Others gradually copied the West. Japan did so without understanding what was important – including taking up empire-building just when the cost started exceeding the benefits. From 1950s other Asian countries started copying West’s industrial model – but were more selective (with an emphasis on science, medicine, consumer society and the work ethic rather than competition and representative government. Now China’s income is 19% of US – a figure others achieved earlier and have since gone beyond. China has had biggest and fastest industrial revolution. Asian century has already arrived. China is close to US share of global manufacturing, and Shanghai is the world’s top megacity. Power shift from West to East is demonstrated by US fiscal crisis (with higher debt to revenue than Greece, and a forecast rise in interest costs from 9% of revenue to 20% by 2020). The $US role as global reserve currency provides breathing space, but even this is being undermined. Many see US quantitative easing as currency war between US and China – but China also benefits (because currency is linked to $US) – so other countries are main losers. China’s output is 20% above pre-crisis levels, while US’s is 2% below. China has a plan to reduce $US reserve accumulation and subsidised exports – a strategy not for world domination on model of Western imperialism but for re-establishing China as the Middle Kingdom – the dominant tributary state in Asia-Pacific. China’s new strategy involves ‘four mores’: consuming; importing; investing abroad; and innovating more. Consuming more will please trading partners – especially emerging markets and commodity producers. Concern about vagaries in commodity markets justifies offshore investment (mainly in Asia and Africa). In Africa China’s mode of operation involves exchanging infrastructure investment for long-term mineral / agricultural leases with no questions asked about human rights abuses of corruption. Resource investment reduces the risk of $US devaluation, and also mobilizes financial power through sovereign wealth funds and justifies naval development to protect transport routes. China is also innovating more – and combined patent applications from China, India, Japan and South Korea now exceed those from the West. The dilemma a rising power poses for departing power is agonising – noting problems UK had with Germany’s rise. Coming to terms with end of Cold War was hard (and went to the heads of many in West). But issue now is end of 500 years of Western predominance. This Eastern challenger is real both economically and geo-politically.

In relation to the points made in the above article, it is suggested for your consideration that:

