Wednesday, December 5, 2012

The Dragon Dance: U.S.-China Security Cooperation - James M. Acton

The Dragon Dance: U.S.-China Security Cooperation

By: James M. Acton Thursday, November 29, 2012 2
China’s nuclear modernization concerns the United States and its Asian allies, but Washington has largely failed to engage Beijing effectively on nuclear strategy. The failure stems at least in part from China’s view that engagement narrowly focused on nuclear issues is a losing proposition. To make progress in his second term, President Obama should offer a broader vision for strategic cooperation that includes reducing nuclear risks by restraining competition in the conventional realm.
Over the last ten or fifteen years, the possibility of a conflict with China has become an ever more important focus of U.S. defense planning. With long-running wars in Afghanistan and Iraq, preparing for such a contingency has not always been the highest-profile item on the Pentagon’s agenda. But, the Obama administration’s “pivot” to Asia is clear evidence of where it believes the risk of interstate warfare, defined in terms of both likelihood and consequence, is greatest.
Sino-American military competition primarily plays out in the conventional domain, and escalation to nuclear use in a U.S.-Chinese conflict is thankfully much less likely than it was during the U.S.-Soviet standoff. Yet both Washington and Beijing still plan for a nuclear war—the ultimate in low-probability, high-consequence catastrophes. For this reason more than any other, the administration of Barack Obama, like the George W. Bush administration before it, has sought to manage the risk by engaging China in a strategic dialogue. The administration is virtually certain to continue these efforts in Obama’s second term.
Certainly, the Obama administration is also driven in part by a desire to create political and security conditions that would enable deep reductions in nuclear weapons, eventually leading to their abolition. One of these conditions is the integration of China’s nuclear arsenal into an arms control framework. However, other reasons to engage China on nuclear deterrence command broader political support. China is slowly expanding and modernizing its nuclear forces, sparking concern in both the United States and among Washington’s Asian allies, most notably Japan. These concerns are exacerbated by Beijing’s refusal to provide information about the size and structure of its arsenal. As long as these trends continue, all U.S. administrations—Democratic and Republican—are likely to try to press Beijing to be more transparent and to explain its motivations and intentions for modernization.
The Obama administration’s “pivot” to Asia is clear evidence of where it believes the risk of interstate warfare is greatest.
As part of this modernization, China is in the process of deploying road-mobile missiles and developing submarine-launched ones to replace its older silo-based weapons, thereby significantly enhancing the survivability of its nuclear forces. It is also developing technologies to defeat U.S. ballistic missile defenses in an attempt to ensure that, should these missiles ever be used, their warheads would reach their targets.
China is also slowly expanding its nuclear forces. In 2002, the U.S. Department of Defense estimated that China had twenty intercontinental ballistic missiles (ICBMs) capable of reaching the continental United States,1 and in 2010, a report placed that number between 30 and 35.2 In addition, China is developing the capability to place multiple warheads on a single missile. If Beijing deployed this technology, it could rapidly expand its nuclear forces, but there is no evidence it has yet done so.
So far, U.S. efforts to engage China on nuclear strategy have had limited success. Part of the reason may be that, given the United States’ huge qualitative and quantitative advantages in nuclear forces, China appears to view engagement narrowly focused on nuclear issues as a zero-sum game that it will likely lose. Strategic cooperation might appear more obviously mutually beneficial if it were based on a broader strategy of reducing nuclear risks by restraining competition in the conventional realm. Of course, there is a real possibility that an ambitious U.S. proposal to expand cooperation would be rebuffed by China. But, if Beijing does engage, the United States and China could make real progress toward managing a genuinely existential threat to both of them.

A Decade of Limited Progress

American efforts to engage China—at both the official and nongovernmental levels—have often attempted to separate nuclear deterrence from the rest of the bilateral relationship. The aim has been to discuss it either completely by itself or, occasionally, alongside other “strategic” issues, such as cybersecurity, space weapons, and missile defense. Most obviously, U.S. officials believe—and regularly and publicly exhort Beijing to understand—that greater transparency about China’s nuclear arsenal would, on its own, help stabilize the two states’ nuclear relationship.
This belief has influenced the way Washington has attempted to engage Beijing in private. The Bush administration sought a dialogue with China focused solely on nuclear strategy. Only one round of this dialogue was ever conducted, and that was in April 2008. The Obama administration’s efforts appear to have been somewhat broader but are still tightly focused compared to the full range of issues in the bilateral military relationship. Specifically, the United States and China held two rounds of a “strategic security dialogue” in May 2011 and May 2012. Very little information about the discussions is available, but the meetings seem to have originated with a suggestion made in January 2011 by Secretary of Defense Robert Gates to his counterpart, General Liang Guanglie, that the two states should engage on “nuclear, missile defense, space, and cyber issues.” Whatever its agenda, the absence of information about this dialogue suggests it is at a fairly nascent stage.
Strategic cooperation might appear more obviously mutually beneficial if it were based on a broader strategy of reducing nuclear risks by restraining competition in the conventional realm.
At a marginally more advanced stage is a dialogue between the five nuclear-weapon states recognized by the Nuclear Non-Proliferation Treaty, including both China and the United States. Formally, this dialogue is focused on topics covered by the treaty (disarmament, nonproliferation, and nuclear energy), not bilateral U.S.-Chinese strategic issues. But, China has agreed to lead work on a glossary of nuclear terminology, which could help promote understanding during future bilateral discussions on nuclear deterrence.
In short, a decade’s worth of U.S. efforts to engage China on nuclear deterrence has led to three rounds of intermittent dialogue and a commitment to develop a glossary: hardly impressive progress. Rightly or wrongly, China apparently does not share the U.S. belief that narrowly focused engagement on nuclear issues would be mutually beneficial.
Why China has been reluctant to engage on nuclear issues is a matter for legitimate debate. Virtually all Chinese and many American analysts—particularly those who have studied Chinese documents—believe that Beijing’s policy is driven, to a significant degree, by a perceived threat from the United States. They argue that Beijing is genuinely concerned that, in a deep crisis, the United States might attempt to eliminate China’s nuclear arsenal with a preemptive “first strike” and that greater transparency could further undermine the survivability of its nuclear forces. In 2003, for instance, Chinese analyst Li Bin wrote that:
The survivability of [China’s] current ICBM force . . . relies on ambiguity surrounding numbers. Because China will not confirm or deny reports on the number of its ICBMs, other states cannot have confidence in any estimates. An attacker considering launching a first strike against China would be uncertain of China’s retaliatory capacity. This is how China’s nuclear deterrent works today.3
By contrast, other U.S. analysts believe that China’s opacity and its modernization program are geared toward unilateral gain. They worry Beijing has concluded that a more robust Chinese nuclear arsenal would deter the United States from intervening in a regional conflict, thus undermining U.S. defense commitments in East Asia.
While less discussed, it is also possible that internal considerations, not just external ones, shape Chinese policy significantly. After all, U.S. and Soviet/Russian nuclear weapons decisions—particularly over procurement—were not based solely (or perhaps even mostly) on cold-blooded cost-benefit calculations. They were shaped by bureaucratic and political factors. The administration of John F. Kennedy, for example, increased defense spending, which included the construction of more nuclear weapons, to stimulate the U.S. economy. Meanwhile, according to an authoritative study of Soviet nuclear policy based on interviews with senior decisionmakers conducted just after the collapse of communism, Soviet acquisitions policy was largely driven by the defense-industrial sector’s use of “its political clout to deliver more weapons than the armed services asked for and even to build new weapon systems that the operational military did not want.”4 While the specific internal factors at play in China may be rather different, there is little reason to suppose that they are absent.
Whatever the reason for China’s recalcitrance, there are advantages to presenting Beijing with an agenda for strategic cooperation that is more attractive than the one currently on offer. If China’s policy is defensively orientated, it might respond positively to a proposed agenda that is more obviously mutually beneficial. If engagement is currently being stymied by internal factors, a more attractive agenda might motivate it to overcome political or bureaucratic roadblocks. By contrast, Beijing’s refusal to engage with a more attractive offer would provide some evidence that Chinese policy is offensively orientated, which would be a potentially valuable insight—although such evidence, it must be recognized, would hardly be conclusive.

