08 July 2022

The Gabe Collins Bookshelf: China Energy, Strategic Resources, Security Implications & More!

Bookshelves China Maritime Studies Institute (CMSI) Cited In (Selected)

Once a versatile China Maritime Studies Institute (CMSI) team member with us at the U.S. Naval War College, subsequently the co-founder (with me) of our China SignPost™ 洞察中国 analytical website, and a valued research colleague ever since, Gabe Collins is one of the only professionals I know of who generates analysis of the highest caliber from a commercial, a legal, and a government perspective.

A native of the Permian Basin, Gabe’s also gone from being the 5th-fastest boys’ 100M sprinter at the 2000 New Mexico State Track Meet (2nd in his school division) to being a Texas-licensed attorney and a leading water, resources, and strategic commodities expert. He was probably the only one of the 4,400 undergraduates at Princeton University when we were there (he as an undergrad, I as a grad student; same Chinese classes and study with Princeton in Beijing) to help pay his tuition by working in the oilfields of Southeast New Mexico as a roustabout.

To earn his sweat money at the Cactus Queen enhanced oil recovery project, Gabe sprayed and pulled weeds, moved pipe, repaired broken pumps and saltwater injection wells, loaded trash trailers, and removed the rotted carcass of a cow that had died under a tank battery—all while handling 105-degree heat, wearing a hydrogen sulfide detector, and avoiding black widow and rattlesnake bites. After all that, nothing that involves sitting at a computer and crunching numbers could possibly faze him. As long as America keeps producing the likes of Gabe Collins, it will have a bright future ahead indeed.

To help make Gabe’s insights more broadly available, I’m sharing links and excerpts from some of his publications below. Given the extreme volume of Gabe’s publications, I’ll keep adding to the content below as time permits…

PUBLICATIONS BY GABE COLLINS (SELECTED):

Gabriel B. Collins and Andrew S. Erickson, “China’s Energy Nationalism Means Coal Is Sticking Around,” Foreign Policy, 6 June 2022.

Green plans are secondary to political demands.

By Gabriel B. Collins, the Baker Botts fellow in energy and environmental regulatory affairs at Rice University’s James A. Baker III Institute for Public Policy, and Andrew S. Erickson, the research director in the U.S. Naval War College’s China Maritime Studies Institute.

China is touting its renewable energy investments and has vowed to “accelerate the pace of coal reduction” in coming years. Yet in practice the country continues doubling down on coal on the back of blackouts, energy security fears, great-power competition, and Europe’s biggest land war in nearly 80 years. Fear and risk aversion both favor coal entrenchment, and both are in ample supply in Beijing these days.

As a result, millions of metric tons per day of additional greenhouse gases surge into the atmosphere. And the coal hopper is being loaded higher. Chinese policymakers recently greenlighted a coal mine capacity expansion of an additional 300 million metric tons in 2022—almost the annual production of the entire European Union. That’s enough coal to fill a train of standard rail hopper cars that would wrap around the entire equator, plus enough left to stretch from Washington, D.C., to Los Angeles. … … …

However much “green leadership” the party talks in international forums, it keeps leading the world in burning coal. It treats climate change as a source of leverage in its unrelenting quest to retain a monopoly on political control domestically and deference abroad. The disasters of the global commons can be easily blamed on the rest of the world; power and economic failures at home demand responsibility, or at least scapegoats. Meanwhile, as Chinese policymakers continued allowing King Coal to undercut Queen Green, millions of metric tons per day of additional greenhouse gases would surge skyward.

Cooperating with Beijing requires trusting in the good faith of a dictatorial regime that backslides on binding international environmental commitments and appears to be copping out on COP26’s call to accelerate the phasedown of unabated coal combustion. Worse still, Beijing demands tangible upfront geopolitical concessions by Washington in exchange for ephemeral half-promises on China’s own part—promises that have never materialized in the past.

Domestic economic and political survival imperatives will consistently shunt aside foreigners’ hopes and aspirations for a cleaner Chinese energy system—just as they are now with Beijing’s approval of one of the biggest annual coal production increases in decades. “Trust but verify” falls apart fast when an interlocutor is structurally disincentivized from sustained positive action and treats entreaties for cooperation as opportunities for exploitation.

Accommodations or self-limitations made to coax China to discuss climate issues would, in fact, make the United States, East Asia, and the world lose twice. America would weaken its economy and stress its social fabric while forfeiting its ability to effectively confront China’s ongoing coercive envelopment efforts in the Indo-Pacific, as Chinese interlocutors stall at the negotiating table. Beijing would win on the geopolitical front, but all parties would ultimately lose from degradation of our shared atmospheric and maritime biosphere.

China’s doubling down on coal so soon after the Glasgow summit makes it clear that climate cooperation simply won’t work with Xi and the party pursuing parochial priorities in ruthless Leninist fashion. The only way to avoid continual cop-outs is clear: It’s time for climate competition.

Gabriel B. Collins is the Baker Botts fellow in energy and environmental regulatory affairs at Rice University’s James A. Baker III Institute for Public Policy, whose funding sources are listed here, and a senior visiting research fellow at the Oxford Institute for Energy Studies.

Andrew S. Erickson is a professor of strategy and the research director in the U.S. Naval War College’s China Maritime Studies Institute and a visiting professor in full-time residence in Harvard University’s Department of Government.

The U.S. Naval War College is funded by the U.S. Department of Defense. The views expressed by the authors are theirs alone. They in no way represent those of the Naval War College, the Navy, the Department of Defense, or any other organization with which the authors are, or have been, affiliated.

***

To make Taiwan an indigestible choking hazard, here’s exactly where to invest now.

Andrew S. Erickson and Gabriel B. Collins, “Eight New Points on the Porcupine: More Ukrainian Lessons for Taiwan,” War on the Rocks, 18 April 2022.

Watching Russia falter in Ukraine, Chinese President Xi Jinping may conclude that if he decides to invade Taiwan, he cannot hope to achieve victory with little or limited fighting. The risk is that this will lead him to prepare a much bigger assault, deploying far heavier and more concentrated firepower to batter the island into submission.

In response to this possibility, a number of recent assessments have called for Taiwan to pursue an “asymmetric” dragon-choking “porcupine strategy” prioritizing “a large number of small things” for its defense. In short, turn the anti-access/area denial issue on its head and present People’s Liberation Army forces with multiple, numerous, hard-to-counter defenses that specifically target key Chinese military weaknesses. Drawing on Ukraine’s experience, there are eight concrete areas where the United States and Taiwan should now invest to make the island tougher to invade, even harder to subdue, and harder still to occupy and govern: ballistic missile defense, air defense, sea-denial fires, shore-denial fires, mine warfare, information warfare, civil defense, and the resilience of critical infrastructure.

The goal of these measures is to present a robust anti-access/area-denial threat to Beijing’s aspirations in Taiwan, clouding its prospects for military and political success and, ideally, keeping the threat of Chinese invasion hypothetical through this critical decade and beyond. … … …

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Check out this must-read testimony on China’s energy import dependency from Gabe Collins at Rice University’s Baker Institute for Public Policy! It’s part of a timely U.S.-China Economic & Security Review Commission (USCC) hearing on PRC energy issues…

Watch the webcast, read the text, or just scroll through Gabe’s 16 data-rich exhibits—and I guarantee you’ll come away with invaluable insights. Access full information, revealing graphics and scrollable screenshots here…

Gabriel B. Collins, “China’s Energy Import Dependency: Potential Impacts on Sourcing Practices, Infrastructure Decisions, and Military Posture,” testimony at hearing on “China’s Energy Plans and Practices,” U.S.-China Economic and Security Review Commission, 17 March 2022.

Click here to watch a webcast of the hearing. 

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FULL TEXT OF TESTIMONY BY GABRIEL B. COLLINS, J.D.:

China’s Oil and Gas Import Dependency: Potential Impacts on Sourcing Practices, Infrastructure Decisions, and Military Posture   

Gabriel Collins, J.D., Rice University’s Baker Institute for Public Policy, Center for Energy Studies[1]

Executive Summary:

  • China is likely to remain heavily reliant on seaborne crude oil, and to a lesser extent, on liquefied natural gas supplies. Sustained high oil and gas prices could incrementally ameliorate the trend by incentivizing conservation, making domestic drilling more profitable, and further accelerating vehicle fleet electrification efforts. Oil and gas storage capacity in China is also likely to expand substantially in coming years.
  • More gas will come overland from Russia, particularly in the wake of the invasion of Ukraine and the likely subsequent move by European consumers to reduce imports of Russia-origin gas.
  • China will generally seek to maximize benefits while minimizing costs, which means a default path of continuing to rely substantially on U.S. control of the global maritime commons outside of East Asia. Certain energy exporter states, particularly in the Gulf Region, seek to play the U.S. off China to maximize their strategic leverage but it remains unclear whether China would try to supplant the U.S. as the chief security guarantor and assume the many burdens that come with that status.
  • A key exception to this trend would come if the U.S. decisively stepped back from the region and left a security vacuum and access to a physical infrastructure presence network constructed over several decades. A lesser, but still impactful version of this scenario could arise if U.S. partners in the Gulf continue doubting long-term U.S. commitments to their security. This dynamic may already be playing out in its early stages.
  • Emphasizing overland oil and gas transit routes for suppliers other than Russia and the Stans would impose steep economic penalties on Chinese consumers. Adopting a more militarized oil and gas import security policy would augment these economic costs and also impose military tradeoffs Beijing would very likely seek to avoid.
  • Rather than spend what could be upwards of $50 billion per year to move seaborne oil onto pipelines and build a Middle Eastern base network, China is more likely to rely on market means (inventories and fuel pricing) and technological transformation—especially electric vehicles—to try and manage risks associated with oil import dependence.
  • China is likely to continue its accelerated naval modernization program, including both quantitative and qualitative improvements to its naval and air assets, as well as special operations forces. Oil and gas import security do not appear to be a core driver of these efforts, but naval, air, and special operations capabilities are fungible across theatres on relatively short notice. A key warning indicator of strategic intent would be pursuit of facility access in energy-rich regions, especially facilities with deep draft ports and airfields able to accommodate mass aerial entry of personnel and materiel and access agreements that permit placement of munitions and execution of kinetic combat operations.

Intro:

This testimony focuses on China’s interests in fossil energy resources and how they affect its energy procurement infrastructure and ability to commercially and physically safeguard this sourcing footprint and the economic interests that depend on it. “Fossil energy resource” means “coal, crude oil, and natural gas,” with the primary emphasis on crude oil and natural gas since China has abundant domestic coal reserves and can rapidly scale up production in response to energy crises, as it did in late 2021 and continues to do. The assessment addresses four core topical areas to set up the final section, which offers six recommendations for actions Congress can take to uphold and advance key U.S. national interests. Key topics are:

  1. Energy Demand and Sourcing: What does China’s current infrastructure for obtaining imported energy look like, was strategic framework was it built under, and how have sourcing approaches evolved over time?
  2. Energy Supply Geography: What volume of energy resources does China import overland versus by sea? To what extent do overland routes offer a potential shortcut to the Persian Gulf?
  3. Handling Energy Supply Disruptions: How is China postured to handle energy supply disruptions, including those from armed conflict?
  4. Military Defense of Energy Sources and Transit Routes: What are China’s current and prospective future capabilities for securing energy imports, both at the source and along key transit routes? To what extent has energy import dependency shaped development of military capabilities including air and naval power projection and ground forces, including special operations?
  5. Recommendations for Congress

 China’s Energy Demand and Sourcing

Oil and natural gas are China’s second and third-largest sources of energy and now account for about 28% of China’s total primary energy use, up from 22% in 2010 (Exhibit 1). Natural gas use alone is now larger than hydropower and exceeds wind, solar, and “other” renewables by about 50%. For oil in particular, China has for years been the world’s largest source of incremental demand growth and even in pandemic-crimped 2020, still saw demand increase by about the same volume of oil that the entire country of Israel consumed daily that year.

Exhibit 1: China’s Primary Energy Use, By Source

note: in raw energy terms, 1 exajoule = ~80 supertankers’ worth of oil

Source: BP Statistical Yearbook of World Energy 2021, Author’s Analysis

The analysis excludes hydropower, renewables (which in China primarily means wind and solar), and nuclear energy. The reason for doing so is that for PRC policymakers, “energy security” is synonymous with “import dependence.”[1]While American analysts might view events such as the 2021 Texas Blackout as energy security issues, their Chinese peers broadly view challenges that are localized and soluble through domestic action as being outside of the securitized paradigm that imported resources fall into. Put differently, Chinese decisionmakers are more likely to consider oil disruptions national security problems (国家安全问题) and electricity supply issues as social/economic problems (社会经济问题).[2] Beijing, provincial, and local officials all respond robustly to both sets of challenges, but with one potentially overtly securitized and the other not.

Accordingly, Yangtze River water spinning generation turbines at the Three Gorges Dam and solar panels produced domestically—or for nuclear power, a combination of domestic uranium reserves, multi-year intervals between refueling, and a mandated 10-year reactor fuel stockpile–mitigates the risks of import disruption and places those energy sources in a non-securitized category.[3] In contrast, oil and gas have both become increasingly vital vectors of import dependency for China. By 2020, China imported more than 70% of its oil and 40% of its natural gas. For perspective, China’s present oil import dependence ratio approximates where the United States was in the early 2000s, a period of acute anxiety over resource security and one where fateful policy decisions—including the invasion of Iraq—were undertaken for various stated reasons, but all under a cloud of perceived oil insecurity.

Exhibit 2: Crude Oil Self-Sufficiency of China and U.S. (Production ÷ Consumption)[2]

1.0 = fully self-sufficient, 0 = fully import dependent

Source: BP Statistical Review of World Energy 2021, Author’s Analysis

Furthermore, the past 20 years make one thing increasingly clear: unlike the United States, China is not going to drill its way to lower crude oil and natural gas import dependence. Between 2000 and 2013, China’s “Big 3” (PetroChina, Sinopec, and CNOOC) ramped up their combined annual capital investment, which peaked in 2013 at about seven times the 2000 level and declined subsequently (Exhibit 3).

Exhibit 3: PetroChina, Sinopec, and CNOOC Combined Investment and Production, 1998-2020

Source: Bloomberg, Author’s analysis

This massive effort brought oil production from 3 million bpd in 2000 up to about 4.4 million bpd in 2020. Gas production grew more substantially, rising about 10-fold. But for both commodities, import dependency steadily deepened because domestic production simply could not keep pace with demand growth despite cumulative nominal expenditures of more than $1 trillion USD.[3]Indeed, it is likely that China’s domestic oil production peaked in 2015.[4] For perspective, U.S. shale producers invested roughly a trillion dollars between 2010 and 2020, during which domestic light tight oil production leapt nearly nine-fold from 842 thousand bpd to 7.4 million bpd.[4]

Instead, Beijing is taking a different tack: (1) taking in additional imports of oil and gas (with seaborne shipment dominating incremental volumes), (2) seeking to maximize its oil and gas procurement flexibility, and (3) aggressively promoting transport electrification to reduce oil demand. China sold approximately 3 million plug-in EVs last year into a car parc of approximately 225 million vehicles—the world’s second largest after that of the United States. As such, even if it doubles the current annual sales rate, fleet turnover is still a multi-decade endeavor. And as the example of Norway shows, even as EVs grab a much greater share of the fleet (more than 80% of new vehicle sales in 2021 and about 20% of the total passenger vehicle fleet), motor fuels demand can remain persistently high.[5]

Oil is consumed by far more than just passenger and light business vehicles and the heavy transport, aviation, and shipping sectors will likely be tougher to electrify. Natural gas, meanwhile, is playing a key role in helping large coastal cities in China improve residents’ health and lives by reducing emissions from home heating and industrial boilers that formerly burned coal.[6] Oil and gas also yield critical petrochemical building blocks—including for materials needed by EVs and other energy transition technologies such as wind turbines and solar panels.[7] In short, China’s leadership will for years to come, have to grapple with significant, and perhaps even larger, oil and natural gas import dependence.

Exhibit 4: China Self-Sufficiency, By Fossil Energy Source

Source: BP Statistical Review of World Energy, Author’s Analysis

It is helpful to frame analysis of China’s energy sourcing with the lens of energy security, which the Chinese government (like other major global energy consumers) presumably seeks to attain via its energy resource-related policies and activities abroad. Energy security incorporates three core concepts: (1) adequacy and diversity of supply, (2) stability of price, and (3) maintaining a relatively low price.[8] For China specifically, the need to ensure adequate and diverse oil and gas import supplies drives an increasing dependence on seaborne imports but is generally handled through day-to-day activity by firms that while often state-controlled, generally behave commercially.

Trying to maintain price stability and affordability presents more complex challenges, ones that implicate internal dynamics in both the importer and exporter countries and thus feature intertwined political, diplomatic, and potentially, military dimensions. For its entire post-Mao industrial rise to date, it has been able to free ride off on U.S. efforts to maintain flows of oil and LNG from the Middle East and the ensure free maritime transit for the tankers that bring molecules to market.

The U.S. retains deep energy-centric interests in the Persian Gulf region.[9] Yet a combination of increased domestic energy abundance over the past 15 years, an apparent breakdown in the historical U.S.-Saudi partnership as OPEC increasingly views U.S. shale producers as competitors, and a push from some quarters to de-emphasize Washington’s military role in the region suggest a much more uncertain future. Multiple scholars now question the wisdom of expensive U.S. military presence to defend Gulf oil and gas flows, while China-focused scholars and strategists frame the Persian Gulf region as a secondary priority that should not detract from strategic focus on ensuring China does not achieve hegemony in Asia.[10]

Pullback discussions may represent perception more than reality, especially as oil prices rise in early 2022. U.S. policy has for decades emphasized paying close geopolitical attention to key oil producing countries.  Indeed, multiple U.S. National Defense Strategy documents acknowledge energy’s importance to national security and the resultant perceived need to engage forward to, as the 2018 NDS puts it: “…foster a stable and secure Middle East that…is not dominated by any power hostile to the United States, and that contributes to stable global energy markets and secure trade routes.”[11]

While price stability is a strategic objective, it has been fleeting in the global oil market and the future looks increasingly inclined to volatility. From 1928, when the so-called Seven Sisters[5]met at Scotland’s Achnacarry Castle to form an oil pricing cartel, until the 1960s when producer country nationalism began to erode their arrangement, oil prices enjoyed a remarkable run of stability. As the Achnacarry Agreement yielded to the next oil cartel, OPEC, oil price volatility followed with the Arab Oil Embargo of 1973 and the Iranian Revolution a few years thereafter. Oil prices were rangebound (in historical terms) from the mid-1980s to late 1990s, and then volatility ensued again as a product of China’s demand and the U.S. shale boom thereafter (Exhibit 5).

Exhibit 5: Historical Global Oil Spot Prices, 1861-2020 (2020$)

Source: BP Statistical Yearbook of World Energy, Author’s Analysis

The confluence of continued strong demand for oil, increasingly intense efforts to starve the sector of capital to try and force accelerated decarbonization[12], and the return of “blood and iron” great power politics—exemplified by Russia’s February 2022 invasion of Ukraine—portends price volatility ahead. Simultaneously, fundamental dynamics in the U.S. domestic energy security discussion suggest that despite oil market turbulence, the U.S. commitment to the Gulf Region remains unsettled.

The U.S. appears clearly positioned to be the world’s largest oil consumer and second -largest importer (after China) for years to come, since even intensified energy transition efforts will take decades to meaningfully shift American oil consumption patterns. Unlike China, the U.S. also appears likely to remain the world’s first or second-largest oil producer through at least 2030. Anti-fossil fuel domestic policies could change the trajectory, but in doing so would risk triggering a political backlash that likely ultimately leads to stronger consensus on the need to maximally exploit domestic shale resources to manage price volatility and perceived import risks.[13]

Coming years will likely feature increasing pressure upon Beijing to reduce oil import dependence by decreasing demand through transport electrification but also, potentially, to assume a more prominent role in Persian Gulf security if the U.S. elects to reduce its large residual military position there. It is even possible that a future U.S. administration more hospitable to domestic oil and gas resource development and less inclined to maintain large forward deployments in the Middle East might actively seek to force a leading Chinese role in Persian Gulf security. This would end its 40-year run of being able to “draft” off the United States and instead make it confront a strategic dilemma Washington has now grappled with for at least a decade—how to allocate combat power between its highest priority theater and the Gulf region.

Convergence of these factors—many of which are mutually reinforcing—points to China likely having to more seriously contemplate assuming a more substantive security role in key oil and gas producing geographies (aside from North America). China had made attempts to establish a presence near the Gulf Region before, including continuously deploying vessels on “anti-piracy” missions off the Horn of Africa since 2008 and building a permanent military base in Djibouti capable of docking any ship in the PLA Navy.[14] Chinese support for Saudi ballistic missile production and revelations in late 2021 of apparent Chinese attempts to build military infrastructure at the UAE’s Khalifa port suggests that Beijing may now be trying to lay deeper diplomatic and physical infrastructure for future energy security efforts.[15]

China’s Energy Supply Geography and Infrastructure

Looking at China’s oil imports by region, a few things immediately jump out. First, it is having to go further from home to buy barrels, with the Asia-Pacific’s share of imports declining from almost 21% in 2005 to only 3.5% in 2020. Among key oil import supply zones, three regions stand out. Russia and Latin America each saw exports to China rise by a bit less than 20% over the past 15 years. Volumes from the Middle East rose by nearly 50%, and account for close to half of China’s total imports (Exhibit 6).  For natural gas, imports come from more geographically adjacent locales, with the biggest portion originating in the Asia-Pacific (primarily Australia, Indonesia, and Malaysia) and Russia/CIS (primarily Turkmenistan and Kazakhstan, with expansion expected from Russia).

Exhibit 6: China’s Oil and Natural Gas Import Sources, By Region

Million tonnes per year                                              Billion Cubic Meters

Source: BP Statistical Yearbook of World Energy, Author’s Analysis

Some of the regional sourcing makes immediately clear how the molecules actually arrive in China. For instance, hydrocarbon supplies from Africa or Latin America obviously come by sea. Other exporters—especially Russia—supply significant volumes of oil and gas to China through both pipelines and maritime channels. Readers seeking a glimpse of the future need look no further than the respective capacities of overland and seaborne import routes for oil and gas. The three inbound oil pipelines at full tilt can transport a combined 70 million tonnes per year—roughly 14% of China’s total crude oil imports in 2021. In contrast, data from the Baker Institute China Energy Map suggest the country’s oil ports can take in 670 million tonnes per year—about 1.3 times what China actually imported in 2021 (Exhibit 7).

Overland routes fare better on the gas side, with approximately 105 billion cubic meters per year of pipeline capacity currently in service versus 169 BCM of gas actual imports in 2021. But like oil, seaborne import capacity is higher than overland (145 BCM/yr vs. 105 BCM/yr) and is also poised to grow faster than pipelines over the next 2-3 years.[16] By the late 2020s, the planned Power of Siberia 2 pipeline, now in the planning phase, could add 80 BCM/yr of pipeline supply (equivalent to about 50 million tonnes of LNG).

Intensifying economic warfare by the U.S. and Europe against Russia in the wake of that latter’s invasion of Ukraine in February 2022 is likely to make pipeline routes to China more attractive to Russia due to loss of European market share if consumers there diversify gas supplies and more attractive to China, which would rather procure preferentially-priced, semi-captive supplies via pipeline from Russia instead of bidding against European, Japanese, and South Korean consumers for premium priced seaborne LNG.

Exhibit 7: China Energy Import Routes Map

Sources: Baker Institute China Energy Map, GADM, S&P Global Platts

For both oil and gas, seaborne supplies have supplied most of China’s incremental import growth. Most additional oil import volumes—including from Russia—have come by sea since 2018.  Pipeline gas was the largest source of imports in the early 2010s, but after 2016, inbound LNG supplies steadily rose while overland pipeline deliveries remained steady (Exhibit 8, Exhibit 9).

Exhibit 8: China Seaborne vs. Overland Oil Imports, 2006-2021 (Million tonnes)

Source: China General Customs Administration

 

Exhibit 9: China Natural Gas Imports, 2006-2021 (Billion cubic meters)

Source: China General Customs Administration

Do Current or Proposed Pipeline Routes Create Shortcuts to the Permian Gulf?

In a purely geographical sense, oil pipelines running north through Iran or offloading ships at Gwadar, Pakistan would each reduce the distance between Middle Eastern oilfields and China’s key refinery clusters by a few thousand kilometers. For instance, the sailing distance from the Strait of Hormuz to Zhoushan’s massive oil terminals is about 11,000 km by sea but closer to 7,000 km if tankers injected their cargoes into a hypothetical Pakistan-China pipeline beginning at Gwadar.

Yet there are distinct reasons such projects have not been built and these same factors are likely to induce Chinese policymakers and parastatal firms to continue favoring seaborne transit of oil and to a lesser, but important extent, natural gas. Key restraining factors include: (1) scale, (2) cost, (3) transit country risk, (4) flexibility of seaborne energy trade and vulnerability of pipelines, and (5) the opportunity costs of capital and excess shipping cost that could be deployed elsewhere in China’s economy—or in its military budget.

This subsection focuses on scale, cost, and pipeline vulnerability. The approximate quantification of capital and operational costs will illustrate the opportunity burden for the Chinese economy and military budget if Chinese importers were to favor pipelines of unprecedented size over proven maritime routes. This analysis runs through the scenarios and seeks to quantify approximate cost burdens not because the author thinks China will build massive pipelines to reduce maritime transit risk, but rather, to illustrate the sheer economic irrationality of doing so.

Scale

To make a real dent in China’s seaborne oil dependency, an overland pipeline project would have to be huge. It would be on par with Saudi Aramco’s East-West Pipeline, whose two parallel lines of 48 inches and 56 inches in diameter run 1,200 km from the country’s oil rich Eastern Province to the Red Sea port of Yanbu and can move 5 million barrels per day of crude oil.[17]Aramco is currently working to expand the system’s capacity to 7 million bpd and aims to complete the expansion by 2023.[18]

Put more bluntly, China would need additional import capacity in the same league as the world’s single-largest oil pipeline. And it would have to build it under much tougher physical and economic conditions. We’ll get into the economics shortly but consider the physical hurdles alone: While the Saudi East-West Pipeline climbs to a maximum elevation of approximately 1,000 meters, a pipeline transporting oil from coastal Pakistan into Western China would need to traverse the 4,700-meter Khunjerab Pass and oil would need to travel approximately 7,000 km to reach oil refining hubs near Shanghai or in Shandong. The distance would be even further to reach China’s third refining and petrochemical cluster in the Pearl River Delta.

Gas import dependency also appears poised to rise. Unlike the United States over the past 15 years, it does not appear that China will enjoy a domestic gas production resurgence large enough to roll back its rising import dependence. China is the logical market for gas reserves in Eastern Siberia that would otherwise be stranded by distance from Europe and the European market’s general lack of gas demand growth compared to China’s. Furthermore, the unfolding Ukraine crisis and Russian revanchist actions may finally prompt European consumer governments to take more dramatic action to reduce their dependence on gas piped from Russia, thus eliminating a potential source of future demand and further incentivizing Gazprom to construct export routes to China.[19]

China’s overall economic growth slowdown introduces uncertainty about how much its gas imports may grow by over the next decade, but it appears likely that Central Asia can only satisfy perhaps 25 BCM/yr of additional demand by 2030—roughly what the country’s gas use is forecast to grow by in 2022 alone.[20] Central Asian producers, especially Turkmenistan, have large reserves, but “above ground” issues will likely impede full development of the resource. Furthermore, a post-Ukraine invasion Russia isolated from opportunities in Europe will be incentivized to stifle (or gain economic control over) additional Central Asian exports to China, lest those displace future Russian gas sales into the increasingly indispensable Chinese market.

Despite Russia’s planned Power of Siberia 2 pipeline project (slated to bring 80 BCM of capacity online, likely in the late 2020s), even a slower rate of gas demand growth in China will thus likely exceed what overland suppliers can provide.[21] Accordingly, unless Chinese energy demand slows dramatically (possible) or there is a U.S. “shale boom-style” domestic gas production revolution (unlikely), the country’s gas import future also looks to be substantially seaborne, but with potentially significant expansion of pipeline gas supplies from Russia.[22] Having greater pipeline capacity and expanded LNG import facilities will give China optionality for gas sourcing, while also minimizing the perceived risk associated with seaborne imports.

Cost

Several real-world examples help quantify the costs and difficulties likely to be associated with a pipeline that would have to traverse difficult topographical, seismic, and temperature environments, we can examine several real-world examples. Figure 10 summarizes important aspects of the projects, which are discussed in more detail below.

Figure 10: Comparable Cost Examples From Selected Major Oil and Gas Pipeline Projects

Note: tan-shaded cells are for projects considered especially representative

Sources: CPC (West-East gas pipeline data), Ecopetrol, Global Energy Monitor Wiki, KCP (Atasu-Alashankou data), Offshore Technology (WEP I and II cost data), Petroecuador, OCP Ecuador, Radio Free Europe (ESPO cost)

To illustrate the costs imposed by high mountain ranges, consider the Transandino, Trans-Ecuadorean, and OCP pipelines in Colombia and Ecuador. Each transports oil from lowland oilfields across the Andes Mountains with a peak line altitude of approximately 4,000 meters. The Transandino line ranges from 10 to 18 inches in diameter, spans 305 km, and can move up to 190,000 barrels per day.[23] The Trans-Ecuadorean line is 26 inches in diameter, about 500km long, and to move its design capacity of 360,000-to-390,000 bpd of crude oil, incorporates more than 101,000 HP of pumping capacity.[24] The OCP line is designed to move up to 450,000 bpd (22 MTPA) of heavier crudes along a 503km route similar to that of the Trans-Ecuadorean system.[25] Transport costs are significant—from $2.14 to $3.50 per barrel on the OCP system (roughly $0.56/100km moved), more than $2.50 per barrel (roughly $0.50/bbl/100km moved) for the Trans-Ecuadorean line and more than $4.50 per barrel for the Colombian project (roughly $1.50/bbl/100 km moved).[26]

These pipelines are much smaller in terms of size and daily capacity than what a Chinese route designed as a shortcut to the Persian Gulf would be and cross less physically severe mountains but incorporate other systems, such as massive uphill pumping capacity and pressure reduction stations for the downhill portions of the line. The capital costs would be enormous.

Data for oil pipelines in Exhibit 10 above—Abu Dhabi Crude Oil Pipeline, East Siberia-Pacific Ocean Pipeline, Goreh-Jask Pipeline, OCP Pipeline, Atasu-Alashankou Pipeline, and Myanmar-China Oil Pipeline—yield an average completed cost of about $3.5 million per km. Assuming a route on the order of 3,500 km linking coastal Iran to China’s western border in Xinjiang, this would imply a capital cost of at least $12 billion for a single line with 1 to 1.5 million barrels per day of capacity. This in turn would imply that a corridor of four such lines capable of meaningfully offsetting China’s maritime oil import dependence could cost $50 billion just to get oil to the Xinjiang border. The corresponding domestic infrastructure expansion necessary to actually get the oil to refineries could realistically double that cost.

Taking the simple average of these three lines’ transportation costs—about $0.85 per bbl per 100 km moved—and applying it to a roughly 3,500km pipeline from Gwadar, Pakistan to Turpan, China would suggest a transport tariff approaching $30/bbl. Maritime transport from the Persian Gulf to China typically costs closer to $2/bbl. Conservatively assuming a transport cost premium of $25/bbl, this means that a 5 million bpd line operating at full capacity would effectively impose an annual tax of nearly $46 billion on Chinese oil consumers—equal to about 18% of China’s total crude petroleum import bill in 2021.

Russia’s Eastern-Siberia-Pacific Ocean Pipeline (ESPO) offers a second example and one that might be more illustrative of the costs if China undertook the highly unlikely choice of building a pipeline route from the Persian Gulf into Turkmenistan along its existing natural gas import pipelines. ESPO traverses nearly 5,000 km from the East Siberian city of Taishet to the Pacific Ocean port of Kozmino, with a spur line delivering oil south to China.

ESPO had to be built in a remote environment with severe climate, but fewer topographical and seismic challenges than a trans-Himalaya route would face. It cost more than $20 billion (roughly $4.5 million per km). As such, its construction costs were about 12.5% higher per km compared to what China’s three large gas import pipelines from Central Asia cost. The costs were about 2.5 times higher per kilometer than Iran’s Goreh-Jask Pipeline.

Russian pipeline operator Transneft charges a tariff of approximately 2,969 rubles per tonne ($3.79/bbl) for oil delivered to the Chinese border ($0.08/bbl/100km moved).[27] Here it’s worth noting that when Russia began pipeline oil shipments to China in 2011, a USD was on average worth about 30 rubles. The rate in early March 2022 is closer to 110 rubles per USD as Putin pursues Ukraine’s subjugation. As such, a Chinese-financed line paid for either in USD or RMB whose value remains tightly linked to the dollar would likely have a tariff that in dollar terms could be 3.5 times the Transneft ESPO tariff, implying a rate on the order of $0.30/bbl/100km or $10.50/bbl to transport oil from the Persian Gulf region to Xinjiang and a similar cost to reach refineries in the Shanghai area or Qingdao. Five million barrels per day of oil delivered at a transport cost of $21/bbl would mean an annual cost of $38 billion—likely 10 times what it would cost to bring the oil by tanker.

Seaborne oil import facilities are generally more cost-effective than pipelines because the builder does not have to pay for the steel vessel that moves the oil from producer to the offload point. Consider the following: Huanghua Port near the city of Cangzhou along the Bohai Gulf is presently constructing an oil berth capable of accommodating 300,000 deadweight ton supertankers. The facility will be able to offload 13 million tonnes of crude annually (about 260,000 bpd) and cost approximately 3 billion RMB (approximately $460 million at a 6.5 RMB/USD exchange rate, or half what the Kazakhstan-China Oil Pipeline cost to deliver a similar average volume).[28] Furthermore, oil ports have the added bonus of being able to import crude from any exporter on earth that can access tidewater.

Vulnerability of Pipelines

Pipeline present three prominent vulnerabilities. First, projects such as the Myanmar-to-China pipeline or a hypothetical Pakistan-to-China pipeline are not overland per se, but rather maritime chokepoint bypasses that must still receive inbound tankers. They therefore would concentrate the target set for an adversary seeking to disrupt oil shipments to China.[29] Interdiction could take the form of a naval blockade, kinetic strikes against the unloading terminal and associated pumping facilities, or denial of access through standoff mining using munitions such as the Quickstrike-ER sea mine.[30]

Second, even fully inland pipeline infrastructure is vulnerable to attack. In some instances, attackers sabotage the line itself.  Damage can often be repaired fairly quickly, but a high attack tempo of even simple assaults can cause serious cumulative loss of throughput. For instance, the Caño Limón pipeline in Colombia has been attacked more than 1,300 times during its 36 years in service and has spent at least 3,800 days offline since it entered service in 1986 due to attacks.[31]In 2013 a series of almost daily attacks forced Colombia to reduce oil production by 35,000 bpd, a loss equal to almost 1/5 of the line’s nameplate capacity.[32]  Chinese firms now grapple with a lower-intensity, but broadly similar threat in Myanmar where there have been multiple attacks against the Myanmar-China pipeline corridor over the past year.[33] The threat is still nascent, with attacks to date directed at regime soldiers guarding pipeline related facilities but could evolve into a more complex threat where anti-regime elements begin targeting the line itself as rebel groups in Colombia do.

More sophisticated attackers can cause more serious disruptions by targeting pumping stations, whose equipment is more expensive and difficult to replace than the hollow steel tube of the line itself. For example, Houthi rebels targeted two pump stations on Saudi Arabia’s strategic East-West oil pipeline with seven explosive-laden drones in May 2019.[34] The Saudi Energy Minister noted that the drones caused “a fire and minor damage to Pump Station No.8.”[35]Houthi militants often employ drones of the Qassem-1 class with a 30kg warhead for these types of attacks.[36] As knowledge of how to make and operate such low-cost, high-impact munitions proliferates, security risk to key overland energy transit facilities in and near restive areas rises.

In the Houthi case, a non-state actor was able to strike and damage assets approximately 800km from the Yemeni border (assuming launch from within Yemen). Furthermore, relatively high-resolution imagery now exists of pipeline pumping stations and other energy transport facilities that is sufficiently accurate to program UAV loitering munitions’ guidance and navigation systems. As an example, consider Exhibit 11 which shows Saudi Aramco’s Pump Station Number 8 and was pulled directly from freely available Google Maps imagery.[6] Deriving precise latitude/longitude data from such imagery software is straightforward. Facilities vulnerable to non-state groups with drones would be even more exposed to modern national militaries, who could target key facilities in remote, sparsely populated areas and rapidly disable pipelines carrying oil or gas into China.[37] Cyberattacks are also a key risk from both state and non-state actors, as the roughly weeklong disruption caused by a ransomware attack on the vital U.S. Colonial Pipeline demonstrated in 2021.[38]

Exhibit 11: Example of Imagery Capable of Guiding Attacks on Energy Transport Infrastructure

Source: Google Maps

Pipelines’ fixed nature also makes them proportionally more vulnerable to natural disasters than maritime shipping. Routes traversing mountain ranges such as the Andes or Himalayas are especially vulnerable given the risk of landslides and seismic activity.[39] Indeed, in December 2021 a landslide damaged the Trans-Ecuador Pipeline and forced a multiday shutdown.[40]Routes crossing Central Asia might generally be less vulnerable given that many of those cross open steppe, but any route between Pakistan and China would have to cross seismically active mountains with severe, landslide-prone topography.

Handling Disruptions and Military Defense of Energy Sources and Transit Routes

In thinking about maritime trade versus overland pipelines, three core themes arise.  The first entails assessing the impact of various disruptive threats upon either the supply of, or demand for, crude oil and natural gas. The second centers on the probability of the event (Exhibit 12). Third is how to best protect oneself via proactive and reactive countermeasures.

Exhibit 12: Oil and Gas Supply Disruptions, Magnitude vs. Probability

Source: Gabriel Collins, “Global Energy Security Implications of a Potential US Strategic Pivot Away From The CENTCOM AOR,” Baker Institute Working Presentation, 13 November 2019, Houston, TX, https://www.bakerinstitute.org/media/files/files/e769e044/ces-collins-centcom-111319.pdf

Potential responses to naval blockades, hurricanes, pirates, producer country instability, and complex market environment threats such as the uncertain state of affairs and price spikes after Russia’s February 2022 invasion of Ukraine sometimes overlap but can also differ substantially. Many potential threat events—including some of the highest impact ones—do not have a military solution, as the world learned from the covid-19 pandemic, for instance. This section will examine how China is postured to handle various types of oil and gas supply disruptions.

Other disruptors, such as naval blockades, may require direct military engagement. Still others, such as piracy, producer country internal problems, and maintaining security of maritime transit lie on a spectrum in between, where kinetic power projection is important, but the necessary degree can vastly differ. For instance, security teams embarked on tankers can repel pirates whereas attacks by nation-states on oil and gas production areas or transit routes via blockade/interdiction campaigns often require high-end combined arms capabilities to deter or defeat.

Accordingly, a three-part taxonomy helps classify Chinese energy security (i.e. oil and gas import security) actions. Some clearly stand apart, while others are mutually reinforcing. Category one encompasses market-oriented solutions including supply diversification, expansion of storage, and longer-term demand management approaches such as transport electrification. Category two covers “hybrid” solutions such as state-flagging of oil tankers and deployment of private security firms to defend resource producing assets or transport supply lines that layer implied or actual kinetic protection capacity atop commercial activity by private or quasi-private actors but doing so short of explicit military involvement by China’s armed forces. Category three involves direct deployment of the PRC government’s nation-state diplomatic and military capacity.

Market-Oriented Solutions

Chinese crude oil and natural buyers have worked to try and diversify their supply sources for many years now. Oil has been the primary focus, given that it remains largely without substitutes as a transport fuel and because efforts to increase domestic supplies have faltered. China’s oil imports more than tripled between 2005 and 2020 and the supplier base has been diversified during that time. But one thing has remained constant—a high dependence on the Middle East, which in 2020 accounted for close to half of China’s oil imports (Exhibit 13). Middle Eastern supplies are unique because they concentrate both producer country risk (key fields geographically close to each other) and transit risks (shipments must transit either the Strait of Hormuz or the Red Sea.

 

Exhibit 13: China Crude Oil Imports by Region, 2005-2020

Source: BP Statistical Review of World Energy, Author’s analysis

Diversification helps insulate an importing country from potential coercion by specific exporter countries or small subsets of them. What it does not do is protect against price spikes caused by removal of oil supplies from the global market, whether the shortfall results from purposeful action like an embargo or attack, or unexpected outages—like an industrial accident at a major oilfield or export facility. Protection against such events comes through two primary pathways: (1) the cushion provided by inventories and (2) policies to manage demand and reduce an economy’s oil intensity per unit of output.

China now has more than 1.3 billion barrels of total oil storage capacity, of which approximately 400 million barrels resides in government strategic petroleum reserve sites (Exhibit 14).[41] The largest storage bases are located near key oil ports and major refining centers. The smaller dots in far Northeast China, far Western China, and Yunnan are all associated with oil import pipeline routes (as well as adjacent domestic production).

 

Exhibit 14: China Oil Storage Locations, Spring 2020

Bubble size reflects scale of site

Source: Ursa Space Systems

For perspective, U.S. commercial crude oil storage capacity in 2021 was approximately 840 million barrels, plus 727 million barrels of strategic petroleum reserve capacity run by the Department of Energy.[42] As of 4 March 2022, commercial crude oil and SPR storage across the U.S. held a combined total of 989 million barrels.[43] Data vendor Kayrros estimates that as of late February 2022, China’s total crude oil inventories were approximately 950 million barrels—92 days of import coverage at 2021 intake rates.[44] As such, although China is not a member state of the International Energy Agency (IEA), its crude oil inventory holding level is now in line with the IEA’s requirement that each member country “hold emergency oil stocks equivalent to at least 90 days of net oil imports.”[45]

The author’s prior research indicates that at multiple key Chinese oil storage locations, utilization rates between late 2016 and early 2019 were typically between 50% and 70% of nameplate capacity.[46] U.S. commercial crude oil storage facilities show similar usage patterns between 2011 and 2021.[47] Having some degree of “headroom” in the national oil storage tank fleet suggests that if circumstances warranted, oil inventories could increase substantially beyond present levels. Indeed, oil inventory data observable from space provide a key strategic warning indicator of potential PRC military action against Taiwan.[48] China is also constructing subterranean rock caverns for oil storage—with the 19 million barrel Huangdao site in Shandong online and several other locations either online or under construction.[49] Underground sites can be cheaper to build in areas with high land costs and also offer far more protection against precision guided munitions strikes in the event of a conflict, unlike surface oil tanks that are readily broken open and ignited.

China’s natural gas storage is much less developed than its crude oil inventory sector is. The country had 14.5 billion cubic meters of working gas space at year-end 2020, according to CEDIGAZ.[50] At the 2020 demand level of 330 BCM, this means China has about 16 days of working gas inventory. For comparison, the United States has approximately 137 BCM of working gas storage capacity against 2020 demand of 832 BCM, implying a storage cushion of closer to 60 days.[51] It is thus likely that if China continues to become more dependent on natural gas, the government will encourage firms to expand storage capacity. Gas storage in China may also assume a different form than is the case in the U.S., for instance. At least one company, CNOOC, appears to be “oversizing” the cryogenic storage tanks at one of its LNG import terminals with largest of kind tanks that can literally each hold the entire capacity of a Q-Max LNG tanker—the world’s largest.[52]

China also has options for “stretching” its existing crude oil and natural gas inventories. Fundamentally, there are proactive options— using fuel pricing to manage demand in the near-term and transport electrification over the medium and long-term—as well as the “reactive” option of demand rationing in the event of a severe disruption. For natural gas, the country can throttle up coal-fired power plants to increase electricity supplies. This option is already in use and appears poised to accelerate as the energy crisis of 2022 continues to unfold.[53] Vice Premier Li Keqiang noted at a National Energy Commission meeting on October 9, 2021 that China must maintain stable and secure energy supply chains and that this effort will include greater development of domestic coal, oil, and gas resources.[54] Just two weeks later, Premier Xi Jinping emphasized the importance of energy security, telling workers at the Shengli Oilfield that China must “ensure that its energy livelihood remains in its own hands” (能源的饭碗必须端在自己手里).[55]

Fuel Pricing

Fuel pricing can be used as a mechanism for managing demand and encouraging more efficient energy consumption behaviors. In parts of Europe, for instance, motor fuels are taxed at very high rates to encourage greater fuel-efficiency in vehicles and use of public transport or non-petroleum powered modes of transportation (bicycles, walking, etc.). In China’s case, the National Development and Reform Commission sets gasoline and diesel fuel prices.

In the mid-2000s, prices tended to stay fixed for periods of many months and often not only lagged behind crude oil price movements, but also undershot them as the Chinese authorities sought to minimize impacts on consumers. The 2010-2014 period saw the wholesale prices of gasoline and diesel begin to track international crude prices more closely and from 2014 onwards the alignment of price movements has been tight (Exhibit 15).

Exhibit 15: Wholesale Gasoline and Diesel Fuel Prices in China vs. Crude Oil Prices

Monthly Index, May 2005 =1

Source: Bloomberg, EIA, Federal Reserve Bank of St. Louis, Author’s Analysis

The NDRC pricing mechanism states that if international oil prices change by more than 50 RMB/tonne (about $1/bbl) and remain at that level for 10 working days, oil products prices will be adjusted in accordance.[56] But while China’s official price setting tracks relative global crude price movements, it does not accurately track their absolute level. In fact, for 7 years and running, both gasoline and diesel prices in China have consistently exceeded their U.S. counterparts by a substantial margin. While U.S. Gulf Coast gasoline spot prices closely track the relative movements and absolute levels of key global crude oil benchmarks, China’s wholesale gasoline price presently exceeds that of its U.S. counterpart by nearly 1/3. A plausible explanation is that the NDRC prefers to keep gasoline and diesel prices high to restrain oil demand growth, promote efficiency, and perhaps also make electric vehicles more attractive to Chinese consumers.

Transport Electrification

China’s historical position vis-à-vis the nexus of transportation and energy has been one in which supply insecurity motivated strategic thinking. On the national security side of the ledger, reducing crude oil import dependency could confer significant strategic benefits. Chinese leaders have long worried that in a conflict, an opposing navy could interdict oil shipments to China via a so-called distant blockade. Even if such a campaign ultimately failed to force China’s capitulation in a conflict, it would very likely cause the country substantial transport disruptions and economic damage.[57] Policies such as vehicle electrification that eventually drive down crude oil dependence can help address these deep-seated strategic concerns by making oil imports a less attractive strategic pressure point for potential adversaries. There is also a financial dimension. With China now importing more than 3.5 billion barrels of crude oil per year, the expenditures are significant—with a dollar price tag second only to that incurred from semiconductor imports.

Finally, China’s industrial policy seeks to make electric vehicles an area of global competitive advantage. The Made in China 2025 concept specifically names “new energy vehicles” as one of 10 priority sectors.[58] The State Council’s New Energy Vehicle Development Plan 2021-2035 articulates EV development and market penetration in holistic terms, noting that policymakers aim to encourage broad collaboration and synergistic activities invoking not just the auto industry, but also the energy, transport, and IT sectors.[59]

Transport electrification, however, allows China an opportunity to harness industrial prowess and a unique hardware + software domestic tech development ecosystem to gain technological first mover advantage, and have a real shot at becoming the prime global market shaper in a manner that was simply never possible with petroleum-based transport fuels and technologies. Indeed, the 15-year new energy vehicle plan released by the State Council in November 2020 emphasizes the “promotion of integrated industrial development” (推动产业融合发展).

The State Council’s “Energy Conservation and New Energy Vehicle Industry Development Plan for 2012-2020” [节能与新能源汽车产业发展规划 (2012-2020年)], which was published in July 2012, laid out these policy goals as well as a set of concrete numerical targets. Most specifically, the document sought to have China achieve production and sales of 500 thousand battery and hybrid-electric vehicles per year by 2015 and 2 million units per year by 2020. China’s automakers fell just short in 2020, but saw a dramatic 2021 in which 3.3 million battery EVs and plug-in hybrids were sold by Chinese firms, with about 500,000 of these destined for export markets (Exhibit 16). The EV sales proportions reached in late 2021 are well-aligned with the target established in the State Council’s New Energy Vehicle Industry Development Plan for 2021-20135 [新能源汽车产业发展规划(2021-2035年)], which seeks to have battery and plug-in hybrid vehicles comprise 20% of total new vehicle sales by 2025.

 

Exhibit 16: China Battery and Plug-In Hybrid EV Sales, Units and Proportion of Total New Passenger Vehicles Sold, Monthly

Source: CAAM, InsideEVs, Author’s Analysis

China’s EV fleet is growing quickly and approximately 8 million vehicles have been sold (versus a total passenger vehicle fleet of 225-235 million units). Rapid EV expansion does not yet appear to have significantly cut into gasoline or broader transport fuel usage. Norway offers a rough yardstick because it has one of, if not the, largest global EV vehicle fleet share.

Data from Statistics Norway allow a small temporal snapshot between 2016 and 2020, with 2019 being the most representative year since it did not suffer pandemic impacts to fuel demand patterns. In 2019, sales of diesel fuel—the largest fuel source for Norway’s car fleet—fell by about 3% year-on-year after posting a slight increase in 2018.[60]Gasoline sales declined by 5.5% YoY, an acceleration from 2018, when they declined by 3%. Battery EVs and plug-in hybrids accounted for about 13% of the Norwegian passenger car fleet in 2019. China will need 30-35 million EVs to reach the same fleet proportion that Norway attained in 2019, suggesting that EVs as a demand management strategy still have a long way to go before they impact oil demand sufficiently to relax policymakers’ concerns about oil import dependency.

