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. …

China Car Sales Image

 

 

 

 

 

 

 

 

 

 

 

 

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-niche market that grows significantly yet does not become a large slice of the overall market. Areas where new car sales will … … …

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Andrew S. Erickson and Gabriel B. Collins, “China SignPost™ ‘Greatest Hits’ #6: Mining & Minerals,” China SignPost™ (洞察中国) 78 (23 December 2013).

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

China’s rise as a top global mineral consumer and producer creates three key dynamics that we believe investors and policymakers should follow closely.

First, the pursuit of minerals is bringing Chinese miners and energy producers into complex and sometimes dangerous parts of the world. In these zones, the growing presence of Chinese workers on the ground and rising Chinese interests in a secure flow of minerals to be either shipped back to China or traded on the global market increasingly makes Chinese national strategic interests overlap with those of the U.S. in such places as Central Asia and the Middle East.

Second, China’s mineral leverage is rising. It is the top global producer of strategic rare earth metals. Despite global consumers’ attempts to diversify supply sources over the past several years, Chinese suppliers remain the dominant players, particularly in the area of processing rare earth ores into actual usable materials.

Third, China’s mining and mineral activities are major wealth generators domestically and abroad. Yet becoming tightly levered to a single country that underpins global metals markets in particular has proved costly for many multinational miners, who have had to scramble to reduce investment budgets and find alternative customers such as India because China’s demand for certain base metals has slowed.

On the bullish side, rising mineral demand has created fabulous wealth domestically in China’s coal belt (Shanxi and Inner Mongolia) and this wealth creation engine appears poised to spread to Xinjiang as well in coming years.

Finally, the past few years have seen Chinese firms become true market movers in key global commodity markets not just as consumers, but also as investors. For instance, potash—a mineral badly needed by Chinese farmers—has in the span of less than 10 years gone from being a salt like compound few people outside the mining and farming communities followed, to becoming a quasi-strategic food security item of broad concern.

Indeed, we estimate that in China, each 10 kilos of pork consumed requires 1 kilo of potash to produce, since Chinese pigs are increasingly fed with potash-hungry corn and soybeans. Similarly, every 44kg of rice eaten in China likely requires 1 kg of potash to grow, with application intensity likely to rise in the year to come as China runs short of arable land and seeks to produce more grain in a relatively constrained physical space.

This and other China Signpost research is in high and growing demand from some of the world’s most sophisticated and exacting consumers of China analysis. As we enter 2014, mining and minerals will remain one of our key areas of focus. China is a big part of that story, and we’ll make sure to keep you posted on key developments and their likely investment impacts.

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Andrew S. Erickson and Gabriel B. Collins, “China SignPost™ ‘Greatest Hits’ #5: Industrial and Technical Development,” China SignPost™ (洞察中国) 77 (23 December 2013).

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

A bevy of recent developments in China’s shipbuilding and aerospace sectors highlights important dynamics playing out in its overall technical-industrial growth and development.

On the shipbuilding front, Chinese naval yards are now the world’s busiest warship builders, with at least six classes of surface combatants and submarines now under construction simultaneously. With China very likely preparing to construct follow-on aircraft carriers to complement the Liaoning, its possession of multiple yards capable of building large vessels with modular construction techniques is a huge strategic asset. China’s large number of empty, or soon to be empty, civilian shipyard spaces may yet prove militarily useful.

China is also rapidly developing significant high-end aerospace engineering and design capabilities, ranging from spacecraft to modern fighter airframes. For instance, it has developed and is now testing the low-observable J-20 fighter, an aircraft that, with the right engines and technical inputs, could shift the air power balance in the Asia-Pacific Region.

Meanwhile, however, China is still struggling to mass-produce high quality and reliable indigenous jet engines for both military and commercial aircraft. The jet engine struggle suggests the limits of an R&D philosophy of “problems can be solved by throwing money at them” and points to the possibility that many segments of Chinese industry may require a significant philosophical, organizational, and management revamp in order to become globally competitive on the basis of true innovation.

Indeed, at the most fundamental level, the jet engine saga is a critical case. It will likely provide a useful barometer for whether China will continue to be a lower-cost assembler or whether multinational corporations will eventually have to contend with a Chinese equivalent of Google, Apple, GE, or Siemens that can compete on quality and innovation, rather than low cost. In turn, moving up the innovation ladder would be positive for wealth creation in China since more of the value-added of products would stay in the hands of Chinese inventors, license-holders, and manufacturers. Increasing domestic innovation capacity, at least to a modest extent, is likely one of the key hurdles for successful transition to the new growth model that China’s economy now needs badly. In following these key factors, a key indicator to watch is where China’s wealthy are making their money.

In 2014 and beyond, China SignPost will examine an even broader array of technological and industrial sectors. This will enable it to better serve as a pathfinder that identifies and illuminates pockets of risk, value, and opportunity in a fast-paced, complex world. In an era of considerable uncertainty, China SignPost works diligently to identify the trends that offer opportunity today and to help you plan and position effectively for the future.

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Andrew S. Erickson and Gabriel B. Collins, “China SignPost™ ‘Greatest Hits’ #4: Macro and Strategic Assessments,” China SignPost™ (洞察中国) 76 (23 December 2013).

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

China SignPost anchors its China macroeconomic research with a tight focus on the sustainability of Chinese economic growth. The country’s comprehensive national power is ultimately predicated on having an economy robust enough to support spending priorities necessary for overall development. Unfortunately for Beijing, China is already experiencing an “S-curved” growth slowdown, both economically and more broadly. A growing array of structural factors such as pollution and chronic disease (e.g., diabetes) are beginning to pull China onto a slower growth curve, a concept introduced in an innovative and novel way by China SignPost. Our readers enjoyed our groundbreaking research on China’s movement into an “S-Curved” path of slower economic growth more than 12 months before our competition began publishing on the subject.

These reports offer a powerful but nuanced argument: China isn’t about to collapse by any means, but its growth rate is already slowing down—with major consequences. Three days after the release of China SignPost’s S-Curve report, Jennifer Richmond, STRATFOR’s Vice President of International Projects reportedly forwarded it to analysts at STRATFOR.

The analysis was widely praised by other experts, including by Thomas P.M. Barnett: “it is worth revisiting an excellent blog post from August by China Signpost’s Gabe Collins and Andrew Erickson entitled, ‘China’s S-Curve Trajectory,’ which argues that structural factors are likely to slow the growth of China’s economy and its ‘comprehensive national power.’” The Council on Foreign Relations deemed a September 2011 summary of our findings a “Must Read,” as one “of the best online analyses and inquiries on foreign policy.” China SignPost’s S-Curve concept has since received attention from U.S. government analysts and been employed widely in the investment research community. It has now achieved the status of conventional wisdom.

In building a larger analytical portfolio, China SignPost strives to tie our broad macro research to specific areas of impact, in order to help integrate our products with one another and better deliver concise and value-added insights to busy readers. For instance, we followed our S-Curve research with a detailed examination of how China’s evolving economic situation may affect the country’s military spending—a core driver of comprehensive national power and international influence.

Finally, China SignPost economic research also strives to develop interesting and effective benchmarks to measure specific sets of economic activity that are barometers for national and local-level economic health. In January 2012, China SignPost gained a jump on its competitors by using earthmover sales to gauge economic growth in a way less subject to official massaging of statistical data. Within 10 days, the Financial Times picked up the indicator and featured it in a “beyondbrics” blog entry.

To keep the scale of Chinese growth in perspective, China SignPost has also offered handy comparisons of how the economic statistics of Chinese municipalities, provinces, and other regions compare with their American and international counterparts.

As we follow China and its many associated metrics into 2014, we’ll continue to combine a broad macro outlook with tight linkages to the specific areas that matter most. We believe strongly that this combination of breadth and depth offers unique value, particularly in this period of growing uncertainty for the most dynamic power in the international system today.

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Gabriel B. Collins and Andrew S. Erickson, “China SignPost™ ‘Greatest Hits’ #3: Agricultural & Consumer Markets,” China SignPost™ (洞察中国) 75 (23 December 2013).

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

Legacies of restrictive farmland ownership policies, in addition to land and water resources overtaxed by pollution and urban development, constrain China’s agricultural production potential significantly. Famine and grain supply problems helped topple at least five of China’s 17 dynasties, and the strong correlation between food supply disruptions and regime change keeps the Chinese Communist Party tightly focused on ensuring sufficient grain supplies.

Despite the supply-side challenges, demand continues to grow. Chinese consumers are becoming wealthier and eating more meat. The changing Chinese diet is characterized by rising fast food intake, an important consumer barometer because even those who cannot afford a passenger car or fancy apartment can afford to visit name-brand chains several times per week. As a result, protein-hungry Chinese consumers are helping to underwrite a long-term global farm commodity boom that is set to yield especially large benefits for the U.S., Brazil, Argentina, Canada, Ukraine, and—to some extent—Russia.

Our research also embraces the complexity of China’s consumer markets. China is not simply a tale of perpetual growth and bullishness. Rather, there are pockets of periodic turbulence wherein it can be much harder to manage risk and locate opportunities for investment, as well as to know what areas to avoid. China SignPost™ helps steer readers through these stormy seas and around hazardous shoals with creative analysis of data to give insights that few other research providers can offer.

Gabriel B. Collins and Andrew S. Erickson, “Downturn to “New Normal”? China’s Consumer Economy is Rolling Over and Sales of Chicken, Cars, and Shoes Are Taking a Hit,” China SignPost™ (洞察中国) 60 (1 August 2012).

Gabriel B. Collins and Andrew S. Erickson, “Can Inland Consumption Soften Coastal Industrial Slump? China’s Weak Earthmover Sales and Poor Coal Demand Point to More Economic Turbulence, But Second and Third Tier Property Markets Show Flashes of Life,” China SignPost™ (洞察中国), 61 (14 August 2012).

As 2014 dawns, followers of China SignPost™ can rest assured that we’ll continue to keep a close eye on key trends and underlying drivers to offer a versatile, reliable compass for understanding Chinese agricultural and consumer developments.

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Gabriel B. Collins and Andrew S. Erickson, “China SignPost™ ‘Greatest Hits’ #2: Military and Security Developments,” China SignPost™ (洞察中国) 74 (23 December 2013).

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

In the three years since we established China SignPost, Beijing’s military developments—both in technical and operational terms—have been nothing short of astounding. We’ve covered the most important milestones closely, offering insights into dynamics of disproportionate impact while debunking misconceptions that threaten to mislead observers seeking to understand the larger implications.

In late 2010, Admiral Robert Willard, Commander, U.S. Pacific Command, stated that the PLA’s DF-21D anti-ship ballistic missile (ASBM)—the first of its kind anywhere in the world—had reached the rough equivalent of what the U.S. military terms “initial operational capability” (IOC). China SignPost™ drew extensively upon Chinese language sources and provided the first comprehensive published analysis of this key strategic development. It was the first publicly available assessment explaining that open source trend lines strongly supported the DF-21D’s having reached ~IOC and initial deployment in small numbers.

This was the first comprehensive unclassified analyses of the ASBM from a U.S. Navy perspective based on trends in Chinese-language sources. It successfully challenged outdated views on such issues as whether China would develop and deploy an ASBM. We persisted despite widespread public skepticism because we were confident that extensive, meticulous analysis of authoritative Chinese-language doctrinal/technical publications yielded meaningful patterns and instructive indications.

This and related publications on China’s ASBM development have been read by U.S. Navy leadership, have been posted on the Fleet Forces Command website, have been discussed widely in U.S. Navy circles and beyond, have received considerable citations (including from then-Under Secretary of Defense for Policy Michèle Flournoy), and have won multiple awards.

In addition to the ASBM analysis, China SignPost™ has also consistently been among the first to provide rapid, accurate analysis of China’s first significant overseas naval and air deployments. Of particular note, we comprehensively assessed both the March 2011 deployment of the missile frigate Xuzhou to the seas off Libya and the PLA Air Force’s mission in which four IL-76 long-range transport aircraft flew from northwest China to Sabha, (east-central) Libya to evacuate hundreds of Chinese citizens stranded there. The 2011 Libya crisis represented a coming of age for China’s military, as it was the first long-range, multi-service deployment in direct defense of Chinese citizens trapped in a dangerous environment.

China’s now five-year-old anti-piracy mission in the Gulf of Aden and the landmark deployments the PLA air and naval forces undertook during the 2011 Libyan Civil War highlight the country’s small but rapidly emerging expeditionary military capabilities and mindset. China’s aircraft carrier Liaoning—which entered service in September 2012—is an important if complicated symbol of the country’s rising sea power.

China SignPost’s analysts have been at the forefront of explaining Liaoning’s strategic impacts. China SignPost’s coverage offers particular value because we delve directly into the strengths and weaknesses of the subcomponents of China’s new naval power push—such as the J-15 fighter aircraft that is operating off Liaoning.

Our analysis is unique because it draws on Chinese language sources as well as insights from former naval aviators to provide a measured, technically informed assessment of what the carrier and its jets can and cannot do. Most importantly, as with much of our research, this product was anticipatory. We published it well over a year before the J-15 began any actual flight operations from Liaoning.

In addition to providing rapid, on-point analysis of breaking events, China SignPost has also published research illustrating the dynamics that are motivating and shaping China’s military modernization, as well as detailed examination of strategic implications for other major powers. When we believe it provides value to our readers, we do not hesitate to take on controversial issues and analyze them rigorously. This we did in our “Strategic Horizons” series, which examined key drivers behind China’s rapid naval modernization and what it means for key regional forces, including those of the U.S. and Japan.

As we enter 2014, China SignPost will continue to follow developments of disproportionate significance and draw upon a wide range of data and ideas that span multiple disciplines to offer original insights into China and its impact on the Asia-Pacific region and beyond. When it comes to breaking and far-reaching developments, we want to make sure that you read solid analysis of them here before it’s available anywhere else.

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Gabriel B. Collins and Andrew S. Erickson, “China SignPost™ ‘Greatest Hits’ #1: Energy & Transportation,” China SignPost™ (洞察中国) 73 (23 December 2013).

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

To conclude 2013 on a high note, we are publishing six category-based compilations, each containing five of the China SignPost™ research pieces that we believe to have been the “greatest hits” in their respective areas.

The first category focuses on energy; primarily oil, natural gas, coal, and the transportation sector. Natural gas has been an important focus for us since China SignPost™’s inception in 2010. Since then, each winter has been marked by serious gas shortages, and it appears that the present season is likely to bring the most severe shortages yet. Given that China’s domestic gas fields are already pumping all out and that the ability to expand pipeline gas imports is very limited in the near-term, that leaves one option to help mitigate the supply side of the shortfall: more LNG. Accordingly, we expect China’s monthly LNG imports to hit record levels this winter.

Natural gas demand is far from the only growth story in China’s energy sector. Passenger car sales have also been very robust through 2013. To help our readers conceptualize what increased car sales mean for gasoline and crude oil demand on a local level, we conducted a detailed analysis of the private car fleets in 36 Chinese cities spread around the country. We then combined this data with information on the typical distance Chinese drivers cover annually in a representative set of cities and developed estimates of daily gasoline demand in the 36 cities, many of which are among China’s largest gasoline markets.

Many of China’s inland cities—particularly in the Southern and Central regions—are not only key passenger car markets but are also emerging as important areas in which coal and natural gas will increasingly compete with one another. This competition will foreshadow how the coal-gas competition dynamic unfolds across other parts of China.

Xinjiang’s vast energy reserves will play a key role in helping to determine how the coal vs. gas competition evolves. The region has the geological potential to become one of the largest producers of thermal coal worldwide and to reshape markets for coal, natural gas, and crude oil as its thermal coal output grows rapidly in coming years.

Xinjiang’s growing importance in China’s energy supply picture highlights another emerging reality—Western China will be an important transit area for oil and natural gas imports from Central Asia and Russia, but these imports will, for the foreseeable future, not be able to meaningfully offset China’s rising dependence on imported crude oil and natural gas.

Gabriel B. Collins and Andrew S. Erickson, “Twilight in the Tundra: Russian and Kazakh Oil Production Cannot Keep up with China’s Rising Demand,”China SignPost™ (洞察中国) 21 (4 February 2011).

Energy and transportation will thus be a major focus for us as we follow China’s latest developments into 2014. We will continue to bring you the latest analysis and insights in this critical area.

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Gabriel B. Collins and Andrew S. Erickson, “China Natural Gas Shortage Poised to Drive Record LNG Imports,” China SignPost™ (洞察中国) 72 (9 December 2013).

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

China’s significant natural gas shortage will catalyze greater investment in pipelines, storage, and domestic drilling.

China is suffering a serious natural gas supply shortage as cool weather collides with serious air pollution problems in cities including Beijing, Harbin, and Shanghai. Local experts believe the structural gas shortage currently afflicting China will likely endure for at least three more years, even as reforms prioritize using natural gas and eliminating barriers and bottlenecks to its use. We concur with this view based on several key factors.

First, China’s demand for natural gas has exploded over the past several years and continues to rise robustly even as the baseline for comparison gets substantially higher each year. Gas demand is growing especially quickly in the residential sector as companies such as China Gas and ENN rapidly build out their local pipe and supply networks.

As a result of this demand growth, production has not kept pace with rising demand. NDRC Vice Director Lian Weiliang reports that through September 2013, China’s gas consumption expanded 13.5% YoY, while production only grew by 9.2% YoY. We estimate that the deficit between China’s natural gas demand and domestic gas production is now approximately 4.6 billion cubic feet per day (Exhibit 1).

Exhibit 1: China’s domestic gas supply deficit

Billion cubic feet per day

China SignPost 72 Exhibit 1_9 December 2013

Source: BP, NBS China, China SignPost™ estimate

To put this number in perspective, we estimate this is enough gas to supply the daily gas needs of more than 120 million Chinese households. Alternatively, it would be enough gas to fuel 23 GW of gas fired power generation capacity, which could displace 251,000 tonnes of steam coal demand per day.

China’s Third Plenum reforms are likely to drive further use of liquefied natural gas (LNG) under the rubric of “Beautiful China” environmental conservation and resource pricing initiatives. Previously, LNG consumption was constrained by relatively high prices and limited infrastructure, which produced periodic shortages, particularly in winter months and away from coastal distribution centers.

Now that LNG offers one of the few ways to readily and substantially offset air pollution, China’s government is likely to support its greater use through pricing incentive schemes and constructing coastal LNG terminals and inland pipeline infrastructure (previously major bottlenecks). Yet, as the analysis below suggests, these measures are complex and take time to implement. In the meantime, serious supply constraints will continue to occur.

To be sure, China is not solely reliant on domestically produced gas. It enjoys access to LNG and pipeline gas from Central Asia, and now Myanmar as well. We estimate at present that China currently has approximately 6.0 BCF per day of gas import capacity (2.9 BCF/day by pipeline from Central Asia and 3.1 BCF per day via the country’s LNG terminals). The number is somewhat lower than the LNG terminals’ total nameplate capacity would suggest because several terminals came online in the past two months and we believe they are not yet fully operational.

On this basis, China’s potential natural gas import capacity likely exceeds the present deficit by more than 20%, which raises the question of why there are such problems with gas shortages over the past several winters. We believe the shortages are a product of four core factors—(1) gas demand growth is outpacing pipeline network expansion, (2) China does not have sufficient gas storage capacity to smooth demand spikes triggered by cold weather, (3) Chinese terminals must compete with buyers from Japan and other locations for spot LNG cargoes, and (4) Chinese domestic gas prices need to be liberalized so importers do not lose money on supplies they bring in.

With respect to pipeline constraints, it is very likely that many Chinese LNG terminals are not optimally integrated with gas pipeline infrastructure beyond their immediate surrounding area where their “anchor customers” (typically power plants) are located. This makes it difficult to divert gas supplies in response to demand swings in other regions further away and contributes to the severity of shortages that emerge. Here it bears noting that some of the most heavily utilized LNG terminal infrastructure in Europe is in France and Belgium, where LNG regas facilities are very well integrated with pipeline infrastructure that allows imported gas to penetrate deep into the marketplace.

Unlike LNG, China pipeline gas exports from Central Asia flow into a well-connected pipeline network that can move molecules relatively seamlessly from Turkmenistan all the way to Shanghai and Guangzhou. The second West-East Gas Pipeline has a trunkline that carries gas from Central Asia and Xinjiang, as well as eight branch lines in Central and Southern China that spans 14 provinces in total. Unfortunately, pipelines are not as able to respond to sudden demand changes as well as LNG terminals can.

China’s pipeline imports from Central Asia have grown substantially since their commencement in 2010, moving from 74 million cubic feet per day in early 2010 to nearly 2.9 billion cubic feet per day by the end of October 2013 (Exhibit 2). China’s pipeline gas import volumes will grow by an additional 1.1 BCF/day in 2014 as the now completed Myanmar-to-China pipeline comes online and further in 2015 and 2016, as additional pipelines carrying gas from Kazakhstan come online.

Exhibit 2: Pipeline Natural gas Imports from Central Asia into China

Million cubic feet per day

China SignPost 72 Exhibit 2_9 December 2013

Source: China Customs

Chinese sources note that Chinese gas inventories are low in relation to the demand pressures that winter cold snaps will put on them.  China’s working gas storage capacity is presently only two percent of annual consumption, according to Caixin. In contrast, the highly developed U.S. gas market has working storage equal to approximately nine percent of annual consumption. Low working storage helps smooth over wide seasonal demand swings. In Beijing, for instance, local sources say daily gas consumption during the winter is eight times higher than in the summer.

Chinese sources report that Beijing and Tianjin receive approximately half of their peak winter gas supply from a cluster of six underground storage facilities in the Dagang oilfield that have a total capacity of 247 BCF. Based on this data, the Beijing/Tianjin metroplex thus has approximately 7 BCF of storage capacity per million residents. Each Chinese city will have unique local climatic and other conditions, but this gives a starting point for assessing the need for additional inventory buildout.

China’s gas storage buildout will incorporate a mix of system, including underground caverns, depleted oil and gas fields, and small-scale LNG facilities that liquefy gas and then store it for time of shortage. For example, the city of Changsha, which has been afflicted by a number of significant gas shortages since 2009, now has an LNG storage facility that can store 424 million cubic feet of gas. Xindi Energy Engineering (新地能源工程技术有限公司), which helped construct the facility in 2011, says it can supply 8-10 days’ worth of gas supply for Changsha.

International Competition for Gas Supplies

Chinese companies wishing to obtain spot LNG cargoes must contend with buyers from Japan and South Korea, who in some ways need the gas even more because they do not have meaningful domestic production. Japan’s decision earlier this year to close all of its nuclear reactors has helped tighten the LNG market and exacerbate competition for spot cargoes.

To help incentivize companies to source gas internationally, the Chinese government recently raised the sale price of imported gas by 26%. The government likely hopes the measure will encourage companies like CNPC/PetroChina—which lost roughly US $7 billion on gas sales in 2012—to maximize imports and help alleviate shortages at home. The problem is that the government’s new price is still only about US $5.67/mmbtu, less than a third of the going price for LNG in the Northeast Asian LNG spot market. Similarly, China’s pipeline gas imports from Turkmenistan are priced on an oil-linked formula that most likely has them above US $5.50/mmbtu at current crude prices.

It therefore remains to be seen (1) what other incentives the government may have to implement in order to incentivize LNG importers to maximize their terminals throughput and (2) if pipeline infrastructure can get additional supplies from LNG imports to inland markets. We estimate that China’s operational LNG terminal could, at least in theory, bring in an additional 200-400 million cubic feet per day of gas supplies if they can successfully compete for spot cargoes.

Responses so far to the emerging Winter 2013–14 gas shortages

Companies are already responding to the gas shortages. On the demand side, suppliers are curtailing gas deliveries to industrial gas consumers to ensure that the growing number of residential gas consumers will have access to adequate to stay warm this winter.

Indeed, in early November 2013, Sinopec began cutting gas supplies to industrial facilities such as a petrochemical plant and the Qilu refinery in Shandong in order to ensure that it has sufficient gas to meet residential consumers’ needs. We estimate this will free up 1.3 million cubic meters per day of supply—enough gas to supply 14,000-16,000 households through the winter.

Based on the relatively cosmetic macro-level impact of such industrial curtailments, we believe there will likely be a much larger number of industrial and power generation gas users who are forced offline this winter in order to prioritize residential gas supplies. We believe the most acute shortages will be in SW China, NE China, and parts of Central China not near the West-East trunk gas pipelines. These are the areas with the least access to gas supplies such as LNG that can be “surged” in response to cold weather and other demand stimuli.

Domestic production “balancing” is likely to end in 2014

China’s Big Three oil & gas companies have also been instructed to maximize natural gas output. Earlier in the year, and in 2012 as well, PetroChina in particular, appeared to be altering its domestic production up and down in response to demand because much of its LNG and pipeline gas import volumes were coming on a “take or pay” fixed volume basis. Therefore, it was more economical for the company to swing its domestic fields and use them as a balancer. Now, however, the Chinese gas market is tightening enough that the big spring drop-offs in domestic gas production seen in 2011 and 2012 will likely come to a permanent end. Indeed, 2013 showed a much smaller spring drop-off than 2012 did and we expect that in 2014 this drop will be much smaller than it was in 2013 (Exhibit 3).

Exhibit 3: China Domestic Natural Gas Production

BCF/day (left axis), YoY change (right axis)

China SignPost 72 Exhibit 3_9 December 2013

Source: NBS China, China SignPost™

What does the rest of this winter portend for China’s gas market?

Our view is that the shortages currently affecting the Chinese natural gas market will worsen as the winter deepens. Industrial users will bear the brunt of supply cuts as the government sacrifices them by decree in order to protect China’s growing ranks of residential gas consumers.

LNG is the most “surge-able” form of natural gas supply in China. CNOOC is bringing a new 2.2 mtpa floating LNG terminal online off Tianjin, which is slated to take its first cargo in December 2013 and could help alleviate local gas supply shortfalls later in the winter as it ramps up. With the pipeline from Central Asia unable to surge production and domestic fields running hard, we expect LNG exports to rise as China fights to keep the gas market supplied.

In 2011 and 2012, December was the largest volume month of the year for LNG imports. As Exhibit 4 (below) shows, 2013 looks poised for a bigger year than the prior two. We therefore believe there is a high probability that December 2013 LNG imports into China could break the 2 million tonnes mark. The prior historical high is 1.8 million tonnes. The fact that industrial facilities were already being kicked offline by fiat by mid-November reinforces our conviction, as there are four solid cold months to go in northern China.

Exhibit 4: China LNG Imports

Metric tonnes per month

China SignPost 72 Exhibit 5_9 December 2013

Source: Gen. Admin. Customs

China can get much colder than it is now…

In conclusion, we call your attention to historical weather data, which suggests Mother Nature could set the stage for a natural gas supply crunch substantially more serious than the one China is grappling with now. Given that 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.

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 airmass makes it into Hunan, we know that it has almost certainly also affected 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 structure 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 Hunan cuisine. Yet in the 1980s, several more severe cold snaps hit Changsha, sending the mercury down to the -8° Celsius range.

The demand effects of a cold snap that went beyond the range many homeowners are accustomed to would likely boost heating and natural gas demand dramatically. Multiple academic studies show that as temperatures move away from the “room temperature” comfort range (usually around 70F), demand for energy for climate control such as heating and cooling increases exponentially—i.e. a 2° F change induced 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.

Exhibit 5: Mean Daily Temperatures for Changsha, Hunan (January 1980-7 December 2013)

Degrees Celsius

China SignPost 72 Exhibit 5_9 December 2013

Source: AccuWeather, China SignPost™

Additional Research:

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Gabriel B. Collins and Andrew S. Erickson, “Counting Cars: Rising Private Automobile Ownership in Chinese Cities Paves Road for Gasoline Demand,” China SignPost™ (洞察中国) 71 (24 June 2013).

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

“Texas-sized” used to be the benchmark for large-scale car ownership, but “China-sized” is emerging as the new metric. We assembled statistical data for 36 cities that account for 30% of China’s 93 million-strong private passenger car fleet and found that Metro Beijing now has more than four million private passenger cars. That’s 45% more passenger cars than are registered in Harris County, Texas, home to car-crazy Houston and several of its major suburbs. At present, no Chinese metropolitan areas other than Beijing have attained Houston’s raw car ownership levels, but three Chinese metro areas now each have more private passenger cars than New York City, with its 1.8 million cars (Exhibit 1).

Exhibit 1: Private Passenger Car Ownership by Selected Metro Area in China and Abroad

Thousand vehicles

China SignPost 71_China car exhibit 1_passenger cars by city

Note: For Chongqing “core city” is specified because the data provided are specific to the metro downtown. Chongqing municipality is much larger geographically than China’s three other provincial-level municipalities (Beijing, Shanghai, Tianjin), and the majority of its territory lies outside its central urban area.

 Source: Municipal statistical bureaus, TexasSure, NYS DMV, China SignPost™ estimate

Why focus on private passenger car ownership in China? We do so for three core reasons. First, private passenger cars are sold and owned in far greater numbers than business-oriented private vehicles, accounting for roughly 80% of passenger cars in China, and thus constitute the largest piece of China’s gasoline demand pie. Second, sales and ownership of these cars are closely correlated with consumer economic activity and the economic well-being of China’s emerging consumer class. Third, ownership of private passenger cars creates a set of economic opportunities that China lacked until recently. Vehicle owners will need services and parts, roads to drive on, places to park, etc. Each link in this vehicular value chain creates direct opportunities for selling goods and services.

Greater use of cars and changing social attitudes regarding car use and ownership also hold significant potential to change basic life patterns in ways that meaningfully impact local economies. Consider the rural farming family who is finally able to purchase a small truck and can now drive goods directly to market instead of spending days waiting for a third party hauling service. This can help to improve China’s sluggish and uneven rural food distribution network, which still suffers significant losses from produce damage and spoilage. While such changes percolate unpredictably through societies as vehicle ownership rises, we believe passenger car ownership levels in key Chinese cities are reaching critical mass and becoming a force in their own right as car owners find new ways to use their prized steeds.

In per capita terms, Xiamen is China’s highest car ownership metro area at present, with 30.5 cars for every 100 residents (Exhibit 2). Guangzhou has a private passenger car ownership rate of just over 20 cars per 100 residents, close to that of Beijing. Suzhou, meanwhile, has an ownership rate of just under 23 cars per 100 residents. Such ownership levels are right on a par with New York City’s 22 cars per 100 residents.

We believe that a per capita private passenger car ownership rate of 25-30 cars per 100 residents is where most Chinese cities will reach a “saturation point” at which car ownership growth plateaus. Car ownership on Taiwan—the PRC’s closest global cultural analogue—has stabilized at approximately 31 cars per 100 residents and gives a sense of how car buyers may behave as some large costal mainland Chinese cities began to approach Taiwanese per capita wealth levels. Indeed, China’s wealthy coastal enclave of Xiamen—opposite Taiwan—now has a per capita private passenger car ownership rate of just under 31 cars per 100 residents.

Second, the car ownership levels seen in foreign cities such as New York and Berlin—which, like many large Chinese cities, have invested heavily in public transport and where cars are expensive to own—give a sense of where a saturation point might reasonably lie under broadly analogous physical conditions in large Chinese metro areas. Car ownership rates in rural China underserved by public transport could ultimately rise to roughly 35 cars per 100 residents.

Exhibit 2: Car Ownership per 100 Residents, By Metropolitan Area

China SignPost 71_China car exhibit 2_per capita car ownership

Source: Municipal statistical bureaus, TexasSure, NYS DMV, China SignPost™ estimate

While China’s most widely recognized car owning cities are located on the country’s Eastern Seaboard, a significant number of large inland metro areas have per capita private passenger car ownership rates nearly as high as coastal cities’. For instance, Chengdu has car ownership rates of nearly 20 cars per 100 residents, while Urumqi and Xi’an each fall just shy of 18 cars per 100 residents.

Other large, booming inland cities have much lower ownership rates—12.27 cars per 100 residents in Changsha and 11.20 per 100 residents in Hefei. Most notably, populous areas that are predominantly rural in layout (the so-called Tier 3, 4 and 5 areas) tend to be poorer and typically have much lower rates of car ownership. If economic growth that drives personal incomes continues, these locales are likely to be centers of car sales growth moving forward.

For instance, Honghe in Yunnan Province presently has a car ownership rate of only 3.03 per 100 residents—less than half the national average rate for private passenger cars. Current sales trends indicate that the Honghe-type cities are already seeing significant car sales increases. The China Automobile Dealers Association says that in 2012 sales volumes increased by only single digits in the first-tier cities (albeit from a high baseline), but rose 131% in second and third-tier cities.

Evolving car ownership patterns

There appears to be a “fan out” effect where a region in China first sees car sales in its largest cities and then smaller municipalities also evolve into demand centers. For example, in 2006, Chengdu was home to 92.7% of Sichuan’s private passenger car fleet but now houses around 70% of the province’s private passenger cars, a clear sign that sales are taking off strongly in Sichuan’s smaller cities and townships. We expect such geographical diversification of sales to continue as places like Beijing and Shanghai enforce increasingly restrictive policies on car sales and use.

China’s domestic car brands already heavily focus their sales efforts on the smaller and inland cities and now the Western automakers and their Chinese JV partners are doing the same. For instance, GM plans to expand its dealership network in China by more than 34% by 2015, adding 1,300 additional dealerships and focusing much more heavily on Tier 3 and Tier 4 cities. Other carmakers are also striving to expand their sales networks in Central and Western China. In the near term, this sets dealers up for thinner margins and tough price competition. But in the three-to-five-year timeframe, growing dealer networks signify that, along with road and highway construction, the elements are aligning for a significant rise in car sales and ownership in China’s interior, a diverse region nearly as physically large as, and more populous than, the U.S.

What’s Motivating Chinese Car Buyers?

In China’s largest cities, car ownership has some practical benefits, but also comes with a significant set of financial and administrative headaches, as New Yorkers will thoroughly appreciate. For instance, researchers at the Centre for Global Engineering at the University of Toronto emphasize that Shanghai charges license fees as high as US$10,000 per vehicle, along with a 10% sales tax, and parking fees of up to US$10/hr in the city’s downtown. For a wealthy person driven by the social status conferred by owning an Audi or BMW, such costs are bearable. However, for a lower income buyer purchasing his/her first entry-level BYD sedan, costs of this level essentially erase the practical benefits of convenience in transportation that the car would otherwise confer.

Car sales in China are driven by a mix of practical concerns, as well as considerations about how cars reflect social status. The best empirical data we could find from a Chinese source that speaks to what influences potential car buyers came from a team of researchers who obtained survey responses from 963 college students at Fudan University in Shanghai and Jiangsu University in Zhenjiang, Jiangsu.[1] Social status issues likely help seal the deal for many car sales—especially among young men on the make looking to impress prospective spouses—but, at least for survey respondents, social considerations still find many potential buyers in the “neutral” category, meaning car sellers must make persuasive marketing pitches.

On the other side of the ledger, the study suggests that potential car buyers’ opinions are more strongly formed with respect to the practical benefits of owning private cars. Indeed, no more than 8% of respondents chose “neutral” when asked about the practicality driven aspects of owning a car (Exhibit 3). Overall, for each of the four statements about practical benefits a car confers, the respondents overwhelmingly agreed or strongly agreed with the statement.

Exhibit 3: Prospective Chinese Car Buyers Driven By Practicality and Perceptions

China SignPost 71_China car exhibit 3_motivations for car buyers

Source: C. Zhu et al., Journal of Transport Geography

These students represent an analytically useful sample for a number of reasons. First of all, they represent a social cohort—future college graduates—who are on average more likely than less-educated members of society to attain an income level capable of supporting car ownership. Second, they are a representative slice of a large group, as China churns out just under seven million new university graduates each year.

Third, the students in the sample are a diverse group, both from the perspective of where they come from and in terms of their prior auto ownership experiences. At one end of the spectrum, roughly one-quarter hail from large cities, and of these 4 in 10 come from families who own cars. At the other end of the spectrum, 29% of the students come from small townships or rural areas, and of this group, fewer than one in twelve come from families who own cars. Most interestingly, despite the wide variance in prior personal experiences with cars, nearly 2/3 of the student respondents (65%) agreed that when they have the financial means, they will “definitely buy” cars, while only 14% disagreed with that statement.

Rubber Meets Road: Examining National and City-Level Gasoline Demand in China

Detailed academic studies conclude that Chinese cars consume 7.9 liters of gasoline per 100 km driven and that the average private passenger car in China travels in the neighborhood of 20,000 km each year.[2] The National Bureau of Statistics says that at year-end 2012, Chinese drivers owned just over 93 million private passenger cars. On this basis, China’s private passenger car fleet is likely consuming approximately 2.28 million bpd of gasoline at present.

Examining gasoline demand by city helps to situate national gasoline demand hotspots relative to the country’s oil production, import, refining, and product transport infrastructure. Beijing leads Chinese private passenger car gasoline consumption at an estimated 97 kbd (Exhibit 4). Tianjin, Chengdu, and Guangzhou come next, at 65 kbd, 47 kbd, and 45 kbd, respectively.

To put these numbers into perspective, the thirstiest U.S. gasoline metropolis—Los Angeles—uses around 123 kbd of gasoline. Given that the majority of gasoline consumption is automotive, this suggests the average Beijinger uses around 15% less gasoline than the average Angeleno and around 60% less than the average Houstonian. On this basis, the total and per capita passenger car ownership rates and gasoline consumption figures in large Chinese cities suggest that even with saturation points significantly lower than those found in the U.S. or Europe, Chinese gasoline and crude oil demand still has meaningful room to grow.

Exhibit 4: Estimated Private Passenger Car Gasoline Use by Selected Metro Area

Thousand bpd

China SignPost 71_China car exhibit 4_China gasoline fleet by city

Note: For Chongqing “core city” is specified because the data provided are specific to the metro downtown. Chongqing municipality is much larger geographically than China’s three other provincial-level municipalities (Beijing, Shanghai, Tianjin), and the majority of its territory lies outside its central urban area.

Source: Municipal statistical bureaus, Energy Policy, China SignPost™ estimate

Within China’s gasoline market, locations poised for significant demand growth include heavily populated inland provinces such as Hunan, Henan, and Hubei, as well as myriad Tier 3, 4, and 5 cities across the country. For instance, Yunnan Province—home to 46 million people—saw its oil products demand, which is more than 90% gasoline and diesel fuel, rise from 8.5 million tonnes in 2011 to more than 10 million tonnes in 2012. Demand is expected to reach 14 million tonnes per year by 2015.

If the inland cities shown in Exhibit 4 each experienced a 50% increase in gasoline demand in the next several years, China’s passenger car gasoline consumption would rise by 570 kbd or 25% above the present level. This number is reasonable in light of the 15% and higher annual growth rates in private passenger car ownership in many of the cities covered. Moreover, Exhibit 4 only captures a snapshot of the hundreds of small and medium-sized Chinese cities that will drive car ownership growth as China’s 7,200+ car dealerships compete to outsell each other in coming years.

The Road Ahead

Future passenger car fleet growth in China will hinge uponThree Ps:Perception, practicality, and policy. The effects that perception and practicality concerns have on potential car buyers in China are discussed at length above. Policy is a major wildcard, as the level of permissiveness or restrictiveness cities maintain toward car sales and ownership will play a pivotal role in determining consumers’ car acquisition activity, particularly in lower reaches of the income spectrum.

Academic researchers have shown the elasticity of 3.6 between increases in GDP and rises in car ownership in Beijing, which until the five years ago maintained a permissive regime towards car owners.[3] Shanghai, in contrast, has applied tough measures to constrain car sales and has an elasticity of only 1.0 between GDP increases and car ownership increases.[4] Shanghai’s policies have skewed car ownership in favor of business vehicles, as opposed to private passenger cars. When people do purchase passenger cars, they tend to be higher-end models because less-well-off car buyers are effectively priced out of the market by high license plate fees and other barriers.

Evidence suggests inland cities may be more willing than their coastal cousins to tolerate car congestion and pollution as a price of development. Xi’an, which is rapidly becoming one of China’s largest car-owning cities, had planned to emulate Beijing. Shanghai, and Guangzhou and restrict license plate issuance to control car fleet growth, but had to rescind the plan in August 2012 following vociferous public outcry against the proposed restrictions. To be sure, not all inland cities share Xi’an’s attitude. Guiyang, Guizhou Province’s capital, has restricted license plate issuancesince summer 2011 despite public outcry, but does offer an unlimited number of plates for drivers willing to forego entering the city’s downtown.

Car sales in China’s Tier 3, 4 and 5 areas are likely to have GDP elasticities exceeding 3.0

The combination of the Xi’an approach, which allows unrestricted growth in car ownership, and the Guiyang approach, which only affect drivers wishing to use their vehicles in the city’s core, point to a future in which vehicle ownership in China’s interior has a Beijing-style elasticity of around 3.5 to GDP growth. Under such conditions, even if China’s economic growth were to slow significantly, many areas could still see double digit annual car sales increases.

Used Cars Will Also Gradually Help Drive Higher Car Ownership Levels

As China’s private passenger car fleet grows, vehicles age, and owners look to trade up, the country’s used car market is likely to expand, which provides an additional channel for lower income consumers to become car owners. Wealthier consumers buying new cars and allowing their old models to percolate through the market as used vehicles is only a nascent factor at present, as China’s used car market remains small—1.25 million vehicles sold in 2012, according to the China Automobile Dealers Association.

That said, used car sales are likely to substantially increase in the next 2-3 years as cars sold during the stimulus-fueled car sales boom in 2009-10 age sufficiently that their original owners seek to trade up for newer models. Moreover, cultural factors that place a premium on ownership of new cars are already clearly visible in South Korea and Taiwan; upper class mainland Chinese can be expected to mirror such trends as their wallets allow.

A Chinese government eager to prop up economic growth and local governments keen to boost local manufacturers and joint ventures are likely to cultivate such societal preferences. A mature auto market such as the U.S. will have used car sales volumes that are 2.5-3.0 times larger than new car sales. China is many years away from this, but within three years, we expect used car transactions to reach 5-6 million per year.

Commodity impacts

Chinese private passenger car fleet growth is very positive for gasoline demand. We estimate that each million new cars sold in China creates 20 kbd of gasoline demand. Based on the average gasoline yields of Sinopec and PetroChina’s refineries, approximately 100 kbd of crude oil are needed to produce 20 kbd of gasoline.

Even lower-end cars will still have substantial gasoline and crude oil market impacts. Carmakers are tailoring their product portfolios in inland parts of China to match offerings to lower income ranges than will be found in wealthier coastal areas. However, a car in Xiangtan, Hunan whose sticker price is 30% lower than a fancier model sold in Shanghai will in many cases still use approximately as much gasoline as its upmarket counterpart. Options and fancy styling consume a lot more money in terms of sticker price, but don’t usually enhance gasoline consumption significantly unless the upmarket vehicle uses a substantially larger engine. However, as more used cars penetrate lower tiers of the market and wealthier consumers upgrade to larger, thirstier SUVs, the net increases in car ownership stand to drive increased gasoline demand.

China’s rising passenger car ownership is reshaping how the country’s refiners operate. During the peak of China’s emergence as a major global oil consumer between 2004 and 2007, refiners worked to favor diesel fuel, which was badly needed to run trucks, earthmovers, and generator sets that kept factory lights on when the power grid overloaded (Exhibit 5). A significant tipping point came in 2012, when Sinopec and PetroChina, the country’s two largest oil refiners, began shifting their output slates back toward the gasoline craved by China’s burgeoning private passenger car fleet.

Exhibit 5:  Sinopec and PetroChina Are Once Again Favoring Gasoline Production

Barrels of gasoline produced per barrel of diesel fuel produced

China SignPost 71_China car exhibit 5_China refiner outputs gasoline versus diesel

Source: Company Reports, China SignPost™ analysis

Other Commodities Positioned to Benefit

As increased car numbers drive greater gasoline demand, they also increase demand for natural and synthetic rubber as cars require original tires when produced, and periodic replacements thereafter.

China’s moves to implement Euro 4 and Euro 5 emission control standards on cars also bodes well for producers of platinum group metals such as platinum, palladium, and rhodium, which are used on automobile exhaust catalysts. In this area, the chronic instability in the mining sector of South Africa—the world’s largest PGM producer—bears close attention.

Wild Cards Affecting Investment Risk

  • What proportion of emerging auto market cities will impose restrictive policies vis-à-vis current and aspiring car owners? While cities like Xi’an are adopting relatively laissez faire policies toward private auto ownership, other emerging car markets such as Shijiazhuang are planning to impose restrictions on ownership and use of private passenger cars within the next year.
  • Will Chinese car buyers become more willing to buy on credit? When one of the authors visited a BYD Dealership in Shanghai in 2010, the salespeople told him that the vast majority of buyers paid cash for their vehicles. Gathering up US$10,000 or more in cash for a car purchase is a tall order. As such, using at least some degree of financing could effectively enable the millions of Chinese who have decent disposable incomes, but may not have this level of cash, to begin accessing the lower end of the car market. A number of our contacts in China say that face-conscious Chinese consumers prefer new vehicles and that they like to buy the very best they can afford. This demand pattern was dramatized to one of the authors in 2011 when he visited Bentley and Lamborghini dealerships in Qingdao and was informed of the companies’ extensive national networks, which today cover 35 and 18 cities respectively.

Greater use of financing plans such as those widely used in the U.S. could significantly expand the horizon of opportunity for many prospective car buyers; the question is whether these consumers will be willing to assume meaningful levels of debt. China’s rising credit card ownership suggests consumers might be more willing to assume debts than before, as the country’s number of credit cards in circulation rose 16% year on year in 2012 to 331 million cards. But by the same token, card users’ behavior appears relatively debt averse. Chinese cardholders tend to pay off their balances more quickly than Americans, with only 3% to 8% of cardholders rolling over balances and incurring interest charges, as opposed to 40% of American credit card holders.

  • Will car ownership undermine use of widely available public transport in larger cities?  The answer to this question will depend largely on whether individual buyers are purchasing cars for practical or perception reasons (i.e., because everybody else is doing so). For a person living well inside the core city, public transport is certainly cheaper than car travel; and in the more congested cities, is also likely faster between points than driving one’s own car would be.
  • Will higher levels of car ownership shift Chinese long-distance travel culture away from railways? The idea of “road trips” that is so popular in North America is not widely shared in China, but as highway infrastructure between cities improves and more people own cars, this could change meaningfully. For trips that would require more than several hours of driving, we believe the wealthier consumers will choose to fly and middle class and below, even if they have a car, would find it cheaper and more convenient to travel by rail.
  • Will a Chinese analog to Zipcar emerge? Zipcar says each one of its cars can replace 20 privately-owned ones. If social perception reasons are the root driver of car purchases, the emergence of a popular Chinese membership-based car sharing company is unlikely to undermine demand growth. If practical demands (i.e., transporting personal items on an irregular basis) predominate, however, then this could have a major impact in congested Chinese cities in which car ownership may be expensive and inconvenient.
  • Will alternative vehicles (e.g., electric vehicles and natural gas-powered vehicles/NGVs) make substantial inroads into the passenger car market?At this point we believe that NGVs will primarily be used a taxis and fleet vehicles due to logistical challenges of obtaining natural gas fuel and the cost of converting gasoline powered cars to run on NG, but more generous government incentives to adopt NGV could change this. Similar dynamics would likely apply to electric vehicles, which might also be promoted by government policies designed to support Chinese companies attempting to capture share of an emerging green vehicle market.

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Gabriel B. Collins and Andrew S. Erickson, “How Obama and Xi Can Avoid California Dreaming,” China Real Time Report (中国实时报), Wall Street Journal, 7 June 2013.

President Barack Obama’s upcoming summit with President Xi Jinping at the Sunnylands estate in Palm Springs, Calif., comes at a crossroads for U.S.-China relations. There are of course the usual frictions. China’s relations with its maritime neighbors such as Vietnam and Japan remain fraught with tension. Hacking, industrial espionage, and Chinese hunger for U.S. pork farms all crowd the headlines.

But this meeting of the highest-profile world leaders is about more than that. This crossroads is one that is very real, and no one is quite sure where the paths emanating from it will lead. Whatever course Sino-American relations take from here, it must be grounded in reality or risk perilous drop-offs and dead ends.

China’s slowing economic growth, the U.S. shale gas and oil boom, and emerging resurrection of U.S. manufacturing and industrial activity point to a new and uncertain world. China’s leaders rode a wave of economically driven hubris following the severe U.S. recession in 2008 and uneven recovery, but the tailwinds are fading and China’s central and local leaders alike will face tough decisions as they seek to keep the country stable and the Communist Party relevant. Beijing’s repeated rollouts of modern new military hardware in recent years signal significant increases in China’s hard power. At the same time, ballooning local debt, pollution, chronic diseases and other challenges threaten to curtail growth significantly decades before China can build comprehensive national power commensurate with its aspirations and rhetoric.

The U.S. also faces huge national challenges that will require long-term vision and skillful leadership. Foremost among them: An increasingly bitter political climate driven by divergent philosophies of governance has stalled Washington’s ability to set government spending on a sustainable path. This economic and political turbulence generates daily problems, like the myriad pains resulting from the ongoing federal budget sequester and its cuts to government spending—ranging from Head Start programs to public defenders to support for front-line military forces.

The potential long-terms effects are more sobering, as the now-five-year bout of post-recession instability is helping to establish a more risk-averse mentality within a broad cross-section of American society. If workers, leaders and executives continue battening down the hatches, they risk sapping a major engine of U.S. growth and dynamism. In short, the U.S. has the tools at its disposal to revive economic growth and resume dynamic change. That said, applying the tools will be difficult and the challenges of balancing the actions needed for domestic revival with the imperative of safeguarding overseas interests in a complex world are substantial. The U.S.-China relationship will play a key — if underappreciated — role in this unfolding saga, as both nations rely on each other economically and are increasingly interdependent in other ways.

China and the U.S. face substantial challenges and opportunities in their relationship. One meeting cannot magically surmount these issues. Therefore, Presidents Obama and Xi cannot afford to engage in California dreaming and ignore the fundamental differences in political systems and national interests that complicate their bilateral relationship. No amount of personal rapport, or even friendship, could hope to solve that.

Instead—even if only tacitly—they should recognize that even if the discussions are not all sunny at Sunnylands, frank, substantive dialogue would still represent a positive outcome. Both Washington and Beijing need to appraise honestly where engagement is presently feasible, where progress is achievable politically, and where cooperation remains difficult if not impossible for the foreseeable future. These broader dynamics, even if implicit, must inform their specific efforts. Both Obama and Xi face significant real world political constraints and must tap reservoirs of political courage to begin realizing the potential of their relationship.

At present, many vital U.S.-China diplomatic discussions—the Strategic and Economic Dialogue, for instance—focus on technocratic agendas that are inadequately informed by a larger vision. These issues are vitally important, but they cannot by themselves replace direct communications between top leaders aimed at setting a realistic agenda for a comprehensive relationship. Such a leadership-informed agenda can’t transcend fundamental problems, but it can certainly help prevent inconsistency and inattention from making existing problems even worse. And in the present context of Sino-American relations, that in itself would represent a victory of sorts.

Working events such as Sunnylands thus offer the chance for the top leaders to build interpersonal relationships that function as the connective tissue linking the efforts of the special working groups into a more powerful whole. If Presidents Obama and Xi use the Sunnylands summit to begin a real dialogue that creates space over time for circumventing and managing core friction points, it will be a true success.

In this spirit, there are three core points for the two to grapple with at Sunnylands. Each helps define the context of a bilateral relationship whose impact reverberates globally.

  • “Selective power status” won’t work anymore. China has become sufficiently powerful that the U.S. is unwilling to facilitate Chinese efforts to “have it both ways” by posing as a poor developing country or an established superpower when convenient. U.S. willingness to accord China international status lies not in its internal development (a task for all nations, including the U.S.) or bilateral negotiations (many of which the U.S. is not a party to) but to the public goods it provides. China’s Gulf of Aden antipiracy missions represent a positive step forward, and have rightly received approbation from the U.S. and many other nations. Any concrete plans for further steps in this direction that Xi might communicate to Obama could have a similarly positive effect.
  • Real reciprocity is essential. The quality of Sino-American relations will be determined by the opportunity for reciprocity in key areas. The key is that each side not be actively prevented by the other from pursuing activities when the other side is legally free to do the same; how and whether to act is their choice. For example, China continues to restrict American firms’ market access with high protective barriers. Opposition to Cnooc Ltd.’s bid to purchase Unocal should be viewed in the larger context: no American firms would even be considered for equivalent opportunities in China. Market access should be emphasized over “currency manipulation,” which is a far more complex issue. As Abenomics suggests, a key U.S. ally like Japan can engage in even more dramatic exchange-rate adjustments. And U.S. quantitative easing policies themselves have been widely criticized abroad for deflating the value of the U.S. dollar. Rather than issuing similar nonspecific complaints annually about the Pentagon’s PLA report, Beijing is free to issue its own report on the U.S. military, as it already does concerning U.S. human rights. More positively, Chinese acknowledgement at the 2013 Shangri-La Dialogue of its conducting military surveillance in America’s undisputed exclusive economic zone may presage reduced opposition to similar activities in China’s own EEZ as China rises as a maritime power with access interests of its own.
  • Strategic adjustment is a two-way street. Over time, Washington and Beijing may need to make strategic arrangements and adjustments vis-à-vis each other. But China cannot simply emphasize what the U.S. should offer while declining to specify what China might offer in return. The U.S. would be ill-advised to repeat its 2009 Joint Statement mistake of accepting vague rhetoric to help with problems of international concern, e.g., vis-à-vis North Korea and Iran, in return for U.S. “acknowledgement” of “core” Chinese national interests. To paraphrase Mark Twain, reports of American decline are greatly exaggerated. Given the likelihood of China’s economic and overall growth slowing in coming years and of enduring U.S. power, Washington should not be pressured into hasty “concessions.”

With these points in mind, far from the klieg lights of either capital’s domestic politics, President Xi will need to explain concretely to President Obama his vision for a “new type of great power relations.” If the concept truly entails meaningful reciprocity with tangible applications, then there should be plenty of room for U.S. attention. If, however, this concept proves to be nebulous rhetoric with undertones of expectation that Washington yield to an ascendant Beijing and its principled positions, it will be a bridge to nowhere. Any idea that is truly worthwhile should be readily forthcoming and understandable.

The grave internal challenges China and the U.S. face and the tough webs of issues Beijing and Washington must confront when dealing with each other mean that the time for California dreaming is over. Presidents Obama and Xi have the opportunity to set a new tone and attack the “real” issues when they meet later this week. Let us all hope they choose the bold path of facing reality over politics of mutual delusion.

***

Gabriel B. Collins and Andrew S. Erickson, “Playing with Fire, Round 2: North Korea’s Potential Missile Threat to Asian Oil Refining Infrastructure,” China SignPost™ (洞察中国) 70 (14 April 2013).

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

We first addressed the issue of potential North Korean threats to oil refining infrastructure in Northeast Asia in the fall of 2010. Unfortunately, the risk of serious crisis or even conflict is once again rising. Because the base level threat is similar, but the specific circumstances somewhat different, we include much of our prior analysis, with relevant updates.

The sequential reminders of military capabilities by the U.S. and South Korean militaries in response to provocations from the North—including a third nuclear test, threats to restart the Yongbyon nuclear facility, and recent ballistic missile tests, with the KN-08 IRBM perhaps being readied—suggest that the Pentagon and its partners in Seoul think there is a very real need to deter Pyongyang from engaging in offensive actions. In Patrick Cronin’s seasoned judgment, “The Korean Peninsula is on a knife’s edge, one fateful step from war. While Koreans are accustomed to periodic spikes in tensions, the risk of renewed hostilities appears higher than at any time in the past 60 years. … the potential for miscalculation and escalation is high.”

Moreover, the high-stakes game of ‘escalation poker’ North Korea has initiated shows no sign of abating soon. Indeed, a number of U.S. military moves—such as hastening the deployment of anti-missile systems to Guam—signal that U.S. military planners view the North Korean threat as an enduring one.

The steady escalation between North Korea and South Korea as well as the U.S. is increasing the risk of armed confrontation, however unintended, in the region. In the still unlikely but nevertheless not impossible event that a shooting war were to erupt, North Korea might threaten to target such critical economic infrastructure as refineries in South Korea and Japan. Saddam Hussein’s Scud attacks against Israel during the First Gulf War in 1991 suggest how despots with large missile forces can lash out in unpredictable ways during a conflict, even to their ultimate detriment.

North Korean actions are steadily eroding the tolerance of both South Korea and its U.S. ally, whose military would almost certainly also participate in military action against the North. North Korea’s sinking of the Cheonan was a human tragedy with 46 crewmembers killed, but at the time it did not sufficiently threaten South Korea’s core interests to make Seoul willing to launch a military response.

Two and one-half years later, the calculus appears to have changed on both sides of the DMZ. South Korea, under President Park Geun Hye’s leadership, seems much more inclined to meet new, serious military provocations by North Korea forcefully. And for its part, North Korea seems to be losing sight of the fact that the now unprecedentedly vitriolic iterations of its chronic ‘shakedown diplomacy’ run a higher risk of sparking real conflict now than even their violently kinetic predecessors did in 2010.

Meanwhile, the U.S. has come to its senses and is no longer willing to be a victim of the periodic Pyongyang hustle. As U.S. Secretary of State John Kerry declared in his remarks with South Korean Foreign Minister Yun Byung-se after their meeting in Seoul on 12 April, “No one is going to talk for the sake of talking, and no one is going to continue to play this round-robin game that gets repeated every few years, which is both unnecessary and dangerous.” This is an extremely sensible approach. Just as Lucy always pulls the football away just before Charlie Brown can kick it in the “Peanuts” comic strip, the Kims of North Korea have long been interested not in any meaningful negotiations but only in manufacturing crises to extract international resources that their own economy is inherently incapable of generating under their totalitarian rule.

Kim Jong-un’s father Kim Jong-il likely prioritized (in descending order) personal, family, regime, and national survival. We are increasingly inclined to think his son is not the same strategically cautious extortion artist that his father was, and that his grandfather eventually became years after unilaterally launching the devastating Korean War. As Chung Min Lee explains, Kim Jong Un, having more to prove than his grandfather or even his father,

“has walked into a self-made trap; namely, that he has to show his people and his generals that he really deserves to be the Young Marshall who can lead his nation to new heights. By rattling his sabers and almost daring South Korea, the United States, China, and Japan to take him on, Kim Jong Un feels that he can earn his military stripes, even though he spent his teenage years at an exclusive boarding school in Switzerland and has lived as a de facto diety, unlike the absolute majority of his countrymen who have lived in fear and hunger.”

What all three Kims have perfected to an art form is finding new and unexpected ways to cause maximum provocation while just managing to avoid a larger escalation that sinks their regime.

Kim Jong-un may have the same basic idea of brandishing a sword to try to extract aid from the outside world, but his regime’s actions now suggest that he has become more risk-acceptant than many observers anticipated. Lacking his predecessors’ sense of when to hold and when to fold, and determined to ensure regime survival by demonstrating nuclear and missile capabilities to a degree that surpasses them significantly, Kim Jong-un has now come too close to the brink for anyone’s comfort, perhaps including ultimately his own.

Consequently, the North’s myriad ballistic missiles and artillery tubes may now increasingly be at risk of being pointed in a worst-case scenario not only at Seoul, but also at regional oil and gas infrastructure, particularly if a conflict started and North Korean leaders realized that regime collapse was imminent, as it likely would be given that the U.S. and South Korea would almost certainly engage militarily until the Kim government was removed from power. Long before that possibility can materialize, it is important to review potential red lines and to warn Pyongyang clearly not to cross them. Indeed, we hope that Beijing is doing just that right now.

To that end, our analysis here focuses on one critical red line that Pyongyang must not cross, and that all nations share an interest in it avoiding completely: actually striking petroleum supplies in a country that is completely import dependent. South Korea could not tolerate this kind of threat, nor could Japan or even China. All three countries are highly energy-interdependent. Additionally, China would be very sensitive to any disruptions in energy supplies in Northeast Asia.

China would understand the South Korean and Japanese reaction to such threats—and would likely curtail its support for North Korea severely if it took such action. After all, China wants to preserve the status quo, and it too is a rational actor. However, unlike North Korea, China’s preference ordering is stable and transparent, and given the billions in trade from Japan and South Korea, China will prioritize the economic relations with those two countries over the increasingly tense relationship with North Korea.

Given the risk of misperception and miscalculation, however, now is a logical time to assess the vulnerability of regional refining infrastructure to a North Korean attack in a worst-case scenario and how the markets might respond to related threats.

North Korean threats against South Korean economic assets such as refineries would mark a new front in the countries’ conflict. The rising risk of this happening should be taken seriously by policymakers because even threats made by Pyongyang for deterrence purposes can have meaningful and negative economic impacts. Indeed, refined oil products are now South Korea’s single-largest export earner, and the country has become Asia’s key regional refined product supplier. North Korean attacks on South Korean refineries would thus have an outsize regional oil market impact and a global one as well.

Financial markets and insurance markets are inherently forward-looking and would quickly price in increased perceptions of risk driven by North Korean threats against South Korean refineries. Such threats could come through public statements (a lower-impact event) or in the form of actions such as missile tests landing in international waters near major South Korean oil ports (a lower-probability, but higher-impact event). Market responses to a North Korean threat might include equity market declines, crude oil and oil product price increases, and higher insurance costs for shippers delivering oil to South Korean refineries.

Unless North Korean gunners managed to hit key portions of the refineries such as cat crackers or used chemical weapons, the plants could still run, but consumers of oil and equity shareholders in the region would bear the costs as risk managers priced the reality that a key global oil refining region could face attacks. In contrast to other countries in the region, North Korea’s economic isolation from the outside world shields it from the impacts of market disruptions triggered by its behavior, potentially making it more willing to use economic threats as part of its “shakedown diplomacy.”

Refineries, at least for deterrence purposes, could in a worst-case scenario represent tempting targets for North Korea, as striking them would cause more economic damage than hitting civilian population centers, while minimizing civilian casualties. Doing so would not require flexibility and decision-making at lower levels (i.e., as might be required for an invasion of Seoul) that might be difficult if not impossible for such a hierarchical regime to allow.

Ballistic missiles with a circular error of probability of several hundred meters such as North Korea’s No-dong would have a good chance of scoring a hit against a refinery, whose processing units, storage tanks, and other infrastructure can occupy an area of multiple square kilometers. An added bonus from Pyongyang’s perspective is that a missile hit on critical parts of a refinery could put the plant out of commission for at least several months.

Based on the latest missile data from Jane’s and other sources, South Korea’s entire refining capacity of approximately 2.8 million bpd lies within range of North Korean Hwasong 6 and 7 and No-dong missiles, while Japan’s 4.7 million bpd of capacity lies fully within the range envelopes of the No-Dong 1 and 2, Musudan, Taep’o-dong, and KN-08 missiles (Exhibit 1).

Exhibit 1: North Korean ballistic strike systems

Exhibit 1_China SignPost 70_North korea threats to refinery infrastructure

Source: Jane’s, Global Security.org, Nuclear Threat Initiative

Hyundai’s refineries at Incheon and Daesan lie within 100km of the border and could be targeted by the KN-02 SRBM, North Korea’s most precise ballistic strike system with a reported circular error probable (CEP) of 160 meters.[1]  Exhibit 1 highlights in yellow the weapons systems (KN-02, Hwasong-5, and No Dong-2) which have reported CEPs of less than 1,000 meters and would thus presumably be able to target specific portions of large industrial facilities like refineries, particularly if armed with warheads containing submunitions that enabled the missile to impact a larger area of the target. North Korea’s other ballistic missiles, in contrast, would be operating more as weapons intended to sow fear and cause disruption of refinery operations, but not necessarily able to specifically target portions of even a large plant.

Because South Korea and Japan are such important refining hubs (8.5% of global capacity), both categories of North Korean missile threat (area- and precision-strikes) would likely cause significant market disruptions. We believe it would not be unreasonable to expect regional seaborne gasoline and diesel fuel prices to spike by 20% or more in the aftermath of a successful strike on a refinery in South Korea and/or Japan. Regional and global crude oil prices would also likely spike by more than 10% in the event of a North Korean ballistic strike on even a single regional refinery.

How missiles might change regional energy supply risk

To provide a clearer sense of how risks to refineries vary with North Korean threats, we use four scenarios (four significant probability and one worst case) to illustrate what we see as the major possible potential outcomes. The probability represents the chances that a particular scenario will materialize. All probabilities are notional, as they are intended to suggest the relative likelihood of possible future scenarios rather than an absolute prediction.

Scenario 1: Confrontation short of full conflict

Probability we attached in November 2010: >45%

Probability we attach now: 40%

Risk of refinery threats: slightly elevated

In this scenario, South Korea and the U.S. would work to pressure the North without resorting to direct military force. Possible means employed could include restricting North Korean maritime transit through South Korean waters, identifying and freezing North Korean-controlled financial assets overseas, imposing travel restrictions on North Korean officials and their family members, and further severing economic and trade ties between North and South Korea. We also see potential for imposing sanctions on companies that do business in North Korea or products produced using North Korean labor or raw materials, which could affect a number of Chinese firms.

Still, Seoul might be extremely reluctant to impose any measures that risked harming economic growth. During the Cheonan and Yeonpyeong Island incidents, for instance, South Korea never evacuated its 700+ workers from the Kaesong Industrial Complex, despite the potential that they might become hostages—or even human shields for North Korean artillery/missiles. It is only North Korean disbarment in recent days that has kept South Korean workers from Kaesong.

Scenario 2: Sparring

Probability we attached in November 2010: 35%

Probability we attach now: 40%

Risk of refinery threats: moderate

Under this scenario, the two Koreas would enter into a period of heightened tensions, to include brinksmanship and threats, and even possibly limited military actions against each other at a level beyond the occasional exchanges of fire. Records of North Korean provocations compiled by the Congressional Research Service show the 1960s were a time of particularly high North Korean activity against the South and there is a meaningful possibility that the ongoing leadership transition process in North Korea will spark a similar pattern, albeit perhaps at a lower level of casualties, over the next several years (Exhibit 2).

Exhibit 2: North Korean provocations (selected)

Exhibit 2_China SignPost 70_North korea threats to refinery infrastructure

Source: Congressional Research Service, China SignPost™

Scenario 3: Return to normal

Probability we attached in November 2010: 15%

Probability we attach now: 15%

Risk of refinery threats: unchanged

There is a lower probability that once the immediate political heat from the current crisis passes, the two countries will return to the pre-attack status quo. We believe this is less likely than the first two scenarios because Kim Jong-un is more risk-acceptant and in need of military credibility than his father, while an increasing portion of the South Korean populace is questioning the merits of previously accommodative “Sunshine” policies toward Pyongyang in the face of its belligerent behavior and disregard for South Korean lives.

Scenario 4: Major North Korean military attack

Probability we attached in November 2010: >5%

Probability we attach now: >5%

Risk of refinery threats and attacks: high

Since the 1953 armistice, there has been a substantial record of North Korean provocations and assaults on South Korean and American assets and citizens. The lack of significant military conflict to date underscores the extraordinary restraint shown by South Korea and its U.S. ally, as well as the lack of attack options that do not allow the North to threaten Seoul with significant civilian casualties via border-based artillery. The probability of a more significant North Korean military attack is the scenario we are most concerned about, despite its relatively low probability. Missile strikes or sabotage against South Korean or Japanese refineries would probably be construed as an act of war and we believe these are only actions the North Korean leadership would take if (1) it were involved in a full-scale shooting war; and more likely, if (2) it realized that the conflict was likely to end in a North Korean loss, with regime change at the hands of ROK and U.S. forces imminent. While such escalation is highly unlikely, Patrick Cronin imagines a conceivable action that could trigger deadly escalation: “…the North Korean leadership orders an assault on South Korean patrol vessels and military fortifications built after the 2010 shelling incident. The regime feels safe in striking out along the maritime boundary because the two sides have repeatedly skirmished in the area in the past 15 years.” Escalation risk comes not just from one side’s actions but the reactions those actions can trigger from others.

Worst-case outcomes are unlikely to materialize both because even North Korea’s currently even more risk-acceptant leadership prioritizes regime survival and because it has been in the interest of South Korea, China, and the U.S. to prevent tensions from escalating to kinetic conflict, even if this entails tolerating extremely escalatory behavior on North Korea’s part. While this scenario is the lowest-probability outcome by far, then, we believe the likelihood of a more significant military exchange has risen significantly with North Korea’s recent belligerence and the calls for a stronger response that it is prompting in many quarters of South Korean society. Moreover, there is the risk of misperception and miscalculation; particularly by a young, uncredentialed leader unprecedentedly-reliant on his king-making military’s support, who may find it extremely difficult to back down in certain situations.

This is a serious risk: what happens if Kim runs out of blustery but relatively non-escalatory cards to play and has no concessions to show for it? Moreover, there is always the risk of surprise—for instance, many analysts failed to anticipate that North Korea would actually fire artillery at South Korea’s Yeonpyeong Island in broad daylight and thereby kill both military personnel and civilians. The risk of some larger military attack or exchange must therefore be viewed in proper context, but even very-low-probability worst-case scenarios deserve serious consideration given the potentially devastating consequences.

Facility vulnerability

To quantify the vulnerability of regional refining facilities, we use a simple index based on the plant’s distance from North Korea (relevant for vulnerability to accurate missile strikes), its distance from the sea (vulnerability to covert sabotage missions), and its capacity (bigger plants represent more appealing targets). The metrics are also weighted to reflect what we believe would be key elements of North Korea’s worst-case targeting calculus in the event a decision was taken to launch strikes, and therefore potentially relevant to its attempts to bolster deterrence.

Overall distance receives the highest weight in our scoring, since targets need to fall in a weapon system’s range envelope. This is followed by distance from the sea, since a covert sabotage operation would have higher deniability than a missile strike, whose origin can be traced based on the rocket’s trajectory. Finally, capacity receives a lower weighting since the main target set of South Korean refineries are, with the exception of Hyundai’s Busan plant, some of the largest facilities in the world, with the ability to process 270,000 barrels of oil per day (kbd) or more. SK’s Ulsan plant (817 kbd) gets the highest score at 213.4, with the other four large South Korean refineries rounding out the five most vulnerable plants, all with scores of between 134.0 and 213.4 (Exhibit 3).

We assess the risk of attacks on Chinese and Russian refineries in the region as much lower. Russia’s capacity in the Far East is small and a military response would likely follow any attack. China, technically an “ally,” remains North Korea’s primary international relationship, with high diplomatic importance due to Beijing’s position as a permanent member of the UN Security Council and as the only regional power willing and able to offset the weight of the U.S. in diplomatic fora such as the Six Party Talks.

So far, the Kim regime has focused on military assets and isolated areas as targets for its provocations. With that in mind, the retaliatory pressures North Korea is likely to face for its latest infractions, such as freezing of senior leadership assets abroad, could trigger threats of further attacks that could expand to include sabotage operations against industrial and economic targets like refineries. But with so much at stake, such threats would simply be intolerable. As Cronin reminds us, “Kim Jong Un may not want war, but amid heightened tensions there are many ways one could start… should war begin again in earnest, its intensity and its duration could prove a nasty surprise, as it did the first time. And the consequences could affect Northeast Asia for the rest of the century.”

Given South Korea’s vulnerability and the U.S.’s lack of further non-military options and unwillingness to endure further “shakedown diplomacy,” China may be the only party left that can talk and pressure North Korea back from the brink. Message to Beijing: your “ally” is, first and foremost, your problem; please act accordingly to safeguard your interests and those of the region. Message to Pyongyang: threatening your neighbors’ sensitive infrastructure is not a card to play to exact concessions, but an un-crossable red line. Don’t even talk about going there.

Exhibit 3: Vulnerability of South Korean and Japanese refineries to North Korean attack (highest to lowest)

Exhibit 3_China SignPost 70_North korea threats to refinery infrastructure

Source: Oil & Gas Journal, Petroleum Association Japan, China SignPost™

***

Gabriel B. Collins and Andrew S. Erickson, “March: China’s Month of Mistakes,” China Real Time Report (中国实时报), Wall Street Journal, 12 April 2013.

March was a tough month for China’s foreign policymakers, with four high-profile foreign policy fumbles, two of which significantly helped to raise the risk of tension and crisis in East Asia. While all but one of these incidents apparently stemmed from deliberate actions approved by Chinese decision-makers at some level, and hence do not constitute errors in execution per se, the negative repercussions they engender may ultimately come back to harm China’s own interests.

At the recently concluded Bo’ao Forum on the southern island province of Hainan, President Xi Jinping was eager to position China as a force for peace in the region.

“For Asia, development is still the top question, development is still crucial for solving many problems and conflicts,” he told attendees. “Without peace, there is no need to talk about development.” Yet China’s actions in March suggest that in pursuing its aims Beijing is all too willing to act at odds with these welcome words.

China has couched its more assertive stance in the region in terms of a natural desire to protect its national interests. All nations pursue their own interests, and one would expect China to desire to project its growing power in service of that goal. The real issue is whether China can project its power in ways that are compatible enough with the interests of others to reduce the potential for outright conflict.

The most serious threat to regional stability at present is North Korea’s latest ramping up of provocations—a process that Beijing abetted in early March by perpetuating the false notion that all parties bear equal responsibility for the situation. Encouraged by the knowledge that Beijing is unwilling to abandon it, Pyongyang lashed out at the sanctions imposed by the United Nations after its February nuclear test, spewing threat after bellicose threat.

Although China joined the U.S. in supporting the U.N. sanctions, it remained meek in the face of North Korean saber rattling. Beijing worries that by removing its support for Pyongyang, it risks hastening regime collapse in North Korea and reunification of the Korean peninsula under non-Chinese terms. Those concerns are understandable. But by aiding and abetting a bad actor that so flagrantly defies international norms and threatens regional stability, while simultaneously suggesting that the problem lies with others, China put its parochial interests above the regional peace and development that it publicly champions.

A similar disregard for others’ interests was in evidence in an incident on March 20, when Chinese patrol boats confronted a Vietnamese fishing boat near the disputed Paracel Islands. According to the Vietnamese Foreign Ministry, two Chinese patrol vessels (hulls 262 and 263 from China Marine Surveillance) chased and fired on a Vietnamese fishing boat named QNg96382, causing a fire that destroyed the boat’s cabin. Chinese reporting on the incident acknowledged that the Chinese vessels had fired, but called the discharges “warning shots.”

The official PLA Daily said another patrol vessel, China Marine Surveillance 786, fired two red flares into the air to warn four Vietnamese fishing vessels to leave waters around the islands. While it remains unclear precisely who did what, photos showing China Marine Surveillance 786 with a cloud of smoke near it and a Vietnamese boat with a burned-out cabin that looks very much like earlier photos of an intact QNg96382 suggest that Chinese boats did indeed set the Vietnamese boat on fire, whether they intended to or not.

Previously reported incidents, such as the cutting by Chinese vessels of a Vietnamese oil exploration vessel’s cables in 2012, make this appear to be part of a larger pattern of Chinese pressure and raise questions about China’s willingness to err on the side of threatening and using force in pushing its claims in disputed waters. The incident also raises questions about how much control China’s State Oceanic Administration has over vessel captains operating under the paramilitary Marine Surveillance agency.

In projecting power around the region, China has demonstrated a certain degree of hypocrisy. This became evident on March 22, two days after the confrontation near the Paracels, when a 4-vessel PLA Navy flotilla led by the amphibious landing ship Jinggangshan moved into waters near the disputed James Shoal—only 80 kilometers (50 miles) from Malaysia —and began a combined arms amphibious exercise.

The flotilla left the South China Sea on a week later and headed through the Bashi Channel between Taiwan and the Philippines to enter the Western Pacific for additional training. The PLAN’s maneuver and an accompanying ceremony near the shoal, during which Chinese sailors swore to uphold China’s territorial integrity and defend its South China Sea interests, no doubt caused consternation in regional capitals, particularly Kuala Lumpur, which has so far made little noise about China’s assertiveness in the area.

While the exercises did not violate international law, they did violate an unofficial standard China has maintained in confronting U.S. reconnaissance missions off its own shores.

When a Chinese J-8 fighter collided with a U.S. EP-3 aircraft in 2001, sparking a diplomatic crisis, the U.S. plane was approximately 70 miles (110 km) from Hainan Island and 100 miles from Chinese facilities in the Paracel Islands.

At the time of its 2009 surrounding and harassment by five Chinese government-controlled vessels, U.S. survey ship USNS Impeccable was roughly 75 miles south of Hainan. China’s opposition to U.S. actions yet willingness to engage in military maneuvers near smaller neighbors like Malaysia evokes the double standard expressed in a Chinese proverb: “Magistrates may set fires but commoners may not even light lamps.”

Finally, with North Korean provocations fully in play, a state-owned Chinese oil tanker was caught loading crude in Iran, another pariah state that enjoys substantial Chinese support. Vessel tracking data indicated that the supertanker Yuan Yang Hu, owned by China Ocean Shipping (COSCO), loaded oil at Iran’s Kharg Island on March 21 in violation of an U.S.-EU embargo. COSCO is a strategic state-owned enterprise whose vessels are tracked both by commercial services and by the China Ship Reporting system (CHISREP), meaning there is little chance for a mistake here. The best explanation we can think of at this point for a Chinese company to risk openly flouting the embargo is that the Iranians are selling some cargoes at significant discounts in order to attract buyers.

China Real Time Report analyzed the potential for Iran to market crude oil in this mannerback in January 2012 when the issue was coming to the fore, and it appears the Iranians may be testing the waters to see what types of sweeteners are needed to bring buyers back into the market. Such Chinese activities help Iran evade sanctions imposed to curb Tehran’s defiance of international norms.

Chinese actions in March have helped to set the stage for a contentious ASEAN summit, slated to kick off on April 24 in Brunei—only 250 km from James Shoal. In the meantime, ongoing tension on the North Korean peninsula presents Beijing with an opportunity to prove that it can be a responsible stakeholder in the region. Indeed, as the serious of the situation became more apparent in the latter half of March, China began stepping up the pressure on Pyongyang.

China, its neighbors, and rest of the world would all benefit if Beijing were to match its lofty rhetoric on regional peace with positive deeds and clear messages to irresponsible actors. This includes holding itself to the same standards of restraint that it demands of others. Yet the reality is that frictions between Beijing and its neighbors and Washington are likely to increase, powered in part by a post-2008 notion that China’s power is waxing as the U.S.’s wanes.

The world should expect China to pursue its national interests in an increasingly forthright fashion as its military power and capabilities rise towards a level more commensurate with its already substantial global economic and security interests.

In some areas, such as the fight against Somali pirates, increased Chinese activity will be beneficial. But with regard to island and maritime disputes in particular, friction and disputes are likely to intensify. China’s tectonic boundaries with Japan in the East China Sea and Vietnam in the South China Sea will remain among Asia’s most volatile flashpoints for the foreseeable future.

Nobody expects China not to pursue its own interests, but all will be watching to see to what extent it does so in a way that respects others’ needs and concerns.

***

Andrew S. Erickson and Gabriel B. Collins, “New Fleet on the Block: China’s Coast Guard Comes Together,” China Real Time Report (中国实时报), Wall Street Journal, 11 March 2013.

JAPANESE TRANSLATION

In a move with significant implications for territorial disputes in the East and South China Seas, the Chinese government announced on Sunday that it plans to centralize bureaucratic control over its maritime law enforcement agencies by consolidating them under the State Oceanic Administration (SOA) and its parent ministry, the Ministry of Land and Natural Resources.

Many analysts—ourselves included—focus heavily on China’s rapidly-developing navy. Yet some of the most profound effects on China’s near-term operations in its maritime neighborhood are likely to emerge from ongoing reforms that put China on a path to creating Asia’s largest coast guard. While further behind in high-end capabilities, China’s civil maritime forces combined currently have nearly as many large-displacement cutters and patrol vessels as Japan’s Coast Guard, the region’s largest and most capable.

In remarks delivered in conjunction with the National People’s Congress on Sunday, State councilor Ma Kai  said that consolidation was needed to remedy the fact that the country’s five separate maritime law enforcement bodies were insufficient to fulfill China’s law enforcement needs, protect its sovereignty, and safeguard its maritime rights and interests, including a maritime economy that could account for 10% of national economic output by 2015 (in Chinese).

For years, China’s five largest civil maritime agencies were controlled by different parent organizations, earning them the moniker “five dragons contending for the sea.” Four dragons are now slated for consolidation under the SOA:

  1. China Marine Surveillance (CMS) [already under SOA]
  2. Border Control Department (BCD) [formerly under the Ministry of Public Security]
  3. Fisheries Law Enforcement Command (FLEC) [formerly under the Ministry of Agriculture]
  4. General Administration of Customs [under the State Council]

The fifth dragon, the Maritime Safety Administration (MSA), under the jurisdiction of the Ministry of Transport, is not generally referenced in official statements describing the merger.

China’s ongoing civil maritime command-and-control reforms have been mentioned intermittently for years, based in part on close study of measures China’s neighbors have taken to improve their own coast guard capabilities. One such study (pdf), published in 2007 by researchers at the Ningbo Maritime Police Academy, noted how South Korea successfully unified different maritime law enforcement agencies into a single, powerful national coast guard. While the jury remains out the ultimate impact of China’s fledgling measures, the years of thought and operational experience behind today’s ongoing reforms suggest that they have strong political support and enjoy a good chance of succeeding in materially enhancing China’s maritime law enforcement capabilities.

Reform Objectives

The broad aim of the reform is to enable Chinese maritime law enforcement capabilities to be used in a more controlled manner while also retaining their effectiveness as an instrument of national power. Stronger central control will help Beijing better ensure that the new unified Coast Guard promotes national objectives while restraining individual commanders from taking rash actions that could trigger unintended escalation of maritime conflicts.

Japan has long recognized the power of Coast Guard forces to protect national interests in an effective manner that arouses less opposition and risk of escalation than use of naval warships. Indeed, local media recently reported that former Japanese Prime Minister Yoshihiko Noda had ordered the country’s Maritime Self-Defense Force to remain out of sight over the horizon during Chinese forays into the vicinity of the disputed Senkaku/Diaoyu Islands, instead letting the Japanese Coast Guard play the front-line role, after his administration nationalized the islands in September.

Now China is moving to further diversify its options by creating a similarly versatile Coast Guard that may even surpass Japan’s numerically within the next few years. China’s civil maritime sector is in the midst of a large shipbuilding spree that could add 36 modern cutters and patrol ships over the next five years (in Chinese) and make China’s Coast Guard the region’s largest by at least some metrics. Civil maritime vessels require mechanical reliability and the ability to operate at sea and support their crew effectively for sufficient periods, but tend to be simpler, cheaper and quicker to build than top-end warships. These factors allow China’s capable shipyards to ramp up numbers rapidly if desired.

Japanese defense analysts are already fretting over the possibility that in two to three years, Chinese Coast Guard forces could become able to deploy more ships to the Senkaku/Diaoyu Islands area than the Japan Coast Guard will be able to handle. As of 1 April 2012, the Japan Coast Guard had a total of 448 vessels and 73 aircraft (pdf). While 51 of the Japan Coast Guard’s cutters are in the 1,000-ton class, China’s civil maritime forces already have 47 such vessels and are expected to add at least 20 by 2015 .

Key Challenges

Among the biggest unknowns in the wake of Sunday’s announcement is whether a top level decree can overcome entrenched constituencies within each of the five maritime law enforcement agencies and break enough “rice bowls” to ensure their effective integration. And even if the reforms are successful, what the consolidated Coast Guard will do to address remaining deficiencies in equipment and other capabilities remains an important question.