  • The features that led to the rising influence of Western societies in recent centuries were more fundamental than your article suggested (ie than competition; scientific revolution; rule of law / representative government; modern medicine; a consumer society; and work ethic). Rather the likely key was creating simplified social environments in which rationality (by individuals, businesses / political leaders) could be effective in problem solving (see Cultural Foundations of Western Strength in Competing Civilizations, 2001 which referred to Christianity and capitalism (as well as the rule of law) as creating such environments). Rationality fails in dealing with complex problems, and the presumed inadequacy of mere ‘thinking’ seems to be the foundation of quite different traditions for problem solving in societies with an ancient Chinese (rather than the West’s classical Greek) heritage (see East Asia in Competing Civilizations);
  • Your suggestion that a consumer society ‘app’ was a feature that various ‘Asian’ economies copied from the West seems invalid. Quite the reverse. Suppressing domestic consumption was vital to the variations of Japan’s system of socio-political-economy that were adopted elsewhere in ‘Asia’ (including eventually China) – see Understanding East Asia's Economic Models and Resist Protectionism: A Call That is Decades Too Late . Where the economic goal is to maximize production (ie turnover / cash flow) rather than profitability, it is critical to avoid dependence on borrowing in international markets, and essential to have trading partners with deep pockets who can afford to run current account deficits (and continue to increase their debt levels) indefinitely;
  • That economic strategy has clearly reached its ‘use-by’ date, as shown by: (a) the role which it played in the emergence of the global financial crisis (see Impacting the Global Economy and GFC Causes); and (b) the inability of trading partners in the developed world to continue increasing debts to sustain international imbalances, and the risks that emerging economies elsewhere face if they don’t also continue to enjoy current account surpluses (see Who's Got Superman?). Many economies were able to proceed beyond the point that China has now reached on the basis of export-driven growth (and domestic demand deficits), because the US continued to play the role of ‘consumer of last resort’. But China’s growth has now killed that particular golden-egg-laying goose;
  • As your article suggested, China seems to be trying re-establish itself as the dominant ‘tributary state’ in the Asia Pacific region, in a way that parallels its role prior to Western expansion (see Creating a New ‘Confucian’ Economic World?). In an economic region based on ‘Asian values’ highly-educated ethnic elites (such as China’s so-called 'Communist' Party and Japan’s bureaucracy) would be freed from the constraints imposed by: capitalism (ie the need to use resources to meet consumer demands); and democracy (ie the need for elites to be responsive to citizens). A key feature of China’s traditional role as a ‘tributary state’ was that others: deferred to China’s elites; provided ‘tribute’ (largely symbolic gifts); and received significant net material benefits in return, because ordinary Chinese were motivated to work hard for very limited reward. Such a system can’t be the basis of an alternative global order because: (a) only those prepared to defer to ‘Asian’ elites can be included; and (b) it is incompatible with maintaining any influential role for domestic consumption;
  • Non-capitalistic economic models, such as China’s, are likely to suffer problems in the long terms – because, without the feedback from consumers that the profitability of enterprises provides, it is very difficult to balance supply and demand. Also the use of savings with little regard to financial return implies that the liabilities of China’s institutions are likely to exceed their assets, and this would be exposed when / if ‘the economic music stops’. And it could well do so if austerity becomes normal in much of the world due to the debts others incurred partly to sustain growth in the face of the financial imbalances required by ‘East Asian’ systems of socio-political-economy. In retrospect, the huge state-driven boost to China’s economy over the past couple of years (on infrastructure, property and over-capacity in diverse industries) might be seen to be the straw that broke the camel’s back (see Heading for a Crash?);
  • Quantitative easing by the US Federal Reserve is unlikely to be simply to devalue the $US and thereby promote export-driven growth (because history shows that changing exchange rates has little impact on trade imbalances). Rather the goal is presumably to stimulate demand directly in emerging economies (ie to do unto others as others long did to the US) – see Currency War? Moreover the latter tactic might be only the first that could be deployed to counter economic strategies that depend on long term financial imbalances (see China may not have the solution, but it seems to have a problem);
  • The fact that a potential civilizational crisis could remain unrecognised by opinion leaders until the point of crisis for advanced Western societies (and thus for international institutions based on their favoured principles) is a reflection of both: (a) the humanities’ faculties of Western universities being ‘asleep at the wheel’, and thus oblivious to the implications of cultural differences; and (b) the central role of deception in ‘Asian’ Art of War strategies.

One point of particular importance is the expectation that 'Asian / Chinese' capital would be able to finance development elsewhere or meet the needs for borrowing by heavily indebted governments elsewhere. because ‘Asian capital’ is not able to be provided on the basis of the balance sheets of financial institutions, but rather requires drawing upon cash flows generated by high-turnover production with limited regard to profitability and enforcing a high rate of national savings. As the domestic demand deficits and international imbalances this strategy requires are getting close to disrupting global economic growth, ‘Asian capital’ could cease to be available to anyone (because, if the strong cash flows abate, there would be no basis for providing capital).

In August 2011, as a consequence of a sovereign debt crisis in Europe (involving risks to quite large economies, ie Spain and Italy) and difficulties in containing US government debts led to the loss of its AAA credit rating, there were again pronouncements about this signally the future global dominance of China. However the issues were far more complex than commentators who failed to consider the origins of major international financial imbalances seemed to realize.  Such commentators' typical implication (ie that China's main risk from the US credit downgrade) was losses on its $US holdings was grossly simplistic.

Its serious for China (email sent 5/8/11)

Ian Verrender

Re: This time its serious, Brisbane Times, 5/8/11

Good article.

However the risk that China faces does not primarily come from its holdings of US debt. Rather its main threat arises from its likely inability to continue adding to those holdings (ie to maintain a current account surplus, and thus a capital account deficit reflecting its offshore investment) in a world where its trading partners face economic constraints due to huge debts. And when China can’t maintain current account surpluses, its financial system is likely to experience a crisis. This point is developed further in the attached email – though the latter was based only on constraints arising from the US’s predicament.

