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China: Fierce Dragon or Asthmatic Lizard?
I am moving all this over to the Resources Section, because there is so much material in one thread, dealing with China.

You hear it over and over again, China will be the next superpower, China will replace that U.S., lookout, here come the yellow hords. But is it fact or fiction reason or fancy? This is a thread to examine the proposition, to separate fantasy from reality.

China has a population of 1,300,000,000 while the U.S. has a population of 300,000,000. There are differing opinions on what will happen,

but they all agree China has severe internal challenges to meet the projections. Having been to China several times, I have some observations and problems with some of the commentary.

1- Often, it is forecast China will follow Japan's path. If it does, it is a foregone conclusion China will pass the U.S. on an aggregate if not on a per capita basis. But there are problems with this analogy stemming from the fact that China and Japan are quite different in many ways. Japan was and is a democracy, China is not. Japan has a long history of internal order and discipline, China has a long history of internal discord, chaos and internal disorder. Japan is a small island nation, China, a large continental nation. Japan existed and exists inside of the protective U.S. aura, Chain exists increasingly in opposition to the U.S. sphere. How these will pan out I frankly haven't decided but, they suggest the analogy is limited.

2-The world is different now. During Japan's post WWII rise, the globe was dominated by a manufacturing economy (industrial age) which played to many strengths of Confucian culture. However, the planet is now moving to an Information Age economy which play to strenghs very much lacking in Confucian culture
(egalitarianism, personal responsibility, free open and honest communication, democracy).

3-China is almost astoundingly overpopulated. Although it is a geographically large country, much of China is unusable desert and mountains. Hence, the coastal belt contains and will continue to contain most of it's population. I believe that demographically, environmentally and socio-politically, this reality will force many Chinese decisions to go in towards social harmony which will in the end hinder long term economic growth.

4-China has been, is now and will be in the future astoundingly corrupt. While this is tolerable for a rapidly developing early stage economy, it is anti-thetical for a developed economy.

In short, I am not pessimistic about China nor do I believe the U.S.-China relationship need be overly problematic. I am, however, suspicious of many of the shallow rosy scenario thinking about China one finds the norm today.
Here are some interesting article on China, that appeared in Stratfor within the last couple of years. Fortunately, I posted them over at IAP and can bring them back for all of us to read.

This first one is about the unrest in the PRC, but it also goes over the contitions in China and what are seen as potential disruptions. Check this one out. It ought to keep you busy.

Quote:The Shanwei Shootings and China's Situation
December 13, 2005 21 17 GMT

By George Friedman

Last week, a group of Chinese villagers staged a demonstration against a wind-power project near Shanwei, a town in Guangdong province about 100 miles from Hong Kong. In the first incident, protesters blocked access to the site of the wind-power generation project. The next day, Dec. 6, demonstrators returned. According to Chinese official reports, they were led by three men -- Huang Xijun, Lin Hanru and Huang Xirang -- and were armed with knives, steel spears, sticks, dynamite and Molotov cocktails. Members of the local People's Armed Police fired tear gas at the crowd, hoping to break things up, but the three leaders rallied the crowd to continue what, depending on who was telling the story, was either a protest or attack. According to the description of events given by the Chinese government, the demonstrators started to throw explosives at the police as night fell. The police opened fire. Official reports said that three people were killed, eight wounded.

The protests in Shanwei had gone on for quite a while before coming to a head last week. The land for the power project was confiscated a few years ago. The farmers who worked the land were never compensated for their dislocation. They formally petitioned for their money in 2004 but were ignored. Public demonstrations began in August 2005, continuing intermittently. With no compensation forthcoming, the protests escalated and then exploded, with last week's incident marking the first reported shootings of demonstrators in China by official security forces since Tiananmen Square in 1989.

The shooting is new. The pattern is not. There has been intensifying unrest in China over the past year -- frequently, as in this case, over issues that have been simmering for years. This has been particularly true for peasants who have seen their land confiscated by the government for industrial projects. Money is issued to local officials by state-owned enterprises and other investment groups to cover the cost of the land. That money passes through the regional and local bureaucracies. By the time it should reach the owners, there often is nothing left; it has been stolen by officials at various levels. No one denies the farmers' claims to the land, but no one acts to compensate them. The laborers go from being small farmers to being destitute.

This is a critical process at the heart of Chinese industrialization. The purchase of land, including forced sale, is considered necessary for Chinese economic development. However, Chinese economic development is driven as much by corruption as by land. The government in Beijing has no particular desire to see the farmers dispossessed; on the contrary, the money is made available for delivery to the farmers. But the diversion of funds is hard-wired into the process. It is one of the primary means for capital formation in China.

One of the paths to entrepreneurship in China is to become a government official who can use one's public office for personal savings and networking -- accumulating enough money and useful contacts to move into business later. With massive expropriations of land over the past decade designed to facilitate economic growth, the opportunities -- and compulsion -- to steal money intended for farmers is powerful. In order to hold onto his job, a government official must maintain a system of relationships with superiors, colleagues and subordinates. These relationships are based on money. If the official doesn't find the money to hold his place in the bureaucracy, he will lose it. Therefore, the diversion of funds is built into the system.

The Chinese government wants it both ways. On the one hand, it does not want unrest among farmers. On the other hand, the Communist Party elite in Beijing live by patronage. They have risen through the system because of the web of relationships that makes Chinese industrialization possible. They can, in very specific cases, take action against cases of corruption. However, a systematic attack on the causes of corruption is impossible, without a systematic attack on their own infrastructure.

This is particularly true in rapidly developing provinces like Guangdong. The interface between the new economy and the old has become a battlefield. The old economy was land-based: Mao created a peasant economy that was overlaid by attempts to industrialize. The new economy regards land as an input into the industrial machine. However, given the nature of the Chinese political system, the farmers are not simply bought out -- they are forced off the land. And that can lead to social explosions.

The recent events in Shanwei are unique only in that they resulted in gunfire and death, and because they were brought to light by the anti-Communist media. After these reports were picked up and widely circulated by the international media, the government in Beijing acknowledged what had occurred, adding details that appeared to show that the demonstrators forced the police into shooting. But later, the government announced that the head of the police unit involved had been arrested -- which seems to imply that the story as originally told by the Chinese wasn't altogether accurate. Why arrest the cop if explosives were being hurled at police?

The specifics of what happened, of course, have no geopolitical consequence. What is important is that tensions in China have been rising steadily. Thousands of demonstrations (74,000, according to figures released last year by the government) have taken place -- some reportedly violent, if not fatal. In one case earlier this year, residents protesting corruption related to land seizures took control of their town, forcing the police out. The Chinese government appeared to capitulate to the demonstrators, giving into their demands -- but weeks later, those who had participated in the rising were quietly arrested. In another incident, which also turned deadly, brute squads believed to have been hired by local officials and businesses attacked protesters. There are numerous other examples to draw from.

Beneath the surface, a number of things are taking place. The Chinese economy has been growing at a frantic pace. This is not necessarily because the economy is so healthy, nor because many of these industrial projects make economic sense. In fact, the government in Beijing has been very clear that the new projects frequently don't make a great deal of economic sense, and has been trying to curb them (though it does not necessarily command obedience in every case from provincial or local governments). On the other hand, China needs to run very hard to stay in place. Within what we will call the entrepreneurial bureaucracy -- with pyramiding, undercapitalized, highly leveraged projects being piled one on top of the other -- new investment projects are needed in order to generate cash that stabilizes older, failing projects. Slowing down and consolidating is not easy when there are bank loans coming due and when money has to be spread around in order to maintain one's position in the system.

That means that aggressive economic growth is needed. It also means that massive social dislocation -- including theft of land -- is embedded in the Chinese system. The flashpoint is the interface between the rapidly spreading industrial plants and the farmers who own the land. The bureaucratic entrepreneurs need not only the land, but also the money that legally is due to the farmers.

China is a mass of dispossessed farmers, urban workers forced into unemployment by the failure of state-owned enterprises, and party officials who are urgently working to cash in on their position. It is a country where the banking system has been saved from collapse by spinning off bad debts -- at least $600 billion worth, or nearly half the GDP of China -- into holding companies. This maneuver cleaned up the banks' books and allowed Western banks to purchase shares in them, shoring them up. But it also left a huge amount of debt that is owed internally to people who will never see the funds. Imagine the U.S. savings-and-loan scandal growing to a size that was nearly half of the national GDP. As it happened, in the United States the federal government swallowed a great deal of the S&L bad loans -- but in China, these bad loans would just about wipe out the country's currency reserves, assuming that the numbers provided by the government are valid.

Under such circumstances, it is no surprise that Chinese money is leaving the country, flowing into the safe havens of U.S. T-Bills or offshore mineral deposits. Moreover, it is not clear that China's economy is continuing to grow. China's imports of oil have topped out and, by some reports, have started to decline -- yet the Chinese are continuing to report unabated growth rates. How can the economy be growing rapidly while oil imports decline? The country lacks sufficient energy reserves to fuel such growth, nor can that level of growth be coming from service industries. At any rate, growth rates do not by themselves connote economic health. The rate of return on capital is the ultimate measure of economic success. Anyone prepared to lose money can generate rapid revenue growth. And anyone facing cash-flow crises due to debt burden knows how easy it is to slip into revenue-growth obsession. The Chinese certainly have.

