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

• Accomplishments
• Economic Engine?
• Cultural / financial issues
• Future of the World?
• Bubble?
• After the GFC?

Introduction

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..

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 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 cultural counter-revolution in the late 1970s (under Deng Xiaoping initially), that China made appreciable progress.

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.

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]. 

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 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. 

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?)

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 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].

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?).

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)

• Constraints (Economic, Financial, Environmental, Demographic and Political)
• Initiatives
• Is Optimism Justified?
• Crisis Scenarios

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.

Constraints

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'. 

Moreover:

• 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 channelled 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].

 

Demography

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 Communist Party'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 reputedly has 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 has seen the merchants driven out of China in many waves - to become the offshore Chinese. If China's commercial drive falters then the 'northern' influences concerned with 'higher' values may well again mobilize to suppress the 'greedy' merchants of 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]; and
• 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 neo-Confucian methods that have been used by the Communist Party (which are built on a social hierarchy) and the social equality aspirations of China's nominal (see Communist Communism Versus Confucianism: The Continuing Contest in China).

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 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] 

Initiatives

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).

• Inadequate Stimulus?
• Export-led Growth has No Future
• No Western-style Reforms
• Doing China's Own Thing
• Creating an 'Asian' Economic World?
• Uncertainty / Conflict?
• Another 'Tiananmen Square' Moment?
• Change and Potential Instability Driven by China's Rising Generation? (Confucian Renewal in China?)
• Heading for a Crash? (Avoiding a Hard Landing in China + A 'Super-Ponzi' economy + S&P's View)
• Future of the World: Again? (Ending the West's Global Predominance? Its serious for China)

China After 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 Communist Party connections, 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]

Economic Reforms on Western Principles are 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.

Why?

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 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]

Change and Potential Instability Driven by China's Rising Generation?

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 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 most 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 China's Communist Party elites 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 Guandong 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 threated 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]

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.

It can also be noted that:

• China’s history over thousands of years has apparently been characterized by periodic civil wars between the commercially oriented south China and the more rural / spiritually oriented north. Those civil wars have seen factions from southern China repeatedly 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;
• China’s market liberalization in 1978 under Deng can also be seen as a resurgence of influence in mainland China (through changes in the so-called Communist Party) by the commercially-oriented Diaspora;
• the post GFC need to shift to domestic demand to drive future growth arguably makes 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 elites coopted national savings from state-controlled banking systems to finance 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;
  • the method used to maintain a China centred political and economic order in Asia prior to Western expansion involved maintaining the loyalty of 'tributaries', because China's people worked hard for little reward (see Creating a New 'Confucian' Economic World);
• 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;
• 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 (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; or making the law even more firmly a tool of the Communist Party.

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]

Heading for a Crash?

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 ideological bias in favour of the West [1] [see comment below].

An Investment-driven Bubble?

However at about the same time it was 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 unforseen 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]

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, 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 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 laning in late 2012 [1]

Possible responses to these challenges have been suggested to lie in gradual appreciation of emerging economy currencies, a shift that would favour increased reliance on domestic demand. [CPDS Comment: 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 Invisible 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.

Regards

John Craig

Structural Problems

China's problems are arguably more fundamental than the immediate risks associated with wasteful spending and property bubbles. Long recognised economic, environmental, demographic and political constraints that China must constantly struggle against were suggested above (eg economic imbalances; wasteful investment; blunt economic management tools; pollution; limited soil and water resources; a soon-to-be rapidly aging population; wealth imbalances; and frequent protests about official actions and corruption). The difficulties of sustaining rapid early-stage growth have also been noted (and was eventually recognised in considering the parallels between Japan's and China's property / investment bubbles (see The Coming China Crash above).

And these difficulties are compounded by increasingly obvious political divisions within China's Communist Party between: (a) the neo-Confucian factions who have provided the engine of China's rapid modernisation through a non-capitalistic market economy built on relationships within an hierarchical social elite; and (b) the 'redder' elements who favour social equality, but would not seek or be able to maintain a market economy  (see Change Driven by China's Rising Generation? And Potential Instability above). Even if the immediate threat to China’s political stability is suppressed, the issue won’t go away, and anything that disrupts the inequalities that have been essential to China’s system of socio-political-economy is likely to be economically disruptive.

