Amidst all that is happening in the Arab world (escalating violence in Syria, and nuclear brinkmanship by Iran) and the never-ending (epic) saga of the Greek sovereign debt crisis, comes the delayed EU-China summit in Beijing this week (February 14, 2012).

Held on Valentine’s Day, it was full of promises for mutual love, respect and accommodation from both sides.  Although the Chinese Premier promised to help resolve the EU debt crisis again (see: ‘Chinese Premier Wen Jiabao vows to help on Eurozone debt’ and ‘China to Get More Involved in Europe Rescue, Hold Euros’), no specific promises were made about contributing to the European bailout fund.

What the EU needs more than anything right now is a firewall to contain the spread of market-driven uncertainly over the viability of government debt in the Mediterranean member of the EU.  From Greece to Portugal, governments have run large public debts and are having a hard (to impossible) time securing financing of their debts from the private sector.

With this in mind, EU leaders created the European Financial Stability Facility (EFSF) in May of 2010 (and in the spring of 2011 its permanent successor, the European Stability Mechanism), with the objective of bailing-out Eurozone states in economic difficulty.

The EFSF is a special purpose vehicle financed by members of the Eurozone to address the European sovereign debt crisis.  The EFSF is authorized to borrow up to 440 billion euros, of which 250 billion euros remained available after the Irish and Portuguese bailout.  The more money available to the EFSF, the less likely it is that the sovereign debt crisis of Greece (and the other southern states) will spread to the core of the Eurozone.

EU leaders have been trying to shore up support for the EFSF, by reaching out to the IMF, the U.S., the oil producing states of the Persian Gulf, and other rich countries around the world.  Of all the nations out there, China has been wooed the most by European leaders to help fund the temporary EFSF, and its permanent successor, the European Stability Mechanism.  Considering the current political climate in the U.S. (election year, partisan gridlock) and the Middle East (Arab Spring, tensions in the Gulf), China, with the world’s largest foreign exchange reserve ($3.2tn, and growing) is uniquely positions among all others to help buttress the Eurozone and the Euro from collapsing under the weight of sovereign debt.

Yet, once again, both the Premier of China (Wen Jiabao) and the Governor of the Peoples Bank of China (Zhou Xiaochuan), promised to come to Europe’s rescue without making any specific promises.  What they both said, in many different ways, was that China stands-by the EU, its very important economic and political partner, but it will have to wait for the right time and the right opportunity to invest in Europe.  In particular, the press statement released after the talks listed 31 points of agreement covering a range of issues from cyber security to urban development, but made no mention of the Eurozone crisis.

China is indeed considering funding options for the EFSF and the ESM through the International Monetary Fund.  According to Mr. Zhou, China can channel its investments through the central bank or the China Investment Corp., which manage the country’s foreign-exchange reserves.  Another source of help could come from other government financial institutions, including China Development Bank and Export-Import Bank of China, or other private Chinese institutional investors.

However, throughout the years, China has always focuses on maintaining good bilateral trade relations with separate member states, rather than with the EU collectively.  Europe is China’s biggest trade partner, with trade worth a combined 560bn euros last year alone.  None-the-less, instead of providing tangible financial support to the Euro and underwriting the longevity of the EU (its main export destination), Beijing is looking for ‘investment’ opportunities in Europe that will yield the highest return.

This ‘opportunism’ from China is what causes countries around the world to be suspicious of Beijing’s intentions and fear any Chinese involvement into their economies.  The EU sovereign debt crisis represents the ultimate proof that China is not ready to lead, but also not ready to appreciate its place in the world we live in and help with safeguarding the global economy.

Rescuing the Eurozone as a destination for its exports and preserving the euro as a reserve currency is in China’s national interest.  It’s a small price to pay now, for economic growth and financial stability in Europe, both of which will prove immensely beneficial to China’s economy in the long run.  Yet, once again, Beijing is confirming what analysts have been suspecting all along: that Beijing does not truly understand how interconnected the global market is, and Chinese officials in Beijing cannot see beyond the boundaries of their ‘Middle Kingdom.’

China promises to come to Europe’s rescue one more time, but it’s more likely that they are buying time to see which way the wind blows, and how to maximize returns on their investments.

Sources:

China to Get More Involved in Europe Rescue, Hold Euros (Feb 15, 2012)

Chinese Premier Wen Jiabao vows to help on Eurozone debt (Feb 14, 2012)

China may invest more in EU debt fund (Feb 2, 2012)

China ‘considering’ Eurozone rescue pledge, Wen says (Feb 2, 2012)

Last year was the Year of the Rabbit for the Chinese – promising among other things good luck!  However, China which came out of the global financial crisis almost unscathed (or at least better off than most major world economies) hit one too many ‘speed-bumps’ in 2011.  Last year’s inflation is threatening a significant slow-down of the Chinese economy, and the housing market is in such collapse that it could lead to real civil unrest.

Overall, in 2011 China assumed a more assertive role on the global stage.  China’s new posture was reflected in an aggressive trade agenda, a push for a larger role in international institutions, and provocative moves in the South and East China Seas.  These actions were both a reflection and a consequence of China’s growing economic prominence and resource needs, as well as China’s view that the United States is in decline while China is ascendant.

China continued the backsliding from market reforms in favor of an increased role of the state in the economy.  China continues to subsidize its state-owned enterprises to the detriment of both private Chinese firms and international competitors.  Despite promises by President Hu Jintao and other Chinese officials to ease a policy of discriminating against foreign companies in government procurement decisions; however, real change remains elusive, particularly among the provincial and local governments.

Currency Liberalization

China continued its aggressive capital controls during 2011, a policy which pegs the renminbi (RMB) to the dollar, restricts the flow of foreign capital in the domestic market, and investing foreign reserves in U.S. Treasury bonds.

By the end of 2011, China’s foreign exchange reserves are projected to be over $3.2 trillion, up nearly one trillion from $2.4 trillion back in January of 2010.  China’s foreign exchange reserves are now roughly three times greater than that of Japan, which has the second-highest foreign exchange reserves in the world.  Roughly two-thirds of China’s foreign exchange reserves are generally thought to be denominated in U.S. dollars, although the exact makeup of the reserves is unknown, because the Chinese government considers it to be a state secret.

Somewhat better known is the volume of China’s foreign exchange reserves that are made up of U.S. Treasury securities.  As of July 2011, the official estimate by the U.S. Treasury Department

stood at $1.2 trillion, up slightly from the same period one year before.  The real amount is considerably higher, since the $1.2 trillion does not take into account any purchases made on the secondary market nor does it factor in purchases made by intermediaries or made through tax havens, such as the Cayman Islands.

On the positive side, the Chinese government allowed the RMB to rise by roughly 6% in nominal terms over the last year, from 6.641 RMB per dollar at the beginning of the year, to 6.30 RMB per dollar by the end of December 2011.  This is the second-fastest rate of appreciation since the Chinese government eliminated its hard peg to the dollar in 2005.

The 12^th Five-Year-Plan

In March 2011, China ratified its 12th Five-Year Plan (2011– 2015), a government-directed industrial policy that focuses on the development and expansion of seven ‘‘strategic emerging industries.’’  The central and local governments will likely continue to combine targeted investment with preferential tax and procurement policies to ensure that Chinese firms emerge as global leaders, or ‘‘national champions,’’ in these industries within the next five years.

One of the main objectives of the 12th Five-Year Plan is to redirect China’s economy to one more focused on domestic consumption and less on exports and investment.  The plan assumes that China’s growth would therefore be more balanced and sustainable.  The plan also emphasizes higher value-added production and increased government support for domestic high-tech industries.

Increasing household consumption, a major goal of the 12^th Five-Year Plan, and the subsequent emergence of a more assertive consumer class, may be in direct contradiction to the Chinese government’s policy of keeping economic power firmly in the hands of the state and may compromise lending to many vested interests, including SOEs and the export sector.

Analysts and foreign business leaders fear that the emphasis on industrial upgrading will lead to the introduction of new government subsidies, which in turn will disadvantage foreign competitors.

In particular, the government’s new growth model includes such goals as:

• Setting a GDP growth target of 7% (down from the current actual GDP growth rate of 10%).  To do that, the government will have to divert money away from construction and corporate subsidies, and instead use public funds to increase household incomes.
• Cutting import tariffs to reduce input-costs, while boosting consumer demand and reducing China’s reliance for growth on exports which generates trade surpluses and contributes to the global trade imbalance.
• Improving the income of farmers and migrant workers, who have benefited the least from China’s phenomenal economic growth, by increasing minimum wages.  In particular, provinces across China have announced a string of double-digit wage increases this year as part of the government desire to increase incomes among the rural regions and migrant workers in the cities.
• Increasing spending on healthcare and full nationwide social welfare insurance to reduce the need for “precautionary savings” and encourage more Chinese consumer spending.
• Raising the minimum threshold for personal income tax.  This could exempt hundreds of millions of people from having to pay taxes, and boost household spending.

The most important short-term priority for the government is to address increases in food price, which Beijing intends to do through price controls.  In order to control inflation, the government intends to keep using the tools and methods that it has been employing thus far: manage liquidity, use price controls, curb real-estate speculation, and “adjust and improve” property tax policies.  Furthermore, the budget for this year shows a 35% increase in spending on low-income housing.

(For more, read: China’s 12th Five-Year-Plan – Will It Help With the Global Trade Imbalance?)

Inflation

While China has taken an externally assertive posture, it faces many internal challenges. The Chinese Communist Party (CCP) relies on economic growth, combined with strict authoritarian rule, to maintain control over a factious and geographically vast nation.  Sharp increases in consumer prices, a pivotal factor in the early days of the student protests in Tiananmen Square in 1989, are once again a problem for the Chinese economy.

Inflation is the Achilles heal of the CCP; inflation is what precipitated the Tiananmen Square demonstrations back in 1989, is what fueled the Arab youth discontent for the status quo, and is what is caused by China’s undervalued currency and current account restrictions.  What was but a prospect of inflation in 2010, turned to a serious threat to the longevity of the Chinese economy in 2011, forcing the government to impose price controls to a number of goods.  The rise in property values during the year, led to fears of a bubble market, and a significant drop of values by the end of 2011.  In the middle of the year, inflation was as high as 6.5%; the second highest level in the past 10 years.

Property Bubble

Following a decade-long boom and nearly two years of attempts by the central government to cool the overheated sector, the housing market in China appears to have turned.  In order to cool the overheating residential-property market, the central government has restricted purchases of multiple homes, demanded larger down-payments and curtailed opportunities for speculators to “flip”, or quickly sell on, properties.  It has curbed developers’ access to bank lending and cut off credit from new trust companies.  It is also encouraging the use of property taxes like those introduced in Shanghai and Chongqing last year.

Taken together, these measures have certainly slowed down the market.  Price growth has been slowing since early 2010.  Analysts suggest that prices fell during December 2011 in 60 of the 100 cities it monitors.  Land prices are falling fast, too.

In 2010, property construction accounted for 13% of Chinas GDP, and for more than 25% of all investment in what is the most investment-dependent economy of the world.  Property directly accounts for 40% of Chinese steel use; the country itself produces more steel than the next 10 producing countries combined, making it by far the most important buyer of inputs such as iron ore.  Construction in China is also important for a host of other industries, from copper, cement and coal to power generation equipment.  Most analysts agree that the sector matters to an extraordinary degree for the overall Chinese growth, for commodity demand, household expenditures, external trade and underlying heavy industrial profitability.

According to government figures, which most analysts believe understate the reality, average housing prices more than doubled in the last four years nationwide, while in Beijing and some other regions the price increase was more like 150%.  Data are incomplete but analysts say the price of an average apartment in a Chinese city is now about 8-10 times the average annual income nationwide; in cities like Beijing and Shanghai the ratio is closer to 30 times.  Now, by some estimates, property prices might fall by as much as 25% in the near future, and by another similar amount in the following two to three years.

However, its impost to remember that before 1998 China did not have a residential real estate market to speak of.  In urban areas, all housing was built and allocated by the state through the ubiquitous “work unit”.  In the countryside, peasant farmers built their own homes on land allotted to them by the state or the collective.

The real estate market that now plays such an important part in China’s overall economy was born when the Communist party decided in the late 1990s to begin transferring ownership of the vast majority of housing to individuals.  It is easy to forget that the market is just over a decade old and, apart from a brief dip in the midst of the 2008 financial crisis when transactions dried up, most Chinese have only seen prices double every couple of years and never seen them fall.  Besides, China is a country where speculative bubbles have been a constant phenomenon since market-based reforms picked up pace in the 1980s.