It has long seemed to me that:

  • the G20 totally failed to address (or even to understand) the problem of international financial imbalances that were a significant factor in the first stage of the GFC (see Structural Indicators of Ongoing Recession / Depression); and thus
  • the GFC would have second and third stages over several years involving: (a) a government debt crisis; and (b) failure of East Asian economic models which relied on financial imbalances that could no longer be sustained (see Unresolved problems and coming crises)

John Craig

An Australian expert on 'Asia' has periodically argued for raising Australia's standards to meet the higher levels of aspiration and excellence that exist in 'Asia', on the assumption (apparently shared by a prominent Australian political leader) that the Western institutions and methods that have been dominant over the past 2 centuries will no longer be relevant (see Learning From, Rather than About, Asia).  However such suggestions about the superiority of Chinese traditions are not accompanied by any clear explanation of what those traditions are (presumably because clarity of understanding is incompatible with those traditions) or of the incompatibility between the authoritarianism that those traditions imply and the liberal values that have underpinned Western societies.

In March 2013 a 'Chinese' view of future international relations based on peaceful development was expressed by China's ambassador to Australia - an aspiration that was both noble and replete with uncertainties.

China's foreign policy is characterised by three wants, and three don't wants. 18th Congress of Communist Party of China pointed out that humanity only has one world to share, and the arbitrary exercise of force can't make the world better. China wants peace not conflict, development not poverty cooperation not confrontation - and advocates building a harmonious world of enduring peace and common prosperity. Thus China wants new international relations system featuring equality, mutual trust, inclusiveness, mutual learning and win-win cooperation and is committed to upholding peace and development of all countries. China will never waver from peaceful development. China won't seek dominance when it becomes strong. It seeks amicable ties with other nations, and won't seek development at cost to others. However China expects others to do the same, and won't sacrifice its national interests. China will follow a win-win strategy in opening up. Robust, balanced and sustainable growth of the global economy will be sought through cooperation (eg in macroeconomic policy with other major economies) and seeking consultation to resolve friction. A prosperous / stable world means opportunities for China, and visa versa. Domestic development and opening up will be coordinated. China's development will be aligned with the world - and a more active role will be played in international affairs. The Dioyou Islands belong to China. Cyber attack is a global problem, and China is one of the main victims - with most attacks originating in countries that accuse China of hacking. China has carried out bilateral law enforcement with many countries recently, and tabled a draft International Code of Conduct for Information Security. China calls on the international community to work together to build a safe, open and cooperative cyber-space. (Chen Yuming., 'China wants a new international order but won't sacrifice national interests', The Australian, 9-10/3/13)

CPDS Comments: The aspirations expressed in the above article are attractive. However there are many uncertainties because:

  • Information is traditionally used in East Asia (which lacks the West's classical Greek heritage) to generate favourable responses from others (ie like propaganda), rather than to provide understanding of enduring 'truth' (see Why Understanding is Difficult);
  • traditional 'Art of War' strategies feature deception and 'winning beforehand' - ie by undermining others in times of peace before conflict. Thus 'peace' is very compatible with an ongoing non-military 'war' to advance the position of particular ethnic communities. None-the-less the use of 'soft power' techniques appears decidedly better than traditional 'hard power' - providing all parties recognise what is going on (see also Comments on Australia's Strategic Edge in 2030);
  • When equality is advocated, this is likely to refer to equality of cultures rather than equality of individuals. The latter is a Western aspiration based on a 'rule of law', but is incompatible with East Asian authoritarian social hierarchies;
  • the notion of an 'open' cyber-space is incompatible with manipulating access to information that appears to be central to the way in which China's neo-Confucian bureaucracy (ie the so-called 'Communist' Party)  exerts power / control in China (see China's Bigger Secret); 
  • While opening China 'in alignment with the world' (ie 'playing by the rules' in terms of President Obama's call to China) was endorsed:
  • there is no guarantee that China will achieve the 'power' to be a major global economic and political influence because of: (a) its very severe domestic challenges (see Heading for a Crash or a Meltdown?); and (b) the incompatibility between East Asian systems of socio-political economy and the current international order which put the latter (and the East Asian systems which in the past have had a 'parasitic' dependence on the international system) at risk (eg see Structural Incompatibility Puts Global Growth at Risk and Debt Denial: Stage 3 of the GFC?)

