Geopolitical Diary: China's Economy, Out of Control
June 15, 2006 02 09 GMT

China announced Wednesday that industrial production increased in May more rapidly than at any time in the past two years. Output rose 17.9 percent compared to May 2005. The numbers exceeded expectations. Exports in May rose by 25.1 percent while domestic retail sales grew by 14.2 percent. In other words, the Chinese government's campaign to slow China's overheating economy is not working. On the contrary, the economy is accelerating.Read the other article below to understand this statement.

That is why the People's Bank of China (PBC), China's central bank, issued a statement Wednesday saying that banks should be concerned about the potential risks associated with the rapid increase in lending, following a meeting between PBC officials and representatives of China's banks. China's M2 -- the broad measure of China's money supply -- grew at 19.1 percent year-on-year, outstripping government targets. More important is the fact that Chinese banks, which are provided annual targets for the amount they should make in loans, have already loaned over two-thirds of that amount -- with more than half a year to go -- and it appears that the rate of lending is accelerating.

Put very simply, the Chinese economy is out of control. One would think that the faster the growth, the better the economy; but at a certain point -- and in this case -- that is not so, which is why the PBC is trying to get control of the situation. The problem is the massive overhang of debt, and in particular, troubled loans. Looked at from the standpoint of Chinese corporations, servicing this debt is a tremendous burden. Looked at from the standpoint of Chinese banks, the loans threaten the banks' viability if they become nonperforming.

The solution of Chinese companies is to sell more products to generate cash to pay off the loans. It is difficult to sell into the Chinese economy because of high savings rates, driven by government policies and economic insecurity. The Chinese government needs a high savings rate to help stabilize the banks; dramatically increasing domestic consumption would undermine the savings rate, threatening the banking system just as surely as defaulting loans would. The solution for these companies, therefore, is to increase exports. In a world already saturated with Chinese exports, the only way to increase cash flow is to cut already low prices. That increases cash flow but does nothing for profitability. In other words, companies already saddled by debt burdens cut into (or below) profit margins to service the debt.

The banks, meantime, do not want to write off nonperforming loans. The trick is to keep them performing -- at least to some extent -- since the definition of a "troubled" loan is both more elastic and less devastating to a bank's balance sheet. To do this, the banks arrange to lend more money to troubled enterprises. This allows some repayment of old debts, but simply puts off the day of reckoning on all sides (and increases the magnitude of reckoning when it arrives). Thus, bank lending accelerates at a breakneck pace -- not going into market-driven opportunities, but maintaining essentially failed enterprises for a while longer. Production surges at lower prices and the entire process moves faster and faster.

The problem is that any slowdown in economic growth decreases cash flow from imports, cuts into debt payments, and increases nonperforming loans until the entire edifice starts to collapse on itself. This is what happened to Japan in slow motion in the 1990s, and to Southeast Asia with dizzying speed in 1997.

The Chinese government knows it needs to slow down growth to avoid hitting a brick wall. It also knows that slowing down the economy can threaten the entire banking system. It is therefore engaged in setting restrained economic targets and expansionary economic policies simultaneously. It is caught between a rock and a hard place. At a certain point, Chinese companies will no longer be able to grow their exports rapidly. In the case of China, it is the speed bump that is the brick wall. Slowing down is dangerous and speeding up disastrous.

At this moment, therefore, the Chinese economy, incredibly, is speeding up. Virtually every economic indicator we see -- with allowances given for uncertainties in Chinese statistical methodology, to put it politely -- is surging out of control. It has been clear to the Chinese government for a while that this is coming, and it is now clear to the Western media that China is in trouble. Business Week, which has normally written breathlessly enthusiastic articles on the Chinese miracle, ran one this week entitled "China: Big Economy, Bigger Peril?"

Indeed.

China: Banking on Shifting Growth to the Interior
April 27, 2006 17 15 GMT


Summary

China's central bank announced April 27 that it is raising interest rates and requested that banks reduce the amount of credit they are extending. The bank's moves reflect China's attempts to slow its breakneck, and increasingly unhealthy, growth in its coastal regions while shifting investment to the interior.

Analysis

China's central bank announced April 27 an increase in its benchmark interest rate from 5.58 percent to 5.85 percent, effective April 28. It is the first increase since October 2004. The central bank also requested that the China's many banks voluntarily restrict lending in order help slow down economic growth.