Strategic Implications

Civil maritime integration affirms that Beijing believes regional maritime disputes will not be resolved anytime soon, but that it wants to have more coordinated policies and operations among its maritime law enforcement agencies. Bureaucratic unification may help to ameliorate risks previously imposed by competing law enforcement agencies being involved in maritime encounters and disputes. Japanese sources have argued that in the past, China’s disparate maritime law organizations and the lack of centralized control over their operations greatly complicated the East China Sea security situation. That hasn’t always been the case. On March 8, 2009, PLAN, CMS, FLEC and other Chinese-government controlled vessels were able to coordinate closely and effectively  in harassing an unarmed U.S. government survey ship in international waters far from China’s coast (pdf). Yet, as Nan Li documents in his landmark study on Chinese civil-military relations (pdf), Beijing’s real-time crisis decision-making and –management still faces formidable challenges. While the current reforms promise to help address this serious problem, it remains to be seen exactly how SOA will merge its new “dragons’” organizational structures and operations.

Building more coherent civilian maritime law enforcement capacity serves China’s core strategic interests.  Outside of China’s immediate neighborhood in the East and South China Seas, many of the security threats it faces come from non-traditional sources such as piracy. A more unified command structure also stands to significantly enhance Chinese maritime law enforcement’s operational effectiveness. For example, in the past, China MSA’s Shanghai Rescue Coordination Center has overseen a vessel-tracking systems that displayed MSA vessels’ locations in real time, but were unable to show where vessels from the other four “dragons” were (pdf). High-level oversight and command unification can help China overcome that and other inefficiencies.

A unified Chinese Coast Guard may expand its portfolio operationally and geographically over time. It also enhances Beijing’s ability to respond with white hulls instead of gray hulls, thereby engaging in moderated messaging and actions, which Lyle Goldstein, a leading expert on the subject, terms “non-military escalation.” Traditionally, among Chinese law enforcement vessels, only BCD’s have been armed with substantial deck guns. The fact that Coast Guards can exert influence without being viewed with the alarm triggered by actual naval deployments make them an extremely useful tool for global maritime powers to safeguard interests in near and distant waters alike. Here it bears noting that the U.S. Coast Guard operates globally. As China’s global maritime interests continue expanding and China begins to see its laws as applying to activities beyond Chinese borders, the leaders of a new, unified maritime law enforcement body may well lobby for a broader set of missions than they currently perform.

Finally, a more unified Chinese Coast Guard command structure facilitates cooperation with other countries.  China and other regional and global maritime powers such as Japan, South Korea, the U.S. and India share common interests in managing fisheries and addressing threats to key sea lanes and ports from piracy, terrorism and other disruptive non-traditional activities. In this respect, having a centralized point of contact in China could foster closer cooperation on areas of mutual interest, provided that its leadership is vested with sufficient political authority to overcome internal opposition from competing entities and interests.

As challenges of bureaucratic unification and coordination are surmounted, China’s new fleet on the block will afford significant operational possibilities for China. Instead of “contending for the seas” among a motley collection of small dragons, a bigger dragon can handle their previous responsibilities more effectively. Beyond its continuing responsibilities within Chinese territorial waters, it may instead contend more intensively with the coast guards and navies of neighboring countries—albeit in a fashion far less escalatory than if China dispatched naval ships. The direction that China’s new Coast Guard takes, the size to which it grows, and the roles it assumes will offer significant indications concerning Beijing’s plans for the seas off its coast.

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Andrew S. Erickson and Gabriel B. Collins, “The Y-20: China Aviation Milestone Means New Power Projection,” China Real Time Report (中国实时报), Wall Street Journal, 28 January 2013.

Escorted by a J-15 fighter and numbered “20001,” China’s domestically-produced Y-20 transport aircraft successfully completed  its maiden flight on Jan. 26 at the People’s Liberation Army Air Force (PLAAF)’s China Flight Test Establishment in Sha’anxi province, remaining airborne for an hour , according to state-run media reports. In an example of selective transparency to boost pride at home and credibility abroad, domestic media were rapidly notified of the Y-20’s test flight (see CCTV broadcast here and here) and Chinese military enthusiasts are energetically welcoming the news.

“First we heard about the test flight of the J-31 stealth fighter jet, then the landing and takeoff of the J-15 on our aircraft carrier, and now we embrace the birth of the Y-20,” the state-run English-language China Daily quoted Qu Renming, a white-collar worker in Beijing, as saying. “The only concern for military fans is when can the Y-20 use our domestically developed engine and enter into service.”

The Y-20’s first flight suggests that China is on the way to joining the U.S., Russia and Ukraine as the fourth nation to independently develop and fly a heavy military transport aircraft. Its development represents a meaningful step toward China being able to develop a more robust ability to project aerial power, both in the form of air transport and aerial refueling. It also offers a large airframe that could eventually provide a foundation for building airborne early warning aircraft and large air tankers capable of supporting long-range strike fighters. Finally, the Y-20 transport could eventually be exported to friendly nations, and perhaps beyond if AVIC can build and sell it for less than the cost of competitors such as the Russian IL-76. The PLAAF currently operates 20 IL-76s, and has reportedly ordered 30 more.

Aircraft Design and Construction Advances

The Y-20 is the third example of a new trend in which AVIC has moved beyond cloning and copying and can now successfully meld aspects of multiple foreign airframes (and technical advice) with domestic designs and improved, domestically-manufactured systems. The J-20 and J-31 were the first two Chinese-made aircraft to make this leap, and now the Y-20 has done so as well.

The Y-20 differs clearly from other heavy transport aircraft like Russia’s Il-76, America’s C-5 and C-17, and Europe’s A400M in fuselage shape, wheels and flap actuators. PLA experts quoted in a story appearing on the English-language website of the People’s Daily claim that the Y-20 outperforms Russia’s Il-76 and say it boasts “Chinese characteristics in supercritical airfoils, integrated avionics, cabin equipment, composite materials and their processing.”  The experts say the plane has three aircrew, a 15-meter height and 47-meter fuselage length, a 66-ton maximum load capacity and a maximum takeoff weight of just over 200 tons. Its capacious cargo hold can “carry the vast majority of combat and support vehicles of the Chinese People’s Liberation Army (PLA),” including the PLA’s heaviest tank, the 58-ton Type-99A2. It can transport them even to underdeveloped “airstrips” thanks to its “strong adaptability to [substandard] take-off and landing fields.” This suggests the PLA has carefully noted the ability of the U.S. C-17 to land on rough dirt airstrips and serve forward combat bases in Afghanistan.

Interestingly, two researchers at China Aerodynamics Research and Development Center asserted in 2007 that a “large transport aircraft” with approximately these specifications would have “performance superior to [that of the] IL-76.” Coupled with Xinhua’s 2008 announcement that one-third of China’s initial 60 billion yuan ($9.6 billion) investment in its state-prioritized large aircraft program would be for military transport aircraft, and a CCTV-7 report that the Y-20 would be unveiled by the end of 2009, this suggests that the Y-20’s development was long-planned. Certainly it is a long-term program.

“If everything goes well, the Y-20 will have to undergo a minimum-three-year-long flight test and a minimum-five-year-long comprehensive test period,” the PLA experts cited on the People’s Daily website state. “Therefore, 2017 is the earliest date by which the PLA Air Force will have home-made large transport aircraft.” This would suggest that the 2017-20 period will see the PLA potentially taking simultaneous large-scale deliveries of the Y-20, as well as fighter jets like the J-20, and possibly the J-31, the J-15 and J-16.

Driving Additional Jet Engine Investment

The Y-20’s capabilities are reportedly close to those of Russia’s Il-476, with one important exception: The Y-20’s Russian D-30KP2 engines lack the thrust and efficiency of the Il-476’s PS-90A76 turbofans. In a sign that even China’s aviation Achilles’ heel – engines – is now receiving major resources, China is developing a high-thrust turbofan called the WS-20 to fill this role as part of a major aeroengine resource and technology push. While progress will likely take time, reports suggest China could invest up to 300 billion yuan ($49 billion) in jet engine development by 2035. Acquisition of foreign technology and breakthroughs in recruiting foreign experts could help accelerate China’s jet engine development.

Financial considerations and a belief that Chinese jet engine makers are behind the Russian technical curve will likely motivate Russia to permit transfers of additional jet engines over the next 2-3 years despite the significant risk AVIC will reverse engineer key portions, if not the entire powerplant. Meanwhile, Ukrainian engineers are already readily available, and their Russian counterparts may become increasingly so as Russia moves its aviation contractor headquarters from prime city real estate near aging engineers’ apartments to Zhukovsky Airfield, which lies 45 km from downtown Moscow and is a long commute even under the best of circumstances given the capital’s congested roads.

Future Directions

The last two years have yielded a growing body of evidence that China is enjoying significant success in simultaneously managing multiple advanced aircraft programs. At present, no other nation can—or does—allocate so many personnel and financial resources so rapidly toward achieving national strategic goals.

That said, the Chinese aerospace sector also has a number of key weaknesses that will be exposed if continuing budget increases fail to yield commensurate technical breakthroughs in critical unproven areas, including aeroengines, electronics and avionics.

So far, by exploiting open source study, commercial joint ventures with tech transfer and industrial espionage, China has been able to leapfrog and save costs and time as it closes its technical gap with advanced aerospace power such as the U.S., Russia and certain European countries.

Yet the closer China comes in capability to other advanced aviation powers, the less of a follower’s advantage it will have, raising questions about how much Chinese aerospace expenditures will need to rise in order to have a chance of creating a comprehensive global aerospace power, as opposed to one that makes snazzy airframes, but struggles with critical subsystems such as the engines and electronics. To boot, getting the hardware right is only part of the challenge, since being able to employ it effectively will require millions of man-hours invested in maintenance, training and learning how to integrate platforms with each other to operate in a way that the whole is more powerful than the sum of the parts.

In short, the Y-20 is a point of national pride and a substantial breakthrough for China’s large aircraft programs, but to begin thinking of it as a true military advancement, we need to see a Y-20 undertake a long flight with heavy cargo, then turn around and do the same thing on a return flight. Proof of an aircraft’s reliability and effectiveness lies in real objectives successfully achieved under real world conditions. A long and interesting road lies ahead for the Y-20.

The authors acknowledge support and insights from an anonymous aerospace and defense expert.

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Andrew S. Erickson and Gabriel B. Collins, “Limited Liftoff Looming: Y-20 Transport Prepares for 1st Test Flight,” The Diplomat, 8 January 2013.

In 2011 and 2012, China flight-tested stealth fighter prototypes developed by Chengdu Aircraft Corporation (J-20) and Shenyang Aircraft Corporation (J-31). In 2013, Xi’an Aircraft Corporation (XAC) will look to get into the new aircraft game by flight-testing a prototype of the Y-20, an indigenously-developed large transport aircraft similar in size to the Russian IL-76 and somewhat smaller than the U.S. C-17. The Y-20 program is part of an effort to develop an indigenous long-range jet-powered heavy transport aircraft, a top priority in China’s “Medium- and Long-Term National Science and Technology Development Program (2006–20)” (MLP).

Now satellite images have revealed the Y-20’s presence at Yanliang airfield, near Xi’an, which hosts the People’s Liberation Army Air Force (PLAAF)’s China Flight Test Establishment (CFTE). There it reportedly began low-speed taxi testing on December 21, 2012. On  January 3, 2013, Aviation Industry of China (AVIC) Chairman and Party Secretary Lin Zuoming visited Yanliang to observe the situation there and offer his gratitude for contributions made and successes achieved by the numerous CFTE and XAC personnel who have been toiling to prepare testing and test flights. While it is only natural for an aviation executive to engage in such activities at a flight test center, the Y-20’s presence there nevertheless suggests that its test flight is one of the ones being readied. What will a Y-20 test flight suggest about China’s aviation development and military capabilities? … … …

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Gabriel B. Collins and Andrew S. Erickson, “Elephant in the Room? Are Mining Companies on Target as They Look to India to Help Compensate for China’s Lost Commodity Demand Growth?” China SignPost™ (洞察中国) 69 (23 December 2012).

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

China’s economy continues to produce a chorus of negative news—slowing earthmover sales, weak coal demand, and a broader acceptance by the leadership that the country appears to be moving onto a path of slower economic growth.

Accordingly, mining companies dependent on the Chinese market are looking for other regions to fill in the growing gap between the China-driven demand level they had planned for and what the market is actually yielding. The evolving content of mining company investor presentations suggests that an increasing number may be tweaking their earlier pure China emphasis and emphasizing India’s commodity demand more heavily than before as they look to other emerging markets to provide growth.

To understand how India is viewed within key boardrooms, we use the following proxy: we search for a given corporation’s initial mention in its investor presentations of India’s capacity to provide commodity demand growth—on a scale that implies it would be capable of at least partially compensating for a slowdown in the pace of Chinese demand for that commodity. This more specific definition helps screen out simple incidental mentions of India and focuses the inquiry on communications that more closely reflect managements’ prevailing view on the likely scale and growth rates of future Indian and Chinese commodity demand relative to one another.

Managements of major natural resource companies have long viewed India as a significant global commodity demand source. However, the shift reflected in the presentations is noteworthy because it suggests that India is no longer viewed as simply complementing Chinese commodity demand growth. Rather, it is being viewed as being large enough to substitute for lost Chinese demand as the Middle Kingdom’s growth slows down faster than many market participants anticipated. It remains to be seen whether Indian commodity demand—especially for coal and copper—will be sufficient to help substantially offset the deficit resulting from China’s natural resource demand moving onto a slower growth trajectory sooner than expected. …

Implications

Indian demand for commodities such as copper, iron ore, and coal is likely to grow substantially in coming years as the country struggles to modernize its infrastructure and fight against power shortages by beefing up its electricity transmission system. The political motivations are strong, for in late July 2012, a massive power outage plunged 680 million people into darkness in 18 Indian states. Yet because Indian political decision making regarding large investment projects and reforms to legal regimes governing private business activity can be chaotic, the demand for the commodities is likely to be “lumpy” and feature more fits and starts than the steadier “ramp” trajectory growth that China delivered during its boom period.

Commodity investors and strategic planners should also bear in mind that while combined Chinese and Indian demand growth for key bulk commodities is likely to remain substantial in coming years, China is very likely headed onto a path of slower growth and India by itself will not be able to entirely supplant the lost demand that results from China’s slowing growth rates. India will to some extent offset the effects of China entering the slower growth part of its S-curve trajectory as China grapples with chronic health problems, inflation, pollution, and other headwinds. However, India will not be able to arrest the trend and the ongoing global pullback and postponement of many hard rock mining investments will not end at the hands of Indian growth alone.

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Gabriel B. Collins and Andrew S. Erickson, “China Military Jet Engine Development Overview: An eReader,” China SignPost™ (洞察中国) 68 (19 December 2012).

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

For the past two years, we’ve worked hard to bring readers cutting edge analysis of China’s military jet engine development. The motivations for our focus are clear. First, to the best of our knowledge, no other open source publications have performed this sort of in-depth analysis of Chinese military and commercial jet engine development. This analytical gap is simply too important to leave unfilled. Second, weakness in jet engine production increasingly threatens to imperil China’s rapid progress in other aerospace dimensions such as airframe design and avionics, which are moving ahead far more quickly. The “linchpin” status of aeroengines makes the subject vital to understand for anyone interested in the future trajectory of China’s military aviation development.

With these powerful strategic forces in mind, we are pleased to bring you a one-stop shop of in-depth analysis, highlighted by our latest work, “The ‘Long Pole in the Tent’: China’s Military Jet Engines,” which just came out in The Diplomat. … … …

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Andrew S. Erickson and Gabriel B. Collins, “The ‘Long Pole in the Tent’: China’s Military Jet Engines,” The Diplomat, 7 December 2012.

Much has been made of Beijing’s growing military might. Developing and producing high-performance jet engines could be the toughest — but most rewarding — advance.

The PLA Navy surprised many foreign observers yet again when an indigenously-produced J-15 fighter became the first known fixed wing aircraft to take off from and land on the aircraft carrier Liaoning since its refitting and commissioning. Yet a critical question remains unanswered: how rapidly and to what extent will the J-15 and other Chinese military aircraft be powered by indigenous engines?

As in so many other areas, China’s overall development and production of military aircraft is advancing rapidly. Yet, as with a tent, it is the “long pole” that is essential to function and undergirds performance. In the case of aircraft, the most critical and difficult-to-produce component—the “long pole”—is the engine. Given the wide array of market-tested alternatives, nobody will buy a unit in which this central component is flawed. Hence, China’s currently significant efforts to make progress there, the outcome and impact of which remains uncertain. … … …

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Andrew S. Erickson and Gabriel B. Collins, “China Aircraft Carrier Style! Assessing the First Takeoff and Landing,” China Real Time Report (中国实时报), Wall Street Journal, 27 November 2012.

Two months after China’s first aircraft carrier Liaoning was commissioned, and a year and a half after it began sea trials, an Chinese J-15 fighter became the first known fixed wing aircraft to take off from and land on it. Footage of the occasion aired on CCTV over the weekend shows the fighter jet, tail-hook clearly visible, successfully catching the arrestor wire on the deck of the Liaoning before coming to a stop and being directed to a designated location for technical checks. The video subsequently shows footage of the aircraft preparing for flight and flying off the end of Liaoning’s ski jump deck.

Once again, China has exceeded the expectations of many foreign observers regarding timelines for military capabilities development, though the tremendous publicity the event has received could limit the country’s ability to move with such speed in developing its aircraft carrier going forward.

Common Steps

One carrier image in particular has caught the Chinese public’s imagination: that of a launch officer’s signal to release the wheels and send the aircraft racing down the runway. This iconic image of a “shooter” in action, popularized in the American film “Top Gun,” encapsulates Chinese aspirations for national success, reaching world standards, and achieving the recognition that has long eluded China. Accordingly, images of Chinese of a wide range of ages and walks of life assuming the stance, some in the most unlikely locations, have flooded the Internet — a meme reminiscent of planking that Chinese Internet users having taken to calling “Aircraft Carrier Style,” after a certain viral video out of South Korea.

In addition to the shooter gesture, American naval aviators with whom we spoke have noted familiar hardware and procedures akin to U.S. Naval Air Training and Operating Procedures Standardization (NATOPS) in footage of the J-15 landing and take-off. The landing signals officer platform, optical landing system, effective non-skid flight deck, and color-specific uniforms are all strikingly similar to their U.S. and Russian equivalents.

How Big a Step Forward?

China clearly appears to be employing a measured, methodical approach and taking the time to get things right. Liaoning and its crew were ready for the new step of landing the J-15 and having it takeoff again. All the pieces were in place, and the weather was ideal.

The takeoff and landing were businesslike and accomplished without fanfare or incident, with the lone exception of the untimely death by heart attack of Luo Yang, president and general manager of Shenyang Aircraft Corp., who had been responsible for the carrier-based J-15’s research and development.

So how to assess the significance of China’s latest military accomplishment? One U.S. Navy expert with whom we spoke described it as a mile run by a former non-runner who is now training to run a marathon in the future. The magnitude of the present accomplishment depends largely on whether it is measured against the zero miles run before, or the 26.2 miles that must be run in the future.

Next Steps

To support future carrier capabilities, China must now establish comprehensive support infrastructure that the U.S. military refers to as doctrine, organization, training, materiel, leadership and education, and personnel and facilities (DOTMLPF). It must develop training, logistics, and maintenance pipelines. It must also develop operational infrastructure, including command and control. In all these areas, which involve primarily hardware and software, it can continue to emulate U.S. and Russian approaches in many respects.

Where China will truly have to develop its own approach is in developing a theory of operations: what its carriers will be used for, how many it will need, and the training and procedures to support such use. Here China may face more difficult challenges.

One obvious use of carriers is to enhance Chinese prestige by showing that Beijing has joined an exclusive international club. As soon as Liaoning’s air wing can be assembled, and operated with some degree of confidence, it will likely depart Chinese waters on a series of cruises to “show the flag” as a Great White Fleet of one.

A second major mission is likely to entail demonstrating, and if necessary using, capacity to pressure neighbors with which China has island and maritime disputes. Being able to use deck aviation to cover an amphibious assault on islands, rocks and reefs—e.g., in the South China Sea—offers Beijing the means to pressure its smaller rivals without confrontation escalating into a shooting war. This approach may be fraught with risk, however, not only politically but also operationally. Carriers are generally ineffective platforms for sea control fighting in confined waters given their extreme vulnerability to missiles and other means of attack. Even a far-less-capable military, such as that of Vietnam, has the ability to develop rudimentary “anti-access” capabilities.

Beyond the possible regional contingencies where Chinese leaders might see a carrier as a useful instrument of national power, there is the question of to what extent the Chinese aircraft carrier program will be governed by the country’s naval strategy, and to what extent the carrier’s existence may reshape Navy leaders’ policy outlook and perception of how many carriers it needs.

Although the ultimate number of aircraft carriers China will build remains uncertain, Chinese sources such as the Liaoning carrier’s deputy chief designer suggest the country seeks multiple carriers. There are relatively straightforward operational reasons behind seeking multiple vessels. For instance, keeping 1-2 carriers operationally ready means that the PLAN would likely need at least 3-4 vessels.

The Problem with Baby Steps

Carrier aviation is an inherently risky business. In “Top Gun,” Nick “Goose” Bradshaw dies in a training accident. In real life, the U.S. carrier program was forged in the crucible of wartime, when severe losses were not just accepted but expected. Planes and pilots were lost at an extreme rate, but the Navy gained invaluable experience in the process. High loss rates persisted well through the early Cold War years. Despite tremendous improvements, even today it is not uncommon for a plane, pilot or deck crew member to be lost.

Chinese deck aviation, by contrast, is being developed in a technologically-advanced peacetime environment that does not justify significant losses. While carriers have always been “high-value units”  whose use has been predicated on acceptable risk, today’s aircraft are more expensive and pilots scarcer in relative terms, making losses much harder to tolerate. Beijing has started with a prestigious, flawless image, and wants to maintain it both abroad and perhaps especially at home. In fact, the very public interest and support that has helped to propel China’s aircraft carrier program may stymie it by making decision-makers extremely risk averse.

This poses a dilemma. Adopting a risk-averse flight posture and avoiding high-volume flight operations may minimize accidents, but it cannot prevent them entirely. Even under ideal conditions—highly-trained senior pilots, careful attention to fuel to compensate for lack of aerial refueling capabilities, and access to divert fields—accidents will occur and aircraft and pilots will be lost.

An American naval analyst has recounted to us a slow-motion tragedy in which a U.S. Navy aircraft caught an arrestor wire and ruptured it without slowing down sufficiently. Unable to stop in time, yet sapped of momentum sufficient to permit a hasty takeoff, the aircraft rolled off the deck in front of the carrier and was promptly run over, causing both aircraft and pilot to be lost. Even the most meticulous Chinese operations could not prevent such an accident.

On the other hand, always choosing “baby steps” over “pushing the envelope” will severely restrict the progress that Beijing can make. Chinese planners thus face important decisions in this regard. How they decide will be reflected in part in how aggressively Liaoning pursues operations at night, in all weather conditions, and in rough seas. Perhaps if public excitement eventually dies down, it will become easier to use the carrier.

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Gabriel B. Collins and Andrew S. Erickson, “‘Death by Blue Water Navy’ Distracts from China’s Real Military Focus,” The Diplomat, 21 November 2012.

(Editor’s Note: Please see “China’s Real Blue Water Navy” and Greg Autry’s response.)

Greg Autry’s passionate response to our recent piece on “China’s Real Blue Water Navy” is somewhat ironic, as he has missed our point. As our substantial body of work on the matter in multiple venues including The Diplomat amply demonstrates, we view China’s naval and military development with the utmost seriousness. Our work is read regularly by military and civilian policymakers, as well as the general public, because we research issues in depth and offer a fact-based, measured account based on what the evidence suggests. We value our readers’ trust and strive to keep our work independent of external ideological influences that could bias it.

Our key objective in writing “China’s Real Blue Water Navy” was to advance an explanation that we believe—based on substantial and objective research—better reflects the true nature of the challenge China’s rising naval power poses for the U.S. and its allies in the Asia-Pacific region than does Autry and Peter Navarro’s book “Death by China: Confronting the Dragon—A Global Call to Action.” The reality is that to properly formulate a strategy to respond to emerging events—and ideally to shape them proactively—one must understand issues for what they really are. Catchy book titles and spicy diatribes usually don’t inform the public or support effective policy. Rather, they offer the illusion of clarity in a way that can mislead—dangerously so, in this case, given the issues at stake. … … …

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Andrew S. Erickson and Gabriel B. Collins, “Taking Off: Implications of China’s Second Stealth Fighter Test Flight,” China Real Time Report (中国实时报), Wall Street Journal, 3 November 2012.

China’s fighter aircraft development efforts appeared to take another leap forward after local media reported that Shenyang Aircraft Corporation (SAC) had successfully tested its J-31 stealth fighter prototype this week. Following the test flight of a Chengdu Aircraft Corporation (CAC) J-20 prototype less than two years ago, the test of the J-31 suggests China could eventually become only the second country behind the U.S. to develop two stealth fighter programs – an important development with serious potential implications for the tactical aircraft export market and well as the U.S. military.

Video and photos posted online Thursday show the J-31 prototype conducting an initial high speed taxi run and 10-minute flight test accompanied by a pair of SAC J-11BS fighters. The J-31’s maiden flight represents the second “unveiling” of a significant new fighter aircraft by SAC in less than a year, the other being the J-16, a two seat multi-role variant of the J-11B, similar to the US F-15E and the Russian Su-30MKK.

China’s defense industry can now sustain multiple overlapping advanced programs. SAC alone is currently working on four major fighter aircraft – the J-31 and the J-16 as well as the J-16’s single seat parent the J-11B and the carrier-based J-15, also based on the J-11B.

Like most modern fighter aircraft, the J-31 will likely be a multi-role combat aircraft capable of employing modern precision munitions in both air-to-air and air-to-surface roles. Despite apparent rapid advancement, however, it will take time for the fighter to reach full operational status. As Xu Guangyu of the China Arms Control and Disarmament Association explains, “there is still a huge gap between China and the US’ fighter jet technologies because we are still testing both the J-20 and the J-31. It might take another couple of years before we can put them on the production line.”

Mr. Xu’s observation raises an interesting question because it is not yet clear if the J-20 and J-31 are intended to complement each other or be competitors. Some Chinese analysts like former Aviation World deputy editor Bai Wei share the view of Western counterparts that they may be complementary as part of a “high-low” mix, with the larger J-20 akin to the F-22 and the smaller J-31 akin to the U.S. F-35 Joint Strike Fighter.

One factor that suggests the J-20 and J-31 could complement one another is that the J-31 could be modified for use on aircraft carriers in a way the larger J-20 is unlikely to be. Sr. Capt. Li Jie of the PLA Navy (PLAN)’s strategic think tank has been quoted in Western media as stating the J-31 prototype “might become a carrier-based fighter jet” because it is smaller and slimmer than the J-20.

Regional Impacts

The prospect of the J-20 and J-31 becoming China’s mainstay tactical strike fighters during the next decade stands to influence regional defense planning and tactical aircraft export markets. Unveiling the J-31 affirms that, save for jet engines, China’s aerospace sector is now in many ways nearly as advanced as Russia’s and suggests that Russian manufacturers will soon be unable to compete with China’s own fighter manufacturers. Beijing is already the world’s sixth-largest arms exporter, and Chinese aircraft export growth would come largely at Moscow’s expense.

This means Russia will need to shift its weapons exports from China to Chinese neighbors such as Vietnam and India. However, given the defense spending cutbacks in the U.S. and Western Europe, Russian firms will have to compete with the likes of Boeing, Lockheed Martin and BAE in a way they never had to when China (which Western defense firms are largely prohibited from selling to by an embargo) was essentially a captive market for Russian weapons exporters. Chinese e increasingly Therefore, the parallel development of the J-20 and J-31 will provide further impetus for China’s aviation industry to master mass-production of modern high-performance jet engines — its last major obstacle to being able to export tactical aircraft.

The J-31 also stands to meaningfully impact decisions on U.S. defense spending, especially if it ends up being produced in conjunction with the J-20 and they end up being complementary to one another. If the J-31 and J-20 both end up in mass production, China could ultimately achieve parity or perhaps even numerical superiority in the Asia-Pacific region in terms of late-generation fighters deployed. There is a rising probability that China’s rapid advancement in indigenous tactical aircraft design will spark a renewed debate in the U.S. over restarting production of the highly advanced but also highly expensive F-22 Raptor.

Bottom Line: China’s Military Aerospace Industry Nearing Critical Mass

It is extremely significant that China may soon join the U.S. as the only other nation to develop two “low-observable” aircraft simultaneously. China’s defense aerospace sector overall may be moving toward an architectural model in which several distinct poles of expertise develop in Shenyang, Xi’an, and Chengdu and then compete with each other on key big ticket projects. Multiple aviation industry bases with significant development and production capacity, including SAC, allow for domestic competition for key aircraft programs. This can minimize the chances of single-point failures jeopardizing development targets, increase efficiency, and maximize the chances of useful breakthroughs.

It is thus not too early to consider the possibility that China’s aviation industry, despite enduring limitations, may already enjoy some key advantages over Western counterparts. As a latecomer, China can draw on knowledge gleaned from industrial espionage, reverse engineering, and study of foreign systems, standards, and specifications, allowing it to save costs by leapfrogging rather than developing every component itself. Meanwhile, it may benefit from lack of legal obstacles to subsidization and technical diffusion through civil-military integration—a lack that Western contractors arguably benefitted from during their Cold War heyday before stricter regulations emerged in the 1980s and 1990s. China’s military aerospace industry is rapidly approaching critical mass. Continuing to add investment to this growing foundation will allow China’s aviation industry to fully harness the flashes of technical prowess shown when new aircraft like the J-31 take flight.

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Gabriel B. Collins and Andrew S. Erickson, “U.S. Navy Take Notice: China is Becoming a World-Class Military Shipbuilder,” The Diplomat, 1 November 2012.

The engine of China’s naval rise has flown under the radar – until now.

China’s military shipyards now are surpassing Western European, Japanese, and Korean military shipbuilders in terms of both the types and numbers of ships they can build. If Beijing prioritizes progress, China’s military shipbuilding technical capabilities can likely become as good as Russia’s are now by 2020 and will near current U.S. shipbuilding technical proficiency levels by 2030. China is now mass producing at least six classes of modern diesel-electric submarines and surface warships, including the new Type 052C “Luyang II” and Type 052D “Luyang III” destroyers now in series production.

Eight key themes, listed sequentially below, characterize China’s rise as a world-class military shipbuilder. For reference, the companies building the warships are China State Shipbuilding Corporation (“CSSC”) and China Shipbuilding Industry Corporation (“CSIC”). … … …

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Andrew S. Erickson and Gabriel B. Collins, “Delicate Touch: Flight Operations Begin on China’s First Aircraft Carrier,” China Real Time Report (中国实时报), Wall Street Journal, 17 October 2012.

Less than a month after China officially commissioned the Liaoning, its first aircraft carrier, photos appearing to show aircraft operating over the carrier have raised a host of questions, including how long it might take for China to make the carrier fully operational.

The photo spread – published earlier this week by the Global Times, a tabloid under the aegis of the official Communist Party mouthpiece People’s Daily – includes several images of a J-15 fighter aircraft flying just above the deck of the Liaoning, as well as images of a Z-8 search-and-rescue helicopter taking off from the carrier.

The first question is what the photos actually show.

Based on the images themselves and circumstances of their publication, it’s most likely that the J-15 was performing a “touch-and-go” flight pattern when it was photographed. Because a successful aircraft launch from the Liaoning would be a major point of pride, worthy of official media confirmation barring mishaps, it seems clear that the J-15 flew in from a shore base. In addition, if the PLAN is allowing photos of any type of carrier flight operations to be published, there would be little strategic reason to only show the touch-and-goes if there had actually been a successful takeoff from the ship.

Moreover, photos meant to publicize an actual takeoff from the ship would most likely include a J-15 sitting in the launch position and an aircraft actually moving up the ramp under power (with afterburners) on its way to becoming airborne. The J-15’s orientation with respect to the deck strongly suggests touch-and-go flight, rather than a launch from the Liaoning’s “ski jump” takeoff ramp. In the photos, the aircraft has all of its wheels off the ground when it is aligned with the ramp. In contrast, Russian video of Sukhoi’s SU-33 Sea Flanker (upon which the J-15 is based) taking off from a ski-jump carrier like Liaoning reveals that the plane’s wheels do not leave the ground until it literally flies off the end of the ramp.

GLOBAL TIMES; CHINESE MILITARY REVIEW; CHINA SIGNPOST

A major gap remains between recent touch-and-go flights and actual combat launches and recoveries. In a real operating environment at significant distance from Chinese air bases, aircraft laden with fuel and weapons will have to take off from a carrier and then later land on it. This is a complex process fraught with risks.

There are three photos that, when they emerge, will reflect how China’s carrier aviation proficiency is really progressing: Images of a J-15 landing on the carrier and coming to a complete stop by catching deck-based arresting wires; images of the fighter sitting in the launch position with engines at full afterburner; and images of the fighter actually going off the end of the flight deck.

In other words, the apparent touch-and-go operations on Liaoning are small steps toward a much bigger leap forward in achieving a fully operational carrier with a capable air wing – an objective that is unlikely to be realized for several years.

On the positive side for the People’s Liberation Army Navy (PLAN), the fact that the ship is out at sea working with fixed wing aircraft and helicopters suggests the PLAN leadership seeks to spend significant time underway and train up carrier crews. Pilots are part of a highly diverse set of personnel who must choreograph their actions very tightly for a carrier to function and be combat-effective. As such, it will be important for the PLAN to give its carrier personnel such as deck crew, air controllers, ordnance handlers, and mechanics opportunities to log significant time at sea to gain experience and improve their skills.

When a navy has only one carrier, it becomes a training carrier simply as a matter of necessity. Yet Liaoning’s outfitting with capable air defenses suggests that even if it is primarily a training ship, it might someday be capable of operational service. Precedence for this can be found in the U.S. Navy with the USS Lexington, which served to qualify student aviators and train active duty and reserve aviators from 1962-1991—and served as a sea-based filmmaking set in later years—and which briefly returned to operational status during the Cuban Missile Crisis.

Indeed, over the past few years, Chinese deck aviation development has evolved in both nature and rhetoric as Beijing gradually voiced carrier ambitions, revealed Liaoning’s refitting, commissioned this first hull, and now is beginning initial flight exercises with it. Beijing has taken pains to maintain a light touch, but is making progress that will add up over time.

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Gabriel B. Collins and Andrew S. Erickson, “New Destroyer a Significant Development for Chinese Sea Power,” China Real Time Report (中国实时报), Wall Street Journal, 8 October 2012.

Now that the People’s Liberation Army Navy (PLAN) has commissioned its first aircraft carrier and may be looking to assemble one or more carrier groups over time, what about the rest of the fleet?

One development that carries broad implications for the enhancement of Chinese sea power is the recent launch of the first editions of the new 6,000-ton Type 052D Luyang III-class destroyer, which marks a new stage in the PLAN’s prolonged period of experimentation with different destroyers.

The Type 052D represents an evolution of the existing Type 052C Luyang II-class destroyer. The latter are now in mass production, with 8 hulls in service, the first commissioned in 2004. At least six 052Cs have been launched since the end of 2010, according to Chinese media reports, of which two are reportedly in service at present. Beijing appears to have decided that the Type 052 series, a rough analog of the Arleigh Burke-class destroyers that form the backbone of the U.S. Navy, is the latest class of warship whose design is good enough to justify large-scale production.

While China mass-produced lower-quality Romeo– (Type 033) and Ming-class (Type 035) submarines and Jianghu-class (Type 053) frigates in an earlier era, today’s large-scale warship production meets much higher standards and is geared primarily to replacing older vessels entering mass obsolescence rather than expanding the fleet numerically. That said, it is well within China’s shipbuilding capabilities to both boost the quality of the fleet and boost its numerical strength, should the country’s leadership decide to do so.

If China fielded 10-15 advanced destroyers like the Type 052D, it would, holding other numbers constant, become the second-largest surface combat force in the Asia-Pacific region after the U.S. Navy. Given the rapid ramp-up of Type 052C production in the past several years, we think the prospect of similar mass production of the Type 052D is quite possible. As a mass-produced vessel class, the Type 052D may now be joining China’s 60+ Houbei-class (Type 022) missile catamarans, 16-19 Jiangkai II-class (Type 054A) air defense frigates, 13 Song-class (Type 039) and 8-9 Yuan-class (Type 041) conventional submarines, and 3 Yuzhao-class (Type 071) amphibious assault ships.

Why mass production of the Type 052D matters strategically

The Type 052D’s emergence suggests that China’s naval shipbuilding capability is maturing further, with China State Shipbuilding Corporation (CSSC) ‘s new shipyard on Shanghai’s Changxing Island becoming a capable facility for constructing modern surface combatants. It offers further evidence that China can produce warships quickly using modular construction techniques and perhaps other advantages such as lower cost labor than its competitors can access. Series production tends to reduce unit costs because shipyard workers and suppliers find ways to increase efficiency as they spend significant time and energy on the same tasks and improve their operational practices.

Analysis by RAND (pdf) demonstrates that doubling the procurement rate of warships in the U.S. decreased unit costs by 10%. Given that Chinese shipbuilders are still building up their modern naval construction industrial base, the efficiency gains in China are likely to be larger as domestic efficiency increases and Chinese manufacturers displace foreign parts that may cost more.

The modular construction capabilities now on display in CSSC’s yards took time to develop, but now China’s warship builders are creating a wide and deep base of expertise in the area. CSSC has been employing such techniques on the Jiangkai series frigates, the first hull of which was commissioned in 2005, as well as the Type 052C and now the Type 052D. This shows that at least three different Chinese shipyards are now able to mass produce advanced surface combatants, which demonstrates that China’s military shipbuilding institutions are clearly becoming “learning organizations.”

The 052D differs significantly from its predecessor the Type 052C in several important ways. It has a completely different type of vertical launch system (“VLS”), with missile canisters instead of what look like revolvers; a different gun system; and what appear to be bigger phased-array radar faces. The VLS system is potentially the biggest development. The 052C’s likely complement of 64 VLS tubes with a more advanced surface-to-air missile (“SAM”) will offer strong area air defense capability, which can enhance the combat effectiveness of other PLAN surface ships and submarines by protecting them from enemy strike and anti-submarine warfare aircraft.

Meanwhile, China’s long-established cruise missile industry is producing a wide range of extremely capable anti-ship cruise missiles (ASCMs). China’s record to date of developing advanced ASCMs gives every reason to believe that new variants of even greater capability will continue to emerge and be outfitted on PLAN vessels like the Type 052D.

Strategic questions moving forward

A host of important questions remain regarding the Type 052D, the answers to which would help military planners and policymakers outside of China better understand the impact that the ship is likely to have. The answers to many of these questions—for instance, how good shipboard electronics systems are and how well crews can use their ship to fight modern battles—will become clearer over time as the PLAN makes decisions regarding operational approaches and training intensity and more Chinese sailors gain experience through both tours in the Gulf of Aden and exercises closer to home.

The Type 052D appears to be a very modern warship that, with continued improvements in China’s maritime surveillance and targeting infrastructure and more intensive training of crews, can help make the PLA Navy even more formidable throughout the Asia-Pacific region. Regional neighbors such as the Philippines, Vietnam, Japan and South Korea are likely to respond by augmenting their own navies and reaffirming diplomatic and security ties with the U.S.

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Gabriel B. Collins and Andrew S. Erickson, “Central and Southwest China: The Key Battleground for Shale Gas and New Low-Cost Coal Supplies from Xinjiang, Mongolia, and Wyoming,” China SignPost™ (洞察中国) 67 (28 September 2012).

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

Shale gas development plans in China have generated excitement throughout the energy community, and the Chinese Ministry of Natural Resources has just completed its second shale gas exploration block licensing round. The 20 blocks are located in Guizhou, Chongqing, Hunan, Hubei, Jiangxi, Anhui, Zhejiang, and Henan Provinces. Yet no blocks in the shale-rich Ordos Basin of Shaanxi, Inner Mongolia, or Tarim Basin of Xinjiang are up for bidding in this latest round.

The choice of location of the new shale exploration blocks may just be coincidence, but it highlights a geographic reality—shale gas reserves near major low-cost coal production areas such as Xinjiang face tough development challenges because the shale gas is likely to cost substantially more per unit of heat than the coal it must compete with in the electrical power generation market.

Sichuan in China’s Southwest and Central Chinese provinces such as Hunan and Hubei are far from the low-cost coal supplies, populous, and are poised to continue growing more quickly than the coastal provinces. As such, the Central-Southwest provinces of Sichuan, Chongqing, Hunan, Hubei, and parts of Henan, Anhui, Jiangxi, and Guangdong will be the key battlegrounds where new supplies of low cost physical coal and coal delivered in the form of electricity battle for market share with shale gas. … … …

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Andrew S. Erickson and Gabriel B. Collins, “The Calm Before the Storm: China’s About to Find Out How Hard it is to Run an Aircraft Carrier,” Foreign Policy, 26 September 2012.

It’s finally official. China’s first aircraft carrier, named Liaoning after the province in which it was refitted, has just been commissioned and delivered to the People’s Liberation Army Navy (PLAN). On Sept. 25, President Hu Jintao, who also chairs the Central Military Commission, presided over a ceremony at a Dalian naval base. Joining him were Premier Wen Jiabao, PLAN Commander Wu Shengli, and other top officials. All must have felt the weight of history on their shoulders as they witnessed the unfulfilled ambitions of their civilian and military predecessors.

This milestone was a long time coming. One of Wu’s distant predecessors had first proposed a carrier for China’s navy in 1928. At the founding of the People’s Republic in 1949, Premier Zhou Enlai and the PLAN commander at the time advocated carrier development, and Chairman Mao Zedong made a supportive speech in 1958. Yet their aspirations were stymied by the far more immediate priorities of domestic ideological campaigns and countering Soviet military pressure amid economic autarky and political isolationism. Subsequently, Gen. Liu Huaqing — PLAN commander from 1982 to 1987 and Central Military Commission vice chairman from 1992 to 1997 — fervently advocated carrier development and initiated studies of foreign technologies and Chinese options.

The procurement and refitting of Varyag, the Ukrainian carrier hull that served as the basis for Liaoning, was an odyssey in itself. The hull was purchased in 1998, but one-and-a-half years of Sino-Turkish negotiations were required to ensure its passage through the Bosphorus. Varyag then began a costly, storm-plagued voyage around Africa in 2001 and did not reach Dalian until 2002. China’s formal carrier program, termed “048,” was officially approved in August 2004 under Hu’s chairmanship of the CMC, making Liaoning’s recent commissioning a centerpiece of his military legacy and one of his last acts in office.

The PLAN’s possession of an aircraft carrier is a great public relations booster for the Chinese military and suggests that Chinese diplomacy will be backed by an even bigger stick in East and Southeast Asia, and possibly beyond. Yet the stick was hard to come by and remains far from a potent tool. In fact, Liaoning has not yet demonstrated the capacity for aircraft launches or landings, which is the essence of carrier operations. Why has it taken so long to get to this point, which is not itself militarily decisive? … … …

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Andrew S. Erickson and Gabriel B. Collins, “Introducing the ‘Liaoning’: China’s New Aircraft Carrier and What it Means,” China Real Time Report (中国实时报), Wall Street Journal, 25 September 2012.

China’s first aircraft carrier, now referred to as the “Liaoning ” by China’s Ministry of National Defense, has been officially “delivered and commissioned” to China’s navy, according official Chinese media. The handover ceremony, with top Chinese leaders presiding, took place on the morning of September 25 at a naval base in Dalian, a port city in northeast China’s Liaoning province.

Just as Liaoning the province was created when existing northeastern provinces and municipalities were merged and integrated into a more powerful whole in 1954-55, so too “Liaoning” the carrier integrates a mix of building blocks into a warship that has the potential to bolster China’s regional influence—and also to force China’s leaders to confront perhaps the most complicated naval diplomacy questions in the PRC’s history.

The Liaoning’s commissioning matters, both symbolically and in terms of China’s naval power and regional influence. The largest ship to be delivered to the Chinese navy to date, the carrier when operational could have a significant influence on regional maritime disputes, in particular China’s smoldering conflicts in the South China Sea.

Names Matter…

Chatter about the commissioning of China’s first carrier began in early September, when photos surfaced online showing the carrier with the hull number “16,” followed by reports in local media that the vessel would be named the Liaoning, after the province that contains Dalian Naval Shipyard, where it has been refitted.

The carrier was built using the hull of an old Ukrainian carrier called the Varyag. Rumors had long circulated among Western analysts that the carrier would eventually be renamed the Shi Lang, after a celebrated Qing dynasty admiral.

In July 1683, Shi Lang used 300 warships and 20,000 troops to defeat the Zheng family, which ruled Taiwan, in a conflict known as the Battle of Penghu. The victory enabled Taiwan’s formal incorporation into the Qing polity, as a prefecture of Fujian Province. This was an historical first: Neither the Ming nor any previous dynasty had ever attempted to incorporate Taiwan directly in to official mainland administration.

Because of Shi’s aggressive efforts to bring Taiwan under mainland administration and his allegedly corrupt and overbearing post-war actions as an official vis-à-vis the island, naming China’s first aircraft carrier after him would send the wrong message for cross-Strait relations, whose stability Beijing seeks to encourage in order to facilitate reunification.

PLA Navy (PLAN) ship naming conventions suggest that ships are typically named after Chinese localities. The rare exceptions in which PLAN ships are named after individuals include training vessels (Deng Shichang and Zheng He) and research ships (Li Siguang ), but not larger combat-operations-focused vessels. Since China’s first aircraft carrier will be its largest and most prominent warship, it would be logical to name it after one of the largest Chinese localities, particularly the one in which it was refitted—hence, “Liaoning.”

But Actions Speak Louder than Words…

Whatever the official nomenclature and symbolism, however, the Liaoning is attracting the world’s attention as a prominent, if modest and incremental in capabilities, indicator of how China will use its growing power. As Major General Qian Lihua declared in November 2008, “The question is not whether you have an aircraft carrier, but what you do with your aircraft carrier.”

Encouragingly, China’s MND lists developing “Far Seas cooperation” and capabilities to address non-traditional security threats as missions for the Liaoning. At the same time, however, it mentions safeguarding national sovereignty as another mission—presumably to address territorial and maritime disputes closer to home.

Despite a statement by Chinese National Defense University Professor and PLA officer Li Daguang that the timing of the Liaoning’s commissioning was designed to demonstrate resolve regarding the Senkaku/Diaoyu islands dispute, for the foreseeable future the vessel cannot pose a direct threat to U.S. or Japanese forces. Yet, even in this modest form, it already worries its smaller South China Sea neighbors. Vietnam, in particular, has reason for concern: It lost skirmishes with Chinese naval forces over disputed islands in 1974 and 1988, even though those forces lacked significant air support. With a vulnerable land border and no U.S. alliance, Hanoi could even conceivably be at risk of suffering defeat in a third clash as it vigorously pursues island and maritime claims vis-à-vis China—this time against a Chinese navy with undeniable airpower from land, and eventually from sea.

China won the Johnson South Reef Skirmish of 14 March 1988, but quickly retreated for fear of Vietnamese air strikes and Soviet retaliation. Rear Admiral Chen Weiwen (PLAN, ret.), commanded the PLAN’s three-frigate force in the conflict with initiative that was temporarily controversial but now widely acclaimed.

In a 2011 interview with Modern Ships, Admiral Chen, who served as a commander in a 1988 conflict with Vietnamese forces in the Spratly Islands, emphasized the difference that an aircraft carrier could make. China had won the battle, but quickly withdrew:

During the Spratly Sea Battle, the thing we feared most was not Vietnam’s surface vessels, but rather their aircraft. At that time, Vietnam had Su-22 fighter aircraft, which had a definite ability to attack ships. The Spratlys are very far from Sanya, and at that time we also lacked airfields in the Paracels. Flying from the nearest airfield, Lingshui [on Hainan Island], our aircraft only had loiter time of 4-5 minutes; in such a short time, they could not solve problems before they had to return, or they would run out of fuel. So we felt deeply that China must have an aircraft carrier: If during the Johnson South Reef Skirmish, we had our own [air] cover from a nearby aircraft carrier, we would simply not have had to fear Vietnam’s air force. Now that the Spratlys have airfields, it is much more convenient. If China’s aircraft carrier enters service relatively soon, and training is well-established, this will solve a major problem. We will seize air superiority; Vietnamese aircraft will not dare to take off.

The idea of using deck aviation to address China’s sovereignty claims is hardly Admiral Chen’s alone. According to “Science of Campaigns,” an authoritative volume written by scholars at China’s National Defense University, carriers can play a crucial role by providing air cover beyond the range of land-based air to support long-range amphibious landing operations against small islands: “Combat in the deep-sea island and reef region is relatively more independent, without support from the land-based force and air force. Under this situation, an aircraft carrier is even more important in winning victory in the campaign.” In a recent interview, Sr. Capt. Li Jie, an expert at the PLAN’s strategic think tank, was quoted as stating that “China’s first aircraft carrier…will play an important role in China’s settlement of islands disputes and defense of its maritime rights and interests.”

Looming Large and Making Waves?

So how might Liaoning ultimately influence Chinese naval operations and future naval procurement? The answers to this question will substantially shape other countries’ views concerning the strategic course China takes.

China’s maritime neighbors in Southeast Asia, as well as Japan, India, South Korea, Russia, Australia and the U.S. will pay especially close attention. With Liaoning officially in the fleet, the next questions that China’s military and civilian leaders must grapple with are, first, how to use the ship; second, how many more carriers to build; and third, how to protect it from the increasingly capable anti-ship weapons being acquired by neighbors such as Vietnam, which is due to take delivery of its first Russian Kilo-class diesel attack submarine by the end of 2012. The Liaoning’s existence will likely impel China to develop more advanced surface combatants and anti-submarine forces to protect the symbolically valuable, but operationally vulnerable, asset.

At present, the Liaoning remains first and foremost an emblem of future Chinese sea power. All of its 10 sea trials to date have occurred well within Chinese waters. Chinese naval aircraft have not achieved the basic milestone of landing on its deck with the help of arrestor wires, or “traps,” a process that their American counterparts have been perfecting for decades.

Yet, while the Liaoning’s capabilities will remain modest for the foreseeable future, it will be watched carefully as an important symbol of Beijing’s intentions. As Rear Admiral Yang Yi wrote in a commentary published immediately after the commissioning was made public: “In order to counterbalance the theory that its new aircraft carrier is a threat, China must not only continue to make clear its strategies and policies, it must also take practical actions to convince the world that with the development of China’s military strength, especially the strengthening of its overseas projection capability, it will enhance its role as a defender of regional stability and world peace.”

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Gabriel B. Collins and Andrew S. Erickson, “Kings of Coal to Barons of Bling? Xinjiang’s Coal Boom Will Drive Sales of Bentleys, BMWs, and Other ‘Bling’,” China SignPost™ (洞察中国) 66 (21 September 2012).

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

So what do coal mines have to do with high-priced Bentley automobiles? In Chinese coal mining towns, a lot. The roster of Bentley dealerships in China is remarkable because while it includes the predictable wealthy East Coast cities like Beijing, Shanghai, and Guangzhou, it also includes Ordos and Taiyuan, which are better known for their coal mines than for their flashy banks and brokerage houses (Exhibit 1). It is very likely that a similar economic boom is coming for Xinjiang, which is on track to become one of the world’s largest coal producers. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Xinjiang Poised to Become China’s Largest Coal Producer: Will Move Global Coal, Natural Gas, and Crude Oil Markets,” China SignPost™ (洞察中国) 65 (20 September 2012).

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

Key points:

  • In 2011, Xinjiang produced 120 million tonnes of coal. In our base case estimate, Xinjiang will produce ~240 million tonnes per year of coal in 2015 and slightly over 750 million tonnes per year in 2020.
  • This would make Xinjiang one of the world’s 5 largest coal producers by volume.
  • By 2020, Xinjiang could export 200 million tonnes per year of coal to other parts of China by rail, 200 million tonnes per year as electricity, and potentially 100+ million tonnes per year as chemicals and liquid fuel.
  • Low-cost thermal coal and coal-by-wire electricity from Xinjiang could pose a significant competitive threat to shale gas development in Central and Southwestern China, which are target markets for coal and electricity produced in Xinjiang.
  • Xinjiang coal could be delivered in physical form to Central China at a cost of around US$3.30 per million BTU, whereas shale gas in the region is likely to cost US$5 per million BTU or more to produce.
  • Xinjiang could produce more than 250,000 bpd of liquid fuels from coal and potentially as much as 1 million barrels per day if producers increased their water use efficiency and China’s National Development & Reform (NDRC) allowed the expansion.

Rising production costs, an unacceptably high death rate in underground mines, and rail bottlenecks in eastern and northeastern China are setting the stage for a new phase in domestic coal production. The largest new coal provider will be Xinjiang. This northwestern region has the potential to become the world’s single largest producer of thermal coal. Xinjiang is in the early stages of a mining and economic boom like that which Inner Mongolia has experienced over the past decade.

In 2011, Xinjiang produced 120 million tonnes of coal. Industry sources estimate that by 2015, the province is likely to be producing well over 200 million tonnes per year, with production potentially rising to 1 billion tonnes per year by 2020. In our base case estimate, Xinjiang will produce ~240 million tonnes per year of coal in 2015 and slightly over 750 million tonnes per year in 2020. … … …

***

Andrew S. Erickson and Gabriel B. Collins, “Double Vision: Making Sense of China’s Second ‘Stealth’ Fighter Prototype,” China Real Time Report (中国实时报), Wall Street Journal, 18 September 2012.

In the span of a week, Chinese government vessels have been dispatched to waters near the contested Senkaku/Diaoyu Islands, anti-Japanese riots have erupted in major Chinese cities — and a new highly-prestigious piece of military hardware has been unveiled.

As if U.S. Secretary of Defense Leon Panetta didn’t have enough to contend with on his current China visit, photos leaked online on Sunday suggest Shenyang Aircraft Corporation (SAC) is making substantial progress on a stealth aircraft prototype, which Chinese netizens and foreign analysts have variously dubbed the “J-21,” “J-31,” and “F60”—a possible future export variant. SAC itself seems to have painted a “31001” designation on the aircraft. (For purposes of consistency, we will henceforth refer to the aircraft as the “J-31.”) The timing of the photo release echoes the events surrounding former Secretary of Defense Robert Gates’ January 2011 visit to China, when the PLA conducted a surprise test flight of Chengdu Aircraft Corporation (CAC)’s J-20 late-generation strike fighter prototype.

In June, Internet photographs and video clips of a heavily-wrapped aircraft being transported by truck appeared. Coupled with previous reports of a J-31 program, this suggests that direct competition has been introduced between CAC and SAC, obviating earlier geographic division of labor that insulated military aviation manufacturers.

Two additional possibilities also raise interesting questions: First, some observers suggest that twin-wheel nose landing gear hints at carrier operations, rendering it strategically noteworthy as the PLA Navy prepares to commission its first carrier, the Liaoning, although the J-31’s configuration and structural outlines may make that unlikely. Second, while the aircraft undoubtedly draws on significant indigenous capacity, it also appears similar in shape and sizeto Lockheed Martin’s F-35 Lightning II. In a report in March, The Australian quoted “senior security figures” saying hackers from China cracked into British defense firm BAE Systems’ computers and siphoned off large amounts of data on the design, performance, and other characteristics of the F-35. Elements of the J-31’s general configuration and contours also resemble those of Lockheed Martin’s twin-engine F-22 Raptor.

While previous Chinese aircraft were generally copies or emulations of a single foreign design, China’s J-31 and J-20 appear to draw on multiple foreign sources, as well as increasingly-robust indigenous design capabilities. This may enable Chinese solutions that have advantages over American ones in some respects. For instance, the basic configuration and possibly weight class of both Chinese aircraft are much more similar to each other than those of the F-22 and F-35, which might enable the Chinese planes to use one common engine, or at least a common base variant. This could reduce R&D costs and enhance operational readiness.

The J-31’s twin-engine configuration could indicate higher take-off weight than similarly-sized foreign aircraft like the F-35. This could be driven by higher fuel loads which, in turn, might suggest designs to enhance range and loiter time for reconnaissance and attack. Those might be compatible with long-range, “over water” operations. Based on this apparent potential for significant fuel and weapons loads, the J-31—- like the J-20 —- may be armed with air-to-air and air-to-surface missiles of sufficient range to pursue strike missions against slow-moving and relatively vulnerable early warning and tanker aircraft, as well as surface ships. Such an approach would pit missiles, a traditional Chinese strength, against key American and allied vulnerabilities.

Alternatively, the J-31’s twin-engine design could also reflect design inefficiencies that would increase the net weight as compared to U.S. airframes of similar size or even lack of trust in the reliability of engines currently available. A single-engine design such as the F-35 for naval operations implies an extremely high degree of confidence in engine reliability.

The bottom line is that much of the J-31 and J-20’s performance will hinge on the parameters and quality of their engines, one of the greatest areas of weakness for China’s aerospace industry but one that has been prioritized for improvement, with Russian imports as a stopgap in the meantime.

Neither the J-31 nor the J-20 has demonstrably advanced beyond the prototype stage, although at least two J-20 airframes have undertaken at least 53 test flights, according to Xinhua. It is too early to determine the extent to which they will succeed, when precisely they will be operational, the extent to which they can utilize indigenous engines, whether they will truly have “stealth” capabilities, and whether those would entail primarily forward stealth or all-aspect stealth. Stealthiness depends not only on geometry but also on radar-absorbent coatings on exterior surfaces (pdf), particularly the leading edges of wings and other reflective points. This “sensitive skin” degrades constantly and has to be maintained vigilantly to retain its effectiveness, but China lacks experience with such “defense dermatology.” Until such a capability is demonstrated, it is better to refer to the J-31 and J-20 as aspiring to be “low observable.”

But what already appears clear is something far more significant for long-term Chinese military aircraft development: Beijing has finally decided that it can sustain multiple overlapping advanced programs. China’s shipbuilding industry—which, aside from its missile and electronics industries, produce its most advanced defense products—has already proven able to do this with its simultaneous construction of multiple modern submarine and warship classes. Now China’s military aviation industry, which has traditionally lagged, also appears to be making this important strategic breakthrough.

China’s military aviation sector remains constrained by history. Isolation of dispersed enterprises with little access to foreign technology until the past twenty years has stunted the development of vital design, manufacturing and management processes. The concentration of heavy industry in areas such as Shenyang during the Japanese occupation, coupled with Mao’s policy of dispersing defense facilities deep in China’s interior, created major contending military aircraft production centers in Chengdu, Shenyang and Xi’an that to this day remain too politically entrenched to merge or cooperate effectively.

These enduring limitations on collaboration, coupled with substantial resource increases, leave internal competition as a means of stimulating military aviation innovation. Yesterday’s strict division of labor, in which SAC produced only heavy fighters and CAC only light fighters, is no more. Rather, with the J-31 and J-20, the two are already developing competing advanced low observable fighters, while Xi’an may be emerging as a third “stealth” hub for unmanned aerial vehicles. In this sense, China now has more internal competition in military than civil aircraft production.

This is part of a larger pattern in which China’s defense industry shows itself to be increasingly capable of developing its own sophisticated systems. Future visits of U.S. officials may well coincide with new Chinese development and testing. Some unveilings are likely to constitute “selective transparency”—targeted signals from an increasingly confident Beijing eager to deter foreign pressure and rally domestic support. But some revelations will simply be byproducts of the profusion of programs and political currents that propel China’s sprawling technocracy.

Even the J-31’s unveiling just prior to Secretary Panetta’s visit this time may be driven by such internal dynamics as programmatic timelines and the positioning of SAC, the PLA and bureaucrats prior to the upcoming 18th Party Congress and final working-out of succession issues. Not everything Beijing does, even militarily, revolves around Washington or its representatives.

***

Gabriel B. Collins and Andrew S. Erickson, “Geography Rules: Why Mongolia’s China Mining Strategy is a Mistake,” China Real Time Report (中国事实报), Wall Street Journal, 6 September 2012.

In May 2012, the Mongolian parliament passed a law requiring parliamentary approval for foreign investors to take a stake larger than 49% in enterprises in strategic sectors such as mining or for investments by state-owned enterprises. The timing of the law — passed shortly after an attempt by the China Aluminum Company (“Chalco”) to purchase a majority stake in coal producer SouthGobi Resources — suggests it was specifically designed with China in mind.

And it was successful: The conditions imposed by the law created an untenable level of uncertainty and on Chalco abandoned its bid on Tuesday.

Mongolia’s fear of China is understandable, but the Mongolian government is making a strategic misstep by in effect categorically rejecting Chinese investment in its mining sector. It can discriminate against Chinese investors, but it cannot change the fact that Mongolia is landlocked and cannot export sufficient mineral volumes via Russian routes to break its dependence on China.

By excluding Chinese direct investments in mines, Mongolia simply trades one form of influence for another. This is because even if coal and copper are mined by American, Australian, Canadian or Mongolian firms, the minerals will naturally flow to China—and in many cases move via Chinese-owned marketing firms such as Winsway, which is now partially-owned by Chalco. If Ulan Bator moves to curtail mineral flows to China, it will simply be embargoing itself.

What are the factors driving Mongolia’s dependence on the Chinese mineral market?

The most obvious, and most important, is geography. Mongolia is far from the ocean and high transport costs render most of its mineral production uncompetitive in the international export market if exported through routes other than China. Russia’s Pacific Ports are more than 4,000 km from coal and copper deposits in the Southern Gobi desert, while the Chinese border is less than 300 km from these reserves — and only 40 km in the case of the giant Ovoot Tolgoi coal project.

Even for coal from Northern Mongolia, the combined transport cost and port fees for shipment through a Russian Pacific Coast port can exceed US$100 per tonne, which renders thermal coal sales cost-prohibitive and makes coking coal uncompetitive against coals from Australia and other seaborne suppliers to the East Asian market.

Another factor is Mongolia’s status as the low-cost supplier for many commodities China needs. Mongolia already exports coal to China, which took 99% of Mongolian coking coal exports in 2011, according to local sources. The country’s mines are also poised to export copper, gold, and fluorite, and—further in the future—electricity, uranium, and possibly potash and oil.

A slowdown that depresses global commodity prices will make Mongolian commodities even more price-competitive in the Chinese market because Mongolian mines tend to be low-cost producers and because they do not have to ship long distances to reach the Chinese market. Australian coal and Chilean copper must traverse thousands of km to reach China, while Mongolian coal and copper can move as little as 40km and be in China.

In addition, Mongolian producers are likely to receive increasingly favorable pricing for coal they sell into China because the production costs of miners in Shanxi—the heart of China’s domestic coking coal production and much of its thermal coal output as well—have been rising quickly in recent years. For instance, data from Yanzhou Coal, one of China’s major underground miners, shows that the cost of goods sold (which broadly reflects production costs) rose by 32% between 2008 and 2011 at its Shanxi subsidiary and continues to rise in 2012.

Finally, Russia has no economic interest in becoming a transit route for competing Mongolian mineral exports. Unlike China, Russia does not actually need the coal and copper Mongolia wants to move to market. Indeed, Russia is an exporter of most of the minerals Mongolia is, or will be, exporting.

Russian miners do not want competition from Mongolian minerals.  For instance, steadily declining coal consumption in Russia and Europe has reoriented Russian coal producers toward the Asian market and filled the Siberian rail lines and Far Eastern coal ports almost to capacity. Politically well-connected Russian coal exporters like SUEK and Mechel will fight hard, and most likely successfully, to keep large volumes of Mongolian coal off Russian rail lines and out of their Pacific Coast export terminals.

With seven major coal projects in Siberia and the Russian Far East aiming to bring as much as 80 million tpy of coal production capacity online by 2020 and Russia’s Pacific coal export terminal capacity likely to grow by less than 30 million tpy, severe capacity constraints will remain and Mongolian coal miners wanting to use Russian routes will either be left in the cold or forced to accept cut-rate prices even lower than those offered by Chinese traders.

On the company-level, a handful of firms may be able to bypass China and use Russian routes to reach the seaborne market. For instance, in the coal sector, an Australian-listed miner with deposits in Northern Mongolia, tells us that it believes it can secure rail and port capacity to market some production through Russia. But even if true in practice, this will be the exception that proves the rule. On the national level (and likely on the company level for any producer wishing to move more than a few million tonnes per year), Russian rails and ports are likely to prove an inhospitable place for Mongolian mineral exports.

Mongolian politicians and portions of the voting public support resource nationalist policies in a large part out of fear that Chinese traders are exploiting the country’s isolation and forcing Mongolian miners to sell at unfair prices. The politicians’ statements and actions imply that they can secure better prices. Yet resource nationalism—particularly for a country that presently has relatively little leverage vis-à-vis China and cannot develop its minerals independently—typically proves a self-defeating path that leaves the populace worse off and angry for the wear.

The paradoxical reality is that continued resource nationalism will blunt Western mining companies’ desire to invest in Mongolia and make Chinese capital the “funds of last resort.” Ulan Bator’s antagonistic stance toward China is also counterproductive because it could help foreclose the opportunity for Mongolia to export resources via Chinese ports. Chinese ports are the only route through which Mongolian resources such as coal could reach international markets at a low-enough cost to remain price competitive.

Ultimately, China appears to seek secure, well-priced mineral supplies from Mongolia, not a re-enactment of the Qing Dynasty period of political domination. If Ulan Bator can establish political and regulatory stability and create a fair investment regime that leaves space for Chinese capital,  Chinese consumers will be able to absorb the large volumes of Mongolian mineral exports they need at prices sufficient to propel robust economic growth for years to come.

***

Gabriel B. Collins and Andrew S. Erickson, “Wyoming and Montana Could Become Major New Coal Suppliers to China and the Asian Market—If They Can Obtain Port Access,” China SignPost™ (洞察中国) 64 (4 September 2012).

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

Wyoming and Montana have the reserves and production to become significant coal suppliers to China and East Asia but need access to large port capacity on the U.S. West Coast in order to compete on price with coal from Australia and Indonesia.

Jero Wacik, Indonesia’s Energy and Minerals Minister, announced in early June that Indonesia needs to restrict future coal exports in order to preserve supplies for its rapidly growing domestic economy. President Yudhoyono’s plan to end all raw metal ore exports by 2014 and refine them locally will be one factor behind reduce coal export ability.

Indonesia’s ambitious plan could require as much as 1 gigawatt of extra electrical generation capacity—which could consume more than 5 million tonnes per year of coal. And with Indonesians buying more appliances and other power-hungry goods, residential electricity demand is growing as well, providing an additional factor that will trim Indonesian coal export potential.

With Indonesian export caps looming, China will face gaps as its exports rise because Indonesia is the world’s largest seaborne thermal coal exporter and has been one of China’s largest thermal coal suppliers. But a solution is already in sight: imports from Wyoming and Montana. Wyoming Gov. Matt Mead visited China in June 2012, in part to explore the potential for marketing coal from Wyoming, which by itself is one of the world’s largest thermal coal producers. Montana, too, is a major coal producer that is looking to export. Montana Governor Brian Schweitzer visited China in June 2011 to promote his state’s coal, wheat, beef, and tourism.

China may import as much as 250 million tonnes of coal during 2012 (coking and thermal coal combined), according to local sources. As such, Wyoming and Montana coal miners have a solid opportunity to market their low-cost, clean burning powder River Basin coal to power plants in Coastal China. … … …

***

Andrew S. Erickson and Gabriel B. Collins, “China’s Real Blue Water Navy,” The Diplomat, 30 August 2012.

China’s navy is not poised to speed across the Pacific to threaten America the way the Soviet Union once did, if not worse. This despite Peter Navarro and Greg Autry’s over-the-top polemic,Death by China: Confronting the Dragon—A Global Call to Action, in which they claim that “[T]he People’s Republic is moving forward at Manhattan Project speed to develop a blue water navycapable of challenging the U.S. Navy.”

Such statements lack basis in fact and present an ideal strategic teaching moment to remind analysts and policymakers that Beijing’s evolving naval structure and operations yet again show that China is not working off a traditional European, Soviet, or American naval development playbook. Even its most nationalistic and ambitious strategists and decision-makers do not seek what they would term a “global Far Oceans blue-water type” (远洋进攻性) navy any time soon. Yet it is also misleading to argue, as one scholar recently did in The National Interest, that “All but the most hawkish hawks agree that the Chinese military will not pose a threat to the United States for decades.” This is off the mark from the other direction—albeit in a considerably more subtle and thoughtful way. As a rare People’s Liberation Army (PLA) delegation visited Washington recently for a series of official meetings, it is important to understand where China’s military is headed and why—particularly at sea, where U.S. and Chinese military platforms encounter each other most frequently.

Here is the critical point that both writings miss entirely—China’s military, and navy, are not high-end or low-end across the board. Rather, in addition to domestic security/homeland defense, they have two major layers:

1.      China has already developed, and continues to develop rapidly, potent high-end navy and “anti-Navy” capabilities. Like their other military counterparts, they are focused almost entirely on contested areas close to home.

2.      It is also developing low-end capabilities. They are relevant primarily for low-intensity peacetime missions in areas further afield.

These two very different dynamics should not be conflated. … … …

***

Andrew S. Erickson and Gabriel B. Collins, “China’s Ballistic Missiles: A Force to be Reckoned With,” China Real Time Report (中国事实报), Wall Street Journal, 24 August 2012.

China dislikes U.S. ballistic missile defense (BMD) developments, existing and potential. Ballistic missiles have long represented one of China’s greatest military strengths, and it does not want them, or the nuclear weapons that they can deliver, negated. Resigned to the fact that the U.S. cannot be forced to halt development of its missile defense systems or reduce its focus on the Asia-Pacific, Beijing appears to be offering selective reminders that its missile forces are growing too strong to contain.

On Thursday, The Wall Street Journal reported that the U.S. plans to enhance its missile defense systems in the Asia-Pacific. Notably, a day prior to that report, images appeared on Chinese government web portal purporting to show a possible new ICBM, termed the DF-41. The website cited a U.S. article claiming that China tested the DF-41 on July 24.

This may be part of a growing pattern in which Chinese entities engage in selective transparency concerning emerging weapons systems to rally citizens at home and deter potential opponents abroad.

Another recent example includes claims in a popular newspaper that a conventional ballistic missile with a range of 2500 miles, sufficient to strike Guam, will be “ready for service” by 2015, and that the carrier-targeting DF-21D anti-ship ballistic missile (ASBM) is already deployed. While the first missile’s status cannot be verified, Taiwan’s annual defense report confirms that “a small quantity of” DF-21D ASBMs “were produced and deployed in 2010.” Meanwhile, an articleposted on the website of China’s Ministry of National Defense states that the “PLA should foster offensive defense thinking in developing long-range strike weapons.”

These explicit examples and implicit claims of Chinese missile prowess hardly represent paper tigers or empty talk. Building on a foundation of focused missile development since the late 1950s, Beijing is backing these data points up with substantive action. According to the latest U.S. National Air and Space Intelligence Center report on foreign ballistic and cruise missile capabilities (pdf), China is “developing and testing offensive missiles, forming additional missile units, qualitatively upgrading certain missile systems, and developing methods to counter ballistic missile defenses.” The U.S. Department of Defense’s 2010 unclassified report on China’s military states that “China has the most active land-based ballistic and cruise missile program in the world.” While this year’s report (pdf) was disappointing in its lack of detail, Chinese activities of late have only reinforced the Defense Department’s assessment.

Most distinctive in independent deployment potential and significant in overall capability are China’s nuclear and conventional ballistic missiles, which are controlled by the Second Artillery Force. With armament of the Chinese navy’s three deployed Type 094 ballistic missile submarines (SSBNs) awaiting final testing of the JL-2 submarine-launched ballistic missile(SLBM), land-based ballistic missiles are currently the sole delivery system for China’s nuclear weapons. As such, Beijing is determined to ensure their ability to penetrate the defense systems of potential opponents.

The goal is to ensure a secure second-strike capability that could survive in the worst of worst-case conflict scenarios, whereby an opponent would not be able to eliminate China’s nuclear capability by launching a first strike and would therefore face potential retaliation. As the U.S. Defense Department’s Ballistic Missile Defense Review points out, “China is one of the countries most vocal about U.S. ballistic missile defenses and their strategic implications, and its leaders have expressed concern that such defenses might negate China’s strategic deterrent.” In Beijing’s view, maintaining second strike capability can deter other powerful militaries from pressuring or attacking China in the first place.

In addition to homeland defense, specific roles envisioned for China’s ballistic missiles include preventing Taiwan from pursuing independence, maximizing Chinese leverage in territorial and maritime disputes, and discouraging the U.S. from intervening in regional crises or conflicts stemming from these or other issues.

Modest investment in ballistic missile defense offers the U.S. valuable technology development, general deterrence and some level of protection against dangerous regimes possessing limited ballistic missile capabilities, such as those of North Korea and Iran.

But while useful for other purposes, missile defense encourages, rather than dissuades, Chinese improvement of strategic nuclear forces.

Beijing can build so many missiles, at such an affordable cost, as to exceed the interception capability of any conceivable missile defense system. Attempting to overcome this reality would risk entering the U.S. into a race that it could not afford to wage, let alone win. China’s military overall still has weaknesses such areas as training and real-time coordination of sensors, but the SAF enjoys particular strengths in these respects as well and should not be underestimated.

Ballistic missile defense cannot be used to deny China secure second-strike—a capability that Beijing is determined, and able, to achieve (pdf). In fact, U.S. senior leaders frequently emphasize to Chinese leaders that U.S. missile defense systems do not have the technical capacity to do anything but stop a few missiles (and not even of the variety that China deploys), and are not aimed at preventing China from achieving secure second strike.

“Today, only Russia and China have the capability to conduct a large-scale ballistic missile attack on the territory of the United States, but this is very unlikely and not the focus of U.S. BMD,” the Ballistic Missile Defense Review explains. “Both Russia and China have repeatedly expressed concerns that U.S. missile defenses adversely affect their own strategic capabilities and interests. The United States will continue to engage them on this issue to help them better understand the stabilizing benefits of missile defense.”

China and Russia remain worried about whether or not they can believe or rely upon these assurances. Reasons include not only strategic distrust of the U.S. generally, but also possible advances in technology and—from their perspective, at least—the uncertainty surrounding whether a future U.S. administration of a different political persuasion might adopt a very different approach. Moreover, political actors in both China and Russia derive benefits from ignoring these assurances and exploit these issues for political gain.

Even with ongoing concerns and enduring differences in national interests, it behooves Washington and Beijing to attempt over time to enhance discussion of the sensitive and important subject of strategic deterrence. To be sure, dialogue is a two-way endeavor and will only be as productive as the sum of the efforts that both sides invest in it. Yet, as disappointing as results have been so far, the alternative to continued efforts at substantive discussion—the risk of misperception through disengagement—is far worse.

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Gabriel B. Collins and Andrew S. Erickson, “North-Central China Offers Massive Market Opportunity for Mongolian Coal Miners,” China SignPost™ (洞察中国) 63 (21 August 2012).

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

Mongolia’s massive and low-cost coal reserves are well-positioned to serve seven nearby Chinese provinces with more than one billion tonnes of annual coal demand

On 7 June 2012, Mongolian Mining Corporation (MMC) broke ground on a rail line that will link its Ukhaa Khudag (UHG) coking coal mine to the Chinese border crossing at Gashuun Sukhait (GS) and help move coal far more cheaply than the 400 trucks currently doing the job. MMC recognizes that China, which took 99% of Mongolia’s coking coal exports in 2011, is Mongolia’s best option for multi-million tonne per year thermal and coking coal exports. Low coal production costs can make Mongolian coal highly competitive in seven nearby Chinese provinces that consumed more than a billion tonnes of coal in 2010, according to official data.

The per capita steel demand levels in the populous and fast-growing provinces of Central and Western China are still only 40% of the levels seen on China’s East Coast. As the Chinese economy recovers, these regions—which are the most accessible to Mongolia’s landlocked coal producers—will provide growth markets able to absorb rising Mongolian coal exports. …

Mongolia’s coal export focus on China will have major risk implications in both coal and natural gas markets, as well as oil markets if investors also build China-facing CTL and CTC projects. Mongolia’s low cost and geographically captive thermal and metallurgical coal supplies will likely help undermine Beijing’s plans to reduce China’s dependency on coal and, in conjunction with new coalfields in Western China’s Xinjiang Province, could even jeopardize PetroChina and Sinopec’s ambitions to develop shale gas and other unconventional resources.

The Chinese seek secure, well-priced mineral supplies from their neighbor, not a re-enactment of the Qing Dynasty period of political domination. Russian transport infrastructure constraints, Russian companies’ antipathy toward competition from Mongolian coal, and the tyranny of distance will naturally direct mineral flows to China. To realize great economic opportunities in an otherwise somewhat sputtering China market in 2012, Mongolia must establish political and regulatory stability and recognize that China needs—and can absorb—large volumes of Mongolian coal exports. Meanwhile, to facilitate this development and profit in the process, investors in Mongolian coal should build rails south, run mines at full bore, and also consider opportunities in the coal-by-wire, coal-to-liquids, and coal-to-chemicals sectors.

***

Gabriel B. Collins and Andrew S. Erickson, “Spaceplane Development Becomes a New Dimension of Emerging U.S.-China Space Competition,” China SignPost™ (洞察中国) 62 (16 August 2012).

Deep Dive–Special In-Depth Report #4

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

Spaceplane development is becoming the newest frontier in the emerging space development competition between the U.S. and China. Winged spaceplanes operate as spacecraft in space and aircraft in Earth’s atmosphere, and typically land on runways. They range from hypersonic cruise vehicles (HCV)s capable of maneuvering at Mach 5+ (3,800+ mph/6,125+ kmh) or more to reusable launch vehicles (RLV)s like the Space Shuttle designed primarily to ferry cargo to orbit and back.

This is a difficult area to master, and U.S. programs have experienced a variety of problems. Yesterday (14 August 2012), instead of reaching Mach 6 as envisioned, Boeing’s X-51 WaveRider unmanned supersonic combustion ramjet (scramjet) demonstrator aircraft went out of control and plunged into the Pacific before its engine could be ignited. The failure was attributed to a faulty control fin.1 Launched from a B-52 bomber, the X-51 is a collaborative effort between the U.S. Air Force (USAF), Defense Advanced Research Projects Agency (DARPA), NASA, Boeing, and Pratt & Whitney Rocketdyne; the USAF Research Laboratory’s Propulsion Directorate oversees the program.2

Developing scramjet engine technology seems to be a priority of the ~$140 million program. A 13 June 2011 test flight succumbed to engine problems. In the program’s one major success to date, the X-51 achieved Mach 5 free flight for approximately three minutes from a B-52 bomber off California’s coast on 26 May 2010. Of four original X-51 aircraft, only one remains, but apparently no decision has been made as to if or when it will be tested.

More promising, Boeing’s X-37 Orbital Test Vehicle (OTV) has now been tested twice without incident. Designed to conduct experiments and send satellite sensors and related technology to and from space, the X-37B is a vertical-takeoff, horizontal-landing spaceplane designed to examine and repair satellites in low earth orbit (LEO). Based on NASA’s X-37 design, and drawing on DARPA inputs, the program is run by the USAF.

On 5 March 2011, in the USA-226 mission, the second X-37B OTV was launched into LEO from Cape Canaveral, where it operated for 469 days before landing at Vandenberg on 16 June 2012.3 Over a month before the touchdown, General William Shelton, commander of Air Force Space Command, pronounced the mission “a spectacular success.”4 The first orbital mission began on 22 April 2010 and ended successfully at Vandenberg 225 days later on 3 December 2010.5 A third is planned for fall 2012.6 Prior to these missions, only the Soviet Buran reusable orbital vehicle had performed an automated post-orbital landing, after returning from a two-orbit flight on 15 November 1988.7 Now Boeing is planning a larger X-37C version.

Meanwhile, across the Pacific, Beijing is pursuing an ambitious but methodical and well-funded space program. 2011 was a pathbreaking year for Chinese space accomplishments. While the U.S. launched more satellites in total, China conducted 19 non-test space launches, one more than the U.S. On 29 September 2011, China launched its first space laboratory module, Tiangong-1 (天宫一号 “Heavenly Palace 1”). On 18 June 2012, the three-person Shenzhou-9 mission—which boasted China’s first female astronaut, Liu Yang–docked with Tiangong-1 in the Chinese space program’s first piloted rendezvous.8

On 24 June, in another Chinese first, Shenzhou-9 undocked and redocked manually with the experimental platform.9 Tiangong-1 is being used to test rendezvous and docking capabilities needed to assemble a space station from a larger configuration of modules. China’s moves toward establishing a space station are attracting considerable attention, particularly as the U.S. retired its first (and, to date, only) manned spaceplane, the Space Shuttle, after just 135 missions with the touchdown of Atlantis on 21 July 2011, and now relies on Russian spacecraft to ferry its astronauts to the International Space Station.

As part of these larger efforts, Beijing may be entering the spaceplane era faster than many would have predicted. A system significant in potential military relevance appears to be emerging with the reported testing a Chinese vehicle prototype,10 and with several related systems apparently in development. Based on an initial announcement from a Sha’anxi TV station, apparently on 8 January 2011,11 multiple Chinese-language media outlets claim that on 8 January 2011, China completed a “test flight” (试飞) of the Shenlong (神龙/Divine Dragon) spaceplane (Exhibit 1).12

One source states that “Military fans in China and overseas media have continuously followed the development of the ‘Divine Dragon’ with great interest. Now that the good news has been conveyed that the test flight of the ‘Divine Dragon’ has succeeded, domestic military fans are elated, while the Western media and defense scholars may intensify their attention to the ‘Divine Dragon’.”13 The “test flight” claim came within a month of the U.S. X-37B orbital vehicle’s return to earth after its first test flight and coincided closely with China’s test flight of its J-20 low-observable fighter prototype.

Exhibit 1:  Images apparently documenting Chinese spaceplane prototype test(s)

Alleged screenshot of coverage by CCTV-7 (China’s official military television channel)’s 军事报道 (Military Report) program of Shenlong test flight.

Source: “‘神龙’ 航空某型号重大专项跨大气层飞行器演示样机 (验证机)” [The “Divine Dragon” —A Certain Major Aviation Project—Trans-Atmospheric Demonstrator Vehicle (Demonstrator)], 空军世界 [Air Force World], http://www.airforceworld.com/pla/shen_long.htm.

Alleged screen shot from Sha’anxi TV’s Sha’anxi News Feed (陕西新闻联播) on 8 January 2011. Caption at top of image reads: “China’s trans-atmospheric vehicle tested successfully”

Source: http://www.xhmil.cn/html/junshixinwen/201101/23-2354.html

To be sure, much remains uncertain about the nature of such a “test,” most likely a glide/aerodynamic test from an H-6 bomber. Shenlong is very likely far less capable than the X-37B and may still be years away from yielding a vehicle with true operational capability. As an article in the monthly journal of the 201st Research Institute of China’s ordnance Industry assesses candidly in 2010, “at present, the photographs that have flowed out show the Shenlong still in airdrop testing status, in research and development still far below the level of the X-37B OTV. Besides, overseas understanding of the Shenlong is still conjectural, even being sketchy on the orientation of the Shenlong. At present, we still are unclear as to whether or not the Shenlongpossesses the capability to remain in orbit for long periods of time like the X-37B. To say that it would be a match for the latter is still far from prudent.”14 Yet the very fact that China appears to be active in this technically challenging dual-use area reflects China’s methodical pursuit of space systems that can potentially switch quickly between civilian and military missions. Moreover, as documented above, the U.S. remains far from having mastered all requisite technologies; China is not hopelessly behind in this field.