Rationing

In the event of a severe oil supply disruption imposed on China specifically (i.e. an oil blockade) rationing could significantly extend inventory life. The author calculated in a 2018 study of how China might respond to a maritime oil blockade that if China was cut off from seaborne oil imports but did not implement rationing, inventories would last approximately 3 months. The numbers would be broadly similar today. Rationing substantially extended inventory life, as a 35% demand reduction would extend inventory life to 10 months and a 45% demand reduction would stretch stock life to nearly 2 years.[61] There is a historical precedent for such drastic action during a time of conflict. Between 1941 and 1944, the United States used a mix of voluntary and compulsory measures to decrease private and commercial highway gasoline consumption (i.e., transportation-driven gasoline demand) by 32 percent.[62]

Hybrid Solutions

Maritime transportation of oil to China, especially if carried in tankers owned or chartered by PRC firms, may lend itself to intermediate protection options. Specifically, tankers can be PRC-flagged and if necessary also embark armed security teams from PRC private security firms. The issue deserves close attention because PRC oil trader Unipec has for multiple years been the world’s largest charterer of very large crude carriers (a/k/a “supertankers”) and in 2021 chartered more VLCCs than the next five charterers combined.[63]

State-flagging tankers is fundamentally a deterrent strategy for situations of heightened tensions but short of full-scale war. A PRC-flagged tanker in government service would enjoy the substantial protection of China’s flag. If an outside power interdicted such a vessel, China would have grounds to claim a sovereignty breach that could justify an armed response.[64] The fact that China’s main oil trading firms are parastatal and are substantially owned/controlled by the PRC government would introduce some degree of ambiguity as to whether a vessel was in “government service” but if Beijing needed to make the argument, it would likely be relatively straightforward. The result is, as we put it nearly 15 years ago an escalatory barrier that “would thus deter adversaries from interdicting PRC oil shipments unless hostilities were either imminent or already underway. It is difficult to imagine a scenario short of major war in which an adversary would risk triggering escalatory behavior by Beijing.”[65]

If Chinese interests wished to augment protection for energy shipments—likely against non-state actor threats—but without incurring the potential diplomatic and economic costs of a military deployment that would be overkill relative to the problem, they could hire from the PRC’s burgeoning private security sector. Embarking armed personnel on ships would reap the bonus of credible protective capacity while minimizing the legal, diplomatic, and practical liability onus that arises when deploying private security forces ashore.[66]

China’s domestic private security contractor (PSC) scene has burgeoned, with one analyst estimating that more than five thousand domestic PSC’s in China employ at least three million people.[67] Yet their overseas operational footprint remains small and Chinese law restricts them from conducting armed missions.[68] Moreover, even if this restraint were removed, Chinese PSCs are very different than their competitors from the United States, the Former Soviet Zone, and other jurisdictions with a substantial supply of highly-trained and combat-hardened ex-military personnel. For the meantime it is therefore likely that even Chinese-flagged vessels needing armed protection short of direct military escort would hire contractors from other countries.

  1. Military Defense of Energy Sources and Transit Routes

Chinese analysts fall into two basic camps, which Zha Daojiong characterizes as “globalists” who favor greater reliance on the market and accelerated energy transition efforts to reduce oil dependence and “nationalists” who favor a more forward-leaning mercantilist posture to protect China’s energy security, which is synonymous with oil and gas import dependence.[69] Many of China’s national-level approaches to date, including maximizing supply diversity, expanding oil storage, solidifying PRC firms’ global presence in key oil procurement and trading nodes, managing domestic demand through fuel pricing, and aggressive pursuit of transport electrification emphasize market reliance with an undercurrent of mercantilist state industrial policy.

A key question thus remains and the potential answers to it regularly and dynamically evolve: to what extent, if at all, are energy security concerns shaping China’s military development? At present, capabilities are growing but do not appear to be driven by a specific mission focus on energy security. Chinese ground forces are not oriented toward large-scale foreign deployments nor are its air assets, perhaps beyond heavy lift assets useful for evacuating Chinese citizens from distant conflict zones.[70] For naval force modernization and posture, the energy security question is more pressing. Ultimately, seapower is highly fungible and oil/gas import security likely comprises an incremental subset of what has become a broad array of potential “far seas” missions for the PLA Navy.

Examining a historical archive of China Defense White Papers dating from 1995 to 2019 supports such a holistic view. The term “energy security” first appeared in the 2004 edition, the same year China’s oil imports ballooned.[71] The 2006 White Paper noted that concerns about energy resource security (along with multiple other non-traditional security threats) were mounting.[72] The 2008 and 2010 White Papers used similar language. The 2019 White Paper offers more nuanced views that likely more accurately reflect leadership thinking about the intersection between naval power and commerce protection, noting that with respect to China’s overseas interests “The PLA conducts vessel protection operations, maintains the security of strategic SLOCs, and carries out overseas evacuation and maritime rights protection operations.”[73]

How recognition translates into reality on the ground (and more importantly, at sea) remains to be seen. China is clearly building naval forces capable of operating further afield. The PLAN is now building its third aircraft carrier, one that will be closer in size and operational orientation—including catapults—to U.S. carriers.[74] It has also launched a total of at least 25 Type 052D destroyers and at least eight Type 055 cruisers, each of which could project serious combat power far from China’s shores.[75] It has also commissioned 10 amphibious ships (8 X Type 071 and 2X Type 075) with more on the way.[76] Watching the construction of these vessel types plus the necessary logistics ships to support them offers a key strategic warning indicator.

China’s quantitative and qualitative improvements to its naval forces, and indeed across its military services, have been impressive in recent years. But it is also worth bearing in mind that seeking to protect energy shipments coming from far overseas ultimately means seeking to contest control of the global commons. As Barry Posen of MIT puts it:

“The specific weapons and platforms needed to secure and exploit command of the commons are expensive. They depend on a huge scientific and industrial base for their design and production … The development of new weapons and tactics depends on decades of expensively accumulated technological and tactical experience embodied in the institutional memory of public and private military research and development organizations. Finally, the military personnel needed to run these systems are among the most highly skilled and highly trained in the world. The barriers to entry to a state seeking the military capabilities to fight for the commons are very high.”[77]

Whether China wants to take this challenge on is far from clear, given the potential distraction from the core strategic priorities of re-incorporating Taiwan and establishing control over the country’s adjacent maritime environment. Furthermore, the PLA Navy would likely need to expand further precisely as the bulge of naval vessels it acquired in the mid-2000s are now reaching midlife and likely becoming more expensive to sustain.[78] It would also require significantly increasing China’s basing and access footprint across the Middle East and Indian Ocean Region.[7] China presently has one permanent base—a facility at Djibouti with an approximately 400-meter runway. In contrast, the U.S. maintains access to dozens of sites in the region, with runways able to handle any aircraft in the inventory and full basing abilities (including munitions storage, repair, and host country approval for kinetic operations) at multiple of these across several countries.

The U.S. Gulf Region experience is not definitive for what China might face but offers useful insight into the time it takes to build a credible, comprehensive security presence in oil and gas-exporting areas, the number and types of capabilities and platforms for handling various situations, and the potential cost to combat power in other theaters of interest. Diplomatic relationships, the base facilities and access that resulted from them, and the force deployments dedicated to the region cost decades of time and hundreds of billions of cumulative dollars—not including wars.

The U.S. presence in the Gulf Region commenced in the late 1940s, grew in the shadow of the dominant British role, and then assumed greater prominence after the 1956 Suez Crisis and Britain’s subsequent decolonization moves. Conjunctive diplomatic action and military deployments by the U.S. intensified in the 1960s through multiple crises.[79] U.S. policy toward the region became more explicitly securitized following the 1979 Iranian revolution and the Soviet Union’s 1979 invasion of Afghanistan. In 1980, President Jimmy Carter introduced the “Carter Doctrine” that came to characterize U.S. policy toward the region as it still exists today, noting that ““Let our position be absolutely clear: An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such an assault will be repelled by any means necessary, including military force.”[80]

The “Tanker War” that ensued a few years later when Iraq and Iran began firing on tankers carrying oil through the Gulf helps illustrate the potential level of military commitment that China could face, were it to become the region’s lead security guarantor. In 1984, Iraq intensified its targeting of tankers serving Iranian export facilities and Iran responded against ships carrying Iraqi oil, as well as vessels loading at Kuwait, which was using a portion of its oil revenues to support Iraq’s war effort.[81] By early 1987, the situation had escalated to the point that Kuwait sought to reflag tankers carrying its oil as American for protection. Worried that the Soviets might seize the opportunity to reflag the tankers under the hammer and sickle and project naval power directly into the Gulf, Washington swung into action and launched Operation Earnest Will to escort tankers and Operation Prime Chance, a covert parallel action to interdict Iranian minelayers and tanker assailants.[82]

Operation Earnest Will saw 13 U.S. warships deployed within the Gulf for escort missions and a total force that included a carrier battle group in the Gulf of Oman that brought the entire deployment to between 25 and 30 vessels in theatre at a given time.[83] U.S. special operations forces also deployed, with the Army’s 160th Special Operations Aviation Regiment (the “Nightstalkers”), Navy SEALs, Special Boat Units, Marines, other Navy personnel and two oil platform construction barges that were converted into floating sea bases.[84] Chinese forces at present would likely struggle (or even be outright unable) to sustain this level of forward deployed maritime combat power due to a combination of inexperience and lack of a well-developed logistics system. Moreover, deployments approaching this scale would materially reduce available naval combat power in East Asia, China’s priority theatre. Smaller deployments such as the ongoing anti-piracy task forces have value for “showing the flag” but offer limited capability for handling nation-state challenges that are less likely, but are the low-probability, high-impact scenario that a robust naval presence ultimately aims to insure against.

Gulf operations also wrought significant battle damage and loss of life upon U.S. forces. In May 1987, an Iraqi aircraft struck the guided missile frigate USS Stark with two Exocet anti-ship missiles, killing 37 crew members and nearly sinking the vessel. Less than a year later, the frigate USS Samuel B. Roberts hit an Iranian sea mine and was nearly lost, precipitating Operation Praying Mantis, the U.S. Navy’s largest surface engagement since World War II.[85]The PLA Navy’s battle damage management skills and the national leadership’s risk tolerance could be rapidly and severely tested if it seeks a more prominent role as a Gulf Region security guarantor.

Major forward deployments motivated by energy concerns also incur substantial financial costs, both for the directly deployed forces and for changes that may ripple through the entire force structure because of specific military commitment in energy-rich regions. And even significant force deployments still do not calm market forces. As one analyst put it, “…force projection is not a remedy for market power but a strategy to contend with its consequences.”[86] If force projection increases propensity to become involved in conflicts, costs can balloon much further—as the U.S. experienced with a multi-trillion dollar campaign in Iraq.[87]

Combining the likely capital and operational costs of Persian Gulf bypass pipelines estimated earlier in this testimony with the fact that a baseline force structure akin to that the U.S. has maintained in the Gulf Region since the 1980s could realistically cost upwards of $20 billion per year suggests that a maximally securitized Chinese oil and gas import protection policy could add $50 billion or more to the country’s annual oil import tab. Beijing would almost certainly avoid voluntarily assuming such an economic burden, especially as its economy slows and other cost centers begin to bite. The economic dynamics and political complexity of major distant force projection, plus the opportunity cost for China’s ability to generate combat power in its existentially vital home region, will likely disincentivize militarized, overland-focused oil and gas security policies.

Recommendations for Congress

Recommendation 1: Identify and monitor key warning indicators of PRC intent to try and establish greater control over key oil and gas exporting regions. Congress should consider creating an annual “China Global Energy Supply Influence Report.” The public version could assess PRC involvement in arms trade, weapons development, financial transfers to, and facilitation of corruption and/or financial influence activities in key oil and gas-exporting countries. It should also track attempts to establish military presence in these areas, particularly efforts such as those seen in the UAE and Equatorial Guinea in late 2021 that could lead to permanent forces access and presence. A non-public addendum to the report could identify targets and methods for legislative, legal, diplomatic, and if necessary, physical actions to address PRC encroachment in areas identified as key energy security interests of the United States and its allies.

Recommendation 2: Impose costs on China’s attempts to upgrade its presence in the Gulf Region, deny it hegemony over key Gulf states. Key state leaderships’ interactions with the Chinese are by all appearances more about keeping the U.S. interested and invested in the region than they are an actual attempt to trade the traditional security guarantor for a new one. U.S. presence is desirable to our partners and they want us there, but they are concerned about our level of commitment.[88]

Do not make the “Bagram mistake” of effectively abandoning high value strategic outposts. Maintain current forward presence in the CENTCOM AOR and the associated diplomatic, economic, and military equipment supply partnerships. If the U.S. were to exit certain facilities, China could gain access at relatively low cost. Conversely, to build its own basing network from scratch, it will face steep diplomatic and economic costs to construct the network and then maintain/sustain it. Finally, forcing Beijing to build its own proprietary basing network creates strategic warning indicators of Chinese intent because the necessary actions take years to unfold and are physically impossible to conceal in most cases.

Recommendation 3: Refocus U.S. high-end maritime combat power further east, build a lower-end footprint tailored to the highest-probability threats to energy flows from Latin America, Africa, and the Middle East. The transition is already well underway for 5th Fleet, with Bahrain now homeporting Cyclone-class patrol boats and two Coast Guard cutters rather than large destroyers.[89] Latin America and Africa also offer rich upside for enhanced naval presence with smaller craft that have missions distinct from their larger blue water brethren. Put more bluntly, having a DDG or guided missile cruiser hunting pirates, drug smugglers, terrorists, and confronting radical Iranian elements in the Gulf is not sensible. Performing these missions with fast, low-draft vessels of 100-to-1,000 tons displacement that can be built in the United States does make sense and preserves high-end platforms for contingencies involving China, Russia, North Korea, and the like.

Ultimately, maintaining a strong lower-end presence aligned with more unconventional threats, while being able to surge higher end forces (air and naval) as necessary in response to crises underpins longstanding relationships in key regions while minimizing opportunity costs for readiness and concentration of combat power in key zones of the Indo-Pacific.

Recommendation 4: Facilitate upgraded U.S. combat power in the Indo-Pacific by reaching a détente with Iran.This is a multi-year process under the best of circumstances, but the time to start is now. Iran is not an existential threat to the United States, even if it were to acquire nuclear weapons. If it did manage to deploy nuclear weapons, it will be highly deterrable given the juxtaposition of a small number of Iranian weapons versus a multi-thousand warhead, highly survivable U.S. nuclear triad. Deterrence has worked to date with North Korea and there is no indication it would not also with Iran. Furthermore, the same reduction of tensions with Iran that would facilitate greater U.S. high-end focus on the Indo-Pacific region would also likely reduce Iran’s incentive to obtain and deploy nuclear weapons—especially weapons designed to be delivered outside the Gulf region.

Recommendation 5: Maximize U.S. strategic room for maneuver through a combination of carbon fees, greater exploitation of domestic energy resources, and promotion of nuclear energy. Carbon fees can help create incentives for deeper electrification of transportation, more efficient use of domestic natural gas, and more rapid deployment of nuclear energy that would help insulate the U.S. and its allies against energy coercion. Imposing costs per unit of carbon emitted is admittedly not a popular subject now amidst high inflationary pressures. But the conversation should begin now because American energy abundance—and by extension, our technological and industrial capacity to outcompete the People’s Republic of China—depends on it.

Recommendation 6: Promote a policy of “climate competition” to foster domestic energy transition and innovation efforts, enhance American international climate partnership credibility, and disincentivize coal use in China.[90] Adopting a competition-oriented approach can help insulate the U.S. from climate traps in which the PRC demands concrete upfront concessions corrosive to the rules-based order in exchange for a “definite maybe” on its part.[91] If successful, it can also help the U.S. build a pro-energy abundance climate coalition that could use carbon border adjustment taxes to help lever China off of its present course, which could see more than one hundred billion additional tonnes of coal burned in the next 25 years and drive up the atmospheric CO2 concentration by an additional 10% relative to today’s level.[92]

ENDNOTES 

[1] The content of the piece exclusively reflects the author’s views and in no way reflects opinions or assessments of Rice University or the Baker Institute for Public Policy. The report covers a dynamic subject area and the author reserves the right to update as may be warranted by events. Author contact: gabe.collins@rice.edu

[2] The ratio is a very rough yardstick, as one of the main reasons the U.S. exports crude oil despite being not quite “self-sufficient” is that its refineries are generally geared toward heavier, higher sulfur crude oils and have limited ability to handle light, low-sulfur crudes from shale plays. It thus makes sense to export some domestic production.

[3] With RMB/USD exchange rate movements amplifying the effective cost borne by PRC firms since domestic costs are generally RMB-denominated.

[4] Author’s estimate based on data from Rystad Energy (CAPEX) and the EIA (production)

[5]   Anglo-Iranian Oil Company (now BP),  Royal Dutch Shell, Standard Oil Company of California (SoCal, later Chevron), Gulf Oil (now merged into Chevron), Texaco (now merged into Chevron), Standard Oil Company of New Jersey (subsumed into ExxonMobil), and Standard Oil Company of New York (also subsumed into ExxonMobil)

[6] Used as an example for operational security reasons since this particular facility has already been targeted and this basic photo has been widely published in news media.

[7] The ensuing discussion focuses on the Middle East and Persian Gulf region because of its central importance to global oil supplies and also LNG. Furthermore, the region must move its resources to market through a handful of vital chokepoints that are frequently threatened with physical attacks by nation-state and non-state actors. Finally, the region has a greater risk of high-intensity warfare than China’s other key oil supply regions (Africa and Latin America) because of potential for conflict between well-equipped, significantly capable nation state militaries.

[1] Guy C.K. Leung, Aleh Cherp, Jessica Jewell, Yi-Ming Wei, Securitization of energy supply chains in China,

Applied Energy, Volume 123, 2014, 316-326, https://doi.org/10.1016/j.apenergy.2013.12.016. (322)

[2] Leung et al. 324

[3] Matthew Bunn, “Enabling a Significant Nuclear Role in China’s Decarbonization,” chapter in Foundations for a Low-Carbon Energy System in China, Cambridge University Press, 2021.

[4] Gabe Collins, “China Peak Oil: 2015 Is the Year,” The Diplomat, 7 July 2015, https://thediplomat.com/2015/07/china-peak-oil-2015-is-the-year/

[5] Maximillian Holland, “Norway’s Plugin EVs Take 90% Share In December — Even Facing One-Off Headwinds,” CleanTecnica, 5 January 2022, https://cleantechnica.com/2022/01/05/norways-plugin-evs-take-90-share-in-december-even-facing-one-off-headwinds/

[6] Source (draw on ENN gas marketing investor slides), as example of the growing use and importance of gas in China’s Tier-1 cities, consider the national-scale disruptions caused in the winter of 2017-2018 by an abrupt transition away from coal in Beijing and other Northern Chinese cities. Siwen Wang, Hang Su, Chuchu Chen, Wei Tao, David G. Streets, Zifeng Lu, Bo Zheng, Gregory R. Carmichael, Jos Lelieveld, Ulrich Pöschl, Yafang Cheng, “Natural gas shortages during the “coal-to-gas” transition in China have caused a large redistribution of air pollution in winter 2017,” Proceedings of the National Academy of Sciences Dec 2020, 117 (49) 31018-31025; DOI: 10.1073/pnas.2007513117

[7] Gabriel B. Collins and Michelle M. Foss, “The Global Energy Transition’s Looming Valley of Death,” Baker Institute Policy Report, 27 January 2022, https://www.bakerinstitute.org/media/files/files/51d51fff/bi-report-012722-ces-global-energy.pdf

[8] https://docs.house.gov/meetings/FA/FA18/20180522/108347/HHRG-115-FA18-Wstate-MedlockIIIK-20180522.pdf

[9] Collins, Gabriel and Jim Krane. 2017. Carter Doctrine 3.0: Evolving US Military Guarantees for Gulf Oil

Security. Policy brief no. 04.27.17. Rice University’s Baker Institute for Public Policy, Houston, Texas.

https://www.bakerinstitute.org/media/files/research_document/e73ec9c9/BI-Brief-042717-

CES_CarterDoctrine.pdf ; See also: Anand Toprani, “Oil and the Future of U.S. Strategy in the Persian Gulf,” War on the Rocks, 15 May 2019, https://warontherocks.com/2019/05/oil-and-the-future-of-u-s-strategy-in-the-persian-gulf/ and Gabriel Collins, “Shale is Not Forever: Why America Should Continue Protecting Gulf Oil and Gas Flows,” The National Interest, 8 July 2019, https://nationalinterest.org/blog/middle-east-watch/shale-not-forever-why-america-should-continue-protecting-gulf-oil-and-gas

[10] See, for instance:  Charles L. Glaser and Rosemary A. Kelanic eds., “Crude Strategy: Rethinking the US Military Commitment to Defend Persian Gulf Oil” and Elbridge Colby, “The Strategy of Denial: American Defense in an Age of Great Power Conflict,” Yale University Press, 2021 (Pgs. 35-36)

[11] Summary of the 2018 National Defense Strategy of the United States of America, https://dod.defense.gov/Portals/1/Documents/pubs/2018-National-Defense-Strategy-Summary.pdf

[12] Gabriel Collins and Michelle Michot Foss, “Want to Derail the Energy Transition? Take Fossil Fuels Out of the Mix,” Foreign Policy, 14 January 2022, https://foreignpolicy.com/2022/01/14/fossil-fuel-divestment-climate-change-energy-transition/

[13] Gabriel Collins and Michelle Foss, “The Global Energy Transition’s Looming Valley of Death,” Baker Institute for Public Policy, Report, 27 January 2022, https://www.bakerinstitute.org/media/files/files/51d51fff/bi-report-012722-ces-global-energy.pdf

[14] Dzirhan Mahadzir, “Chinese Navy Piracy Patrol Shepherds Fishing Fleet Through Gulf of Aden,” 6 January 2022, USNI News,   https://news.usni.org/2022/01/06/chinese-navy-piracy-patrol-shepherds-fishing-fleet-through-gulf-of-aden ; Sam LaGrone, “AFRICOM: Chinese Naval Base in Africa Set to Support Aircraft Carriers,” 20 April 2021, USNI News, https://news.usni.org/2021/04/20/africom-chinese-naval-base-in-africa-set-to-support-aircraft-carriers

[15] Jared Malsin, Summer Said, and Warren P. Strobel, “Saudis Begin Making Ballistic Missiles With Chinese Help,” The Wall Street Journal, 23 December 2021, https://www.wsj.com/articles/saudis-begin-making-ballistic-missiles-with-chinese-help-11640294886 and Gordon Lubold and Warren P. Strobel, “Secret Chinese Port Project in Persian Gulf Rattles U.S. Relations With U.A.E.,” The Wall Street Journal, 19 November 2021, https://www.wsj.com/articles/us-china-uae-military-11637274224

[16] Xu Yihe, “Ramping up imports: China endorses new LNG infrastructure projects worth $2bn,” Ypstream Online, 24 February 2022, https://www.upstreamonline.com/lng/ramping-up-imports-china-endorses-new-lng-infrastructure-projects-worth-2bn/2-1-1173498

[17] “East-West Crude Oil Pipeline,” Global Energy Monitor Wiki, https://www.gem.wiki/East-West_Crude_Oil_Pipeline (accessed 7 March 2022)

[18] Katie McQue and Daniel Lalor, “FEATURE: Saudi crude keeps flowing to Red Sea as East-West Pipeline repairs continue,” S&P Global Platts, 22 December 2020, https://www.spglobal.com/platts/en/market-insights/latest-news/shipping/122220-feature-saudi-crude-keeps-flowing-to-red-sea-as-east-west-pipeline-repairs-continue

[19] See, for instance: Gabriel Collins, Ken Medlock, Anna Mikulska, and Steven Miles, “Strategic Response Options If Russia Cuts Gas Supplies to Europe,” Baker Institute Working Paper, 11 February 2022, https://www.bakerinstitute.org/media/files/files/d18d1719/ces-wp2-russiagas-021122.pdf

[20] James Henderson, “Central Asian Gas: prospects for the 2020s,” Oxford Institute for Energy Studies, December 2019, https://www.oxfordenergy.org/wpcms/wp-content/uploads/2019/12/Central-Asian-Gas-NG-155.pdf (Pg.33); Eric Yep and Shermaine Ang, “Commodities 2022: China’s natural gas demand, LNG import growth to slow,” S&P Global Platts, 12 January 2022, https://www.spglobal.com/platts/en/market-insights/latest-news/lng/011222-commodities-2022-chinas-natural-gas-demand-lng-import-growth-to-slow

[21] “Power of Siberia 2 Gas Pipeline,” Global Energy Monitor Wiki, https://www.gem.wiki/Power_of_Siberia_2_Gas_Pipeline (accessed 7 March 2022)

[22] For what a demand slowdown scenario could look like, consider Gabriel Collins, “China’s Debt Bubble and Demographic Stagnation Pose Major Risks to Global Oil Prices—and U.S. Shale Prospects,” Baker Institute Issue Brief, 13 August 2020, https://www.bakerinstitute.org/media/files/files/afbb11ca/bi-brief-081320-ces-chinadebt.pdf

[23] “Bost Project,” United Refineries, http://www.uncounitedrefineries.com/content/bostproject2.php (accessed 21 February 2022)

[24] Salazar Baño, Alfredo Geovanny. “El Sistema de Oleoducto Transecuatoriano (SOTE) en Quito: evaluación de percepción de riesgo y estrategias de mitigación.” (2020). https://minerva.usc.es/xmlui/handle/10347/24163

[25] Robert Goodland, “Independent Compliance Assessment of OCP with the World Bank’s

Social and Environmental Policies.,” 9 September 2002, https://www.praxis-horumersiel.de/cv/download/ocpberic.pdf; “Tarifas reguladas vigentes de Julio 01 de 2020 hasta Junio 30 de 2021,” Cenit, copy on file with author.

[26] “El OCP pone sus esperanzas en el petróleo del bloque ITT,” https://www.primicias.ec/noticias/economia/oleoducto-ocp-crudo-transporte-itt/

[27] https://www.transneft.ru/u/section_file/62931/tarifi_s_21.02.2022.pdf.  Calculated as follows:  Transneft tariff of 2,968.71 rubles per tonne ÷ 80 rubles per USD ÷ 7.33 bbl of crude oil per tonne.

[28] 黄骅港散货港区将建30万吨级原油码头, Sohu.com, 26 April 2020, https://www.sohu.com/a/391290637_754963

[29] Andrew S. Erickson and Gabriel B. Collins, “China’s Oil Security Pipe Dream: The Reality, and Strategic Consequences, of Seaborne Imports,” Naval War College Review 63.2 (Spring 2010): 88-111. https://www.andrewerickson.com/wp-content/uploads/2010/03/China-Pipeline-Sealane_NWCR_2010-Spring.pdf

[30] Tyler Rogoway, “B-52 Tested 2,000lb Quickstrike-ER Winged Standoff Naval Mines During Valiant Shield,” The Drive War Zone, 20 September 2018, https://www.thedrive.com/the-war-zone/23705/b-52-tested-2000lb-quickstrike-er-winged-standoff-naval-mines-during-valiant-shield

[31] “Colombia halts Cano-Limon pipeline after rebel attack: sources,” Reuters, 28 August 2017, https://www.reuters.com/article/us-colombia-oil/colombia-halts-cano-limon-pipeline-after-rebel-attack-sources-idUSKCN1B900J

[32] “New links should help to dramatically increase competitiveness,” Oxford Business Group, https://oxfordbusinessgroup.com/analysis/new-links-should-help-dramatically-increase-competitiveness

[33]China-Backed Pipeline Facility Damaged in Myanmar Resistance Attack, The Irrawaddy, 15 February 2022, https://www.irrawaddy.com/news/burma/china-backed-pipeline-facility-damaged-in-myanmar-resistance-attack.html

[34] Arthur Macmillan, “Seven Houthi drones attacked Saudi pipeline, says letter to UN,” The National, 15 May 2019, https://www.thenationalnews.com/mena/seven-houthi-drones-attacked-saudi-pipeline-says-letter-to-un-1.861997

[35] Saudi Energy Minister says two pump stations on the East-West pipeline were attacked, confirming sabotage targets global oil supply., Saudi Press Agency, 14 May 2019, https://www.spa.gov.sa/viewfullstory.php?lang=en&newsid=1923830#1923830

[36] Shay Saul, “The Houthi Drone Threat in Yemen,” International Institute for Counterterrorism, 2 March 2019, https://www.ict.org.il/Article/2331/The_Houthi_Drone_Threat_in_Yemen#gsc.tab=0

[37] Erickson and Collins, 17

[38] Colonial Pipeline Cyber Incident,

Office of Cybersecurity, Energy Security, and Emergency Response, https://www.energy.gov/ceser/colonial-pipeline-cyber-incident

[39] Rex L. Baum, Devin L. Galloway, and Edwin L. Harp, “Landslide and Land Subsidence Hazards to

Pipelines,” USGS, Open-File Report 2008–1164, https://pubs.usgs.gov/of/2008/1164/pdf/OF08-1164_508.pdf

[40] “Key Ecuador crude oil pipeline ruptures while halted by erosion,” Reuters, 14 December 2021, https://www.reuters.com/markets/commodities/key-ecuador-crude-oil-pipeline-ruptures-while-halted-by-erosion-2021-12-15/

[41] Ursa Space’s China Inventory Coverage, https://storymaps.arcgis.com/stories/c715c48c68484a659628dd24ee390435; Li, H., Sun, RJ., Dong, KY. et al. Selecting China’s strategic petroleum reserve sites by multi-objective programming model. Pet. Sci. 14, 622–635 (2017). https://doi.org/10.1007/s12182-017-0175-0

[42] Working and Net Available Shell Storage Capacity, Energy Information Administration, https://www.eia.gov/petroleum/storagecapacity/; SPR Quick Facts, https://www.energy.gov/fecm/strategic-petroleum-reserve-9

[43] “Weekly Stocks,” EIA, https://www.eia.gov/dnav/pet/pet_stoc_wstk_dcu_nus_w.htm(accessed 10 March 2022)

[44] Chen Aizhu, Dmitry Zhdannikov, “EXCLUSIVE-China boosts oil reserves, ignoring U.S. push for global release,” Nasdaq (via Reuters), 27 February 2022, https://www.nasdaq.com/articles/exclusive-china-boosts-oil-reserves-ignoring-u.s.-push-for-global-release-0

[45] Oil Stocks of IEA Countries, IEA, 11 February 2022, https://www.iea.org/articles/oil-stocks-of-iea-countries

[46] Data provided by Ursa Space Systems, copy on file with author.

[47] Calculated with data from “Working and Net Available Shell Storage Capacity,” Energy Information Administration, https://www.eia.gov/petroleum/storagecapacity/

[48] Gabriel B. Collins and Andrew S. Erickson, U.S.-China Competition Enters the Decade of Maximum Danger: Policy Ideas to Avoid Losing the 2020s (Houston, TX: Baker Institute for Public Policy, Rice University, 20 December 2021). https://www.bakerinstitute.org/media/files/files/b63419af/ces-pub-china-competition-121321.pdf

[49] Meng Meng and Chen Aizhu, “China goes underground to expand its strategic oil reserves,” Reuters, 6 January 2016, https://www.reuters.com/article/us-china-oil-reserves-idUSKBN0UK2NO20160106

[50] “UNDERGROUND GAS STORAGE IN THE WORLD – 2021 STATUS,” CEDIGAZ, 3 December 2021, https://www.cedigaz.org/underground-gas-storage-in-the-world-2021-status/

[51] “Underground Natural Gas Working Storage Capacity,” EIA, 30 April 2021, https://www.eia.gov/naturalgas/storagecapacity/

[52] “China’s CNOOC is Building the World’s Largest LNG Storage Tanks,” Maritime Executive, 22 February 2022, https://maritime-executive.com/article/china-s-cnooc-is-building-the-world-s-largest-lng-storage-tanks

[53] Gabriel Collins and Michelle Michot Foss, “The Global Energy Transition’s Looming Valley of Death,” Baker Institute Report no. 01.27.22. Rice University’s Baker Institute for Public Policy, Houston, Texas. https://www.bakerinstitute.org/media/files/files/51d51fff/bi-report-012722-ces-global-energy.pdf

[54] “Li Keqiang presided over a meeting of the National Energy Commission, emphasizing ensuring stable energy supply and safety, enhancing green development support capabilities Han Zheng attended,” Xinhua News Agency, October 11, 2021, http://www.gov.cn/xinwen/2021-10/11/content_5641907.htm.

[55] “Xi Jinping encourages the majority of oil workers to achieve better results and new achievements,” Xinhua News Agency Weibo, October 22, 2021, http://www.news.cn/politics/leaders/2021-10/22/c_1127983430.htm.

[56] “China to raise gasoline, diesel retail prices,” The State Council, People’s Republic of China, 31 December 2021, https://english.www.gov.cn/statecouncil/ministries/202112/31/content_WS61cee70ec6d09c94e48a3004.html

[57] Collins, Gabriel (2018) “A Maritime Oil Blockade Against China—Tactically Tempting but Strategically Flawed,” Naval War College Review: Vol. 71 : No. 2 , Article 6. http://digital-commons.usnwc.edu/nwc-review/vol71/iss2/6; Gabriel B. Collins and William S. Murray, “No Oil for the Lamps of China?,” Naval War College Review 61, no. 2 (Spring 2008), p. 88, available at www.usnwc.edu/.

[58] Max J. Zenglein and Anna Holzmann, “Evolving Made in China 2025: China’s industrial policy in the quest for global tech leadership,” MERICS Papers on China, Mercator Institute, July 2018, https://www.merics.org/en/papers-on-china/evolving-made-in-china-2025

[59] 《新能源汽车产业发展规划（2021—2035年）》, 国办发〔2020〕39号, 2 November 2020, http://www.gov.cn/zhengce/content/2020-11/02/content_5556716.htm

[60] Data and calculations on file with the author.

[61] Collins, Gabriel (2018) “A Maritime Oil Blockade Against China—Tactically Tempting but Strategically Flawed,” Naval War College Review: Vol. 71 : No. 2 , Article 6.

Available at: https://digital-commons.usnwc.edu/nwc-review/vol71/iss2/6

[62] Bradley Flamm, “Putting the Brakes on ‘Non-essential’ Travel: 1940s Wartime Mobility, Prosperity, and the U.S. Office of Defense,” Journal of Transport History 27, no.1 (March 2006), p. 87.

[63] Craig Jallal, “Top 10 VLCC spot charterers: Unipec No 1, again,” 12 January 2022, Riviera Maritime Media https://www.rivieramm.com/news-content-hub/top-ten-vlcc-spot-charters–unipec-is-no-1-again-69168

[64] Andrew S. Erickson and Gabriel B. Collins, “Beijing’s Energy Security Strategy: The Significance of a Chinese State-Owned Tanker Fleet,” Foreign Policy Research Institute, Orbis 51.4 (Fall 2007): 665-84. https://www.andrewerickson.com/wp-content/uploads/2010/11/Chinas-New-Tanker-Fleet_Orbis_Fall-2007.pdf (680-681)

[65] Erickson and Collins, 681

[66] Andrew S. Erickson and Gabriel B. Collins, “Enter China’s Security Firms,” The Diplomat, 21 February 2012. https://thediplomat.com/2012/02/enter-chinas-security-firms/

[67] Alessandro Arduino, “China’s Private Security Companies: The Evolution of a New Security Actor,” NBR Special Report #80, September 2019, https://www.nbr.org/wp-content/uploads/pdfs/publications/sr80_securing_the_belt_and_road_sep2019.pdf

[68] Alessandro Arduino, “China’s Private Army: Protecting the New Silk Road,” Diplomat, March 20, 2018, https://thediplomat.com/2018/03/chinas-private-army-protecting-the-new-silk-road

[69] Zha Daojiong,  “Debating China’s Energy Security,” China  Quarterly of International

Strategic Studies, Vol. 2, No.2, 219-238. https://www.worldscientific.com/doi/pdf/10.1142/S237774001650010X

[70] Gabe Collins and Andrew Erickson, “The PLA Air Force’s First Overseas Operational Deployment: Analysis of China’s decision to deploy IL-76 transport aircraft to Libya,” China SignPost™ (洞察中国), No. 27 (1 March 2011). https://www.chinasignpost.com/wp-content/uploads/2011/03/China-SignPost_27_Analysis-of-PLAAF-IL-76-deployment-to-Libya_201103012.pdf and “Tonga receives new emergency relief delivered by Chinese military,” CGTN, 28 January 2022, https://news.cgtn.com/news/2022-01-28/Tonga-receives-new-emergency-relief-delivered-by-Chinese-military-17btyYQYcgg/index.html (two Y-20s delivered tsunami relief supplies to Tonga).

[71] “China’s National Defense in 2004,” https://www.andrewerickson.com/wp-content/uploads/2019/07/China-Defense-White-Paper_2004_English-Chinese_Annotated.pdf

[72] (“…能源资源、金融、信息和运输通道等方面的安全问题上升。) China’s National Defense in 2006

Information Office of the State Council of the People’s Republic of China

December 2006, https://www.andrewerickson.com/wp-content/uploads/2019/07/China-Defense-White-Paper_2006_English-Chinese_Annotated.pdf

[73] Full Text of 2019 Defense White Paper: “China’s National Defense in the New Era” (English & Chinese Versions), https://www.andrewerickson.com/2019/07/full-text-of-defense-white-paper-chinas-national-defense-in-the-new-era-english-chinese-versions/

[74] Ronald O’Rourke, China Naval Modernization: Implications for U.S. Navy Capabilities—Background and Issues for Congress, RL33153 (Washington, DC: Congressional Research Service, 20 January 2022). https://crsreports.congress.gov/product/pdf/RL/RL33153/259

[75] Ibid.

[76] Ibid.

[77] Barry Posen, “Command of the Commons: The Military Foundation of U.S. Hegemony,” International Security 28, no. 1 (Summer 2003): 5-46.

[78] Gabriel B. Collins and Andrew S. Erickson, Hold The Line through 2035: A Strategy to Offset China’s Revisionist Actions and Sustain a Rules-Based Order in the Asia-Pacific (Houston, TX: Baker Institute for Public Policy, Rice University, 12 November 2020). https://www.bakerinstitute.org/media/files/files/1e07d836/ces-pub-asiapacific-111120.pdf

[79] Robert Schneller Jr., “Anchor of Resolve: A History of U.S. Naval Forces Central Command/Fifth Fleet,” https://www.history.navy.mil/content/dam/nhhc/browse-by-topic/War%20and%20Conflict/operation-praying-mantis/AnchorOfResolve.pdf (6)

[80] “Address by President Carter on the State of the Union Before a Joint Session of Congress,” 23 January 1980, Foreign Relations of the United States, 1977–1980, Volume I, Foundations of Foreign Policy, United States Department of State, Office of the Historian, https://history.state.gov/historicaldocuments/frus1977-80v01/d138

[81] Robert Schneller Jr., “Anchor of Resolve: A History of U.S. Naval Forces Central Command/Fifth Fleet,” https://www.history.navy.mil/content/dam/nhhc/browse-by-topic/War%20and%20Conflict/operation-praying-mantis/AnchorOfResolve.pdf (14)

[82] Ibid. 15

[83] Ibid. 15

[84] Dwight Jon Zimmerman, “Operations Prime Chance and Praying Mantis: USSOCOM’S First Test of Fire,” Defense Media Network, 27 October 2021, https://www.defensemedianetwork.com/stories/ussocoms-first-test-of-fire-operations-prime-chance-and-praying-mantis/

[85] “Operation Praying Mantis,” Naval Heritage and History Command, https://www.history.navy.mil/browse-by-topic/wars-conflicts-and-operations/middle-east/praying-mantis.html (accessed 7 March 2022)

[86] Stern, Roger. (2010). United States cost of military force projection in the Persian Gulf, 1976–2007. Energy Policy. 38. 2816-2825. 10.1016/j.enpol.2010.01.013.

[87] “Costs of the 20-year war on terror: $8 trillion and 900,000 deaths,” Brown University, September 2021, https://www.brown.edu/news/2021-09-01/costsofwar

[88] William F. Wechsler, “US Withdrawal from the Middle East: Perceptions and Reality,” https://www.atlanticcouncil.org/wp-content/uploads/2019/10/MENA-Chapter-one.pdf

[89] “Coast Guard cutters arrive at Bahrain homeport,” United States Coast Guard, 26 May 2021, https://www.dcms.uscg.mil/Our-Organization/Assistant-Commandant-for-Acquisitions-CG-9/Newsroom/Latest-Acquisition-News/Article/2634801/coast-guard-cutters-arrive-at-bahrain-homeport/

[90] Andrew S. Erickson and Gabriel Collins, “Competition with China Can Save the Planet: Pressure, Not Partnership, Will Spur Progress on Climate Change,” Foreign Affairs 100.3 (May/June 2021): 136–49. https://www.foreignaffairs.com/articles/united-states/2021-04-13/competition-china-can-save-planet ; Lauri Myllyvirta, “Sino-U.S. Competition Is Good for Climate Change Efforts,” Foreign Policy, 21 April 2021, https://foreignpolicy.com/2021/04/21/united-states-china-competition-climate-change/; Steven Stashwick, “U.S.-China Competition Can Still Produce Climate Wins,” Foreign Policy, 9 July 2021, https://foreignpolicy.com/2021/07/09/us-china-competition-climate-change/

[91] Gabriel B. Collins and Andrew S. Erickson, China’s Climate Cooperation Smokescreen: A Roadmap for Seeing Through the Trap and Countering with Competition (Houston, TX: Baker Institute for Public Policy, Rice University, 31 August 2021). https://www.bakerinstitute.org/media/files/files/0f95cafa/ces-pub-china-climate-083121.pdf

[92] Gabriel Collins, “Competition First? Anchoring U.S. Climate & Energy Strategy Amidst the Geostrategic Contest With China,” Houston, TX, November 2021, https://www.bakerinstitute.org/media/files/files/7f582f43/update-collins-china-climate.pdf

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Gabriel B. Collins and Andrew S. Erickson, U.S.-China Competition Enters the Decade of Maximum Danger: Policy Ideas to Avoid Losing the 2020s (Houston, TX: Baker Institute for Public Policy, Rice University, 20 December 2021).

As China’s relative power peaks during this decade, Xi Jinping is likely to make a catastrophic move against Taiwan if he calculates that his probability of success is sufficiently high. To protect American interests, regional security, and the rules-based international order, the United States and its allies must immediately mobilize resources to deter PRC aggression.

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EXECUTIVE SUMMARY

  • U.S. and allied policymakers now face a “decade of danger” through roughly 2030 emanating from the confluence of a peaking paramount leader (Chinese President Xi Jinping), a peaking Chinese Communist Party (CCP), and a peaking People’s Republic of China (PRC) as the country begins to experience the “S-curved slowdown”1 common to great powers.
  • The PRC has achieved an extraordinary rise in power over the last two-plus decades and has succeeded in multiple regional coercion actions over the past decade; but its comprehensive national power will likely peak between 2030 and 2035—or, quite possibly, sooner.
  • Within the next five years, PRC leaders are likely to privately conclude that China’s deteriorating demographic profile, structural economic problems, and technological estrangement from global innovation centers are eroding its leverage vis-à-vis Taiwan and other strategic objectives. As Xi internalizes these challenges, his foreign policy is likely to become even more risk-embracing.
  • Xi’s risk appetite will likely be amplified by his nearly decade-long track record of successful revisionist actions against the rules-based order. Notable examples include the PRC perpetrating atrocities against humanity in Xinjiang,2 coercively enveloping Hong Kong,3 occupying Bhutanese lands,4 violently challenging its borders with India, occupying and militarizing disputed features and zones in the South China Sea,5 ramping up air and maritime incursions against Japan and Taiwan,6 and seeking to illegally restrict or endanger foreign military activities in international waters and airspace even as it operates permissively—sometimes covertly, sometimes aggressively—around the world and across all domains.
  • For the Party, these “victories” have substantively exhausted the “lower-cost, high-payoff” options for aggrandizement, while emboldening Beijing as it eyes the biggest single revisionist prize: Taiwan.
  • Xi, the CCP he leads, and the PRC they control, are presently pursuing extremely ambitious strategic goals for China’s “national rejuvenation.” Addressed in the nation’s five-year plans, these objectives are linked to key anniversaries, including two centenaries—the 100th anniversary of the CCP’s founding in 2021 and that of the PRC in 2049.
  • Unless deterred successfully, Xi likely seeks a major historical achievement regarding Taiwan by the end of this decade, his maximum expected window of personal health and political opportunity. The 68-year-old leader, whose personal abilities, preparations, and available national power are all coming to a peak, will likely be tempted to make his mark on history through a major move against Taiwan near a third key milestone goal year—2027, the 100th anniversary of the founding of the People’s Liberation Army (PLA), with its “original mission” of defeating the Kuomintang. Indeed, China has advanced key PLA modernization goals from 2035 to 2027.
  • Furthermore, the PRC’s externally-facing aggression increasingly appears to be structural in nature. For instance, the lack of apparent pushback from within the CCP against danger-generators, like its increasingly hardline approaches toward Taiwan, suggests that the Party has internalized an aggressive approach to foreign and security policy. Key challenges could therefore outlive Xi if he lost influence, became incapacitated, or—in a less likely scenario—was removed from power.
  • Beijing’s actions during the past 10 years have triggered countermeasures, such as the Australia-United Kingdom-United States (AUKUS) trilateral security pact,7 but concrete constraints on China’s strategic freedom of action are currently not on track to fully manifest until beyond 2030. Absent stronger diplomatic, economic, and military pushback, Beijing will likely conclude that the 2021-to-late-2020s timeframe still favors the PRC. It is quite remarkable, and dangerous, how little cost China has suffered from its actions over the last decade.
  • While China’s growth in national power is slowing, the United States and its allies cannot simply avoid the contest of the decade by “waiting Beijing out.” The situation will get far worse before it gets better, and we will only avoid disaster if we “hold the line” at this critical time. Failure to do so would allow unacceptable consequences in the process, such as losing Taiwan and severely damaging or destroying regional alliances and partnerships—transformative debacles that would remove remaining guardrails to PRC aggression and give it a “second wind.”
  • Precisely when China will peak is uncertain, but it is very likely to do so within the next few years. Given the potential for irreversible catastrophe if near-term PRC aggression is not countered effectively, the United States and its allies should optimize planning and preparations to address maximum up-front threats, and accept corresponding tradeoffs and risks: the best directed-energy weapons in coming decades will matter little if we lose Taiwan on our watch.
  • Accordingly, U.S. planners must urgently mobilize resources, effort, and risk acceptance to maximize capacity to deter PRC aggression throughout this decade—literally starting now.
  • In athletic terms, the U.S. and its allies must now marshal their efforts and focus to “peak” near-term capabilities and maximize their strategic impact by innovatively employing assets that currently exist or can be operationally assembled and scaled within the next several years.
  • Xi’s repeated revisionist success indicates that to “hold the line,” proactively push back, and preserve the rules-based order during the 2020s decade of danger, America and its allies must dramatically enhance the robustness and agility of their collective deterrence and warfighting posture. “Holding the line” is fundamentally about maintaining the status quo, but doing so in practice requires opposing the PRC’s revisionist “slow boil” that has rendered Taiwan and the region less secure and will continue to do so absent concerted, impactful counter-actions.
  • U.S. and allied efforts must emphasize to China that: (1) the window for action against Taiwan is closed tight; (2) PRC attempts at regional revisionism will be met robustly across the diplomatic, economic, technological, and operational spectrum—including intensified presence and operations vis-à-vis the East and South China Seas; and (3) the U.S. and its allies are jointly preparing, planning, and exercising to ensure maximum interoperability, coordination, and capacity to prevail should deterrence fail.
  • The United States has taken too long to warm up to, and focus on, great power competition with China, but it retains formidable advantages and agility that will help it to prevail—provided that it goes all in now. This will require resourcing the mission commensurate with its importance. The U.S. consistently spent $50 billion annually (and sometimes much more) in Afghanistan and Iraq for much of the past two decades.8 Yet the Fiscal Year 2022 defense budget recently approved by Congress only appropriates $7.1 billion for the Pacific Deterrence Initiative serving the vast, vital Indo-Pacific region. To avoid “losing the 2020s”—and with it the 2030s and beyond—Washington must put its maximum money and effort where its mouth is, starting now.

An Unforgiving Gauntlet to Run

Washington now has an unforgiving, but vital, “gauntlet” to run. This rough metaphor—having no choice but to push through a hostile assembly in order to reach a critical goal, while being exposed to vituperation and danger—conveys the urgent, serious situation in which America must prevail over peaking PRC threats during this decade.

Beijing’s tactical public actions and propaganda mask a growing private awareness that its power and latitude for irredentist action face looming constraints. Meteoric PRC achievements are likely to taper and level off in coming years. The closer China approaches leading-edge military capabilities, for instance, the more expensive, complicated, and difficult it will be for it to advance further. Moreover, China’s erstwhile adversaries are not standing still. As Washington intensifies its strategic focus on China and the Indo-Pacific region, rallies a coalition of allies and like-minded states, and deploys new military hardware, Beijing will face a formidable combined economic and military mass backed by a strategic focus that was absent during most of the past 20 years as China rose to become a regional colossus.

Not knowing exactly when domestic and external constraints will bite conclusively—but knowing that when Beijing sees the tipping point in its rearview mirror, major rivals will soon recognize it too—amplifies Xi’s anxiousness and may impel him to act on a compressed timeline. This dynamic has likely helped to drive the dramatic acceleration in China’s revisionist actions following Xi’s ascension to power in 2012. … … …

Gauntlet over Gizmos: Protecting Taiwan from Peak PRC Pressure through Early 2030s

The flexibility and resilience of America and its advanced-economy allies represent the polar opposite of China’s state-directed planning and implementation model. Their openness to people, ideas, and capital flows makes them creative dynamos, as well as fuels world-class research universities and yields demographic dividends by attracting talented and motivated people from all over the world. These qualities underpin their long-term comprehensive national power and the bloc’s global competitiveness. It also makes their responses to an assault formidable and favors their odds the longer a major cold or hot war continues. But free-wheeling systems also complicate near-term proactive preparation to head off conflicts.