The Inseparability of Nuclear and Conventional Security Dynamics

Conventional weapons that are not usually deemed “strategic” can be inextricably linked to nuclear dynamics. At the most general level, the overall state of the conventional balance can significantly affect nuclear doctrine. Many nuclear-armed states facing a conventionally stronger adversary—including the United States during the Cold War and Russia and Pakistan today—have openly advertised their nuclear weapons as an offset for their weakness.
China has been an exception in this regard because it has pledged not to use nuclear weapons first, although there is a debate within the United States about the credibility of this commitment. In particular, some analysts believe that China would resort to the use of nuclear weapons to avoid defeat in a major conventional war. This debate aside, however, it is possible that if China fails in its current efforts to close the United States’ conventional advantage in the western Pacific, it may openly place a greater emphasis on nuclear weapons. Conversely, if China succeeds in gaining a meaningful conventional advantage, the United States might revert to a much greater role for nuclear weapons in fulfilling defense commitments to its allies.
Beyond these high-level dynamics, there are some much more direct—and pernicious—linkages between conventional and nuclear weapons in the U.S.-Chinese relationship. There is a vigorous conventional competition in the western Pacific, with the United States seeking to retain the ability to project power throughout the region and China seeking to deny it the ability to do so. In turn, Chinese efforts to deter and defeat U.S. power-projection capabilities are leading the United States to develop “strategic conventional” capabilities, which Beijing argues are forcing it to expand and modernize its nuclear forces.
To be concrete, China is developing both anti-satellite weapons and anti-access/area-denial capabilities. By using the former to destroy American communications, guidance, and reconnaissance satellites, China might hope to deny or impede the United States’ ability to project power. Chinese anti-access/area-denial capabilities are designed to hinder U.S. access to the western Pacific and its freedom of movement within the region. The highest-profile Chinese system designed to contribute to these operations is an anti-ship ballistic missile, the DF-21D. Chinese military writings suggest that its primary target would be U.S. aircraft carriers.
Both anti-satellite weapons and anti-access/area-denial capabilities constitute important arguments within the United States for developing long-range, very fast conventional weapons in a program known as Conventional Prompt Global Strike (CPGS). Two commanders of U.S. Strategic Command have, in public testimony before Congress, stated that CPGS weapons could be used to prevent further attacks in the event that China destroys a U.S. satellite. Meanwhile, the 2010 Quadrennial Defense Review lists experimenting “with conventional prompt global strike prototypes” among its efforts to develop long-range strike capabilities to combat anti-access/area-denial threats.
Whether Chinese defense strategists concerned with “counterintervention” (as they term anti-access/area-denial operations) view CPGS as a particular threat is unclear. However, Chinese officials and analysts working on nuclear deterrence issues have expressed deep worries about the effect that CPGS could have on the survivability of China’s nuclear arsenal. In fact, Chinese concerns about the effect of advanced conventional capabilities on the nuclear balance may be more acute than more documented concerns about ballistic missile defense.5
Chinese concerns about the effect of advanced conventional capabilities on the nuclear balance may be more acute than more documented concerns about ballistic missile defense.
Moreover, U.S. missile defense deployments in East Asia are driven, at least in part, by Chinese conventional regional ballistic missiles, which include not only the DF-21D but also land-attack weapons that could be used to target U.S. and allied assets in Taiwan, Japan, and Guam. In public, U.S. officials have stressed the threat from North Korea in justifying recent plans to expand missile defenses in the region. Yet, the presence of missile defense assets in Taiwan is clear evidence that missiles from North Korea are not the only ones that the United States seeks to defeat. Indeed, in an oblique reference to a conflict with China, Secretary of Defense Leon Panetta has acknowledged that missile defense is designed to help “forward-deployed U.S. forces.”
Chinese analysts and officials certainly assume this to be the case. Li Bin, for example, has argued that the locations of planned U.S. radar installments provide evidence that Chinese ballistic missiles are targets for American defenses.6 However, Chinese concerns are not limited to the impact that these defenses may have on its arsenal of regional missiles. Beijing is also concerned that U.S. defenses could eventually be able to counter intercontinental ballistic missiles armed with nuclear warheads, thus undermining China’s nuclear deterrent. There is little doubt that this concern partly motivates well-connected Chinese analysts’ criticism of U.S. plans to expand missile defenses in East Asia.

The Security Dilemma

These dynamics may be manifestations of a burgeoning “security dilemma.” A security dilemma is created when a state procures weapons for defensive purposes, inducing an adversary, who fears the buildup might be offensively oriented, to do likewise. The adversary’s buildup can, in turn, spark a countervailing reaction in the first state, resulting in an arms race.
Almost by definition, it is impossible for a state with a security dilemma to definitively identify it as such at the time. Washington cannot know for sure that China’s nuclear modernization or lack of transparency is a defensive reaction to a perceived first strike threat from the United States. For that matter, Beijing cannot be certain that U.S. strategic conventional weapons programs, not to mention the pivot, are defensively oriented and geared toward preventing China from using force to change the status quo. But it is clear that the United States and China have a shared interest in creating a process that will allow each to test the other’s intentions. Such cooperation could help mitigate the security dilemma, if indeed there is one.
For its part, Beijing would benefit from calming the U.S. security concerns that are helping to drive American programs that it finds threatening—including CPGS and ballistic missile defense. Because these programs might be catalyzing Chinese modernization efforts and precluding transparency, Washington has an interest in easing Chinese concerns.
It is clear that the United States and China have a shared interest in creating a process that will allow each to test the other’s intentions.
These negative feedback loops are already creating friction in the extremely complex U.S.-China relationship. If left unchecked, they could create a qualitative or quantitative nuclear arms race. The U.S. Congress has already held hearings on—and expressed concern about—China’s nuclear modernization program. If this program continues unabated it could become a powerful domestic argument in the United States for the development of new nuclear warheads (if for no other reason than to symbolize that the United States still takes nuclear deterrence seriously). China’s modernization program is also creating concern that it seeks numerical parity with the United States and Russia, complicating further U.S.-Russian arms control—something that China certainly benefits from, even if it is not a party to any agreement. Both Beijing and Washington have a mutual interest in preventing these outcomes, the latter for reasons of cost if nothing else given the state of the U.S. budget.

