05 July 2015

China SignPosts for PRC Economy and Broader Prospects: Short-Run Stock Market Volatility, Limited Reforms, Long-Run Overall S-Curve Trajectory

At this challenging, uncertain time for China’s financial markets, it is worth revisiting what we consider to be three of China SignPost’s highest-impact reports thus far. We believe that these analyses elucidate key short-term and longer-term dynamics and prospects for China’s economic conditions, its broader development trajectory, and the Party-State’s prospects for managing both effectively.

On 14 June 2015, barely two days after the Shanghai Composite Index reached its recent peak, we offered the following assessments in China SignPost #89:

  • China’s stock market rally is not underpinned by robust real economy activity.
  • Real economy indicators suggest that China’s stock market is markedly decoupled from underlying economic reality.
  • Specifically, the “Keqiang Index”—an aggregation of statistics concerning electricity consumption, rail cargo volume, and amount of loans disbursed reportedly advocated as a more accurate metric of real Chinese economic activity by Premier Li Keqiang himself—has suggested substantially lower GDP growth than have official figures.
    • The massive speculative updraft in the Chinese stock market stands in marked contrast to weak electricity demand.
    • The Shanghai Stock Exchange has risen approximately 150% over the past year, while electricity consumption has flat-lined for the past five months and counting.
    • Given China’s industrially driven economic model, this reflects serious weakness.
  • Many Chinese economic statistics remain “the mystery meat of emerging-market countries.”
    • Even these official figures, which Premier Li reportedly denounced as “man-made,” have themselves been ebbing.
  • The abovementioned factors underpin our concern that this stock market boom is unsustainable.
  • President Xi is the ultimate margin trader in this market.
    • His margin account is not just economic but political as well.
      • Stock market downdrafts on the heels of euphoric upswings can be devastating to far more than pocketbooks.
      • They sow fear and destroy confidence—the lifeblood of both economic growth and political stability.

This report came just under eight months after we expressed skepticism in China SignPost #81 (23 October 2014) that China’s leadership was willing and able to implement reforms sufficient to maintain then-current levels of economic growth amid gathering challenges. We concluded:

  • President Xi Jinping’s vigorous promotion of new policy paths is colliding with powerful vested interests.
  • China’s leaders appear to know what economic reforms are needed, but howwhen, and to what degree can they actually implement them without assuming unacceptable political risks?
    • This remains the problem, and it remains unanswered.
  • Bottom line: China faces increasingly necessary reforms that its political power structure appears ill-suited to implement effectively.
    • Accordingly, reforms will progress more slowly, and less successfully, than expected.

This analysis, in turn, followed just over three years after we published what we consider to our most significant macro analysis to date, China SignPost #44 (15 August 2011). Looking forward, we continue to believe that larger dynamics we articulated there will continue to place the growth of China’s economy, and its overall “comprehensive national power,” on an S-curve-shaped slowdown trajectory. Here’s our rationale:

  • China faces costly internal and external challenges that are likely to shift the country onto a structurally constrained slower-growth trajectory.
  • For all its policy navigation, efforts to guide national development, and claims of exceptionalism, China is not immune to larger patterns of economics and history.
  • It will thus almost certainly experience an S-Curve-shaped growth slowdown like so many previous great powers have suffered, and the one that so many observers believe the United States is undergoing today.
  • In fact, China is encountering such headwinds at a relatively much earlier stage in its development than did the U.S. and other great powers.
    • This is due in part to China’s late start in modernization, its dramatic internal disparities, and its draconian one child policy and other political dynamics.
  • Growth rates will therefore slow as key internal and external challenges—including pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—feed off of one another and exact increasingly large costs.

For your convenience, the full text of all three reports follows:

China SignPost™ (洞察中国) #89—“China’s Stock Market Boom: Buckle Up for a Wild Ride!”

Gabriel B. Collins and Andrew S. Erickson, “China’s Stock Market Boom: Buckle Up for a Wild Ride!China SignPost™ (洞察中国) 89 (14 June 2015).

China seems to be bubble surfing—two years ago it was an overheated housing market—and now the country is riding a surge of stock market enthusiasm. The stock market craze involves a much broader population base than the housing speculation did. The reason is simple: a lower barrier to entry. Houses are expensive in Chinese cities—especially in major markets like Beijing, Shanghai, and Guangzhou. In contrast, scrape up a few thousand RMB and open an online brokerage account, and you’re off to the stock trading races. No need for research, just talk to your relatives, your barber, your greengrocer, or even your taxi driver regarding what’s hot. Better yet: juice your returns (and build in a precipitous downside), trade on margin with borrowed funds. At least, that’s what far too many Chinese are doing these days…

Frenetic market activity has created enormous paper value: on the order of US$6.5 trillion over the past 12 months, according to Bloomberg. Based on World Bank and IMF data, China’s stock market capitalization currently stands just below 90% of GDP. This is significantly below pre-crisis Japan in 1989, where stock market capitalization peaked at 145% of GDP, but it still concerns us given that the rally is not underpinned by robust real economy activity.

Quite to the contrary: real economy indicators suggest that the stock market is markedly decoupled from underlying economic reality. Juxtapose the massive speculative updraft in the Chinese stock market with weak electricity demand. Given China’s industrially-driven economic model, this reflects serious weakness (Exhibit 1). The Shanghai Stock Exchange has risen approximately 150% over the past year, while electricity consumption has flat-lined for the past five months and counting (Exhibit 2).

Exhibit 1: Shanghai Stock Exchange (June 2014 to June 2015)

Source: Google Finance

Exhibit 1_CSP_Shanghai Stocks vs weak electricity demand_12 June 2015

In contrast…

Exhibit 2:  Weak Electricity Consumption

Billion kWh, monthly

Exhibit 2_CSP_Shanghai Stocks vs weak electricity demand_12 June 2015

Source: NBS China

Because many Chinese economic statistics remain “the mystery meat of emerging-market countries,” electricity consumption is among the best measures of real Chinese economic activity. It is one of three indicators (aside from rail cargo volume and amount of loans disbursed) that Premier Li Keqiang reportedly views as far more reliable than other official statistics because they are much more difficult to falsify. For some time now, this “Keqiang Index” has suggested substantially lower GDP growth for China than official “man-made” figures, which have themselves been ebbing.

The cautionary analysis above does not seek in any way to denigrate China’s growing day trader ranks. Save for real estate and stock speculation, non-elites have few vibrant investment opportunities. Rather, it underpins our concern that this stock market boom is unsustainable. China’s stock trading masses have created a pocket of economic and political risk that could potentially have momentous global consequences when the moment of deleveraging comes. Such events are confidence-driven and it is extremely difficult to predict when and how they will happen. But whether it unfolds next week or 12-15 months from now, even paramount leader Xi Jinping will be unable to stop it. Depending on how the de-leveraging happens and how the Chinese government and a diverse range of market participants respond, the consequences for a range of global asset classes—and perhaps political stability in China itself—will be enormous.

President Xi is the ultimate margin trader in this market. To be sure, the farmers and shopkeepers are staking risky bets, and could lose a lot if the market falls and margin calls come. But Xi and his coterie are wagering much more: his margin account is not just economic. Rather, he is effectively pledging his own political future; and in the more extreme scenarios, the Communist Party’s political legitimacy and social stability itself.

Stock market downdrafts on the heels of euphoric upswings can be devastating to far more than pocketbooks. They sow fear and destroy confidence. Confidence, in turn, is the lifeblood of economic growth and stability, as well as political stability. Indeed, financial history books are replete with examples of how sudden losses in confidence can systemically endanger an entire national economic and political system. Consider Black Tuesday and the beginnings of the U.S. Great Depression. Or more recently, consider how close the global financial system came to the precipice in August and September of 2008. The bottom line is that China now lives in “interesting” economic times. It will be an unprecedented ride in the months ahead, so buckle up and good luck! In the meantime, be careful what “mystery meat” you load up on, and don’t borrow your friend’s life savings to invest in local government debt…

China SignPost™ (洞察中国) # 81: “Physician, Heal Thyself: Modest Expectations in Order for China’s Reforms as Third Plenum Anniversary Approaches”

Andrew S. Erickson and Gabriel B. Collins, “Physician, Heal Thyself: Modest Expectations in Order for China’s Reforms as Third Plenum Anniversary Approaches,” China SignPost™ (洞察中国) 81 (23 October 2014).

President Xi Jinping’s vigorous promotion of new policy paths is colliding with powerful vested interests. China’s leaders appear to know what economic reforms are needed, buthow, when, and to what degree can they actually implement them without assuming unacceptable political risks? This remains the problem, and it remains unanswered. The bottom line is that China faces increasingly necessary reforms that its political power structure appears ill-suited to implement effectively. Accordingly, those dealing with the PRC should prepare for reforms to progress more slowly, and less successfully, than expected.

Key Challenges to Reforms (rank-ordered in descending order of seriousness):

1. Deep and entrenched corruption

2. Local officials’ significant ability to passively resist reforms

3. State-owned enterprises’ massive economic heft and commensurate behind-the-scenes political influence

Important Takeaways

1. High-profile anti-corruption campaigns will kill a few “tigers,” who also often happen to be political opponents of the current governing elite. But corruption will remain a serious problem until the Party fundamentally revises its personnel management, judiciary, and legal systems.

2. Substantial reforms are likely in the next 2-5 years in sectors key to social stability and human wellbeing—particularly healthcare and hospitals. We also expect the availability and use of clean burning natural gas in large coastal cities and larger inland cities away from the coal belt will each continue to grow at more than 10% annually for at least the next five years.

3. There will be continued piecemeal attempts at state owned enterprise (SOEs) reform—such as Sinopec’s recent packaging for sale of what was technically a ~30% stake in its downstream retail business. But the state will retain deep economic influence even in such “reformed” areas if they have any substantial ties to “commanding heights” sectors such as natural resources, public utilities, high technology, shipbuilding, and aerospace.

Big Meeting

With the 18th Communist Party of China (CPC) Central Committee’s Fourth Plenum on legal issues having just concluded in Beijing, it is time to offer a balance sheet on the results of the Third Plenum and future prospects. At the Third Plenum on 9-12 November 2013, China’s leaders unveiled the “Decision of the CPC Central Committee on Some Issues concerning Comprehensive Reforms.” This was part of an annual meeting of the Central Committee’s 205 members and 171 alternates to “discuss major policy decisions.” What was particularly significant was Xi’s role in personally leading the group drafting the decisions, which included the ideologically ambitious—and as yet unfulfilled—concept of “market forces playing a decisive role in resource allocation.”

The 2013 meeting emphasized that China must shift to a more fiscally and environmentally sustainable growth model. The leadership is now on the clock, since the goal is to have “decisive results” from reforms by 2020—in time for the CCP’s 100th anniversary in 2021.

A key question looms: can the leadership of President Xi and Premier Li—which is stronger than that of their predecessors Hu Jintao and Wen Jiabao—allow the currently proposed reforms to have an impact potentially as large as that of Deng Xiaoping’s reforms? Given the challenging, time-consuming nature of implementation, it will take several years to judge the actual outcome. But we are nearly one-quarter of the way on a four year measuring stick and already the prospects for rapid, comprehensive implementation appear limited.