Fortunately, Beijing’s belligerent behavior has helped solidify multiple allied diplomatic and military initiatives that, while presently insufficient to defend the rules-based order, nonetheless constitute a solid foundation on which to build. Diplomatic proofs of concept such as the Quadrilateral Security Dialogue (“Quad”),81 security alignments such as AUKUS, and hard security actions such as the Pacific Deterrence Initiative82 are now falling into place. The stage is set for follow-up measures to comprehensively “peak” the non-authoritarian world’s protective actions to hold the line in the Indo-Pacific.83

Throughout this decade of danger, American policymakers must understand that under Xi’s strongman rule, personal political survival will dictate PRC behavior. For Washington and its allies, the struggle centers on preserving and expanding the type of human well-being yielded by a system oriented toward freedom and rules-based governance that emphasizes reason and fair process over coercion and force. Conversely, Xi (like fellow authoritarian leaders such as Vladimir Putin and Kim Jong-un) uses a totally different operating system: rule for life, non-transparency, a ruthless “ends-justify-any-means” mindset, and policies that ultimately tend to be one-way, high-leverage bets on continued successful (and lightly opposed) revisionist actions abroad and near-absolute control domestically.

Xi’s personalist leadership and nearly comprehensive suppression of dissenting voices in the Party’s senior ranks simultaneously raises the chances of making policy mistakes while reducing the flexibility to deal with them early. In such an embrittled system, the proverbial “leverage” that would have left Xi with outsized returns on a successful bet instead amplifies the downside, all for which he personally and exclusively signed. The “best-case” scenario entails continued stagnation and rot within the Party along the lines of what Minxin Pei has articulated.84 The “intermediate case” is an accelerated version of that, with Xi suffering a loss of status and authority on the heels of a policy disaster, internal challengers rising within the PRC, and internecine strife leading to accelerated weakening of the Party. The “bad case” scenario—which, in practice, would likely be interrelated with the intermediate one—is that Xi would double down on a mistaken course of action to prioritize political self-preservation. If such mistakes led to—or were made in the course of—a kinetic conflict, personal survival measures could rapidly transmute into regional or even global (i.e., nuclear, space, cyber) threats.

If Xi triggered a “margin call” on his personal political account through a failed high-stakes gamble, it would likely be paid in blood. Washington must thus prepare the American electorate and its institutional and physical infrastructure, as well as that of allies and partners abroad, for the likelihood that tensions will periodically ratchet up to uncomfortable levels—and that, despite the promise of determined deterrence, actual conflict cannot be ruled out. Si vis pacem, para bellum (“If you want peace, prepare for war”) must unfortunately serve as a central organizing principle for a range of U.S. and allied decisions during the next decade with respect to China under Xi.85

Given these unforgiving dynamics, the implications for U.S. leaders and planners are stark:

  1. Do whatever remains possible to reach “peak” preparedness for deterrent competition against China by the mid-to-late 2020s and accept the tradeoffs.86
  2. Nothing the U.S and its allies might theoretically achieve after 2035 is worth pursuing at the expense of realistic capabilities relevant to defending Taiwan that currently exist or can be operationally assembled and scaled within the next several years.
  3. Much will be decided by the end of this decade. If America falters at this critical time—whether through creeping corrosion of the rules-based order at Beijing’s hands or the shocking impact of failing to defend Taiwan against military attack—many aspects of the world and future will be determined at the expense of U.S. interests and values.

The decade of danger is upon us. With existential stakes for American interests and values looming, there is no time left to waste. Washington and its allies must push to maximize their competitive edge as rapidly as possible to avoid an outcome they cannot afford—“losing the 2020s.” At what point the PRC reaches its peak may ultimately defy precise prediction, but the strong possibility of it occurring over the next few years should front-load America’s bottom-line planning and preparations, given the potential for irreversible linchpin effects. Near-term preparation to run this decade’s unforgiving gauntlet justifies any corresponding long-term tradeoffs and risks: “losing the 2020s” would also mean losing the 2030s and beyond. Ultimately, the best achievements in coming decades will matter little if we lose Taiwan on our watch. More broadly, allowing PRC revisionism to run as rampant in the 2020s as it did in the 2010s would risk negatively reshaping the world order for decades to come and could actually set the stage for even worse conflicts by destabilizing the planet’s most populous region. Alternatively, proactive deterrence actions now can sow the seeds for a more peaceful and prosperous future that would benefit all Indo-Pacific countries, China included. The mission is vital, the stakes are high, and the clock is ticking.

ADDITIONAL SAMPLE CONTENT FROM REPORT:

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Andrew S. Erickson and Gabriel B. Collins, “A Dangerous Decade of Chinese Power Is Here,” Foreign Policy, 18 October 2021.

China’s Power is Peaking—As is the Danger for the United States

Beijing knows time isn’t on its side and wants to act fast.

U.S. and allied policymakers are facing the most important foreign-policy challenge of the 21st century. China’s power is peaking; so is the political position of Chinese President Xi Jinping and the Chinese Communist Party’s (CCP) domestic strength. In the long term, China’s likely decline after this peak is a good thing. But right now, it creates a decade of danger from a system that increasingly realizes it only has a short time to fulfill some of its most critical, long-held goals.

Within the next five years, China’s leaders are likely to conclude that its deteriorating demographic profile, structural economic problems, and technological estrangement from global innovation centers are eroding its leverage to annex Taiwan and achieve other major strategic objectives. As Xi internalizes these challenges, his foreign policy is likely to become even more accepting of risk, feeding on his nearly decadelong track record of successful revisionist action against the rules-based order. Notable examples include China occupying and militarizing sub-tidal features in the South China Sea, ramping up air and maritime incursions against Japan and Taiwan, pushing border challenges against India, occupying Bhutanese and Tibetan lands, perpetrating crimes against humanity in Xinjiang, and coercively enveloping Hong Kong.

The relatively low-hanging fruit is plucked, but Beijing is emboldened to grasp the biggest single revisionist prize: Taiwan.

Beijing’s actions over the last decade have triggered backlash, such as with the so-called AUKUS deal, but concrete constraints on China’s strategic freedom of action may not fully manifest until after 2030. It’s remarkable and dangerous that China has paid few costs for its actions over the last 10 years, even as its military capacities have rapidly grown.

Beijing will likely conclude that under current diplomatic, economic, and force postures for both “gray zone” and high-end scenarios, the 2021 to late 2020s timeframe still favors China—and is attractive for its 68-year-old leader, who seeks a historical achievement at the zenith of his career.

U.S. planners must mobilize resources, effort, and risk acceptance to maximize power and thereby deter Chinese aggression in the coming decade—literally starting now—and innovatively employ assets that currently exist or can be operationally assembled and scaled within the next several years. That will be the first step to pushing back against China during the 2020s—a decade of danger—before what will likely be a waning of Chinese power.

As Beijing aggressively seeks to undermine the international order and promotes a narrative of inevitable Chinese strategic domination in Asia and beyond, it creates a dangerous contradiction between its goals and its medium-term capacity to achieve them. China is, in fact, likely nearing the apogee of its relative power; and by 2030 to 2035, it will cross a tipping point from which it may never recover strategically. Growing headwinds constraining Chinese growth, while not publicly acknowledged by Beijing, help explain Xi’s high and apparently increasing risk tolerance. Beijing’s window of strategic opportunity is sliding shut. … … …

Only the most formidable, agile American and allied deterrence can kick the can down the road long enough for China’s slowdown to shut the window of vulnerability. Holding the line is likely to require frequent and sustained proactive enforcement actions to disincentivize full-frontal Chinese assaults on the rules-based order in the Indo-Pacific. Chinese probing behavior and provocations must be met with a range of symmetric and asymmetric responses that impose real costs, such as publishing assets owned by Chinese officials abroad, cyber interference with China’s technological social control apparatus, “hands on” U.S. Navy and Coast Guard enforcement measures against Maritime Militia-affiliated vessels in the South China Sea, intensified air and maritime surveillance of Chinese naval bases, and visas and resettlement options to Hong Kongers, Uyghurs, and other threatened Chinese citizens—including CCP officials (and their families) who seek to defect and/or leave China. U.S. policymakers must make crystal clear to their Chinese counterparts that the engagement-above-all policies that dominated much of the past 25 years are over and the risks and costs of ongoing—and future—adventurism will fall heaviest on China.

Bombastic Chinese reactions to emerging cohesive actions verify the approach’s effectiveness and potential for halting—and perhaps even reversing—the revisionist tide China has unleashed across the Asian region. Consider the recent nuclear submarine deal among Australia, the United States, and the United Kingdom. Beijing’s strong public reaction (including toleration of nuclear threats made by the state-affiliated Global Times) highlights the gap between its global information war touting China’s irresistible power and deeply insecure internal self-perception. Eight nuclear submarines will ultimately represent formidable military capacity, but for a bona fide superpower that believes in its own capabilities, they would not be a game-changer. Consider the U.S.-NATO reaction to the Soviet Union’s commissioning of eight Oscar I/II-class cruise missile subs during the late Cold War. These formidable boats each carried 24 SS-N-19 Granit missiles specifically designed to kill U.S. carrier battle groups, yet NATO never stooped to public threats.

With diplomatic proofs of concepts like the so-called AUKUS deal, the Quadrilateral Security Dialogue, and hard security actions like the Pacific Deterrence Initiative now falling into place, it is time to comprehensively peak the non-authoritarian world’s protective action to hold the line in the Indo-Pacific. During this decade, U.S. policymakers must understand that under Xi’s strongman rule, personal political survival will dictate Chinese behavior. Xi’s recreation of a “one-man” system is a one-way, high-leverage bet that decisions he drives will succeed.

If Xi miscalculates, a significant risk given his suppression of dissenting voices while China raises the stakes in its confrontation with the United States, the proverbial “leverage” that would have left him with outsized returns on a successful bet would instead amplify the downside, all of which he personally and exclusively signed for. Resulting tensions could very realistically undermine his status and authority, embolden internal challengers, and weaken the party. They could also foreseeably drive him to double down on mistakes, especially if those led to—or were made in the course of—a kinetic conflict. Personal survival measures could thus rapidly transmute into regional or even global threats.

If Xi triggered a “margin call” on his personal political account through a failed high-stakes gamble, it would likely be paid in blood. Washington must thus prepare the U.S. electorate and its institutional and physical infrastructure as well as that of allies and partners abroad for the likelihood that tensions will periodically ratchet up to uncomfortable levels—and that actual conflict is a concrete possibility. Si vis pacem, para bellum (“if you want peace, prepare for war”) must unfortunately serve as a central organizing principle for a variety of U.S. and allied decisions during the next decade with China.

Given these unforgiving dynamics and stakes, implications for U.S. planners are stark: Do whatever remains possible to “peak” for deterrent competition against China by the mid-to-late 2020s, and accept whatever trade-offs are available for doing so.

Nothing we might theoretically achieve in 2035 and beyond is worth pursuing at the expense of China-credible capabilities we can realistically achieve no later than the mid-to-late 2020s.

Andrew S. Erickson is a professor of strategy in the U.S. Naval War College’s China Maritime Studies Institute and a visiting scholar in full-time residence at Harvard University’s John King Fairbank Center for Chinese Studies.

Gabriel B. Collins is the Baker Botts fellow in energy and environmental regulatory affairs at Rice University’s Baker Institute for Public Policy and a senior visiting research fellow at the Oxford Institute for Energy Studies.

***

Andrew S. Erickson and Gabriel B. Collins, “China Is Disrupting the Ocean’s Blue Carbon Sink,” Foreign Policy, 10 September 2021.

Washington and Beijing need to protect the global seabed—and address the staggering loophole in greenhouse gas reporting.

Bottom line: The U.S. Must Address China’s Blue Carbon Disruption

By Andrew S. Erickson, a professor of strategy in the U.S. Naval War College’s China Maritime Studies Institute, and Gabriel B. Collins, the Baker Botts fellow in energy and environmental regulatory affairs at Rice University’s Baker Institute for Public Policy.

As the United States and China prepare for the 26th U.N. Climate Change Conference of the Parties (COP 26) in Glasgow, Scotland, this November, U.S. special climate envoy John Kerry and his team should put “blue carbon”—carbon captured and stored by coastal and marine ecosystems—on the agenda for the first time. Blue carbon is a strategic global climate asset, but disruptions to it are currently not even systematically measured, much less reported, by leading disruptor China or any other nation. Kerry can publicly highlight the issue and begin making the case for factoring seabed and marine ecosystem disruption into the global climate policy equation.

The ocean covers 71 percent of the world’s surface, but less than 10 percent of the seafloor has been mapped using modern sonar, according to the National Oceanic and Atmospheric Administration. Wide-ranging salt marshes, mangroves, seagrass beds, and the ultra-deep abyssal seabed may be out of sight and mind for most people, but they are very much alive and keeping us all well—particularly by absorbing large quantities of carbon dioxide from the atmosphere and balancing critical ecological and climate systems. Disrupting such millennia-old processes before we even partially understand them risks grave and potentially irreversible harms.

A landmark study recently published in the scientific journal Nature underscores that “marine sediments are the largest pool of organic carbon on the planet,” with an estimated volume on the order of seven trillion metric tons—more than three times the cumulative anthropogenic carbon dioxide emissions since 1750. These carbon sequestration zones are subject to both a major existing threat (bottom trawl fishing) and an emerging one (seabed mining for polymetallic nodules). China plays a massive role in both activities. … … …

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Gabriel B. Collins and Andrew S. Erickson, “China Is Laying Climate Traps for the United States,” Foreign Policy, 2 September 2021.

With the Glasgow conference approaching, U.S. diplomats must be careful.

By Gabriel B. Collins, the Baker Botts fellow in energy and environmental regulatory affairs at Rice University’s Baker Institute for Public Policy, and Andrew S. Erickson, a professor of strategy in the U.S. Naval War College’s China Maritime Studies Institute.

Special presidential envoy for climate John Kerry, representing the United States in China-based talks this week, faces a formidable opponent: a Chinese Communist Party (CCP) responsible for nearly one-third of current global carbon dioxide emissions. China burns more coal than the rest of the world combined—and pushes the United States to compensate for its own planet-poisoning ways. This is a major challenge for the administration of U.S. President Joe Biden as it seeks to promote the “Road to Glasgow,” where the United Kingdom will host the 26th U.N. Climate Change Conference (COP26) from Nov. 1 to Nov. 12.

Hopes of coaxing China into lowering emissions before COP26 are a dead end. The only sustainable solution is an U.S. climate competition strategy, leveraging the threat of carbon taxation to incentivize a timely Chinese energy and policy transition to safeguard the atmosphere and oceans for future generations. But first, Kerry needs to make it through his China meetings.

Kerry and his team face three major traps their Chinese counterparts keep striving to lay. The Biden administration—including Kerry himself—has explicitly promised not to make concessions to Beijing in return for climate cooperation. But despite that pledge, linkage remains a real trap. The CPP’s unrelenting pursuit of political leverage at home and abroad invariably overrides its concern for the climate.

Leading-emitter China keeps pushing to link its political priorities to other countries’ climate priorities. And progressive groups keep pushing the administration to dance with the devil and accept this Faustian bargain. But make no mistake: When foreign supplicants collide with the CCP’s self-interest, they will pay with both upfront concessions and wasted time, during which critical climate systems could be pushed beyond the point of no return.

And there is little possibility of domestic accountability in China itself because the CCP harshly suppresses environmental and climate dissent. It won’t even accept or air the professional assessments of its own environmental officials in key instances. Case in point: former China Central Television journalist Chai Jing, known as “China’s Rachel Carson.” Soon after being commended by Chinese Minister of Environmental Protection Chen Jining, her 2015 TED-style documentary, Under the Dome, was abruptly censored—as were her personal communications and even Chen’s own discussion of her. Silencing China’s Silent Spring-inspired movement before it could even begin to stimulate badly needed discussion speaks louder than any words. Moreover, even after the disastrous Henan floods, Chinese state media coverage after major Chinese weather disasters tends to avoid mentioning climate change, let alone acknowledging China’s own emissions might be a factor influencing it. All the more reason Beijing’s so-called progressive climate sweet talk is only for naïve ears.

Two other major traps loom large for the United States on the road to Glasgow’s conference. One is getting sidetracked. Beijing loves to talk about dialogue but hasn’t come close to making meaningful climate commitments—which, in any case, the CPP will blatantly violate if it finds them inconvenient. The CCP has a long track record of breaking even the most binding of promises. Among the many examples are the Sino-British Joint Declaration on Hong Kong, registered at the United Nations as an international treaty, and Chinese President Xi Jinping’s assurance, delivered at a public press conference with then-U.S. President Barack Obama in 2015, that China would not militarize key contested areas in the South China Sea—a pledge promptly invalidated by the People’s Liberation Army’s own actions even as Chinese Premier Li Keqiang called for “dialogue and consultation.” And in the climate realm specifically, China has repeatedly backslid and not consistently honored key commitments it made when it ratified the Montreal Protocol 30 years ago in 1991. … … …

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Gabriel B. Collins and Andrew S. Erickson, China’s Climate Cooperation Smokescreen: A Roadmap for Seeing Through the Trap and Countering with Competition (Houston, TX: Baker Institute for Public Policy, Rice University, 31 August 2021).

China accounts for approximately 29% of global carbon dioxide emissions but has an “abiding commitment to coal,” write the authors. Their report outlines a climate competition strategy — specifically, leveraging the threat of carbon taxation — to incentivize a timely transformation in Beijing and provide a viable pathway to preserving the atmosphere and oceans for future generations.

KEY POINTS

  • Beijing’s quest for political leverage at home and abroad overrides its concern for the climate.
  • Leading-emitter China pushes to link its political priorities to others’ climate priorities.
  • When foreign supplicants collide with the Chinese Communist Party’s (CCP) self-interest, they will pay with both up-front concessions and wasted time, during which critical climate systems could be pushed beyond the point of no return.
  • This is a major danger facing the administration of President Joe Biden.
  • Real pro-climate progress requires fundamentally shifting the CCP’s calculus by actually altering the economic bottom line on which its power hinges.
  • Climate competition—specifically, leveraging the threat of carbon taxation—is the only Archimedean lever powerful enough to incentivize a timely transformation.
  • This paradigm-shifting approach would curtail China’s latitude for exploitative geopolitical maneuvering and empower sidelined reformers.
  • Climate competition supports a whole-of-coalition “race to the top” for pro-climate actions, with the EU carbon border tax proposal an extant example.
  • Crucially, it could also anchor the bipartisan domestic support necessary to keep Washington a reliable long-term climate leader and partner of choice.
  • Finally, it offers on-ramps for China itself to engage more decisively on climate change both domestically and internationally, and to benefit accordingly.
  • No silver bullet exists, but climate competition offers the most viable pathway to preserving the atmosphere and oceans for future generations.

EXECUTIVE SUMMARY

This report expands on an essay the authors published in the May/June 2021 issue of Foreign Affairs.1 It provides additional explanation of how President Biden and his team can, and must, avoid two important foreign policy pitfalls: (1) entrapment in climate cooperation negotiations with Beijing that compromise vital American interests up front without corresponding Chinese concessions (let alone reciprocation), and/or (2) economic self-sabotage if the United States makes great climate sacrifices unilaterally, but the People’s Republic of China (PRC) fails to do its part. To help manage these looming risks, this report provides a roadmap to guide U.S. policymakers through Beijing’s climate cooperation smokescreen and into emissions-constraining competition with China.

The most viable path to sustainable biosphere security entails first competing with China by rallying a climate coalition whose alignment Beijing will ultimately seek by making more credible commitments than Washington itself could prompt unilaterally. It is time for a signature American initiative that brings allies and partners from the world’s largest market bloc into a massive U.S.-led movement. This conglomerate of the committed can generate the one Archimedean lever too powerful for Beijing to ignore. The fulcrum: carbon taxation and border adjustment taxes that would impose a heavy cost on future PRC climate destruction, directly impacting not only China’s international reputation, but—far more consequentially—its core growth model. No amount of domestic repression, propaganda, or recalcitrance could hide or offset an undermining of that growth model, a cornerstone of Chinese Communist Party (CCP) legitimacy.

To that end, this report first explains the empirical roots of China’s contradictory stances on carbon and greenhouse gas emissions and how Beijing’s attempts to extract concessions actually reflect a fundamental weakness in its competitive position on carbon. It then articulates a set of actionable, forward-leaning policy ideas aimed at regaining the climate initiative through a novel course of action—competition. A proactive whole-of-coalition effort can incentivize Beijing
to defend its global diplomatic, economic, and industrial competitive position in ways that unilateral supplication simply cannot—with much greater prospects for success. Only such a realignment has the potential to bring China to the table for productive negotiations rather than the distracting or extractive ones it currently pursues.

Our report leverages extensive empirical evidence to help explain China’s abiding commitment to coal and the CCP interests that drive the ongoing obfuscation in its climate rhetoric.2 For policymakers, it also outlines a climate competition strategy to incentivize Beijing to become a positive force for climate progress, rather than a selfish spoiler. While competition is presently not a universally popular approach, it offers Washington’s most plausible route (in concert with allies and partners) to help fundamentally recalibrate China’s incentive structure in the interests of global biosphere security. Competition is also the pathway most congruent with achieving emissions reductions and reshaping the international climate diplomacy paradigm, while also making progress on domestic emissions reduction. While this report emphasizes competition, it also leaves open on-ramps to simultaneous avenues for engagement, should Beijing finally elect to participate in good faith.

SAMPLE CONTENT FROM REPORT:

Gabriel Collins, J.D.

Baker Botts Fellow in Energy & Environmental Regulatory Affairs, Rice University’s Baker Institute for Public Policy

Andrew S. Erickson, Ph.D.

Professor of Strategy, China Maritime Studies Institute, Naval War College

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Grateful for the opportunity to participate in this debate on U.S.-China climate cooperation vs. competition with leading experts! It’s based on our earlier Foreign Affairs article. We explain why America currently can’t trust China to match its green rhetoric with coal-curtailing action—and offer the one Archimedean lever big enough to finally change Beijing’s carbon-spewing ways for the better of all.

Sam Geall, Rebecca Peters, and Byford Tsang; Andrew Erickson and Gabriel Collins, “Can America Trust China to Fight Climate Change? The Debate Over Competition and Cooperation,” Foreign Affairs, 23 July 2021.

  • SAM GEALL is Acting CEO of China Dialogue and an Associate Fellow at Chatham House.
  • REBECCA PETERS is Leland Foundation Association of Marshall Scholars Transatlantic Academy Fellow at Chatham House.
  • BYFORD TSANG is Senior Policy Adviser at the think tank E3G.
  • ANDREW S. ERICKSON is Professor of Strategy at the U.S. Naval War College’s China Maritime Studies Institute and a Visiting Scholar at Harvard University’s Fairbank Center for Chinese Studies.
  • GABRIEL COLLINS is Baker Botts Fellow in Energy and Environmental Regulatory Affairs at Rice University’s Baker Institute for Public Policy and a Senior Visiting Research Fellow at the Oxford Institute for Energy Studies.

… …some policymakers and analysts in the United States argue that it is folly to cooperate with China on climate change. Washington, they contend, should not be suckered into believing that Beijing will sacrifice its economic and political ambitions on the altar of emission reduction. In Foreign Affairs, Andrew Erickson and Gabriel Collins (“Competition With China Can Save the Planet,” May/June 2021) describe China’s climate commitments as little more than hot air. “Serious decarbonization remains a distant prospect,” they write. “Xi’s bullish talk of combating climate change is a smokescreen for a more calculated agenda.”

That agenda… involves making “the United States and other countries supplicants” by extracting “concessions in other domains” for China’s participation in climate negotiations. Erickson and Collins argue that cooperation with China is a fool’s game and that instead the United States should embrace competition. Only a more aggressive stance will force China to mend its ways: a Washington-led global system of carbon border taxes will compel Beijing to seriously cut its emissions. … … …

ERICKSON AND COLLINS REPLY

Sam Geall, Rebecca Peters, and Byford Tsang offer an idealistic exhortation for U.S.-Chinese climate cooperation. What they miss, however, is that Beijing’s quest for geopolitical leverage overrides its concern for the climate. …

Those inclined to kowtow to Beijing should first do the coal math. Although senior officials in the Chinese Communist Party talk a big game about green energy and climate diplomacy, their domestic actions are on track to lock in 100 billion additional metric tons of coal burning by 2045–60. This contradiction underscores the CCP’s paramount interest: domestic political survival, which depends on keeping the engines of industrial growth humming. That, in turn, requires a massive portion of total global coal use—nearly 55 percent in 2020.

At more than four billion metric tons per year, China’s current coal habit portends a dire climate future. … China’s emissions of the six key greenhouse gases covered by the Kyoto Protocol—carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride—already exceed the emissions of all developed countries combined. China was the only major industrial power whose emissions actually rose during the 2020 global pandemic-induced recession, as policymakers leaned on king coal to power industrial recovery.

Beijing reaches quickly for coal to dial up economic output but will likely move much more slowly to reduce its reliance on it—particularly as growth slows or sputters in the coming years. Internationally, China seeks to goad the United States and the EU into serving as the industrial crash-test dummies for aggressive decarbonization, encouraging them to cut emissions unilaterally and take the resulting economic hit. …

Geall, Peters, and Tsang seem to take the CCP at its word and believe that outsiders will benefit by negotiating with its leadership on climate. But when foreign supplicants collide with the CCP’s self-interest, they will pay with both upfront concessions and wasted time, during which critical climate systems could be pushed beyond the point of no return. Real progress on climate change requires fundamentally shifting the CCP’s calculus by altering the economic bottom line on which its power hinges. Climate competition—and threatening carbon taxation in particular—is the only Archimedean lever powerful enough to incentivize a timely transformation.

Climate competition would curtail China’s latitude for geopolitical exploitation and empower sidelined reformers. Crucially, it could also anchor the bipartisan domestic support necessary for Washington to remain a reliable long-term climate leader. No silver bullet exists, but the cooperation that Geall, Peters, and Tsang advocate is a fanciful remedy. Competition offers the most viable pathway to preserving the atmosphere and oceans for future generations.

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Andrew S. Erickson and Gabriel Collins, “Competition with China Can Save the Planet: Pressure, Not Partnership, Will Spur Progress on Climate Change,” Foreign Affairs 100.3 (May/June 2021): 136–49.

  • China’s climate diplomacy stands at a great remove from the country’s coal-hungry industrial reality.
  • When it comes to climate change, the United States should compete, not cooperate, with China.

ANDREW S. ERICKSON is Professor of Strategy at the U.S. Naval War College’s China Maritime Studies Institute and a Visiting Scholar at Harvard University’s Fairbank Center for Chinese Studies.

GABRIEL COLLINS is Baker Botts Fellow in Energy and Environmental Regulatory Affairs at Rice University’s Baker Institute for Public Policy and a Senior Visiting Research Fellow at the Oxford Institute for Energy Studies.

Despite Chinese President Xi Jinping’s pledge that his country will reach “carbon neutrality” by 2060, “serious decarbonization remains a distant prospect,” argue Andrew S. Erickson and Gabriel Collins in Foreign Affairs. “China remains addicted to coal, the dirtiest fossil fuel. It burns over four billion metric tons per year and accounts for half of the world’s total consumption.”

Furthermore, the authors find the use of coal-fired power plants in China dramatically expanded in 2020, warning that the ongoing investments in coal are evidence that China will remain reliant on it for decades to come.

“When it comes to climate change, the United States should compete, not cooperate, with its rival,” the authors contend. “A cooperation-first approach in which Beijing sets the fundamental terms is doomed to fail. Countries seeking cooperation with China are supplicants and, under a best-case scenario, will be forced to make concessions first, after which Beijing might finally deign to engage.”

Erickson and Collins argue that Xi and Chinese policymakers know that their country is critical to curb greenhouse gas emissions on an international level and use that leverage to advance their interests in other areas—suggesting that “Xi’s bullish talk of combating climate change is a smokescreen for a more calculated agenda.”

“Beijing will likely continue using negotiations on climate issues to shield its domestic human rights record and regional aggression. Worse still, it will probably demand economic, technological, and security compromises from the United States and its allies—such as their agreeing not to challenge China’s coercive activities in the South China Sea.”

The authors recommend that U.S. officials “build a coalition of like-minded partners—largely drawn from the industrialized member states of the Organization for Economic Cooperation and Development—to pressure China into sourcing its energy supplies more sustainably.” This coalition should then seek to implement “carbon taxation—a levy on goods or services corresponding to their carbon footprint, or the emissions required to make them.”

Erickson and Collins explain that “a coordinated system would make carbon-intensive Chinese goods less competitive and reduce the disadvantages that manufacturers in the United States face from coal-fired Chinese competitors. But more important, it would force China to take decarbonization seriously.”

“Negotiating proactively with China cannot curtail climate change; Beijing would impose unacceptable costs while failing to deliver on its end of any bargain,” the authors conclude. “Only a united climate coalition has the potential to bring China to the table for productive negotiations, rather than the extractive ones it currently pursues.”

This article is part of the May/June issue of Foreign Affairs, which will be released in full on April 20, 2021.

Late last year, Chinese President Xi Jinping pledged that his country would reach “carbon neutrality” by 2060, meaning that by that time, it would remove every year from the atmosphere as much carbon dioxide as it emitted. China is currently the world’s largest greenhouse gas emitter, responsible for nearly 30 percent of global carbon dioxide emissions. Targeting net-zero emissions by 2060 is an ambitious goal, meant to signal Beijing’s commitment both to turning its enormous economy away from fossil fuels and to backing broader international efforts to combat climate change.

But this rhetorical posturing masks a very different reality: China remains addicted to coal, the dirtiest fossil fuel. It burns over four billion metric tons per year and accounts for half of the world’s total consumption. Roughly 65 percent of China’s electricity supply comes from coal, a proportion far greater than that of the United States (24 percent) or Europe (18 percent). Finnish and U.S. researchers revealed in February that China dramatically expanded its use of coal-fired power plants in 2020. China’s net coal-fired power generation capacity grew by about 30 gigawatts over the course of the year, as opposed to a net decline of 17 gigawatts elsewhere in the world. China also has nearly 200 gigawatts’ worth of coal power projects under construction, approved for construction, or seeking permits, a sum that on its own could power all of Germany—the world’s fourth-largest industrial economy. Given that coal power plants often operate for 40 years or more, these ongoing investments suggest the strong possibility that China will remain reliant on coal for decades to come.

Here’s the inconvenient truth: the social contract that the Chinese Communist Party (CCP) has forged with the Chinese people—growth and stability in exchange for curtailed liberties and one-party rule—has incentivized overinvestment across the board, including in the coal that powers most of China’s economy. China may be shuttering some coal plants and investing in renewable energy, but serious decarbonization remains a distant prospect.

Xi’s bullish talk of combating climate change is a smokescreen for a more calculated agenda. Chinese policymakers know their country is critical to any comprehensive international effort to curb greenhouse gas emissions, and they are trying to use that leverage to advance Chinese interests in other areas. Policymakers in the United States have hoped to compartmentalize climate change as a challenge on which Beijing and Washington can meaningfully cooperate, even as the two countries compete elsewhere. John Kerry, the United States’ senior climate diplomat, has insisted that climate change is a “standalone issue” in U.S.-Chinese relations. Yet Beijing does not see it that way.

After U.S. Secretary of State Antony Blinken declared in late January that Washington intended to “pursue the climate agenda” with China while simultaneously putting pressure on Beijing regarding human rights and other contentious policy issues, Zhao Lijian, the Chinese Foreign Ministry’s spokesperson, warned the Biden admin- istration that cooperation on climate change “is closely linked with bilateral relations as a whole.” In other words, China will not compartmentalize climate cooperation; its participation in efforts to slow global warming will be contingent on the positions and actions that its foreign interlocutors take in other areas.

Zhao’s conspicuously sharp-tongued riposte is already inducing key U.S. partners to pull their punches in climate interactions with China. For instance, in a February video call with Han Zheng, China’s top vice premier, Frans Timmermans, the executive vice president of the European Commission and the EU’s “Green Deal chief,” reportedly steered clear of discussing human rights and the EU’s plans for a carbon border tax, issues China finds contentious. Beijing will likely continue using negotiations on climate issues to shield its domestic human rights record and regional aggression. Worse still, it will probably demand economic, technological, and security compromises from the United States and its allies—such as their agreeing not to challenge China’s coercive activities in the South China Sea—for which those countries would receive little, if anything, in return.

As a result, U.S. officials seem to face a stark choice. If they make concessions to win China’s cooperation in tackling climate change, Beijing will offer only those climate promises that it would outright fail to fulfill, find itself unable to fulfill amid opposition from powerful domestic interests, or, less likely, fulfill merely by default if its economic growth slows more rapidly than widely expected. But if they refuse to deal with China, they may imperil efforts to slow global warming. There is another option, however. When it comes to climate change, the United States should compete, not cooperate, with its rival. … … …

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Jacob Koelsch, Michelle Michot Foss, Gabriel Collins, and Steven Lewis, “Chinese Firms Position For An Energy Transition Copper Supercycle,” Forbes, 5 April 2021.

If China’s dominance of rare earth element supplies is the global energy transition’s “elephant in the room”, then copper is the 800-pound gorilla.  China’s push for outbound investment, with attendant strategic nuances, are a hallmark of emerging concerns about raw materials supply chains. Chinese firms recognize copper’s value from at least four perspectives. First, relative to internal industrial demand, China’s domestic production is inadequate. Second, as Chinese outbound investment has evolved to procure supply, they also are positioning themselves to capture international commodity trading opportunities. Third, Chinese outbound investment does help to enlarge the supply pie for a key raw materials essential to ongoing economic growth and for new energy systems, including those within China aimed at reducing pollution. However, China’s rush to build “green energy” scale and global market heft have fostered expansion of industrial pollutants as well as greenhouse gas emissions. Fourth, strong positions in the copper value chain can facilitate China’s larger industrial policy goals of making China-based enterprises, often “locally” controlled, indispensable hardware and technology suppliers for new energy development worldwide. These dynamics constitute the driving force behind a likely copper supercycle, as global supply comes under significant pressure from green energy ambitions. … … …

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Gabriel B. Collins and Andrew S. Erickson, Hold The Line through 2035: A Strategy to Offset China’s Revisionist Actions and Sustain a Rules-Based Order in the Asia-Pacific (Houston, TX: Baker Institute for Public Policy, Rice University, 12 November 2020).

The authors offer strategies to counter an increasingly aggressive China and to position the Indo-Asia-Pacific for continued prosperity and growth under a rules-based regional system. Their recommendations comprise a dynamic blend of diplomatic, information, military and economic action.

Executive Summary

  • Between now and 2035, imposing costs on strategically unacceptable Chinese actions while also pursuing behind-the-scenes “defense diplomacy” with Beijing offers a sustainable path to influence PRC behavior and position the Indo-Asia-Pacific for continued prosperity and growth under a rules-based regional system.
  • The United States should resist yielding strategic principles and position to a People’s Republic of China (PRC) that is facing increasing constraints on its economic potential, national power growth, and prioritization of competition over citizens’ welfare.
  • The United States should accept greater strategic risk to “hold the line” against PRC revanchism in the Asia-Pacific through Beijing’s key national planning milestone of 2035.
  • Empirical data and emerging structural trends suggest that by 2035, demographic decline, debt overload, and societal expectations will likely substantially curtail China’s national power growth relative to currently expected levels. Beijing’s present hubristic outlook would likely be reduced under such conditions.
  • During the 2020s, Beijing may reach the zenith of its ability to mobilize resources for repression at home and abroad. 2035 thus represents the likely closing of a “window of vulnerability” with heightened risk of conflict between the PRC and regional neighbors, including—by extension through alliances and presence—the United States itself.
  • “Holding the line” is not a passive policy and is likely to require frequent and sustained proactive enforcement actions to disincentivize PRC assaults on the rules-based order in the Asia-Pacific. PRC probing behavior and provocations must be met with a range of symmetric and asymmetric responses that impose real costs.
  • American policymakers must understand that under paramount leader Xi Jinping’s strongman rule, personal political survival will dictate PRC behavior. Washington must prepare the American electorate as well as allies and partners abroad for the likelihood that tensions will periodically ratchet up to uncomfortable levels.
  • American policymakers must also make clear to their counterparts in China that the engagement-above-all policies that dominated much of the past 25 years are over and that the risks and costs of ongoing—and future—adventurism will fall heaviest on the PRC.
  • To reduce PRC leverage, government at all levels in the United States should take steps to de-link supply chains for critical defense and medical goods from the PRC and PRC-domiciled entities as quickly as possible.
  • A strategy of holding the line through 2035 leaves open a pathway to more fully integrate China into the rules-based regional system if and when Beijing steps back from the Chinese Communist Party (CCP)’s present emphasis on aggressive nationalism and regional revisionism.

Summary Slides (Separate from Report)

Other Images from Report

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Gabriel Collins, “China’s Debt Bubble and Demographic Stagnation Pose Major Risks to Global Oil Prices—and U.S. Shale Prospects,”  Issue brief no. 08.13.20 (Houston, TX: Baker Institute for Public Policy, 13 August 2020).

China has become the global oil consumer of last resort—accounting for 63% of global incremental liquids (i.e., “crude oil”) demand growth in 2019.2 The oil markets now understandably focus on near-term pressure factors such as OPEC+ behavior and coronavirus-induced shutdowns.3

But looking a few quarters further out, a sustained slowdown in China’s oil demand growth is, from the risk perspective, a lurking crocodile.4 If the croc bursts onto the riverbank, it could set in motion a complex chain of events that would likely reset the global oil supply/demand picture, cost curve, and investment thesis in ways deeply challenging to multiple oil exporters as well as U.S. unconventional liquids plays, even the Permian Basin.

Three key ingredients made the U.S. shale boom work: (1) cheap capital made available through quantitative easing by central banks around the world, (2) China adding several hundred thousand barrels per day or more of incremental crude/ liquids demand annually in most years since 2004, and (3) U.S. oil patch ingenuity and entrepreneurial spirit. But factor #3 would never have blossomed without #2, and #1 would likely have been much less possible without China’s need to recycle its massive savings glut back into the  global economy. Various analysts may reasonably apply different weights to the chicken-and-egg loop described above, but the virtually inescapable bottom-line conclusion remains: China’s rise has been indispensable in shaping the global oil architecture and underpinning new capital flows and wealth creation, including in  Texas, where the author is based.

My calculations indicate that between  2003 and 2014 (when oil prices first crashed), China’s own oil demand grew by about 5.4 million barrels per day. But the combined oil demand growth in Africa, Central and South America, the former Soviet Union, and the Middle East (commodity exporting regions heavily leveraged to Chinese growth) clocked in at 7.3 million barrels per day—134% of China’s own demand growth.5

From 2015 to 2019, the major commodity exporters’ oil demand only rose by 32% of what China’s did, a far slower rate even adjusting for the shorter time frame. The core commodity exporting regions—led by the Middle East—saw a meaningful uptick in incremental oil demand growth in 2019. Whether this is an outlier remains to be seen. If, for instance, proposed cuts to fuel subsidies are postponed as a result of the coronavirus pandemic, or conversely, accelerate with a change of leadership in certain key regional countries, oil use could move significantly in either direction.

But a question now arises: How much more runway for growth does China’s oil demand have? If examined through the lenses of demographics, debt, and other emerging slowdown factors, the picture increasingly trends toward pessimism. The issue deserves special attention because it is structural, and if it happens, will unfold and exert itself for years to come—unlike the coronavirus lockdowns, which are short-term demand catastrophes with impacts that should rapidly recede once governments choose to lift them.

To quantify the impact that China’s emerging demographic decline, debt burden, and increasingly likely structural economic growth downshift could have on oil and gas markets, consider the following facts:

  1. During the past 20 years, China accounted for 39% of net global oil demand growth. From 2010-2019 during the shale boom period, China accounted for a nearly identical 38% of net global oil demand growth.
  2. During the past 20years, seven of the 10 highest annual oil demand increases of any country were posted by China. The U.S. accounted for the other three. There is no country—or even group of countries—that in the foreseeable future could consistently generate sufficient oil demand growth to offset a significant slowdown in China’s oil consumption, were that contingency to manifest itself. … … …

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Hong Kong’s long-deteriorating situation has come to a head. On 30 June 2020, Beijing railroaded through a popularly-opposed National Security Law negating the Special Autonomous Region’s judicial system and cherished freedoms. Political opponents are vulnerable as never before; everyone is potentially at risk. Beijing has abruptly abandoned binding commitments and reassurances, which underwrote Hong Kong’s handover from Britain in 1997, and its subsequent special treatment by the United States and other nations. Hong Kong’s identity and status lies damaged and altered irrevocably. Key questions remaining are how bad things will get, and what to do in response. This policy report offers assessments and options for American decision-makers to address these challenging dynamics.[2]

Click HERE to download PDF.

Gabriel B. Collins and Andrew S. Erickson, “Policy Options to Impose Costs on Beijing’s Coercive Envelopment of Hong Kong: Version 1.0,” China SignPost™ (洞察中国) 102 (30 June 2020).

Executive Summary:

Beijing has chosen to breach legal commitments it made to assure Hong Kong’s autonomy until at least 2047, most prominently through the sweeping national security law it is preparing to impose.[3] PRC actions are part of a broader pattern of revisionist and destabilizing behavior across an arc stretching from the Himalayas to the East China Sea and deep into Southeast Asia. Beijing increasingly operates according to a “might makes right” approach that eschews institutional, legal, and normative constraints and instead relies on raw coercion. Such behavior undermines the regional diplomatic, economic, and security architecture that suppressed interstate warfare in the Asia-Pacific region and drove robust economic growth and improvements in human wellbeing over the past 70 years.

In disturbing ways, the spirit of Beijing’s actions in Hong Kong echoes Russia’s annexation of Crimea in 2014. PRC decisionmakers utilize more legal trappings, and otherwise place more velvet on their bayonets, than President Putin and his advisors did in 2014; but the blade nonetheless lies just beneath. Moreover, unless met with robust and sustained pushback that begins to shift the cost/benefit calculus, the blade likely will not stop in Hong Kong. Accordingly, this report presents a set of more than 15 calibrated response options that U.S. policymakers should consider utilizing to:

(1) impose costs on Beijing’s ongoing coercive envelopment of Hong Kong and other malign behaviors;

(2) undermine China’s ability to exploit Hong Kong as a preferential channel/“white glove” (白手套) for economic power projection and influence operations abroad, and;

(3) signal resolve to U.S. allies and partners including, but not limited to, Japan, the Philippines, and Taiwan.

U.S. partners and allies will want to see a nuanced approach from Washington that can be adapted in response to fluid circumstances. Accordingly, our analysis prioritizes measures that can be readily implemented as the first step in an overall, layered approach where pressure may need to be dialed up and down over time as actions and counter-actions evolve. It can serve as a “living document” that is updated and revised as events and initial policy formulation and implementation unfold.

Summary of Key Recommended Policy Measures

  1. Create safe havens in the United States and allied/partner countries to absorb Hong Kongers fleeing political persecution and other forms of repression as Beijing exerts power more directly over daily life and activities in Hong Kong.
  2. Prohibit the export of semiconductor manufacturing equipment and support services, as well as other core dual-use technologies, to Mainland China and Hong Kong.
  3. Amend Section 241 and other relevant portions of the Countering America’s Adversaries with Sanctions (“CAATSA”) law in order to leverage an effective and existing set of options for calibrated, targeted measures against selected PRC Mainland and Hong Kong entities and persons whereby pressure can be modulated in response to events.
  4. Intensify Freedom of Navigation and presence operations to challenge illegal PRC maritime claims and land reclamation activities in the South China Sea and East China Sea.
  5. Review and enhance finely-calibrated and-targeted aspects of the U.S. diplomatic, economic, and security relationships with Taiwan.

I. Hong Kong Envelopment Reflects a Broad, Worrisome Pattern of Revisionist Actions by the PRC Government

Beijing is unilaterally abrogating formal, binding legal promises the PRC made to Hong Kong and the world, despite the fact that the “one country, two systems” agreement still guarantees 27 years of protections for the people of Hong Kong.[4] Hong Kong’s government has long branded its home “Asia’s World City,” with a London- and New York-class “Commitment to maintaining the rule of law, freedom of expression and association, the free flow of information, openness and diversity.”[5] This was no temporary ad campaign but a core component of a set of explicit legal commitments to Hong Kong and enshrined in multiple binding agreements, including: (1) the Sino-British Joint Declaration, an important international treaty registered by the Chinese and British governments at the United Nations on 12 June 1985; (2) in the Basic Law, which Beijing’s National People’s Congress (NPC) ratified; and (3) even in the PRC’s own Constitution.

Today’s PRC leaders and their advisors no longer believe that they need to play by existing rules and can make their own (key example: One Country above Two Systems, a refrain that has reverberated since at least 2014, but came to the fore with the Extradition Bill in 2019).[6] Chinese commentators well-placed to understand official government positions do not acknowledge how jurisprudence and the independence of courts work in practice, which suggests that the Chinese Communist Party (CCP) refuses to be bound by law.[7]

The PRC leadership’s abandonment of commitments regarding Hong Kong should not be viewed in isolation, but as part of a broader, increasingly worrisome pattern in which Beijing takes actions that flagrantly violate international law and normative principles and dares others to stop it. (See Exhibit 1, below.) For example, in the South China Sea, the PRC has built artificial features and deployed weapons on them despite President Xi explicitly promising no militarization during a joint White House press conference with President Obama in 2015.[8]

Beijing has additionally dismissed out of hand an arbitral tribunal ruling on the South China Sea features not being islands—despite the PRC being a signatory to the UN Convention on the Law of the Sea (UNCLOS).[9] It has also sought to establish an enhanced Air Defense Identification Zone (ADIZ+) in the South China Sea even more extensive than the one it unilaterally imposed over the East China Sea.[10] Other malign PRC actions include the militarization of the East China Sea and Yellow Sea, the use of lethal force in the intensifying border dispute with India; restriction of the Mekong River’s flow;[11] intensified air and naval intrusions into and around Taiwan’s airspace/waters; dredging in the Taiwan Strait; ramming of Taiwan coast guard vessels around Jinmen/Quemoy; harassment of Indonesian fishing vessels; and influence operations in Australia and elsewhere extending all the way to American soil, infrastructure, and cyberspace.[12]

Exhibit 1: China’s First Ring of Coercive Envelopment

Hong Kong, Macau, and Taiwan are all maritime, but only Taiwan has a sea-moat protecting it from the PRC

Note: the blue lines indicate the numerous submarine telecommunications cables connecting these economies as key conduits to world.

A picture containing text, map Description automatically generated

Map by Andrew Rhodes, 2020

All this is happening nearly simultaneously. The PRC’s move against Hong Kong is the latest indication that Beijing believes coercion trumps pre-existing legal commitments and norms of international behavior on any issue defined as a “core interest.”[13] Beijing’s “core interest” seems to be a variable concept; hence appeasement (or even just acceptance or insufficient resistance) risks inducing the PRC leadership to expand what it views as “core interests,” potentially accelerating ongoing revisionist actions. Conversely, if “core interests” are variable, Beijing can conceivably adjust them away from confrontation as well if PRC actions face sufficient pushback. The variability of “core interests” further suggests that the PRC’s current pattern of predations will proliferate until external action persuades China’s leadership that the costs of revisionist actions have begun to exceed the perceived benefits. Accordingly, U.S. and allied country responses to PRC actions in Hong Kong will be critical to begin imposing costs for Beijing’s revisionism.

A. The First Shoe is Already Dropping: Hong Kong’s Special Status vis-à-vis Washington

The long-standing blanket policy of treating Hong Kong as being substantively separate from mainland China is fast becoming untenable. Beijing’s actions will legally obligate the United States to renounce the preferred status Hong Kong enjoyed under the U.S.-Hong Kong Policy Act (USHKPA) of 1992, which conferred special benefits to Hong Kong in certain areas not available to the PRC at the time. The USHKPA’s provisions are reinforced by the Hong Kong Human Rights and Democracy Act of 2019 (HKHRDA), which explicitly requires that Hong Kong must “…remain sufficiently autonomous from the People’s Republic of China to ‘justify treatment under a particular law of the United States, or any provision thereof, different from that accorded the People’s Republic of China.’”[14]

The PRC government’s move to impose its national security law on Hong Kong severely undermines the territory’s autonomy from the PRC. Readers should note that the loss of “autonomy” does not imply the PLA garrison marching through the streets and in fact much more likely to be a steady and subtle process akin to a vine strangling a tree. Consider, for instance, the ambiguous jurisdictional provisions of the new National Security Law whereby the Mainland authorities “may exercise jurisdiction over a tiny number of criminal cases that jeopardize national security under specific circumstances.”[15]

Such language confers enormous discretionary latitude upon the Mainland law enforcement apparatus. This is troubling when one considers that to date, there are multiple instances of what in Hong Kong might previously been standard business activities being criminalized in the Mainland as “national security” concerns.[16] The resulting uncertainty is likely to be chilling to business activity, because an activity that is permissible in one day’s political situation can be deemed criminal the next—even retroactively. Beijing’s tendency to criminalize routine business behaviors if it finds it expedient to do so will be particularly true in “commanding heights” sectors such as high-tech, energy, and certain commodities. It will also likely affect media and information businesses, a risk foreshadowed by the Causeway Books detentions in 2015 and 10-year prison sentence imposed upon Swedish citizen Gui Minhai by the PRC as part of that case.[17]

One of the first challenges to the new National Security Law could arise from Hong Kong-based entities writing future contracts with PRC entities to be governed by British, American, or Australian law and have those jurisdictions rather than Hong Kong be the venue for hearing any disputes that may arise under the agreement. A coercive (even if subtly so) PRC response to this rational adjustment by businesses fearing legal risk created by the National Security Law in Hong Kong would be one potential concrete lead indicator of further erosion of Hong Kong’s autonomy.