Broadening the Agenda

A broadened agenda for U.S.-China strategic cooperation that includes the conventional domain should be viewed by leaders in both states as attractive. The basic principle of turning a perceived zero-sum game into a mutually beneficial one by linking issues is common to all areas of negotiation, from labor relations to nuclear arms control. That said, addressing the whole range of interlinked military issues in the U.S.-Chinese relationship is truly daunting—impossibly so for the time being.
Over the long term, it might be possible—through treaty or restraint—to develop a durable balance of conventional forces so that each state is confident in its ability to protect its vital interests without nuclear weapons. But profound political change will be needed to achieve such an outcome, much like in Europe toward the very end of the Cold War. NATO and the Warsaw Pact were only able to negotiate limits on conventional forces that effectively precluded the possibility of a surprise attack by either party after Moscow had started the process of internal reform that led to a thawing of the Cold War (and, ultimately, the Soviet Union’s demise). Today, realistically speaking, the United State and China should identify more modest steps that could help mitigate some of the most risky interactions between conventional and nuclear weapons.
For example, while the linkage between Chinese anti-access/area-denial capabilities, particularly the DF-21D anti-ship ballistic missile, and the U.S. CPGS program could produce a potentially destabilizing buildup cycle, it could also be leveraged to enable strategic cooperation. The two states could inform one another about the number of weapons they intend to procure and deploy each year for, say, the next five years. A data exchange like this could help mitigate tendencies to base procurement on worst-case intelligence assessments.
Chinese involvement in this kind of transparency arrangement would not be as unprecedented as widely believed. In 1997, for instance, China, Russia, and three Central Asian Republics negotiated an agreement on conventional force limitations near their borders. This extremely long and detailed document (it runs to over 17,000 words in English) contains extensive provisions for data exchange and demonstrates that Beijing will agree to transparency measures if it views them to be in its interests.
Much more ambitiously, the United States and China could enact a ban on the encryption of diagnostic data, known as telemetry, transmitted during tests of agreed-upon long-range high-precision conventional weapons (such as the DF-21D and a U.S. CPGS system) to allow for more accurate capability assessments. Clearly, such a ban would require a substantial degree of trust to be built first and so cannot be a short-term ambition. But, the U.S.-Soviet agreement to ban telemetry encryption as part of the 1991 Strategic Arms Reduction Treaty (START) demonstrates that, over time, confidence building on the necessary scale is possible.
One particular advantage of broadening the scope of strategic cooperation to include conventional forces is that it becomes possible to pair roughly symmetric capabilities. China’s nuclear arsenal is much smaller and less sophisticated than that of the United States, complicating efforts to persuade Beijing that it is in China’s interest to become more transparent. By contrast, while the DF-21D is less sophisticated than any of the systems being developed under the CPGS program, it is at a significantly more advanced stage of development. This rough symmetry makes confidence-building measures involving these capabilities more obviously beneficial to both parties.
Other linkages—such as the connection between Chinese regional ballistic missiles and U.S. regional missile defenses—could also be exploited for strategic cooperation. Crucially, however, a necessary prerequisite to any progress in this direction is an official Sino-American dialogue broad enough to encompass all the relevant strategic interactions. The existing strategic security dialogue, while a step in the right direction, probably does not go far enough. While it appears to include nuclear weapons, missile defense, and space, it leaves out a number of critical pieces of the puzzle in the form of conventional U.S. power-projection capabilities and various Chinese efforts to defeat them.
Analysts and some government officials (particularly in Russia) have recently discussed bringing China into negotiations toward a multilateral arms control treaty. While this is a desirable long-term goal (that discussions among nuclear-armed states at both an official and unofficial level can advance), it is also a premature one. For multilateral arms control to have any chance of success, the dynamics that are driving Chinese modernization must be addressed. To the extent that these dynamics are related to Sino-U.S. strategic competition they must be addressed bilaterally.
Moreover, there are still large quantitative and qualitative gaps between U.S. and Chinese nuclear forces. For example, while China has 30 to 35 missiles, each armed with a single warhead, capable of reaching the United States according to the most recent detailed estimate from Department of Defense, the United States has over 1,000 deployed warheads capable of reaching China. Efforts by the United States in cooperation with Russia are needed to close this gap before China can reasonably participate in the negotiation of a limitations treaty.
The asymmetry between U.S. and Chinese nuclear forces also argues strongly against attempting to import the Cold War arms control framework wholesale into the U.S.-China relationship. While U.S.-Soviet and U.S.-Russian treaties can provide useful ideas, such as the ban on telemetry encryption, the United States needs to take a novel approach to have a reasonable chance of receiving the reassurance it wants about China’s modernization.

Prospects for Success

It would be naïve to believe that expanding the scope or depth of strategic cooperation between the United States and China would be anything other than extremely difficult. While there is a compelling case to be made that expanded cooperation would be mutually beneficial, there is also the potential for significant resistance. Within the United States and among its allies, there would unquestionably be opposition to any form of cooperation that requires the United States to provide China with valuable information about U.S. plans and programs—even though China would be required to provide equally valuable information in return. Indeed, confidence-building measures that connect, for instance, Chinese regional ballistic missiles to U.S. regional missile defenses would probably be harder to “sell” than confidence-building measures purely within the nuclear realm. There is also absolutely no guarantee that Beijing will agree to participate; it might doubt U.S. sincerity, be unable to circumvent domestic obstacles, or, conceivably, view cooperation as fundamentally undesirable.
The potential benefits of trying to start wide-ranging strategic cooperation with China dwarf the downside risks.
That said, the potential benefits of trying to start wide-ranging strategic cooperation with China dwarf the downside risks. Strategic competition between the United States and China is not only expensive but adds friction to the bilateral relationship—a relationship that simultaneously holds more promise and carries more risk than any other. If strategic cooperation does nothing more than curb some pernicious aspects of this competition it would be worthwhile. If it catalyzes a co-evolutionary process in which deep cooperation builds strategic trust and strategic trust enables deeper cooperation, it could usher in a sea change.

1 Department of Defense, “Annual Report on the Military Power of the People’s Republic of China,” 2002,, 27.
2 Department of Defense, “Military and Security Development Involving the People’s Republic of China,” 2010,, 66. If weapons capable of reaching Alaska are included, the number rose from about 30 in 2002 to between 45 and 65 in 2010.
3 Li Bin, “China and Nuclear Transparency,” in Transparency in Nuclear Warheads and Materials: The Political and Technical Dimensions, edited by Nicholas Zarimpas (Oxford: Oxford University Press for SIPRI, 2003), 55.
4 John G. Hines, Ellis M. Mishulovich, and John F. Shull, Soviet Intentions 1965–1985, Volume I, An Analytical Comparison of U.S.–Soviet Assessments During the Cold War (McLean, Va.: BDM Federal, 1995), 24–25, available from
5 Lora Saalman, China and the U.S. Nuclear Posture Review, Carnegie Paper (Beijing: Carnegie-Tsinghua Center for Global Policy, 2011),, 9.
6 Li Bin, “China and the New U.S. Missile Defense in East Asia,” Proliferation Analysis, Carnegie Endowment for International Peace, September 6, 2012,