Xi and Li work in a different environment than Deng did. In the late 1970s and early 1980s there was not the same web of vested interests to block the eventual implementation of reforms. In fact, it was the state-led economic development combined with political retrenchment post-1978 that has produced the present sclerosis. State owned enterprises (SOEs) and lack of a unified construction land market, and most of all, severe and deeply entrenched corruption are likely to remain key obstacles.

Corruption is the single most substantial barrier because any reform instantly threatens thousands of “shadow rice bowls” that were feeding local officials’ lifestyles off the books. High-profile campaigns such as that current being conducted against former Central Political and Legislative Committee Secretary Zhou Yongkang have a “kill the chicken to scare the monkey” aspect in that the Central leadership hopes they will frighten lower level officials and deter them from entering into various corrupt activities. But the reality is that the thousands—if not tens or hundreds of thousands of lower level officials with their hands in the cookie jar—will simply lay low during the high profile purges, then (1) resume with business as usual and (2) drag their feet to try and defeat central edicts that threaten their personal “under the table” financial interests. This massive collective friction will be a powerful brake on many different types of reform—particularly any reforms that require substantial local participation across the country, such as reforms concerning local governments’ involvement in land transactions.

While headlines devote ample space to discussing the sectors affected by the “anti-corruption” crusade, and VIP spending has declined overall, equity markets in China are not simply pricing in austerity. Sales of Maotai liquor—a staple at any official banquet—have declined significantly since Xi’s campaign began, with Wuliangy—a major Maotai producer—reporting that its revenue in the first six months of 2014 declined approximately 25% year-on-year. However, the stock market, which is a forward looking indicator, has for more than six months consistently priced China’s three largest publicly-traded Maotai distillers at significant premiums to both the Shanghai and Shenzhen Composite indices (Exhibit 1).

Exhibit 1: Liquor producers stock prices rising despite official anti-corruption campaign

Exhibit_China corruption Maotai stock prices vs exchanges

Source: Google Finance, China SignPost

Xi’s Vigorous Style and Early Power Consolidation

Xi Jinping combines an outgoing, effective leadership style with an unusually strong background and formative and professional experiences to amass advantages that his immediate predecessors lacked. The general trend in PRC politics has been for the paramount leader of each generation to become more constrained, technocratic, and colorless. While collective decision-making has become the norm overall, in many respects the fifth-generation Xi has turned the clock back toward dynamics enjoyed by the third-generation Jiang. He is taking significant political risk by (1) launching an anti-corruption campaign that targets officials even up to ex-Politburo level (Zhou Yongkang), (2) putting a substantial personal stamp on economic reform plans, and (3) engaging with the Chinese military in ways not seen for decades.

Xi’s relationship with the People’s Liberation Army (PLA) deserves special attention due to the effects it is likely to have on China’s foreign and security policies—an area where a single leader can exert much more control than he can over something as large and diffuse as the world’s second largest economy. In the specific area of relations with China’s military, Xi enjoys rapport and ease of interaction not enjoyed since Mao and Deng.

As the son of first-generation CCP leader and PLA co-founder (as a founder of the CCP guerilla movement in Shaanxi) Xi Zhongxun, Xi undoubtedly benefitted from observing his father’s professional contacts and interactions. A consensus candidate in many respects, Xi understands the CCP, the social dynamics and interconnections of its extended ‘red royalty,’ and the levers of PRC power extremely well. Likely thanks in part to his father’s connections, he served from 1979-82 as secretary to Xi Zhongxun’s former subordinate Geng Biao. As vice premier and Secretary-General of the Central Military Commission (CMC), Geng was effectively China’s secretary of defense.

Xi never gained operational experience and never commanded even a regiment—Mao and Deng were likely the last paramount leaders to enjoy such military credibility. But even Xi’s limited military experience puts him ahead of Jiang and Hu. Hu was widely regarded as uncomfortable and remote when dealing with the PLA, and there is no evidence that he ever succeeded in imposing his will by forcing it to do something it did not want to do bureaucratically, or preventing it from doing something it wanted to do bureaucratically.[1]

Even Jiang, who succeeded in ending PLA participation in most commercial sectors in 1998, took years to consolidate his power and promote key allies in the PLA. Until Deng’s death in 1997 and the retirement of his key allies, Admiral Liu Huaqing and General Zhang Zhen, as Central Military Commission Vice Chairman, Jiang was constrained significantly. By contrast, Xi has appeared extremely comfortable and confident in his interactions with the PLA from the start. He understands the PLA’s traditions, symbolism, and bureaucratic language—factors important to militaries worldwide, but perhaps especially so for this historically-transformative Party Army.

Xi’s closer relationship with the PLA—Is it a potential liability?

From the perspective of external security and stability, Xi’s capabilities and predilections bring both strengths and risks. Certainly the Party has commanded the gun consistently in recent years, so even Xi’s more militarily-limited predecessors were always clearly in charge of China’s military. The likely difference lies in Xi’s willingness and ability to engage closely with the PLA.

In peacetime, he may see it as more of a power base and be more comfortable attempting to cultivate modest tensions for domestic political purposes (e.g., vis-à-vis Japan) than were his immediate predecessors. In the event of a crisis, however, he likely has greater ability to act rapidly and decisively to halt trends that he sees as inimical to Chinese interests, even if it requires making politically-difficult demands of the PLA.

That said, in this respect, Xi’s higher level of comfort with the PLA could prove problematic. If Xi allows or perhaps even quietly encourages a managed confrontation (e.g., with Vietnam or Japan), the encounter could very easily spin out of control. If this happened, the politics would shift from conversations with generals and admirals over whom he has comprehensive influence, to a broader situation in which a popular nationalist reaction creates nearly irresistible escalatory pressures as popular nationalist outrage places the government in a position where it must either (1) escalate the fight with the foreign “foe,” (2) back down and lose legitimacy, or (3) crack down severely on popular elements demanding government action (and thereby also lose legitimacy).

Political risks will temper reform measures

Another key characteristic dating from Xi’s early formative experiences is strong political caution even as he considers economic reforms pragmatically. His father’s being purged by Mao and sent to factory work in Luoyang when Xi was 10, and being jailed during the Cultural Revolution when Xi was 15, before he reemerged as a top reformer under Deng could only have been searing experiences. Xi himself was sent down alone to the Shaanxi countryside in 1969. All CCP leaders must protect their ‘left’ political flank to some extent, but Xi’s background and determination never to face the trials that befell his father impels him to do this more than most. Hence Xi’s Maoist rhetoric, vow that he would never become a ‘Chinese Gorbachev,’ and tightening of domestic security to a degree even greater of that under Hu’s administration.

With regard to the Third Plenum reforms, what is most significant is Xi’s early and apparently comprehensive consolidation of power. This may well have been facilitated by cooperation with Jiang in the unusually-significant and -late inter-factional jockeying preceding the October 2012 18th Party Congress. Xi was well-placed to organize and negotiate the articulation of what are overall a set of ambitious, sweeping reforms. Nevertheless, a significant challenge looms: even a leader as powerful and capable as Xi faces considerable complications endemic to China’s system that will make it extremely difficult to fully match rhetoric with implementation.

Areas of Special Concern

Areas of particular emphasis in the Third Plenum reforms include opening-up, ‘new type’ urbanization, and “Beautiful China” environmental conservation. Areas of opening-up include deregulation of government administration, liberalization of the financial system, and adjustment of the fiscal policy and taxation system. An overall approach is to use financial tools to “let the market play a decisive role in the allocation of resources” (要紧紧围绕使市场在资源配置中起决定性作用深化经济体制改革). This may involve reducing energy and land subsidies. Among other applications, “Beautiful China” is to be facilitated in part by increased market pricing of resource inputs. Another issue is “food security” which was explicitly singled out in recent CPCCC sessions. In the short-run, grain supplies appear bountiful, but this is certainly going to be a hot topic given the association between previous Party policies and famine. Finally, an anti-corruption drive appears targeted at recentralizing authority rather than addressing root systemic causes of China’s endemic corruption. Yet many of these areas were priorities of China’s previous generation of leadership under Hu-Wen. What will be different this time?

One difference is greater efforts to establish bureaucratic structures to facilitate implementation of the reforms. After all, a high-level bureaucratic footprint is one of the greatest indicators of prioritization and political power in PRC system. This includes establishing a Central Comprehensive Reforms Group, drawing in part on capabilities and responsibilities associated with the National Development and Reform Commission. According to China Daily, “Part of the new group’s duties, apart from economic reform, is to plan and carry out reform on modernizing China’s ‘governance system’ and ‘governance capability’.” The other major bureaucratic announced in the context of the Third Plenum is the establishment of a National Security Commission (国家安全委员会).[2] This appears intended in part to ensure a stable environment for the reforms, which will create temporary winners and losers even if they offer major positive-sum contributions in the long run.

Reforms’ Relative Prospects

As explained above, the key determinant of the reforms’ success and significance will be their actual implementation. It is therefore useful to review their relative prospects. Here, three major categories suggest themselves for progress over the rest of Xi’s term: (1) lowest prospects for substantive reform, (2) likely mixed results, and (3) greatest prospects for tangible achievements.

  1. Lowest Prospects for Substantial Near-Term Reform: State-Owned Enterprises

In the Third Plenum-related text, China’s SOEs are in many respects akin to the dog that didn’t bark. Here, lack of significant wording changes signals unwillingness/inability to implement meaningful reform in this key area. Efforts are clearly underway to separate the incentives, loyalties, and compensation of Party administration from executive management, but these strands remain extremely entangled. Given the high-level interconnection among Chinese political and economic elites and their families, this is hardly surprising. China’s ~120 large SOEs have become a textbook case of vested interests: an unholy alliance of 钱 (money) and 权 (power), including at highest central elite level.

Efforts to date have been a mixed, tightly-cinched bag. Under a drive toward equity ownership, “mixed shareholding” structures are promoted but state shareholders retain de facto control of the companies. This undermines reform by curtailing incentives to enhance corporate governance. Moreover, centrally-owned SOEs are partially paralyzed by the high-level anti-corruption investigations unleashed by Xi, with China’s national oil companies particularly affected due to their recent connection with Zhou Yongkang. In the energy sector, retail petrol and diesel fuel stations, as well as some CNPC pipeline assets, are being put up for sale. However, due to the underlying strategic nature and sheer size of these assets, most prospective buyers are state or state-controlled entities, which undermines the ostensible goal of bolstering economic efficiency and instead simply creates an additional layer of SOEs that future reform actions will have to contend with.

Meanwhile, the National Development and Reform Commission (NDRC) continues to set prices in key sectors such as refined products, coal, electric power, and natural gas. Elsewhere in infrastructure, the Ministry of Railways has been corporatized, with possible spin outs of regional railway bureaus and/or discrete operating companies such as Railway Express. “Experimental” market pricing of freight rates has been introduced in some jurisdictions. As in the energy sector, however, foreign investment is not welcomed. Ultimately, these types of “reforms” break up monopolies, but effectively create a situation where each elephant that formerly lived on the state-run farm has been replaced by four cattle or eight sheep, all of which are still state-controlled.