(For more, read: China Property – A lofty ceiling reached)

WTO – 10 Year Anniversary

In December of 2011, China celebrated 10 years since its entry into the World Trade Organization (WTO).  Last year also marks the end of China’s probationary period, under the terms of its Accession Agreement to the WTO.  The probationary period required China to lower its tariffs to levels below those of many other developing countries.  But compared with most industrialized countries, China was allowed to impose considerably higher tariffs (on average around 25%, while U.S. tariffs are mostly under 5%) — tariffs China has retained even as its economy has subsequently grown to No. 2 in the world.

Practices such as forced technology transfer and the creation of joint venture companies as a condition to obtaining access to the Chinese market; the adoption of unique, Chinese-specific standards for high-tech equipment; and extensive intellectual property rights violations are among the faulty policies designed to help China achieve its economic and development goal, while blatantly violating the spirit and often the letter of WTO law.

In the ten years since China joined the World Trade Organization (WTO), China has maintained a steep growth trajectory, outpacing both Germany and Japan to become the second largest economy in the world. China’s gross domestic product (GDP) has grown from $1.32 trillion in 2001 to a projected $5.87 trillion in 2011 (an increase of more than 400%).  Concurrently, China has lifted 400 million of its citizens out of poverty and has experienced the largest rural-to-urban migration in history.

However, 2011 has been a particularly confrontation year in terms of trade disputes with the U.S., China’s most important trade partner.  The U.S. initiated consultations with the Chinese government on a number of cases (chicken products, subsidies, and internet restrictions), and China followed suite in the case of imports of U.S. cars.  Currently, three previous WTO cases involving U.S.-China trade are both open and active.  The Raw Materials case, which resulted in a decision favorable to the United States, is under appeal as of August 31, 2011.  The Flat-rolled Electrical Steel case and the Electronic Payments case have both advanced to formal dispute settlement, though no decision has been reached.

(For more, read: Sino-American Trade Relations – A heated exchange)

Soft Power – Climate Change

In December 2011, the World Climate Change Summit in Durban, South Africa, was considered a (at least very promising) success, thanks in part to the new found commitment of China to the cause.  More specifically, for the first time since the Kyoto agreement back in 1997, large emerging economic powers such as China, India and Brazil agreed to legal constraints on their emissions (unlike their previous resistance in 2007 and 2009, which clearly doomed past climate change efforts).

In the past, a familiar stalling point has been the refusal by emerging powerhouses such as China to agree to legal targets.  That has prompted others – most notably the US – to insist that they could not sign up to such pledges.  China, which in 2007 overtook the US to become the globe’s largest emitter, was one of the largest obstacles. However, China is still classed as a developing country under UN climate conventions and therefore not subject to legally binding constraints.

Having been blamed for wrecking the 2009 Copenhagen talks, Beijing went to Durban eager to promote its green credentials.  In a series of side events, its delegates boasted of China’s rising dominance of renewable energy markets and a five-year plan that for the first time includes plans for emissions trading and carbon intensity reduction targets.

There is still a lot of follow-up needed to make these new commitments real, but it seems that climate change (and the profitable side of this issue: development and marketing of green energy sources) is one area where China is willing to ‘play ball’ with the rest of the world and stretch its ‘soft power’ muscles.

(For more, read: Climate Change – The great regrouping)

Taiwan Strait

Despite the continuing improvement in economic and diplomatic relations across the Taiwan Strait, China deploys some 1,200 short-range ballistic missiles against the island.  In 2011 we saw the sale by the U.S. to Taiwan of a new $5.8 billion package of upgrades to its aging fleet of F–16 fighter jets.  In response to that, China indicated that it might suspend a series of military-to-military engagements.

However, as much as military build-up and confrontation across the Taiwan Strait will always define the China-Taiwan relationship, the upcoming Taiwanese Presidential election overshadowed developments at the end of last year.  China’s strategic planners are very alarmed by the uncertainty over the outcome of this month’s presidential election in Taiwan.

President Ma Ying-jeou, the Beijing government’s preferred candidate who has steered a path of warmer ties and direct economic links with the mainland, is suddenly in a tough race for reelection.  Ma’s chief opponent is Tsai Ing-wen, chairwoman of the Democratic Progressive Party, which officially backs the independence of Taiwan.  Tsai has raised the Beijing government’s ire for her refusal to publicly support an informal, unwritten, 20-year-old agreement between the two sides stipulating that there is just “one China.”

For months, the election was expected to hand an easy reelection victory to Ma, from the ­Kuomintang, or Nationalist Party, after he steered the island through the worst of the global recession and secured a new trade deal with China.  But the race became more unpredictable with the entry of a third candidate, James Soong, a former Nationalist Party stalwart who founded the People First Party.

For China, a victory by the DPP will be considered a setback to cross-strait relations, and could lead to an military escalation as China is preparing for its own leadership transition.

China in South-East Asia

To the consternation of its neighbors, China asserts its expansive territorial claims in the South and East China Seas.  China is increasingly capable of pursuing its own interests at the expense of regional, perhaps even global, stability.  David Gordon of the Eurasia Group recently argued that China has overplayed its hand in Asia, and its rapid growth and aggressive posturing (both economic and military) “is inadvertently driving Asian states to build closer economic and strategic ties with the U.S. and each other.”

Over the past 18 months China has taken a very aggressive tone towards territorial disputes in the South China Sea and elsewhere.  Mr. Gordon further argues that Beijing has miscalculated its ability to cater to nationalist feelings domestically without alarming its neighbors, and is now (inadvertently) driving Asian nations to build closer economic and strategic ties with the U.S. and each other.

The Chinese leadership is very concerned with developments with the Trans-Pacific Partnership, a U.S. led effort for freer trade among Pacific economies which the Chinese press often casts it as an aggressive U.S.-led ploy to squeeze China out of South East Asia.  During the fall, the U.S. formally accede to the East Asia Summit (the ASEAN+3 – just like China did back in 2005), a move that the other SE Asian nations welcome, as they hope that the U.S. could provide a counterweight to China in the region.

Last but not Least – Domestic Unrest

Every year, China experiences some kind of public unrest, be it because of food product contamination that was not handled properly by the authorities, or some natural disaster that was not remedies properly afterword’s, or some transportation accident that could have been averted.  Last year was no different.  However, what happened during the fall in a couple of rural places could have greater ramifications for this year.

In the Southern village of Wukan, protests began on 21–23 September 2011 after officials sold land to real estate developers without properly compensating the villagers.  Several hundred to several thousand people protested in front of and then attacked a Chinese Communist Party building, a police station and an industrial park.  Residents of Wukan had previously petitioned the national government in 2009 and 2010 over the land disputes.

In an apparent attempt to ease tensions, authorities allowed villagers to select 13 representatives to engage in negotiations.  Security agents abducted five of the representatives and took them into custody in early December.  The protests strengthened after one of the village representatives, Xue Jinbo, died in police custody in suspicious circumstances.  The villagers forced all Communist Party officials and police to flee the village, which came back with reinforcements and laid siege to the village, preventing food and goods from entering the village.

Eventually, the village representatives and provincial officials reached a peaceful agreement, satisfying the villager’s immediate requests.

During December, protests in the town of Haimen, of Guangdong province, which drew thousands of participants were ignited over plans to expand a coal-fired power plant in the town—a plan that residents opposed, arguing that existing coal-fired plants had caused environmental and health damage.  Demonstrations began on 20 December when thousands of residents barricaded a freeway and surrounded government offices in an attempt to block the project.

Riot police fired tear gas into the crowd and beat protesters with riot sticks.  Tensions cooled by 23 December, after Communist Party officials declared that the plant expansion plans would be temporarily suspended, and authorities agreed to release detained protesters.  Although the protests in Haimen were unrelated to demonstrations in nearby Wukan, Haimen residents told Reuters that they had followed developments in Wukan closely, regarding it as a good model of how citizens might negotiate with authorities.

This is not the beginning of China’s ‘Arab Spring’ moment.  China is a very large and very diverse country.  But when the people at the bottom of the ‘food chain’ can justify physical confrontation with the authority as the only viable way of ‘negotiating’ with the government, then everyone should be paying very close attention!

I wonder, what will the year of the Dragon bring…  more assertiveness by local people, or more resolve by the government in Beijing?

Last month Secretary of State Hillary Clinton proclaimed, in an article for the Foreign Policy Magazine, ‘America’s Pacific Century’! This week, President Obama will be laying the foundation through a series of multilateral meetings involving Pacific Rim countries. He will start with the Asia-Pacific Economic Cooperation (APEC) meeting in Hawaii (Nov 12th-13th), and continue at the Association of South-East Asian Nations (ASEAN) summit in Bali, Indonesia (Nov 17th-19th).

At the margins of both these world leader gatherings, President Obama will be pushing hard for the Trans-Pacific Partnership (TPP), a little-known but fairly liberal trade grouping which could put real pressure on China to finally change its mercantilist trade policies and undervalued currency.

Currently, the TPP includes only 4 small economies: Brunei, Chile, New Zealand and Singapore. During the past couple of years, Australia, Malaysia, Peru, Vietnam, and the U.S. have been negotiating entry into the group. Now Japan has also announced that it will participate in the negotiations to form what, at least in theory, has come to be perceived as the “gold standard” for trade agreements that would go further than any existing arrangement.

All these Asian summits officially present an excellent opportunity for President Obama to take his effort for economic growth and job creation internationally. Two-way trade between the U.S. and the 8 TPP nations totaled $171 billion in 2010, compared with $457 billion with China, $181 billion with Japan and $88 billion with South Korea, according to the U.S. Commerce Department. Overall, the APEC economies account for half of global output, and represent the main target of the president’s efforts to double U.S. exports in the near future.

Unofficially however, U.S. efforts within APEC and more specifically the nature and composition of the TPP are designed to confront China on its mercantilist trade policies – especially the manipulation of its currency.

MCT 2011. [Papua New Guinea Current account balance is in millions of $US].

What Is So Special About The TPP

According to Iwan Azis, head of the Asian Development Bank’s regional integration office (quoted in an interview by the FT), the agreement is intended to deal with what he calls “behind the border” issues. These include areas of what could be deemed domestic policy which go beyond the normal scope of trade agreements.

Currently, almost everything other then labor mobility is up for liberalization through the TPP, making it one of the most comprehensive free-trade treaties yet conceived. Beyond the ambitious goal of eliminate all tariffs over 10 years, the most significant areas that are currently negotiated include: government procurement, rules governing the conduct of state-owned enterprises, and intellectual property standards.

The TPP promises something truly groundbreaking: persuading Asian governments to accept new rules on the role of state-owned enterprises, the cornerstone of Asian-style capitalism. State-owned enterprises often benefit from cheap financing or government protection. China, in particular, is often criticized for seeking to ensure the success of national champions to the detriment of free trade and honest competition.

According to Bloomberg, Asian governments operate in many markets through state-owned companies with large bundles of cash reserves at their disposal. They exist both to make a profit and to build state power. Ten years ago, emerging countries added $100 billion a year combined to their reserves. In 2009, they took in $1.6 trillion. Sovereign wealth funds now control 12% of investment worldwide, according to the U.S. State Department. Sometimes, state-owned enterprises work in secrecy and without accountability to shareholders, independent boards and regulators. The lack of transparency puts U.S. companies at a disadvantage.

On the other hand, China undervalues its currency, by pegging the renminbi (RMB) to the dollar at an artificially low level. This, along with other subsidies and mercantilist trade policies, keeps Chinese exports cheap, and thus more attractive to consumers in the U.S. and Europe. Because China is the manufacturing hub for South-East Asia, where most assembling and export happens, China’s artificially undervalued currency is also impacting trade throughout the region.

As a result, other regional countries have pegged their currency to the RMB (Singapore, Taiwan, Malaysia, and of course Hong Kong) in order to compete with Chinese exports, but also to align their production pricing with China. More recently, Japan has been forced to intervene in the foreign currency markets 4 times during the past 14 months, in order to lower the value of the yen and thus facilitate greater exports for its manufacturing sector.

This is where the TPP can provide leverage for the U.S. The U.S. has not been able to convince China to change its trade and currency policies. Now it must try to put pressure on the other Pacific Rim countries to embrace the U.S. agenda. The timing could not be more opportune.

