04 January 2013

Eye on China: 10 Key Trends to Watch in the Year of the Snake

Andrew S. Erickson and Gabriel B. Collins, “Eye on China: 10 Key Trends to Watch in the Year of the Snake,” China Real Time Report (中国实时报), Wall Street Journal, 4 January 2013.

As 2013 dawns, following a yearof policy uncertainty and leadership transition , China looms large as a key force that will shape global economic and security events. This shaping will come both through China’s growing strength on the military-technology front and through the glimpses of weakness reflected in its slowing economy and increasingly exposure of its sclerotic, corruption-plagued political system. Below we have rank-ordered our projections, most important first, of 10 major trends and events likely to materialize in 2013. These are issues that policy makers, businesspeople and the general public should follow closely to understand China’s growth and evolution.

1. China will continue shifting onto a slower economic growth track. This development is part of a larger pattern in which the BRICS’ economic performance is not living up to previous hype amid stagnant global growth. Some, like China, increasingly face a “middle-income trap” as they struggle to advance up the value-added industrial production chain. China’s trap appears to be springing much sooner than expected as a number of headwinds  including chronic diseases, pollution, and unfavorable demographics caused by the one child policy come home to roost. China’s economic growth will continue, but at a substantially slower rate than previously anticipated. China is here to stay economically, but 2013 will affirm that it has moved decisively onto a slower growth trajectory.

2. Rising wages and a shortage of new young workers will continue to reduce China’s global manufacturing competitiveness. The average Chinese factory worker’s wage rose more than four-fold between 2000 and 2011, while wages in Mexico rose by only 40% during that time, according to HSBC. This reflects how rising wage costs driven by both popular expectations and China’s shrinking pool of potential workers are eroding the country’s manufacturing competitiveness vis-à-vis global competitors. Indeed, China’s working-age population is projected to peak (PDF) within three years and then begin falling. An additional sign that the most important part of the working age population—young adults—is already shrinking is that university applications in China actually declined in 2010.  The reality that China’s former hammerlock on manufacturing is slipping is likely to further drive efforts move beyond the existing fixed investment and foreign direct investment-heavy approach with its diminishing returns in favor of attempting to stimulate a more active consumer economy.

3. China’s demand for new housing will remain weak. Although housing prices have crept upwards  in a number of Chinese cities, and appear stable in the nation’s political-diplomatic-economic-technology headquarters, Beijing, they have recently plummeted in others, namely Wenzhou. Chinese earth-mover sales continue trending down as measured by the 12-month rolling average of sales for excavators and wheel loaders, the two earth-mover types most heavily used in real estate construction. Twelve month rolling sales averages are a quality barometer because they more clearly reflect the trends on the medium to longer-term timeframes investors use when planning for capital-intensive projects like real estate.

Declining sales reflect pessimism on the part of Chinese construction contractors, who fear expending six-figure sums on machinery that would be at a high risk of sitting unused in a market that they expect to remain weak. Falling sales figures also suggest that there remains a substantial overhang of underutilized machinery that was bought in the expectation that the 2009-10 housing construction boom would continue apace, but that with the market moving to a lower “normal,” the demand for new earth-moving equipment has in fact declined.

4. Corruption  will receive added attention from China’s new leadership. Political housecleaning under the guise of “anti-corruption” efforts is an old staple of Chinese politics. However, while nobody should hold their breath in anticipation of dramatic high-level results, the latest campaign seems different in at least two ways. First, against a backdrop of high and rising inequality of income and opportunity, popular outcry led by China’s growing netizens against corrupt officials and “princeling” children is mounting. The resulting crescendo is commanding Beijing’s attention. Even as China’s government manages domestic social media with perhaps unprecedented restrictiveness, it is nevertheless monitoring it carefully with an eye toward spotting and removing hopelessly selfish and incompetent officials, particularly at lower levels. Second, the government is taking substantive steps—for instance a ban on banquets by the military —that have been large enough to significantly depress the stock prices of China’s leading maotai liquor distillers. Targeting such a time-honored tradition (lavish banquets) enjoyed by such a powerful institution (the People’s Liberation Army), suggests that 2013 could see anticorruption activities move beyond the purely symbolic and into a realm that might actually help the Party restore some of the popular luster it has lost in recent years.