The SOEs’ economic heft in China is massive and their political clout—and thus ability to dilute and resist reforms not in their self-interests—is commensurate. Credit Suisse estimates that at the end of 2013, the total assets of non-financial SOEs were equivalent to 160% of China’s GDP. Even a leader with Xi’s capabilities would not want to expend his political capital goring politically-well-connected ‘oxen.’ The CCP seeks to maintain control, influence, positions, and profit even beyond key sectors with national security implications. The proof is in the pudding: Chinese airlines, banks and other SOEs continue to grow in size and geographic reach, often using obvious state subsidies.

At most, there are likely to be compromises among key interest groups, and an incrementalist, lowest-common-denominator approach. This is readily apparent even in the two areas where SOEs are envisioned to be linked to reforms.

The first is an eventual state levy on 30% SOE dividends. On the one hand, the SOEs are a known quantity and will have to make some ‘patriotic contributions.’ This will help fund the development of a welfare state (detailed in category three, below). Yet given the latitude for creative accounting as the State Owned Assets Supervision and Administration Commission (“SASAC,” 国务院国资委) deals with the SOEs under its supervision, this may well yield less revenue that one might think. To further their bureaucratic interests, SOEs will no doubt figure out how to shift some rent seeking from bottom line profits to top line cost items. There are many ways to ‘compensate’ employees, particularly at the top level, that need not show up on the books as such.

Second, there is a proposal to cut SOE executives’ salaries by as much as 70%. Such an action makes sense, given the fact that some SOE corruption already stems from the fact that managers’ official salaries are arguably far out of alignment with their actual value contributions, there will be costs to further decreasing incentives to profitability.

But it is not without potentially serious side effects. For instance, one immediate result may to make managers even more cautious and less innovative, as avoiding mistakes under their tenure is their surest guarantee of promotion to a better future assignment in China’s bureaucracy. It may also drive SOEs to compensate executives “in kind” via housing subsidies, payment of private school tuitions or to issue stock options or other “deferred compensation.” Either route opens ample avenues for malfeasance and continued corruption if the salary reforms are not coupled with meaningful improvements to oversight—such as creation of truly independent auditors.

The idea the SOEs can be subjected to market forces through closer association with other entities—including private capital—is similarly likely to play out more complexly in practice. SOEs remain the 800-pound gorillas in China’s economic ecosystem, so at very least they will shape the entities with which they are associated, not simply be shaped by them. Cross-shareholding among SOEs and collective and private ownership may extend the State’s control top-down at the expense of entrepreneurship and competitiveness having a chance to percolate up from bottom. Paradoxically, this could create a new wave of 国进民退 (“advancing of the state advances, retreating of the private sector”), and thereby further exacerbate the already serious problems caused by SOEs “crowding out” smaller, more dynamic private enterprises.

  1. Areas likely to see mixed results

China’s new leaders, particularly Li Keqiang, view continued urbanization as one of the few ways to ensure continued economic growth. Increasing rural property rights and possible creeping residence permit (户口, hukou) reform are logical ways to attempt to continue urbanization while preserving social stability. Indeed, a leading source of protests has been rural land appropriation and the impact on the environment of the polluting industries that are often developed on this land.

But urbanization is far from being a panacea for China’s structural economic problems. First, the rate of urbanization appears to be slowing. This development is in part driven by China’s troublesome demographic profile, where its rapidly aging population has highlighted the relative lack of younger workers and contributed to rapid wage inflation in many parts of the country. Essentially, fewer young workers means fewer potential migrants to cities.

Urbanization reforms highlights local officials’ vital role in successful implementation

Second, attempts at reforming China’s urbanization model highlight a broad challenge that affects all reforms proposed by the Xi government—the necessity of persuading local officials to truly and positively participate in policy implementation. In some ways local officials may produce greatest resistance: they are least efficient, with fewest alternatives, and the most to lose. How can the districts over which they preside remain solvent and meet growth and employment targets without their land sales tool, particularly as resources are likely to be continually diverted to keep SOEs’ official balance sheets acceptable?

The raw numbers show why local officials are so critical to implementation. China has ~3,200 local party leaders: 2,862 counties, 333 prefectures and 31 provincial-level divisions (not counting Hong Kong and Macau). The central government will likely attempt to reorient local leaders’ incentives by assuming more responsibilities of its own and thereby reducing ‘unfunded’ or ‘underfunded mandates.’ Even if tax reforms and other schemes are implemented to compensate for lost revenue, however, local officials are likely to be skeptical that this will fully meet their needs.

While local officials cannot defy their superiors outright, they nevertheless have their own sources of leverage, under the time-honored rubric of 上有政策, 下有对策 (“from above there is a policy, from below there is a countermeasure”). In many cases, they will be able to feign compliance while resisting, delaying, or slow-rolling implementation. They can benefit from strength in numbers: the central government cannot evaluate or pressure them all simultaneously.

Hukou reform faces similar obstacles. As an upgrading of welfare benefits for certain category(ies) of individuals, it will raise the cost of urban social services provision significantly; increased consumption will only partially offset this. If the central government does not clearly provide sufficient funding alternatives, there are likely to be some of the same problems of official resistance as with rural property rights.

Even if local officials can be made to see hukou reform as better than a zero-sum game, resistance from existing urban hukou holders is likely to be significant and a sensitive issue for the CCP. One of China’s greatest challenges lies in its sheer internal disparities—most dramatically, between coastal cities with major swathes of G7 living conditions and Third World hinterlands. In China and around the world, people at different stages of economic development typically have very different life priorities.

To a degree that is unusual for a country of its economic size and aggregate development, China contains individuals on virtually all conceivable rungs of such a hierarchy. Geographic segmentation of residential rights and benefits, through the hukou system, has been the CCP’s primary method to deconflict these contradictory expectations as much as possible and thereby avoid social unrest and challenges to its leadership. In effect, China has established different social contracts with individuals at different levels of its hukou hierarchy.

This is where a volatile challenge to hukou reform comes in. China’s relatively urban dwellers are some of the nation’s most privileged and globally aware. Part of the CCP’s bargain with them has been that in exchange for accepting limitations on specific areas of political expression and participation, they enjoy a protected position at the top of Chinese society. Implicit in this contract is that the present authoritarian system will protect them from hordes of needy peasants with very different priorities. Preserving urban privileges while expanding rural opportunity appears difficult.

Even if new hukou benefits are more modest in name and substance, there is likely to be urban opposition—witness local reactions to integrating an outlying district of Chongqing into the urban core. China’s leadership is clearly aware of these problems. Not surprisingly, hukou-related proposals appear extremely modest thus far. Top-tier coastal cities are not even under consideration. Modest pilot programs thus far appear to target cities of such low tiers that many rural hukou residents would not want to move there anyway—the opportunities available there are too modest to outweigh the limitations but relative security of a rural homestead and plot of land. Such a parcel has the added benefit that agricultural property rights are more easily claimed if and when genuine land reform ever occurs. For reasons such as these, few want to move to, or live in, T3/4/5 cities. They can hand out hukous all day, but it won’t accelerate real urbanization.

Other areas pose challenges as well. Reigning in bank lending will likewise be difficult. Major infrastructure investment continues, shifting in part from highways to subways. Anti-corruption actions will remain selective and symbolic. This will likely remain a high-end luxury goods suppression story (e.g., regarding expensive watches) at most. A major concern for Beijing, particularly if PRC conditions are expected to deteriorate, will be how to limit capital flight through Macau while safeguarding casino revenues, on which the local economy depends.

  • Best Prospects for Reform: Where the CCP Can, and Must, Show Results

Despite the above areas of difficulty, there are also substantial opportunities for implementation of Third Plenum reforms. Xi Jinping will need to show results, making this ‘low hanging fruit’ particularly important to grasp. Substantial, decisive measures should thus be anticipated in several key areas.

  1. Opening the Welfare State Floodgates

As Xi Jinping and his generation of leadership seek to make virtue out of the necessity of economic slowdown, furthering their vision of improving living standards and a more just society while safeguarding social stability. Building a Chinese welfare state is thus an idea whose time has clearly come. Societal pressure will likely ensure that social responsibility is shifted upward from local governments to central government for national medical and pension coverage, asYanzhong Huang has documented cogently, but doing so will divert tremendous resources from future economic growth and defense spending. Pension reserves currently stand at only about2% of GDP and benefits are extremely small, especially in rural areas.

Social or Policy Housing is another societally-compelling idea that risks falling victim to political contradictions. As the recent Pledged Supplementary Lending (PSL) facility opened to China Development Bank for Shantytown (slum) Redevelopment illustrates, this is an area of serious policy effort. As with hukou reform, the political lowest common denominator of targeting numerous smaller cities where few want to live is likely to bolster official reports but underperform on the ground.

One of China most critical—and most underappreciated—challenges is the fact that it is getting gray and becoming unhealthy well before it becomes rich. There is an increasingly broad consensus that the rapid aging resulting in large part from decades of toughly enforced “One Child” policies will slow China’s economic growth relative to what it potentially could have been. Citigroup economists estimated in late 2013 that 3.25 percentage points could be shaved from China’s annual GDP growth over the next two decades as a result of rapid aging that leaves society top-heavy in terms of pension obligations and short of workers it needs to fully staff the economy.

In addition, a rising burden from chronic health conditions also threatens to weight on China’s economic growth prospects moving forward. To some extent, the full economic effects may be masked by the fact that rising healthcare expenditures still show up as positive GDP data. But the reality is that spending vast sums to treat patients with diabetes, heart disease, cancer, and other ailments is not as “productive” in terms of propelling sustainable growth as investment in technology, education, and other economic sectors would be.

To give a sense of the problem’s scale, China already has approximately as many diabetics per capita as the U.S., even though the Middle Kingdom’s annual per capita GDP levels are only a fraction of those in the U.S. Similarly, China is in the throes of a world-scale Alzheimer’s/dementia crisis. A 2013 study published in The Lancet estimates that China now has nearly 6 million Alzheimer’s patients and more than 9 million elderly suffering from dementia. For comparison, the Alzheimer’s Association estimates that the U.S., which has a much more developed (albeit still incomplete) mental health system than China, currently has roughly 5.2 million Alzheimer’s sufferers. When compared to the challenges and costs aging-related mental health issues pose in the wealthier U.S., it becomes clear just how serious a burden China faces.

To address these and other problems, the hospital system—and indeed the national healthcare infrastructure overall—badly needs investment and operational reforms, which could be driven by managers brought in by private investors. But for at least the next 3-5 years, private investment will likely come nowhere near the volumes of capital the sector needs. The reason? The legal status of privately invested hospitals is deeply unclear and private investors are likely to be very gun shy about entering a sector that is politically charged, and one in which the government may well turn private capitalists into scapegoats for any hiccups in reforming and attempting to improve the system. This is a deep irony because the government’s own missteps and failures to act when needed have helped create the gargantuan health and welfare challenges China now faces.