In July 2013 it was noted that China's economy has been and remains highly dependent on external support from global companies that are based in advanced economies.

China frightens the west, but there is a need to consider how west looks to China. Peter Nolan, Cambridge Uni, pointed out that China is not buying the world. The West is in China, not the other way around. The world economy is dominated by major (systems integration) companies rooted in advanced economies. Such companies can raise finance for large projects, invest in R&D, buy state-of-art IT and leading edge human resources. As they invest across borders, such companies lose national characteristics and become harder to tax and regulate. China's success has been built on its willingness to allow its workers to the world's producers. Significant percentages of China's output results from such companies. China has far more inward than outward foreign investment. China's firms are seldom involved in major international mergers / acquisitions. China has few globally significant companies. Thus China sees itself as heavily dependent on others' know-how.  [1]

September 2002  - and amended October 2003 and from November 2007

Attachment: Debating China's State

Debating the Chinese State

On 4/11/12 an article was received from a member of a China-focused forum which had suggested that China's system of government was more legitimate that that of the west - but that the reasons for this are outside Western experience (ie because it was regarded as being like the head of a family comprising the whole of Chinese civilization). This led to an interchange which illustrated differences concerning the role of Confucianism and the Chinese state.

Outline of: Is China more legitimate than the West? (Jacques M. BBC News Magazine, 2/11/12)

US / Chinese political styles in selecting leaders are radically different. Chinese state enjoys greater legitimacy than any in the west - for reasons that are quite outside western experience. China is a civilization-state rather than a nation-state (ie for Chinese what matters is the civilization - ie its integrity / unity) . The state is the embodiment and guardian of Chinese civilisation. Its most important responsibility is maintaining the unity of the country. The legitimacy of the state lies, above all, in its relationship with Chinese civilisation. However Chinese people also say they are happy with the state - though there are still some conflicts. Chinese governments display paranoia (controls on the press and the internet, the periodic arrest of dissidents) to guard against unexpected instabilities. In the West it is believed that the role of the state should be codified in law, there should be clear limits to its powers, and there are many areas in which the state should not be involved. The Chinese idea is quite different. The state is seen as an intimate / member of the family (the head of the family). The family is a template for the state, and the state is an extension / representation of themselves. This lends the Chinese state authority, ubiquity and competence. The competence of the state has now become a serious issue - which China's rapid rise resulting from a competent state, and massive problems associated with incompetence in the West. No Western state could be like China's - as it is the product of a different history and a different relationship between state and society. None-the-less the West could learn from China, just as China has learned from the West. The new Chinese paradigm combines a highly competitive market, with a ubiquitous and competent state.

In response CPDS circulated the following comments to members of that forum.

From John Craig (4/11/12).

I doubt that Martin Jacques’ suggestions in this article are valid. Questions about China’s legitimacy are not likely to be relevant for long for reasons that are suggested in Heading for a Crash or a Meltdown?

While the issues involved are complex, because the neo-Confucian cultural foundations of China’s rapid economic advancement cannot be easily understood from a Western viewpoint (see Understanding is difficult), China faces structural difficulties that could easily precipitate financial, economic and political crises such as :

  • The dependence of East Asia’s non-capitalistic financial systems on the willingness and ability of developed economies (most notably the US) to continue tolerating current account deficits and ever-increasing debts. If such countries decided that they wanted to resist the mercantilism implicit in the East Asian systems, the latter would be in real trouble (see China may not have the solution, but it seems to have a problem);
  • The potential for a domestic revolution based on recognition of the neo-Confucian character of China’s economic miracle, noting that: (a) China’s real communists favour social equality, whereas the is not a feature of the current system; (b) a Confucian approach was apparently favoured by the Nationalists that Mao’s Communist Party drove out of China in 1949 – but was secretly reintroduced in the late 1970s as a neo-Confucian component of the market-opening agenda introduced under Deng; and (c) China’s people have been (but may no longer be) willing to sacrifice themselves to support the authoritarian state because of a belief that this would enable China to gain vengeance against those who in the past oppressed China (ie Western societies and Japan). It now seems possible that it was Japan that sponsored the introduction into China of a variation of the neo-Confucian methods that had been the basis of its post-WWII economic miracles (see Fingleton’s comments). Even more potentially significant (if it is valid) is Fingleton’s suggestion that those methods were developed by the Japanese military in Manchuria during Japan’s invasion of China in the 1930s. The current friction between China and Japan probably needs to be considered in that context (see Friction between China and Japan: The End of the Asian 'Century'?).