In a free market system (that is working well) higher rates lead to a more realistic and rational allocation of capital. Thus, a hike in interest rates in the United States makes some borderline investments no longer attractive. China's system, however, does not work that way.

In China money is not considered a limited resource. The combination of the yuan peg and subsidized loans allow firms to expand broadly without regard for profitability. The residential construction sector is perhaps the best example. Between building for the 2008 Olympics and the sheer challenge of sheltering 1.2 billion people, China's need for housing is astronomical, and as expected, some one-sixth of all loans granted go to efforts to build more housing. But the structures being built are not structures Chinese citizens need. As such, China has a housing shortage, but 700,000 empty apartments.

Similar trends exist across all sectors, with investment flowing into either high- or low-end products for which there is little demand. That sustained surge in mindless growth has made China one of the largest consumers of a host of raw materials in the world, but has earned it just under 5 percent of global gross domestic product (GDP). China's numbers do indicate growth, but to see it as healthy growth one must have a very skewed perspective.





China's problem is that slowing this growth is not easily done. In addition to the ossified political links between state-owned firms and state-owned banks and local governing officials (all of whom have vested personal interests in keeping the cheap money flowing) -- which make political moves on the issue cumbersome -- as lousy as these firms are, they do employ people. The last thing the government wants to do is put 100 million or so people out of work in a country with as powerful regional crosscurrents as China has (but more on that later). Thus, the central bank paired its hike to financing costs with a request that China's banks ease off a bit -- the unspoken goal being that if banks tighten up credit, then perhaps all those inefficient firms will begin treating money like a resource worthy of conserving.

But there is more to the Chinese appeal than the headlines reveal. China wants growth and wants it desperately. One of the many lessons China has learned by coming late to the game of Asian development is that one's economy can be stable only if it has domestic demand. Economies based on exports alone (as China's currently is) will fall, and fall badly. Raising interest rates specifically dampens the sort of domestic consumer demand China so desperately wants and needs. This step was taken only because China faces an even larger problem.

China wants growth, but it wants more of that growth in specific places. China's rulers have always struggled to keep the outward-oriented coastal regions in sync with the more insular interior. Whenever one of the two regions becomes too disparate relative to the other, China suffers a catastrophe that re-establishes the balance.

In the late 19th century, China's coastal regions in effect declared economic independence from the interior, throwing their fates in with foreign powers, giving rise to Western spheres of influence on the coast. When Mao's revolution began, he had to go to the interior to gather forces. And in order to re-establish China's internal balance, he had to wreck the coastal economies in the Great Leap Forward and the Cultural Revolution.

That balance is again out of whack, but this time around, the Chinese government would prefer to raise the wealth of the interior instead of decimating the coast. It is not so much about dampening growth, as redirecting it. And therein lies the subtext of the central bank's request to curb lending. The government does not want breakneck growth on the coast. The coast has had its turn, and a glance at fixed investment rates and residential disparities indicates how unstable China is: Beijing wants growth in the interior in order to prevent any Long Marches leading to the Politburo.

Earlier this year, the government formally adopted a new five-year plan that can be summed up as "send your money west." At the time, we noted that we did not expect many businessmen, particularly the state-owned enterprise sort, to heed the call. In fact, we expected those businessmen to turn to more exotic sources of funding. The more reputable turned to overseas banks, the less reputable to loan sharks. We also noted that the central government would begin making ever more direct appeals, eventually turning into threats -- and ultimately punishments -- should the business community not follow the central diktat. The central bank has now raised financing costs and called on the banks to slow the flow of loans. Next come the threats.

On China, we said, "Our forecast is for a deeply troubled China, increasingly torn by domestic strife, with a government, in the face of it, alternating between brutal repression and helplessness." China appears to be facing no such intense struggle, at least on the surface. However, not far below these placid waters swirls a mix of economic, social, political and security issues waiting for the slightest external stimulus to bring them bubbling to the top.

As for the rest of East Asia, we said, "The Korean Peninsula will become the epicenter of tensions in Northeast Asia" -- a forecast we see taking shape. In Southeast Asia, we said, "Indonesia will continue to be the center of attention as it struggles to maintain unity and redefine its role among its neighbors" - again, a prediction we still stand by.