  1. Cleaning up the Air: Beautiful China

For a variety of reasons mentioned above, “Beautiful China” environmental conservation and resource pricing initiatives will be another area of significant achievement. First, China’s leadership realizes that the tremendous environmental damage wrought by three decades of meteoric economic development imposes an increasing toll on health and economic growth. Second, stemming environmental degradation has become a key objective for preserving CCP legitimacy. Pollution is an increasing source of both urban and rural protests. It is also one of the greatest disappointments of privileged urban dwellers, whose priorities have evolved to the point where they would support trading off economic growth for environmental improvement—a common dynamic that has driven the cleanup of other nations’ environments after they initially profited from developing their economies dirtily.

Third, environment and resource issues lend themselves to the sorts of statistical metrics, engineering solutions, and green technology development opportunities with which China’s technocratic leadership is comfortable and which its system is oriented to support. But environmentalists should not jump for joy just yet, as China is not killing the use of coal—it is simply shifting coal fired plants away from cities and clogged railway lines, and closer to the world-class thermal coal deposits in Central and Western China. Exhibit 2 (below) highlights this overall trend with data from the sometimes-optimistic World Resource Institute showing the amount of coal-fired generation capacity planned by province as of late 2012. Some specific data point have almost certainly changed on the margins, but this body of data reflects the core dynamic—coal will still grow for some time along with other energy sources. This is an especially important concept to consider given the fact that installing coal-fired capacity with significant capital investments now effectively “commits” the plants to emitting billions of tonnes of carbon dioxide over their operating lifetimes—which may be as much as 40 years.[3]

We have adjusted the data (originally in megawatts) to show how many millions of tonnes of additional coal per year will be needed to fuel these plants if they run at capacity.

Exhibit 2: China Planned Coal Power Capacity Additions, by Province (million tonnes’ coal demand)

China Coal Plants by Province_1H2014

Source: World Resources Institute, China SignPost™ analysis

The single biggest ‘deliverable’ from Third Plenum reforms in this regard is likely to be increased use of natural gas. This gas supply will come from four core sources (in descending order of anticipated importance): (1) pipeline gas from Central Asia, Myanmar, and possibly Russia, (2) liquefied natural gas (“LNG”), (3) conversion of Western China coal deposits into synthetic natural gas (“SNG”) and (4) greater domestic drilling.

Previously, LNG consumption was constrained by relatively high prices and limited infrastructure, which produced periodic shortages, particularly in winter months and away from coastal import terminals. Now that natural gas offers one of the few ways to quickly, and substantially, offset air pollution, China’s government is supporting greater gas supply and use through pricing incentive schemes and constructing coastal LNG terminals and inland pipeline infrastructure. For example, China Gas, one of the country’s largest private city gas suppliers, has increased its gas prices for industrial consumers by approximately 82% since 2006 (Exhibit 3).

Exhibit 3: China Gas price for industrial consumers, FY 2006-FY 2014, RMB/M^3

China gas pricing_3rd Plenum Exhibits

Source: China Gas, China SignPost™ analysis

To temper its growing reliance on imported natural gas and help speed the switch from direct burning of coal to generate electricity, China is also working to increase output of coal-based synthetic natural gas. We estimate each billion cubic feet (“BCF”) of SNG produced will require ~85,000 tonnes of coal. In terms of import substitution, four million tonnes of coal could generate enough SNG to replace one million tonnes of LNG imports. To put the SNG sector into perspective, gasifying 1 million tonnes per day of coal would supply more than 1/3 of China’s current total natural gas needs. SNG by itself cannot replace other sources of supply, but it holds the potential to substantially reduce China’s dependence on imported gas and gives it a bargaining chip to use against Russia and other potential suppliers it is currently negotiating with.

SNG is not an environmental panacea, as the production process uses massive volumes of water and emits significant volumes of carbon dioxide. It also poses engineering challenges that are manifesting themselves as companies begin to ramp up SNG output. For instance, Datang Power had to shut down its Keqi plant for three months in early 2014 to repair corrosion in its gasifier units. The need for alternative gas sources is sufficiently great that we have high confidence Chinese producers will resolve engineering problems resulting from scaled up SNG production.

With respect to emissions, the bottom line is that CO2 will not restrain China’s push to make coal-based SNG a significant portion of the national gas supply. As we wrote in February 2014:

“Chinese leaders care the most deeply about emissions that are visible (smoke) or acutely toxic (sulfur, NOX, and mercury). Such properties increasingly generate local opposition, particularly in wealthy coastal cities where residents’ priorities have changed rapidly to emphasize quality of life over rapidity of economic growth. Greenhouse gas emissions—which produce global, not local, problems, are a very different story.

With respect to carbon dioxide (CO2), an odorless, colorless, and non-toxic gas, Zhongnanhai clearly emphasizes the economic and social benefits of stable, low-cost energy generated from domestic coal. China’s leaders will pay lip service to concerns about CO2 emissions, but the reality is that growth still wins out over green energy.

Other Asian industrial powers with significantly less imperative for all-out economic growth than China have already calculated that higher CO2 emissions are a price worth paying to maintain economic competitiveness. Since 2000, South Korea, Taiwan, and Japan have all significantly increased the share of coal in their power generation at the expense of nuclear energy (Exhibit 4).

In South Korea, coal use rose from 35% of primary energy consumption in 2000 to nearly 53% in 2012, while Taiwan boosted coal use from 57.7% of primary energy use in 2000 to 69.4% in 2012. Japan increased coal use from 28.5% of primary energy in 2000 to 35.6% in 2012, a trend that could continue with opposition to nuclear power.

It is especially telling that each of these Asian Tigers increased coal use relative to that of other fuels even after they had far surpassed China’s current per capita GDP level. This strongly suggests that leaderships of industrial powers in the region will readily prioritize affordable, secure electricity supplies over more abstract concerns about possible long-term effects of CO2emissions. This is a classic ‘tragedy of the commons’ problem—individuals and societies tend to prioritize present parochial benefits over future collective goods.

Exhibit 4: Coal as % of Total Primary Energy Consumed in Japan, South Korea, Taiwan

Screen Shot 2014-02-20 at 7.03.53 PM

Sources: BP, China SignPost

Given that South Korea, Taiwan, and Japan are all representative democracies, it also suggests the populations supported greater use of coal because it was in their economic interest to do so.

Such regional evidence from societies far wealthier (and environmentally conscious) than China and ones in which the government must sell policy changes to citizens directly points to a future in which President Xi and his advisors continue supporting coal use—just in less air-polluting ways.”

On the visible air pollution front, reforms and technical development unfolding now are likely to have a substantial impact—particularly in China’s wealthier East Coast cities. However, on the carbon emissions front, change is likely to come much more slowly. The bottom line is that nuclear, wind, and hydro power cannot meet China’s call for affordable power in coming years unless significant new coal-fired capacity continues to come online each year.

Wind is inefficient and intermittent, requiring huge land areas and substantial thermal power backup ready to come online if the wind dies down. Nuclear power is a superb baseload electricity source, but China is not adding sufficient capacity for nuclear to significantly displace coal-fired generation. Even with the current aggressive reactor buildout, China is slated to add a maximum of 32 GW of nuclear power in the next five years—roughly half of the coal-fired capacity it has added annually in recent years. Moreover, this high-end number assumes that all reactors currently under construction are (1) actually built and (2) completed on time. Finally, hydropower is vulnerable to droughts and environmental opposition that is much fiercer and more locally-concentrated than coal plants face.

The nuclear plants currently under construction are also exclusively located in coastal provinces (Exhibit 5). This strongly suggests that coastal nuclear plants are simply displacing coal-fired generation capacity that is then effectively re-constituted further inland. Moreover, NIMBYopposition to nuclear plants may grow, particularly in the most affluent coastal areas.

Exhibit 5: China Nuclear Power Capacity Under Construction, by Province

China nuke capacity under construction_Sep. 2014

Source: IEAE, WNI, China SignPost

Gathering Slowdown and Dissipation: S-Curve Factors Setting In

One of the greatest challenges facing Xi Jinping and the success of the Third Plenum reforms is that even as overall implementation remains challenging over the next few years, larger structural factors are already beginning to slow China’s economic growth overall.

S-Curve Trajectory

China’s present growth trajectory may not be sustainable. The economic model that served China so well for the past three decades appears unlikely to propel rapid economic growth much longer. China already suffers from acute domestic problems, including resource (water) constraints, environmental degradation, corruption, urban-rural division, and ethnic and religious unrest; these may grow further and be combined with looming demographic and gender imbalances to strain both China’s economic development and internal stability. These problems could combine with rising nationalism to motivate Chinese leaders to adopt more confrontational military approaches, particularly concerning unresolved Near Seas claims. Rather than portending an impending “collapse,” however, these factors may herald China’s version of the same slowdown in national trajectory that has afflicted great powers throughout history.

As the American political scientist Robert Gilpin has documented, great powers tend to follow an “S-curved” trajectory in which the very process of growth and development sows the seeds for its eventual abatement. Initial territorial and institutional consolidation and infrastructure development underwrites rapid growth, fueled by cheap labor and resources. Particularly impressive results may be achieved if the government promulgates and enforces effective policies in the right areas, and stays out of the way in other areas. Eventually, however, a wealthier society demands increases in wages and social spending. Commitments abroad become unprofitable because of allied free-riding and collective action problems in public goods provision. Urbanization and improved living conditions change social mores and individual priorities, thereby reducing birth rates while life spans lengthen. However morally desirable any of these three trends may be, they all reduce the growth of economic and national power. If it does not fall in absolute terms, it levels out or at least slows.

While China may have limited its foreign commitments for now—and even abandoned forms of foreign aid that were burdensome to an impoverished China during the Cold War—it may be headed for rapid changes in the other two areas. In fact, the unleashing of Chinese society in 1978 after a century of foreign predation and internal turmoil and three decades of abnormally constricted individual possibilities and economic growth may have disguised the subsequent three decade economic boom—facilitated though it was by pragmatic policies and globalization—as a “new normal” when in fact it was an exceptionally-well-managed catch up period that cannot last. Indeed, this one-time funneling of national potential, which has produced urbanization of unprecedented scale and rapidity, coupled with the world’s greatest artificial demographic restriction (the “one child” policy) and dramatic internal disparities, may be sending China along the “S-curve” faster than any other major power has gone before. Any relaxation of one child policy comes too little too late for averting demographic slowdown. A new CASS report projects that by 2030, China will have world’s highest proportion of people over 65, higher than even Japan. China is already approaching a Lewis Turning point into a labor shortage economy. China may thus be further along the “S-curve” than many realize. A 2012 OECD report forecasts that India and Indonesia will surpass China’s GDP growth rate by 2020.

Even if implemented with the greatest success conceivable, some of the key reforms that Xi Jinping is proposing—and many of the most likely to garner popular support sufficient for their successful implementation—are themselves connected with potent S-curve factors, and will even accelerate and deepen their impact. Expanding China’s welfare state, for instance, will crowd out other forms of spending. One of China’s greatest strengths in recent years is its ability to obligate tremendous resources rapidly to programs for security, infrastructure, and technology development. Many of these programs are not seen as particularly efficient at yielding results commensurate with resources allocated, however. As competition for resources intensifies, ability to generate goods efficiently will face unprecedented tests. This is the central problem with “forcing growth” at ~7.5% of whatever target is specified. China is achieving this only through theaccumulation of debt, which—while still moderate—is mounting very rapidly.