There is, therefore, a tremendous tension within China's new economy. The root problem is simple: Capital allocation has been driven by political and social considerations more than by economic ones. Who gets loans, and at what rates, frequently has been decided by the borrower's relation to the bureaucracy, not by the economic merits of the case. As a result, China, as a nation, has made terrible investments and is trying to make up for it with rapid growth. That is where things get difficult: As before with Japan and East Asia, the economy is thrown into a frenzy of growth in efforts to stabilize the system, but that growth throws off cash that cannot easily be capitalized and therefore is invested abroad. Meanwhile, bad debts -- stemming from continued investment into nonviable or unprofitable businesses, for social or political reasons -- surge, and the government tries to come up with ways to shuffle the debt around. In other words, the origin of the problem is simple -- but the evolution of the problem becomes dizzyingly complex.

This leads to stresses within the advanced economic sector. In China's case, these manifest as competition between different political factions for access to the funds needed to maintain their enterprises. But that is nothing compared to the tension between the new economy and farmers and the unemployed. As the system tries to stabilize itself, it seeks both to grow and to become more efficient. As it grows, the farmers are forced to give up their land. And as it seeks efficiency, industrial workers lose their jobs.

This is an explosive mix in any country, but particularly so in China, which has a tradition of revolution and unrest. The idea that the farmers will simply walk away from their land or that the unemployed will just head back to the countryside is simplistic. There are massive social movements in play that combine the two most powerful forces in China: workers and peasants. Mao did a lot of work with these two groups. Their interests are now converging. The decisions of the bureaucratic entrepreneurs are now causing serious pain, which is becoming evident in increasing social unrest. At Shanwei, that unrest broke into the open, complete with casualties.

The important thing to note is that both the quantity and intensity of these confrontations is increasing. While the Western media focus on the outer shell of China's economic growth -- the side that is visible in Western hotels throughout major cities -- the Chinese masses are experiencing simultaneously both the costs of industrialization and the costs of economic failure. The sum of this equation is unrest. The question is how far the unrest will go.

At the moment, there does not appear to be any national organization that speaks for the farmers or unemployed workers. The risings are local, driven by particular issues, and are not coordinated on any national scale. The one group that tried to create a national resistance, Falun Gong, has been marginalized by the Chinese government. China's security forces are capable, growing and effective. They have prevented the emergence of any nationalized opposition thus far.

At the same time, the growth and intensification of unrest is there for anyone to exploit. It won't go away, because the underlying economic processes cannot readily be brought under control. In China, as elsewhere, the leadership cadre of any mass movement has been made up of intellectuals. But between Tiananmen Square and jobs in Westernized industries, the Chinese intellectuals have been either cowed or hired. China is now working hard to keep these flashpoint issues local and to placate localities that reach the boiling point -- at least until later, when arrests can be made. That is what they are doing in Shanwei. The process is working. But as the economy continues to simultaneously grow and worsen, the social unrest will have to spread.

The discussion about China used to be about "hard" and "soft" landings -- terms that were confined to economics. The events in Shanwei raise the same question in another domain, the political. Police shooting down demonstrators is not an everyday event in China or anywhere else. But it has happened, and this event didn't just come from nowhere. The question of soft and hard landings now must be considered more literally than before.

And in China, hard landings over the past couple of centuries have been bloody affairs.

Here are two more for you to read. Wink1

Quote:Geopolitical Diary: China's Economy, Out of Control
June 15, 2006 02 09 GMT

China announced Wednesday that industrial production increased in May more rapidly than at any time in the past two years. Output rose 17.9 percent compared to May 2005. The numbers exceeded expectations. Exports in May rose by 25.1 percent while domestic retail sales grew by 14.2 percent. In other words, the Chinese government's campaign to slow China's overheating economy is not working. On the contrary, the economy is accelerating.Read the other article below to understand this statement.

That is why the People's Bank of China (PBC), China's central bank, issued a statement Wednesday saying that banks should be concerned about the potential risks associated with the rapid increase in lending, following a meeting between PBC officials and representatives of China's banks. China's M2 -- the broad measure of China's money supply -- grew at 19.1 percent year-on-year, outstripping government targets. More important is the fact that Chinese banks, which are provided annual targets for the amount they should make in loans, have already loaned over two-thirds of that amount -- with more than half a year to go -- and it appears that the rate of lending is accelerating.

Put very simply, the Chinese economy is out of control. One would think that the faster the growth, the better the economy; but at a certain point -- and in this case -- that is not so, which is why the PBC is trying to get control of the situation. The problem is the massive overhang of debt, and in particular, troubled loans. Looked at from the standpoint of Chinese corporations, servicing this debt is a tremendous burden. Looked at from the standpoint of Chinese banks, the loans threaten the banks' viability if they become nonperforming.

The solution of Chinese companies is to sell more products to generate cash to pay off the loans. It is difficult to sell into the Chinese economy because of high savings rates, driven by government policies and economic insecurity. The Chinese government needs a high savings rate to help stabilize the banks; dramatically increasing domestic consumption would undermine the savings rate, threatening the banking system just as surely as defaulting loans would. The solution for these companies, therefore, is to increase exports. In a world already saturated with Chinese exports, the only way to increase cash flow is to cut already low prices. That increases cash flow but does nothing for profitability. In other words, companies already saddled by debt burdens cut into (or below) profit margins to service the debt.

The banks, meantime, do not want to write off nonperforming loans. The trick is to keep them performing -- at least to some extent -- since the definition of a "troubled" loan is both more elastic and less devastating to a bank's balance sheet. To do this, the banks arrange to lend more money to troubled enterprises. This allows some repayment of old debts, but simply puts off the day of reckoning on all sides (and increases the magnitude of reckoning when it arrives). Thus, bank lending accelerates at a breakneck pace -- not going into market-driven opportunities, but maintaining essentially failed enterprises for a while longer. Production surges at lower prices and the entire process moves faster and faster.

The problem is that any slowdown in economic growth decreases cash flow from imports, cuts into debt payments, and increases nonperforming loans until the entire edifice starts to collapse on itself. This is what happened to Japan in slow motion in the 1990s, and to Southeast Asia with dizzying speed in 1997.

The Chinese government knows it needs to slow down growth to avoid hitting a brick wall. It also knows that slowing down the economy can threaten the entire banking system. It is therefore engaged in setting restrained economic targets and expansionary economic policies simultaneously. It is caught between a rock and a hard place. At a certain point, Chinese companies will no longer be able to grow their exports rapidly. In the case of China, it is the speed bump that is the brick wall. Slowing down is dangerous and speeding up disastrous.

At this moment, therefore, the Chinese economy, incredibly, is speeding up. Virtually every economic indicator we see -- with allowances given for uncertainties in Chinese statistical methodology, to put it politely -- is surging out of control. It has been clear to the Chinese government for a while that this is coming, and it is now clear to the Western media that China is in trouble. Business Week, which has normally written breathlessly enthusiastic articles on the Chinese miracle, ran one this week entitled "China: Big Economy, Bigger Peril?"

Here is the second, earlier part, that will help you understand the former article.

Quote:China: Banking on Shifting Growth to the Interior
April 27, 2006 17 15 GMT


China's central bank announced April 27 that it is raising interest rates and requested that banks reduce the amount of credit they are extending. The bank's moves reflect China's attempts to slow its breakneck, and increasingly unhealthy, growth in its coastal regions while shifting investment to the interior.


China's central bank announced April 27 an increase in its benchmark interest rate from 5.58 percent to 5.85 percent, effective April 28. It is the first increase since October 2004. The central bank also requested that the China's many banks voluntarily restrict lending in order help slow down economic growth.

In a free market system (that is working well) higher rates lead to a more realistic and rational allocation of capital. Thus, a hike in interest rates in the United States makes some borderline investments no longer attractive. China's system, however, does not work that way.

In China money is not considered a limited resource. The combination of the yuan peg and subsidized loans allow firms to expand broadly without regard for profitability. The residential construction sector is perhaps the best example. Between building for the 2008 Olympics and the sheer challenge of sheltering 1.2 billion people, China's need for housing is astronomical, and as expected, some one-sixth of all loans granted go to efforts to build more housing. But the structures being built are not structures Chinese citizens need. As such, China has a housing shortage, but 700,000 empty apartments.

Similar trends exist across all sectors, with investment flowing into either high- or low-end products for which there is little demand. That sustained surge in mindless growth has made China one of the largest consumers of a host of raw materials in the world, but has earned it just under 5 percent of global gross domestic product (GDP). China's numbers do indicate growth, but to see it as healthy growth one must have a very skewed perspective.

[Image: 1_13_china_shares.JPG]

China's problem is that slowing this growth is not easily done. In addition to the ossified political links between state-owned firms and state-owned banks and local governing officials (all of whom have vested personal interests in keeping the cheap money flowing) -- which make political moves on the issue cumbersome -- as lousy as these firms are, they do employ people. The last thing the government wants to do is put 100 million or so people out of work in a country with as powerful regional crosscurrents as China has (but more on that later). Thus, the central bank paired its hike to financing costs with a request that China's banks ease off a bit -- the unspoken goal being that if banks tighten up credit, then perhaps all those inefficient firms will begin treating money like a resource worthy of conserving.

