From Rabbit to Dragon? More Like the Other Way Around. A Review of China in 2011.

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?