Not the Last Word, But…

Xi’s present efforts could conceivably help create political and security context for more difficult future reforms. But is that his intention, and if so can he pull it off? Specifically: Can China achieve an economic rebalance to avoid the middle-income trap that typically plagues developing economies before S-curve factors develop overwhelming momentum of their own?

It seems unlikely that the leadership’s goal of rebalancing to a domestic consumption-based economy sufficient to support a new growth model can be achieved. A true transition from government investment and manufacturing toward an innovative service economy would appear to require reforms that vested interests are likely to block and leaders are likely to view as being too politically risky.

The heart of the problem is that China’s leaders are beset with strategic ambivalence: they know what they need to do from an economic standpoint, but cannot do it fully because this would undermine their authority. Beijing cultivates notions of a “Chinese dream,” but cannot afford to allow individuals to define it for themselves—particularly in the public square. Faced with this dilemma, short-term stability to preserve the CCP’s power will always prevail. And true reform will always yield to strengthening the existing political-institutional order. Even the dynamic Xi-led leadership is thus likely to muddle through some of the most difficult areas, leaving insufficient progress before S-curve slowdown factors become increasingly limiting.

As Larry Summers warns, it would be a mistake to fall for “Asiaphoria.” Given these realities, “Chinaphoria” is a sort of irrational exuberance that should be particularly avoided.

**The authors thank two anonymous China political risk and investment experts for helpful inputs.

[1] Nan Li, Chinese Civil-Military Relations in the Post-Deng Era: Implications for Crisis Management and Naval Modernization, Naval War College China Maritime Study 4 (January 2010), http://www.usnwc.edu/Research—Gaming/China-Maritime-Studies-Institute/Publications/documents/China-Maritime-Study-No-4-January-2010.aspx.

[2] Joel Wuthnow, “Decoding China’s New ‘National Security Commission’,” CNA China Studies (November 2013), CPP-2013-U-006465-Final, http://cna.org/research/2013/decoding-chinas-new-national-security-commission.

[3] For more on this emerging mode of thought, please see the work of two eminent climate scientists from UC Irvine and Princeton who pioneered the idea. Stephen J. Davis and Robert H. Socolow, “Commitment accounting of CO2 emissions,” Environ. Res. Lett. 9 (2014),http://iopscience.iop.org/1748-9326/9/8/084018/pdf/1748-9326_9_8_084018.pdf.

China SignPost™ (洞察中国) #44: “China’s S-Curve Trajectory: Structural factors will likely slow the growth of China’s economy and comprehensive national power”

Gabe Collins and Andrew Erickson, China’s S-Curve Trajectory: Structural factors will likely slow the growth of China’s economy and comprehensive national power,” China SignPost™ (洞察中国), No. 44 (15 August 2011).

China SignPost™ 洞察中国–“Clear, high-impact China analysis.”©

Key Points:

 –China is likely to follow an S-Curve-shaped path of slowing growth as key internal and external challenges—including pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—feed off of one another and exact increasingly large costs.

 –One prominent China-based economist believes that the country’s growth will need to slow to 3-4% per year—less than half the current rate—if it is to sort out structural imbalances in its economy.[1]

–China is encountering these headwinds at a much earlier stage in its development than did the U.S. and other great powers, thanks in part to its late start in modernization and its dramatic internal disparities.

 –China could very well continue to expand its economy (and by extension its national power) at a rate that the U.S., Japan, and many European countries would envy.

 –However, the global economic, environmental, and security implications of 4-5% Chinese economic growth are very different from a 7-8% annual growth regime.

China faces costly internal and external challenges that are likely to ease the country onto a structurally-constrained slower-growth trajectory. For all its policy navigation, efforts to guide national development, and claims of exceptionalism, China is not immune to larger patterns of economics and history. As such, it will likely not be able to avoid the S-Curve-shaped growth slowdown that so many previous great powers have experienced, and that so many observers believe the U.S. is undergoing today.

Where China is headed domestically and internationally has major implications across the board for virtually everyone on this planet. According to the U.S. National Intelligence Council (NIC), “China is poised to have more impact on the world over the next 20 years than any other country.”[2] China is already the world’s second largest economy, second largest energy importer, largest natural resource importer by volume, and largest emitter of greenhouse gasses.

China’s future trajectory is a hotly debated global question in part because America is depicted in many quarters (with considerable exaggeration, we would argue), as a Roman Empire in terminal decline, a weary Great Britain in danger of being surpassed—most likely by China, and even an over-extended and over-militarized Soviet Union that faces devastating collapse if it fails to reorder its priorities drastically.

In a recent speech, China expert Ambassador Chas Freeman, President Nixon’s interpreter during his 1972 visit to China, declared: “The balance of prestige, if not yet the balance of power, between the United States and China has shifted… In some disturbing ways, Sino-American competition is beginning to parallel the contest between us and the Soviet Union in the Cold War. This time, however, the United States is in the fiscally precarious position of the USSR, while China plays the economically robust role we once did.”[3]

These historical analogies gain traction because relevant patterns may be discerned in history, most famously by Paul Kennedy in The Rise and Fall of the Great Powers. Kennedy claimed that a declining “Great Power is likely to find itself spending much more on defense than it did two generations earlier, and yet still discover that the world is a less secure environment—simply because other Powers have grown faster, and are becoming stronger….”[4] Sound familiar?

Indeed, the S&P has downgraded the U.S. credit rating from the AAA level it held for 70 years down to AA+ with a negative outlook, and Beijing is lecturing the U.S. to protect its investments. In a strongly worded editorial on 6 August 2011, Xinhua, one of China’s main state-controlled media entities, declared that “China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.”[5]

China has risen at a rate beyond even its leaders’ expectations over the past three decades and a power shift is afoot in the international system. The fully unipolar system that persisted from 1989 to roughly 2008 is no more. To many, this signals a clear power transition in which China is poised to overtake the United States as the world’s foremost power.

Estimates emerge constantly as to when China’s economy will become larger than that of the U.S., and there are larger assumptions that China’s diplomatic, information, and military aspects of national power will grow in proportion. Proponents of this view may cite predictions like those made by Goldman Sachs and PricewaterhouseCoopers, which predicted that China’s GDP would exceed that of the U.S. by 2027 and 2020, respectively.[6] Here it is worth noting that Goldman’s newer number is a revised forecast based on the firm’s original view, expressed in 2003, that China’s GDP would surpass that of the U.S. in 2041.[7]

Yet at workshops, policymakers’ offices, and water coolers around the world, a substantial portion of discussions revolve around a more immediate question: “by how much is China’s economic growth going to drop in 2011?” One prominent China-based economist believes that the country’s growth will need to slow to 3-4% per year—less than half the current rate—if it is to sort out structural imbalances in its economy.[8]

This consensus has important implications for near-term economic policies and financial asset allocation decisions, as continued weak U.S. growth, an ongoing debt crisis, and an earthquake-weakened Japan leave China as the single main financial engine that could help sustain global economic growth. Yet China also faces a litany of problems and itself is already highly extended on its own stimulus plans, which were implemented in response to the 2008 global financial crisis. Beijing’s criticism of current events in the U.S. is reasonable and understandable, but the leaders in Zhongnanhai face a range of equally pressing, if not larger structural challenges to growth and development in their own country. Indeed, this is likely part of the reason—propaganda opportunities aside—that China is so concerned about what happens in the U.S., given the potential impacts on China’s own growth.

The ever-increasing importance for China as a global economic and political player raises a larger, and far more fundamental, question: “are China’s economy and national development following an S-Curve trajectory that will bring slowing growth rates in coming years?” Manifold internal and external challenges China faces are likely to increasingly become headwinds for growth. Despite the skill and will of China’s leadership to keep the country on a robust growth course, the fundamental nature of many of these issues make it seem ever-more-likely that China may be easing onto a structurally-constrained slower-growth trajectory.

In its early years of modernization, China exploited low labor costs and initial infrastructure investment to grow rapidly but is beginning to assume social welfare and international burdens that will likely slow growth progressively and may even check China’s rise in the international system as its leaders are forced to make much more difficult sets of “guns vs. butter” decisions.

China’s unfolding confluence of factors that may retard national development is especially noteworthy given the country’s massive size and global importance and because China is encountering these headwinds at a much earlier stage in its development than did the U.S. and other great powers, thanks in part to its late start in modernization and its dramatic internal disparities.

China could very well continue to expand its economy (and by extension its national power) at a rate that the U.S., Japan, and many European countries would envy. However, the global implications of 4-5% Chinese growth, with considerable risks that are shifting from upside to downside[9] virtually across the board, are very different from a 7-8% annual growth regime. As such, we hope to catalyze useful discussion on how to cope with a lower-growth S-Curve future that could be very different from the optimistic straight-line growth projections that dominate current views of China.

What is an S-Curve?

The S-Curve concept comes from a mathematical model that was later applied to other fields including physics, biology, and economics, to show how entities’ growth patterns typically change over time. In his seminal work War and Change in World Politics, Robert Gilpin uses the concept of an S-Curve to describe how great powers rise and decline.[10] He argues that a state must inevitably decline because of an historical tendency for national efficiency to decrease as society ages, thereby creating a downward spiral of increasing consumption and decreasing investment that undermines the economic, military, and political underpinnings of a state’s international position. A society or country experiences slow growth at its inception, then enjoys more rapid growth as more resources flow into the state treasury.

The process continues until the state reaches its maximum growth rate, an inflection point at which various countervailing forces begin to constrain expansion and set the economy onto a slower growth path or even a state of equilibrium. Domestically, social spending and rent seeking behavior may threaten productive investment and economic growth. Internationally, a hegemon tends to ‘overpay’ for influence in the international system because of the tendency for allies to ‘free-ride,’ and the inherent propensity toward technological diffusion may threaten to undermine a hegemon’s economic and technological leadership. But differences in national system and circumstances may have profound implications for the creation and maintenance of national power.

Rather than using Gilpin’s observation and the S-Curve pattern as iron laws, it is more instructive to use them as conceptual lenses with which to examine the potential future trajectory of great powers. Indeed, business authors point out that companies can undergo multiple S-Curve development cycles and there is no reason in theory why a country could not do the same.[11]However, for a nation-state, such a rebirth typically takes decades if it happens at all, especially in one as large and diverse as China. Exhibit 1 (below) shows an S-Curve trajectory for national development.

Exhibit 1: National Development S-Curve Schematic


Many have argued recently that S-Curve-like factors such as explosive growth in healthcare and pension costs and military/overseas commitments threaten American prosperity and preeminence, but few have considered the possibility that similar factors could constrain China—and perhaps much sooner than commonly anticipated.