But there is more to the Chinese appeal than the headlines reveal. China wants growth and wants it desperately. One of the many lessons China has learned by coming late to the game of Asian development is that one's economy can be stable only if it has domestic demand. Economies based on exports alone (as China's currently is) will fall, and fall badly. Raising interest rates specifically dampens the sort of domestic consumer demand China so desperately wants and needs. This step was taken only because China faces an even larger problem.

China wants growth, but it wants more of that growth in specific places. China's rulers have always struggled to keep the outward-oriented coastal regions in sync with the more insular interior. Whenever one of the two regions becomes too disparate relative to the other, China suffers a catastrophe that re-establishes the balance.

In the late 19th century, China's coastal regions in effect declared economic independence from the interior, throwing their fates in with foreign powers, giving rise to Western spheres of influence on the coast. When Mao's revolution began, he had to go to the interior to gather forces. And in order to re-establish China's internal balance, he had to wreck the coastal economies in the Great Leap Forward and the Cultural Revolution.

That balance is again out of whack, but this time around, the Chinese government would prefer to raise the wealth of the interior instead of decimating the coast. It is not so much about dampening growth, as redirecting it. And therein lies the subtext of the central bank's request to curb lending. The government does not want breakneck growth on the coast. The coast has had its turn, and a glance at fixed investment rates and residential disparities indicates how unstable China is: Beijing wants growth in the interior in order to prevent any Long Marches leading to the Politburo.

Earlier this year, the government formally adopted a new five-year plan that can be summed up as "send your money west." At the time, we noted that we did not expect many businessmen, particularly the state-owned enterprise sort, to heed the call. In fact, we expected those businessmen to turn to more exotic sources of funding. The more reputable turned to overseas banks, the less reputable to loan sharks. We also noted that the central government would begin making ever more direct appeals, eventually turning into threats -- and ultimately punishments -- should the business community not follow the central diktat. The central bank has now raised financing costs and called on the banks to slow the flow of loans. Next come the threats.

Let's not stop there. Here is more. BTY, I'm still looking for the Stratfor Decade outlook, which will give you a wonderful analysis on it's Huge Banking Problem.

Here is another article, from Stratfor, on the same vein.

Quote:Global Market Brief: Beijing's New Effort to Limit Loans
June 15, 2006 21 03 GMT

China has come under increasing pressure to address looming bank crisis. To address the situation, it has considered numerous options to curb lending, many of which have unwanted side effects -- or simply do not work.

The People's Bank of China (PBC) announced June 13 it is offering "special bills" to Chinese banks. Offering, however, is not the right word. It is forcing banks to buy these bills -- at paltry returns -- to reduce the amount of cash the banks have in hand, thereby limiting the number of loans Chinese banks can make.

China's trade surplus brings in foreign cash, which the PBC buys with freshly printed yuan, thus increasing the liquidity in the system. This excess liquidity has enabled loose lending practices. Thus, China's banks are flush with cash -- and contributing to investment and real estate bubbles. Furthermore, banks have funded unsound projects under dubious lending practices, untempered by a healthy understanding of risk. These banks have been bailed out so often that risk assessment is meaningless to them. The consequent loans to unreliable investors and businesses promise to plague China with more nonperforming loans (NPLs) in the very near future.

Cooling off its economy is necessary for China's survival. When real estate and investment bubbles burst and investors lose confidence in China, there will be a drop in new investment. And without a steady pace of investment, China will face an unemployment crisis, which will translate into a political crisis.

All of the policy prescriptions for cooling down the economy, however, come at a price. One option is to let the yuan float, which would invariably lead to its appreciation. This is something the United States has pestered China to do for quite some time now. A revaluation of the yuan would slow the influx of Chinese goods into foreign markets as their prices rise. It would also hurt Chinese agriculture as foreign agricultural products -- namely rice -- become cheaper on the Chinese market than domestically grown rice. And this will stoke what Beijing fears most: unemployment. Unemployment not only threatens the economy, it threatens social stability, and hence, the Chinese Communist Party's (CCP) grasp on power. The CCP has managed to retain power thus far because it has delivered economic benefits. Not being able to deliver these benefits because of an economic slowdown, however, would spell disaster for the Party.

A second option to deal with the money glut would be to raise interest rates. This would make it less attractive for investors to take out loans, but it would also make servicing existing loans more difficult, pushing more loans on the brink of sustainability into the NPL category.

Rejecting these two options leaves the government with few mechanisms for restraining lending. Beijing has presented another option -- forcing banks to buy "special bills" issued by the PBC. This proposal is aimed especially at banks that have refused to rein in lending. Banks have already lent $26.2 billion in the first five months of 2006 -- two-thirds of the total target for the year, making lending 16 percent higher than at the same time in 2005. This has caused the overall money supply to rise 19 percent -- a level also exceeding government targets.

The new measure was tested June 13 when the PBC absorbed $12.5 billion by issuing one-year bills. The yield on the bills was set at 2.1138 percent, lower than the 2.48 percent rate of return normally offered by the bank. Beijing set the new yield rate as a message to unruly lenders: curb lending or face the consequences.

The new special bills constitute a stopgap measure to preserve China's banking system for just a while longer -- until another stopgap measure must be instituted. Chinese investors and banks are inured to Beijing telling them to slow down without taking any significant steps to back up its orders. When Beijing did enact a loan freeze in 2005, investors just went to the underground economy or to foreign banks to get loans. Furthermore, China's stopgap measures do not address the NPL problem, which is a major block in a teetering Chinese superstructure.

Beginning in January, when China is mandated by the World Trade Organization to open its banking sector to foreign competition, investors and businesses can go to foreign bank subsidiaries in China for loans. Then the fun will really begin.

Here is the latest of what STRATFOR has to say about China. Indeed Interesting.
Quote:China: Crisis and Implications
Jun 20, 2006

By George Friedman

The Chinese government is continuing efforts to cope with its runaway economy. The People's Bank of China has raised interest rates. Banks have been told to curb lending. The government has said that it will implement procedures to rein in foreign acquisitions at low prices -- or, in other words, to block fire-sales of Chinese companies. As a recent headline in the Japan Times put it, "China's Monetary Surge Dooms Its Boom."

A lot of things have gone into dooming China's boom, and the money surge is one of the more immediate problems. However, as we have argued (and this article should be read in the context of past analyses), the end of the Chinese boom was inevitable. The issue now is how all of this will play out in China and in the world.

What must be understood is that China now is moving from an economic problem to a socio-political one. The financial problem is a symptom; the fundamental problem is that tremendous irrationality has been built into the Chinese economy. Enterprises that are not economically viable continue to function through infusions of cash. Some of the cash comes from borrowing, some by exporting at economically unsustainable prices. The result is a squandering of resources. The reasons that this continues have nothing to do with economic rationalism and everything to do with political and social reality.

If interest rates were to rise and lending were to become disciplined, many of China's enterprises would fail. This would bring several consequences.

First, and most important, it would result in a massive increase in unemployment. At this point, the irrationality has been going on for years. It is not only state-owned enterprises that are economically unsustainable; many newer enterprises, including those in which Western companies have invested, are not succeeding. When we look at the figures for nonperforming and troubled loans, they amount to nearly half of China's gross domestic product. That represents a lot of irrationality, a lot of financial failures and a lot of unemployment. And unemployment is a political and social problem. The question is whether China politically can afford the economic solution.

Second, lending has become a system for maintaining the political solidarity of China's elite. Loans have been made not only to avoid the problem of unemployment; they also were made as part of political arrangements that allowed the Chinese Communist Party and regional party organizations to avoid conflict and divisions. As long as the pie was growing, everyone could have a piece. But if the pie starts contracting, there will be losers and winners. The question of who will go bankrupt and who will not will become a highly divisive and potentially destabilizing political crisis. Again, the economic solution -- austerity -- and political reality may run counter to each other.

Obviously, China has massive cash reserves. These may not be massive enough to cover the financial crisis, but they are sufficient to allow the government to put off addressing the problem for a while. China also has the ability to promulgate rules and regulations that allow bankrupt entities to continue functioning. However, it always must be remembered that on the other side of a bad loan is a damaged creditor. A loan that can be deferred by fiat is an asset that can no longer be used. When you avoid economic disaster for the debtor, you transfer the pain -- and potentially the disaster -- to the creditor. And since the creditor is normally the economically healthier entity, you postpone the death of the weak by weakening the strong. The more you do this, the worse it becomes. Thus, whether the Chinese use cash reserves to postpone the problem or use regulation to do so, the net result will be buying time at the cost of increased pain.

China's Likely Path

Asia has been here before. Japan encountered this problem around 1990, and East and Southeast Asia encountered it in 1997. Roughly three models for dealing with the problem exist:

Japan model: Use reserves and formal and informal measures to avoid actions that would trigger massive bankruptcies and unemployment. Accept economic stagnation for the better part of a generation.

South Korea model: Move rapidly to restructure the economy, using economic and political means. Control social unrest with security measures. Move out of the problem in a matter of years.

Indonesia model: Lacking resources to manage the crisis, suffer both financial dysfunction and political strife among the elite and between regions.

Japan was able to do what it did because it is a highly disciplined, cohesive society, in which shared pain is viewed as preferable to social dislocation. South Korea was able to do what it did because the magnitude of its crisis was relatively less than Japan's, and because the state had the means for suppressing unhappiness. Indonesia failed to do what it needed to do because it lacked resources and political power.