Friday, November 30, 2012

The coming crash of construction industry in China - Foreign Affairs

Indebted Dragon

The Risky Strategy Behind China's Construction Economy
Construction workers install scaffolding on the top of a building in Shanghai. (Aly Song / Courtesy Reuters)
For four decades, the Chinese economy has grown by between seven and ten percent each year. It is the envy of the world, despite its relatively sluggish recent performance. Visitors to Beijing, Shanghai, and other major Chinese cities are quickly awed by impressive skyscrapers, glittering shopping malls, new highways, and high-speed rail lines, all of which leave the impression that China is a developed economy -- or at least well on its way to becoming one. Even in some smaller cities in inland provinces, government buildings make those in Washington and Brussels appear meager. In an area of Anhui Province that is officially designated an "impoverished county," the government office block looks exactly like the White House, only newer and whiter.
Underwriting the impressive facade, however, is an incredibly risky strategy. Governments borrow money using land as collateral and repay the interest on their loans using funds they earn from selling or leasing the same land. All this means that the Chinese economy depends on a buoyant real estate market to keep grinding. If housing and land prices fall dramatically, a fiscal or banking crisis would likely soon follow. Meanwhile, local officials' hunger for land has displaced millions of farmers, leading to 120,000 land-related protests each year.
The recklessness can be traced to two things: First, local Chinese officials are evaluated for promotions and other rewards based on how well the economy they manage performs. Construction and real estate activities are among the most straightforward ways to stimulate growth. White-elephant construction projects thus offer eager officials a perfect opportunity to impress their political superiors, even if massive developments do not necessarily make any economic sense. Take, for example, the city of Ordos in Inner Mongolia: Its elaborate urban infrastructure and its sea of new flats and office blocks are nearly all unoccupied, making it China's largest ghost city.
Another factor was China's fiscal recentralization reform of 1994, in which the central government raised its own revenue by taking back power from local governments to levy some major taxes. The move lowered local governments' revenues but left their financial responsibilities -- providing education, health care, subsistence allowances, and pensions -- unchanged. So local officials had to find other ways to generate money.
In the wake of the tax reform, sales and business taxes on construction, real estate, and other service industries became the main source of tax revenue for municipal governments. Not surprisingly, in the 1990s, local authorities started to engineer real estate and construction booms. According to Chinese law, collectively owned farmland must be converted to state ownership before it is leased to private developers. Local governments were thus able to expropriate farmland from villagers and then rent it to private commercial ventures such as factory owners and real estate companies. According to a 2011 survey by Landesa, a Seattle-based nonprofit organization, local governments earn on average $740,000 per acre of land. That is 40 times the average amount they pay to displaced farmers.
The involvement of municipal governments in land sales goes beyond leasing. To entice property developers, officials also invest in infrastructure. Although they sometimes finance that development directly with land transfer revenue, more often they simply use the land as collateral to borrow from state-owned banks. They generally work through local-government-incorporated urban development and investment companies (UDICs, or chengtou gongsi) and local government financing platforms to skirt laws prohibiting such borrowing. To service interest payments, local governments typically draw from land transfer revenue, taxes, or user fees and charges.
Using bank loans to finance infrastructure investment is not necessarily bad or unusual. It has been common practice in the United States for years, and tax experts say it is a fair and efficient way of building public infrastructure. The problem with China's approach is that the local-government financing platforms are not regulated or subject to any disclosure standards. And although the law formally prohibits local governments from borrowing recklessly, the central government's financing practices encourage them to do so in a roundabout way.
Until Beijing started conducting audits in mid-2009, neither the central government nor the banking regulator knew how much debt local governments had racked up. Since then, official estimates by the National Audit Office, the People's Bank of China, and the China Banking Regulatory Commission have put the size of local government debt at 5 trillion to 14.4 trillion yuan (803 billion to over two trillion dollars) 13 to 36 percent of GDP -- as of the end of 2010. Private analysts often put the number much higher: between 50 and 100 percent of GDP, depending on whether local governments' contingent liabilities or indirect debts (debts owed by government-owned and government-related entities) are included.
On the surface, banks' balance sheets have remained healthy despite these debts, since banks tend to roll over or "ever green" loans by issuing new loans to help borrowers "repay" old ones. In addition, local governments have been able to make their interest payments using their land as collateral.
The banks' accounting tricks treat only a symptom of the problem. Eventually, banks will become unable to roll over loans because they will run out of fresh money. And officials' ability to pay off loan interest depends on the continued rise of real estate prices and a buoyant economy, neither of which can be taken for granted. Some analysts are already saying that China's real estate bubble has burst. That could be terrible, but as I have argued elsewhere, Beijing cannot and will not let banks that hold the savings of ordinary people go under. Bank runs would send millions of depositors into a panic and lead to widespread social unrest.
Even before it pops, China's real estate bubble is causing social harm. An inevitable effect of state-led urbanization is that farmers are forced to vacate their land. Close to 300,000 peasants are removed from their villages every year to make room for the construction of airports, highways, and buildings. Since 1980, more than 60 million peasants, roughly the population of the United Kingdom, have been moved.
The displaced are not usually consulted before relocation. Governments frequently force them to leave by suspending the supply of utilities, such as electricity, to their homes. Increasingly, local governments are even hiring or colluding with gangsters to intimidate villagers who refuse to move. Tellingly, in some villages, these mobsters are known as the "second government."
Compensation to farmers who do move is often inadequate, because negotiations over the value of their land take place without them. The opacity allows authorities to line their own pockets with funds meant for farmers. It is no surprise, then, that in a recent Landesa survey of nearly 1,800 rural households across 17 provinces, about 20 percent of the displaced (which made up 43 percent of the survey's sample) had not received any compensation. Of those who had received remuneration, 53.4 percent reported that they were "very dissatisfied" or "dissatisfied" with it, compared with 25 percent who were either "satisfied" or "very satisfied." When asked why, 80 percent complained of inadequate compensation, 47 percent said it was determined without their input, 38.4 percent said payment was insufficient to maintain their previous standard of living, 28.6 percent said they were unable to find nonagricultural income after having their land taken away, and 25 percent reported that compensation had been intercepted by local officials.
For Chinese farmers, farmland is both a livelihood and a form of social insurance. In bad times, when temporary work or factory jobs dry up in cities and towns, migrant workers can return to subsistence living in villages. By way of comparison, urban residents are entitled to state-provided social welfare, namely, subsistence allowance, unemployment insurance, and pensions.
Unsurprisingly, demolition, relocation, and land expropriation have become the leading causes of social unrest in China. Discontented peasants typically try to air their grievances using China's petition system, but when efforts through official channels prove futile, they take to the streets: The number of "mass incidents" in China continues to rise.
Given slower growth rates and falling real estate prices this year, the frequency of land expropriation is slowing down. But the truth remains that much of urbanization in China is a state-driven phenomenon, using resources drawn from the financial sector. Although the central government recognizes the seriousness of the problem, it seems to lack any real resolve to tackle the issue head on. Muddling through seems to be so much easier. So until a major slowdown in the economy happens, the Chinese real estate market will continue on its current course. 

Saturday, October 13, 2012

Huawei in America - John Gapper (Financial Times)

Financial Times October 10, 2012 7:23 pm

Too late for America to eliminate Huawei

Ingram Pinn illustration©Ingram Pinn
To read the scathing condemnation of Chinese telecoms equipment suppliers fired from Washington this week, you would think we still lived in another world. In that world, telecoms networks were built by national monopolies such as AT&TFrance Telecom and British Telecom, and outsiders stayed away.
But we don’t.