In response one forum participant (XXX) suggested (5/11/12) ...

... I am not sure you all have been to China lately. ......

My parents fled China in 1949 ..... I have been back to China several times a year since ...... From what I have witnessed, China has been self-correcting, swiftly moving up, while the United States two party "democratic" system is zig-zaging down: This democracy is dysfunctional, election every 4 year wastes a lot of energy and resources, reducing productivity of many talents, which can be better utilized otherwise.

Again, we need input from political scientists like ........

Below is the comments from my UK colleague who has been to China frequently (YYY).

"Thanks ...., very interesting and I would support much of this. I often say to people that as a visitor, I feel much more free in China than I do in the US…. It’s a fascinating blend of capitalism, individual empowerment and carefully managed state strategy and control."

From John Craig  (4/11/12)

I can’t claim any useful on-the-ground expertise. I was in China for only the second time last year, and only as a very sick tourist.

However, I do suggest that China (like Japan) does not have a ‘capitalistic’ economy (ie one that is driven by the profit motives of independent enterprises) – so YYY (who XXX quoted) is not quite right in that respect (eg see Understanding East Asia's Neo-Confucian Systems of Socio-political-economy). However a ‘non-capitalistic’ market economy has a highly disruptive impact on the international economic environment, because it requires a domestic demand deficit that is macroeconomically unsustainable unless its trading partners are willing to make the financial sacrifices needed to support it (see Impacting the Global Economy).

This situation is a product of the adoption of neo-Confucian methods which have simply not been understood in Europe or the US, and certainly not by economists or political scientists who view the world in terms of Western analogies (eg see Babes in the Asian Woods). There is a need to recognise the implications of radically different ways of thinking (eg see Epistemology: The Core Issue and Competing Thought Cultures). This would normally be the domain of those in the humanities faculties of Western universities. However the latter have been off in a post-modern dream world (in which there are no real consequences of cultural differences).

Moreover it seems very likely that Japan has treated the US to a dose of traditional East Asian Art of War methods since its defeat in WWII (see Coalitions of Interests?). Those methods include an emphasis on deception and ‘winning without fighting’. While the US Federal Reserve (through what some have described as its ‘currency war’) has arguably sought to ‘do unto others as others have been doing to the US’, the US’s political establishment has not yet publicly caught onto what has possibly / probably been happening and the issues involved. However, when / if it does it is likely that the US will not be amused (no matter who is in power).

A strategic approach to Asia literacy is arguably possible, and this would seem likely to: (a) deprive the neo-Confucian systems of their main current competitive advantage; (b) generate unity of purpose; and (c) reduce the risk that Western responses would be diverted by poorly informed economists or defence analysts. And there is a lot that could be done (eg as suggested in Getting out of the Economic Quicksand and Suggested Strategic Response). And while there is no public political mention of such issues it is noted that: Obama has beaten the drum about whether China ‘plays by the rules’ and has written about the need for nation building in the US; while Romney has backed away from a militaristic approach to US foreign policy.

The implications of a real Asian Century attack the heart of the individual liberty that drove Western resistance to authoritarians during the 20th century. YYY suggested that ‘individual empowerment’ exists together with ‘carefully managed state strategy and control’ in China. The character of that empowerment needs to be considered (eg see ‘Chinese individualism’) as does the constraint on states in centrally coordinated efforts to define / control strategy. Very large complex organisms do not exist in nature because the coordination / control systems can’t be effective.