Other countries have fallen somewhere along this continuum. China will make its own path. However, it should be pointed out that China is not socially similar to either Japan or South Korea. Like Indonesia, China is a diverse and divided nation. The Communist Party lost its moral standing in the 1970s. As with Suharto's government, its legitimacy now derives from the fact that it has created prosperity. When prosperity slows down or stops, the Party cannot fall back on inherent legitimacy, as was the case with the system in Japan. And the wildly diverse levels of economic development make a single, integrated solution, as was used in South Korea, unlikely. The most likely direction for China, therefore, is massive social and political instability.

Now, the Communist Party may lack moral authority, but it does wield tremendous power. The People's Liberation Army and the various security forces are an enormous presence in China. Indeed, the government already is using its security forces aggressively, cracking down on dissent and against at least some business leaders, in anticipation of coming troubles. The ability to suppress unrest is not trivial. Therefore, the most likely path for China in a post-boom environment is to increase suppression and reimpose systematic dictatorship.

This is not an absolute given. There are many in the Party who now are arguing that China has abandoned its Communist principles and its social base. In other words, they want to reach out to the peasants in the interior, who have benefited little from the boom and who resent the prosperity of the coastal regions. The idea is to use these peasants in a process of renationalization -- or, at least, a process in which the free market is dramatically limited and at least some of the wealth is redistributed.

This goal makes little economic sense, but what China needs economically is unsupportable socially and politically. Imposing a crushing austerity for five to ten years would solve the economic problem, but it is unlikely that the political center could hold. Indeed, if the Chinese were to follow this course, they could do it only with massive political suppression at the same time.

The Party's Tangled Web

Therefore, one likely path is the reimposition of dictatorship, followed by whatever economic solutions the leadership might want to make. But there is a problem here: The interests of Party and People's Liberation Army leaders in Shanghai diverge from those of the central government. These leaders are deeply involved in the financial process of the coastal area, in bringing in foreign investment, in taking advantage of the nonmarket access to capital. They have no inclination to stop. Indeed, their wish is to see the irrational boom continue as long as possible.

There are splits in the interests of regional Party leaders, as well as a split between the regions and Beijing. The interests of coastal leaders lie not with Beijing so much as with Tokyo, New York and London. They have integrated themselves in the international financial system, and they are busy making plans for sustaining their regional enterprises in the event of a crisis. Meanwhile, Party leaders from the interior are demanding that these actions be stopped and that investment flow to their regions instead. Beijing is riding two horses that are running in very different directions.

Beijing well might fall off the horses. China has a history of cycling between a dictatorial system that closes it off from the world (a poor, but equal and stable China) and a system in which China is open to the world but torn apart from the inside out. Consider: Mao marched into the interior, raised a peasant army, came back and liquidated the internationalist bourgeoisie in 1948. He closed off the country and united it, throwing out the foreigners. Under the other model, preceding Mao, the country was open to foreigners, who tore it apart in regional conflicts while the interior starved.

The end result of China's economic crisis, therefore, will be a deep-seated political crisis. Only ever-increasing amounts of money have allowed China to maintain the current political alignment. Without that, it has two options. The first is a return to some sort of dictatorship from Beijing, under which economic problems would be dealt with inefficiently but unambiguously. The other is to accept a split between the coastal regions and the interior, the weakening of Beijing's authority and a period of instability and intense regionalism. It all depends on the political moves Beijing is making now, but our bet would be on the latter course. The instruments of power that Beijing has are too complicit in the financial crisis, and have too many diverging interests, to make the first option likely.

Geopolitics and Ripple Effects

Two possible geopolitical models emerge from this. Under one -- in its extreme form -- China returns to some sort of geopolitical Maoism. It encloses itself from the world, becomes increasingly bellicose but is limited by its own geography in what it can do. Under the other model, China slowly fragments and becomes a cockpit for the ambitions of foreign economic interests -- backed up by political and military power, with regional Chinese officials collaborating with foreigners to continue economic development. Oddly, the latter model would be more destabilizing to the world than the former, inasmuch as everyone will want to maintain their investments in China and expand them. In this scenario, China would again be a magnet for problems.

Mind you, these are not absolutes, but represent extremes on a continuum. There is surely a model under which Beijing would muddle through, as have the Japanese or Indonesians. No coherent strategy would emerge; it would all be tactical. It is difficult for us to see how this would not lead to regional destabilization, but then, China might be able to live with that. How it handles the unemployment and displaced peasant issue, however, is yet another question. This is a possible mid-point on the spectrum, but not in itself likely, it would seem.

As for the effects on the international economy, there has been a great deal of discussion about China's ownership of U.S. Treasury instruments and the consequences if that money were withdrawn in a crisis. In fact, this is the last thing that is going to happen. If China has a massive financial crisis, no one -- including the Chinese government -- is going to shift money from a safe haven into an uncertain cauldron. In crisis, the tendency would be a flight to safety. That means that rather than being pulled out, money would surge into the U.S. market -- legally and illegally, from the Chinese standpoint.

It is interesting to correlate the massive U.S. market surges that began in 1991, after the recession, and intensified dramatically in 1997 and 1998, with trends in Asia. In both cases, these surges followed major economic crises in rapidly expanding Asian economies. The events were, in our opinion, linked. The crisis in Japan in 1990 and 1991 led to major capital flight and helped to fuel the U.S. market rise. Similarly, the impending and expected East Asian meltdown in 1997 produced massive capital flight from Taiwan, South Korea and elsewhere to safer havens. A massive withdrawal from the U.S. market is the last thing to be expected.

What are in danger, of course, are foreign investments in China. There is the obvious financial issue: Many of these investments were not economically viable to begin with. But there is a political problem as well. The Party is going to have to blame someone for China's troubles, and it will not be the leadership. The obvious culprits will be corrupt officials and their paymasters in the international banking system. The truth or falsehood of the charge will matter little; corrupt officials and bankers already are being arrested, in the early stages of the crisis. As the situation intensifies, we would not be surprised to see foreigners investigated for corrupt practices as well.

But the bottom line is this: China has a history of nationalization and expropriation, and the party that enacted those measures is still in power. No one would have believed that the Party of Mao possibly could have become what it is today, but one should not assume that the evolution of the Chinese Communist Party is complete. Leaders could find that they have reason to re-enact some of Mao's own economic policies. We would be surprised to see a complete return to Maoism. We would not, however, be surprised to see the Party deliberately reverse some transactions that are no longer in its interests or (as and if things get more intense) take even more radical steps. It is still a Communist Party, it might be useful to recall.

Ultimately, the choice that China is now making is how quickly it will allow the consequences of its economic irrationality to unfold. The economic answer to the problem is to let shaky enterprises fall -- but the political cost of doing so will be too great, and a solution has already been long delayed. The longer an economic solution is delayed, the less one becomes possible and the more intense becomes Beijing's need to address the problem with political and security solutions. The more dependent the Chinese become on such measures, the more catastrophic will be the consequences if these solutions don't work.

China is long past the point of being able to solve the problem easily. The question is simply whether to buy time and pay in intensity, or force the crisis now. At some point, there no longer will be a choice. But the single most important thing to understand is that China does not really have an economic crisis any longer. The time for that has come and gone. There is now a political crisis at hand.

Here is another post about PRC and its threats to Tiawan.

Quote:Obviously other countries are taking China and it's stance to Taiwan and other neighbors seriously. Some of them are beginning to take action.

Check this out.

In the coming months, US and Japanese military officers and defense officials will be sitting down in Tokyo, the Pacific Command in Hawaii and Washington to determine ways to put muscle into the swiftly maturing alliance between the US and Japan.

If all goes well, those efforts will produce a joint declaration by US President George W. Bush and Japanese Prime Minister Junichiro Koizumi next autumn that will reflect the most fundamental and far-reaching revision of the alliance since the US-Japan Security Treaty was rewritten in 1960.

The critical feature: The US and Japan will transform their security bond from one of senior partner-junior partner to one of more nearly equals in policy and strategy, even if the military power of the US still overshadows that of Japan.

Among the vital issues to be worked out, Japanese and US officials say, are:

One, roles and missions, in which Americans and Japanese will decide on a division of labor and which forces will be responsible for what missions, to make best use of those forces and to preclude duplication.

Two, expanded combined operations and training, especially between Japan's Ground Self-Defense Force and the US Army and US Marine Corps. The navies and air forces, which already coordinate many operations, would do more of the same.

Three, sharing intelligence as the Japanese, in particular, strengthen their ability to collect and analyze information and then to meld it with intelligence produced by US services.

Four, revised war plans, a touchy subject that officials are reluctant to discuss in public. A US official said, however: "We continually review our bilateral coordination mechanisms and processes."

Five, moving a US Army corps headquarters to Japan from the US to put it in the region where it would operate and into close proximity to Japan's Ground Self-Defense Force for combined planning, training and operations.

Six, researching and building a combined ballistic missile defense that would be aimed first at the missile threat from North Korea, which fired a missile over Japan in 1998, and then at the longer range threat from China.

All of this is part of US Secretary of Defense Donald Rumsfeld's plan for a rigorous overhaul of the US military posture in Asia. It calls for dismantling the many-layered command structure in South Korea, consolidating control into a streamlined US headquarters in Japan, reducing US forces in South Korea and giving those that remain a regional rather than a local mission.