Some CPDS' observations about structural challenges that China faces are in:

• China may not have the solution, but it seems to have a problem - which suggests that China probably lacks the ability (eg even by significant revaluation of its currency) to redress the international financial imbalances that must otherwise make global economic growth unsustainable. Similar points are explored in China can't fix the global currency crisis without economic disaster;
• Time May not be on China's Side - which comments on media reports about how the Chinese state works, noting its limitations in the international arena and the difficulties being experienced in promoting ethical behaviour, and the uncertainty of resolving such problems by re-emphasising Confucianism;
• China can't be properly understood in terms of Western economics - which suggests that the limitations that Western economists perceive in China's economic model are only part of the story;
• China can't fix the global currency crisis without economic disaster - which highlights its structural inability to do so;
• Communism versus Confucianism: The Continuing Contest in China - which draws attention to the incompatibility between the social equality aspirations of China's nominal Communism and the Confucian-style social-hierarchy that has been the driver of its rapid economic modernisation. Another Communist revolution in China (revolting against the so-called-Communist-but-actually-Confucian factions in power) is anything but impossible. China's history is littered with civil wars between 'commercial factions' in southern China (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) and northern China

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Other 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 Communist Party's announced intention 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]

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]

As the rest of the world stagnates economically because of failure to deal with international financial imbalances (see Too Hard for the G20?), China 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 seemed to be seeking to do in late 2010) will 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 Communist Party has perhaps created an economy 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 investors).

Comment: China's Super-Ponzi-like Economy

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 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 Economic Models).

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 high interest rates 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 frittered away by losses on investments that are perceived to be be in the 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 "systemwide 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. .

Arguably China's wild (and desperate?) spending and credit creation following 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).

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

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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-20^th 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 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
SMH

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

In December 2011, an Australian expert on 'Asia' argued that case for raising Australia's standards to meet the higher levels of aspiration and excellence that exist in 'Asia', on the assumption (apparently shared by an Australian political leader) that the Western institutions and methods that have been predominant over the past 2 centuries will no longer be relevant.  However such suggestions seem somewhat simplistic.

Lifting Australia's Standards in Response to 'Asia' (email sent 2/12/11)

Reg Little

Re: For every ying there is a yang, On Line Opinion, 1/12/11

I should like to try to add value to your suggestion that Australia had better lift its educational, scientific, corporate, political and administrative standards to meet what you describe as the higher Asian standards of excellence and aspiration that will be dominant in future. I note that your case builds on the apparent conclusion by a former Liberal Party Leader (Malcolm Turnbull) that the global predominance enjoyed by Western societies over the past two centuries seems likely to prove transitory (because, for example, it was the result of being the first to exploit fossil fuels),

In the first place I submit that, in order to enable your readers to properly understand what you are suggesting, there is a need to be more specific about what the dominance of ‘Asian’ traditions over those of Western societies implies. The former seem, for example, to be based on the rejection of individualism, a rule of law, truth and universal values, rationality, egalitarianism and serious political debate. Such points should not be glossed over.

Furthermore it is by no means certain that the decline of the features of Western societies that have contributed to their strength is inevitable or desirable. For example, it seems to me that:

• the neo-Confucian systems of socio-political-economy that have been the basis of economic miracles in East Asia have been dependent on the strength of financial systems in their Western trading partners, and on the latter’s willingness and ability to continually increase their overall debt levels;
• those neo-Confucian systems arguably played a major role in generating the financial imbalances and debt crises that currently put global growth at risk – though this is a fact that it is difficult for Asia-illiterate observers to understand; and
• the financial institutions that have been central elements of the neo-Confucian systems are intrinsically at risk of financial crises, and the changes that trading partners will ultimately need to make to achieve future growth (ie reversing their ongoing build-up of debts by structural reforms rather than mere counter-cyclical policies) are very likely to trigger those crises, and thus render the neo-Confucian systems unsustainable.

Moreover despite your suggestion about the superior approach to environmental issues in ‘Asia’, China long neglected its escalating environmental challenges and the latter remain more daunting than those confronting almost any other country. China also faces world class problems in terms of imbalances in wealth, potential political instabilities and population aging.