Depending on its precise nature, which will likely emerge over time, Shenlong’s reported test may be part of a larger trend: a shrinking time gap between when the U.S. first reveals a prototype military system and when China publicly shows a system comparable in type (if not equivalent in capabilities or immediately operational). For previous aerospace developments, China typically revealed its systems’ existence at least 15 years after the U.S. first showed its analogous platforms (Exhibit 2).

Exhibit 2:  Gap in years between first unveiling of select U.S. and Chinese weapons systems

Source: China’s Defence Today, USAF, Southern Weekend, Chinese Internet

The immediate implication is that in some areas of space operations, China may be attempting to emulate the U.S. and develop advanced capabilities that could give it strategic advantages; as well as to reveal selected development efforts in order to further patriotism at home and deterrence abroad. Of course, it is also possible that China is exaggerating its efforts or even engaging in deception in an attempt to enhance deterrence, but presumably such ploys would be detectable over time by the principal target of influence—the U.S. government. Given the high U.S. reliance on space-based C4ISR (15) capabilities, then, Chinese development of space systems such as Shenlongwarrant close attention.

Development of Shenlong and other spaceplane programs

Data on Shenlong and other spaceplane-related programs remain sparse in both English and Chinese-language sources. Nevertheless, China is clearly pursuing a wide range of hypersonic flight vehicle programs. Efforts are underway at at least four major centers:

–China Aerodynamics Research and Development Center (CARDC, 中国空气动力研究与发展中心), a General Armaments Department (GAD) test base in Mianyang, Sichuan

–10th Research Institute (Near Space Flight Vehicle Research Institute), in the China Academy of Launch Technology (CALT), or First Academy, of China Aerospace Science and Technology Corporation (CASC)

–China Academy of Space Technology (CAST)

–The 611 Research Institute, Chengdu Aircraft Corporation, Aviation Industry Corporation of China (AVIC)

Perhaps drawing on its successful and wide-ranging R&D on extended-range cruise missiles, China’s defense establishment also appears to conducting conceptual design work on HCVs. A multitude of Chinese researchers have published numerous papers on various HCV-related topics. At an international conference in 2006, experts from China Academy of Launch Vehicle Technology (CALT) asserted that RLVs represent “the main trend of space transportation system[s].” With respect to new-generation Long March launch vehicles, they offered a “RLV roadmap… including development goals, system concepts, and approach[es] for maturing key technologies.”

The researchers stated that CALT would decide whether to develop an RLV within the next few years, and possibly select between “two system architectures,” both of which entailed “taking off vertically, landing horizontally, two stage to orbit, and partially reusable.”16 One Chinese study has outlined the results of modeling and simulation of a scramjet-powered vehicle with a range of between 1,000-2,000 km, flying toward its target at an altitude of between 25-30 km and speed of Mach 6.17 Other HCV efforts are underway at CAST for the Second Artillery.

Mark Stokes tells us that CARDC is GAD’s primary wind tunnel facility for national-level programs. A wind tunnel testing facility, it would support the design team. Scramjet engine testing may be underway there. One study of possible relevance focused on a HCV adopting a skipping trajectory with an upper altitude of 60 km and lower altitude of 30 km.18 In addition to researching optimal design methods,19 and addressing specific guidance, navigation, and control issues, Chinese aerospace engineers also have been carrying out basic research into an air-turbo rocket (ATR) propulsion system, an air-breathing system that combines elements from both turbojets and rocket engines.20 Simulations validated one design that operates at speeds up to Mach 4 and altitudes of up to 11 km.21

As for Shenlong specifically, Chinese sources say it is part of the 863 State High-Techology Research and Development Plan (国家高技术研究发展计划) and that the People’s Liberation Army (PLA) considers it a priority system for development.  Established in March 1986, the 863 Program is a state-led effort to develop dual-use high-tech sectors deemed essential to China’s long-term strategic security and economic competitiveness. In arguably the greatest instance of top-level leadership engagement since the promulgation of China’s 1956-67 long-range science and technology development plan, which set the stage for China’s storied Cold War nuclear weapons, ballistic missile, and satellite (“Two Weapons and One Satellite”) development, China’s “Medium- and Long-Term National Science and Technology Development Program (2006–20),” or MLP, was promulgated in 2006.22 Specifically,Shenlong may be a popular term for the 863-706 Program.23

The MLP contains some projects from the 863 Program, but also new projects: “Major special items refer to major strategic products, key generic technologies, and major projects that are to be completed within certain time frames through core technology breakthroughs and resource integration in order to achieve national goals; they are the priority of priorities in China’s S&T development. The Program Guidelines identify 16 major special items…24 China’s Ministry of Science and Technology (MOST) likewise lists 16 these “National Science and Technology Mega-Projects” (国家科技重大专项 项目) as “priorities of priorities.”25 While the nature of three of the projects have not been announced publicly, leading China defense industry organization scholar Tai Ming Cheung believes that they are most likely the:

–Shenguang (神光) laser project for inertial confinement fusion, especially for nuclear fusion-related research

–2nd generation Beidou satellite navigation system

–Hypersonic vehicle technology project—R&D at new Qian Xuesen experimental base in Huairou?26

It is noteworthy that two of the three suspected programs are directly space-related. If the third item of speculation is true, it would indicate significant state prioritization of HCV development. This, in turn, would explain in part the profusion of Chinese research articles on the subject.

In any case, spaceplane/HCV-technology research is clearly underway. In October 2006, Jane’s states, CASC displayed an air-launched satellite launch vehicle (ASLV) three-stage solid propellant vehicle model. It had dual small delta-shaped wings, similar to the U.S. Pegasus air-launched SLV.27 Chengdu Aircraft Corporation’s 611 Research Institute led Shenlong’s design and testing, according to Jane’s. Jane’s also believes the Nanjing University of Aeronautics and Astronautics, Northwest University, and the Harbin Technical University assisted in the craft’s design and testing.28

In what might be emerging as a significant competitor to CARDC, the CASC First Academy contains a new shop, the 10th Research Institute (Near Space Flight Vehicle Research Institute), devoted to HCV design.29 The existence of an institute devoted to something not yet operational is significant, and speaks to the resources, breadth, and rapid development of China’s defense industrial base. Formerly chief designer of a major solid fueled ballistic missile system, Director Bao Weimin [包为民] also enjoys influence as CASC First Academy S&T Committee Director, head of the PLA/GAD’s General Missile Technology Expert Working Group, and deputy director of the PLA/GAD Precision Guidance Expert Group under the 863-4 Advanced Defense (先进防御) projects series.30 According to Mark Stokes and Dean Cheng, “The establishment of such a separate research institute – one that focuses on a single capability – within China’s premier launch vehicle and ballistic missile academy serves as a prominent indicator of the priority that senior civilian and military leaders place on new generation long-range precision strike vehicles.”31

Physical dimensions

In its currently observable configuration, at least, Shenlong appears much smaller than America’s X-37B. We are not aware of any Chinese sources disclosing Shenlong’s precise dimensions. Based on available photos, we estimate that its body is roughly 1 meter tall, with a length of between 5 and 6 meters (Exhibit 3). As such, it is likely only about 1/3 the size of the X-37B. By contrast, Jane’s estimates larger dimensions of 1.1 m and 12.0 m respectively, with a 4.0 m wingspan, though this might apply to another three-stage ALSV variant.32 The disparity could be caused by several different factors, including the possibility that:

–the 2006 model was refined into a smaller real world version due to engineering considerations;

–the existence of a smaller version in 2006 was considered sensitive and thus was not publicly disclosed at the same time; or

–there are two different versions (large/small) with differing missions.

For example, the larger version ASLV may enable insertion to geostationary orbit (GEO), whereas the smaller Shenlong need only reach LEO, and

–payload miniaturization may have resulted in a smaller launch configuration, allowing for lower cost and opportunity to build more vehicles for flexibility.

Indeed, the existence of three separate U.S. HCV programs suggests both a range of programmatic possibilities and direct sources of inspiration for China. In any case,Shenlong’s small size may have been dictated in part by the ability of the H-6 bomber to carry it under its fuselage, attached by a specialized pylon. Images of an allegedShenlong spaceplane prototype have a body configuration remarkably similar to a small version of the U.S. Space Shuttle or the X-37B (Exhibit 3).

 Exhibit 3: Shenlong vs. X-37B

Source: Chinese Internet, China SignPost™, USAF

According to Jane’s, Shenlong may have INS/GPS navigation. It is reportedly designed to be launched from an H-6 bomber at an altitude of ~10 km. Following ignition, a first-stage motor would take the 13,000 kg spacecraft to 490 km in ~8 minutes before a second stage burn would take it to 600 km altitude. A third stage would then accelerate the spacecraft prior to dispensing a satellite of ~50 kg into sun-synchronous orbit before landing on a runway in its return to Earth.33 These parameters might apply toShenlong or an ASLV variant thereof, and it is possible that the current Shenlongvehicle is a technology demonstrator for the latter or even a different follow-on program.

One important technical issue is how to launch a spaceplane. Apparently dropped off an H-6 bomber in a glide/aerodynamics test already, Shenlong might later be launched on a Long March rocket if launch capacity is sufficient, perhaps the LM-5 heavy-lift booster when it comes online.

Strategic Implications

At a minimum, Shenlong appears to be a technological development/validation program. A successful Chinese spaceplane program would have two key strategic implications. First, on the broad level, it would signify that the Chinese space program has come one step closer to being able to build a Space Shuttle-type capability. On a related note, further test flights, particularly if they involve X-37B-style maneuvering by a larger derivative of Shenlong, would also strongly suggest that China’s command and control system for space assets has become much more capable, with commensurate implications for both military and civil space operations.

Which service would control a fully-developed Shenlong remains uncertain, as GAD, the PLA Air Force (PLAAF), and even the Second Artillery contend for control of operational space assets—and some Chinese thinkers argue for the formation of a separate Space Force (天军). GSD probably is another authority for operational control of some satellites. Not surprisingly, as Kevin Pollpeter informs us, PLAAF-connected writers are already citing spaceplane development as yet another reason why their service should handle space operations.

Second, spaceplanes confer a number of capabilities that conventional launchers cannot offer. First of all, they are reusable and their payloads can be changed between missions. These features offer versatility and may even offer some cost savings, especially for reconnaissance missions. Rocket boosters for putting a spaceplane in orbit might cost ~US$150-200 million. Spaceplane costs also include the spaceplane itself (with robust structure and shielding), extensive post-flight refurbishment, integration costs, possible manpower costs for flying the spaceplane, payload costs, and recovery costs. Launching a relatively small satellite with a spaceplane as opposed to on a single-use rocket may not realize large costs savings, but it is an option that Chinese planners would likely want to have available eventually.

Larger future iterations of Shenlong and related systems could materially enhance China’s space-based C4ISR capabilities through both on-board sensor systems and the ability to deploy microsatellites and other sensor systems that boost space situational awareness. Spaceplanes can also rapidly change orbits to hinder tracking, survey different areas, or potentially avoid an opponent’s anti-satellite (ASAT) systems. During its maiden flight, the X-37B was said to have changed orbits, confounding amateur spotters for several days until one located the craft in its new orbital path. Finally, a spaceplane’s ground-based status could allow it to sidestep Beijing-promoted international agreements restricting the deployment of weapons in space, and thus add to its appeal as a potential ASAT platform.

Many Chinese writers see the X-37 program as evidence of American determination to develop anti-satellite (ASAT) capability and engage in a space arms race.34 At the same time, according to Stokes and Cheng, “China’s counterspace program appears to parallel interest in countermeasures [e.g., kinetic kill vehicles, as demonstrated in China’s 11 January 2007 ASAT test and 11 January 2010 missile defense test] against advanced U.S. long-range precision strike capabilities that would transit space, and are expected to be in place by 2025,” which might include the X-37B, the X-51A, and the Force Application and Launch from the Continental U.S. (FALCON) Hypersonic Technology Vehicle (HTV).35

Additional spaceplane-relevant U.S. projects: will China follow suit?

DARPA has just released details on the 11 August 2011 test flight of the FALCON HTV. Constructed by Lockheed Martin Corp., FALCON is part of a multiyear DARPA effort to develop an air-breathing platform that could deliver a payload at Mach 20 (~13,000 mph) via near-space altitudes anywhere in the world within an hour. While HTV-2 reached its planned speed and obtained valuable data, the flight ended after only 9 minutes rather than the planned 30 and impacted the ocean far short of the planned splashdown area near Kwajalein Atoll. Shockwave-induced skin peel and resulting destabilization of the vehicle shortened the flight. A previous test flight occurred 22 April 2010, its conclusion similarly premature.36 No future test flight plans have been scheduled, apparently, leaving the program’s future uncertain.37

Even though it is just a prototype or proof of concept, there is much Chinese technical and media writing on the X-37B and other U.S. efforts. PLA coverage of U.S. development and testing of spaceplanes may suggest how it views them conceptually, including what represents the most promising approaches and what challenges are involved, as well as what it feels the need to respond to.

Conclusion: Internal and External Competition?

By involving both China’s aviation and space sectors, development of near space vehicles appears be setting the stage for bureaucratic competition, or at least “coopetition,” as the Second Artillery, PLAAF, and even GAD may all fund and field similar systems. For example, a spaceplane built by China’s aviation industry would have to be launched on a rocket produced by the space industry, just as when Boeing had to launch its orbital vehicle on a Lockheed Martin Atlas 5, whereas a spaceplane built by CASC would have direct rocket access. This appears to be part of a larger pattern in which China’s defense industrial bureaucrats are increasingly allowing, and even encouraging, similar programs to develop in parallel—as with Chengdu and Shenyang’s low observable aircraft programs for the PLAAF—to foster productive competition.

What seems clear overall is that China’s investments of considerable funding, time, talent, technology in space, spaceplane, and hypersonic vehicle development are integrating, and coming to fruition. Particular attention and investment are being applied to critical areas, such as materials, including thermal protection systems for hypersonics. Given the complex, interdisciplinary nature of hypersonics, their development is particularly challenging, but if successful, also promises to stimulate a wide range of other sectors. This is just the sort of comprehensive development that many Chinese bureaucrats seek to bolster China’s power.

China’s large, broad-based spaceplane development effort, with its large number of supporting programs, has put multiple systems in the defense industrial development pipeline. Funding prototype programs is much different from funding high-volume systems. With its significant defense industrial resources, China can afford to invest considerably in multiple spaceplane prototypes. This augurs the prospect of the PLA having a range of space systems from which to choose.

Operationalization is a more complex question, and hinges in part on larger policy decisions. Ground-based ASAT capabilities and facilities involving kinetic kill vehicles and lasers, already extant, are being improved; a major question is which organization(s)—e.g., the PLAAF or the Second Artillery—will control them. Some single organization is already overseeing a given platform’s concept development and R&D, and would likely control the platform if/when successful.

Long-range bombers, by contrast, do not appear to constitute a development priority at this point, as they go against a range of national policies. It would be quite unsurprising to see spaceplane(s) developed for ISR and even some ASAT missions, with the GSD perhaps playing a major role. For now, at a minimum, Shenlong and other early Chinese spaceplane development efforts would appear to represent prototype(s) to show the U.S. other foreign actors what China is capable of, a demonstration of Chinese science and technology development that confers prestige, and an early indicator of China’s technical dynamism and ability to fund a wide range of programs.

It should thus not be surprising if China continues to narrow the development time gap with U.S. programs; Chinese Ph.D.s in relevant fields are being trained in the same places as their U.S. counterparts, and limited American experience in this area makes it much easier for China to close this gap than those in some other areas where the U.S. enjoys a greater lead. Shenlong is merely the first test item in this new Chinese frontier; we can expect to see many related efforts to emerge, with potential major impact in the next 5-10 years. New, previously-improbable possibilities must be considered. If the X-37B is just a prototype, for instance, could China get out in front with something to which the U.S. has to react? In any case, new thinking is in order: the U.S. has not had a near peer in space this advanced and dynamic in 20-30 years.

In most areas of military competition, China strives to take an asymmetrical approach that maximizes its strategic leverage while sparing it the cost of a head-to-head platform competition with the U.S. In space, however, China’s approach is both asymmetric and symmetric, as it seeks to build a comprehensive space capability. The development of ground-launched anti-satellite (ASAT) systems, the Beidou/Compasssatellite position, navigation, and timing (PNT) system, more robust space-based ISR capabilities, manned spaceflight ability, space station presence, and now—in whatever form— Shenlong and other spaceplane-related programs all suggest that Beijing indeed views space as the ultimate high ground and desires a capable and independent military space infrastructure.

The bottom line: foreign policymakers need to take China’s space ambitions seriously. Beijing’s development of spaceplane programs is broad-based, and their trajectory will represent a key barometer of its civil and military space intentions.

[i] W.J. Hennigan, “Test Flight of Hypersonic X-51A Aircraft Ends in Failure,” Los Angeles Times, 15 August 2012, http://www.latimes.com/business/money/la-fi-mo-hypersonic-x51-test-flight-20120815,0,7169817.story.

[ii] “X-51A Waverider,” Fact Sheet, U.S. Air Force, 23 March 2011,http://www.af.mil/information/factsheets/factsheet.asp?fsID=17986.

[iii] Leonard David, “Secretive Air Force Space Plane’s Purpose Questioned,”Space.com, 25 June 2012, http://www.space.com/16293-x37b-space-plane-purpose.html; Mike Wall, “Air Force Video Reveals Secret X-37B Space Plane’s Robotic Landing,” Space.com, 16 June 2012, http://www.space.com/16173-secret-x37b-space-plane-landing-video.html.

[iv] Leonard David, “Secret Air Force X-37B Space Plane Mission a ‘Spectacular Success’,” Space.com, 8 May 2012, http://www.space.com/15575-secret-x37b-space-plane-mission-success.html.

[v] “X-37B Orbital Test Vehicle,” Fact Sheet, U.S. Air Force, 3 March 2011,http://www.af.mil/information/factsheets/factsheet.asp?id=16639.

[vi] Leonard David, “Air Force’s Mysterious X-37B Space Plane Survives 1 Year in Orbit,” Space.com, 6 March 2012, http://www.space.com/14799-secret-air-force-space-plane-x37b.html.

[vii] Boris Chertok, Rockets and People: The Moon Race, Vol. 4 (Washington, DC: NASA, 2011), 577.

[viii] Craig Covault, “Chinese Crew Works in Tiangong after 1st Manned Shenzhou Docking,” AmericaSpace, 19 June 2012, http://www.americaspace.org/?p=21458.

[ix] “Chinese Spacecraft Shenzhou 9 Makes First Manual Docking with Space Module,”The Guardian, 24 June 2012,http://www.guardian.co.uk/world/2012/jun/24/chinese-spacecraft-first-manual-docking.

[x] For the most comprehensive survey of potential Chinese space plane programs to date, see Richard Fisher, Jr., “China’s Space Plane Program,” International Assessment & Strategy Center, 27 July 2011,http://www.strategycenter.net/research/pubID.253/pub_detail.asp. See also Craig Covault, “Evidence Builds for Chinese Mach 15 Spaceplane Test from 60 mi. Altitude,”AmericaSpace, http://www.americaspace.org/?p=9076;  Richard Fisher, Jr., “Shenlong Space Plane Advances China’s Military Space Potential,” International Assessment & Strategy Center, 17 December 2007,http://www.strategycenter.net/research/pubID.174/pub_detail.asp#.

[xi] Footage available at “中国跨大气层飞行器试飞成功” [Test Flight of China’s Exo-atmospheric Flight Vehicle Succeeds], Sina.com, 12 January 2011,http://video.sina.com.cn/v/b/44970858-1304604555.html; “国产跨大气层飞行器试飞成功” [Test Flight of Indigenous Exo-atmospheric Flight Vehicle Succeeds],http://www.youtube.com/watch?v=CWoiBubBpQI;http://www.tudou.com/programs/view/e_c2guok-gc/.

[xii] 责任编辑: 焦隆 [Editor: Jiao Long], “中国公开隐形‘太空轰炸机’是对美国第二次警告” [China’s Publicly-Invisible “Space Bomber” is the Second Warning to the United States], 人民网 [People’s Net] (Original Source: 环球时报 [Global Times]), 30 January 2011, http://gs.people.com.cn/GB/183362/198667/198669/13851458.html; 编辑: 黄小路 [Huang Xiaolu, Editor], “从J20到跨大气层飞行器让我们无限遐想” [Following the J-20 with the Exo-atmospheric Flight Vehicle Makes Us Dream Boundlessly], 成都全搜索 [Chengdu Quan Sousuo], 13 January 2011,http://opinion.news.chengdu.cn/topic/2011-01/13/content_624934.htm?node=12802. For similar reporting, which appears to draw in part on foreign sources as many Chinese media reports do, see also作者: 编译 柴志廷 选稿: 张侃理 [Translator and Editor: Chai Zhiting; Text Selector Zhang Kanli], “美国军事专家称中国神龙太空轰炸机撩开面纱” [U.S. Military Expert(s) State That China’s Divine Dragon Space Bomber Has Lifted the Veil], 世界报 [World News], 23 January 2011,http://mil.eastday.com/m/20110123/u1a5686810.html. Of note, Nanfang Daily has also republished this article. For a Chinese citation of a Canadian news report on the subject, see “中国官媒曝中国空天飞机已成功试飞” [China’s Official Media Reveal that China’s Space Plane Has Had a Successful Test Flight], 星岛环球网 [Globe and Mail], 10 January 2011, http://news.stnn.cc/glb_military/201101/t20110110_1491145.html. See also http://news.ynxxb.com/content/2011-1/25/n94035777685.aspx.

[xiii] Original text: “中国的军迷和海外媒体一直对 ‘神龙’ 的发展非常关注, 如今传来 ‘神龙’ 试飞成功的好消息, 在令国内军迷欢欣鼓舞的同时, 西方媒体和防务学者可能会更加紧盯 ‘神龙’.” See 责任编辑: 焦隆 [Editor: Jiao Long], “中国公开隐形 ‘太空轰炸机’ 是对美国第二次警告” [China’s Publicly-Invisible “Space Bomber” is the Second Warning to the United States], 人民网 [People’s Net] (Original Source: 环球时报 [Global Times]), 30 January 2011, http://gs.people.com.cn/GB/183362/198667/198669/13851458.html.

[xiv] 李想 [Li Xiang], “太空霸天虎: 深度解析美国X-37B空间机动飞行器” [Space Master Sky Tiger: In-Depth Analysis of the United States X-37B Space Maneuver Vehicle (SMV)], 现代兵器 [ModernWeapons] (September 2010): 22.

[xv] C4ISR: command, control, communications, computers, information, surveillance, and reconnaissance

[xvi] Yong Yang, Defeng Hu and Menglun Yu (China Academy of Launch Vehicle Technology), “Roadmap of Long March Reusable Launch Vehicle,” 57th International Astronautical Congress, Hyderabad, India, 2006, IAC-06-D2.4.03, 1-5.

[xvii] See, for example, Che Jing and Tang Shuo, “Research on Integrated Optimization Design of Hypersonic Cruise Vehicle,” National Natural Science Foundation study, 21 August 2006. The authors are from the Northwest Polytechnical University’s College of Astronautics, which hosts a GAD-funded flight vehicle laboratory.

[xviii] Zhan Hao, Sun Dechuan, and Xia Lu, Northwest Polytechnical University College of Astronautics, “Preliminary Design for Soaring Hypersonic Cruise Vehicle,” Journal of Solid Rocket Technology 30.1 (2007).

[xix] Jing Che and Shuo Tang, College of Astronautics, Northwestern Polytechnic University, “Research on Integrated Optimization Design of Hypersonic Cruise Vehicle,” Aerospace Science & Technology 12.7 (October 2008): 567-72,http://www.sciencedirect.com/science/article/pii/S1270963808000242.

[xxi] Chen Xiang, Chen Yuchun, Tu Qiuye, Zhang Hong, and Cai Yuanhu, Northwest Polytechnology Unversity School of Power and Energy “Research on Performance of Air-Turbo Rocket,” Journal of Projectiles, Rockets, Missiles, and Guidance 29.2 (2009):162-165; Li Huifeng, Chen Jindong, and Li Naying, Beijing University of Aeronautics and Astronautics (BUAA) Space College, “Research on Midcourse Navigation of Hypersonic Cruise Air Vehicles,” Modern Defense Technology 34.6.

[xxii] For background on the MLP, see Tai Ming Cheung, Fortifying China: The Struggle to Build a Modern Defense Economy (Ithaca, NY: Cornell University Press, 2009), 239-41.

[xxiii] See “‘神龙’ 航空某型号重大专项跨大气层飞行器演示样机 (验证机)” [The “Divine Dragon” —A Certain Major Aviation Project—Trans-Atmospheric Demonstrator Vehicle (Demonstrator)], 空军世界 [Air Force World], http://www.airforceworld.com/pla/shen_long.htm.

[xxiv] “国家中长期科学和技术发展规划纲要” [Guidelines for the Medium- and Long-Term National Science and Technology Development Program (2006-2020)], Xinhua, 9 February 2006. “11. National Defense IV. Major Special Items Historically, China’s implementation of a number of major projects, epitomized by ‘two bombs and one satellite,’ manned spaceflight, and hybrid rice, has played a vital role in improving overall national strength. … While identifying a number of priority subjects in key fields, these guidelines also further highlight key areas; select a number of major strategic products, key generic technologies, and major projects as major special items in which to achieve breakthroughs through giving full rein to the superiority of the socialist system in concentrating resources on undertaking major endeavors and to the role of market mechanisms; and aim to bring about the development of productive forces by leaps and bounds and to fill national strategic gaps through the realization of partial exponential growth in S&T. The basic principles for determining major special items are: One, keep firmly in mind the major needs of economic and social development and nurture strategic industries with core proprietary intellectual property rights that can give a significant impetus to improving enterprises’ independent innovative capabilities. Two, accentuate key generic technologies that have an overall impact on and can provide a strong impetus to raising overall industrial competitiveness. Three, resolve major bottlenecks that impede economic and social development. Four, give expression to the principle of combining military and civilian production and embedding military capabilities in civilian capabilities, which has great strategic significance for ensuring national security and enhancing overall national strength. Five, act in line with China’s national conditions and to the extent that our national strength can support. A number of major special items have been determined in accordance with the aforementioned principles with a view to developing new- and high-tech industries, promoting the upgrading of traditional industries, resolving bottlenecks in national economic development… and ensuring national security. Major special items will be carried out one by one in keeping with the country’s development needs and the extent to which the conditions are ripe for implementation. At the same time, major special items will be adjusted dynamically and carried out step by step in light of the country’s strategic needs and changes in the country’s development situation. Regarding major special items aimed at strategic products, we will give full rein to the principal role of enterprises in R&D and investment, make R&D on major equipment a breakthrough point in technological innovation by enterprises, make more effective use of market mechanisms in allocating S&T resources, and channel state-guided investments primarily toward tackling key and core technological problems.”

[xxv] 国家科技重大专项 [National S&T Mega-Project] website,http://www.nmp.gov.cn/zxjs/dxfj/.

[xxvi] Tai Ming Cheung, “Science and Technology in Chinese Thinking on Security and Development: Techno- Nationalism and S&T Innovation as Seen Through its Technology Development Programs,” presentation at “IGCC 2012 Summer Training Workshop on the Relationship between National Security and Technology in China,” Study of Innovation and Technolgy in China Project, University of California Institute on Global Conflict and Cooperation, La Jolla, CA, 10 July 2012. Wording quoted directly from presentation.

[xxvii] “Air-launched Satellite Vehicle,” Jane’s Strategic Weapon Systems, 22 January 2012, www.janes.com.

[xxviii] “Strategic Weapon System—China,” Jane’s Sentinel Security Assessment – China and Northeast Asia, 20 January 2012, www.janes.com.

[xxix] It is also possible that CASC’s 10th Research Institute is not a direct a competitor to CARDC. CASC’s counterpart to CARDC is the 701 Research Institute, which has morphed into an independent academy.

[xxx] Mark A. Stokes with Dean Cheng, China’s Evolving Space Capabilities: Implications for U.S. Interests (Arlington, VA: Project 2049 Institute, 26 April 2012), 56, 60, http://www.uscc.gov/RFP/2012/USCC_China-Space-Program-Report_April-2012.pdf.

[xxxi] Ibid., 18.

[xxxii] “Air-launched Satellite Vehicle,” Jane’s Strategic Weapon Systems.

[xxxiii] Ibid.

[xxxiv] Xin Dingding, “U.S. Spacecraft Sparks Arms Race Concerns,” China Daily, 24 April 2010, http://www.chinadaily.com.cn/world/2010-04/24/content_9770149.htm; Zhang Xiang, “U.S. Military Launches Unmanned ‘Space Plane’,” Xinhua, 23 April 2010, http://news.xinhuanet.com/english2010/world/2010-04/23/c_13263726.htm.

[xxxv] Stokes and Cheng, 44.

[xxxvi] “Engineering Review Board Concludes Review of HTV-2 Second Test Flight,” DARPA, 20 April 2012,http://www.darpa.mil/NewsEvents/Releases/2012/04/20.aspx; “Falcon HTV-2,” Tactical Technology Office, DARPA,http://www.darpa.mil/Our_Work/TTO/Programs/Falcon_HTV-2.aspx.

[xxxvii] W. J. Hennigan, “Pentagon Releases Results of 13,000-mph Test Flight over Pacific,” Los Angeles Times, 20 April 2012,http://www.latimes.com/business/money/la-fi-mo-darpa-hypersonic-missile-20120420,0,4564567.story.

***

Gabriel B. Collins and Andrew S. Erickson, “Can Inland Consumption Soften Coastal Industrial Slump? China’s Weak Earthmover Sales and Poor Coal Demand Point to More Economic Turbulence, But Second and Third Tier Property Markets Show Flashes of Life,” China SignPost™ (洞察中国) 61 (14 August 2012).

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

With Chinese consumers holding on to their wallets (See China SignPost 60), the People’s Republic of China (PRC)’s near-term economic fate hinges heavily upon its real economy, which still revolves around heavy industrial activity. This means excavating and building, burning coal, making steel, and so forth. The latest earthmover sales data are not quite as deeply negative as they were late in the first quarter of 2012, but they remain weak, with sales of excavators, a bellwether for construction activity, down 20% year-on-year (“YoY”) in June and down by 28% YoY in July. The structural trend looks bad as well, with the 12-month rolling sales figure still declining, albeit less sharply than it was earlier in the year….

Slowing earthmover sales reflect substantial uncertainty among construction companies, who fear spending large sums on machinery that could end up sitting idle if the property and infrastructure markets do not pick up soon. China has been announcing a number of “stimulus” measures since April 2012. However, our sense is that many of the projects included in the announcements were already on the drawing boards when the economy slowed down and are simply being re-packaged as “stimulus measures.” In practical terms, this means they have political significance, but that the main construction commodity markets (earthmovers, steel, concrete, copper) have already effectively priced in the demand the projects are likely to create. Also, not all projects are equal in size or potential impact, and some projects counted for statistical purposes are not very large or significant.

Unlike the massive economic stimulus plan of 2008-09, announced as a RMB 4 trillion (US$586 billion) investment, subsequent stimulus measures are likely to be limited. Investors should avoid being swayed by what may become a fool’s rally in which major traders ride the small bursts of stimulus while they can, only to dump holdings once it becomes clear that the ride is over. Small investors and poorly-managed funds that don’t move quickly enough may face a hard landing indeed. There will be a big commodities piece to this story, as China’s real economy is fueling a substantial part of the global and regional commodities boom, and its softening will affect prices across the board.

China’s overall economic downturn will serve as an acid test of whether or not the Central and Western provinces can return to robust growth and meaningfully compensate for the slowdown on the East Coast. Four of China’s 10 largest provincial economies in 2011 were in interior provinces (Henan, Hunan, Sichuan, and Hubei), accounting for 28% of the combined GDP of the 10 largest provincial economies.

The presently weak thermal coal demand and drop off in steel production evidenced by reduced coking coal demand bode poorly for these interior provinces’ ability to underpin growth in the near-term and we think it realistic to expect continued economic stagnation at least through the October 2012 political transition period. No major policy changes are likely until after the 2,270 delegates of the 18th National Congress of the Communist Party of China meet to transfer power to a fifth generation of PRC leadership.

***

Gabriel B. Collins and Andrew S. Erickson, “Downturn to ‘New Normal’? China’s Consumer Economy is Rolling Over and Sales of Chicken, Cars, and Shoes Are Taking a Hit,” China SignPost™ (洞察中国) 60 (1 August 2012).

Beijing is likely to come under more significant pressure to implement stimulus measures as key parts of the consumer economy slow. With growth remaining lethargic in the U.S. and Euro zone, China’s consumers are badly needed to pick up the slack. But the data over the last two quarters suggest that China’s consumer class is also becoming a bit less sure about the future, and guarding their wallets accordingly. …

The slowdown in sales of key consumer goods is a telling element of today’s larger China market story: growth that might seem reasonable or even impressive in mature Western economies, but that is a significant comedown from China’s largely pedal-to-the-metal growth since reforms began in 1978. The Chinese Communist Party’s legitimacy and policies revolve around robust economic growth and the slowdown poses a major challenge for China’s fifth-generation leadership, poised to assume power at the 18th Party Congress this October.

The old growth model that worked so well in many ways for the past three decades has largely run out of gas, a new model based on greater consumer demand will be hard to implement because of strong vested interests that join political and economic power to degrees unparalleled in the West, and global demand for Chinese exports appears likely to remain disappointing for at least the next 12 months. Major policy changes in Beijing are unlikely as everyone waits for China’s next paramount leader, Xi Jinping, to consolidate power and build consensus behind the policies he will pursue. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Like it or Not: State Oil Company Becomes ‘Flag’ in South China Sea,” China Real Time Report (中国事实报), Wall Street Journal, 7 June 2012.

Update: “Long Tao” is apparently a pseudonym, most likely for Dai Xu. Dai is a People’s Liberation Army Air Force (PLAAF) colonel (not a senior colonel) and hence not the most senior of PLA officers.

Sometimes oil companies follow the flag, sometimes the flag follows them — and sometimes they themselves become the flag.

The third scenario has come to pass in the highly contested South China Sea with the recent launch of a new deepwater rig by China’s state-run China National Offshore Oil Corporation (CNOOC) roughly 320 kilometers south of Hong Kong.

On May 9, CNOOC Chairman Wang Yilin described the company’s new rig in terms befitting of an aircraft carrier, calling it “mobile sovereign territory” and a “strategic weapon” for developing South China Sea energy resources – a statement that has led many to wonder whether CNOOC is in effect serving as a tool of state policy in the South China Sea.

At the very least, it seems Beijing is permitting CNOOC to increase operations in a maritime arena in which the Chinese government has actively sought to prevent other nations from conducting similar operations—even as close as 70 miles from their own coasts. And it puts CNOOC equipment and personnel in a position in which it would be very difficult for Beijing not to defend them in the event of tensions or crisis.

Beijing probably has not directly ordered CNOOC to drill. That would be redundant given the company’s longstanding plans (pdf) to expand its deepwater production in the South China Sea. That said, the close correlation between China’s official policy stance and national interests and CNOOC’s desire to expand its South China Sea oil & gas production effectively make it a tool of state policy whether or not it sees itself as a private actor.

In addition, tacit state backing could embolden CNOOC to consider pushing deeper into the South China Sea. We do not see this as a high probability at present, but the apparent coincidence of state and corporate interests displayed in the current case suggest that the risk of China deciding to drill outside its internationally-accepted exclusive economic zone has risen.

The new rig, dubbed the Haiyang Shiyou 981, greatly expands CNOOC’s drilling options. China’s old rigs are typically only able to drill in waters less than 200 meters deep. In contrast, the HYSY 981 can drill in up to 3,000 meters of water, giving CNOOC the ability to extract oil and gas virtually anywhere in the South China Sea apart from the deepest parts of the abyssal plain.

Notable locations include deep waters near the Paracel and Spratly islands and other areas within what is known as the “nine-dotted line,” a u-shaped dotted line printed on maps published in China that covers the vast majority of the South China Sea and which Beijing seems to view as a boundary within which China has priority rights of resource development.

CNOOC’s current drilling area clearly lies within Chinese-administered waters, but is close enough to disputed zones that China’s neighbors will likely interpret CNOOC’s actions as the commercial maritime equivalent of a show of force near a disputed border. The new deepwater rig provides a national flag platform that extends Chinese companies’ options for drilling in the South China Sea and has aroused widespread concern among China’s neighbors, who likely fear it represents the first step in China’s unilateral assertion of control over maritime zones and resources in contested portions of the sea.

Like any listed company, CNOOC generally seeks to maximize profits and keep shareholders happy. Beyond East Asia, in fact, CNOOC’s actions appear to be relatively independent of specific Chinese foreign policy objectives. In the South China Sea, however, both direct and indirect factors may cause CNOOC to function effectively as a tool of China’s foreign policy.

Since June 2011 Beijing has tried a more measured approach to managing claims. Yet influential voices affiliated with the People’s Liberation Army continue to express positions at odds with this more peaceful approach. Some—such as senior PLA officer Long Tao—even advocate surgical strikes to reclaim reefs and waters occupied by the Philippines and Vietnam as a means of teaching the smaller nations a lesson. While Long’s hawkish stance, cited recently in an essayby Henry Kissinger, does not represent official Chinese policy, it reveals a significant strain of thought among PLA officers that their civilian leaders are either unwilling or unable to suppress. Against this backdrop, China’s maritime neighbors may well see CNOOC’s new exploration program as a double standard favoring Chinese development at others’ expense.

Chinese oil producers typically behave in a market-oriented, profit-driven manner. However, “typically” does not mean “always.” The timing and wording of CNOOC’s statements about the rig deserve special attention because they take place in a well-armed neighborhood where multiple governments must manage intense nationalist pressures and because the risks of miscalculation that could spark armed conflict are uncomfortably high.

In a commodity market, investors’ risk perceptions (and consequently the market) are often most forcefully moved by surprises and events that represent the exception to the generally-accepted view and spark feelings of fear and uncertainty. Thus, CNOOC’s decision to move its new deepwater drilling rig into an area near an internationally-disputed zone merits a thorough assessment, not a glib dismissal that strategic concerns don’t matter.

A commercial entity can play vital roles in advancing national interests and providing services that the government itself may not be able to provide. Private oil companies based in Western countries often play a substantial, if unstated, role in shaping and advancing national foreign policies, particularly regarding energy security. One example is the close cooperation and communication between the U.S. government and Exxon and Chevron when the Caspian Sea oil reserves opened to outside investors in the early 1990s.

Recent events in China have showed that during a time of crisis the government has the power to press state-controlled companies analogous to CNOOC into national service. In the wake of the massive snowstorms that disrupted coal supplies in early 2008, Premier Wen Jiabao calledon transport providers to press all available assets into service. China Ocean Shipping Co. subsequently deployed 34 extra bulk carriers to help replenish dwindling thermal coal stocks.

CNOOC’s actions suggest that the company has the potential to serve as a de facto arm of state policy in a much more direct manner than the China National Petroleum Corporation ever did in Sudan. The recent rig deployment merits careful discussion and analysis because the issue is likely to repeat itself as CNOOC pursues greater production in the South China Sea amidst rising tensions between China and its maritime neighbors.

China’s move raises the likelihood that its maritime neighbors will consider similar assertive moves to assert sovereignty over their claims in disputed zones — moves Beijing is likely to try to shut down. How might China respond if PetroVietnam attempts to initiate a drilling program in the Spratlys or Philippine Department of Energy renew its exploration near Scarborough Shoal (Huangyan Island), where Chinese and Philippine vessels have repeatedly confronted each other since March 2011?

Given the stakes involved, CNOOC will likely find that the South China Sea—however inviting in terms of potential resources—is a politically-complex place in which to operate, and that it will not be able to make decisions on market factors alone.

***

Gabe Collins offers his personal perspective concerning the latest annual Pentagon report on China’s military.

Gabe Collins, “12 Things Missing from China Report,” The Diplomat, 1 June 2012.

The latest version of the Pentagon’s report on China’s military rise was disappointing. There’s plenty that has been missed out.

The progressive neutering of the annual Pentagon China military power reports is unfortunate, as the report has been among the most authoritative sources of information on specific Chinese military capabilities in recent years. Given the People’s Liberation Army’s unwillingness to reveal this information itself, the report has been one of the few reliable sources of transparency to inform foreign analysts, scholars, and citizens about important Chinese military developments that often have global repercussions. China has experienced important military and security changes over the past year, yet aside from its reformatted font and graphics, the 2012 report proves thin on new content.

While Chinese government spokespeople consistently criticize the Pentagon reports, they don’t provide specific evidence of inaccuracies. There’s no reason to water the report down in the face of criticism unsupported by factual counter-evidence, as doing so deprives citizens around the world of the opportunity to monitor the actions of governments – Chinese, U.S., or any other – and hold them accountable for their actions.

Moreover, like any other sovereign country, China is free to publish its own reports about the U.S. military, and already does so regarding its views on U.S. human rights. It would be very frustrating to think that certain officials in Washington were, at Beijing’s behest, effectively imposing self-censorship of useful and beneficial public discussions of China’s growing military capabilities.

In this spirit of transparency and government accountability, the analysis below looks at the 12 most critical shortcomings and omissions of the 2012 China Military Power Report.

1) The American taxpayer should have access to the highest quality source information on China’s military development given the implications for U.S. national interests. Shying away from critical analysis of important aspects of Chinese military development is a grave disservice to forward deployed U.S. forces in Asia. Our servicemen and women need American taxpayers to be kept well apprised of China’s rapidly growing military power so that voters will be ready to support measures to pay for equipment needed to adapt to the changing circumstances. The Office of Naval Intelligence’s detailed 2009 report on China’s naval development provides an excellent example of a report that provides the type of detail and insights that taxpayers deserve. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Is China About to Get Its Military Jet Engine Program Off the Ground?” China Real Time Report (中国事实报), Wall Street Journal, 14 May 2012.

Tensions in the South China Sea—most recently with the Philippines—and Beijing’s unease about Washington’s renewed strategic focus on Asia are likely to strengthen calls from the People’s Liberation Army (PLA) for more modern fighters and strike aircraft. Russia has historically supplied the high performance military jet engines that power these craft. However, China’s defense industry is working hard to become capable of mass producing Chinese-made military jet engines in order to end dependence on Russia, give China maximum strategic flexibility, and begin to compete with Russian-made combat aircraft in export markets.

But how soon is China’s domestic jet engine effort likely to achieve lift-off?

China’s inability to domestically mass-produce modern high-performance jet engines has been a persistent Achilles heel of the Chinese military aerospace sector. Although Chinese military engineers have made progress is building jet engines, the effort continues to suffer from problems with standardization and a shortage of skilled workers, in addition to an inability to consistently produce high quality turbine blades. Indeed, a recent article in People’s Daily quotes Russian sources saying China can copy most parts of the AL-31 engines that power much of China’s J-10 and J-11 fighter fleets, but still must import turbine blades from Russia.
The problems have likely slowed development and production of the J-15, J-20, and other late-generation tactical aircraft and are now attracting political attention at the highest levels.

In late 2010, President Hu Jintao gave Gan Xiaohua, chief engineer of the Air Force Armament Research Institute, an award in recognition of his 26 years of work on China’s military jet engine programs. High-level leadership engagement is important to help break down bureaucratic barriers that Mr. Gan says have hindered China’s ability to take a more integrated approach to building a jet engine industrial base and production infrastructure.

Despite the increased attention and resources China has focused on the manufacturing of jet engines, Mr. Gan’s concerns appear to remain valid. Engine production facilities remain geographically divided between the cities of Shenyang (Liaoning Province), Xi’an (Shaanxi Province) and Anshun (Guizhou province). This organizational structure produces more micro-level, but less macro-level, “competition” than Western norms. In addition, publicly reported figures concerning numbers of Chinese personnel working on particular programs appear surprisingly low by Western standards—unless there are significant “off balance sheet” resources somewhere else.

With jet engines, “Western standards” would appear to remain relevant, as the world’s few top jet engine producers are all located in the U.S. and Western Europe (with Russia a distant second in quality). Lack of cooperation and coordination among the various branches of the PLA the jet engine end-users, appears to be a problem. Localized bargaining and patronage may produce duplication of effort, mismanagement of resources and increased time-to-market. Dispersing resources among competing research entities to the extent that China does may be counterproductive, particularly at this stage of development.

The Soviet defense industrial base, on which China’s was originally modeled, failed in precisely this area: Talented designers and technicians presided over balkanized “feudal” design bureaus and irregularly-linked production facilities. Lack of standardization and quality control rendered that system less than the sum of its parts, helping the U.S. to win the space race with its superior systems integration—as facilitated by such private corporations as AT&T.

One of China’s great theoretical advantages over earlier Soviet efforts—widespread access to and exploitation of foreign technology—has worked in other areas previously, but it may prove problematic in practice when developing and producing systems as complex and demanding as high performance jet engines.

Standardization and integration, essential for jet engine development, may suffer particularly from an ad hoc, eclectic approach to strategic technology development and acquisition. Without advanced quality management practices such as Six Sigma or Total Quality Management (TQM), sophisticated components and systems design and integration capabilities, and an organizational culture that ensures honest reporting of problems, China’s technology will not add up to high-performance engines in practice. And with jet engines, there is little if any room for error or substandard approaches.

China’s ability to resolve the domestic engine production problem matters because if China’s engine makers can attain the technical capability level that U.S. manufacturers had 20 years ago, China will be able to power its latest-generation fighter and strike aircraft with domestically-made engines.

The new J-20 strike fighter program (first unveiled during Defense Secretary Gates’ January 2011 visit to China), especially needs domestic engine development and production breakthroughs because Russia appears reluctant to sell the high-powered engines that could enable the J-20 to supercruise (sustain supersonic flight without using inefficient afterburners) and thereby match the performance of the world’s most modern fighters such as the Lockheed Martin F-22 and Sukhoi T-50/PAK FA. Such developments would help cement China as a formidable regional air power and deserve close attention from policymakers.

However, evidence still suggests that China’s main military jet engine maker—Aviation Industry Corporation of China (AVIC)—is struggling to maintain consistent quality control as it scales up production of the WS-10 Taihang turbofan that China hopes to use to power more of its fighter fleet. This issue is causing problems with reliability and keeping China’s tactical aircraft heavily reliant on imported Russian engines. China’s July 2011 order of 123 additional AL-31 jet engines supports the view that domestically-made engines still are not good enough to rely on as the mainstay to power Chinese fighters.

The latest jet engine import numbers suggest Chinese engines may now power roughly 20% of the country’s most modern fighters and strike aircraft as well as the JF-17 fighters it is exporting to Pakistan. That means at least 80% of China’s tactical aircraft fleet runs on Russian-made engines and will likely continue to rely substantially on imported Russian engines to support its tactical aircraft programs over the next two years. China’s high-performance jet engine programs are nearing takeoff but they, and China’s development of a more competitive precision manufacturing sector, appear to still have some additional runway ahead of them.

***

Andrew S. Erickson and Gabriel B. Collins, “China’s Rising Seaborne Food and Fuel Imports: Propelling Naval Expansion?” China SignPost™ (洞察中国) 59 (12 May 2012).

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

Strategic Horizon 1C: The U.S.-China relationship will be central to international relations in the twenty-first century, as the two great Asia-Pacific powers compete, coexist, and cooperate across the full spectrum of national capabilities. While they share many important interests and are increasingly interdependent, particularly in the economic realm, Beijing and Washington regrettably retain presently-irreconcilable differences regarding important security issues. While this friction can likely be managed, albeit at the cost of tremendous effort and patience on both sides, occasional crises are likely, and conflict cannot be ruled out completely if wisdom and diligence prove insufficient. The best way to avoid conflict is to understand its potential nature and cost.

To that end, this four-part series will examine four major issues:

  • China’s Near Seas military focus and capabilities
  • China’s economic environment and implications for military development
  • Chinese energy and resource imports and their potential to drive naval expansion
  • China’s conflict triggers and mitigating factors, particularly economic interdependence

While this series will retain China SignPost™ (洞察中国)’s traditional Sino-centric focus, it must be noted that the U.S. and its capabilities, policies, and actions clearly represent a major part of the strategic equation, and Beijing clearly has its own views and concerns about them.

Chinese Energy and Resource Imports and Their Potential to Stimulate Naval Development

The extent to which Chinese energy and resource import trends might drive expansion of China’s navy and “blue water” capabilities is one of the most important yet difficult questions for analysts forecasting Beijing’s military development.(1)

Experts agree that China’s imports of energy resources such as crude oil will likely rise significantly in coming years.(2) In 2011, China imported roughly 40% of its crude oil supply, 182 million tonnes of coal (3), roughly 6% of total demand; and 12% of its natural gas supply by sea. More importantly, these numbers are likely to rise. For instance, even if the Chinese economy slowed substantially, the country could still add more than 300,000 barrels per day of new crude oil demand each year—the equivalent of adding a Philippines to the global oil market annually.

Geologic and economic realities strongly suggest that China’s dependence on seaborne energy imports will continue to surge. China’s domestic oilfields are hard pressed to maintain current output levels, and barring major breakthroughs, will not provide a net expansion in domestic supplies that could replace oil imports.

As a result, more than half of China’s total oil supply is now imported. Roughly 90% of imports come by sea and pipeline construction will not reduce this, as oil output growth in Russia and Kazakhstan—China’s overland oil suppliers—has not kept pace with China’s rising oil demand. Russian oil production grew by 170 thousand barrels per day (bpd) in 2011, while China’s oil consumption grew by 566 thousand bpd during that same period.

Grain imports are also likely to rise significantly, even though China already obtains 67% of its soybean supplies by sea. If each of China’s roughly 200 million “middle class” who have enough disposable income to periodically eat out begin to consume one five-ounce chicken sandwich per week, this would create an additional 3.2 million tonnes per year of grain demand (in the form of corn and soybeans). China’s push to rebalance its economy in favor of domestic consumption, coupled with a small per capita arable land base and a water supply crisis in the North China wheat bowl, is generating increased seaborne imports of staple grains from places like Australia, the U.S., Brazil, and Argentina.

Securing China’s Seaborne Natural Resource Imports

Under a wide range of plausible scenarios, Chinese energy/natural resource imports will continue rising. Less clear is how China might respond to rising dependency on foreign-sourced seaborne oil, mineral, and food. Some analysts believe that Beijing will continue to free ride off U.S.-led sea lane security that protects oil and natural resources being shipped to any different Asian consumers. Others contend that Beijing will be impelled to build a blue water navy to defend its resource lifelines and protect its trade.

People’s Liberation Army Navy (PLAN)-affiliated writers often advocate that their service develop further capabilities to protect maritime transit and resources. Together with many of their civilian counterparts, they view such comparatively abundant and under-exploited resources, newly accessible thanks to emerging technologies, as timely replacements for increasingly depleted continental reserves. However, opinions on the nature and extent of the threat to China’s sea lane security and what corresponding policies are feasible and desirable vary widely, and there appears to be an extreme lack of consensus across the board.

These factors make it extremely difficult to predict the extent to which natural resource imports are likely to stimulate PLAN development. While some researchers emphasize the extent of China’s proximity to Russian energy sources, domestic energy supplies, and political ability to ration supplies for military use in crisis, few serious experts dispute the overall trend of higher dependence on imported natural resources and the strategic vulnerabilities that might result. There is greater debate concerning how Beijing is likely to respond to the challenge.

Some analysts go so far as to view concerns over protection of seaborne natural resource imports as a potent, rapid driver of Chinese blue water expansion. They tend to cite statements by Chinese experts expressing grave concern about Chinese seaborne energy reliance. Others emphasize the inherent difficulty of blockading China or Chinese analyses citing the advantages of relying on the public good of sea lane security provided by the U.S. Navy and openness to cooperation as reasons why Beijing has not (yet) assumed defense of its critical sea lanes.

In fact, China appears at a strategic crossroads. Today’s objects of focus in the Near Seas offer compelling strategic cohesion and consensus. There is far less agreement concerning the ability and advisability for China to develop similarly kinetic capabilities in the Far Seas/Oceans. It thus seems likely that China’s long range “blue water” naval capability will primarily be a slowly-growing, lower-level supplement to the naval forces geared for a conflict closer to China’s coast, unless or until one or more of the following conditions are met:

  • China makes major progress concerning Near Seas objectives
  • China achieves economic strength sufficient to pursue intense development in both arenas
  • Significant events or strategic changes convince Beijing that further action is needed

Growing Resource Imports Will Likely Influence Naval Procurement

China’s tremendous appetite for natural resources will remain a key influence behind economic and maritime security policies in the East Asian region and abroad. Geographically, Chinese policymakers will likely focus the bulk of their efforts on the South China Sea and Indian Ocean regions, as they form the most active seaborne commodity corridor feeding China.

Providing sea lane security in these areas will involve China’s uniformed maritime security services (and civilian counterparts, in the South China Sea). It will also likely become a focal point as the PLAN begins building its first carrier group. China’s State Oceanic Administration has ordered 36 additional patrol vessels and also plans to add 16 patrol aircraft to its force in coming years. (4)

These vessels could be used for sea lane security patrols in the South China Sea and thereby help free up PLAN assets for deployment further afield. (5) The PLAN itself is also presently building the new Type 056 light corvette, which appears geared toward operations in the South China Sea area. (6) Finally, the December 2011 deployment of the 3,000-ton Haijian 50 (7), China’s largest coast guard patrol vessel, to disputed areas of the East China Sea suggests that Beijing intends to use its growing civil maritime forces to help secure key maritime transit zones in coming years.

Natural resource security is of course far from the only reason that deck aviation platforms would be useful to the PLAN, but natural resource-driven sea lane security missions could well comprise a major part of the “protect China’s overseas economic interests” mandate that carrier advocates can cite to gain traction in defense budget allocation debates.

Resource security missions could use either carriers, amphibious vessels (8), or both; and the way Beijing allocates resources for carrier and amphibious vessel construction over the next five years will suggest how extensively the PLAN wants to be able to handle higher-intensity maritime contingencies as opposed to simply being able to show the flag along key sea routes and suppress piracy.

A carrier group would offer immense diplomatic benefits in providing a visible Chinese naval presence in the South China Sea, Southeast Asia, and along key Indian Ocean sea lanes. Ultimately, several carrier groups would be necessary for persistent presence in these areas, however, to allow for periodic training and maintenance.

Greater focus on carrier group development would suggest that Chinese leaders want to bolster their capacity to handle higher-intensity expeditionary missions than would be the case if ship procurement focuses more on smaller deck aviation-capable platforms such as amphibious vessels.

Bottom Line: China’s rising dependence on seaborne imports for critical fuel and food supplies will help the PLAN leadership argue for the resources and support it would need to enhance China’s long-range naval power projection capabilities. The pace and extent of this modernization remains highly uncertain, however, and will hinge heavily on China’s finances and perception of threats to its maritime resource lifelines.

1. For detailed analysis, see Andrew S. Erickson and Lyle J. Goldstein, “Gunboats for China’s New ‘Grand Canals’? Probing the Intersection of Beijing’s Naval and Energy Security Policies,” Naval War College Review 62.2 (Spring 2009): 43-76, http://www.usnwc.edu/getattachment/f655705e-0ef3-4a21-af5a-93df77e527fa/Gunboats-for-China-s-New–Grand-Canals—Probing-t.
2. Hearing: China’s Global Quest for Resources and Implications for the United States, U.S.-China Economic and Security Review Commission 26 January 2012, http://www.uscc.gov/hearings/2012hearings/written_testimonies/hr12_01_26.php.
3. “NDRC: China’s Coal Imports/Exports, Production and Consumption Performance in 2011,” 2 February 2012, http://www.chinamining.org/News/2012-02-02/1328167659d53916.html
4. Wang Qian, Maritime Forces to be Beefed up amid Disputes,” China Daily, 17 June 2011, http://www.chinadaily.com.cn/cndy/2011-06/17/content_12718806.htm.
5. Lyle J. Goldstein, Five Dragons Stirring Up the Sea: Challenge and Opportunity in China’s Improving Maritime Enforcement Capabilities, Naval War College China Maritime Study 5, April 2010, http://www.usnwc.edu/Research—Gaming/China-Maritime-Studies-Institute/Publications/documents/CMSI_No5_web1.pdf.
6. “Could This Be the First Photos of Type 056 Light Corvette Under Construction?” [sic] China Defense Blog, 3 January 2012, http://china-defense.blogspot.com/2012/01/could-this-be-first-photos-of-type-065.html.
7. “Largest Patrol Ship Makes First Trip to East China Sea,” Global Times, 14 December 2011, http://www.globaltimes.cn/NEWS/tabid/99/ID/688384/Largest-patrol-ship-makes-first-trip-to-East-China-Sea.aspx.
8. “Fourth Chinese Navy Type 071 LPD launched at Shanghai Shipyard,” Naval Forces News – China, Navy Recognition, 28 January 2012, http://www.navyrecognition.com/index.php?option=com_content&task=view&id=301.

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Andrew S. Erickson and Gabriel B. Collins, “Shenlong ‘Divine Dragon’ Takes Flight: Is China Developing its First Spaceplane?” China SignPost™ (洞察中国) 58 (4 May 2012).

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

The age of the spaceplane upon us, and it is trans-Pacific, with the U.S. and China the only current active participants. Winged spaceplanes operate as spacecraft in space and aircraft in Earth’s atmosphere, and typically land on runways. They range from hypersonic cruise vehicles (HCV) capable of maneuvering at Mach 5 (3,840+ mph/6,150+ kmh) or more to reusable launch vehicles (RLV)s like the Space Shuttle designed primarily to ferry cargo to orbit and back.

Defense Advanced Research Projects Agency (DARPA) has just released details on the 11 August 2011 test flight of the Force Application and Launch from the Continental U.S. (FALCON) Hypersonic Technology Vehicle 2 (HTV-2). Constructed by Lockheed Martin Corp., this HCV is part of a multiyear DARPA effort to develop an air-breathing platform that could deliver a payload at Mach 20 (~13,000 mph) via near-space altitudes anywhere in the world within an hour.

While valuable test results were obtained, and HTV-2 reached its planned speed, the flight ended after 9 minutes rather than the planned 30 with an ocean impact far short of the Kwajalein Atoll, whose vicinity it had been hoped to reach from Vandenberg Air Force Base near Santa Barbara, CA. Shockwave-induced skin peel and resulting destabilization of the vehicle ended that plan. A previous test flight occurred 22 April 2010, its conclusion similarly premature. No future test flight plans have been scheduled, apparently, leaving the program’s future uncertain.

More promisingly, Boeing’s X-51 WaveRider unmanned supersonic combustion ramjet (scramjet) demonstrator aircraft achived Mach 5 free flight from a B-52 bomber off California’s coast on 26 May 2010. A 13 June 2011 test flight succumbed to engine problems, however. A collaborative effort among the U.S. Air Force (USAF), DARPA, NASA, Boeing, and Pratt & Whitney Rocketdyne, it is run by the USAF Research Laboratory’s Propulsion Directorate.

Most successfully, Boeing’s X-37 Orbital Test Vehicle (OTV) has been tested three times without incident. Designed to conduct experiments and send satellite sensors and related technology to and from space, the X-37B is a vertical-takeoff, horizontal-landing spaceplane designed to examine and repair satellites in low earth orbit (LEO). Based on NASA’s X-37 design, and drawing on DARPA inputs, the program is run by the USAF. On 5 March 2011, in the USA-226 mission, the second X-37B OTV was launched into LEO from Cape Canaveral, where it has been ever since. The first orbital mission began on 22 April 2010 and ended successfully at Vandenberg 225 days later on 3 December 2010. A third is planned for fall 2012. Prior to these missions, only the Soviet Buran reusable orbital vehicle had performed an automated post-orbital landing, after returning from a two-orbit flight on 15 November 1988. Now Boeing is planning a larger X-37C version.

Meanwhile, across the Pacific, Beijing may be entering the spaceplane era faster than many would have predicted. A similarly-militarily-relevant system appears to be emerging with the development of China’s own vehicle. Multiple Chinese-language media outlets state that on 8 January 2011, China completed a test flight of the Shenlong (神龙/Divine Dragon) spaceplane.

The test flight announcement from a Sha’anxi TV station came within a month of the U.S. X-37B orbital vehicle’s return to earth after its first test flight and come almost simultaneously with China’s test flight of its J-20 fighter prototype. This reflects China’s growing technical proficiency in the aerospace sector. It hints at China’s pursuit of space systems that can potentially switch quickly between civilian and military missions.

Shenlong’s test also reflects a shrinking time gap between when the U.S. first reveals a prototype military system and when China publicly shows a system comparable in type (if not equivalent in capabilities or immediately operational). For previous aerospace developments, China typically revealed its systems’ existence at least 15 years after the U.S. first showed its analogous platforms (Exhibit 1).

The immediate implication is that in some areas of space operations, China may be attempting to emulate the U.S. and develop advanced capabilities that could give it strategic advantages; as well as to reveal selected development efforts in order to further patriotism at home and deterrence abroad. Given the high U.S. reliance on space-based C4ISR capabilities, Chinese space platform developments such as Shenlong warrant close attention.

Exhibit 1: Gap in years between first unveiling of select U.S. and Chinese weapons systems

Source: China’s Defence Today, USAF, Southern Weekend, Chinese Internet

Shenlong’s development

Data on the Shenlong program remain sparse in both English and Chinese-language sources. Perhaps drawing on its successful and wide-ranging R&D on extended-range cruise missiles, China’s defense establishment also appears to conducting conceptual design work on HCVs. At an international conference in 2006, experts from China Academy of Launch Vehicle Technology (CALT) asserted that RLVs represent “the main trend of space transportation system[s].”

With respect to new-generation Long March launch vehicles, they offered a “RLV roadmap… including development goals, system concepts, and approach[es] for maturing key technologies.” The researchers stated that CALT would decide whether to develop an RLV within the next few years, and possibly select between “two system architectures,” both of which entailed “taking off vertically, landing horizontally, two stage to orbit, and partially reusable.”

One Chinese study has outlined the results of modeling and simulation of a scramjet-powered vehicle with a range of between 1,000-2,000 km, flying toward its target at an altitude of between 25-30 km and speed of Mach 6. Mark Stokes tells us that scramjet engine testing may be underway at China Aerodynamics Research and Development Center (CARDC, 中国空气动力研究与发展中心) in Mianyang, Sichuan. Another study focused on a HCV adopting a skipping trajectory with an upper altitude of 60 km and lower altitude of 30 km. In addition to researching optimal design methods, and addressing specific guidance, navigation, and control issues, Chinese aerospace engineers also have been carrying out basic research into an air-turbo rocket (ATR) propulsion system, an air-breathing system that combines elements from both turbojets and rocket engines. Simulations validated one design that operates at speeds up to Mach 4 and altitudes of up to 11 km.

As for Shenlong specifically, Chinese sources say it is part of the 863 State High-Tech Development Plan (国家高技术研究发展计划) and that the People’s Liberation Army (PLA) considers it a priority system for development. In October 2006, Jane’s states, China Aerospace Science and Technology Corporation (CASC) displayed an Air-launched Satellite Launch Vehicle (ASLV) three-stage solid propellant vehicle model. It had dual small delta-shaped wings, similar to the U.S. Pegasus air-launched SLV. Chengdu Aircraft Corporation’s 611 Institute led Shenlong’s design and testing, according to Jane’s. Jane’s also believes the Nanjing University of Aeronautics and Astronautics, Northwest University, and the Harbin Technical University assisted in the craft’s design and testing.

Today the CASC First Academy contains a new shop, the 10th Research Institute (Near Space Flight Vehicle Research Institute), devoted to HCV design. Formerly chief designer of a major solid fueled ballistic missile system, Director Bao Weimin [包为民] also enjoys influence as CASC First Academy S&T Committee Director, head of the PLA/General Armaments Department (GAD)’s General Missile Technology Expert Working Group, and deputy director of the PLA/GAD Precision Guidance Expert Group under the 863-4 Advanced Defense (先进防御) projects series.

According to Mark Stokes and Dean Cheng, “The establishment of such a separate research institute – one that focuses on a single capability – within China’s premier launch vehicle and ballistic missile academy serves as a prominent indicator of the priority that senior civilian and military leaders place on new generation long-range precision strike vehicles.”

Physical dimensions

In its currently observable configuration, at least, Shenlong appears much smaller than America’s X-37B. We are not aware of any Chinese sources disclosing Shenlong’s precise dimensions. Based on available photos, we estimate that its body is roughly 1 meter tall, with a length of between 5 and 6 meters (Exhibit 2). As such, it is likely only about 1/3 the size of the X-37B. By contrast, Jane’s estimates larger dimensions of 1.1 m and 12.0 m respectively, with a 4.0 m wingspan, though this might apply to another three-stage ALSV variant. The disparity could be caused by several different factors, including the possibility that:

–The 2006 model was refined into a smaller real world version due to engineering considerations;

–The existence of a smaller version in 2006 was considered sensitive and thus was not publicly disclosed at the same time;

–There are two different versions (large/small) with differing missions;
For example, the larger version ASLV may enable insertion to geostationary orbit (GEO), whereas the smaller Shenlong need only reach LEO, and

–Payload miniaturization may have resulted in a smaller launch configuration, allowing for lower cost and opportunity to build more vehicles for flexibility.

Indeed, the existence of three separate U.S. HCV programs suggests both a range of programmatic possibilities and direct sources of inspiration for China. In any case, Shenlong’s small size may have been dictated in part by the ability of the H-6 bomber to carry it under its fuselage, attached by a specialized pylon. Images of an alleged Shenlong spaceplane prototype have a body configuration remarkably similar to a small version of the U.S. Space Shuttle or the X-37B (Exhibit 3).

Exhibit 2: Shenlong as compared to X-37B

Source: Chinese Internet, China SignPost™, USAF

Exhibit 3: Alleged images of new Chinese spaceplane prototype
Caption at top of slide reads “China’s trans-atmospheric vehicle tested successfully”

Source: Chinese Internet

According to Jane’s, Shenlong may have INS/GPS navigation. It is reportedly designed to be launched from an H-6 at an altitude of ~10 km. Following ignition, a first-stage motor would take the 13,000 kg spacecraft to 490 km in ~8 minutes before a second stage burn would take it to 600 km altitude. A third stage would then accelerate the spacecraft prior to dispensing a satellite of ~50 kg into sun-synchronous orbit before landing on a runway in its return to Earth. These parameters might apply to Shenlong or an ASLV variant thereof, and it is possible that the current Shenlong vehicle is a technology demonstrator for the latter or even a different follow-on program.

Strategic Implications

At a minimum, Shenlong appears to be a technological development/validation program. A successful Chinese spaceplane program would have two key strategic implications. First, on the broad level, it would signify that the Chinese space program has come one step closer to being able to build a Space Shuttle-type capability. On a related note, further test flights, particularly if they involve X-37B-style maneuvering by a larger derivative of Shenlong, would also strongly suggest that China’s command and control system for space assets has become much more capable, with commensurate implications for both military and civil space operations. Which service would control Shenlong remains uncertain, as GAD, the PLA Air Force (PLAAF), and even the Second Artillery contend for control of operational space assets—and some Chinese thinkers argue for the formation of a separate Space Force (天军). Not surprisingly, as Kevin Pollpeter informs us, PLAAF-connected writers are already citing spaceplane development as yet another reason why their service should handle space operations.

Second, spaceplanes confer a number of capabilities that conventional launchers cannot offer. First of all, they are reusable and their payloads can be changed between missions. These features offer versatility and may even offer some cost savings, especially for reconnaissance missions. Rocket boosters for putting a spaceplane in orbit might cost ~US$150-200 million.

Spaceplane costs also include the spaceplane itself (with robust structure and shielding), extensive post-flight refurbishment, integration costs, possible manpower costs for flying the spaceplane, payload costs, and recovery costs. Launching a relatively small satellite with a spaceplane as opposed to on a single-use rocket may not realize large costs savings, but it is an option that Chinese planners would likely want to have available eventually.

Larger future iterations of Shenlong could materially enhance China’s space-based C4ISR capabilities through both on-board sensor systems and the ability to deploy microsatellites and other sensor systems that boost space situational awareness. Spaceplanes can also rapidly change orbits to hinder tracking, survey different areas, or potentially avoid an opponent’s anti-satellite (ASAT) systems. During its maiden flight, the X-37B was said to have changed orbits, confounding amateur spotters for several days until one located the craft in its new orbital path.

Finally, a spaceplane’s ground-based status could allow it to sidestep international agreements restricting the deployment of weapons in space and add to its appeal as a potential ASAT platform. Many Chinese writers see the X-37 program as evidence of American determination to develop anti-satellite (ASAT) capability and engage in a space arms race. At the same time, according to Stokes and Cheng, “China’s counterspace program appears to parallel interest in countermeasures [e.g., kinetic kill vehicles, as demonstrated in China’s 11 January 2007 ASAT test and 11 January 2010 missile defense test] against advanced U.S. long-range precision strike capabilities that would transit space, and are expected to be in place by 2025,” which might include the FALCON HTV, the X-37B, and the X-51A.

What is clear already is that China is pursuing an ambitious but methodical and well-funded space program. On 29 September 2011, for example, China launched its first space laboratory module, Tiangong-1 (天宫一号 “Heavenly Palace 1”). This experimental platform will be used to test rendezvous and docking capabilities needed to assemble a space station from a larger configuration of modules. China’s moves toward establishing a space station are attracting considerable attention, particularly as the U.S. retired its first (and, to date, only) manned spaceplane (the Space Shuttle) after just 135 missions with the touchdown of Atlantis on 21 July 2011, and now relies on Russian spacecraft to ferry its astronauts to the International Space Station.

Multimedia Sources
http://video.sina.com.cn/v/b/44970858-1304604555.html

http://www.tudou.com/programs/view/e_c2guok-gc/

***

Gabriel B. Collins and Andrew S. Erickson, “Tilling Foreign Soil: New Farmland Ownership Laws Force Chinese Agriculture Investors to Shift Strategies in Argentina and Brazil,” China SignPost™ (洞察中国) 57 (28 March 2012).

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

Chinese consumers’ growing appetite for meat is driving increased grain imports, which is great news for corn and soybean growers in Argentina and Brazil. Yet Chinese agriculture and investment companies’ interest in the pampas and cerrado are not universally welcome, and Buenos Aires and Brasilia have both promulgated laws restricting foreign land ownership.

Argentina’s Law on Rural Lands, which passed the upper house of parliament by a vote of 62-1 in December 2011, caps foreign ownership at 15% of the country’s total arable land area. For reference, the UN Food and Agriculture Organization estimates that foreigners currently own approximately 10% of the country’s arable land. The new law also sets a ceiling of 1,000 hectares per individual plot of land owned by a foreign entity and calls on the government to create an inter-ministerial national land registry to keep tabs on who owns what pieces of land.

In 2010, Brazil’s Attorney General responded to concerns driven in part by fears that Chinese investors wanted to purchase major chunks of land in Brazil’s interior by re-interpreting a 1971 land ownership law in a way that would prohibit foreign entities from owning more than 25% of any municipality or possessing more than 100 “modules” of land, which can vary from 100 to 10,000 hectares in size (Reuters). … … …

***

Andrew S. Erickson and Gabriel B. Collins, “China’s Economic Environment: Implications for Military Development,” China SignPost™ (洞察中国) 56 (14 March 2012).

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

Strategic Horizon 1B: The U.S.-China relationship will be central to international relations in the twenty-first century, as the two great Asia-Pacific powers compete, coexist, and cooperate across the full spectrum of national capabilities. While they share many important interests and are increasingly interdependent, particularly in the economic realm, Beijing and Washington regrettably retain presently-irreconcilable differences regarding important security issues. While this friction can likely be managed, albeit at the cost of tremendous effort and patience on both sides, occasional crises are likely, and conflict cannot be ruled out completely if wisdom and diligence prove insufficient. The best way to avoid conflict is to understand its potential nature and cost. To that end, this four-part series will examine four major issues:

  •  China’s Near Seas military focus and capabilities
  • China’s economic environment and implications for military development
  • Chinese energy and resource imports and their potential to drive naval expansion
  • China’s conflict triggers and mitigating factors, particularly economic interdependence

While this series will retain China SignPost™ (洞察中国)’s traditional Sino-centric focus, it must be noted that the U.S. and its capabilities, policies, and actions clearly represent a major part of the strategic equation, and Beijing clearly has its own views and concerns about them.

Rich Nation, Strong Army? Not So Fast…

History is on the march, and in many observers’ eyes, it appears to be favoring the Middle Kingdom. An unprecedented transfer of wealth from West to East is underway, with 2014 termed “the watershed year when the Asia-Pacific area will contribute within 1% as much to the global economy as the United States and the EU combined.” [i]

In the region that produced the concept of “Rich Nation, Strong Army,” and keeps it alive today—albeit in a post-imperial era,[ii] an equivalent transfer of military power would seem likely to coincide. This year, in fact, Asian defense spending is likely to exceed that in Europe.[iii]

At the center of this tectonic shift is China. Beijing’s officially reported defense budget is already the world’s second largest and is set to grow by 11.2% to 670.2 billion RMB ($106.4 billion) in 2012.[iv] This level of defense spending allows China to develop an increasingly capable military and could be raised should Beijing deem it necessary.

But, regardless of how precisely Chinese defense spending is calculated—itself the subject of much debate in foreign analysis,[v] the reality is more complex, and straight-line projections are likely to prove wrong. As in other areas, Beijing faces an uncertain economic environment and diminishing returns on key inputs. China’s leaders must therefore continue to decide how to prioritize its large but hardly unlimited defense resources.

They are likely to continue to focus on improving their military’s capabilities to further Beijing’s interests in the three “Near Seas” (the Yellow, East, and South China seas), home to the vast majority of China’s outstanding territorial and maritime claims. This is a major development in its own right, but it should not be misrepresented as anything close to a path to global military dominance. Given the economic limitations that China is likely to face increasingly, such a projection is premature, even if Beijing’s leaders favored such an approach—which they likely do not.

Alternative Scenarios for China’s Economy

There is a variety of possible Chinese growth futures, and analysts inside and outside of China heatedly debate a range of possibilities.[vi] Whatever the ultimate result, it is likely to affect Beijing’s military development significantly. China’s economy has been growing rapidly for the past three decades.[vii] Estimates emerge constantly as to when China’s economy will become larger than that of the U.S., and there are larger assumptions that China’s military power will grow in proportion. Proponents of this view cite projections like those made by Goldman Sachs and PricewaterhouseCoopers, which have predicted that China’s GDP would exceed that of the U.S. by 2027 and 2020, respectively.[viii]

Aside from several PRC-government stalwarts, notably Chief Economist and Senior Vice President of the World Bank Justin Yifu Lin—who recently declared: “It is very likely that China will maintain around an 8 percent GDP growth rate for another twenty to thirty years”[ix]—most experts believe that China’s rate of economic growth is in the process of slackening substantially and is becoming subject to some degree of uncertainty. Implications for military development are less clear, but current spending levels seem quite sustainable.

While the growth of China’s comprehensive national power may continue to proceed rapidly, it may, alternatively, abate, more than many analysts expect.[x] China is not immune to larger patterns of economics and history. History suggests that China faces costly internal and external challenges that will hinder its ability to avoid the S-Curve (logistics curve)-shaped[xi] growth deceleration that so many previous great powers have experienced,[xii] and that so many observers believe the United States is undergoing today.[xiii]

Beijing itself assumes that maintaining 10%+ economic growth is no longer feasible or desirable; Premier Wen Jiabao unveiled a target of 7.5% GDP growth for 2012 at the National People’s Congress on 5 March 2012, while 7% is the target for the current Twelfth Five Year Plan (2011-15).[xiv]

But increasing numbers of economists and policymakers are beginning to question whether even this growth trajectory can be maintained in the face of clear and substantial structural challenges[xv] that include pollution, corruption, chronic diseases, water shortages,[xvi] growing internal security spending, and a rapidly aging yet under-supported population[xvii]—all mutually-reinforcing factors that impose mounting costs on the Chinese state and economy. Indeed, Premier Wen himself noted that China faces “significantly higher costs of factors of production at home” and acknowledged that “China’s economy is encountering new problems. There is downward pressure on economic growth.”[xviii]

At very least, to maintain rapid economic growth, China needs to “rebalance”[xix] and reform its economy by embracing a new development model that is less reliant on infrastructure investment to prop up growth rates.[xx] This is the conclusion of the recent “China 2030” study co-produced by the World Bank and the Chinese government, which states: “China should complete its transition to a market economy—through enterprise, land, labor, and financial sector reforms—strengthen its private sector, open its markets to greater competition and innovation, and ensure equality of opportunity to help achieve its goal of a new structure for economic growth.”[xxi]

Unfortunately, there is widespread skepticism that this is likely to happen expeditiously, for three reasons. First, because of bureaucratic politics, dramatic policy changes are unlikely before or immediately following Beijing’s political power transition in October 2012. Second, a major difference between the last time sweeping economic reform was undertaken—in the late 1970s—and today is that three decades of prosperity have created entrenched “vested interests,”[xxii]particularly in key state-owned enterprises, whose close connections to political elites make it difficult to pursue reforms that could harm their parochial concerns.[xxiii] China’s national oil companies and coal industry, which have thwarted the establishment of a robust Energy Ministry, are prime examples of this phenomenon, which is prevalent across the board.[xxiv] Such sclerosis worries some wealthy Chinese, who are rapidly acquiring foreign passports, sending assets overseas, and even emigrating.[xxv]

Third, even if these challenges can be overcome, Chinese policymakers face a genuine dilemma in achieving a “soft landing” with regard to real estate,[xxvi] and opening financial markets and liberalizing capital flows, which often increases the risk of financial instability[xxvii]—and hence the potential for political turmoil.[xxviii]

One prominent China-based economist believes that the country’s growth will need to slow to 3-4% per year—less than half the current rate—for it to address structural imbalances in its economy.[xxix] The country’s need for rebalancing comes as it begins to face swelling costs from health problems and chronic diseases fueled by pollution and changing diets. For example, assuming that China can treat its 92.4 million diabetes patients at only 1/3 of the annual U.S. per-patient cost and that even 25% of China’s diabetics are being actively treated, the annual price for treatment alone would reach roughly US$46 billion per year. This is equal to 44% of China’s officially-stated 2012 defense budget.[xxx]

There is thus a strong possibility that China is already facing increasing headwinds that may constrain its economic growth and by extension, its future ability to spend on defense. The burdens imposed by chronic disease and other rising internal challenges reduce the potential funds available for defense spending and stand to affect hardware acquisition moving forward.

Yet perhaps even more importantly, these costs may also restrict the People’s Liberation Army (PLA)’s ability to afford expensive training, retain qualified soldiers, sailors, and airmen, and meet the substantial facilities access and logistical support costs necessary to build a more robust regional military force and limited high-end power projection ability in areas like the Indian Ocean.

If China desires to create a more globally-capable military that can project combat power to the point of being able to challenge an adversary’s naval and air forces in a distant theater such as the Indian Ocean region, its military budget needs would rise substantially, both for acquiring the platforms, and especially for training the personnel to man them and building the logistical system necessary to support such forces at a high operational tempo far from home. This currently appears to be a lower probability scenario, even if some Chinese political and military leaders would welcome such extensive capabilities.

The more probable outcome is one in which China achieves a rudimentary, limited power projection ability by building several carrier groups and expanding its nuclear-powered submarine force. Pursuing this approach would give Beijing highly visible (and eventually capable) “influencers” that it could deploy throughout East and Southeast Asia, the Western Pacific, and the Indian Ocean’s strategic sea lanes. A more capable nuclear submarine force, particularly if it includes quieter attack subs armed with long-range land-attack cruise missiles, would offer additional credibility for coercive diplomacy by Beijing as well as a mechanism for bringing hard power to bear, should the need arise.

How Effectively Can the PLA Use Additional Funding?

This question must be explored to understand the types of decisions that PLA leaders might confront if the national economy proves able to support lower military spending levels than originally anticipated. In theory, such policy options could best be eluciated by methodical analysis of Chinese defense industry production costs and subsequent maintenance costs.[xxxi]

Unfortunately, such calculations are difficult, if not impossible, to make conclusively and comprehensively using available open source information. Even for major, tangible, well-known platforms, the specifics of Chinese capabilities are extremely difficult to determine specifically. For instance, the Type 052C Luyang II-class destroyer’s command and control system cannot be determined from open sources. Previous Chinese ships used derivatives of the French Thomson CSF Tavitac naval combat system.[xxxii]

The Type 052C may use an improved system to better engage anti-ship missiles, and to process data from its helicopter; the Ka-28 ASW helicopters must pass data back to its host ship for processing. Such limitations on available detail about capabilities render making solid comparisons difficult if not impossible. Even a discrete capability with strong civilian linkages (e.g., to Chinese universities) still defies accounting, because it is difficult if not impossible to total systematically the Chinese university investment and the effective investment foreign universities make in educating engineers that return to China, much less the military investment.

Second and third order effects compound the analytical challenge. For example, manifold practical problems with using military equipment in the field (i.e., in training) under different performance parameters can deny easy quantification for anyone, including specialists in China themselves. Then there is the still-more intangible concept of net capability, or the capability of a given Chinese platform/weapons system when used in conjunction with other Chinese systems against an opponent’s constellation of weapons systems.

At the most general level of analysis, historical analogies may prove illuminating. One of the most penetrating unclassified studies available examines Japan between the first and second world wars. It concludes that, in the long run, a nation tends to spend a constant percentage of its economy on defense.

Meanwhile, the cost of ships and weapons rises far faster than inflation—at roughly 9% annually in real terms. In the interwar period, Japan’s economy grew with sufficient speed to afford the rising costs of ships and weapons, and was motivated to develop advanced surface vessels and submarines by the prospect of achieving regional naval dominance.[xxxiii] Today Beijing enjoys the economic growth, and potentially the strategic motivation, to achieve such a dramatic naval buildup—while avoiding Tokyo’s mistakes in militarism.

Even at a more specific analysis, some broader statements about Chinese defense industrial capabilities are possible. In some cases, China can produce large weapons and equipment at very competitive costs. For example, Chinese shipyards are said to be able to produce Type 071 amphibious warfare vessels (LPDs) for about one-third what it costs to build a San Antonio-class LPD in a U.S. yard, meaning that China’s costs are likely around US$565 million per ship.[xxxiv]

However, as military equipment becomes more technology intensive and less labor-intensive, China’s cost advantages decrease significantly. The J-10 fighter, for example, is estimated to cost roughly U.S.$28 million per aircraft.[xxxv] This is nearly as much as the F/A-18 C and D series and the Russian Su-34, which cost US$29 million per unit and US$36 million per unit, respectively, for aircraft that are in many ways substantially more capable than the J-10.[xxxvi]

As costs of acquiring equipment rise, so too do the costs of maintaining the new hardware, supporting sufficient training, and compensating the individuals that constitute the backbone of the military. Personnel, equipment, and operational costs are all rising for the PLA, and there will be a limit to what it can afford in the future. Increased personnel costs already consume an increasing percentage of the PLA’s overall budget as it works to improve soldiers’ living standards. PLA officers, for example, now bring home roughly US$845 (5,400 RMB) per month on average, the highest in PRC history, a very competitive wage compared to Chinese state owned enterprise employees’ average monthly earnings of closer to US$626 (4,000 RMB).[xxxvii]

The bottom line is that true military modernization will not come cheaply for China, especially in light of growing cost convergence, as well as inflation and the host of internal challenges described above that will consume funds that could otherwise potentially be invested in the military.

Near Seas: China’s Front Line, for Foreseeable Future

Constraints on Beijing’s defense spending relative to originally-anticipated baselines could begin to manifest themselves even as China challenges U.S. forces via asymmetric means. Geographically, the Near Seas deserve special focus since Beijing views them as core zones of national interests where credible access denial and combat capabilities are needed regardless of competing budget priorities. Moreover, strong land-based support from Second Artillery and aviation forces, as well as sensor and communications architecture, offer numerous cost-effective “work-arounds” concerning limitations in coordination through temporal and spatial deconfliction of weapons.