When US and Japanese officials began discussing the realignment of US forces in Japan, the US focused on the command element while the Japanese sought to reduce the friction of US bases next to Japanese neighborhoods. Before the negotiations went far, the two sides agreed that they needed basic reassessment of the alliance.

In Japan, Koizumi formed a commission on security led by a prominent business executive, Hiroshi Araki of Tokyo Electric Power. The commission recommended in October last year that Japan forge an "integrated security strategy" through "strategic consultations" with the US.

Then came two declarations in Tokyo and one in Washington that would have been unthinkable five years ago from a Japan that had wrapped itself in a pacifist cocoon after the devastating defeat of World War II.

In December, Koizumi's government published a new defense guideline and a plan to expand Japan's defenses over the next five years. The guideline said: "Japan's defense forces are the ultimate security of its national security."

The guideline further said(rt)0314p09.tif Japan should "engage in strategic dialogue" with the US to include role-sharing, intelligence exchange, cooperative operations, exchanges of technology and "efforts to make the stationing of US forces in Japan smoother."

Last month, Japan's Foreign Minister Nobutaka Machimura, Defense Minister Yoshinori Ohno, US Secretary of State Condoleeza Rice and Rumsfeld met in Washington to approve "common strategic objectives" that called for US and Japanese forces to "maintain the capability to address contingencies affecting the United States and Japan."

Machimura said that the strategic dialogue has three stages: The review of strategic objectives just concluded, an examination of Japanese and US missions and capabilities now started, and scrutiny of US bases in Japan.

Japan and the US have thus come a long way in sixty years. In April 1945, US and Japanese troops were locked in the bloody battle of Okinawa in which 250,000 people, including 150,000 Okinawan civilians, perished. Today, Japanese and US military officers sit side by side poring over maps and tables to figure out how best to deter mutual adversaries in the future.

And there's more.

Quote:Here is a portion of what Strategic Forcasting has to say about China, Japan and Taiwan. Perhaps if there are more interested, I will post the portion dealing with Asia.

Note that China's options are few. They are about to go through what their famous curse suggests. They are about to live through 'interesting' times/

As China's economy triggers social upheaval, other Asian states will look for different sources of strength and regional leadership. The alternative to China is Japan, and Japan is embarking on a more aggressive assertion of its leadership role in Asia and seeking to spread its influence and security sphere along its energy supply lines through the Indian Ocean to the Middle East. This process will continue through the decade.

Japan already has the capability of projecting its military power better than China. Although the Chinese possess a larger fleet of Landing Ship Tanks (LSTs) and landing craft, they lack important logistical and support elements necessary to project maritime power. China's navy also lacks a sufficient number of large-scale and advanced landing ships -- amphibious assault ships and dock landing ships. Although China can eventually build these capabilities, Japan already has the experience and the technical ability to sustain forces overseas for extended periods of time. Its involvement in Iraq -- where Japan has 900 troops, naval vessels, helicopters and aircraft (the biggest deployment since 1945) -- and Aceh, Indonesia, demonstrate that. By the end of the decade, Japan also intends to have a significant aerial refueling capability, which is essential for power projection. China's aerial refueling capability continues to be based around the aging H-6. With no deliveries of the Backfire bomber, the H-6 continues in the bomber role and few have been converted to aerial refueling. Finally, Japan has the experience of training with the United States and its allies for decades.

Japan is a modern state suffering from a lasting economic malaise and looking to reshape its role while seeking new economic strength and security. The Japan of the Cold War was content to rely on Washington for its security needs, and the unnatural state of the world's largest economy protecting the fundamental interests of the world's second largest economy with little outlay by Tokyo is long gone.

Japan sits in a volatile region, and the United States is looking to establish Tokyo as a cornerstone of an enhanced regional security alliance system. With Japan watching a fading China, however, Tokyo is unlikely to stand by and simply watch the downturn -- and unrest -- and wait to see what happens. Tokyo will seek to exploit the economic advantage, supporting coastal areas of China, backing Taiwan and generally assisting in the disintegration of the Chinese state apparatus.

Looking at a China that is fanning the flames of nationalism, Taiwan will seek to align itself with Japan, because Tokyo can offer Taipei security benefits that Beijing cannot. This situation will feed on itself: China will react strongly to a Taipei-Tokyo axis, and Chinese reaction will prompt closer cooperation between Taiwan and Tokyo.

And HERE is what I was looking for, in which I posted the Far East Decade Forecast From Stratfor. I am lucky to have found all this.


East Asia

In its 1995-2005 decade forecast, Stratfor said: "We strongly feel that the last decade's surge in East Asian economies will be peaking early during the 1997-98 cycle." This proved very prescient. We also said it was "extremely unlikely" that China's growth spurt would continue. And while China did see a dip in its growth rates following the Asian economic crisis, it hopped back on the wagon relatively quickly.

The 2000-2010 forecast for East Asia centered on China and Japan. Regarding the latter, we noted that "the country likely to take a leading role in Asia is Japan" -- an assessment we see playing out. Japan's shift toward formalizing its role as a military player rather than remaining solely an economic player has accelerated since the Sept. 11 attacks in the United States. Japan's movement toward military power also illustrates Stratfor's core idea for East Asia in the 2000-2010 forecast: Nations that had relied on their economies in the previous decade as the sole measure of their international standing and influence would move toward a "more balanced reality in which economic power by itself will be supplemented by political and military power."

On China, we said, "Our forecast is for a deeply troubled China, increasingly torn by domestic strife, with a government, in the face of it, alternating between brutal repression and helplessness." China appears to be facing no such intense struggle, at least on the surface. However, not far below these placid waters swirls a mix of economic, social, political and security issues waiting for the slightest external stimulus to bring them bubbling to the top.

As for the rest of East Asia, we said, "The Korean Peninsula will become the epicenter of tensions in Northeast Asia" -- a forecast we see taking shape. In Southeast Asia, we said, "Indonesia will continue to be the center of attention as it struggles to maintain unity and redefine its role among its neighbors" - again, a prediction we still stand by.

On the whole, Stratfor's long-term East Asian forecasts have been right on the money. However, we have always been bearish on China -- not for ideological reasons but for structural ones -- and our forecasts, which we believe remain fundamentally accurate, have not matched the bullish view that others give to the Chinese economy and national status. Our view of China's future is in stark contrast with the positive outlooks we see coming from investment houses and others.

One key reason for the difference is that most forecasts on China are linear -- in essence they say that since the Chinese economy is clipping along at 8 percent or 9 percent GDP growth each year, in 10 or 20 years China will dominate the global economy. Our basic supposition, however, is that the shape of the world today is probably the least likely shape of the world a decade or two out. The world operates in cycles, long and short, and linear extrapolations fail to take into account the reactions and arrestors on growth or decline. For example, in 1990, a year after the Tiananmen Square incident, the prediction that China would be the regional economic engine a decade later would have been laughable, as foreign investors fled the country and the hands of repression were clearly seen. A decade later, it was hard to keep foreign money out of China, and Beijing was even beginning to look at ways to slow the economy.

China is obviously a major factor for East Asia in the next decade. And in looking at China, the status of the economy -- particularly growth -- is the core issue. It is our view that China's economic growth rates, driven largely by foreign investment, trade and government spending, will continue to slow. This slowing will exacerbate underlying structural tensions in the Chinese economic system -- between the urban and rural areas, between the coast and the interior, between the north and south, between the rich and poor and between the center and the periphery -- and at its core between the state-controlled and market economies.

Why, then, if Stratfor sees a China on the verge -- if not already in the midst -- of massive internal upheaval, is there a general global acceptance of the idea that not only is China on an unstoppable rise, but that people should pour their money into the Chinese economy? In part, this is due to tunnel vision -- assessors of the Chinese economy are looking only at the booming center-coastal economies in and around Shanghai. In part, it is intentional self-delusion, a failure to connect the dots.

There is no shortage of reporting on the underlying weaknesses of the Chinese banking system, the state-owned enterprises (SOEs), the unemployment problems, the uneven distribution of wealth and labor and myriad equally troubling and seemingly insurmountable problems. However, the holy grail of selling a single orange to each of the 1.3 billion Chinese continues to blind others to the reality of the situation, and the desire for a piece of what someone else might get has fed a steady stream of investment into China, keeping the system on life support and "justifying" the positive outlooks.

But on this last point, something has been overlooked: In recent years, foreign direct investment (FDI) moving into China has declined, but this trend is hard to see clearly. U.S. investment in China was the key driver in bringing China up from the Asian economic crisis. Weary of waiting for the return on investment in China, U.S. investors slowed the flow of FDI. However, the herd mentality and the shiningly optimistic assessments of China as the next golden goose led to a successive wave of European investments. This was followed by Asian investors, who did not want to be left behind.

This rush of foreign investment and interest in China has masked the Chinese economy's underlying weaknesses and given the government tools to maintain control. But it will not last. Already there is dissent forming in the international community, and the need for quicker profits -- or any profits -- is driving companies and investors to look elsewhere. Rising interest rates and the perception of strong market fundamentals are bringing investments to the United States. High energy prices, sector bubbles and the resurgence of "China threat" fears are taking the shine off the Chinese economy.