China’s countervailing forces are not deterministic, but managing them will require major shifts in the country’s economic, and perhaps, political structure. This may substantially constrain the country’s potential economic growth and proportionately, its ability to invest in education, innovation, the military, and other factors that help determine a country’s comprehensive national power.

This analysis divides key challenges that China faces into the following categories: political, demographic, structural, economic, and security. We follow this order because the political system’s prior emphasis on ‘growth first, other things second’ helped produce a variety of the structural issues discussed below (such as high incidences of cancer and other chronic diseases), as well as the economic issues (such as local governments’ use of debt), and because civilian and military officials decide China’s military strategy and then have to find ways to pay for it, taking into account the financial environment in which they are, and will be.

A key point here is that these problems do not occur in isolation. Rather, they interact as a dynamic system and have real potential to be mutually reinforcing. For example, if the high local government debts end up yielding a large pool of non-performing loans that require the central government to liquidate them, that would effectively remove funds that could otherwise have been used to address chronic diseases or invested in value-accretive items such as education, research and development, or the Chinese military.

Exhibit 2: Key Factors that are Tipping China’s Economic Growth Scale


Political Issues

Official views of growth. China’s leaders are struggling to balance growth and social stability. Foreign analysts should consider the possibility that a substantial portion of Chinese leaders, especially at the national level, may privately welcome a shift to a structurally lower, but still robust growth path that emphasizes quality of development as opposed to sheer quantity of GDP. The new 5-Year Plan’s target of 7% annual GDP growth,[12] in contrast to the previous 7.5% annual growth benchmark, suggests shifting internal perceptions regarding the importance of balancing quality and quantity of economic growth.[13]

For a central government with a long-term development strategy, 20 years of steady and slower economic growth could potentially be a more attractive path than five years of above-target annual growth followed by 15 years of slow growth as unchecked pollution, chronic health issues, and other sustainability challenges exact a toll. Stable, medium-paced growth potentially offers a brighter future for China than overheated growth that creates boom-bust dynamics. A local official attempting to get promoted to the next level, by contrast, is judged on short-term growth just as an American corporation is preoccupied with quarterly profits, often at the expense of long-term strategy. Herein lies one of China’s most intractable governance challenges.

Potential Political Evolution

China’s leadership is becoming increasingly pluralistic, with each successive leadership transition creating more of an oligopoly; as opposed to a virtual monopoly in which one paramount leader like Mao Zedong or Deng Xiaoping could steer the country largely by himself. The Communist Party retains an absolute hold on political power, but there is a rising probability that coming years could see a transition into a leadership that is still authoritarian in many respects, but which more explicitly bases its legitimacy on a mix of technical competence and nationalism and allows for more pluralistic expression and consideration of policy suggestions, at least within government channels.

Of course, if such approaches fail to satisfy the ever-higher demands of public opinion, it is always possible that political change could occur more rapidly, and perhaps in a more disruptive manner. Political unrest might also materialize in specific areas, spurred by ethno-religious disaffection in Xinjiang or Tibet, or in response to a variety of other concerns there and elsewhere. No matter what the ultimate course, it seems likely that a broader range of political movements and viewpoints will find their expression in Chinese politics over time.

If China’s popular press and web discussions are any indicator of broader public sentiment, a political pluralization that allows more competing views to vie for influence may initially increase nationalism and see it expressed in aggressive and assertive ways, as happened with the U.S. via the Yellow Press during the 1890s and through military and police actions in the Caribbean in the late 19th and early 20th century. History suggests much to worry about in this regard.

However with the passage of time, sometimes several decades, a nation that has transitioned to a more diverse political system will have arguably a greater chance of being stable, predictable, and “responsible” in its policies toward is neighbors, etc.—perhaps because its leaders, who must compete for public support, may face more checks and balances in spending their subjects’ blood and treasure; and national security policies, while sometimes harder to arrive at consensus on, will tend to be more reliable and durable over time because they reflect greater citizen support.

Demographic Issues

People matter, and so too do population trends, which are typically decades in the making and take equally long to reverse (if they can be at all in a relatively developed ‘post-Modern’ society), particularly in a country like China that does not have, and likely cannot accept, significant immigration to help rebuild the population. Demographic decline may enhance China’s domestic manifestation of Gilpin’s pattern. By ca. 2030-35 in even the most optimistic estimates, China will start aging to such a degree as to call any straight-line projections of its economic growth and other national power trends into serious doubt.

As demographer Nicholas Eberstadt relates, “China has been a sub-replacement society for perhaps twenty years [with a] current net replacement rate (NRR) [of] just 0.77, and some authoritative estimates suggest that it could be even lower than this.”[14] China’s population of young male manpower (ages 15-24) has already begun to decline.[15] Its total working age population is poised to start decreasing in 2015. This trend is exacerbated by traditions of early retirement, e.g. in clerical jobs, particularly for female workers. Already, the proportion of older, sicker, and less educated workers is starting to rise.

These trends threaten the core of China’s current labor-intensive growth model, which is built on manufacturing conducted by large numbers of extremely low-salaried workers. While China’s technological capabilities have improved in many respects, it has not yet succeeded in moving far up the added value chain. For the first time since China’s economic boom started in the 1980s, large numbers of factories in the industrial heartland of Guangdong’s Pearl River Delta have closed and others have struggled to find workers even after raising wages significantly.

China’s one child policy, for all its loopholes and unevenness in application—combined with the financial and social opportunities and pressures accompanying some of the world’s most rapid urbanization—is yielding a “4-2-1 problem”—an increasing population of “kinless families” of single children of single children with no aunts, uncles, or cousins, only ancestors and a child or two of their own at most. By one estimate, “by 2020 roughly 42% of urban China’s prospective parents [may] be only children… by 2030 only children would account for the clear majority (58%) of adults in this group.”[16]

“By any yardstick one cares to select,” explains Eberstadt, “Chinese society overall will be graying at a tremendously rapid, and indeed almost historically unprecedented, pace over the next generation.”[17] By 2040, “China’s projected proportion of senior citizens 65 years and older would be far higher than that of the United States or Europe today—indeed, possibly higher than any level yet recorded for a national population.”[18] “In urban China, fertility today is extraordinarily low, with TFRs [Total Fertility Rates] averaging perhaps 1.2 and TFRs of barely 1.0 in the largest metropolitan areas such as Beijing, Shanghai, and Tianjin.”[19] Meanwhile, albeit in part because of an exodus of young workers to cities, China’s countryside—envisioned to be the location of China’s next wave of low-cost growth to reduce inequality—is graying even more rapidly than its cities.

With sole responsibility for the care of four parents, couples in this position may increasingly look to the government for assistance. However morally valuable the pension and health care programs that emerge from this, they will take significant effort to establish as China lacks them almost completely now, and will detract from economic growth and defense spending.

A further consequence of the one child policy is a growing “surplus” of males that is already among the highest in the world. The current official sex ratio for 1-4 year old children is 123 (vice the biological norm of 105), and sex-selective abortion continues unabated. This may increase the number of men in their late thirties who have never been married from 5% to 25% by 2040—a trend of potentially significant social consequences, particularly in a country where universal marriage remains the norm.[20] In certain impoverished rural areas, it is already becoming extremely difficult for men to marry, which is fueling sham marriages and human trafficking and could ultimately result in unrest, as large pools of unmarried men in a society often spell trouble.[21]

Structural Issues

Chronic Health Problems and Pollution. China faces growing internal challenges from regional income disparities and rising incidences of chronic health problems such as cancer and diabetes that will require very significant financial resources to address while still trying to maintain economic growth. These health challenges are exacerbated by the rapid aging of Chinese society described above. World Bank studies have estimated that air pollution caused damages that could be worth as much as 4.6% of China’s GDP in 1995 and nearly 4% in 2003, while a recent MIT study estimates that the damages may have been as much as 6% of GDP in 2005.[22] Water pollution is also a serious problem. The bottom line is pollution has likely kept China from producing at its full economic potential.

Rising incidences of cancers that may be related to pollution (such as the more than 450 “cancer villages” clustered in heavily polluted areas) and lifestyle and diet-driven ailments like diabetescreate a major political dilemma: absorb the costs and treat the patients, or allow the many patients who cannot afford expensive long-term treatment to die and risk further alienating many segments of China’s population, which can communicate increasingly well through microblogs, mobile phones, and other means despite official Internet censorship and other controls.

Despite these problems, however, China will be less willing than many other countries “to sacrifice output growth to avoid environmental harm.”[23] Most economies, including those of the U.S., Europe, and the Asian Tigers, have developed using highly polluting industries first, and then improved environmental conditions when resulting growth in standards of living generated new societal priorities. Beijing’s desire to reduce the disparity between China’s First World coastal cities and Third World countryside make it unlikely that the ‘grow first’ mentality can be changed soon.

Water constraints. “Thousands have lived without love; not one without water,” as Anglo-American poet W. H. Auden reminds us. Access to potable water represents one of the greatest potential sources of conflict in the 21st century. In China, fresh water represents perhaps the most pressing resource shortage, since it directly impacts local and global food security. Local experts such as Zheng Chunmiao, director of Peking University’s Water Research Center, say that China needs to begin reducing water consumption or it will face dire consequences within 30 years.[24] Given that agriculture accounts for more than 60% of China’s water consumption, a logical step would be to either increase water prices or enact administrative restriction on use. Both options would likely reduce domestic grain production and force the country to import more staple grains, which in turn could increase global grain prices and trigger instability in the developing world akin to the food riots that occurred during 2008.

Economic Issues

Debt-fuelled growth. Chinese economic growth has relied heavily in recent years on fixed asset investment in roads, rails, bridges, and airports, among other things. To finance these projects, many local governments took out bank loans, creating a local government debt burden that China’s National Audit Office estimates to be worth US$1.65 trillion, or roughly 27% of China’s 2010 GDP. The People’s Bank of China has estimated that the real figure could be closer to US$2.1 trillion, according to Minxin Pei.

Pei’s work points out that many of the local infrastructure projects are highly leveraged, meaning that the borrowers are likely to face substantial debt service costs. This will be a major problem if Pei’s analysis holds true, as he cites a local banking regulator as claiming that only 1/3 of the investment projects will produce cash flows large enough to cover their debt service burden.[25]

Beijing’s decision to increase interest rates as it fights inflation may help slow the pace of debt accumulation in China, but with the existing burden, if China’s growth slows—driven by the factors we discuss, or possibly others—non-performing loans could quickly become a major problem. In turn, the diversion of state financial assets to resolve bad debt problems would exact opportunity costs by keeping the money from being used for more productive purposes.

Sustainability and future challenges of rapid infrastructure buildout

China’s rapid buildout of roads, rails, ports, airports and other physical infrastructure in the past several decades has been amazing in terms of its speed and scale. However, events such as the tragic July 2011 high speed train crash near Wenzhou raise three very important questions:

1.  What is the quality of this shiny and quickly-built new infrastructure?

2.  Are there large hidden future costs of having to demolish and rebuild infrastructure that was built for speed and sparkle rather than quality and safety?