You know things have come to a pretty pass when US politicians throw their weight behind a French company because the alternative is worse. That would be the effect of barring Huawei and ZTE from the US market on the grounds that they are shifty front organisations for the Chinese government and the People’s Liberation Army.
It would aid Alcatel-Lucent, the troubled 2006 merger of the French company with Lucent, descended from Western Electric of Cleveland, Ohio, which was bought by AT&T in 1881. Things have since moved on and Huawei Technologies and ZTE of Shenzhen in southern China are the new Western Electrics.
The US House of Representatives intelligence committee, with its demand to bar Huawei or ZTE from gaining US contracts or merging with US companies, is living in the past. The time to declare telecoms a strategic, protected industry like defence, was 20 years ago; now is the time to make a deal.
“Huawei and ZTE represent something new: a former third-world country producing first-world technology. The American corporate psyche finds this difficult to handle,” says John Quelch, dean of the China Europe International Business School in Shanghai.
It was obviously tough on the House intelligence committee, which has thrown many accusations at both companies, in particular Huawei, which has grown to share industry leadership with Ericsson of Sweden since it was founded in 1987 by a former PLA officer.
This sounds dodgy, given the PLA’s ambitions in cyber espionage and mass efforts by Chinese hackers to acquire US military and industrial secrets. Former executives of Nortel Networks, the Canadian group that was Huawei’s rival until it went into Chapter 11 bankruptcy protection in 2009, complained of constantly being hacked from China in the 2000s.
“A number of states are engaged in economic espionage and China is the most prolific,” says Mike McConnell, a former head of the US National Security Agency who is vice-chairman of Booz Allen Hamilton, the consultancy. “Research and development costs a lot and it is cheaper to steal it.”
The chief accusation is that, if permitted to build networks for operators such as AT&T and Verizon, Huawei would build traps into the software and hardware. Its friends in the Communist party could then use them to hack databases or to bring the networks down in a war.
It is foolish to ignore the potential security holes in telecoms networks. The NSA has itself been accused of spying on US and foreign internet traffic by monitoring traffic passing over American networks.
But barring Chinese companies does not solve it. Alcatel-Lucent has a venture in China with Shanghai Bell and much of the equipment used by Ericsson and others is made in China. If the party and the PLA wanted to be sneaky they would tamper with these components.
Nor is there direct evidence of malfeasance against Huawei and ZTE in the report, although one section is classified. Meanwhile, the committee alleges that the companies breach patents and enjoy support from China in the form of soft loans.
Both could be true but they are the stuff of trade and intellectual property disputes rather than an intelligence concern. The committee undermines its case by sounding as if it seeks any excuse to exclude Chinese competitors.
The companies have not helped themselves. Huawei is a reclusive outfit that did not publish the names of its directors until a few years ago. Sun Yafang, its chairwoman, is reported to have once worked at the Ministry of State Security and, like other companies, it has an internal Communist party committee whose exact purpose is mysterious.
Yet Huawei is not easily categorised as a state stooge. It is not state-owned (ZTE has closer links with Guangdong province) and was among start-ups that flourished in Shenzhen’s economic zone in the 1990s. It is still private and claims to be wholly employee-owned. “Huawei is an independent, quite arrogant, company,” says Duncan Clark, a Beijing-based consultant.
In some ways, it is a symbol of the very China the west has an interest in encouraging. China’s government declared in 2006 that telecoms was one of seven strategic industries over which state-owned enterprises should retain “absolute control” yet Huawei was built by an entrepreneur who admires Silicon Valley.
Huawei seized 20 per cent of the global market, according to Bernstein Research, by producing equipment at lower prices than western rivals, triggering a wave of consolidation. In the US, where competition has been effectively curbed, Ericsson and Alcatel-Lucent have a duopoly.
The best thing for US consumers would be to admit Huawei and ZTE with safeguards. In the UK, Huawei’s equipment is examined by former staff of GCHQ, the UK intelligence service, before being used by BT. The US and Australia, which has barred Huawei from a planned network, could go further.
The US might require Huawei to list in London or New York to illuminate who owns the company; submit technology to the NSA; and separate its US division like a defence group. It could even demand the dissolution of its Communist party committee. What it cannot do is recreate the past.
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Wednesday, July 4, 2012

A Monetary History of China - Peng Xinwei (book review)

Title: A Monetary History of China
Published by EH.Net (July 2012)
Peng Xinwei, A Monetary History of China. Bellingham, WA: Center for East Asian Studies, University of Western Washington, 1994.  (Translation by Edward H. Kaplan of Zhongguo huobi shi, third edition, Shanghai, 1965.)  xlix + 929 pp. (2 volumes) $50 (paperback), ISBN: 0914584812. 
Reviewed for EH.Net by Kurt Schuler, Center for Financial Stability.
Anyone who claims to know the history of civilization must know something of the history of China. Even so, Peng Xinwei’s monumental book, published almost half a century ago in Chinese and almost two decades ago in English translation, has remained obscure among economists.  The translation, the only version likely to be accessible to most readers outside of China, seems never to have been reviewed in any economics journal or Web site, though it is known to historians and numismatists who specialize in China. I am therefore writing to call attention to a work that has few peers as a feat of scholarship in monetary history.
Peng Xinwei (1907-1967) studied economics at the London School of Economics and apparently also studied or lived in Japan at some point. Before the communist takeover of China in 1949 he worked as a banker; afterwards, he taught economics at Fudan University in Shanghai.  The first edition of his book appeared in 1954. He finished revising the third edition in 1962 and it was published in 1965. He died as one of the hundreds of thousands of victims of Mao’s great bonfire of Chinese civilization, the Cultural Revolution. Edward Kaplan (1936-2006), the translator, was an associate professor of history at Western Washington University. The translation, an impressive feat of scholarship in its own right, was published by the university’s Center for East Asian Studies, from which it remains available.
The book spans the whole of Chinese monetary history from centuries before the birth of Christ to the end of imperial rule in 1911. Had Peng written about the republican period, his life might have been cut short even sooner. Peng sprinkled some Marxist catch phrases about feudalism, imperialism, and colonialism into his writing, but they are merely protective coloration and do not affect his analysis, which is far more influenced by Carl Menger than by Karl Marx.
The book is divided into eight parts, corresponding to major Chinese dynastic periods. Within each part, Peng covers the monetary systems, purchasing power of money, monetary thought, and credit institutions of a period. To understand how large a task Peng set for himself, one must understand that China’s huge size and population make it in many respects more like a continent than a country. China has frequently had multiple monarchies within its current borders, and even when under a single government has had wide provincial or local variations in monetary arrangements.
Certain historical motifs strike the reader. One is the persistence of copper rather than gold or silver as the basis of most everyday monetary transactions. Another is the resort to depreciation, fiat paper money, and relatively high inflation by dying dynasties trying to finance their governments. The dynasties that replaced them extinguished the old currency and followed sounder monetary policies until they too got themselves into financial difficulty. Yet another theme is the paucity of Chinese monetary thought, inferior to European monetary thought well before Europe’s scientific revolution. Finally, there is the interplay between the government and the private sector. The government frequently failed in providing an adequate supply of coinage or a trustworthy paper currency. The private sector, to the extent it was allowed to do so or could evade the law, sought to fill the gaps, but often met with hostility from government officials that was counterproductive to China’s economic development.
China was the first country to have coins, or the first along with Lydia in Asia Minor; the first to have paper currency, free banking (competitive issue of notes), and a government monopoly of paper currency; perhaps the first to have a kind of currency board (circa 1270); and a pioneer in some fairly sophisticated forms of exchange control. By 1700, though, it had fallen behind European financial practice, and it was slow to adopt more modern forms of organization and banking technique. After adopting them, it then discarded them for a while under communism, which was what turned Peng himself from banking to an academic career.
I am a reader of Chinese monetary history but, knowing no Chinese, not a scholar of the subject. Among those who are scholars, the book continues to be cited in English and, I am told, in Chinese. Like other works of its kind, it has been superseded in many particulars. The reason for its continuing value is the flavor of the intellect that could produce a work of such scale and scope — an intellect rare enough in any time or place that it merits notice even decades belatedly.
Kurt Schuler is Senior Fellow in Financial History at the Center for Financial Stability in New York. He is the editor ofHistorical Financial Statistics, a free, online data set at the Center. These are his personal views.
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Monday, June 4, 2012