Far Seas operations (south and west of the South China Sea and east of Guam),[xxxviii] by contrast, lack these advantages, and would impose expensive and vulnerable reliance on global C4ISR and other systems.[xxxix] In the absence of significant consensus among Chinese leaders that such operations deserve prioritization, Beijing’s capabilities in this regard are unlikely to develop rapidly. China increasingly faces choices in how to allocate finite defense resources: the global revolution in military affairs (RMA) imposes corresponding increases in technology and personnel[xl] costs for China,[xli] as it does all nations determined to master cutting-edge ways of war.

Moreover, economic problems and even resulting political instability that hinder the PLA’s ability to build a more robust long-range power projection capacity could combine with rising nationalism to motivate Chinese leaders to adopt more assertive military approaches, particularly regarding unresolved territorial and maritime claims in the Near Seas. If so, the era in which China poses the greatest potential to challenge U.S. strategic interests and the efficacy of the global system—and is doing so in practice—may have already begun.

Assuming that high intensity kinetic conflict can be avoided—fortunately, a highly likely prospect, particularly given Washington and Beijing’s substantial shared interests—China’s greatest challenge to U.S. interests and the global system might thus be the already-unfolding strategic competition, friction, pressuring, and occasional crises in the Near Seas.

Bottom Line: Enriching the Nation, Strengthening a Near Seas-Focused Army

Possessing the world’s second largest defense budget will allow China to develop an increasingly capable military and spending could be increased quickly should Beijing deem it necessary. Nevertheless, in the longer term, structural economic and demographic dynamics could greatly restrict China’s ability to sustain rapid military spending growth, regardless of its leaders’ intentions. The strength of China’s army will thus hinge in large part on China’s wealth. The two-century quest to realize China’s perceived potential thus continues today, together with attendant debates.

China’s wide range of possible economic growth futures are unlikely to substantially alter its current Near Seas military trajectory, in which it is already affording significant A2/AD capabilities. Developing equivalent Far Seas capabilities, by contrast, would require tremendous spending just as a wide range of factors are likely to restrain economic growth and impose competing priorities.

[i] Abraham M. Denmark, “Asia’s Security and the Contested Global Commons,” in Ashley J. Tellis, Andrew Marble, and Travis Tanner, eds., Asia’s Rising Power and America’s Continued Purpose (Seattle, WA: National Bureau of Asian Research, 2010), 174, http://www.nbr.org/publications/issue.aspx?id=206; Andrew S. Erickson, “The U.S. Security Outlook in the Asia-Pacific Region,” in Asia Pacific Countries’ Security Outlook and Its Implications for the Defense Sector, NIDS Joint Research Series No. 6. (Tokyo: National Institute for Defense Studies, January 2012), http://www.nids.go.jp/english/publication/joint_research/series6/pdf/07.pdf.

[ii] For a discussion of Japan’s “political commitment to realize the national slogan fukoku kyohei[富国強兵, ‘rich nation, with strong army’]” see Paul Kennedy, The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000, (New York: Vintage Books, 1989), 206-09; Richard J. Samuels, “Rich Nation, Strong Army”: National Security and the Technological Transformation of Japan (Ithaca, NY: Cornell University Press, 1996). The characters for the Chinese equivalent, fuguo qiangbing, are identical. For research that explores this concept in the modern Chinese context, see Andrew S. Erickson and Adam P. Liff, “A Richer Nation Builds a Stronger Army: China’s Defense Expenditures, Economic Basis and Implications,” paper presented at “Fuguo Qiangjun Revisited: An Interdisciplinary Analysis of China’s Economic, Foreign, and Security Policy Since the Late Qing” conference, John King Fairbank Center for Chinese Studies, Harvard University, 13 May 2011, http://fairbank.fas.harvard.edu/event/felix-boecking-workshop.

[iii] “Military Balance 2012 – Press Statement,” International Institute for Strategic Studies, http://www.iiss.org/publications/military-balance/the-military-balance-2012/press-statement/.

[iv] “China’s Defense Budget to Grow 11.2 Pct in 2012: Spokesman,” Xinhua, 4 March 2012, http://news.xinhuanet.com/english/china/2012-03/04/c_131445012.htm.

[v] Andrew S. Erickson and Adam P. Liff, “Understanding China’s Defense Budget: What it Means, and Why it Matters,” PacNet 16 (9 March 2011), http://csis.org/files/publication/pac1116.pdf.

[vi] Dan Blumenthal, “The ‘Beijing Model’ Bubble,” The Weekly Standard, 12 March 2012, http://www.aei.org/article/economics/international-economy/the-beijing-model-bubble/;  Michael Schuman, “Why China Will Have an Economic Crisis,” Time, 27 February 2012, http://business.time.com/2012/02/27/why-china-will-have-an-economic-crisis/; Derek Scissors and Arvind Subramanian, “The Great China Debate: Will Beijing Rule the World?” Foreign Affairs(January/February 2012), http://www.foreignaffairs.com/articles/136785/derek-scissors-arvind-subramanian/the-great-china-debate; Ambrose Evans-Pritchard, The Telegraph (Blog), “China’s Very Mysterious Data,” 26 January 2012, http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100014380/china%e2%80%99s-very-mysterious-data/; Paul Krugman, “Will China Break?” The New York Times, 18 December 2011, http://www.nytimes.com/2011/12/19/opinion/krugman-will-china-break.html?_r=1; Arvind Subramanian, “The Inevitable Superpower: Why China’s Dominance Is a Sure Thing,” Foreign Affairs (September/October 2011), http://www.foreignaffairs.com/articles/68205/arvind-subramanian/the-inevitable-superpower; Salvatore Babones, “The Middling Kingdom: The Hype and the Reality of China’s Rise,” Foreign Affairs (September/October 2011), http://www.foreignaffairs.com/articles/68207/salvatore-babones/the-middling-kingdom.

[vii] For the latest data, see China Econtracker, The Wall Street Journal, http://graphics.wsj.com/documents/ECONTRACKER_CHINA/#ind=gdp.

[viii] “How to Get a Date: The Year When the Chinese Economy Will Truly Eclipse America’s is in Sight,” The Economist, 31 December 2011, http://www.economist.com/node/21542155; “Convergence, Catch-Up and Overtaking: How the Balance of World Economic Power is Shifting,” PricewaterhouseCoopers LLP, January 2010, http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1626; Jim O’Neill, “China Shows the World How to Get Through a Crisis,” Financial Times, 23 April 2009, http://www.ft.com/intl/cms/s/0/dd9b5a1e-2f9f-11de-a8f6-00144feabdc0.html#axzz1BfEyxaV7.

[ix] Richard Gunde, “The Future of the Greater China Economy,” The Third Wilbur K. Woo Conference on the Greater China Economy Held at UCLA, http://www.international.ucla.edu/asia/article.asp?parentid=21291.

[x] Alistair Thornton, “China Could Be Slowing Faster Than We Think,” Lowy Institute for International Policy International Economy Comments 23, 24 February 2012, http://www.lowyinstitute.org/Publication.asp?pid=1801.

[xi] Paul Nunes and Tim Breene, “Jumping the S-Curve: How to Beat the Growth Cycle, Get on Top, and Stay There,” Accenture High Performance Institute, 16 November 2010, http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Jumping_the_S_Curve.pdf; 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), http://www.chinasignpost.com/wp-content/uploads/2011/08/China-SignPost_44_S-Curves_Slowing-Chinese-Econ-Natl-Power-Growth_20110815.pdf; Robert Gilpin, War and Change in World Politics (Cambridge, UK: Cambridge University Press, 1983), 78, 107.

[xii] Kennedy, The Rise and Fall of the Great Powers, xxiii.

[xiii] 黄迎旭 [Huang Yingxu], “沉着应对美国重新布阵亚太” [Respond Calmly to the U.S. Redeployment to the Asia-Pacific Region], 学习时报 [Study Times], 27 February 2012, 7, http://www.studytimes.com.cn:9999/epaper/xxsb/html/2012/02/27/07/07_33.htm; Michael Beckley, “China’s Century? Why America’s Edge Will Endure,” International Security 36.3 (Winter 2011/12): 41-78, http://www.mitpressjournals.org/doi/pdf/10.1162/ISEC_a_00066; Amb. Chas Freeman, as quoted in Mark Thompson, “Veteran U.S. Diplomat: We Are Becoming the USSR,” Battleland Blog, 17 May 2011, http://battleland.blogs.time.com/2011/05/17/veteran-u-s-diplomat-we-are-becoming-the-ussr/.

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

[xv] Gabe Collins and Andrew Erickson, “Digging In: Earthmover sales reflect risks to China’s economic growth,” China SignPost™ (洞察中国), No. 52 (17 January 2012), http://www.chinasignpost.com/wp-content/uploads/2012/01/China-SignPost-52_Digging-in_Earthmover-sales-as-barometer-of-economic-conditions_201201171.pdf.

[xvi] Leslie Hook, “China Warns on Growing Water Shortages,” Financial Times, 16 February 2012, http://www.ft.com/intl/cms/s/0/131bb6dc-588f-11e1-9f28-00144feabdc0.html?ftcamp=published_links/rss/global-economy/feed//product#axzz1mbx0HcRq; Elizabeth Economy, “China’s Growing Water Crisis,” World Politics Review, 9 August 2011, http://www.worldpoliticsreview.com/articles/9684/chinas-growing-water-crisis.

[xvii] Nicholas Eberstadt, “Asia-Pacific Demographics in 2010-2040: Implications for Strategic Balance,” in Tellis, Marble, and Tanner, eds., Asia’s Rising Power and America’s Continued Purpose, 243-53; Phillip Longman, “Think Again: Global Aging,” Foreign Policy (November 2010), http://www.foreignpolicy.com/articles/2010/10/11/think_again_global_aging?page=full.

[xviii] Wen Jiabao, Premier of the State Council, Report on the Work of the Government, Delivered at the Fifth Session of the Eleventh National People s Congress on March 5, 2012, 1, 8, 10, http://online.wsj.com/public/resources/documents/2012NPC_GovtWorkReport_English.pdf.

[xix] Nicholas Lardy, “China’s Rebalancing Will Not be Automatic,” East Asia Forum, 22 February 2012, http://www.eastasiaforum.org/2012/02/22/china-s-rebalancing-will-not-be-automatic/; Lardy, Sustaining China’s Economic Growth after the Global Financial Crisis (Washington, DC: Peterson Institute for International Economics, 2011), http://www.piie.com/lardy.cfm.

[xx] “The End of Cheap China: What do Soaring Chinese Wages Mean for Global Manufacturing?” The Economist, 10 March 2012, http://www.economist.com/node/21549956; “The Paradox of Prosperity: For China’s Rise to Continue, The Country Needs to Move Away From the Model That Has Served it So Well,” The Economist, 28 January 2012, http://www.economist.com/node/21543537.

[xxi] China 2030: Building a Modern, Harmonious, and Creative High-Income Society(Washington, DC: The World Bank Development Research Center of the State Council, People’s Republic of China, 27 February 2012), http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2012/02/28/000356161_20120228001303/Rendered/PDF/671790WP0P127500China020300complete.pdf.

[xxii] 国务院参事任玉岭 [Ren Yuling, State Councillor; Member, 10th National Committee, Chinese People’s Political Consultative Conference, and Director of the State Research Institute for Eastern, Central and Western Development and Reform], “既得利益话语权大改革政策难以出台” [Vested Interests’ Discursive Power is Great, Hard to Launch Reform Policies], 羊城晚报 [Yangcheng Evening News], 24 January 2012, http://www.ycwb.com/ePaper/xkb/html/2012-01/20/content_1306977.htm.

[xxiii] “Panel Discussion: China’s Economy—Bulls and bears debate” and “Panel Discussion: China’s Demographic Dividend—Has the Pay-out Ended?” at “The ‘Chinese Century’: Promises. Pitfalls. Presumption?” China Summit conference, sponsored by The Economist, 18 November 2011, Beijing,

http://www.economistconferences.asia/video/china-summit-2011/652; “World Bank Protest Highlights China Reform Tension,” CBS Money Watch, 27 February 2012, http://www.cbsnews.com/8301-505245_162-57386349/world-bank-protest-highlights-china-reform-tension/.

[xxiv] “Reviving Hope in Deng’s Legacy of Reform,” Caixin Online, 6 February 2012, http://english.caixin.com/2012-02-06/100353783.html?utm_source=mail.caixinonline.com&amp;utm_medium=referral&amp;utm_content=caixinonline_news_mail&amp;utm_campaign=caixinonline.

[xxv] Jeremy Page, “Plan B for China’s Wealthy: Moving to the U.S., Europe,” The Wall Street Journal, 22 February 2012, http://online.wsj.com/article/SB10001424052970203806504577181461401318988.html?mod=WSJ_hp_LEFTTopStories#print.

[xxvi] Andy Xie, “Bubble Therapy: Andy Xie Doubts China’s Property Market Will Again Scale the Giddy Heights Even if Sales Curbs Were Removed, Despite the Wishful Thinking of Developers and Speculators Who Are Holding on to a Vast Housing Stock,” South China Morning Post, 12 March 2012, http://www.scmp.com/portal/site/SCMP/menuitem.2af62ecb329d3d7733492d9253a0a0a0/?vgnextoid=bb176e50b8106310VgnVCM100000360a0a0aRCRD&ss=China&s=News.

[xxvii] Michael Schuman, “Why China Faces a Catch-22 on Financial Reform,” Time, 12 March 2012, http://business.time.com/2012/03/12/why-china-faces-a-catch-22-on-financial-reform/; Patrick Chovanec, “China’s Real Estate Bubble May Have Just Popped: A Host of Factors Are Set to Undermine the Country’s Economic Growth,” Foreign Affairs, 18 December 2011, http://www.foreignaffairs.com/articles/136963/patrick-chovanec/chinas-real-estate-bubble-may-have-just-popped.

[xxviii] “Unrest in China: A Dangerous Year—Economic Conditions and Social Media Are Making Protests More Common in China—At a Delicate Time for the Country’s Rulers,” The Economist, 28 January 2012, http://www.economist.com/node/21543477.

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

[xxx] Gabe Collins and Andrew Erickson, “Internal Challenge: China’s diabetes epidemic highlights how rising healthcare costs could constrain economic growth and military spending,” China SignPost™ (洞察中国), No. 36 (31 May 2011), http://www.chinasignpost.com/wp-content/uploads/2011/05/China-SignPost_36_China%E2%80%99s-Diabetes-Epidemic-Highlights-How-Rising-Healthcare-Costs-Could-Constrain-Economic-Growth-and-Military-Spending_201105312.pdf.

[xxxi] The authors are indebted to a top-level expert on China’s shipping industry for his extensive help with this section.

[xxxii] Mathieu Duchâtel and Alexandre Sheldon-Duplaix, “The European Union and the Modernisation of the People’s Liberation Army Navy: The Limits of Europe’s Strategic Irrelevance,” China Perspective 4 (2011): 37, http://www.cefc.com.hk/perspectives.php.

[xxxiii] Philip Pugh, The Cost of Seapower: The Influence of Money on Naval Affairs from 1815 to the Present Day (London: Conway Maritime Press, 1986).

[xxxiv] “Type 071 Yuzhao class Amphibious Transport Dock (LPD), Global Security, http://www.globalsecurity.org/military/world/china/yuzhao.htm; “LPD-17 San Antonio Class: The USA’s New Amphibious Ships,” Defense Industry Daily, 1 March 2012, http://www.defenseindustrydaily.com/lpd17-san-antonio-class-the-usas-new-amphibious-ships-updated-02322/ .

[xxxv] Lucy Hornby, “China Air Force Woos Allies with J-10 Fighter Jet,” Reuters, 13 April 2010, http://in.reuters.com/article/2010/04/13/idINIndia-47657420100413?pageNumber=1&virtualBrandChannel=0.

[xxxvi] “Russia Receiving SU-32/34 Long-Range Strike Fighters,” Defense Industry Daily, 1 March 2012, http://www.defenseindustrydaily.com/russia-to-begin-receiving-su34-longrange-strike-fighters-02595/.

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

[xxxviii] For detailed analysis of China’s potential Far Seas operations, see Andrew S. Erickson, Abraham M. Denmark, and Gabriel Collins, “Beijing’s ‘Starter Carrier’ and Future Steps: Alternatives and Implications,” Naval War College Review, 65.1 (Winter 2012): 14-54, http://www.usnwc.edu/getattachment/647f61ae-c554-4475-b344-6e3b8c3d551f/Beijing-s–Starter-Carrier–and-Future-Steps–Alte.

[xxxix] Andrew S. Erickson, “Through the Lens of Distance: Understanding and Responding to China’s ‘Ripples of Capability’,” Changing Military Dynamics In East Asia Policy Brief 10, January 2012, Project on the Study of Innovation and Technology in China, University of California Institute on Global Conflict and Cooperation, http://igcc.ucsd.edu/assets/001/502847.pdf.

[xl] 妮爾硯 [Ni Eryan], “止戈為武: 重視軍人收入增長帶來的喜憂” [Military Forces Are to be Used for Peace and Order—Advantages and Disadvantages in Increasing Income Growth of Servicemen], 文匯報 [Wenhui Bao], 16 June 2011, http://www.wenweipo.com/news_print.phtml?news_id=PL1106160007.

[xli] Gabe Collins and Andrew Erickson, “China’s Defense Spending Dilemma,” China Real Time Report (中国事实报), Wall Street Journal, 5 March 2012, http://blogs.wsj.com/chinarealtime/2012/03/05/chinas-defense-spending-dilemma/.

***

Andrew S. Erickson and Gabriel B. Collins, “Near Seas ‘Anti-Navy’ Capabilities, not Nascent Blue Water Fleet, Constitute China’s Core Challenge to U.S. and Regional Militaries,” China SignPost™ (洞察中国) 55 (6 March 2012).

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

Strategic Horizon 1A: The U.S.-China relationship is central to international relations in the twenty-first century, as the two great Asia-Pacific powers compete, coexist, and cooperate across the full spectrum of national capabilities. While they share many important interests and are increasingly interdependent, particularly in the economic realm, Beijing and Washington regrettably face substantial differences regarding important security issues. This friction can likely be managed, albeit at the cost of tremendous effort and patience on both sides, but occasional crises are likely (akin to the 2001 EP-3 incident), and conflict cannot be ruled out completely if wisdom and diligence prove insufficient. The best way to avoid conflict is to understand its potential nature and cost. To that end, this four-part series will examine four major, under-researched issues:

  •  China’s Near Seas military focus and capabilities
  • China’s fiscal environment and implications for military development
  • Chinese energy and resource imports and their potential to drive naval expansion
  • China’s conflict triggers and mitigating factors, particularly economic interdependence

While this series will retain China SignPost™ (洞察中国)’s traditional Sino-centric focus, it must be noted that the U.S. and its capabilities, policies, and actions represent a major part of the strategic equation. Beijing’s views and concerns about them will shape Chinese actions that will, in turn, influence U.S. policy decisions.

The Near Seas: Sino-American Strategic and Military Dynamics

For all their potential progress elsewhere, for the foreseeable future, the U.S. and China are unlikely to reach a mutually acceptable understanding over the status of, and norms within, the Near Seas (Yellow, East, and South China seas). This maritime area contains the vast majority of China’s outstanding territorial claims, as well as all its disputed maritime claims. The Sinocentric concept of Near Seas (近海)—like Middle (中海) and Far Seas (远海), as depicted in the map above—was defined by Admiral Liu Huaqing, who modernized China’s Navy as its Commander from 1982-88.[i]

Contested islands claimed by China include Taiwan (first and foremost), the Senkakus/Diaoyus in the East China Sea, and the Spratlys and Paracels and other islands and reefs in the South China Sea. China cites the 1982 UN Convention on the Law of the Sea (UNCLOS) and typically claims a 200 nautical mile exclusive economic zone (EEZ) around these islands. UNCLOS has been ratified by 161 states and the European Union but not by the U.S., which is only a signatory—greatly limiting its ability to lead and influence in the critical international maritime law arena.

China’s claims are often contested or overlap with those of its neighbors, and it promotes revisionist and inconsistent interpretations of what activities are legally permissible in the EEZ. For instance, China leads a 23 state group of the 192 UN member states who seek a minority interpretation of UNCLOS that would restrict foreign military access within China’s claimed EEZ and the airspace above it.[ii] If this approach were adopted, China could prohibit foreign military operations in major swaths of South China Sea, thereby threatening freedom of navigation in some of the world’s most important shipping and energy lanes. Accepting the minority view on EEZ access would also set a precedent for the 38% of the world’s ocean area potentially claimed as EEZ to be similarly restricted—even by states such as Somalia that utterly lacks the capacity to maintain order in the face of sub-state threats.

Beijing opposes foreign military involvement in the Near Seas, fearing that it could affect the disposition of Chinese maritime claims, and limit China’s growing influence as a regional power. As part of this policy, China objects to U.S. surveillance and reconnaissance (SRO) activities in international waters and airspace within and over its claimed EEZ. To assert its displeasure and to apply political pressure, China regularly intercepts aerial SRO missions.

China also increasingly uses civil maritime enforcement vessels and government-controlled fishing vessels to pressure U.S. ships engaged in SRO. Chinese tactics have been quite aggressive, as with the harassment of the survey vessel USNS Impeccable in March 2009 in international waters 75 miles south of Hainan Island.[iii] Meanwhile, China is developing, deploying, and displaying military platforms and weapons systems potentially capable of threatening, rendering inoperable, or even destroying U.S., allied, and friendly platforms that attempted to intervene in the unfortunate event of conflict. These capabilities are termed “counter-intervention” by Chinese sources and “anti-access/area denial” (A2/AD) by the U.S. military. While some substantive nuances are alleged to exist between these concepts, the difference is fundamentally one of perspective as they are two sides of the same coin.[iv] Chu Shulong, a professor of international relations at Tsinghua University’s School of Public Policy and Management, encapsulates Beijing’s motives in this regard: “China is aiming to deny the capability of possible American intervention in the western Pacific. That has been clear since 1996.”[v]

This Chinese determination to establish a maritime buffer zone chafes increasingly against U.S. efforts to defend open access to the global commons, public zones in the seas, air, space, and cyberspace that are used by all nations but owned by none. Of particular concern for Washington, and many of China’s neighbors, is freedom of navigation in the South China Sea, which carries a substantial portion of global commerce and seaborne energy flows.

Henry Kissinger captures the respective concerns prevalent in each nation:

Some American strategic thinkers argue that Chinese policy pursues two long-term objectives: displacing the United States as the preeminent power in the western Pacific and consolidating Asia into an exclusionary bloc deferring to Chinese economic and foreign policy interests. … China’s neighbors, dependent as they are on Chinese trade and uncertain of the United States’ ability to react, might adjust their policies according to Chinese preferences. Eventually, this could lead to the creation of a Sinocentric Asian bloc dominating the western Pacific. …

On the Chinese side, the confrontational interpretations follow an inverse logic. They see the United States as a wounded superpower determined to thwart the rise of any challenger, of which China is the most credible. No matter how intensely China pursues cooperation, some Chinese argue, Washington’s fixed objective will be to hem in a growing China by military deployment and treaty commitments, thus preventing it from playing its historic role as the Middle Kingdom. In this perspective, any sustained cooperation with the United States is self-defeating, since it will only serve the overriding U.S. objective of neutralizing China. Systematic hostility is occasionally considered to inhere even in American cultural and technological influences, which are sometimes cast as a form of deliberate pressure designed to corrode China’s domestic consensus and traditional values.[vi]

“Anti-Navy,” Not “Blue Water Navy,” Constitutes Primary Challenge to U.S. Forces

Concerns about a Chinese “blue water navy” fundamentally mischaracterize the true nature of China’s present and medium-term challenge to the U.S. Navy and other U.S. and allied forces.[vii] Because of the fundamentally different cost dynamics, and China’s very different levels of military capability in the Near and Far Seas, it is important for analysts not to conflate Near Seas high-intensity A2/AD with Far Seas low-intensity presence, and even influence.[viii]

Beijing’s “blue water” naval expansion remains years from posing a serious problem for Washington. Indeed, as a growing great power, it is only natural for China to play an increasing role in this realm, and in many respects it should be welcomed. The U.S. has and will continue to have many viable options to address any problems that might emerge in this area, at least with respect to the potential for high-intensity kinetic conflict.

For instance, Chinese forces themselves are highly vulnerable to precisely the same types of “asymmetric” approaches (e.g., missile attacks) that they can employ to great effect closer to China’s shores. In fact, there is substantial room for cooperation beyond the Near Seas. This potential may even be said to be growing, as China’s overseas interests and capabilities increase, thereby allowing it to contribute in unprecedented ways. In this area, which covers the vast majority of the globe, China appears to be cautiously open to U.S. ideas about “defense of the global system”—which in fact offer excellent opportunities for “free riding” off U.S.-led provision of security for key global sea lanes such as the Strait of Hormuz.

The problem for the U.S. is that in the Near Seas themselves China is working to carve out a sphere of strategic influence within which freedom of navigation and other important international system-sustaining norms are seriously constricted. Thus, China’s already-present ability to engage in A2/AD operations within the Near Seas and their immediate approaches has the potential to seriously undermine U.S. national security interests.

Assisted in part by the land-based Second Artillery Force, anti-satellite capabilities, and global cyber activities, this A2/AD challenge threatens U.S. naval platforms, but is far more than just a Chinese navy-based threat; some U.S. government experts have called it an “anti-navy.” It could already be difficult to handle kinetically with current U.S. approaches, and the situation appears to be worsening rapidly. The U.S. may not have years to develop new countermeasures and prepare to address the most difficult aspects of the problem; in that sense, “the future is now.”[ix]

Radiating Range Rings, Through the Lens of Distance

The most common source of error in Chinese and U.S. analyses of People’s Liberation Army (PLA) development is the conflation of two factors: scope and intensity. A stone dropped into the water forms waves that radiate outward, gradually dissipating in the process. Close to home, China’s military capabilities are rapidly reaching a very high level. However, they are making much slower progress, from a much lower baseline, further away. The major exceptions to this pattern occur in space, in which China’s capabilities are more evenly distributed and hence more global in nature, and in cyberspace in which physical distances are largely meaningless.

To call this a “tale of two militaries” oversimplifies, since some platforms and weapon systems can contribute in both areas, but it captures the basic dynamic. Many vehicles and armaments are primarily relevant in one area or the other. Cherry-picking the characteristics of either of these “layers” or “levels” to characterize overall Chinese military/maritime power risks fundamentally misrepresenting its critical dynamics.

On one hand, it is a mistake to exaggerate the scope of China’s military buildup: China is not developing a “blue water” power-projection navy nearly as rapidly as it is deploying shorter-range platforms and weapon systems such as missiles for land, air-, sea-, and undersea-based platforms. On the other hand, it is equally misguided to suggest that restraint and limitations in the Far Seas indicate restraint and limitations in the Near Seas, when in fact Chinese actions across the military and diplomatic spectrum strongly suggest the opposite.

“Counting all the beans” by treating side-by-side comparison of all Chinese and U.S. forces as the key metric, as sometimes done by those who would minimize the PLA’s significance, is only relevant if one assumes that the pertinent scenario is a Cold War-style Sino-American global conflict—a virtual impossibility, fortunately. Rather, China is seeking to further its core interests by pursuing an asymmetric approach that maximizes its advantages in a contingency relatively close to China’s maritime periphery.

Bottom Line: “Anti-Navy” Friction and Navy Cooperation

For the foreseeable future, Washington and Beijing are unlikely to agree on the status of the Near Seas, and what activities are acceptable within this zone. Given its essential interests in the area, Beijing is developing “keep out”[x] capabilities to thwart American intervention. Meanwhile, Washington’s commitment to maintaining the existing global system of free access to the global aerial and maritime commons leads it to oppose China’s aims.

Therefore, the key immediate and medium-term challenge to the U.S. Navy and military more broadly is not nascent Chinese “blue water naval development”—which in fact could support substantial cooperation—but rather China’s rapidly growing asymmetric multi-service A2/AD capabilities within the Near Seas and their immediate approaches. U.S. forces may not be fully prepared to contend with this Dragon’s Lair[xi] of layered anti-access systems and the issue drives considerable debate in Washington.[xii]

In this time of geostrategic ferment, Henry Kissinger offers a possible way forward:

Just as Chinese influence in surrounding countries may spur fears of dominance, so efforts to pursue traditional American national interests can be perceived as a form of military encirclement. Both sides must understand the nuances by which apparently traditional and apparently reasonable courses can evoke the deepest worries of the other. They should seek together to define the sphere in which their peaceful competition is circumscribed. If that is managed wisely, both military confrontation and domination can be avoided; if not, escalating tension is inevitable. It is the task of diplomacy to discover this space, to expand it if possible, and to prevent the relationship from being overwhelmed by tactical and domestic imperatives.[xiii]

[i] 刘华清 [Liu Huaqing], 刘华清回忆录 [The Memoirs of Liu Huaqing] (Beijing: People’s Liberation Army, 2004); Nan Li, “The Evolution of China’s Naval Strategy and Capabilities: From ‘Near Coast’ and ‘Near Seas’ to ‘Far Seas,’” Asian Security, 5.2 (June 2009): 144-69.

[ii] Peter A. Dutton, “China’s Efforts to Assert Legal Control of Maritime Airspace,” in Andrew Erickson and Lyle Goldstein, eds., Chinese Aerospace Power: Evolving Maritime Roles (Annapolis, MD: Naval Institute Press, 2011), 90-107, http://www.andrewerickson.com/2011/06/chinese-aerospace-power-evolving-maritime-roles-cmsi-vol-5/.

[iii] “USNS Impeccable Harassed by Chinese Vessels,” video footage of Impeccable Incident, uploaded on 25 March 2009. http://www.youtube.com/watch?v=hQvQjwAE4w4.

[iv] Anton Lee Wishik II, “An Anti-Access Approximation: The PLA’s Active Strategic Counterattacks on Exterior Lines,” China Security 19 (2011): 37-48, http://www.chinasecurity.us/index.php?option=com_content&view=article&id=487; Thomas G. Mahnken, “China’s Anti-Access Strategy in Historical and Theoretical Perspective,” Journal of Strategic Studies, 34.3 (June 2011): 299-323, http://www.tandfonline.com/toc/fjss20/34/3.

[v] “Continuing Buildup, China Boosts Military Spending More Than 11 Percent,” New York Times, 4 March 2012, http://www.nytimes.com/2012/03/05/world/asia/china-boosts-military-spending-more-than-11-percent.html?pagewanted=2&_r=1&hp.

[vi] Henry A. Kissinger, “The Future of U.S.-Chinese Relations: Conflict Is a Choice, Not a Necessity,” Foreign Affairs (March/April 2012), http://www.foreignaffairs.com/articles/137245/henry-a-kissinger/the-future-of-us-chinese-relations.

[vii] Leo Hindery, Jr., “China: Continued Abusive Trade and Now a ‘Blue Water Navy’,” Huffpost, 10 January 2012, http://www.huffingtonpost.com/leo-hindery-jr/china-continued-abusive-t_b_1196360.html.

[viii] For misguided comparison of U.S. overall (global) capabilities with Chinese overall (regionally-focused) capabilities, see Amitai Etzioni, “In China’s Shoes (Commentary),” The National Interest, 23 January 2012, http://nationalinterest.org/commentary/chinas-shoes-6366.

[ix] For details, see Andrew S. Erickson, “Through the Lens of Distance: Understanding and Responding to China’s ‘Ripples of Capability’,” Changing Military Dynamics In East Asia Policy Brief 10, January 2012, Project on the Study of Innovation and Technology in China, University of California Institute on Global Conflict and Cooperation, http://igcc.ucsd.edu/assets/001/502847.pdf.

[x] See, for example, Paul S. Giarra, “A Chinese Anti-Ship Ballistic Missile: Implications for the U.S. Navy,” in Chinese Aerospace Power, 359-74.

[xi] Regarding potential implications for U.S. military operations, see Roger Cliff, Mark Burles, Michael S. Chase, Derek Eaton, and Kevin L. Pollpeter, Entering the Dragon’s Lair: Chinese Anti-Access Strategies and their Implications for the United States (Santa Monica, CA: RAND, 2007), http://www.rand.org/pubs/monographs/2007/RAND_MG524.pdf.

[xii] Andrew F. Krepinevich, Jr., “The Pentagon’s Wasting Assets: The Eroding Foundations of American Power,” Foreign Affairs (July/August 2009), http://www.foreignaffairs.com/articles/65150/andrew-f-krepinevich-jr/the-pentagons-wasting-assets; Thomas Donnelly, Philip Dur, and Andrew F. Krepinevich Jr., “The Future of U.S. Military Power: Debating How to Address China, Iran, and Others,” Foreign Affairs(November/December 2009), http://www.foreignaffairs.com/articles/65507/thomas-donnelly-philip-dur-and-andrew-f-krepinevich-jr/the-future-of-us-military-power;

[xiii] Kissinger, “The Future of U.S.-Chinese Relations.”

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Gabriel B. Collins and Andrew S. Erickson, “China’s Defense Spending Dilemma,” China Real Time Report (中国事实报), Wall Street Journal, 5 March 2012.

China’s always-controversial defense budget announcement will attract particular notice this year.

While the U.S. implements potentially dramatic cuts to its defense spending growth, China is robustly increasing its military spending, which is officially set to grow at a clip of 11.2%to 670.2 billion RMB ($106.4 billion) in 2012. (This figure does not cover all of China’s defense-related spending, but then no nation’s defense budget does —including that of the U.S.) Defense dollars (or yuan) can be spent in many ways, though budget cuts are typically not an effective way to increase military power or credibility with potential adversaries. Beijing appears well aware of this reality.

But even with this impressive expansion, China, like the U.S., is beginning to feel defense spending pressures—both in growth of mission scope, and in technology and personnel costs.

China’s growing global interests are driving the military to look increasingly “beyond Taiwan” and its immediate maritime periphery to inform its strategy and procurement. Meanwhile, China’s assertive behavior in the South and East China seas gives its neighbors strong incentive to hedge through military upgrades of their own and closer ties with the U.S. — at a time when China has no allies able to provide reliable security assistance. Each of these realities is likely to propel Chinese military spending.

China’s expeditionary capabilities will likely grow in coming years, as the number of Chinese citizens, investment and economic interests abroad rises steadily. The People’s Liberation Army’s naval forces (PLAN) have sustained successful anti-piracy deployments to the Gulf of Aden for more than three years now, with 11 task forces escorting more than 4,400 ships. While these anti-piracy missions cracked open the door, the Libya evacuationopened it more. Over time, the PLAN will likely seek to open it fully with a more sustained presence in the Indian Ocean region, and perhaps the Persian Gulf as well. Such efforts will not produce a high-end “blue water” navy (pdf) anytime soon, but they require investment now.

A more sustained Chinese presence in the Indian Ocean region will likely unnerve India and help reinforce a vicious cycle in which China’s rise and behavior provoke defense hardware upgrades and security realignments by neighboring countries – moves that will, in turn, help drive further defense spending by a China that feels “encircled.”

For budgetary purposes, building even a medium global expeditionary capability, such as the three or more aircraft carriers China could eventually add to its fleet, would require very substantial additional acquisitions of military hardware as well as outlays to support training with those assets and the logistics needed to support them when they are deployed.

In the wake of the deployment of the missile frigate Xuzhou and IL-76 aircraft to Libya to aid and rescue Chinese citizens trapped amid the violence there a year ago, senior PLAN and civilian leaders now recognize the utility of forward-deployed military assets for a country like China with growing global interests. This matters for budgetary purposes because once strong institutional constituencies exist for shaping a specific set of military missions and capabilities, a combination of inertia and ambition tends to drive additional deployments and the hardware procurement to support greater capability.

In terms of hardware, China’s military modernization appears to be focusing heavily on naval, space/reconnaissance assets and air power. On the naval side, Chinese shipyards have reportedly built four Type 071 amphibious warfare vessels, are engaged in series production of the Type 054 frigates that will constitute future Chinese task forces, and are preparing to build the new Type 056 corvettes that could become the PLAN’s key vessel for handling future South China Sea contingencies.

China’s build-out of the Beidou satellite constellation, which will provide an indigenous equivalent of GPS that the PLA could use to enhance its weapons targeting abilities, suggests that Chinese military leaders view their new ships, satellites and aircraft as part of an increasingly integrated war-fighting package. Beidou now offers service in China and aims to offer Asia-Pacific regional coverage by the end of 2012, with global coverage to be in place by 2020. China’s rapid pace of satellite launches, which tied the U.S. number in 2010 and surpassed it in 2011 (with 19 Chinese satellite launches), reflects strong growth in China’s space-based reconnaissance capabilities and hints that this area will remain a high priority in future military budget planning.

China’s air power is also growing rapidly, with progress on the new J-20 late-generation fightersuggesting that by 2020, China could field true 5th-generation fighter aircraft. To become a top regional air power and create a limited global expeditionary capability, the PLA Air Force and Navy will need more late-generation fighters like the J-10, J-11 series and J-20; aerial refueling tankers; airborne early warning aircraft; modern long-range bombers; and long-range air-launched precision guided munitions such as land attack cruise missiles. These areas, as well as military jet engine production, are likely to be high priorities in current and future Chinese defense investment.

China’s military modernization costs likely to rise substantially

The need for more technology-intensive weapons systems underscores a new reality for China’s military planners: While some items such as ships can be produced more cheaply in China than in Western countries, China’s cost advantages decrease significantly as military equipment becomes more technology- and materials-intensive and less labor-intensive.

This will be especially true in the aerospace sector. While exact costs are extremely complex to calculate, basic estimates are possible. China’s J-10 fighter, for example, probably costs roughly $28 million per aircraft. This is nearly as much as the F/A-18 C and D series and the Russian SU-34, which cost $29 million per unit and $36 million per unit, respectively, for aircraft that are in many ways substantially more capable than the J-10. The J-20, meanwhile, likely costs somewhere around $110 million per unit, less than the F-35 and F-22, but in the neighborhood of the estimated $100 million unit cost of the Russian T-50 late-generation fighter aircraft.

 

Rising personnel and training costs may start to constrain PLA’s ability to modernize hardware

As costs for acquiring equipment rise, so do the costs for maintaining the new hardware, supporting sufficient training and paying the operators. Personnel, equipment and operational costs are all rising for the PLA, and there will be a limit to what can China can afford in the future.

Several major factors drive rising PLA personnel costs. The various branches of China’s military, which seek to increase retention and improve soldiers’ quality of life, must compete increasingly with the private sector for the smart, energetic people needed to use and maintain complex modern weapons in a more technology-driven environment.

PLA officers, for example, now bring home at least 5,400 yuan ($845) per month on average, a very competitive wage compared to Chinese state owned enterprise employees’ average monthly earnings of closer to US$626 (4,000 RMB).

We believe there is a real chance that the PLA will, more quickly than it expects, end up in a position where it is spending significantly more of its budget on personnel than it is on procurement. The U.S. military is challenged similarly, but the issue is even more pressing for China. The PLA is still struggling to create a force that has comprehensive technologies equivalent to what the NATO militaries had by the late 1980s, whereas the U.S. already has modern equipment, trains intensively and is weighing rising personnel costs against its desire for cutting-edge equipment for the future.

Thus, the challenge China’s leaders face with regard to balancing personnel, training, and equipment costs resembles that of the Chinese economy more broadly, which has become huge in absolute terms, but remains relatively poor in per capita terms. China’s defense “pie” is growing rapidly, but the cost of key ingredients is rising faster still.

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Gabriel B. Collins and Andrew S. Erickson, “Benefits for China in New East African Resource Rush,” China Real Time Report (中国事实报), Wall Street Journal, 2 March 2012.

A new great game is afoot as recently uncovered stores of mineral resources in East Africa create competition between Brazilian, Japanese, Indian, Irish, Anglo-Australian and Chinese investors.

Already a strategic region for China due to its 54 United Nations votes and location astride key trade routes, East Africa is about to become even more important to the world’s second-largest economy. The rapid economic growth that natural resource development stands to produce will likely fuel heightened commercial and diplomatic competition in coming years as more Chinese companies and businessmen enter the region and jockey for position. The prize: oil, gas and coal money that by 2020 could equal roughly 50% of the current GDP in Mozambique and more than 10% of GDP in other producer countries.

Mozambique and Tanzania are now believed to host at least 70 trillion cubic feet of offshore gas reserves. Mozambique also holds some of the world’s largest coking coal deposits, while Uganda enjoys at least 1.1 billion barrels of oil reserves. Ethiopia’s Danakil Basin is home to a world-class potash deposit.

The mineral-producing countries (plus neighbor Kenya) also boast a combined consumer market of more than 225 million people – an potentially lucrative opportunity for Chinese entrepreneurs already schooled in the navigation of emerging economies.

As Chinese investment and citizens crisscross the vital but volatile area, Beijing will have to decide how to promote and protect its people and interests without stepping too deeply into complex local politics. But the rewards could be substantial: Based on the projections for production from the companies developing East African resources and the likely baseline prices for the commodities in question, new commodity production in Mozambique, Tanzania, Ethiopia and Uganda could be worth more than $24 billion per year by 2020 (Exhibit 1), when extraction projects are likely to be in full swing. Even under bearish conditions, that figure is likely to hit $17 billion.

Here are some of the ways Chinese companies stand to benefit:

* Enter projects by partnering with lead developers who desire a cash rich Chinese partner

Chinese companies have two key advantages as they seek assets in East African resources. First, many of them—both those that are state-backed and those that are privately held—tend to be cash-rich, making them desirable partners. In March 2011, Tullow Oil Plc., which is leading exploration activities in Uganda, sold one-third stakes in three exploration areas to China National Offshore Oil Corporation (CNOOC) and Total for US$2.9 billion. Similarly, in December 2011, Kenya’s government awarded China’s Fenxi Mining Group development rights for coal reserves in its Eastern Province, which can help fuel the Kenyan cement and steel industries and generate electricity.

Second, they offer a pipeline into the large and growing Chinese market for oil, coking coal, liquefied natural gas (LNG) and potash. In many cases, they are even willing to pay for development costs in order to obtain longer-term assured resource supplies. In November 2009, for instance, Allana Potash (pdf) reported that China Minerals provided 35% of the company’s initial mine construction cost for its Danakil Basin project in Ethiopia in exchange for the right to purchase 20% of production at a discount to market potash prices. Furthermore, contrary to perceptions that prevailed during the Unocal fiasco in 2005, many major Chinese natural resources companies like CNOOC have proven themselves to be sophisticated global operators who are willing to invest in mutually beneficial ways with a wide range of partners and market commodities to end users worldwide when the economics make sense.

* Sell digging equipment to the miners and infrastructure builders

Chinese companies are also well-positioned to supply mining and construction equipment even if Chinese miners are not directly involved in a project. Shantui, China’s largest bulldozer manufacturer by market share, recently opened a sales office staffed by 160 people in Kenya because East Africa has become one of its top export markets, where the company sold more than 300 construction machines during 2011. To put this number in perspective, the company only sold 110 bulldozers to Angola in 2005 when that country was one of the top destinations for Chinese construction investment outside of China itself.

In Mozambique, where Chinese companies missed out on gaining a stake in several coking coal deposits, Chinese equipment makers have still been able to secure some supply contracts. Among them is China CNR Corporation, which signed a deal in April 2011 to provide 330 coal rail wagons to help Vale transport coal from its expanding Mozambican mines.

* Help build the necessary roads, rails and ports needed to get resources to market

In East Africa, a lack of high-volume transport infrastructure presently limits miners’ ability to bring natural resources to market and monetize them. Now Chinese firms are poised to write a new chapter in the history of their cooperation with developing countries.

Between 1970 and 1975, in what was then Beijing’s largest single foreign aid project, China built the Tazara Railway to link Zambia to the Tanzanian port of Dar es Salaam, freeing the landlocked country from exporting copper through white-supremacist Rhodesia. Today similar assistance from Chinese firms appears welcome. Booming Mozambique, for instance, needs to refurbish at least 340km of existing rail lines and probably double-track them so that large volumes of coal from the country’s interior can be moved by rail and river barge to the coast for export (pdf). As Mozambican rail lines and ports are augmented to handle rising coal traffic, Chinese construction firms and construction workers from China may well secure work. Similarly, the country’s offshore natural gas development presents opportunities to sell pipe and construction materials, as well as a chance to purchase stakes in LNG projects by dangling the prospect of guaranteed sales into the Chinese market.

As Allana Potash builds the transport infrastructure to support its planned Danakil Basin potash mines, Chinese firms will almost certainly play a role since the project requires road and rail construction and a new port in Djibouti, all of which are areas of expertise for companies like China Railway Construction Corp (CRCC), which is already working in Ethiopia. In December 2011, CRCC reported that China Ex-Im Bank had agreed to provide Ethiopia with a $3 billion credit line over the next three years to support infrastructure development. Similarly, oil infrastructure projects in Uganda will likely attract Chinese suppliers, as will the need for additional regional transport linkages, like the superhighways Chinese companies are currently building in Kenya.

* Serve growing consumer economies

Chinese companies—particularly small and medium enterprises—are well positioned to capitalize as East African natural resource development drives demand for appliances and consumer goods, construction of homes and hotels, and other items. Indeed, a 2011 article in Asia & Africa Review by a scholar from Hunan University notes that at least 1,500 small- and medium-sized enterprises from China already operate in Africa (as opposed to 100 large companies).

An influx of resource revenue that drives consumer activity further increases the opportunity for Chinese entrepreneurs who have the advantage of having learned how to serve their own internal emerging market. Kazakhstan’s economy grew more than five-fold between 1990-2010 (from $26 billion to $149 billion) and we believe similar growth rates could be possible in Mozambique, Tanzania and Uganda if the countries’ resource bounties turn out to be as large as developers believe and can be successfully brought to market.

Bottom line: East Africa’s emerging natural resource boom has not received the same attention as that of other frontier commodity plays such as Mongolia. Yet rising mineral production and consumer economy booms are likely to lure heightened Chinese investment and migration into the region, with security implications as China’s footprint grows amidst complex local politics that are likely to be unsettled further by large revenue inflows.

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Andrew S. Erickson and Gabriel B. Collins, “Enter China’s Security Firms,” The Diplomat, 21 February 2012.

Chinese private security companies are seeing an opportunity as the U.S. withdraws troops from Iraq and Afghanistan. But plenty of complications await them.

A security vacuum is developing around Chinese workers overseas. The recent kidnapping of 29 Chinese workers in Sudan (where another worker was shot dead during the abduction) and 25 workers in Egypt has sparked a strong reaction in China. As a result, Beijing is looking to bolster consular services and protection for Chinese citizens working and travelling overseas. On the corporate side, private analysts are urging companies to do a better job of training employees before they are sent abroad. Yet with at least 847,000 Chinese citizen workers and 16,000 companies scattered around the globe, some of them in active conflict zones such as Sudan, Iraq, and Afghanistan, key projects and their workers are likely to require more than just an expanded consular staff to keep them safe.

It’s with an eye on this growing danger that new Chinese private security providers see a business opportunity. Shandong Huawei Security Group appears to be a leader among Chinese security providers, which thus far have predominantly focused on the country’s robust internal market for bodyguard and protective services. Huawei provides internal services, but in October 2010, opened an “Overseas Service Center” in Beijing. The company’s statement on the center’s opening explicitly cites the withdrawal of U.S. troops from Iraq, and the potential for a security vacuum to result, as key drivers of its decision to target the Iraq market. … … …

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Andrew S. Erickson and Gabriel B. Collins, “China’s New Challenge: Protecting Its Citizens Abroad,” China Real Time Report (中国事实报), Wall Street Journal, 10 February 2012.

Recent incidents in which a total of 54 Chinese citizens working in Sudan and Egypt were abducted — with one killed during a rescue attempt — highlight the increasing risks Chinese expatriates face as the country ventures into volatile parts of the world in search of resources and business opportunities. Unfortunately for China’s more than 847,000 citizens overseas, with their more than 13,000 enterprises and more than $1 trillion in assets, Beijing’s foreign policy is becoming increasingly unpopular in the same restive areas in Africa and the Middle East where Chinese businesspeople are chasing fortunes.

Compounding this trend, Chinese in unstable areas tend to cluster in easily-identified compounds and are perceived not to engage with locals socially.

With China’s hunger for resources and markets only expected to grow further, how capable is the country of protecting its own?

New trouble spots

While China’s footprint in Africa has been covered extensively in the international media, not much public attention has been paid to the country’s growing economic and human presence in Iraq and Afghanistan. These two countries have high potential to become trouble spots for Chinese workers as Chinese investment increases, the U.S. military reduces its presence, and Chinese companies and workers increasingly have to provide for their own security.

In Iraq, China’s largest oil and gas producer CNPC is helping to develop oilfields with reserves estimated to exceed 20 billion barrels and likely has at least 1,200 workers in the country. Given that CNPC’s oil operations in Iraq are likely to eclipse its Sudanese projects in terms of both physical scale and oil output — and that Chinese firms are also likely to seek opportunities in helping to repair and expand Iraq’s oil and civil infrastructure — it is not unreasonable to expect the eventual total Chinese presence in Iraq to exceed 20,000 workers. Depending on the opportunities available for small businessmen from China, this number could rise even further.

In Afghanistan, Chinese investment projects include the huge Aynak copper mine and a series of oilfield developments by CNPC that this year are slated to bring Afghanistan its first ever domestic oil production. Afghanistan’s mineral sector has significant potential, with U.S. government officials estimating that the country may hold as much as $1 trillionin lithium, copper, cobalt, iron, gold and other minerals. As such, we anticipate that Chinese investors will increasingly seek to develop mines and supporting infrastructure, and that the total number of Chinese workers and businessmen in the country could eventually rise to at least several thousand.

As China’s profile rises relative to that of the U.S. in Iraq and Afghanistan, it is likely to become a lightning rod that attracts attention and forces Beijing to take a more hands-on approach to protecting citizens overseas. We do not expect in the next few years to see special forces operations like the recent U.S. Navy SEAL raid to rescue hostages in Somalia, but Beijing is likely to take a more muscular approach to protecting Chinese citizens working overseas as its military power projection ability grows and nationalistic pressure rises at home.

Increasing Capabilities… and Expectations

China’s power projection capabilities and Indian Ocean presence are growing gradually but substantially. This has important implications for the security of Chinese worker groups and economic assets in Iraq and Afghanistan as the U.S. draws down and removes its forces.

From a very low baseline, China has been launching unprecedented responses to incidents threatening citizens overseas with increasing frequency and muscularity. In response to the pirating of Chinese-flagged vessels in the Gulf of Aden, China has since December of 2008 dispatched 10 naval task forces to the region. In a textbook example of logistical coordination, amid the overthrow of the Gaddafi regime by rebels, China dispatched the guided missile frigate Xuzhou to symbolically oversee the sea-borne component of the evacuation of all 35,000 of its expats from Libya in February 2011. The PLA Air Force also sent four IL-76 long-range transport aircraft to evacuate Chinese nationals from central Libya. Following the murder of 13 Chinese sailors on a cargo vessel on a Thailand-controlled portion of the Mekong River, a Chinese paramilitary People’s Armed Police (PAP) border unit began joint patrols on the river with its Thai, Lao and Burmese counterparts.

These successful operations, and the fact that the PLA Navy just took delivery of its fourth Type 071 amphibious warfare vessel, raise expectations at home that Beijing will protect its own. The first aspect of this push is likely to come via improved consular service to keep track of Chinese citizens abroad, apprise them of risks, and assist in evacuation and rescue operations.

In response to the abductions in Egypt and Sudan, Zhejiang University’s non-traditional security center director Yu Xiaofeng and his colleague Gan Junxian penned an op-ed in the Chinese edition of the Global Times calling for expanding consular protection of Chinese overseas based on best practices of the U.S., UK and Japanese governments. China’s Foreign Ministry issues travel advisories and coordinates evacuations of citizens in emergencies, but so far has not played the hands-on protective role that its American and other Western counterparts do.

Opportunity for Private Security Contractors

Private security contractors are also likely to play a larger role in protecting Chinese workers overseas, since they can provide an armed presence in a less escalatory way than direct deployment of military or police forces in foreign countries. The Sudan incident appears to herald a new factor in protection and recovery of Chinese overseas workers: As The Wall Street Journal reported, Sudanese troops engaged in the rescue effort were joined by a dozen armed Chinese private security contractors. Among China’s emerging private security providers, Shandong Huawei Security Group advertises an “Overseas Service Center” based in Beijing that includes personnel drawn from retired military special forces and the PAP. While the source of the contractors who may have assisted in Sudan remains unclear, Shandong Huawei or one of its brethren seem like a probable source.

The idea that Chinese companies would hire private security providers to help them manage risks in volatile frontier areas has been in discussion for some time. In the spring of 2010, a prominent Western private security firm told us that a number of large Chinese firms use its services and that it had “definitely seen an increased interest” from Chinese energy, natural resources and construction firms seeking expert advice on the political, operational and security risks associated with their investments and projects in Africa, Middle East and other far-flung locations.

We suspect these firms’ expertise in risk management will be increasingly welcome in Chinese boardrooms and investment sites abroad as Beijing’s rising profile forces it to take sides in local conflicts where Chinese citizens live and work, thereby attracting popular anger and potentially fueling additional violence against PRC expats. Beijing might ultimately rather see private contractors on the front lines than risk the diplomatic fallout that could result from sending active duty military or police personnel into conflict zones to protect Chinese workers and economic assets. Controlling the actions of private security firms will be a key concern for Beijing, however, particularly following Washington’s problems with doing so in Iraq.

An additional complicating factor is that private security services are expensive. Cash-strapped Chinese small businessmen might instead choose to arm themselves, which could further escalate any confrontations that might occur with locals. On 15 October 2010, for instance, Chinese supervisors Xiao Lishan and Wu Jiuhua—allegedly acting in self-defense—shot 13 Zambian miners out of a larger group protesting wage conditions at Collum Coal Mine, a major coal supplier for Zambia’s copper and cobalt sector. While Zambian prosecutors dropped the case in 2011, it generated outrage among locals, who resent the leverage Chinese companies obtain from investing over $1 billion a year and building most new infrastructure.

Individual PRC nationals working as traders and businessmen in volatile areas often work unregistered and will likely be invisible to Beijing until a high-profile attack or systemic anti-Chinese violence erupts. Once this happens, nationalist pressures to intervene and protect will kick in and the Chinese government will be placed in a reactive position. Beijing looks to be in for an interesting time as more PRC citizens and China-based companies venture into Iraq and Afghanistan in search of economic opportunity.

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Gabriel B. Collins and Andrew S. Erickson, “Supersize Me: Rising Fast Food Sales Suggest China Will Keep Driving a Global Farm Commodity Boom,” China SignPost™ (洞察中国) 54 (9 February 2012).

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

Chinese consumers are rapidly changing their diets as disposable income rises and fast food items from Western companies like Yum Brands are playing a centerpiece role in the shift. The company reports that it now operates in more than 700 Chinese cities. Importantly for policymakers and investors alike, Yum’s China menu is, with the exception of breakfast, dominated by meat-intensive items. As such, the burgeoning growth of Yum and other fast food sellers in China highlights how meat-hungry Chinese consumers are likely to help sustain a global boom in demand for corn, wheat, chicken and other agricultural commodities for some time to come.

Iron ore and base metals may be under the gun as construction slows down in China, but with China’s domestic farm sector already hard pressed to feed the country, continuing demand for grain-intensive meats is great news for farmers in breadbaskets like Brazil, Argentina, the U.S., and Ukraine. At the same time, higher food prices are bad news for Chinese policymakers who are attempting to restrain inflation while still maintaining reasonably robust economic growth rates. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Cornering Commodities Markets: For China, Xstrata/Glencore deal would have larger impact than Facebook IPO,” China SignPost™ (洞察中国) 53 (7 February 2012).

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

Facebook’s plans to go public are a headline grabber, but in terms of fundamental global economic impact, the proposed US$90 billion merger between two Zug, Switzerland-based firms—mining giant Xstrata and premier global commodity trader Glencore—deserves much closer attention. People can live well without a Facebook account, but life gets a lot harder if prices for the copper that brings power to their computer suddenly climb when a large miner/trader acquires the potential capacity to squeeze the market.

Combining and integrating the two firms’ global network of mines, smelters, warehouses, transportation assets, and savvy traders creates a range of opportunities for the new company to use its market intelligence and sheer size to extract premium prices from consumers of the vital raw materials it produces. Chinese commodity buyers could face a company with great influence in the copper, lead, zinc, nickel, cobalt, and seaborne coal markets. The combined Xstrata/Glencore entity would control an estimated 7.5% of global copper production, 8.8% of seaborne thermal coal supplies, 10.2% of global zinc production, and 10.5% of global seaborne coking coal supplies…. … …

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Gabriel B. Collins and Andrew S. Erickson, “Chinese Traders Poised to Profit From Iran Oil Embargo,” China Real Time Report (中国事实报), Wall Street Journal, 26 January 2012.

Europe’s decision to embargo Iranian oil exports is strategically sound, since a nuclear-armed Iran is in no one’s interest. Yet, policymakers are overlooking how an embargo may strategically reshape the global oil trade in China’s favor. Major Chinese oil traders are building businesses that are world class in terms of volumes traded. The latest oil embargo will help them further their ambitions.

The first Iranian oil embargo beginning in 1979 effectively handed Marc Rich, whose company ultimately became Glencore (one of the world’s largest physical oil and commodities traders), the keys to a multibillion dollar oil-trading kingdom. Now China’s increasingly global oil trading companies are in the catbird seat. Chinese firms can be confident that Beijing values stable and secure oil supplies much more than cooperation with the U.S. on the Iranian nuclear issue.

The EU sanctions, which will affect about 450,000 barrels per day of oil imports to Europe (pdf), will likely engender the transfer of billions of dollars in oil earnings from the Iranian government to China’s main oil trading firms: Zhuhai Zhenrong, Unipec, Chinaoil, and Sinochem. These firms have become major players in the global physical crude oil market. In 2010, 3 of the 10 largest global crude oil and products traders hailed from China (see chart).

Unipec, China’s largest oil trader does not publicly report trading volumes past 2006, when it sold 106 million tonnes of crude oil and 14 million tonnes of refined products. Based on the company’s trading more than 3 million barrels per day of crude in 2011, we estimate that Unipec’s trading volumes now exceed 150 million tonnes per year, potentially making it a larger oil trader than even Vitol and Glencore. Unipec’s activities in the global oil tanker market suggest it is moving very large volumes of oil. In 2011, the company was the world’s second-largest tanker charterer, trailing only Royal Dutch Shell, according to Poten & Partners (pdf).

Of the Chinese oil traders, Zhuhai Zhenrong may be the best positioned to profit because it has strong relationships in Iran and also well-insulated from U.S. and European political pressure that will follow once U.S. and European governments realize that this embargo is likely to be just as leaky as any other. The company enjoys Beijing’s blessing, has no exchange traded stock, has no U.S. assets, and offers virtually no leverage that could be exploited by outside interests seeking to pressure it. Sinochem and Unipec have slightly more exposure to external pressure since their parent companies have parts of the company that are publicly traded, but will still enjoy strong political and diplomatic support from Beijing.All this said, the embargo is likely to trigger significant conflicts within the Chinese government. Once the embargo is in place, Iran will likely need to substantially reduce the price its crude in order to entice Chinese buyers to purchase larger than normal volumes. The question will then be “who enjoys the profits created by the provision of discounted oil?”

There is a range of possibilities. One option is for the traders to simply keep shipping the bulk of their oil to Chinese refineries as they have been doing and let the refineries enjoy the windfall of having lower-cost oil supplies. This might be the simplest outcome in domestic political terms, particularly since Chinese refineries have often lost profits under policy restrictions in recent years. However, it is more likely that the Chinese traders will either sell the oil on the international market for cash, or swap it for oil from other countries that can then be sent to China or other markets.

For example, if the crude oil spot price were $100 per barrel and Iran had to discount its oil to $80 per barrel to entice buyers, a Chinese trader could then swap the Iranian crude to another firm. By swapping its Iranian crude for another oil cargo at market prices (or a higher price than it paid the Iranian sellers), the company can gain “extra” oil relative to what it originally paid in Iran and resell it for a profit.

To make the oil palatable to buyers who want Iranian oil, but do not want to run afoul of U.S. and EU sanctions, traders can blend it with oil from other countries and take other means to disguise the oil’s origin. This is common practice when oil thieves sell oil from Nigeria and one also used by Saddam Hussein’s government, which at points smuggled up to 480,000 barrels per day of oil into the world market despite UN sanctions (pdf). Iran’s heavy crude oil, the country’s largest export stream at present, is similar in weight and sulfur content to the Ural blend that Russia exports, potentially creating swap or trading opportunities. We also anticipate that Iran will trim exports of heavy, higher sulfur crude in favor of more valuable lighter oils that have less sulfur and could be more easily blended and sold into the global market.

China’s refinery operators will not be happy if they have to keep buying crude from the traders at market prices when the traders have been getting discounted Iranian barrels that could have been shipped back to China. Since both sides of the equation have strong political allies, and in some cases are parts of the same corporate constellations (Unipec is a wholly-owned subsidiary of Sinopec, China’s largest oil refiner measured by the amount of oil processed), the politics stand to become contentious: Trading bosses may want to maximize their units’ profits, as opposed to transferring crude at below-market prices to the company’s refineries. Alternatively, if China’s domestic market for refined products weakens, firms like Sinopec may sell or swap more of their Iranian crude into the world market and embrace the traders as a profit center.

Policymakers and investors alike must consider how EU sanctions targeting Iran’s nuclear program may well help reshape the physical oil trading world in ways that favor China’s rising state-backed oil traders. In today’s globalized, economically dynamic, and resource-hungry world, unintended consequences can matter tremendously.

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Andrew S. Erickson and Gabriel B. Collins, “Year of The Water Dragon: 12 Chinese Maritime Developments to Look for in 2012,” China Real Time Report (中国事实报), Wall Street Journal, 23 January 2012.

China has now entered the Year of the Dragon. According to traditional geomancy, for the first time since 1952, the year will be associated with the element water. Sixty years ago, in the throes of the Korean War, Beijing could scarcely have been further from the water. Today, however, China’s shipyards are humming and the PLA Navy (PLAN) is sustaining operations half a world away in the Gulf of Aden.

Beginning with the major potential newsmakers, here are 12 key things to watch for and what they mean:

  • A sharper than expected fall in economic expansion in 2012 would shed light on how China’s 5th-generation leadership might balance domestic concerns and defense modernization if China begins moving onto a slower economic growth path. Most analysts appear to be forecasting GDP growth of greater than 8% in 2012. If growth falls at the low end of the forecasted range, and especially if it comes in closer to the long-term official benchmark of 7% GDP growth, China’s new leaders might limit capital-intensive naval modernization that will not provide immediate capabilities to ensure funds for economic stimulus measures.
  • Expect continued friction and possible skirmishes in the South China Sea, especially between Chinese and Vietnamese maritime forces. Beijing’s assertive approach regarding maritime issues in the South and East China Seas will likely generate additional friction with Japan, South Korea, Vietnam, and the Philippines. South Korea plans to begin using military special forces personnel armed with firearms on fishing enforcement missions. Serious confrontations involving Chinese fishermen are highly likely.
  • The PLAN will likely take steps to sustain a longer-term presence in the Indian Ocean region. New Delhi will take notice. Sustained expeditionary military operations necessitate access to regional replenishment and repair facilities. The PLA’s Gulf of Aden deployment is allowing it to build relationships through port visits in places like Port Salalah in Oman that stand to help it gain more formal access to regional harbors and airfields, which can be used to provide logistical support for future missions. China is most likely to pursue a “places, not bases” approach, since large fixed bases on foreign soil might create major diplomatic and security challenges that would undermine Beijing’s ability to portray its behavior as being different from that of the U.S. Locations where the PLAN might seek additional logistical support and access that in the foreseeable future include Tanzania, Kenya, Madagascar, the Seychelles, Djibouti, Salalah (Oman), Karachi (Pakistan), Jeddah (Saudi Arabia), Chittagong (Bangladesh), Hambantota and Colombo (Sri Lanka), Mauritius (where Port Louis has sufficient draft to accommodate a large warship), Kyukaphu (Burma) and Singapore.
  • PLAN ship construction will continue at a robust pace as yards build a wide array of modern warships including the Type 071 amphibious vessel and the new Type 56 corvette. Unlike the West, where procurement is suffering amidst defense budget cuts, Chinese military shipbuilding continues steadily. Evidence of China’s first indigenous carrier hull may emerge even as its first foreign-purchased hull, the ex-Varyag, begins rudimentary flight operations.
  • 2012 may bring China’s first lethal or casualty-generating engagement with pirates in the Gulf of Aden. Over the past three years, 10 PLAN task forces with 8,400 officers have performed 409 escort missions for 4,411 Chinese and foreign ships in and near the Gulf of Aden. The PLAN has also helped 48 vessels that had been attacked or released by pirates. While the PLAN has thus far not re-taken a hijacked vessel kinetically or inflicted casualties on pirates as the U.S., French or Indian navies have, it may end up trading fire with pirates in 2012 thanks to accidents or unforeseen contingencies.
  • A second-ever PLAN-facilitated evacuation of Chinese citizens from an unstable coastal nation could well become necessary. Yemen and Syria loom large, with Sudan and Pakistan more remote possibilities. Following the overwhelming success of China’s first such effort in Libya last March (with token air force and naval support), Chinese at home and abroad have heightened expectations. Locals would do well to avoid harming Chinese in crisis zones.
  • China may conduct its first naval humanitarian assistance and disaster relief operation.In 2010, Beijing sent helicopters to Pakistan to assist with flood relief. Its Type 071 amphibious warship and Peace Ark hospital ship might play even more useful roles if they could reach a crisis zone in time.
  • China’s first real sea-based nuclear deterrent is approaching. China’s Jin-class ballistic missile submarines remain too noisy to patrol confident that they won’t be detected by other navies’ anti-submarine platforms. However, apparently successful tests of the JL-2 submarine launched ballistic missile in December 2011 suggest China’s seaborne nuclear deterrent program is making meaningful progress.
  • China’s civil maritime forces will expand their capabilities and activities.China’s non-Navy maritime security services are likely to increasingly support the PLA Navy (PLAN) in 2012. This can help free up PLAN vessels for missions further afield. Key missions will likely include additional patrols and probing operations in disputed zones such as the East and South China Seas where using PLAN forces could risk escalating maritime conflicts more than using the Coast Guard forces would.  China’s dispatch of its largest patrol vessel, newly-commissioned Haijian 50, to contested parts of the East China Sea in December 2011 is a bellwether.
  • China expects to begin drilling its first ultra-deepwater oil/gas well with a domestically-made drillship. Vietnam and the Philippines will likely be unsettled, despite the fact that the initial deepwater well will most likely be drilled in the northern South China Sea within the undisputed portion of China’s claimed EEZ.
  • China’s seaborne crude-oil import dependency will rise further. Overland pipelines cannot offset growing demand and oil delivered by pipelines is in many instances less secure and more expensive than oil delivered by sea. High and rising dependence on seaborne natural resource imports will likely help PLAN strategists make a stronger case for building a blue water navy.
  • Beijing will scrutinize American and European fiscal challenges and government spending and policy implications in search of opportunities. China will likely intensify its push to persuade the EU to lift its arms embargo, which was imposed in the wake of Tiananmen Square.

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Andrew S. Erickson and Gabriel B. Collins, “China’s New Strategic Target: Arctic Minerals,” China Real Time Report (中国事实报), Wall Street Journal, 18 January 2012.

As policymakers in Washington focus on China’s expanding presence in Africa and growing assertiveness in the South China Sea and Indian Ocean region, Danish diplomatic assistance is opening the gate for China to establish a strategic foothold in the Arctic.

Denmark has made a strategic decision to prioritize its economic relationship with China and is now becoming the key gateway for Beijing’s commercial and strategic entrée into the Arctic. Denmark advocates giving China a seat at the Arctic policy table. Friis Arne Peterson, the Danish ambassador to China, stated in October that China has “natural and legitimate economic and scientific interests in the Arctic.” Copenhagen likewise supports giving China permanent membership on the Arctic Council, the eight-nation forum that includes the five Arctic Ocean coastal states (the U.S., Canada, Denmark, Norway and Russia) as well as Sweden, Iceland and Finland.

Greenland’s substantial deposits of minerals including rare earths, uranium, iron ore, lead, zinc, petroleum, and gemstones make the Arctic island a key bargaining chip as Denmark cultivates Beijing. Copenhagen administers Greenland’s foreign policy and will likely dangle the island’s rich geological potential in front of Beijing as it works to bolster the China-Denmark trade relationship. Indeed, Greenland’s minister for minerals, industry, and labor traveled to China for a trade mission in November that included participation in a major mining and minerals trade show in Tianjin.

Danish exports to China rose 17% and Chinese exports to Denmark rose 25% in 2010, according to figures provided by the Danish embassy in Beijing. Yet Danish exports to China were worth just US$2.6 billion and Chinese exports to Denmark amounted to US$6.9 billion, a small fraction of the volumes traded between China and its primary trade partners. The minerals that lie under Greenland’s snow are the real prize, worth far more in both monetary and strategic terms to China than the imported goods or export market Denmark itself can provide.

Danish diplomacy is literally following the money as some of the country’s policy elites turn away from the U.S. Copenhagen’s largest embassy is in Beijing, and is twice the size of its embassy in Washington. Denmark’s ploy to pull China closer is likely to work: From Beijing’s perspective, having Chinese companies buy several billion dollars per year worth of pharmaceuticals and machinery and doing container shipping business with Maersk is well worth it to gain access to Arctic negotiating tables and Greenland’s minerals.

Greenland is the best geographic entry point for Chinese entities interested in Arctic mineral resources because its government lacks the ability to develop mineral resources independently and because its Danish overseer will likely actively support Chinese investment in the island’s resources. Companies from Russia, the U.S., Canada and Norway already dominate the development of oil, gas and other natural resources within their home countries’ respective territorial zones.

With this politically and geologically favorable backdrop, Greenland’s high mineral production potential will likely attract Chinese interest despite the risk and uncertainty inherent in developing a new mineral source. London Mining aims to produce 15 million tonnes per year of high grade iron ore pellets by 2015 at its Isua project, which includes investment from Sinosteel and China Communications Construction Corp. Greenland Minerals and Energy claims its Kvanefjeld deposit could produce 20% of the global rare earth supply and large amounts of uranium with first production in 2016 (pdf). Kvanefjeld’s potential to influence global prices would make it a project of strategic interest to Chinese companies like Inner Mongolia Baotou Steel Rare Earth, the world’s largest rare earth metals producer.

Chinese firms will not have first-mover advantages in Greenland, as small miners from Australia and the UK dominate the local investment scene. That said, they stand to enjoy active support from the Danish government should they choose to invest on the island. We anticipate that larger companies, including buyers from China, will seek strategic stakes in mining projects initiated by enterprising smaller firms like those mentioned above. It is also very likely that given Greenland’s small population, Chinese firms will import substantial numbers of workers from China to build the power plants, transmission lines, ore processing facilities and other supporting infrastructure for Chinese-invested mines in Greenland.

As in so many other areas, China is entering a new global arena. It remains to be seen whether it will follow existing norms, or attempt to change the system over time. “China has a legitimate right to be interested in and participate in what happens in the Arctic, but it requires that the rules are observed,” Greenland premier Kuupik Kleist said in November. Countries like China “must not believe that they can come and decide about the residents and just take care of the resources in the Arctic, which are regulated by laws, treaties and binding agreements. Those cannot be tampered with.”

It will be interesting to watch how Danish and other regional experts’ perceptions evolve on this issue as China’s Arctic presence increases. According to SIPRI researcher Linda Jakobson, “There is some irony in the statements by Chinese officials calling on the Arctic states to consider the interests of mankind so that all states can share the Arctic. These statements appear to be contrary to China’s long-standing principles of respect for sovereignty and the internal affairs of other states.” (pdf)

In the three Near Seas (Yellow, East China and South China), Beijing promotes an extreme minority perspective on international law at odds with the UN Convention on the Law of the Sea that holds that coastal states have the right to regulate and restrict non-resource-related activities between the 12 nautical mile limit of their territorial waters and the 200 nautical mile limit of their claimed exclusive economic zone, or EEZ. Beyond its own region, by this logic, Beijing must honor similar claims by Arctic states. Canada, for instance, maintains that foreign vessels must obtain permission before transiting its vast northern archipelago.

Transit permission may become important if China continues building its icebreaker fleet and summer passage through the Canadian and Russian Arctic routes becomes increasingly viable. China currently has only one operational icebreaker, the Xuelong, but a new 8,000 tonne vessel is due to enter the fleet in 2014. The likely westbound route from Nuuk in Western Greenland to Qingdao via the Canadian Arctic is around one-half the distance to Qingdao through the Panama Canal, while the likely eastbound route via the Russian Arctic is less than two-thirds the distance to Qingdao via the Cape of Good Hope.

The Great Game for Arctic resources is heating up and China is likely to play an expanding role as Denmark opens the door for Beijing to enter the Arctic on the diplomatic front and on the investment front via mining projects in Greenland.

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Gabriel B. Collins and Andrew S. Erickson, “Digging In: Earthmover Sales Reflect Risks to China’s Economic Growth,” China SignPost™ (洞察中国) 52 (17 January 2012).

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

  • Earthmover sales are a useful economic indicator because China’s construction and fixed asset-driven economy is very heavy equipment-intensive. Also, construction machines are not a speculative asset in the way copper and other commodities can be.
  • Earthmover sales are a forward looking indicator, since construction contractors buy machines based not just on current needs, but also on growth potential they see in coming months and years.
  • Sales of bulldozers, hydraulic excavators, and wheel loaders in China’s domestic market slowed significantly in the second half of the year and were quite weak compared to trend. This matches up well with housing prices declines in major Chinese cities.
  • Anecdotal data point to a large market for used heavy equipment in China, but sales of new machines are still the best bellwether for economic activity as the country’s fleet expands.
  • Zoomlion, one of China’s largest heavy equipment dealers by market share, reports that its trade receivables (i.e. money owed to it by customers) was 67% higher on 30 September 2011 than it was at the end of 2010.
  • This suggests some equipment buyers are falling behind on making payments, perhaps because a construction slowdown is reducing their revenue streams.

Finding data that accurately reflect real economic activity and are not easily manipulated for political reasons is a key challenge in assessing the Chinese economy. We believe that earthmover sales are one such indicator.

Contractors are very unlikely to treat earthmovers as a speculative value store the way many Chinese have stockpiled copper and other base metals over the past 18 months, despite the fact that they had no ability to consume the metal themselves (Financial Times). Rather, bulldozers, excavators, and wheel loaders are depreciating assets whose prices decline the moment they leave dealership lots.

The machines’ value comes from the work they can do, not because there is a futures contract in bulldozers. As such, earthmover equipment sales shed a truer light on the state of China’s real economy than do “apparent consumption” number for copper and other commodities. The other metrics are undeniably valuable, but their data are more vulnerable to distortion than earthmover sales are. … … …

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Andrew S. Erickson and Gabriel B. Collins, “China’s 2012 Challenges,” The Diplomat, 8 January 2012.

China enters the New Year confronting challenges and opportunities that will be shaped in turn by how its government and populace respond to them. Here outlined are twelve key items and issues that will help define 2012 for China, both at home and abroad. 2012 will be a “two-level” year in which internal and external factors are linked ever-more-clearly. As a new generation of leadership prepares to govern China, millions of citizens and netizens and their foreign counterparts will be watching Beijing’s actions more closely than ever before.

1) The run-up to Beijing’s once-in-a-decade political transition in October 2012 is likely to generate intensified clampdowns internally and assertive rhetoric abroad as China faces rising domestic challenges, and finds itself constrained internationally. Fearful neighbors may further strengthen ties with the United States. Pariah/failed state “allies” North Korea, Pakistan, and Iran will likely experience problems that affect China’s own interests. Externally, China is likely to be more intransigent than before. Internally, Beijing will resist making difficult decisions about economic reforms, particularly reforms that might harm key state-owned enterprises and monopolistic/oligopolistic concerns connected with families of political elites. Domestically and internationally, Chinese leaders will attempt to postpone difficult policy decisions until after the transition.

2) Slowing economic growth will likely increasingly expose the flaws and unsustainable nature of China’s infrastructure-driven growth model.One local banking regulator cited by Minxin Pei claims only 1/3 of the investment projects currently under construction will produce cash flows large enough to cover their debt service burden. This may rapidly reduce economic growth and commodity demand in 2012. … … …

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Gabriel B. Collins and Andrew S. Erickson, “China’s Growing Meat Consumption is Driving Corn Imports and Creating a New Strategic Dependency,” China SignPost™ (洞察中国) 51 (2 January 2012).

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

China will likely import 3.0 million tonnes of corn in the 2011/12 market year, more than triple the amount it took in 2010/11 (USDA).  As Chinese consumers eat more meat, China’s corn imports are likely to evolve along the trajectory of its soybean imports, which have risen fourfold in the past decade. Because of rapid, highly polluting industrialization and other development, China’s progressively diminishing arable land and clean water base is already almost fully utilized.

As a growing consumer economy demands more grain, China’s transport and infrastructure boom is helping to erode the country’s already thin arable land base.  In 2011, road and rail projects took an estimated 700,000 hectares of arable land out of use, according to China Daily.  This would be enough land to produce 3.7 million tonnes of corn at China’s average corn yield over the past 5 years.

The likelihood that corn production will receive a higher priority than the cultivation of other essential grains such as wheat and rice in China is low, effectively placing a ceiling on the country’s potential for boosting corn production. Nationally, China harvests nearly as much corn acreage as the U.S. (31.5 million hectares vs. 32.9 million hectares in the 2010/11 crop year), yet only manages to produce about half the tonnage of corn grown in the U.S.

Chinese farmers’ corn productivity, as measured in tons per hectare, has remained relatively stagnant over the past 20 years at a rate roughly half that of the U.S., which now produces nearly 10 tons per hectare. The yield gap suggests that U.S. farmers have a strong competitive advantage vis-a-vis their Chinese peers and that increased corn exports from the U.S. to China make economic sense.

The U.S. and Argentina are the largest global corn exporters, respectively, and are well situated to capitalize on Chinese consumers’ growing taste for corn-intensive meat. Corn farmers in Iowa, Nebraska, and Cordoba can look forward to exporting more corn to China as the inhabitants of Shanghai, Zhengzhou, and countless other Chinese cities put more meat dishes on the table. … … …

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Andrew S. Erickson, Abraham M. Denmark, and Gabriel Collins, “Beijing’s ‘Starter Carrier’ and Future Steps: Alternatives and Implications,” Naval War College Review, 65.1 (Winter 2012): 14–54.

Just as a newlywed couple wants a “starter home,” a new great power wants a “starter carrier.” China’s navy has finally realized its longtime dream of obtaining an aircraft carrier and sending it to sea. This is the first step in a long journey that will change China’s navy and how it relates to the world.

At 5:40 AM local time on Wednesday, 10 August 2011, more than eighty years after the idea was originally proposed, China’s first carrier disappeared into the fog under tight security from Dalian harbor’s Xianglujiao Port, in northeast Liaoning Province, to begin sea trials in the Bohai and northern Yellow Seas. This was yet another coming-out party for China as a great power on the rise. Upon its launch, the nation burst with patriotic pride over the achievement. Major General Luo Yuan, deputy secretary-general of the China Society of Military Sciences, declared, “Well begun is half done. . . . [T]he effect of having something is completely different from the effect of having nothing.” Plans are under way to commemorate this new era of Chinese sea power, and to boost the economy further in the process. Tianjin, one of the country’s four municipalities, plans to do its part in October 2011 by opening China’s first aircraft carrier–themed hotel, based on Kiev, once the Soviet Pacific Fleet’s flagship and now the centerpiece of the Tianjin Binhai Aircraft Carrier Theme Park. A Chinese flagship as capable as Kiev once was remains far away, but Beijing has taken the first step and is already reaping added influence at home and abroad.

Before foreign strategists start hyperventilating about the “beginning of the end,” however, a deep breath is needed. China’s initial carrier foray followed a six-year refit and lasted only four days. China’s starter carrier—a vessel originally purchased incomplete from Ukraine in 1998—is of very limited military utility; it will serve primarily to confer prestige on a rising great power, help the Chinese military master basic procedures of naval airpower, and project a bit of military power—perhaps especially against the smaller neighbors on the periphery of the South China Sea. This is not the beginning of the end; it is the end of the beginning. To realize its ambitions for the future, China had to start somewhere.

Late in 2010, Admiral Liu Huaqing, the father of China’s modern navy, passed away. Liu had sought to build China’s navy first into a “green water” force and thereafter, eventually, into a “blue water” navy capable of projecting power regionally, though not globally. He insisted that he was not China’s Alfred Thayer Mahan, but his concept of “Near Seas defense” was roughly comparable to Mahan’s views on U.S. naval strategic requirements (i.e., dominance of the Gulf of Mexico, the Caribbean, Panama, and Hawaii). The key to the realization of Liu’s vision was an aircraft carrier, and Liu reportedly vowed in 1987, “I will not die with my eyes closed if I do not see a Chinese aircraft carrier in front of me.” Admiral Liu’s eyes can close now.

Much of the Asia-Pacific region, as well as the Asia-watching strategic community in the United States, is hotly debating the implications of Chinese aircraft carrier development. Admiral Robert Willard, commander of U.S. Pacific Command, said in April 2011 that he was “not concerned” about China’s first carrier going to sea, but allowed, “Based on the feedback that we received from our partners and allies in the Pacific, I think the change in perception by the region will be significant.” Australian brigadier general John Frewen contends, “The unintended consequences of Chinese carriers pose the greatest threat to regional harmony in the decades ahead.” Former director of Defense Intelligence Headquarters in the Japan Defense Agency Admiral Fumio Ota, JMSDF (Ret.), asserts, “The trials of China’s first aircraft carrier . . . mark the beginning of a major transition in naval doctrine. . . . Aircraft carriers will provide Beijing with tremendous capabilities and flexibility. . . . [A] Chinese carrier could pose a serious threat to Japanese territorial integrity. . . . China’s new aircraft carrier increases its tactical abilities and the chances of a strategic overreach. Other countries in the region should be worried.”

Yet while the Asia-Pacific region is hotly debating the implications of China’s aircraft carrier, there should be little surprise that a Chinese aircraft carrier has finally set sail. Indeed, what is most surprising about China’s aircraft carrier program is that it took this long to come to fruition. Given the discussions about an aircraft carrier that have percolated in China’s strategic community for decades, it should have been clear to the entire region that this was a long time coming. … … …

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Gabriel B. Collins and Andrew S. Erickson, “New Access for U.S. Forces in Australia: Is it driven by China?” China SignPost™ (洞察中国) 50 (14 November 2011).

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

What is happening?

A substantial enhancement in US-Australia military ties first referred to approximately one year ago now appears to be materializing.  A range of media outlets report that President Obama’s upcoming visit to Australia will feature an announcement of an agreement that gives US Navy and Marine Corps personnel “permanent and constant access” to existing facilities in Darwin (The Australian). They would be hosted at the Robertson Barracks, a major Australian Army base near Darwin (The Sydney Morning Herald).

According to Australian Defense Minister Stephen Smith, the agreement will also allow pre-positioning of U.S. supplies and equipment for disaster relief and humanitarian assistance (Australian Dep. of Defense). Defense Minister Smith also has noted that he expects (from the U.S. military) “more troops in, troops out, more ships in, ships out and more planes in and planes out. And the Territory is an obvious prospect with some of the Defence facilities that we have here, both in and around Darwin, but in the [Northern] Territory generally.” A higher tempo of visits by U.S. forces will further enhance the already substantial interoperability of the U.S. and Australian armed forces.