3.  Will China be able to bear the longer-term costs of maintaining it in good, safe, working order?

With proper supervision, Chinese construction firms can build world-class infrastructure at competitive prices. However, in practice, the potent cocktail of politically-induced time pressure, corruption, and a safety culture that remains lax for a country with China’s aspirations have combined to yield an infrastructure base that far too often literally kills.

Examples in recent years include the increased death toll in the 2008 Sichuan earthquake due to shoddy buildings constructed by corrupt contractors who cut corners to pocket the difference between the cost of high and low quality materials; and the July 2011 Wenzhou train crash, which killed 40 people when lightning allegedly stopped a bullet train that was then rear ended by another. In contrast, Japan, which has operated its bullet train system for decades through major earthquakes and other events, has only experienced one fatal accident (when a passenger was caught in a door).[26] A key difference is that Japan spent the time and resources required, not only to build in both physical safety features (“hardware”) but also to train operators (“software”) to a very high standard.

Certain types of infrastructure are inherently dangerous and even countries with very strong safety cultures can experience major problems, as Japan has with its Fukushima nuclear power plants in the wake of the powerful March 2011 Tōhoku earthquake and tsunami. However, China’s ‘get it done as fast as possible’ infrastructure build-out mentality raises concerns as the country looks to build complex and potentially dangerous projects in coming years, including more than 26 nuclear reactors that are currently under construction and an additional 8,000 km to its high speed rail network if the full network that was planned before the Wenzhou crash is completed.[27]

The second concern is that additional Wenzhou-type accidents could generate pressure to re-do substantial portions of China’s infrastructure base, particularly railways. Such rebuilds would be very costly, would probably double the cost of originally building the project, and would also incur the opportunity cost of removing transport routes from service for a considerable time.

A third concern, and one that has largely gone unmentioned amidst the focus on building the infrastructure, is how much will it cost to maintain it? This is an issue that is not likely to manifest itself immediately, but could become an increasingly important issue in the 10-15 year timeframe, particularly if a substantial portion of the country’s infrastructure turns out to be low quality.

Poorly built infrastructure can kill and maim immediately, as China’s train crash shows, but even well built infrastructure can become unsafe as it ages if it is not cared for properly. Take, for example, the 4-year old I-35W bridge in Minneapolis, Minnesota, which collapsed on 1 August 2007, killing 13 people and injuring 145.[28] Rising wages and materials costs are likely to magnify the infrastructure maintenance burden China will face in coming years.

Rising production costs and the need to move up the economic value-added ladder. The majority of Chinese exporters serve as global subcontractors, effectively leaving a large portion of a product’s value added on the table. This is particularly true in the electronics sector, where Foxconn, perhaps the world’s premier electronics contract manufacturer, typically makes gross margins of 8-10%; while Apple, which develops and sells the iPhones and other gadgets, generally enjoys gross margins that hover between 35% and 40%. More broadly, Chinese export-focused industrial firms have generally made profit margins in the 3-5% range during the last seven years, according to JP Morgan.

For the Chinese government, the concept of moving up the value chain is a question of pride and profit. Foxconn is a powerful company, but likely does not represent the sort of national champion that Beijing wants to build its long-term economic development strategy around since an approach based on cost-competitiveness as opposed to quality, innovation, and branding leaves major parts of the economy highly resource-intensive relative to their output value and also exposes China to outsourcing risks of its own.

China also needs better intellectual property protection to move up the value added chain.[29]There is a rising culture of using the court system to defend intellectual property and business interests. A potentially thorny issue for Beijing is that as intellectual property and business assets receive increasing legal protection, Chinese citizens may ask why the country has space in the court system for safeguarding economic assets, but cannot extend the same level of legal protection to private property and personal liberties.

Continued repression of alternative viewpoints and covering up of information, like that seen in the wake of the tragic July 2011 Wenzhou bullet train crash, is not a promising sign in a country that needs a degree of openness for ideas and innovation to arise.

Improving quality control and branding. The two go hand in hand, because melamine-tainted milk and buildings that collapse spontaneously in Shanghai do not inspire the consumer confidence necessary to build a strong global brand and reap the economic rewards. Chinese companies are often highly innovative and efficient, but with the exceptions of Haier and several other firms, few have created global brands. A greater global brand presence would be a significant boost to China’s economic growth potential.

China’s domestic heavy equipment sector clearly shows how powerful branding is, with Caterpillar, John Deere, and other foreign vendors able to charge much higher prices for comparable equipment than can most domestic manufacturers. Brand building within China is likely to depend heavily on how well the business law and intellectual property (IP) regimes can protect innovations from the rampant and rapid copying that currently makes it difficult for innovative Chinese firms to recoup their product development costs and fully enjoy the economic value of their product and re-invest in new developments. For example, in terms of what a company can do, US$1 billion in revenue at 5% margins is very different from US$1 billion at 20% margins, which allows a company to invest more in its R&D and generally sets up a dynamic that can foster greater innovation and economic dynamism moving forward.

Security Issues

Internal security. China experienced as many as 180,000 “mass incidents” in 2010 and the government spent more last year on domestic security than it did in its official military budget.[30]The decision of Chongqing, China’s most populous metropolitan area, to install at least 200,000 additional security cameras in the next three years as part of its “Peaceful Chongqing” initiative, atop the 300,000 it already has in place, sheds light on the sense of insecurity Chinese officialdom currently feels. Installing the project infrastructure is expected to cost at least 5 billion RMB (US$774 million), according to the Chongqing Daily.

The camera system will be paired with a range of analytical software and authorities also aim to link a range of diverse camera feeds to allow more effective monitoring. The upfront investment in such projects is huge and can run into the billions of dollars for a large city. However, over the longer-term, greater use of automation helps reduce China’s traditional reliance on a very people-intensive approach to security and surveillance. Large video surveillance networks backed by analytical software and server-based video archiving may offer a cheaper (and more effective) tool for monitoring dissent. In essence, cameras are simply replaced when they get old and do not sleep on the job, or demand pay raises, benefits, and pensions.

Also, once the basic network and analytical architecture are built, additional cameras can be added at a relatively low unit cost and likely for much less over time than the US$2,500-to-5,000 or more per year that it would likely cost to employ each human intelligence agent. At the same time, other Chinese approaches to security, bureaucracy, and commerce remain extremely people-intensive, and it is unclear how sustainable these approaches may be as wages and personal expectations rise in coming years.

External Security. China’s military modernization likewise depends heavily on the state of the economy. Strong increases in spending will be essential for China to secure the role it desires as East Asia’s most powerful non-U.S. military force. To truly displace the U.S. from the region and become a more globally-capable power, even larger spending increases would be needed. In addition, the country’s robust economic growth has also injected China’s leaders with a new confidence and assertiveness, particularly since the 2008 financial crisis, while also allowing the People’s Liberation Army (PLA) to rapidly boost its military spending and modernize its arsenal. In short, China’s rise as a key global economic and security player depends critically on its economy and the trajectory of its power moving forward is likely to hinge heavily on the country’s economic growth path.

Demography too is likely to influence the PLA’s future doctrine and capabilities. Many trainees from urban areas—the vast majority of which are single children—are said to be physically unfit and psychologically fragile. But part of this trend is spreading even to rural areas, which traditionally supply the bulk of PLA recruits. By some estimates, 80% of enlistees in PLA operational units are single children.[31] The consequences of the PLA becoming a “Single Child Military” should not be underestimated—it may have significant implications for families’ willingness to part with sons for conscription periods that could interfere significantly with rural agriculture, and could even increase casualty aversion to unprecedented levels that might not be compatible with some elements of PLA doctrine.

In the longer term, a variety of factors may limit PLA budget growth, at least to some extent. Various structural factors including higher health care and pension costs and rapidly rising wages that will erode the Chinese defense industry’s labor cost advantages could greatly restrict China’s ability to sustain rapid military spending growth, regardless of its leaders’ intentions. Personnel, equipment, and operational costs are all rising for the PLA, and there will be a limit to what can be afforded in the future. In coming years, China’s leaders are likely to face wrenching tradeoffs not seen since the post-1978 reforms as China’s population ages, develops increased lifestyle expectations, questions the wisdom of tolerating a growth-at-all-costs mentality, and yet is likely to remain strongly nationalistic.

Additionally, even if the PLA budget continues to grow steadily, factors internal to the PLA could compound the national structural factors discussed above and limit its overall force structure and capabilities.[32] For example, increased personnel costs are already consuming an increasing percentage of its overall budget as the PLA works to improve the living standards of its soldiers and their families. PLA officers, for example, now bring home roughly US$845 (5,400 RMB) per month on average, the highest in PRC history, a very competitive wage compared to Chinese state owned enterprise employees’ average monthly earnings of closer to US$626 (4,000 RMB).[33]

Even at a lower level of defense spending, China could still increase its power and influence substantially in East Asia and even challenge U.S. and allied interests there substantially, but the nature of the challenge could be very different depending on how Beijing chose to allocate its resources between national defense and pressing domestic priorities such as education and healthcare.

China’s military is developing in concentric layers of progressively lower emphasis and capability, with mainland China’s domestic security as the highest priority and most intensely emphasized area of development; the Near Seas (Yellow, East China, and South China Seas) second; the Indian Ocean third, and other “far seas” fourth. Beijing’s current focus developing conventionally-powered submarines, missiles, sea mines and other platforms and weapons systems that focus on anti-access/area denial (A2/AD) missions in the Near Seas by targeting specific physics-based limitations in foreign systems is an extremely efficient and cost-effective approach.

Developing high-level combat operations capabilities far beyond the Near Seas would negate many of these efficiencies for Beijing. It would entail a loss of strategic focus, new operational liabilities, and perhaps more complex and costly strategic relations. It would require both massive platform and weapons systems investments and operational and personnel costs; as well as mastering, and becoming more reliant on, the developments in air- and space-based platforms and C4ISR needed to support significant military operations far from the many facilities on or near China’s shores.

Ironically, these systems might become more vulnerable to the very sort of electronic, computer network, and kinetic attacks and other asymmetric measures that Beijing is pursuing to offset U.S. military power. This could place PLA forces at the costly end of some of the same asymmetric arms races from which they have thus far benefitted.


China’s rise could be slowed, complicated, or even threatened in critical aspects with derailment by a wide range of other issues, including water and resources shortages, environmental devastation, ethnic and religious discord, income and urban-rural inequality, enduring corruption, social unrest, and political transition.[34] “Any of these problems might be soluble in isolation,” assesses the NIC, “but the country could be hit by a ‘perfect storm’ if many of them demand attention at the same time.”[35]

Such setbacks could be particularly dangerous for the Party given popular expectations of rising living standards and foreign treatment of China being based in part on its perceived future potential. Substantial economic and even political reforms—at least increased rule of law, political pluralism, and freedom of expression—may be needed to address the needs of Chinese society in the future.

Disruptions to China’s growth would hit mineral exporting countries particularly hard, as demand for iron ore, copper, oil, soybeans, machinery, and other good and resources has come to drive much of the economic growth enjoyed by Brazil, Chile, Russia, Australia, Indonesia, and other resource producers. China accounts for a large percentage of global demand of many key commodities, including crude oil, copper, aluminum, coal, and soybeans (Exhibit 3). In many cases, China’s share of demand for the commodity has increased substantially. For example, China consumed an estimated 22% of global copper demand in 2006 and 37% in 2010 and 20% of global soybean demand in 2006 and 27% in 2010.