Princelings and paupers - John Garnaut

Princelings and paupers

John Garnaut
The Age, May 25, 2012

WHEN the kingmaker of Chinese politics, Zeng Qinghong, asked to see the quintessential Australia, his diplomatic minders treated him to jugs of beer and an oversized fillet steak at Brisbane's Breakfast Creek Hotel. Next stop was Sydney, where he dropped in to Rupert Murdoch's Fox studios and was introduced to Nicole Kidman and Ewan McGregor on the set of Moulin Rouge. "He had a grin from ear to ear," says a source who accompanied him at the time.
Zeng was then taken for a leisurely early dinner at Lachlan Murdoch and Sarah O'Hare's mansion in Wolseley Road, Point Piper. Rupert Murdoch was accompanied by his new wife, Wendi Deng, who performed as Zeng's guide and translator and took the lead in persuading him why News Corporation's Star TV should be beamed into China. ''Wendy was definitely running the show,'' the chaperone says.
One of Sydney's finest restaurants was closed for the day so its chefs could prepare Zeng's seafood extravaganza, featuring huge green-lip abalone, to be consumed as the sun set over the Sydney Opera House and Harbour Bridge.
Zeng had clearly enjoyed rolling up his sleeves and bantering with the punters at the Breaky Creek Hotel, but he was even more impressed with the Murdochs' stunning harbour views. In 2008, just after he had brokered the deal that installed Xi Jinping next president and Communist Party secretary, Zeng's son paid $32 million for a home with an identical harbour vista, diagonally across the road.
The century-old mansion, Craig-y-Mor, used to be the home of Australia's most famous insider trader, Rene Rivkin. The Chinese purchase did not attract attention until 2010, when Zeng Wei applied to Woollahra Council for approval to knock it down and build something more expansive. Zeng Wei won the council battle and demolition workers are expected soon. But he is rarely home, as there is still too much money to be made in China.
As the lure of the market grows ever greater and the Communist Party refuses to fetter its administrative powers or subject itself to any laws, ambitious officials and entrepreneurs have found it difficult to accumulate wealth and impossible to defend it without currying the favour of princelings or others welded into the party-state. They gravitate to the ''princeling'' children of leading revolutionaries, like Zeng Qinghong, and grand princelings, like Zeng Wei, knowing that doors open for them and officials or competitors won't dare disturb their interests.
Four years after Zeng Wei's purchase - which remains the most egregious confirmed example of Communist Party princelings flaunting their wealth - China's leaders are again grappling with being unable or unwilling to control the privileges that flow towards their relatives. The reformist advocacy of Premier Wen Jiabao has long been discounted because of his wife and son's aggressive uses of family status to pursue private business opportunities. And now the purged Politburo member Bo Xilai also stands exposed to allegations of great hypocrisy as foreign journalists pore over his family's financial dealings.
While Bo Xilai was reviving Maoist nostalgia on his official's salary of about $US1600 a month, his son was renting a presidential-style suite at Oxford and driving a Porsche in the United States. Bo Xilai's elder brother adopted an alias to control $US10 million worth of shares at the Hong Kong-listed subsidiary of a state-owned bank. Two sisters of Bo's wife control business interests worth $US126 million, according to what a Bloomberg investigation could identify. And his wife, Gu Kailai, stands accused of murdering an English friend, Neil Heywood, after they fell out over money.
Zeng Qinghong, Bo Xilai and Wen Jiabao are all immensely capable individuals, engaging and at ease in any company. Zeng and Bo, who were born into the heart of the communist aristocracy, are far more interested in accumulating power and defending the regime than acquiring the trappings of wealth. In today's China, however, even simple living and apparently idealistic leaders have found it difficult to deny their families access to the power and largesse that naturally flow their way.
Of the nine members of the current Politburo Standing Committee, at least six have children who have profited handsomely from their family status. Since the tragedy of Tiananmen, leaders have collectively failed to find a way of limiting each other's family privileges without fracturing the solidarity between them. It is becoming a regime-threatening vulnerability.
The Communist Party has not seriously tackled corruption among its princeling children since 1986, when the country was poor and tentatively opening itself to the power of the market. The reformist party chief, Hu Yaobang, fought to limit the privileges of leaders' children and even empowered his security apparatus to arrest the son of a Politburo member, Hu Qiaomu, over an embezzlement and pornography racket. Many party elders were disturbed by his audacity, given they also had children who were engaged in murky business dealings. Hu Yaobang's attempt to limit princeling corruption was a factor in him being purged in 1987, according to one of his children.
Nepotism, corruption and specifically the fortunes of leading princeling children fanned the popular outrage that became the Tiananmen protests after the trigger of Hu Yaobang's death. Hu's reformist successor, Zhao Ziyang, moved to respond to protester demands by proposing to have his own family assets investigated, but he himself was purged. When Zhao's successor, Jiang Zemin, was flown in by helicopter from Shanghai to piece the party back together, he brought with him the princeling powerbroker Zeng Qinghong.
The mission was no longer to limit princeling largesse but to manage egos, ambitions and jealousies within that rarefied world in order to optimise the political support that flowed from it. Zeng became the go-to man for favours, positions and advice. He managed, cajoled and manipulated China's most powerful princelings. But his prodigious powers of persuasion stopped at his own front door. He could not control his own son.
In 1993, as head of the party's General Office, a post akin to cabinet secretary, Zeng asked a friend to place his son, Zeng Wei, in a Melbourne university, because he had been unable to gain a place in China's intensely competitive system. ''Let him go out and work, in a restaurant, don't let him lean on others,'' said the father, according to a source familiar with the conversation. Zeng's friend found a sponsor in the Chinese community and arranged university entry and accommodation. But 25-year-old Zeng Wei never turned up.
Zeng Qinghong proudly explained to his friend that his son had decided instead to become an ordinary businessman, engaged in laboriously selling real things that people needed, and had even delivered his father a truckload of watermelons to prove it. Neither the father or the friend had any inkling that within one year after Zeng Wei's no-show in Melbourne, he had progressed from selling melons to promoting multimillion-dollar events. The friend recalls seeing Zeng Wei in a corporate box at the Workers' Stadium in 1994 for an exhibition soccer match between the Beijing soccer team and AC Milan, and embarrassing himself by trying to make an introduction with the CITIC boss, Wang Jun.
''Wang Jun said, 'I know him well, this game is sponsored by Zeng Wei, he invited AC Milan','' recalls the friend. ''He went from study, to watermelons, to this!''
By the time Zeng Qinghong was planning his trip to Sydney in 1999, his son was a wealthy man. Ambitious businessmen across the country, including many princeling children of his father's friends, were falling over themselves to cut deals and be seen to be close to the son of China's most important political powerbroker. ''Talking about all these princelings taking positions in government and wealth in the private sector, I think it's quite natural and may not be a bad thing,'' says the Chinese head of a foreign investment bank in China, who counts himself as a friend of Zeng Wei. ''If it's not them making money it will be somebody else.''