It bears noting that the Royal Australian Air Force’s (RAAF), considers RAAF Darwin to be one of its “main forward operating bases.” In addition, there is a possibility that the precedent set by access to Darwin opens the door for greater U.S. access to RAAF Tindal, a key F/A-18 base located in the Northern Territory, as well as other facilities. The RAAF’s heavy use of U.S.-made aircraft means that RAAF bases already have the necessary maintenance infrastructure to service a range of key U.S. platforms that could pass through, including the C-17, F/A-18C, and F/A-18 E/F Super Hornet. Putting Marines at Robertson Barracks also raises the possibility of building on the existing joint training center at Bradshaw Field via increased reciprocal Australian access to U.S. base facilities for training and other purposes. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Electric Bikes are China’s Real Electric Vehicle Story,” China SignPost™ (洞察中国) 49 (7 November 2011).

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

Along with its booming market for petroleum-fueled autos, China is also a global leader in promoting greater use of electric and alternative fuel vehicles. Automakers are responding to the government’s ambitious objective to have 1 million electric cars on Chinese roads by 2015, with BYD now selling its E6 electric sedan to individual buyers (Bloomberg).

Yet the real Chinese electric vehicle story is the strong sales of electric bicycles and scooters, with more than 25 million likely to be sold in 2011. An estimated 120-to-140 million of these marvelous little machines currently whiz silently down bike lanes and roads throughout China. To put this number in perspective, Chinese drivers now own roughly 72 million passenger cars, according to People’s Daily.

Exhibit 1: An electric bike in China shows off its substantial carrying capacity

Source: China Digital Times

Regulatory risks to the growth in e-bike sales are rising as municipalities become increasingly concerned with climbing accident rates and death tolls as fast and silent e-bikes are mixed in with slower traditional bicycles. For instance, Shenyang and Foshan have restricted or banned e-bike use in certain zones of the city, Wuhan and Zhuhai have banned them outright in city limits, and Changsha has restricted the issuance of new licenses for e-bike riders. In addition, the central government issued rules in 2009 capping e-bike speeds at 20 km per hr (12mph) and restricted the weight to no more than 40 kg (88lb) (Bloomberg).

However, we believe the fleet will still grow and that two-wheelers will remain China’s premier electric vehicle for at least the next 5 years. Administrative restrictions will likely trim e-bike sales growth rates below their potential maximum level, but most Chinese municipalities lack the resources or desire to devote major attention to going after e-bike riders.  Indeed, arbitrarily curtailing the use of such a popular mode of transportation on a large scale could spark major public backlash, which is the last thing Beijing wants as it grapples with inflation and other challenges.

The continuing growth in e-bike sales does not mean Chinese will stop buying cars, but the growing number of e-bikes and how they interact with personal cars and investment in expanded public transit systems has significant implications for how vehicle use patterns will evolve in China in coming years. In turn, these dynamics potentially hold major implications for China’s gasoline and crude oil demand moving forward.

Why Urban Chinese like E-bikes

1)      They are highly affordable.

Chinese car buyers can currently purchase BYD’s entry-level F3 sedan for around US$10,000, according to data from China Autoweb. BYD’s new E6 electric sedan costs closer to US$60,000 before subsidies, according to Bloomberg. In contrast, an e-scooter from Hangzhou Hangpai Electric Vehicle Co. can be had for US$700, or about 7% the price of the basic gasoline car and 1.1% the price of the unsubsidized electric car (1.7% the price of the E6 with all subsidies). Electric bicycles are even cheaper. For instance, Damei Strong Bicycle’s GT-S Top Class E-bicycle costs as little as US$335, or about 3% the price of the BYD F3 sedan.

2) They are cheap to operate.

E-bikes and scooters cost much less to operate than cars do. A Chinese driver who drives 300 days per year and covers an average of 12.5 miles per day (20km) with an average fuel efficiency of 25 miles per gallon at today’s average Chinese retail gasoline price of around US$4 per gallon will pay US$4.16 per day to operate his car. Our estimate accounts for the cost of fuel burned, as well as maintenance, parking, and incidental costs car owners are likely to face over the course of each year they own their vehicle.

Paying around US$4 per day to commute to work and run errands might sound good to drivers in Europe, Japan, or the U.S., where operating a car is much more expensive, but it does not look so good to China’s emerging urban middle class, members of whom we estimate can operate an e-bike for roughly 21¢ per day (1/20 the cost of owning and driving a car). Even for the higher tiers of the middle class in urban areas who might own a car, this large cost disparity can make e-bikes highly attractive as second or third vehicles for regular around town use.

3) E-bikes are much more convenient than cars in urban areas.

Anyone who has sat for a half-hour or more amidst the exhaust fumes and irritation of a traffic jam in Beijing, Shanghai, or other Chinese cities and watched e-bikes silently shoot by in the designated bike lanes can appreciate the machines’ ability to smoothly and quickly work through congested urban areas. With respect to electric vehicles, electric cars will save gasoline, but will contribute to road congestion and spend just as much wasted time sitting in traffic jams as their petroleum-fueled cousins.

Certain Chinese cities have begun restricting or even banning e-bike use in some areas because their speed and silence create hazards to pedestrians and other bicyclists, but the two-wheelers continue to have a major advantage over cars in terms of accessibility in crowded urban zones and do so without the noise and smoky exhaust of gasoline-powered scooters and motorbikes.

Convenience of parking and charging

E-bike expert Dr. Christopher Cherry calculates cars typically require 28 square meters of parking space, while an e-bike or e-scooter only needs 2 square meters. Many urban areas in China are short on parking space (please see our detailed research on the subject). While more parking lots are being built, shortages are likely to persist for years as people living in areas built with few parking options continue to purchase vehicles.

Also, unlike electric cars, which typically require specialized docking stations to charge, the e-bikes can be plugged into the wall outlet in an apartment. Plugging into an unmodified wall outlet is considerably cheaper than setting up dedicated charging stations like those required by electric cars (at a cost of US$2,000 plus tax and licensing fees for the Nissan Leaf’s at-home charging station). Also, prospective electric vehicle buyers in China face the fundamental problem that most existing Chinese housing complexes do not include integrated parking facilities and even fewer Chinese have access to the personal garages or nearby private parking space upon which the American model of at-home electric vehicle charging is predicated.

Implications of e-bikes for China’s oil consumption

In terms of oil demand displacement potential, if the average car user drives 12.5 mi (20km) per day in a BYD F3 class sedan (25 mpg fuel economy), using 1.9 liters of gasoline, the average car would use roughly 4.1 bbl of fuel per year, after accounting for fuel wastage idling in traffic jams (equivalent to 15% of distance driven).

Thus, the more than 10 million e-bikes likely to be added to China’s fleet in 2011 could likely effectively replace more than 20 million barrels of gasoline per year (we discount the actual arithmetic number of 40 million barrels to account for the fact that many households, especially in urban areas, may own and use both cars and e-bikes and that people may also use public transport or their personal cars during inclement weather, for example).

Based on Sinopec’s 2010 ratio of 1 barrel of gasoline produced for every 5 barrels of crude oil processed, this could translate to more than 100 million barrels per year, or 274,000 bpd of oil supplies. This is equal to roughly 3% of China’s total daily oil demand and is nearly 25% larger than the average of 220,000 bpd of oil that China is likely to import from Kazakhstan in 2011 (Reuters).

E-bikes lead demand and environmental risks

E-bikes bring substantial oil conservation benefits, but pose environmental costs in other ways. First, they increase electricity demand in a country where 80% of power comes from coal-fired plants. Second—and more pressing—their batteries use as much lead as a car in many cases. The average e-bike uses 10.3kg of lead per unit, while larger and more powerful e-scooters use 14.7kg of lead per unit on average, according to the Asian Development Bank. As such, China’s anticipated production of 33 million e-bikes in 2011 will require 340,000 tonnes of lead, or 8.3% of China’s total forecast lead demand for 2011.

Furthermore, because e-bike batteries are charged and discharged more often than car batteries, they must typically be replaced much more frequently (every 1-2 years on average). The high replacement rate is a matter of concern because although Chinese battery recycling rates have risen rapidly and now likely exceed 85%, PRC-based battery recyclers in many cases still use outdated technology and practices and have much higher lead emission rates than comparable facilities in Europe or the U.S.

To put e-bike lead emissions into perspective, consider that a 2009 Asian Development Bank study estimated that an average Chinese e-bike accounts for 520 mg of lead emissions per km of use over its lifetime. In contrast, a U.S. car burning leaded gasoline in the 1970s at a 30 mpg fuel economy emitted only 33 mg of lead per km of use, an amount that nonetheless was deemed unacceptable and helped drive the phase-out of leaded fuels in the U.S.

Here it bears noting that a car burning leaded fuel actually emits lead while driving, whereas the e-bikes do not emit lead while operating, but rather help drive high lead emissions that are concentrated in areas near mines and smelters. Heavy metal pollution in industrial zones across China from Guangdong and Hunan in the South to Huludao in the Northeast garners increasing political attention and smelter shutdowns have resulted.

Likely modes of reducing e-bike lead emissions include closing smaller smelter that use dated technology and promoting the use of batteries that use lithium. Crackdowns on the most polluting smelters will likely continue, while lithium battery use will grow only slowly since lithium batteries are still not cost-competitive with the traditional lead-acid units.

***

Gabriel B. Collins and Andrew S. Erickson, “Transparency is Not Just for the Military: Improved Commodity Data Reporting from China Good for Chinese and Global Consumers Alike,” China SignPost™ (洞察中国) 48 (14 October 2011).

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

Just last week, the China Non-Ferrous Metals Industry Association estimated the country’s copper reserves at year-end 2010 to have been 1.9 million tonnes—roughly as much as the U.S. used in 2010 and nearly 27% to 50% higher than the previous estimates of foreign analysts (Financial Times).

We have no reason to doubt the Chinese association’s high number, particularly in light of a number of credible reports in the Financial Times and Wall Street Journal over the past 18 months regarding collateral financing schemes that boosted China’s apparent demand and stockpiles of copper and zinc, among other materials, and off-exchange hoarding of cotton by farmers hoping for better prices.

Markets are not fond of surprises and a lack of reliable data on supply and demand and inventories in China injects unnecessary uncertainty into global markets and injures consumers worldwide. The negative impacts of global commodity price volatility, coupled with China’s rise as a top consumer of a range of energy, metal, and agricultural goods, have heightened the importance of obtaining timely and reliable inventory data from the large and dynamic Chinese market.

The U.S., the world’s other commodity superpower, already has a reasonably sophisticated and transparent reporting system in place for tracking flow and volume changes in its basic material use, especially in the energy and agriculture sectors. In particular, the U.S. Department of Energy (DOE) and Department of Agriculture (USDA) regularly provide a broad range of detailed data on supply, demand, and stockpiles for oil, oil products, natural gas, and agricultural goods and typically present them in a reasonably user friendly way.

China would help all market participants, including itself, by building similar systems to bolster inventory and supply/demand transparency. To be certain, better inventory tracking and reporting will not change the reality that demand and supply can diverge drastically from expectations, but they will provide additional clarity in a timely way that can give brokers and traders a more accurate picture of what the state of the world really is, thereby permitting more rapid adjustments, and reducing the risk of destructive commodity price shocks.

It is, of course, fair to ask “why is it in China’s interest to help build more comprehensive commodity stock and flow tracking infrastructure?” The answer is straightforward: price volatility exacerbated by unexpected and irregular disclosures or leakage of information into the market harms Chinese consumers. In essence, it is better to make inventory and demand changes a routine, and perhaps even boring weekly report than to trigger destructive market turmoil as numbers fluctuate and are disclosed on an irregular and/or incomplete basis. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “A Chinese ‘Heart’ for Large Civilian and Military Aircraft: Strategic and Commercial implications of China’s Campaign to Develop High-bypass Turbofan Jet Engines,” China SignPost™ (洞察中国) 47 (19 September 2011).

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

Deep Dive—Special In-Depth Report #3

This in-depth report analyzes China’s prospects for building large turbofan jet engines for civilian aircraft, and the potential impact of it succeeding in this area.

Key points

  •  Buyers in China are expected to purchase 5,000 commercial aircraft and more than 2,300 business jets in the next 20 years, a number of aircraft that could require nearly 16,000 commercial turbofan engines to be purchased in the base scenario and 13,000 engines in the pessimistic growth scenario.
  • Major large aircraft buys by China’s military could easily add another 500-1,000 engines to these totals.
  • Aviation Industry Corporation of China (AVIC) Commercial Aircraft Engine (ACAE) plans to spend an average of US$300 million per year on jet engine R&D during the next five years, according to People’s Daily.
  • This is much less than the current jet engine market leaders (Rolls Royce, GE, Pratt & Whitney), who spent between US$1.4 and US$2.0 billion each on R&D in 2010 (8.3% to just under 13% of their respective sales revenue).
  • ACAE’s lower investment level may not enable it to catch up and develop a competitive commercial (and military) jet engine construction capability.
  • Civilian aeroengine development has military implications. The same large high-bypass turbofans used in civilian airliners can, with little or no modification, power large military aircraft including tankers, transports, Airborne Warning and Control System (AWACS) aircraft, and others. The major U.S. heavy lift aircraft (C-17 and C-5), tankers (KC-10 and KC-135), and AWACS and others (E-3A and P-8A) all either are, or can be, powered by engines that are basically identical to commercial aircraft powerplants.
  • Joint ventures with jet engine market leaders like General Electric (GE) have the potential to give the Chinese aerospace industry a 100 piece puzzle with 90 of the pieces already assembled. Enough is left out so that the exporting companies can comply with the letter of the export control laws, but in reality, a rising military power is potentially being given relatively low-cost recipes for building the jet engines needed to power key military power projection platforms including tankers, AWACS, maritime patrol aircraft, transport aircraft, and potentially, subsonic bombers armed with standoff weapons systems.
  • While already a significant source of potentially damaging technology transfer, the imperative to prioritize quarterly profits today over long-term profits and strategic concerns may be exacerbated as long-term military spending constraints in Europe, Japan, and now even the U.S. may drive Western aeroengine manufacturers even further into Chinese joint ventures to replace revenue.
  • Building these aircraft types would be contingent on advances in China’s ability to indigenously fabricate large airframes. Nonetheless, being able to build the engines indigenously would remove a major barrier.

Large turbofan engines are marvelous in their ability to reliably propel aircraft weighing more than 200 tonnes[1] at speeds of more than 800 km per hour for thousands of kilometers over vast expanses of land and sea hour after hour with very few accidents or even incidents. Yet they can do so only because they are supported constantly by a massive global infrastructure of standards, technology, and technicians.

China aims to enter this field, one of the most challenging endeavors in the world of commercial technology. It is a sector with many barriers to entry, but also a potentially lucrative one with billions of dollars in engine sales and aftermarket service contracts at stake, as well as one that would help ensure China’s ability to produce large military aircraft indigenously, free of dependence on foreign engine suppliers.

Current status of China’s commercial jet engine program

Aviation Industry Corporation of China (AVIC) Commercial Aircraft Engine (ACAE) is investing heavily in the new engine and says that it wants to increase its commercial turbofan design and development staff to 500 people by the end of 2011.[2] This would represent a more than 60% increase in staffing for the company’s commercial turbofan division and the company would like to see 40% of the new hires come from abroad, according to People’s Daily. ACAE is hiring substantially from abroad already and has held a recruitment event in the UK, and is planning one in the U.S.[3]

ACAE plans further expansion, with the company website saying the company plans to add 3,000 staff over the next 5-8 years.[4] To put ACAE’s staffing increase plans into context, an industry expert tells us that to develop a truly indigenous commercial jet engine could require on the order of 5,000 to 10,000 or more workers.[5] For instance, GE and SNECMA may have used a staff of as many as 2,000 engineers and as many as 5,000 or more technicians to develop the CFM56 engine, if all sub-suppliers are counted.[6] Even with this staffing level, electronics, sub-modules, fasteners, and other components came from outside vendors.[7] In light of this, the staffing levels that ACAE currently plans mean that: (1) the engine is unlikely to be fully indigenous and (2) that it is likely to receive substantial “off the books” funding.

In late June 2011, COMAC displayed a 1:2 scale model of the engine, which it calls the CJ-1000A (Exhibit 1). The company also says that it has already conducted trials of prototype engine components and that it intends to release an overall design plan for the CJ-1000A by the end of 2011. The C919 passenger jet is scheduled to enter service in 2016.

It is set to be powered, at least initially, by the CFM International (CFMI) Leap-X1C high-bypass turbofan engine.[8] One of the world’s premier commercial jet engine makers, CFMI is a 50-50 joint venture company between GE Aviation (U.S.) and Snecma (France) formed expressly to produce the CFM56 engine family. Based on the CFM56-5B and CFM56-7B, the Leap-X1C will reportedly offer enhanced composite materials use, a blisk fan in the compressor, a second-generation Twin Annular Pre Swirl (TAPS II) combustor, a ~10-11:1 bypass ratio, and fuel consumption reduced by 16%  compared to the CFM56 Tech Insertion engines used in the Airbus A320 and next generation Boeing 737s.[9]

This will give the C919 a world-class state-of-the art engine; the Leap-X will be employed simultaneously on the Airbus A320neo (new engine option) and reportedly also on the Boeing 737 MAX. If this all proceeds as planned, aeroengine hardware per se will be one area in which the C919’s competitors cannot add value to justify higher prices—though there may well be many others, including engine maintenance and global after-service support.

Commercial Aircraft Corporation of China, Ltd./中国商用飞机有限责任公司 (COMAC) hopes to produce up to 2,000 C919s and it appears that while the first aircraft will likely be powered by foreign engines, China aspires to fly later versions of the plane with indigenous power plants, as reflected by an April 2011 Global Times article stating that China’s domestically made large jet engine would enter service “around 2020.”[10]

Exhibit 1: Scale Model of COMAC’s Indigenous Large Jet Engine

Source: COMAC

To us, this suggests that the company feels the commercial jet engine human capital base in China remains inadequate and that it will be more effective to simply try to poach experienced personnel from global commercial engine leaders like Rolls Royce (RR), GE, and Pratt & Whitney (P&W), the “Big Three,” as opposed to developing them in China. Coming years will be interesting in terms of seeing how China’s domestic universities can turn out graduates capable of designing and building competitive commercial turbofans, and in terms of how many “technical haigui” will return to China with critical skills.

ACAE plans to spend an average of US$300 million per year on jet engine R&D during the next five years, according to People’s Daily.[11] For comparison, the current jet engine market leaders (RR, GE, and P&W) spent between US$1.4 and US$2.0 billion each on R&D in 2010 (8.3% to just under 13% of their respective sales revenue). Viewed in this light, ACAE’s investment level may not enable it to catch up and develop a competitive commercial (and military) jet engine construction capability.

An industry expert tells us that possible explanations include: (1) ACAE may in fact have a less advanced goal (either in engine performance or in the degree of integration/indigenization), (2) it enjoys significant off-budget subsidies, (3) its projections are quite over-optimistic, or (4) some combination of these factors. By design or necessity, then, it is always possible that ACAE will focus on assembly and continue to rely on imported components. In any case, since competition in the commercial jet engine sector is an iterated game, and ACAE would likely have the power of the Chinese state behind it, Big Three engine manufacturers would likely only challenge such illegal non-market subsidies (as defined in the World Trade Organization/WTO agreement on Subsidies and Countervailing Measures) if Chinese aeroengines became competitive on the global marketplace.

Exhibit 2: Global jet engine maker R&D investment comparison

Amount in million USD (left vertical axis), % of sales (right vertical axis), 2010

Source: Company reports, China Securities Journal, CIA World Factbook

Requirements for successful commercial aeroengine development

China will need to develop a general product development strategy. Options include stand-alone engines for each aircraft type, or a family concept like P&W’s Geared Turbofan (GTF) or RR’s Trent; as well as focusing on certain aircraft types/sizes or serving as an across-the-board supplier.

A general architecture strategy necessiates important choices. Among Big Three aeroengine manufactueres, one of the most important choices has involved three shafts vs. two shafts. RR’s Trent employs a relatively complex three-shaft-design, which it advertises as offering sufficiently enhanced engine rigidity and reduced performance degradation in service to justify a price premium. P&W’s GTF, its new-generation engine for the Airbus 320Neo and the Mitsubishi Regional Jet (MRJ), is advertised to have impressive fuel efficiency.

From a functional perspective, challenges fall into several categories. First, there is the engineering itself. This involves exhaust gas temperature (EGT) margin stability; acceleration/deceleration properties; cold/hot start properties; high and hot (H&H) performance; general performance; foreign object damage (FOD) resistance; volcanic ash resistance; high angle of attack (AOA) performance to avoid airflow disruption; vibration resistance of the entire engine, including the engine control unit (ECU); fuel lines; and emissions/noise trade-offs (carbon dioxide vs. nitrogen oxide vs. dirt vs. noise). Emissions/noise trade-offs are particularly complex, as the relevant regulations can vary by time and market. It is fairly easy to reduce CO2emissions, but only at the expense of increasing noise and particulate emissions; how to optimize these parameters against eachother and maintain the balance over time is challenging.

Even basic areas that might appear ripe for outsourcing to subcontractors can produce serious systemic problems. Typical “low-tech weak points” include the gear box, starter, and variable stator vane (VSV) system. The tradeoffs assumed in developing and integrating these systems typically impose significant design implications and path dependency.

The technological and systemic challenge of integrating an aeroengine with an aircraft as a whole is significant. Effective coordination of objectives and activities by COMAC and ACAE will be essential; otherwise, significant problems and suboptimal outcomes could manifest themselves. Even in a best-case scenario, decisions regarding such as hydraulic and electrical systems can lead to major unintended consequences. Optimization of integration and maintainability among such key components as the engine, nacelles, cowlings, pylon, and thrust-reversers, is another important factor. Engine efficiency despends to a large degree on efficient air inflow; the aerodynamic configuration of the inlet cowling alone can make a meaningful difference in efficiency (e.g., as measured in fuel burn).

Other principal requirements include:

–Performance guarantees (regarding thrust; on-wing-life; reliability/plannability—mean time between failures/MTBF, i.e., how long an engine lasts; and mean time before overhaul/MTBO, i.e., how often an engine must be serviced fully) impose non-fungible requirements.

–Design/total lifecycle management tools (including computational fluid dynamics capabilities).

–U.S. Federal Aviation Administration (FAA)-European Aviation Safety Agency (EASA) certification. This requires transparency regarding design processes and intellectual property (IP), making IP theft difficult to conceal.

–Extended Twin Operations (ETOPS) certification. This FAA/EASA-Japan Aviation Administration (JAA) global rule allows twin-engined airliners to fly long-distance routes, thereby increasing reliability demands on aeroengines.

–Maintainability, including ease of engine change, ease of replacing submodules (e.g., swapping access panels without dissassembly), ease of correcting for vibrations, transportability of engines (i.e., some GE90 variants must be split to fit into B747 freighter) is a major consideration of potential purchaser airlines.

–Global spare parts and special tooling (e.g., installation slings, engine change kits) support (in-house vs. outsourced after-service function).

–Parts manufacturing authority (PMA) parts policies/management/lock-out.

–Global spare engine availability. A global engine population is far more costly to maintain than the ~200 engines that might be needed to support China’s domestic market.

–Global 24/7 “Aircraft on Ground” (AOG) support.

–Global 24/7 engineering support.

–Credible Airworthiness Directive (AD)/ Service Bulletin (SB) management  to address mandatory inspections and modifications.

–Functional and customer-friendly training—service culture matters in a competitive market.

–Residual value guarantees for first (many) launch customer(s) that front-loads cost and liability for aeroengine producers.

–Financing is an important factor in attracting customers.

–Pricing (in US$ or RMB)? Implications of US$ pricing given likely long term changes in USD-RMB exchange rates.

These factors will be explored in the context of China’s specific conditions in subsequent sections.

What is at stake as China tries to build a commercial jet engine?

Prospective Chinese jet engine makers are driven by a range of strategic and economic motivations. On the commercial side, the vast engine sales and service market in China will create a wealth of opportunities for Chinese engine makers to exploit. Citibank has estimated that some jet engine makers may derive seven times the revenue from aftermarket service and parts sales for their engines that they do from the sale of the powerplants themselves.[12]

For example, in 2010, GE Aviation obtained 36% of its $17.6 billion in total revenues from servicing commercial engines, 25% from selling commercial engines, and 23% from selling and servicing military engines. Also, servicing jet engines tends to be much more profitable than selling the engines themselves, leading some analysts to say that many engines makers “sell the hot air moving out of engines” as opposed to the engines themselves (Economist).

Buyers in China are expected to purchase 5,000 commercial aircraft and more than 2,300 business jets in the next 20 years, a number of aircraft that could require nearly 16,000 commercial turbofan engines to be purchased in the base scenario and 13,000 engines in the pessimistic growth scenario (Exhibit 3).[13] Either way, the likely engine needs of China’s commercial aviation sector are going to be huge in the coming two decades. Atop this, major large aircraft buys by China’s military could easily add another 500-1,000 engines to these totals.

Exhibit 3: Potential Chinese Demand for Large Jet Engines for airliners and business jets[14]

Source: Boeing, Bombardier, CFMI, China SignPost™

Engine demand comes from a base assumption of 2 engines in each aircraft, plus an inventory of one spare engine for each 10 engines in operation. Of the engines needed, at least half are likely to need to produce 20,000 or more pounds of thrust, enabling them to power civilian airliners as well as a range of military transport and tanker aircraft.

In addition, if Chinese firms can master commercial jet engine production, they may be able to also eventually enter the export market by packaging Chinese engines with Chinese-made passenger aircraft. AVIC could order that Chinese-made aeroengines be included on aircraft sold by the company. A key question is how the resulting aircraft would sell in a competitive market. Foreign buyers could simply decline to purchase them, but Chinese airlines would confront a more complex situation. Faced with official indigenous engine use requirements, Chinese airlines could not refuse outright, but could nevertheless marginalize/minimalize/sideline said aircraft in practice.

Chinese commercial jet engine exports are at a minimum many years away, but given China’s record of becoming a serious export competitor once it masters domestic production of a product, is one that deserves consideration. Emerging markets in which China is building an increasing economic presence are among the largest growth markets for commercial aircraft over the next 20 years.

On the strategic side, government and company officials may also seek to reduce China’s dependence on P&W, GE, and RR for its jet engines. This would be driven primarily by a desire to be able to power future Chinese military tanker, transport, and airborne early warning (AEW) aircraft with domestically-made engines that would never be hostage to embargoes or disputes over prices and other issues with foreign suppliers (this strategy only works if all critical subcomponents and parts are produced indigenously).

A country can build a robust commercial aircraft industry with a global supply chain, as Embraer has done in Brazil, but reducing reliance on foreign vendors offers strategic advantages for military aircraft production. Eliminating reliance, by contrast, is typically unrealistic: at present even the U.S. uses foreign engine technology for some of its military aircraft; for example, many U.S. non-combat military aircraft are powered by CFM engines, from a U.S.-French joint venture, and even the content of combat aircraft engines is not 100% U.S. domestically designed/produced. For China to even approach this level of limited reliance would be a very tall order indeed.

Prestige and Development of Other Industries

China’s desire to build commercial jet engines is also likely driven by national industrial pride and the desire to develop other industries. For example, aero-derivative gas turbines can be used as “stand-alone” powerplants to generate electricity. Jet engine derivatives can be used to power ships, especially those for which speed is an issue; a “low performing” jet engine can still make a potent propulsion system for frigates, destroyers, and cruisers.

Jet engine production involves exceedingly complex supply chains and ACAE will face significant challenges in creating a sufficiently large and flexible supplier base when it becomes capable of producing its own commercial engines. The company’s status as an aspiring producer of commercial and military engines both means that it is likely to try and obtain as many components as possible domestically. NPO Saturn currently sources more than 90% of its components locally and we believe that ACAE is more likely to take this route than it is to emulate a global supply chain approach such as that used by RR, for example.

ACAE might achieve such a local sourcing goal as a second or third step; going indigenous for all subassemblies and parts would take a very long time and make for “non-disaggregated” learning curve(s). It would be much easier to design one or a few components domestically and see how they hold up in otherwise “reliable” imported systems and next higher assemblies (NHAs)[15] rather than having the NHA fail in its entirety and not knowing where to start the root cause analysis. In terms of industrial clustering of manufacturers and suppliers, the Xi’an, Chengdu, Shenyang, and Shanghai areas will be the primary zones of importance.

Joint Ventures and Subcontractors

To reduce NHA failure risk, ACAE may emulate the Big Three engine makers’ production model. This involves identifying the 5-10 most critical sub-modules, thereby narrowing down areas of potential problems. It entails roughly 80% indigenous and 20% foreign content. China’s reported allocation of people and resources to date appears inconsistent with an all-indigenous aeroengine approach. Indeed, even the Big Three themselves do not pursue such an approach—to do so would be too expensive and too risky technologically.

That is where joint ventures (JVs) play a useful role. Aviation is a low-quantity business, making economies of scale and learning curves tremendously important. As a leading aeroengine producer, GE makes only several thousand engines per year. By comparison, auto plants of major manufacturers such as Honda often have the capacity to produce 250,000 or more vehicles per year and in the U.S. typically run at capacity utilization rates of between 60% and 90%, depending on economic conditions.[16]

It is thus no accident that CFM engines are produced by a JV involving GE and SNECMA: this distributes risk, matches complementary expertise, and enhances financing and market access. GE, for instance, lacks technological knowledge in certain specialized areas, especially in low-level assemblies, e.g., with specialized clamps. It would be tremendously inefficient for GE to develop such expertise.

Chinese engine makers are likely to make even greater use of JVs, but likely have different motives, incentives, and constraints because of their government connections and subsidies. Their pursuit of dual-use civilian and military technology and expertise is likely to be much better coordinated and targeted to further military programs that cannot obtain such advances directly. With respect to indigenization and production, their approach will likely be to identify which subcomponents, assemblies, and parts are lacking in China, and have JVs focus on the most important ones. Prioritized items will likely include those that (1) cannot be purchased freely on the world market, because of export controls or monopolistic supplier structures; and (2) offer critical knowledge for military programs.

Examples include high-pressure turbine technology and airflow computational software. A counterexample would be clamps and big fan cases for which there are several global suppliers, and for which supply is not restricted. In practice, where parts are localized will likely hinge on both production logic and path dependence in China’s industrial base. If a certain facility has historically produced a certain type of component or system, and retains the requisite bureaucratic support, it is likely to retain ownership of those areas to protect “rice bowls.”

IP and tech transfer challenges

In public statements, foreign companies express confidence that Chinese firms will not be able to obtain and reverse engineer, or improve on their engine technology. For example, in June 2011 Chaker Charour of CFMI told the Wall Street Journal that the company does not see an indigenous Chinese jet engine as a near-term threat. “We’re not really concerned with intellectual property in China,” he adds. “We know how to integrate with them without transferring technology. We know how to play that game and protect our property.” Such statements are in fact made to maintain good relations with Chinese decision-makers and to avoid looking weak vis-à-vis competitors; in fact, we are told that all foreign companies are extremely worried, as none has found an effective way of protecting IP.

CFMI tells us it has signed a memorandum of understanding (MOU) with AVIC “to discuss the potential of establishing a final assembly line in Shanghai, as well as an engine test facility, but nothing has been finalized. The working team noted the in that release is still developing a viable business model. There are many factors to be considered and, at this point, we have not yet determined where LEAP final assembly will take place. We do source extensively in China for our current product line, so I am certain that will remain the case for LEAP, however, we are also still in the process of selecting our suppliers overall, so it is too early to say what parts will be produced in China.”[17]

We suspect one of the reasons the process is taking so long is because the engine makers want to use the “maquiladora model” in China whereby they fabricate the most critical components (such as turbine blades) in places where they know their intellectual property will be protected, and then ship them to China for final assembly. Airbus’s state-of-the-art Tianjin assembly line, the most modern foreign airliner assembly facility in China today, is a case in point. Airbus fabricates the parts at its Hamburg, Germany plant, and then ships all of the components to Tianjin for final assembly.[18] In this case, China-based assembly does not even seem to be driven by cost concerns. Rather, it is driven by the importance of having a figurehead manufacturing element on Chinese soil in order to secure product sales in that market, as well as the creation of production capacity needed above and beyond the Toulouse (TLS) and Hamburg (HAM) final assembly lines (FALs).

China’s auto industry has had similar experiences with JVs with foreign partners that in reality either transferred little technology overall or only transferred technologies that were basically obsolete in developed markets. This issue is likely to remain a sticking point between ACAE and potential foreign engine manufacturing partners because China will work hard to avoid being a secondary market into which outmoded technologies can be transferred to wring out a bit more profit. Automotive components, for instance, offer a great example of how IP protection did notwork. Today, following years of assiduous technology transfer effort by multiple means, many Chinese JV partners are serious competitors in the domestic automotive component industry, threatening foreign suppliers, including in the area of R&D.

What are the differences between military jet engines and commercial engines?

There is a reason why there are only a handful of globally trusted aeroengine producers in the world at this time—it is a very difficult business indeed, and there is no tolerance for error. China is making progress in both fields, but there are substantial differences. Military engines represent primarily an engineering challenge, a key Chinese strength.

Civilian engines, by contrast, require engineering (R&D); design-to-cost; global support (e.g., parts, cosignment inventory, engineering, aircraft on ground/AOG status, training, spare engines, airworthiness directive/AD and service bulletin/SB management, parts manufacturing authority /PMA parts policies/management/lock-out); residual value guarantees; FAA/EASA certifiability; global management; cooperation; as well as IP coordination and guarantees that whatever IP is used in the first place was obtained licitly.

After-market service comes with very strong expectations per global industry standards. AOG status means that an aircraft has been grounded, entitling it to priority service from suppliers, albeit at a price premium. Servicing within 24 hours is typically expected, with only 12 hours allowable in some cases. This norm must be upheld or clients will hesitate to procure products; establishing a large warehouse in the Seattle, WA area dramatically enhanced Airbus’s spare parts supply in the U.S., and hence greatly facilitated its market entry there.

Safety must be ensured on a 24-7-365 basis or international standards bodies will rescind certifications. For instance, ADs are internationally standardized means by which commercial regulatory authorities can communicate urgent action requests to aviation operators, i.e., concerning a specific aircraft type or component, regarding mandatory actions to be taken (e.g., grounding, inspection, and replacement). SBs are global standards communications means between an original equipment manufacturer (OEM, e.g. a Chinese aeroengine manufacturer) and an operator (e.g., a foreign airline).

Meeting such requirements demands both performance and service delivery, with little room for learning on-the-job. This requires a responsive managerial setup and a global resource and service network, including technically-qualified English speakers to ensure real-time global product service and thereby ensure consumer safety and confidence. A fully indigenous engine might require 500-1,000 people for ongoing customer support alone. The range of technology on sub-modules requires a range of experts on all areas to issue SBs at any time. For this, good coordination with subcontractors in real time is imperative. Here, unauthorized technical shortcuts to speed development and production could prove extremely costly in the long run. Airline requirements can include borrowing special tools per prior customer service agreement. Service is the key to profits, and keeping initial engine prices low to attract customers.

In contrast to OEM parts, PMA parts are generic. Like a printer and its ink cartridges, an aeroengine itself is relatively cheap compared to the costs of parts and servicing over time. PMA parts offer airlines a key way to control costs, since OEM parts typically carry a hefty markup. PMA versions are typically only available for lower-performance, less-sensitive parts, e.g., screws, washers, clamps, and less-demanding fan blades. At a mere 20-30% of OEM part costs, they offer the same properties, and sometimes better performance. Compatibility can be an issue, and what PMA usage aeroengine manufacturers will accept grudgingly from what customers (e.g., tolerating PMA parts for lower-performance spares) is the subject of constant negotiation. Some companies do not allow PMA parts on leased aircraft. Litigation and counter-litigation concerning technical prominence and performance of parts, especially PMA parts, occurs constantly.

Residual value guarantees represent commitments by manufacturers to make up the difference between expected and actual market value after a fixed period of time (e.g., for resale after 5 years). They can be critical to securing a sale, are required by aeroengine buyers in many cases, and would likely be demanded for all Chinese aeroengines, at least initially. This is on top of a warranty, typically lasting 2-5 years, negotiated individually, and documented in a detailed multi-paged contract stipulating specific provisions. To ensure confidence in its products, a Chinese aeroengine manufacturer would have to go far beyond providing the generous warranties that eased Korean manufacturer Hyundai’s automobiles into the U.S. market despite concerns about their reliability.[19]

One area in which Chinese aeroengine suppliers may actually already enjoy an advantage is in financing. Chinese government organizations and SOEs can draw on substantial resources when authorized, and have significant experience in tailoring financing to a client’s needs. A complicating factor is pricing currency, as thus far the U.S. dollar remains the global transaction standard. To the extent that China attempts to indigenize aeroengine inputs, it will lack a natural hedge against the exchange rate. With the RMB likely to appreciate further, this creates an unfavorable dynamic for an exporter. This is likely surmountable given policy prioritization of aeroengine development, but will impose additional costs.

Designing engines based on tight operating and ownership cost parameters and providing reliable global technical and maintenance support represent key weaknesses and gaps in capability that may hinder China’s ability to enter and compete successfully in the global market. For military applications, performance is more important than cost. For civilian applications, the total cost of ownership (TCO)—over the entire life cycle of the engine—is far more important than marginal increases in performance, once a sufficient level is reached.

The initial purchase price of a civil aeroengine pales in importance compared to the on-wing time and maintenance costs over the total operational lifecycle. The aviation industry, in which a major airline consumes several billion dollars of fuel per year, is extremely sensitive to total operating costs. Here Chinese products would face a very different calculus than in other markets; Chinese aeroengines, if they were to be sold at low prices but could not demonstrate high reliability and low total operating and ownership costs, could be viewed widely as a source of false economy.

It is unclear exactly how much ACAE’s leadership truly understands how difficult complying with global certifications and efficiency benchmarks can be in practice. Their bureaucratic-corporate positions may make them far more attuned to technical manufacturing standards than to international after-market service demands. This is a problem of both culture and resource allocation.

Chinese firms have yet to prove themselves in the critical areas of design, certification, sales, servicing, and other after-market support; these remain terra incognita for them in virtually all respects for commercial aviation inasmuch as Chinese aircraft/engine OEMs have not yet placed products with leading operators outside China. In addition, widely available service infrastructure makes engines for large commercial jets more attractive for military applications. With respect to the CFM56 (military designation F108) engine that powers the KC-135 Stratotanker, Snecma notes that “The use of a Commercial Off the Shelf (COTS) product has allowed the USAF to leverage commercial experience and hardware improvements into its fleet. The worldwide base of commercial repair facilities also provides the USAF with a significant level of “warm base” support.”[20]

Another vital difference is that for China’s military jet engine programs to have a major positive impact on the country’s ability to produce fighters that can attain 5th-generation aerodynamic performance with indigenous components, it only needs to reach 1990s-level technology standards (meaning engines analogous to the P&W F119 that powers the F-22 Raptor). With the bar slightly lower, even just attaining the ability to reliably mass produce engines with performance equivalent to the 1980s-era P&W F100 or GE F110, which power the F-15 and F-16, would enable China to build its J-10, J-11, and J-15 fighters entirely from domestically-made parts, a major strategic improvement.

For “hare-like” military engines, peak performance is the key variable. This necessitates such specific efforts as squeezing the last bit of performance out of a given alloy. Other factors may be compensated for as the user sees fit; for example, engine maintenance and life limitations may be addressed to some extent by purchasing additional engines. This calls to mind country western singer Toby Keith’s lyric “I’m not all that I once was, but for once I’m all that I ever was.” This makes for a good song and a tolerable military turbofan in a developing country—but not a civilian engine in a competitive developed market.

“Tortoise-like” civilian turbofans, in contrast, support commercial activity and are judged on long-term profitability. This makes them arguably more technologically challenging overall. Commercial engines need to be at or very near the global state of the art in terms of fuel efficiency; durability (on-wing life); reliability; exhaust gas temperature (EGT) margin stability; emissions; noise; weight; maintainability; optimization of fit between the engine, cowls, nacelles, thrust reversers (TRs),[21] etc.; and safety to be competitive in the market. EGT monitoring and management is essential to maximizing fuel burning efficiency and avoiding metal fatigue. It is easy to design for increased thrust; keeping it stable over time on-wing even with gradually deteriorating subcomponents is the real challenge.

Beijing could conceivably create a protected market space for less advanced Chinese-built commercial jet engines by using indigenous content rules that mandate the use of domestically-made engines in aircraft sold to operators based in China. That said, it is unlikely that Chinese airline executives will be content with lower profits caused by having to fly their aircraft with inferior, less efficient domestic engines. They would also face customer defection on routes served by foreign airlines with more efficient, safer engines. Furthermore, Chinese carriers—and any non-Chinese user, for that matter—might fear that in case of serious quality/reliability/safety issues putting pressure on Chinese engine OEMs could be much more difficult than on foreign engine OEMs due to the nature of ownership of the former and the prevalence of the user base of the latter.

Given such perceptions, China’s own airline CEOs could remain a very powerful base of support for using foreign-made engines if Chinese-made commercial engines cannot rapidly attain the performance and efficiency parameters of the CFM56 or newer Leap-X engines. As a harbinger of Chinese airlines putting their interests in customer preferences and quarterly profits before those of long-term national development goals, we note that state-controlled airlines in China have already pushed back against the government because they do not want to make substantial promises to purchase the domestically-made ARJ21 and C919 airliners, despite Beijing’s desire to see COMAC grow into one of the world’s key producers of regional jets and larger airliners.[22] Moreover, other “non-commercial/-profit” factors such as the aforementioned, especially the ability—or lack thereof—to put pressure on a state owned enterprise (SOE) like AVIC in case of problems, may exert influence.

Development and Maintenance Challenges

Military turbofans’ development must typically be far more independent of foreign assistance than that of their civilian counterparts, particularly for a nation that is relatively new to the field (or at least its advanced commercial areas), such as China. By contrast, in civil engines, the low-pressure components and turbofans can benefit from extensive joint ventures and foreign suppliers of sub-modules. Industrial espionage is also much easier in the civilian realm, as information controls are far more relaxed. For high-pressure components, by contrast, it is much harder to get help even in the civilian realm, and in the military realm it is often virtually impossible.

Sales and Services

Chinese military turbofan engines are built with the assumption that the primary customer is the People’s Liberation Army (PLA), with the additional possibility of small-scale exports to friendly countries that lack ability to set standards or otherwise influence the product. Hence, the primary challenge is engineering.

Civilian turbofans, by contrast, face a complex, demanding, and constantly yet unpredictably evolving set of end user expectations over thousands of flights. Engineering is not the primary challenge; rather, supply, after-market servicing, and intellectual property rights (IPR) management are the greatest trials (as well as the other issues mentioned above). Both domestic and foreign customers have unyielding efficiency and safety expectations and—in case of certification by the FAA/EASA—complete transparency requirements in case of mistakes, and even along a normal “steady-as-she-goes” design/manufacturing process.

No special exceptions can be made even for a government-supported national champion aircraft such as the COMAC C919. This would potentially go against critical aspects of the corporate culture found in many Chinese SOEs. Engines constantly face maintenance issues and risk FOD at any time. Maintaining and supporting engines overseas requires sophisticated engineering and spare support infrastructure. Engineering and design chain management, and especially supply chain management, are extremely difficult. Technology partnerships and sub-modules delivery (i.e., obtaining engine control units from Honeywell) offer useful opportunities, but raise complex contractual and IPR issues.

Certification

Civilian engines must pass demanding certification processes in each of the major advanced markets in which they will be used. To be a top-tier supplier, one’s engines must be certified by the FAA and EASA, as well as JAA, which has an independent process that draws on the former two metrics. These are extremely difficult markets to enter and stay in. Providers of aviation liability/risk insurance compel airlines to compel regulators to demand these extremely complex, but entrenched and effective standards that are critical to ensuring safety in an unforgiving operating environment.

Lower-tier producers that cannot meet these demanding standards are restricted to limited, less-desirable markets. Aircraft that use Russian aeroengines, e.g., Tupolev aircraft flown by the Russian carrier Aeroflot, cannot be sold to top-tier international carriers that operate in the lucrative North American, European, or Japanese markets.

Meeting FAA/EASA standards is extremely demanding, in terms of both quality and process. Being systematic, remaining transparent, and maintaining route traceability are mandatory. The relevant FAA inspector’s design process handbook runs to several thousand pages.[23] It stipulates how to keep track of changes in engineering drawings, changes must be authorized, how quality control gates must be managed, and how documentation must be filed and processed. Requirements include an English-language document specifying how to number different versions of a drawing.

If FAA/EASA standards are revised, this necessitates painstaking revisions to such a numbering document, as well as thousands of pages of other paperwork. Every single screw, shim, bolt, fastener, and rivet must be certificated. The paperwork needed to document the design and certification of a single new screw, bolt, washer, or clip nut runs to several inches in thickness.

These standards cover all aspects of aircraft design and production, not just aeroengines. The slightest failure to achieve formal or substantive compliance has immediate consequences, even for non-working parts of an aircraft, let alone its vital propulsion systems. Depending on the nature of the shortfall, a single aircraft or even all the aircraft of a given type may be grounded. This is precisely what happened with Boeing 737-800 and Airbus aircraft that used seats produced by Koito.

When it was discovered that the Japanese company had falsified fire resistance and strength test results (on as many as 150,000 seats on 1,000 aircraft from 32 airlines), the aircraft using the seats were delayed in delivery, and as a result Boeing and Airbus immediately selected alternate suppliers and replaced the seats.[24] In addition to these major OEMs, some airlines are currently working with Koito to get their old seats certificated. Magnitude and expense are no excuse for delay when it comes to meeting standards.

Becoming “certificated” by the FAA and its counterparts thus has huge implications for design processes, and how people are qualified. How China will address these requirements in its aeroengine/aircraft development remains an open question. The ARJ-21 did not comply with the process during its development. China is now trying to “back end” its way into FAA compliance, but will likely not succeed—and that is affordable for China, as the ARJ-21 is intended primarily as a low-volume, likely non-profitable “test project” or “stepping stone,” rather than a major commercial success in its own right. But China has much higher expectations for the COMAC C-919—it must become an alternative to Boeing and Airbus in its own right.

Unlike with certain WTO provisions and other international norms, safety and commercial interests in the aviation industry make it too hard for Beijing to easily “steamroll” standards. This places a premium on what will happen with the C919, on which China is lavishing billions to make it succeed. Accordingly, China, working in consultation with foreign JV partners, is involving the FAA at a much earlier development stage. Yet it probably still faces a rude awakening in meeting demanding standards that it cannot simply bend to its perceived local necessities.

The exacting and meticulous FAA/EASA standards requirements, in accordance with the highest safety regulations and federal laws, also raise intriguing questions regarding how China could deal with irregular development processes and any unauthorized covert incorporation of foreign technology (e.g., of A320 technology in the C919). Conceivably, this might require reverse engineering both the design and the testing process in real time to hide any illicit technology transfer. While such procedures are certainly possible, they would add considerable cost, complexity, and potential for error.

Civilian Military Integration (CMI) Potential

In most countries that attempt military and civil aeroengine production, the same organizations and firms are involved in both sectors, and military programs in effect subsidize civilian programs. This is vital, as a new generation civilian engine such as the CFM56 can require something on the order of $5 billion to develop, test, and certify. The one major technology power to attempt civilian-centric aeroengine production, Japan, has not succeeded, and lack of military subsidies is one of the key explanations.

Civilian aeroengine development can also help military aeroengine development. It is much easier for civilian entities to obtain such capabilities as foreign design/lifecycle management software, project management tools/systems for multiple parallel critical paths, test cell design, managerial processes, design processes, and revision and document control. These can then be transferred in some form to military counterparts.

Perhaps most notably, the same large high-bypass turbofans used in civilian airliners can, with little or no modification, power large military aircraft including tankers, transports, and AWACS. The major U.S. heavy lift aircraft (C-17 and C-5), tankers (KC-10 and KC-135), and AWACS and others (E-3A and P-8A) all either are, or can be, powered by engines that are basically identical to commercial aircraft powerplants.

For example, CFM56 series engines like those that power the Boeing 737 and Airbus A320 single-aisle airliners are also used in the KC-135 tanker, E-3A AWACS, and P-8A maritime patrol aircraft (which is itself essentially a modified B737-800 smaller airframe with a slightly modified 737-900-derived larger wing, the better to hold additional fuel and allow thicker aluminum skin to better withstand the marine environment). Lockheed’s C5-M Super Galaxy military transport uses CF6 engines. Similarly, the PW2000 turbofan that powers the Boeing 757 and Ilyushin IL-96 airliners is the base for the F117 PW100 engine used in the C-17 transport aircraft, the backbone of the U.S. airlifter fleet (Exhibit 4).

Exhibit 4: Civilian-Military Crossover for Select Large Aircraft Engines

Source: GE, P&W, Boeing

Strategic implications of large engine production

Joint ventures with jet engine market leaders like GE have the potential to give the Chinese aerospace industry a 100 piece puzzle with 90 of the pieces already assembled. Enough is left out so that the exporting companies can comply with the letter of the export control laws, but in reality, a rising military power is potentially being given relatively low-cost recipes for building large jet engines that could power key military power projection platforms which could be regionally destabilizing.

While already a significant source of potentially damaging technology transfer, the imperative to prioritize quarterly profits today over long-term profits and strategic concerns may be exacerbated as long-term military spending constraints in Europe, Japan, and now even the U.S. may drive Western aeroengine manufacturers even further into Chinese JVs to replace revenue.

Building these aircraft types, including tankers, AWACS, maritime patrol aircraft, transport aircraft, and potentially, subsonic bombers armed with standoff weapons systems, would be contingent on advances in China’s ability to indigenously fabricate large airframes. Nonetheless, being able to build the engines indigenously would remove a major barrier.

Commonality is an interesting topic, with countervailing implications. The more commonality Chinese-made engines have, the more selling them to non-Chinese users could become an issue. What if the PLA vetoes selling essentially the same engine that powers its AWACs, tankers, etc. to, say, a potential adversary like the U.S.? And even if that PLA requirement is not made explicit, what would need to be done to convince a non-Chinese airline customer that might buy a Chinese-made engine on the basis of a 15-year-long business plan that this sort of threat would never materialize? What if tensions between the U.S. and China worsen to the extent that spare and engineering support gets cut off? What about the very long-term prospects of fitting a Chinese-made engine on a non-Chinese airframe? China’s growing prowess in civilian aeroengine production raises some very complex long-term questions for all concerned.

[1] Boeing 737s and Airbus 320 family-type aircraft are lighter, and regional and business jets lighter still.
[2] “British talent may join China’s large aircraft project,” People’s Daily, 24 March 2011, http://english.peopledaily.com.cn/90001/90778/90860/7330324.html.
[3] Ibid.
[4] “Staffing Management and Ideas,” AVIC Commercial Aircraft Engine (ACAE), http://www.acae.com.cn/ACAENEWWEB/ACAE/ACAE_RCZX/ACAE_RCZX_ZLRLZYKFYGL/default.asp.
[5] Interview, September 2011.
[6] Ibid.
[7] Ibid.
http://online.wsj.com/article/SB10001424052702303310004576393501621845100.html, http://www.cfm56.com/press/news/cfm+international+and+comac+sign+master+contract+to+finalize+leap-powered+c919+agreement/608.
[9] “CFM Unveils New LEAP-X Engine,” CFMI, 13 July 2008, http://www.cfm56.com/press/news/cfm+unveils+new+leap-x+engine/441.
[10] “New Breakthrough: Domestically-made Large Aircraft Engine Should Enter Service Around 2020,” Global Times, 3 April 2011, http://mil.huanqiu.com/china/2011-04/1608129.html.
[11] AVIC to invest 10 billion yuan in engine R&D,” 13 April 2011, People’s Daily, http://english.peopledaily.com.cn/90001/98649/7349148.html.
[12] “Rolls Royce: Britain’s Lonely High Flier,” The Economist, 8 January 2009, http://www.economist.com/node/12887368.
[13] Data from Boeing and Bombardier China market forecasts.
[14] The S-Curve scenario is based on our prior analytical work on potential risks that could move China’s economic growth onto a slower path and assumes a 15% lower demand for commercial airliners and a 25% lower demand for business jets, which are likely to be even more price sensitive. 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), http://www.chinasignpost.com/2011/08/china%e2%80%99s-s-curve-trajectory-structural-factors-will-likely-slow-the-growth-of-china%e2%80%99s-economy-and-comprehensive-national-power/.
[15] A NHA is the product of given subcomponents.
[16] East Liberty Auto Plant, Honda of America Manufacturing, http://www.ohio.honda.com/manufacturing/elap.cfm. See also Bill Visnic, “Despite Slim-down, Automakers Still Hung With Too Much Capacity,” Edmunds Auto Observer, 27 August 2010, http://www.autoobserver.com/2010/08/despite-slim-down-automakers-still-hung-with-too-much-capacity.html.
[17] Interview, September 2011.
[18] Roger Cliff, Chad J. R. Ohlandt, and David Yang, Ready for Takeoff: China’s Advancing Aerospace Industry (Santa Monica, CA: RAND, 2011), 39, http://www.rand.org/pubs/monographs/MG1100.html.
[19] Mike Ramsey and Evan Ramstad, “Once a Global Also-Ran, Hyundai Zooms Forward,” Wall Street Journal, 30 June 2011, http://online.wsj.com/article/SB10001424052702303627104576413971267185128.html.
[20] CFM-Powered KC-135R Tanker Fleet Logs 11 Million Flight Hours,” SNECMA, 11 December 2007, http://www.snecma.com/cfm-powered-kc-135r-tanker-fleet,881.html?lang=en.
[21] TRs deploy once the main landing gear touches the tarmac, offering stopping power in addition to the brakes and flaps.
[22] Cliff, Ohlandt, and Yang, Ready for Takeoff: China’s Advancing Aerospace Industry, 42.
[23] The FAA handbook concerning how to supervise maintenance activities of airlines once an aircraft is fully developed itself runs to roughly one thousand pages.
[24] “Airliner Seat Maker Koito hit for Fabricating Fire-Resistance Data,” Kyodo News, 10 February 2010, http://search.japantimes.co.jp/cgi-bin/nn20100210a5.html; Mary Kirby, “Boeing Stops Offering Koito Seats to New Customers,” Flight Global, 7 February 2010, http://www.flightglobal.com/articles/2010/07/02/344008/boeing-stops-offering-koito-seats-to-new-customers.html.

***

Andrew S. Erickson and Gabriel B. Collins, “China’s S-Shaped Threat,” The Diplomat, 6 September 2011.

Analysts of international relations have focused lately on China’s potential challenges to the international system. But China’s greatest challenges may in fact be internal. The implications will be significant.

China is assumed by many to be destined to overtake the US as the world’s leading power. But history shows the dangers of extrapolating from today’s growth numbers.

According to the US National Intelligence Council (NIC), ‘China is poised to have more impact on the world over the next 20 years than any other country.’ China is already the world’s second largest economy, second largest energy importer, largest natural resource importer by volume, and largest emitter of greenhouse gasses. Indeed, following the S&P downgrading of the US credit rating to AA+, Beijing feels empowered to declare that it ‘has every right now to demand the United States to address its structural debt problems.’

However, despite its astute policy navigation, efforts to guide national development, and claims of exceptionalism, China isn’t immune to larger patterns of economics and history. And those patterns tell us that China faces costly internal and external challenges that will hinder its ability to avoid the S-Curve-shaped growth slowdown that so many previous great powers have experienced, and that so many observers believe the United States is undergoing today.

Where China is headed domestically and internationally has major implications across the board for virtually everyone on this planet. The country has risen at a rate beyond even its leaders’ expectations over the past three decades, and a power shift is afoot in the international system. The fully unipolar system that persisted from 1989 to roughly 2008 is no more. To many, this signals a clear power transition in which China is poised to overtake the United States as the world’s foremost power. Estimates emerge constantly as to when China’s economy will become larger than that of the United States, and it’s assumed that China’s diplomatic, information, and military aspects of national power will grow in proportion.

But many policymakers and economists question whether China’s current growth trajectory can be maintained in the face of clear structural challenges that include pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—all factors that feed off of one another and exact increasingly large costs for the Chinese state and economy. … … …

***

Andrew S. Erickson and Gabriel B. Collins, “Did China Tip Cyber War Hand?” The Diplomat, 25 August 2011.

A programme broadcast on the military channel of China’s state TV raises new questions about Beijing’s support for cyber attacks.

Amid growing US concerns over ongoing Chinese cyber attacks, attribution remains the most complex issue. At the open source level at least, it has been hard to find a ‘smoking cursor.’ That is, until the broadcast of a recent cyber warfare programme on the military channel of China’s state TV network.

The programme appeared to show dated computer screenshots of a Chinese military institute conducting a rudimentary type of cyber attack against a US-based dissident entity. However modest, ambiguous—and, from China’s perspective, defensive—this is possibly the first direct piece of visual evidence from an official Chinese government source to undermine Beijing’s official claims that it never engages in overseas hacking of any kind for government purposes. Clearly, Washington and Beijing have much to discuss candidly here if they are to avoid dangerous strategic tension.

China Central Television 7 (CCTV-7) is China’s official channel for military and agricultural issues. As part of its wide-ranging coverage, every Saturday it runs a 20-minute programme called ‘Military Science and Technology.’ It’s always worth watching, given the range of timely topics covered and the detailed analyses offered by Chinese specialists. The July 16 edition was particularly so.

Entitled ‘The Internet Storm is Coming’ (网络风暴来了), it begins with a broad discussion of cyber attacks. It showcases a statement by then-US Defense Secretary Robert Gates at the Shangri-La Dialogue in Singapore in June. This important international conference was also attended by Gates’ Chinese counterpart Gen. Liang Guanglie. Emphasizing that the United States was extremely concerned about the cyber attacks that it was continually suffering from, Gates suggested that some attacks could rise to the level of an act of war and prompt the United States to respond with force.

Chinese Military expert Du Wenlong then highlights President Barack Obama’s May 2009 remarks in which he emphasized the importance of securing the nation’s digital infrastructure and declared it a strategic national asset. Du explains that Washington would regard some types of cyber attacks as acts of war because modern military operations rely heavily on digital networks and cyberspace: ‘networks have become the basis for military action and for winning a war.’ Du appears to be well acquainted with his subject matter, and provides cogent explanations of complex cyber issues.

But here is where the programme deviated from its typical theoretical coverage of broad military trends for six seconds to offer an unusually-specific Chinese example. An initial screen was labelled ‘Vulnerability Report’ in large letters; a narrator intones that ‘there are many Internet attack methods.’

As the narrator discusses a means of implementing hard and soft cyber/network attacks, footage displays what appears to be a human-operated cursor using a software application with Chinese character labelling to launch a ‘distributed denial-of-service’ (DDOS) attack.

This particular DDOS is against a website formerly affiliated with the dissident religious group Falun Gong. Under large characters reading ‘Select Attack Target,’ the screenshot shows ‘Falun Gong in North America’ being chosen. Here it must be emphasized that DDOS attacks are generally extremely rudimentary. As will be explained later, if the footage in question was real, it’s likely a decade old.

Drawing on a ‘Falun Gong website list’ encoded in the software, the cursor selects the ‘Minghui Website’ from a pull-down menu of Falun Gong websites. Minghui.org is the main website of Falun Gong’s spiritual practice, and hence a logical target.

Hovering over a software window labelled ‘IP Address of a Website Chosen to Attack,’ the cursor selects the IP address 138.26.72.17. This was once linked to the University of Alabama in Birmingham. According to the Falun Gong-supporter-founded Epoch Times, a UAB network administrator ‘recalled that there had been a Falun Gong practitioner at the university some years ago who held informal Falun Gong meetings on campus. They couldn’t confirm whether that individual used the IP address in question, and said it had not been used since 2010.’ PC World added that the site was created ‘by “a former student and was decommissioned in 2001 as it violated our acceptable use policy,” according to Kevin Storr, a UAB spokesman.’

During this sequence, some interesting characters remained at the top of the screen: ‘Attack system…PLA Electronic Engineering Institute.’ … … …

***

Andrew S. Erickson and Gabriel B. Collins, “A Smoking Cursor? New Window Opens on China’s Potential Cyberwarfare Development: CCTV 7 Program Raises New Questions About Beijing’s Support for Hacking,” China SignPost™ (洞察中国) 46 (24 August 2011).

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

The positions expressed here are the authors’ personal views. They do not represent the U.S. Naval War College, Navy, Department of Defense, or Government, and do not necessarily reflect the policies or estimates of these or any other organizations.

Amid growing U.S. concerns of ongoing Chinese cyberattacks, attribution remains the most complex issue. At the open source level at least, it has been hard to find a “smoking cursor.” That is, until the broadcast of a recent cyberwarfare program on the military channel of China’s state television network. It appeared to show dated computer screenshots of a Chinese military institute conducting a rudimentary type of cyberattack against a United States-based dissident entity. However modest, ambiguous—and, from China’s perspective, defensive—this is possibly the first direct piece of visual evidence from an official Chinese government source to undermine Beijing’s official claims never to engage in overseas hacking of any kind for government purposes. Clearly, Washington and Beijing have much to discuss candidly here if they are to avoid dangerous strategic tension.

What Happened?

China Central Television 7 (CCTV-7) is China’s official channel for military and agricultural issues. As part of its wide-ranging coverage, every Saturday at 1440-1500 Greenwich Mean Time (GMT), CCTV-7 runs a 20-minute program on military S&T developments in China and abroad called “Military Science and Technology.” It’s always worth watching, given the range of timely topics covered and the detailed analyses offered by Chinese specialists. The 16 July 2011 edition was particularly so.

Entitled “The Internet Storm is Coming” (网络风暴来了), as pictured above in a CCTV-7 website screenshot, it begins with a broad discussion of cyberattacks. It highlights a statement by then-U.S. Secretary of Defense Robert M. Gates at the Shangri-La Dialogue in Singapore on 4 June 2011. This important international conference was also attended by Gates’ Chinese counterpart General Liang Guanglie. Emphasizing that the U.S. was extremely concerned about the cyberattacks that it was continually suffering from, Gates suggested that some attacks could rise to the level of an act of war and prompt the U.S. to respond with force.[1]

PRC Military expert Du Wenlong (pictured above) then highlights President Obama’s May 2009 remarks in which he emphasized the importance of securing the nation’s digital infrastructure and declared it a strategic national asset. Du explains that Washington would regard some types of cyberattacks as acts of war because modern military operations rely heavily on digital networks and cyberspace: “networks have become the basis for military action and for winning a war.”[2] Du appears to be well acquainted with his subject matter, and provides cogent explanations of complex cyber issues. The program proceeds to explain how cyberwarfare may be waged, in both the defensive and offensive dimensions.

Here is where the program deviates from its typical theoretical coverage of broad military trends, many focused on foreign militaries for six seconds to offer an unusually-specific Chinese example. An initial screen (below) is labeled “Vulnerability Report” in large letters; a narrator intones that “there are many Internet attack methods.”

As the narrator is discussing means of implementing hard and soft cyber/network attacks (at 11:04 in the program time code), footage displays what appears to be a human-operated cursor using a software application with Chinese character labeling launching a “distributed denial-of-service” (DDOS) attack (as pictured below).

This particular DDOS is against a website formerly affiliated with the dissident religious group Falun Gong. Under large characters reading “Select Attack Target,” the screenshot below shows “Falun Gong in North America” being chosen. Here it must be emphasized that DDOS attacks are generally extremely rudimentary. As will be explained later, if the footage in question is real, it is likely a decade old.

Drawing on a “Falun Gong website list” encoded in the software, the cursor selects the “Minghui Website” from a pulldown menu of Falun Gong websites (as pictured below). Minghui.org is the main website of Falun Gong’s spiritual practice, and hence a logical target. The other options visible are “Falun Dafa websites in North America, Falun Dafa in Alabama Area; Falun Dafa Websites, Minghui Website; and Falun Gong Witness Site (1).” The cursor then depresses a large button on the bottom left corner of the software menu labeled “Attack.” The one on the bottom right corner, labeled “Cancel,” is not selected.

Hovering over a software window labeled “IP Address of a Website Chosen to Attack,” the cursor selects the IP address 138.26.72.17. This was once linked to the University of Alabama in Birmingham (UAB).  According to the Falun Gong-supporter-founded Epoch Times, a UAB network administrator recalled that there had been a Falun Gong practitioner at the university some years ago who held informal Falun Gong meetings on campus. They could not confirm whether that individual used” the IP address in question, “and said it had not been used since 2001.”[3] PC World adds that “The site was created ‘by a former student and was decommissioned in 2001 as it violated our acceptable use policy,’ according to Kevin Storr, a UAB spokesman.”[4]

During this sequence, some interesting characters remain at the top of the screen, as pictured in light blue highlighted against a dark blue background block in the cropped image below: “Attack system..[periods in original] PLA Electronic Engineering Institute.”

The program then returns to general cyberattack themes.

As this research note went to press, the program footage remained readily visible and viewable on the CCTV website at <http://mil​itary.cntv​.cn/progra​m/jskj/201​10717/1001​39.shtml>.

Why it Matters

It is significant that an official Chinese state television channel showed even a symbolic representation of a cyberattack, particularly one on entities clearly located in a foreign sovereign nation. First, as one of its central emphases, China insists forcefully on realizing an extremely expansive definition of national sovereignty—it is difficult to see how such activities could possibly be in accordance with this overall approach. One of the greatest sources of friction in U.S.-China relations are fundamental differences regarding the scope of sovereignty, with China almost invariably the more indignant and assertive party. Second, official spokespeople for most other nations thought to have substantial offensive cyber and intelligence capabilities studiously refrain from addressing those capabilities directly, and hence from potentially making statements that did not appear to be credible about such issues. But Chinese officials instead issue blanket denials in this regard.

In September 2007, for example, Chinese Foreign Ministry spokeswoman Jiang Yu declared: “Some people make groundless accusations against China… China has all along been opposed to and forbids criminal activities undermining computer networks, including hacking. China is ready to strengthen cooperation with other countries, including the U.S., in countering Internet crimes.”[5] In 2010, Jiang again denied that China has been responsible for cyberattacks: “Some reports have, from time to time, been heard of insinuating or criticising the Chinese government… I have no idea what evidence they have or what motives lie behind. Hacking is an international issue and should be dealt with by joint efforts from around the world.”[6]

Unfortunately, despite this recent incident and a larger “Inbox” of mounting evidence to the contrary, Chinese official responses are likely to follow the well-trod path of deliberate denial of responsibility—thereby further straining Beijing’s credibility in foreign audiences.

Alternative Explanations

As with many incidents involving apparent, alleged, or uncertain Chinese military capabilities, this one raises more questions than answers:

  • What was the motive for displaying the software footage?
  • Where did the footage come from, and how was it created?
  • At what level were decisions to insert and retain coverage made?
  • Who was the intended audience?

Since it seems unlikely, given its professed cyber security concerns and substantial technological capabilities, that Beijing allows itself to be defenseless against what it alleges to be the extensive predations of others in the offense-dominant domain of cyberspace, the alternative would appear to be that China is not being forthcoming in public about its development of offensive cyber capabilities. But why should this be, since virtually no Western experts or government officials believe such statements to be true? The most plausible answer would appear to be that China’s government sees value in appearing to be defensive, and morally virtuous, before a domestic audience—its most important audience, and the most important audience for virtually any government. It is also possible that calling too much Chinese public attention to the nation’s cyber capabilities could remind Chinese netizens further of the extensive Internet censorship that currently constrains their lives online, and which many find increasingly frustrating. Then there is the issue of the extent to which China’s government may work with semi-, loosely-, and irregularly-affiliated, or firewalled-off, “Patriotic Hackers” to do its bidding. Perhaps it is seen as best to preserve at least some form of “plausible deniability” to deflect inquiries concerning these controversial issues, the better to unite citizens against perceived “foreign threats.”

None of this, of course, explains the CCTV-7 footage’s provenance and appearance per se. On the one hand, a large “Attack” button may seem cartoonish. On the other hand, this is no doubt a popular concept among Chinese cyberwarriors and their foreign counterparts alike, who have been schooled originally in video and computer games like World of Warcraft and may have some say in how things are constructed—there is no reason why such a configuration would be inherently disfunctional.

Perhaps the least unlikely explanation is that program producers sought specific footage to document specific cyberattack techniques. For reasons of Chinese pride, and perhaps PLA assertiveness, they wanted to show that China could do something itself in the face of perceived threats. Falun Gong, particularly despised by Beijing, offered a politically-correct and “morally justified” target even for ideologically dubious techniques. Footage from previous interviews and interaction with the PLA Electronic Engineering Institute may have happened to be available in convenient form, and met visual requirements. In any case, it would seem that nobody in the decision-making chain objected at the time.

Perhaps most importantly, the CCTV-7 software contents appear to correlate so closely with a set of attacks that China is alleged to have engaged in a decade ago that their construction would appear to be tedious for the production schedule of a major weekly television program.

Larger Picture

Regardless of the realities concerning these particular software images, there does appear to be a larger pattern of related Chinese government activity. A 2002 RAND study by noted China security/cyber experts Michael Chase and James Mulvenon offers both context and a plausible explanation for the CCTV-7 footage. It may date to activities occurring in 1999 and 2000 that they analyze in depth, marshaling a range of sophisticated inductive and deductive approaches to support their arguments:

There is some evidence to suggest that the Chinese government or elements within it have engaged in hacking of dissident and antiregime computer systems outside of China. … evidence exists to support the conclusion that the Chinese government or elements within it were responsible for one or more of the China-origin network attacks against computer systems maintained by practitioners of Falungong in the United States, Australia, Canada, and the United Kingdom. After the exposure of the role of certain Chinese security agencies in the attacks, the later, more sophisticated intrusions were believed to have been carried out by cut-outs, making it more difficult to ascertain the extent of government involvement. This was especially true of the attacks that occurred in winter and spring 2000.[7]

A 27 July 1999 attack on the www.falunusa.net website, for instance, was traced to the IP address 202.106.133.101, registered according to the Asia-Pacific Network Information Center (APNIC) database to 14 East Chang’an Street/ Dong Chang An Jie 14 in Beijing—precisely the location of China’s Ministry of Public Security (MPS). While Chase and Mulvenon are careful to acknowledge that in theory a third party could have exploited this IP address to launch its own attack, they offer four reasons why this was not likely the case in practice:

First, the network had been established shortly before the information operations began and was divorced from other explicitly identified MPS networks in other parts of Chinese cyberspace, such as the domain spaces belonging to the MPS web page (www.mps.gov.cn). Second, the name of the organization in the database—Information Service Center—suggests an intent to deceive outsiders about its actual affiliation. Third, at least one Western media source claimed to have called the telephone numbers listed… and was told by the person answering the phone that the numbers belonged to the Ministry of Public Security. A later call by the same news organization to the telephone operator at the ministry confirmed that the numbers belonged to the MPS Computer Monitoring and Supervision Bureau. The fourth and most telling piece of evidence resulted directly from the impending exposure in the Western media of the network’s governmental affiliation. Probably as a result of the increasing media attention, especially an imminent article by Michael Laris in the Washington Post, the information in the APNIC database was altered on 29 July 1999…. Most important, the owners of the network space changed the damning street address of the owner of the network from #14 East Chang’an Street to #6 Zhengyi Road (…Zheng Yi Lu 6).

If the ministry’s network had itself been the victim of an attack and was thus wrongly accused as the perpetrator of the attacks on the Falungong site in the United States, why go to the trouble of changing the database information to an address other than MPS headquarters? And was it a coincidence that the network information was changed on the eve of an exposé in a major Western newspaper of the MPS’s alleged role in the attack? Most damning, the new street address (No. 6 Zhengyi Rd) is the address of the Ministry of Public Security’s No. 3 Research Institute, which is responsible for computer security. The evidence cited earlier, along with this last attempt to further disguise the true owner of the network, strongly suggests that the perpetrator was caught with its “hand in the cookie jar.”[8]

Chase and Mulvenon acknowledge that an MPS “rogue element” might conceivably have perpetrated these attacks without senior party leadership or MPS leadership sanction. In analyzing the considerably-more-sophisticated follow-on attacks of 2000, however, they offer evidence to suggest a state-level interest in their coordination:

The first of the renewed attacks against Falungong servers occurred on March 11, 2000, coinciding with the meetings of the National People’s Congress in Beijing. The hack, which used a denial-of-service technique… brought down the main server in Canada (www.minghui.ca), as well as three mirror sites (www.falundafa.ca, www.falundafa.org, and www.minghui.org). …

Attacks on Falungong servers reached a crescendo in mid-April 2000, when five sites—three in the United States (www.falunUSA.net, www.falundafa.org, www.truewisdom.net)…. The timing of the attacks coincided with two sensitive political events: (1) the impending vote in the United Nations Human Rights Commission on a UN resolution condemning Chinese human-rights abuses, including persecution of Falungong; and (2) the one-year anniversary of the April 25, 1999, gathering of Falungong practitioners outside the central leadership compound in Beijing.[9]

In viewing this summer’s CCTV-7 footage, then, we are quite possibly afforded a peek into relatively unsophisticated techniques from a decade ago. It certainly looks like a “smoking cursor,” albeit a relatively modest one. China undoubtedly has far superior capabilities at its disposal today.

Conclusion

Regardless of the Chinese government’s public positions for domestic consumption regarding cyberattacks launched from Chinese soil, it will have to deal increasingly with an important foreign audience. The U.S. International Strategy for Cyberspace, issued in May 2011, reflects the increasing seriousness with which the U.S. government views cybersecurity. The report declares that “When warranted, the United States will respond to hostile acts in cyberspace as we would to any other threat to our country. All states possess an inherent right to self-defense, and we recognize that certain hostile acts conducted through cyberspace could compel actions under the commitments we have with our military treaty partners. We reserve the right to use all necessary means—diplomatic, informational, military, and economic—as appropriate and consistent with applicable international law, in order to defend our Nation, our allies, our partners, and our interests.”[10] To be sure, identifying an attack source that could be retaliated against is exceedingly difficult. However, taking a more aggressive stance against cyberattacks, even to the point of having cyberattacks serve as a potential trigger for alliance mutual defense obligations such as Article 5 of NATO, raises a number of interesting doctrinal possibilities. One is that physical infrastructure utilized in a cyberattack on U.S. Government assets could be held at risk, while another is that—similar to the U.S. position on terrorism—the source country of a cyberattack could be held responsible for the actions of parties operating from its soil, whether or not they can be credibly linked to the country’s government.

As one of his last major official contributions to U.S.-China relations, former Secretary of Defense Robert Gates placed a very important message in China’s inbox:

I think we could avoid some serious international tensions in the future if we could establish some rules of the road as early as possible that let people know what kinds of acts are acceptable, what kinds of acts are not, and what kinds of acts may in fact be an act of war… I think all countries should see the cyber threat as a potential problem for them. …One of the things that I have been trying to get going over the last four, four-and-a-half years, is to examine this world of cyber in the context of defense responsibilities, and what in fact does constitute an offensive act by a government. …I think that one of the things that would be beneficial would be for there to be a more open dialogue among countries about cyber (threats) and establishing some rules of the road [to achieve] clearer understanding of the left and right lanes, if you will, so that somebody doesn’t inadvertently or intentionally begin something that escalates and gets out of control.[11]

At the very least, it is in both Washington and Beijing’s interest to have such substantive cyber talks before attacks enter into new domains in ways that neither nation wants to see. It is vital for the security of both Pacific cyber powers that Beijing reply in kind without attempting to block or delete the message.

[1] For additional details, see “04 June 2011 – – Agence France Presse – US calls for talks on cyber threats,” International Institute for Strategic Studies, http://www.iiss.org/whats-new/iiss-in-the-press/june-2011/us-calls-for-talks-on-cyber-threats/?locale=en.

[2] For the original text of President Obama’s address, see The White House, Office of the Press Secretary, “Remarks by the President on Securing Our Nation’s Cyber Infrastructure,” 29 May 2009, http://www.whitehouse.gov/the_press_office/Remarks-by-the-President-on-Securing-Our-Nations-Cyber-Infrastructure/.

[3] Matthew Robertson and Helena Zhu, “Slip-Up in Chinese Military TV Show Reveals More Than Intended: Piece Shows Cyber Warfare against US Entities,” Epoch Times, 23 August 2011, http://www.theepochtimes.com/n2/china-news/slip-up-in-chinese-military-tv-show-reveals-more-than-intended-60619.html.

[4] Robert McMillan and Michael Kan, “China Hacking Video Shows Glimpse of Falun Gong Attack Tool,” PC World, 23 August 2011, http://www.pcworld.com/businesscenter/article/238655/china_hacking_video_shows_glimpse_of_falun_gong_attack_tool.html.

[5] “China Denies Hacking Pentagon Computers,” USA Today, 4 September 2007, http://www.usatoday.com/tech/news/computersecurity/hacking/2007-09-04-china-us_N.htm

[6] “PRC FM Spokesman Denies Canadian Hacker Claims,” AFP, 6 April 2010.

[7] “Chapter 2: Government Counterstrategies,” in Michael S. Chase and James C. Mulvenon, You’ve Got Dissent! Chinese Dissident Use of the Internet and Beijing’s Counter-Strategies(Santa Monica, CA: RAND, 2002), MR-1543, 71, http://www.rand.org/content/dam/rand/pubs/monograph_reports/MR1543/MR1543.ch2.pdf.

[8] Ibid., 72-75.

[9] Ibid., 79-81.

[10] International Strategy for Cyberspace: Prosperity, Security, and Openness in a Networked World (Washington, DC: The White House, May 2011), http://www.whitehouse.gov/sites/default/files/rss_viewer/international_strategy_for_cyberspace.pdf.

[11] For additional details, see “04 June 2011 – – Agence France Presse – US calls for talks on cyber threats,” International Institute for Strategic Studies, http://www.iiss.org/whats-new/iiss-in-the-press/june-2011/us-calls-for-talks-on-cyber-threats/?locale=en.

***

Gabriel B. Collins and Andrew S. Erickson, “Tango for Trade, Samba for Sales: Strategic Implications of China’s Growing Investment and Commercial Ties in Latin America,” China SignPost™ (洞察中国) 45 (19 August 2011).

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

Executive Summary

  • China’s annual trade with Latin American countries is now worth at least US$118 billion per year, nearly 12 times larger than what it was in 2000. This makes China’s trade with Latin America roughly the same size as its growing trade with Africa, a region whose ties with China receive much attention.
  • Chinese companies made investments in a range of Latin American energy, mining, agricultural, industrial, and financial assets worth more than U.S.$25 billion in 2010, a watershed year that saw Latin America account for more than 40% of China’s large overseas investment deals, based on China Global Investment Tracker data.
  • China’s natural resource-focused investment in Latin America will continue, but is also likely to diversify into local manufacturing as well as retail and other consumer-oriented businesses.
  • China’s relations with Latin American countries are driven primarily by economics and a bit by politics, mainly the desire to isolate Taiwan. China sees soybeans, oil, iron ore, and burgeoning local consumer markets as the prize and will use its growing leverage to secure better economic terms, not force Latin countries to do its political bidding. Beijing does not want to overly irritate Washington, its most important foreign relationship. … … …

***

Gabriel B. Collins and Andrew S. 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) 44 (15 August 2011).

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

Key Points:

  •  China is likely to follow an S-Curve-shaped path of slowing growth as key internal and external challenges—including pollution, corruption, chronic diseases, water shortages, growing internal security spending, and an aging population—feed off of one another and exact increasingly large costs.
  • One prominent China-based economist believes that the country’s growth will need to slow to 3-4% per year—less than half the current rate—if it is to sort out structural imbalances in its economy.[1]
  • China is encountering these headwinds at a much earlier stage in its development than did the U.S. and other great powers, thanks in part to its late start in modernization and its dramatic internal disparities.
  • China could very well continue to expand its economy (and by extension its national power) at a rate that the U.S., Japan, and many European countries would envy.
  • However, the global economic, environmental, and security implications of 4-5% Chinese economic growth are very different from a 7-8% annual growth regime.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is an S-Curve?

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

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

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

Exhibit 1: National Development S-Curve Schematic

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

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

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

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

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

  Political Issues

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

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

Potential Political Evolution

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

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

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

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

Demographic Issues

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

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

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

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

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

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

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

Structural Issues

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

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

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

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

Economic Issues

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

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

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

Sustainability and future challenges of rapid infrastructure buildout

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Security Issues

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

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

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

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

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

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

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

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

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

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

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

Implications

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

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

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

Exhibit 3: China share of global demand for key commodities

% of total global consumption, by year

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[15] Ibid., 262.

[16] Ibid., 250.

[17] Ibid., 248.

[18] Ibid., 246.

[19] Ibid., 247.

[20] Ibid., 249.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

***

Andrew S. Erickson and Gabriel B. Collins, “China Realizes Carrier Dream,” The Diplomat, 10 August 2011.

Following is a guest entry from Gabe Collins and Andrew Erickson, co-founders of China Sign Post.

China’s Navy has finally realized its longtime dream of obtaining an aircraft carrier and putting it to sea. It has been a long road from the Guomindang’s 1929 rejection of naval commander Chen Shaokuan’s proposal for building a Chinese aircraft carrier to the acquisition and refitting of the former Ukrainian carrier Varyag in Dalian Naval Shipyard, a task essentially as complex as building a carrier from scratch.

On August 10, 82 years after Adm. Chen’s proposal, China’s first carrier disappeared into the fog under tight security at 0540 local time from Dalian Harbour’s Xianglujiao Port in northeast Liaoning Province to begin sea trials. Liaoning Maritime Safety Authority has declared a temporary exclusion zone in a rectangular sea area nearby.

A newly-wed couple wants a ‘starter home,’ a new great power wants a ‘starter carrier.’ China’s ‘starter carrier’ is of very limited military utility, and will serve primarily to confer prestige though naval diplomacy, to help master basic operational procedures, and to project a bit of power—perhaps especially vis-à-vis smaller neighbours in the South China Sea. Having avoided the winds and waves recently sent to the Yellow Sea by Typhoon Muifa, the carrier will subject China to even more diplomatic turbulence as its neighbours react to the reality that their giant neighbour now has a basically-functioning carrier. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “China’s ‘Starter Carrier’ Goes to Sea,” China SignPost™ (洞察中国) 43 (9 August 2011).

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

What’s happening

The long-awaited official announcement has finally been made.

The first confirmations came in Chinese: “China’s aircraft carrier platform is undergoing sea trials today (中国航母平台今日进行出海航行试验). Xinhua News: China’s aircraft carrier platform is undergoing sea trials on August 10 (新华网快讯: 我航母平台8月10日进行出海航行试验).”

Xinhua’s English-language news service subsequently reported: “China’s refitted aircraft carrier left its shipyard at Dalian Port in northeast Liaoning Province on Wednesday morning to start its first sea trial. Military sources said that the first sea trial was in line with schedual [sic] of the carrier’s refitting project and would not take a long time. After returning from the sea trial, the aircraft carrier will continue refit and test work.”

China’s Navy has finally realized its longtime dream of obtaining an aircraft carrier and putting it to sea. It has been a long road from the Guomindang’s 1929 rejection of naval commander Chen Shaokuan’s proposal for building a Chinese aircraft carrier to the acquisition and refitting of the former Ukrainian carrier Varyag in Dalian Naval Shipyard, a task essentially as complex as building a carrier from scratch. Now, 82 years after Admiral Chen’s proposal, China has launched its first carrier for a set of sea trials that Hong Kong media sources estimate will last for 15 days (香港商報訊 [Hong Kong Commercial Daily]).

Having avoided the winds and waves recently sent to the Yellow Sea by Typhoon Muifa, the carrier will subject China to even more diplomatic turbulence as its neighbors react to the reality that their giant neighbor now has a basically-functioning carrier.