Certainly (as XXX  suggests) ‘China has been self-correcting, swiftly moving up”. But it has been encountering very real domestic political obstacles at a time when its external difficulties are likely to escalate. China appears to be responding to its domestic political difficulties by seeking to make consultation within the neo-Confucian bureaucracy (ie the so-called 'Communist' Party) a less unreliable guide to the broader community (consider parallels with what is being done to China’s state controlled media – see Reading China's Mind?). However there are limits to which complexity can be encompassed within a unified / centralised control system.

From XXX: (9/11/12)

Thank you for your thoughtful input. Sorry that I didn't get to respond sooner. We had a superstorm Sandy last week which paralysed the East Coast  .........

I hope you will be healthy on your next trip to China so you can gain more on-the-ground experience to better appreciate the traditional values of an old civilization, beyond the modern history during which the Western Powers with Japan tried unrelentingly to divide and conquer China. I include a chart of "China's Re-emergence as a Power" based on the data from Angus Maddleson in 2001, which showed China was the world leading economy in the first 18th centuries.

I believe that unlike the USA, China does not consider it is a priority to be #1 in the world, as it is to feed all the people in the nation. (Confucius). Thus, historically, the leaders assume the responsibility as the parents in a family.


Here is also China's 18th National Congress of CPC

From John Craig  (8/11/12)

Thanks for your feedback.

Glad that recovery from Sandy seems to be getting underway – though I gather that other weather problems are arising.

My impression is that China is facing a different sort of ‘bad weather’ that could well impede its re-emergence.

From XXX (9/11/12)


China has never been as good as it is now in the modern history. The obstacles are lessoned now than before. Martin Jacques is only half right.

It is not my priority to teach the ignorant, but you should travel to China to learn from the ground up, instead of only from readings. There is a saying, "Garbage in, garbage out!"

From XXX (10/11/12)

Just after the 6 Bullion USD spent on the US election, you all might find this of interest. Knowledge is power.

Hu calls for building China into maritime power 2012-11-08 10:40
Hu calls for efforts to enhance social ethics 2012-11-08 10:11
Hu stresses improving socialist market economy 2012-11-08 10:03
Hu vows to boost domestic demand 2012-11-08 09:55
Hu outlines 'overall approach' for modernization drive 2012-11-08 09:43
China firmly follows socialism with Chinese characteristics: Hu 2012-11-08 09:26

Key quotes from Hu's report to CPC congress Updated: 2012-11-08 12:53 (Xinhua)

BEIJING - Chinese leader Hu Jintao delivered a report on Thursday at the opening of the 18th National Congress of the Communist Party of China (CPC). The following are key quotes from his report:

On Scientific Outlook on Development

-- The most important achievement in our endeavors in the past ten years is that we have formed the Scientific Outlook on Development and put it into practice.

-- This theory provides new scientific answers to the major questions of what kind of development China should achieve in a new environment and how the country should achieve it.

-- Together with Marxism-Leninism, Mao Zedong Thought, Deng Xiaoping Theory and the important thought of Three Represents, the Scientific Outlook on Development is the theoretical guidance the Party must adhere to for a long time.

On socialism with Chinese characteristics

-- We must unswervingly follow the path of socialism with Chinese characteristics.

-- Our overall approach is to promote economic, political, cultural, social, and ecological progress, and our general task is to achieve socialist modernization and the great renewal of the Chinese nation.

On building moderately prosperous society

-- We need to have a correct understanding of the changing nature and conditions of this period, seize all opportunities, respond with cool-headedness to challenges, and gain initiative and advantages to win the future and attain the goal of completing the building of a moderately prosperous society in all respects by 2020.

-- An examination of both the current international and domestic environments shows that China remains in an important period of strategic opportunities for its development, a period in which much can be achieved.

-- On the basis of making China's development much more balanced, coordinated and sustainable, we should double its 2010 GDP and per capita income for both urban and rural residents.

-- To complete the building of a moderately prosperous society in all respects, we must, with greater political courage and vision, lose no time in deepening reform in key sectors and resolutely discard all notions and systems that hinder efforts to pursue development in a scientific way.