Rupert Murdoch had been fast to grasp the potential of the Chinese market and that his fortunes there would depend on Chinese politicians. When he heard about Zeng's visit his staff peppered Australian diplomats with phone calls until he had carved out a large slice of the Sydney itinerary. At the mansion in Point Piper, Murdoch brought in singer-guitarist Jimmy Little to perform and arts consultant Jean Battersby to hang the finest of his Australian works on the walls.
The next year Zeng returned the hospitality by hosting Murdoch and Deng at the Chinese opera in Beijing. (In the end Murdoch's lobbying efforts failed and he pulled out of the market.)
In 2002, Zeng was promoted to the Politburo Standing Committee and then to vice-president, while his patron Jiang bowed out from front-line duties. Ambitious politicians, officials and entrepreneurs continued their efforts to cultivate ties. Zeng's brother, based in Hong Kong, earned a reputation for aggressively muscling into business opportunities and facilitating compromises with Hong Kong businesspeople who encountered regulatory problems on the mainland.
Zeng Wei, meanwhile, was working on an altogether bigger plane. In the 1990s, Zeng Wei became close friends with the deputy chairman of the Securities Regulatory Commission, Wang Yi, according to a Zeng family friend and business associates of Zeng Wei. The friendship blossomed at a time when the regulator was discovering that it had access to valuable information about state-owned companies that were seeking to list shares on China's nascent stock exchanges. It also had the power to make or break fortunes by providing private companies with listing approvals.
Wang Yi fancied himself as a composer and a composition under his name became the anthem of the Shenzhen Stock Exchange and later a staple of the China National Symphony Orchestra. The friendship turned disadvantageous when Wang was detained by party investigators in a probe into securities market violations, although he was later jailed on unrelated corruption charges.
In 2007 investigative reporters at Caijing Magazine found that 92 per cent of the shares in the power-generating company Luneng, with net assets valued at 74 billion yuan, had been transferred to two unknown private companies for 3.7 billion yuan. A follow-up magazine edition was recalled. Sources close to the Zeng family and the investigation reveal Zeng Wei was involved in the multibillion-dollar transfer of government assets.
Zeng Wei also teamed up with coal barons from Shanxi province, who were searching for protection from the risk of having their assets appropriated by entrepreneurs and officials further up the food chain. One of his partners hosted the wedding of his daughter at a beach resort in March, where the dowry alone was reported to consist of six Ferraris.
Zeng Wei became very close to a Hong Kong property developer, Renhe Commercial, which made its money by streamlining military approval processes and converting bomb shelters into shopping centres in southern China. The company president, Dai Yong'ge, joined Zeng and wife Jiang as directors of a company in Australia, shortly before Renhe listed on the Hong Kong stock exchange.
THE blurring of state and private interests that took place with the early princelings in the '80s looks trifling compared with the melding of politics and business today.
Some of China's most respected public intellectuals are warning that the society and economy are being held hostage to the wealth-maximising requirements of the political elite. Such warnings are being echoed privately in business circles, too.
The private wealth of the party's princelings is usually well concealed, including through the use of multiple identities. But they provide key bridges between politics and the market. Many are joining or establishing investment vehicles and have inserted themselves as agents to lubricate or clog the arteries of private-sector wealth. Stock exchanges double as vehicles for converting family political capital into cash, which can be reconverted into political power. State-owned enterprises can allocate massive contracts in their favour and entrepreneurs split their profits with them in exchange for regulatory protection.
In investment banking and private equity circles, the best known princeling entrepreneurs are Winston Wen, son of Premier Wen Jiabao; Li Tong, daughter of the propaganda chief; and Wilson Feng, whose father-in-law heads the National People's Congress and has responsibility for state-owned enterprises. Other children of China's top nine leaders are said to be aggressively pursuing opportunities. They include:
■ Jia Jianguo, son of the head of the party's ''united front'' work (involved in one of Beijing's most controversial developments, at Dongzhimen Station);
■He Jintao, son of the party's anti-corruption chief and former Organisation Department head (facilitated a complicated restructuring of the Guangdong Investment Trust and Investment Corporation, which left creditors frustrated);
■Zhou Bin, son of oil czar and security chief Zhou Yongkang (contracting with China's big oil companies).
The business operations of all six princelings relate to the portfolios of their fathers (or father-in-law, in the case of Wilson Feng).
China's army of propaganda officials ensure that the private dealings of cadre children never make it into mainstream Chinese media. Nevertheless, even China's official mouthpieces acknowledge the public's growing discontent when it suits them, as they did shortly after the purge of Bo Xilai. ''The spouses and children of some cadres have taken advantage of their power to seek personal gains, disregarding the law, thus stirring public outcry,'' said Xinhua on April 14.
The hypocrisy of Communist Party leaders using socialist ideals to justify their dictatorship, while allowing their children to make millions, is not only alienating ordinary citizens, it is splitting the princelings. Many believe the recent crop of leaders has betrayed and may yet destroy the Communist Party their parents spilled blood for. These descendants of revolutionary leaders reject the term ''princelings'' for its aristocratic connotations and draw a line between themselves and children of ''mere bureaucrats'', such as those listed above.
''In recent years we've heard about the second-generation bureaucrats (guanerdai) but we are not - we are the red successors (hongerdai),'' says Hu Muying, the daughter of Mao's long-time speech writer, Hu Qiaomu, who runs a large ''red successor'' organisation. ''My father's generation worked for the interest of the people, but officials today work to become officials, not serving the people but striving for their own power and interests while their children make huge profits from their parents' power.''
The Communist Party's ''red successors'' speak as if they would do anything to rid the nation of corruption. But their determination stops at the family home. What Hu Muying did not say was that it was her brother, Hu Shiying, who the reformist party boss Hu Yaobang had jailed for corruption in 1986. She has never forgiven Hu Yaobang.
Political analysts see the families of Zeng Qinghong, and his patron Jiang Zemin, as the pioneers of modern princeling business.
Since brokering a deal that saw him hand the vice-presidency to his princeling associate, Xi Jinping, at the 17th Party Congress in 2007, Zeng has confined his political activities to advising former president Jiang. According to a friend, his son's business dealings had contributed to his decision to decline even honorary positions, as they provided too much ammunition to his political enemies.
It seems the lasting legacy of Zeng Qinghong's visit to the Murdoch Point Piper mansion was his son's decision to begin the process of business migration to Australia. Zeng Wei wants his two sons to be educated in Australia, far from the white-knuckle adventures of Chinese politics and business. Regulatory scrutiny has also motivated Zeng to find an overseas refuge, should it be required, but the Communist Party has proven over 25 years that it hasn't got the stomach to discipline its own children.