The U.S. Strategy So Far

Over the years, high on the list of U.S. international trade priorities has been getting commitments from China to enact more flexible currency rate standards to help balance trade; respect intellectual property rights; and limit the role of state-owned enterprises in the market. The TPP reads like the U.S. trade agenda with respect to China, now being formalized with some of the most important economies of the region.

So far, China has not been very responsive to U.S. demands for currency appreciation and more domestic (Chinese) consumption. In last year’s APEC meeting, President Obama directly pressed China over its massive exports aided by a cheap RMB, and urged countries with large trade surpluses (like China, Japan, and S. Korea) to shift away from their unhealthy dependence on exports and take steps to boost domestic demand. President Obama’s pleas fell on deaf ears (both then and now) as the Chinese leader insisted (as always) that China will make reforms at its own pace.

Unfortunately, singling out China as the worst offender (in mercantilist trade policies) has not worked so far as a strategy. On the other hand, the U.S. has greater leverage and a much different/better relationship with most of the other Asian member of APEC. Therefore, the U.S. should push the partnership to curb currency manipulation, Internet censorship, forced intellectual-property sharing and coerced joint ventures with state-owned companies. If the rest of Asia moves closer to the U.S. model, that could pressure China to do the same. Experts hope that creating a free-trade block of sufficient mass will put pressure on China to join and thus open and liberalize more of its economy. The idea is for the TPP to be a structure on to which other nations, including possibly South Korea, and eventually even China, could be eventually integrated.

Furthermore, China’s efforts to internationalize the RMB make it all that more pressing to confront them on their undervalued currency. (see, China’s Efforts to Internationalize its Currency) Although it is the most appropriate forum, doing this through APEC will not be easy. China has gotten very good at manipulating international organizations and getting what it wants out of them.

Although active at the technical level, China has not been helpful at the leader’s level with APEC’s efforts to achieve anything even remotely approaching regional free trade. While not wanting to be seen as obstructionist, China can nevertheless be expected to effectively exploit APEC’s inherent inability to act decisively in order to help ensure that the organization never fully achieves any meaningful trade reform. APEC will need strong leadership from the U.S. and President Obama to both address the trade distorting nature of China’s currency policy and strengthen regional free trade.

The ‘Elephant’ in Room – China

David Gordon of the Eurasia Group recently argued that China has overplayed its hand in Asia, and its rapid growth and aggressive posturing (both economic and military) “is inadvertently driving Asian states to build closer economic and strategic ties with the U.S. and each other.” Over the past 18 months China has taken a very an aggressive tone towards territorial disputes in the South China Sea and elsewhere. Mr. Gordon further argues that Beijing has miscalculated its ability to cater to nationalist feelings domestically without alarming its neighbors, and is now (inadvertently) driving Asian nations to build closer economic and strategic ties with the U.S. and each other.

And you know that the Chinese leadership is concerned when commentary in the Chinese press often casts the TPP as an aggressive U.S.-led ploy to squeeze China out of SE Asia. Of course this is exactly what China did back in 2005, with the China-ASEAN Free Trade Area. Covering more than 1.8 billion people, this FTA is the world’s largest in terms of population; and amounting to a combined $6 trillion in GDP, the third largest after the EU and NAFTA. The obvious advantage was that such an approach removed the US – and its oftentimes confrontational agenda – from the equation and it undermined U.S. economic linkages in the region. Now the U.S. is poised to formally accede to East Asia Summit (the ASEAN+3) next week, a move that the other SE Asian nations welcome, as they hope that the U.S. could provide a counterweight to China in the region.

Conclusion

Undersecretary of State Robert Hormats was recently quoted as saying: “There’s competition between the American economic model and the more state-centered economic model of China and other countries.” Many have been arguing for a serious debate on the damaging role of state capitalism on the global economy, and the ideological differences between the U.S./EU rule based global economy and SE Asia’s mercantilist trade practices.

Although there is a deeply pragmatic driving force behind the TPP, undoubtedly, it also has an element of seeking to wrest back global trade for nations perceived to play by the rules. The Obama administration might have finally found a trade strategy to deal with China’s undervalued currency and mercantilist economic policies.

Some Sources –

Trans-Pacific Trade Deal Could Revolutionize Commerce: View by the Editors of Bloomberg BuisnessWeek. (http://www.businessweek.com/news/2011-11-11/trans-pacific-trade-deal-could-revolutionize-commerce-view.html)

Trans-Pacific Partnership: Far-reaching agreement could form powerful new trade bloc, By David Pilling. (http://www.ft.com/intl/cms/s/0/47dd4d14-06cc-11e1-90de-00144feabdc0.html#axzz1dKBjz1mp)

America’s Pacific Century, By Hillary Clinton. (http://www.foreignpolicy.com/articles/2011/10/11/americas_pacific_century)

Obama heads to Asia focused on China’s power, by David Nakamura and William Wan. (http://www.washingtonpost.com/world/obama-heads-to-asia-with-sharp-focus-on-chinas-growing-power/2011/11/10/gIQAOsQkBN_story.html)

A trade opportunity Washington shouldn’t pass up, by David Gordon. (http://www.washingtonpost.com/opinions/a-trade-opportunity-washington-shouldnt-pass-up/2011/11/10/gIQA1K3t9M_story.html)

Global economic developments this year, along with the impact of safe-haven investment flows have led to the appreciation of the dollar in global markets, contributed to the high level of unemployment in the U.S. and increased the chances for a double-dip recession in America.  All these developments have further highlighted the international tensions over exchange rates, with the value of the Chinese renminbi (RMB) and U.S.-China bilateral trade taking center stage this fall.

In the U.S., the unfortunate economic development of the past decade has been the explosion of the trade deficit.  Returning the U.S. economy to economic health would be much easier if the country was not spending $500 billion more (then exports) each year on imported goods and services.  To bring the U.S. trade deficit down, American products need to become more competitive internationally, which in practice means that the value of the dollar must fall in terms of other currencies.  This notion that a weaker currency leads to a stronger economy is of course a strategy employed by many other governments, most notably China.

Fall Developments by the Administration –

This fall we saw a number of moves by both the U.S. executive and the legislative branch to pressure China to change its mercantilist trade policy and artificially undervalued currency.

On September 20, the U.S. Trade Representative Ron Kirk announced that the U.S. has filed a case against China before the World Trade Organization (WTO) to protect up to 300,000 American agricultural jobs that are being threatened by China’s imposition of duties on imports of American chicken products.

On October 6, Ambassador Kirk announced that the U.S. was submitting information to the WTO, identifying nearly 200 subsidy programs that China has failed to notify as required (and 50 subsidy programs by India) under WTO rules.  Through this action at the WTO, the U.S. is seeking the prompt provision of detailed information and data from China, in order to ascertain whether Beijing is violating its WTO obligations.  China is required to provide information on domestic subsidies programs every year, something that it has done only once since joining the WTO ten years ago.

On October 19, Ambassador Kirk announced that the U.S. is seeking detailed information (under WTO consultation provisions) on the trade impact of Chinese policies that may block U.S. companies’ websites in China, creating commercial barriers that especially hurt America’s small business.  What is of concern to the U.S. government is that businesses based outside of China face challenges when offering services to Chinese consumers when their websites are blocked by China’s national firewall.

Next month (end of November) signatories of the Government Procurement Agreement (GPA) are hoping to finally receive China’s long-awaited revised offer for accession to the GPA.  This would address a major demand by the U.S. and other GPA parties, who had criticized China’s initial offer in 2007 and a revised one in July 2010 for being not only incomplete (only covering central government procurement, and not also including sub-central entities such as provincial and local authorities), but also being grossly overdue (China promised to join the GPA as part of its WTO accession – some 10 years ago).

The Senate Currency Bill –

Meanwhile, the U.S. Senate approved S. 1619 on October 11 by a bipartisan 63-35 margin.  This currency legislation will make it harder for the U.S. executive branch to avoid taking action to counteract the trade effects of undervalued currencies such as the Chinese RMB.  In particular, the Senate bill will remove the question of ‘intent’ from Treasury’s bi-annual analysis of the exchange rate policies of major trading partners, and trigger retaliatory tariffs if the Treasury finds any country’s currency to be ‘misaligned.’

The legislation also instructs the Commerce Department that it cannot dismiss allegations that undervalued currency serves as an export subsidy in trade remedy cases simply because the benefits of currency undervaluation don’t extend only to exporters.  Currently, the Commerce Department considers countervailing duties when a country targets a specific industry or product, such as steel or shrimp or bedroom furniture.  The bill will require the Commerce Department to use estimates of currency undervaluation when calculating ‘countervailing duties,’ imposed against imports deemed to be state-subsidized (effectively treating the undervalued RMB as a subsidy offered by the Chinese government).

Therefore, the Senate bill will make it more difficult for the Commerce and Treasury departments to ignore currency manipulations and sidestep retaliatory measures against countries like China.

The Devil of the Details –

This is clearly a significant push by both branches of the U.S. government to force China to be more accountable with its trade policy.  Unfortunately, the acts are rather symbolic and the impact will be fairly small!

First, WTO cases take forever (at least 3 years), and China has learned how to ‘litigate’ at the WTO.  Although the Obama Administration has been much more active in the WTO then the Bush Administration, the precedent in which China drags its feet and even brings counter-cases (see China’s request for the establishment of WTO panel on the use of zeroing in U.S. trade remedy cases) has been set.

Second, the currency bill will only be significant on subsidies cases, and considering that trade remedies cases cover less than 4% of all U.S. imports it’s hard to see how it will have a major impact on Chinese exports (see past article by this author).  Also, many trade policy experts believe that the currency bill is vulnerable to a WTO challenge, because a benefit offered by the government to all domestic producers (like an undervalued currency) is not quite a subsidy under the WTO Subsidies Agreement.  Finally, the Senate bill will have to be approved by the House and signed by the President as well, both of which right now are looking very uncertain.

Third, according to many analysts, the appreciation of the RMB will not change the current U.S.-China trade imbalance.  This is because many items made in China are usually just assembled in China.  Although China exports a number of indigenous low value-added products, the majority of high-tech goods coming out of China are usually designed and developed in Japan, South Korea and Taiwan, and are only assembled in China.  Also, if Chinese exports become less competitive, jobs are more likely to move to other low-wage countries of south-east Asia and less likely to move to the U.S.

However, the U.S. is not alone in its frustration with China.  According to Steven Mufson of the Washington Post, Brazil has taken a variety of measures to combat imports from China.  Brazil changed government procurement rules to favor locally made products.  It boosted by 30% a tax on imported cars, which have been gaining market share.  It revived an old law restricting the amount of farmland that foreigners can purchase.  And, Brazil recently suggested that WTO laws be changed to permit tariffs to be imposed against imports from countries with undervalued exchange rates.

Changes in China’s Domestic Economy –

China’s currency has been rising in value, and along with inflation in China it is putting an extra burden on Chinese manufactures and the Chinese economy.  Growing wages and a demand for more cheap labor mean that China is no longer the world’s top cheap producers.  Inflation is a real problem within the Chinese economy, rising to at least 6.5% this year.  Along with 7% appreciation of the RMB since June of 2010, doing business in China is almost 14% more expensive than a year ago, and consequently so are exports to the rest of the world.

Therefore, according to an article by Keith Richburg of the Washington Post, China’s trade surplus is now less than 3% of the country’s gross domestic product, down from 11% in 2007.  China has actually cut its trade surplus relative to the size of its economy, although this could be due to the global recession.

Finally, according to the Peterson Institute for International Economics, it is currently costing the Chinese central bank about $240 billion per year to hold down the value of the Chinese currency relative to other currencies, and this cost is growing rapidly.  To put this cost in perspective, $240 billion is considerably larger than China’s trade surplus of $183 billion in 2010.  Based on calculations by the Peterson Institute, the cost is about 4% of China’s GDP in 2010.  Moreover, this cost does not include the implicit tax on the banking system associated with China’s reserve holdings which are passed on to Chinese households in the form of depressed rates of interest on savings deposits.

The Bigger Picture –

Robert Samuelson of the Washington Post reported recently that what’s at stake is not just the U.S. trade balance with China but the nature of the global trading system, according to a recent book by economist Arvind Subramanian of the Peterson Institute (“Eclipse: Living in the Shadow of China’s Economic Dominance”).  Since World War II, the United States has presided over an open, non-discriminatory global trading system, which has been a big success.  However, that has only served the needs of the U.S., with its comparative advantage over the rest of the world in capital, technological innovation, and the largest protected domestic market.