While the presentation of specific official “scalps”—regardless of the evidence of their culpability or their access to standardized legal protections—may tamp down public anger on occasion, a larger fundamental challenge will be far harder to address: the complex intertwining of elite political and economic influence that has metastasized over three decades of “Wild West” capitalism with Leninist characteristics. “Unholy alliances” of money and power have created vested interests that influence the awarding of the most lucrative of contracts, confer monopolistic or oligopolistic power on state owned enterprises and other select entities, and fortify them with massive loans and other desirable resources at the expense of measures that would otherwise enhance consumers’ income and living standards. Much as trust busting, press freedom, consumer-friendly regulations, and a progressive income tax were essential over a century ago to moving the U.S. from the Gilded Age to a more representative, dynamic society, similar reforms may be needed for China to transition to a sustainable, consumer-centric economy. China’s system does not allow for the likes of either a Teddy Roosevelt or an Ida Tarbell, however, and smashing the large “rice bowls” necessary to proceed productively in this regard would be a daunting task for anyone. The new year will offer initial indications of whether China’s new leadership is willing to move in this direction.

5. Chinese investors will continue to seek additional assets and opportunities abroad, particularly in North America. Key sectors include real estate, agriculture … and manufacturing, which is needed for market access and technology transfer. According to the U.S. National Intelligence Council’s Global Trends 2030 report, “In the next 20 years, Chinese firms will probably need to go outside China to obtain the next level of technological and managerial innovation and sophistication. To do so, China will have to engage in foreign direct investment in other countries—a logical step at this stage of development and possibly the only way for China to move up the value chain.” Building on years of elite children being educated at top U.S. universities, a broader range of Chinese students are now studying across the spectrum of U.S. institutions, which are increasingly eager to recruit them because they pay full tuition and boost university coffers. Growing dissatisfaction with environmental and corruption problems, coupled with beliefs that China’s education and workplace promotion systems stifle both innovation and mass opportunity, is causing those who can afford it to purchase citizenship and property overseas, send part of their family there, or even emigrate wholesale.

6. Chinese investors in Iraq and Afghanistan will be increasingly responsible for providing their own security as the U.S. and NATO continue reducing their military presence in both countries. As of June 2012, there were more than 16,000  Chinese enterprises operating overseas, employing at least 847,000 Chinese nationals. These expat operations have a substantial direct economic impact on China ($57 billion in remittances  during 2011), but often operate in hostile areas where cooperating with the host government may have limited effectiveness. As the U.S. and NATO reduce their presence in Iraq and Afghanistan, new Chinese private security providers  like Shandong Huawei Security Group see business opportunities in helping Chinese companies investing in valuable, fixed-location projects such as mines secure their assets. Shandong Huawei Security Group (which has no relation to the global IT firm Huawei) explicitly cites  the withdrawal of U.S. troops from Iraq, and the potential for a security vacuum to result, as key drivers of its decision to target the Mesopotamian market.

Employing such firms raises the risk that Beijing will face a “Fallujah moment” in which acts of ostensibly private security contractors force the government to take actions it might prefer to avoid, but cannot due to public pressures. Such expectations could be strong in light of China’s popular nationalism and perception of rising military capability. Here pointed questions arise. For instance, would Beijing be prepared to take punitive measures if insurgents in Sudan, Iraq, or Afghanistan managed to ambush Chinese private security guards? Would Beijing be willing to seek the help of the U.S. military for a rescue operation if Chinese contractors came under fire in an area of Iraq or Afghanistan where U.S. Special Forces were in theater? China’s leadership is closer than ever before to confronting such questions.