John Garnaut is writing a book on China's princelings. A version of this story will also appear at

A Family Affair

China's princelings are running amok. And Bo Xilai is just the tip of the iceberg.


Saturday, May 26, 2012

Bear in a China shop - Arthur Kroeber (Foreign Policy)

Bear in a China Shop

It's not the booming economy that's about to burst -- it's bigger than that. Social discontent and, yes, income inequality could rip China apart at the seams.


Time and again, China has defied the skeptics who claimed its unique mixed model -- an ever-more market-driven economy dominated by an authoritarian Communist Party and behemoth state-owned enterprises -- could not possibly endure. Today, those voices are louder than ever. Michael Pettis, a professor at Peking University's Guanghua School of Management and one of the most persistent and well-regarded skeptics, predicted in March that China's economic growth rate "will average not much more than 3% annually over the rest of the decade." Barry Eichengreen, an economist at the University of California, Berkeley, warned last year that China is nearing a wall hit by many high-speed economies when growth slows or stops altogether -- the so-called "middle-income trap."
No question, China has many problems. Years of one-sided investment-driven growth have created obvious excesses and overcapacity. A weaker global economy since the 2008 financial crisis and rapidly rising labor cost at home have slowed China's vaunted export machine. Meanwhile, a massive housing bubble is slowly deflating, and the latest economic data is discouraging. Real growth in GDP slowed to an annualized rate of less than 7 percent in the first quarter of 2012, and April saw a sharp slowdown in industrial output, electricity production, bank lending, and property transactions. Is China's legendary economy in serious trouble?
Not just yet. The odds are that China will navigate these shoals and continue to grow at a fairly rapid pace of around 7 percent a year for the remainder of the decade, overtaking the United States to become the world's biggest economy around 2020. That's a lot slower than the historical average of 10 percent, but still solid. Considerably less certain, however, is whether China's secretive and corrupt Communist Party can make this growth equitable, inclusive, and fair. Rather than economic collapse, it's far more likely that a decade from now China will have a strong economy but a deeply flawed and unstable society.
China's economic model, for all its odd communist trappings, closely resembles the successful strategy for "catch-up growth" pioneered by Japan, South Korea, and Taiwan after World War II. The theory behind catch-up growth is that poor countries can achieve substantial convergence with rich-country income levels by simply copying and diffusing imported technology. In the 1950s and 1960s, for instance, Japan reverse-engineered products such as cars, watches, and cameras, enabling the emergence of global firms like Toyota, Nikon, and Sony. Achieving catch-up growth requires an export-focused industrial policy, intensive investment in enabling infrastructure and basic industry, and tight control over the financial system so that it supports infrastructure, basic industries, and exporters, instead of trying to maximize its own profits.
China's catch-up phase is far from over. It has mastered the production of basic industrial materials and consumer products, but its move into sophisticated machinery and high-tech products has only just begun. In 2010, China's per capita income was only 20 percent of the U.S. level. By most measures, China's economy today is comparable to Japan's in the late 1960s and South Korea's and Taiwan's around 1980. Each of those countries subsequently experienced another decade or two of rapid growth. Given the similarity of their economic systems, there is no obvious reason China should differ.
For catch-up countries, growth is mainly about resource mobilization, not resource efficiency, which is the name of the game for lower-growth rich countries. Historically, about two-thirds of China's annual real GDP growth has come from additions of capital and labor. Mainly this means moving workers out of traditional agriculture and into the modern labor force, and increasing the amount of capital inputs (like machinery and software) per worker. Less than a third of growth in China comes from greater efficiency in resource use.
In a rich country like the United States -- which already has abundant capital resources and employs all its workers in the modern sector -- the reverse is true. About two-thirds of growth comes from efficiency improvements and only one-third from additions to labor or capital. Conditioned by their own experience to believe that economic growth is mainly about efficiency, analysts from rich countries come to China, see widespread waste and inefficiency, and conclude that growth must be unsustainable. They miss the larger picture: The system's immense success in mobilizing capital and labor resources overwhelms marginal efficiency problems. 
All developing economies eventually reach the point where they have moved most of their workers into the modern sector and have installed roughly as much capital as they need. At that point, growth tends to slow sharply. In countries that fail to make the tricky transition from a mobilization to an efficiency focus (think Latin America), real growth in per capita GDP can virtually grind to a halt. Such countries also find themselves stuck with high levels of income inequality, which tends to rise during the resource mobilization period and fall during the efficiency phase. Some worry that China -- which for the last decade has had by far the highest capital spending boom in history -- is already on the edge of this precipice. But the data do not support this pessimistic view. First, much surplus agricultural labor remains. Just over one-third of China's labor force still works in agriculture; the other northeast Asian economies did not see their growth rates slow noticeably until the agricultural share of the workforce fell below 20 percent. It will take about a decade for China to reach this level.
And despite years of breakneck building, China's stock of fixed capital -- the total value of infrastructure, housing, and industrial plants -- is not all that large relative to either the economy or the population. Rich countries typically have a capital stock a bit more than three times their annual GDP. For China, the figure is about two and a half. And on a per capita basis, China has about as much fixed capital as Japan did in the late 1960s and less than a third of what the United States had as long ago as 1930. Further large-scale investments are still required. So China's economy can continue to grow in part based on capital spending, though a gradual transition to a consumer-led economy does need to begin soon.
One illustration of China's enduring capital deficit is housing. Scarred by the catastrophic U.S. housing bubble, many observers see an even scarier property bubble in China. Robert Z. Aliber, who literally wrote the book on financial manias, called China's housing boom "totally unsustainable" this January. And it's true: Since 2005, land and housing prices have rocketed, and the outskirts of many cities are dotted by blocks of vacant apartment buildings.
But China's housing situation differs dramatically from that of the United States. The U.S. bubble started with too much borrowing (mortgages issued at 95 percent or more of a house's supposed market value), which caused a rise in housing prices far beyond the well-established trend of the previous 40 years and sparked the construction of far more houses than there were families to buy them. In China, mortgage borrowing is modest; price appreciation was mainly a one-off growth spurt in an infant market, rather than a deviation from established trend; and there is a desperate shortage of decent housing.
Since 2000, the average house in China has been bought with around 60 percent cash down, according to research by my firm, GK Dragonomics, and the minimum legal down payment has been something in the range of 20 to 30 percent -- a far cry from the subprime excesses of the United States. House prices rose rapidly, but that's partly because they were artificially low before 2000, when state-owned enterprises allocated most of the housing and there was no private market. Much of the home-price appreciation of the last decade was simply a matter of the market catching up with underlying reality. And despite articles about "ghost cities" of empty apartment blocks, the bigger truth is that urban China has a housing shortage -- the opposite of what typically happens at the end of a bubble.
Nearly one-third of China's 225 million urban households live in a dwelling without its own kitchen or toilet. That's like the entire country of Indonesia living in factory dormitories, temporary shelters on construction sites, basement air-raid shelters, or shanties on city outskirts. Over the next two decades, if present trends continue, another 300 million people -- equivalent to nearly the entire population of the United States -- will move from the countryside to China's cities. To accommodate these new migrants, alleviate the present shortage, and replace dilapidated housing, China will need to build 10 million housing units a year every year from now to 2030. Actual average completions from 2000 to 2010 were just 7 million a year, so China still has a lot of building to do. The same goes for much basic infrastructure such as power plants, gas and water supplies, and air cargo facilities. 
Yet the housing market also illustrates China's true problem: not that growth is unsustainable, but that it is deeply unfair. The overall housing shortage coexists with an oversupply of luxury housing, built to cater to a new elite. Although most Chinese have benefited from economic growth, the top tier have benefited obscenely -- often simply because of their government or party connections, which enable them to profit immensely from land grabs, graft on construction projects, or insider access to lucrative stock market listings. A 2010 study by Chinese economist Wang Xiaolu found that the top 2 percent of households earned a staggering 35 percent of national urban income. A handful of giant state firms, secure in monopoly positions and flush with cheap loans from state banks, has almost unlimited access to moneymaking opportunities. The state-owned banks themselves earned a staggering $165 billion in 2011. Yet private firms, which produce almost all of China's productivity and employment gains, earn thin margins and suffer pervasive discrimination.
At the root lies a political system built on a principle of unfairness. The Communist Party ultimately controls the allocation of all resources; its officials are effectively immune to legal prosecution until they first undergo an opaque internal disciplinary process. Occasionally a high official is brought down on corruption charges, like former Chongqing party secretary Bo Xilai. But such cases reflect elite power struggles, not a determined effort to end corruption. In a few years' time, China will likely surpass the United States as the world's top economy. But until it solves its fairness problem, it will remain a second-rate society.