The response may be an unofficial one where PRC officials use back channels to make clear to state-owned firms (and potentially others as well) that they must only sign agreements governed by Hong Kong law and with Hong Kong and the despite resolution venue. Or, a more overt response would be for the PRC to try and grab jurisdiction away from the foreign court in the event of a dispute arising from activities in Hong Kong or attempt extra-legal means to override legitimate judicial processes taking place beyond the bounds of PRC control.

Through the dynamics described above, the National Security Law is also likely accelerating the impacts of pre-existing CCP self-injection into Hong Kong commercial affairs. In 2017, at least 30 Hong Kong-listed subsidiaries of PC state-owned enterprises with a combined market capitalization at the time exceeding $1 trillion added language to their central documents that assure the CCP an integral role in corporate decision-making.[18]

With Hong Kong’s loss of autonomy increasingly laid bare, Washington will likely move expeditiously, with the first broadly visible impacts emerging in coming days and weeks. Indeed, on 29 May 2020, President Trump declared, “I am directing my administration to begin the process of eliminating policy exemptions that give Hong Kong different and special treatment.”[19]

Hong Kong’s preferred status has long covered a broad range of important areas, including continued access to items export controlled under the Coordinating Committee for Multilateral Export Control (COCOM) and separate import quotas and certificates of origin.[20] Hong Kong also has thus far been considered a separate customs territory from the Mainland and subject to lower tariffs on goods exported to the United States than would be the case for PRC-origin items.[21] The law essentially preserves the treatment Hong Kong received as a British colony prior to its transfer to the PRC on 1 July 1997, so long as Hong Kong remains “sufficiently autonomous to justify” such treatment.

Hong Kong enjoyed preferred status vis-à-vis the United States in other areas as well. For instance, it has been treated as a full member of the WTO, regardless of the PRC’s membership, status as well as granted permanent normal trade relations (PNTR). Beyond those areas, the United States recognizes commercial ships and airplanes registered and licensed in Hong Kong, and provides access to U.S. ports and airports, and visa applications by Hong Kong residents are treated separately from PRC visa applications (relevant for business and commercial relations).

Furthermore, Beijing’s actions also jeopardize several bilateral agreements between the United States and Hong Kong that provide special treatment. The HKSAR government lists all the treaties and bilateral agreements to which it is a party at: https://www.doj.gov.hk/eng/laws/treaties.html#mf. In terms of the United States, this includes:

  • A double taxation avoidance agreement (16 August 1989)
  • An air services agreement (7 April 1997)
  • A consular arrangement (1 July 1997)
  • A surrender of fugitive offenders agreement (21 January 1998)
  • A transfer of sentenced persons agreement (17 April 1999)
  • A mutual legal assistance agreement (21 January 2000)
  • A taxation information exchange agreement (20 June 2014)

Comparing these agreements with the ones Washington has with Beijing can suggest which ones might or might not be relevant now that the United States has formally recognized that Hong Kong has been subsumed by the PRC’s coercive envelopment. Now is also an ideal time to allow the long American tradition of lawmaking in a transparent manner to “signal” resolve to Beijing. Deterrence is key both in warfare and politics, and the United States has powerful instruments to wield. Many of the special treatment areas enumerated above benefit large business interests and high net-worth individuals in Hong Kong’s economic elite, and so the prospect of their reduction or removal may prompt meaningful domestic pressure for Beijing to preserve more of Hong Kong’s autonomy than might have otherwise been the case.

B. Practical Realities

CCP leaders may believe that the United States is either unable or unwilling to execute actions that impose costs in any sustained way and will have to be disabused of this misperception. Hong Kong has been a practical, permissive “economic airlock” for accessing the global capital flows that have helped underpin China’s meteoric economic rise over the past four decades; and previously sustain Maoist China as a unique conduit for external trade, technology transfer, and foreign currency. The CCP overlooked Hong Kong’s ideological outlier status because the benefits of the status quo outweighed the benefits of overturning it, plus the costs of change were too high.

Now, because of hubris, over-confidence, desperation, or some combination thereof, the benefits of maintaining the status quo and the costs of change no longer seem prohibitive to Beijing. In focusing on Hong Kong’s transition from accounting for nearly 20% of PRC GDP to the current 3%, PRC leaders likely underappreciate the importance of Hong Kong’s legal and political autonomy as a key platform for facilitating financial flows in and out of Mainland China. Consider, for instance, recent remarks by Wu Xinbo, dean of the Institute of International Studies at Shanghai’s Fudan University, who emphasized that Beijing sees Hong Kong as a “sovereignty” issue that plays a vital role in Chinese domestic politics and for President Xi’s internal standing.[22] A clear implication is that the PRC leadership is likely willing to accept substantial damage to the broader U.S.-China relationship in order to establish more explicit political control over Hong Kong. But Beijing’s cost acceptance is almost certainly finite; and mounting direct damage to PRC economic interests could prompt Beijing to rebalance its cost/benefit calculus.

Beijing has worked hard to decrease Hong Kong’s airlock role and subsume it as merely one location among nine cities and two Special Administrative Regions (SARs) in the Greater Bay Area of the Pearl River Delta.[23] (See Exhibit 2, below.) Yet Hong Kong’s economic role is likely impossible for China to replace in the near-term or even in a comparably useful form (e.g., with Shanghai, let alone financial/human capital-limited Macau and Hainan). Indeed, even other non-PRC regionals hubs such as Singapore or Tokyo would for various reasons likely be unable to fully supplant Hong Kong.[i] Massive flows pass to and from the Mainland via Hong Kong. At year-end 2018, the stock value of utilized foreign direct investment from Hong Kong in mainland China was estimated at $1.1 trillion by China’s Ministry of Commerce, while the stock volume of non-financial outbound FDI from the Mainland into Hong Kong (i.e., capital outflows) was estimated to be $622 billion.[24]

Exhibit 2: The PRC’s “Greater Bay Area”

Suffocating and Subsuming Hong Kong within a Constellation of Mainland Cities

A picture containing text, map Description automatically generated

Map by Andrew Rhodes, 2020

An estimated 60% of all FDI into China during 2018 came through Hong Kong—while Chinese banks hold more than $1 trillion in assets in Hong Kong and Mainland companies raised 25% of their offshore U.S. dollar debt in the Hong Kong market.[25] Furthermore, more than 400 PRC-origin firms are listed on the Hong Kong Stock Exchange and nine of the ten largest IPOs in Hong Kong since 1986 were Mainland companies.[26]

The magnitude of these flows and capital stocks—and their highly PRC-centric nature—strongly suggest that while Hong Kong is also of vital economic interest to the United States, if the territory ceases to function as an “economic airlock,” the downside may ultimately fall most heavily on PRC interests. Even as Beijing seeks to constrain Hong Kong’s agency, and may attempt to rebrand it as a service center oriented primarily toward Mainland firms,[27] the reality remains that the territory’s primary commercial comparative advantage is as an entrepôt that can facilitate bidirectional capital flows between the PRC and global markets.

Hong Kong is in an increasingly challenging politically-tectonic position: it exists financially at the indulgence of the U.S. (and partner country) regulatory and financial systems and it exists physically at the indulgence of the PRC. Hong Kong has never enjoyed geostrategic or resource autonomy from China. In marked contrast to Taiwan (with approximately the same population as Australia and an economy larger than Poland, Thailand, or Sweden), it is too small, close, and thus highly vulnerable to losing the very factors that have made it such a vital open-access commercial hub. Beijing can easily envelop Hong Kong and is doing so now.

But losing that hub’s previous advantages will likely pose larger than anticipated problems for Xi and his team, whose pattern of action during stock market declines and other financial turbulence suggests deep discomfort with free markets.[28] Beijing’s desire to consolidate political and economic control, but also maintain an internationally acceptable airlock as a capital access and egress point constitutes a major point of American and allied country leverage. The strong American stakes in Hong Kong include the security of its 85,000 citizens living there—more than the 72,000 that had been living in mainland China before the pandemic.[29]

As Beijing recognizes Hong Kong’s systemic economic importance and feels the pressure resulting from America rescinding Hong Kong’s special status, it is likely to respond dynamically—and, potentially, quite aggressively. The U.S. government (USG) must thus maintain heightened vigilance regarding PRC retaliation toward U.S. companies and individuals, or even action in international organizations. Beijing has already proven willing to take drastic retaliatory actions against innocent foreign citizens and annual commerce flows worth billions of dollars against countries that acted decisively to uphold the rule of law.

Consider, for instance, the substantial (and law- and norm-violating) steps the PRC took in the wake of Huawei CFO Meng Wanzhou’s December 2018 arrest in Vancouver. Two Canadian citizens in China were soon detained and in the words of former Canadian Ambassador to China David Mulroney “are being held hostage,” while a third had a fifteen-month sentence for drug smuggling upgraded to the death penalty after Meng’s arrest.[30] The two detainees—Michael Kovrig and Michael Spavor—were charged by the PRC with espionage in June 2020 after a Canadian Court ruled that Meng’s extradition process could proceed.[31] China has also significantly curtailed agricultural imports from Canada.[32]

The prospect of such a severe backlash from Beijing may deter some American allies and partners from initially participating openly in the pushback against Beijing’s envelopment of Hong Kong. As such, Washington should operate on the assumption that it may have to initially proceed unilaterally to get things moving, at which point partner countries may find it more tenable to publicly join the efforts. The United States may also need to (1) offer layers of participation as it has done with other security initiatives such as the Proliferation Security Initiative, and (2) offer assurances through action to convince partners that it has their back if China retaliates against them.[33]

Given these complex circumstances, it would be wise to address problematic behavior by the PRC government and its facilitators across three layers.

  • Layer 1 is for immediate implementation and would focus on key individuals. Responses in this layer are designed to demonstrate to executors of PRC policies that their actions are being scrutinized and egregious acts in Hong Kong (and elsewhere) may prove costly. It also emphasizes the need to immediately curtail exports of certain key technologies.
  • Layer 2 would focus on corporate and business entities and entail more systematic actions broadly targeting key aspects of Hong Kong’s financial system and creating legal risks to capital inflows and outflows. Some measures can be implemented relatively quietly too if need be, but the effects will be larger. Some would be much more public and escalatory in their effects.[34]
  • Layer 3 consists of actions to signal resolve to U.S. allies and partners in the Asia-Pacific. Given the broader regional import of Beijing’s action against Hong Kong, their implementation should begin immediately.

Since the stakeholders affected by each level of action are often different, measures can be mixed and matched to increase friction among key actors if need be. Publicity and actors affected can be calibrated to control escalation and adjust for proportionality. This should provide options for the USG, even if it does not have to necessarily lead all of the potential actions outlined in subsequent sections. Layers 1 and 2, which pertain directly to Hong Kong would be implemented in sequentially. Layer 3—which applies to areas of concern beyond Hong Kong—should be set into motion concurrent with the commencement of Layer 1 actions in Hong Kong.

IV. LAYER 1 RESPONSES—FOR IMMEDIATE AND SIMULTANEOUS IMPLEMENTATION

Options in this layer include sanctioning key officials and CCP-connected elites and targeting some of the most egregious trade abuses, such as illicit/coerced technology transfer. Many of them put a premium on government analytical capacity, but the United States already needs such significant capacity to handle China’s overall challenges. Others, such as the first option, focus on specifically protecting Hong Kongers who face political persecution.

Option 1: Create multiple U.S./allied & partner country safe havens for Hong Kongers, particularly those at elevated risk of suppression and political persecution

Beijing’s tightening grasp on the territory will likely prompt many Hong Kong citizens to emigrate. This presents the United States a chance to admit migrants or also facilitate their moves to Canada, the UK, Australia, New Zealand, or other destinations, should they prefer those destinations. Hong Kong has experienced several past waves of migration during and after periods of political turmoil, and the societies that admitted them saw real upside. Vancouver and Toronto in particular benefitted from an earlier wave of Hong Kongers justifiably worried about the 1997 handover. The emigration numbers could prove substantial if even 5-10% of the population decamps, as 7.4 million people live in Hong Kong today.

In a strong historical parallel to migration from the USSR to Israel following the 1974 Jackson–Vanik amendment, PRC authorities are likely to ultimately allow Hong Kong dissenters to flee into self-exile.[35] So, where might these emigrants go? Taiwan is the physically closest potential destination, and in some ways is the key witness to the demise of the Basic Law in Hong Kong, and the remaining frontier of freedom within the major territories claimed as sub-entities by the PRC. But its ability to absorb refugees remains limited at this time—making the United States and certain other allied countries more likely destinations for large-scale migration from Hong Kong.[36] Taiwan is linked to U.S. Hong Kong policy in important ways; and has other positive contributions to make centered on its own security and sustainment, as will be elaborated in Section 3.

The UK seems to be preparing to receive a large portion of current Hong Kong. London has stated that it is prepared to offer 12-month extendable visas to, at a minimum, the 350,000 Hong Kong citizens who currently hold British National Overseas (BNO) passports.[37] BNO passports were issued between 1987 and the July 1997 handover of Hong Kong from the UK to the PRC.[38] The passport confers limited rights and does not give holders British citizenship or a right of UK consular assistance, nor does British National (Overseas) status pass by default to one’s children.[39]

Prime Minister Boris Johnson stated in early June 2020 that if China imposes the national security laws ratified by the NPC, “the British government will change its immigration rules and allow any holder of these passports from Hong Kong to come to the UK for a renewable period of 12 months and be given further immigration rights including the right to work which would place them on the route to citizenship.”[40] An ongoing political debate in the UK suggests the country could end up accepting a much larger number of Hong Kong refugees, potentially including the 2.5 million Hong Kongers eligible to apply for BNO passports.[41]

For Hong Kongers who do not hold BNO passports or who are not eligible to apply for them, the United States, Canada, Australia, and New Zealand should create a meaningful number of priority immigration slots for those seeking to escape political persecution in Hong Kong. We acknowledge the difficult nature of the immigration debate in both the United States and some of our allies. Given how America already has a significant existing Hong Kong-origin community, the Washington could likely accommodate many immigrants from Hong Kong—should PRC repression induce large-scale migration.

The United States should now offer visa application pipelines for carefully-vetted Hong Kongers. The volume of emerging Congressional proposals is encouraging. In the House, Representatives Mike Gallagher and John Curtis are introducing legislation to designate Hong Kong citizens as Priority 2 Refugees and direct Secretary of State Michael Pompeo to coordinate their relocation among the United States and its allies.[42] Senator Ben Sasse is similarly introducing a Hong Kong Asylum Bill.[43]

Admitting those seeking freedom from repressive regimes represents America at its best, and has served our Nation well – as recent examples illustrate, including communist Hungary (tens of thousands in 1956) and Cuba (thousands since 1959), fallen regimes like South Vietnam (hundreds of thousands post-1975), or religious persecution (half a million Soviet Jews and Pentecostal Christians in the 1970s and ’80s).[44] Following the Tiananmen Massacre in 1989, Congressional pressure ultimately allowed PRC citizens already in United States to stay.

The United States has a special opportunity to welcome a wave of typically-younger and sometimes less-established individuals, who in most cases will not enjoy BNO status. At a time when slowing immigration and plummeting domestic birthrates are eroding America’s heretofore exceptional demographics, thereby bringing the sustainability of entitlement programs and other budget outlays into question, here is a golden opportunity to bring in highly capable individuals whose development and English-language education is already fully paid for, yet have decades to contribute productively to society. A further demographic dividend awaits, from Hong Kongers desiring children but waiting to bear them, or having young children but anxious to raise them, in a place where they can have a good future. We must seize this unique opportunity, for their future and for America’s alike.

Accepting what could ultimately be a substantial number of Hong Kong migrants is both the correct moral decision and would also have the practical impact of reassuring dissidents, journalists, and other civil society participants that if the situation truly deteriorates, they have a safe haven to retreat to. This can help incentivize a certain proportion of Hong Kong residents to push back harder against repression than they might if they felt there was no potential escape option. PRC citizens were allowed to remain in U.S. post-Tiananmen—a precedent worth revisiting.

As for related security precautions, America must have capabilities and vigilance to detect and handle transgressors anyway, on top of the PRC agents who have long operated under diplomatic cover, and the known intelligence operatives who have heretofore knowingly operated under the guise of state media personnel.[45]

Option 2: Tighten export controls.

Hong Kong has historically enjoyed separate status from the PRC under U.S. export control regulations. Indeed, the 1992 USHKPA specifically notes that “The United States should continue to support access by Hong Kong to sensitive technologies controlled under the agreement…‘COCOM’…for so long as the United States is satisfied that such technologies are protected from improper use or export.”[46] Hong Kong has likewise enjoyed different treatment from the PRC under The Committee on Foreign Investment in the United States (CFIUS).[47] This has allowed more sensitive and advanced technology to move to Hong Kong, whereby it could be transferred into the PRC proper.

Deteriorating conditions in Hong Kong have rightly prompted Congress to begin revisiting the territory’s special status. Specifically, with the 2019 HKHRDA, Congress amended the 1992 USHKPA with several export control concerns in mind. First, Congress asked the Departments of Commerce, Treasury, and State for the next seven years to submit an annual report on potential violations of U.S. and UN export control laws occurring in Hong Kong, including whether the PRC is using Hong Kong as a permissive portal to acquire technologies Beijing would use to further its mass surveillance and social credit initiatives.[48]

Additionally, Congress has already asked the Department of Commerce and other relevant agencies to consider adjusting U.S. export controls to prevent “the supply of crowd control and surveillance equipment that could be used inappropriately in Hong Kong.”[49] At this juncture, Hong Kong’s waning insulation from malign PRC influence suggests additional items should face stiffer export controls. Semiconductor manufacturing equipment and related items would be an especially high-impact addition to the export restricted list. Finally, any hosting of data centers or research centers in Hong Kong should be more closely vetted to limit the outflow of sensitive technology. The hosting of global data centers in Hong Kong is now untenable.

1. Semiconductor Manufacturing Equipment

One of the most important technological force multipliers today and moving forward is the ability to fabricate state-of-the-art chips. Despite massive investments, PRC-based fabricators remain significantly behind their competitors in North America, Europe, Japan, and Taiwan, in critical part because mainland China must import the highly specialized semiconductor manufacturing equipment (SME) and operational expertise that lies at the heart of cutting-edge production. The United States should thus lead a multilateral effort to immediately begin imposing strict SME export controls on PRC-domicile firms and their affiliates.

One of the most critical sets of manufacturing equipment for high-end chips is extreme ultraviolet photolithography equipment,[50] which is produced and sold by a single firm worldwide—Netherlands-based ASML.[51] Keeping this equipment out of chip fabrication facilities (“fabs”) controlled by PRC entities means the country must basically choose to either (1) remain at least a generation behind the U.S./Taiwanese/South Korean leading edge or (2) import cutting-edge chips from these places.

As Saif Khan and Carrick Flynn of Georgetown University’s Center for Security and Emerging Technology indicate, “SME export controls imposed by the United States, the Netherlands, and Japan could decisively maintain China’s continued dependency on democratic states for chips at or near state-of-the-art.”[52] Khan and Flynn note that “If SME export controls successfully reduce China’s chip fab capacity, the United States, Taiwan, and South Korea—the only remaining economies with significant near-state-of-the-art chip fab capacity—could coordinate on further, targeted end-use and end user controls to advance the cause of human rights and global stability.”[53] This point is of special relevance as Beijing wraps the tentacles of its security apparatus more tightly around Hong Kong civil society.

At least one ad hoc U.S. export control action has demonstrated PRC entities’ vulnerability to export controls that focus on critical technology inputs. On 30 October 2018, the Commerce Department added Fujian Jinhua Integrated Circuit Company (“Jinhua”) to its restricted entity list due to alleged theft of designs for dynamic random access memory (DRAM) integrated circuits from Micron, a U.S. firm.[54] The listing meant that any exports of controlled commodities, software, or technologies to Jinhua would require a license and that license applications would be “reviewed with a presumption of denial.”[55] ASML and other critical technology vendors pulled employees from the nearly-finished Jinhua chip plant within days, essentially destroying the company as a viable commercial entity.[56]

2. Heightened Protections for Sensitive Data, Data Center Use, and Key Software

There is also a case that personal and business data, cloud hosting on colocation and proprietary data centers, fiber optic cable security vetting, and software used to manage sensitive data in both enterprises and data centers should also be more tightly restricted. These steps derive from the risk that the Hong Kong security services are now much more likely to be influenced by and subsumed into Beijing’s surveillance and social control apparatus. Furthering that point, the absorption and ensuing loss of the due process and procedural protections provided under pre-June 2020 Hong Kong law may not become fully apparent until well after the fact. This increases the importance of taking action now under the assumption that certain sensitive data channels potentially accessible to Hong Kong’s disciplined services have already been compromised by Mainland agencies.

Multiple firms listed in the United States and its allies operate data centers in Hong Kong—including NTT Communications (Japan), Cyxtera Technologies (U.S.), Equinix (U.S.), Microsoft (U.S.), and Rackspace (U.S.).[57] Given recent events, it may now be appropriate to require that entities wishing to operate in the American market and participate in USG procurement activities certify explicitly that: (1) that they are not voluntarily participating in efforts by Hong Kong or PRC security bodies to obtain personal or business information that could be used to facilitate human rights violations or otherwise be utilized in contravention of the policy objectives the 1992 USHKPA aims to support and (2) if they become aware of attempts by Hong Kong or PRC security and law enforcement authorities to obtain data from data centers on Hong Kong territory, such attempts must be immediately reported to the USG. Some years ago, Apple separated its PRC data center operations from its data center operations elsewhere. That could be a model to encourage for firms that still wish to risk doing business in China.[58]

Similar protections should be applied to sales of “dual use” software packages with ostensibly permissible uses that could also be used to facilitate human rights violations and/or repression in Hong Kong. Given the sensitive personal, commercial, and other information that could be exchanged, programs for network analysis, AI processing of video footage, and video conferencing should be particularly scrutinized for such risks.[59] One way to accomplish this would be through an export licensing program in which prospective software sellers would need to certify that their proposed customers are not linked to restricted entities through corporate structures or other reasonably foreseeable linkages—such as board seats occupied by known CCP officials or Hong Kong authorities linked to repression activities.

Where universities store research and data should likewise be examined, particularly if they receive USG funding.[60] Finally, PRC tech firms offering products on the U.S. market should be subject to greater scrutiny. This affects privacy and data security as well. WeChat, TikTok, and Zoom should be examined for potentially allowing access by the PRC into the IT systems of American companies and citizens, as well as those of U.S. allies.

Option 3: Tax-free repatriation of assets from Hong Kong into U.S. markets and assets

Hong Kong’s foreign direct investment stock in 2018 was nearly US $2 trillion, according to Santander Bank.[61] U.S. FDI stock in Hong Kong during 2018 was estimated at $82.5 billion, according to the USTR.[62] While FDI inflows do not directly necessarily correlate with FDI/capital stocks in a given jurisdiction, they likely provide at least a rough sense of who holds what general proportion of capital stock. In 2017, the three largest sources of FDI inflows into Hong Kong according to Santander Bank were: British Virgin Islands (38.2%), Mainland China (20.8%), and the Cayman Islands (18.8%).

With 80% of inbound FDI flows emanating from either Mainland China or offshore havens frequently used by Chinese private and red chip companies, it is a good bet that a substantial portion of the volume derives from the round tripping of capital in and out of the PRC through the “economic airlock” that Hong Kong provides. The fact that more than one in every five dollars of inbound FDI come from Mainland China also points to Hong Kong’s role as a warehouse in which funds can be stored beyond the reach of Mainland capital controls and thus be rapidly deployed at scale without having to seek permission from foreign exchange regulators in Beijing.

Nevertheless, there is a strong case for leaving the airlock open for a while insofar as outbound capital movement in concerned in order to allow capital flight from Hong Kong as the Mainland authorities clamp down. The increasingly uncertain legal environment described early in this report from the duality being introduced into the Hong Kong legal system via the National Security Law is likely to catalyze outbound movement of capital from Hong Kong. Furthermore, as the suffocating vine of the Mainland’s “political control at nearly any cost” mentality creeps deeper into Hong Kong life, capital flight will likely accelerate.

Data from the Monetary Authority of Singapore (MAS) show substantial increases in foreign currency deposits held within Singapore’s banking system beginning in July 2019 (Exhibit 3). The MAS stated in early June 2020 that with respect to the capital inflows, “No single region or country source dominates.”[63] Nevertheless, the upswing correlates closely with rising unrest in Hong Kong and also triangulates with anecdotal news stories about Hong Kong tycoons beginning to move substantial amounts of assets offshore in 2019 to keep them out of Beijing’s reach.[64]

Exhibit 3: Dramatic Increases in Foreign Currency Deposits Held in Singapore Coincide With Unrest and Prospect of Greater Mainland Involvement in Hong Kong (Million Singapore Dollars)

Sources: MAS, Authors’ analysis

Option 4: Publish the assets of PRC officials associated with the erosion of Hong Kong’s autonomy, including, but not limited to, National People’s Congress delegates and Hong Kong officials who voted to impose Beijing’s national security law on the territory

Multiple former officials have recently advanced an excellent and timely idea: investigating the assets of CCP officials.[65] Key officials include NPC delegates; as well as individuals on the Chinese People’s Political Consultative Conference (CPPCC), a United Front entity. Such investigations should also include family members and close associates whom officials might use as proxies. Asset freezes and other sanctions actions that can be brought against designated persons pursuant to the 2019 HKHRDA potentially trigger protracted legal battles and can take substantial time to implement. But publishing assets of CCP officials involved in Hong Kong repression and human rights rollback can be done more quickly and have immediate impact. It also would present evidence that contradicts the Party’s official line of virtue and rectitude.

U.S. public diplomacy efforts should thus emphasize corruption within China’s ruling establishment by publicizing financial activities of key PRC officials and their close associates. The issue is a sensitive point for the Chinese leadership, as evidenced by censorship of discussions related to the Panama Papers, as well as pressure on Bloomberg for publishing a 2012 exposé on finances of Xi Jinping’s extended family shortly before he became paramount leader.[66] Moreover, building a comprehensive list of assets held either directly by CCP officials or by their relatives helps facilitate multiple options discussed below by mapping the list of assets and persons that would potentially be targeted under a sanctions regime.

USG agencies logically equipped to handle asset tracking and targeting may be overtaxed given recent events such as the ongoing coronavirus pandemic and North Korea’s ongoing sanctions violations coupled with renewed belligerence. If this be the case, one possible way to jump start the initiative would be to leverage the substantial pre-existing private sector expertise in mapping PRC industrial and military infrastructure, entity structures, and personnel and turn this toward asset tracking.[67] Subject matter experts could be supported with USG grant funds and potentially also collaborate with attorneys and accountants with knowledge and experience in locating financial and real property assets whose owners seek to hide.

The USG should also consider potential ways of indirectly facilitating the activities of investigative journalism organizations, such as the International Consortium of Investigative Journalists (ICIJ).[ii] The ICIJ is highly capable, as proven by its Panama Papers scoop in 2016 and Paradise Papers reporting in 2017.[68] It also already does substantial China -focused reporting, including on the abusive surveillance state Beijing has built throughout Xinjiang. Another independent journalist organization is Bitter Winter, which has done excellent investigative reporting on abuses in Xinjiang, including on supply chains of large multinationals.[69] Think tanks in allied countries could be a resource too, with the Australian Strategic Policy Institute (ASPI) offering a strong example.[70] This process can also uncover financial links with key persons in other parts of the world that can be involved in PRC influence operations.

Option 5: Close Macau Loophole

In pursuing the above countermeasures, it is important to make sure that Macau does not become a loophole in U.S. efforts to manage financial flows to and from the PRC via Hong Kong. Capacity constraints prevent Macau from fully replacing Hong Kong in any scenario, but has some advantages over areas inside the PRC proper. Indeed, Macau has historically leveraged its exceptional position to profit from activities banned elsewhere. In some respects, casinos provide an even easier venue to move cash around. Macau is a loophole that needs to be closed as well, and the United States has experience dealing with Macau and the financing there with respect to the DRPK.

LAYER 2 ACTIONS—POTENTIAL FOLLOW-ON ACTIONS

Layer 2 actions combine a range of economic pressure measures and law enforcement actions. Most powerfully, the United States can leverage a tool already created for competition with revisionist powers: the Countering America’s Adversaries Through Sanctions Act (CAATSA). CAATSA, which was enacted in 2017, provides a broad range of sanctions authority and options for imposing costs on Iranian, North Korean, and Russian entities engaged in various types of malign activity. It is a powerful weapon to be used with restraint and discretion. Potential use against PRC or Hong Kong entities would also be enormously complex because those entities are often systemically important on a global level in a way that most entities from Iran, North Korea, or Russia simply are not. Policymakers must also be prepared for the PRC to take retaliatory actions against U.S., and potentially, partner country entities as well.

Amending CAATSA has multiple advantages over creating new statutes from scratch. First, CAATSA’s existing framework for approaching Iran, North Korea, and Russia incorporates a high degree of ability to calibrate actions, including some with very high impact.[71] Second, Section 254 of CAATSA contains positive assistance provisions that could prove extremely useful for assisting civil society groups in Hong Kong and for helping bolter Taiwanese readiness in the face of rising coercion by the PRC. Third, USG agencies and partner country entities are familiar with the law’s provisions and implementation.

Fourth, using CAATSA as the baseline framework for exerting economic pressure on selected Mainland PRC and Hong Kong entities would leverage existing legislation that had strong bipartisan support. Working with a proven existing statute can also reduce legislator and staff workloads—an important strategic consideration during a time when multiple critical issues including coronavirus pandemic responses, anti-racism actions, and policing reform are competing with China policy for attention on Capitol Hill. Finally, changes to CAATSA—even as few as several dozen key words and phrases—would signal American seriousness about holding the line in Hong Kong and beyond. The subsequent discussion outlines CAATSA’s potential impact factor, as well as four specific ways the statute could be amended to impose costs on Beijing’s revisionist actions vis-à-vis Hong Kong.

In a strictly legal sense, Congressional actions such as CAATSA amendment are not necessary and the White House could take direct executive action to avail itself of sanctions tools. If the President were to declare a national emergency arising from the threat that PRC coercive envelopment of Hong Kong to U.S. economic, national security, and/or foreign policy interests, he would then acquire the legal basis to take a range of punitive actions similar to those enumerated in CAATSA and other statutes that enable sanctions.[72]

However, given the momentous economic and strategic stakes implicated in confronting Mainland PRC entities and their Hong Kong collaborators, we believe Congressional action is very important. Buy-in from Congress would demonstrate bi-partisan support for economic actions that might be taken against certain PRC and Hong Kong entities. It would also clearly demonstrate to Beijing that key U.S. political constituencies have consented to a campaign that could last for years and sustainably transcend Presidential administrations, thus amplifying the deterrent message even before concrete actions are taken.

A. CAATSA Offers High Impact Tools to Policymakers

In September 2018, the Departments of State and Treasury sanctioned China’s Equipment Development Department (EDD) and its director, Li Shangfu, for the 2017 purchase of SU-35 combat aircraft and the 2018 purchase of S-400 surface-to-air missile system equipment from Rosoboronexport, a sanctioned entity.[73] The sanctions got the PRC government’s attention, with law firm Baker McKenzie noting in a client update on the matter that “China’s Ministry of Foreign Affairs reportedly summoned the US Ambassador to China to protest their imposition.”[74]

In the case of EDD, the sanctions were primarily a signaling action since that entity is in practical terms substantially air-gapped from global capital markets and does not need to access and periodically interact with the U.S. financial system to conduct basic business activities. But that would very likely not be the case for commercial entities—even subsidiaries of state-owned enterprises—which require access to global market environments that could be severely curtailed if the United States imposed primary sanctions on the entities and raise the specter of applying secondary sanctions to any counterparties that facilitated their transactions and business activities.

The case of Russian aluminum producer Rusal, which was listed as a blocked entity by the U.S. Treasury Department in April 2018, illustrates how catastrophic such a designation can be. Rusal’s stock (which, incidentally, is listed on the HKEX) immediately plunged by more than 40%, while counterparties in multiple jurisdictions worldwide were forced to halt and unwind transactions with the company.[75] The Office of Foreign Assets Control (OFAC) eased the sanctions within weeks due to protestations from U.S. allies and systemic disruptions to the global aluminum market and delisted the entities less than a year later. [76] Nevertheless, the episode illustrates the truly global reach of sanctions imposed under CAATSA as well as the devastating consequences they can create for the targeted entities.[77]

Option 1: Amend Specific Sections and Provisions of CAATSA to Create Additional Policymaker Tools vis-à-vis PRC and Hong Kong Entities

1. Change TITLE II of CAATSA from “SANCTIONS WITH RESPECT TO THE RUSSIAN FEDERATION AND COMBATING TERRORISM AND ILLICIT FINANCING” to instead read “SANCTIONS WITH RESPECT TO THE RUSSIAN FEDERATION, PEOPLE’S REPUBLIC OF CHINA, HONG KONG SAR, AND COMBATING REVISIONIST ACTIVITIES, TERRORISM AND ILLICIT FINANCING”

2. Amend Section 241 of CAATSA to enable mapping of key business and political persons and PRC parastatal entities.

Section 241 requires the Treasury and State Departments, along with the Director of National Intelligence to submit a report on senior political figures and oligarchs in Russia, including ties to Vladimir Putin and other members of Russia’s ruling elite, net worth, and other data points. Section 241 also requires the agencies to map Russia’s parastatal entity ecosystem and assess U.S. economic exposure to them, as well as the likely effects of imposing debt and equity restrictions on these entities and/or adding key personnel to the OFAC Specially Designated Nationals list and the likely effects of imposing secondary sanctions pertaining to these entities. China presents a larger and far more complex entity target set, but the existing framework used for assessing key Russian economic players per CAATSA requirements should be generally adaptable to the PRC. The USG will also be able to leverage substantial pre-existing private sector and academic knowledge of multiple dimensions of the Chinese economic system.

3. Add a section to Title II, Part 2 of CAATSA to prohibit Restrictions on Directors & Officers’ insurance policies for directors and officers of designated PRC/Hong Kong entities

Hong Kong is a global insurance hub, with dozens of the world’s leading providers incorporated there. Amend CAATSA to prohibit U.S. persons from (1) transacting with any entity that writes director and officers (“D&O”) insurance policies[78] for board members and officers and (2) accepting “in kind” indemnification from entities affiliated with, or operating on behalf of, a designated entity.

As U.S.-China economic tensions rise, there is a substantial probability that PRC/Hong Kong entities could follow a playbook used by Russian parastatal energy firms as they sought to project an image of greater international legitimacy during the 2000s. In perhaps the starkest example, the Nord Stream project consortium that imports Russian gas to Germany via an undersea pipeline and seeks to complete another hired former German Chancellor Gerhard Schroeder as the Chairman of its Shareholders’ Committee, a position he has held since 2006.[79] Additionally, Rosneft (Russia’s largest oil producer) named Schroeder Chairman of its Board of Directors in 2017.[80]

PRC/Hong Kong entities are frequently far better resourced than their Russian counterparts and can also operate much more sophisticated commerce-enabled influence activities, should they choose to do so. Therefore, dis-incentivizing key high-profile U.S. and allied country persons from serving as “legitimizers” for such activities should be a policy priority. Furthermore, given the complex, often family-based networks that wield great influence over certain commercial activities in East and Southeast Asia, the policy outlined above puts the primary diligence onus on the insurance firms that seek to underwrite D&O policies globally but also (presumably) consider the U.S. marketplace and American clients to be high commercial priorities.

4. Amend Title II, Part 2 of CAATSA to prohibit direct and indirect correspondent banking account use by PRC and Hong Kong persons implicated in human rights violations and repression in Hong Kong

A correspondent account is defined as “an account established for a foreign financial institution to receive deposits from, or to make payments or other disbursements on behalf of, the foreign financial institution, or to handle other financial transactions related to such foreign financial institution.”[81] Foreign financial institutions including virtually all PRC banks and red chip companies utilize such accounts to process U.S. dollar transactions. Accordingly, denial of access to correspondent accounts would effectively cut affected entities off from the dollar and U.S. financial system. For commercially-oriented entities, this would cause severe direct impacts on their ability to raise funds and do business.

The legislative template for such an amendment already exists. Specifically, Congress could draw upon the designation language contained in Section 104 of the North Korea Sanctions and Policy Enhancement Act of 2016 (specifying more than 20 types of prohibited conduct) and operationalized by Section 321 of CAATSA. Sec. 104 of the North Korea Sanctions and Policy Enhancement Act of 2016 aims to prevent WMD proliferation and various malign activities by the North Korean regime, but the basic intellectual and legal framework would be highly transferrable for imposing costs on actors who facilitate Beijing’s coercive envelopment of Hong Kong.

For full practical effect, a CAATSA amendment targeting correspondent account use by certain PRC and Hong Kong persons would likely need to seek direct prohibitions against these persons using such accounts, as well as prevent U.S. persons from doing business with such sanctioned parties. The resulting counterparty risk would help reduce the probability of sanctioned parties using intermediaries to indirectly access dollar clearing services.[82]

5. Amend Section 254 of CAATSA to allow Coordinating Aid and Assistance Across Europe, Eurasia AND the Asia-Pacific Region

This amendment would tap into CAATSA’s positive side—the ability to fund capacity-building and relationship-strengthening. The existing language focuses geographically on Europe and Eurasia, but the underlying matters of concern embodied in the Russian behavior CAATSA seeks to deter—such as cyberattacks, disinformation, use of economic and physical aggression to coerce smaller neighbors, and corruption/influence operations—are also hallmarks of Mainland PRC actions toward Hong Kong, Taiwan, and other regional neighbors.

The existing language’s broad provisions for supporting critical infrastructure protection and capacity building would also be broadly relevant in the Asia-Pacific. Protection from malign cyber activity by PRC actors is highly important to Taiwan and offers a ready engagement point, while support for civil society organizations is relevant in both the Hong Kong and Taiwan contexts.

We do not profess to know precisely how much additional funding would be needed to fully breathe practical life into an expanded Section 254 of CAATSA. If such amendments were made with the implementation of the Layer 3 recommendations of this analysis in mind, $100 million per fiscal year would likely enable the robust commencement of multiple actions to bolster Hong Kong civil society (to the extent it remains) and especially, to bolster the U.S. relationship with Taiwan.

6. If U.S.-China tensions intensify sufficiently, add a section to CAATSA that parallels existing Section 232, but that rather than Russian export pipelines, instead sanctions offshore RMB transaction clearing by the Bank of China (Hong Kong)

Hong Kong plays a critical role in Beijing’s attempts to internationalize the RMB. It uses Hong Kong as an airlock where the Bank of China’s local branch clears offshore RMB transactions, allowing parties abroad to use RMB but without having to directly expose domestic Mainland RMB exchange rates to the pressures of the market. For China, internationalizing the RMB is seen in part as a way to reduce global reliance on the U.S. dollar, and thus undermine the economic and strategic benefits Washington reaps from the dollar’s omnipresence in multiple key financial and commodity markets.

Data from SWIFT show that over the past 3 years, approximately 75% of offshore RMB payments in any given month are made through Hong Kong.[83] The Bank of China (Hong Kong) is the clearing bank for offshore RMB activities in Hong Kong,[84] and selective sanctions imposed under CAATSA on the bank would thus likely be a major setback to the PRC’s capacity to promote the RMB as an alternative currency to the US dollar.

Option 2: Intensify U.S. and allied/partner country investigation and enforcement of long-arm jurisdiction anti-corruption laws such as the U.S. Foreign Corrupt Practices Act and UK Bribery Act against Hong Kong entities with links to Beijing.

As Beijing deepens its control over Hong Kong and potentially turns the territory into a more narrowly PRC-oriented “permissive portal,” there is a risk that Hong Kong-based entities and money flows could be increasingly used to facilitate actions that undermine rule of law. One policy option to push back against this would be to intensify scrutiny of Hong Kong-origin deals in places such as Southeast Asia, Africa, and Latin America by the U.S. DOJ and UK Serious Fraud Office. Greater investigative attention would help keep the portal clean, create barriers to using it as a window for PRC economic power projection, and maintain its vitality as a commercial hub for the benefit of Hong Kong’s population. If investigations did begin to turn up problems, the relevant authorities should not hesitate to bring FCPA and UKBA cases.

Option 3: Require U.S. public pension funds and public university endowments to divest from the debt, equity, and other securities/assets of specified PRC firms linked to repression and human rights violations in Hong Kong.

Chinese entities are incorporated into global funds; they are collateralized into diverse and widely-used financial instruments. Nevertheless, specified firms could be targeted either (A) on a binary “complicit or not complicit” basis or (B) according to their degree of participation in, or facilitation of activities that violate Hong Kongers’ human rights and reduce the city’s political and economic autonomy. Degree ranking would be more resource and evidence-intensive to implement but would potentially provide a greater degree of calibration and ability to differentially pressure the offending firms. The U.S. entities would from the date of designation be restricted to $200 million in asset ownership for firms in the lowest risk class, but which had a nexus to activities that contravene human rights, political, and economic freedoms in Hong Kong. For Class II violators, the ownership limits would be $50 million in securities/asset holdings—collective across the named entity and all affiliates. For the most serious Class III violators—for instance, firms that supplied lethal equipment to security authorities in Hong Kong that was then used in repression actions—U.S. public pension funds and university endowments would be banned outright from holding any assets. Divestment actions would need to provide investors with a grace period in which to act—180 days from the date of notification, for instance.

V.    LAYER 3 RESPONSES: REGIONAL SECURITY, SUPPORT, AND SIGNALLING BEYOND HONG KONG IMPLEMENTED CONCURRENTLY WITH LAYER 1 ACTIONS IN HONG KONG

It is important to emphasize what measures and messages Washington intends to send beyond the PRC and Hong Kong—in support of Taiwan (a vital partner, as enshrined in the Taiwan Relations Act),[85] as well as U.S. treaty allies Japan, the Philippines, Australia, and Canada, among others. All have been subject to direct pressure by the PRC and will see mismanagement of Hong Kong as threatening. And all might expect to face challenges from Beijing in coming months and years, emanating from Hong Kong and in the South China Sea, trade, and other areas as well.

Option 1: Selectively Exempt Hong Kong Entities, Target Those From PRC

Although Washington is working to address the ways that China has forced a change in Hong Kong’s status, that doesn’t mean that we cannot attempt to influence behavior inside Hong Kong. The Trump Administration’s successful insistence on bilateral reciprocity with PRC airlines (while not involving Hong Kong airlines like Cathay Pacific) offers a potential example. Such effort could be made conditional on whether Hong Kong firms actively support malign developments like the National Security Law. They could also be designed to nudge important non-Hong Kong firms with a large Hong Kong footprint (for instance, the HSBC and Standard Chartered banks).

Such microtargeting will be challenging because much of the PRC’s infringement on Hong Kong rights—at least in the coming 2-3 years—will be the measures that are erosive, but generally speaking, marginally or non-actionable on an individual basis. One example is the PRC’s August 2019 move to review staffing of Cathay Pacific flights transiting Chinese airspace and bar those with crew or staff who participated in pro-democracy demonstrations in Hong Kong.[86] But compounded over time across a hitherto free economic, political, and legal system, such acts will likely coalesce into serious negative impacts.

Whether the USG uses CAATSA or another statute as the legal basis for targeted actions against certain PRC entities, it will likely need to broadly define sanctionable actions in order to reduce the risk that the PRC engages in “salami slicing” that is cumulatively erosive to Hong Kong’s status, but where any individual action generally falls below a sanctionable threshold. One possible response is to ensure that enabling legislation for sanctions and other actions incorporates a “totality of circumstances” standard that more effectively captures the effect of salami slicing and enables incremental PRC coercion to be met with decisive action.

Option 2: Hold the Line Beyond Hong Kong, Starting with Taiwan

Xi’s increasing pressure and suppression of Hong Kong and related messaging appears intended in part to intimidate Taiwan. Washington should reject such pressure on Taipei, and instead link it to both ensured and judiciously increased support for Taipei in a carefully calibrated manner. Taiwan has many advantages: nearly 24 million citizens, undeniably sustaining an autonomous capitalist democracy, buffered by over 100 miles of water and airspace. Washington should hold a strong defensive line there in this new era of great power competition, while supporting Hong Kong as well as possible in light of enduring and emerging realities.

One of the best ways to deter Beijing from smothering Hong Kong is to show that such aggressive actions will generate progressive American interactions with, and defenses of, Taiwan that will be self-defeating to PRC expansionism thereto. Here is an opportunity to complicate the PRC’s propaganda and outreach efforts. Part of the message that the PRC is sending is essentially that what is happening to Hong Kong is Hong Kong-specific, since Hong Kong is part of the PRC. This has obvious implications for Taiwan but is designed to make it easy for other U.S. allies and key partners to write-off valid concerns. Of course, the subtext is that going against PRC wishes will incur significant costs.

The way to complicate this message is to highlight the direct implications of a hobbled Hong Kong for other actors in the region. This should be possible given that businesses and sovereign wealth funds and other funds have a lot of exposure to Hong Kong. This is an effort to turn PRC leverage against it. Another part of this counter should be to highlight that standing up to PRC excessiveness is less costly than standing up to the PRC collectively. After all, the PRC will probably find it more difficult and trickier to punish a variety of actors simultaneously.

Public diplomacy efforts should also highlight the example that Taiwan presents of a successful democracy in a place that is culturally Chinese amid great diversity and that successfully transitioned from authoritarianism. Emphasizing those two vital dimensions of what Taiwan demonstrates can help illustrate the alternative, positive path available to the PRC in the longer run if political reforms occur, while complicating Beijing’s near-term efforts to link Chinese culture with submission to the PRC’s Controlocracy.

One of the PRC’s approaches has been to isolate targets and make examples of them. A U.S. approach emphasizing the interconnections between events in Hong Kong, and the interests of Taiwan and other regional actors, can force the PRC to fight on multiple fronts concurrently, thus imposing greater diplomatic and financial costs.

  1. Immediate Additional Actions to Support Taiwan

The following measures to enhance U.S.-Taiwan relations align clearly with American values and interests and follow logically from well-established policies. As such, the United States should pursue them immediately and publicly.

a. Enter a bilateral free trade agreement, deepen Taiwan’s role in measures to diversify critical supply chains away from the PRC

The United States should actively pursue a bilateral trade agreement with Taiwan. This can take the shape of either a formal Free Trade Agreement (FTA)[87] such as several other nations are pursuing, or a series of agreements that, taken together, are the functional equivalent of an FTA. To establish a bilateral trade agreement, it would be natural the USG to announce new bilateral trade talks and send relevant officials to Taiwan for that purpose. Each side brings strong comparative advantages to the table. For its part, American agricultural exports can help bolster Taiwan’s food security.[88] Taiwan, meanwhile, can help reduce American overdependence on PRC supply chains, particularly for critical pharmaceuticals, medical devices, and IT products and services. We offer detailed recommendations concerning what such efforts should look like in an April 2020 Baker Institute policy report.[89] Efforts should include the involvement of Taiwanese entities in third country locations beyond Taiwan, including projects in the United States. An ideal example of such cooperation would be the establishment of a new latest-generation chip fab (3 nanometer) by a top company like TSMC in the United States.

Both economies have much to gain from such a long overdue initiative. This will resolve a long-running contradiction in U.S. Taiwan policy by both strengthening Taiwan in the security and helping to improve its economic competitiveness. With Taiwan confronting the diminishing demographics of a severely aging society and enduring political obstacles to increasing the defense share of government spending,[90] increasing government revenues through sustainable economic growth is one of the best possible investments in Taiwan’s future as a free, friendly partner for the United States.

b. Move USG-sponsored Mandarin language study programs to Taiwan

In the less-formal cultural sphere, the USG could fund a massive Mandarin-language and cultural immersion program in Taiwan and greatly expand American overall public diplomacy efforts there, which are currently very modest. Under the Obama administration the USG funded a massive people-to-people effort with the PRC. Since the USG has already moved its Chinese-language programs across the Strait to Taiwan, the USG could now the same—or better—people-to-people effort with Taiwan. The bipartisan, bicameral Taiwan Fellowship Act offers an excellent example human capital investment promising excellent yields. Similar efforts could increase educational programs linking Taiwanese and American universities. As conditions worsen in Hong Kong and mainland China, some U.S. non-governmental organizations (NGOs) working in Asia should be helped to set up shop in Taiwan, especially those facing concerted harassment.[91] Direct commercial flights could be encouraged between Washington, DC, and Taipei—perhaps initially on a weekly basis to help underpin commercial viability.

c. Increased intelligence cooperation, especially on cyber issues

The USG should also encourage Taiwan to follow Japan’s positive example in modernizing protocols and processes safeguarding classified material and the management of cleared access thereto. This, in turn, would allow the deepening and normalization of civilian and military information and intelligence sharing. Across the military and civilian domains, the United States should simultaneously strengthen cooperation with Taiwan in cybersecurity, an area in which Taiwan has considerable relevant knowledge and capabilities.[92]

d. More robust and overt support for Taiwan in international organizations

In the diplomatic sphere, the PRC can functionally block Taiwan’s participation in nearly every major international organization, greatly limiting American options to help Taiwan in this regard. With the United States having withdrawn from the World Health Organization (WHO), it is left for Japan to push for Taiwan regaining its observer status at the World Health Assembly (WHA). The United States should use its influence to allow Taiwan more space within accessible international fora and specialized security fora (e.g., the Halifax International Security Forum/HISF[93]). Moreover, as long as Taiwan is barred from participating at UN specialized institutions, the United States and its allies and other partners should consolidate alternative mechanisms for information-sharing with Taiwan. The United States should keep expanding the Global Counter-Terrorism Forum (GCTF),[94] widen its visibility, encourage other democracies to join, increase exchanges and secondments, bringing in more partners to the workshops.

e. Increased, higher-level, more public meetings between U.S. and Taiwanese officials

In the diplomatic sphere, the United States could increase the seniority of U.S. officials visiting Taiwan, and vice versa. It could fully complete ongoing gradual efforts to remove longstanding limits on Taiwanese officials entering U.S. government buildings. In particular, if the PRC steals away more of Taipei’s diplomatic allies, and when pandemic progress allows travel once again, Washington could invite President Tsai and other Taiwanese officials to visit, rather than transit, the United States. Higher-level U.S. officials, such as the Deputy National Security Advisor, could visit Taiwan for relevant discussions.