Beijing has enjoyed a brief respite from these fears. The external pressures on China were set to increase in late 2000 with the election of U.S. President George W. Bush. By early 2001, China and the United States were in a tense standoff as a U.S. E-P3 sat on a Chinese runway on Hainan Island. The incident was resolved, but the strains on U.S.-Chinese relations were not relieved. The came the Sept. 11 attacks in the United States, and suddenly China became a back-burner issue. Beijing even became, briefly, a fellow "target" of international terrorism, convincing Washington that Uighur militants were tied to Osama bin Laden and out to create a greater Islamist state in western China and Central Asia.

But while Beijing had some time -- and took advantage of it to effect a relatively smooth transition from Jiang Zemin to Hu Jintao, the so-called Third and Fourth Generation leadership -- Washington's overwhelming infatuation with bin Laden, al Qaeda and international jihadism began taking a more proportional position in the American global strategy. For China, this means the return of U.S. pressure.

The same factors that led to the downfall of the Qing Dynasty in 1911 are still inescapable today. China is showing classic symptoms apparent before the end of dynasties: the disruption of internal economic wealth, increasing gaps between rich and poor and between regions, the economic encroachment of outside powers and the undermining of the social contract with the state. The central government has lost its legitimacy after trading ideology for money that is now supplied from afar rather than from within.

The balance between the center, which seeks to pacify and stabilize the vast interior population, and the coastal periphery, whose economic and political interests lie in foreign trade and are therefore ultimately aligned more with foreign nations than the center of China, continues to create friction. The center, in order to maintain control of the interior, must take money from the periphery. Fears of issues of social stability lead the center to take action in the interior, which might be anathema to the interests of the coastal provinces.

China today has two economies: the import/export economy based in the densely populated coastal regions and the remains of the old Maoist SOE-based economy in the interior and the Northeastern "rust belt." FDI supports the import/export economy, while the central government must keep the SOEs afloat. In 2003, SOEs employed 375 million of 750 million workers and controlled 57 percent of the country's industrial assets. The SOEs are kept alive -- and at times bailed out -- by preferential bank loans, but the inefficient enterprises are giant capital vacuums, compounded by corruption and continued mismanagement.

Bad loans in China, most of which stem from lending to SOEs, have been estimated to reach as high as $500 billion -- by no less than the investment houses who have a vested interested in making this number appear as low as possible. That is not far off China's $609.9 billion -- as of Jan. 1, 2005 -- in foreign currency reserves. Beijing is constantly pulling from its own reserves to feed the state banks, which in turn feed the SOEs. Since 1999, Beijing has spent about $275 billion in asset transfers and bailouts in attempts to solve the bad loan problem. All such "fixes" have failed, since they do not require the SOEs to change their operating policies. The SOEs, in turn, feed the people who, under the communist system, came to expect -- and depend on -- the continued existence of a state-sponsored Iron Rice Bowl.

The coastal areas, where the import/export economy is based, received 87 percent of China's FDI in the last three years, but western China, which is home to many SOEs and farming operations, received only 3 percent of FDI in the same period. In these areas, where nearly a quarter of China's population lives, per capita income fell from 84 percent of the national average to 56 percent from 1980 to 1999.

The forces at work within China's SOE-based economy are preventing the country from capitalizing on its current growth and will eventually drain the energy from the import/export economy. Fearing the urban unemployed even more than the rural unemployed, since poor farmers at least have land and can feed themselves, Beijing is offering life support; but unemployment, which in 2002 was between 6.2 percent (official data) and 13.1 percent (estimated by a 2004 University of Michigan study), continues to rise. This triggers wave after wave of demonstrations and protests -- which have thus far been isolated incidents -- but the chances for coordination increase daily. And Beijing's only response will be repression, sending in troops to end by force whatever opposition it perceives, as it did at Tiananmen Square.

China recovered from Tiananmen not because of the continued crushing of the students and their supporters but through capitulation to the population, which resulted in the state taking a steadily decreasing role in the lives of the average Chinese. But this capitulation to the masses, while initially resulting in pacification, also has served to raise material expectations. Turning back is no longer an option. Beijing is, therefore, stuck. It options are limited and time is running out. The mandate of heaven, it appears, is being repealed.

Beijing knows the troubles it is in. The strains between the coast and the interior, the rich and poor and the north and the south are growing more and more tense, and Beijing's ability to maintain the system is fading. This is compounded by corruption, which not only drains government coffers but further de-legitimizes the Party.

China's leadership is presented with few options.

First, it can implement a sudden and swift overhaul of the entire economic system, similar to South Korea's actions following the 1997 economic crisis. This, however, would require a government characterized by lethargy and fear of social instability to make a sharp, painful and -- if done effectively -- relatively swift move. The massive social dislocation of such a move makes it untenable.

Second, Beijing could revert to the Deng and Jiang method of encouraging unabated and unequal growth at the expense of profit, occasionally trimming dead wood in SOEs, pumping money into the banks to recycle into the insolvent SOEs and thereby maintain the bare minimum of social stability to avoid significant unrest. Any small stirrings are met with crackdowns on social movements. This, however, only furthers the underlying structures that have rotted out China's economic expansion, and, in relying on the "Asian" model and the "Communist" model, it fails to address the true problems.

A third method is that being attempted by Jintao. This involves slowing growth a few percentage points, more closely regulating the economy from the center and trying to direct FDI into the worst of the SOE areas, namely the northeast. In the midst of this, Beijing seeks to take a million small steps toward addressing underlying weaknesses. This simply prolongs the pain -- even if regionally isolated -- and builds tensions between haves and have-nots. And it relies on foreigners' good will or poor judgment to invest in the worst of the Chinese state institutions. Ultimately, if social stability can be maintained (and this seems unlikely for long), China's best case is a sustained slump, reminiscent of the past few decades in Japan.

The fourth option is the "Mao" method: Close the country and economy and undertake a massive social restructuring. This is not really an option among the Chinese leadership, which has a vested interest in expanding trade with the outside world. It also would result in a loss of international power, at least for a decade or so. Without the ideological underpinnings that allowed Mao Tse-Tung's social revolutions, gaining any sense of national buy-in for another "Cultural Revolution" would be highly unlikely, and the opposition to such a path would be anything but quiet.

The first and fourth options appear untenable now and in the foreseeable future. The fight is not over closing the economy or keeping it open, but over the pace and scope of economic growth versus economic fundamentals. It is a core question of defining strength. While the "Hu" method has won out for now, if things start to bite -- and they likely will -- there will be a renewed push for the "Jiang" method, though whether China can entice others into a new "boom" too many times is unclear.

The government is challenged now to prove its legitimacy as the center of the nation. Under Mao, the underpinning was ideology and a sense of international embattlement. Under Deng and Jiang, that underpinning was the promise of money and material goods. China's rapid growth economy is very young, and tearing that promise away -- even in the name of market fundamentals -- is extremely dangerous. The only way South Korea managed it was to rely on a very close sense of ethnic nationalism and to put the blame for the pain on a non-state actor, the International Monetary Fund. China has neither the ethnic homogeneity nor pervasive sense of nationalism to ask for much self sacrifice, and the stresses on the system will continue to compound.

If China adheres to the World Trade Organization (WTO) accession agreement and opens its banking system in 2006, the SOEs will collapse, since China's banks would no longer able to funnel money to bail out non-performing companies. Strengthening the SOEs through reform creates massive new pools of unemployed labor, leaving even more disgruntled and disillusioned former state workers with no jobs and nowhere to turn. Ending bank lending to the state institutions creates hundreds of millions of new unemployed. A social cataclysm of that magnitude will tear the country apart -- or at minimum lead to the collapse of the Party and the government. Therefore, China will choose another path.

Beijing will want to prop up the SOEs as long as possible to buy time to convert them into productive members of China's economy. However, time is not on China's side; the country must open its economy before the SOEs can be converted. The center will want to forestall this as long as possible and is therefore unlikely to accede to its full obligations under the WTO agreement.

Beijing, then, will seek to mitigate the internal upheavals now apparent from the 1979 economic opening and reform the system. Mismanagement, rampant corruption and the combination of an Asian (growth-driven rather than profit-driven) and Communist (social control over profits) economy has left Beijing with few immediate solutions. If China slows its opening and reforms -- the most likely path, albeit done in a subtle Chinese way -- FDI will begin to dry as foreign investors shift away from China. When FDI dries up, growth in the import/export economy will slow down. When growth slows down, social stability issues will become more pronounced, since there will be less and less money to pump into the SOEs. Capital flight by Western investors already has begun, with Asian investors making up the difference, but they will be unable to sustain adequate levels for very long.

FDI decreases also factor into the rifts between the center and the periphery in somewhat unexpected ways. A decrease in FDI is what triggered the 1999 corruption crackdown. In 1999, FDI going into China decreased by more than 11 percent as a result of the Asian financial crisis. With less money coming into the country, the center tried to keep the SOEs afloat with money from the import/export economy. This was met with resistance in the periphery, and the center responded by moving in and taking what it wanted under the guise of a crackdown on corruption. In extreme cases, the periphery reacted violently; in others it simply took the money and ran.

China will struggle on through 2008. The Olympics are a powerful force, driving economics and providing a rallying point to keep divergent interests temporarily subdued. That will not last. Nationalistic entreaties playing off the Olympics, space programs and the like can do little to hold the disparate interests and factions together. Intentionally or not, the face of the Chinese Communist Party will shift in the years shortly following the Olympics.