My reasons for making such suggestions (together with an outline of your comments) are presented in more detail on my web-site. The latter also includes suggestions that, while there is a need for Australia to lift its standards, this may be more appropriately thought of in terms of coping with (and helping to reduce) the problems that are generated by some ‘Asian’ traditions (eg a lack of universal values and the use of ‘Art of War’ efforts to undermine outsiders), rather than emulating those methods.

John Craig

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Outline of Article and Detailed Comments

Outline of 'For every ying there is a yang', On Line Opinion, 1/12/11

Former Liberal Party Leader, Malcolm Turnbull, showed that some Australians are aware of the challenge ahead. At LSE, he suggested that: (a) until mid 19th century China and India were the world's two largest economies - based on Angus Maddison's work; (b) few countries have a sense of cultural continuity and exceptionalism like China; (c) Australia's education standards needed to be raised; and (d) after manufacturing, political and military influence will shift to Asia. This suggests that the renaissance of Asia economies should not be surprising; the West should have created Asian sense of rigor and excellence in education; and Australia is unprepared for a world in which Asia norms and standards demand more excellence / aspiration. Turnbull suggests that Western prominence over the past two centuries may follow from being first user of fossil fuels in transport / military areas, together with mobilization of poorly used human energies under corporate structures. Western dominance has led to both transformation and destruction - leaving unanswered environmental / health / medical / well-being / civilizational wisdom questions. Problems in fossil fuel supplies and corporate excesses suggest that first mover advantage no longer benefit the West. Economic confidence now focuses on China / India / Asia generally, and financial / political problems in America and Europe undermine confidence. Environmental confidence is best raised by the renaissance of people who maintained high production with less environmental destruction than the West. And China is investing more than anyone else in alternative energies and environmentally enhancing measures. Few apart from Turnbull in Australia seem to realize what is happening. Peter Lee suggested that the US could be the new 'sick man' of Asia. US efforts to promoted cooperation through APEC could be merely afflicting the region with imperial malaise. Australians need to recognise US's dire economic straits, and how this limits what it can do in the Pacific. Global economic and political developments are leading to the end of the world Australia has known for two centuries. An appropriate response would be: higher education standards; re-evaluation of the West's post-enlightenment materialism, scientific reductionism (which adversely affect food quality, water, energy and the environment); re-evaluation of the economic role of corporations - to optimize productivity and minimize greed; a political system that does not leave outcomes at the mercy of lobbyists (a nearly terminal situation in the US) ; and general community support for excellence in administration. Few such considerations are on Western agendas - because of threats of financial disintegration. Australia needs to do to participate in the best of Eastern times, and avoid the consequences of the end of Western times.

Detailed Comments (Incomplete Draft]

In essence the above article suggests that Australia had better lift its standards to meet the higher Asian standards of excellence and aspiration that will be dominant in future.

Clarifying What This Means

In advocating change the article is anything but clear about the basis of those 'Asian' standards or how this differs the Western institutions and methods that are seen to have now passed their 'use by' date.

An attempt to address this in Competing Civilizations - specifically in sections on Cultural Foundations of Western Strengths and East Asia.

In brief this suggests that Western societies have succeeded in recent centuries on the basis of initiative by rational individuals. This has been built particularly on the West's Judeo-Christian and classic Greek heritage, and has been supported by social, political and economic arrangements that reduce the limits to rationality that apply in dealing with complex systems (eg by concern for individuals, a rule of law, coordination of economic activities through a capitalistic search for profit and democracy). 

By contrast in East Asian societies with an ancient Chinese cultural heritage no emphasis on either rationality or individuals in East Asian societies that have an ancient Chinese cultural heritage. Rather individuals are expected to be compliant components in hierarchical social groups whose directions are determined by group intuition and consensus. 

'Asian' traditions involve the effective rejection of individualism, a rule of law, truth and universal values, rationality, egalitarianism and serious political debate.

Traditions that are so radically different to those of Western societies have practical consequences, and speculations about these are also

Complexities

Similar in China as the Future of the World Ending the West's Global Predominance

 

 

September 2002  - and amended October 2003 and from November 2007