As a basis for these actions, the United States should build on recent legislation, including the Taiwan Travel Act[95] signed into law by President Trump on March 16, 2018; the Asia Reassurance Initiative Act signed by President Trump in December 2018; Taiwan Allies International Protection and Enhancement Initiative (TAIPEI) Act of 2019;[96] and the Taiwan Assurance Act introduced in Congress in March 2020. For example, the Taiwan Travel Act states, “the United States Government should not place any restrictions on the travel of officials at any level of the United States Government to Taiwan to meet their Taiwanese counterparts or on the travel of high-level officials of Taiwan to enter the United States to meet with officials of the United States.” Of note, neither the Taiwanese equivalents of the U.S. National Security Advisor or Deputy National Security Advisor are among the five top officials of Taiwan—the democratically-elected president and vice-president, the prime minister, the defense minister, and the foreign minister—whom State Department guidelines have historically prevented from visiting Washington, DC to meet with their American counterparts.

f. Strengthened, expanded military cooperation between the United States and Taiwan, potentially including allied/partner countries at a later date

The military domain is arguably both the most well-established, straightforward, and pressing area where deeper U.S. engagement can help ensure Taiwan’s security and deter PRC adventurism against it. The United States must maintain the best possible plans and capabilities for responding to various types of PLA campaigns against Taiwan. To succeed, the United States must be creative and practical in identifying and addressing campaigns both at and below the threshold of high-intensity kinetic operations between the U.S. and Taiwanese militaries and the PLA. This requires engaging in what some experts term “counter-coercion planning.”

The premise here is that Beijing does not have to choose between accommodation and war because it has diligently prepared a spectrum of hostile steps it can take towards Taiwan, including hybrid warfare measures taken in the “gray zone” that fall below traditional kinetic action, but still exert real strategic effect. Accounting for gray zone actions will be essential in coming years, as the PRC’s preferred response to Taiwan under President Tsai will likely involve a multi-faceted campaign of coercion short of overt violence that attempts to undermine the confidence and collective identity of Taiwan’s leaders and citizenry.

These efforts should include the further development of ways for both Taiwan alone, and the United States and Taiwan acting together, to counter various types of PRC coercion short of kinetic conflict. For example, careful scrambling to counter PLA Air Force and PLA Navy Aviation intrusions into Taiwan’s airspace is an important tool of counter-coercion, primarily because it increases public confidence in the military (which needs significant shoring up).

The United States should continue to help Taiwan improve its own defenses. To enhance force multiplication of Taiwan’s limited active duty numbers, the United States should help support the reform of Taiwan’s Reserve Forces. It is also important to increase the capacity of the civilian side of Taiwan’s civil-military relations to avoid any possible misperceptions that Taiwan’s Ministry of National Defense (MND) is pursuing a non-transparent monopoly over defense policy.

Washington should continue to review and approve appropriate requests for defense articles and services for sale to Taiwan.[97] In keeping with the terms of President Reagan’s Six Assurances, Washington should not consult Beijing in advance of any arms sales to Taiwan.[98] Also consistent with the Six Assurances, the United States should make it clear that threatening or coercive behavior toward Taiwan is a reason for enhanced U.S. military and technical support for Taiwan.

The United States should simultaneously continue to strongly encourage Taiwan’s government (both executive and legislature) to increase defense spending. To help ensure the maximum effectiveness of whatever spending is achieved, the United States should continue to encourage and help Taiwan’s MND to implement an asymmetric defense strategy, which has made encouraging strides, but remains a work in progress.[99]

To ensure the security of the 79,000 American citizens in Taiwan[100] in any potential contingency, including a Noncombatant Evacuation Operation (NEO), the United States should strengthen its defense section and Marine Security Guard detachment at the American Institute in Taiwan (AIT) in Taipei.

As for specific deliverables, the U.S. Navy and Taiwan’s Navy (officially still called the Republic of China Navy), as well as their respective Coast Guards, together with other relevant services, should hold humanitarian assistance and disaster relief (HA/DR) exercises. Units involved could include U.S. Marine Corps (USMC) personnel based nearby in Okinawa, which would be responsible for contributing to any regional security maintenance. Such exercises should emphasize Taiwan’s exemplary anti-Coronavirus capacity and competence, as well as the necessity of protecting civilians from the typhoons and earthquakes endemic to the region. Additionally, the U.S. Navy should invite its Taiwanese counterpart to participate in the next Rim of the Pacific (RIMPAC) exercise in Hawaii. The United States should likewise seek to have active duty military officers participate in Taiwan’s annual Han Kuang exercises.

2. Further—and Potentially Contingent Options—vis-à-vis Taiwan

There are many further actions and communications that U.S. decision-makers could consider vis-à-vis Taiwan; particularly in response to negative PRC behaviors, including the further coercive envelopment, suppression, and weaponization of Hong Kong. We assess these based in their likely impact on the cross-Strait military balance, as well as the intimately correlated escalatory impact they would likely have on thinking in Beijing.

Given the inherent opportunities and challenges, any such efforts might best be considered in conjunction with a USG review of Taiwan policy. This has not been done since before Taiwan transitioned to a liberal democracy more than 25 years ago. As part of this review, the USG could consider modifying and updating the interpretation or application in practice of currently operative Taiwan-related State Department guidelines; as well as consider modifying and updating the guidelines themselves. A simple place to start would be retiring clunky government-speak terms—like using “Taiwans” to mean “Taiwanese people” or “citizens of Taiwan”—that sound unnatural to speakers of plain American English and arguably even unintentionally dehumanizing.[101]

Moderate Impact and Escalatory Effect: The United States could send active duty personnel to Taiwan’s service schools, command schools, and National Defense University as both students (particularly for Chinese language) and instructors. Small units could be sent as advisors, trainers, and liaison officers.

Moderate Impact and Escalatory Effect: The United States could endeavor to integrate Taiwan into regional military exercises, possibly starting with search and rescue (SAR), and HA/DR; particularly using Coast Guard personnel.[102] It could also “greenlight” closer defense/security collaboration between Taiwan and Japan. Low-key cooperation with regional allies such as South Korea and Australia, as well as other partners, could help to build support for U.S. efforts, improve burden sharing, and prepare for contingencies. The sea and air around and above Taiwan are important for Korean trade with Southeast Asia, South Asia, the Middle East and Europe, including energy imports.

Moderate Impact and Escalatory Effect: A variety of ship and aircraft visits could be considered. Bilateral training and exercises at the relevant facilities in the United States and Taiwan could include anti-submarine warfare (ASW), special forces/urban warfare, anti-landing, anti-air, missile defense. Such activities could begin subtly, but then become public later after they are routine and established.

High Impact/High Escalatory Effect: The military realm abounds with further options. The United States could consider offering to deploy conventional anti-ship missiles on or near Taiwan’s main island and/or offshore islands in the South China Sea such as the Pratas, including ground-launched long-range conventional missiles as they become available following Washington’s withdrawal from the Intermediate-Range Nuclear Forces (INF) Treaty.[103] Additionally, the United States could consider working to pursue the integration of Taiwan’s missile defense into a regional network.

Option 3: Enhanced Freedom of Navigation and presence operations to challenge illegal Chinese maritime claims in the South China Sea

Washington should take the lead in helping allies and partner countries (to the extent they invite U.S. assistance) positively assert their maritime rights. One prong would entail U.S. freedom of navigation operations (FONOPS) that in most cases are unilateral activities, but which may increasingly involve allies and partner states. U.S. naval forces conducted nine FONOPS in 2019.[104] Maintaining or exceeding this pace and type of operations would be a “demonstrative” action to show Washington’s resolve in the face of excessive PRC maritime claims. This can include helping allies with training exercises to defend/re-take islands (e.g., through amphibious operations), and complicating efforts to dominate an area, including through gray-zone activities.

The U.S. Navy and Air Force should also consider enhancing their freedom of transit operations. Potential options that could be used, but to our awareness have not yet been include:

  1. Calibrating FONOPs to coincide with dredging/resupply of artificial features.
  2. Simultaneous FONOPS. For instance, have three vessels pass by three disputed reefs in a single 24-hour period.
  3. More flybys. Run more flight routes through disputed SCS and ECS zones. Potentially change aircraft types and numbers—for instance, use a flight of 4-to-8 F-15Es from a regional base or multiple F/A-18 Super Hornets from a carrier strike group operating in the area.
  4. Intensified ASW patrols. Greater presence of P-8 Poseidon ASW aircraft would send a strong message about the U.S. Navy building familiarity with a potential battle space while introducing Phase Zero pressure on PLAN submarine operations from Hainan.

Option 4: Go “hands on” with definitive actions to help regional partners secure their maritime rights in the South and East China Seas

The U.S. Navy and Coast Guard should also begin engaging in “definitive” actions that affirm a readiness to go “hands on” in challenging PRC activities in the South and East China Seas that violate international and local law. Exhibit 4 (below) outlines six feasible actions that could be taken in short order as the situations presented themselves.[105]

Exhibit 4: Definitive Actions to Support Allies and Partners in Maritime East and Southeast Asia

A range of actors thus has a variety of stakes in opposing the PRC’s unacceptable maritime behavior. Maritime rights of allies apply to allies South Korea and Japan, close partner Taiwan, and the regional states of Vietnam, Indonesia,[106] Malaysia, and the Philippines. As a tactical action, the United States should help provide these regional states with more advanced technology and training capabilities to better enable them to detect, report, and use non-lethal means to repel unwelcome PRC gray zone operations and incursions. Examples of key stakeholders the right to freedom of navigation and access include Australia, the UK, Singapore, and India. Trade with and in East Asia, including the East and South China Seas, is important to all of them. Even if they are unable to provide sustained military presence or support, their combined diplomatic and political weight can be another cost imposed on the PRC to encourage good behavior.

VI. Conclusion

The policy measures outlined above are not just about saving Hong Kong, its people, way of life, and unique entrepôt role. Beijing has already smothered those flames such that the previous fire can likely never be revived. U.S. and partner country actions with respect to Hong Kong proper will likely increasingly entail a combination of selective targeting of discretely identifiable malign actors, while salvaging remaining economic value and providing outlets for victims of political repression and others seeking refuge from the PRC’s smothering tech-enabled Controlocracy. The core importance of U.S. actions focused on Hong Kong now increasingly far transcends the territory and instead entails taking a strong stance to demonstrate to Beijing that revisionism has real costs and to signal to allies and partners that Washington will stand with them in the face of coercive pressure from the PRC. This will complicate CCP propaganda messaging and demonstrate that Chinese and other Asian societies in fact have different choices available to them. Taiwan in particular can offer a powerful example not only to mainland China, but also to defuse PRC claims about “Chinese” cultural determinism leading to submission to the CCP regime.

Robust action today can help prevent the PRC from undermining confidence in the present regional architecture and creating a fait accompli that disadvantages everyone in the region aside from Beijing. The response package outlined in this analysis is a set of defensively-oriented protective measures designed to impose costs so that Beijing ceases and desists from destabilizing revisionist actions. The goal is to preserve—and ultimately, improve upon—a status quo that China accepted for most of the past 40 years and has continued to benefit from to this day even as it seeks to undermine it. The options package incorporates multiple off-ramps. The onus for escalation thus lies with the PRC. This recognizes an important reality: the greatest danger that Beijing poses to the United States and its allies and partners is not power in capabilities per se, but rather how it is using those capabilities. There is more Washington can do to shape behavior than it can Beijing’s capabilities. Focusing clearly on behavior also provides a more tangible and realistic measure of what needs to change.

Moving forward, Washington will need to calibrate its policies in light of evolving events. Particularly important will be further tests of Hong Kong’s remaining autonomy by PRC- and affiliated-entities. The key indicator will not be daily patterns so much as what happens when Beijing and its representatives want something vis-à-vis Hong Kong that the territory’s laws, regulations, and system previously should have been expected to prohibit. Here, under the National Security Law, economic and state security will likely be conflated as never before, with significant implications for economic transactions and far more. As U.S. decision-makers take stock of Hong Kong’s further-compromised system and react accordingly, they should pay particular attention to lawsuits in Hong Kong courts against PRC-registered State Owned Enterprises and princeling-run firms. Both uncertainty and the certainty of oppression are bad for business. China’s coercive envelopment of Hong Kong will incur mounting, ever-wider costs. If Beijing refuses to honor a major treaty that it signed and registered with the UN, how can it be trusted to live by other, often less formal, agreements? PRC actions regarding Hong Kong have severely compromised trust. China under Xi and his Party is aggressively pursuing self-defined national unification in increasingly costly and disruptive ways. Now is the time to push back before the damage spreads drastically.

Protecting the structures now that helped the Asia-Pacific become a global engine for growth and human development is the first critical step to making them even stronger in the future. But getting to that future requires imposing costs on PRC revisionism today, holding our ground, and inspiring others to stand with us. This response options package offers part of the foundation we can stand on as this multi-year course of action unfolds.

Mr. Gabriel B. Collins is the Baker Botts Fellow in Energy & Environmental Regulatory Affairs at Rice University’s Baker Institute for Public Policy. He’s a licensed attorney who runs a global research portfolio focused on China, Russia, water, energy, and a range of environmental, legal and national security issues.

Dr. Andrew S. Erickson is a Professor of Strategy (tenured full professor) in the U.S. Naval War College’s China Maritime Studies Institute. He is currently a Visiting Scholar in full-time residence at Harvard University’s John King Fairbank Center for Chinese Studies, where he has been an Associate in Research since 2008. Erickson blogs at www.andrewerickson.com.

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 Chinese developments, with particular focus on natural resource, technology, industry, and trade issues.

 China SignPost™ 洞察中国 founders Dr. Andrew Erickson and Mr. Gabe Collins have more than three decades of combined government, academic, and private sector experience in Mandarin Chinese language-based research and analysis of China.

The positions expressed here are the authors’ personal views. They do not represent the policies or estimates of the U.S. Navy, the U.S. Government, or any other organization. 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.

[i] What is likely to go over to Singapore and Tokyo are private assets, but they can possibly be managed and leveraged through U.S. money laundering regulations, given their global reach.

[ii] One potential approach would be for the IRS to temporarily treat private donations to independent investigative journalism organizations as being tax-deductible, perhaps even at an enhanced level (for instance a $0.50 tax offset for each $1 donated). One would also need to expect that certain USG officials would become investigative targets as attractive in some ways as senior PRC officials. The key difference of the investigations’ potential effects lies is in each society’s respective system. Certain U.S. officials may be non-transparent about their wealth and its origins, but at the high-level, are likely better able to survive disclosure of wealth or offshore accounts. In an ostensibly Communist system like the PRC’s, with its official emphasis on rectitude, such disclosures could prove much more damaging.

[1] This report is based solely on the authors’ personal views and not the positions of any organizations with which they are affiliated. It is designed to offer potential policy ideas, not advocate for specific private sector outcomes. The authors greatly appreciate extremely generous inputs from a wide range of anonymous experts. Neither author has a financial stake involved, or any conflict of interest pertaining to the subjects discussed. Contact information: gabe.collins@rice.edu and andrew_erickson@fas.harvard.edu.

[2] “China Passes Controversial Hong Kong Security Law,” BBC News, 30 June 2020, https://www.bbc.com/news/world-asia-china-53230391; Eva Dou and Shibani Mahtani, “China Enacts Hong Kong Security Law, Escalating Confrontation With U.S.,” Washington Post, 29 June 2020, https://www.washingtonpost.com/world/asia_pacific/china-enacts-hong-kong-security-law-escalating-confrontation-with-us/2020/06/29/59ad568c-b9bb-11ea-97c1-6cf116ffe26c_story.html. For a periodically-updated compilation of related developments and analysis, see Andrew S. Erickson, “The Hong Kong Watch Floor,” China Analysis from Original Sources 以第一手资料研究中国, 29 June 2020, https://www.andrewerickson.com/2020/06/the-hong-kong-watch-floor-2/.

[3] Kimmy Chung and Gary Cheung, “Judges With ‘Dual Allegiance’ Because of Foreign Nationality Should Not Handle National Security Cases, Beijing Says,” South China Morning Post, 24 June 2020, https://www.scmp.com/news/hong-kong/politics/article/3090400/hong-kong-national-security-law-citys-leader-must-have.

[4] The PRC agreed in a Basic Law ratified by China’s National People’s Congress that until July 2047 “…the Hong Kong Special Administrative Region will exercise a high degree of autonomy; no socialist system or policies will be practiced in the Region, the original capitalist society, economic system and way of life will remain unchanged and the laws previously in force in Hong Kong will remain basically the same…” The Basic Law of the Hong Kong Special Administrative Region of the People’s Republic of China, Chapter I, https://www.basiclaw.gov.hk/en/basiclawtext/images/basiclaw_full_text_en.pdf.

[5] See “Brand Hong Kong,” https://www.info.gov.hk/info/sar4/easia.htm.

[6] Such actions call into question Beijing’s willingness to abide by international agreements it signed onto, including UNCLOS. This seems to be a pattern starting with its treatment of the arbitration. Stressing and imposing costs of reneging is one way to encourage Beijing to play by the rules—literally. That is also one of the larger points at stake. Blog post on National Security Law, Thread Reader, 6 June 2020, https://threadreaderapp.com/thread/1269509690951524352.html.

[7] See https://mp.weixin.qq.com/s/RiL_L70xKWcsPW5DZk2_rQ.

[8] Jeremy Page, Carol E. Lee and Gordon Lubold, “China’s President Pledges No Militarization in Disputed Islands,” The Wall Street Journal, 25 September 2015, https://www.wsj.com/articles/china-completes-runway-on-artificial-island-in-south-china-sea-1443184818

[9] Tom Phillips, Oliver Holmes, and Owen Bowcott, “Beijing Rejects Tribunal’s Ruling in South China Sea case,” The Guardian, 12 July 2016, https://www.theguardian.com/world/2016/jul/12/philippines-wins-south-china-sea-case-against-china.

[10] Alexander Vuving, “Will China Set Up an Air Defense Identification Zone in the South China Sea?” The National Interest, June 5, 2020, https://nationalinterest.org/feature/will-china-set-air-defense-identification-zone-south-china-sea-160896.

[11] Alan Basist and Claude Williams, “Monitoring the Quantity of Water Flowing Through the Upper Mekong Basin Under Natural (Unimpeded) Conditions,” Sustainable Infrastructure Partnership, Bangkok, 10 April 2020, https://558353b6-da87-4596-a181-b1f20782dd18.filesusr.com/ugd/bae95b_0e0f87104dc8482b99ec91601d853122.pdf?index=true.

[12] See, for instance: Josh Rogin, “It’s time to End China’s ‘United Front’ Operations inside the United States,” Washington Post, 10 June 2020, https://www.washingtonpost.com/opinions/2020/06/10/its-time-end-chinas-united-front-operations-inside-united-states/.

[13] See, for instance: “China Island Tracker,” Asia Maritime Transparency Initiative, CSIS, https://amti.csis.org/island-tracker/china/.

[14] “Hong Kong Human Rights and Democracy Act of 2019,” Public Law 116–76, https://www.congress.gov/116/plaws/publ76/PLAW-116publ76.pdf. See also https://www.congress.gov/bill/116th-congress/senate-bill/1838/text and https://www.congress.gov/bill/116th-congress/house-bill/3289.

[15] “Xinhua Headlines: China’s Top Legislature Reviews Draft Law on Safeguarding National Security In HKSAR,” Xinhua, 21 June 2020, http://www.xinhuanet.com/english/2020-06/21/c_139154411.htm.

[16] For an especially egregious example, see that of Xue Feng, an American citizen who was imprisoned for seven years for possessing a commercial dataset of 30,000 oil wells in China. Sneha Shankar, “China Releases American Geologist Xue Feng Jailed for Over 7 Years on Spy Charges,” 4 April 2015, https://www.ibtimes.com/china-releases-american-geologist-xue-feng-jailed-over-7-years-spy-charges-1869702.

[17] Lily Kuo, “Hong Kong bookseller Gui Minhai jailed for 10 years in China,” The Guardian, 25 February 2020, https://www.theguardian.com/world/2020/feb/25/gui-minhai-detained-hong-kong-bookseller-jailed-for-10-years-in-china.

[18] Jennifer Hughes, “China’s Communist Party Writes Itself Into Company Law,” The Financial Times, 14 August 2017, https://www.ft.com/content/a4b28218-80db-11e7-94e2-c5b903247afd.

[19] Laura Kelly, “Trump to End Special Treatment for Hong Kong,” The Hill, 29 May 2020, https://thehill.com/policy/international/500164-trump-to-end-special-treatment-for-hong-kong.

[20] See https://www.congress.gov/bill/102nd-congress/senate-bill/1731/text?q=%7B%22search%22%3A%5B%22Hong+Kong+policy+Act%22%5D%7D&r=1&s=4.

[21] “Explainer: How Ending Hong Kong’s ‘Special Status’ Could Affect U.S. companies,” Reuters, 22 May 2020, https://www.reuters.com/article/us-usa-china-hongkong-trade-explainer-idUSKBN22Y22Z.

[22] Jeremy Page and Chun Han Wong, “Beyond Hong Kong, an Emboldened Xi Jinping Pushes the Boundaries,” The Wall Street Journal, 29 May 2020, https://www.wsj.com/articles/beyond-hong-kong-an-emboldened-xi-jinping-pushes-the-boundaries-11590774190?mod=searchresults&page=1&pos=1.

[23] “Greater Bay Area,” (粤港澳大湾区), https://www.bayarea.gov.hk/en/home/index.html.

[24] Tianlei Huang, “Why China Still Needs Hong Kong,” PIIE, 15 July 2019, https://www.piie.com/blogs/china-economic-watch/why-china-still-needs-hong-kong.

[25] Noah Sin “Explainer: How Important is Hong Kong to China As a Free Finance Hub?” Reuters, 29 May 2020, https://www.reuters.com/article/us-hongkong-protests-finance-explainer-idUSKBN2350VO.

[26] Ibid.

[27] See, for instance the views of economist Francis Lui Ting-ming. Karen Yeung and Sidney Leng, “Hong Kong Security Law: City’s Future is in Servicing Chinese Firms, Says Top City Economist,” South China Morning Post, 29 May 2020, https://www.scmp.com/economy/china-economy/article/3086559/hong-kong-security-law-citys-future-servicing-chinese-firms.

[28] Consider Beijing’s clampdown in response to the 2015 and 2018 stock market declines in China. Gabriel Wildau, “China’s ‘National Team’ Owns 6% Of Stock Market,” Financial Times, 25 November 2015, https://www.ft.com/content/7515f06c-939d-11e5-9e3e-eb48769cecab; and Samuel Shen and John Ruwitch, “In China, Response to Pledged Share Meltdown Stirs Concern,” Reuters, 8 November 2018, https://www.reuters.com/article/us-china-markets-pledgedshares-insight-idUSKCN1NE0PD.

[29] “Ian Easton on Taiwan: Why the U.S. defends Taiwan,” Taipei Times, Op-Ed, September 16, 2019, 6, http://www.taipeitimes.com/News/editorials/archives/2019/09/16/2003722357.

[30] Chris Hall, “Our Dismal Relationship With China Just Got a Whole Lot Worse,” CBC News, 28 May 2020, https://www.cbc.ca/news/politics/china-meng-wanzhou-extradition-kovrig-spavor-1.5587636; Andy Blatchford, “Canada Braces for Consequences from China After Huawei Exec Loses Bid to Dismiss Extradition to U.S.,” Politico, 27 May 2020, https://www.politico.com/news/2020/05/27/canada-consequences-china-huawei-extradition-us-284779.

[31] Mark Katkov, “China Charges 2 Canadians with Espionage in Case Tied to U.S. Prosecution Of Huawei,” National Public Radio, 19 June 2020, https://www.npr.org/2020/06/19/880741322/china-charges-2-canadians-with-espionage-in-case-tied-to-u-s-prosecution-of-huaw.

[32] Dominique Patton, Julie Gordon, “China Widens Ban on Canadian Canola Imports to Second Firm, Viterra,” Reuters, 26 March 2019, https://www.reuters.com/article/us-china-canada-trade-canola-idUSKCN1R713S.

[33] The U.S. can also discuss layers of publicity by allied and partner countries to afford them options to manage their risks while bringing pressure to bear on the PRC. Multiple layers of participation in PSI and Container Security Initiative (CSI), for instance, provide some precedent. “Statement on Proliferation Security Initiative,” 4 September 2003, Statement by the White House Press Secretary, https://georgewbush-whitehouse.archives.gov/news/releases/2003/09/20030904-10.html.

[34] Note that this report does not recommend interdicting certain PRC and Hong Kong financial bodies, including China Securities Depository and Clearing Corporation, HK Securities Clearing Corporation, China Central Depository Clearing Corporation, Shanghai Clearing House Corporation, and Hong Kong Interbank Clearing Limited. The key reason for this is that the calibration potential of CAATSA and its broad reach make it a primary action vehicle. Targeting specific financial entities and clearing houses in a systemically important economies like the PRC and Hong Kong does not, in our assessment, deliver sufficient leverage to offset the downsides, including the potential for stimulating substantial Wall Street opposition in the United States.

[35] Other suggestions of such allowances include long-established policies to bring in Mainlanders to become Hong Kong citizens and statements expressing desire to transform the SAR’s demography in a “patriotic” direction.

[36] Nick Aspinwall, “For Hong Kong Refugees, New Life in Taiwan Means Traversing a Legal Twilight Zone,” Washington Post, 24 February 2020,https://www.washingtonpost.com/world/asia_pacific/for-hong-kong-refugees-new-life-in-taiwan-means-traversing-a-legal-twilight-zone/2020/02/23/c924a4d4-4648-11ea-91ab-ce439aa5c7c1_story.html.

[37] Patrick Wintour and Helen Davidson, “Boris Johnson Lays Out Visa Offer to Nearly 3m Hong Kong Citizens,” The Guardian, 3 June 2020, https://www.theguardian.com/world/2020/jun/03/britain-could-change-immigration-rules-for-hong-kong-citizens. To be sure, Beijing has publicly promised consequences for the UK for allowing Hong Kong residents to relocate, seeing it as an infringement on its right to domestic jurisdiction. The question is whether Beijing will carry out this threat. Along with Taiwan, dialogue and coordination with the UK could prove helpful and informative.

[38] David Vetter, “What is a British National (Overseas) Passport and What Is a Holder Entitled To?” South China Morning Post, 1 August 2018, https://www.scmp.com/news/hong-kong/politics/article/2157756/what-british-national-overseas-passport-and-what-holder.

[39] Ibid.

[40]Patrick Wintour and Helen Davidson, “Boris Johnson Lays Out Visa Offer to Nearly 3m Hong Kong Citizens,” The Guardian, 3 June 2020, https://www.theguardian.com/world/2020/jun/03/britain-could-change-immigration-rules-for-hong-kong-citizens

[41] Ibid.

[42] Dennis Romboy, “Utah Rep. John Curtis Proposing to Give Hong Kong Residents Priority Refugee Status as China Asserts Control,” Deseret News, 28 May 2020, https://www.deseret.com/utah/2020/5/28/21273539/china-hong-kong-protests-national-security-law-john-curtis-refugees.

[43] “Sasse Introducing Hong Kong Asylum Bill,” 30 May 2020, https://www.sasse.senate.gov/public/index.cfm/2020/5/sasse-introducing-hong-kong-asylum-bill.

[44] Jeff Jacoby, “Open America’s doors to refugees from Hong Kong,” Op-Ed, Boston Globe, 2 June 2020, https://www.bostonglobe.com/2020/06/02/opinion/open-americas-doors-refugees-hong-kong/.

[45] The PRC/CCP has likewise used student groups and native place associations to mobilize and police citizens, former citizens, and even other people with ethnic Chinese heritage in the United States and elsewhere. Protecting civil liberties are an important American value; but it is also important to protect against these channels of CCP influence and United Front work. Countermeasures should usually be restrained but decisive where necessary. Relevant examples include Australia’s experience with such organizations and the Chinese Students’ Associaition at Columbia University, which was shut down some years ago. See

https://www.forbes.com/sites/jnylander/2015/03/25/columbia-university-closes-chinese-student-organisation/#1ad1fc741a7d, https://www.aspistrategist.org.au/the-party-speaks-for-you-foreign-interference-and-the-chinese-communist-partys-united-front-system/, and https://www.news.com.au/finance/economy/australian-economy/china-is-infiltrating-australia-on-multiple-fronts-from-politics-to-business-via-its-powerful-and-covert-united-front-agency/news-story/9318c7799e540164dd0b985b9e8969c2.

[46] S.1731 – United States-Hong Kong Policy Act of 1992 (Sec.103, Subpart 8), Congress.gov, https://www.congress.gov/bill/102nd-congress/senate-bill/1731/text.

[47] The Committee on Foreign Investment in the United States (CFIUS) (Washington, DC: Congressional Research Service, 26 February 2020), https://crsreports.congress.gov/product/pdf/RL/RL33388.

[48] https://www.congress.gov/116/plaws/publ76/PLAW-116publ76.pdf

[49] Ibid.

[50] Harry J. Levinson, Principles of Lithography, 4th ed. (SPIE, the international society for optics and photonics, 2019); Vivek Bakshi, EUV Lithography, 2nd ed. (SPIE, 2018); Chris Mack, Fundamental Principles of Optical Lithography: The Science of Microfabrication (Wiley, 2007); Patrick Naulleau, “Optical Lithography,” in David L. Andrews, Robert H. Lipson and Thomas Nann, eds., Comprehensive Nanoscience and Nanotechnology (Second Edition), 2019.

[51] “Big Steps in Tiny Patterns,” ASML, https://www.asml.com/en/technology.

[52] Saif M. Khan and Carrick Flynn, “Maintaining China’s Dependence on Democracies for Advanced Computer Chips,” Brookings Institution, April 2020, https://www.brookings.edu/wp-content/uploads/2020/04/FP_20200427_computer_chips_khan_flynn.pdf.

[53] Ibid.

[54] “Addition of Fujian Jinhua Integrated Circuit Company, Ltd (Jinhua) to the Entity List,” U.S. Department of Commerce, 29 October 2018, https://www.commerce.gov/news/press-releases/2018/10/addition-fujian-jinhua-integrated-circuit-company-ltd-jinhua-entity-list.

[55] Ibid.

[56] “The Chip Maker Caught in US Assault on China’s Tech Ambitions,” Bloomberg (via South China Morning Post), 26 November 2018, https://www.scmp.com/tech/big-tech/article/2175031/chip-maker-caught-us-assault-chinas-tech-ambitions

[57] “Hong Kong Data Center Market,” Baxtel, https://baxtel.com/data-center/hong-kong; Rita Ngai, “Microsoft Asia’s Biggest Datacenter Pair: Hong Kong and Singapore,” Microsoft, 28 November 2018, https://news.microsoft.com/en-hk/2018/11/28/microsoft-asias-biggest-datacenter-pair-hong-kong-and-singapore/

[58] See https://www.datacenterknowledge.com/apple/apples-icloud-china-set-move-state-controlled-data-center.

[59] Protection of personal data is particularly important, since breaches into databases of the U.S. Office of Personal Management and health insurance firms seem to aim at allowing trawling of data to find vulnerabilities to exploit.

[60] During the past academic year, for instance, one of the authors has learned, a PRC firm was offering a free set of social science research tools at a top-tier research university in the United States, in exchange for researchers sharing their data and methodologies. Some collaboration is necessary and important, but such sharing should be deliberate and done with care, not simply out of convenience or expedience.

[61] See https://santandertrade.com/en/portal/establish-overseas/hong-kong/foreign-investment.

[62] See https://ustr.gov/countries-regions/china-mongolia-taiwan/hong-kong.

[63] “Growth in Singapore’s Foreign Currency Deposits Comes From Diverse Sources: MAS,” Channel News Asia, 7 June 2020, https://www.channelnewsasia.com/news/business/mas-foreign-currency-deposits-growth-singapore-hong-kong-12813418.

[64] See, for instance: Greg Torode, “Exclusive: Hong Kong Tycoons Start Moving Assets Offshore as Fears Rise Over New Extradition Law,” Reuters, 14 June 2020, https://www.reuters.com/article/us-hongkong-extradition-capitalflight-ex-idUSKCN1TF1DZ. This article quotes an unnamed Hong Kong-based financial adviser as saying “The fear is that the bar is coming right down on Beijing’s ability to get your assets in Hong Kong. Singapore is the favoured destination.”

[65] Paul Wolfowitz and Frances Tilney Burke, “Hong Kong Sanctions With Teeth,” The Wall Street Journal, 2 June 2020, https://www.wsj.com/articles/hong-kong-sanctions-with-teeth-11591119841.

[66] “Panama Papers: China Censors Online Discussion,” BBC, 4 April 2016, https://www.bbc.com/news/world-asia-china-35957235; “Bloomberg Sites Blocked in China Days after Xi Family Wealth Story,” Reuters, 4 July 2012, https://www.reuters.com/article/us-china-censorship-bloomberg-idUSBRE86306820120704.

[67] See, for example, “Open Arms: Evaluating Global Exposure to China’s Defense-Industrial Base,” C4ADS, 2019, https://static1.squarespace.com/ static/566ef8b4d8af107232d5358a/t/5d9 5fb48a0bfc672d825e346/1570110297719/ Open+Arms.pdf; Gabriel B. Collins, “Foreign Investors and China’s Naval Buildup,” The Diplomat, September 9, 2015, https://thediplomat.com/2015/09/foreigninvestors-and-chinas-naval-buildup/.

[68] “All Our Investigations,” International Consortium of Investigative Journalists, https://www.icij.org/investigations/.

[69] See https://bitterwinter.org and https://bitterwinter.org/ccp-stepping-up-the-pace-of-uyghur-forced-labor-into-inner-china/.

[70] See https://www.aspi.org.au/.

[71] Specific relevant actions would include:

Corporate/entity level

1)           denial of export licenses;

2)           a prohibition on foreign exchange transactions under U.S. jurisdiction;

3)           a prohibition on transactions with the U.S. financial system; and

4)           blocking of all property and interests in property within U.S. jurisdiction;

Personal level

1)           a prohibition on foreign exchange transactions under U.S. jurisdiction;

2)           a prohibition on transactions with the U.S. financial system;

3)           blocking of all property and interests in property within U.S. jurisdiction; and

a visa ban.

[72] See “50 U.S. Code § 1702.Presidential authorities,” Legal Information Institute, https://www.law.cornell.edu/uscode/text/50/1702

[73] “Sanctions Under Section 231 of the Countering America’s Adversaries Through Sanctions Act of 2017 (CAATSA),” U.S. Department of State, 20 September 2018, https://www.state.gov/sanctions-under-section-231-of-the-countering-americas-adversaries-through-sanctions-act-of-2017-caatsa/.

[74] Kerry B. Contini, Inessa Owens, and Daniel Andreeff, “US Government Sanctions Chinese Entity for Engaging in Transactions with Russian Defense Sector Under CAATSA Section 231 List, Clarifies CBW Act Waiver, and Extends Expiration of General Licenses Related to RUSAL and EN+ Group,” Baker McKenzie, 24 September 2018, https://sanctionsnews.bakermckenzie.com/us-government-sanctions-chinese-entity-for-engaging-in-transactions-with-russian-defense-sector-under-caatsa-section-231-list-clarifies-cbw-act-waiver-and-extends-expiration-of-general-licenses-rela/.

[75] Treasury Designates Russian Oligarchs, Officials, and Entities in Response to Worldwide Malign Activity, U.S. Department of the Treasury, 6 April 2018, https://home.treasury.gov/news/press-releases/sm0338; “Rusal shares plunge over 40 percent on U.S. sanctions,” Reuters, 8 April 2018, https://www.reuters.com/article/us-usa-russia-sanctions-rusal-stocks-idUSKBN1HG04H.

[76] “OFAC Delists En+, Rusal, and EuroSibEnergo,” U.S. Department of the Treasury, 27 January 2019, https://home.treasury.gov/news/press-releases/sm592

[77] In contrast, Washington should not consider broader sanctions against international tax havens such as the Cayman Islands that facilitate PRC entities’ foreign transactions. This would be hugely complicated, and is impracticable on many levels. It is better to leave these windows open as avenues of capital flight from the PRC. However, key individuals’/organizations’ assets going to these tax havens can be highlighted, including through support of investigative journalism.

[78] D&O insurance policies offer liability cover for company managers to protect them from claims which may arise from the decisions and actions taken within the scope of their regular duties. As such, D&O insurance has become a regular part of companies risk management. “D&O Insurance Explained,” Allianz, https://www.agcs.allianz.com/news-and-insights/expert-risk-articles/d-o-insurance-explained.html (accessed 6 June 2020).

[79] “Our Shareholders’ Committee,” Nord Stream, https://www.nord-stream.com/about-us/our-shareholders-committee/.

[80] “Board of Directors,” Rosneft, https://www.rosneft.com/governance/board/item/187923/.

[81] See 31 CFR § 1010.605(1)(i).

[82] There is also precedent under the Magnitsky Act. Conversely, there can be protection of U.S. assets of people politically persecuted. This follows along the lines of the U.S. SPEECH Act. This can help protect entities like HKDC and even Apple Daily, which help to expose what is going on in Hong Kong, and that the PRC state is likely to want to target. Beijing will continue to retaliate against U.S. businesses, as it already has against the NBA. To the extent that U.S. firms are encouraged and supported to withstand such retaliation, their effects can be minimized. See, for example: https://www.govinfo.gov/content/pkg/PLAW-111publ223/html/PLAW-111publ223.htm and https://www.congress.gov/bill/111th-congress/senate-bill/3518/text.

[83] “RMB Tracker June 2020,” RMB tracker document centre, SWIFT, https://www.swift.com/our-solutions/compliance-and-shared-services/business-intelligence/renminbi/rmb-tracker/document-centre?tl=en#topic-tabs-menu.

[84] International Financial Centre, HKMA Annual Report 2019, 137, https://www.hkma.gov.hk/media/eng/publication-and-research/annual-report/2019/15_International_Financial_Centre.pdf.

[85] Taiwan: Issues for Congress R44996 (Washington, DC: Congressional Research Service, 30 October 2017), https://crsreports.congress.gov/product/pdf/R/R44996; Shirley A. Kan, China/Taiwan: Evolution of the “One China” Policy—Key Statements from Washington, Beijing, and Taipei (Washington, DC: Congressional Research Service, January 5, 2015), https://shirleykannet.files.wordpress.com/2019/10/one-china-policy.pdf; Jeffrey W. Hornung and Scott W. Harold, “Should the U.S. Move to Strengthen Ties with Taiwan?” Op-Ed, The Hill, 5 June 2020, https://thehill.com/opinion/international/501343-should-the-us-move-to-strengthen-ties-with-taiwan.

[86] Trefor Moss, “China Orders Cathay Pacific to Remove Employees Involved in Hong Kong Protests From Mainland Flights,” The Wall Street Journal, 9 August 2019, https://www.wsj.com/articles/china-orders-cathay-pacific-to-remove-employees-involved-in-hong-kong-protests-from-mainland-flights-11565360471.

[87] For specific FTA ideas, see Daniel Blumenthal and Michael Mazza, A Golden Opportunity for a U.S.-Taiwan

Free Trade Agreement (Arlington, VA: Project 2049 Institute, February 14, 2019), https://project2049.net/wp-content/uploads/2019/02/US_TW_Trade_Blumenthal_Mazza_P2049_021419.pdf.

[88] Leading with USDA-certified organic and all natural products could help pave the way.

[89] Gabriel B. Collins and Andrew S. Erickson, Economic Statecraft: Options for Reducing U.S. Overdependence on Chinese-supplied Materials and Medications (Houston, TX: Baker Institute for Public Policy, Rice University, 23 April 2020), https://www.bakerinstitute.org/media/files/files/000f91f7/bi-report-042320-ces-statecraft.pdf.

[90] See, for example, Andrew S. Erickson, “The Michael Chase Bookshelf: Leading-Edge Research on China’s Rocket Force and Strategic & Cross-Strait Security Issues,” China Analysis from Original Sources 以第一手资料研究中国, 17 December 2017, https://www.andrewerickson.com/2017/12/the-michael-chase-bookshelf/.

[91] Potential organizations to support include the National Democratic Institute (NDI), the National Endowment for Democracy (NED), and the International Republican Institute (IRI).

[92] Matthew Ha, “Let’s Get Serious About US-Taiwan Cybersecurity Cooperation,” Washington Examiner, May 19, 2020, https://www.washingtonexaminer.com/opinion/op-eds/lets-get-serious-about-us-taiwan-cybersecurity-cooperation.

[93] See https://halifaxtheforum.org/.

[94] See https://www.thegctf.org/About-us/Background-and-Mission.

[95] See https://www.congress.gov/bill/115th-congress/house-bill/535/text.

[96] See https://www.congress.gov/bill/116th-congress/senate-bill/1678/text.

[97] Scott W. Harold, “Making Sense of US Arms Sales to Taiwan,” Institute Montaigne, 23 July 2019, https://www.institutmontaigne.org/en/blog/making-sense-us-arms-sales-taiwan.

[98] Russell Hsiao and Marzia Borsoi-Kelly, “The Taiwan Relations Act at 40: Reaching a New Optimal Equilibrium in U.S.-Taiwan Policy,” Foreign Policy Research Institute, https://www.fpri.org/article/2019/04/the-taiwan-relations-act-at-40-reaching-a-new-optimal-equilibrium-in-u-s-taiwan-policy/.

[99] See, for example, Andrew S. Erickson, “The Prof. William Murray Bookshelf: Keen Insights into China’s Military Buildup & Taiwan’s Defense Options,” China Analysis from Original Sources 以第一手资料研究中国28 November 2017, https://www.andrewerickson.com/2017/11/the-prof-william-murray-bookshelf-keen-insights-into-chinas-military-buildup-taiwans-defense-options/.

[100] “Ian Easton on Taiwan: Why the U.S. defends Taiwan,” Taipei Times, Op-Ed, September 16, 2019, 6, http://www.taipeitimes.com/News/editorials/archives/2019/09/16/2003722357.

[101] While the authors lack access to a comprehensive, authoritative list, based on public sources—including comparison of the following websites <https://www.state.gov/countries-areas/china/> and <https://www.state.gov/countries-areas/taiwan/>—they understand the relevant guidelines to have historically included some version of the following:

  1. Meetings between USG officials and Taiwan authorities outside the United States must be held outside USG and Taiwan offices (e.g., at private meeting rooms or restaurants).
  2. Embassy personnel may accept invitations to private functions hosted by Taiwan representatives either in restaurants or in their homes, but not in residences of Taiwan’s principal representatives or ambassadors.
  3. U.S. Embassy and Consulate personnel may host Taiwan representatives at private functions in restaurants or in their homes, but not in U.S. Chief of Mission residences. Taiwan representatives may not be invited to U.S. functions of an official nature or to functions held on official U.S. premises.
  4. U.S. Government representatives should not correspond directly with authorities from Taiwan, but rather should send letters through AIT-TECRO channels. Individuals from Taiwan whom U.S. Executive Branch officials contact are generally referred to by name, title, and city without use of international nomenclature (e.g., Director General Chang, Civil Aviation Bureau, Taipei). Correspondence to these individuals is prepared on plain white stationery and signed with a personal name without a USG title.
  5. All Executive Branch personnel (of rank of Senior Foreign or Executive Service or military equivalent) who plan to travel to Taiwan for work-related reasons must have prior concurrence from the State Department’s office of Taiwan Coordination before requesting travel clearance from AIT Taipei. USG personnel travel to Taiwan in the capacity of consultants to AIT. Official travel is not permitted for State or Defense officials above the rank of Office Director or for uniformed military personnel above the level of 06 (Colonel, Navy Captain) without the written permission of EAP/TC. For personal travel, senior Executive Branch officials at or above the level of Assistant Secretary or three-star flag officers must obtain clearance from EAP/TC. All travel by Executive Branch personnel to Taiwan or transiting through Taiwan must be on a regular (tourist) passport. Diplomatic and official passports should not be used for travel to Taiwan.
  6. Guidelines on Taiwan Military Uniforms and ROC Flags: In keeping with the unofficial nature of our relations with Taiwan and the fact that the United States does not recognize Taiwan as an independent, sovereign state, military representatives of the authorities on Taiwan should not wear their uniforms while in the United States or on U.S. premises overseas, and the “ROC” flag should not be displayed on USG premises.

[102] Emphasizing such Maritime Law Enforcement professionals, generally considered civilian in nature, would allow more calibration, taking a page from the PRC playbook of leveraging salami slicing and semantics.

[103] Gabe Collins, “Time to Put China’s Rocketeers on Notice,” The National Interest, 8 February 2017, https://nationalinterest.org/feature/time-put-chinas-rocketeers-notice-19372?page=0%2C1.

[104] John Power, “U.S. freedom of Navigation Patrols in South China Sea Hit Record High in 2019,” South China Morning Post, 5 February 2020, https://www.scmp.com/week-asia/politics/article/3048967/us-freedom-navigation-patrols-south-china-sea-hit-record-high.

[105] Ryan D. Martinson and Andrew Erickson, “Re-Orienting American Seapower For The China Challenge,” War on the Rocks, 10 May 2018, https://warontherocks.com/2018/05/re-orienting-american-sea-power-for-the-china-challenge/.

[106] Indonesia is in an unusually complex position. China and Indonesia both claim they do not have overlapping claims. Yet, Indonesia is taking umbrage to increasingly aggressive Chinese fishing and law enforcement (Coast Guard) activities in its Exclusive Economic Zone.

***

Gabriel B. Collins and Andrew S. Erickson, Economic Statecraft: Options for Reducing U.S. Overdependence on Chinese-supplied Materials and Medications (Houston, TX: Baker Institute for Public Policy, Rice University, 23 April 2020).

This policy report explains how specific tools of economic statecraft can be applied to reduce risks caused by dependence on People’s Republic of China-dominated supply chains for critical goods. It offers foundational building blocks for the formulation and implementation of a larger strategy to reduce American vulnerabilities to China.

  • We have previously argued that it is “Time to Curb America’s Manufacturing Dependency on China.”
  • The present report suggests actionable pathways to facilitate and accelerate manufacturing sector onshoring for those goods most critical to U.S. national and economic security.
  • It explains critical scenarios, identifies key weak points, and suggests 12 potential countermeasures.
  • While employing these tools will be neither easy nor cheap, the coronavirus already reveals the alternative: mounting costs in American economic wellbeing, strategic resilience, and lives.

From the outset, we want to be crystal clear about a core premise of our thinking: the United States will—and decidedly should—remain closely connected to the global economy. But the corporate quest over the past 25 years to cut supplier costs, with insufficient concern for resilience, has saddled the nation with gaping strategic vulnerabilities in the supply chains for certain critical materials, medications, and technology inputs. Our analysis describes what it will take to begin reclaiming U.S. security and strategic autonomy in those areas.

Our list prioritizes pressing weaknesses that Beijing would likely exploit to gain leverage against Washington during a crisis, as well as pharmaceutical vulnerabilities that are already adversely affecting Americans’ health. It should therefore be viewed as a “living document” to be updated and revised as events and initial policy formulation and implementation unfold. … …

Gabriel B. Collins, J.D., Baker Botts Fellow in Energy & Environmental Regulatory Affairs

Andrew S. Erickson, Ph.D, Professor of Strategy, China Maritime Studies Institute, Naval War College

***

Gabriel B. Collins and Andrew S. Erickson, “Time to Curb America’s Manufacturing Dependency on China,” China SignPost™ (洞察中国) 101 (24 March 2020).

Coronavirus Crisis Offers an Opportunity to Revitalize U.S./North American Manufacturing, Restore Regional Partnerships, Reduce Dependence on Beijing

Whether between people or countries, co-dependency relationships rarely work well over time when the understandings undergirding them erode. It’s thus unsurprising that the unfolding coronavirus pandemic raises two fundamental strategic and industrial policy questions:

  • Should American consumers have to rely so heavily on Chinese factories as a virtual sole source of key antibiotics, heart medications, and other potentially life-critical goods?
  • Have we reached a point at which the People’s Republic of China (PRC) has become sufficiently unreliable as a strategic economic partner that it is time to rebuild key portions of the industrial base in our own hemisphere?

A growing body of evidence suggests the answers are “no” to question 1 and “yes” to question 2.

Key Point 1: Bringing High-End Supply Chains Home Can Help Repair America’s Social Fabric

Crises present unique opportunities to forge long-needed changes. It’s time for federal, state, and local leaders to seize the moment. Policies crafted in response should be based on the core principle of bringing much more of the most vital, sensitive supply chains—for pharma, apex technologies, and other high-end goods back onto American soil, as well as into our two great neighbors. If PRC manufacturers continue to dominate manufacturing of low-end items, that is fine. But the more technologically advanced and life-essential items increasingly should be manufactured at home or just across our southern or northern borders by amicable neighbors easily accessible by a panoply of efficient, resilient transportation links.

This view will attract some pushback, in part based on the idea that even if items are assembled abroad, the lion’s share of value capture still occurs in the U.S. For an iPhone7 sold in 2016, roughly 42% of the device’s total $649 value would have been effectively captured at Apple’s corporate level, according to the 2017 World Intellectual Property Report. But, as the peculiar blanket reopening of Apple stores in China even as they remain closed elsewhere suggests, resting on the current value distribution is a strategic mistake. An enduring reality of industrial development is that “innovation in manufacturing gravitates to where the factories are.” There is a symbiosis and gravitational attraction between the two activities and combining the two within a country becomes a natural driver of jobs and economic growth.