According to Mr. Subramanian, China might supplant this system with one focused on its needs.  It might pursue preferential access to needed raw materials (oil, grains, minerals); it might discriminate in favor of its friends and against adversaries; it might subsidize its exports and seek protected markets for them.  It already does all these things — and as its power grows, it may do more.  Just as the U.S. enjoyed the economic benefits that come with having the world’s reserve currency, now China is using its undervalued currency to shape the world economic system to serve its needs.  (see also: China’s Efforts to Internationalize its Currency)

In Conclusion –

The two ways out of the current U.S.-China trade/currency war could not be more divergent.  On the one hand, many experts (including this author) have proposed an across the board 25% to 40% tariff on all imports from China.  This indiscriminate measure could put real pressure on China to dramatically change its currency policy, and shift its economic growth model from export led growth to domestic consumption.  On the other hand, Yao Yang of the Center for Economic Research at Peking University advocates for a Free Trade Agreement between the U.S. and China, arguing that it could be better for both sides than currency revaluation.  Chinese tariffs for imports of consumer goods are fairly high (thus making up only 3% of China’s $1.4 billion imports last year), and an FTA between the U.S. and China could only benefit U.S. exports of consumer goods to China.

Unfortunately, once again, incrementalism trumped substance… Currency issues (from manipulation, to exchange, to sustainability) are vitally important to the global market and economic growth around the world.  They should be the main focus of America’s trade policy, to be considered in a grand debate of how to fix the global economy.  Instead, America’s politicians are stuck in the mock, deliberating on minutia that promises ‘revenge’ but fails to address the bigger issues!

It is a well know fact that China undervalues its currency, by pegging the renminbi (RMB) to the dollar at an artificially low level.  This, along with other subsidies and mercantilist trade policies, keeps Chinese exports cheap, and thus more attractive to consumers in the U.S. and Europe.  Because China is the manufacturing hub for South-East Asia, where most assembling and export happens, China’s artificially undervalued currency is also impacting trade throughout the region.  As a result, other countries in the region have pegged their currency to the RMB (Singapore, Taiwan, Malaysia, and of course Hong Kong) in order to compete with Chinese exports, but also to align their production pricing with China.

Furthermore, China and most of the other regional economies (in particular Japan, S. Korea, and Taiwan) pursue aggressively export-led growth strategies, relying on growth through exports and not through domestic consumption.  The combination of Chinas currency policy and the regional growth strategy has significantly contributed to the global trade imbalance, where the U.S. and the EU do most of the consuming while South-East Asia does most of the producing/exporting!

The U.S. and the EU have repeatedly tried to put pressure on China to let the RMB appreciate, or at least trade freely.  So far, China has not been very responsive to any demands for currency appreciation or a meaningful increase in domestic (Chinese) consumption.  On the contrary, instead of letting the RMB float freely, Beijing is actively pursuing the ‘internationalization’ of its currency.

Many Chinese leaders and experts seem to believe that one of the major causes of the global financial crisis was the deregulation of the international monetary system and the dominance of the dollar since the Bretton Woods agreement.  Therefore, if the international economic environment is to be stabilized, the international monetary system needs to be reformed and the power of the U.S. dollar must be reduced.  Beijing is hoping to achieve this by advancing the goal of a supranational reserve currency (IMF’s Special Drawing Right’s), and by promoting the internationalization of the RMB.  This strategy has come to clearer focus recently, on both fronts.

Multilateral Internationalization through the IMF –

China has been pushing for some time for further integration of the RMB into the basket of currencies that fix the value of the IMF’s Special Drawing Rights (SDR’s) – a ‘paper gold’ created by the IMF back in the 1960’s that could replace the U.S. dollar as a reserve currency if the dollar should ever fail.  Every five years the nature and relative weighting of the component currencies that make up the SDR is revised.  The next revision is due in 2015, and Beijing intends to demand that its currency be included in the basket of currencies.

However, under IMF rules and regulations, including the RMB in the SDR basket is technically inappropriate.  The RMB does not meet the two criteria for including a currency in the SDR basket.  The RMB is not a ‘traded currency’, meaning it is not a currency that is being used for international trade, and it is not a ‘freely usable currency’ that is available on the exchange markets.  To overcome these obstacles, Beijing is reaching out to individual countries and making bilateral deals.

Bilateral Internationalization through Offshore Centers –

Recently, Beijing has been accelerating efforts to push the RMB deeper into world markets by allowing for the establishment of offshore trading center besides Hong Kong.  China’s central bank is moving ahead with new rules that make it easier to bring RMB funds raised offshore back onto the Chinese mainland, in an effort to create a new financial ecosystem with the RMB at its center.

Currently, Chinese officials have to approve bringing any sizeable amount of currency (foreign or domestic) into the country.  This has been Beijing’s policy ever since the Asian Financial Crisis of 1997, to closely manage the exchange rate and prevent speculation on the RMB.  The new rules make it easier and more attractive for global companies to access cheap funding in Hong Kong’s RMB-bond markets and then use that money to boost their Chinese business.

Now Beijing is expanding the use of the RMB in other financial centers, to allow for foreign holdings of the currency to be used for direct investment in China.  According to Arvin Subramanian of the Financial Times, “the process is micro-managed, interventionist, and enclave-based – not a day seems to pass without some foreign entity, or country being granted greater but selective access to the renminbi.”  Last week, the Financial Times reported that “China is for the first time to give formal backing to moves by British banks to turn the City of London into an offshore trading center for the renminbi.”  Furthermore, the Economist reports that “in Singapore, banks now offer yuan deposits and bond funds.  Its central bank is one of a dozen that have agreements with the Peoples Bank of China to swap their currencies for yuan.”

The RMB as a Reserve Currency –

Another step in internationalizing the RMB is by allowing more central banks to hold RMB as part of their reserves.  Central banks around the world are making plans to start buying RMB now that China is allowing the limited conversion of its currency for investment.  According to Bloomberg, Nigeria’s government will shift 10% of its $35 billion of foreign-exchange reserves in the RMB, and the central bank is hoping to establish the same kind of swap-line like Singapore.  The Bank of Thailand was approved by China to invest 7 billion RMB in the onshore interbank bond market.  A couple of years ago, the Peoples Bank of China signed a bilateral currency swap agreement worth 70 billion RMB with the Argentine Central Bank, and similar deals are under negotiation with Brazil, Russia, and many African banks.

Finally, in terms of trade, this gradual relaxation by Beijing of the rules on the use of the RMB in international transactions means that 7% of China’s external trade is now settled in their national currency (up from 1%, 12 months ago).  The RMB is already widely welcome in ASEAN countries and has been regarded as a hard currency there.  All this international recognition and legitimacy while Beijing is still maintaining a peg on the dollar and is enforcing strong capital controls domestically.

Understanding China’s Currency Manipulation and Capital Controls –

To appreciate China’s obsession with an undervalued currency and strict capital controls, one must first understand the implications of these policies.  When a Chinese company sells to the U.S. or any other foreign consumer, it gets paid in dollars (and other foreign currencies).  The regime in Beijing does not want all these dollars in circulation, because of fears of inflation.  Therefore, the Peoples Bank of China exchanges dollars and other foreign currencies for RMB before they can go into circulation in China.  Then, in a process designed to fight the inflation in China that otherwise would occur from so much RMB being added to the economy, the central bank issues RMB-denominated bonds.

Without the dollar purchases by the central bank, the supply of dollars in circulation in China would rise rapidly and quickly lose value relative to the RMB.  In a standard macroeconomic model, exchange rate intervention should also lead to monetary expansion, which in turn drives up domestic prices, nullifying the real effect of intervention.  China’s financial system, however, is owned and managed by the government.  Capital controls are in place for most domestic capital flows (and all large FDI has to be approved by the government).  Capital controls and bank lending policies are governed by decree, so that the government can force banks to buy trillions of low-yielding RMB bonds or alter their reserve ratios.  Deposit and lending rates are also set by the government.  This has allowed China to intervene in the foreign exchange market while retaining total control over domestic monetary aggregates.

Although this policy has worked well for both China and the United States (export growth for China and cheap imports and public debt financing for the United States), the unintended consequence of sustained currency intervention was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China and the State Agency for Foreign Exchange (SAFE).  At 2000 China had currency reserves of $165 billion, slightly above 10 per cent of GDP.  By the end of 2010 currency reserves had reached $2.84 trillion, equivalent to almost 50% of China’s 2010 GDP.

In the depressed conditions caused by the financial crisis, China’s dollar peg poses a major threat to the Chinese economy.  The inflows of hot money is straining the capital controls system to breaking point, the RMB-dollar peg is now contributing to a dangerous overheating of China’s economy, with inflation reaching a three year high of 6.5%.  However, since June 2010, the RMB has appreciated only 6.5% (from 6.83 to 6.38 RMB/dollar).

Inflation is the number one concern of the regime in Beijing, fearing that the only thing that could turn people against them is high prices and luck of jobs.  The recent events of the Arab Spring, where inflation and a spike in food prices played a significant role in the peoples uprising, have further focuses Beijing’s attention on inflation.  If the Chinese leadership was ones concerned about the effect of inflation on the peoples mood, after seeing the role that inflation and unemployment played in the Arab Sprig they are now ten times concerned!

Conclusion –

The Chinese government pegs the RMB to the dollar so the powerful and wealthy export sector can continue selling in Europe and America (and thus employment stays high).  The government also maintains strict capital controls in order to prevent inflation from hurting the vast lower and middle class.  China’s currency has become a modern-day opium, and the authorities have been searching for a way out of their current economic model which relies on growth from an undervalued currency and capital controls.  Internationalizing the RMB offers one such exit.

Eventually, wider use of the RMB outside China could redefine the balance of power in global currency markets, as the rest of the world begins trading more RMB-based assets and settling its bills with China in RMB instead of the U.S. dollar.  Beijing gets to keep its currency system, while gaining economic leverage and diplomatic legitimacy around the world.

A lot has been said by the major Western news sources (WSJ, Bloomberg, FT, NY Times) about China’s reaction to the downgrade of the U.S. creditworthiness.  Although there has been no official comment from Beijing since the downgrade, the Xinhua news agency (the official mouth-piece and the usual government ‘attack dog’ for criticizing the U.S.) came up with a very harsh commentary over the weekend.  (See: After historic downgrade, U.S. must address its chronic debt problems)  Western reaction to China’s reaction has been just as critical, and with a good reason.

To quote the WSJ: “The official Xinhua news agency’s Saturday editorial was a hilarious moral lecture, suggesting that an addicted America’s ability to print dollars should be put under “international supervision.” But if borrowing is really an addiction that has sapped America’s self-discipline, China is both the pusher and a user.”

No one can dispute that the U.S. (government and people) needs to curb its spending addiction, save more, invest at home, and pay down its debt.  But China’s export led growth, capital controls, and fixed (at an undervalued level) currency have been feeding the U.S. addiction, and are a major cause of our current global financial crisis!

China’s Exposure to U.S. Debt -

To be fair, the downgrade is particularly painful to China since it is the largest holder of Treasuries.  As Patrick Frost demonstrated with his recent post, China holds officially $1.1 trillion in U.S.-government debt instruments, which comes up to $2 trillion if you include nongovernmental securities and Chinese purchases through other jurisdictions.

For many years the government in Beijing has been bragging about its sound stewardship of the Chinese economy and the profitable investment of the people’s hard-earned dollars in U.S. Treasury’s.  Now, China’s portfolio seams over-exposed, and many domestic critics are chastising the government for its careless handling of the profits earned by the ‘blood and sweat’ of the Chinese workers.  (If the Americans are irresponsible, then why did you lend them your money?)

Indeed, the reason why Beijing has purchased so mach U.S. debt is not benign.  It’s the result of China’s policy to encourage exports by holding down the value of its currency, the yuan.  Beijing does this by buying dollars from exporters in exchange for yuan, and using those dollars to buy U.S. Treasury’s. More accurately, the Peoples Bank of China requires the exchange of dollars in the Chinese market (earned by exporters) with yuan, which the government borrows from the Chinese people through the issuing in its own bonds.