What it means

A newly-wed couple wants a ‘starter home,’ a new great power wants a ‘starter carrier.’ China’s ‘starter carrier’ is of very limited military utility, and will primarily serve to confer prestige on a rising great power, to help the military master basic procedures, and to project a bit of power.

The carrier’s maiden voyage appears to be a show cruise conducted close to home to both make the vessel a bit less accessible to prying eyes (and unauthorized digital cameras) and also keep it near its home port if any mechanical problems materialize. Key questions that may arise in the course of this voyage include:

(1)   How reliable is the vessel’s propulsion system? The ship’s powerplant and drivetrain are among the highest probability risk factors that could complicate the maiden cruise.

(2)   Will China more aggressively intercept reconnaissance flights and/or declare a maritime and aerial exclusion zone in the ship’s vicinity? The carrier’s first excursion from port offers an excellent opportunity for air and seaborne reconnaissance assets from the U.S., Japan, and other regional armed forces to gather photographic, acoustic, and perhaps signals intelligence on the new Chinese carrier.

(3)   Will PLAN Aviation attempt to land aircraft on the ship at sea? Other possibilities include helicopter operations and touch and go runs, which could be facilitated by the growing base of PLAN helicopter pilots with shipborne operating experience, courtesy of the Gulf of Aden anti-piracy mission.

Aircraft operations are of course the fundamental reason for having a carrier capability, and we would be surprised if the maiden cruise includes actual landings of fixed wing aircraft (takeoffs represent a lower hurdle, thought the aircraft would somehow have to reach the deck in the first place). When operating aircraft from carriers, accidents are highly likely as carrier aviation is a risky and costly business.

Prof. Robert Rubel (CAPT, Ret.), a former U.S. Naval Aviator who is now Dean of the Center for Naval Warfare Studies at the U.S. Naval War College, notes that between 1949, when jets started being deployed in large numbers by the U.S. Navy, until 1988, when the combined U.S. Navy/USMC accident rate was lowered to USAF levels, the naval services lost almost 12,000 aircraft and 8,500 aircrew.[i] In 1954 alone, the Navy and Marines lost 776 aircraft and 535 crewmen and carrier-based tactical aviation suffered higher proportionate losses than the naval services as a whole.[ii]

To be sure, China has resolved some of the most fundamental physical issues involved in launching and landing aircraft from a small moving airfield, but the process remains immensely difficult and even a less-aggressive carrier operator than the U.S. is almost certain to suffer substantial unexpected losses of aircraft and crew as it works to build its operational knowledge and human capital. It remains uncertain what financial and political costs Chinese carrier aircraft losses will incur, but clearly the first Chinese carrier aviators and ship captains face steep challenges ahead.

Still, after waiting over eight decades for a carrier of its own, China can afford to be patient and methodical in mastering its operation.

Additional reading on China’s carrier program:

[i] Robert Rubel, “The U.S. Navy’s Transition to Jets,” Naval War College Review 63.2 (Spring 2010): 51,  http://www.usnwc.edu/getattachment/76679e75-3a49-4bf5-854a-b0696e575e0a/The-U-S–Navy-s-Transition-to-Jets.

[ii] Ibid., 52.

***

Gabriel B. Collins and Andrew S. Erickson, “What if the China Housing Bulls Are Right? Assessing Potential Commodity Demand from Urbanization in China’s Top 10 Residential Markets, 2011–2019,” China SignPost™ (洞察中国) 42 (2 August 2011).

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

Summary:

  • Chinese farmers are likely to continue abandoning tough and unprofitable farm work to seek their fortunes in cities across China.
  • Land ownership reforms would also likely send waves of farmers into the cities in search of work.
  • By 2019, the Economist Intelligence Unit estimates that the cities of Chongqing, Chengdu, Zhengzhou, Tianjin, Beijing, Xi’an, Changsha, Shanghai, Shenzhen, and Dongguan will see a net increase of roughly 4.0 billion m2 of housing space—more than 50% larger than the 2.6 billion m2 net increase that the entire U.S. market is expected to experience by 2020 (based on data from Macroeconomic Advisors and the U.S. Census Bureau).
  • Our base case commodity demand analysis anticipates that housing construction in the 10 target cities between now and 2019 will use at least 967 million tonnes of cement, 313 million tonnes of iron ore, 232 million tonnes of coal, and 4 million tonnes of copper.
  • This would mean annual iron ore demand roughly equivalent to the entire annual ore production of Cliffs Natural Resources, the largest North American producer, which says it expects to produce more than 38 million tonnes of iron ore worldwide in 2011.
  • The 10 cities’ average annual cement demand in our base case scenario would be 35% larger than the entire volume of cement consumed by the United States in 2010.

China watchers, and investors in particular, increasingly fall into two major camps: the China housing bulls, who perceive substantial housing shortages that will keep prices up and drive construction; and the housing bears, who believe that Chinese property buyers have overextended themselves and that in the memorable words of prominent hedge fund James Chanos, the country is on an economic “treadmill to hell” driven by overinvestment in fixed assets. Time will tell whose view is more accurate regarding this globally consequential set of questions. That said, amidst the heavy focus on what China’s residential property prices are doing “this month,” or even “this year,” we believe it is important to:

1)      Look beyond 2011

2)      Consider that, among other factors, the fundamental inefficiency of Chinese agriculture is likely to continue driving farmers and their families into China’s urban areas

3)      Assess the attendant implications

China faces a double dilemma with respect to agriculture, which currently employs more than 35% of its workforce, according to the CIA World Factbook. First, the bulk of its farmers currently cannot compete with large, low-cost grain producers in the U.S., Brazil, Argentina, Australia, Russia, and Ukraine and are likely to continue abandoning tough and unprofitable farm work and seek their fortunes in cities across China. Second, the land ownership reforms necessary to make Chinese farming more efficient would fly in the face of the Party’s rural revolutionary history of “land for all” and would also send waves of farmers into the cities in search of work.

China’s level of urbanization remains quite low, even by developing economy standards, a fact that—taken in conjunction with the agricultural reform dilemma mentioned above—suggests that there remains substantial upside for movement into the cities. It also hints that the estimates that McKinsey and others make of the urban population in China growing by as many as 350 million people in total over the next 20 years are realistic.

China’s leaders do not want to see Mumbai- or Johannesburg-style shantytowns on the outskirts of Chinese cities, raising the question of how housing will be built to accommodate new arrivals, as well as current urban residents who may wish to upgrade their domiciles as incomes rise. This in turn raises the question of what level of raw material demand new housing additions are likely to create. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “How Do the Economic Outputs of China’s 8 Most Productive Cities Compare to Those of U.S. Cities?” China SignPost™ (洞察中国) 41 (29 July 2011).

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

Economic discussions involving the U.S. and China often focus on national-level matters such as currency valuation, duties, and trade policy. Yet decisions and economic activity at the local level are immensely important, as they form the building blocks of a strong national economy. This analysis therefore takes nominal  gross metropolitan product (GMP) data from the eight most productive Chinese cities from 2009, the last year for officially reported data, and compares it to 2009 GMP data from U.S. cities. We chose eight cities because of the number 8’s significance as a sign of good fortune in Chinese culture.

Chinese cities are growing impressively, while many of their U.S. counterparts are struggling to recover from a hard-hitting recession. In 2009, Shanghai’s US$221 billion in economic output put it on par with Seattle (Exhibit 1). Based on IMF data, Shanghai’s purchasing power parity adjusted economic output in 2009 was worth approximately US$400 billion—roughly equivalent to Washington DC and larger than Dallas or Houston. In total, these eight cities accounted for slightly over 20% of China’s GDP. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “China’s Jet Engine Future,” The Diplomat, 13 July 2011.

Following is a guest entry from Gabe Collins and Andrew Erickson, co-founders of China Sign Post.

China’s military jet engine capability is increasing at a rapid pace, with implications not only for China’s independent military capabilities, but also for the global defence industry. Yet China also faces major impediments in achieving its strategic aim of establishing itself as an independent manufacturer in one of aerospace’s most complex engineering technologies: high-performance turbofan engines. Our recent paper, Jet Engine Development in China, found that China’s progress is uneven but that the resources being devoted to the task will likely result in significant strides that will have profound strategic implications. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “12 in ’12: Strategic Challenges Facing the U.S. and China as the 2012 Political Season Approaches,” China SignPost™ (洞察中国) 40 (11 July 2011).

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

Executive Summary:

Challenges Washington faces that will affect relations with China

1) Adapting to a sometimes contradictory “frenemies” type relationship with China.

2) Accepting that China’s idea of what constitutes “responsible behavior” on the world stage may be very different from what Washington wants.

3) Reassuring countries like Japan, South Korea, and Singapore, as well as other ASEAN members, that it intends to maintain—and possibly strengthen—its focus on the Asia-Pacific region while trying not to overly antagonize China.

4) Currency and trade policies, along with the hollowing out of the U.S. heavy industrial base, will almost certainly be major issues in the upcoming elections.

5) China faces more profound structural economic and human development problems such as chronic diseases that may prompt its new leadership to focus more closely on internal issues, while also adopting more muscular external policies designed to secure the resources and political support that it needs to confront internal challenges.

6) The most profound foreign policy challenges and opportunities that the U.S. faces in coming years lie in the Asia-Pacific region, not the Middle East.

Challenges Beijing faces that will affect relations with the U.S.

1) Grappling with inflation and higher labor costs that are driven as much by demographic pressures as they are by economic forces.

2) Monitoring how U.S. economic policies affect China’s massive U.S. bond holdings.

3) Deciding whether to improve market access for U.S. firms wishing to do business in China.

4) Managing the Taiwan question.

5) Deciding how to handle maritime disputes with its neighbors, particularly in the South China Sea.

6) Reign in cyber attacks on the U.S. by Chinese hackers. … … …

***

Abraham M. Denmark, Andrew S. Erickson, and Gabriel Collins; Jean-Clément Nau, translator, “Faut-il avoir peur du nouveau porte-avions chinois?” [Should We Be Afraid of China’s New Aircraft Carrier? Not yet.], Foreign Policy, 5 July 2011.

For original English-language article, see Abraham M. Denmark, Andrew S. Erickson, and Gabriel Collins, “Should We Be Afraid of China’s New Aircraft Carrier? Not yet.,” Foreign Policy, 27 June 2011.

Il y a six mois, le général Lui Huaqing mourrait. Il était le père de la marine chinoise moderne, et en fut le commandant de 1982 à 1988 (selon le quotidien d’Etat People’s Daily, il fut aussi un «membre distingué du Parti communiste chinois, un combattant communiste aguerri, un révolutionnaire prolétarien remarquable, un homme politique, un stratège, et un excellent leader, que ce soit au niveau du Parti, de l’Etat ou de l’armée»). Liu voulait transformer la marine chinoise en flotte de défense des côtes; et ce avant d’en faire une flotte de haute mer capable de projeter sa puissance sur de vastes distances.

Le général ne pouvait réaliser ce rêve sans porte-avions. Il aurait même fait cette déclaration: «Si je ne vois pas de porte-avions avant de perdre la vie, je mourrai les yeux ouverts». Liu est peut-être mort les yeux ouverts, mais il peut désormais les fermer. Le premier porte-avions de l’Armée populaire de libération quittera bientôt le port de la base navale de Dalian, dans le nord-est de la Chine. Et dans la majorité des pays de la région Asie-Pacifique, tout comme chez les observateurs américains de l’Asie, on débat aujourd’hui âprement des conséquences possibles de cette nouvelle donne. …

Aux Etats-Unis, les implications militaires directes du nouveau porte-avions chinois sont limitées. L’U.S. Navy sait parfaitement comment détruire une cible de grande taille; un porte-avions chinois ne survivrait sans doute pas plus de quelques heures si un conflit de grande échelle venait à éclater entre la Chine et les Etats-Unis. Et si les deux pays se disputaient un jour le contrôle de Taiwan, un porte-avions ne serait pas d’une grande utilité: la Chine pourrait se contenter de projeter ses forces aériennes depuis ses bases terrestres, situées sur le continent.

Mais dans la région Asie-Pacifique, et tout particulièrement dans la mer de Chine méridionale (où les tensions sont plus intenses), les implications stratégiques du porte-avions chinois pourraient être significatives. La Chine se montre de plus en plus déterminée lorsqu’un conflit survient dans ces eaux riches en ressources et très fréquentées; que ce soit avec le Vietnam ou avec les Philippines. La couverture aérienne assurée par le Varyag pourrait empêcher ces deux pays de se défendre efficacement face à une éventuelle attaque chinoise.

C’est également en Asie du Sud-est que les implications politiques d’un porte-avions chinois ont le plus de poids. La région Asie-Pacifique peut s’attendre à des escales périodiques du Varyag dans les prochaines années. La rhétorique entourant ces escales sera sans doute centrée sur les intentions pacifiques de la Chine et les promesses inhérentes à une coopération avec Pékin; le message sous-jacent (et presque transparent) étant que la Chine est désormais une superpuissance avec laquelle il faut compter. Ces pays se tourneront sans doute alors vers les Etats-Unis pour que ces derniers servent de contrepoids à cette menace militaire implicite, et Washington doit se préparer à répondre à cet appel au mieux de ses intérêts.

Ce serait une erreur que d’exagérer les conséquences stratégiques de l’existence du premier porte-avions chinois. La mise en service du Varyag ne modifiera pas l’équilibre des forces militaires de manière conséquente dans la région Asie-Pacifique, et elle ne remettra pas en question la domination militaire américaine. Mais le porte-avions est un important signe annonciateur des temps à venir.

La puissance maritime de la Chine s’accroît de jour en jour. Lorsque ses porte-avions et ses navires d’escorte sillonneront les eaux du Pacifique occidental, de la mer de Chine méridionale et de l’océan Indien à une fréquence croissante, Washington sera contraint de prendre en considération la volonté sous-jacente de domination militaire continue qui est à la base de sa stratégie d’ensemble. Compte-tenu des contraintes budgétaires qui pèsent aujourd’hui sur les Etats-Unis, il est plus que jamais essentiel d’envisager avec lucidité les intérêts et les défis à long-terme de l’Amérique. L’avenir commence aujourd’hui.

Abraham M. Denmark, conseiller au Center for Naval Analyses. Andrew S. Erickson, enseignant à la U.S. Naval War College et anime un blog. Gabriel Collins, spécialiste des matières premières et des questions de sécurité, est le co-fondateur du site China Sign Report.

Traduit par Jean-Clément Nau

***

A newly-wed couple wants a ‘starter home,’ a new great power wants a ‘starter carrier.’ Before foreign strategists start hyperventilating about the “beginning of the end,” a deep breath is needed. China’s ‘starter carrier’ is of very limited military utility, and will primarily serve to confer prestige on a rising great power, help the military master basic procedures, and to project a bit of power. This isn’t the beginning of the end; it’s the end of the beginning.

(This text is not included in the below Foreign Policy article.)

Published Article:

Abraham M. Denmark, Andrew S. Erickson, and Gabriel Collins, “Should We Be Afraid of China’s New Aircraft Carrier? Not yet.,” Foreign Policy, 27 June 2011.

Six months ago, Gen. Liu Huaqing — the father of China’s modern navy and its commander from 1982 to 1988 (and, according to the state-run People’s Daily, “a distinguished member of the CPC, a seasoned loyal Communist fighter, an outstanding proletarian revolutionist, politician and strategist, and an excellent leader of the Party, the state and the military”) — passed away. Liu sought to build China’s navy first into a “green water” fleet and, eventually, into a full-fledged “blue water” navy capable of projecting power over vast distances. Key to realizing Liu’s vision was an aircraft carrier, and Liu reportedly vowed: “I will not die with my eyes closed if I do not see a Chinese aircraft carrier in front of me.”

While Liu may have died with his eyes open, they can close now. From the harbor at Dalian naval shipyard in northeast China, the first aircraft carrier of the People’s Liberation Army Navy (PLAN) will soon set sail for the first time. And much of the Asia-Pacific region, as well as the Asia-watching strategic community in the United States, is hotly debating the implications of this move. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Jet Engine Development in China: Indigenous high-performance turbofans are a final step toward fully independent fighter production,” China SignPost™ (洞察中国) 39 (26 June 2011).

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

Deep Dive—Special In-Depth Report #2

Executive Summary:

  • Engines commonly used in Chinese and other modern aircraft may be divided into several major categories: (1) low-bypass turbofans typically power military jets; (2) high-bypass turbofans typically power jet airliners; (3) turboprops typically power more fuel-efficient, usually lower-speed aircraft, including civilian commuter aircraft and military transports and surveillance and battle management aircraft; and (4) turboshafts typically power helicopters. This study will address the first category, low-bypass turbofan engines; other categories will be addressed in follow-on China SignPost™ reports.
  • China’s inability to domestically mass-produce modern high-performance jet engines at a consistently high-quality standard is an enduring Achilles heel of the Chinese military aerospace sector and is likely a headwind that has slowed development and production of the J-15, J-20, and other late-generation tactical aircraft.
  • The Chinese aerospace industry is driven by four key strategic imperatives as it pursues the ability to manufacture large volumes of high-performance tactical aircraft[1] engines: (1) parts dependence avoidance, (2) Russian supply unwillingness, (3) aircraft sales autonomy, and (4) poor Russian after-sales service.
  • To address these shortcomings, AVIC is treating engine development as a high priority and plans to invest 10 billion RMB (US$1.53 billion) into jet engine research and development over the next 5 years.
  • However, evidence still suggests that AVIC’s engine makers are having trouble maintaining consistent quality control as they scale up production of the WS-10, causing problems with reliability and keeping China’s tactical aircraft heavily reliant on imported Russian engines.
  • Key weak points of the Chinese military jet engine industry include: turbine blade production and process standardization.
  • Standardization and integration may be the one area in which the costs of China’s ad hoc, eclectic approach to strategic technology development truly manifest themselves. The Soviet defense industrial base failed in precisely this area: talented designers and technicians presided over balkanized design bureaus and irregularly-linked production facilities; lack of standardization and quality control rendered it “less than the sum of the parts.”
  • We estimate that based on current knowledge and assuming no major setbacks or loss of mission focus, China will need ~2-3 years before it achieves comprehensive capabilities commensurate with the aggregate inputs in the jet engine sector and ~5-10 years before it is able to consistently mass produce top-notch turbofan engines for a 5th generation-type fighter.
  • If China’s engine makers can attain the technical capability level that U.S. manufacturers had 20 years ago, China will be able to power its 4thgeneration and5th-generation aircraft with domestically made engines (3rd and 4th-generation in Chinese nomenclature, respectively). These developments would be vital in cementing China as a formidable regional air power and deserve close attention from policymakers.

China has a clear strategic interest in developing indigenous high-performance aeroengines to power its military aircraft. This is one of the greatest aerospace engineering challenges, however, one that only a small handful of corporations worldwide have truly mastered. This should not be surprising: an engine is effectively an aircraft’s cardiovascular system; it can be transplanted but not easily modified. Unlike a human system, it can be designed and developed independently, but faces temperature, pressure, and G-force challenges that only the most advanced materials, properly machined and operated as an efficient system, can handle. While China has made progress in recent years with materials and fabrication, it appears to remain limited with respect to components and systems design, integration, and management—the keys to optimizing engine performance in practice—and to making logistical and operational plans at the force level based on reliable estimates thereof.

Based on available open source evidence, Chinese progress in this critical area remains uneven and the whole remains “less than the some of the parts.” Given the overall capabilities inherent in China’s defense industrial base and the resources likely being applied to this problem, we expect that China will make significant strides, but barring major setbacks or loss of mission focus, it will take ~2-3 years before it achieves comprehensive capabilities commensurate with the aggregate inputs in this sector and ~5-10 years before it is able to consistently mass produce top-notch turbofan engines for a 5th generation-type fighter. When it does, however, the results will have profound strategic significance, as China will have entered an exclusive club of top producers in this area and eliminated one of the few remaining areas in which it relies on Russia technologically.

How is domestic engine production strategically relevant?

The Chinese aerospace industry is driven by four key strategic imperatives as it pursues the ability to manufacture large volumes of high-performance tactical aircraft engines: (1) parts dependence avoidance, (2) Russian supply unwillingness, (3) aircraft sales autonomy, and (4) poor Russian after-sales service. First, China likely seeks to avoid dependence on Russian suppliers for vital parts. Chinese leaders will not want the country’s most modern fighter aircraft to be dependent on foreign inputs for a core system such as propulsion. Second, Russia’s own armed forces are likely to buy significantly more of its jet engines in the next 10 years than they did over the 20 years since the Soviet Union dissolved. This is an important development given that the collapse in military procurement after the Soviet Union fell was the key driver of Russian jet engine sales to China.

The Russian Air Force’s plans to enhance its aircraft through refurbishment and re-engineering of existing systems and acquisition of new platforms like the SU-34, SU-35, and T-50/PAK FA could stretch Russian engine makers to the point that they have little export willingness, and perhaps restrained export capacity. The Kremlin, which controls Russia’s jet engine makers, will likely prioritize the export of entire aircraft such as Sukhoi Flankers that require advanced engines and the Indo/Russian 5thgeneration fighter project, which will also demand the most advanced engines Russia’s defense suppliers can produce. The bottom line is that the combination of new Russian Air Force aircraft purchases, continued exports of late model Flankers, and Russia’s joint 5th generation fighter project with India will stretch suppliers enough that even if the People’s Liberation Army Air Force (PLAAF) can get some advanced Russian engines, it likely will not be able to obtain enough to support its desired levels of aircraft production.

Exhibit 1:  Estimated Total Chinese Demand for Non-Russian Military Turbofans (2011-20)

Sources: Sukhoi, Ria Novosti, Reuters, India MoD, UMPO, Jane’s, Sinodefence.com

Third, China is a growing exporter of advanced combat aircraft, as shown by its recent deals to sell FC-1 and J-10 fighters to Pakistan, and will not want foreign engine suppliers having veto power over its arms sales. A major hang-up in the FC-1 deal was that the aircraft uses the same Russian-made RD-33 engines as the MiG-29, but sells for a much lower price and is thus a threat to Russian aircraft exports in the developing world. Russia finally granted China permission to make the FC-1 sale to Pakistan, but the experience almost certainly taught Chinese aircraft makers that it will be much easier to export Chinese-made aircraft if they use Chinese engines.

This is especially true given the fact that China’s J-10 and J-11B (if SAC is permitted to export it) are comparable to existing Russian tactical aircraft exports and would likely be formidable competitors in terms of price and capability. We note here that a January 2011 editorial in Nanfang Daily anticipates China becoming a major jet engine exporter within the next 10 years.[1] High aspirations by no means imply the ability to actually achieve the desired capability, but these sentiments shed light on the broad importance Chinese policymakers and thinkers place on bolstering domestic jet engine production capabilities.

Fourth, China has had painful experience with poor Russian after-sales service for components, e.g., engines. This includes engineering and spare parts support that is expensive, delayed, or simply nonexistent and manuals that are limited, in Russian only, or not available at all.

Where does China’s tactical turbofan sector stand today?

In an April 2011 interview, China Aviation Industry Corporation (AVIC) head Lin Zuoming noted that despite China’s rapid development as an aerospace power, the country’s ability to produce modern jet engines remains a glaring weakness.[2] To address these shortcomings, AVIC is treating engine development as a high priority and plans to invest 10 billion RMB (US$1.53 billion) into jet engine research and development over the next 5 years.

China’s WS-10 Taihang turbofan engine and its derivatives have performance parameters on par with the Pratt & Whitney (P&W) F100 and GE F110 engine families, which power the U.S. F-15 and F-16 fighters. The Taihang family is said to power the J-11B and is also likely slated to eventually take over from the Russian AL-31 as the main powerplant for the J-10 and J-15. Media reports from November 2010 state that a version of the WS-10 Taihang turbofan producing 27,500 lbs of thrust is now in series production and is being used to power the J-11B fighter-bomber.[3]Exhibit 2 (below) shows a timeline of China’s advanced military turbofan production.

Exhibit 2: China Military Turbofan Development and Production Timeline (WS-10, WS-15)

Sources: Jane’s, Global Times, China.com

However, evidence still suggests that AVIC’s engine makers are having trouble maintaining consistent quality control as they scale up production of the WS-10, causing problems with reliability and keeping China’s tactical aircraft heavily reliant on imported Russian engines. Russia’s defense industry appears to believe that China will continue to be unable to attain reliable mass production of high-performance military turbofans. For example, NPO Saturn, a key Russian military jet engine maker, forecasts that it will continue serving as the primary engine supplier for China J-10 and FC-1 fighter programs through 2019.[4] Saturn’s optimism may stem in part from the fact that is it currently in talks with China over the possible sale of 190 D-30KP-2 turbofans, which could be used on China’s IL-76 aircraft.[5]

The lack of a sufficient supply of reliable domestically made jet engines could significantly impede future production of the J-10, J-11, J-15, and J-20 fighter aircraft. The J-20 program especially needs domestic engine development and production breakthroughs because the Russia appears reluctant to sell the 117S series engines that could enable the J-20 to have sufficient power to allow the aircraft to supercruise (sustain supersonic flight without using inefficient afterburners) and match the performance of 5th-generation fighters such as the Lockheed Martin F-22 and Sukhoi T-50/PAK FA.

Software is a vital aspect of aeroengines, one that China will have to master to produce its own high-performance engines; and one that it will likely consider controlling carefully should it decide to market them when they reach the requisite quality and price level. Many aeroengine performance parameters can be adjusted using software; a manufacturer may charge a customer significantly for upgrades that are easily implemented but may alter engine function significantly. There is a tremendous disparity between civilian (uncertificated) and military (certificated) source codes: the former may have explanations embedded in them, while the latter may have source codes and explanations stored separately.

Military source codes can take up to twenty times longer to produce on a per-line basis because of requirements concerning annotation, documentation, line traceability, integration, and module- and robustness-testing. How to handle the relevant engine source code is therefore a key question for any exporter of packages that include aeroengines. The U.S. is typically able to avoid divulging source codes, despite repeated requests from such customers as Israel, because its military aircraft are so desirable.

Recent developments increasingly suggest that it is unwise to underestimate China’s defense-industrial complex. We believe that barring major unforeseen disruptions or shifts in focus, China’s aerospace industry already has sufficient financial support and is close to attaining a critical mass of human capital that over the next ~2-3 years will help it make substantial breakthroughs in its ability to produce sufficient volumes of reasonably dependable jet engines, and reach the ability to consistently produce 5th-generation fighter performance-level aeroengines in ~5-10 years. This, in turn, will help enable robust growth of modern Chinese airpower if the country’s civilian and military leaders choose to expand and upgrade China’s Air Force and Navy tactical air fleets. Ongoing limitations in tooling, design capability, and systems operations and maintenance and will be key areas to monitor, however, as these may limit the performance parameters of Chinese engines and shape their development in “path dependent” ways (meaning that future options are limited by are limited by past actions, even after the circumstances that shaped those actions are no longer relevant).

Strong and Weak Points of China’s Jet Engine Industry

High performance jet engines are exceedingly hard to produce, as they can contain tens of thousands of parts that must be made of durable exotic materials machined to tolerances measured in microns. In addition, jet engines used in tactical fighter and strike aircraft must be able to operate reliably under extreme conditions including high temperatures, high speeds, intensive maneuvering, and frequent throttle changes. Jet engine compressor blades, for instance, can experience centrifugal forces as high as 20,000 times the force of gravity during flight.[6] The challenge that a turbofan blade faces in performing without significant deflection despite being exposed to heat that exceeds the melting point of most metals, and consequent materials and metallurgical requirements, has been likened to stirring hot soup with a spoon made of ice.

Chinese design capabilities remain uncertain, though manufacturing capabilities are clearly improving. To reach the pinnacle of aeroengine development and performance, China must model, refine, and optimize the total system, which can only be done with top-level total lifecycle tools, software, and cradle-to-grave support. Even in a less complex machine such as an automobile, for instance, it is relatively easy to manufacture a crankshaft, but relatively difficult to make the system perform well as a unified whole and to understand the complex interaction of its components under different conditions.

To consider an aeroengine-specific example, for optimum aerodynamics, it is necessary to model the airflow implications of a turbofan blade changing slightly. A high-pressure turbine might be strengthened, but if its thermal characteristics change, then it might not expand in the same way, and the resulting discontinuity in surface geometry could lead to a failure that destroys the engine. Important areas to design for and model therefore include airflow, fatigue, and reliability.

The most important aeroengine performance metrics include mean time between failure (MTBM)—i.e., how long an engine lasts; and mean time before overhaul (MTBO)—i.e., how often an engine must be serviced fully. This, in turn, is linked to the degradation pattern/structure, which is vital to managing engine maintenance and anticipating performance. “Hitting the wall,” or experiencing a sudden and marked decline in engine performance, is particularly hazardous in military aviation, where even slight deviation from optimum performance parameters can be highly problematic. Unpredictable dynamics, or lack of knowledge of existing patterns, can be make it much more difficult to make the best use of engines—even in training, but especially in combat.

Compensating for shortcomings in either of these areas might require factoring in a substantial margin of error by dedicating additional engines and airframes; were the need great enough, something like 200 Flankers might be needed to ensure the mission fulfillment capabilities of roughly 100 F-15s. Other important metrics include acceleration/deceleration patterns, foreign object damage (FOD) resistance (Russian engines have historically fallen significantly short in this regard), and cold/hot temperature starts (the former is usually more difficult than the latter, but the amount of difference varies by engine model).

In short, an aeroengine system is only as good as its design, monitoring, and lifecycle management. This may be an area of particular weakness for China, as it has traditionally relied heavily on copying and emulating foreign designs. This approach does not confer ability to design and manage aeroengines; on the contrary, it can impose path-dependent limitations that lead to dead ends or substandard, poorly integrated systems that are costly and difficult to alter and thus remain “less than the sum of their parts.”

While this systemic component of Chinese turbofans remains uncertain, however, the techniques and processes to support their manufacture are clearly improving. Chinese gas turbine experts say the country’s aerospace industry has improved its jet engine manufacturing abilities in key areas, including:[7]

  • Precision cutting, welding, and machining, e.g., five-axis milling for production of turbine blades.
  • Special materials blade production. China’s largest turbine blade production facility, located at Xi’an Aero-Engine, can now undertake mass-production of turbine blades made from superalloys, titanium alloys, cobalt alloys, and stainless steel. The turbine blade quality rate is now said to exceed 95%.
  • Hollow fan blade production. China is entering the nascent stages of being able to produce hollow fan blades. Hollow titanium fan blades are 15-20% lighter than their equivalents and make an engine more fuel efficient. They also reduce rotating mass and allow a tactical aircraft engine to spool up more quickly during maneuvers.[8]
  • Greater automation. This improves standardization and efficiency.
  • Process modeling. Computer-aided process modeling help manufacturers anticipate problems with materials, welds, and behavior of parts under heat stress. Flagging potential trouble spots before machines are started helps save time and money and also ultimately helps produce a higher quality, more durable engine.[9]
  • Enhanced ability to use numerically-controlled milling machines to produce turbine disks.
  • Better ability to produce high-quality, standardized spare parts. Reliable access to such parts is essential to supporting aircraft performance, particularly at the high and unpredictable operational tempo inherent in many operational scenarios. Spare parts have traditionally represented an area of weakness in China’s aviation industry.

Still unclear, however, are key design, system, software, and reliability aspects of engine systems and components. Vibration testing of components is important (e.g., under high-G forces for military engines). It is difficult to determine China’s stage of development for Fully Automatic Digital Engine Control (FADEC), or the capability of the engine to communicate with the cockpit; and for Engine Control Units (ECU), the “brain” of the engine, which helps it to regulate itself.

Many of the Chinese jet engine industry’s recent improvements center on turbine blade production, which is logical given turbines’ location at the heart of any jet engine. However, a comprehensive analysis by experts from the China Gas Turbine Establishment, which played a major role in designing the WS-10 engine, does not discuss improvements in engine reliability. Thus, better blade manufacturing and machining may still not have brought about commensurate improvements in quality control and engine reliability. The WS-10A is now said to be flying in the PLAAF’s J-11B, and as engines accumulate flight hours it will be telling to see how powerful and efficient they are, how they hold up, and how frequently they require overhaul. The PLA is notably opaque about aircraft losses, but occasional reports do slip through, providing a barometer of reliability to watch as domestically-made engines spend more time in the air.

What challenges do Chinese military jet engine makers continue to face?

China’s attempts to mass produce P&W F100-class jet engines and develop an engine powerful enough to give the J-20 true 5th generation performance levels face a range of technical and process challenges. On the technical side, Chinese gas turbine researchers say weaknesses remain in turbine casting, powder metallurgy for creating turbine disks, and molding hollow titanium parts.[10] Many of these areas were named as ones in which substantial progress has taken place in recent years. Nonetheless, progress may be from a very low baseline, making the claims that problems remain while progress has occurred compatible with each other.

Chinese engine makers likewise need to create advanced production lines to ensure effective logistical support for domestically-made engines and must also automate their production facilities to a greater extent. Part of the technical challenge stems from the fact that machining the tough superalloys used in jet engines requires twice the cutting force of other types of machining and that cutting tools may have to be changed up to 10 times more often than when machining softer materials like those used for making auto parts.[11]

While this necessitates highly specialized production lines, however, a given engine needs to be produced on the same line to ensure economies of scale and quality consistency. Once systems are optimized, separating production into different lines should be avoided, as a stand alone approach could disrupt or crack the system. It is one thing to make a single turbofan blade in a laboratory, and another entirely to ramp up to mass production of several thousand (a single engine contains 400-500 blades in up to two dozen stages of 2-3 dozen blades each) blades of standardized, reliable quality. This requires mastering both the metallurgy grade and mastering the industrial process to reliably produce a high-quality product.

In the very limited publicly available discussions of China’s jet engine manufacturing weaknesses, local experts focus heavily on process weaknesses as major constraints on China’s ability to produce high-performance turbofans of consistently good quality. Chinese analysts cite the need to better integrate the research and manufacturing segments of the industry, creating databases to save knowledge that can be used to make construction more effective, reducing the boundaries between the jet engine design, materials, and fabrication sectors, and doing a better job training new technical and engineering staff.[12] Exhibit 3 (below) depicts key technical and process weaknesses currently affecting China’s tactical turbofan production.

Exhibit 3:  Where China’s Military Jet Engine Makers Continue to Experience Problems

Source: Defense Manufacturing Technology, USCC, China SignPost™

To put these weaknesses into context, they suggest that in some areas Chinese engine makers are roughly three decades behind their U.S. peers. Technical reports by U.S. manufacturers discussing challenges of actually making hollow fan blades that date back to 1977, implying that Chinese engine fabricators could be three decades behind the state-of-the-art curve at present.[13]

Abstracts of P&W technical papers from 1976 discuss using nickel superalloy powders to forge turbine discs for the F100 engine.[14] In contrast, as mentioned above, researchers from the China Gas Turbine Establishment cite powder metallurgy for turbine disc production as an enduring weak spot for China’s jet engine industry.[15]Of course, this may represent an attempt to secure additional funding, as opposed to a true reflection of current status; when did the U.S. Air Force (USAF) ever run out of update programs for its fighters?

One cautionary point here is that Chinese jet engine makers have a latecomer advantage, which allows them to learn from other engine makers’ successes and failures and potentially to shave years from their own research-development-production sequence. To put matters in perspective, the P&W F119 engine that powers the F-22 Raptor was developed and refined in the 1980s and ’90s, so China does not necessarily need to attain the current 2011 state-of-the-art in tactical jet engine technology to field formidable propulsion systems that could give the J-20 true 5thgeneration fighter performance characteristics.

What China must achieve, however, is a methodology akin to Six Sigma or Total Quality Management (TQM) to ensure quality control and sufficient organizational honesty to ensure that actual problems are reported and that figures are not doctored. Otherwise, standardization and integration may be the one in which the costs of China’s ad hoc, eclectic approach to strategic technology development truly manifest themselves. The Soviet defense industrial base failed in precisely this area: talented designers and technicians presided over balkanized design bureaus and irregularly-linked production facilities; lack of standardization and quality control rendered it “less than the sum of the parts.”

Mapping China’s Key Jet Engine R&D and Production Assets: Size and Resources

Chinese jet engine makers may remain slightly understaffed relative to U.S./UK producers of military jet engines, but comparably staffed relative to their Russian and French peers. Liming Aero-Engine and Xi’an Aero-Engine, AVIC’s flagship large military jet engine makers, have a combined staff of less than 20,000. By comparison, P&W, Rolls-Royce, and GE Aviation, the world’s largest military jet engine makers, each have more than 35,000 staff (Exhibit 4).

Exhibit 4:  Number of Workers at Major Global Tactical Turbofan Makers

Source: Company reports

Examining overall employment figures tends to over count personnel relevant to “Big Three” engine production and undercounts it for other manufacturers, however. The total head count at the former includes individuals involved in civilian, military, and global services programs (typically fairly-evenly-subdivided), not just dedicated R&D personnel. That at the latter does not include many R&D and metallurgy-relevant individuals employed in other organizations.

China’s jet engine complex may increase staffing somewhat if it seeks to become largely or fully self-sufficient in military turbofan production. With 15,000 workers, Russian manufacturer UMPO planned to produce 109 AL-31 and AL-41 engines in 2010.[16] Larger firms like GE Aviation, by contrast, can deliver approximately 200 high performance turbofans and 800 total military jet engines and helicopter engine turboshafts per year.

Technical Challenges

High-performance tactical jet engines are difficult to produce, but the work does not stop there, as the engines often undergo demanding usage and pose key maintenance and logistical challenges. Key potential constraints China will likely face in operating the high-performance tactical turbofans it is beginning to series-produce include issues involving technical, performance, and environmental factors, the ability to obtain sufficient materials for mass production of multiple engine families, and political/economic challenges.

Thermal cycling. The engines on a large transport or tanker typically run at a fairly steady speed setting for most of a flight. Engines on tactical aircraft, by contrast, undergo extreme speed changes as pilots frequently and quickly change throttle settings during high-intensity maneuvering. As the engine undergoes rapid temperature changes, thermal cycling generates significant wear. The experiences of the USAF with the first truly high-performance U.S. afterburning turbofan, the P&W F100, exemplify the unexpected safety and maintenance challenges that thermal cycling can generate.

While developing the F100, P&W engineers believed that the key determinant of stress on engine parts would be the length of time spent at the highest temperatures (i.e. full power and/or very high speed flight).[17] In practice, however, the F100’s unprecedented performance enabled new air combat techniques and training regimens that emphasized rapid and frequent maneuvering. This incurred relatively little time at full power or high Mach numbers, but entailed far more throttle changes than the engine designers had anticipated.

In fact, while the F100 design requirements called for being able to accommodate 1,765 full throttle transients during the engine’s service life, actual operational use showed that engine life ended up being more than 30% lower than expected because the engine was undergoing more than five times the number of full throttle transients it had been designed for—10,360 cycles (Exhibit 5).

Exhibit 5:  Key usage parameters of the F100 afterburning turbofan, November 1979

Source: The Great Engine War

As China develops indigenous high performance tactical turbofan engines, more intensive air combat training will make shortened engine life from thermal cycling an important issue to resolve. It is unclear how much experience China has in this area to date given that most Chinese pilots do not fly nearly as much as their U.S. counterparts and also may not be engaging in as intensive or realistic training. PLAAF and PLA Navy (PLAN) newspapers and other documents describe exercises in which engine use in particular is minimized wherever possible, as well as a variety of accidents that were caused by engine failures. Likewise, lower flight times in the Soviet/Russian air force, combined with different tactics, may mean that Russian engine makers are not able to draw on the same firsthand experience with combating thermal cycling wear that their American peers have.

Chinese technicians are making real progress in learning how to improve engines that are already fielded and wring the maximum life possible out of them. China’s 5719 Jet Engine Repair Plant has allegedly found a way to extend the operating life of Russian-made AL-31F engines from 900 hours to 1,500 hours.[18] It is almost certain that the WS-10 and any new jet engines made in China will incorporate any life extension and other improvements that the PLAAF and PLAN Aviation have gleaned from the Russian engines that are currently the backbone of their flight operations.

Other Environmental Factors

Vibration resistance is another key determinant of engine performance. If an engine sucks in a small stone, for instance, it can nick a plate, thereby producing a small vibration, which in turn can lead to performance degradation and even failure. Environmental factors that can have negative impact include high/hot airfields (H&H), “sandy” air, salt-water corrosion, and FOD. Russian engines, for example, typically have less FOD resistance than those of Western design. Indian Air Force Su-30MKI aircraft reportedly exhibited significant limitations at the Red Flag 2008 exercises at Nellis Air Force Base because of the FOD vulnerabilities of their Russian engines. These problems were not caused by Indian maintenance procedures; agreements with Russia require that any damaged engines be shipped back to Russia for servicing.[19]

Performance Possibilities

It remains to be seen whether China can develop reliable engines with key high-performance capabilities essential for world-class military aircraft. These include thrust vectoring, the ability to control an aircraft’s attitude or angular velocity by redirecting its exhaust slightly; continuous power-output at all speed and altitude settings without performance drops; and stall resistance. The last two factors could be particularly important, yet difficult, for China to master. The engine used in the Russian Su-27, the AL-31F turbofan, reportedly experiences performance power drops at certain power demands, e.g., high angle of attack (AoA) maneuvers. Under such conditions, there is a risk of disturbed air and fuel flow.

Particularly in a non-thrust vectored aircraft, if the engine becomes air-strained at a high AoA, the engine can suddenly have difficulty in using fuel, possibly leading to blade stall or discontinuous airflow, thereby starving the engine of oxygen. China’s J-11 variant uses these engines, and its canards suggest that it is designed for precisely these sorts of maneuvers. The key to avoiding such problems is to design the engine inlet to optimize its cross-section geometry while avoiding a tendency toward stalling. Sophisticated modeling is needed to deconflict these countervailing factors, however; hence the importance of determining Chinese capabilities and approaches in these critical areas.

Structural Challenges

China’s military jet engine sector faces a number of critical structural problems. Many of these are human and bureaucratic issues that can be much more difficult to resolve successfully than technical problems are. Two vulnerabilities stand out.

First, China’s defense officials will have to deal with single source contractor risks. China’s domestic military jet engine production all lies under the control of Aviation Industry Corporation of China (AVIC), a state-owned aerospace conglomerate. AVIC’s jet engine production facilities at Shenyang, Xi’an, and Guizhou compete to some extent, but we suspect that the competitive and innovative pressures are not as acute as those which companies like P&W and GE Aviation face. When present in moderation, competitive pressure helps produce innovative engines, lowers costs, speeds up development, and tends to incentivize better aftermarket service. In the late 1970s and early ’80s, the behavior of P&W, then a single-source supplier that the USAF felt was not being responsive to its concerns, prompted the government to foster competition between GE and P&W in the military jet engine sector. The resulting “Great Engine War” helped create architecture whereby U.S. combat aircraft can be designed around a range of powerplants produced by two competing firms. This organizational structure appears to work well. In China’s case, by contrast, there may be less “competition” at the macro level but more at the micro level. This may allow for localized bargaining and patronage that leads to duplication of effort, mismanagement of resources, and an increase in time to market. Here it will be necessary to determine how the “system” of organizations involved in Chinese aeroengine development and production actually work in practice, and whether and to what degree they are “more than the sum of the parts” in practice.

Second, analyses of jet engine development and production in the U.S. credit inter-service cooperation, management stability in both the companies and government, and the use of small teams that were allowed to take risks with a minimum of red tape helped foment jet engine development and production breakthroughs.[20]

Of these two areas, China is likely to struggle most deeply with issues of inter-service cooperation, since service chiefs in China likely view themselves as competitors for slices of the pie in any given budgetary period. Resource constraints will pose less of a challenge since military jet engines typically cost between US$2.5 million and US$5 million apiece. Supporting a very aggressive tactical aircraft buildout by producing 500 tactical turbofans per year would account for only about 2% of China’s total 2011 defense spending. Overall, structural issues pose major challenges, but can be dealt with incrementally once a country masters the basic technology and metallurgy of jet engine making.

Technologies and business practices to improve engine production

Quality control shortcomings have plagued Chinese indigenous jet engine production to date, particularly for high performance engines like the WS-10 series. In response to this and broader concerns, AVIC has declared 2011 to be a “year of quality” and pledges a tight focus on quality control across the aerospace production chain, which presumably will apply to aeroengine manufacturing as well.[21] AVIC’s motion follows on the heels of a September 2010 State Council document that outlines steps for achieving better quality control in military hardware production in China.[22] The report does not specially mention aerospace or jet engine production, but its existence implies that the commitment to improving China’s indigenous military systems production of all varieties runs straight to the top. How and to what extent these directives are realized in practice will hinge on design capability (e.g., involving materials, airflow, simulation and calculations, MTBF, systems integration, and FADEC/ECU design). It will be essential to avoid imbalances in which some parts are “better” than others, as this can introduce asymmetries and problems at the system level.

AVIC’s press statement covering its desire to bolster quality control does not discuss specific details. That said, well-documented quality control programs implemented by key global jet engine makers can shed light on the likely basic mechanics of how AVIC’s plans may take shape. P&W, one of the largest military jet engine makers in the world, has a system known as Achieving Competitive Excellence (ACE). ACE entails a focus on the following factors:

  • Total productive maintenance
  • Quality Clinic Process Chart
  • Root Cause Analysis
  • Mistake Proofing (this can be measured by first pass or final yield)
  • Process Certification
  • Setup Reduction
  • Standard Work

China currently does not use total lifecycle (design) tools like the ones that Western corporations such as France’s Dassault employ. The CAD-CAM (computer-aided design and computer-aided manufacturing) stand-alone tools widely employed in China are optimized for design, not operational usage. Focusing only on design at the expense of buildability and maintainability can lead to situations in which fixing parts may be problematic because of problems with fitting hydraulic tubes between electric lines, etc.

There appears to be recognition that current approaches are inadequate. A number of sources reflect the Chinese jet engine industry’s interest in using process modeling and computer simulation to reduce build costs and construction time by envisioning problems before metal is cut.[23] China’s shipbuilding industry already uses these technologies on an industrial scale and there is significant potential for the aerospace and jet engine sectors to learn best practices from shipbuilders, with the caveat that different tolerances become a terrible problem for aircraft under extreme environmental conditions in ways that ships never experience.

China’s privately-owned shipyards are leading the way in this area. Jiangsu-based Rongsheng Heavy Industries is using concurrent design and computer simulation techniques to boost its production efficiency.[24] Concurrent design entails designing the ship hull, as well as electronics, internal components and other “guts” of the ship simultaneously using Tribon software.

Potential for Technology Transfer Between Civil and Military Industries

Military and commercial jet engines often have radically different performance parameters, but unlike other dual-use sectors like shipbuilding, the materials and construction techniques used to make key components of high-bypass turbofans for commercial airliners are in many cases quite similar to those used in making low-bypass turbofans for higher performance tactical aircraft. This is particularly true for the engine core. For example, the highly popular CFM56 commercial engine appears to share aspects of the core of the P&W F101 engine that powers the B-1B—at a minimum, there seems to be significant design overlap.

China’s aerospace industry has a growing list of joint ventures (JVs) with foreign partners including GE Aviation, P&W, and SNECMA, primarily in the areas of final assembly (vice basic design and components) and maintenance, repair, and overhaul (MRO). A good example of the latter is MTU Maintenance Zhuhai, a 50-50 joint venture between MTU Aero Engines and China Southern Airlines.[25] MRO is perhaps the most important are of major aeroengine JVs for China, as it can help Chinese experts figure out how to perform after-market, in-service overhaul and how to feed repair data back into the design and MTBF loop to improve design and performance.

As such, these JVs hold real potential for transferring technology and know-how that then could trickle into military jet engine design, production, and maintenance and potentially provide tangible improvements in Chinese air combat capabilities. China’s 2010 Defense White Paper states explicitly that “Defense-related enterprises and institutions are regulated and guided to make use of civilian industrial capabilities and social capital to conduct research into and production of weaponry and equipment.” The concept of harvesting civilian technology for military use is already being implemented in practice, as exemplified by the recent jet engine research and development cooperation agreement signed between China Southern Airlines and the PLA’s Armed Forces’ Engineering Institute in May 2011.[26]

Against the backdrop of China’s stated intention to use civilian industry as a source of militarily-relevant technology, presuming that jet engine-related cooperation is “commercial only” is at best naïve. JVs involving the construction and/or maintenance of jet engines deserve scrutiny based not only on the simple adherence to the letter of the law in export control regulations, but also on the potential for such jet engine technology transfer to erode U.S. competitive trade advantages and to potentially facilitate the development of a much more formidable Chinese air warfare capability, as well as contribute to greater Chinese exports of highly capable aircraft that U.S. forces might later face with respect to a third country such as Iran.

CFM International, one of the world’s largest commercial jet engine makers, is a joint venture between GE Aviation, a division of General Electric of the United States; and Snecma, a division of Safran of France. Thus drawing on some of North America and Europe’s most advanced aeroengine technology, it is also a designated aeroengine supplier for China’s C-919 Large Aircraft Program. CFM International signed an MOU with AVIC in December 2009 to discuss the potential of establishing a final jet engine assembly line in Shanghai, as well as an engine test facility, but says nothing has been finalized yet. The company tells us that as of May 2011, it has not determined where LEAP final assembly will take place.[27]

CFM sources extensively in China for its current product line and is likely to do so for the advanced new Leap-X1C engine as well, but says it is too early to say what parts will be produced in China. The company’s parts sourcing for the Leap-X1C merits close attention because the engine’s core uses advanced technologies including integrally bladed rotor disks called “blisks” in which the rotor disk and fan blades are machined or cast from a single, unitary piece of metal.[28]

Blisks offer the advantage of greater reliability and significant weight savings—up to 30% over conventional blades and disks in some cases.[29] Blisks are now utilized in a range of advanced military turbofans including the GE F414 (F/A-18 Super Hornet), P&W F119 (F-22 Raptor), and P&W F-135 and GE F136 (F-35 Lightning JSF) and learning how to manufacture blisks via commercial engine cooperation would be very helpful to Chinese engine makers as they work on the WS-15 and other advanced military turbofan engines.

Engine materials

Obtaining exotic materials and having the ability to properly machine them are vital both to physically making jet engines and for keeping manufacturing costs competitive. The General Manager of IHI’s Soma No. 2 Aeroengine Works in Japan says materials account for 50% of the cost of engine components made at his plant.[30]

Modern high-performance jet engines incorporate a number of high-strength, high-temperature materials. These include titanium, nickel, aluminum, composites, and superalloys based on nickel and cobalt. China is well-positioned to source many of these key materials from domestic producers. For example, flagship producer BaoTi says it can supply 95% of the Chinese aerospace industry’s titanium needs. Similarly, Jinchuan Nickel uses imported ores and concentrates to produce nickel and cobalt and has the capacity to produce 130,000 tonnes per year of nickel and 10,000 tonnes of cobalt. Jinchuan produced around 4,000 tonnes of cobalt in 2010—18% of the global total—according to Norilsk Nickel. To put this number into context, a large commercial jet engine (40,000 lb thrust) typically contains between 50-60 kg of cobalt, meaning that if Jinchuan supplied only 5% of its annual cobalt output to jet engine producers, there would theoretically be enough to manufacture more than 3,000 engines per year.

“Theoretically” is the operative word because the main material constraint faced by jet engine producers is not limited to securing the raw nickel, cobalt, and other metals they need. Perhaps the most critical area is being able to purchase or produce the high-temperature superalloys needed for making a jet engine. China currently is not self-sufficient in superalloys according to Sealand Securities, which estimates that the country produces around 10,000 tonnes per year of superalloys, against consumption of 20,000 tonnes per year.

Commercial jet engines typically contain between 0.7 and 2.0 tonnes of superalloys per engine, according to the Metal Powder Industries Federation. Since most high performance tactical turbofans weigh less than 2 tonnes, we assume 1 tonne of superalloy per engine, giving China to current capability to supply superalloy for 1,000 military turbofans per year if it devotes 10% of domestic superalloy production to the jet engine sector. As such, superalloys pose a more significant potential bottleneck for jet engine production in China than base metal supplies do and are likely to see higher production facilities investment in the next 5 years.

Outlook and Strategic Implications

The history of U.S. jet engine and aircraft development shows an average correlation of nearly 1-to-1 between the creation of new aircraft and new jet engines. China is now entering a period of more rapid aircraft development, and in particular, one that increasingly involves indigenous designs or modifications of airframes that are sufficiently radical to potentially warrant the development of entirely new engines or derivatives to power them. At present, China is developing or preparing to mass produce a range of tactical aircraft including the J-15, J-16, J-20, and potentially others.

Robust aircraft development and production programs plus a desire to move into the 5th generation aircraft space where the Russians may be reluctant to supply later model engines such as the 117S create powerful motivators for achieving a greater measure of domestic jet engine production self-sufficiency. It is likely that the next 2-3 years will bring surprising breakthroughs in China’s ability to produce high performance jet engines for tactical aircraft independently, with Chinese production of reliable top-notch engines perhaps 5-10 years away.

Key metrics to watch in determining Chinese progress in engine capabilities include engine thrust-to-weight ratio and specific fuel consumption. The first is an indicator of both design quality and production quality (i.e., of material tolerance). The second denotes the amount of fuel that the engine burns to reach a given level of performance, which in turn determines combat range, time over target, and the amount of strain on the engine.

Major systems management indicators include on-wing reliability (MTBF) and ease of in-field replacement and repair. China could take a variety of approaches to address these issues, including overcoming low MTBF by simply having more engines available, a process that the U.S. employed for many years when its own engines were less reliable, as was the case with the F-4 Phantom in Vietnam (in contrast to, e.g., the F-15 today).

If China’s engine makers can attain the technical capability level that U.S. manufacturers had 20 years ago, China will be able to power its 4thgeneration and5th-generation aircraft with domestically made engines (3rd and 4th-generation in Chinese nomenclature, respectively). These developments would be vital in cementing China as a formidable regional air power and deserve close attention from policymakers.

[1] For the purposes of this analysis, “tactical aircraft” means fighter aircraft, strike-fighters, and attack planes.

[1] “胡参谋长: 中国航空发动机超越俄罗斯不是神话” [Chief of Staff Hu: The Idea of China’s Jet Engines Surpassing Russia’s is Not a Myth], Nanfang Daily, 23 January 2011,http://opinion.nfdaily.cn/content/2011-01/23/content_19516764.htm.

[2] “林左鸣: 投资一百亿打一个航空发动机的翻身仗” [Lin Zuoming: 10 Billion RMB Will be Invested in Standing up China’s Military Jet Engine Development], 17 April 2011, http://military.people.com.cn/GB/52934/67858/14407966.html.

[3] “军报: 国产太行量生并装备歼-11B推力12.5吨” [Military Times: China’s Domestically-Made 12.5 Tonnes Thrust Taihang Engine Now Being Series Produced to Equip the J-11B], Global Times, 19 November 2010,

http://mil.huanqiu.com/china/2010-11/1270688.html.

[4] NPO Saturn, Quarterly Report, 1st Quarter 2011, http://www.npo-saturn.ru/upload/editifr/2011/38_0_greport_201101.pdf.

[5] Ibid.

[6] Global Gas Turbine News, International Gas Turbine Institute, 51:1 (February 2011): 51.

[7] “先进航空发动机关键制造技术研究” [Key Manufacturing Technology Research of Advanced Aero-Engine], China Gas Turbine Establishment, Defense Manufacturing Technology, 6 (2009): 47.

[8] G.A. Fitzpatrick and A.D. Lloyd, “Establishing Best Practice in the Design and Manufacture of Hollow Titanium Fan Blades,” Paper presented at the RTO AVT Workshop on “Intelligent Processing of High Performance Materials,” 13-14 May 1998, 4-1.

[9] R.C. Reed, P.D. Lee, and M. McLean, “Process Modelling of the Fabrication of Critical Rotating Components for Gas Turbine Applications,” Paper presented at the RTO AVT Symposium on “Reduction of Military Vehicle Acquisition Time and Cost through Advanced Modelling and Virtual Simulation,” 22-25 April 2002.

[10] “先进航空发动机关键制造技术研究” [Key Manufacturing Technology Research of Advanced Aero-Engine], China Gas Turbine Establishment, Defense Manufacturing Technology, 6 (2009): 48.

[11] Carol Hui, “High-Flying Investments,” Metalworking World, No. 2 (2008): 11,http://www2.coromant.sandvik.com/coromant/downloads/articles/aerospace/MWW208_aerospace_japan.pdf.

[12] “先进航空发动机关键制造技术研究” [Key Manufacturing Technology Research of Advanced Aero-Engine], China Gas Turbine Establishment, Defense Manufacturing Technology, 6 (2009): 48.

[13] M.M. Allen, “Iso-Forging of Powder Metallurgy Superalloys For Advanced Turbine Engine Applications,” P&W, April 1976, DTIC.

[14] CEK Carlson, JL Cutler, WJ Fisher, and JV Memmott, “Diffusion Bonded Boron/Aluminum Spar-Shell Fan Blade,” June 1980, DTIC.

[15] “先进航空发动机关键制造技术研究” [Key Manufacturing Technology Research of Advanced Aero-Engines], China Gas Turbine Establishment, Defense Manufacturing Technology, 6 (2009): 48.

[16] «В 2010 году ОАО ‘УМПО’ планирует увеличить товарный выпуск на 4.7%», AviaPort, 16 February 2010,http://www.aviaport.ru/digest/2010/02/16/190463.html.

[17] Robert Drewes, The Air Force and the Great Engine War (Honolulu, HI: University Press of the Pacific, 2005), 60.

[18] “Rise with Enthusiasm: China’s Jet Engine Technology is Surpassing that of Russia’s AL-31F,” 28 August 2010, MilChina,http://www.milchina.com/2010/0828/4519.htm.

[19] “USAF Pilot Describes IAF Su-30MKI Performance at Red Flag-08,” The DEW Line, 5 November 2008, http://www.flightglobal.com/blogs/the-dewline/2008/11/usaf-pilot-describes-iaf-su30m.html.

[20] William S. Hong and Paul D. Collopy, “Technology for Jet Engines: Case Study in Science and Technology Development,” Journal of Propulsion and Power, 21.5 (September-October 2005): 775-76.

[21] “中航工业全面推进航空产品质量管理工作” [AVIC Seeks to Comprehensively Improve Quality Control Management of Products it Produces], Aviation Industry of China, 28 January 2011, http://www.avic.com.cn/xwzx/jtxw/364941.shtml.

[22] “‘现公布’武器装备质量管理条例” [Ordinances Pertaining to Weapon Equipment Quality Control], 30 September 2010, State Council of the People’s Republic of China,http://www.gov.cn/zwgk/2010-10/08/content_1717050.htm.

[23] 陈美宁, 朴英, 王大磊 [Chen Meining, Piao Ying, and Wang Dalei], “某型航空发动机风扇串列叶栅的数值模拟” [Numerical Simulation of Tandem Cascades in an Aeroengine Fan], Journal of Aerospace Power, 5 (2010).

[24] Rongsheng Heavy Industries, http://www.rshi.cn/Design.html.

[25] “MTU Aeroengines,”http://www.mtu.de/en/company/corporate_structure/locations/zhuhai/index.html.

[26] “装甲兵工程学院与中航南方公司签约燃气轮机应用研究” [Armed Forces Engineering Institute and China Southern Airlines Sign Agreement on Research of Gas Turbine Applications], Ministry of National Defense of the People’s Republic of China, 16 May 2011, http://news.mod.gov.cn/headlines/2011-05/16/content_4242087.htm.

[27] Interview with company representative, May 2011.

[28] John Croft, “CFM: Serving no LEAP before its Time,” FlightGlobal, 8 March 2010, http://www.flightglobal.com/articles/2010/03/08/339093/cfm-serving-no-leap-before-its-time.html.

[29] “Repair of Blisks Made of Ti 6246,” Fraunhofer-Institut für Lasertechnik ILT, Annual Report 2005, 76, http://www.ilt.fraunhofer.de/eng/ilt/pdf/eng/jb05/s76.pdf.

[30] Carol Hui, “High-Flying Investments,” Metalworking World, No. 2 (2008): 14,http://www2.coromant.sandvik.com/coromant/downloads/articles/aerospace/MWW208_aerospace_japan.pdf.

***

Gabriel B. Collins and Andrew S. Erickson, “China’s J-15 No Game Changer,” The Diplomat, 23 June 2011.

Following is a guest entry from Gabe Collins and Andrew Erickson, co-founders of China Sign Post.

Gen. Chen Bingde, Chief of Staff of the People’s Liberation Army (PLA), has reportedly said that, for the first time, a Chinese ‘aircraft carrier is under construction.’ China is also already preparing the refitted ski-jump carrier Varyag, purchased from Ukraine in 1998, to go to sea.

Given these developments, it seems a good time to look at the first carrier-based aircraft that China will employ: the new J-15 ‘Flying Shark’ carrier-based heavy fighter-bomber.

As currently configured, the J-15 is no ‘great leap forward,’ but is nevertheless triggering concern in the region because it indicates rapid improvement in Chinese naval aviation, and suggests Chinese determination to extend its regional blue water presence. The J-15’s initial role will be linked to, and limited by, its first operational platform: a ‘starter carrier’ to project a bit of power, confer prestige on a rising great power, and master basic procedures. … … …

Andrew Erickson is an associate professor at the US Naval War College and fellow in the Princeton-Harvard China and the World Programme. Gabe Collins is a commodity and security specialist focused on China and Russia. This is an edited and abridged version of a longer analysis. The full version can be read here.

***

Gabriel B. Collins and Andrew S. Erickson, “‘Flying Shark’ Gaining Altitude: How Might New J-15 Strike Fighter Improve China’s Maritime Air Warfare Ability?” China SignPost™(洞察中国) 38 (7 June 2011).

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

General Chen Bingde, Chief of Staff of the People’s Liberation Army (PLA), has just been quoted as confirming that a Chinese “aircraft carrier is under construction now.” According to Global Times, “This is the first time the PLA has officially acknowledged the existence of a Chinese aircraft carrier.”[i] General Chen is likely referring to a future indigenously constructed Chinese aircraft carrier, which U.S. government sources have projected will be operational sometime after 2015. As U.S. Department of Defense projected in 2010: “Analysts in and out of government project that China will not have an operational, domestically produced carrier and associated ships before 2015.  However, changes in China’s shipbuilding capability and degree of foreign assistance to the program could alter those projections.”[ii] Meanwhile, however, China is already preparing the refitted ski jump carrier Varyag, purchased from Ukraine in 1998 and brought to Dalian Shipyard in 2002, to go to sea.

Given these developments, it is time to analyze the first carrier-based aircraft that China will employ: the new J-15 “Flying Shark” carrier-based heavy fighter-bomber. Pictures of the J-15 have been appearing for almost two years and a video of it flying has been on YouTube for about a year,[iii] so the sudden surge of attention to the aircraft likely comes because Varyag (renamed “Shilang,” according to some Chinese sources) could begin sea trials as early as this summer. (Chinese Internet sources frequently mention 1 July 2011 as a potential date, though a knowledgeable Chinese expert with whom one of the authors has spoken cautions that the exact date is impossible to predict given the uncertainties inherent in systems development and integration).

As currently configured and supported, the J-15 is no “great leap forward,” but is nevertheless triggering concern among regional nations because it indicates rapid improvement in Chinese naval aviation and suggests Chinese determination to supplement current anti-access/area denial (A2/AD) approaches by developing some form of regional blue water presence beyond the First Island Chain. (This demarcation, envisioned by Chinese strategists such as former PLA Navy/PLAN commander Admiral Liu Huaqing, extends through Japan, Taiwan, the Philippines, and Malaysia, and encompasses the three “Near Seas”: Yellow, East China, and South China. They regard it as both a “benchmark” of PLAN progress and a “barrier” fortified with foreign military facilities.) The J-15’s initial role will be linked to, and limited by, its first operational platform: a “starter carrier” to project a bit of power, confer prestige on a rising great power, and master basic procedures.

What’s happening now?

On 24 April 2011, Chinese Internet sources posted new photos of a J-15 sitting outside a hangar at the airfield of the No. 112 Factory of Shenyang Aircraft Corporation (SAC). First assembled at SAC in 2008, J-15 prototypes reportedly made their maiden flight on 31 August 2009 and their first takeoff from a land-based simulated ski jump on 6 May 2010 at China Flight Test Establishment (CFTE), Yanliang Air Base, Shaanxi Province.[iv]

The J-15, which has an airframe closely resembling that of the Russian Su-33, boasts more advanced, indigenously made avionics, including a wide-angle holographic Heads-Up Display (HUD);[v] as well as more complex trailing-edge double-slotted flaps.[vi] Small canard foreplanes and enlarged folding wings enhance low-speed handling. A shortened tailcone helps to avoid tail-strike during high angle of attack (AoA) landing. An arresting hook helps shorten landing distance, and strengthened landing gear with twin nose wheels helps absorb impact. The J-15 is likely to have similar avionics, radar, and weapons capabilities to the land-based J-11B, which itself emulates the Su-27SK, albeit with improvements in precisely these areas, as well as to the airframe. The airframe changes might include structural reinforcements to support arrested landings in the tailhook, wing/body attachments, and wing/weapon pylon attachment areas.

The lack of a second seat for a Naval Flight Officer (NFO) to operate the avionics and radar suite in the images of the J-15 currently available on Chinese websites suggests that the PLA believes its electronics suite is sufficiently integrated and automated to require only one person to operate all the plane’s functions, including navigation and targeting. This is normal practice for carrier aircraft: most U.S. Navy F/A-18s are single seat, as are most Russian Su-27s and derivatives. Modern weapons systems are highly automated and can be operated well by a single pilot. Two seats are used primarily in order to operate in bad weather at low altitudes and when the systems cannot be as automated, as in the EA-18 Growler electronic warfare airplane. The J-15 is single seat because a) this is normal for carrier aircraft, and b) a crewed aircraft would give up too much performance at takeoff from the ski jump.

China’s push to refurbish “Shilang” could potentially reunite the basic Su-33 airframe with the ski jump carrier from which it was originally designed to fly. PLAN Aviation has reportedly conducted a test flight on land using a ski jump. Google Earth and Internet photos suggest that the cities of Huludao and Xi’an have ski jump runway-style pilot training facilities, with two sets of arresting gear also present at Huludao. This ski jump approach, while it may help launch China into the deck aviation field, will limit significantly whatever performance parameters the J-15 achieves.

What it means

The J-15’s emergence offers potential capabilities that are noteworthy because China is starting from such a low baseline in naval aviation that virtually any progress could make a big difference. It means that when the J-15 becomes operational (potentially by 2014), PLAN Aviation will have a carrier-based airframe with relatively advanced sensors and electronics, the maneuverability to be a credible close-in fighter, and even the potential range and payload to be a serious strike platform for use against maritime and terrestrial targets—if China develops its naval aerial refueling capabilities significantly. The J-15 has a retractable refueling probe that is likely derived from that of the Su-30MKK, but overall this is an area in which China has yet to demonstrate notable progress. For now, it would seem to be dependent on land-based tankers as launch of tankers (or buddy-to-buddy refueling, which adds significant weight, making ski jump-launching difficult of not impossible) would have to rely on shore-based tankers until China develops or acquires catapults.

As for potential mission applications, the J-15 is a large aircraft and likely has a normal takeoff weight in the 25 tonne range, which is roughly similar to that of America’s now-retired F-14 Tomcat. It remains to be seen precisely what capabilities the J-15’s avionics suite possesses, but if they can support a ground attack mission (the tricky part might be targeting radar with land and ocean seek/guidance modes), the J-15 will have two primary uses in a future Chinese carrier group, with a third role of providing air cover as necessary during future operations to protect and/or evacuate Chinese citizens threatened by violence in Africa and other regions.

If properly equipped, supported, and employed—and these are significant “ifs”—the J-15 could affect the regional military balance substantially, as it likely exceeds or matches the aerodynamic capabilities of virtually all fighter aircraft currently operated by regional militaries, with the exception of the U.S. F-22 Raptor. If China is able to eventually employ an effective indigenous active electronically scanned array (AESA) radar in the J-15, it could potentially come close to approximating the electronic capabilities of the F/A-18 E/F Super Hornet, the U.S. Navy’s primary strike fighter. AESA radars offer stealth and high jamming-resistance and the potential ability to track and engage cruise missiles such as the Tomahawk; they could possibly be used in electronic countermeasures (ECM) applications as well. While too many variables remain at this time to determine precisely how the J-15 will contribute to China’s “system of systems” of military capabilities, its very existence suggests for the first time the possibility of China developing serious maritime aviation capabilities—a prospect that would have regional implications. In fact, there is already a substantial likelihood that the J-15’s existence will prompt China’s maritime neighbors to purchase additional late-generation fighter aircraft.

One concrete example of a fighter program that the J-15 could influence is the F-35B, which currently faces possible cancellation or cuts. The F-35B’s short takeoff and vertical landing (STOVL) capabilities would make it the only aircraft that the Japan Maritime Self-Defense Force (JMSDF) would be able to operate off of its Hyuga-class helicopter destroyers. As early as the late 1980s, parts of the JMSDF have sought to incorporate fighters into their destroyer operations as a way to enhance defense against bombers and anti-ship cruise missile (ASCMs).[vii] Rising perceptions of threats from carrier-based Chinese J-15s could sharpen Japanese interest in acquiring a meaningful number of F-35Bs.

The F-35B’s attractiveness is enhanced by the fact that with its STOVL characteristics, it would also be deployable in case of a first strike on Japanese/U.S. airbases on Okinawa, or other areas such as Guam, that led to damaging or loss of runways. As such, planners could use the F-35B as the core of a “centralized battle-management, decentralized air asset staging” concept that could help counter the risk that the PLA’s growing, highly accurate ballistic missile arsenal poses to airfields in the region. The question would be the range of Okinawa or Guam from the area of operations as the F-35B in STOVL mode suffers from the same kind of limitations that the J-15 would suffer when operating from a ski jump.

Possible J-15 missions

While the Flying Shark’s capabilities remain uncertain, its potential is significant. If deployed effectively, it could offer China new options for combat air patrol (CAP) and maritime strike.

Long-range CAP. The Sukhoi Flanker/J-11/J-15 basic design features high internal fuel capacity and allows for a substantial operational radius, given the Su-27’s genesis as a Soviet long-range interceptor with a roughly 10 tonne internal fuel load. Even with the reduction in fuel and weapons loadout imposed by a ski jump launch, it is reasonable to assume that a J-15’s combat radius could extend as far as 700 km from the carrier, particularly if the buddy tanking capability is included, which can add more than 300 km of operational radius, according to Carlo Kopp of Airpower Australia. (This would be provided by a buddy pod, an external store generally containing a hose and drogue system that allows one aircraft to transfer fuel to another). The J-15 will likely be able to carry China’s PL-12 air-to-air missile, adding an additional 100km to its reach out range. Currently, China’s longest-range maritime air cover in blue water situations comes from the 200 km-range HHQ-9 naval surface to air missile.

When the J-15 is deployed, it could help push potential foes much further away from a Chinese carrier given that the range of most potential opponents’ air-launched anti-ship weapons is 300km or less. Organic fighter cover would be vital for maritime security missions located far enough from land to preclude land-based air support. Chinese fighters would likely be at a significant numerical disadvantage in any confrontations involving the U.S. Navy, but J-15s armed with the PL-12 air-to-air missile, which has similar performance parameters to the Russian R-77 and US AIM-120A Advanced Medium-Range Air-to-Air Missile (AMRAAM), would nonetheless have to be taken very seriously by potential opponents. In a close-in fight, the J-15, which likely has a 10% better thrust-to-weight ratio and 25% lower wing loading than the F/A-18 Super Hornet (the mainstay U.S. Navy fighter for a long time to come), could be a dangerous foe. More powerful versions of the indigenous WS-10 turbofan engine, as China is able to develop them, would improve the J-15’s aerodynamic performance.

Maritime strike/anti-ship missions. If armed and able to launch successfully with the Kh-31 supersonic anti-ship missile or the indigenous YJ-82 supersonic ASCM, carrier-based J-15s could credibly hold surface platforms within 500 km of the Chinese carrier group at risk. We base this assessment on the 200+ km range of the air-launched YJ-83 ASCM, which could give PLAN aviators in J-15s the ability to trade fuel for weapons in a weight-restricted ski jump takeoff scenario. This would add an additional threat dimension for which fleet commanders would have to account. Existing Chinese surface combatants and submarines launching late-model ASCMs like the Klub pose a very serious threat to surface vessels, but they take much longer to move into firing positions and thus can be more easily accounted for by planners and air defense personnel (though submarines might be difficult to detect if operated quietly).

Whereas a Kilo-class diesel submarine or future nuclear attack submarine (e.g., Type 095) or a Type 054 frigate could require hours to close to ASCM firing range with a surface ship several hundred km from a Chinese carrier group, a J-15 strike package could cover the distance in minutes, giving Chinese commanders much greater tactical flexibility. China’s growing space-based intelligence, surveillance, and reconnaissance (ISR) capabilities will help facilitate the J-15’s maritime strike potential.

One creative way in which the PLA might attempt maximize the impact of deck aviation in a regional conflict would be to “lily pad” by launching a number of fully loaded J-15s from coastal airbases, aerially refuel them within the protective envelope of land- and carrier-based fighter aircraft, and subsequently use the carrier(s) for airplane recovery after the first-strike mission with a full weapons loadout. The carrier(s) could then potentially generate successive, more lightly-loaded sorties from their ski-jumps. The aircraft might then refuel just enough to get back within tanking range from home base. The U.S. did a form of this in the 1973 Yom Kippur War, ferrying A-4 Skyhawks to Israel via a series of carriers in the Atlantic and Mediterranean.

At longer ranges the strike package would be subject to significant tradeoffs, possibly limited by the need to designate some aircraft as buddy tankers and the need for retaining fighters for CAP, lest the carrier be left open to air attack. J-15s on an anti-ship mission would also be vulnerable to attack by opposing fighters if operating against U.S. forces.

Ski jump carriers: no great leap forward

Regardless of the J-15’s specific capabilities, however, it is likely to be limited severely by the deck aviation platform from which it operates. For the foreseeable future, this would seem to be a ski jump, as seen on the ex-Varyag. As a former carrier aviator at the U.S. Naval War College emphasizes, a ski jump design imposes significant restrictions; such carriers have very limited operational capability. Using a ski-jump does not allow an aircraft to approach maximum take-off weight, and even then it requires maximum thrust to keep it in the air at less than 100 mph when it hits the end of the jump. The only aircraft that can use a ski jump effectively is a high thrust-to-weight jet like the Su-33, and then without much load. Ski jump launch cannot produce sufficient lift to allow full gross weight takeoffs. Vertical and/or short take-off and landing (V/STOL) jets like the Harrier or F-35B obtain benefit from a ski jump, which lets them carry more load that if they took off vertically or using a straight deck. But China currently lacks V/STOL capabilities.

One of the great operational limitations of a ski jump carrier is that it must depend on helicopters to provide the essential capability of airborne early warning (AEW). Compounding matters, helicopters are one of the PLAN’s greatest areas of weakness; its fleet remains extremely small and underdeveloped. It appears that the PLAN may employ Ka-31 AEW helicopters imported from Russia until it can develop an adequate indigenous platform, perhaps based on the Z-8. As long as the PLAN operates ski jump carriers, therefore, it is unclear how much the air group on the carrier will contribute to the overall ISR picture, since ISR aircraft are typically underpowered relative to their weight and sophisticated versions would have difficulty launching via ski jump.

A Chinese carrier likely will not be launching anything but J-15s, because a plane with near 1:1 thrust to weight ratio is required to do anything but fall after leaving the ski jump. A Chinese ski jump carrier, then, will not be operating robust fixed-wing ISR assets like the U.S. Navy’s E-2 Hawkeye or S-3 Viking, which could not launch safely from it, and it does not possess their equivalents in any case. Nor could it safely launch a heavily-loaded twin-engine cargo aircraft like the C-2 Greyhound, which is likewise dependent on catapult launch. Thus, even if China had three carriers in the fleet, up from zero today, PLAN Aviation would still be a primarily land-based air force; how it will (or will not) integrate with the PLA Air Force remains a key uncertainty. Nor can a ski jump carrier operate tankers, whose aerial refueling is essential for extending naval aircraft range. The U.S. Navy used to deck-launch S-2 Trackers, fully outfitted with anti-submarine warfare (ASW) gear, but the carrier had to be producing considerable wind over the deck to accomplish this; typically, a catapult was used.

For these reasons, Chinese ski jump carriers simply cannot be used in any of the combat roles that U.S. Navy carriers have performed. At best, they could provide limited air cover for amphibious forces and some close air support, akin to what U.S. Marine Corps Harriers have long provided. Ski jump carriers derive most of their combat power from helicopters or from deck-launched ASCMs. Any fighters they carry would have little or no capability to man distant combat air patrol (CAP) stations, so for defense, they would either rely solely on surface-to-air missiles (SAMs) or perhaps alert interceptors. However, given the limited amount of AEW they would have, the alert interceptors would be largely undefended once they went over the radar horizon.

Conclusion

While a new step for China and an important indicator, the J-15 is limited in capability; its launch platform even more so. It is important not to overstate the land attack and anti-ship potential of the J-15 airframe flying off of short take off but arrested recovery (STOBAR) carriers such as “Shilang,” particularly against large U.S. military facilities like Guam and Diego Garcia. Even if J-15s could get off the deck with a reasonable weapons load, their range would be greatly reduced—it would be significantly less coming off of the ski jump than for comparable U.S. aircraft coming off catapults. China could in theory refuel planes in the air (assuming China buys or develops a buddy pod) but this sort of “operational triage” would reduce the air group by turning a significant number of fighters into tankers. Employed in isolation, buddy pods are of limited utility (and might not be all that launch-able from ski jumps in the first place).

To obtain significantly extended range it is necessary to use large tankers, which the U.S. Air Force (USAF) employs extensively, but China lacks. Fuel is the heaviest thing an aircraft carries, it seems unlikely that a ski jump- launched J-15 with a buddy pod would have significant ability to provision other fighters. Even a catapult launched F-18 with a buddy store only has about 4,000 lb of fuel to transfer. Given the limitations on number of aircraft carried and the takeoff weight limits of ski jump launched aircraft, “Shilang” could not generate operationally significant numbers of sorties unless the game was to get one or two aircraft into a strike firing position. Essentially, they would just be able to do aerial sniping against weakly armed opponents. Combined with the need to hold some jets back for defense, then, Chinese planners would face with a very difficult choice—attack at longer ranges with a greatly reduced strike package (probably insufficient to seriously damage a large target), or bring the carrier in close to get more aircraft on target and expose the entire carrier group to greater risk.

While a first-generation Chinese carrier would not represent a threat to U.S. ships and facilities in the way that the U.S. uses carriers, however, it could nevertheless be employed to provide significantly increased air defense to a group of surface ships in order to get them within ASCM range of a U.S. carrier group, or—should the Chinese develop a naval land attack cruise missile (LACM)—to get the LACM shooters within range of a key U.S. base. The same is true of ASW protection in theory, although this might be done better by additional destroyer-based helicopters, with which China has more experience and which would not offer such a large, consolidated, and easily detectable target set.

In addition, while a Chinese carrier group would not last very long in a head-to-head confrontation with the U.S. Navy, the very existence of a Chinese carrier capability, even a limited one, would potentially exert significant pressure on China’s South China Sea neighbors to settle maritime disputes in ways favorable to China. If regional leaders perceive “Shilang” as a confirmation of waxing Chinese naval power and something that erodes the credibility of U.S. security guarantees, this could potentially prompt Vietnam, Malaysia, and others to seek bilateral accommodation with China.

Aside from a focused worst-case mission to damage a very specific target at the risk of limited operational effectiveness and high friendly losses then, the J-15’s development is part of a long-term PLAN Aviation effort to “dip its toe” in the water in order to build more robust capabilities in the long run. The oceans are vast and promising, but the water can be cold and the salt often stings.

Remaining issues & challenges.

1)     Since ski jump launches reduce an aircraft’s potential fuel and weapons payload relative to catapult launches, it will be telling to see if China’s future indigenous carrier hulls employ a catapult launch instead. For operations outside of the range of China’s handful of land-based large tanker aircraft (i.e., essentially the entire strategic zone between the straits of Hormuz and Malacca), this will greatly limit combat effectiveness since J-15s launched from the carriers will be able to carry fewer weapons and can only rely on their internal fuel stores. Even in local contingencies, Chinese forces would quickly face a shortage of tankers, particularly given China’s trouble acquiring the IL-78s needed to refuel Flanker-derivative planes like the J-15.

2)     A related question concerns the ability of the plane’s landing gear to absorb the impact of landing. The heavier the machine at landing, the more stress on the airframe. If a pilot lands too fast or the arresting gear is set for the wrong weight, then the hook could come off the airplane or the arresting gear engines could be ruined. Cross deck pendants (flexible steel arresting cables/wires strung across the carrier deck to catch the arresting hook of an incoming aircraft) do break, but rarely. When they do, due mostly to a faulty swedge fitting (where the pendant attaches on each side to the wires that go down into the engines) or poor quality assurance in pendant fabrication, the results are gruesome. Many people on deck are killed and maimed, not to mention the damage to aircraft.

3)     To function at maximum combat effectiveness, carrier-based fighters need AEW and tanker support. The U.S. and French Navies use variants of the E-2 Hawkeye to provide AEW capability. The tanker issue may prove more challenging for operations beyond China’s immediate region. U.S. naval aviators typically rely on USAF tankers operating from forward bases in the Middle East and other regions to support them during expeditionary air operations. China would need to negotiate access agreements of some type to deploy tankers to support any possible future operations in the Western Indian Ocean and Northeastern Africa.

4)     One question that will affect the J-15’s combat potential directly is: will China deploy more advanced, longer-range air-to-air and air-launched anti-ship missiles in the next few years? If China can build a sufficiently robust ISR and targeting chain, missiles in the class of Russia’s 300km-range Novator K-100 or Vympel R-37 and BrahMos-class air-launched ASCMs (~300 km range) would help compensate for range restrictions induced by lower fuel payloads during ski jump operations. This would be in keeping with China’s larger “missile-centric” approach.

5)     If China plans to fully indigenize J-15 production, it will need to have the domestically made WS-10 turbofan engine or other variant attain world-class reliability standards to enable safe and confident overwater operation. Global Times claims that Aviation Industry Corporation of China (AVIC) is series-producing WS-10 engines for the J-11B, but other sources indicate that reliability issues remain, which is a major safety issue for an overwater aircraft. The engines would also need to be made salt water-resistant to allow marine operation. Many analysts believe the J-15 is now using Russian-made AL-31 engines, which China is able to refit and overhaul on its own. Aeroengine development is among the greatest technological challenges for any aerospace power, and China has yet to demonstrate top-tier indigenous production capabilities here.

6)     What types of follow-on modifications might SAC make to the J-15 as it moves toward becoming operational? We think it is realistic to expect modifications including thrust vectoring engine nozzles similar to those found on other Flanker-derived aircraft and changes to engine intakes and other structures to reduce radar cross section. The aircraft’s avionics suite will almost certainly become more capable over the next 5 years.

7)     How many J-15s will PLAN Aviation acquire? Deploying a carrier with a full component of highly capable strike fighters sends a very different strategic message than deploying a carrier outfitted primarily with helicopters.