Moving key industrial value chains back onshore will take considerable money, effort, and time. But it also should be viewed as a re-investment in the fabric of economic opportunity that forms the interstitial tissue of the United States’ political system at the local, state, and federal levels. Revitalizing the U.S. industrial base and manufacturing sector can address many of the economic justice concerns that represent central issues in the 2020 presidential election. Overall, a healthy, more balanced economy sets the stage for a more robust society.

In the context of America’s global role, a healthy society at home translates into sustainable projection of positive influence abroad. In the simplest terms, pulling more of our supply chain out of China ultimately helps empower the U.S. and her allies and partners in the contest of systems now unfolding between Washington and Beijing.

Furthermore, as globalism cedes ground to regional realities, our home hemisphere beckons. Given the existing cross-border industrial ecosystems linking the U.S., Canadian, and Mexican economies, an American-led reboot of high-end manufacturing here can begin repairing and deepening key relationships with our vital neighbors. They are already among our greatest trading partners. Indeed, in a time when trade agreement of any kind tends to be elusive, a new “NAFTA 2.0” free trade accord has already been ratified by all three countries: the Agreement between the U.S., Mexico, and Canada (USMCA). Neither Canada nor Mexico will ever attempt to threaten or undercut the U.S. the way China already has. North America is well-placed to do more business, effective immediately!

Key Point 2: The Time is Right for Action

The broader American political climate is likewise ripe for bringing truly critical supply chains home. Growing calls to re-structure our economic and strategic relationships with China are the latest iteration in a disturbing pattern of Beijing regularly reneging on promises and dashing expectations. But this time, a growing rift has generated irreconcilable differences. During prior upsets, disenchantment with China was primarily restricted to specialist communities in Washington, DC, while commercial firms consistently bubbled with anticipation at the chance to enhance and retain access the vast China market. That division led business interests to lobby to restrain the Washington defense and security community’s rising desire to counter worrisome behavior by China. Moreover, well into the early 2000s China was far from being a core public concern with voters. No longer.

China is now a systemic global player in multiple dimensions. Its actions suggest a desire to displace the United States as the pre-eminent power in the Asia-Pacific region (and perhaps beyond) and there carve out a zone excluded from international laws and norms. China’s state-sponsored industrial development policies helped hollow out multiple key portions of the U.S. manufacturing base, including many of the areas now worst affected by the opioid epidemic (and where fentanyl, one of the most lethal synthetic opioids, largely originates from China). U.S. business executives, meanwhile, have recognized that China’s web of policy barriers mean that for most firms it will remain a vast theoretical market that rarely delivers returns commensurate with what was promised.

Beijing’s actions on the military, economic, industrial policy, and technology transfer fronts have created an unprecedented bipartisan consensus whereby U.S. Defense professionals, businesspeople, and lay voters now increasingly agree that China poses a multidimensional challenge that needs to be confronted more directly and decisively. To capitalize on the shift, Washington needs to proactively offer other countries, whether in the EU, ASEAN, or Western Hemisphere, positive economic, investment, and ideological alternatives to a PRC worldview centered on coercion and control.

Legislative stimulus will be a key part of this process. To that end, the Pharmaceutical Independence Long-Term Readiness Reform Act (H.R. 4710) introduced in October 2019 gives a preliminary taste of what after the coronavirus is likely to become a much larger flow of legislative action.

Key Point 3: U.S. High-End Manufacturing Renaissance Can Offer Other Countries a Strategic Economic Alternative to Dependence on China

The global strategic opportunity before us is masked now by the fact that neither Beijing nor Washington are handling all of their key relationships deftly, particularly in Europe. But the difference is stark: America’s sometimes ham-handed messaging may be readily improved, and is periodically renewed. China’s “shotgun diplomacy” in Europe, on the other hand, reflects Beijing’s institutional approach to other countries, which becomes harsher as China’s perception of its own power grows. Indeed, the Chinese Communist Party owns every single PRC policy catastrophe since 1949, and currently appears to only be doubling down. In such an environment, taking steps to ratchet down China’s importance to vital global supply chains and enhancing the availability of industrial investment opportunities outside of the PRC can in turn reduce Beijing’s ability to strong-arm and threaten.

The U.S. strategic position does not suffer if China continues to supply much of the world’s Walmart shelves. Being a world-class maker of low-end goods does not support and sustain superpower strength. But remaining a world leader in high technology, biomedical R&D, pharmaceutical production, transportation infrastructure, and other high-end manufacturing is the cornerstone of global economic leadership. Given events to date and looming future risks, leaving core portions of critical supply chains in China has become simply incompatible with core U.S. national interests. We cannot remain co-dependent with an increasingly adversarial great power. Now is the time to generate and sustain a strategic American manufacturing renaissance, closely connected to healthy hemispheric trade with our North American neighbors.

Mr. Gabriel B. Collins is the Baker Botts Fellow in Energy & Environmental Regulatory Affairs at Rice University’s Baker Institute for Public Policy. He’s a licensed attorney who runs a global research portfolio focused on China, Russia, water, energy, and a range of environmental, legal and national security issues.

Dr. Andrew S. Erickson is a Professor of Strategy (tenured full professor) in the U.S. Naval War College’s China Maritime Studies Institute. He is currently a Visiting Scholar in full-time residence at Harvard University’s John King Fairbank Center for Chinese Studies, where he has been an Associate in Research since 2008. Erickson blogs at www.andrewerickson.com.

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 Chinese developments, with particular focus on natural resource, technology, industry, and trade issues.

 China SignPost™ 洞察中国 founders Dr. Andrew Erickson and Mr. Gabe Collins have more than three decades of combined government, academic, and private sector experience in Mandarin Chinese language-based research and analysis of China.

The positions expressed here are the authors’ personal views. They do not represent the policies or estimates of the U.S. Navy, the U.S. Government, or any other organization. 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.

***

Gabriel B. Collins, “Pandemic and Price War: Early Energy Market Insights From the 2019-2020 Wuhan Coronavirus Outbreak,” Research Presentation, China SignPost™ (洞察中国), 20 March 2020.

Click here to download full slide deck.

Executive Summary:

  • The coronavirus is likely the biggest global oil demand shock for China and other major industrial powers for the past 50 years, exceeding even the impact of the 2008 Global Financial Crisis. This risk is magnified by the fact that the massive 2009-2010 China stimulus measures, which drove an oil demand increase of approximately 1 million bpd, are likely not in the cards this time around.
  • Oil use foregone during the lockdown period is most countries likely will not be recouped and it will likely take multiple quarters for demand to attain pre-pandemic levels. This is likely to be especially true for air travel, one of the most discretionary forms of consumer oil use. One potential offset could come through consumers eschewing planes and trains and using personal cars for a greater share of inter-city travel. Personal car use is generally significantly more oil-intensive per capita than flying on a plane.
  • At the same time, Saudi Arabia has declared an oil price war on Russia and Moscow wants to suppress US shale. Russia can likely sustain the price war through the remainder of 2020 and I think the Saudis will blink first. That said, several tough quarters lie ahead.
  • Keep your heads up! The economic restart and recovery will take time and feature fits and starts as supply chain kinks are worked out, but the underlying physical infrastructure remains intact and can be switched back on fairly quickly. In that respect, Covid-19 is very different than a natural disaster that physically disrupts and destroys key assets. Critical basic services such as water, gas, power, and internet services will likely remain available even if the infection burden gets much worse.
  • Pandemic disruptions are rooted in our natural human fear response—and in the fact that some proportion of the population may become sick and temporarily unable to function (or even suffer longer-term disability or death). The virus attacks our confidence and strains our institutions, but leaves physical assets untouched.
  • We will recover, but the architecture of our commercial intercourse and consumption patterns could be altered for some time. The near-term downturn will likely be deeper than what happened in 2008-2009. It’s going to be volatile and challenging through 2020, and perhaps into the first quarter of 2021.

***

Gabriel Collins, “What If China Ceases to Be the Global ‘Oil Consumer of Last Resort?’” China SignPost™ (洞察中国) 100 (13 November 2019).

What happens to the world oil market if China can no longer serve as the “consumer of last resort?” The question is uncomfortable to contemplate, but is increasingly relevant as a longer-term structural slowdown in Chinese growth becomes more likely.

In the past 15 years, China accounted for about 40% of net global oil demand growth.[1]The country’s consumption increase between 2003 and 2018 amounted to about 7 million barrels per day–roughly equivalent to the volume of oil that Brazil, Russia, and Malaysia together consumed per day in 2018.[2] What’s more, oil demand in China continued to grow even during recessions such as 2008-2009 when overall global demand declined, suggesting the actual market impact of Chinese consumption is even larger than the net demand numbers indicate.

Since the late 1990s, oil producers worldwide have increasingly depended upon Chinese demand to absorb the barrels they produce and send into the global marketplace (Exhibit 1). China’s economic expansion over the past 4 decades has been remarkable. But it is increasingly likely over the next decade that the country’s exceptional run will taper off and that growth rates will revert to something closer to the global mean GDP growth rate.[3] As tracked by the World Bank, this figure averaged just under 3% annually from 2003 to 2018.[4] If China slid onto a 3-to-4% annual economic growth trajectory (perhaps ranging lower) and its oil demand downshifted commensurately, the global oil market impacts would be momentous.

Exhibit 1: China as a % of Annual Net Global Oil Demand Growth, 1966-2018

There is a “chicken and egg” aspect to the prior statement, as China’s explosive oil demand uptick in 2004 helped set global oil prices on the path to the nearly $150/bbl level achieved in the summer of 2008, which in turn helped catalyze the US shale oil boom. But the common thread is that whether Chinese demand for crude oil is the “chicken” or the “egg” that hatched it or a little bit of each, removing one or the other breaks the lifecycle. And here that lifecycle implicates a global market that now trades nearly 100 million barrels per day of crude oil worth nearly $2 trillion annually at today’s prices, and whose price movements influence industrial value chains worth trillions of additional dollars and dozens of other critical global commodities and fundamental economic benchmarks.

How Did China’s Oil Demand Get To Where It Stands Now?

Several factors have driven China’s explosive economic growth over the past 25 years. First, the country started from a low baseline.[5] Second, there was a ready supply of underemployed rural workers who moved to cities in search of employment opportunities. Moving rural workers into an industrializing urban setting can raise their productivity by a factor of 3-to-6 times.[6] Third, foreign technology–whether transferred voluntarily, under duress, stolen, or purchased–has been easily accessible. Technology access facilitated high-velocity “catch up” growth as existing, proven technologies were combined with the cheap labor then available in China and in some cases, incrementally innovated upon. Fourth, an artificially low cost of capital in China helped facilitate government policy that obsessively promoted large investments in fixed-assets such as roads, bridges, and buildings, even if the demand to fill them might not come for years after construction.[7]

From an oil demand perspective, the confluence of the aforementioned factors yielded two distinct oil demand epochs, which overlapped in the mid-2000s. Diesel fuel, closely linked to industrial and construction activity, dominated Epoch 1. But diesel fuel demand has likely structurally peaked in China on the back of slowing industrial growth.[8]  Rising personal car sales beginning in 2005-2008 ushered in Epoch 2 of China’s oil demand expansion–the gasoline era. Epoch 2 continues, but gasoline demand growth is slowing more sharply than many experts have forecast over the past several years.[9] Consider that China’s passenger car fleet rose by 130% and gasoline demand by 50% between 2012 and 2018, but that with a 27% increase in the car fleet between 2016 and 2018, gasoline demand only rose by 6%.[10] … … …

***

Gabriel Collins, “Satellite-Based Radar Assesses CNPC Management of Crude Pipelines,” Oil & Gas Journal, 2 September 2019.

Oil inventories measured by satellite-based synthetic aperture radar can help market participants and policymakers more accurately assess how CNPC is managing the pipelines that carry crude oil into China from Kazakhstan, Myanmar, and Russia.

***

Andrew S. Erickson and Gabriel B. Collins, “China’s Rare Earth Dominance: How Usable a Weapon?” The National Interest, 6 June 2019.

It could provoke a response from Washington that Beijing does not want to see.

As Washington and Beijing brace for a protracted trade war, Chinese sources increasingly discuss the potential for weaponizing the Middle Kingdom’s major mineral advantage: rare earth elements (REE). Some link this impending “Battle of Rare Earths” (稀土之战) to the statements of Deng Xiaoping himself. Several things are already clear. China has long understood its REE preeminence and has sought to strengthen it. Beijing has leveraged it in recent years, and now threatens to do so again. But just how usable a weapon is China’s REE production preponderance and its current near-dominance in processing REE ores into finished metal?

China National Radio’s website shows a photo of “Deng noting in a speech he made January 1992 during his Southern Tour, ‘The Middle East has its oil, China has rare earths’ “中东有石油, 中国有稀土.’” Various sources quote Deng elaborating during a speech in Jiangxi, “China’s rare earth deposits account for 80 percent of identified global reserves, you can compare the status of these reserves to that of oil in the Middle East: it is of extremely important strategic significance; we must be sure to handle the rare earth issue properly and make the fullest use of our country’s advantage in rare earth resources.”

Now Beijing seeks to brandish that advantage for dramatic effect. On May 29, People’s Daily published a strident commentary declaring that “the U.S. wants to use the products made by China’s exported rare earths to suppress and counter China’s development. The Chinese people will never agree. At present, the United States completely overestimates its ability to manipulate the global supply chain….” Importantly, this authoritative publication states, “I advise the US side not to underestimate China’s ability to safeguard its own development rights and interests, don’t say I didn’t warn you!” (奉劝美方不要低估中方维护自身发展权益的能力,勿谓言之不预!).

This “rare Chinese phrase that means ‘don’t say I didn’t warn you’” is clearly deliberate and important. “The specific wording was used by the paper in 1962 before China went to war with India, and ‘those familiar with Chinese diplomatic language know the weight of this phrase,’ the Global Times, a newspaper affiliated with the Communist Party, said in an article last April. It was also used before conflict broke out between China and Vietnam in 1979.” As Bill Bishop emphasizes in his Sinocism newsletter, China also employed these warning words “before the Zhenbao Island Incident with the USSR in 1969.” An authoritative Xinhua commentary, republished by People’s Daily, adds: “if necessary, China has plenty of cards to play.”

So exactly what options does China have for potentially weaponizing its commodity advantage? In theory, Chinese mineral might is fearsome as Beijing is the world’s leading REE producer. Despite global consumers’ attempts to diversify supply sources, PRC suppliers remain the dominant players—particularly in the area of processing ores into actual usable materials. In fact, the sole American REE producer, MP Materials, sends REEs it mines in Mountain Pass, California, to China for processing. Moreover, Beijing guards this advantage jealously. As Australian industry advisor Dudley Kingsnorth puts it, “China and rare earths is a bit like France and wine—France will sell you the bottle of wine, but it doesn’t really want to sell you the grapes.”

Now, Beijing appears to be pressing this advantage, while Washington seeks to mitigate risks. China has already raised tariffs from 10 percent to 25 percent on REE ores that MP Materials sends to China for processing. Meanwhile, Washington has left REEs off the list of its next set of prospective tariffs covering roughly $300 billion in Chinese goods.

So far, however, this is still an initial posturing. How has Beijing wielded REEs as a tool of geoeconomic influence in the past, and how might it do so today?

The extant signature example came in the fall of 2010 when the Chinese government restricted exports of rare earths to Japan following Tokyo’s detention of a Chinese fishing boat captain after he collided with two Japan Coast Guard vessels near the disputed Senkaku Islands. China’s ban fanned fears of over-dependence on Chinese suppliers for critical commodity inputs. Yet the Japan REE embargo saga illustrates at least three factors that would seriously undermine a Chinese attempt to weaponize REEs against the United States.

First, a new attempt to wield REEs aggressively would turbocharge diversification measures. The 2010 embargo helped catalyze the restart of the Mountain Pass mine in California (one of the world’s largest rare earth deposits) and Lynas Corporation’s Mt. Weld operations in Australia. A 2019 REE embargo against the United States would not only reinforce the rationale for having mines outside of China, but perhaps more importantly, would dramatically strengthen the case for creating additional REE ore processing capacity outside of China. Some observers argue that China’s present processing preeminence locks in its strategic position in rare earths markets for “years” to come. Yet if Beijing weaponizes the minerals against American interests, this could galvanize and accelerate existing plans to build U.S.-based REE processing capacity.

Second, an REE embargo would reinforce the narrative that China-based commodity supply chains are inherently untrustworthy. This would not only reinforce REE supply diversification measures such as those described above, but could also prompt companies to re-think China-based sourcing more broadly. If a sufficient mass of foreign firms decided that sourcing higher-end products and critical input materials from China posed unacceptable risks, a rolling exodus of such operations would set back Beijing’s ability to realize many of its key industrial development objectives, such as moving higher up the global manufacturing value-added chain.

Third, an REE embargo could lead to much more damaging reciprocal American responses—such as more severe restrictions on the export of semiconductors and other critical technology subcomponents that many Chinese firms literally cannot survive without. China controls substantial parts of the global rare earths supply chain, but as described above, users can diversify their sources. They can also adapt their production processes to use less of the materials, incorporate alternatives, or prioritize some consumers—such as the defense sector—over others until alternative supplies become available.

In addition, an embargo would likely raise REE prices, which would give Chinese suppliers strong economic incentives to smuggle REEs into the market. Even if the metals were not sold “directly” to American customers, simply by making their way into the market at a premium price they would help ensure that necessary supplies are available. And the premium price would likely not be overly burdensome to manufacturers or the final consumers of REE-containing products. Whereas a motor vehicle literally contains hundreds of kilograms of steel, and is thus very exposed to changes in steel commodity prices and physical availability, REE are more like “vitamins of chemistry.” In other words, a product often cannot function without them, but a given phone, computer, etc., only needs a very small quantity to achieve its functionality goals.

An iPhone, for instance, may contain as little as one-fourth of a gram of rare earths. This means that for neodymium, one of the densest rare earths, a piece of metal the size of an easily smuggled Coca-Cola can would be sufficient to produce at least 10,000 iPhones. Thus, the effects of even significant price increases would be diluted by the rare earths’ small share of overall production materials input. This dynamic ultimately helps underpin market adaptability in the face of politically-motivated supply restrictions.

Now for the other side of this Sino-American trade war equation. In contrast to the dozens of China-based rare earth producers and refiners (and the attendant likelihood of embargo leakage), the highest-end semiconductors and semiconductor production equipment are controlled by a handful of firms that guard the intellectual property of their high-added-value products jealously. These are predominantly domiciled either in the United States, Western Europe, or close U.S. allies in Asia such as Japan and South Korea. Such high concentration and political alignment would likely make enforcement of tighter restrictions highly feasible. And without certain levels of chip performance, many tech products will either perform at a much lower level—or in some cases, not work at all. In other words, semiconductors are generally much less fungible than are rare earths.

And so, China would also find itself on the wrong end of the adaptation timeframe. As one former rare earths trader puts it in a recent interview with The Verge: “Producing rare earth concentrate is near trivially simple…I, or any other competent person, could produce that from a standing start within six months in any volume required.” During a crisis, even an intensely regulated jurisdiction such as the United States could find ways to override the environmental hurdles that currently dis-incentivize domestic rare earth ore refining. But while customers of Chinese rare earths could likely adapt, draw down inventories, and source and process rare earths using alternative channels, Chinese firms reliant on imported semiconductors would face a much longer, harder, and uncertain adaptation slog. Jay Huang Jie, a former Intel Managing Director in China, noted that if China seeks to build its own chip industry, it “…should be prepared for a marathon of at least a decade, which will also be loss-making [along the way].”

During those ten years, it is also possible that foreign firms could further extend their technological lead over China’s homegrown champions, especially if the negative effects of a technological “bamboo curtain” fell disproportionately on China’s semiconductor sector. The impacts of falling further behind and having to settle for “good enough” technology goods would be momentous. As one of the authors said recently, “Technology is a …‘winner take all’ world…The country (or company) that establishes technological dominance does not just get the prime corner of the sandbox. It also determines the box’s shape, the type of sand and, at a basic level, the terms that others must meet if they wish to enter the box and play.”

The bottom line is that the risk of a potential Chinese rare earth export embargo directed against the United States should be taken seriously. But the collateral consequences for China are underappreciated and could be far more dire than any impacts visited upon the U.S. side. China is either bluffing or has not fully factored in the downsides it faces, were it to impose such an embargo. China’s REE weapon is a crude weapon to detonate at best, with the self-inflicted fallout likely prohibitively harmful to the country’s economic well-being.

Dr. Andrew S. Erickson is a professor of strategy in the China Maritime Studies Institute and the recipient of the  inaugural  Civilian Faculty Research Excellence Award  at the Naval War College. He is currently a visiting scholar at Harvard University’s John King Fairbank Center for Chinese Studies. He received his Ph.D. from Princeton University and blogs at  www.andrewerickson.com.

Mr. Gabe Collins is the Baker Botts Fellow in Energy & Environmental Regulatory Affairs at Rice University’s Baker Institute for Public Policy.

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Gabriel Collins, “Low-Speed Electric Vehicles: An Underappreciated Threat to Gasoline Demand in China and Global Oil Prices?” Issue brief no. 05.15.19 (Houston, TX: Baker Institute for Public Policy, 15 May 2019).

“If nonconsumers choose an EV as their first car, there is a good chance they will stay electric for the long term, which eliminates a source of gasoline demand growth that otherwise would have occurred if they had instead upgraded to a gasoline-powered car.”

The rising use of low-speed electric vehicles (LSEVs) in China may have a dramatic effect on local gasoline demand and therefore global oil prices, writes energy fellow Gabriel Collins.

Disruptive innovation is typically a Silicon Valley buzzword and not one commonly associated with discussions of gasoline markets.1 Yet the past several years in China have seen the emergence of a potential disruptor: low-speed electric vehicles (LSEVs or 低速电动车). These little vehicles typically lack the aesthetic appeal of a Tesla, but they protect drivers from the elements better than a motorcycle, are faster than a bicycle or e-bike, are easy to park and charge, and perhaps most endearing to emerging consumers, can be purchased for as little as $3,000 (and in some cases, less).2 In light of China’s importance to global oil markets, this analysis explores the role LSEVs could play in reducing the country’s gasoline demand growth.

The International Energy Agency (IEA) estimated China’s LSEV fleet at 4 million vehicles as of midyear 2018.3 While small, this already equals about 2% of China’s passenger cars. LSEV sales in China appear to have slowed in 2018, but LSEV manufacturers still sold nearly 1.5 million vehicles, roughly 30% more units than conventional electric vehicle (EV) makers did.4 Depending on how proposed government regulations of the sector unfold in 2019 and beyond, sales could rise significantly as LSEVs penetrate deeper into lower-tier markets where motorcycles and bicycles remain the prevalent means of transport, as well as into the increasingly crowded urban areas where space is at a premium and many residents still cannot afford larger vehicles (Figure 1).

China’s LSEV makers are producing potentially momentous changes on at least two accounts. First, as Chadresekar Iyer of Tata Consultancy Services puts it, their primary market is the “nonconsumer” of cars—the “people in rural China who have never owned one” and who value affordability, accessibility, and simplicity first and foremost.5 China’s rural population exceeded 550 million people last year (roughly the combined populations of the U.S. and Brazil), many of whom do not yet own a four-wheeled personal vehicle.

If nonconsumers choose an EV as their first car, there is a good chance they will stay electric for the long term, which eliminates a source of gasoline demand growth that otherwise would have occurred if they had instead upgraded to a gasoline-powered car. LSEVs also have the benefit of being able to charge from home electrical outlets, eliminating the need to use gas stations that may be far away, as well as the need to invest in the expensive specialty home chargers that larger EVs with higher capacity lithium ion batteries generally require.

LSEVs have only been sold at scale— meaning 1 million plus units per year—for a few years, so it is not yet clear whether their owners will eventually upgrade to larger vehicles that use gasoline. But if these golf-cart-sized machines help condition their owners to prefer electric propulsion and become an item that consumers stick with long-term, the gasoline demand consequences could be significant. When consumers step up from motorcycles to a gasoline-powered car, their personal oil usage will likely jump by nearly an order of magnitude or more. For those who use bicycles or e-bikes, the jump in personal petroleum consumption would be even more significant (Figure 2). … … …

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Gabriel Collins, “China’s Gasoline Demand Growth: Is Recent Deceleration Near-Term Noise or Early Stages of a Structural Shift?” Baker Institute Research Presentation, March 2019.

Executive Summary

  • China’s gasoline demand growth rate has slowed markedly in the past 3 years despite continued robust car fleet growth and appears likely to plateau sooner than expected—perhaps within the next 2-3 years.
  • The core story is not about gasoline demand growth being “rolled back”—rather, it is about a contest between drivers’ desires and local and national level policy imperatives.
  • Several potential high-level explanations co-exist: (1) incremental gasoline demand growth potential being lost due to slowing or declining vehicle utilization; (2) incremental gasoline demand being captured by electrical vehicles and alternative fuels such as methanol; and (3) greater use of vehicle sharing services that “consolidates” gasoline demand into a subset of more efficient vehicles.
  • Factors 2 and 3 are direct products of central and local government policies—such as restrictions on license plate issuance and local policies that promote methanol as a vehicle fuel. Restrictions on car ownership that impose steep financial costs and in some cases make it administratively impractical to own a personal car (for instance due to years’ long waits to get a license plate) also help increase the attractiveness of car sharing ride services. Such hindrances may also stimulate greater use of public transport.
  • Finally, the increasing penetration of small and micro electric vehicles into lower-tier cities and the rural market may curtail gasoline demand growth that would have otherwise originated from those areas. In some instances, drivers who might have bought a used gasoline vehicle for their first car may instead buy small, cheaper electric vehicles. If these new drivers did not already have deeply held preferences for internal-combustion cars, they will likely stay electric for the remainder of their driving lives, thus permanently foreclosing potential gasoline demand.

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Gabriel Collins, “China’s Oil-Backed Loans to Venezuela Appear Headed for a Haircut,” The National Interest, 10 February 2019.

Venezuela is now gripped by an acute political crisis as President Juan Guaidó’s government—officially recognized by the United States, most of the European Union, and many of Venezuela’s neighbors—vies for power with the regime of Nicolas Maduro. This raises questions for Chinese creditors, who likely now wonder how a new Venezuelan government might treat the large oil-backed debts owed to Chinese lenders.

In theory, Venezuela’s massive oil resources offer ample support for at least $50 billion in loans that China has provided since 2007, perhaps $20-to-$25 billion of which remain outstanding. Yet for Chinese lenders exposed to Venezuela’s chaos, the country’s oil shows itself to be an increasingly illusory underpinning for the loans. The situation is becoming a classic example of “geoeconomics gone wrong” and highlights the reality that even large money outlays often fail to purchase lasting strategic influence in chaotic places. To the contrary, such influence is, at best, temporarily “rented” and can be rapidly degraded, if not outright destroyed, by events beyond the lender’s control. Venezuela’s current situation provides a dose of sober reality for Beijing’s Belt and Road Initiative, for which large-scale strategic financing from China’s parastatal lenders are a central element.

Exhibit 1: The Risks to Creditors of Venezuela’s Politically-Driven Oil Production Decline Were Initially Masked by High Commodity Prices

Source: Bloomberg, EIA, Author’s Analysis

Oil-backed loans to Venezuela from the China Development Bank (CDB) generally use the following repayment structure: first, state oil company Petróleos de Venezuela (PDVSA) sells oil to Chinese oil companies at prevailing market prices; second, the Chinese oil buyers pay the purchase money for those oil cargoes into an account controlled by CDB; and third, CDB retains the amount needed to service the loan. … … …

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Gabriel Collins and Elsie Hung, “Using Satellite Data to Crack the Great Wall of Secrecy Around China’s Internal Oil Flows,” Baker Institute Report no. 09.07.18 (Houston, TX: Baker Institute for Public Policy, 7 September 2018).

Comprehensive, reliable, and publicly available data on China’s domestic oil flows and inventory movements are essentially inaccessible. In this report, the authors propose creating a forum to collect and analyze satellite data to shed more light on the inner workings of China’s oil sector.

China’s heft in the global crude oil market exerts profound global effects across the energy, environmental, and human well- being dimensions. Yet comprehensive, high-frequency, reliable, and publicly available data on China’s domestic oil flows and inventory movements are essentially inaccessible. In particular, for on-the- ground primary commercial intelligence collection, such as that performed by Genscape and other independent analytical companies in the U.S. market, China’s oil sector is effectively a “denied area.”

This is not because the data themselves do not exist or aren’t being collected. Rather, it is a challenge at its core rooted in:

  1. the Chinese government’s obsession with secrecy and maximum control of information; and
  2. data costs. The prime purveyors of insights derived from satellite imagery are generally startups that must first answer to investors seeking returns and are thus often economically constrained from sharing data at a price point low enough to allow large-scale analysis of China’s energy sector by academic parties and various NGOs.

Many of the puzzle pieces already exist for high-quality public domain analysis of oil sector flows in China. For instance, the Joint Organisations Data Initiative (JODI) publishes monthly data for estimated oil flows and refined product usage in China, albeit with several months of delay and without specifying flow data by location, a potentially critical omission. The Global Energy Observatory project offers limited data on part of China’s oil refinery fleet and the country’s main oil ports.1 TankerTrackers offers insights into various global seaborne oil flows.2

However, the specific oil storage data and other information that would improve analysts’ ability to ascertain flow patterns within China are not disclosed by the Chinese government in a regular and comprehensive fashion, leaving analysts to try and piece together numerous missing pieces of a very large and complex oil puzzle. In response to this globally important omission, we propose creating a forum to more systematically collect and analyze satellite data capable of shedding more light on the inner workings of China’s oil sector. Such imagery can be fused with other data sources and cross-analyzed, with the aim of yielding a level of insight into China’s oil inventory and flow dynamics that would be exponentially deeper than the current general state of knowledge. … … …

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Gabriel Collins, “Brains vs. Grains: U.S. Technological Leadership Faces a Stiff Challenge as Competition with China Heats Up,” Issue Brief  (Houston, TX: Rice University’s Baker Institute for Public Policy, 25 June 2018).

As the competition between the U.S. and China intensifies, energy fellow Gabriel Collins calls for U.S. leadership in a technology race that will determine global influence for decades to come.

The intense US focus on trade deficit reductions during recent negotiations with China brings to mind a vivid and appropriate Chinese idiom: “grasping the sesame seeds while dropping the watermelon” (捡了芝麻丢了西瓜). A core US position to date—expressed after meetings in May 2018 between the Trump administration and a Chinese delegation led by Liu He, the special envoy of China’s President Xi Jinping—emphasizes “meaningful increases in United States agriculture and energy exports” to China.1 There is an increasing risk that as the trade conflict ramps up, the administration will back down from its tough recent rhetoric and instead settle for a mercantilistic deal under which China agrees to imports more US goods and services. Such an outcome would prioritize small, near-term domestic political gains while failing to appropriately position US policy for a technology race that will determine global influence for decades to come.

Natural resource businesses centered on the production and sale of fungible commodities such as corn and oil are fundamentally cost-based. The party who can produce the most volume at the lowest price gets the best and biggest corner of the sandbox. The corollary, however, is there is still a lot of sandbox left for participants higher up the cost curve to vie for market share.

Think of Saudi Arabia’s role in the oil market versus that of the Russians, US shale drillers, Canadians, and more than two dozen other producers and you’ll start to get the picture. Saudi Aramco can supply up to 12 million barrels of oil per day (bpd) into a market requiring slightly less than 100 million bpd. This is a big share by any measure, but one that leaves approximately 85 million more bpd of required volume that other producers can compete to supply.

Technology is a much more “winner take all” world, highlighting the differences between cost advantage—which is crucial in commodity markets—and technological dominance. The country (or company) that establishes technological dominance does not just get the prime corner of the sandbox. It also determines the box’s shape, the type of sand and, at a basic level, the terms that others must meet if they wish to enter the box and play. … … …

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Morgan Clemens, Gabriel B. Collins, and Kristen Gunness, “The Type 054/054A Frigate Series: China’s Most Produced and Deployed Large Modern Surface Combatant,” China SignPost™ (洞察中国) 93 (2 August 2015).

Executive Summary and Key Points

This report discusses the evolution of the Type 054/054A frigates (FFGs) by examining their roles and missions, research, development, and acquisition, and design process to include foreign assistance that Chinese shipbuilders received on various systems, components, and weapons. We also discuss procurement practices and provide a cost model for the ship, as well as examine implications for future development.

  • China has commissioned 19 Type 054A Jiangkai-II class frigates to-date, and is working on at least four additional vessels. China’s total production of Type 054, 054A, and 054B/other follow on frigates could ultimately exceed 30 vessels.
  • The lack of reporting to date in Chinese or foreign sources regarding engine failures or other major mechanical problems suggests that the Type 054A has recorded decent operational reliability in the six and a half years (and counting) that the People’s Liberation Army Navy (PLAN) has maintained its Gulf of Aden anti-piracy mission.
  • While the Type 054A represents an exponential improvement in the quality and capability of the PLAN’s frigate force, it nonetheless remains a distinctly limited design, certainly in terms of its size and armament but most especially in terms of its electronics outfit. The Chinese appear to recognize this fact and view the 054A as an intermediary design intended to play a specific, limited role in fleet defense.
  • Notwithstanding its physical shortcomings, the Type 054A has performed well handling lower intensity long-range mission In this regard, it has arguably surpassed the capabilities of the French Lafayette-class frigate that influenced its original design. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Peaking Prematurely? China Commodity Peaks May Emerge Sooner Than Expected,” China SignPost™ (洞察中国) 92 (27 July 2015).

CSP 92 main image_Ghost-town-Bodie-California-73

Peak China? Not yet. Peak Party? No. Peaks in demand for, and production of, specific commodities? You bet! Here’s our take…

For much of the period since 2000, China-centric commodity analysis focused like a laser on growth. Now the commodity bulls’ horns are being trimmed and the China commodity bears are growling with increasing ferocity. Indeed, the late July heat is re-awakening fears of another market downdraft like we saw earlier this month. On Monday, 27 July 2015, crude oil prices and the U.S. Dow Jones Industrial Average came under significant pressure, in no small part due to investor fears sparked by a continuing stream of negative data points from China.

The markets are cycling into a new paradigm characterized by pockets of peak demand and pockets of significant upside opportunity. To us, the shift deserves classification as a clear, multi-year theme—hence this SignPost. China remains the world’s fastest-growing multi-trillion dollar economy, but its rate of growth is slowing undeniably. Accordingly, China-driven demand has peaked—or is currently peaking—for several large, globally traded commodities to which millions of investors and at least hundreds of billions of USD in capital are exposed. As we churn through this new, volatile world, our focus will be on steel and iron ore, coal, crude oil, passenger cars, and several other commodities and related items to be determined as our analysis unfolds.

For a snapshot of how profoundly China’s rise has driven global commodity demand, consider the steel market. Here, China accounted for 35.8% of the increase in global demand between 1992 and 2000, 62.0% of the demand increase between 2000 and 2007, and a whopping 98.3% of the net global demand increase between 2007 and 2014 (Exhibit 1). Between 2007 and 2014, steel demand actually fell in the OECD and economically advanced countries, leaving China as the prime mover behind the entire global steel and related raw materials market—including the seaborne iron ore boom which marked that period. While the percentages vary, the concept of China becoming an ever-larger driver of marginal demand (and higher pricing) repeated itself across numerous raw materials markets during the last 15 years.

Exhibit 1: China as a Percentage of Total Global Steel Demand Growth, 1992-2014

CSP 92_China as percentage of global steel demand_1992 thru 2014

Sources: World Steel Institute, China SignPost analysis

We started to have our doubts about the sustainability of China’s nearly hyperbolic growth trajectory in the summer of 2011. Please see 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). In our view—despite some recent speculation that we believe exceeds available, reliable data—there is no compelling evidence to date suggesting that Peak China or Peak Party lie in the near future. Instead, peaks in specific commodity areas are coming into view, with significant implications for China’s internal development and external impact alike. Indeed, the speed of the real economy slowdown over the past 12 months has been profound. For evidence, one need look no further than the rapid softening of numerous global commodity markets, especially materials such as crude oil and coal that were fueled by China’s ravenous appetite for imported resources. This offers insights into important aspects of China’s economic trajectory: specific commodity statistics are generally more reliable than Beijing’s official aggregate economic figures.

Through the rest of the summer and likely into the fall and winter, we will therefore release a number of analyses focusing on commodity classes where China’s demand has peaked, is peaking now, or is likely to peak/plateau sooner than commonly expected. First up: crude oil. On July 7, The Diplomat published a Feature piece written by Gabe Collins on China’s peaking domestic crude oil production, how the sector is evolving, and what potential global oil market impacts will arise from a peak or plateau of crude oil production in China, the world’s fifth-largest producer.

Structural factors drive the existing slowdown in China’s demand for many key raw materials. Now, the stock market crash, destruction of several trillion dollars in wealth, and erosion of investors’ confidence in Beijing’s ability to steer the market are adding additional bearish factors. Losses of confidence can cripple markets in ways that take years to recover from. And in China’s case, recent events risk catalyzing bricks and mortar demand slowdowns that bring peak consumption of certain commodities sooner than consensus estimates anticipated. Those are the emerging peaks to be scanning the horizon for, and so we shall—expect more research soon!

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Gabriel B. Collins and Andrew S. Erickson, “Djibouti Likely to Become China’s First Indian Ocean Outpost,” China SignPost™ (洞察中国) 91 (11 July 2015).

Chinese bab-al-mandeb region image

China is now laying the diplomatic and legal foundations for a long-term naval presence in Djibouti, with a range of recent media reports alleging that Beijing is negotiating for naval access in the country. The facilities would likely be located at Obock, on Djibouti’s northern coast (Exhibit 1). While China will not formally call the facilities a “base” anytime soon, it will likely function in a manner that brings it awfully close to being one in all but name.

Durable access to facilities in Djibouti that can be easily improved by Chinese construction firms would give China a formidable—and more permanent—maritime and potentially aerial springboard deep into the Northwestern Indian Ocean Region, as well as North, East, and Central Africa. The black circle in Exhibit 1 shows the territory lying within a 2,500 km radius of Djibouti—a conservative estimate of the rough distance a Shaanxi Y-8 class maritime patrol aircraft would be able to cover without aerial refueling.

Exhibit 1: Djibouti’s Strategic Position in the Indian Ocean Region

CSP 91_Map 1_Djibouti

Source: GADM, Authors’ analysis

The idea of more enduring Chinese military presence in Djibouti has clearly advanced far beyond the realm of speculation, and is now approaching the stages of signing paper, moving assets, and potentially soon pouring concrete. Negotiations appear well underway. Even more definitive than Djibouti President Ismail Guelleh’s direct statements to Western media that his government has been negotiating with China to establish a Chinese facility is the excerpt below from the interview he granted to Saudi-owned newspaper Al-Hayahon 1 June 2015:

Q: You have a U.S. base, another French base, and a Japanese base. I think that a Chinese base will be opened soon. What if Iran proposed to you the opening of a base for it in Djibouti?… Have the military bases benefited Djibouti?
Guelleh: Yes, a great deal…. We will now sign an agreement with China. We are bound by strong ties with them [the Chinese].
Q: When will the Chinese base start working?
Guelleh: Perhaps we will sign the agreement officially after two weeks.
Q: And what if India requested a base for it[self]?
Guelleh: We have no intention of approving the opening of other bases. That is enough.

Djibouti has been a critical cog in the PLAN’s now 78-month long anti-piracy deployment off the Horn of Africa. Chinese naval vessels have reportedly visited the port more than 50 times since the mission began in December 2008. China cemented the diplomatic foundation for basing with a February 2014 meeting between President Guelleh and General Chang Wanquan, after which the two countries signed a defense and security pact.

Since then, the “strong ties” that Guelleh stresses have continued to develop, and furthered both sides’ interests. On 1 July 2015, the Information Agency of Djibouti reported proudly, Xi Jinping sent best wishes for the country’s National Day and praised the “development of China-Djibouti relations.” Beyond the two countries’ growing economic cooperation, which includes major Chinese infrastructure investment in Djibouti, the Red Sea nation is beginning to receive technological blandishments from Beijing. On 18 June 2014, the Djiboutian Air Force received a MA-60 transport aircraft. During Djibouti’s 27 June 2015 Independence Day parade, its armed forces displayed aNorinco WMA301 Assaulter tank destroyer.

To seal matters from the Chinese side, a strong domestic legal framework now sits atop the robust pre-existing diplomatic ties. China’s National People’s Congress in May 2015 laid the foundation for the military to claim that long-range overseas missions are a legally recognized operational mandate. Specifically, Clauses 28 and 30 of the new National Security Law (国家安全法) call for the protection of strategic energy supply channels, PRC citizens abroad, and other external interests.

The timing—and Beijing’s refusal to deny reports of a pending grant of basing access—are striking, particularly since the Somali pirate threat used to justify the deployment in the first place has dwindled over the past year. In a complete lack of a denial and indeed in theory a possible trial balloon of sorts, China Daily’s U.S. edition reported on 26 May, “Earlier this month, foreign media reported that China was building a permanent military base in the African country of Djibouti.” Evidence increasingly suggests Beijing intends to maintain a forward naval presence even if the risk of pirate attacks withers away. Having forward-deployed naval assets in a volatile and strategically vital region is simply too useful a capability to relinquish, as amply demonstrated by non-combatant evacuation operations from Libya in 2011 and Yemen in 2015 that each utilized warships dispatched from the PLAN’s Gulf of Aden task force.

Why Djibouti?

Chinese naval forces have increased their port call tempo across the Indian Ocean region in recent years, visiting Salalah, Oman and Djibouti more than 20 times apiece and visiting Pakistan, Myanmar, Burma, and Singapore multiple times as well. So, with such a plethora of options, why the focus on Djibouti? Below we outline several of the most important factors and offer a map illustrating Djibouti’s proximity to a number of regions that are of rising strategic interest to China.

First, geography. Djibouti offers unparalleled access to the Gulf of Aden and sits astride the strategic Bab al-Mandeb, a key global maritime energy transport artery that moved 3.8 million barrels per day of crude oil in 2013, according to the EIA, making it the world’s 4th busiest maritime energy chokepoint. It also offers an entry point into the Arabian Peninsula, the northwestern Indian Ocean, and a fair-sized chunk of Eastern and North-Central Africa. Furthermore, it is located only a few days’ sail from the Eastern Mediterranean.

Second, it’s the most secure and politically stable location near the largest number of key maritime and terrestrial interests China has in the region. We draw this somewhat semantically-heavy distinction because Singapore is obviously highly secure and stable, but it is also located too far away from the PLAN’s new forward operating areas in the Northwest Indian Ocean Region to be operationally useful in that regard. The primary contenders among current ports are Djibouti (i.e., at Obock), Aden, Salalah, Karachi, and Gwadar. Down the road, Bagamoyo (Tanzania) and Mombasa could enter the mix.

Yemen is a dangerous port area—especially with the current complex violence rending the country. But even before the contemporary cataclysm, Yemen had a bad history. The USS Cole attack in 2001 and the October 2002 attack on the supertanker Limburg almost certainly cooled Chinese naval planners’ willingness to risk using Aden as a resupply port. Pakistan also poses serious security challenges, particularly if China aspires to heavily utilize Gwadar, which sits near the core areas of a decades-long Balochi insurgency that has even claimed Chinese workers’ lives in the past 15 years. And with respect to Karachi, there is a crowded port to deal with, as well as a teeming and increasingly violent city that the PLAN likely does not want its sailors venturing into. Finally, Karachi is sufficiently far from major Indian Ocean transit routes as to impose extra sailing distance with its use.

Against this baseline, Djibouti would be an attractive basing location even if it were not as stable and secure as it in fact is. The tiny country has for more than a decade hosted thousands of French, U.S., and Japanese personnel who (especially the Americans) have been actively operating and even conducting kinetic strikes (drone missions) originating in Djibouti. Yet there have been no significant publicly disclosed security incidents. Democracy activists would certainly prefer to see President Guelleh loosen his grip on power, but the country’s population has been pacific for years and nothing appears poised to destabilize things in the foreseeable future. In the region, this is about the best political set up once can ask for. It is made all the better by the fact that the bases are largely self-contained, thus avoiding problems triggered by soldier misbehavior off base, but the bases inject enough money into the local economy that local officials (and probably a decent number of residents) are happy to host them. In addition, the military presence enhances Djibouti’s value as an East African entrepôt because pirates or dangerous neighbors (think Houthi rebels from Yemen) will shy away from operating near such a formidable concentration of military capability. Locals engaged in trade will appreciate this military umbrella.

Third, it offers the facilities and draft to accommodate any PLAN vessel in service now or in the foreseeable future. China’s largest forward-deploying warship at present, the Type 071 LPD, draws seven meters of water. Djibouti’s existing port can accommodate vessels drawing 18 meters. This is deep enough that it could even physically accommodate the entry of an aircraft carrier into the port. When China might in fact conduct such as mission remains unclear, but the physical capacity to accommodate this large a ship exists now at Djibouti’s existing port.

Fourth, it fits into the known Chinese strategic thought about how to go about creating an Indian Ocean supply and support network. PLAN scholar Jing Aimingprovides a useful framework through which to examine the PLAN’s thought on creating more permanent access points in the Indian Ocean Region.

Presumably bearing such fundamentals in mind, Jing offers a three-level typology of possible locations. The lowest-level entry points, in Tier 1, would allow refueling and supply, as well as commercial transactions. Leading candidates include Obock, Djibouti and Port Salalah, Oman. Jing also mentions Aden, Yemen—a location previously running some distance behind them in third place, but no longer in the running given Yemen’s civil war.

The next level up, Tier 2, would support fixed schedules of PLAN ship supply, air-based reconnaissance and platform replenishment, and crew rest. Jing deems Port Victoria, Seychelles the archetypal candidate in this regard. It clearly meets the political stability and support requirement. China has long pursued development finance projects in Seychelles. In 2011, Seychelles offered China an anti-piracy supply port arrangement. In March 2012, China announced plans to establish a presence in the Seychelles to support its anti-piracy mission. In May 2012, the two countries concluded an agreement (apparently still unused) allowing the PLAN to transfer detained pirates to Seychelles. In July 2013, the two sides signed various bilateral cooperation agreements. Less certain is Seychelles infrastructure potential and ability to support robust basing without becoming overwhelmed environmentally and socially. Such factors have reportedly limited the scope of U.S. access there to low-profile drone basing. But an informal Chinese “place” might be possible there, and preexisting U.S. entrée could make China appear less unilateral in pursuing it.

The highest level, Tier 3, begins to look a bit more like what the U.S. would at least term a “place” if not a full-fledged “base.” Jing envisions long-term, bilateral contractual agreements that enable more comprehensive supply, replenishment, crew rest, reorganization, possibly large-scale and even weaponry repair. Karachi, Pakistan, with some of the region’s stronger ship repair facilities, is the leading candidate for such a facility.

Jing’s analysis contemplates that within a decade, the PLAN could create modal supply network with a North/west Indian Ocean replenishment line incorporating ports in the Middle East as well as northern and eastern Africa and Central and southern lines relying on the Seychelles and Madagascar. Comprehensive access networks that effectively grid out the Indian Ocean region for the PLAN exist only in strategists’ minds at present. However, current events on the ground suggest such opinions should be viewed more seriously than would have been the case even five years ago. Analysts and policymakers should recognize that candidate ports’ positions in the Tiers ranking are not static. For instance, civil war in a country takes its ports off the list, but a change in Beijing’s strategic thinking, coupled with a receptive host government willing to allow Chinese investment in port facility upgrades could cause a port to rapidly jump to Tier 2 or even Tier 3 status within as little as 2-3 years.

China appears likely to fortify its presence in the IOR, but what form might this take in practice? Using a deductive approach, it is possible to imagine the possibilities. One possible answer lies in a network of “support points” with a hierarchical division of labor. Within a decade, Jing believes, China might develop a nodal network system in the IOR. He envisions two principal vectors: North/west Indian Ocean replenishment lines incorporating ports in the Middle East as well as northern and eastern Africa; and central and southern lines relying on the Seychelles and Madagascar. From a deductive perspective, it is useful to consider Jing’s vision and how it might play out in practice.

Criteria for effective locations include host nation political stability and support, favorable geography, adequate infrastructure, and port characteristics (primarily deep draft sufficient to accommodate most if not all naval ships).

To assess China’s IOR access prospects (and thereby test Jing’s vision), it is important to “follow the dragon tracks” and look inductively at what actions China has actually taken to date. Layering port characteristics and Chinese actions therein suggests that Obock, Djibouti and Port Salalah, Oman are the frontrunners to become “1st tier” support points by far. Both meet key criteria for basing desirability. They are located in resource-limited oases of stability in geopolitically complex regions. Their governments seek economic and political benefits by cultivating positive strategic relations with diverse outside powers. The ports offer the deepest draft of China’s regional options (18 m and 17.5 m respectively). Not surprisingly, then, they have received the most PLAN port calls (>20 each since 2009). But, as explained above, Djibouti appears to have pulled into the lead for more formally supporting the PLAN in the Indian Ocean Region. And it appears that it will do so from the port of Obock.

A Bit About Obock

Among the few candidate locations in Djibouti, Obock offers perhaps the best potential for the seclusion and expansion that China doubtless seeks, while simultaneously offering the host country the chance to develop and monetize a fallow backwater. At the current time, Obock is essentially a small fishing village, albeit one that with a few years of Chinese-led infrastructure investment could become an excellent military support facility. The authors have not yet been able to locate definitive data on Obock Port’s current draft limitations, but an analysis of overhead imagery suggests there is a deep natural channel entering the port from the south. Chinese engineering firms are clearly adept at rapidly dredging deep draft ports, as evidenced by China Communications Construction Company’s creation of more than three square miles of reclaimed land in the South China Sea in recent months.

Obock also would give the Chinese military a relatively “exclusive” operating area. Pan Chunming, deputy director of an SSF political division has noted that “Once we coordinated with a foreign port to berth for three days. However, the port later only allowed us to stay for one day, because a Japanese ship was coming.” Pan was almost certainly referring to Djibouti and his statement highlights the need for proprietary access point real estate—especially when China would be sharing access to Djibouti with other militaries that, in the case of the U.S. or Japan, are potential adversaries. The area’s relative isolation and space to accommodate an airfield with large runways also would provide a number of other strategic advantages.

