China's Development: Assessing the Implications

• 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;
• following the bursting of China's economic 'bubble' by the global financial crisis, there is a possibility that China's leaders, having no market-oriented way to further increase their power, may turn to aggressive nationalism as an alternative.

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'.

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;

• 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]

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]

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.
• 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);
• 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]

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].

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 Driven by China's Rising Generation?

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 proved 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 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 limited 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.

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].
• 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 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 which are being taken 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. 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', 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.

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].

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.

Change 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]

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 (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.

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?.

Mao felt the need for a 'cultural revolution' in the 1960 to free China of traditions that blocked the adoption of his ideal 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.

September 2002  - and amended October 2003 and from November 2007