8)     It will be interesting see if Chengdu Aircraft Industry Group promotes a follow-on version of the slightly-navalized variant of its J-10 fighter that it has already developed—perhaps as an alternative or supplement to SAC’s J-15. This assumes, of course, that the J-10 can be turned into a successful carrier fighter. The U.S. examined just such a possibility with the F-16, it turned out to not be a suitable design. Rumors about a carrier-capable J-10 have circulated on the Chinese Internet for years, but open sources have not yet offered concrete evidence of such a development. Delta-wing canard fighters can operate from a carrier, although they may require substantial strengthening in order to withstand the rigors of arrested landings and possibly catapult launches if China’s future carriers move away from ski jumps. This can sometimes make a fighter too heavy, as exemplified by BAE Systems’ proposed navalized Eurofighter Typhoon, which can operate from ski jump carriers but would be too heavy relative to competitors if it were beefed up for catapult operations. In a positive example, the French Rafale C is an effective, combat proven aircraft with successful land- and carrier-based versions. A competitive twin engine naval J-10 using Russian RD33 engines or the WS-13 turbofan China has developed for the FC-1/J-17 export fighter would likely have aerodynamic characteristics similar to the Rafale.

[i] Liu Chang, “PLA Chief Confirms Vessel is ‘Under Construction’,” Global Times, 8 June 2011, http://military.globaltimes.cn/china/2011-06/662887.html.

[ii] Military and Security Developments Involving the People’s Republic of China 2010, Annual Report to Congress (Washington, DC: Office of the Secretary of Defense, August 16, 2010), 48.

[iii] “J-15 Next-Generation Carrier-based Fighter Caught on Camera,” YouTube, 8 July 2010,
http://www.youtube.com/watch?v=trYUWQvKees.

[iv] “J-15 Flying Shark,” Chinese Military Aviation, http://cnair.top81.cn/J-10_J-11_FC-1.htm.

[v] “New Shipborne Navy Jet Fighter Makes Waves Among Analysts,” Global Times, 25 April 2011, http://military.globaltimes.cn/china/2011-04/648200.html.

[vi] David A. Fulghum, “New Chinese Ship-Based Fighter Progresses,” Aviation Week, 27 April 2011,  http://www.aviationweek.com/aw/generic/story.jsp?channel=defense&id=news/asd/2011/04/27/02.xml&headline=New%20Chinese%20Ship-Based%20Fighter%20Progresses&next=10.

[vii] Yoji Koda, VADM (ret.), “A New Carrier Race: Strategy, Force Planning, and JS Hyuga,” Naval War College Review (Sumer 2011): 46.

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Gabriel B. Collins and Andrew S. Erickson, “The 10 Biggest Cities in China That You’ve Probably Never Heard of,” China SignPost™ (洞察中国) 37 (1 June 2011).

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

China already has more than 150 cities with populations of more than one million people and could have as many as 221 cities with one million or more people by 2025, according to the McKinsey Global Institute (MGI). Yet relatively few of China’s larger cities, each with its own special history and contributions to China’s development, are known outside of China.

Indeed, we suspect that even Chinese from major coastal metropolises are relatively unfamiliar with many of the sizeable but lower-profile cities in China’s vast hinterlands. Thus, this research note selects 10 of China’s largest, but less well-known cities and provides a brief profile of each. Our list is based on taking the most populous cities in China and excluding Beijing, Shanghai, Tianjin, Guangzhou, Shenzhen, Harbin, Qingdao, Wuhan, and several other large Chinese cities that are reasonably well-known outside of China. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Internal Challenge: China’s Diabetes Epidemic Highlights How Rising Healthcare Costs Could Constrain Economic Growth and Military Spending,” China SignPost™ (洞察中国) 36 (31 May 2011).

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

As analytical attention (including a substantial portion of ours) focuses on China’s growing military power and economic influence, both in East Asia and further afield, it is also important to step back and realistically assess major domestic challenges that Beijing faces. Healthcare costs are becoming a key issue as China grapples with a rising incidence of diabetes, which already afflicts roughly 10% of Chinese adults—almost identical to the U.S. rate of 11%. China is now has roughly 92.4 million diabetes sufferers, the largest number of any country. Sadly, the numbers continue to rise rapidly, exacting an increasing toll in economic and human terms.

In 2007, China’s diabetes epidemic accounted for more than 14% of healthcare expenditures and cost the country at least 0.6% of GDP in lost productivity, according to the Economist Intelligence Unit. The EIU based its assessment on the assumption that 4.3% of Chinese have diabetes, but new estimates place the rate at around 10%, meaning that the costs of diabetes on China’s economy from productivity losses are probably closer to 1.5% of GDP. Atop this, the International Diabetes Federation estimates that in 2010, China directly spent around US$6.9 billion on diabetes treatment.

This suggests that many patients are not being treated or are receiving inadequate care, setting the stage for additional costs and higher mortality from complications later. Managing Type 2 diabetes (the most common type) currently costs an average of US$6,000 annually per patient in the U.S., according to The New York Times. Assuming China can treat diabetes patients at 1/3 of the annual U.S. per patient cost and that even 25% of China’s estimated 92.4 million diabetes population is being actively treated, the annual cost for treatment alone would come out to roughly US$46 billion per year. This is equal to half of China’s officially stated 2011 defense budget. … … …

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Gabriel B. Collins and Andrew S. Erickson, “The ‘Flying Shark’ Prepares to Roam the Seas: Strategic Pros and Cons of China’s Aircraft Carrier Program,” China SignPost™ (洞察中国) 35 (18 May 2011).

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

China’s budding aircraft carrier program is provoking energetic debate among Chinese and foreign observers. The former Ukrainian carrier Varyag (called “Shi Lang” by some Chinese Internet sources) is now being rapidly refitted in China’s Dalian Naval Shipyard. It is likely to represent a modest and training-focused beginning to a small set of first-generation Chinese dedicated deck aviation platforms, which will ultimately employ such indigenously-developed carrier aircraft as the J-15 Flying Shark.

China will likely build ~3-4 hulls to permit at least one to be at sea while the others are being used for training or being refitted. Various Chinese sources predict that the ex-Varyag could be “launched” and have some form of “harbor and sea trials” this year, perhaps as early as July. If so, when combined with the 11 January flight test of the J-20 stealth fighter and increasing training involving J-10 aircraft (a variant of which may be exported in the next few years), this will be a banner year for Chinese military aviation development.

Against this backdrop, it is important to provide a proper strategic context and assess the likely pros and cons the development and eventual deployment of carriers holds for China. A viable carrier capability would certainly offer the beginnings of a new level of power projection capability. Having a clear sense of what the strategic advantages and weaknesses of carriers are for the PLA Navy (PLAN) will help the U.S. and other regional powers formulate more effective plans and strategies to help cope with China’s nascent carrier capability. … … …

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Gabriel B. Collins and Andrew S. Erickson, “A Foreign Corrupt Practices Act with Chinese Characteristics: Step 1,” China SignPost™ (洞察中国) 34 (1 May 2011).

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

  • In late February 2011, the National People’s Congress ratified an amendment to China’s Criminal Law that makes it illegal for PRC nationals and companies to bribe foreign government officials or officials of non-governmental organizations.
  • The amendment, which became effective on 1 May 2011, is the first step in a long and complex process, but nonetheless sets a welcome precedent by implicitly recognizing that bribery abroad is destructive to Chinese interests.
  • The rapid penetration of smartphones and other forms of Internet connectivity in the developing world provide opportunities for common citizens to help enforce the laws by independently reporting graft involving Chinese business activities in their country.
  • The efforts of the Janaagraha Centre for Citizenship and Democracy and its new IPaidABribe.com bribe reporting website offer a shining example of how technology can be harnessed to improve transparency and fight graft.
  • IPaidABribe.com, which went live in fall 2010, has so far garnered more than 436,000 hits and over 8,400 reports discussing bribes paid.

Thus far, China’s lack of anti-bribery mechanisms that apply to companies operating abroad like the U.S. Foreign Corrupt Practices Act (FCPA) has been a major competitive advantage for Chinese businessmen competing overseas against foreign firms, which must often adhere to strict laws at home forbidding graft in corporate activities abroad.  Yet a recent development suggests Beijing is increasing its commitment to reduce bribery by Chinese firms and individuals doing business overseas. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Southeast Trade Winds: East Coast and South Experienced Fastest Value-Adjusted Growth of All U.S. Regions in Exports to China over Past Decade,” China SignPost™ (洞察中国) 33 (14 April 2011).

China SignPost analyzed the data for U.S. exports to China by state from the 2010 U.S. Exports to China by State report from the U.S.-China Business Council. The results shed light on both how strongly U.S. exports to China have grown in the past 10 years and how regionally diverse they are becoming.

Between 2000 and 2010, U.S. exports to China rose from $16.2 billion to $91.9 billion. This 468% increase far outstrips the 55% rate that U.S. trade with the rest of the world grew at over the past decade. The West Coast, which enjoyed 778% growth in its exports to China over the past decade, remains the powerhouse of U.S. exports to China, accounting for 30% of total U.S. exports to China in 2010. However, the East Coast, which now provides nearly 20% of U.S. exports to China, saw its exports to the Middle Kingdom rise by more than 1,000% between 2000 and 2010. Exports from southern states (18% of total US exports to China) boosted their sales to China by 949%, midwestern exporters (12% of total) increased exports to China by 681%, and the southwest, anchored by Texas and Arizona, expanded exports to China by 375% and now accounts for 13% of U.S. exports to China. … … …

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Gabriel B. Collins and Andrew S. Erickson, “China Defense White Paper 2010: Better Transparency, But What Key Developments Were Left Out of the Discussion?” China SignPost™ (洞察中国) 32 (5 April 2011).

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

China’s National Defense in 2010 continues the tradition of offering additional bits of incremental information each year, but still refrains from delving into the concrete discussion of China’s military capabilities that foreign defense analysts hope for. To its credit, the 2010 White Paper is a carefully-written document that offers insight into China’s defense policy and some general trends in its military development. Beijing’s ongoing moves toward defense transparency are positive even if they fall short of foreign expectations.
We recognize that China’s Defense White Papers to date have shied away from discussing specific systems and capabilities, but believe that even discussions that might not be as fact-rich as documents published by the U.S. or other foreign militaries would still help China build strategic trust with other regional powers. In addition, a rapidly modernizing military like China’s that performs an increasing range of activities in its home region has much to gain from greater transparency about capabilities and intentions, as such disclosure could help reduce its neighbors’ incentives to create new negatively-focused security arrangements aimed at counteracting the rising power.
With regard to higher transparency regarding equipment and capabilities among militaries outside of the PRC, the U.S. military’s Quadrennial Defense Review and Nuclear Posture Review are excellent examples of documents that combine discussion of strategic intentions with more detailed and concrete discourse on hardware and acquisition plans. In addition, other militaries tend to publish a regular flow of official policy statement and documents discussing procurement and other activities. The biannual China Defense White Paper, on the other hand, has covered insufficiently or overlooked entirely key developments in a rapidly changing country where two years of change can be far more momentous than would be the case in the U.S., Japan, or the EU.
A number of specific military developments cause significant concern to China’s Asian neighbors, as well as the U.S. If the PRC leadership were to permit a more detailed discussion of these types of matters in future White Papers, it would likely help assuage foreign concerns about China’s military modernization in Asia and beyond.

To help quantify the importance of the systems and developments that are not discussed, but in our opinion should be, we assign them an importance ranking of between 1.0 and 10.0, with a higher number suggesting that an issue is of more pressing concern to foreign analysts of China’s military development.

China’s anti-ship ballistic missile (ASBM) development (9.0)
The report contains no mention of China’s ASBM program, which, according to the U.S. Navy, reached the equivalent of initial operational capability in late 2010. The timing of this particular announcement might be a bit late for inclusion in the report, especially with Beijing’s official silence on the matter, but for the program to reach the equivalent of IOC in late 2010, it had been in development for a number of years prior. From the perspective of the U.S. and regional militaries, an operational Chinese ASBM system with a range that is likely at least 1,500 km is a major event, since may prompt a re-think of carrier operations within a threat envelope that now potentially extends far into the South China Sea, Northern Indian Ocean, and Western Pacific.
In turn, any restrictions on carrier operations would have two key effects: (1) they could cause U.S. allies in the region to question Washington’s true security commitment during a confrontation with China, since the U.S. might be perceived as confronting a choice as to whether to expose carriers to serious risk of damage, for example; and (2), the ASBM reinforces the importance of submarines for regional navies, since large capital surface ships may not be nearly as survivable as before, particularly for countries other than the U.S. and Japan that lack advanced ship-based anti-ballistic missile systems.
For more information on China’s ASBM program and assessment of initial operational capability, please see: Andrew S. Erickson and Gabriel B. Collins, “China Deploys World’s First Long-Range, Land-Based ‘Carrier Killer’: DF-21D Anti-Ship Ballistic Missile (ASBM) Reaches ‘Initial Operational Capability’ (IOC),” China SignPost™ (洞察中国) 14 (26 December 2010).
China rapidly growing space-based intelligence, surveillance, and reconnaissance (ISR) capabilities (7.0)
In 2010, China’s number of space launches equaled the U.S. launch figure for the first time. More importantly, a significant portion of China’s launches involved satellites that are helping to build up a persistent and survivable ISR capability along China’s maritime periphery and beyond. China has launched 7 Yaogan surveillance satellites since December 2009, suggesting that a more robust spaced-based reconnaissance capability is a high priority for the PRC. Yaogan satellites 9 A, B, C are particularly interesting because they fly in a formation, which suggests that they function as some form of naval ocean surveillance system (NOSS). Jane’s says these satellites carry infrared sensors to help them locate ships, meaning they could probably provide accurately positional locations for ASBM targeting. China is also reportedly preparing to launch a second Tianlian data link satellite in June 2011, which in conjunction with the existing Tianlian-1, could provide coverage over as much as 75% of the earth’s surface. Improved data linking capabilities would help strengthen China’s ASBM “kill chain” by further linking sensors with shooters.
ABM/ASAT test in January 2010 (6.5)
In January 2010, China successfully tested a midcourse intercept anti-ballistic missile (ABM) system likely based on the same SC-19 booster system that powered the direct ascent anti-satellite (ASAT) system the PLA used to destroy an aging weather satellite in January 2007. China’s multiple successful tests indicate that the PLA is becoming proficient at using hit to kill kinetic intercept vehicles that could be launched from Chinese soil and hold valuable U.S. reconnaissance and other military satellites at risk during a conflict.
The J-20 advanced fighter test flight (5.5)
China’s first test of a 4+ generation fighter comes 20 years behind that of the U.S. (the F-22 Raptor first flew in 1990), but could become an aircraft that makes Washington rue its decision to cap F-22 Raptor production at 187 aircraft. Analysis from Airpower Australia’s Dr. Carlo Koppstrongly suggests that a J-20 with 5th generation characteristics could outperform the F-35 Lightning II at virtually all levels, potentially leaving the U.S. and allies operating the F-35 at a disadvantage to a PLA Air Force armed with supercruising, stealthy, and maneuverable J-20s. Of course, there are a wide variety of other ways to target and mitigate attacks from opposing aircraft.
For additional in-depth analysis of the J-20 program and its strategic implications, please see: Gabriel B. Collins and Andrew S. Erickson, “China’s New Project 718/J-20 Fighter: Development Outlook and Strategic Implications,” China SignPost™ (洞察中国) 18 (17 January 2011).China’s aircraft carrier development (5.0)
The 2010 China Defense White Paper also contained no mention of China’s aircraft carrier program. The New York Times reports that one of the paper’s presenters, Sr. Col. Geng Yansheng, sidestepped questions about the carrier program during the 31 March 2011 news conference at which the paper was unveiled.

China appears to be rapidly refurbishing the ex-Soviet carrier Varyag; the U.S. Office of Naval Intelligence (ONI) projects that it will be operational by 2012. According to Asahi Shimbum, China has decided to embark on a national carrier program in which it would build domestically a 50,000-60,000 tonne conventional carrier by 2014 (ONI projects that it will be completed after 2015) and a nuclear-powered carrier by 2020. China certainly faces substantial challenges in equipping a carrier, training pilots in carrier operations, and building a carrier group. That said, the country’s rising defense budget (officially $91.5 billion in 2011) and the experience of domestic shipyards in building increasingly complex large commercial ships make it likely that physical construction barriers can be overcome in a reasonable amount of time.

Mastering the intricacies of carrier operations will take longer and a Chinese carrier group would likely not survive very long in a direct confrontation with the U.S. Navy. Nevertheless, a carrier group would offer immense diplomatic benefits in providing a visible Chinese naval presence in the South China Sea, Southeast Asia, along key sea lanes in the Indian Ocean, and for humanitarian missions such as the response to the 2004 Indian Ocean tsunami. Several carrier groups would be necessary for persistent presence in these areas, however, to allow for periodic maintenance.
For more analysis of how Chinese shipyards’ growing capabilities could help the PLA Navy build an aircraft carrier, please see: Gabriel B. Collins and Andrew S. Erickson, “LNG Carriers to Aircraft carriers? Assessing the Potential for Crossover between Civilian and Military Shipbuilding in China,” China SignPost™ (洞察中国) 12 (18 December 2010).
The PLA’s growing access to and use of foreign ports and airfields (4.0)
The February/March 2011 Libya evacuation operation involved a forward-deployed PLAN missile frigate, Xuzhou, which had recently replenished in Oman, as well as the use of the Khartoum, Sudan airport to refuel IL-76 transports headed to and from Libya to evacuate Chinese nationals trapped there.
For any future military deployments for noncombatant evacuation operations (NEOs) or other such expeditionary military activities, port and airfield access in the region concerned is crucial for supporting and sustaining platforms involved in the mission. Areas for potential deepening of PLA logistical support and access during times of crisis that merit close watch in coming years include: Tanzania, Kenya, Madagascar, Djibouti, Salalah (Oman), Aden (Yemen), Gwadar and Karachi (Pakistan), Chittagong (Bangladesh), Hambantota (Sri Lanka), Mauritius (where Port Louis has sufficient draft to accommodate a large warship), Sittwe (Burma), and Singapore.
China’s use of military assets to support Libya rescue & evacuation operation (2.0)
The 2010 Defense White Paper makes no mention of the deployment of PLAN and PLAAF forces to help secure the evacuation of Chinese citizens from Libya, an historical first. It will be interesting to see how Beijing evaluates and portrays such efforts in the future. They are positive and understandable, but may raise expectations among Chinese for what their government can do to address subsequent threats to the security of Chinese citizens overseas. China’s 2008 Defense White Paper did not include discussion of the PLA Navy’s precedent-setting Gulf of Aden counter-piracy mission, which began at the very end of 2008, but the deployment made it into the 2010 White Paper. We strongly suspect the 2012 Defense White Paper will include meaningful discussion of the Libya evacuation operation and the PLAN and PLAAF roles in the historic mission.

For more detailed analysis of the unprecedented use of military assets to safeguard Chinese citizens in Libya, please see:

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Gabriel B. Collins and Andrew S. Erickson, “China Aims to More Than Triple Its Oil & Gas Production in the South China Sea over the Next 10 Years,” China SignPost™ (洞察中国) 31 (3 April 2011).

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

New deepwater oil & gas exploration and production will likely complicate the South China Sea maritime security environment.

  • China is aiming for oil & gas production of 500,000 barrels of oil equivalent (boe) per day by 2015 and 1 million boe per day by 2020 in deepwater areas of the South China, according to China 5e. CNOOC, China’s dominant offshore producer, had total output of roughly 290,000 boe per day from the South China Sea during 2010.
  • Shanghai Waigaoqiao Shipyard has built the HYSY 981 drilling rig, which can drill in 3,000 m of water to a total well depth of 12,000 meters.
  • The HYSY 981 deepwater rig gives China the physical capacity to drill virtually anywhere in the South China Sea apart from the deepest parts of the abyssal plain.
  • Greater Chinese oil & gas production in portions of China’s EEZ in the South China Sea near major international sea lanes could exacerbate Chinese sensitivities regarding freedom of navigation in the area.
  • Although China’s sovereign deepwater drilling capabilities are set to rise, we believe Beijing will exercise restraint in unilaterally exploiting energy resources further than 200 nautical miles from the Chinese Coast.  Even the benefits of a large new oil or gas field would not outweigh the negative implications of catalyzing more formal anti-China regional security alignments. … … …

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Gabriel B. Collins and Andrew S. Erickson, “The Saudi Arabia of Corn: Reduce U.S. Ethanol Production and Boost Corn Exports to China to Trim the Trade Deficit and Ensure China’s Food Security,” China SignPost™ (洞察中国) 30 (28 March 2011).

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

In 2010, the U.S. used roughly 138 million tonnes of corn to produce ethanol—43% of the nation’s total corn crop of 316 million tonnes. This is a phenomenal change from 1980, when less than one million tonnes of corn was used for brewing ethanol in the U.S. When considering the environmental and economic merits of any policy, total costs and benefits must be calculated over the entire lifecycle of a given process—not just for a given stage of usage. Biofuels will constitute an important part of the U.S. and global energy portfolio in the future, but a one-dimensional reliance on corn-based ethanol—with its attendant economic and environmental shortcomings—is not the best approach for maximizing the economic and strategic value of U.S. corn production. … … …

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Gabriel B. Collins and Andrew S. Erickson, “India Plays Catch-up with China: Asia’s Titans Boost 2011 Defense Budgets,” China SignPost™ (洞察中国) 29 (14 March 2011).

Air and naval implications of India’s higher spending and evolving strategic priorities.

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

China announced on 5 March 2011 that it would boost defense spending by 12.7% in 2011 to US$91.5 billion, up strongly from the 7.5% increase seen in 2010. India, China’s other Asian peer aside from Japan, recently boosted its defense budget by 11.6% for 2011 to US$36.5 billion, after a rise of only 4% in 2010 (Nezavisimaya Gazeta). India’s defense procurement spending is slated to rise by 14% in 2011, to US$15.4 billion, with the Indian Navy’s budget set to rise by nearly 17%, the Army budget by 23%, and the Air Force budget by 24%, according to Defense News.

We find the spending increases noteworthy because while China is preparing for a range of contingencies and sees the U.S. as its key strategic competitor, India is taking a Pakistan- and (increasingly) China-centric approach to its defense planning and acquisitions. A recent example of a more China-facing Indian strategic choice is the Indian Air Force’s decision to deploy two squadrons of SU-30 fighters—India’s most capable—to Chabua and Tezpur airbases in Assam, which lies near the strategic border state of Arunachal Pradesh (Hindustan Times). They will complement two new infantry divisions being raised, likewise to strengthen defense in India’s northeast. Meanwhile, China has been building and upgrading transport infrastructure on the Tibetan Plateau to facilitate faster movements near the border and patrols the area aggressively. India’s Defense Ministry accuses China of making at least 350 illegal border incursions over the past several years in Arunachal Pradesh alone (Indian Defence).

The Indian Navy plans to acquire 60 new ships, submarines, an aircraft carrier, maritime surveillance aircraft, and satellites in addition to 32 vessels and six submarines being built in India over the next 10 years, according to Defense News. This suggest the country’s leadership recognizes the need for building and maintaining a strong maritime presence in the Indian Ocean as other rising powers such as China also focus on the Indian Ocean region. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Implications of China’s Military Evacuation of Citizens from Libya,” Jamestown China Brief 11.4 (10 March 2011): 8–10.

The People’s Liberation Army Navy (PLAN) made history with the news on February 25 that the frigate Xuzhou, one of the navy’s most modern warships, had been dispatched to waters near Libya to support and protect the evacuation of Chinese citizens. The Libya operation is the Chinese military’s first operational deployment to Africa and the Mediterranean, as well as its largest noncombatant evacuation operation (NEO) to date, with virtually all 35,000 PRC citizens in the country evacuated as of March 3. The bulk of Chinese nationals in Libya were evacuated by sea on chartered merchant vessels (primarily from Benghazi), in addition to chartered aircraft (primarily from Tripoli), military aircraft (Sabha to Khartoum, Sudan), and overland (buses to Tunisia and Egypt). A significant number of individuals are still traveling back to China via international transit hubs, but none are vulnerable to the growing violence in Libya. The deployment of Xuzhou sets a major precedent because it marked the first time China has sent military assets to a distant part of the world to protect its citizens there. This is an historical first for China, and represents Beijing’s growing capability to conduct long-range operations that it was both incapable of doing, and unwilling to do, only a decade ago. … … …

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Gabriel B. Collins and Andrew S. Erickson, “China’s Economic & Strategic Interests in CENTCOM’s Area of Responsibility: Assessment and Policy Recommendations,” China SignPost™ (洞察中国) 28 (9 March 2011).

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

China’s recent operation to evacuate its citizens in Libya saw PLA ships and aircraft pass through the U.S. Central Command’s (CENTCOM) area of responsibility (AOR), suggesting that contact between the U.S. and Chinese militaries in the Middle East is likely to increase. To help policymakers, we give a brief rundown of China’s strategic and economic interests in countries within the CENTCOM AOR. Energy is a key interest, with countries in the AOR accounting for more than 2.2 million bpd of oil supply to China in 2010 (~45% of China’s total oil imports). … … …

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Gabriel B. Collins and Andrew S. 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) 27 (1 March 2011).

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

China’s evacuation of its citizens from Libya became a multi-service operation on the afternoon of 28 February 2011, when the PLA Air Force (PLAAF) flew four IL-76 long-range transport aircraft from Diwopu International Airport in Urumqi, Xinjiang Uyghur Autonomous Region (Northwest China). Their destination: Sabha, in east-central Libya. According to China Central Television (CCTV)-7, Beijing’s official military channel, the mission is to rescue Chinese citizens “stranded” in Libya. The PLAAF’s deployment of assets into a theater where the PLA Navy already has theXuzhou missile frigate scheduled to arrive in waters off Libya very shortly sets an historic precedent for deploying military assets to protect Chinese nationals abroad.

The deployment is the longest range PLAAF air deployment yet that we know of. Turkish media report that Chinese SU-27’s refueled in Pakistan and flew via Iran to Turkey in mid-September 2010 for a bilateral air exercise, Anatolian Eagle, in Anatolia. The flight distances involved in the Libya rescue operation are several thousand km further than the 2010 mission and likely involve total distances of between 9,500 and 10,500 km, depending on route and wind and weather conditions. Deploying aircraft from the headquarters location of the Xinjiang Military Region Air Force in Urumqi makes sense, as it offers the shortest flight to Libya. A stylized great circle route (the shortest theoretical flight path) is depicted below. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Missile Frigate XuzhouTransits Suez Canal, to Arrive off Libya ~Wednesday 2 March: China’s First Operational Deployment to Mediterranean Addresses Libya’s Evolving Security Situation,” China SignPost™ (洞察中国) 26 (27 February 2011).

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

Current situation

Libya’s security situation is becoming increasingly volatile as embattled leader Col. Muammar Gaddafi faces an increasingly capable set of opposition forces. Anti-government forces have been bolstered by the decision by most of Libya’s 80,000-strong armed forces to lay down their arms, according to the Globe and Mail. Anti-government forces are also capturing territory in western Libya, Gaddafi’s traditional regional stronghold, and are now deploying tanks and other heavy weapons, reports the Los Angeles Times.

We project that if Gaddafi indeed attempts to retain power until the end, the stage will be set for high-casualty confrontations between pro- and anti-regime forces, which are becoming ever-more-evenly matched. Chinese remaining in Libya risk getting caught in the crossfire. China National Petroleum Corporation (CNPC) says that while its 391 employees in country are all safe, some of its oil facilities there have been attacked. Against this volatile backdrop, the desire of China and other countries to deploy military platforms to oversee the evacuation of citizens still trapped in Libya is highly understandable. Chinese Vice Foreign Minister Song Tao says that as of 25 February, 12,000 of the ~30,000 Chinese citizens in Libya had been evacuated by chartered planes, ships, and buses (Xinhua).

To ensure a reliable backstop to these continuing operations in accordance with Beijing’s robust conception of national sovereignty, China’s navy is conducting its first-ever operational deployment to the Mediterranean. It is designed specifically to safeguard evacuation operations in uncertain conditions, to ensure that Beijing has a voice in critical regional issues, and to help guarantee that China’s government is seen as capable and competent both at home and abroad. As Qu Xing, president of the China Institute for International Studies, told China Central Television (CCTV): “No matter what kind of attitude the foreign media are having when seeing China, they will have to agree that China has the efficiency, power, and mobility to handle such activities.” … … …

***

Gabriel B. Collins and Andrew S. Erickson, “China Dispatches Warship to Protect Libya Evacuation Mission: Marks the PRC’s First Use of Frontline Military Assets to Protect an Evacuation Mission,” China SignPost™ (洞察中国) 25 (24 February 2011).

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

What we know

The PLA Navy has just dispatched Xuzhou, a Type 054 Jiangkai-II class missile frigate, from the ongoing seventh PLAN anti-piracy task force deployment off Somalia to steam to Libyan coast to provide support and protection for the ongoing evacuation mission there. The escort mission has been approved by the Central Military Commission, according to Xinhua, and at least 6,300 of the roughly 30,000 PRC citizens in Libya have been evacuated. The news agency adds that the Chinese evacuation is also utilizing chartered aircraft, overland routes to Egypt and Tunisia, ships from China’s major state shipping firms, and Greek merchant vessels in the region, which are said to be closely coordinating their operations with the Chinese government and plan to evacuate up to 15,000 Chinese from Libya.

Beijing’s speedy response shows nimbleness in handling a situation where descent into chaos has directly impacted Chinese citizens’ security. As of 23 February 2011, the Ministry of Commerce said at least 27 Chinese-run construction sites had been attacked by armed individuals and that there were numerous injuries. Commissioned in 2008, Xuzhou is a 4,000-ton frigate with a Vertical Launch System capable of launching HHQ-16 surface-to-air missiles to protect against air threats and a hangar with one Z-9 helicopter. It is a solid medium-sized warship, but cannot carry many people and thus would not be useful as a rescue vessel. Xuzhou’s escort mission is likely designed to serve several related immediate objectives, including avoiding a USS Cole-style terrorism or irregular attack scenario that could harm evacuees, and sending a clear message to various elements in Libya not to harm Chinese civilians or disrupt their evacuation. This latest initiative is part of a larger ongoing increase in Chinese power, presence, and influence around the world, and should come as no surprise. China has global interests, cannot free ride forever, and requires a presence in critical areas and situations in order to have a voice. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Libya Looming: Key strategic implications for China of unrest in the Arab World and Iran,” China SignPost™ (洞察中国) 24 (22 February 2011).

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

As violence flares in Libya and elsewhere across the Arab countries and Iran, we see a number of core interests that China will look to maintain. These include physical safety of PRC citizens in these countries, as well as energy security concerns, which could become especially significant if Iran’s Green Movement protests against the ruling regime spark national unrest on a par with that which occurred in Egypt or that which is now gripping Libya. Some Chinese responses, such as tighter controls on Internet content and phone text messaging, have been widely covered. Others have not received as much media attention: for example, the potential need to mount additional evacuations of PRC citizens in the Middle East or potential domestic unrest in Xinjiang, an issue The Economist recently touched upon, as well as in Tibet. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Chinese Now Pay 33% More for Gasoline and 16% More for Diesel than Americans,” China SignPost™ (洞察中国) 23 (21 February 2011).

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

  • With the latest price increase on 20 February 2011, Chinese drivers now pay more than US$4 per gallon of gasoline and diesel fuel—more than 30% more than US drivers pay for gasoline and nearly 20% more than they pay for diesel fuel.
  • Fuel demand appears to remain strong, as China imported 5.13 million bpd of crude oil in January 2011—a 27% year-on-year increase.
  • Future reductions in Chinese oil use would most likely not come from domestic pricing reforms but from higher global oil prices or demand-side measures such as alternative fuel vehicles; these would have a bigger impact on oil use. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Keeping the Mandate of Heaven: Why China’s Leaders Focus Heavily on Grain Prices and Security,” China SignPost™ (洞察中国) 22 (17 February 2011).

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

  • Famine and grain supply problems helped topple at least 5 of China’s 17 dynasties.
  • Global grain prices are already near the 2008 levels that sparked food riots in some countries, and continue to rise.
  • The Chinese government has already pledged nearly US$2 billion to fight drought in China’s wheat producing North, where 42% of the crop area is currently affected by drought.
  • Combating food price inflation will likely remain a major policy priority for Beijing throughout 2011. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Twilight in the Tundra: Russian and Kazakh Oil Production Cannot Keep up with China’s Rising Demand,” China SignPost™ (洞察中国) 21 (4 February 2011).

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

  • China’s oil demand growth each year is likely to exceed the delivery rate of the current Russia-to-China pipeline.
  • Oil production in Eastern Siberia will likely increase, but Moscow clearly wants to market this oil to a diverse customer base via seaborne sales from the port of Kozmino.
  • Despite oil pipeline projects such as the Skovorodino-to-Daqing line, China’s dependence on seaborne crude oil imports will rise.
  • China’s leaders are likely to remain preoccupied with maritime oil transport security.
  • China will continue to “free ride” on U.S. provision of sea lane security for now, but desire to achieve limited autonomous capabilities in this area could help to drive its future naval development.
  • The difficulty and undesirability of implementing a distant or close blockade of China’s seaborne oil supplies will continue to provide some protection for China, however. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Counting the Barrels: Heavy Truck Sales Are a Better Barometer than Car Sales of China’s Oil Demand Growth,” China SignPost™ (洞察中国) 20 (31 January 2011).

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

  • Chinese dealers sold more than one million heavy trucks in 2010 and sales could hit 1.2 million vehicles in 2011.
  • New heavy trucks sold in China during 2011 could add 380,000 barrels per day of diesel fuel demand.
  • Truck buyers have high incentive to maximize their trucks’ use and we believe that there is tighter correlation between heavy truck sales and diesel fuel consumption than is the case for cars and gasoline.

In 2010, heavy truck sales in China rose by roughly 60% versus 2009 levels, driven in part by the government’s 4 trillion RMB stimulus plan. Truck sales are important to watch because they offer real-time and forward looking insights into oil demand and industrial and construction activity. Chinese oil demand growth is especially relevant in light of the oil price spike triggered by Egypt unrest, with Brent crude hitting US$100 per bbl for the first time since 2008.

Sales of new heavy trucks in China have grown rapidly in recent years, rising from roughly 86,000 vehicles in 2000 to roughly one million in 2010. Truck sales are likely to slow in 2011 as stimulus-related investment projects wrap up and the government works to reign in food and real estate price inflation. Based on our analysis of Chinese company statements and sales forecasts by Chinese vehicle sector experts, we believe heavy truck sales in China during 2011 will be approximately 1.2 million vehicles, for a year-on-year sales increase of slightly under 18%. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Dissecting China’s Economy: 15 Chinese Provinces and Municipalities Could by Themselves Qualify as Top-50 Global Economies,” China SignPost™ (洞察中国) 19 (23 January 2011).

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

As China reports strong national GDP growth for 2010 (10.3%), we think it is interesting and worthwhile to see how the economic output of China’s provinces individually compares to those of national economies around the world in both aggregate and per capita terms. Our analysis uses nominal GDP data since the Chinese government, to the best of our awareness, does not publicly report purchasing power parity (PPP) adjusted data on the provincial level.

This note provides a portrait that takes readers beyond the oft-resorted to conception of China as a monolithic behemoth of economic activity. We think this portrait helps reflect the magnitude of economic activity in different regions of China. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “China’s New Project 718/J-20 Fighter: Development Outlook and Strategic Implications,” China SignPost™ (洞察中国) 18 (17 January 2011). 

Japanese translation now available.

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

  • China’s J-20 fighter has the potential to be a formidable air combat system in the Asia-Pacific region, but a number of technical hurdles will need to be overcome before mass production can commence.
  • Key technical capabilities that we await demonstration of are thrust vectoring, sensor fusion, active electronically scanned radars, and a higher level of tanker and AWACS support. Operating a low-observable aircraft also requires major maintenance inputs.
  • The Chinese aerospace industry is making rapid technical progress, but the ability to build late-generation, supercruise-capable engines issue in particular will be a key bottleneck that helps decide the J-20’s initial operational capability (IOC) date as a true stealth platform.

For the past two weeks, a series of photos and video clips showing a prototype of China’s new 5th-generation fighter aircraft have electrified defense specialists around the world. The atmosphere became particularly charged after the aircraft made a short test flight two days after U.S. Secretary of Defense Robert Gates began a visit to China on 9 January 2011. It is especially interesting that the J-20’s test flight occurred on 11 January 2011, precisely three years after its first anti-satellite (ASAT) test in 2007 and one year after its first anti-ballistic missile (ABM) test in 2010. As with those tests, China’s Foreign Ministry and other branches of government appeared to be out of synch with the People’s Liberation Army (PLA) in their initial responses to inquiries on the subject; this prompted foreign speculation about the civilian leadership’s degree of control over the military.

Chinese test aircraft (e.g., the J-15) are typically painted with a plain yellowish-green primer. The J-20, by contrast, had a military-style paint job complete with PLA insignia. Significant numbers of Chinese were able to watch parts of the test, which could have been easily prevented. According to some Chinese military websites and photos, future Chinese President Xi Jinping and fellow Politburo Standing Committee member Wu Bangguo were in Chengdu on 10 January, and Xi even entered the J-20’s cockpit. It was cloudy, however, so the test flight was cancelled. Like all other Politburo Standing Committee members, therefore, President Hu Jintao should have known that the J-20 was ready for a test flight. He probably did not know the exact time of test flight because that depended on such unpredictable factors as weather conditions.

Secretary Gates’ initial statement that President Hu was “unaware of the flight test” almost certainly means unaware it would take place on that specific date, rather unaware of the J-20’s status entirely. Considering the importance, and likely cost, of China’s fifth-generation fighter program (designated “Project 718” in what appear to be official Internet photographs), China’s senior civilian leadership would certainly be aware of its progress at least in general terms, presumably including the flight test stage was approaching. The PLA may have its own perspective and its own organizational interests, but the Party still controls the gun. Indeed, Hu himself subsequently confirmed to Gates that the test flight had indeed occurred, but assured him that the timing was coincidental. “I asked President Hu about it directly, and he said that the test had absolutely nothing to do with my visit and had been a pre-planned test,” Gates told reporters in Beijing.

China’s J-20 test thus resembles a muted strategic communication to an international audience, not a formal one that might provoke diplomatic discord in advance of President Hu Jintao’s 19 January state visit to the U.S. Jane’s quoted Chinese sources as suggesting that “China may have accelerated the schedule for the J-20’s maiden flight after the US Department of Defense (DoD) finally agreed to modernise Taiwan’s fleet of Lockheed Martin F-16A/B fighter aircraft.” Regardless of the precise intention this time, such releases of military information are increasing of late as China for the first time has world-class capabilities to show off, and engages in “selective transparency” to get credit for those capabilities—both from its domestic populace, and from potential competitor nations.

Exhibit 1:  J-20 in flight

Source: Chinese Internet

That said, our analysis seeks to move beyond the timing of the J-20’s maiden flight, and instead focus on what the test suggests about China’s rapidly developing aerospace industry and what capabilities the J-20 might offer to the Chinese military.

Exhibit 2:  J-20 development timeline

Source: DoD, Reuters, Wall Street Journal, Sina.com

Secretary of Defense Gates recently clarified his earlier remarks about China not having an operational 5th generation fighter until 2020, telling reporters accompanying him on his flight to Beijing on 9 January 2011: “What I said was that in 2020 or 2025 that there would still be a vast disparity in the number of deployed fifth generation aircraft that the United States had compared to anybody else in the world.”

U.S. intelligence community estimates currently anticipate the J-20 achieving initial operation capability (IOC) around 2018, according to the Wall Street Journal. VADM David Dorsett, Deputy Chief of Naval Operations for Information Dominance, told reporters on 5 January 2011 that “I think one of the things that is probably true, true from my observation in the last several years, is we have been pretty consistent in underestimating the delivery and IOC of Chinese technology, weapon systems. They’ve entered operational capability quicker...” We think there is a substantial possibility that this could happen with the J-20 as well. Admiral Dorsett added, however, that “developing a stealth capability with the prototype and then integrating that into a combat environment is going to take some time.”

China’s military aerospace complex is clearly very busy at present, working hard to develop a carrier-based fighter (J-15), build out the J-10 fleet, develop and produce transport and AWACS aircraft, and now to develop the J-20. That said, we believe that Beijing’s generous support of its increasingly skilled aerospace research & development complex, rising defense budget (officially ~US$78 billion for 2010; and probably significantly higher, according to foreign estimates, particularly if purchasing power parity is factored in), and ability to rapidly build industrial infrastructure create a very real possibility that the J-20’s IOC date comes before 2018.

Ability to move to mass production

China has sufficient financial resources that a shift toward more rapid J-20 production could begin to produce airframes quickly—if the country’s aviation industry can master high-performance jet engine production, an extremely difficult task achieved by only a handful of firms around the world, for which it has yet to demonstrate requisite capability.

To give a sense for what additional production capacity for a late-generation fighter costs, a 2010 RAND study cites a cost of between US$150 million and US$554 million to restart F-22 Raptor production after termination. We acknowledge there are significant differences between creating production capacity and restarting production of an aircraft whose production had been cancelled but for which some “industrial muscle memory” remains, but even a US$1 billion cost is only 1.3% of China’s current announced defense budget. China’s defense budget is likely more hardware-centric than the U.S. budget, which is dominated by personnel-related costs.

In terms of the cost of individual aircraft, we think it reasonable to assume the J-20 has a unit cost of somewhere from US$100-to-$120 million. While a variety of factors make the exact cost extremely difficult to assess, for the purposes of very rough comparison this offers a useful benchmark. By contrast, the F-22 costs around US$143 million per plane, and the F-35A US$111.6 million, according to DoD and the National Defense Industry Association. Russia’s T-50 costs “less than US$100 million per plane,” according to RIA Novosti.

The U.S. usually represents the high end of the cost curve by far for high-end defense systems, but we believe that the industrial production cost advantages China enjoys for many simpler systems do not necessarily apply to their highest-end counterparts. For example, the F-16 C/D sells for US$18.8 million per plane (DoD), while the J-10 actually costs more at roughly US$27.8 million per plane, according to Reuters. Production of 20 aircraft per year beginning in the 2014 timeframe at US$110 million per plane would still probably account for only about 2% of China’s defense budget.[1]

The J-20 versus other 5th-generation fighters

A major question is: can the J-20 be considered a full-fledged 5th-generation aircraft with stealth, high maneuverability, supercruise, sensor fusion, and other such capabilities? Quick “by the numbers” assessment shows that the J-20 is a large aircraft that has the potential to share key characteristics such as low observability and supercruise with its U.S. and Russian peers. Its physical dimensions are particularly interesting, with Dr. Carlo Kopp of Air Power Australia classifying the J-20 as an F-111-class aircraft in terms of its physical size and likely takeoff weight.

The J-20 flight video clips and photos available on the Internet thus far do not show any radical air combat-type maneuvering, but the aircraft’s front canards and movable tail structure suggests that despite the plane’s size, it would be highly nimble—with appropriately powerful engines. The large size also points toward a platform with a large internal fuel capacity and long combat radius, particularly with supercruise capable of carrying significant weapons loads.

Exhibit 3:  Comparison of selected late-generation fighter aircraft

 

Source: LockheedMartin, Sukhoi, Aviation Week

Visually, the J-20 resembles an F-22 front end mated with an SU-47/ MiG 1.42 main fuselage, MiG 1.42 wings and canards, and a tail assembly like the Russian T-50, which bears an uncanny resemblance to the Northrop YF-23 (Exhibit 4). The resemblance of aspects of the design to those of U.S. aircraft are noteworthy, particularly given that cyber intruders allegedly traced back to China were able to steal several terabytes worth of data pertaining to the F-35’s design and electronics beginning in 2007, according to the Wall Street Journal.

Exhibit 4:  J-20 resembles aspects of other late-gen fighters

Source: USAF, Air Power Australia, FAS, Aviation Explorer, Air Force Technology

Key problems that may restrain further development and moves toward IOC

Materials

To the best of our knowledge, no Chinese sources have published a materials composition breakdown for the J-20. Materials are key in a late-generation fighter for two major reasons. First, the plane must be sufficiently robust to withstand violent maneuvering and the heat generated by sustained high-speed operation. We think China’s aerospace industry now has most if not all of the requisite capabilities. Baoti, one of China’s largest titanium producers, says that it supplies 95% of the titanium used by China’s aerospace complex, suggesting that the company can produce high-grade materials. This is a key point because the other main global suppliers of aerospace grade titanium are all potential competitors—the U.S., Russia, and Japan.

Second, advanced composites and surface coatings (e.g., special radar-absorbing paint) help reduce radar signature. The F-22 and T-50 are each roughly 25% composite by weight. We think it is likely that the early J-20s are more titanium and metal-intensive and that as the design is refined to reduce radar cross section (RCS), the composite content will rise. As China pursues low-observable aircraft and UAVs, we expect significant advances in the domestic composite and coatings industry as the defense complex strives to avoid reliance on key imported components.

The ability to maintain a low-observable platform deserves special attention. Maintaining a low observable aircraft requires substantial human and financial resources. Due to surface wear, an aircraft’s RCS degrades every time the aircraft is flown. The U.S. has almost three decades of experience in maintaining successive generations of stealth aircraft including the F-117, the B-2, and now the F-22 and arguably the B-1B, often under high sortie combat conditions.

A key aspect of this is that each new design incorporates lessons learned from earlier designs even to the point of having experienced crew chiefs assist the design team. Chinese military culture may be less amenable to having such design inputs from personnel who are actually maintaining the aircraft’s “sensitive skin.” Moreover, the J-20 will be China’s low-observable aircraft to operate and maintain.

Engines

Engines are critical for any aircraft. This is one type of system that either works well or does not, with little potential for significant incremental adjustment. Some Russian sources quoted in a recent Sina.com article claim that the J-20 is using AL-41 engines, but most Chinese, Russian, and English-language sources and photo imagery suggest the J-20 prototypes are likely using a version of the WS-10 (already used in the J-11B, according to China Air and Naval Power) and the Russian AL-31 engines (Exhibit 5). According to Shanghai Daily/People’s Daily Online, “two [J-20] prototypes have been developed, with one employing a Russian engine and the other a Chinese one. It wasn’t clear which prototype flew” on 11 January.

Exhibit 5:  J-20 prototype engine nozzles are different (top image AL-31, bottom WS-10A)

Source: Jane’s

If that indeed were the case, the aircraft would likely already have the potential to be supercruise-capable. The J-20 exhaust nozzles in Exhibit 6 appear to be jointed in a way that implies thrust vectoring capability, but only further test photos and video footage will be able to confirm this feature.

Exhibit 6: J-20 rear nozzles and Russian T-50’s thrust vectoring powerplant

Source: Russian internet, Sina.com

Chengdu Aircraft Co.’s decision to use both a variant of the WS-10 and the Al-31 suggests that the PLA, the aircraft designers, or both have low confidence in the WS-10’s reliability and thrust vectoring ability. Indeed, China’s 4th-generation fighters still rely heavily on Russian engines, with blog postings on Global Times in late November 2010 reporting that the PLA Air Force (PLAAF) has only recently begun fitting J-10s with the indigenous WS-10A turbofan. On its website, Russian jet engine maker Salut says that it can produce the AL-31F, series 42 M1 engine with thrust vectoring capability.

A Russian aerospace expert recently quoted in Huanqiu Shibao says China’s inability to produce world-class high-performance jet engines will be a major barrier to large-scale production of the J-20 and in the meantime will hinder China’s ability to full test the airframe’s capability in the ways that it could with engines making 35,000-40,000 lbs of thrust like the AL-41 and U.S. F119 engines can.

The Russian experts statements lead to two core logical conclusions: (1) China is unlikely to want to rely on imported components for its latest generation fighter, and (2) in the wake of the disputes over China’s reverse engineering of Flanker variants (into China’s J-11 and J-15) and subsequent slowdown/suspension of new orders of Russian combat aircraft, Saturn and other Russian jet engine makers are unlikely to receive Kremlin approval for selling substantial numbers of high-end engines like the Saturn S117/AL-41 (used in the T-50) to China.

An aviation industry expert tells us that the primary disadvantage of Russian and Chinese engines more than in-flight performance is on-wing and total lifetime, although foreign object damage (FOD) resilience is a significant issue. This could be overcome, in the expert’s view, by simply building a much larger number of engines and a somewhat larger number of airframes to compensate for downtimes—both affordable in theory given Chinese military funding.

Our source likewise states that Russian-built thrust vector engines do not provide the type of air combat maneuvering (ACM) agility that one might expect, but that thrust vectoring does help to reduce fuel consumption (and stress on the airframe) by lessening reliance on primary flight controls. Thrust vectoring entails altering the direction of the exhaust flow in order to control an aircraft’s altitude and angular velocity, typically utilizing a swiveling nozzle.

Exhibit 7 shows technical capabilities of select U.S. tactical jet engines, as well as their thrust to weight ratios. The technology and performance parameters by time period displayed in the table suggest that China’s fourth-generation WS-10 is by and large a 1970s or at best a 1980s engine system. The fifth-generation WS-15 now under development, if completed successfully, would bring Chinese engine performance numbers closer to those of the F119.

Exhibit 7: Performance and technology parameters of select U.S. tactical jet engines

Source: GE, Pratt & Whitney, RAND

But China has not yet solved some of the problems associated with the WS-10, and perfecting the WS-15 implies a quantum leap in aeroengine technology. Can China achieve this by 2018 or before? An interim option might be to bring the J-20 to IOC with WS-10/AL-31F engines, but this would entail a very significant stealth penalty. These fourth-generation engines are not stealth-capable, and their largely unshielded intakes and jet nozzles would cause a large infrared signature to be emitted from both engine ends.

Avionics/electronics

We are watching carefully for indications that China has developed sensor fusion capabilities and an advanced active electronically scanned array (AESA) radar systems, which allow an aircraft to scan for adversaries while being hard to detect. AESA systems also confer jamming resistance, an important advantage in an intense electromagnetic environment like that which would likely characterize a modern Asian military contingency.

Personnel/training

Much more so than more automated systems such as missiles, aircraft performance hinges to a great degree on pilot capabilities. In recent years, China has worked hard to develop an elite if still limited corps of increasingly skilled pilots. The skill level of support personnel, particularly for such specialized tasks as maintenance of stealth capabilities, remains uncertain.

Since the 1990s, increasingly realistic training and organizational reforms (including downsizing of personnel, streamlining of bureaucratic structures, and reconfiguration of logistics and maintenance) facilitate modernization of China’s air forces. Facilities, faculty, curricula, and research at PLAAF educational institutions are being improved, in part through increased funding and even monetary rewards.

Officers of unprecedented caliber are being recruited. Increasing the number of civilian-college-graduated officers through the National Defense Student Program is raising technical capabilities and may permit consolidation and merger of other PLAAF and PLA Navy aviation institutions (while raising new service culture challenges). The enlisted corps is being similarly improved. Pilots with a greater level of higher education (military and civilian) are being recruited, and higher performance in challenging situations is already being attributed to their greater theoretical and technical knowledge. The quality and education level of non-commissioned officers (NCOs) remains a problem, however, necessitating remedial education. Cultivating sufficient numbers of experienced combat pilots remains challenging.

The PLA has gradually increased its technological research and development, military and educational exchanges, attaché offices abroad (though few have PLAAF attachés), and has conducted various joint exercises with Russia, Turkey, and other nations. China’s air forces are receiving a larger proportion of PLA personnel and funding as the PLA is transformed into a leaner, more technology-intensive force through successive personnel reductions (particularly of the ground forces).

How would J-20 deployment change PLA air warfare capabilities?

The J-20’s size, range, and stealth could also make it a formidable long-range strike platform, particularly if bomb-carrying planes were mated with air-to-air missile-armed J-20s as part of a strike package to hit high-value targets in the vicinity of the first and second island chains. China is in the process of developing, acquiring, and deploying a number of upgraded air-to-air and air-to-sea/ground missiles that could make the J-20 an even more powerful platform.

A truly low observable, supercruise-capable, well-armed, and well-flown J-20 could, if China can produce sufficient numbers, pose a serious air challenge to the U.S. and its treaty allies in the Pacific region. A high endurance Chinese fighter that is stealthy and can quickly close to shooting distance (with supercruise) would make it much more difficult to protect the tankers and AWACS aircraft that are such as integral part of the U.S. air warfare approach. At the same time, the J-20’s large size and range could make possible deployment at airfields further inland (easier to protect than coastal air bases, but still offering strike range including the main island of Taiwan and other potential flashpoints).

This raises a larger issue for Chinese air forces in general: what type of sortie rate can they sustain in high-end combat conditions? Nobody really knows (including Chinese planners) because China has no modern combat experience in this area. This is a critical metric for the performance of modern air forces. That issue as much if not more than pilot skill is what allowed the Israeli Air Force (IAF) to dominate its opponents in war. Egyptian President Gamal Abdel Nasser remarked after the 1967 Six Day War that the Israeli’s ability to turn sorties (16 times faster than Egypt’s) meant that the IAF was effectively three times larger than its number of aircraft alone would suggest.

More broadly, however, the U.S. is challenged by the fact that it relies on aircraft (particularly carrier based) for high-intensity kinetic operations far more than does China. China’s overall anti-access/area denial (A2/AD) approach is producing a variety of challenges to U.S. power projection in the Western Pacific. Chinese ballistic and cruise missile strikes, for instance, could allow the PLA to shut down enemy air bases and threaten aircraft carrier strike groups (CSGs) and their operations. Surface-to-air missiles (SAMs) can threaten approaching enemy aircraft. The J-20 might fit into this emerging order a multirole aircraft with both air superiority and strike capabilities, thereby combining with anti-ship ballistic missiles (ASBMs) and related systems to serve as a “U.S. advantage killer.”

Perhaps in the common tradition of inter-service rivalry, the J-20 is part of an PLAAF/PLA Navy vs. Second Artillery dynamic, in which the former two services wish to prevent China’s strategic rocket force from monopolizing anti-U.S. carrier strike group capabilities by producing relevant capabilities of their own. Other key elements of the PLA’s larger system include submarines, surface ships, maritime strike aircraft, and even mines.

Even without the J-20, China is still building a formidable air defense system that includes various variants of the Flanker, the J-10, as well as older but upgraded fighters such as the J-8. The problem is that even the most advanced U.S. fighter aircraft, e.g. the F-22, must all be placed at land and sea-based feeder bases within range of an increasing constellation of overlapping Chinese threats.

Implications

Engines will play a key role in determining the capabilities of Chinese military aircraft. This is a key, often overlooked part of combat aircraft programs. The reason Nazi Germany never fielded an effective four-engine bomber in World War II despite several attempts to do so was because it was at least a generation behind the U.S. and the U.K. in the development of engines for large aircraft.

Imperial Japan had similar problems: a generation behind in aircraft engine technology, it tried to design modern combat aircraft around under-performing engines. To save weight, engineers had to sacrifice even the most basic protection measures to include armor and self-sealing fuel tanks. Today’s China is clearly determined to avoid similar bottlenecks, however, and  Chinese sources are beginning to claim that significant breakthroughs have been made. This will be a key area to watch.

As the J-20 begins to comprise a larger portion of the PLA’s aerial order of battle, the impetus to export the J-10, including more capable variants than the current export model, is likely to increase. China’s previous military aircraft exports have been largely confined to strategic ally Pakistan and limited number of smaller militaries, particularly in nations that face severe cost limitations and/or in pariah states that lack alternative sources for political reasons. In the coming decade, as with other Chinese-produced platforms and weapons systems, aircraft may enjoy higher demand, with attending geopolitical implications and consequences for regional stability.

To the extent that it proves to be a capable combat system powered by high-performance engines, the J-20’s emergence is likely to shape Russia’s development and sales decisions and India’s acquisition decisions; as well as U.S. fighter development, production, and foreign sales. It may raise difficult questions about the Pentagon’s decision to cap F-22 production at 187 aircraft.

Depending on the feasibility of restarting the Georgia-based production line and reactivating subcontractor linkages at affordable cost, this could increase pressure on the U.S. to field more F-22s and perhaps even to sell the F-22 to key East Asian allies Japan and South Korea. The U.S. is highly unlikely to sell F-22s or even F-35s to Taiwan, however. While based on larger geopolitical concerns, this—together with the A2/AD developments mentioned above—will help to end decisively the era in which Taiwan could counter Mainland Chinese military quantity with its own military quality.

In part because of this larger PLA buildup, and related concerns that regional nations may feel pressured by China, the J-20’s emergence alone (regardless of its development trajectory) will almost certainly prevent the cancellation of the F-35 program. Though designed to be more economical and more focused on air-to-ground missions than the F-22, the F-35 has been developed with the association of many other U.S. allies and friends. Some former F-16 customers may now wish to purchase it.

[1] The final cost per aircraft would depend on the application of Chinese accounting standards and the extent to which R&D costs are a) properly recorded and allocated to the J-20 project in the first place, b) capitalized at all or simply treated as time cost, and c) allocated to individual aircraft either on “real” or “pro forma” basis. We thank a friend with deep commercial aircraft expertise for sharing this point.

***

Gabriel B. Collins and Andrew S. Erickson, “Dying for a Spot: China’s Car Ownership Growth is Driving a National Parking Space Shortage,” China SignPost™ (洞察中国) 17 (10 January 2011).

  • Major Chinese cities are suffering from a serious shortage of parking space as supporting infrastructure lags rapid car fleet growth. In Luoyang, a man was beaten to death recently in a fight over a parking space.
  • China had 79 million cars on its roads in 2009, according to the National Bureau of Statistics and we estimate the number for 2010 is roughly 85.5 million vehicles.
  • In eight cities we examined, parking fees likely account for more than 1/3 of the annual costs of owning a car for owners who must pay for parking. Tighter restrictions or higher fees and taxes related to parking could discourage potential car buyers in the next 12 months. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Southern Sudan Referendum: Potential Security Problems for China,” China SignPost™ (洞察中国) 16 (5 January 2011).

Key Points

  • The independence referendum in Southern Sudan scheduled for 9 January 2011 is likely to test China’s non-interference policy.
  • China increasingly faces: 1) assumptions by the global community that it will behave as a global stakeholder that engages with humanitarian and security matters beyond those of immediate national interest, and 2) nationalistic pressure from its own citizens who think that economic assets and PRC expatriate communities in volatile areas should be more robustly protected.
  • If Southern Sudan gains independence, there is threat of renewed North-South fighting, as well as internecine conflict in the South. The vote may also inspire separatists in Angola’s oil-rich Cabinda province, fomenting instability in another African country where China has significant economic interests and a large worker presence.

Sudan is a case study because China has major commercial interests and a large expat worker presence in the country and will face tough choices regarding its “non-interference policy” if renewed civil war erupts between the North and South in the wake of a pro-independence vote by the South, which accounts for around 80% of Sudan’s roughly 490,000 bpd of oil production. … … …

***

Gabriel B. Collins and Andrew S. Erickson, “Eleven for ’11: Key Things and Events to Watch for in China during 2011,” China SignPost™ (洞察中国) 15 (1 January 2011).

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

As China and the world bound into the Year of the Hare, it is worth examining key trends and events that are likely to shape events in China, as well as global perceptions of how China intends to utilize its growing economic, diplomatic, and military clout.

The eleven key items we choose as “things to watch” in 2011 are signposts to guide readers. We readily acknowledge China’s complexity and recognize that a multitude of other events will also define 2011 in China and look forward to maintaining a strong flow of detailed, interesting, and anticipatory research and analysis. … … …

***

Andrew S. Erickson and Gabriel B. Collins, “China Deploys World’s First Long-Range, Land-Based ‘Carrier Killer’: DF-21D Anti-Ship Ballistic Missile (ASBM) Reaches ‘Initial Operational Capability’ (IOC),” China SignPost™ (洞察中国) 14 (26 December 2010).

Japanese translation: “中国の対艦弾道ミサイル開発に関する最近の報道について”

[ACCOMPANYING GRAPHICS AVAILABLE IN FULL COLOR VIA LINKS TO PDF COPY ABOVE]

For further information on Chinese ASBM development, see also “China Testing Anti-Ship Ballistic Missile (ASBM); U.S. Preparing Accordingly–Updated With Latest Analysis & Sources.”

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China Deploys World’s First Long-Range, Land-Based ‘Carrier Killer’:

DF-21D Anti-Ship Ballistic Missile (ASBM)

Reaches “Initial Operational Capability” (IOC)

“Deep Dive”—Special In-Depth Report I

Andrew Erickson and Gabe Collins

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

As we enter the Year of the Hare, China has achieved a major military milestone far faster than many foreign observers thought possible.[i] In a December 2010 interview with veteran national security journalist Yoichi Kato of the Asahi Shimbun, Admiral Robert F. Willard, Commander, U.S. Pacific Command, offered significant new revelations:

Kato: Let me go into China’s anti-access area denial (A2AD) capabilities. What is the current status of China’s anti-ship ballistic missile (ASBM) development, and how close is it to actual operational deployment?

Willard: The anti-ship ballistic missile system in China has undergone extensive testing. An analogy using a Western term would be “initial operational capability (IOC),” whereby it has—I think China would perceive that it has—an operational capability now, but they continue to develop it. It will continue to undergo testing, I would imagine, for several more years.

Q: China has IOC?

A: You would have to ask China that, but as we see the development of the system, their acknowledging the system in open press reporting and the continued testing of the system, I would gauge it as about the equivalent of a U.S. system that has achieved IOC.

Q: China has already perfected the technology to fly that missile and also the sensor systems for targeting. Has the entire system integration been completed?

A: Typically, to have something that would be regarded as in its early operational stage would require that that system be able to accomplish its flight pattern as designed, by and large.

Q: But they have not conducted the actual flight test or the test to attack moving ships yet, have they?

A: We have not seen an over-water test of the entire system.

Q: But do you believe they already have that capability?

A: I think that the component parts of the anti-ship ballistic missile have been developed and tested.

Q: Is it a bigger threat to the United States than submarines in terms of their anti-access area denial?

A: No, I don’t think so. Anti-access area denial, which is a term that was relatively recently coined, is attempting to represent an entire range of capabilities that China has developed and that other countries have developed.

It’s not exclusively China that has what is now being referred to as A2/AD capability. But in China’s case, it’s a combination of integrated air defense systems, advanced naval systems such as the submarine, advanced ballistic missile systems such as the anti-ship ballistic missile, as well as power projection systems into the region.

The anti-access area denial systems, more or less, range countries, archipelagos such as Japan, the Philippines and Vietnam, so there are many countries in the region that are falling within the envelope of this, of an A2AD capability of China. That should be concerning—and we know is concerning—to those countries.

While it may be largely designed to assure China of its ability to affect military operations within its regional waters, it is an expanded capability that ranges beyond the first island chain and overlaps countries in the region. For that reason, it is concerning to Southeast Asia, (and) it remains concerning to the United States.

So now we know: China’s DF-21D ASBM is no longer aspirational. Beijing has successfully developed, tested, and deployed the world’s first weapons system capable of targeting a moving carrier strike group (CSG) from long-range, land-based mobile launchers. The Second Artillery, China’s strategic missile force, already has a capability to attempt to use the DF-21D against U.S. CSGs in the event of conflict, and therefore likely expects to achieve a growing degree of deterrence with it. Exhibit 1 shows two recent types of missiles in the DF-21 series.

Exhibit 1: Chinese DF-21 Missiles

Source: ONI

This photo shows two CSS-5/DF-21 variants on transporter-erector-launchers (TELs). The missile on the right appears to be a DF-21C. The Office of Naval Intelligence (ONI) termed the missile on the left a “new” variant in 2009. This suggests that it could conceivably be a DF-21D ASBM.

Since the 1920s, the U.S. Navy has built its carrier forces around the idea that the air group represents the first and best line of defense for the carrier. The ASBM potentially bypasses the air group and removes it from the defensive equation.

Only one other major system has ever offered the possibility of doing this. That is the submarine, and while China is developing a potent fleet, it cannot today effectively conduct advanced anti-submarine warfare (ASW), while the U.S. can—using carrier-based aircraft. Defense against missiles, by contrast, is potentially an extremely difficult problem for any military.

According to the U.S. Department of Defense (DoD)’s 2010 report on the People’s Liberation Army (PLA), China’s ASBM is based on the “D,” or “Delta,” variant of the Dong Feng-21 medium-range ballistic missile (MRBM), known in the West as the CSS-5 Mod 5. “The missile has a range in excess of 1,500 km, is armed with a maneuverable warhead, and when integrated with appropriate command and control systems, is intended to provide the PLA the capability to attack ships, including aircraft carriers, in the western Pacific Ocean.” Exhibit 2 shows how China’s ASBM works; Exhibit 3 displays the area within which it can currently threaten enemy vessels.

Exhibit 2: Schematic Diagram of ASBM Flight Trajectory with Midcourse and Terminal Guidance

Source: DoD[ii]

Note the depiction of control fins on the reentry vehicle, which would be critical to steering the ASBM through terminal maneuvers to evade countermeasures and home in on a moving target. This makes an ASBM different from most ballistic missiles, which have a fixed trajectory during the terminal phase of flight.

Exhibit 3: Range Rings for Chinese ASBM and other Conventional Anti-Access Capabilities

Source: DoD[iii]

This exhibit shows the maximum Range of DF-21/CSS-5 ASBM from launch locations in mainland China. Note the large area potentially covered, far beyond Taiwan and the First Island Chain into the Western Pacific.

THE MEANING OF “INITIAL OPERATIONAL CAPABILITY” (IOC)

What exactly does “Initial Operating Capability” mean? According to one authoritative U.S. open source, the DOD Dictionary of Military and Associated Terms, IOC is “The first attainment of the capability to employ effectively a weapon, item of equipment, or system of approved specific characteristics that is manned or operated by an adequately trained, equipped, and supported military unit or force.”[iv] The U.S. Defense Acquisition University website, the authoritative source perhaps most relevant in this case due to its specialized nature, states that IOC is “attained when some units and/or organizations in the force structure scheduled to receive a system 1) have received it and 2) have the ability to employ and maintain it.”[v]

This is still short of Full Operational Capability (FOC). The DOD Dictionary recognizes yet does not explain this term,[vi] but the U.S. Defense Acquisition University defines FOC as occurring “when all units and/or organizations in the force structure scheduled to receive a system 1) have received it and 2) have the ability to employ and maintain it.”[vii]

Perhaps most importantly, IOC goes significantly beyond the nebulous status of Initial Threat Availability (ITA), a term sometimes used to describe a system that has been tested successfully but not deployed. When describing a different missile system in 2007, a DoD official explained: “the system is available and could be used if China’s leaders determine that they wanted to. The distinction between initial threat availability and initial operational capability is that right now we assess that DF-31 may not be fully integrated into the force structure, may not have all the requisite supporting personnel/equipment that we believe they would need to have to be considered fully operational. …it’s a distinction that says that the system is ready or available now but it’s not necessarily fully operational.”[viii]

All the aforementioned terms have very specific definitions and connotations within the U.S. defense community, making it challenging to draw exact parallels with foreign systems. This is a very problematic issue that can lead to misunderstanding if the nuances are not fully accounted for. Admiral Willard appears to be working hard to put the term “IOC” within a proper U.S. context while emphasizing that it is a U.S.-specific term.

Exhibit 4: China’s Current ASBM Status

Initial Threat Availability (ITA) Initial Operational Capability (IOC) Full Operational Capability (FOC)
“the system is available and could be used if China’s leaders determine that they wanted to. …may not be fully integrated into the force structure, may not have all the requisite supporting personnel/equipment….” “when some units and/or organizations in the force structure scheduled to receive a system 1) have received it and 2) have the ability to employ and maintain it.” “when all units and/or organizations in the force structure scheduled to receive a system 1) have received it and 2) have the ability to employ and maintain it.”

Sources: DoD, Defense Acquisition University

It thus seems that China’s DF-21D ASBM weapon system has probably been deployed to operational unit(s)—as opposed to test or training unit(s)—and that those unit(s) are capable/certified/qualified to employ the weapon system in combat. How effective the Second Artillery would be at employing the ASBM and related systems under realistic conditions, including against U.S. and allied countermeasures, remains difficult if not impossible to determine at this time.

Based on standard U.S. military definitions of IOC, as well as connecting the numerous ASBM data point “dots” that have been emerging from China for some time, the following conclusions are in order:

  1. Tests. China must have conducted a rigorous program of tests sufficient to demonstrate that the DF-21D ASBM is mature enough for initial production, deployment, and employment. This would have likely entailed a variety of flight tests, albeit none fully integrated over water thus far.
  2. Production. Today’s IOC status strongly suggests that the reported completion of a DF-21D rocket motor factory in autumn 2009, or some equivalent preparation, has already occurred.
  3. Units. Chinese unit(s) must have already received the DF-21D. These unit(s) have been trained to deploy, employ, and maintain the ASBM, support infrastructure, and related systems. This might correlate with the reported July 2010 announcement of a new Second Artillery missile brigade in Shaoguan, Guangdong province.
  4. C4ISR. While doubtless an area of continuous challenge and improvement, the DF-21D’s C4ISR (command, control, communications, computers, information, surveillance, and reconnaissance) infrastructure must be sufficient to support basic CSG-targeting capabilities. China’s rapid succession of advanced satellite launches over the past year suggests a concerted effort to accrue the space-based architecture to support this initial capability, however modest.
  5. Deployment. Based on previous Second Artillery deployment patterns, we anticipate that ever-better-performing and -C4ISR-linked versions of the DF-21D will be deployed in “waves” to different units until the vast majority of ASBMs reach a level of capability the PLA deems sufficient to meet its present deterrence objectives.
  6. Deterrence. On the basis of present capabilities, we anticipate that China already expects to achieve some level of (growing) deterrence benefits from its DF-21D ASBM.

Finally, one important caveat—Countermeasures. An IOC status for China’s ASBM says nothing about the countermeasures that U.S. and allied forces may be able to employ to negate its effectiveness.

While IOC status is a significant revelation, numerous ASBM data point “dots” have been emerging from Chinese sources and U.S. official statements and reports for years now, available to anyone willing to connect them. They offer a case study useful not only to those involved with Sino-American strategic relations, but also to anyone conducting analysis under conditions of incomplete information. In what follows, we offer general context, address these seven issue areas in depth, trace the indicators that emerged in each, and examine broader implications.

Exhibit 5: ASBMs in the Family? America’s Pershing II and China’s DF-15/CSS-6 and DF-21/CSS-5 Missiles.

Source: China Defense Forum.

According to Chinese sources, China’s DF-21 ASBM is based on the distantly-related U.S. Pershing II MRBM (left), as is China’s DF-15 missile (center). Following their 1987 Intermediate-Range Nuclear Forces (INF) Treaty, Washington and Moscow eliminated all their 500-5,500 km-range nuclear and conventional ground-launched ballistic and cruise missiles, including Pershing II; Beijing has filled this vacuum by developing the world’s foremost sub-strategic missile force. The U.S. Pershing II (left) has adjustable reentry vehicle (RV) control fins for terminal maneuver. Positively identified photos of a CSS-5 outside its launch canister are not known to exist. But the DF-15 missile (center) has an RV virtually identical to the Pershing II’s. Based on the strong visual resemblance, it is possible that the DF-15 employs terminal maneuvering technology similar to that of Pershing II. The RV that China obviously has here could easily have been mated with a variant of the DF-21/CSS-5 booster (right), which might then produce an effective ASBM.

STRATEGIC BACKGROUND

What is China Doing, and Why?

China’s progress in this area is logical and long-term. Chinese development of ASBM systems and related capabilities has been documented publicly by previous U.S. government unclassified analyses as well as statements by senior officials. In November 2009, Scott Bray, Senior Intelligence Officer-China, ONI, stated that: “ASBM development has progressed at a remarkable rate…. In a little over a decade, China has taken the ASBM program from the conceptual phase to nearing an operational capability. …China has elements of an [over-the-horizon] network already in place and is working to expand its horizon, timeliness and accuracy.”

It’s not hard to see why China is developing and testing an ASBM–it strongly desires the ability to both deter Taiwan independence advocates and prevent U.S. CSGs from intervening effectively in the event of a future Taiwan Strait crisis. Beijing has defined its immediate strategic concerns clearly in this regard.

More broadly, China is interested in achieving an ASBM capability because it offers the prospect of limiting the ability of other nations, particularly the United States, to exert military influence on China’s maritime periphery, which contains several disputed zones of core strategic importance to Beijing. ASBMs are regarded as a means by which technologically limited developing countries can overcome by asymmetric means their qualitative inferiority in conventional combat platforms, because the gap between offense and defense is the greatest here.

China’s ASBM is part of a much larger pattern in which the development and proliferation of various weapons systems–such as ballistic and cruise missiles, submarines, and naval mines–threatens to hold U.S. platforms at risk in vital areas of the global maritime commons. Today U.S. operations in the Western Pacific appear most threatened in this regard, but similar challenges are emerging in the Persian Gulf, and might eventually materialize elsewhere.

Chinese open source publications provide strong indications that Beijing has been developing an ASBM ever since the 1995-96 Taiwan Strait Crisis. The deployment of the USS Nimitz and Independence CSGs in response to China’s missile tests and military exercises in the Taiwan Strait then was a move that China could not counter. Whether seen by China’s leaders as a largely successful use of coercive diplomacy (albeit one that produced some unintended consequences), or as a strategic debacle, it likely convinced them to never again allow U.S. CSGs to intervene in what they consider to be a matter of absolute sovereignty. Exhibit 6(below) offers a timeline of known ASBM development.

Exhibit 6: Chinese ASBM Development Timeline

Source: China SignPost™

What is China Saying About its ASBM development?

Quite a lot, actually, albeit with no direct official statements thus far. A wide range of doctrinal, technical, and generalist literature has proliferated over the past decade, with the majority published in the past five years. Even China’s military, in an apparent attempt to deter the U.S. from intervening vis-à-vis Taiwan and other claimed areas on China’s disputed maritime periphery, has provided significant hints of its own ASBM progress, as well as some thought-provoking mysteries. In an unexplained cartoon animation at the end of a lengthy 29 November 2009 program on ASBMs broadcast on China Central Television Channel 7 (China’s official military channel), a sailor falsely assumes that his carrier’s Aegis defense systems can destroy an incoming ASBM as effectively as a cruise missile, with disastrous results.[ix]

Exhibit 7: China Central Television ASBM Program Footage

Source: CCTV

Still, Chinese officials have yet to address their nation’s ASBM development directly in an open public forum. On 26 October 2009 General Xu Caihou, Central Military Commission Vice Chairman, delivered an address and entertained questions at the Center for Strategic and International Studies, Washington, D.C. When asked why China was developing ASBMs, Gen. Xu did not respond directly, instead stating more broadly that ballistic and cruise missile development was necessary for mainland China to safeguard its interests vis-à-vis Taiwan.

IN-DEPTH ANALYSIS

Tests

China must have conducted a rigorous program of tests sufficient to demonstrate that the DF-21D ASBM is mature enough for initial production, deployment, and employment. This likely would have entailed a variety of flight tests, albeit not yet fully integrated over water—perhaps because of a desire to avoid embarrassing failures in view of worried citizens of East Asia and a U.S. military increasingly refocused on the region. Indeed, China appeared to place particular emphasis on ballistic missile testing this year. In an October 2010 post on his well-regarded Information Dissemination blog, Galrahn emphasized that it appears that “China has conducted on average [of] two tests of major ballistic missiles [per month] over the last 4 months. That is a lot of ballistic missile testing in a short time.”

Several unverifiable media reports, including at least two from China, suggested that ASBM tests were being conducted during summer 2010. A 16 August 2010 article in South Korea’s Chosen Ilbo stated:

“China will test its new the [sic] Dong Feng 21D anti-ship ballistic missile, the country’s state media said Friday [August 13]. There is speculation that Beijing is responding to the U.S. deployment of the nuclear-powered aircraft carrier George Washington to the West Sea [i.e., the Yellow Sea] and the South China Sea to join naval exercises with Korea and Vietnam, which China considers too close for comfort. Internet China National Radio said the China Aerospace Science and Industry Corporation will soon test-fire ‘a weapon under an important state weapons project.’ Although it did not specify what this project was, it carried a photo of a Dong Feng 21C medium-range ballistic missile, the same series as the Dong Feng 21D, and an artist’s drawing of such missiles attacking an American aircraft carrier.”[x]

Yet there have been no direct confirmations to date of ASBM-specific flight tests, at least in the unclassified realm. The best open source analysis in this area was done by subject matter experts who extrapolated from other data points. Mark Stokes of the Project 2049 Institute stated on 4 June 2010 that “odds are what you’re seeing now in terms of testing is… flight tests of the [DF-21D] motor itself and the airframe… the final step would be most likely going against a target at sea in a realistic environment.” While system components may be tested separately, and on the ground in many cases, fully integrated flight test(s) would be almost certainly necessary to give the PLA confidence in approving full-scale production and deploying ASBMs in a full operational state.

This disparity suggests the need for humility on the part of open source analysts, some of whom have misconstrued the absence of publicly documented flight tests as conclusive proof that noflight tests have occurred. It is always risky to stake one’s analytical reputation on the claim that one has proven a negative.

As China’s ASBM moves toward FOC, we are likely to witness even more sophisticated flight tests—including fully integrated tests over water against increasingly challenging targets—that are ever more difficult to conceal. And, aside from specific information about potential vulnerabilities, perhaps Beijing not want to conceal further testing—further successful tests would only strengthen deterrence.

Exhibit 8: ASBM Joint Technical Research

Source: Journal of System Simulation

This is one of many Chinese technical articles on using ASBM-deployed submunitions to render carrier-based aircraft inoperable. Note authors’ affiliations with both Second Artillery and PLA Navy.

Production

“Augmented by direct acquisition of foreign weapons and technology, [defense industry] reforms have enabled China to develop and produce advanced weapon systems that incorporate mid-1990s technology in many areas, and some systems—particularly ballistic missiles—that rival any in the world today,” DoD explains in its 2010 report. “Production trends and resource allocation appear to favor missile and space systems…. China has the most active land-based ballistic and cruise missile program in the world. It is developing and testing several new classes.”

The DF-21D’s IOC status strongly suggests that the reported completion of a DF-21D rocket motor facility, or some equivalent preparation, has already occurred. According to a Hohhot, Inner Mongolia government website, the 6th academy of China Aerospace and Industry Corporation in August 2009 completed the construction of the 359 factory (also known as Honggang), whose role is to produce motors for the DF-21D.

As for the DF-21D’s current rate of production, no authority from any nation has offered details, let alone a parallel to U.S. status terms. U.S. Defense Acquisition University defines “low rate initial production (LRIP)” as “The first effort of the Production and Deployment (P&D) phase. This effort is intended to result in completion of manufacturing development in order to ensure adequate and efficient manufacturing capability and to produce the minimum quantity necessary to provide production or production-representative articles for IOT&E [independent initial operational test & evaluation]; establish an initial production base for the system; and permit an orderly increase in the production rate for the system, sufficient to lead to full-rate production upon successful completion of operational (and live-fire, where applicable) testing.”[i] Based on Admiral Willard’s estimate that China will continue ASBM testing for  “several more years,” it might seem too early to witness a Chinese equivalent to the next step in the U.S. production lexicon, or Full Rate Production (FRP), in which a “system is produced at rate production and deployed to the field or fleet. This phase overlaps the Operations and Support (O&S) phase since fielded systems are operated and supported (sustained) while Full Rate Production (FRP) is ongoing.”[ii] Again, however, China may instead display unique “Chinese characteristics” in its approach. It has had a history of building small numbers of weapons systems, deploying them; developing improved follow-on variants and deploying them in successive “waves”; and replacing older systems with newer systems as capabilities and numbers permit. Some PLA sources refer to this pattern as “rolling deployment.”

[i] “Low Rate Initial Production (LRIP) of Production and Deployment Phase,” ACQuipedia, https://acc.dau.mil/ILC_LRIPOP&DP.

[ii] “Full-Rate Production / Deployment of Production & Deployment Phase,” ACQuipedia, https://acc.dau.mil/ILC_FRPDOP&DP.

Units

Chinese unit(s) must have already received the DF-21D. These unit(s) have been trained to deploy, employ, and maintain the ASBM, support infrastructure, and related systems. This might correlate with the reported late July 2010 announcement of a new Second Artillery missile brigade. Based on sophisticated organizational analysis, Mark Stokes and his colleague Tiffany Ma suggested on 3 August 2010 that the Second Artillery might be constructing ASBM missile brigade facilities in the northern Guangdong Province municipality of Shaoguan:

“Last week, China’s state-run media quietly announced the construction of facilities for a new Second Artillery missile brigade – the 96166 Unit – in… Shaoguan… [Guangdong] province is already home to a Second Artillery short-range ballistic missile (SRBM) brigade (the 96169 unit in Meizhou)….”

“Although the introduction of the 1,700km range solid fuelled, terminally guided DF-21C ballistic missile into Guangdong is possible, the brigade is also a candidate to be the first unit equipped with the DF-21D anti-ship ballistic missile (ASBM). The DF-21C, first introduced into the active inventory in 2005, is designed to attack fixed targets on land. If an ASBM is successful in passing the necessary design reviews and a sufficient sensor network is in place, the Shaoguan brigade could become the first in the PLA to field a lethal capability against moving targets at sea out to a range of 1,500-2,000km or more from launch sites.”

Shaoguan’s location near Hunan Province, with the inter-provincial Nanling Mountains and tunnels through them (under construction since at least 2008) that complicate foreign satellite surveillance, offers significant advantages:

“Whether the unit is equipped with the DF-21C or the more advanced DF-21D maritime variant, the establishment of a conventionally-capable medium range ballistic missile brigade in Guangdong would decisively expand the Second Artillery’s striking radius. More specifically, it would enable the Second Artillery to support the Central Military Commission to enforce territorial claims in the South China Sea, or strike targets in a Taiwan-related contingency without having to overfly Japanese territory.”

Exhibit 9: Chinese Conception of ASBM Target Detection and Tracking, ca. 200

Source: Missiles & Space Vehicles[xiii]

C4ISR

While doubtless an area of continuous challenge and improvement, the DF-21D’s C4ISR infrastructure must be sufficient to support basic CSG-targeting capabilities. China’s rapid succession of advanced satellite launches over the past year suggests a concerted effort to achieve the space-based architecture to achieve this initial capability, however modest. In a series of events little noticed by most China watchers, let alone the general public, China has been orbiting the Yaogan series of advanced electro-optical and synthetic aperture radar (SAR) remote sensing satellites. Yaogan 1, launched on 27 April 2006, has since completed its mission. Yaogan 2 through 11 were launched between 25 May 2007 and 22 September 2010, for a total of 12 satellites currently operational in orbit.

The rapid pace of recent launches (7 since 9 December 2009) suggests high prioritization. Of particular interest with respect to potential for ASBM cueing is the 5 March 2010 launch of Yaogan 9A, B, and C. These satellites fly in formation in similar orbits, apparently as a type of Naval Ocean Surveillance System (NOSS). The U.S. Navy reportedly deployed such a system beginning in the early 1970s, apparently to detect surface vessels by sensing their electronic emissions and locating the using time distance of arrival. Yaogan-11 was launched with two picosatellites that will co-orbit with it for three months.[xiv] Ian Easton at the Project 2049 Institute tells us: “My guess is that it is a test-bed for something like a RORSAT [Radar Ocean Reconnaissance SATellite]-style carrier-hunting platform or something similar that combines ELINT [electronic intercept] and SAR.”

Another possible indication of relevant C4ISR progress is a news release published on 20 May 2010 attributed to China Aerospace Science & Industry Corporation (CASIC) citing Wang Genbin, Deputy Director of its 4th Department, as stating that the DF-21D can hit “slow-moving targets” with a CEP (circular error probable, meaning half of missiles fired will strike within) of dozens of meters.

“The PLA Navy is improving its over-the-horizon (OTH) targeting capability with Sky Wave and Surface Wave OTH radars. OTH radars could be used in conjunction with imagery satellites to assist in locating targets at great distances from PRC shores to support long range precision strikes, including by anti-ship ballistic missiles,” states DoD’s 2010 report. “Over the long term, improvements in China’s C4ISR, including space-based and over-the-horizon sensors, could enable Beijing to identify, track, and target military activities deep into the western Pacific Ocean.”