On economy

-- Taking economic development as the central task is vital to national renewal, and development still holds the key to addressing all the problems we have in China.

-- The underlying issue we face in economic structural reform is how to strike a balance between the role of the government and that of the market, and we should follow more closely the rules of the market and better play the role of the government.

-- We should firmly maintain the strategic focus of boosting domestic demand, speed up the establishment of a long-term mechanism for increasing consumer demand, unleash the potential of individual consumption, increase investment at a proper pace, and expand the domestic market.

-- We should give high priority to rural areas in developing infrastructure and social programs in the country.

On political structure reform

-- We must continue to make both active and prudent efforts to carry out the reform of the political structure, and make people's democracy more extensive, fuller in scope and sounder in practice.

-- We should place high importance on systemic building, give full play to the strength of the socialist political system and draw on the political achievements of other societies. However, we will never copy a Western political system.

On improving people's wellbeing

-- We should keep making progress in ensuring that all the people enjoy their rights to education, employment, medical and old-age care, and housing so that they will lead a better life.

On ecological progress

-- We must give high priority to making ecological progress and incorporate it into all aspects and the whole process of advancing economic, political, cultural, and social progress, work hard to build a beautiful country, and achieve lasting and sustainable development of the Chinese nation.

On military modernization

-- Building strong national defense and powerful armed forces that are commensurate with China's international standing and meet the needs of its security and development interests is a strategic task of China's modernization drive.

-- We should attach great importance to maritime, space and cyberspace security. We should make active planning for the use of military forces in peacetime, expand and intensify military preparedness, and enhance the capability to accomplish a wide range of military tasks, the most important of which is to win local war in an information age.

On Taiwan

-- We are ready to conduct exchanges, dialogue and cooperation with any political party in Taiwan as long as it does not seek Taiwan independence and recognizes the one-China principle.

-- We hope that the two sides will jointly explore cross-Straits political relations and make reasonable arrangements for them under the special condition that the country is yet to be reunified.

-- We hope the two sides will discuss the establishment of a cross-Straits military security confidence-building mechanism to maintain stability in their relations and reach a peace agreement through consultation so as to open a new horizon in advancing the peaceful growth of these relations.

On foreign affairs

-- China will unswervingly follow the path of peaceful development and firmly pursue an independent foreign policy of peace.

-- We are firm in our resolve to uphold China's sovereignty, security and development interests and will never yield to any outside pressure.

-- We will decide our position and policy on an issue on its own merits and work to uphold fairness and justice.

-- China is committed to peaceful settlement of international disputes and hotspot issues, opposes the wanton use of force or threat to use it, opposes any foreign attempt to subvert the legitimate government of any other countries, and opposes terrorism in all its manifestations.

-- China opposes hegemonism and power politics in all their forms and will never seek hegemony or engage in expansion.

On Party building

-- Combating corruption and promoting political integrity, which is a major political issue of great concern to the people, is a clear-cut and long-term political commitment of the Party. If we fail to handle this issue well, it could prove fatal to the Party, and even cause the collapse of the Party and the fall of the state.

-- Leading officials at all levels, especially high-ranking officials, must readily observe the code of conduct on clean governance and report all important matters. They should both exercise strict self-discipline and strengthen education and supervision over their families and their staff; and they should never seek any privilege.

From John Craig (9/11/12)

You suggested that my concerns about China’s prospects were unfounded.

However I don’t believe that my ability to understand China would be aided by going there again to learn from the ground up (see Why?). My interest is in understanding the way of thinking, and how this translates into methods of political and economic organisation (amongst many other things). On the ground I suspect that I would be more likely to be exposed to ‘garbage’ than if I rely on diverse other sources.

Hu’s address to the Party Congress (that you mentioned subsequently) spoke of boosting China’s maritime power, social ethics, socialist market economy and domestic demand while continuing to rely on ‘socialism with Chinese characteristics’.