The turmoil this will likely cause will lead to a loss of central control and a regionalization of power, as has often been seen in Chinese dynastic transitions, in which the country -- while nominally unified -- will in fact become a cluster of fiefdoms, effectively modern warlord states. The capital will have a national leader but the center's reach and influence will be at the mercy of the regions. In a place such as Afghanistan, this is called status quo; in China, warlordism -- only this time, there will be nuclear weapons in play.

As China's economy triggers social upheaval, other Asian states will look for different sources of strength and regional leadership. The alternative to China is Japan, and Japan is embarking on a more aggressive assertion of its leadership role in Asia and seeking to spread its influence and security sphere along its energy supply lines through the Indian Ocean to the Middle East. This process will continue through the decade.

Japan already has the capability of projecting its military power better than China. Although the Chinese possess a larger fleet of Landing Ship Tanks (LSTs) and landing craft, they lack important logistical and support elements necessary to project maritime power. China's navy also lacks a sufficient number of large-scale and advanced landing ships -- amphibious assault ships and dock landing ships. Although China can eventually build these capabilities, Japan already has the experience and the technical ability to sustain forces overseas for extended periods of time. Its involvement in Iraq -- where Japan has 900 troops, naval vessels, helicopters and aircraft (the biggest deployment since 1945) -- and Aceh, Indonesia, demonstrate that. By the end of the decade, Japan also intends to have a significant aerial refueling capability, which is essential for power projection. China's aerial refueling capability continues to be based around the aging H-6. With no deliveries of the Backfire bomber, the H-6 continues in the bomber role and few have been converted to aerial refueling. Finally, Japan has the experience of training with the United States and its allies for decades.

Japan is a modern state suffering from a lasting economic malaise and looking to reshape its role while seeking new economic strength and security. The Japan of the Cold War was content to rely on Washington for its security needs, and the unnatural state of the world's largest economy protecting the fundamental interests of the world's second largest economy with little outlay by Tokyo is long gone.

Japan sits in a volatile region, and the United States is looking to establish Tokyo as a cornerstone of an enhanced regional security alliance system. With Japan watching a fading China, however, Tokyo is unlikely to stand by and simply watch the downturn -- and unrest -- and wait to see what happens. Tokyo will seek to exploit the economic advantage, supporting coastal areas of China, backing Taiwan and generally assisting in the disintegration of the Chinese state apparatus.

Looking at a China that is fanning the flames of nationalism, Taiwan will seek to align itself with Japan, because Tokyo can offer Taipei security benefits that Beijing cannot. This situation will feed on itself: China will react strongly to a Taipei-Tokyo axis, and Chinese reaction will prompt closer cooperation between Taiwan and Tokyo.

That the confrontation between China and Japan will move beyond the political and economic sphere toward the military realm before the end of the decade appears likely. Should there be a war between China and Japan, Korea will attempt neutrality, though leaning toward one side -- China. However, Korea will seek U.S. assistance to stand between its two neighbors. If Washington is unable or unwilling to stop Beijing and Tokyo, Korea will be left dangling.

Korea is clearly defined by its geography. A peninsula situated between two regional, historic, competitive powers, Korea has been a conduit for technology and culture and the main avenue for invasion -- in several directions. Korea's traditional solution was to pay suzerainty to China -- its contiguous neighbor -- while isolating itself from Japan, its maritime neighbor. When faced with invasion, Korea calls on outside powers, be they China, Russia or the United States.

This pattern is ingrained in the geographic features of Korea, and has been unchanged by the division of the peninsula.

Korea is, therefore, a reactive state -- whether the reaction is expressed as isolationism or as an invitation to foreign powers. Korea's future is rarely shaped by domestic desires or strategic planning because its size and location leave it always vulnerable to the designs and actions of its neighbors.

The divided Korea has exploited its neighbors in an attempt by each side to gain the upper hand. The Cold War gave Korea tremendous strategic importance in the confrontation between the Soviet Union and the United States, as well as in the often contentious relationship between the Soviet Union and China. Seoul clearly benefited from the former, Pyongyang from the latter.

The end of the Cold War also ended the support network that kept Korea divided. That is not to say the situation cannot continue, but the interests of the two Koreas have rarely been different -- only the ideology has. Both Koreas seek a strong, independent Korea, and with the Cold war structures shattered, the two are working closer together to achieve this -- in spite of their ideological differences.

Over the next decade, this cooperation will become more apparent, though ideology will still present a barrier for significant cooperation early on. While there is concern in the South over the economic effects of unification, it is ideology -- seeking a face-saving way for neither ideology nor elite to be de-legitimized -- that stands in the way of unification.

Friction points between Japan and China will include areas beyond Korea and Taiwan, with competition for sea-lane control, however one-sided. The wild card is whether the tensions between Beijing and Tokyo at some point exceed Washington's comfort zone -- or interests. Intervention between two Asian powers is something not readily leaped into, and Washington could engage in a balance-of-power strategy between the two, keeping them occupied in East Asia and preventing either from ever rising to challenge U.S. control of the seas.

The Indonesian archipelago will be a friction point while Australia peruses a policy of using Indonesia and the Pacific Islands as a bulwark against encroachment from the mainland and the South China Sea. Indonesia could be out of oil by then, but Canberra must ensure Jakarta (or Australia) remains in control of the islands in order to keep the Chinese (or multiple militant groups, criminal gangs and other powers) away from the Australian heartland and prevent them from having interdiction capabilities in the major shipping lanes. Australia can expect U.S. support in this endeavor.

Russia/Former Soviet Union

Ten years ago, Stratfor said Russia would regain lost parts of its empire by 2005. Our mistake was taking for granted that the Russian people and leadership at the time would have the political will to do so. Russia remained capable of attaining its former greatness -- despite the fall of the Soviet Union -- but the desire to use its capabilities never materialized. Russia's moderately pro-Western leadership for the past decade -- under former President Boris Yeltsin and during the early years of President Vladimir Putin's regime -- has driven the country toward the West, and the Russian people have tolerated this course so far, albeit grudgingly.

In 2000, Stratfor said that, by 2010, Russia would re-emerge and reclaim its former territories, beginning with the Baltics and Georgia; return the Russian army to the Polish and Romanian borders; and cooperate with China to block the United States. As of 2005, we have again been wrong -- and for the same reasons. Until now, Russian and Chinese leaders have thought they could gain more by cooperating with Washington than with each other.

Stratfor believes our forecast from five years ago will come true, if not by 2010 then by 2015. We base this belief on objective reasons, such as the hard geopolitical realities Russia has faced for hundreds of years. Pro-Western governments content with supporting roles in a U.S.-dominated world might come and go, but Russia and its inevitable geopolitical challenges remain.

We believe Russia is at the beginning of a reversal that will take it on an anti-U.S. course. The turning point could come soon, or it could be years away. Russia's deepening systemic crisis and a fierce and continuous struggle between nationalist forces and pro-Western, Washington-supported factions will make for a very painful reversal of indeterminable length and depth. A series of policy failures -- possibly including the loss of territories, such as those in the Caucasus, or even Russia's disintegration to the point where Moscow has only nominal control and some regions declare independence -- will happen during the next decade. But by the end of 2015, Russia will be more of a nationalist and statist entity.

Russia's current geopolitical phase -- marked by continuing decline -- began in 1992, after the disintegration of the Soviet Union. Given that Russian phases usually last 25 to 45 years (such as the building of Soviet Russia as the second superpower from 1917 to 1961 and a period of stagnation from 1962 to 1991), the current phase might end as early as 2014 or 2015. Even before then, however -- it is unclear exactly when, but sometime in the next decade -- centripetal forces will replace the current centrifugal forces as Russia's center of gravity.

What do we think will bring about Russia's reversal in the coming decade? Geopolitically speaking, with Russia's brother state Ukraine -- vital to Russia's survival -- joining the West as a geopolitical junior ally in 2005, Russia is running out of room to hide from a coming conflict with the West. Moscow and central Russia will become indefensible if there is a war between the North Atlantic Treaty Organization (NATO) and Russia. The prospect of a pro-U.S. "revolution" -- the likes of which already have changed regimes in several former Soviet republics -- adds urgency, too. Central Asia, the Caucasus, Moldova, Belarus and virtually all of the former Soviet Union (FSU) will see attempts -- with varying degrees of success -- to replace even moderate pro-Western regimes with openly pro-Western governments.

Furthermore, on its current course, Russia has been collapsing slowly but surely -- and there is no reason to believe this decline will stop without a change in strategic course. As an independent geopolitical power and perhaps even as a sovereign united state, Russia must either strike back at foreign interlopers soon or die.

The odds are currently against Russia. Centrifugal forces tearing it apart and bringing it down prevail. Inside the country, Russia's post-Soviet elite has been Westernized, and many would not mind seeing Russia go the way of the Soviet Union. Members of this elite also value their checkbooks more than their country, and since economic ties between Russia's center and its outlying regions are becoming weaker than those between the outlying regions and foreign neighbors, the elite has little use for areas beyond the center. Russia's fundamental crisis also is deepening; separatism among ethnic minorities is on the rise; Islamist militancy is spreading from Chechnya to other Muslim-populated regions; militant attacks continue unabated; and demographics show that ethnic minorities with no allegiance to Moscow outlive ethnic Russians.