To quote the same WSJ article: “The U.S. dollar assets and yuan liabilities are roughly balanced on the central bank’s balance sheet. If the U.S. government is addicted to debt, so is China’s.”

China’s Contribution to Global Financial Crisis –

China’s need to subsidize its exports has already reached dangerous levels for the global economy during this past decade.  If Beijing did not apply strict capital controls, and allowed the yuan to appreciate, then its growth during the past decade would have led to higher real wages, which would have led to a certain level of natural inflation (a rise in all prices), and thus increase in the cost of exports.  China would have moved away from the production of low-cost goods, its citizens would have consumed more, and the economy would have transitioned to production and export of higher-end goods.

Instead, China’s continuing production and export of cheap goods, coupled with its purchases of U.S. Treasury’s have helped to keep U.S. interest rates low for years, facilitated the continuing consumption in America, and also contributed to the housing bubble that eventually tanked the global economy.  We live in such an interconnected world, where it is impossible to consider any major economic policy by a major global economy (like China or the U.S.) that is not impacting the whole world.

The Need for a Rebalancing -

The leadership in Beijing needs to remember that ‘a crisis can also be an opportunity.’!  Inflation is on the rise in China (although reports are predicting a leveling in the coming months), which is putting pressure on the yuan.  Although the government has allowed the currency to appreciate during the past 12 months, reaching its strongest position since 1993, more needs to be done.  Although the yuan has appreciated by 6% against the dollar, it has actually depreciated against most of the other major currencies during the same period.

If the U.S. needs a balanced approach to reducing its national debt (cutting spending and increasing revenues), then China needs to rebalance its economy away from just exports of labor intensive goods and more towards the a consumption and innovation based economy!

If the Peoples Bank of China stopped buying U.S. Treasury’s and other dollar assets, the result would be an immediate increase in the value of the yuan.  A more valuable yuan would put more money in the pockets of consumers by making imported goods cheaper in local currency terms.  This will improve consumption, which has steadily fallen as a percentage of economic growth.  However, this cannot happen as long as the authorities are reluctant to dismantle capital controls.  The government imposed capital controls ensure that Chinese savings remain in the domestic banking system, offering a cheap and abundant source of funding for investments.

And What about Europe?

Ultimately, Mr. Samuelson’s question should be answered to the affirmative: “Would China contemplate bailing out Europe?”  Only the reason for doing so will be self-preservation, and not some Machiavellian geopolitical maneuver.

In the short term, if China cannot stop its export led growth, and buying U.S. debt is deemed too risky, then diversifying to the ‘less risky’ European or Japanese debt might be an alternative.  In the longer term, China should stop buying any foreign debt, makes the yuan convertible, and liberalize the financial system to integrate it into the world economy.

If either of these options sounds unpalatable for China’s Government, it’s because they are.  Beijing must recognize that it has a vested interested in the long term health and longevity of the Euro (as an alternative reserve currency) and the European market (as an alternative destination for Chinese exports).  Gradual appreciation of the yuan, and gradual relaxing of capital controls, coupled with a  gradual diversification of foreign exchange reserves (from dollars to euros) and a gradual decoupling from the U.S. export market should be China’s short-term and long-term strategy.

Otherwise, it’s stuck with Uncle Sam, who seems to like his ‘Tea Parties’, ‘Made in America’, and ‘China-bashing’ these days.

More on China and the EU to follow…

For all the talk about economic stagnation (U.S.), public debt (EU), food and resource allocation (China), or democratic deficits (Arab Spring), it will ultimately be global trade which will facilitate the much needed economic growth, increase government revenues, and alleviate food shortages around the world.  In particular, it will be up to China and the U.S., the two largest economies in the world and top importer-exporters to keep the global economy going.  When Niall Ferguson and Moritz Schularick coined the phrase ‘Chimerica’, they were describing the symbiotic relationship between the U.S. and China and the dangers to the global economy if tensions between the two nations escalated to a currency war.  Now, this Chimerica could be the driving force behind the global economic recovery!

Next year (2012) will be a significant year politically, for both China and the U.S.  For China, barring any unexpected developments, Xi Jinping and Li Keqiang will assume the leadership of the country the party and the government next year.  Such transitions are usually followed by a period of internal and external tensions, as the new leadership is emerging under the shadow of the previous generation and is trying to assert itself both domestically and internationally.  The underlying question therefore is ‘will the domestic and foreign policies of Xi and Li differ from current policies’?

On the other side of the Pacific, the U.S. will be holding presidential election in 2012.  Barack Obama, who inherited the housing bubble which caused the global economic recession, not to mention two wars, the Arab Spring, and two environmental disasters, has not done a good job of either appreciating the importance of the U.S.-China symbiotic relationship or managing the impact of Chimerica on the global economy.  He spend his first two years pushing through Congress a stimulus plan and an expansive healthcare law, only to see the nation turn against his policies and elect a Congress bent on reversing his domestic policies and drastically reduce the size of the U.S. government.

Reversing the global economic recession and tackling political unrest around the world will require enhanced cooperation between the U.S. and China, and visionary leaders at the helm.  But most importantly, a U.S. president who would know how to handle the new Chinese leaders and would truly appreciate the dangers and opportunities present in this symbiotic relationship.  President Obama has not demonstrated that he is that man, while Jon Huntsman, former U.S. ambassador to China and possible presidential candidate for the Republican Party, could just be the perfect man for the job.

Starting in 2012, the U.S. government will have to embark on an aggressive and persistent cooperation with and courting of the new Chinese leadership in Beijing.  Leadership at a global stage will still be the U.S.’s responsibility, as developing China will always put its national interests above those of the global good.  In climate change, nuclear proliferation, North Korea and Iran, the Arab Spring, global trade, the European debt crisis and the (very important) survival of the Euro, and now Pakistan, the U.S. will need China’s support, acquiescence and participation in any global or regional efforts to address these issues.

Starting in 2012, the U.S. president will have to be without a doubt, a China expert!  The U.S. president will not only have to understand domestic developments in China (see: Socialism 3.0 in China) but also address domestic U.S. concerns about China (see: GOP sees red over China).  The next U.S. president will have to know how China truly works in order to convince Beijing to adopt more carbon reducing policies, expand domestic consumption, appreciate the RMB, better protect foreign intellectual property, and expand civil and political freedoms.  Conversely, the next U.S. president will have to change American attitudes towards China (a plurality considers China the greatest international threat to the U.S.), impose discipline to the federal budget, reduce the national debt, and re-engage the global community with respect to some of our most pressing global problems.

Cultural, linguistic, and political differences can stand in the way of turning an often tense U.S.-China relationship to the true engine of both economic growth and global cooperation.  Jon Huntsman, with his intimate knowledge of China’s cultural and political idiosyncrasies, would be the best man to lead Chimerica for the next decade.

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On to the Other China, Taiwan – Current Taiwanese President, Ma Ying-Jeou (Mă Yīngjiŭ: 马英九) of the Guomingdang (KMT, Koumingtang: 中国国民党革命委 员会) will be facing re-election on January 14, 2012, and it already looks to be an uphill battle for the Incumbent as his popularity continues to slide.  Ma is seen by some on the island (and maybe many more in the West) as being a practical politician who is trying to balance Taiwan’s interests with those of China,  while trying to avoid military conflict.  Others on the island see Ma as a pro-China sellout whose policies are making Taiwan increasingly dependent on China economically, at a time when China continues to isolate Taiwan internationally.  It is probably safe to say that many on the island do not quite know what to make of Ma, but are not yet convinced of a viable alternative.

Taiwanese President Ma Ying-jeou – credit Digital Politics

Since Ma took office in 2008, the Mainland China and Taiwan have indeed moved toward unprecedented closer economic integration.  They have begun direct flights and shipping links, and tourism of mainlanders to Taiwan.  In fact the number of Chinese tourist to Taiwan has jumped to 1.6 million last year, a 40% increase from the previous year, which in turn has brought millions of dollars in revenue to the tourist and retail industry.  Exports have also increased over 14% since the previous year, to the tune of US$20 billion with more gains expected.  For his part, Ma also wants Taiwanese firms to operate on the Mainland under a stronger bilateral agreement on investment and property rights protections. Further, the Ma administration is negotiating the ability of Taiwanese firms to sell financial products in China, Taiwanese professional credential recognition on the Mainland, and investment restrictions lifted on the entertainment industry.  The main problem for Ma is all of this will take years to implement, so he has little to show in way of substantive benefit to Taiwan, but for the Economic Cooperation Framework Agreement with he Mainland (ECFA: 两岸经济合作框架协议).

The landmark agreement is not helping Ma in Taiwan as much as some Western critics tend to think.  Ma’s Taiwanese critics contend that the economic data he flaunts as proof of the  ECFAs success are not coming from Taiwan’s Ministry of Economic Affairs (MOEA), but China, therefore they are bias.  Further, they argue that Ma’s policies do nothing but to further hollow-out the island’s industrial base, which only benefit the wealthy while taking Taiwan from a industrial economy to a service economy which is ever increasingly dependent on the Mainland.  At the same time, Taiwan, due to Beijing’s objections, is unable to make independent trade deals with many of its neighbors (such as the ASEAN states), due to China’s diplomatic objections, which it uses as blackmail for “good behavior”.  In fact, opponents point to Tung Chen-yuan, a professor at Taipei’s National Chengchi University’s Graduate Institute of Development Studies, who claims that the ECFA has not been responsible for an increase in exports to China, because no increases occured:

“In January 2010, after the free-trade area between China and ASEAN took effect, China accounted for 32.3 percent of Taiwan’s exports. After the ECFA took effect in 2011, China only accounted for 29.3 percent of Taiwan’s exports.”

SNIP

He finds that China’s proportion of Taiwan’s imports saw a marked increase from 13.9 percent last year to 15.9 percent this year.

It seems many other Taiwanese are not buying what Mr. Ma is trying to sell:

While 47.3 percent of the public think cross-strait exchanges over the past three years have not negatively impacted Taiwan’s sovereignty, 40 percent believe that there has been a severe erosion of sovereignty following the cross-strait exchanges initiated by President Ma Ying-jeou’s (馬英九) administration since 2008, according to a survey released by the Taiwan Brain Trust yesterday.

The article above cites Ma’s approval rating somewhere between a modest 40.2-32.9% .  Ma already knee deep into the ECFA has no choice but to “double down” and make the ECFA the centerpiece of his re-election campaign.

In his defense, Ma supports believe the downward trend in Taiwan’s industrial base, the growing wealth gap, souring real-estate prices, and capital investment flight has nothing to do with ECFA, but is a pre-existing trend that many industrialized nations are undergoing.  So any claims that Taiwan is suffering due to ECFA are premature at best.

In an effort to show some results ahead of the election, Ma sought to speed things along on May 6 of this year with a meeting in the southwestern Chinese city of Chengdu.  The forum focused on how to deepen trade and economic cooperation. More than 400, industrial and business, leaders from both sides of the Strait discussed increasing the number of direct flights and allowing Chinese tourists to visit Taiwan without having to join tour groups.  The island is also searching for ways to jointly develop key industries with China, such as biotech and tourism.

Ma will stand against Taiwan’s first female candidate for president, Tsai Ing-wen (Cài Yīngwén: 蔡英文).  Tsai, of the Democratic People’s Party (DPP,: mín zhŭ jìn bù dăng: 民主进步党) Ms. Tsai has called for trade links with China to be developed in balance with its links to the rest of the world, basically, an end to Taiwanese diplomatic isolation.  More on Tsai:

Tsai resembles Ma in many ways. Like Ma, she is a graduate of National Taiwan University’s school of law. Like Ma, she holds a PhD from a prestigious foreign institution and speaks fluent English. And both served at the Mainland Affairs Council and are versed in the art of dancing with mainland China.

Tsai’s nomination represents the beginning of a generational shift that is renewing the DPP. She is the first DPP leader who did not rise to prominence in the crucible of the 1979 Kaohsiung demonstrations that sparked Taiwan’s democracy movement. Under her quiet but firm leadership, the party recovered from the ethically deficient leadership of former president Chen Shui-bian, who is now in jail for corruption. Tsai convinced the public to give the DPP a second chance; for that feat alone, she deserved the nomination.