Exhibit 3: China share of global demand for key commodities

% of total global consumption, by year

Source: International Copper Study Group, Rusal, USDA, BGRIMM, China SignPost

In recent years, China has accounted for the lion’s share of global demand growth for a range of very important commodities. In some instances this reflects the shift of energy and commodity-intensive industries to China—as is the case for aluminum, lead, and zinc, for example. In other cases such as soybeans, it reflects the reality that China’s domestic demand for a given natural resource or agricultural product is growing explosively as consumption of meat and other goods rises.

On the microeconomic level, companies—particularly in the natural resources sector—are making multibillion dollar investments predicated on assumptions of strong Chinese growth for decades to come. Lower economic growth rates in China would still produce substantial annual increases in mineral demand due to the country’s massive economy, but a mining firm that uses 7-8% Chinese growth as a base case for developing a project could face difficulties if the longer-term growth rate turns out to be ‘only’ 4% per year.

The same construction and commodity demand boom has also made China a key focal point for the investment community, which is arguably coming to care as much or more about Beijing’s economic policy measures as it does about the actions of the U.S. Federal Reserve Bank. Viewed in this light, anyone who owns stocks or receives a pension from funds with investments in Chinese firms or companies who are deriving a substantial portion of their profits and growth from the China market should pay attention to this.

On the strategic front, slower growth and rising costs from internal challenges could crimp China’s ability to spend on military modernization. This could substantially curtail the country’s ability to become a major naval and air power outside of its immediate neighborhood.

As for the S-Curve dynamic and what can be done about it, Beijing’s leaders will surely state that they retain control. As for the United States’s own S-Curve dynamic, its far-less-externally-unified leadership will likely continue to put faith in the American system to perpetuate prosperity and preeminence. Such a ‘strategy’ of ‘hope,’ is hardly more realistic than one of central planning, however.

To be sure, the U.S. still enjoys abundant resources, cutting-edge universities and research institutions, an innovative capitalist economy, the world’s largest and most advanced military, a diverse and adaptable democratic society, a robust and reasonably efficient legal and regulatory system, attractive cultural “soft power,” and the most favorable demographic and immigration profile in the OECD, and allies, friends, and partners with which to cooperate.

China itself enjoys the advantages of relatively high government policymaking coherence and a large population with an enterprising spirit that values education and has a tremendous work ethic.

Having studied the history of great powers’ rise and fall closely, Paul Kennedy approvingly cites 19th century German statesman Otto von Bismarck as stating that such nations are condemned to “‘steer with more or less skill or experience’” in a “‘stream of Time’” that they can “‘neither create nor direct’.”[36] Time will tell the extent to which Beijing and Washington are chained to their S-Curve trajectories. Regardless of their respective courses, the impact will shake the world.

About Us

China Signpost™ 洞察中国–“Clear, high-impact China analysis.”©

China SignPost™ aims to provide high-quality China analysis and policy recommendations in a concise, accessible form for people whose lives are being affected profoundly by China’s political, economic, and security development. We believe that by presenting practical, apolitical China insights we can help citizens around the world form holistic views that are based on facts, rather than political rhetoric driven by vested interests. We aim to foster better understanding of key internal developments in China, its use of natural resources, its trade policies, and its military and security issues.

China SignPost™ 洞察中国 founders Dr. Andrew Erickson and Mr. Gabe Collins have more than a decade of combined government, academic, and private sector experience in Mandarin Chinese language-based research and analysis of China. Dr. Erickson is an Associate Professor at the U.S. Naval War College’s China Maritime Studies Institute (CMSI) and an Associate in Research at Harvard’s John King Fairbank Center for Chinese Studies. Mr. Collins is a commodity and security specialist focused on China and Russia.

The authors have published widely on maritime, energy, and security issues relevant to China. An archive of their work is available at www.chinasignpost.com.

[1] Michael Pettis, “Get Used to Slower Chinese Growth,” The Wall Street Journal, 11 August 2011, http://www.carnegieendowment.org/2011/08/11/get-used-to-slower-chinese-growth/4li5.


[2] Office of the Director of National Intelligence, Global Trends 2025: A Transformed World(Washington, DC: National Intelligence Council, November 2008), vi-vii,http://www.dni.gov/nic/PDF_2025/2025_Global_Trends_Final_Report.pdf.

[3] Mark Thompson, “Veteran U.S. Diplomat: We Are Becoming the USSR,” Battleland Blog, 17 May 2011, http://battleland.blogs.time.com/2011/05/17/veteran-u-s-diplomat-we-are-becoming-the-ussr/.

[4] Paul Kennedy, The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000 (New York: Vintage Books, 1989), xxiii.

[5] “After Historic Downgrade, U.S. Must Address its Chronic Debt Problems,” Xinhua, 6 August 2011, http://news.xinhuanet.com/english2010/indepth/2011-08/06/c_131032986.htm.

[6] “Convergence, Catch-Up and Overtaking: How the Balance of World

Economic Power is Shifting,” PricewaterhouseCoopers LLP, January 2010,http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1626; and Jim O’Neill, “China Shows the World How to Get Through a Crisis,” Financial Times, 23 April 2009, http://www.ft.com/intl/cms/s/0/dd9b5a1e-2f9f-11de-a8f6-00144feabdc0.html#axzz1BfEyxaV7.

[7] “Dreaming with BRICs: The Path to 2050,” Global Economics Paper No. 99, 1 October 2003,http://www2.goldmansachs.com/ideas/brics/book/99-dreaming.pdf.

[8] Michael Pettis, “Get Used to Slower Chinese Growth,” The Wall Street Journal, 11 August 2011, http://www.carnegieendowment.org/2011/08/11/get-used-to-slower-chinese-growth/4li5.

[9] “Upside” risks are possible trends that could drive further growth—for example, urbanization and higher domestic consumption. “Downside” risks are possible trends that could constrain growth and development—for example, chronic health problems and high local government debts.

[10] Robert Gilpin, War and Change in World Politics (Cambridge, UK: Cambridge University Press, 1983), 78, 107.

[11] See, for example, Paul Nunes and Tim Breene, “Jumping the S-Curve: How to Beat the Growth Cycle, Get on Top, and Stay There,” Accenture High Performance Institute, 16 November 2010,http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Jumping_the_S_Curve.pdf.

[12] Jason Dean and Jeremy Page, “Trouble on the China Express,” The Wall Street Journal, 30 July 2011,http://online.wsj.com/article/SB10001424053111904800304576474373989319028.html.

[13]“China sets same growth targets for GDP and resident income to rebalance development,” Xinhua, 5 March 2011, http://news.xinhuanet.com/english2010/china/2011-03/05/c_13763059.htm

[14] Nicholas Eberstadt, “Asia-Pacific Demographics in 2010-2040: Implications for Strategic Balance,” in Ashley J. Tellis, Andrew Marble, and Travis Tanner, eds., Asia’s Rising Power and America’s Continued Purpose (Seattle, WA: National Bureau of Asian Research, 2010), 243.

[15] Ibid., 262.

[16] Ibid., 250.

[17] Ibid., 248.

[18] Ibid., 246.

[19] Ibid., 247.

[20] Ibid., 249.

[21] Andrea Den Boer and Valerie M. Hudson, “A Surplus of Men, A Deficit of Peace: Security and Sex Ratios in Asia’s Largest States,” International Security, 6.4 (Spring 2002), 5-39,http://belfercenter.ksg.harvard.edu/publication/331/surplus_of_men_a_deficit_of_peace.html.

[22] Kira Matus, Kyung-Min Nam, Noelle E. Selin, Lok N. Lamsal, John M. Reilly and Sergey Paltsev, “Health Damages from Air Pollution in China,” MIT Joint Program on the Science and Policy of Global Change, Report No. 196, March 2011,http://globalchange.mit.edu/files/document/MITJPSPGC_Rpt196.pdf.

[23] Peter A. Petri, “Asia and the World Economy in 2030: Growth, Integration, and Governance,” in Ashley J. Tellis, Andrew Marble, and Travis Tanner, eds., Asia’s Rising Power and America’s Continued Purpose (Seattle, WA: National Bureau of Asian Research, 2010), 61.

[24] Jonathan Watts, “China Told to Reduce Food Production or Face ‘Dire’ Water Levels,” The Guardian, 28 June 2011.

[25] Minxin Pei, “China’s Ticking Debt Bomb,” 5 July 2011, The Diplomat, http://the-diplomat.com/2011/07/05/china%E2%80%99s-ticking-debt-bomb/.

[26] “Dissent in China: Of Development and Dictators,” The Economist, 5 August 2011,http://www.economist.com/node/21525419.

[27] World Nuclear Association, http://www.world-nuclear.org/; see also Keith Bradsher, “High Speed Rail Poised to Alter China,” The New York Times, 22 June 2011,http://www.nytimes.com/2011/06/23/business/global/23rail.html?pagewanted=all.

[28] Amy Forliti, “URS Says it Didn’t Know I-35W bridge Would Fall,” Minnesota Public Radio, 8 July 2010, http://minnesota.publicradio.org/display/web/2010/07/08/35w-bridge-contractor/.

[29] Richard P. Suttmeir and Xiangkui Yao, “China’s IP Transition: Rethinking Intellectual Property Rights in a Rising China,” National Bureau of Asian Research, Special Report 29 (July 2011), http://www.nbr.org/publications/specialreport/pdf/Free/SR_29_ChinaStandards.pdf.

[30] Michael Forsythe, “China Cracks Down in Wake of Riots, Bombings,” Bloomberg, 13 June 2011, http://www.bloomberg.com/news/2011-06-13/china-cracks-down-in-wake-of-riots-bombings.html.

[31]“More than 80% of PLA soldiers are single children,” (解放军作战部队独生子女已超八成), 15 August 2011, Beijing Wanbao,http://military.china.com/news/568/20110815/16706353.html

[32] Leading indicators of changes in the parameters of China’s defense spending include the Chinese economy’s growth, the central government’s ability to collect revenues and propensity to spend them on non-military programs (e.g., a future national pension system and other welfare benefits for China’s increasingly socially stratified and rapidly aging population), personnel salaries (e.g., competitive pay to attract a dwindling population of draft-eligible individuals amid increasingly attractive private sector alternatives), national spending on research and development, and weapons imports.

[33] “Survey: PLA Officers Monthly Income Hits 5,400 Yuan,” People’s Daily, 19 May 2011,http://english.peopledaily.com.cn/90001/90776/90882/7385774.html.

[34] For further discussion, see “Changing, Challenging China,” Harvard Magazine (March-April 2010): 25-33, 73.

[35] Office of the Director of National Intelligence, Global Trends 2025: A Transformed World(Washington, DC: National Intelligence Council, November 2008), 30,http://www.dni.gov/nic/PDF_2025/2025_Global_Trends_Final_Report.pdf.

[36] Paul Kennedy, The Rise and Fall of the Great Powers, 540.