First, Djibouti is a useful muster and temporary refuge point for noncombatant evacuation operations (NEO) operations aimed at evacuating Chinese citizens from various conflict zones in Northern and Eastern Africa, as well as the Arabian Peninsula and broader Middle East. Indeed, the spring 2015 evacuation of Chinese from Yemen used Djibouti as a drop-off location. On 30 March 2015, PRC Foreign Ministry spokeswoman Hua Chunying acknowledged the country’s reliability, saying “relevant parties in… Djibouti have provided great assistance, to which the Chinese side expresses sincere appreciation.”

Second, if China ever needed to conduct other, possibly more covert types of operations, Obock would be a useful base for this once it includes an airfield capable of accommodating IL-76/Y-20 class aircraft that could move substantial quantities of equipment and personnel. It is located within the un-refueled flight range of an IL-76 taking off from airbases in southern Xinjiang carrying a 40 tonne payload. The large transports can land there, and because it is surrounded by barren desert and separated from the other countries’ Djiboutian bases by the Gulf of Tadjoura, it is reasonably well protected from prying eyes, particularly if aircraft land under the cover of darkness. Access to Djibouti does not mean China can or will conduct these types of missions, but having dependable, high-capacity forward basing access would be an essential pre-requisite for Chinese special operations in Africa and the Arabian Peninsula, should such contingencies ever arise.

Should Outside Observers Be Surprised by Greater Chinese Military Access to Djibouti?

In a word, no. Evidence points increasingly to a more permanent PLAN presence in the country. China and Djibouti both have powerful strategic motivations for deepening their relationship to include a more permanent Chinese military presence in the country.

For its part, the Djiboutian government has become a virtual “basing rentier state.” The country’s economy is tiny, generating approximately US$1.6 billion in GDP for 2014. As such, the total economic output generated by French, U.S., and Japanese military facilities (through rentals, local procurement, etc.) offers an enormous boost to the country’s formerly port and service-based economic structure. Under these conditions, a Chinese naval facility, particularly one that comes with major construction investment, facility improvements, and financial sweeteners, is almost irresistible because it would be another large shot in the arm for the local economy.

A greater and more formalized Chinese presence also offers useful political and diplomatic diversification to Djibouti’s leader. Guelleh will be less beholden to U.S. and French political and military influence if he has the option of playing the Chinese card during tough negotiations or situations. It also boosts Guelleh’s prestige by allowing him to claim that he hosts bases by the two largest economies on earth, as well as two other G7 countries. Moreover, the diverse foreign military presence offers a superb insurance policy to Djibouti, which inhabits a tough neighborhood whose security tectonics can rapidly shift, as we have seen in the past year with Saudi Arabia and Iran fighting a proxy war in Yemen. Few parties—state or non-state—wish to infringe upon a country which is important to the national interests of both the U.S. and China. Allowing China quasi-basing access hammers that point home with the stroke of a pen, the pouring of some concrete, and the docking of a PLAN ship or two in Obock.

Finally, the Chinese military has filled the last decade with hardware and posture developments that surprised many external analysts and materially improved the country’s military capability. The emergence of the Yuan-class submarine, the J-20 fighter, the J-31 fighter, the anti-ship ballistic missile (ASBM), and the decision to engage in South China Sea land reclamation operations offer illuminating examples. Given the magnitude of the aforementioned developments, gaining more permanent access to facilities in Djibouti capable of supporting forward-operating military forces would not be a surprise at all. And in the wake of the data and insights collated by this analysis, it should not be a surprise.

What To Expect Moving Forward From China’s Presence in Djibouti

China has found its forward-deployed anti-piracy force incredibly useful. Besides suppressing piracy, it has rescued Chinese non-combatants from Libya and Yemen and helped escort multiple shipments of Syrian chemical weapons headed to be destroyed. It has also been a great opportunity to show the flag, exert influence, and allow legions of sailors to gain real operational experience.

Alas for China, the time in which it can use the Somali pirate threat as a cloak for forward deploying naval forces is likely coming to a close. As such, Beijing must decide whether it will pull back or instead more openly seek to maintain a permanent military presence in the region. So far, in keeping with China’s overall maritime goals and progress, all the signs point to the latter.

The PLAN’s operating experience to date in the Indian Ocean region highlights the force’s need for robust formal access points. Enhancing forward presence is essential to increasing PLAN deployed presence overseas. Otherwise, even with significant fleet growth, the operational tempo (OPTEMPO) math simply doesn’t work. A forward presence will be essential for safeguarding core Chinese national interests, foremost among the seaborne energy security. China will continue to develop overland pipelines but with limited capacity they likely cannot reduce demand for seaborne crude oil. Pipelines are also highly vulnerable to single-point disruptions and interdiction.

Interposing these factors and viewing them holistically suggests that the PLAN needs long-term, cost-effective IOR presence solution. Emerging IOR overseas access architecture will be an important bellwether of China’s plans for distant operations, and indeed, of its naval strategic intentions more broadly. Access points—including Obock—will probably remain limited in capabilities. Likely to be included: refueling, replenishment, crew rest, low-level maintenance. Less likely to be found at foreign access points: repair, rearmament capabilities.

At this point, the permanent access matters much more than the specific capabilities. A Chinese decision to seek more permanent operational access—and a host country’s decision to grant such access—represent monumental leaps for Chinese diplomatic and military policy. China has for decades proudly proclaimed its lack of military facilities on foreign soil, so seeking long-term military access at a quasi-base level is a massive about face. With long-term PLAN access to Obock likely coming soon, China is poised to cross the rubicon. Djibouti is thereby helping to catalyze a potentially significant symbolic and substantive shift in China’s foreign security policy.

China is not seeking to build a foreign base network capable of supporting high-end naval combat the way the U.S. has. But, for now at least, it need not take that path in order to achieve its strategic goals. More permanently deploying warships, and potentially aircraft, in the Indian Ocean region furthers Chinese diplomacy and geostrategy without firing a shot. Presence and perception matters greatly in this regard. By signing and operationalizing a forces access deal in Djibouti, the PLAN will be laying roots in a vital region that is likely to see sustained, significant growth in Chinese naval activity.

***

Andrew S. Erickson and Gabe Collins, “Stock Slump Casualty: The Myth of Chinese Exceptionalism,” China Real Time Report (中国实时报), Wall Street Journal, 6 July 2015.

China’s dramatic stock market plunge and the resulting uncertainty as to how Beijing will try to manage the situation are calling China’s economic growth and political stability into question. This financial risk story could ultimately have much greater implications for the global economy than the Greek debt drama much of the world is currently fixated on. Yet it is also one of widespread myths and hubris.

As data points fly later today and over the course of the week, it’s important to consider the structural factors behind the current difficulties. The more one considers the larger picture, the less the latest developments should be surprising. The bottom line is that China is not as exceptional as its leaders claim, or as some Chinese and foreigners imagine. It is not immune to laws of economics, the business cycle, or the gradual slowing of national economic growth and power accretion that typically besets maturing societies. And Beijing has not created a superior hybrid state-market model that can miraculously reap the benefits of more market- and legally-oriented economies while avoiding their drawbacks. Instead, it has created a massive bureaucracy that is strong and concentrated in some respects, but weak and conflicted in others. Moving forward, in assessing China’s prospects, analysts need to take a hard look—in part by considering the issues outlined below.

Suspending Stock Disbelief

The last few quarters should have sounded alarm bells for more investors as China’s stock market completely decoupled from the country’s weak underlying economic fundamentals. The market rose meteorically, traded on easily available funds and massive leverage, and eschewed fundamental analysis of China’s rapidly slowing real economy and largely tepid consumer economy. Real economy indicators suggested that China’s stock market rally was not underpinned by robust “bricks and mortar” activity.

One had only to consider the “Keqiang Index,” an aggregation of statistics concerning electricity consumption, rail cargo volume, and amount of loans disbursed. The resulting figure — reportedly advocated as a more accurate metric of real Chinese economic activity by Premier Li Keqiang himself — suggested substantially lower GDP growth than did official numbers. Even these official figures, which Premier Li reportedly denounced as “man-made,” had themselves been ebbing. Tellingly, before the downdraft began, the Shanghai Stock Exchange had risen approximately 150% in the past year, while electricity consumption had basically flat-lined for the past five months and counting.

Where are Reforms When You Need Them?

So why wasn’t China’s vaunted bureaucracy able to head off this policy train wreck? Well-documented bureaucratic turf wars between the People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) helped sow the seeds of some of China’s most pressing current economic problems—such as ballooning debt and use of shadow banking. Such infighting continues impeding the Chinese government’s response to the current market downdraft. Unlike other major central banks, the PBOC is not politically independent. Indeed, in a Chinese political system where “de facto federalism” is the default modus operandi, banking is one of the few areas where policy authority is far more centralized, in part a product of the pre-WTO reforms spearheaded by former Premier Zhu Rongji.

As such, the PBOC likely faces significant political pressure to continue pumping the stock market up, as this helps distract the populace from the fact that the market for residential real estate—the prior hot investment area—is flagging. For its part, the CBRC has likely been “captured” by the very banks it is supposed to regulate, further contributing to amplified systemic risk from shadow banking activities that are tougher to track and regulate than lending conducted through normal bank channels. Ultimately, conflicting bureaucratic priorities and infighting send contradictory messages to investors and likely fuel additional market instability.

This is part of a larger pattern in which China increasingly needs reforms that its political power structure appears ill-suited to implement effectively. China’s leadership has proved unwilling and unable to implement reforms sufficient to maintain current levels of economic growth amid gathering challenges. Markets were clearly over-optimistic about President Xi Jinping’s reform agenda: reforms have progressed more slowly, and less successfully, than expected. Xi and other Chinese leaders appear to know what economic reforms are needed, but how, when, and to what degree can they actually implementthem without assuming unacceptable political risks? This remains the problem, and it remains unanswered. Initial enthusiasm for new policy initiatives, for instance state-owned enterprise reform, faded fast with opposition from “red families” and other powerful vested interests.

Broader Headwinds for Growth

Fundamental economic and social forces are amplifying Beijing’s struggle to regulate financial markets and implement economic reforms. Left unchecked, these internal and external challenges—including pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—will feed off of one another and exact increasingly large costs. Projections by former World Bank Chief Economist and Senior Vice President Justin Yi Fu Lin in 2013 that “China can maintain an 8% annual GDP growth rate for many years to come” and that “annual growth potential should be… 8% for the 2008-2028 period” were never realistic.

Without dramatic—and potentially politically untenable policy shifts—these structural factors will continue to place the growth of China’s economy, and its overall “comprehensive national power,” on an S-curve-shaped slowdown 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.

None of this means that a Chinese “collapse” is inevitable. Indeed, the multi-trillion-dollar economy and the nation behind it retain significant strengths. Rather, it’s time to debunk the myth of PRC exceptionalism and achieve a “new normal” in China analysis. This should be sobering not just for China’s leaders—who surely know their nation’s specific weaknesses more than nearly anyone else—but for people around the world. China’s comprehensive global market-moving power has become immense and spans equity, debt, and hard asset markets with trillions of U.S. dollars in combined investor exposure.

The corollary of this power is that China’s ability to transmit risk into global markets has also become massive. Indeed, at present there are perhaps only three other individual countries to which global financial markets are so comprehensively exposed: the United States, Japan, and Germany. While specific decisions by Chinese political actors are almost impossible to predict from outside, we recommend that investors and policymakers focus on the structural factors we outline, as these provide the fundamental framework within which Chinese regulators will likely take their policy actions.

***

Gabriel B. Collins and Andrew S. Erickson, “Three SignPosts to Guide You as China’s Stock Market Crisis Unfolds,” China SignPost™ (洞察中国) 90 (5 July 2015).

China stockmarket crash image_July 2015_China Daily

For the past 10 days, the Greek debt drama has drawn media coverage and popular attention from important events on the other side of the globe. Today’s resounding “no” vote in Greece’s national referendum on whether to accept the terms of an international bailout only fuels that dynamic. Yet even if Greece exits the Euro, the global economic consequences are minor compared to the potential impact of events now unfolding in China. Indeed, focusing on Greece while a potentially larger crisis brews in Asia evokes a colorful, fitting Chinese idiom: “picking up sesame seeds but dropping the watermelon” (撿了芝麻, 丟了西瓜).

China’s economic story and political stability are now very much at stake in this challenging and uncertain time. Accordingly, it is worth revisiting what we consider to be three of China SignPost’s highest-impact reports. These analyses have anticipated, respectively: limitations in the implementation and efficacy of Xi Jinping-era reforms (#81), China’s recent stock market slump (#89), and a long-run S-curved slowdown in China’s economic growth rate and overall development trajectory (#44). We believe that they 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.

Stock Market Chaos

To begin, we recognize the reality of a Chinese stock market that completely decoupled from weak underlying economic fundamentals. The market rose meteorically, traded on easily available funds and massive leverage, and eschewed fundamental analysis of China’s rapidly slowing real economy and largely tepid consumer economy. 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.

Well-documented bureaucratic turf wars between the People’s Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) helped sow the seeds of some of China’s most pressing current economic problems—such as ballooning debt and use of shadow banking. Such infighting continues impeding the Chinese government’s response to the current market downdraft. Unlike other major central banks, the PBOC is not politically independent. Indeed, in a Chinese political system where “de facto federalism” is the default modus operandi, banking is one of the few areas where policy authority is far more centralized, in part as a product of the pre-WTO reforms spearheaded by the Premier Zhu Rongji.

As such, the PBOC likely faces significant political pressure to continue pumping the stock market up, as this helps distract the populace from the fact that the market for residential real estate—the prior hot investment area—is flagging. For its part, the CBRC has likely been “captured” by the very banks it is supposed to regulate, further contributing to amplified systemic risk from shadow banking activities that are tougher to track and regulate than lending conducted through normal bank channels. Ultimately, conflicting bureaucratic priorities and infighting send contradictory messages to investors and likely fuel additional market instability.

China’s Leadership is Hesitant to Push Genuine Reforms

China SignPost #81 (23 October 2014) expressed our deep skepticism 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 that:

  • 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 how, when, 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, expect reforms to progress more slowly, and less successfully, than expected.

Fundamental Constraints on Growth Are Exerting Themselves

Approximately four years ago, we published what we consider to be China SignPost’s most significant—and prescient—macro analysis to date, “China’s S-Curve Trajectory: Structural factors will likely slow the growth of China’s economy and comprehensive national power,” No. 44 (15 August 2011). Looking forward, we maintain our view that the 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.

China’s comprehensive global market moving power has become immense and spans equity, debt, and hard asset markets with trillions of USD in combined investor exposure. The corollary of this power is that China’s ability to transmit risk into global markets has become commensurately massive. Indeed, at present there are perhaps only three other individual countries to which global financial markets are so comprehensively exposed: the U.S., Japan, and Germany. While specific decisions by Chinese political actors are almost impossible to predict, we recommend that investors and policymakers focus on the structural factors we outline, as these provide the fundamental framework within which Chinese regulators will likely take their policy actions.

***

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).

CSP 88_cover image_stock market trading from China Daily

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…

***

Gabriel B. Collins and Andrew S. Erickson, “China’s Public Hospital Governance Reforms are Setting the Stage for Corporatization,” China SignPost™ (洞察中国) 88 (26 January 2015).

Xinhua hospital picture_2009 passengers from Mexico quarantined

With appropriate legal and policy support, corporatization could begin within the next 2-3 years.

Key Points:

  • China’s public hospital reform experiments thus far have laid a foundation for corporatization that is stronger than many observers believe.
  • Public hospitals now are where the SOEs were in the 2-3 years before the 1994 Company Law was promulgated.
  • Taiwan and Singapore offer potential models for corporatization and improving hospital governance structures, but we believe due to China’s sheer size, as well as its political realities, it will ultimately follow a “corporatization with Chinese characteristics” path.
  • Without national guidelines on corporatization of hospitals, Beijing risks either perpetuating the skewed incentives that have helped spark social unrest and prompted the 2009 hospital reforms in the first place or having such a lack of legal clarity that investors balk at providing the full volume of capital that China badly needs in order to avoid having the public hospital system become a substantial drag on the national balance sheet.
  • Events may begin to force policymakers’ hand if they do not move decisively to corporatize, or at least more clearly define the legal status of public hospitals in China. There are a sizeable number of local deals—primarily in 2nd and 3rd-Tier cities—where investors are taking majority stakes in public hospitals (typically ones suffering from some type of financial problems), with local governments as the minority partner.
  1. Introduction

China’s presently serious shortage of quality healthcare is a humanitarian black mark and also prompts a significant and rising trend of frustrated patients and their families resorting to violence against hospital staff and doctors.[1] Additionally, reigning in hospital-related costs, which comprise the lion’s share of healthcare expenditures in China, could help stimulate the consumer economy. The mechanism is that improving hospitals’ cost effectiveness and improving access to health insurance will reduce out of pocket medical costs, thereby incentivizing people to spend on other goods and services, instead of over-saving to self-insure against future medical problems.

Hospitals are the logical focal point because China’s healthcare system is extremely hospital-centric, with public hospitals delivering approximately 90% of the inpatient and outpatient care consumed in China today.[2] Chinese patients’ inclination to seek care at hospitals is reflected in a 2013 interview with then Vice Mayor of Shanghai Shen Xiaoming, himself a doctor. Vice Mayor Shen noted:

I have an electronic map in my office, and I can see in real time the traffic situation in all of Shanghai…For twenty-four hours in the day, the most congested spots in Shanghai are the front entrances of Ruijin Hospital, Huashan Hospital, and Zhongshan Hospital [in Central Shanghai].[3]

The situation is similar more broadly across China. In 2012, close to two-thirds of China’s total healthcare spending occurred in the hospital sector, as opposed to the 30%-to-45% seen in many OECD countries.

This paper aims to analyze the evolving organizational structures used by hospitals in China and assess how economic reform pressures may have influenced this evolution. State involvement in the hospital sector has, in many ways, played out very differently than in other key industrial and financial sectors. Indeed, while the government worked hard to retain control of key “commanding heights” sectors of the economy such as oil, steel, and shipbuilding during the Reform Era, it has largely left hospitals—a massively strategic sector—on their own. In doing so, it created a system where government ownership co-exists with a distinctly private set of operational incentives, such as the need to sell pharmaceuticals, lab tests, and other services to stay afloat financially.

Hospital organizational structures offer a unique analytical opportunity because unlike the late Qing Self-Strengthening, and PRC corporate buildout and the SOE reforms post-1978, hospitals do not need to “create” a market. The market of Chinese citizens who need healthcare is already booming, and has been for some time. It is also changing focus. During the Mao years, infectious diseases, child mortality, and other common developing world issues were the main challenges China’s healthcare system faced. Many of these could be dealt with at low cost by the legion of “barefoot doctors” then dispatched to the countryside.

Yet since 1978, and especially in the last decade, China has experienced a rising tide of serious chronic illnesses such as cancer and diabetes that are in many ways direct products of prosperity—such as sedentary lifestyles and richer diets—as well as externalities of growth, such as cancers caused by industrial pollution.[4] These ailments are typically beyond village clinics’ ability to handle and instead require more sophisticated treatments that are usually administered in hospitals by doctors trained in Western-style medicine. In this new environment, the hospitals’ task is to find the ways to best serve that market through more accessible and affordable healthcare.

As the Central government re-engages with healthcare and hospitals with a focus not seen since the early Mao period, the question arises of whether or not public hospitals will be corporatized the way SOEs were. China’s public hospitals are now approaching a crossroads similar to that which the large SOEs faced in the late 1980s and early 1990s and the likelihood of public hospitals being granted independent legal personality and allowed to corporatize is rising rapidly.

Corporatizing hospitals impacts legal structure and status of hospitals and would ideally have a direct positive effect on operational efficiency. It will also aid the State’s campaign to attract private sector infusions of capital and expertise into the hospital sector by making it easier to define the value of potential investments. Attracting new investment and private sector capital into the public hospital sector will be especially important in coming years as existing hospitals, many of which were built in the 1950s, approach the end of their useful service lives and require replacement or substantial remodeling.

In light of these challenges and opportunities, this report aims to clarify the Chinese public hospital sector’s place on the road to corporatization, how the situation is evolving, and what this means for investors, scholars, and policymakers wishing to engage this vital segment of China’s healthcare value chain.

  1. Historical Landmarks for Public Hospitals in China

When China began to undertake broad economic reforms in the late 1970s, it enjoyed one of the most effective and cost-efficient healthcare systems in the developing world.[5] Between 1960 and 1980, the average PRC resident’s life expectancy rose from 43 years to nearly 67, an improvement in human wellbeing unsurpassed anywhere else in the world during that time, and one which sprang largely from significant improvements in the provision of public health services.[6]

Along with economic reforms, the Chinese government also began to reform the country’s public hospital system (which at the time included virtually all of China’s hospital capacity). This section of the paper will discuss the three key waves of reform that the government has unleashed on the hospital sector, with a specific focus on how they have affected the operations of China’s public hospital sector. Wave One spanned 1980-2003, Wave Two spanned 2003-09, and Wave Three covers 2009 to the present time.

Wave One: 1980-2003

This reform wave focused on introducing market incentives to public hospitals, primarily by reducing government subsidies to hospitals and giving them autonomy to earn income from selling pharmaceuticals and services. These reforms first affected the rural areas, and only much later came to affect larger urban hospitals.

In 1992, the Ministry of Health grated hospitals substantial financial autonomy, allowing them to charge for services, sell pharmaceuticals at a profit, keep surpluses they generated, and bear responsibility for debts and operating losses.[7] In essence, Beijing wanted to move the costs of hospital operations off of the government balance sheet as economic reforms deepened. The result was that unless a public hospital was affiliated with a deep-pocketed entity such as a large university or the military, it had no choice but to become a quasi-commercial entity that happened to be publicly-owned. As one Chinese analyst colorfully puts it “the hospitals relied on the government to get built, but had to rely on themselves to eat” (建设靠国家, 吃饭靠自己).[8]

“Relying on themselves to eat” and the ensuing commercialization of public hospital operations rapidly created a number of un-intended consequences that the state became increasingly unable to ignore. Most critical, access to quality healthcare declined as the combination of reduced insurance coverage (a product of other healthcare sector reforms) and higher charges for drugs and procedures priced many Chinese out of the market. Out of pocket payments rapidly came to comprise the lion’s share of total healthcare expenditures, reaching an apogee of 60% in 2001 before a second wave of reforms began to stem the expense burden directly borne by patients.[9]

Wave Two: 2003-09

The 2003 SARS epidemic played a pivotal role in highlighting weaknesses across China’s healthcare system, particularly on the governance front, and helped focus public outcry in a way that grabbed policymakers’ attention and helped prompt additional reforms.[10]  In addition, the accession of a new set of leaders to power also presented an opportunity for them to capitalize politically by promoting healthcare reforms.

However, the reforms between 2003 and 2009 focused primarily on increasing health insurance coverage, rather than on reforming the public hospital system. For instance, in 2003 the government established the New Rural Cooperative Medical Insurance (NRCMI) for China’s rural population, expanded the Urban Employees Basic Medical Insurance (U-Employee) for urban employees, and finally, established the ‘rural medical assistance’ for impoverished rural residents.[11]

Wave Three: 2009-Present

In April 2009, the Chinese government announced the largest and most focused set of healthcare reforms since perhaps the Mao era. Pilot hospital reforms comprised one of the five key pillars of the 2009 program.[12] The State Council Reform Office followed up in 2010 by issuing reform guidelines, after which the government chose 745 public hospitals in 17 counties and 37 pilot provinces and cities in which to experiment with new governance and operational practices.[13] This is a broad sample size and represents approximately 5.5% of China’s total public hospitals—a meaningful number that is large enough to create a groundswell if reform measures currently being tried out end up succeeding.

  • Current Legal and Ownership Status of Public Hospitals in China

Legal Status of Hospitals in China

Hospitals in China presently fall into two broad categories of legal personality. One is the “enterprise legal person” used in the 2005 Company Law. Enterprise legal person status governs private hospitals, whether Chinese or foreign-invested, as well as joint ventures. For example, Changning District Central Hospital in Shanghai (foreign-invested) and Changcheng Hospital in Foshan, Guangdong (Chinese-invested) are both enterprise legal persons operating as limited liability companies.[14]

All public hospitals in China are currently classified as “Enterprise Danwei Legal Persons” (事业单位法人). [15] The “enterprise danwei legal person” class is a legacy of the old SOE period, when the firms controlled a whole constellation of assets such as hospitals, theaters, and schools that were not directly connected to the core focus of the enterprise. While corporatized SOEs are now “enterprise persons,” as recognized in Article 3 of the 2005 Company Law, public hospitals still remained burdened with the weak Enterprise Danwei legal personality.

Legal structure and ownership status become less clear (and much more adventurous for the risk seeking) once we transition over to public hospitals. The matter is both intellectually interesting and deeply useful from a policy and commercial perspective. Chinese analysts say the legal status of public hospitals is currently vague and that this can create major problems because the legal lines of demarcation between hospitals and the government  bodies working with them and, to some extent funding them, is not clear.[16]

Despite the current problems, there should be a path for resolution. Public hospitals’ inherent characteristics do not logically preclude them from enjoying independent legal personality under Chinese law. Most public hospitals operate as quasi-private entities, are effectively self-funding, possess increasing internal competence to make operational decisions within a market context, and their assets can be transferred and even privatized. In short, they share many traits with existing SOEs in China, which the law bequeaths with independent legal personality as “enterprise legal persons.”

Indeed, as early as 2003, public hospital assets had their value defined and were privatized. In 2003, United States China Hospital Inc. purchased the “entire rights, interests, and liabilities” of Anqiu City People’s Hospital. The agreement included a transfer of land rights and a pledge by the purchaser to continue improving the office buildings and hospital rooms to make a “garden-style hospital.”[17] These data points all overwhelmingly point to a transaction based on buying actual bricks and mortar formerly owned by the state, as opposed to management rights only.

The Anqiu deal is noteworthy because the buyer dealt directly with the State Asset Management Bureau of Anqiu City, who functioned as the “owner” of the hospital assets. Other examples exist of local state asset management bodies being willing to offload hospitals. For instance, the Beijing State Owned Assets Management Co. notes that in recent years it has helped “dispose of” at least three public hospitals: Beijing University People’s Hospital (北京大学人民医院), the Health Ministry’s Beijing Hospital (卫生部北京医院), and the Beijing University No. 3 Hospital (北京大学第三医院).

Ownership Status of Hospitals in China

Hospital ownership in China splits into two primary levels—physical asset rights (ownership of bricks, mortar, medical equipment, employees) and management rights. Physical ownership typically resides with the investors for private facilities and with the state for public hospitals.

The management rights appear to be effectively severable, allowing the state to retain ownership of the building, employees, and so on; but allowing a private management company to purchase management rights that allow it to try and wring efficiencies out of hospital operations. Indeed, making management rights severable allows the state the option of “privatization lite” where the government retains ownership of the physical hospital itself, but can sell or rent out the management rights for all or part of the hospital’s operational functions to a market-driven private actor.

Management Companies Highlight Murky Delineation of Property Rights in Public Hospitals

The management companies present interesting legal questions because some, such as Golden Meditech are totally private; while others, such as Sinopharm, are SOEs or wholly-owned subsidiaries of SOEs.[18] For instance, Sinopharm Midland Hospital Management Company manages five hospitals in Henan province: Xinxiang Central Hospital (新乡市中心医院), Xinxiang No. 2 People’s Hospital (新乡市第二人民医院, Xinxiang Maternal and Child Healthcare Center (新乡市妇幼保健院), Xinxiang Hospital of Chinese Medicine (新乡市中医院), and Xinxiang No. 3 People’s Hospital (新乡市第三人民医院).[19]

The five hospitals are all public hospitals, and have enterprise danwei legal personality.[20]Sinopharm Midland Hospital Management Company gained the rights to manage the hospitals after the Xinxiang City Government and Sinopharm Group Company (Midland’s ultimate parent) reached an agreement with each other.[21] There do not appear to be publicly available data on what the consideration for the agreement was, which raises significant questions about what property rights, if any, the management company may have acquired beyond a right to manage operations. One possibility is that these management companies are following an approach similar to that used by Phoenix Healthcare, perhaps China’s largest private hospital management company. Phoenix uses a so-called “invest-operate-transfer” (“IOT”) model, under which it agrees to make a fixed investment to improve hospital facilities as well as clinical services of a hospital “in exchange for the right to manage and operate that hospital and…receive performance-based management fees and the ability to supply pharmaceuticals, medical devices and medical consumables for a period ranging from 19 to 48 years. If the relevant IOT agreements are not renewed or extended after such period, the management rights will be transferred back to the hospital owner.”[22]

The IOT arrangement in many ways appears to be kicking the can down the road, as it still does not address the fundamental underlying legal question of who owns what. This lack of clarity is reflected by the fact that early investors in public hospitals have already had to deal with a range of entities, including the Ministry of Health (“MOH”), local State Owned Assets Supervision and Administration (“SASAC”) offices, and city governments in order to broker deals, and each city often poses a different contractual scenario.

Given that hospital’s legal status is intimately intertwined with the evolving ownership structures, the next section examines how new reforms are changing the public hospital governance framework in ways that move the sector closer to corporatization.

  1. Where Chinese Public Hospitals are Now on the Corporatization Spectrum

The most appropriate classification for most Chinese public hospitals now would be “autonomized organizations.” Essentially, this means they are in a state where they are still government-controlled, but have, or are in the process of, shifting meaningful decision-making authority into the hands of those actually managing the assets, rather than those pushing paper in a far-away ministry office (Exhibit 1).[23]

Exhibit 1: Past, Current, and Projected Status of Chinese on Corporatization Spectrum

Ex. 1--Stages of Reform_where Chinese public hospitals are now

Source: Preker and Harding, China SignPost™ assessments

  1. Why Haven’t Public Hospitals in China Corporatized Yet?

Key Chinese healthcare officials—up to the ministerial level—have expressed support for public hospital governance reforms, but opposed “corporatization.” Such views appear to be driven by a fundamental misconception—namely that “corporatization” diminishes an asset’s ability to be used with an emphasis on the public good. The October 2009 statement of the Vice Minister of Health, Ma Xiaowei, offers a clear example of this misunderstanding:

State-owned assets can gain financial value from reforms, while public hospitals have to protect the public interest. Reforms can help make healthcare gains but we should thoroughly understand the difference between the two [increasing asset value versus protecting the public interest]. We should be mindful of lessons but not proceed indiscriminately and must avoid conflating the grant of legal personality with actual corporatization. (国有企业以国有资产保值增值为改革目标,而公立医院则以保证公益性、提高健康绩效为改革目标,在改革中必须充分认识二者的差异,借鉴而不照搬,避免公立医院‘法人化’演变为‘公司化).[24]

It very much appears that Vice Minister Ma is equating “corporatization” with full-on “privatization.” Yet corporatized entities can still put state or public interests first and foremost in their operations. Indeed, Ma’s statement is actually deeply ironic given the ways that China has used, and continues to use, corporatized (sometimes even publicly-traded) SOEs to pursue national interest-oriented projects in a variety of sectors.

For their part, potential domestic investors have a more nuanced view, but still admit that unclear delineation of property rights plus hospitals’ critical social function pose real challenges that hinder investment, but which would also need to be addressed for successful corporatization to occur. For example, Feng Suqiang, a managing director at private equity firm Zero2IPO Group, notes that commercial (read: hospital operators) and private equity investors alike must tread carefully due to lack of clarity with respect to property rights, as well as the need to balance profitability with social duties after an investment is made in a public hospital.[25]

Opposition to corporatizing public hospitals in China also overlooks the reality that two core motivations for corporatization are arguably already deeply embedded in China’s public hospital sector. First is the idea that by granting hospitals the right to retain residual revenue, managers have incentive to ensure that the hospital operates more efficiently.[26]  For more than two decades, public hospitals in China have been permitted to keep the surpluses they generate and are also responsible for any debts or operating losses they may incur.[27]

Second is giving hospital managers greater decision-making autonomy creates more latitude for them to optimize hospital operations.[28] Chinese public hospital managements arguably have not yet been granted broader residual rights to control, namely the rights to “make any decision regarding as asset’s use not explicitly contracted by law or assigned to another by contract.”[29]Many areas remain where public hospitals in China are still sufficiently entwined with—and constrained by—bureaucratic authorities, that they are some distance from being able to be called “corporate.” That said, it is very likely that if the Chinese government decides to allow hospital corporatization, it will proceed much more smoothly and rapidly than it did when the first SOEs were corporatized.

There are several reasons for this. First, the hospitals already have substantial experience operating as quasi-market entities and are not being forced to move directly from planned economy operations into a market environment. Second, the legal framework, regulatory knowledge base, and service elements (bankers/lawyers, etc.) that are needed to breath functional life into corporations already exist in decent measure in China owing to the prior SOE reforms. Third, Chinese policymakers can examine lessons from other Asian political entities, namely Taiwan and Singapore, which share meaningful cultural similarities with the PRC—and which have more evolved public hospital systems than the PRC does at present.

Path One—Taiwan (not likely)

Of Taiwan’s roughly 500 hospitals, approximately 80% are privately owned, according to 2012 Ministry of Health and Welfare data.[30] The remaining public hospitals are primarily controlled by either the Ministry of Health and Welfare or the Taiwanese military. Taiwan’s public hospitals are not corporatized and instead are directly administered by the government.

The Taiwanese model is likely not appropriate for the PRC given Beijing’s policy objectives. First and foremost, roughly 90% of PRC hospital capacity lies in the public hospitals, which are likely to remain the focal point of care for decades to come. Second, part of the reason the PRC is seeking to reform public hospital governance is that the leadership wisely recognizes that trying to govern thousands of hospitals—each of which are very important locally—from the center is unworkable if the system is to be made more efficient and effective.

Third, much of Taiwan’s private hospital capacity is controlled by large corporations, whose wealthy entrepreneur founders have established private foundations that control and manage the hospitals. Among these is Chang Gung Memorial Hospital, which has 9,000 beds in its system and is one of the world’s largest hospital organizations.[31]Chang Gung was established by the founder of Formosa Plastics after his father (named Chang Gung) died of an intestinal obstruction that could have been easily remedied with access to modern medical care.[32]

A private hospital sector is emerging in China as reforms progress, but in contrast to Taiwan, private providers are unlikely to become the core of healthcare provision in the PRC. Moreover, China’s largest corporate bodies—the core SOEs—are assiduously trying to rid themselves of hospitals that are a drag on corporate finances and distract from the firms’ core businesses.

Path Two—Singapore (more promising)

In contrast to Taiwan, public hospitals dominate Singapore’s system, providing ¾ of hospital beds.[33] Furthermore, Singapore chose to corporatize its public hospitals. As Ramesh describes, the primary phase of corporatization occurred between the mid-1980s and the early 1990s, after which the government asserted more robust government “direction” of hospital activities.[34] The Singapore government’s primary rationale for imposing stricter direction was that the rise in competition following corporatization had also driven up healthcare costs.[35]

Singapore selected a hospital management structure in which the government owns a holding company called MOH Holdings.[36] In turn, MOH Holdings owns NHG and SingHealth, which between them control all public hospitals in Singapore, which are structured as separate private companies (Exhibit 2).[37]

Exhibit 2: Singapore Private Hospital Ownership Structure

Ex 2--Singapore Hospital Organizational Structure

Source: “Autonomy and Control in Public Hospital Reforms in Singapore,” MOHH, SingHealth

The Singaporean example is noteworthy, both for the potential insights it offers into paths China could take, as well as key distinctions that will make China’s hospital reform program very different. In the similarities column, China also relies on public hospitals to provide the bulk of care. Likewise, Singapore also faced—and is competently addressing—corporatized hospitals’ propensity to act as quasi-private profit seekers at the expense of providing high quality, accessible care. Finally, both countries have semi-authoritarian governments whose relevant top officials are on balance arguably more technically competent than most of their counterparts in Western democracies.

Several differences exist as well. First, China’s hospital system is an order of magnitude larger than Singapore’s, with commensurately greater administrative complexity in terms of achieving final solutions when implementing policies. As a subset of the scale problem, China’s vast expanse means there will likely be enduring disparities in healthcare quality, particularly between rural areas and inland urban areas vis-à-vis their coastal cousins (where most of China’s top hospitals are located).

Second, in relative terms, China’s population faces much greater burdens from complex chronic diseases such as diabetes and cancer than the Singaporeans do, a reality that will likely substantially increase the relative demand for hospital-centric care in China. Third, China’s current mélange of regional and city-level administrative experiments in hospital governance and overall thrust of localizing hospital governance may present political challenges in terms of standardizing healthcare costs and quality in practice.

Fourth, China’s population is aging rapidly, creating a situation whereby the country will most likely “get gray” before it gets rich, which increases the insurance cost burden on the remaining young people who then must bear a proportionally larger burden to ensure their aging parents, aunts, uncles, etc. Finally, China’s existing public hospital problems are serious enough that Beijing will not have the luxury of time Singapore enjoyed (15 years to corporatize all public hospitals).

Path Three—Public Hospital Governance Improvements with Chinese Characteristics

A huge set of related questions looms over China’s public hospital reform campaign—will Chinese public hospitals be corporatized? Do they need to be corporatized in order to achieve Beijing’s reform objectives? Might there be reforms short of corporatization that are conducted first to lay the groundwork for later corporatization? Will public hospitals in China be corporatized in a way that reflects local characteristics? Based on the research, analysis, and Chinese-language source evidence outlined here, the short answer to these questions is “yes.”

At present, public hospital ownership and governance models are in flux in China. A great amount of experimentation is under way, as has been for more than a decade. Quiet structural reform experiments began in 2002 in Shanghai (addressed in greater detail below) and more followed in other locations, but the real wave came following the April 2009 promulgation of the “Medicine and Healthcare Systemic Reform Near-Term Implementation Plan for 2009-2011” (医药卫生体制改革近期重点实施方案 (2009-2011年).[38]

Exhibit 3 (below) highlights (1) of how diverse the public hospital governance reform attempts are and (2) how many of them predate by several years the 2009 official blessing for reforms.

Exhibit 3: Sample China Public Hospital Governance Reforms

Ex 3--sample hospital reforms in China

Source:  Zhang et.al, “Analysis of Shanghai’s public hospital governance structure with the Preker-Harding model.” 2013

The themes which most deeply permeate the governance reform experiments center on creating city-level management structures—a clear signal that the ultimate policy results stand a good chance of increasing local governments’ influence over, and involvement with, public hospitals in their jurisdictions. This tracks with the assessment of Wang Hufeng from the Health Reform and Development Center in Beijing, who notes that three primary models of reform aimed at separation of ownership and management are emerging in China’s public hospital sector, all focused on city-level political entities.[39]

The reform packages also emphasize separations of ownership and management. The weaker legal personality given to public hospitals makes the current governance reforms aimed at separating ownership and management very important. Indeed, Li Weiping and Huang Erdan, senior analysts at the Ministry of Health’s Institute of Health Economics have written that the 管办分开 (guanban fenkai, or “separation of control and operations”) campaign should be thought of as an action that effectively confers more robust legal personality upon public hospitals.[40]Moreover, it is telling that these two well-positioned analysts also believe moves to separate ownership and governance actually reinforce legal personality at three key points in the public hospital system: individual hospitals, groups of affiliated public hospitals (where this applies), and new overarching hospital governance structures being created primarily at the municipal level.[41]

One of the core challenges in implementing guanban fenkai will be figuring out what powers continue to reside in public hospital Party Committees. Most, if not all, public hospitals (certainly the large ones) have Party Committees embedded within them. There appears to be very little discussion of what the full extent of these committees is, but there is reason for concern that as more operational power is granted to local-level bodies, the Party Committees may become a backdoor trump card that the Central or Provincial governments can use to hinder reforms or actions with which they come to disagree. This would be akin to the veto power that Party Committees can exert within the large SOE banks or enterprises governed by the 2005 Company Law, where Article 19 leaves a large space for the Party to serve as a “checking” mechanism versus management.

The vague manner in which some hospitals define the role of their Party Committees should grab the attention of potential investors, who should be aware of this potential “dormant volcano.” For instance, Huashan Hospital, one of Shanghai (and China’s most capable) says that its Party Committee exists to carry out a range of duties, including “faithfully implementing whatever work the Party leadership may hand down” (…认 真完成党委领导交办的其它各项任务).[42] In a similarly broad and open-ended manner, Leshan People’s Hospital (serving the prefecture-level city of Leshan in Sichuan) says its Party Committee functions as a “comprehensive social order governance and peaceful development small working group” (社会治安综合治理和平安创建工作领导小组).[43]

Guanban fenkai is also important because if the policy goals are implemented with sufficient speed, Chinese public hospitals may undergo significant governance changes before they achieve independent legal personality. This would put them on a different path than core SOEs, which were granted independent legal personality in 1986 by the General Principles of Civil Law, but did not begin significant governance reforms until 1992, when the State Council promulgated the Regulation on Transforming the Management Mechanism of the Industrial Enterprises Owned by the Whole People.[44]

  1. Public Hospital Governance Reforms: Steps Toward Corporatization?

China’s latest round of hospital reforms points to a trend of making hospitals more “independent,” while also more clearly delineating lines of authority and control and clarifying public hospitals’ relationship with the political power structure. Basically, this is being done by formalizing a devolution of significant governance authority and putting more power in the hands of new municipal health bureaus and other administrative bodies specifically tasked with overseeing public hospital operations.  This analysis will specifically emphasize a case study of governance structures being adopted by Shanghai for its public hospitals.

Public Hospital Governance Reforms in Shanghai

Shanghai offers useful insights into public hospital reforms because it is a very large healthcare market (more than US$14 billion spent in 2011) and is further from the central powers that-be than Beijing, the country’s largest healthcare market. As such, Shanghai offers a better laboratory for reforms and is large and influential enough that if reforms work, there is a high probability other local and provincial governments will emulate the Shanghai model.

Shanghai’s “old” hospital governance model featured lines of authority that tended to emphasize centralization at the expense of local governance that could recognize and adapt to ground-level realities (Exhibit 4). For instance, hospitals owned by the Ministry of Health were directly under the ministry’s jurisdiction.[45] This reduced local administrative leverage, because as former Shanghai Vice Mayor Shen Xiaoming puts it “the simple rule of thumb is, whoever gives hospitals money, the hospitals will listen to them.”

Exhibit 4: Shanghai’s Old Public Hospital Governance Structure

Ex 4--Old Shangai Hospital Governance Structure

Source: Health Affairs, China SignPost™ analysis

While government funds do not constitute a large portion of public hospital budgets, they are large enough at 6-8% that a threat to that money flow will attract attention in the hospital management suite. Even more to the point, the hospitals will also listen to whoever wields regulatory and approval power over the actions managers want to take. The local authorities largely lacked this power under the old system, particularly if the bricks and mortar building already existed and was furbished, thus removing the potential lever of withholding construction permits.

Shanghai’s public hospital sector reform has taken shape over nearly a decade and yielded a dramatically different organizational chart. The campaign began with the 2005 establishment of the Shanghai Healthcare and Hospital Development Center (申康医院发展中心), a state-owned non-profit legal person (国有非营利性的事业法人) charged with overseeing major decisions and investments made by public hospitals formerly under the MOH’s direct control.[46] The Hospital Development Center now oversees at least 24 public hospitals in Shanghai, including some hospitals affiliated with Fudan University (Exhibit 5).[47]

In 2008, the State Council enabled the establishment of the Shanghai Health Bureau (上海市卫生局) via the Shanghai City People’s Government Structural Reform Plan (上海市人民政府机构改革方案).[48] The Shanghai Health Bureau discharges a wide supervisory mandate, and is specifically tasked with “strengthening supervision of the Shanghai Healthcare and Hospital Development Center according to law.”[49] Local sources suggest the Shanghai Health Bureau plays a more distant supervisory function and that the most direct supervisory hierarchy for the public hospitals in Shanghai under the Hospital Development Center’s authority is (1) Hospital Development Center, (2) Shanghai Health Council, and (3) the Shanghai city government (Exhibit 5). The local SASAC branch also helps supervise investment decisions.

Exhibit 5: Shanghai’s New Hospital Governance Structure

Ex 5--Shangai Hospital Governance Structure

Source: Zheng et.al, Economic Observer

Signs of Greater Local Regulatory Strength

The Hospital Development Center appears to be entering a new and more established and robust phase of operations. One clear point of evidence is the organization’s centerpiece role in a pilot program to create a Chief Accountant Small Working Group that spans hospital bureaucratic lines.[50] As of October 2013, the Hospital Development Center was searching for 18 Chief Accountants, whose responsibilities would include “helping hospital chiefs strengthen internal accounting, economic analysis and monitoring, and management of state assets.”[51]Qualified applicants need to have at least three years’ relevant experience in accounting, auditing, or state asset management.[52] The job listing also specifically notes that applicants should be under the age of 50.[53]

This suggests a clear intent to build a cadre of relatively young accountants who are competent and less likely to have been a product of command and control thought processes. Most importantly, it shows that Shanghai wants to put real expertise and local-level financial analytical capability into the regulatory structure to catch problems early and improve information transparency. There will be capacity questions since so many hospitals regulated by the Hospital Management Center, but building initial capability is an important step on the road to having sufficient capacity, since once capability exists it can be scaled up into greater capacity more easily than capability can be achieved to begin with.

The Hospital Development Center personnel listings also suggest another importance governance development is afoot—a nascent market for professional public hospital management personnel that will become deeper and more dynamic as additional cities join the public hospital reform process. A number of large cities, including Beijing, Chengdu, Kunming, Shanghai, and Shenzhen now have either hospital management centers or municipal hospital management bodies.[54]

These entities’ fundamental administrative purpose and operative functions are similar and as they grow out, will create an increasingly fungible corps of professional managers with the relevant capabilities and experience who can work in a variety of cities. To be sure, this process will have fits and starts.

For instance, nearly 70% of a pool of 173 hospital middle managers surveyed in Wuhan in 2013 said that a lack of separation between ownership and management in public hospitals is the biggest impediment to professionalizing the hospital manager ranks.[55]This suggests two key dynamics: first, deeper guanban fenkai reforms can reinforce professionalization of hospital managements and second, many of the younger hospital managers are either not strongly affiliated with the Party, or even if they are, nonetheless strongly support making public hospitals more independent of the government, a potential positive sign for continued moves toward true corporatization.

So in light of the new ownership and control structure, how “autonomous” are Shanghai’s public hospitals and how close are they to being corporate entities? A recent assessment by researchers from the Ministry of Health, Fudan University School of Public Health, and Shanghai First People’s Hospital speaks to these questions.[56] The researchers applied a set of metrics drawn from Preker and Harding’s seminal work and used them to see how much autonomy public hospitals in Shanghai have under the new control regime relative to the old one (Exhibit 6).

The rights to appoint senior and middle hospital managers, dispose of assets, disposal of residual funds and claims, and to make strategic financial and investment decisions lie at the heart of organizational autonomy and would be rights that most corporate entities would expect to enjoy substantial latitude to exercise. For all four rights, entities above the public hospital level in Shanghai continue to exercise a dominant degree of control. In addition, even for areas such as pricing where hospitals nominally appear to have meaningful authority, the government still exerts a powerful backdoor influence over pricing of procedures, since it can shape how much, and for what procedures, the public health insurance program reimburses.

To be fair, the fact that the dominant degree of control is now localized at the city level in Shanghai denotes significant progress. Yet at the same time, it suggests that true corporatization of public hospitals in the city (and elsewhere in China) most likely is at least 2-3 years down the road, and potentially further.

Exhibit 6:  How “Autonomous” Are The Shanghai Public Hospitals?

Ex 6--Shanghai Hospital Autonomy Metrics

Source: Zhang et.al, Shanghai Jiaotong University

The Shanghai government’s insistence on keeping its hand firmly on key levers of public hospital operations helps explain investors’ substantial hesitation to enter into public-private partnerships, lest they end up as a modern version of Zhang Jian’s shareholders—along for the ride, but with little to no influence over management despite advancing significant amounts of capital. In short, specialist private hospitals presently offer a more clearly defined legal, political, and economic risk profile.

  • What Additional Barriers to Corporatization Do Public Hospitals in China Face?

China’s public hospital system is far from monolithic and managers—particularly the growing generation of relatively apolitical professionals—will likely emphasize their own hospitals, as opposed to a propagandistic ideal of a “greater national good.” So the bottoms-up reform constituency looks increasingly robust. As such, political inertia and resistance from ministerial-level rice bowls comprises the single most significant barrier to corporatization that public hospitals must overcome.

Analysts writing in hospital sector trade publications say that the core challenges for further reforms aimed at separating ownership and management lie in two primary zones. First, what will the Ministry of Health’s relationship with public hospitals be as governance structures evolve and hospitals become more independent from the Central Government? How will the Ministry respond to a set of changes that forces it to begin transitioning from an “omnipotent” regulatory mentality to a more “service-oriented” one where power is devolved away from the center?[57]

It is too early to draw high-confidence conclusions. That said, the fact that Shanghai’s hospitals have been able to transition into their new locally-focused governance structure without undue overt opposition from the central Ministry of Health and the fact that the new governance structures appear to be taking an ever deeper hold suggest a positive future in terms of there being a favorable political climate for public hospital reforms that afford localities and their hospitals greater autonomy. In addition, the Shanghai public hospitals have strong political top cover to continue reforms, as the city’s mayor Yang Xiong stated in May 2013 that public hospital reforms are “difficult” but are also “among the most important.”[58]

Second, will China’s public hospitals be endowed with a robust independent legal personality, and if so, when might this happen and what might catalyze the change?  An interpretation of healthcare reform priorities in the 18th Third Plenary Session provided by Xinhua in February 2014 helps provide some clarity as to what relative importance the Central Government attaches to various public hospital reform steps. The hospital-centric portion of the interpretation came before the other three (pricing, diagnostics, and drug subsidies) and noted that along with defining the government’s responsibility for public hospitals and separating ownership and management, reforms should also occur with respect to granting public hospitals independent legal personality (落实公立医院独立法人地位).[59]

Chinese sources currently appear not to specify what forms an independent legal personality for hospitals should take. Some authors from the Institute of Medical Information take the position that none of the country’s four current forms of legal personhood (企业法人、机关法人、事业单位法人、社会团体法人四类) suffice because the public hospital resides in an unusual space where it functions basically as a marketized entity, but also must fulfill important social responsibilities.[60] If this type of view prevails in the policy debate, one potential outcome is that China would need to create a “Hospital Law” that plays an enabling role in the way that the Company Law does, including defining what type of legal personality a public hospital has and what rights this entails.