While the neo-Confucianism that is called ‘socialism with Chinese characteristics’ can be presented idealistically (as you suggested) as involving leaders who “assume the responsibility as the parents in a family”, the reality is that this involves:

  • social inequality which: (a) has translated into the world’s most extreme imbalances in wealth; and (b) is so incompatible with the original aspirations of China’s socialist revolution that it has led to political instabilities (the Bo Xilai affair) and even warnings about the risk of another Cultural Revolution;
  • opportunities for corruption – in the absence of any clear foundation for social ethics;
  • a growing gap between the ever increasing knowledge of China’s population and the ability of internal Communist Party consultations to take account of what the community knows / fears and to ensure community support;
  • economic and financial systems that are critically dependent on the [now exhausted] willingness and ability of trading partners to continue increasing their debt levels indefinitely – and which are thus (like Japan’s) clearly past their use-by date;
  • incompatibility between the specialised knowledge / skill requirements of China’s future economic environment and an education system that is still shifting towards educating future generations in a Confucian framework (ie to encourages unthinking responsiveness to leaders rather than creativity / initiative);
  • a fairly poor basis for international relationships – as harmony can only be promoted amongst those who are insider to the hierarchical ‘family’ – while those on the outside are confronted with a lack of information and at times deliberate deception in the perceived interests of the ‘family’

China’s premier (Wen Jiabao) acknowledged in 2007 that China faces severe economic challenges (ie he described the economy as unstable, unbalanced, uncoordinated and unsustainable) and Hu Jintao has often spoken of the need for political reforms.

But there have been obstacles to change, and these problems remain. The speech that Hu (who won’t be president much longer) gave at the Party Congress in 2012 was virtually identical to that he gave in 2007 [1]. And it is not at all clear that the incoming leadership in the Politburo has any clear idea of what to do now, or any way to get such ideas.

Response from a Chinese American (ZZZ), who prefers to remain anonymous (10/11/12)

Well said about the problems and issues exist in China's culture & political system in which a few of the top leaders always “assume the responsibility as the parents in a family” in their effort to manage and lead the nation and their people. Unfortunately, being an American of Chinese origin I have enough "down-to-the-ground knowledge" about culture, people and political systems of both China and the US, and I have to say that your observations on China are pretty accurate and right on the mark. In fact, my observation and view points on China's system are much the same as yours. Especially I share very much your views about the effect of a social foundation of China that is built on the "Confucian framework" which encourages unthinking responsiveness to leaders rather than creativity / initiative of the individuals. I would also add that this has been the key culture elements or heritage which prevented (for thousands of years) China from becoming a strong nation even though China was the richest nation on the planet for more than 10 centuries in human history.... I often argued with many of my American or Chinese friends that, despite of becoming world's No. 1 economy in the near future (I have zero doubt on this one), it is unlikely for China to become a military power (or a strong country in technology innovation, creation of industrial revolution etc.) simply due to the culture heritage that is deeply rooted in the extremely conservative of Confucius ideology. So, my theory is that China needs another truly culture revolution (of course, not the violent style of Mao's revolution) for seriously confess and revitalize on the weaknesses of a Confucius ruled culture & society for China to become a truly democratic, strong and vibrant nation....

Another aspect of observation on China I want to add is that the huge risks and instability that the system carries on behalf of the nation and its people. In other words, Chinese society as a whole can be many times more efficient and doing well in terms of leadership capacity for reaching out and fulfilling some goals setup by the top leadership, however the system and its economy can be extremely vulnerable and could collapse within a very short period of time if the people at the very top happen to be corrupted or lack of wisdom. There have been many historical lessons throughout the long history of China that one dynasty was wealthy and prosperous yet, the next dynasty could collapse in very short period of time....

Nevertheless, it is impossible for China to adopt the western system or wise versa due to the culture heritages which dominates how people think and behave. One of the most sad culture phenomenon in the "parent ruling" style social & political system of China is extreme lack of trust between people and between people and their leaders.

I am not surprised at all to see that Hu's current report at this CPS Congress is almost identical as that of his 2005 version; an excellent observation of you John!

Of course, the western system has its own problems & serious issues but we can discuss one at a time....

An exchange continued amongst members of the online forum about the role of Confucianism in Chinese society and the character of the Chinese state.