On the whole, Stratfor's long-term East Asian forecasts have been right on the money. However, we have always been bearish on China -- not for ideological reasons but for structural ones -- and our forecasts, which we believe remain fundamentally accurate, have not matched the bullish view that others give to the Chinese economy and national status. Our view of China's future is in stark contrast with the positive outlooks we see coming from investment houses and others.

One key reason for the difference is that most forecasts on China are linear -- in essence they say that since the Chinese economy is clipping along at 8 percent or 9 percent GDP growth each year, in 10 or 20 years China will dominate the global economy. Our basic supposition, however, is that the shape of the world today is probably the least likely shape of the world a decade or two out. The world operates in cycles, long and short, and linear extrapolations fail to take into account the reactions and arrestors on growth or decline. For example, in 1990, a year after the Tiananmen Square incident, the prediction that China would be the regional economic engine a decade later would have been laughable, as foreign investors fled the country and the hands of repression were clearly seen. A decade later, it was hard to keep foreign money out of China, and Beijing was even beginning to look at ways to slow the economy.

China is obviously a major factor for East Asia in the next decade. And in looking at China, the status of the economy -- particularly growth -- is the core issue. It is our view that China's economic growth rates, driven largely by foreign investment, trade and government spending, will continue to slow. This slowing will exacerbate underlying structural tensions in the Chinese economic system -- between the urban and rural areas, between the coast and the interior, between the north and south, between the rich and poor and between the center and the periphery -- and at its core between the state-controlled and market economies.

Why, then, if Stratfor sees a China on the verge -- if not already in the midst -- of massive internal upheaval, is there a general global acceptance of the idea that not only is China on an unstoppable rise, but that people should pour their money into the Chinese economy? In part, this is due to tunnel vision -- assessors of the Chinese economy are looking only at the booming center-coastal economies in and around Shanghai. In part, it is intentional self-delusion, a failure to connect the dots.

There is no shortage of reporting on the underlying weaknesses of the Chinese banking system, the state-owned enterprises (SOEs), the unemployment problems, the uneven distribution of wealth and labor and myriad equally troubling and seemingly insurmountable problems. However, the holy grail of selling a single orange to each of the 1.3 billion Chinese continues to blind others to the reality of the situation, and the desire for a piece of what someone else might get has fed a steady stream of investment into China, keeping the system on life support and "justifying" the positive outlooks.

But on this last point, something has been overlooked: In recent years, foreign direct investment (FDI) moving into China has declined, but this trend is hard to see clearly. U.S. investment in China was the key driver in bringing China up from the Asian economic crisis. Weary of waiting for the return on investment in China, U.S. investors slowed the flow of FDI. However, the herd mentality and the shiningly optimistic assessments of China as the next golden goose led to a successive wave of European investments. This was followed by Asian investors, who did not want to be left behind.

This rush of foreign investment and interest in China has masked the Chinese economy's underlying weaknesses and given the government tools to maintain control. But it will not last. Already there is dissent forming in the international community, and the need for quicker profits -- or any profits -- is driving companies and investors to look elsewhere. Rising interest rates and the perception of strong market fundamentals are bringing investments to the United States. High energy prices, sector bubbles and the resurgence of "China threat" fears are taking the shine off the Chinese economy.

Beijing has enjoyed a brief respite from these fears. The external pressures on China were set to increase in late 2000 with the election of U.S. President George W. Bush. By early 2001, China and the United States were in a tense standoff as a U.S. E-P3 sat on a Chinese runway on Hainan Island. The incident was resolved, but the strains on U.S.-Chinese relations were not relieved. The came the Sept. 11 attacks in the United States, and suddenly China became a back-burner issue. Beijing even became, briefly, a fellow "target" of international terrorism, convincing Washington that Uighur militants were tied to Osama bin Laden and out to create a greater Islamist state in western China and Central Asia.

But while Beijing had some time -- and took advantage of it to effect a relatively smooth transition from Jiang Zemin to Hu Jintao, the so-called Third and Fourth Generation leadership -- Washington's overwhelming infatuation with bin Laden, al Qaeda and international jihadism began taking a more proportional position in the American global strategy. For China, this means the return of U.S. pressure.

The same factors that led to the downfall of the Qing Dynasty in 1911 are still inescapable today. China is showing classic symptoms apparent before the end of dynasties: the disruption of internal economic wealth, increasing gaps between rich and poor and between regions, the economic encroachment of outside powers and the undermining of the social contract with the state. The central government has lost its legitimacy after trading ideology for money that is now supplied from afar rather than from within.