So far Ma’s camp have questioned Ms. Tsai’s sexuality, her experience in politics, and hinted at a forthcoming new round of ” the politics of fear”.  The political epicenter of Ms. Tsai’s party is the south of Taiwan, a region known for it’s pride in local Han Taiwanese culture (bensheng ren: 本省人).   This region, like the party is unapologetically pro-independence. Although the DPP is unlikely to declare independence even if elected, Ma will argue that the risk of bringing forth the ire of the Dragon is too great.

Unlike past elections, when China tried to persuade those on Taiwan to make the “right electoral decision” by lobbing missiles over the island, this time, so far,  stern ominous words have been used:

Jia Qinglin, chairman of the Chinese People’s Political Consultative Conference (CPPCC), urged the people of Taiwan to “choose the right person” in two upcoming major elections on the island in order to maintain the stable development of the cross-strait relationship.

It remains to be seen if Beijing will do something to aid a flailing Ma, such as withdraw missiles that have for years been positioned adjacent Taiwan on the Mainland.

So how is the U.S., Taiwan’s chief defender, viewing things?  Or better yet, how should it view things?  Well, the U.S. probably should not be rejoicing over Taiwan moving closer to China, while defense spending under the Ma administration drops.  China acquiring Taiwan into it’s orbit will give China more of a reach in the South China and East China Seas, places Washington is currently seeking to contain China’s growing naval power.  We will look more at this in my next post on “The Other China”.

U.S. experts and politicians are starting to hone into the ‘dangers’ of R&D and technology transfers to China, as the most serious long-term threat to the U.S. economy and national security.  U.S. comparative advantage (innovation and new technologies) is being undermined by outsourcing of manufacturing to China, the relocation of R&D facilities to Chinese tech-parks, the forced technology transfers required for access to the Chinese market, and the continuing theft and lack of government enforcement of intellectual property rights (IPR)… all this according to witnesses testifying at a U.S.-China Economic and Security Review Commission (USCC) hearing last week.  (Testimonies available at the USCC website – transcripts of the hearing to follow)

The path to China’s industrialization is well documented, as is the role of foreign companies and the government’s industrial policy.  Once China was the proverbial ‘wild west’ where multinational corporations could move production, use China as an export platform, and enjoy enormous profits.  With time, Chinese officials have learned how to use multinational companies to advance the Communist Parties objectives for growth and technological development.  First they forces multinationals to form joint ventures with national champions and transfer their latest technology to Chinese companies in exchange for current and future access to the domestic market.  Now they demand that companies transfer to China their cutting-edge research and development labs (R&D) along with manufacturing and production.

The WTO has broad prohibitions on forced technology transfers and local content requirements, but these provisions are complex and easy to subvert.  Couple that with China’s absence from the WTO Government Procurement Agreement (which requires that government companies and entities engaging in commercial activity do not discriminate on the basis of nationality) and the dominant role of State Owned Enterprises (SOE’s) in China, and Beijing can do whatever it wants in terms of innovation policy.

Most China experts in the U.S. believe that China’s hi-tech achievements are based upon foreign investment in the country, government procurement regulations, compulsory licensing of patents or improvements of existing foreign patents.  However, Alan Wolff testified at the USCC hearing that China uses a variety of promotional measures to spur innovation, most of which do not differ that much from those of its trading partners.  “It fosters STEM education, and graduates a prodigious number of engineers each year.  It supports research consortia and builds enormous science and technology parks.  It is increasing public spending on R&D.”

And then there was ‘Indigenous Innovation’ -

Even China’s ‘Indigenous Innovation’ policy is viewed with suspicion and objection, considered by most U.S. experts and politicians to be either forced technology transfer or technology theft.  It originates from its National Medium- and Long-Term Program for Science and Technology Development (2006-2020), and it is identified as a guiding principle for China’s “great renaissance”.  For China, “indigenous innovation” is defined as “enhancing original innovation, integrated innovation, and re-innovation based on assimilation and absorption of imported technology” through the creation and use of Chinese intellectual property owned by Chinese companies to improve China’s national innovation capability.  (For more see: “China’s Perceived Threat to Transatlantic Security” by Mei Gechlik)

China has already been very successful at extracting technologies out of multinational companies, building the internal capacity of its own SOE’s, and then excluding the foreign companies from the Chinese market.  Notable examples include high-speed rail equipment and systems, wind, solar, telecommunications hardware, and auto-parts (soon to include whole cars).

The U.S. Office of the Trade Representative (USTR) considers China’s ‘Indigenous Innovation’ policy highly controversial and harmful to U.S. interests and international trade.  It has consistently demanded concessions from the Chinese government, and during recent meetings has gotten commitments from the Chinese: to delink innovation policies from government procurements preferences, make innovation policies consistent with WTO principles of non-discrimination, ensure strong IPR enforcement, and to allow technology transfer and production process agreements between individual entrepreneurs free of ‘government interference’ and consistent with WTO rules.

The U.S. perspective -

On the other hand, the USCC has been highly critical of the lack of urgency on the part of the U.S. government officials in recognizing the link between outsourcing of manufacturing and technological innovation, as well as the long-term implication for the U.S. economy and national security if China overcomes America’s comparative advantage.  During last week’s hearing, Commissioners pondered the appropriate U.S. government response to China’s innovation tactics.

Witnesses testifying at the USCC hearing last week offered the usual recommendations on how the U.S. should content with China’s innovation policies.  They recommended that the U.S. government monitors more closely Chinese policies that cause competitive harm to U.S. commercial interest, and litigate WTO cases more aggressively.  They also recommended a more intensive and continuous dialogue with the Chinese government, with prompt, effective and full compliance by China of its existing commitments.

However, the stronger recommendation was directed towards domestic U.S. policies, and the need to develop a comprehensive and strategic approach both towards China and with regards to innovation.  Simply put, if the U.S. government wants to maintain its competitive advantage in innovation and new technologies it will have to adopt some of its competitor’s policies: develop national champions, better target venture capital, fund basic R&D, improve universities and facilitate science parks, improve retention of high-skilled immigrants, and better fund and promote STEM education

On the other hand, some Commissioners asked whether now was the time to be tough with China, considering all the recent political and economic developments.  Due to rising prices and the rising inflation in China, the leadership transition that is taking place in the next couple of years, and the influence of the ‘Arab Spring’ on people’s minds and attitudes, now might be the best time to push the Chinese government on IPR and currency manipulation.  Therefore, a lot of experts have been advocating for a tougher U.S. policy towards China, one that includes high (punitive) tariffs for IPR violations and the continuing manipulation of the Chinese currency.

China is still a developing country -

As a national strategy, China is trying to build an economy that relies on innovation rather than imitation.  Chinese leaders recognize that real economic value lies with design and promotion of advanced high-tech products rather than being the world’s low-cost workshop for assembling.

Last year, the State Intellectual Property Office of China published the National Patent Development Strategy (2011-2020).  According to the patent office, it is China’s goal to drastically increase the nation’s production of patents to as much as 2 million annually by 2015.  In 2009 alone, China produced close to 600,000 patents, while the U.S. only produced 480,000 during the corresponding 12 month period.  Quality of patents aside, the Chinese government has introduced an array of incentives to lift its patent count.  They include cash bonuses, better housing for individual filers and tax breaks for companies that are prolific patent producers.  (When Innovation, Too, Is Made in China)

From Beijing’s point of view, China has paid a huge amount of royalties for technology import while the U.S. is still hampering China’s development with restricting on hi-tech exports to the country.  China’s ‘Indigenous Innovation’ policy will no doubt affect the old order and tip the old balance as technology exporting countries lose their leverage in the market.  China has to pursue innovation any way it can, in order to further develop and grow, and if the U.S. cannot rebalance the situation by adjusting its domestic policies, it will only end up like all the other countries which lost their competitive advantage to a new emerging power.

On the other hand, a new book about Chinese innovation (Run of the Red Queen), analyzed in a recent article by the Economist (Bamboo innovation), argues that it is wrong to equate innovation solely with the invention of breakthrough products.    “In an emerging economy, other forms of innovation can yield bigger dividends.  One is ‘process innovation’: the relentless improvement of factories and distribution systems.  Another is ‘product innovation’: the adaptation of existing goods to China’s unique requirements.”  Therefore, China’s current ‘comparative advantage’ is as the world’s middleman: being both part of product innovation and production, and being proficient at adopting new ideas for the mass market and global distribution.

In Conclusion –

China’s development efforts and its pursuit of ‘indigenous innovation’ are only natural, and a part of the countries evolution in the ever changing world we leave in (thank you globalization).  Those in the U.S. concerned with China’s innovation policies should look at the growth and evolution of Japan during the past 30 years.  Inventing new products and new technologies has always been the result of free enterprise and creative imagination (requiring a culture which tolerates risk and embraces uncertainty), something that command and control economies (like Japan and China) do not possess.  Therefore China, like Japan, is great at perfecting existing products and improving production methods, but not at creating new technologies and new innovations… at least not yet!

China is currently the second largest aggregate economy in the world, and also its most populous nation with 1.34 billion people.  This is  about 4/5 more populated than the United States, but with ~3.5% less arable land  (at 14.9%) and 16% of the spending power (US$7,519 per capita/PPP).  About 49.7% of Chinese live in cities today, a number which already rose from 36%  just a decade ago.  Many of those were young migrants attracted to rich urban areas, especially along the eastern seaboard.  Perhaps the most telling figure, more than 220 million Chinese had worked away from home for over six months in 2010, almost double the previous figure.

Like many industrialized nations, of which China is not, its fertility is below replacement level (2.1 children), and it’s population  growing rapidly older.   This is profound if one looks at China’s demographic history over the previous century; much has changed.  In 1950, the average life expectancy in China was 46, this was almost thirty years below the average developed nation of the same period.  The death rate during from this time has dropped from 18 per 1,000 to 7.6.  By the year 2000 average life expectancy was 70, which placed China only about 5 years behind the U.S.

Better nutrition and healthcare can account for the extended life spans seen over the last century, but historically China was quite fecund.  Could the implementation of the One Child Policy in 1979 account for the capricious decrease in fertility? When China carried out its first census in 1959,  the country had 594 million people, less than half the current number. During this time, China experienced rapid population growth, because fertility remained high, having the population double ever 25 years, which was encouraged by Mao Zedong, as a means of Chinese defense from invasion by the Soviet Union or the United States.  China would simply be too large and populous to invade successfully, something that might have already been the case during WWII (ask the Japanese).  Although China has long been heavily populated, due to extremely productive rice farming,  rates of growth like this were largely unknown in Chinese history, a nation that had long survived just above the Malthusian margin.

Major fertility reduction took about half the time it took to decrease the death rate.  From 1970 to 1980, total fertility was cut  from 5.8 to 2.3 per woman.  Instead of staying at replacement for decades, as was the trend in many Western nations, it took just two decade for Chinese fertility to drop below replacement by the 1990′s.  This trend actually started in the 1970′s, likely due to the upheaval of the Cultural Revolution, but the One Child Policy, which called for  Han Chinese women to have only one child, greatly precipitated  the existing trend.  Minorities are technically exempt from the One Child Policy, although there have been many reports of minority woman being forced to undergo abortions after having “too many children”. The number being arbitrarily determined by local communist party cadre.  There are other categories and stipulations as well, in the end about 63% of Chinese are subject to the policy.  As China likes to point out, thanks to the policy, 400 less mouths needed to be fed, clothed, educated, and employed – making China’s current rate of development possible.

As a result, by 2005 China’s growth rate was 0.5%, down from 2.5% in 1970.  What is interesting is China  growth rate tracked well with various other  nations in its region, despite their less draconian government policies.  This has been chalked up to common Confucianist cultural norms,  which respond to a “strong-state” setting a social expectation for smaller families.  If anything, the One Child Policy is just a much harsher, but efficient, manifestation.  As Wang found, many couples in China, as their neighbors in the region, said they wanted less children due to economic concerns.As a result, there is no surprise that the problems that come with low fertility are hitting China faster than most other nations that have made this transition.

There are consequences to this relatively swift change in demographics. Due to population age structure, currently having a  fairly young population will prevent China’s population from maxing out until around 2026, at 1.38 billion, if government projections hold, after which it will decline, so what will happen then?

Brookings via The Economist

IMPLICATIONS:

-Adjusting the One-child Policy may not be affective in increasing or stabilizing demographic trends, because as noted by Wang, Chinese people cite similar concerns about large families as their East Asian counterparts, who are also in demographic free-fall, with some of the lowest birth rates in the industrialized world.  Where the One Child Policy is already lax, rural areas, minority areas – there is no population boom.