A more sensible approach would be to corporatize more along the Singapore model analyzed above and make public hospitals “enterprise legal persons” (企业法人) governed by the 2005 Company Law. This would tap into the already substantial body of law and expertise on the Company Law. Enterprise legal persons must meet five core criteria to be recognized under Chinese law and public hospitals could, with sufficient legal tweaks, fulfill these requirements.

Foremost among the logical changes, the Chinese government could enable the creation of fully state-owned hospital holding companies similar to how Singapore has done, which could then step into the shoes of local SASAC branches as the “owner-controllers” of the public hospitals’ physical assets. There is already at least one precedent in a national-scale city—Chengdu—for diluting local SASAC power over hospital assets. In Chengdu, the recently created Hospital Bureau that supervises public hospitals is independent of the local SASAC branch.[61]

First, the enterprise legal person must be approved and recognized by a competent authority.[62]Second, it must possess its own property.[63] This could be accomplished via the holding company, as Singapore has done with MOH Holdings and its subordinate companies, SingHealth and NHS. Third, the enterprise legal person must possess its own name, organizational structure, and premises.[64] Again, the corporate holding structure coupled with the hospitals’ existing names and premises would fulfill this requirement. Fourth, the enterprise legal person must be able to independently assume civil legal obligations.[65] The holding structure would allow this, while simultaneously providing a pathway for the state to maintain full control over important social assets. Fifth, the enterprise legal person must have the capacity to engage in civil legal actions, of which a corporatized hospital would presumably be capable.[66]

  • Conclusion: Corporatize Now Based on National Guidelines, or Face Major Problems Down The Road

While Beijing is clearly doing its best to exit the direct public hospital management business (yet again), the political credibility buck ultimately stops at the national level if provincial and local problems and dissatisfaction with public hospital services become sufficiently serious. And with that in mind, events may begin to force policymakers’ hand if they do not move decisively to corporatize, or at least more clearly define the legal status of public hospitals in China. There are a sizeable number of local deals—primarily in 2nd and 3rd-Tier cities—where investors are taking majority stakes in public hospitals (typically ones suffering from some type of financial problems), with local governments as the minority partner.[67]

As such deals proliferate, there is a rising sentiment that these hospitals are actually “privatized” once the investment capital comes in, even if they still must fulfill the same social functions that their MOH-owned predecessors did. And the ground level reality is that in practical terms, their behavior (pricing and service offerings) will change fast at the expense of patients who in some areas may not have many other options for obtaining medical services they can afford.

A broad empirical study of U.S. hospital behavior suggests that public hospitals are “the most likely to supply the unprofitable services that are disproportionately needed by poor and underinsured patients,” which typically makes them “caregivers of last resort.”[68] The U.S. experience is primarily driven by economic forces that largely transcend the otherwise formidable differences between the U.S. and Chinese healthcare ecosystems. What’s more, in the Chinese context, public hospitals are likely to be the caregivers of first and last resort, making them even more important to the bulk of the population, which will likely not be able to afford care at specialist private facilities which are profit-driven.

The fact that local governments are becoming actual shareholders in the hospitals also raises problems because the government previously managed hospitals with an eye to service (and cost-minimization), as opposed to profitability, which engenders a much different range of incentives that run counter to providing a broad spectrum of care at affordable prices. These potentially massive conflicts of interest are largely hidden now, but would likely assert themselves rapidly in the event of an economic slowdown that made dividends and income from local hospital operations a more important source of government financing than they are now.

For the central, or even provincial, governments to try and unwind this growing tangle of informal local “corporatization” and “privatization” of public hospitals would be a major drain of funds and political bandwidth. Yet the problems could be pre-empted by adopting a system whereby hospitals were officially corporatized based on national-level guidelines and laws, but à la Singapore, remain public institutions, perhaps with non-profit status.

The bottom line: China’s public hospital reform experiments thus far have laid a foundation for corporatization that is stronger than many observers believe. Public hospitals now are where the SOEs were in the 2-3 years before the 1994 Company Law was promulgated. Chinese leaders need to act soon to lay down additional, corporatization-specific ground rules for public hospital reforms moving forward. Without national guidelines on corporatization of hospitals, Beijing risks either (a) having public hospitals being privatized and perpetuating the skewed incentives that have helped spark social unrest and prompted the 2009 reforms in the first place or (b) having such a lack of legal clarity that investors balk at providing the full volume of capital that China badly needs in order to avoid having the public hospital system become a substantial drag on the national balance sheet.

[1] Lan Fang, Li Yan, Luo Jieqi, Ren Zhongyuan Lin Jinbing and Han Xiaomei. “Anger and Angst in Hospitals Where Doctors Die,” Caixin, 20 November 2013,http://english.caixin.com/2013-11-20/100607242.html

[2] Ruth E. Brown, Dionisio Garcia Piriz, Yuanyuan Liu, and Jonathan Moore. “Reforming Health Care in China,”  April 2012, http://sites.fordschool.umich.edu/china-policy/files/2012/07/PP_716_Final_Policy_Paper_Health-Final.pdf (21)

[3]Tsung-Mei Cheng, “Explaining Shanghai’s Health Care Reforms, Successes, And Challenges,” Health Affairs, 32, no.12 (2013):2199-2204

[4] 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).

[5] M. Ramesh, Xun Wu, and Alex Jingwei He. “Health Governance and Healthcare Reforms in China,” Health Policy and Planning 2013; 1-10. Doi:10.1093/heapol/czs109.

[6] World Bank Development Indicators, World Bank, http://data.worldbank.org/data-catalog/world-development-indicators. Also, to be sure, years of war and revolutionary turmoil likely helped “pad” the baseline for these numbers, but they nonetheless represent a remarkable improvement.

[7] Madhurima Nundy and Rama Baru, “Recent Trends in Health Sector Reforms and Commercialization of Public Hospitals in China,” ICS, 2013, Paper 12, Vol.2.

[8] Cao Yanlin, Wei Zhanying, Wang Jiangjun, “Discussion on Public Hospitals’ Independent Legal Status,” (公立医院独立法人地位探讨), Chinese Hospitals, Vol.14, No.12, 2010. (18-19)

[9] Ramesh 3

[10] Zhe Dong and Michael R. Phillips, “Evolution of China’s Health Care System,” The Lancet, Vol. 372, November 2008. (1715)

[11] Wei Zhang and Vicente Navarro, “Why hasn’t China’s high-profile health reform (2003−2012) delivered? An analysis of its neoliberal roots,” Critical Social Policy 2014 34: 175 originally published online 23 January 2014. DOI: 10.1177/0261018313514805.

[12] Vivian Lin, “Transformation in the healthcare system in China,” Current Sociology 2012 60:427, DOI: 10.1177/0011392112438329.

[13] Sarah L. Barber, Michael Borowitz, Henk Bekedam, and Jin Ma. “The hospital of the future in China: China’s reform of public hospitals and trends from industrialized countries.” Health Policy and Planning 2013: 1-12. Doi: 10.1093/heapol/czt023.

[14] See, for example: Shanghai Changning District Central Hospital Joint Venture Contract,http://www.sec.gov/Archives/edgar/data/922717/000092271702000002/contractualjvcontract.htm, and Shanghai Fosun Pharmaceutical (Group) Co. DISCLOSEABLE TRANSACTION ACQUISITION OF 60% EQUITY INTEREST IN CHANCHENG HOSPITAL,http://www.hkexnews.hk/listedco/listconews/sehk/2013/1009/LTN20131009561.pdf

[15]Li Weiping and Huang Erdan (李卫平, 黄二丹), “The Path and Strategy for Making Public Hospitals Into Independent Legal Entities,” (实现公立医院独立法人地位的途径和策略), Health Economics Research Institute (卫生经济研究), Vol. 11, 2010.

[16] Song Lingxia and Jiang Hong, “The Exploration about Public Hospitals Corporate Governance Structure in China,” (我国公立医院法人治理结构模式探索). Value Engineering (价值工程). Issue 25, 2012.

[17] Anqiu City People’s Hospital Asset Transfer Agreement,http://www.sec.gov/Archives/edgar/containers/fix170/1277425/000104746905003737/a2151652zex-10_22.htm

[18] Golden Meditech, Business Overview,http://www.goldenmeditech.com/eng/business/overview_b.php (accessed 20 April 2014).

[19] China Sinopharm Intl Corporation, Products and Services, Hospital Management,http://www.sinopharmintl.com/nr/cont.aspx?itemid=37&id=122. (accessed 20 April 2014).

[20]新乡市市直事业单位法人信用等级评定结果公示, 28 January 2013,http://www.xinxiang.gov.cn/sitegroup/root/html/4028815814acaf060114acb5c05d002a/20130128165615831.html

[21] 公立医院集团化改革 新乡5家医院踏上央企快车, 20 June 2013, 东方今报http://www.jinbw.com.cn/jinbw/xwzx/zzsx/201306201176.htm (accessed 20 April 2014).

[22] Company Prospectus, November 2013, Pg. 138 (copy on file with author)

[23] April Harding and Alexander Preker, “Understanding Organizational Reforms,” World Bank, September 2000,http://www.who.int/management/facility/hospital/Corporatization.pdf

[24]“Vice Health Minister Says: Public Hospital ‘Legal Personalization” Reforms Should Avoid ‘Corporatization,’”(卫生部副部长:公立医院”法人化”改革应避免”公司化”), Xinhua, 30 October 2009, http://news.xinhuanet.com/politics/2009-10/30/content_12358519.htm

[25]“Private Capital Shuns County-Level Hospitals While Second and Third-Level Public Hospitals are Investment Hot Spots,” (民资冷落县级公立医院 二甲三乙医院成投资热点), China.com, 28 February 2014,http://finance.china.com.cn/industry/medicine/yyyw/20140228/2220403.shtml

[26] “Autonomization/Corporatization,” World Bank,http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTHEALTHNUTRITIONANDPOPULATION/EXTHSD/0,,contentMDK:20190817~menuPK:438810~pagePK:148956~piPK:216618~theSitePK:376793,00.html, accessed on 25 April 2014.

[27] Fixing the Public Hospital System in China,” World Bank, China Health Policy Notes,http://siteresources.worldbank.org/HEALTHNUTRITIONANDPOPULATION/Resources/281627-1285186535266/FixingthePublicHospitalSystem.pdf

[28] Ibid.

[29] April Harding and Alexander Preker, “Understanding Organizational Reforms,” World Bank, September 2000,http://www.who.int/management/facility/hospital/Corporatization.pdf (6)

[30] Ministry of Health and Welfare, 2012 Hospitals,http://www.mohw.gov.tw/EN/Ministry/Statistic_P.aspx?f_list_no=474&fod_list_no=3905&doc_no=29655

[31] Don Shapiro, AmCham Taipei, “Examining Taiwan’s Hospitals,”http://www.amcham.com.tw/topics-archive/topics-archive-2009/vol-39-no-3/2696-cover-story-examining-taiwans-hospitals

[32] Ibid.

[33] M. Ramesh, “Autonomy and Control in Public Hospital Reforms in Singapore,” The American Review of Public Administration 2008 38:62. DOI: 10.1177/0275074007301041.

[34] Ibid. 67

[35] Ibid. 67

[36] Ramesh 70

[37] Ibid.

[38]“Analyzing the Medical Sector Reforms—2009 Marks the Start of Public Hospital Reform,” (医改方案解读——公立医院改革2009年开始试点), Xinhua, 14 April 2009,http://news.xinhuanet.com/politics/2009-04/14/content_11184470.htm

[39] Wang Hufeng (王虎峰), “Public Hospital Reform: Assessing Achievements and Development Trends,” (公立医院改革：阶段性成果和发展趋势), China Medical Insurance (中国医疗保险), Issue 5, 2013. (25)

[40] Ibid. 6.

[41] Ibid. 6.

[42] “Administration,” Huashan Hospital, http://www.huashan.org.cn/roomcontent/261

[43] “Opinion Regarding The Implementation of Social Harmony management Work,” (关于加强医院社会治安综合治理工作的实施意见), Leshan Hospital, 31 March 2008,http://www.leshan-hospital.com.cn/viewgovarticle.asp?id=40

[44] Geng Xiao, “Reforming the governance structure of China’s

state-owned enterprises,” PUBLIC ADMINISTRATION AND DEVELOPMENT

Public Admin. Dev. 18, 273±280 (1998).  http://www.econ.hku.hk/~xiaogeng/research/Paper/PAD-Chinese%20SOE%20governance.pdf

[45] Tsung-Mei Cheng, “Explaining Shanghai’s Health Care Reforms, Successes, And Challenges,” Health Affairs, 32, no.12 (2013):2199-2204, 2201.

[46] Shanghai Healthcare and Hospital Development Center, “About Us,”http://www.shdc.org.cn/shenkang.action

[47] Zhang Donghui, Tu Shiyi, and Xue Di, “Analysis of the Responsibilities and Authorities in Governance Structure of Public Hospitals in Shanghai City,” (上海市公立医院治理结构的职能和权力分析), Chinese Hospital Management， 2012, 32（3):9-11

[48] “Shanghai City Health Bureau,” Shanghai Government, http://www.shanghai.gov.cn/shanghai/node2314/node2319/node2405/node3641/

[49] Ibid.

[50]“Regarding the Communication on the ‘Shanghai City Level Public Hospital Chief Accountant Pilot Management Program,’”(关于印发《上海市市级公立医院总会计师委派管理试行办法》的通知), Shanghai Finance Bureau, 19 March 2013,http://www.czj.sh.gov.cn/zcfg/gfxwj/kjl/qtkjl/201303/t20130319_141323.html

[51]Shanghai Healthcare and Hospital Development Center Job Posting (上海申康医院发展中心公开招聘), 9 October 2013, www.shdc.org.cn

[52] Ibid.

[53] Ibid.

[54] See for example, Beijing Municipal Hospital Administration, http://www.bjah.gov.cn/, also Public Hospital Administration of Shenzhen Municipality,http://www.szpha.com/szpha/view?id=2, and finally, Chengdu Hospital Authority,http://www.cdyg.gov.cn/. (All accessed 27 April 2014)

[55] Yao Hongwu, Fang Pengqian, and Xie Jinliang, “Specialization of Directors in Public Hospitals: Hospital Middle Managers’ Cognition and Revelation,” (公立医院院长职业化： 中层管理者的看法于启示), Chinese Hospital Management(中国医院管理), Vol.33, No.9, September 2013. (54)

[56] Zhang Donghui, Tu Shiyi, and Pan Changqing, “Analysis of Shanghai’s public hospital governance structure with the Preker-Harding model,” (利用Preker-Harding 模型分析上海市公立医院治理模式), Chinese Health Resources, Vol.1, Jan. 2013. (43-44)

[57] Zhang Guimin (张贵民), “Ownership and Management are Tough to Separate,” (管办难分), China Hospital CEO, Z1, 2013. (47-48).

[58] “Shanghai Mayor Says Public Hospital Reforms Are Among the Most Important,” (公立医院改革是医改重中之重杨雄主持市府常务会部署三年行动计划强调让群众真正感受到实惠), 7 May 2013, http://www.gov.cn/gzdt/2013-05/07/content_2397106.htm

[59]“Analysis: How to Speed Up Public Hospital Reforms and Encourage Social Management of Medicine,” (解读：如何加快公立医院改革和鼓励社会办医), Xinhua, 14 February 2014, http://www.gov.cn/jrzg/2014-02/14/content_2599665.htm

[60] Cao Yanlin, Wei Zhanying, Wang Jiangjun, “Discussion on Public Hospitals’ Independent Legal Status,” (公立医院独立法人地位探讨), Chinese Hospitals, Vol.14, No.12, 2010. (18-19)

[61] “Chengdu Creates a Hospital Management Bureau that is Independent From SASAC and is Equal to the Local Health Bureau,” (成都设立医院管理局 既独立于国资委又平行于卫生局), People’s Daily, 21 May 2012, http://politics.people.com.cn/GB/17939324.html

[62] Zhao Zhongfu, “Enterprise Legal Persons: Their Important Status in Chinese Civil Law,” Law and Contemporary Problems, Vol.52, No.3, Summer 1989. (5-9)

[63] Ibid

[64] Ibid

[65] Ibid

[66] Ibid

[67] See for instance, “Xuzhou Third People’s Hospital Reforms By becoming For-Profit as Sanbao Group Takes an 80% Shareholding,” (徐州第三人民医院改制营利性 三胞集团控股80%), Sohu, 25 April 2014, http://roll.sohu.com/20140425/n398808719.shtml; also,  “Kunming Children’s Hospital Reforms, Changes its Path, and is No Longer a Public Hospital,”(昆明儿童医院改制路崎岖 已不是公立医院), Healthcare Report, 17 June 2013,http://health.takungpao.com/q/2013/0617/1694119.html

[68] Jill R. Horwitz, “Making Profits and Providing Care: Comparing Non-Profit, For-Profit, and Government Hospitals,” Health Affairs, 24, no.3 (2005): 790-801.

***

Gabriel B. Collins and Andrew S. Erickson, “Volkswagen’s China Dealership Expansions Suggest Substantial Upside for Continued Growth in Car Sales—and Gasoline Consumption,” China SignPost™ (洞察中国) 87 (17 December 2014).

CSP 88_Haikou VW dealer_March 2013_China Daily

China’s passenger car sales volumes have been strong thus far in 2014, with roughly 15% YoY growth between January and November 2014. Gasoline demand has followed suit, expanding by nearly 9% YoY between January and October 2014 (see China SignPost 87). Against this backdrop, and with oil prices low and China’s demand for other commodities such as steel and coal weak, a question arises: “how sustainable is China’s passenger car sales boom?” Depending on how this question plays out, the implications for oil markets and the large global automakers could be profound.

The question of China’s future passenger vehicle market trajectory is huge in scope and complexity. To begin peeling away some layers of the onion, we examine the evolving dealership footprint of Volkswagen—the largest passenger car seller in China’s massive, growing market. Volkswagen reports that between January and July of 2014, it held a 22% share of the passenger car market in China. The company’s heft and presence across the country, as well as its stated ambition to further grow its sales make its sales and service infrastructure decisions a useful barometer for assessing how the “smart money” sees passenger car demand unfolding in various regions of China.

VW discloses data for dealerships by province at approximately quarterly intervals between the fourth quarter of 2012 and the second quarter of 2014. Our analysis of the data shows that the 10 provinces with the largest increase in number of dealerships during this time were (in descending order): (1) Jiangsu, (2) Zhejiang, (3) Hebei, (4) Shandong, (5) Guangdong, (6) Sichuan, (7) Henan, (8) Yunnan, (9) Anhui, and (10) Hunan (Exhibit 1). For reference, Exhibit 2directly follows Exhibit 1 and shows the total number of VW dealerships by province as of 2Q2014, including Audi, Porsche, and Skoda dealers.

Exhibit 1:  VW Dealerships Added by Province between 4Q2012 and 2Q2014

VW_dealership additions_4Q12 to 2Q14

Source: Company reports, China SignPost™

Exhibit 2:  VW Dealerships by Province, 2Q2014

VW_Dealerships by province_2Q2014

Source: Company reports, China SignPost™

VW’s recent dealership addition patterns distinctly favor the populous and prosperous Eastern provinces. By our count using VW’s data, 45% of its new dealerships opened in East Coast provinces accounting for only 35% of China’s population (Exhibit 3). Provinces in Central and Southwestern China saw significant growth in the number of VW dealerships, but at a proportion lower than we would have expected based on the provinces’ population and latent demographic and economic potential for increasing auto sales. Dealership additions in Northeast, Northwest, and Western China (Xinjiang, Tibet, Ningxia, Qinghai) were low relative to population, but this is less surprising given these regions’ relative poverty compared to places like Jiangsu and Sichuan.

Exhibit 3:  VW Dealership Additions by Region, 4Q2012 to 2Q2014

China SignPost 88_Regional car dealership spread_15 December 2014

Source:  Company reports, NBS China, China SignPost™

An important question with respect to assessing future upside for auto sales increases in China is: “how geographically distributed are dealerships within a given province?” Performing such an analysis for all 31 provinces and administrative areas is beyond the scope of this report, so we have chosen Jiangsu as a proxy for the populated and relatively wealthy coastal markets and use Sichuan as a proxy for the populous but less well-developed interior passenger car markets. These data are current as of 10 December 2014.

The data reveal that in Jiangsu, five key metropolitan areas—Suzhou, Nantong, Wuxi, Nanjing, and Changzhou—have only 38% of the province’s total population but 62% of VW dealerships (Exhibit 4). Suzhou, which has the most VW dealerships in Jiangsu (34), accounts for 21% of the province’s dealerships. Sichuan’s distribution is even more skewed, with the five key metro areas—Chengdu, Deyang, Mianyang, Leshan, and Luzhou—accounting for 36% of the population but 72% of Sichuan’s VW dealers (Exhibit 5).

Exhibit 4:  VW Dealership Distribution in Jiangsu, circa 10 December 2014

China SignPost 88_Jiangsu car dealership exhibit_15 December 2014

Source:  Company reports, China SignPost™

Exhibit 5:  VW Dealership Distribution in Sichuan, circa 10 December 2014

China SignPost 88_Sichuan car dealership exhibit_15 December 2014

Source:  Company reports, China SignPost™

Chengdu alone accounts for 44% of the VW dealerships located in Sichuan. Chengdu’s proportion of total Sichuan-based VW dealerships is very high and is comparable to that of Shaanxi, where the Xian metro area accounts for 38% of VW dealerships in that province. These data suggest that: (1) certain provinces—especially Sichuan and Shaanxi—host two of China’s largest passenger car cities in terms of total passenger car fleet size (Chengdu and Xian), but (2) outside the provincial economic center of gravity, passenger car ownership rates are much lower. Whether this reflects low market penetration or a market that does not offer much room for car sales growth outside the giant metro areas remains to be seen. Our hunch is that in the poorer rural areas, residents will purchase cheaper local car brands and/or used cars that trickle out of the big cities as their owners upgrade.

Implications

  • VW’s continued focus on the East Coast provinces suggest that in these areas the mid- and upper-tier car markets have not yet become saturated. Larger cities such as Shanghai and Suzhou likely are close to saturation, if not there already, but the myriad 3rd, 4th, and 5thtier markets in the coastal provinces still have substantial room for growth, particularly for the lower-cost car brands.
  • Likewise, the relative under-representation of Central and Southwest China in VW’s dealership buildout suggests that between 2012 and 2014, company management did not believe these areas were as “ripe” for substantial sales increases as the East and South Coasts were. It is likely that the next two years will see the dealership addition rate relative to population become more balanced between the East Coast and key interior provinces such as Sichuan, where a number of large metro areas such as Deyang, Mianyang, and Leshan are just now turning into significant auto markets.
  • For example, Deyang, an industrial metropolis of 3.9 million people located 85km north of Chengdu, had a private passenger car ownership rate of 6.6 vehicles/100 residents in 2013. For comparison, this is where Chengdu’s car ownership rate was in the 2006-07 timeframe and in 2013 Chengdu had 18.1 vehicles per 100 residents.
  • Each city is different and Deyang likely won’t triple its car ownership in a short span the way Chengdu did, but the car ownership disparity between the cities suggests that barring a truly epic economic slowdown, Deyang and other large Sichuan cities could see substantial increases in their local passenger car fleets, with commensurate increases in gasoline consumption.
  • Similar dynamics exist in many other interior provinces and for this reason, we remain bullish on China’s gasoline demand growth prospects, although it will be some time before gasoline demand growth becomes large enough to fully offset China’s stagnant diesel fuel demand.

***

Gabriel B. Collins and Andrew S. Erickson, “Gasoline, Natural Gas, and Aluminum are Bright Spots for China Commodity Demand in 2014 as Steel and Coal Weaken,” China SignPost™ (洞察中国) 86 (12 December 2014).

CSP 87_Main Image

Gasoline, natural gas, and aluminum are China’s commodity demand bright spots so far in 2014—amidst a significant downturn in consumption of key basic materials, namely coal, steel, and diesel fuel.  Gasoline consumption in China rose by 8.9% YoY between January and October. These results are not surprising given that new car sales rose nearly 16% YoY during the same time period. Healthy growth in transportation equipment output—especially automobiles, subways, and aerospace items—also drives aluminum demand, and apparent aluminum consumption is up 6.5% YoY in the first 10 months of 2014 (Exhibit 1). Finally, natural gas demand is also growing strongly as large Chinese cities work to clean up their air.

Exhibit 1:  China Key Commodity Demand Growth for First 10 Months of 2014, YoY Change

China SignPost 87_Exhibit 1_First 10 months 2014 Commodity Demand

Source: NBS China, local media, China SignPost™

China’s fixed asset investment and heavy industrial activity are clearly slowing. Electricity consumption data—one of the more reliable indicators of economic activity levels—shows that between January and October 2014, China’s “secondary” industries saw their power usage rise by 3.9% YoY. The secondary industries (“第二产业”) encompass most forms of manufacturing, fuel and water production, and construction and account for nearly ¾ of China’s electrical power consumption. In contrast, secondary industries’ power use rose by6.7% YoY during the first 10 months of 2013, suggesting that activity is expanding much less robustly in 2014.

Taken in conjunction with the fact that demand for diesel fuel (which is used to move goods around the country and to the ports) is also down, weaker electricity demand bears close attention because the electricity demand growth figure is a useful proxy for assessing what “real” economic growth in China is at present.

Likewise, China’s coal and steel demand have turned negative for the first time in decades, signaling that demand is plateauing faster than many—especially the mining companies—expected. Depending on how the first six months of 2015 turn out, it may be appropriate to call “Peak Steel” for China—and possibly, “Peak Coal” as well.

Bottom Line:  Global commodity markets are in a new phase, and as China continues to slow, the lowest-cost commodity producers will attract the lion’s share of any capital that remains willing to invest in the commodity space. China’s demand for a number of bulk commodities—particularly metals and coal—is flattening decisively—and events in 2015 will clarify if the trend is temporary or permanent. Our belief is that the plateauing demand for steel, coal, and cement, in particular, is more permanent. The dynamics playing out now align with the S-Curves research we first published in the summer of 2011.

***

Gabriel B. Collins and Andrew S. Erickson, “Mapping China’s Gas Pipeline Buildout: Follow Lights and Railroads,” China SignPost™ (洞察中国) 85 (25 November 2014).

China lights and rail map_22 November 2014

China’s gas supply deficit continues to rise. It is being propelled by booming demand and slowing domestic gas production increases (the deficit was 45% of demand as of June 2014). Now looming on the horizon: a future of much greater Chinese gas import volumes. Pipelines from Central Asia, Myanmar, and perhaps Russia, as well as LNG terminals, will bring gas supplies into the Middle Kingdom. Once the gas enters China, internal trunk pipelines represent the primary mode of moving molecules to market. Thus far, China’s trunk gas pipelines clearly flow to the parts of the country with the most intense nighttime light emissions. After all, light emissions are a strong proxy for aggregate economic activity and energy consumption (Exhibit 1).

Exhibit 1: China Trunk Gas Pipelines* vs. Nighttime Light Emissions

*Data from May 2013. Additional construction has occurred since, but this dataset gives an accurate macro overview of areas served by large, trunk gas pipelines in China.

China Gas Lights Map_2013 light vintage

Source: Harvard Center for Geographic Analysis, NASA, China SignPost™

One key takeaway from Exhibit 1 is that there are densely populated areas of North and Central China with increasingly intense economic activity and energy consumption, yet they are either completely unserved or partially underserved by gas pipelines. For gas use to really take off in these areas—as must happen for China to meet its new pledge to make natural gas 10% of total energy supply by 2020—high-volume gas supply infrastructure must be built.

The bottom line: future gas trunk pipeline construction in China is likely to mirror the country’s rail corridors. China’s existing trunk gas network already closely correlates location-wise with the country’s primary rail lines. This trend will likely continue. The reasons for the close relationship are straightforward: (1) both railways and pipelines link demand and supply centers for the resource/service being provided, (2) rail and gas supply services both typically prioritize locations with the highest economic activity, and (3) railway and pipeline builders tend to favor the most topographically sensible (flattest) path between locations to minimize cost and construction time (Exhibit 2).

Exhibit 2: China Railroad Network Paths Show Where Future Gas Pipelines Will Likely Go

China lights and rail map_22 November 2014

Source: Harvard Center for Geographic Analysis, NASA, China SignPost™

The Way Forward

Using rail lines as a proxy for future gas supply corridors strongly suggests that many parts of the North China Plain and Central China, in particular, remain significantly under-serviced. These locations, along with Guangdong Province, will be key areas of natural gas trunk pipeline construction activity over the next decade as China moves to clean up urban air by boosting natural gas consumption. Large areas of Qinghai and Tibet, by contrast, will likely remain peripheral in terms of geography, economics, and gas grid infrastructure.

While radically improving Chinese air quality will be difficult, projecting China’s overall gas pipeline buildout is not: existing lights and railroads will point much of the way.

Exhibit 3:  China Trunk Gas Pipelines (2013) and Main Railways, Overlaid

China gas pipes vs railroads map

Source: Harvard Center for Geographic Analysis, NASA, China SignPost™

***

Gabriel B. Collins and Andrew S. Erickson, “Tank Watch: What Do China’s November 2014 SPR Data Tell Us?” China SignPost™ (洞察中国) 84 (24 November 2014).

China Zhejiang oil storage tanks_undated_from China Daily 2009

On November 20, China’s National Statistics Bureau unveiled a G-20 surprise by publishing inventory data for four of the country’s strategic petroleum reserve (SPR) sites: Dalian, Huangdao, Zhenhai, and Zhoushan. These four sites can store approximately 103 million barrels of crude combined. The reported crude inventory level on November 20 was 89.5 million barrels, yielding an average capacity utilization rate of just under 87%.

The capacity utilization by site varies, with Dalian at 82.8%, Huangdao at 89.4%, Zhenhai at 83.2%, and Zhoushan at 91.1%. These utilization rates are significantly lower than the U.S. SPR, which between January 2007 and the present has averaged a 97% capacity utilization rate and never dropped below 94% utilization (Exhibit 1).

Exhibit 1: China’s November 20, 2014 SPR Utilization Rates vs. US SPR Utilization Rates Since January 2007, % of total capacity in use

China SignPost 84_China SPR Analysis_Exhibit 1

Source: DOE, EIA, NBS China, China SignPost™ analysis

We choose the U.S. as a basis for comparison because: (1) together with China, it constitutes the “G-2” of global oil consumption, (2) the U.S. now has decades of SPR management experience under its belt, and (3) the countries have different economic structures and geological characteristics (e.g., U.S. salt domes) that shape their SPR management approaches.

It is likely that crude oil has a lower “dwell” time and higher turnover ratio in the Chinese SPR system, driven in part by the fact that SPR and “commercial” storage are closely co-located and are likely frequently commingled in practice. For instance, the Zhenhai storage site near Ningbo has 52 tanks which are located immediately next to commercial tank farms of 20 tanks and 26 tanks, whose combined capacity approaches that of the SPR facility itself (Exhibit 2). In addition, Sinopec revealed in 2007 that it had “rented” storage space in the Zhenhai SPR facility, so there is a precedent for commercial use of SPR tankage in China.

Exhibit 2: Zhenhai SPR Imagery Shows Co-Location of “Strategic” and “Commercial” Storage

China SignPost 84_China SPR Analysis_Exhibit 2_final image

Source: Google Earth, China SignPost™ analysis

Additional data points will be required to understand China’s SPR management philosophy more comprehensively. The data we hope to see China disclose would include additional statistical data of inventory levels over time, as well as publication of inventory data from inland SPR sites such as Lanzhou and Dushanzi.

While conclusions are very preliminary, two key facts suggest that China’s SPR may be managed quite differently than its American counterpart. First, these reserve sites have all been operating since 2009 and have had ample time to fill up to full capacity, were that the operator’s objective. Second, oil prices have declined sharply and offer lower cost filling opportunities. In practical terms, 10 Suezmax cargoes or 5 VLCCs’ worth of crude injections would bring the four Chinese SPR sites’ storage capacity utilization to the average U.S. level.

Bottom Line: Several further SPR data disclosures will enable us to draw firmer conclusions, but it already appears likely that China is managing its SPR is a dynamic, quasi-commercial fashion more akin to South Korea’s “time swap” system in which commercial crude users can “borrow” oil from strategic reserves so long as they return an equal amount within a set period. As such, China oil use forecasts will need to assume that SPR injections will often be “lumpy” and volatile, with fundamental oil demand, internal refinery operation decisions, and global crude pricing all influencing SPR fill and drawdown decisions.

***

Gabriel B. Collins and Andrew S. Erickson, “China’s First Cold Snap Will Once Again Expose Serious Natural Gas Shortages and Drive Historically High LNG Import Demand,”China SignPost™ (洞察中国) 83 (9 November 2014).

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China’s weather so far in Fall 2014 has been relatively mild, in contrast to 2009 and 2013, when November cold waves prompted major gas shortages in much of Eastern and Central China.

The first cold snap this coming winter will very likely set the stage for another round of serious natural gas shortages in many parts of China. CNPC researchers estimate this winter’s gap between supply and demand could grow to 13.6 billion cubic meters—roughly twice as large as last winter’s gap and approximately 42% more gas than wasdelivered to the municipality of Beijing in the entire year of 2013.

Over the past seven years, China’s gas supply deficit has burgeoned dramatically, and as of June 2014, stood at nearly 45% (Exhibit 1). In recent months, domestic gas supply increases have tapered off and the supply deficit is now likely even more acute than it was during the summer, increasing China’s dependency on pipeline and LNG imports.

Exhibit 1: China Gas Supply Deficit

Shortfall as percentage of domestic production

China SignPost 83_Exhibit 1 China gas supply deficit

Source: BP, NBS China, China SignPost™ analysis

This growing reliance poses challenges because import infrastructure is not optimized to respond to rapid demand spikes in China’s populous and increasingly gas-hungry central regions—especially Chongqing, Sichuan, Hubei, Hunan, and Anhui—where many gas demand centers cannot easily access “surge” gas supplies from seaborne LNG imports, the most responsive supply source when sudden demand spikes occur.

CNPC, Sinopec, and others are working to build out gas storage capacity, but China’s storage caverns and tanks still fall short of the coverage ratio the country will need to ensure gas supply security during cold winters—12-15% of total annual demand, as opposed to the roughly 2-3% working coverage now likely in place. To put recent storage capacity additions in perspective, consider that CNPC’s Hutubi storage facility in Xinjiang, which came online in 3Q2013; and Xiangguosi facility near Chongqing, which came online in 3Q2014; can store a combined total of approximately 15 billion cubic meters of gas.

But this capacity is constrained by infrastructure availability and—given the current state of gas trunk pipeline coverage in China—is not well-positioned to augment supplies in much of Central and North-Central China when the full winter chill hits. Hutubi can inject 11.23 million cubic meters per day of extra gas into the pipeline system in Xinjiang and Xiangguosi can put another 10 million cubic meters per day of supplementary gas into the pipelines near Chongqing.

However, in a serious cold snap that ranges across Central and Eastern China, this will likely prove insufficient to restore supply stability. For instance, in January 2013, the city of Wuhan by itself faced peak gas supply shortfalls of 700,000 cubic meters per day, which if multiplied across China’s populous (and increasingly gas-hungry) inland provinces, quickly absorbs the additional gas injections and leaves many areas still short on gas supplies. And if the winter is colder than expected (think U.S. “Polar Vortex” in 2013-14), the city of Chongqing itself, which ran a 20% gas supply deficit this past winter, would likely effectively absorb all of the molecules Xiangguosi injected before they ever made it to consumers further downstream.

China can get much colder than we have seen in recent winters…

Mother Nature could set the stage for a natural gas supply crunch substantially more serious than the ones China has encountered during the past several winters. Since Central China is an area that has been repeatedly affected by natural gas supply shortages since 2009, when large-scale shortages were first reported, it is worthwhile to assess temperature curves for the region and see how they looked when gas shortages occurred. Perhaps more importantly for assessing risk, examining such historical data—in this case, 33 years’ worth—sheds light on how much worse things could potentially be relative to where they stand now (Exhibit 2).

Exhibit 2: Mean Daily Temperatures for Changsha, Hunan (January 1980-7 December 2013)

Degrees Celsius

China SignPost 83_Exhibit 3_Changsha weather

Source: AccuWeather, China SignPost™

We chose data for the city of Changsha because it is a sizeable natural gas market and because it lies far enough south that when a cold Siberian air mass makes it into Hunan, we know that it has almost certainly also chilled a vast swath of North and Central China—home to more than 500 million people. As such, a Siberian blast powerful enough to affect Changsha has a very high probability of straining the natural gas supply infrastructure and causing disruptions.

The mean daily temperatures during the very serious 2009 natural gas shortages were in the neighborhood of 0° Celsius. To be sure, this is frigid for a city located at approximately the same latitude as Orlando, Florida and renowned for summers that are as hot as its signature Hunanese cuisine. Yet in the 1980s, several more severe cold snaps hit Changsha, sending the mercury plummeting to the -8° Celsius range.

The demand effects of a cold snap that fell below the range many homeowners are accustomed to would likely boost heating and natural gas demand dramatically, thus exacerbating supply shortages and infrastructure problems that might arise.

A Severe Cold Snap Would Likely Trigger Exponential Increases in Gas Demand

Multiple academic studies show that as temperatures move away from the “room temperature” comfort range (usually around 70°F), demand for energy for climate control such as heating and cooling increases exponentially. A 2°F decrease induces a 4.6% increase in electricity demand. We expect that in parts of China where gas has penetrated into the residential market, such an exponential effect would also apply to gas demand during times of extreme temperature variation.

Bottom Line

China’s first 2014 cold snap will likely drive a sharp increase in LNG imports, as these quick response supplies can react to market changes much more rapidly and flexibly than pipeline imports can. Last winter, LNG imports into China peaked at nearly 4 billion cubic feet per day (“BCF/d”)—roughly 1.5 times what the municipality of Beijing consumes on peak winter demand days (Exhibit 4). We estimate multiple cold snaps this winter could see LNG imports spike at 4.5 BCF/d in order to rebalance the Chinese gas market, with commensurate positive price impacts in the NE Asian and global LNG markets.

Exhibit 4: LNG and Central Asian Pipelines Both Supply Baseload Gas, but LNG Balances Gas Supplies During Peak Demand Times

BCF/d

China SignPost 83_Exhibit 4_LNG as the market balancer

Source: NBS China, China SignPost™ analysis

***

Gabriel B. Collins and Andrew S. Erickson, “Gasoline Alley: How Much Gasoline Demand Are Each Million Cars Sold in China Worth?” China SignPost™ (洞察中国) 82 (3 November 2014).

Sinopecs full-year profit edges higher as oil prices rise

Key Takeaways:

  • Over the past two years, gasoline output at Sinopec and CNPC/PetroChina has surged relative to diesel fuel, reaching a new high of 0.71 barrels of gasoline produced for each barrel of diesel fuel. This is primarily a result of surging passenger car sales and stagnating industrial demand for diesel fuel.
  • Our data analysis of the past four years of car sales and gasoline consumption levels suggests each million new cars sold will add 10.5-to-13 kbd of annualized gasoline demand.
  • A serious economic slump could knock this down to 5-to-7 kbd of incremental gasoline consumption per million new cars sold.
  • In 2014 and 2015, we project that Chinese drivers will add 220-to-250 kbd of new gasoline demand each year.

China’s legion of passenger car owners—280 million of them at year-end 2013 according to the Ministry of Public Security—cannot by themselves salvage the currently weak global oil demand picture. Based on what the data show so far, gasoline demand should rise by approximately 10% year-on-year in 2014.

This represents an increase of ~220 kbd, equivalent to ~500 kbd of incremental crude oil demand—roughly the amount China has been injecting into its strategic petroleum reserve earlier in the year. But even this respectable growth cannot make up for stagnant demand for diesel fuel—China’s industrial mainstay liquid energy source. Slower trucking activity substantially crimps fuel demand because one working industrial truck likely uses as much fuel as 5-10 passenger cars.

Over the past four years, China’s two largest refiners, Sinopec and PetroChina, have substantially increased gasoline production relative to diesel production in their plants. There are other refiners in China, but Sinopec and PetroChina account for more than 80% of the country’s gasoline output. Furthermore, China’s refined product imports and exports are de minimisrelative to overall demand, so the product output slate from the “Big 2” refiners is a good proxy for assessing how demand for gasoline, diesel, and other products are shifting relative to each other.

Over the past two years, gasoline output at Sinopec and CNPC/PetroChina has surged relative to diesel fuel, reaching a new high of 0.71 barrels of gasoline produced for each barrel of diesel fuel (Exhibit 1). This is primarily a result of surging passenger car sales and stagnating industrial demand for diesel fuel, a dynamic discussed further below.

Exhibit 1: Sinopec and CNPC Gasoline/Diesel Production Ratio

Barrels of gasoline per barrel of diesel produced

China SignPost 82_Exhibit 1_Gasoline vs Diesel refinery output

Source: Company Reports, China SignPost™ analysis

Three core dynamics grab our attention as we assess the China gasoline situation. First and foremost, refiners’ decision to favor gasoline output at some level reflects weakness in China’s industrial economy, where trucking drives diesel demand. Unlike the U.S., with its well-developed intermodal logistic system, China’s consumer economy relies much more heavily on trucks to move goods, as the railroad system primarily moves coal and other bulk commodities. The Big 2 refiners’ diesel and gasoline production trends over the past 2 years reflect stagnation in diesel demand and strong growth in gasoline consumption in China, albeit with flattening in recent months (Exhibit 2).

Exhibit 2: Sinopec and CNPC Gasoline and Diesel Fuel Production Volumes, Kbd

Diesel fuel production on left vertical axis, gasoline production on right vertical axis

China SignPost 82_Exhibit 2_diesel and gasoline production volumes

Source: Company Reports, China SignPost™ analysis

Second, China’s car fleet continues expanding rapidly, but many cars are not being driven as much as refiners and crude oil suppliers might hope. New car sales are still growing strongly in relative terms (although sales have slowed a bit recently) and dealers sell massive numbers of new cars each quarter—nearly 4.8 million in 3Q2014 alone (Exhibit 3).

New car sales give solid insights into how China’s overall passenger car fleet is expanding, since the real explosion in sales began slightly over five years ago, meaning that the burgeoning number of cars that have entered the fleet during the recent car buying spree still have many years of service left in them, scrapping rates are very low, and the relationship between new cars sold and the number of cars entering the vehicle fleet on a net basis is much closer to one-to-one than it would be in a more mature market.

Exhibit 3: Sales of New Passenger Cars in China, by Quarter

Units sold

China SignPost 82_Exhibit 3_China quarterly passenger car sales thru 3Q2014

Source: CAAM

Car Usage Not As Intense as In Other Markets

To look at the new car sales data from a different angle, consider that between the first quarter of 2007 and second quarter of 2014 (the latest period for which the Big 2 have reported gasoline production), the number of cars sold per quarter grew by more than 350%, while Big 2 gasoline output only rose by 70% (Exhibit 4). Taken in conjunction with the slowing increase in the gasoline/diesel ratio shown in Exhibit 1, the data in Exhibit 3suggest lots of cars are being sold, but that they are mostly prestige items that sit in garages and driveways and do not see much pavement time. It also suggests that China is not developing a strong long-distance car travel culture like that which exists in the U.S., for instance. The country is investing heavily in adding and expanding highways between cities, but by the looks of gasoline demand, these investments are likely not promoting a groundswell increase in inter-city car travel.

Exhibit 4: China Car Sales Have Grown Several Times Faster Than Gasoline Sales Since 2007

China SignPost 82_Exhibit 4_China quarterly passenger car sales thru 3Q2014

Source: CAAM, Company Reports, China SignPost™ analysis

Chinese drivers are much less sensitive to fuel price changes than their American peers. There are two core reasons for this. First, Chinese car buyers tend to be much more affluent in relative terms than car buyers in the U.S., where a lack of public transportation makes private car ownership a necessity even for impoverished citizens in many areas. Second, with China’s notorious traffic jams, congestion is a much stronger influencer of car use than pump prices. Improved infrastructure and traffic management policies that restore traffic flow would do much more to stimulate increased car use in China than lower gasoline prices ever could, since even free gasoline is not helpful if the road subjects drivers to the frustration of gridlock.

Implications

Ultimately, we expect China’s passenger car fleet to continue growing at a slower, but robust rate for at least 2-3 more years, but it will not deliver a market-saving oil demand growth bonanza. Gasoline demand growth will be respectable, it just will not support the market-shaking oil hunger that characterized much of the 2004-12 period in China. Jammed up urban areas will thwart greater car use and inter-city travel for the bulk of Chinese largely remains a game of buses, trains, and planes—not personal cars. Each Lunar New Year features hordes at train stations, long lines at bus stops, and angry flyers in crowded airports. Yet images of jammed expressways between cities (reminiscent of U.S. Interstates during holidays—Boston to New York on I-95 or I-84, anyone?) remain conspicuously absent.

China’s gasoline demand—and by extension, need for crude oil—will continue to grow meaningfully as auto dealers work to penetrate 3rd, 4th and 5th Tier markets. Our data analysis of the past four years of car sales and gasoline consumption levels suggests each million new cars sold will add 10.5-to-13 kbd of gasoline demand.

This time period is, in our mind sufficient—coupled with our in-depth analysis of Chinese passenger car owners’ driver behavior—to make us comfortable providing this shorthand metric for assessing how car sales will likely translate into incremental gasoline demand. The biggest upside risk to our view is that as China’s used car market grows and rural car ownership creeps up, rural drivers may drive more miles than their city cousins and thus help bump up the incremental fuel demand benchmark.

Because the biggest “bulge” in the car boom came in 2009, there are likely at least five more years before fleet retirements began to slightly erode the positive impact new car sales have on gasoline demand. For 2014 and 2015, we project that Chinese drivers will add 220-to-250 kbd of new gasoline demand annually.

***

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).

Xi at Third plenum

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 how, 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, as Yanzhong Huang has documented cogently, but doing so will divert tremendous resources from future economic growth and defense spending. Pension reserves currently stand at only about 2% 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 CO2 emissions. 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 the accumulation 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.

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Gabriel B. Collins and Andrew S. Erickson, “King Coal Reigns: North America’s Shale Gas Boom Will Force China to Continue Relying on Coal,” China SignPost™ (洞察中国) 80 (21 February 2014).

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

Key Points: Unless Chinese industrial consumers use low-cost coal, they will likely not be competitive in the export market with their global peers in North America and elsewhere who benefit from the shale gas boom and more favorable demographics. Energy costs matter more now for Chinese industry because Mexican manufacturing wages have become roughly equivalent to those in many parts of China. By 2015, manufacturing wages in Mexico could be as much as 30% lower than those in China on a productivity-adjusted basis. Nuclear, wind, and hydro power will not displace coal significantly for at least 10 years. Even with the current aggressive reactor buildout, China will likely only add 32 GW of nuclear power in the next five years—roughly half of the coal-fired capacity it has added annually in … … …

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Gabriel B. Collins and Andrew S. Erickson, “China Car Sales: New Pockets of Opportunity,” China SignPost™ (洞察中国) 79 (29 December 2013).

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

  • China’s market for new passenger cars is maturing, but the overall outlook for 
car fleet expansion remains bright for at least 5-7 more years.
  • Even in a pessimistic scenario, Chinese are likely to buy more than 18 million passenger cars in 2020—a nearly 30% increase over the number of cars likely to be sold in 2013.
  • The greatest market and growth potential lies in (1) “mid-level” cars—250,000- 800,000 RMB (US$ 40,000-130,000) for larger cities and (2) lower cost vehicles for inland regions.
  • Luxury vehicles (RMB 800,000-1,000,000+/US$ 130,000-165,000) are likely to remain an important-but-niche market that grows significantly yet does not become a large slice of the overall market.
  • Areas where new car sales will likely outperform the national average include Henan, Hubei, Sha’anxi, Shanxi, Hunan, Sichuan, Anhui, Yunnan, and Chongqing.
  • As new car sales numbers begin to plateau, carmakers will come to rely increasingly on sales of certified used vehicles and on providing maintenance services to vehicles of their respective brands.
  • China’s used car market has great growth upside over the next decade. 370,000 pre-owned vehicles were traded in 2001, 2.4 million in 2010, and 4.8 million in 2012.
  • China Automotive Dealer Association forecasts that used car sales could reach 20 million units by 2018. This suggests that new and used car sales could be at 1:1 parity within five years.
  • EVs are unlikely to displace gas-powered auto sales, particularly in China’s interior.
  • While most major Chinese cities have basic restrictions on car use, they are unlikely to dampen car sales significantly on a nationwide basis. …

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How Sustainable Are China’s Car Sales And What Do They Mean for Volume and Location of Gasoline Demand? China’s market for new passenger cars is maturing, but the overall outlook for car fleet expansion remains bright for at least 5-7 more years. Even in a pessimistic scenario, Chinese are likely to buy more than 18 million passenger cars in 2020—a nearly 30% increase over the number of cars likely to be sold in 2013. The greatest market and growth potential lies in (1) “mid-level” cars—250,000-800,000 RMB (US$ 40,000-130,000) for larger cities and (2) lower cost vehicles for inland regions. Luxury vehicles (RMB 800,000-1,000,000+/US$ 130,000-165,000) are likely to remain an important-but-nich