7. Facing growing internal challenges, China’s new leaders may adopt a more nationalistic foreign policy, particularly vis-à-vis regional disputes. Beyond regime stability and homeland security, Beijing’s territorial and maritime claims in the three “Near Seas” (Yellow, East China, South China seas) remain its foremost military focus. Despite improving cross-Strait relations, Japan’s claims and strength of forces and the likelihood of U.S. involvement in any crisis or conflict therein make the East China Sea is most dangerous and volatile “Near Sea,” with the greatest possibility for high-end warfare and most dangerous force-on-force engagements. Beijing’s deployment of aircraft and ships to the Senkaku/Diaoyu Islands area reflects its turn to nationalism and implementation of a harder-edged foreign policy. Such actions also raise the potential for unintended encounters, accidents, and even a skirmish between China and Japan, as Japan scrambles fighter aircraft  in response to Chinese aircraft that are entering the area increasingly. Meanwhile, the South China Sea is less likely to see high-intensity conflict but most likely to witness friction and unexpected encounters between Chinese and foreign military platforms. China’s interests are increasing there, and China has shown willingness to use limited force there—it is the only theater of Chinese naval conflict in the past four decades.

8. China will be the world’s single largest builder of warships. While the prospects for and sustainability of China’s recent economic growth rate may have been exaggerated by many of late, the pace and intensity of its military-technological development has been underestimated repeatedly in many quarters over the past several years. Programs and investments, increased significantly starting in the mid- and late-1990s, are now coming to fruition, and will continue to yield systems of growing capability for the foreseeable future. No other great power today enjoys China’s availability to dedicate such vast amounts of capital and personnel so dynamically to such a wide range of new programs. China’s defense industry wastes resources and still suffers from extreme forms of some of the inefficiencies that plague the larger economy, but it has already become world class in comprehensiveness and specific areas of capability.

In the naval domain, for instance, China is now constructing six classes of modern surface warship and submarines simultaneously. A decision to add additional carriers to the PLA Navy’s fleet could increase the pace of this buildout. Beyond the Near Seas and their immediate approaches, the geographic scope of Chinese naval ambition remains unclear. The National Intelligence Council goes so far as to predict that “As global economic power has shifted to Asia, the Indo-Pacific is emerging as the dominant international waterway of the 21st century, as the Mediterranean was in the ancient world and the Atlantic in the 20thcentury. U.S. naval hegemony over the world’s key sea lanes, in this and other oceans, will fade as China’s blue-water navy strengthens.” (PDF) Thus far, China’s navy appears focused on keeping its hull numbers roughly even while rapidly improving quality by replacing old platforms with new ones at a pace unmatched by any other major maritime service. It already has highly-capable shipyards at its disposal for all but nuclear-powered submarine production.

9. Details of China’s next aircraft carrier will emerge. Evidence that a new, indigenous carrier is at some stage of development and construction would be a powerful indicator of China’s future naval intentions. Areas of particular interest would include whether the ship uses a catapult to launch aircraft and to what extent it will otherwise resemble China’s existing ski-jump carrier, the Liaoning.

10. The Y-20 transport aircraft will take its first flight. China’s aviation industry, an area of disproportionate weakness since the 1950s, has come a long way. This aircraft is the most recent to emerge publicly in an ambitious, well-resourced array of military and civilian aircraft programs. A successful test flight of the Y-20 would affirm that China is now able to fabricate an airframe that could serve as the basis for both a large transport aircraft and a relatively capable aerial-refueling tanker or airborne early-warning platform.

In a nutshell, 2013 will be a particularly dynamic year as China continues to reap the fruits of its long-term investment in economic growth and the dividends that effort yields in terms of improving citizens’ lives, modernizing its military, and gaining regional and global influence. At the same time, even more than 2012, 2013 will elucidate both the limits of Beijing’s current growth model and how China’s comprehensive national power will evolve and be wielded by a leadership that faces the prospect of a lower economic growth rate than was achieved over any of the past three decades since the reforms of 1978.