- To maintain economic growth at current levels, China must transition to another model as the labor force will not be as young, productive, and inexpensive in the future.  This demographic shift will have far reaching effects on not only the Chinese, but the global economy, due to China’s status as the world’s manufacturing hub.

- At a time when China is trying to ween itself off of dependence on export-led growth, Beijing is in a race against time to grow domestic consumption demand, at a time when it should be naturally decreasing due to to the fact that young people are the most active consumers and an ever shrinking percentage of the population.

- The sex ratio is also  already seriously asymmetric, with 120 boys per 100 girls, which will leave as many as 20 million men without partners. Historically, societies with large percentages of unmarried male can become socially unstable and even trend faster toward warfare.  Keep in mind, that China is already a nation with over “90,000 mass incidents” (riots and public disturbances) a year.

- China will also have to increase retirement benefits for people who outlive their children or have none.  Historically, China was a society where the eldest son was responsible to care for elderly parents.  Due to the One Child Policy, many families are left without male heirs.  Fear of retirement income may dampen domestic demand even more.

- China will also be forced to change its draconian residency system, known as the Hukou, so that labor can freely migrate inside the country without special permission, fear of a loss of government benefits, effectively making Chinese citizens “illegal migrants” in their own nation.   This system,  which originated in Imperial China as a way to track China’s large population, because a way, under communist rule,  to aid in administering the command economy.  The current system is simply not dynamic enough to meet the needs of labor supply in a more capitalist China.

From the article:

Transneft spokesman Igor Dyomin told Fairplay: “We signed a contract with CNPC to value the oil [we deliver] at the market price with the use of market mechanisms. So Transneft uses the Petro-Argus prices to measure the oil cost at the Pacific Ocean. The Chinese side have agreed on that. Now they go back on their word, claiming that the pricing mechanism is unfair and pointing out the difference in oil prices between Skovorodino and Kozmino. The fact is that the oil price does not include extraction and transportation costs, but the market situation alone. Most East Siberian-Pacific Ocean [ESPO] pipeline oil is taken from the [Rosneft] Vankor field. But there are other fields closer to Kozmino, and still the price is the same.

“Even if we admit that transportation costs do count, Russia applied the uniform tariff for East Siberia and the Far East, and there is no price difference for oil companies as to where they enter ESPO and where they exit, the tariff is the same. So that means the Chinese side would like to interfere in Russia’s domestic affairs and enforce their socialism upon us. Russia is long out of socialism — we want fair market pricing.”

Further, there is apparently a dispute over shipment volumes as well. The CNPC wants to double the agreed upon shipment volume from 15 to 30 million tonnes a year. China is also not paying the agreed US$20 million a month, so Russia does not want to send more oil to only have a larger payment shortfall. Transneft said that they are now more focused on Japan, South Korea, and even the U.S. as customer.  Remember, Russia, does not want China to be its primary oil buyer, because this will give China too much leverage over oil prices, which is critical to the Kremlin, as high fossil fuel prices are good for Putin’s political approval rating.

The CNPC has not responded, but the Chinese Foreign Ministry spokesman, Hong Lei, said:

“At present all operations are going smoothly, and oil supplies are stable. As for some concrete problems encountered during cooperation, we believe both sides can fully resolve this in a positive way via friendly negotiations and on a mutually beneficial, win-win basis.”

In regard to how this affects trade, many analyst have paid careful attention to what should be the most obvious sector of trade between the two nations, an area that has long showed lackluster growth,  fossil fuels.  China is the fastest growing importer of fossil fuels in the world, and Russia is in the top 5 of all fossil fuel exporting nations; however, Russia only provided 6% of China’s total oil imports over the last year.

This situation may change:

On Jan. 1, China received its first commercial delivery of oil through the 990-kilometer (615-mile) [Skovorodino-Daqing oil pipe] line [from Siberia] to its northeast oil capital of Daqing, news services said.

Crude oil from Siberia is now flowing at the rate of 42,000 tons (307,000 barrels) per day, according to the official Xinhua news agency.

The pipeline will allow Russia to effectively double its oil exports to China, Reuters reported.

The doubling of oil flow  maybe be physically possible, but it is not clear if it will occur.  Russian Prime Minister Vladamir Putin has stated that he expected 30 million tons of crude per year and possibly 50 million at some indefinite point in the future by all routes currently available.  As large as it seems, that only  accounts for 10% of Russia’s total oil output from ports and pipelines that have  traditionally served Europe.  Still, Russia has long debated if it should build the pipe line to China at all, thinking it might be better to build it out to the Pacific, for the Korean and Japanese markets.

The reason being, the Russians were afraid of China becoming their largest single buyer on the route, because it would give Beijing the ability to influence price.   A variation on an old saying, if you owe the bank US$100,000 the bank owns you.  If you owe the bank US$1 billion, you own the bank.  Russia has to balance its apprehension with the reality that Europe’s five biggest oil importers will see decreases in their imports by 1.1% in 2011, while China will grow by at least 6.5%.

In the end, the Russians decided to hedge their bets by building one branch of the pipeline going into Northeast China, and another, scheduled to open in 2013, to the Pacific.  While Russia’s Gazprom expects to reach a deal with China over natural gas soon, it is clear that China wishes to diversify it’s gas imports, as it has it’s oil imports, by investing heavily in a  gas pipeline  from Turkmenistan through Uzbekistan and Kazakhstan, an area Russia considers it’s “Near Abroad”.  Needless to say, Russia is cautiously observing Chinese movements.

Russia also wants to see itself as an energy technology producer, not just a commodities seller, this would include nuclear power and renewable energy projects.  Russia wants to fully exploit its resources in Siberia and the Russian Far East, while at the same time raising living standards and increase the population of its  indigent citizens in the regions.

Besides the traditional attacks on security institutions, Chinese hackers have placed a new focus on private business.  For example, over the last several months network, security experts have noticed that Facebook internet traffic has been purposely routed through China.

“It’s real. It is happening. It can’t be described as an ‘accident’ anymore,” Joffe [Rodney Joffe, senior technologist at DNS (Domain Name System) registry Neustar], who observed similar traffic snafus involving China last year, said in an e-mail to CNET today.

Although Beijing is notorious for draconian internet censorship, having invested inordinate resources in a 30-50,000 man-strong  internet shield, known as the Golden Shield (金盾工程: jīndùn gōngchéng), the new focus is on offensive international attacks and data gathering raids.  In the case of Facebook, analyst are concerned that China is spying on foreign users in order to lift session ID information, personal information, e-mails, photos, chat conversations, all in order to  lift propitiatory information, as well as monitor human rights activism.

The issue of Intellectual Property theft has become a palpable one.  Western economies, especially the U.S., have become knowledge based service economies, where first mover advantage and property right protections are essential to long term economic growth.  The technological advantages the U.S. has enjoyed since the end of the Second World War has been depreciating much faster over the last 10-15 years, especially in relation to the Pacific Rim.   Due to the ease of information transfer, technical capital is being distributed far more quickly than in the past.  Any developed nation, including the U.S.,that wants to maintain its economic edge must address these increasing  cyber security threats.

The infamous “Google E-mail Hacks” of 2010, are a case and point.  Google openly implicated China in an e-mail hacking scandal, but this situation is actually not uncommon, it is just that Google went public and garnered significant media attention due to its status.  Over 34 other companies, tech and defense firms, are also thought to have been targets for corporate espionage by government and non-government actors from China.  Companies doing direct business with “Chinese partners” usually come under attack immediately.  The real numbers are astounding, reported in the press:

A study released by computer-security firm McAfee and government consulting company SAIC on March 28 shows that more than half of some 1,000 companies in the United States, Britain and other countries decided not to investigate a computer-security breach because of the cost. One in 10 companies will only report a security breach when legally obliged to do so, according to the study.

Further Wiki Leaks Revealed,

“Since 2002, (U.S. government) organizations have been targeted with social-engineering online attacks” which succeeded in “gaining access to hundreds of (U.S. government) and cleared defense contractor systems,” the cable said. The emails were aimed at the U.S. Army, the Departments of Defense, State and Energy, other government entities and commercial companies…Between April and October 2008, hackers successfully stole “50 megabytes of email messages and attached documents, as well as a complete list of usernames and passwords from an unspecified (U.S. government) agency,” the cable says.

In a private meeting of U.S., German, French, British and Dutch officials held at Ramstein Air Base in September 2008, German officials said such computer attacks targeted every corner of the German market, including “the military, the economy, science and technology, commercial interests, and research and development,” and increase “before major negotiations involving German and Chinese interests,” according to a cable from that year…French officials said at the meeting that they “believed Chinese actors had gained access to the computers of several high-level French officials, activating microphones and Web cameras for the purpose of eavesdropping,” the cable said.

In mid-2009, representatives of the China Institutes for Contemporary International Relations, a nominally-independent research group affiliated with China’s Ministry of State Security, contacted James A. Lewis, a former U.S. diplomat now with the Center for Strategic and International Studies.  The U.S. government is using Mr. Lewis as a proxy, there have been 3 formal meetings between him and his Chinese counterparts, but no progress has been made.

Various groups in China knows that innovation, like natural resources, is key to keeping the economy growing, which in turn will keep the communist party and it’s hangers-on in the business elite in power.  It appears China will innovate “by hook or by crook”.    The easiest and most cost effective  way to innovate is to steal.  Corporate espionage can be quite profitable:

Business Software Alliance, an international software industry group, estimates that 79% of the software sold in China in 2009 was illegally copied, creating a loss to the industry of US$7.6 billion in revenue. Even more important to Beijing, these statistics mean the vast majority of Chinese computer systems – government and private alike – remain vulnerable to malware.

Malware is important to the Chinese government, because China also claims it has also been the victim of numerous cyber attacks, and therein lies “the rub”.

As Minister of Public Security Meng Jianzhu said in December 2009, “The Internet has become a major vehicle through which anti-Chinese forces are perpetuating their work of infiltration and sabotage and magnifying their ability to disrupt the socialist order”.

Lets get a translation of what Mr. Meng is really saying.  Shall we?

China is no doubt facing a paradox as it tries to manipulate and confront the growing capabilities of Internet users. Recent arrests of Chinese hackers and People’s Liberation Army (PLA) pronouncements suggest that China fears that its own computer experts, nationalist hackers and social media could turn against the government.

And it seems as if China has a lot of disgruntled netizens.  Are “chicken’s coming home to roost”?

In June 2010, the State Council Information Office published a white paper on the growing threat of cyber-crime and how to combat it. Clearly, these challenges have been addressed this year. The Ministry of Public Security (MPS) announced on November 30 that it had arrested 460 suspected hackers thought to have been involved in 180 cases so far in 2010. This is part of the MPS’ usual end-of-year announcement of statistics to promote its success. But the MPS announcement also said that cyber-crime had increased 80% this year and seemed to blame the attacks only on hackers inside China…

These new efforts all contradict China’s long-standing policy of cultivating a population of nationalistic computer users. This effort has been useful to Beijing when it sees a need to cause disruption, whether by attacking US sites after perceived affronts like the Chinese Embassy bombing in Belgrade or preventing access by powerful foreign entities like Google.

Domestic hackers turning on the CCP, is such a concern that the People’s Liberation Army (PLA) has two military units dedicated to this issue, the Seventh Bureau of the Military Intelligence Department (MID) and the Third Department of the PLA. The MID is the offensive arm (or terrorist/spy wing, depending on how you wan t to see things). The Third Department is focused on national defense.  Still, do not expect China to take serious means to halt cyber attacks imminating from the Mainland, instead, expect China to crackdown on non-government aligned hackers who may pose a threat to the CCP (Chinese Communist Party).

Sino-American mutual suspicions are all the rave these days.  Much less discussed in the Western media, but has been on this blog, China’s  love/hate relationship with Russia.  The next installment of this series will look out how increased trade is not necessarily bringing the two Eurasian giants closer together.

Although in China inflation is largely driven by food costs, which rose 12% in March from a year earlier, Beijing is very concerned about the effect that rising property prices in many cities are having on inflation.  China’s fixed-asset investment in non-rural areas, a reliable indicator of construction activity, rose 25% in the January-March period from a year earlier.  Strong growth in property investment, which rose 34.1% in the first quarter from a year earlier, also demonstrates that restrictions on speculation and oversupply in the real estate sector did not impact incentives to invest.