The balance between the center, which seeks to pacify and stabilize the vast interior population, and the coastal periphery, whose economic and political interests lie in foreign trade and are therefore ultimately aligned more with foreign nations than the center of China, continues to create friction. The center, in order to maintain control of the interior, must take money from the periphery. Fears of issues of social stability lead the center to take action in the interior, which might be anathema to the interests of the coastal provinces.

China today has two economies: the import/export economy based in the densely populated coastal regions and the remains of the old Maoist SOE-based economy in the interior and the Northeastern "rust belt." FDI supports the import/export economy, while the central government must keep the SOEs afloat. In 2003, SOEs employed 375 million of 750 million workers and controlled 57 percent of the country's industrial assets. The SOEs are kept alive -- and at times bailed out -- by preferential bank loans, but the inefficient enterprises are giant capital vacuums, compounded by corruption and continued mismanagement.

Bad loans in China, most of which stem from lending to SOEs, have been estimated to reach as high as $500 billion -- by no less than the investment houses who have a vested interested in making this number appear as low as possible. That is not far off China's $609.9 billion -- as of Jan. 1, 2005 -- in foreign currency reserves. Beijing is constantly pulling from its own reserves to feed the state banks, which in turn feed the SOEs. Since 1999, Beijing has spent about $275 billion in asset transfers and bailouts in attempts to solve the bad loan problem. All such "fixes" have failed, since they do not require the SOEs to change their operating policies. The SOEs, in turn, feed the people who, under the communist system, came to expect -- and depend on -- the continued existence of a state-sponsored Iron Rice Bowl.

The coastal areas, where the import/export economy is based, received 87 percent of China's FDI in the last three years, but western China, which is home to many SOEs and farming operations, received only 3 percent of FDI in the same period. In these areas, where nearly a quarter of China's population lives, per capita income fell from 84 percent of the national average to 56 percent from 1980 to 1999.

The forces at work within China's SOE-based economy are preventing the country from capitalizing on its current growth and will eventually drain the energy from the import/export economy. Fearing the urban unemployed even more than the rural unemployed, since poor farmers at least have land and can feed themselves, Beijing is offering life support; but unemployment, which in 2002 was between 6.2 percent (official data) and 13.1 percent (estimated by a 2004 University of Michigan study), continues to rise. This triggers wave after wave of demonstrations and protests -- which have thus far been isolated incidents -- but the chances for coordination increase daily. And Beijing's only response will be repression, sending in troops to end by force whatever opposition it perceives, as it did at Tiananmen Square.

China recovered from Tiananmen not because of the continued crushing of the students and their supporters but through capitulation to the population, which resulted in the state taking a steadily decreasing role in the lives of the average Chinese. But this capitulation to the masses, while initially resulting in pacification, also has served to raise material expectations. Turning back is no longer an option. Beijing is, therefore, stuck. It options are limited and time is running out. The mandate of heaven, it appears, is being repealed.

Beijing knows the troubles it is in. The strains between the coast and the interior, the rich and poor and the north and the south are growing more and more tense, and Beijing's ability to maintain the system is fading. This is compounded by corruption, which not only drains government coffers but further de-legitimizes the Party.

China's leadership is presented with few options.

First, it can implement a sudden and swift overhaul of the entire economic system, similar to South Korea's actions following the 1997 economic crisis. This, however, would require a government characterized by lethargy and fear of social instability to make a sharp, painful and -- if done effectively -- relatively swift move. The massive social dislocation of such a move makes it untenable.

Second, Beijing could revert to the Deng and Jiang method of encouraging unabated and unequal growth at the expense of profit, occasionally trimming dead wood in SOEs, pumping money into the banks to recycle into the insolvent SOEs and thereby maintain the bare minimum of social stability to avoid significant unrest. Any small stirrings are met with crackdowns on social movements. This, however, only furthers the underlying structures that have rotted out China's economic expansion, and, in relying on the "Asian" model and the "Communist" model, it fails to address the true problems.

A third method is that being attempted by Jintao. This involves slowing growth a few percentage points, more closely regulating the economy from the center and trying to direct FDI into the worst of the SOE areas, namely the northeast. In the midst of this, Beijing seeks to take a million small steps toward addressing underlying weaknesses. This simply prolongs the pain -- even if regionally isolated -- and builds tensions between haves and have-nots. And it relies on foreigners' good will or poor judgment to invest in the worst of the Chinese state institutions. Ultimately, if social stability can be maintained (and this seems unlikely for long), China's best case is a sustained slump, reminiscent of the past few decades in Japan.