A 16 August 2010 background briefing by a senior DoD official suggested that China still needed to successfully integrate its ASBM with C4ISR in order to operationalize it: “the primary area… where we see them still facing roadblocks is in integrating the missile system with the C4-ISR. And they still have a ways to go before they manage to get that integrated so that they have an operational and effective system.”

Various obstacles could limit China’s ability to employ ASBMs effectively, particularly in the areas of detection, targeting, data fusion, joint service operations, and bureaucratic coordination. The exact status of this progress remains unclear at this point, but to achieve IOC, it would seem that the DF-21D and its supporting systems would have had to address at least some of the most basic problems.

Deployment

Based on previous Second Artillery deployment patterns, we can anticipate that ever-better-performing and -C4ISR-linked versions of the DF-21D will be deployed in “waves” to different units until the majority of ASBMs reach a level of capability the PLA deems sufficient to meet its present deterrence objectives. This has been the pattern with previous Second Artillery missile systems.

Exhibit 10: Second Artillery Vision for ASBM Employment

The authoritative high-level handbook Science of Second Artillery Campaigns details how China’s strategic rocket force conceives of the use of ASBMs against carriers. “Harassment strikes” involve hitting CSGs; “frontal firepower deterrence” involves firing intimidation salvos in front of a CSG “to serve as a warning”; “flank firepower expulsion” combines interception of a CSG by Chinese naval forces with intimidation salvos designed to direct it away from the areas where China feels most threatened; “concentrated fire assault” involves striking the carrier’s control tower and aircraft; and “information assault” entails attacking the CSG’s command and control system electromagnetically to disable it.

Deterrence

On the basis of present capabilities, we can anticipate that China already expects to achieve some level of (growing) deterrence benefits from its DF-21D ASBM. The purpose of the ASBM is straightforward. First it is a potent system for deterrence purposes, especially in conjunction with all of China’s other A2/AD capabilities. If deterrence is successful, China’s adversary decides to stay outside the range ring in a crisis or a conflict, thus diminishing the adversary’s operational effectiveness and making it easier for China to achieve its operational and strategic objectives. If deterrence fails, then China can use it to achieve a mission kill or possibly disable or even sink an enemy ship (assuming the enemy is willing to run the risk of escalation), or complicate defense in a way that could allow another weapon to do the same.

As Ronald O’Rourke, Congressional Research Service, explains: “Observers have expressed strong concern about the DF-21D, because such missiles, in combination with broad-area maritime surveillance and targeting systems, would permit China to attack aircraft carriers, other U.S. Navy ships, or ships of allied or partner navies operating in the Western Pacific. The U.S. Navy has not previously faced a threat from highly accurate ballistic missiles capable of hitting moving ships at sea. Due to their ability to change course, the MaRVs on an ASBM would be more difficult to intercept than non-maneuvering ballistic missile reentry vehicles.” PLA sources reveal extreme confidence in China’s ability to control escalation in the process.

The ASBM is envisioned primarily as a deterrent weapon by Chinese analysts; to many, this makes it inherently “defensive” in nature. Wu Riqiang, a former CASIC missile designer with six years’ work experience, believes that ASBMs and related weapons are “essentially ‘political chips,’ the mere mention of which ha[ve] already achieved the goal of making U.S. warships think twice about operating near China’s shores. … ‘It’s an open question how these missiles will do in a conflict situation. But the threat—that’s what’s most important about them.’”[xv]

A 6 September 2010 editorial in the English-language edition of the nationalistic Chinese newspaper Global Times declared that “China needs powerful” ASBMs and other “carrier-destroying measures.” Apparently written for a foreign audience, the editorial elaborated:

“Since US aircraft carrier battle groups in the Pacific constitute deterrence against China’s strategic interests, China has to possess the capacity to counterbalance.” To end “speculation” by Western intelligence agencies: “China ought to convince the international community of its reliable carrier-killing capacity as soon as possible….”

“While developing its anti-ship missile capacity, China should also let Westerners know under what circumstances will such weaponry be used.”

“An external anxiety over China’s development of its military is somewhat understandable. The greater strategic deterrence China possesses, the more cautious it should be in using force. China should carefully explore how to present its deterrence. This is a new subject for China.”

Global Times is not an official newspaper but is sponsored by and produced under the auspices of People’s Daily, the official daily newspaper of the Communist Party of China Central Committee. In any case, these are extremely pointed statements on a strategically important–and previously sensitive–subject.

With cross-Strait relations relatively stable at present, perhaps Beijing’s statements in summer 2010 that the U.S. should not deploy a CSG in the Yellow Sea represented early efforts to see how such enhanced deterrence might be exploited in peacetime.

Exhibit 11: Chinese Internet Coverage of Previous Statement by Admiral Willard

This graphic comes from an article posted on the website of Dongfang Ribao (Oriental Daily), a Shanghai newspaper, covering Admiral Willard’s 25-26 March 2010 testimony in writing before the U.S. congressional Armed Services committees that “China is… developing and testing a conventional anti-ship ballistic missile….”

Countermeasures

An IOC status for China’s ASBM says nothing about the countermeasures that U.S. and allied forces may use to negate its capabilities. A Chinese ASBM system of systems could be difficult and/or highly escalatory to defend against. But related efforts appear to be well underway. On 29 September 2010, Secretary of Defense Robert Gates emphasized the need to factor ASBM development into future carrier operations.

“What I’ve been trying to do is get people to think about… adaptability. If the Chinese or somebody else has a highly accurate anti-ship cruise or ballistic missile that can take out a carrier at hundreds of miles of ranges and therefore in Asia puts us back behind the second island chain, how then do you use carriers differently in the future than we’ve used them in the past?”

“I’m trying to get people to think about how do we use [carriers] in a world environment where other countries will have the capability, between their missile capabilities and their satellite capabilities, to knock out a carrier if you get to a certain point… within range.”

In a slightly earlier interview, Undersecretary of the U.S. Navy Robert O. Work addressed a broader but closely-related issue: that of increasing A2/AD challenges to U.S. forces. Having been asked, “What issues regarding the department keep you awake at night?” Work replied in part: “Secretary Gates has just asked the Navy and the Marine Corps to say how we’re going to operate in what he terms an anti-access area denial environment where the enemy has a battle network that is as capable as our own and has the ability to fire lots of guided weapons. We’ve never faced an enemy like that before. We have essentially had a monopoly on guided weapons warfare since the early ’90s.”

The following, as reported in the December 2010 issue of Popular Mechanics, suggests a measured but proactive U.S. response: “Adm. Patrick Walsh, the current commander of the U.S. Navy’s Pacific Fleet, sees preparation as a way to avoid a future fight. ‘When we look at these sorts of developments, such as the ASBM, they are technological developments that we respect, but do not necessarily fear,’ Walsh says. ‘The key element in any sort of deterrent strategy is to make it clear to those who would use a given piece of technology that we have the means to counter it, and to maintain a technological edge.’”

U.S. ships will not offer a fixed target for such “asymmetric” weapons, including Chinese ASBMs. U.S. military planning documents, including the March 2010 Joint Operating Environmentand February 2010 Quadrennial Defense Review (QDR)—the Pentagon’s guiding strategy document—clearly recognize China’s growing A2/AD challenge; the QDR charges the U.S. military with multiple initiatives to address it. For example, the Air Force and Navy are pursuing AirSea Battle, a new operational concept designed to preserve U.S. power-projection capabilities in an era of aerospace-maritime battlespace fusion, increasing jointness, tightening budgets, and Chinese and Iranian A2/AD capabilities.

In a world where U.S. naval assets will often be safest underwater and in more dispersed networks, President Obama’s defense budget supports building two submarines a year and investing in a new ballistic-missile submarine, as well as a variety of missile defense systems. As Ronald O’Rourke outlines, ASBM-relevant measures more broadly include:

“The U.S. Navy and (for sea-based ballistic missile defense programs) the Missile Defense Agency (MDA) have taken a number of steps in recent years that appear intended, at least in part, at improving the U.S. Navy’s ability to counter Chinese maritime anti-access capabilities, including but not limited to the following:

  • increasing antisubmarine warfare (ASW) training for Pacific Fleet forces;
  • shifting three Pacific Fleet Los Angeles (SSN-688) class SSNs to Guam;
  • basing all three Seawolf (SSN-21) class submarines—the Navy’s largest and most heavily armed SSNs—in the Pacific Fleet (at Kitsap-Bremerton, WA);
  • basing two of the Navy’s four converted Trident cruise missile/special operations forces submarines (SSGNs) in the Pacific (at Bangor, WA);
  • assigning most of the Navy’s ballistic missile defense (BMD)-capable Aegis cruisers and destroyers to the Pacific—and homeporting some of those ships at Yokosuka, Japan, and Pearl Harbor, HI;
  • expanding the planned number of BMD-capable ships from three Aegis cruisers and 15 Aegis destroyers to 10 Aegis cruisers and all Aegis destroyers; and
  • increasing the planned procurement quantity of SM-3 BMD interceptor missiles.”

“In addition, the Navy’s July 2008 proposal to stop procurement of Zumwalt (DDG-1000) class destroyers and resume procurement of Arleigh Burke (DDG-51) class Aegis destroyers can be viewed as having been prompted in large part by Navy concerns over its ability to counter China’s maritime anti-access capabilities. The Navy stated that this proposal was driven by a change over the last two years in the Navy’s assessment of threats that U.S. Navy forces will face in coming years from ASCMs, ballistic missiles, and submarines operating in blue waters. Although the Navy in making this proposal did not highlight China by name, the Navy’s references to ballistic missiles and to submarines operating in blue waters can be viewed, at least in part, as a reference to Chinese ballistic missiles (including ASBMs) and Chinese submarines.”

How best to develop and implement ASBM countermeasures is a topic of vigorous discussion in U.S. Navy circles. In addition to those in the U.S., civilian and military leaders in other nations are following Chinese ASBM development closely and considering relevant countermeasures. “As far as a weapon like ASBM is concerned, if it is operationally fielded, certainly it is a matter of concern,” Indian Navy Chief Admiral Nirmal Verma stated on 2 December 2010. “The areas in which it (ASBM) will be deployed in our area of operation is something we need to look at. And certainly we need to have something in place with respect to ASBM-type of weapon and we will put it in place.”

While taking steps to prevent China’s ASBM from changing the rules of the game in the Western Pacific, the U.S. is working to reduce the possibility of conflict in the first place by improving strategic communications with China. Admiral Willard has suggested that Chinese ASBM development should be raised in sustained discussions with China’s military to help reduce misunderstanding and miscommunication, which could produce disastrous and unintended results: “trying to understand what the … anti-ship ballistic missile system is designed for and against, and its relation with other anti-access capabilities – what that strategy entails is very much an issue that we would like to discuss mil-to-mil with the Chinese. I think this raises the importance of a continuous military-to-military dialogue….”

Exhibit 12: USS George Washington

Source: DoD

For the past several decades, the U.S. Navy has used aircraft carriers to project power around the world, including in and around the Taiwan Strait. Pictured here is USS George Washington, currently based in Yokosuka, Japan.

CONCLUSION

The significance of a top U.S. military authority likening the DF-21D’s status to IOC is that it must now be taken seriously by foreign observers. Previously, a few naysayers stated that an ASBM was technologically impossible; more said that there was no evidence that China could achieve such a capability. But physics allows for an ASBM, and physics is the same for the Chinese as it is for everyone else. Now that the Commander of the U.S. Pacific Command, with his information access and operational judgment, has weighed in definitively, those positions have become untenable. Admiral Willard now views China’s ASBM system as viable and one that must be taken into account. This system is not science fiction. It is not a “smoke and mirrors” bluff. It is not an aspirational capability that the U.S. can ignore until some point in the future.

The question is rather: what level of operations can China achieve, and how soon? More broadly, from a strategic perspective, how will this influence regional deterrence dynamics and what will it mean for U.S. strategy, operational concepts, and force development plans? Even China’s Second Artillery itself cannot know exactly how the DF-21D would function under actual combat conditions. Nobody will know for certain if this ASBM actually works as intended unless it is actually used.

It is well established, by contrast, that the basic concept of the anti-ship cruise missile cruise missile (ASCM) works. Whether Chinese ASCMs work as well as advertised or at their advertised ranges may be unclear, but the essentials have been battle-tested (as the Royal Navy learned in the Falklands War of 1982). The same is true for torpedoes, laser guided bombs, and GPS-guided bombs.

At the same time, the ASBM is not a stand-alone system. It is part of a system of systems that includes submarines, strike aircraft, and even surface vessels. Thus, even if the weapons system has flaws that can be countered, it represents one more problem that U.S. forces would have to deal with in a crisis scenario in the Western Pacific. The 4-7 June 1942 Battle of Midway—one of the World War II Pacific Campaign’s, and of that war’s, most decisive naval engagements—is instructive in this regard. It concluded with Japanese defeat when three squadrons of U.S. carrier-based dive bombers took Japanese carriers Soryu, Akagi, and Kaga out of action, forcing their eventual abandonment and scuttling. Prior to that, however, the Japanese carrier force was subjected to attacks from two groups of U.S. land-based dive bombers, two groups of land-based torpedo bombers, one group of land-based high-altitude bombers, three squadrons of carrier-based torpedo bombers, and one submarine. None one of these alone succeeded in causing significant damage to the Japanese carrier force and they took heavy casualties in general, but in aggregate they succeeded in preoccupying the Japanese air defenses and in confusing Japanese commanders regarding how prosecute the battle. This ultimately helped the dive bomber squadrons break through. Therein lies the larger point—even if U.S. forces could counter China’s ASBM, would doing so divert attention away from another threat (i.e., a submarine) that can sneak in and fire a shot? While that question is unanswerable at present, the ASBM should not be viewed in isolation from other capabilities.

What’s the Chinese for, “Go ahead, make my day”?

The core implication of the DF-21D’s IOC status is that certain possibilities now have to be taken into account as never before. With the ASBM, the uncertainty arguably works in China’s favor with regard to deterrence. In a crisis or combat situation, U.S. operators would have to draw a range ring for the DF-21D and then decide whether or not to risk sending CSGs into that range ring. This operational uncertainty evokes the 1971 crime thriller Dirty Harry, in which San Francisco Police Department Inspector Harry Callahan (Clint Eastwood) challenges a bank robber:

“I know what you’re thinking: ‘Did he fire six shots, or only five?’ Well, to tell you the truth, in all this excitement, I’ve kinda lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: ‘Do I feel lucky?’ Well do ya, punk?”

In that particular case, it later turns out that the gun was empty, but the robber surrendered because he was unwilling to risk being killed. In the film’s climactic scene, faced with a similar choice, the serial killer “Scorpio” (Andy Robinson) makes the opposite decision and ends up dead from a chest wound. In an actual combat situation, the relevant U.S. commander would have to make a decision as to how much risk s/he was willing to tolerate, and then act accordingly.

Today, an increasingly assertive China is determined to defend what it defines as its own sovereignty and jurisdictional order. Regardless of the DF-21D ASBM’s actual combat capabilities, a new dynamic has entered Sino-American strategic relations. As we enter a new year, let us hope that Beijing and Washington can find better, more peaceful means of settling their differences.

 

FURTHER READING

[i] Citations and links not provided in this document may be found at Andrew S. Erickson, “China Testing Anti-Ship Ballistic Missile (ASBM); U.S. Preparing Accordingly–Updated With Latest Analysis & Sources,” 22 December 2010, http://www.andrewerickson.com/2010/12/china-testing-anti-ship-ballistic-missile-asbm/; “Selected ASBM-Related Content from Ronald O’Rourke’s 1 December 2010 Congressional Research Service Report ‘China Naval Modernization,’” 22 December 2010, http://www.andrewerickson.com/2010/12/selected-asbm-related-content-from-ronald-o%E2%80%99rourke%E2%80%99s-1-december-2010-congressional-research-service-report-%E2%80%9Cchina-naval-modernization%E2%80%9D/.

[ii] Tan Shoulin and Zhang Daqiao, Second Artillery Engineering College and Diao Guoxiu, PLA Unit 96311, Huaihua, “Determination and Evaluation of Effective Range for Terminal-Guidance Ballistic Missile(s) Attacking Aircraft Carrier(s),” Command Control and Simulation 28, no. 4 (August 2006), p. 9; republished in Office of the Secretary of Defense, Military and Security Developments Involving the People’s Republic of China 2010, Annual Report to Congress (Washington, DC: Office of the Secretary of Defense, 16 August 2010), 30.

[iii] Ibid., 32

[iv] “Initial Operational Capability,” DTIC Online, http://www.dtic.mil/doctrine/dod_dictionary/data/i/4810.html.

[v] “Initial Operational Capability (IOC),” ACQuipedia, https://acc.dau.mil/CommunityBrowser.aspx?id=28937.

[vi] “FOC,” DTIC Online, http://www.dtic.mil/doctrine/dod_dictionary/acronym/f/12979.html.

[vii] “Full Operational Capability (FOC),” ACQuipedia, https://acc.dau.mil/ILC_FOC.

[viii] U.S. Dept. of Defense, Office of the Assistant Secretary of Defense (Public Affairs), “DoD Background Briefing with Defense Department Officials at the Pentagon,” 25 May 2007, http://www.defense.gov/transcripts/transcript.aspx?transcriptid=3971.

[ix] “China Central Television New Observations on Defense: ASBM—The Aircraft Carrier’s Natural Enemy?,” Part 2, http://www.youtube.com/watch?v=R-nNVvtacXU&feature=related.

[x] See also China Space News, 12 August 2010, http://news.ifeng.com/mil/2/detail_2010_08/12/1935618_0.shtml.

[xi] “Low Rate Initial Production (LRIP) of Production and Deployment Phase,” ACQuipedia, https://acc.dau.mil/ILC_LRIPOP&DP.

[xii] “Full-Rate Production / Deployment of Production & Deployment Phase,” ACQuipedia, https://acc.dau.mil/ILC_FRPDOP&DP.

[xiii] “Figure 1,” in Chen Haidong et al., Beijing Institute of Astronautical Systems Engineering; Zeng Qingxiang, Beijing Institute of Special Mechanical and Electronic Devices; “Study of a Guidance Scheme for Reentry Vehicles Attacking Slowly Moving Targets, Missiles & Space Vehicles, No. 6, 2000, 6.

[xiv] “Yaogan-11 Launches Atop CZ-2D Chinese Rocket,” http://www.youtube.com/watch?v=7ClxFcBVIIo.

[xv] John Pomfret, “Military Strength Eludes China, Which Looks Overseas for Arms,” Washington Post, 25 December 2010, http://www.washingtonpost.com/wp-dyn/content/article/2010/12/24/AR2010122402788.html.

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Gabriel B. Collins and Andrew S. Erickson, “Still a Pipedream: A Pakistan-to-China rail corridor is not a substitute for maritime transport,” China SignPost™ (洞察中国) 13 (22 December 2010).

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

The recent flurry of trade deals and MOUs (worth US$35 billion) signed during Premier Wen Jiabao’s recent visit to Pakistan have brought the possibility of a more robust Pakistan-to-China transport corridor back into the spotlight. The trade deals stand to drive increased economic activity by Chinese companies in Pakistan in coming years.

However, our assessment is that while the trade and investment agreements may help cement an “all weather” alliance between Beijing and Islamabad, they do not mean that an all weather transport corridor becomes viable. An expanded road and rail network linking Pakistan to China faces three key challenges. The bottom line is that maritime shipping routes will remain a cheaper, simpler, and more secure option for moving crude oil and other goods into China. … … …

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Gabriel B. Collins and Andrew S. Erickson, “LNG Carriers to Aircraft Carriers? Assessing the Potential for Crossover between Civilian and Military Shipbuilding in China,” China SignPost™ (洞察中国) 12 (18 December 2010).

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

Key policy implications:

  • China’s growing proficiency in building massive ore carriers and oil tankers suggests that Chinese yards can physically fabricate ship hulls of up to supercarrier size.
  • However, the ability to fashion a carrier’s hull has little bearing on the ability to build the ship’s internals and turn it into a floating airbase with planes, fuel, munitions, catapults, and at least several hundred personnel aboard.
  • Building the internal components of the ship and then learning to operate this immensely complex vessel as part of a battle group will likely require many years of trial and error unrelated to China’s growing shipyard capacity. … … …

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Gabriel B. Collins and Andrew S. Erickson, “In Hot Water: High-Efficiency Heat Pump Water Heaters Will Reduce Residential Energy Use in China,” China SignPost™ (洞察中国) 11 (16 December 2010).

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

The comfort of a hot shower is hard to beat and Chinese homeowners are moving quickly to install water heaters as they move into new housing or refurbish existing dwellings. China’s total water heater sales are booming, with 27 million units sold thus far in 2010 (20% more units year to date than in the comparable period in 2009), according to appliance dealer Wanhe. … … …

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Gabriel B. Collins and Andrew S. Erickson, “China’s Natural Gas Approach: Pipelines Are Best Way to Resolve Shortages,” China SignPost™ (洞察中国) 10 (10 December 2010).

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

China’s gas grid expansion is economically, environmentally, and strategically significant. Beijing’s desire to adopt cleaner sources of energy and facilitate their effective movement around China helps reduce pollution and energy price volatility, which hurts Chinese and foreign energy consumers alike. Chinese actions in the natural gas sector sometimes appear alien to those outside the country, particularly Americans and Europeans who are used to the market allocating supplies through price. … … …

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Gabriel B. Collins and Andrew S. Erickson, “U.S. Pecan Growers Crack into Chinese Market,” China SignPost™ (洞察中国) 9 (9 December 2010).

Chinese pecan buyers are accumulating supplies as they prepare for the next Chinese New Year in early 2011, a peak nut consumption period in China. Rising incomes and increased demand for healthy foods are driving higher tree nut purchases in China. Pecan farmers in the US are benefiting from skyrocketing pecan exports to China in recent years. Exports grew from less than 5,455 tonnes in 2006 to 40,273 tonnes in 2009. Based on conversations with growers, we believe U.S. exports of whole, in-shell pecans to China could exceed 54,000 tonnes in 2010. …

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Gabriel B. Collins and Andrew S. Erickson, “Playing with Fire? Potential Impact of a North Korean Threat to South Korean Oil Refineries,” China SignPost™ (洞察中国) 8 (29 November 2010).

North Korea’s recent shelling of South Korea’s Yeonpyeong Island raises the risk of armed confrontation in the region. If its core demands were not met, North Korea might threaten to target such critical economic infrastructure as refineries in South Korea and Japan in the low-probability, but high-impact event that a shooting war erupted. Saddam Hussein’s Scud attacks against Israel during the First Gulf War in 1991 suggest how despots with large missile forces can lash out in unpredictable ways during a conflict, even to their ultimate detriment. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Follow the Money: ‘Rich Lists’ Hint at Sectors that May Become Future Wealth Generators,” China SignPost™ (洞察中国) 7 (26 November 2010).

Forbes Magazine recently published “rich lists” of the wealthiest people in China and the US. Analyzing the holdings of the 100 wealthiest people in each country helps give insights into the structure of the Chinese economy at present and what types of shifts and evolution might be expected as the country attempts to move toward a more consumption-oriented economy. The US does not, of course, provide a precise blueprint of what the Chinese economy will evolve toward, but gives some a sense for the direction general trends could take. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Factors Behind China’s Latest Diesel Fuel Shortage,” China SignPost™ (洞察中国) 6 (21 November 2010).

Over the past few weeks, many parts of China have been experiencing diesel fuel shortages. The existence of the shortages has been well-chronicled by many Chinese and foreign media outlets, but there has been much less coverage and analysis of the factors driving the shortage. This year’s diesel shortage appears to be one of the most acute since those 2004 and 2005, when power shortages forced many power consumers to turn to diesel powered generators. … … …

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Gabriel B. Collins and Andrew S. Erickson, “Gray Gold: China’s Rare Earth Power Play, Impacts, and Suggested Consumer Responses,” China SignPost™ (洞察中国) 5 (3 November 2010).

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

***Note: this summary version does not contain graphics, which are available in the PDF edition.***

Tighter export quotas for rare earth elements (REEs) from China and the recent embargo on exports to Japan are driven primarily by the desire to support domestic manufacturing and promote technology transfer to China, with consolidating the REE industry and strengthening environmental protection as secondary objectives.

The frantic response and sharp price increases for REEs highlights how the hand-to-mouth supply policies of many industrial consumers have left them highly exposed to disruptions in supplies of critical mineral inputs. REEs are 17 elements vital to producing a range of essential commercial and military products, from smart phones to fiber optics. Meanwhile, demand for higher purity mixed and separated inputs for green technologies and electronics seems poised to rise for the foreseeable future. It also shows how China’s focused national industrial policies have given it a hammerlock on supplies of rare earths, tungsten, and other key inputs whose markets are small in value terms relative to commodities like crude oil, but which are nevertheless irreplaceable in many industrial processes and therefore have immense strategic value. Today, China produces 97% of the world’s REEs, the US none.

While the recent embargo on REE exports to Japan is truly problematic, the situation concerning export quotas—at least thus far—is more complex. Data from Dacha Capital show that Chinese REE exporters used only 66% of the rare earth export quota available in 2008 and 53% in 2009, suggesting that the significant export quota reductions implemented in July 2010 aim to align quotas more closely with actual overall export demand. The major cuts undertaken in 2010 bring the quota usage rate to 93% in Dacha’s estimate. The quota usage rate is the percentage of the quota that is actually exported in a given year. Dacha analysis suggests that a key risk comes from rare earth suppliers choosing to use their smaller quota allotments to ship more valuable heavy rare earths first, potentially engendering shortages to exportable supplies of lighter REEs like cerium. Dacha tells us non-Japanese buyers are actually being offered discounts in some cases as Chinese REE exporters scramble to use up the remainder of their 2010 quotas.

Why are REEs so important?

Rare earths are special in that while only small amounts of them are needed in most applications, they are typically irreplaceable as substitutes are nonexistent, inferior, or even more expensive. The users are typically relatively price insensitive, although the small portion of rare earths in many products and their small portion of total raw material costs make manufacturers’ product price increases deceptive in terms of how they reflect the minerals’ strategic value.

For example, rare earth investors tell us refinery catalyst makers such as W.R. Grace and Albemarle have faced a roughly 700% increase in the price of lanthanum (a critical input for catalytic converters) in the past year, but have only increased final product prices by about 5% as they pass higher input prices along to consumers. Although lanthanum represents only a small portion of the companies’ raw material costs (hence the small product price increase), they could not manufacture the catalysts without it. As such, industrial consumers’ REE stockpiles are not a matter of buffering against price shocks (as is the case with oil or copper), but rather, a matter of competitive survival.

Dacha Capital tells us at the beginning of 2010, Japanese REE users likely had six-to-nine months of stocks on hand, while consumers in the US and Europe had less. Since then, the firm tells us all three consuming regions have seen stock draws and that inventory levels in some areas may now be closer to two months’ of consumption. Alkane Resources also believes that Japanese consumers likely now have around 6 months worth of REE inventory, while it thinks some European users may be nearly out. Alkane also tells us China is rumored to have large stocks of light REEs, but little in the way of heavy REE inventories.

The likelihood that non-Japanese REE users have even lower inventories than their Japanese competitors leads us to conclude that China’s motives for delaying raw REE exports extend beyond the stated objective of “counter smuggling.” The critical nature of REEs for industrial processes make it unlikely that other users would sell to embargoed Japanese firms that probably still have larger stockpiles, since making a few million USD in profit from liquidating REE inventories is simply not worth the production halt that lack of REE supply would cause.

Specific impacts of an REE supply crunch

Alkane Resources tells us “the industries that will be most impacted will be magnets (Nd, Dy) and phosphors (Y, Tb). NiMH [nickel metal hydride] batteries will also be impacted to some degree (Nd). There will also be some flow on effect to catalysts and special ceramics (Y).” Dacha Capital concurs, telling us supplies of neodymium, a key input for making magnets that already costs $80,000/ton in Japan, will likely be impacted in the next six months.

Lynas Corp. estimates that magnets will account for 26% of total rare earth demand volume in 2010 and 29% in 2014. Rare earth magnets are valued for their high power-to-size ratio, which makes them valuable for applications including hybrid car electric motors, jet engines, smart bomb and missile guidance systems, satellite power and communications systems, lasers, and computer hard drives.

Fluidized cat cracker catalysts, which are used in oil refining, are the next largest source of REE demand (16% in 2010 and 13% in 2014). If catalyst makers outside China cannot obtain sufficient raw materials, Chinese manufacturers will have a window of opportunity to grab market share before alternative supplies come online.

Dacha also tells us that supplies of ytterbium, yttrium, and europium to the lighting industry are likely to be pinch points over the next 12-to-18 months, particularly since a number of countries are presently seeking to phase out incandescent bulbs and replace them with more efficient bulb types that also happen to require REEs. The company believes there will be little to no supply-side response to a supply crunch or higher prices since the elements’ concentrations in their ores are so low.

The supply/demand balances as measured by the deficit or surplus as a percentage of demand for some of the most heavily used REEs, including neodymium and lanthanum, are expected to be meaningfully negative for at least several more years. Continuing deficits for many key REEs is driving heavy investment in new producing projects to tap the estimated 64% of REE reserves outside China, such as Mt. Weld in Australia (forecast to account for 13% of global supply in 2014) and revival of mothballed mines like MolyCorp’s Mountain Pass project, formerly the world’s leading producer (nearly 12% of global supply in 2014). Significant untapped and underutilized reserves are also present in Canada, India, Brazil, Russia, South Africa, Malaysia, and Malawi.

Yet even with new mines coming online, China will still account for more than 2/3 of global REE supply in 2014. Some commentators advocating recycling as a source of REE elements to offset restriction in exports of raw materials from China. However, we believe the economic costs and environmental regulations associated with “urban mining” (electronic recycling) will be prohibitively high in many cases and thus will prevent this channel from making a substantial impact on global supplies. This view is borne out by Lynas’s estimates, with recycling accounting for only 3.5% of the REE supply in 2014.

China currently produces more than 95% of the global REE supply, will retain significant global REE market influence, and in the face of rising foreign production may further tighten export quotas. The reason for this is that the ultimate rationale for the REE power play is not simply a desire to protect the environment or rationalize the structure of the industry (e.g., consolidating firms and reducing smuggling).

Rather, it stems from at least three additional factors. First, Chinese manufacturers need sufficient inputs, and already consume more REEs than the rest of the world’s combined. To a lesser degree, the coincidence of REE export interruptions with key Chinese policy statements—such as opposing a WTO challenge on market access for REE-reliant solar and wind power technologies manufactured in China—and conspicuous absence of detailed explanation on Beijing’s part—suggests some effort to influence foreign governments, particularly that of Japan (itself a major supplier of REE products to the US).

Beijing may be increasingly cautious about using this blunt instrument, which has already catalyzed foreign REE supply diversification efforts in Japan, the US, and other consumer nations. Most importantly from a foreign perspective, forcing more REE-containing components to be manufactured in China can help promote technology transfer and further the government’s objective of moving Chinese economic activity higher up on the industrial value-added chain. We believe Beijing is honest in citing the environmental and industrial structure motives—with the caveat that they are secondary in importance to incentivizing tech transfer, a consequence that seems increasingly likely as more foreign companies move REE-dependent operations to China.

Policy recommendations

1)      Work to establish common global REE processing facilities in a third country such as Indonesia, the Philippines, or Singapore that is not a major producer or consumer, but lies near major users and producers. China currently hosts most global REE processing capacity, particularly for the heavy REEs. Experts tell us that if each aspiring producer also builds processing facilities, the right-sizing process could be very chaotic and possibly disruptive to the market. A common, independently-run facility would reduce this problem and also alleviate concerns that any one company would have with processing its ores as a competitor’s facility.

2)      Build a US strategic REE stockpile. Consider also establishing a global common stockpile managed by a body created by key consumer governments including China, Japan, and the US. The US government sold the last of its strategic rare earth inventory in 1998, but the House of Representatives recently passed (by a margin of 325 to 98) H.R. 6160, the Rare Earths and Critical Materials Revitalization Act of 2010, for the creation of a US rare earth supply chain. The bill’s full text is available at http://www.govtrack.us/congress/bill.xpd?bill=h111-6160. The Congressional Research Service lists four other pieces of REE-related legislation that members may consider, including the following (italicized wording derived from CRS):

  • H.R. 4866, the Rare Earths Supply-Chain Technology and Resources Transformation Act of 2010. The bill aims to “reestablish a competitive domestic rare earths minerals production industry; a domestic rare earth processing, refining, purification, and metals production industry; a domestic rare earth metals alloying industry; and a domestic rare earth based magnet production industry and supply chain in the United States.”
  • S. 3521, Rare Earths Supply Technology and Resources Transformation Act of 2010. The bill would expedite permitting for exploration and development of REE deposits in the US.
  • H.R. 5136, the Fiscal Year 2011 National Defense Authorization Act. This measure would require the Secretary of Defense to assess the rare earth material supply chain to determine what, if any, of the materials are of strategic importance to the US If the material is determined to be strategic, the Secretary would be required to develop a plan to ensure long-term availability by 31 December 2015. The legislation calls for the Secretary to submit a report to Congress on the assessment and plan no later than 180 days after enactment of the legislation.
  • P.L. 111-84, the Fiscal Year 2010 National Defense Authorization Act. In the proposed House and Senate (H.R. 2647/S. 1390) versions of the defense authorization bill for 2010, Representative Mike Coffman and Senator Evan Bayh introduced legislation to direct the Comptroller General to determine the extent to which specific military weapons systems are currently dependent upon rare-earth materials and the degree to which the United States isdependent upon sources that could be interrupted or disrupted.

Congressional support should be enhanced by the presence of REE reserves in states in every major region of the country.

3)      Establish a detailed set of guidelines to advise private sector firms and support their efforts to source and stockpile rare earths and other strategic metals more strategically. Free markets are generally the best solution, but the REE market is disproportionately small (only ~$2 billion annual global value) and strategic (significant price fluctuations have driven key sources, e.g. Mountain Pass, out of business—and may do so again absent government support). We therefore believe that for certain irreplaceable inputs such as REEs, it is appropriate to have a higher level of government guidance for sourcing and stockpiling practices. To date, Washington’s level of engagement with the issue has been very low. Experts in the US national laboratory system tell us they currently “don’t track this particular issue on an ongoing basis” and that in order for them to study REE-related questions, they would need a request for analysis from the Department of Homeland Security. Such a request should be issued without delay.

4)      Create a national strategic mineral inventory reporting system similar to Energy Information Administration (EIA) weekly petroleum inventory data reporting. This would help prioritize measures to avoid bottlenecks regarding supplies of critical resources. Given the importance of REEs to the production of critical military systems, the US Defense Department should track REE use in all major US military systems—something neither it nor its contractors do thoroughly at present.

5)      Provide financial incentives such as subsidized storage to encourage commercial REE users to hold larger inventories. Policymakers would need to determine what a “minimum acceptable” level is, perhaps six months’ worth of consumption. The Defense Department should provide financial support in relevant areas.

6)      Consider recycling more electronics within the US and using old electronic goods to create a strategic reserve of REE magnets. Sourcing this way reduces market disruption relative to buying raw REEs and during a time of economic difficulty, is likely to gain Congressional support for its job creation potential. A major US rare earth magnet dealer tells us its cost of obtaining magnets has “almost doubled” in 2010 and that its magnets come from China, a situation broadly repeated across the industry.

7)      Increase stockpile holdings of REEs, tungsten, cobalt, and other strategic metals that come from monopoly or near-monopoly suppliers. This will help to hedge against supply interruptions and help undercut efforts at monopoly pricing.

8)      Support establishing a global REE pricing system, especially for the more commonly used elements such as lanthanum, cerium, and neodymium. The London Metals Exchange now has a contract for cobalt, another strategic metal with a global trade level of roughly 55,000 tonnes per year (less than half that of REEs combined volume), and it is likely that an REE contract might be feasible as well.

9)      Create an “equal access” framework agreement with China stipulating that raw material supply disruptions of one month or longer not caused by accidents or natural disasters or other conditions clearly beyond the control of the producers or institutions of the exporting country’s government can lead to punitive tariffs on goods from the country that supplies these raw materials. One possible approach would be to develop rules that enable a panel of other World Trade Organization (WTO) members voting by a 2/3 or greater majority to support a claim that the disruption is politically motivated or otherwise designed to promote unfair trade conditions. Already, the US, Japan, and EU may be preparing to file a WTO complaint against China for its restriction of REE exports.

10)   Increase federal R&D funding for investigating ways to improve efficiency of REE use as well as identify potential substitutes. China already has a major REE research effort underway. MolyCorp estimates that China’s research establishment currently employs more than 1,000 PhD level scientists who are conducting government-sponsored rare-earth-related research efforts ranging from making extraction and separation more efficient for producing better magnets and other end products.

***

Gabriel B. Collins and Andrew S. Erickson, “Be Careful What You Wish For: Further Appreciation of China’s Currency Would Deliver Positive and Negative Results for U.S.,” China Signpost™(洞察中国) 4 (12 October 2010).

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

On 29 September 2010, the US House of Representatives passed the Currency Reform for Fair Trade Act by a margin of 348 to 79 (http://www.govtrack.us/congress/billtext.xpd?bill=h111-2378). The bill seeks to amend the Tariff Act of 1930 and allows punitive tariffs to be imposed on goods imported from countries deemed to have currencies that are “fundamentally undervalued.” The bill comes as House members, many of whom face a hard fought election in less than a month, work to bolster their credentials as protectors of American jobs and economic interests. Washington has followed up on the Currency Reform for Fair Trade Act with pressure on Chinese officials during the 9-10 October 2010 IMF meetings and will almost certainly continue pressing Beijing to appreciate the renminbi (RMB) in the months ahead, particularly if US jobs data remain weak.

However, if China were to substantially revalue the RMB, the effects would likely disappoint US voters, to whom RMB revaluation is being billed as a key tool for reviving the fortunes of the US manufacturing sector. This analysis will examine several key economic realities of a continued RMB appreciation of 15% or more in value relative to the US Dollar. The bottom line: for Washington, a sustained clash with China over the RMB would at best result in a small economic and political perception victory for the US. Confrontation would likely render China less willing to engage wholeheartedly on other strategic priorities for the US such as managing North Korea, containing or rolling back Iran’s nuclear program, energy and climate diplomacy, and maritime security in the East and South China Seas and beyond.

Disappointing effects of continued RMB appreciation versus the Dollar

1) Don’t expect RMB appreciation to bring the US manufacturing sector back to its glory days. The labor and operating cost gap is too wide for even a major exchange rate increase to bridge. A prominent expert on US-China trade issues tells us he thinks appreciation of the RMB could create a few hundred thousand jobs—very meaningful to workers who get them, but only a fraction of the number of jobs that the bill’s supporters claim have been lost to Chinese currency manipulation. Based on average wage data from the US Bureau of Labor Statistics (2009), the US full-time worker earns approximately US$45,000 per year. By comparison, the average Chinese worker made slightly over US$2,600 per year in 2009, according to the National Bureau of Statistics. Electronics maker Hon Hai’s recent response to labor cost increases in its core Southeast China factory zone gives a more accurate indication of what further RMB appreciation might do to manufacturing. Hon Hai is preparing to spend billions of dollars to construct manufacturing bases to tap a lower cost workforce near the inland Chinese cities of Chengdu, Wuhan, and Zhengzhou, which could eventually employ nearly two-thirds of the firm’s workforce, according to the Wall Street Journal. In addition to moving to China’s interior, manufacturers facing higher labor costs from RMB appreciation would also likely relocate portions of their operations to countries such as Vietnam with even lower average wages than China’s. As such, the US would likely experience a diversification of its trade deficit, as opposed to a significant reduction.

Negative effects of continued RMB appreciation versus the Dollar

2) Inflation from higher commodity buying in China will likely put pressure on US consumers as commodity prices rise and potentially restrain US and global growth outside China. A more valuable RMB would make it less expensive for Chinese industrial firms and traders to purchase commodities that China needs such as crude oil, corn, coal, iron ore, and copper, which are often sold in dollar-denominated terms. Over the longer-term, a stronger RMB is also likely to boost domestic consumption in China, which stands to unleash sustained higher demand for oil (through rising vehicle ownership), electricity, grains (through higher meat consumption), as well as paper and aluminum as the domestic demand for goods packaging expands. This would be great news for Exxon and Alcoa as well as US farmers, but not for US consumers more generally.

3) China might purchase fewer dollars or rebalance its foreign exchange portfolio, creating downward pressure on the dollar and causing challenges for managing the US national debt and maintaining the dollar’s position as a key global reserve currency. In a recent piece in Caijing, Fudan University economist Sun Lijian points out that continued US pressure to increase the RMB’s valuation could force China to trim its US debt holdings, which could destabilize financial markets and reduce confidence in the dollar as a stable international currency. (如果美国这种强权的举措导致贸易货币国, 比如中国人民币大幅升值, 那么, 中国政府很可能不得不减持价值收到日益侵害的美国国债的比例, 这样也不利于美国金融市场和国际金融市场的稳定和作为世界信用货币的美元的稳定.)

Key positive impacts of continued RMB appreciation versus the Dollar

4) The bill draws a line in the sand with respect to mercantilistic Chinese economic policies and is a first step toward re-establishing the credibility of US economic diplomacy with China. The bill’s overwhelming passage through the House, combined with growing anti-trade sentiment in the US, is garnering attention in China. Over the past few weeks, Chinese media outlets have published many news and opinion pieces on the issue. By putting Beijing on notice that its key partner is ready to take tough action, Washington can help tip the internal debate in China in favor of those leaders who support a more free market economic policy approach.

5) Chinese companies would likely become more active in acquiring hard (i.e bricks and mortar) assets outside China, opening a new avenue of global investment and advisory opportunities. A stronger RMB would increase Chinese corporations’ ability to buy dollar denominated assets overseas. Sectors likely to see the most activity include natural resources, IT, and possibly real estate. Outbound investment would likely become more focused on North American and European assets than in the past, when frontier markets offered more attractively priced assets and a more welcoming posture concerning Chinese investment. In certain areas, this could introduce Chinese competition into the business and real estate sectors that American firms and property owners did not have to face previously.

6) A stronger RMB will be good for US companies that export to China. Many Americans don’t realize that the U.S. still has the largest manufacturing sector in the world, and that China is only now poised to assume the #1 global manufacturing position. US factories produced US$1.7 trillion worth of goods in 2009, while Chinese manufacturers produced US$1.6 trillion of goods, according to IHS Global Insight. A stronger RMB and its positive effects on Chinese consumers’ purchasing power will be positive for companies such as Caterpillar and Boeing that export high quality, high cost equipment.

7) A stronger RMB can help China move its economy onto a more sustainable path in which domestic consumption occupies a larger portion of GDP and higher value-added sectors such as IT receive more investment. More robust growth in value-added sectors with greater reliance on intellectual property can drive development of stronger rule of law in China, as inventors seek legal protection for the fruits of their labor.

The net effect for US consumers and the US economy from the Currency Reform for Fair Trade Act is likely to be neutral or even negative, which could leave voters disappointed and drive US economic diplomacy down a more protectionist path. Americans from all economic strata are casting an increasingly skeptical eye on trade, with 53% of respondents in a recent Wall Street Journal poll saying free trade agreements hurt the US (up from 46% in 2007 and 32% in 1999). Currency valuation is important but US economic and trade diplomacy with China should also strive to ensure that fair competitive practices are followed (i.e that state interference is minimized) and that the intellectual property of US-based firms operating in China is protected. It remains to be seen whether the Senate will pass the Currency Reform for Fair Trade Act, but the immediate concrete effects in terms of job creation and reductions in the US trade deficit would likely leave voters disappointed when the smoke cleared.

***

Gabriel B. Collins, “Salt of the Earth: BHP Billiton’s Bid for Potash Corp Likely to Drive Chinese Potash Investment in Belarus, Russia, and Africa,” China Signpost (洞察中国)™ 3 (18 September 2010).

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

A successful deal would give BHP control over more than 20% of global potash production. This share would rise as the Canadian deposits BHP already owns are brought online and additional capacity expansions are completed at mines now owned by Potash Corp. Potash Corp estimates that it will account for nearly one-quarter of global potash production in 2015, according to its latest investor presentations. Beijing is unlikely to want to become even more dependent on BHP Billiton, which is already one of China’s major iron ore and non-ferrous metal suppliers. China’s leaders are especially sensitive to foreign influence over supplies of grain and key agricultural inputs such as fertilizers, particularly one like potash that cannot be synthesized.

Potash is the only large-scale source of potassium for agriculture. Although potash is not applied as frequently as nitrogen fertilizers, going more than one season without potash application can have significant effects on grain productivity. Soybean test plots in Brazil showed a 29% decline in yield relative to the base year in years two and three and 75% decline in year four without potassium application.

Uralkali says 28% of China’s potash fertilizer use supports cultivation of rice, the national staple grain. USDA data show that during the last four market years, China’s rice production has exceeded consumption by an average of only 1.3%, a relatively thin margin for a country that is by far the world’s largest rice consumer (more than 135 million tonnes of demand projected for the 2010/11 market year). Food production problems could trigger serious unrest in China and other major rice consuming countries if potash supply issues increase production costs or cause production shortfalls that force China to import large quantities of rice.

BHP says it would eventually sell potash produced in Canada directly, rather than through the export cartel Canpotex, which controls 20% of global potash export volume. Beijing would likely be happy to see potash sales outside the purview of Canpotex, or for that matter, BPC, the other main global potash export cartel. Nonetheless, the potash market share that BHP would have would likely be perceived as a food security threat as China’s food consumption becomes increasingly meat intensive and demand for feed grains rise accordingly. For reference, producing a kilo of chicken requires more than 2 kg of grain, while pork requires an average of 3.5 kg feed grain, and beef, up to 8 kg of grain to produce 1 kg of meat.

Bottom Line:

Further expansion of domestic potash production at China’s flagship producer Qinghai Salt Lake is likely to be constrained by availability of fresh water supplies and countervailing demands for increased lithium and magnesium production from Qinghai’s salt lakes. Thus, securing foreign supplies of potash will remain a priority. There is a significant probability over the next six months that Chinese investors could purchase a stake in Belarus Potash Company and possibly Uralkali or Silvinit of Russia in order to secure existing supplies. To diversify future supplies and profit from growing global grain demand, Chinese fertilizer producers may also invest in frontier potash projects in Ethiopia and the Republic of Congo.

Potential outcomes, ranked by probability that event materializes by March 2011

1) (25%) Sinofert or other Chinese companies purchase a minority stake in Belarus Potash Company to help ensure stable supplies. Belarus has said it is willing to sell a large, but non-controlling minority stake and Chinese investors are said to have expressed interest.

2) (20%) Chinese investors seek long-term “loans for potash” agreements with Uralkali or Silvinit of Russia. Chinese banks already have “loans for resources” set-ups in place with Russian oil and coal producers, so there are strong precedents for such a deal in the potash space. Loans are more likely than share purchases. Uralkali’s free-float was only about 17% as of 15 June 2010 (last time company reported this data). Therefore, Chinese buyers would likely not be able to easily accumulate a significant minority equity stake on the open market. In addition, the probability of Uralkali and Silvinit merging in the near future is rising and Chinese investors may be hesitant to risk investing ahead of a merger while the Russian parties will likely not want to add another heavyweight to merger negotiations.

3) (20%) Chinese investors acquire greenfield potash resources in Africa. Allana Potash (Ethiopia) would be attractive due to its proven reserves and proximity to the Indian Ocean, over which potash could be easily shipped to China. Allana tells us China Minerals provided 35% of the project’s initial capex in exchange for the right to 20% of production at a discount to market potash prices. It also tells us production is likely to begin in 2013 and that production costs may be as low as US$80 per tonne, as opposed to Potash Corp, which produces at closer to US$150 per tonne. Locking up frontier assets would also reduce the options for other large miners that China depends on—such as BHP and Rio Tinto—to buy potash reserves. Chinese investors have access to state-backed financing and can also help build the infrastructure needed to develop the mines and export the potash produced.

4) (15%) Chinese consortium led by Hopu, China Investment Corp, or other major investor counterbids for entire Potash Corp or significant portion of company’s assets. A number of obstacles stand in the way of this happening. First, amassing more than US$45 billion in capital support to top BHP’s bid will be tough. Second, the government of Canada’s Saskatchewan province already expresses reservations about potential Chinese ownership of a critical asset like Potash Corp. Third, a range of North American agricultural interests would likely oppose Chinese ownership of one of their key fertilizer suppliers.

5) (10%) The Chinese government attempts to use its new anti-monopoly regulatory powers to block a BHP-Potash Corp merger.

6) (5%)  Chinese consortium seeks to purchase a minority blocking share in Potash Corp to hinder a sale to BHP. This tactic proved ineffective in 2008 when Chinalco bought a strategic stake in Rio Tinto and it is not likely a top arrow in the quiver of Sinofert or other Chinese fertilizer investors.

7) (5%) The proposed BHP/PCS deal is abandoned, no other acquisition attempts arise, and the market situation returns to its original state.

***

Andrew S. Erickson and Gabriel B. Collins, “Looking After China’s Own: Pressure to Protect PRC Citizens Working Overseas Likely to Rise,” China Signpost 洞察中国™ 2 (17 August 2010).

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

Numerous Chinese citizens are entering Africa and other conflict-prone areas, both as employees of large corporations and as individual entrepreneurs in pursuit of profit. There they face physical security problems including crime, terrorism, and fallout from internal conflicts. China’s nascent but growing power projection capability raises pressure for Beijing to intervene when PRC citizens are threatened. Combatant commanders, advisors, and other personnel in CENTCOM, AFRICOM, PACOM and other regions with internal security challenges and growing contingents of PRC citizens living and working within their area of responsibility (AOR), as well as policy makers and strategists in the United States, must understand these emerging dynamics. This article assesses China’s capabilities for intervening on behalf of Chinese citizens working overseas and the risks inherent in each option.

Context

In April 2007, seven Chinese oil workers were killed in Ethiopia during an attack on Ethiopian forces guarding a Sinopec facility. In 2008 nine Chinese oilmen were taken hostage in Sudan’s South Kordofan state; five perished in a failed Sudanese government rescue attempt. In April 2010, multiple bombs exploded at a dam construction site in northern Burma’s Kachin state, killing four Chinese workers, according to Reuters and Burma Rivers Network.[1]

Several factors increase the likelihood that the Chinese government may be more able and willing to respond with force to future hostage situations or other targeted violence against PRC citizens. The first is the growth in the number of PRC citizens in these areas. China’s Ministry of Commerce estimates that at the end of 2009, more than five million Chinese citizens were working overseas, up from just under 3.5 million at the end of 2005. The number of officially reported workers has grown at between 8.7 percent and 10.1 percent each year for the past four years. With 8 percent growth in 2010, there would be approximately 5.5 million PRC citizens working overseas.

We have canvassed a wide range of industry, media, and diplomatic sources to assemble a rough outline of the ‘footprint’ of PRC citizens working overseas. Of particular interest are countries with a significant risk of internal violence becoming serious enough that Beijing must consider NEO operations or an intervention under conditions where use of force may be necessary. Notable countries on the list include Nigeria with an estimated 45,000 PRC citizens and Sudan with an estimated 24,000 PRC citizens.

Nigeria’s oil-rich south remains unstable and the country’s leadership is scrambling to prepare for elections in 2011. Sudan faces the potential for serious violence driven both by the situation in Darfur and the looming independence referendum in South Sudan, since Khartoum is unlikely to want the South to become independent and take substantial oil reserves with it. The Democratic Republic of Congo has an estimated 10,000 PRC citizens living and working in country and this number is probably rising as higher copper prices increase mining activity. Ethnic Indians’ substantial economic influence in proportion to their numbers in Africa—especially Uganda, Tanzania and Kenya—has made them targets of economically-driven violence, and could portend similar trouble for the Chinese. To take the extreme example, in Uganda, Idi Amin dispossessed and expelled ethnic Indians in the early 1970s, and they had to wait decades before President Yoweri Museveni invited them back. Pakistan also hosts an estimated 10,000 Chinese workers and has been the site of fatal attacks on Chinese workers in the past (2004).

The second factor is the PLA’s nascent, but growing, force projection capacity. The Chinese Navy’s ongoing anti-piracy deployment in the Gulf of Aden likely reflects the changing official attitude regarding the protection of Chinese citizens’ commercial activities overseas. At least nine Chinese vessels have been hijacked by pirates operating from Somalia. In response, the PLA Navy has maintained an armed counter-piracy mission in the Gulf of Aden since December 2008. As of 30 June 2010, the PLA Navy had escorted more than 2,200 vessels in the Gulf of Aden and Indian Ocean off of Somalia. This increasingly muscular effort to protect Chinese ships and their valuable cargoes has yet to be matched on land, with its very different political and legal realities, but China’s increasing participation in UN PKOs may signal a shift toward greater comfort with distant land deployments.

As the PLAN anti-piracy mission continues, an open debate on China’s need for overseas bases has emerged. For the first time, officially sanctioned publications such as Global Times are carrying opinion pieces advocating the establishment of some form of overseas facilities for Chinese forces.[2] Some of the authors, such as Fudan University professor Shen Dingli, argue for an approach similar to the U.S. “places, not bases” concept, emphasizing facilities in strategic areas that can be quickly accessed but are low-cost and have a far lower profile than a large facility like Marine Corps Air Station Futenma in Okinawa, which can galvanize local opposition.[3]

The third factor is the Chinese leadership’s increasingly assertive worldview as the country emerges strongly from the deep global economic recession. Premier Wen Jiabao’s stiff-arming of President Obama at the December 2009 Copenhagen climate talks was noteworthy. As Beijing senses that its power is increasing relative to that of other major global players, it may become less willing to rely on others to provide security for Chinese nationals living and working overseas in places that are strategic and resource rich, but also often suffer from chronic instability and internal violence.

Also relevant are strong nationalist pressures of the kind that brought protesters into the streets to stone the U.S. Embassy in Beijing after the accidental targeting of the Chinese Embassy in Belgrade during Operation Allied Force in 1999. The nationalistic outpouring from bloggers, e.g. that following the April 2007 attack on a Sinopec facility in Ethiopia, in which nine Chinese workers perished, also reflects the rise of such pressures.

Intervention capabilities and risks

In part to deal with these emerging challenges, China has established a new, reinvigorated overseas Chinese affairs office under State Council control. In May 2007 the Ministry of Foreign Affairs established a division of consular protection under the Department of Consular Affairs. It is the ministry’s largest single department, with 140 staff in Beijing and more than 600 at China’s overseas consulates. Beijing’s present reliance on diplomatic channels to protect overseas workers can be seen in the cooperation between China National Petroleum Corporation and the Ministry of Foreign Affairs and the Ministry of Commerce to secure the release of nine of its workers after their kidnapping in Nigeria in 2007, and a similar, unsuccessful effort in Sudan in 2008.[4]

Over the last few years, Chinese embassy staff overseas have been designating rotating duty officers in charge of cell phones with their numbers posted on embassy/consulate websites, and land line backup at larger embassies. Emergency procedures have been established, which include consulting with the Ministry of Foreign Affairs in Beijing as necessary. Yet as Beijing faces further, perhaps more sophisticated attacks on its citizens overseas, other Chinese agencies may become involved, with attendant bureaucratic complications.

China’s evolving policy of peacekeeping involvement (e.g., in Africa, where as of July 2010 some 2,013 Chinese military personnel, police and observers were serving on peacekeeping missions) serves as a means of at once demonstrating international good will (a soft-power objective) and showing a willingness to engage in out-of-area military operations (a hard-power goal), in addition to participating positively in the existing international system. Such precedence might give Beijing, on balance, more latitude for using military force for the protection and rescue of Chinese nationals.

China has less power projection capability than other countries with significant numbers of citizens living and working in areas with security challenges. This power projection index uses current U.S. power capabilities as the baseline against which other nations’ are measured. Aerial refueling and long-range transport aircraft fleet size, deck aviation fleet size, number of naval medium and heavy helicopters, and level of special operations forces (SOF) support are the metrics used in the rankings.

The type of security threat is a key factor in deciding possible PRC government responses. Our basic framework differentiates between a non-targeted threat such as the criminal attacks faced by Chinese in South Africa and more systematic violence that is either: 1) directed towards Chinese such as that seen in Zambia during 2007 and 2008, 2) carried out by terrorist or rebel groups such as the 2007 attack on oil workers in Ethiopia, or 3) caused by civil strife or other collapse of order, such as that which might result from a 2011 South Sudan independence referendum.

Following future attacks of a systematic nature, there may be a greater push within the government to deploy Chinese police personnel to protect workers at Chinese firms’ overseas projects. In December 2009, China’s Global Times carried an extensive discussion of the possibility of using Chinese police forces to protect Chinese copper mining assets in Afghanistan.[5] One complexity here is that much of China’s security forces, especially those of the People’s Armed Police, have tight links to the military and their deployment would likely be viewed by local and international parties as tantamount to stationing of military personnel abroad.

Chartering commercial aircraft, as Beijing has done to evacuate citizens from Thailand and Equatorial Guinea during civil unrest in 2008 and Thailand and Kyrgyzstan in 2010, is still likely to be the lowest risk (and thus preferred) evacuation option. China’s nationally-flagged airline, Air China, has more than 60 inter-continental range aircraft that might be pressed into service during an evacuation. So long as an area has suitable airfields, China already possesses indigenous air assets that could evacuate Chinese expatriates and assets from a nearby conflict zone. No aerial refueling would be needed—only landing rights at secure airfields as well as over flight clearance.

Large Chinese companies can also hire foreign private security providers. A prominent private security firm tells us it counts a number of large Chinese firms as clients and that “in the last few years, we have definitely seen an increased interest by Chinese energy, natural resources and construction firms seeking expert advice on the political, operational and security risks associated with their investments/projects in Africa, Middle East and other far-flung locations.”[6]Another major security firm told us that it would like to increase its work for Chinese clients operating in high-risk areas.[7] Beijing might ultimately rather see private contractors engaging in sensitive activities than risk the diplomatic fallout that could result from sending military or paramilitary (PAP) personnel overseas to protect Chinese workers and assets.

Overall, private security providers are a logical solution for large companies facing threats in Sudan, Nigeria, and other volatile areas. That said, smaller firms and individual entrepreneurs in the same hot zones will likely not be able to afford private security. Commercial shippers were reportedly paying upwards of US$25,000 per trip for armed security to escort them through the pirate-infested Gulf of Aden in early 2010. Longer-term contracts in regions with real, but lower, probability of attack will cost less on a time basis, but even a purely advisory relationship is cost-prohibitive for smaller firms facing tight margins and substantial price competition.

Chinese businesspeople who cannot afford private security services may choose to arm themselves, further escalating any confrontations that occur. Individual Chinese traders and businessmen in select countries will likely be largely invisible to Beijing until a high profile attack or systemic violence erupts, at which point China’s government will be placed in a reactive position and face nationalist pressures to intervene on their behalf.

This leaves the intervention and evacuation options that are much more likely to require military force, and that with a few exceptions, are operations that only states can typically conduct. Situations in which Chinese working abroad are abducted are one such case. When the Qingdao-based coal carrier Dexinhai and its crew, which included 25 PRC citizens, was taken by pirates off Somalia in October 2009, the Chinese Defense Ministry said it would take “whatever measures are necessary” to free Dexinhai and its crew, presumably including military action since the PLAN had forces in the Gulf of Aden at the time.[8] The vessel was ultimately released in late December 2009 after the payment of a US$4 million ransom, but military action abroad will be an increasingly realistic option as China’s long-range transport and SOF capabilities improve.

Non-combatant evacuation operations (NEOs) can be very demanding in terms of coordinating air and sea platforms operating far from their home bases and in potentially hostile areas. Operation Sharp Edge, a large-scale evacuation of American citizens from Liberia in 1990, involved four vessels and 2,100 Marines.[9] Yet China will likely continue to pursue increasingly significant NEOs, even if they do not approach this operational level. It has a come a long way since its first NEO, from the Solomon Islands in 2000. There ethnic tensions threatened Chinese citizens, but Honiara then recognized Taipei, so Beijing had to run operations out of its embassy in Port Moresby, Papua New Guinea. Following its usual practice of working with local Chinese organizations and federations to collect information and disseminate advisories, diplomats obtained situational updates from local Chinese. Having obtained the telephone number of the local rebel leader and the section of the city he controlled, they called him and negotiated safe passage before dispatching a COSCO ship and evacuating approximately 120 Chinese, as well as arranging flights out of the country. Apparently the PLAN may have been asked to send a vessel but was unable to do so; today things might be completely different. Subsequently, China has organized a variety of NEOs, including from Fiji during the 2006 military coup.

Sea Evacuation

The Somali piracy problem has made the political climate for muscular major-power naval operations more permissive than it was before, and Chinese power projection capabilities are growing. China’s Type 920 Anwei hospital ship, commissioned in 2008, might conceivably be used to support ill or injured Chinese in a crisis overseas (e.g., in Africa). Training vessel 082 Shichang can be configured into a hospital ship. It can support two helicopters, as can Type 071 landing platform dock 998 Kunlunshan. A number of Chinese destroyers and frigates can support up to two helicopters each, and could play a limited role in a NEO operation.

In the future, a dedicated helicopter carrier would be particularly useful for sea evacuation in a hostile area. A carrier offshore would offer better operational-security and -flexibility than would land-based alternatives that require permission from potentially hostile governments or risk exposure to mortar bombardment, IEDs, and other attacks.

Sea-based evacuation operations with rotary wing aircraft increase a commander’s options, as the NEO is not tied to one airfield. In addition, a vessel relatively close to the evacuation area has more options in terms of time slots for launching aircraft. Finally, armed helicopters can accompany the evacuation helicopters if the situation dictates, providing a level of firepower that long-range military aircraft with embarked security forces lack. The PLA does not have the capability of the U.S. to conduct a helicopter NEO. In Operation Eastern Exit (1991), USS Trenton launched CH-53E choppers from more than 450 miles offshore at night and successfully evacuated the U.S. Embassy in Mogadishu.[10]

China’s military is years from having this level of capability. The PLA(N) is still very weak in helicopters; most are short-range platforms that cannot carry many people. Its attack helicopters have short range and limited warloads. The PLA has mostly short-range Z-9Gs, and a higher level of joint cooperation would be required before ground force helicopters operated off a Navy platform.

To respond to a distant crisis on short notice, Beijing could requisition the Chinese-flagged merchant vessels nearest to the crisis zone and, in conjunction with chartered aircraft, could use them to help rescue Chinese expatriates. Beijing’s ability to locate and summon PRC-flagged vessels benefits from the China Ship Reporting (CHISREP) System, which requires Chinese-registered ships over 300 GT engaged in international routes to report position daily to the PRC Shanghai Maritime Safety Administration.[11] This capability has been used before. In January 2008, following coal shortages caused by snowstorms, the Ministry of Communications requisitioned bulk carriers from China Shipping Group and COSCO and pressed them into service hauling coal to help replenish stockpiles.[12]

Air Evacuation

If the situation on the ground is too dangerous for a chartered commercial aircraft to safely land and embark passengers, the PLA Air Force (PLAAF) has 14 Ilyushin IL-76MD transport aircraft, which could probably evacuate at least 120 people apiece. An IL-76MD operating from China’s westernmost airbase at Kashi could fly to Khartoum or Nairobi and then onward to and from any destination in Africa with 100 passengers without any need for aerial refueling. The IL-76MD could also carry up to 45 tons of vehicles and materiel if physical assets needed to be evacuated.

Conclusion

While great uncertainties remain, the chances of Beijing using force to protect citizens overseas are rising. The growing presence of Chinese citizens in volatile areas potentially creates a number of scenarios that could inspire armed Chinese NEO operations, even near areas where U.S. forces may be based or operating. For all this progress, however, Beijing’s acute sensitivity regarding sovereignty issues makes it highly unlikely to intervene on another nation’s soil without explicit permission. In the event of a crisis, China is likely to supply intelligence, and its security personnel might work with their local counterparts, with an emphasis on isolating and evacuating Chinese nationals. But it is at sea that we are already witnessing the most dramatic developments. China’s ongoing anti-piracy mission in the Gulf of Aden is arguably the first step in overseas military deployments to protect PRC citizens working overseas.

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Andrew S. Erickson and Gabriel B. Collins, “Oversea Trumps Overland: China’s Oil Supply Future is Maritime,” China Signpost 洞察中国™ 1 (26 May 2010).

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

  • China is now the world’s second-largest oil user.
  • 40% of its oil comes by sea.
  • Pipelines will not reduce China’s growing seaborne oil imports.
  • Increasing reliance on sea lane security worries Chinese policy makers.
  • Growing maritime capabilities increase both China’s combat potential and its ability to make collective security contributions.
  • 5 Chinese task forces to the Gulf of Aden have rescued 23 vessels from pirates so far.
  • China’s Type 920 Daishandao/Peace Ark (岱山岛号, AHH 866) hospital ship will reportedly conduct humanitarian operations in the Middle East and Africa in 2010.
  • China’s former Ukrainian Kuznetsov-class aircraft carrier Varyag will likely become operational around 2012 and be used for training.
  • China will probably have a domestically produced carrier operational after 2015.
  • Like the U.S. and Chinese navies in general, China’s carriers will have humanitarian as well as combat uses.
  • Washington and Beijing can pursue common interests even amid their disagreements.

In the latest of sporadic attacks on infrastructure associated with Burma’s junta, bombs recently exploded at a controversial hydropower project being built jointly with Beijing’s state-owned China Power Investment Corporation. This underscores the challenges China faces in helping to construct an oil pipeline through restive Burmese minority regions. A senior scholar informs us that China has been particularly careful in addressing issues surrounding Burma’s Wa minority because of the politically and physically vulnerable pipeline.

So why allow such sensitive issues to condition Beijing’s foreign policy? A major factor: oil. Chinese demand, growing rapidly, has reached 8.5 million barrels per day (mbpd) and the country likely became a net gasoline importer by the end of 2009. While still a very significant oil producer, China is now the world’s second-largest oil user. It imports more than half of its crude oil, with imports of 4.9 million bpd in March 2010. Seaborne imports constitute more than 80 percent of this total. At present, therefore, 40 percent of China’s oil comes by sea.

China’s oil security concerns will determine to what extent China will seek to transform itself from a continental to a continental-maritime power. China’s dynamic maritime development already demonstrates significant movement in the maritime direction.

Chinese security analysts and policy makers worry about their nation’s “excessive” reliance on seaborne oil shipments. Many believe that by investing in pipelines from neighboring oil producers like Russia and Kazakhstan and building additional lines to “bypass” the Malacca Strait, China can protect its oil imports from possible interdiction during a conflict. A robust internal debate is being waged within China at multiple levels regarding how to ensure access to oil supplies. At stake is the extent to which China should cooperate with international economic institutions versus seeking unilateral military solutions; should develop as a maritime versus continental power; and should focus on defending against state, as opposed to non-state, actors.

Despite this diversity of opinion, a wide variety of influential Chinese experts, including scholars, policy analysts, and members of the military, believe that the United States can sever China’s seaborne energy supplies at will and in a crisis might well choose to do so. It is widely claimed, for instance, that “whoever controls the Strait of Malacca effectively grips China’s strategic energy passage, and can threaten China’s energy security at any time.”

Such views are widely cited to justify the development of a nationally-flagged tanker fleet, as well as pipeline construction, which is proceeding rapidly. China already has seventy thousand kilometers of oil and gas pipelines and aims to reach ninety thousand km during the Twelfth Five- Year Plan (2011–15).

Yet China’s overland oil supply plans appear largely to be driven by a combination of incomplete assessment of security issues and lobbying by sectoral and local commercial and political interests of an overtaxed national energy policy-making apparatus.

At present, the Kazakhstan–China pipeline is operational, a Russia–China line could become operational by late 2010 (and is likely to be in commercial operation by 2011), the Burma–China pipeline is now under construction, and a China–Pakistan pipeline remains entirely aspirational.

Some projects—such as the line from Russia that is now under construction and an existing line from Kazakhstan—are indeed economically viable overland conduits that will bring at least limited diversity to China’s oil supplies. Others, however, like the Burma pipeline and especially the proposed line via Pakistan, make much less economic and security sense.

In the end, pipelines are not likely to increase Chinese oil import security in quantitative terms, because the additional volumes they bring in will be overwhelmed by China’s demand growth; the country’s net reliance on seaborne oil imports will grow over time, pipelines notwithstanding. Chinese decision makers must face the fact that, barring discovery of an economically viable large-scale substitute for crude oil, their nation’s dependence on seaborne imports will likely only increase. Cooperative steps to safeguard free markets and the seaborne flow of energy imports will best support Chinese access to reliable, affordable oil supplies in the future.

The U.S. and China, now the world’s two largest oil consumers, share an interest in maintaining secure, stable, and affordable oil supplies. They should consider establishing a joint petroleum inventory reporting system. Their navies should address maritime crises in areas far from sensitive areas surrounding China and the U.S. (e.g. preventing Somali pirates from hijacking tankers in the Gulf of Aden). While it is indeed developing anti-access capabilities that could threaten the presence of the U.S. military and those of its allies and friends in the Western Pacific, China is also commissioning and deploying surface platforms that enable it to make positive contributions to the security of the global maritime commons.

Since 26 December 2008, China’s navy has dispatched twelve ships in five counter-piracy task forces to the Gulf of Aden. As of 20 March 2010, these forces had escorted 1,768 ships in 179 convoys. Sixteen Chinese naval operations have rescued 10 Chinese and 13 foreign-flagged vessels from pursuit by pirates.[1] As of 25 December 2009, 3,300 Chinese naval personnel had participated and 405 foreign vessels had been escorted.[2] China’s purpose-built hospital ship, the Type 920 Daishandao/Peace Ark (岱山岛号, AHH 866), is now operational, having completed an initial mission in the South China Sea. As the first of what will reportedly be annual international deployments, Peace Ark is slated to conduct humanitarian operations in the Middle East and Africa in 2010.[3]

Admiral Robert F. Willard, Commander, U.S. Pacific Command, recently testified before Congress that he “expect[ed]” China’s former Ukrainian Kuznetsov-class aircraft carrier Varyag “to become operational around 2012 and likely be used to develop basic carrier skills.”[4] The Office of Naval Intelligence estimates that “the PRC will likely have an operational, domestically produced carrier sometime after 2015.”[5] Scott Bray, Senior Intelligence Officer-China, ONI, assesses that “China likely intends to use aircraft carriers to bring the air component of maritime power to the South China Sea and other regional areas to protect Chinese sea lanes, shipping, and enforcing maritime claims. Additionally, an aircraft carrier would likely be used in regional humanitarian assistance and disaster relief missions.”[6] As they pursue shared interests even amid areas of strong disagreement, Washington and Beijing should also consider establishing a joint threat reporting database for vital Sea Lines of Communication (SLOCs). Washington should also encourage Beijing to join the International Renewable Energy Agency (IRENA); as well as the International Energy Agency (IEA), to facilitate closer SPR management cooperation.

[1] “Sailing into the Storm: International Praise for Chinese Escort Fleets Protecting Merchant Ships against Somali Pirates,” Beijing Review, 19 April 2010.

[2] Li Xiaokun and Peng Kuang, “Anti-Piracy Special: Calming Troubled Waters,” China Daily, 29 December 2009.

[3] Senior Captain Duan Zhaoxian, Assistant Chief of Staff, PLA Navy, presentation in “Session 5: Humanitarian Assistance and Disaster Relief,” Maritime Security Challenges Conference 2010, Maritime Forces Pacific, Canadian Navy, Victoria, British Columbia, 29 April 2010.

[4] Statement of Admiral Robert F. Willard, U.S. Navy, Commander, U.S. Pacific Command Before the House Armed Services Committee on U.S. Pacific Command Posture, 23 March 2010.

[5] The People’s Liberation Army Navy: A Modern Navy with Chinese Characteristics (Suitland, Md.: Office of Naval Intelligence, July 2009), p. 19.  

[6] Quotation obtained from ONI Public Affairs Office.

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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.

This article was required reading for the Naval War College National Security Decision Making Department’s Strategy and Theater Security course.

It is widely believed in China that overland pipelines would greatly enhance the security of its oil supply. Market and geopolitical analysis, however, shows that they would not. Chinese decision makers must face the fact that, barring discovery of an economically viable large-scale substitute for crude oil, their nation’s dependence on seaborne imports will only increase. The Chinese would be better advised to explore cooperative steps to safeguard free markets and the seaborne flow of energy imports.

This article assesses the relative dependence of China (as a consumer) on seaborne oil flows between now and 2025. China’s oil security concerns will help shape its military and policy priorities fundamentally, with significant implications for the U.S. Navy in coming years. For the present, it underscores a question of fundamental importance concerning China’s strategic orientation: To what extent will China seek to transform itself from a continental to a continental-maritime power?

Chinese oil demand, growing rapidly, has reached 8.5 million barrels per day (mbpd), even amid the global recession. China became a net oil importer in 1993 and likely became a net gasoline importer by the end of 2009. While still a very significant oil producer, China is now the world’s second-largest oil user. It now imports half of its crude oil, with imports reaching a record 4.6 million bpd in July 2009. Seaborne imports, which overland pipelines will not reduce, constitute more than 80 percent of this total. At present, therefore, 40 percent of China’s oil comes by sea.

Chinese security analysts and policy makers worry about their nation’s “excessive” reliance on seaborne oil shipments. Many believe that by investing in pipelines to deliver oil from neighboring oil producers like Russia and Kazakhstan and building additional lines to “bypass” the Malacca Strait, China can protect its oil imports from possible interdiction during a conflict. A robust internal debate is being waged within China at multiple levels and across a number of disciplines regarding how to ensure access to oil supplies. At stake is the extent to which China should cooperate with international economic institutions versus seeking unilateral military solutions; should develop as a maritime versus continental power; and should focus on defending against state, as opposed to nonstate, actors.

Despite this diversity of opinion, a wide variety of influential Chinese experts, including scholars, policy analysts, and members of the military, believe that the United States can sever China’s seaborne energy supplies at will and in a crisis might well choose to do so. It is widely claimed, for instance, that “whoever controls the Strait of Malacca effectively grips China’s strategic energy passage, and can threaten China’s energy security at any time.” Such views are widely cited to justify pipeline construction, which is proceeding rapidly. China already has fifty thousand kilometers of oil and gas pipelines and will nearly double the amount, to ninety thousand, during the Twelfth Five- Year Plan (2011–15).

Yet as this analysis will demonstrate, China’s overland oil supply plans may largely be a “pipe dream,” driven by a combination of a misunderstanding of global oil market mechanisms, incomplete assessment of security issues, and the lobbying by sectoral and local commercial and political interests of a massively overtaxed national energy policy-making apparatus. Some projects—such as the line from Russia that is now under construction and an existing line from Kazakhstan—are indeed economically viable overland projects that will bring at least limited diversity to China’s oil supplies. Others, however, like the proposed lines through Burma and Pakistan, make much less economic and security sense. In the end, pipelines are not likely to increase Chinese oil import security in quantitative terms, because the additional volumes they bring in will be overwhelmed by China’s demand growth; the country’s net reliance on seaborne oil imports will grow over time, pipelines notwithstanding.

The first portion of the analysis will examine operational and prospective pipelines oriented toward China. At present, the Kazakhstan–China pipeline is operating at partial capacity, a Russia–China line could become operational by late 2010 (and is likely to be in commercial operation by 2011), the Burma–China pipeline is now under construction, and a China–Pakistan pipeline remains entirely aspirational. The second portion of the study will examine Chinese views of how pipelines might enhance China’s oil security and assess the potential for, and utility and disadvantages of, a pipeline-centric oil-security strategy. The final, and concluding, section will suggest how China might enhance its energy security at lower financial and diplomatic cost. … … …

***

Gabriel B. Collins and Lieutenant Commander Michael C. Grubb, U.S. Navy, A Comprehensive Survey of China’s Dynamic Shipbuilding Industry: Commercial Development and Strategic Implications, Naval War College China Maritime Study 1 (August 2008).

China’s dynamic shipbuilding sector now has the attention of key decision makers in Washington. During testimony before the Armed Services Committee of the House of Representatives on 13 December 2007, Chief of Naval Operations (CNO) Admiral Gary Roughead observed, “The fact that our shipbuilding capacity and industry is not as competitive as other builders around the world is cause for concern.” Pointing directly to Beijing’s new prowess in this area, he concluded, “[China is] very competitive on the world market. There is no question that their shipbuilding capability is increasing rapidly.” The present study aims to present a truly comprehensive survey of this key sector of the growing Chinese economy. In doing so, it provides decision-makers and analysts with the clearest possible picture of the extraordinary pace of activity now under way in China’s ports, as well as the commercial and strategic implications flowing from this development. … … …

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Gabriel B. Collins, Andrew S. Erickson, Lyle J. Goldstein, and William S. Murray, eds., China’s Energy Strategy: The Impact on Beijing’s Maritime Policies (Annapolis, MD: Naval Institute Press, 2008).

China’s rapid growth has prompted Beijing to undertake an aggressive search for resources on a truly global scale. The resource most directly tied to continued growth in China is energy. Rising consumer appetites in China, coupled with occasional rolling blackouts due to spiraling demand in Chinese cities, have prompted intense anxieties in China concerning energy security. Since 80 percent of Chinese fossil fuel imports pass by ship through the Malacca Strait, an important component of Beijing’s concerns have come to be known in China as the “Malacca Dilemma.” This book draws on America’s finest experts in the fields of economics, energy, China studies, and naval strategy in order to explore China’s “Malacca Dilemma” and its implications for global maritime security.

The essays in this volume draw from a wide variety of viewpoints, but a central theme of the analyses is that the United States needs to be concerned that China is drawing upon much of the world’s remaining oil reserves for its exclusive use. The resulting competition for this diminishing resource could lead to energy insecurity and may support other tendencies toward rivalry that in turn could foster a naval arms race neither side seeks. One of the major conclusions of this study is that there is, in fact, ample room for Sino-American energy dialogue and cooperation in the maritime domain and that the competition for limited energy sources like oil need not lead to conflict.

The book’s authors are all authorities in their fields; many of the contributors are frequent advisers to major oil, shipping, and other multinational corporations, as well as governments. As a result, this volume takes into account an unprecedented range of influences and factors befitting such an important and complicated topic.

This is the second book in the series “Studies in Chinese Maritime Development” published jointly by the China Maritime Studies Institute and the Naval Institute Press.

Information on Chinese-language edition:

[美] 加布里埃尔·B.柯林斯 [Gabriel B. Collins], 安德鲁·S.埃里克森 [Andrew S. Erickson], 莱尔·J.戈尔茨坦 [Lyle J. Goldstein], 威廉·S.默里 [William S. Murray], 编者[Editors]; 李少彦 [Li Shaoyan], 姜代超 [Jiang Daichao], 薛放 [Xue Fang], 刘宏伟 [Liu Hongwei], 译者[Translators]; 中国能源战略对海洋政策的影响 [China’s Energy Strategy: The Impact on Beijing’s Maritime Policies], 海洋战略与海洋强国论丛 [Maritime Strategy and Maritime Great Power Forum Series], 十二五国家重点出版物出版规划项目 [Twelfth Five-Year Guideline State Key Publications Planning Initiative] (Beijing: 海洋出版社 [Ocean Press], 2015).

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Gabriel B. Collins and William S. Murray, “No Oil for the Lamps of China?” Naval War College Review 61.2 (Spring 2008): 79–95.

The ubiquitous Made in China stickers and labels on consumer products remind us daily of China’s incredible economic rise. The world is accustomed to this powerful phenomenon and seems to expect that China’s economy will grow at 10 percent annually for at least another decade. Such remarkable economic progress has lifted millions of Chinese out of poverty and also substantially benefited the global economy. It is also arguably the cornerstone of Chinese Communist Party legitimacy.

Western and Asian hunger for inexpensive Chinese goods fuels much of this growth, but China’s economic engine cannot run without imports of raw materials, such as bauxite, iron ore, timber, and, perhaps most significantly, crude oil. Once a significant exporter, China became a net importer of crude in 1993 and now struggles to deal with this dependency.

Chinese security analysts fear that oil import dependency is a potential pressure point that could be exploited by future adversaries of the People’s Republic of China (PRC). Approximately 80 percent of China’s 3.3 million barrels per day (bpd) in crude oil imports passes through the Straits of Malacca. Such funneling could facilitate interdiction of China’s oil lifeline in times of crisis. The United States, India, and Japan are all seen as potential blockaders, but Chinese observers appear to believe that only the United States has both the capability and the will to blockade oil shipments to China. One recent Chinese article postulates that the most likely triggers of an oil blockade of China include a fight over Taiwan and a situation in which China’s rise becomes hostile and directly threatening to other major powers.

Some Chinese analysts argue that the need to protect shipments of oil and other vital raw materials is a key driver behind the PRC’s intensive aerial and naval modernization programs. Yet despite impressive improvements, the People’s Liberation Army Navy (PLAN) lacks the ability to defend the sea lines of communication (SLOCs) over which Chinese oil supplies flow. Among other limitations, the PLAN lacks guaranteed access to ports for refueling, repairing, and replenishing as well as adequate numbers of at-sea-replenishment vessels necessary to support long-range missions. More fundamentally, the PLAN rarely undertakes long-distance operations, which would provide vital training and experience for SLOC-protection missions.

In contrast, some of Beijing’s potential adversaries have decades of blue-water experience, world-class logistical capacity, global access to replenishment ports, and doctrine and equipment oriented toward warfare on the high seas. Beijing’s strategists recognize this disparity and are presumably devising plans to counter any possible future efforts to cut China’s petroleum umbilical cord.

This article examines potential Chinese responses to possible forms of energy blockade. The first two sections discuss how a distant blockade might be conducted and surveys possible Chinese responses to such an action. The third section hypothesizes a close blockade and then analyzes potential courses of action in response. The fourth section examines the possibility of a “blockade by convoy,” while the final section considers an energy-denial strategy that would target China’s ability to transport and process crude oil.

The authors conclude that an energy blockade of China would not only fail to achieve its objective but also send destructive shock waves through the global economic and political landscape. Frankly discussing energy sea-lane security will, ideally, promote trust and lay a foundation for deeper energy security cooperation between China and other major oil consumers. … … …

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Andrew S. Erickson, Gabriel B. Collins, Lyle J. Goldstein, and William S. Murray, “Chinese Evaluations of the U.S. Navy Submarine Force,” Naval War College Review 61.1 (Winter 2008): 68–86.

Republished as a two-part series:

Perhaps partly inspired by the great successes of the U.S. submarine force, navies around the world have invested heavily in undersea warfare, especially in submarine capabilities. China stands out among these as an emerging submarine power. Over the last decade, Beijing has been building four different classes of boats while importing the Kilo-class diesel submarine from Russia in large numbers. Indeed, China’s intense focus on undersea warfare has led some to speculate that a transpacific rivalry is already under way, at least with respect to submarine capabilities. As policy makers in Washington grapple with the challenge of China’s rise, therefore, it may be wise to consider how Beijing is approaching its evolving naval strategy dilemmas.

This article examines Chinese views of the American submarine force. As that submarine force constitutes one of the most vital elements of Washington’s overall strategy for establishing and maintaining sea control in times of conflict, Beijing’s assessment of those capabilities may be critical to uncovering the future evolution of this nascent rivalry. The U.S. Navy submarine force is thought to represent a key capability for conflict scenarios involving China. This part of the U.S. Navy has undertaken major efforts at transformation within a new geostrategic and technological environment. The American submarine force represents a rather well-defined warfare area and thus lends itself to a bounded research effort.

Overall, this article finds that Chinese naval analysts study the U.S. submarine force in excruciating detail, as concretely manifested in thousands of both strategic and technical articles that focus on it. Such assessments underline the importance of a closer examination of Chinese perspectives concerning the American submarine force. … … …

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