The real estate market is immensely important to the Chinese economy.  With few other outlets for investment (depositing money in a Chinese bank is a losing investment, given low interest rates and high inflation), many families have been directing their savings into apartments, resulting in what some analyst describe as a bubble.  A recent article in the New York Times by Andrew Jacobs, describes the many undesirable repercussions of China’s unrelenting real estate boom.  Since 2007 real estate prices nationwide have risen by 140%, and during the past eight years by as much as 800% in Beijing.

However, a recent study by the Economist Intelligence Unit (EIU) is painting a different picture.  “China is not facing a major housing bubble, although there could be a short-term mild correction.  The Economist Intelligence Unit’s new models of population and incomes in China’s cities point to strong underlying demand for housing throughout the next decade.  They indicate that housing demand in China is growing so quickly that a correction in the next couple of years will be short-lived.”

Non-the-less, current market predictions for the housing market are rather grim.  Moody’s Investors Service downgraded China’s property sector last week to “negative” from “stable,” on concerns that rising interest rates and reduced bank lending would deteriorate credit conditions and dampen demand.  It appears that home purchasing restrictions had a significant impact on new home sales, with sales in Beijing down nearly 40% in the first quarter of 2011, compared to the previous three months.  The Moody’s report also said that reduced bank lending, rising interest rates and increasing property supply would inevitably bring down sales and profit margins while also worsening the balance sheet liquidity for some developers.

The nation’s real-estate obsession is especially noteworthy given China’s relatively recent embrace of home ownership.  According to Mr. Jacob’s, the sale of residential property was not allowed until the late 1980s, and even then under a leasehold system that gives buyers 70 years of ownership.  Today, about two-thirds of all Chinese under 40 own their own homes, slightly higher than the average for Americans of the same age group.  The frenzy starts with the local governments that sell off land at steep prices, and is further exacerbated by overeager developers who force residents out of old neighborhoods.  China’s response to the global financial crisis, a stimulus package which channeled a record 17.5 trillion RMB ($2.7 trillion) of lending over 2009 and 2010, is also contributing to the current housing situation.

New supply would also flood the market after Beijing pledged to roll out more affordable housing amid growing public concern over rising prices, with plans to build 10 million low-income apartments this year.  According to the Moody’s report, the government’s priorities of maintaining social stability (by controlling inflation and containing any emerging property bubble) will continue to heavily influence the direction of the property market.  Moody’s downgrade came a day after Premier Wen Jiabao told a cabinet meeting that home prices were still rising fast in some cities and reaffirmed intentions to keep tightening policies in place against property speculators.

Beijing has rolled out a number of measures to curb housing inflation in the past year and a half, including four rises in interest rates since October and restrictions on multiple home purchases.  On Sunday, China raised banks’ reserve ratio requirements for the fourth time this year.  In particular, China’s central bank said it was raising the reserves that commercial banks must deposit with the central bank to 20.5%, up from 20% previously, with effect from April 21.  Premier Wen Jiabao even said last week that China’s central bank is considering increasing the RMB’s flexibility to help counter inflation.

EIU Report on the Sustainability of China’s Housing Boom –

Although soaring house prices in Chinese cities have led to widespread concerns of a property bubble, and the repercussions of a major collapse would be severe enough to send the world into a mini-recession and to cause serious damage to resource-focused economies, the EIU report reaches some more optimistic conclusions than Moody’s recent downgrade.

Furthermore, although the EIU report also agrees that China does have a high level of per-head floor space given its income levels, it does not believe that this will lead to a structural collapse of housing demand.  The EIU report argues that “China’s love affair with housing is driven by cultural factors linked to the gender imbalance, and relatively light taxation of housing as an investment.  Neither of these factors is likely to change significantly this decade.”

On the other hand, demand for housing in China has both global and domestic implications.  The EIU report concludes that “the global commodity demand set off by China’s housing industry will continue to underpin commodity prices, particularly for steel and oil.”  The EIU report also argues that “within China, the housing industry is associated with broad opportunities in construction, retail and transportation.”

Source: Economist Intelligence Unit

Chinese Society Unique Characteristics:

Although there is no doubt that China remains the most over-housed countries, according to the EUI report there are a number of characteristics of the Chinese society that may account for the countries housing exuberance:

• Property sector taxation: The absence of a significant nationwide property tax, such as that enforced in most other countries, greatly boosts the attractiveness of real estate in China.  China has just begun to experiment with property taxes, but as they are currently at such a low level they are having minimal impact.

• Small households: The average size of a Chinese household is 3.3 persons (2.8 for urban households), which is relatively low for a developing country.  The one-child policy has clearly played an important role, but aging will also contribute to the growth of single households (men tend to die earlier than women), as will the gender imbalance and changing family values.

• Gender imbalance: China has the world’s most skewed gender ratio among young people, which has multiple implications for housing.  A small but thorough pool of researchers contend that gender imbalance, combined with a materialistic approach to marriage, is the reason behind China’s high household savings rate.  A higher ratio of men to women in China means that the latter can be more selective about their spouses, while the former must try harder.  Young men thus save feverishly, often with the help of their parents, to be able to offer their desired partners a suitably impressive home.

• Building quality: While Chinese citizens enjoy living space that is almost on a par with their much richer Japanese counterparts, the quality of buildings is likely to be on a different level.  It is difficult to obtain objective benchmarks on building quality across countries, but anecdotal evidence from China certainly suggests lower-quality construction.  According to Pan Jiahua, a researcher at the Chinese Academy of Social Sciences, the average lifespan of a Chinese building is 30 years, compared with 132 years in the UK. … Shoddier construction holds costs down, so it is quite possible that there is a trade-off between home size and building quality.

Risks and the impact of housing on steel and energy:

The significant role that China’s property sector plays in driving the domestic economic cycle is well documented and not in doubt.  However, China’s property sector is also increasingly important for other global sectors.

According to the EIU report, “Chinese demand is crucial for determining global prices of key commodities ranging from iron ore and oil to aluminium and copper. …  As a broad driver of economic activity, housing construction sets off a range of indirect demands for commodities and energy that are important to measure.”  One example provided by the EIU report has to do with the close link between housing construction and demand for cars, as new home owners in more affordable satellite towns rely more on cars for commuting.  Therefore, the resulting increase in demand for cars requires further inputs of steel and energy.

The EIU report goes as far as to forecast what a given level of housing activity means to demand for total steel and energy.  “Over the five years to 2014, as floor space per capita head rises by 25%, steel demand will rise by 22% and energy demand by around 50%.”  Such an increase will have a dramatic impact on global markets.  “The main winners will be countries exporting iron ore and oil, while consumers everywhere will face relatively higher prices.”

A free summary of the report (The Sustainability of China’s Housing Boom) is available at:

http://www.eiu.com/public/topical_report.aspx?campaignid=china_realestate_wp

What frames the findings of this ESI study are its two truisms.  1) “The one over-arching objective which informs and drives (China’s) conduct is the need for stability.  Chinese leaders need – above all else – to ensure the existence of a benign and conducive global environment for China to continue to grow economically at a fast but sustainable pace — in short, to continue its ‘peaceful rise.’”  Above all else, according to the ESI, is the need for stability – China needs a stable global environment in which it can successfully pursue the very high growth rates that it absolutely requires.

The second ESI truism has to do with the ever changing nature of the world.  2) “Institutions will either evolve to reflect the reality of the world in which they operate, or they will gradually drift toward irrelevance.  Not long ago, the G-8 was one of, if not the most important institutions on the global stage. Today, it has been supplanted and largely subsumed by the G-20. China’s growing economic and strategic might was one of the driving forces behind this dramatic shift in the G-8/G-20 constellation, and it would be naïve and unrealistic to think that the G-8/G-20 will be the only institutions profoundly impacted by China’s rise.”

Post Global Financial Crisis -

China as we all know is a major trade and investment player internationally, an important source of aid and development assistance, and an increasingly attractive model of economic development for other countries.  The recent global financial crisis has made China even bolder in its dealings within international organizations.  Beijing’ economic development model shielded China from the global financial crisis, and has now supplanted that of the United States in the eyes of many developing nations.  The ESI study argues that America’s economic weakness and China’s post financial crisis recovery means that in the years and decades to come international organizations “will evolve differently, and in some respects, away from the U.S.-influenced philosophical foundations upon which they were built.”

“New organizations, built upon a different set of assumptions and philosophies, will come into being and in some instances challenge the relevance of their predecessors.  China did not have a seat at the table when the rules were written for the first-generation international institutions, but China has a seat at the table today, and it’s getting bigger.  It will use its rising influence to shape, to the extent it can, the rules of the game.”

Some Negative Trends –

The ESI study argues that overall, “China has become more effective in utilizing international organizations to advance national interests, and to extract what it needs from these institutions.”  This is a result of China’s greater maturity and a steadily increasing activism and assertiveness in international organizations in recent years.

“This growing assertiveness can be measured on several levels: in its ability to shape policies and positions within organizations, in its ability to use these organizations as platforms to project both hard and soft power, and in its ability to promote national interests. It is also noteworthy to point out that China has grown remarkably direct, and in some instances, almost confrontational in articulating its positions.”

Furthermore, China has evolved into a highly effective player in international organizations.  “Both in terms of its ability to advance its own agenda, as well as its ability to deflect objectionable proposals from other quarters, China is a shrewd, savvy, and successful operator.”  Examples mentioned by the ESI study include China’s ability to shift the G-20 agenda away from issues it prefers not to discuss, and China’s success in the Copenhagen Climate Summit, the outcome of which was almost entirely in line with China’s objectives.

Finally, with some institutions (for example, APEC), China is an active participant not out of desire to achieve a particular objectives or to support the institutional mission, but rather to monitor the agenda and to deflect (when need be) proposals or initiatives that it finds objectionable.  Therefore, activism and participation by China does not necessarily denote support, and in fact can sometimes signal the exact opposite.

“China would have ambivalent feelings about APEC ever becoming a forceful and powerful vehicle for fostering trade and investment cohesion with the Asia Pacific.  Given the prominent role the US plays in APEC, China would much prefer to see an alternative structure (one which does not include the United States) play this role.  Therefore, within APEC, China can be content to play a defensive game on issues or agenda items which advance the APEC role on trade and investment, thereby ‘taking time off the clock’ while institutions like ASEAN + 3 have an opportunity to solidify their position and role.”

Some Positive Trends –

However, the ESI study also finds positive aspects of China’s increased and more effective participation in international organizations.  “China’s growing role not only supports its strategic interests, but, it should be acknowledged, is also frequently constructive and helpful for the organizations in which it participates.”  The ESI found that when China wants, it can be very thorough, exceedingly well-prepared and well organized about executing its responsibilities as an institution member, especially when it comes to administrative issues.  “Importantly, from a tactical point of view, China’s constructive engagement in these organizations is shrewd because it heightens Chinese credibility, which further strengthens China’s influence and its ability to achieve its objectives.”

Furthermore, China’s greater engagement in international organizations is having a direct effect on China as well.  According to the ESI study, “as China becomes more integrated into the system of international institutions, there are some respects in which the policies and practices of the institution are able to impact – at least in small ways — the way China operates.  To be clear, international institutions have not and will not cause any bold or dramatic policy shifts in China, but some modest examples do exist of China moving towards practices which reflect the operating ethos of the organizations in which it participates.”

Finally, China has demonstrated an impressive ability to learn throughout all the institutions in which it participates.  This can best be attributed in large part to the high quality individuals and officials that China sends to participate in these institutions.  “China has, in recent years, chosen to send its best and brightest — extremely smart, capable, articulate and frequently Western-educated individuals to represent its interests.”

Recommendations for US –

The 96-page report describes strategies the U.S. should adopt to deal with the Chinese in international organizations.  Overall, the United States needs to realize that its period of influence has ended, and that China has stopped listening to its lectures on such issues as the manipulation of its currency.  For example, China has already had a direct influence in the IMF and G-20 on the issue of its currency.  Furthermore, the ESI suggests that the U.S. should accept the inevitable rise of China, and be more pragmatic: “When China’s rising influence within a particular organization puts it in a position to deflect U.S. interest, look elsewhere.”

The full report, “The Evolving Role of China in International Institutions,” cat be found at the U.S.-China Commission web-site:

http://www.uscc.gov/researchpapers/2011/TheEvolvingRoleofChinainInternationalInstitutions.pdf