The fourth option is the "Mao" method: Close the country and economy and undertake a massive social restructuring. This is not really an option among the Chinese leadership, which has a vested interest in expanding trade with the outside world. It also would result in a loss of international power, at least for a decade or so. Without the ideological underpinnings that allowed Mao Tse-Tung's social revolutions, gaining any sense of national buy-in for another "Cultural Revolution" would be highly unlikely, and the opposition to such a path would be anything but quiet.

The first and fourth options appear untenable now and in the foreseeable future. The fight is not over closing the economy or keeping it open, but over the pace and scope of economic growth versus economic fundamentals. It is a core question of defining strength. While the "Hu" method has won out for now, if things start to bite -- and they likely will -- there will be a renewed push for the "Jiang" method, though whether China can entice others into a new "boom" too many times is unclear.

The government is challenged now to prove its legitimacy as the center of the nation. Under Mao, the underpinning was ideology and a sense of international embattlement. Under Deng and Jiang, that underpinning was the promise of money and material goods. China's rapid growth economy is very young, and tearing that promise away -- even in the name of market fundamentals -- is extremely dangerous. The only way South Korea managed it was to rely on a very close sense of ethnic nationalism and to put the blame for the pain on a non-state actor, the International Monetary Fund. China has neither the ethnic homogeneity nor pervasive sense of nationalism to ask for much self sacrifice, and the stresses on the system will continue to compound.

If China adheres to the World Trade Organization (WTO) accession agreement and opens its banking system in 2006, the SOEs will collapse, since China's banks would no longer able to funnel money to bail out non-performing companies. Strengthening the SOEs through reform creates massive new pools of unemployed labor, leaving even more disgruntled and disillusioned former state workers with no jobs and nowhere to turn. Ending bank lending to the state institutions creates hundreds of millions of new unemployed. A social cataclysm of that magnitude will tear the country apart -- or at minimum lead to the collapse of the Party and the government. Therefore, China will choose another path.

Beijing will want to prop up the SOEs as long as possible to buy time to convert them into productive members of China's economy. However, time is not on China's side; the country must open its economy before the SOEs can be converted. The center will want to forestall this as long as possible and is therefore unlikely to accede to its full obligations under the WTO agreement.

Beijing, then, will seek to mitigate the internal upheavals now apparent from the 1979 economic opening and reform the system. Mismanagement, rampant corruption and the combination of an Asian (growth-driven rather than profit-driven) and Communist (social control over profits) economy has left Beijing with few immediate solutions. If China slows its opening and reforms -- the most likely path, albeit done in a subtle Chinese way -- FDI will begin to dry as foreign investors shift away from China. When FDI dries up, growth in the import/export economy will slow down. When growth slows down, social stability issues will become more pronounced, since there will be less and less money to pump into the SOEs. Capital flight by Western investors already has begun, with Asian investors making up the difference, but they will be unable to sustain adequate levels for very long.

FDI decreases also factor into the rifts between the center and the periphery in somewhat unexpected ways. A decrease in FDI is what triggered the 1999 corruption crackdown. In 1999, FDI going into China decreased by more than 11 percent as a result of the Asian financial crisis. With less money coming into the country, the center tried to keep the SOEs afloat with money from the import/export economy. This was met with resistance in the periphery, and the center responded by moving in and taking what it wanted under the guise of a crackdown on corruption. In extreme cases, the periphery reacted violently; in others it simply took the money and ran.

China will struggle on through 2008. The Olympics are a powerful force, driving economics and providing a rallying point to keep divergent interests temporarily subdued. That will not last. Nationalistic entreaties playing off the Olympics, space programs and the like can do little to hold the disparate interests and factions together. Intentionally or not, the face of the Chinese Communist Party will shift in the years shortly following the Olympics.

The turmoil this will likely cause will lead to a loss of central control and a regionalization of power, as has often been seen in Chinese dynastic transitions, in which the country -- while nominally unified -- will in fact become a cluster of fiefdoms, effectively modern warlord states. The capital will have a national leader but the center's reach and influence will be at the mercy of the regions. In a place such as Afghanistan, this is called status quo; in China, warlordism -- only this time, there will be nuclear weapons in play.