Meanwhile, foreign interest in getting something from the crumbling Russia and FSU -- from control of largely untapped natural resources to chunks of territory -- is greater than it was even during the period of foreign intervention in Russia from 1918 to 1922. Even tiny Estonia has territorial claims to Russia.

However, we think Russia will preserve -- or restore -- its territorial integrity and sovereignty and again become a major international player with a traditional anti-Western geopolitical course. The main geopolitical threat to Russia this coming decade comes from the U.S.-led West, which threatens Russia more than all other players combined, so it will be against the West that Russia responds.

An understanding of Russia's fundamental geopolitical patterns is required to understand why Russia is not about to go quietly into oblivion. A power more than 1,000 continuous years in the making, Russia is not about short-term trends; it should be analyzed and predicted in its entirety, in terms of long-standing geopolitical traditions.

One such tradition is that, even at its lowest, Russia has always remained essentially an integrated, vital state. Also, foreigners' previous attempts to use Russian collaborators to remake Russia to their liking have invariably failed. Traditionally, Moscow's strategic response to life-threatening events has always been slow -- from outsiders' perspectives, too slow -- and we suspect Russia will again take its time in the course of its upcoming reversal, no matter how risky it is to move slowly in this situation. Another long-term Russian tendency is to show its best and, in fact, succeed every time its very existence is in mortal danger. There is no reason to believe Russia will behave differently this time around.

Russia has always been saved by movements that begin outside the country's centers of power, with new forces frequently emerging from within Russia to preserve the nation. This time, we expect Russia's geopolitical revival will not begin in Moscow or St. Petersburg -- which have less to do with the real Russia than New York or Washington, D.C., have to do with the real United States -- but in the outlying areas. Intelligence shows that, while pro-Western tendencies still dominate Moscow, an anti-Western backlash is growing in the provinces and within many strata of Russian society -- even in some parts of the current elite (though Russia might form a new elite to make its upcoming move a success).

There are two schools of thought on how to revive Russia from within, i.e., how to strengthen its economy. One was represented in the early 1980s by then-Communist Party General Secretary Yuri Andropov, who argued the regime could only be saved by opening to the West and modifying the Soviet system while accommodating Western geopolitical appetites in exchange for economic benefits. Communist Party General Secretary Mikhail Gorbachev used this theory to develop his policies of glasnost and perestroika. After Gorbachev failed, the same camp decided the Soviet Union should be disintegrated, though the same elite would remain in power as new capitalist Russian leaders.

Putin is an heir to that thread. Right now, the levers of power and the state apparatus are essentially in the hands of the Andropovites.

The state itself has consistently re-evaluated its position out of increasing discomfort with the cost-benefit analysis. Putin does not want to change Russia's fundamental strategy, but he hopes to make a few technical changes. However, his continuing drive toward the West has not brought Russia any success and has left it with an ever-deepening internal crisis, raising Shakespeare's question of "to be or not to be" for the Russian nation.

The other school of thought on Russian revival is that Andropov was wrong and the current and coming consequences are not because of Yeltsin and Putin's mismanagement but because of a fundamental misunderstanding of the forces driving Western policies and the effect of the market on Russia. The Andropov position calls for technical changes in Russia's economy and marketization; the second position argues that Russia's current policy is a fundamental failure and must be adjusted. In Russia -- and this is dramatically different from China and India -- pro-market forces have been pro-Western at the expense, it seems, of Russian national interests. Many pro-Western reformers in Russia do not see themselves as part of Russia; some of them argue they are citizens of Earth rather than Russia, and that they must contribute to the success of the global market rather than the Russian market. This attitude cannot help but alienate these pro-Western members of the elite from many other Russians.

Because the Andropovites failed to deliver, we expect the second school of thought to take over in the coming decade. We already see the first two issues that will take Russia in this direction: Ukraine and the retirement problem. Ukraine is an issue of foreign encroachment and shows Russia's former allies moving toward the West. Russia's retirement situation, where the elderly are no longer paid benefits and have no savings to draw from, is an enormous problem affecting more than a quarter of Russia's population -- and, as an extension of the marketization of Russia, it points to the failure of the country's current course.

The retirement issue might be the impetus for genuine popular resistance to any further market system inroads -- and it could escalate into a struggle against Russia's current pro-Western course. Certainly, the existing protests are a far cry from what is usually required for a change of regime or course. These particular protests likely will die down, but new demonstrations will arise because the overall crisis in Russia will not go away anytime soon; on the contrary, it will deepen.

Stratfor senses a powerful counterforce coming gradually but certainly to confront Russia's current regime. This movement will come from those population segments the Russian oligarchic elite has excluded systematically from wealth acquisition -- Russians from rural areas and small cities and the elderly -- who seem to be stirring for more and larger protests. This, coupled with Russia's being pushed from the FSU and its internal systemic crisis, indicates that a defining moment for Russia is coming.

One such moment came in the 1980s, when the KGB realized the Soviet Union might not survive and the Andropov strategy was born. Another such moment was when Yeltsin and Gorbachev faced off over the question of Soviet survival, and the Soviet Union was dismantled. Yet another pivotal moment came after NATO's Kosovo war, when Russia had the chance to confront the West, and Yeltsin decided the costs of doing so would outweigh the benefits, so he stayed his pro-Western course. It seems to us that in the coming decade, Russia's decision will be different, even if Putin has to be replaced to clear the way for Russia to strike at the West.

The Russian people see the state as essentially a Jewish monopoly exploiting the Russian masses -- a majority of Russia's top oligarchs are Jewish -- to enrich a very small, cosmopolitan and pro-Western segment of Russian society (the segment the West sees as the whole of Russia). Though Russia has money and reserves, these are not in the hands of the country but of individuals -- from state officials to oligarchs -- who are out for their own interests. For example, though there are people literally starving in some provincial areas, Russia's agricultural industry exports food and reaches out to only some inside the country. Likewise, Russian end users rarely see the effects of Russian oil industry revenues.

It can no longer be argued that the West is benign or that the market economy is working for most Russians; the only argument that can be made is that the current difficulties are temporary, and over time, Russia's current course will work out. But if Ukraine joins NATO, Russia will lose the buffer between itself and the West, and Russia will have no time to wait and see if Westernization will work in its favor.

Furthermore, an attempt by Washington to replace Putin with a more accommodating Russian president might happen soon -- but that attempt could spiral out of control and result in anti-Western forces backed by Russian masses taking power instead. And beyond that, death tolls from HIV/AIDS in Russia will probably snowball three years from now and remain high for a long while, finally driving home the point that the Russians and their nation are dying -- and not as gradually as in the past.

Thus, a reversal of Russia's course is highly probable. We are not sure how it will take place, but there are several possibilities:

1. The elite holds on to Russia's capital and center while the rest of the country crumbles. St. Petersburg and Moscow remain Westernized enclaves in a country that has no interest in what goes on there. This could result in the delegitimization of the Russian state and hence disintegration, with nationalist enclaves emerging in the provinces.

2. A popular uprising from the streets overthrows the regime and introduces a more traditional Russian government with anti-Western characteristics.

3. A palace coup pushes Putin or his successor aside, and Russia's course changes from within the government.

4. Under undeniable pressure from a majority of Russians, Putin changes his tack and becomes nationalist and statist.

On the whole, we expect a fundamental Russian crisis and prolonged fighting in various forms -- including military conflict at times. A number of scenarios could play out, but in the end, Russia will become the nationalist, statist entity it was before the last 20 years of openness and marketization.

The question now is what the reversal will look like. The Communist Party is likely finished in Russia; it will not be the driving force. A new, anti-Western leading force will emerge from street protests and popular anger. Moreover, a completely new elite will probably form from this period of turmoil. The new elite will consist of national capital representatives, mostly from the production economic sector; patriotic intellectuals; officers in the military, security and intelligence; and popular resistance leaders.

By 2015, the regime will probably be religion-oriented, with the Russian Orthodox Church taking a leading role, joined by moderates from other large religious traditions in Russia, such as Islam and Buddhism. A new regime will have to draw upon one resource or another for its strength; traditionally, Russian morality and human capability have been vital to the country's success. With the communist ideology in crisis and the market ideology inspiring relatively few Russians, moral strength can be drawn from revived religious values that argue for a strong Russia and a just society. Also, it will probably be a very conservative regime, resting on the foundation of a production economy, with low-paid workers, intellectuals and peasants as well as those dependent on social benefits.

As the largest continental power and chief influence over Eurasia, Russia cannot escape its geopolitical fate: to maintain its territory by fighting seafaring powers (the United States, the United Kingdom and Japan) looking to assert influence in the strategically valuable Eurasian region. Russia and its immediate neighbors -- within whose borders Russia has direct security interests -- happen to be located in a very strategic area. If Russia disagrees with the U.S., U.K. and Japanese visions of its future and that of its neighbors, then Russia will have to fight. Thus, no matter the extent to which Russia's current pro-Western government shies away from confronting these forces, it will not be able to avoid the fight forever. It will probably join forces with other continental powers -- Germany, China and India -- by 2015.

The regime will accept the idea of private property and adopt some form of market economy with state control. The economy will give priority to the development of Russian national capitalism, caring for Russian internal economic development and creating Russian competitive high-tech products. It will not cater to Western monopolies or be based on selling Russia's natural resources as it is now. The government will be much more geopolitically assertive, having as its foundation the principle of respected international power and Russia's international greatness.

Similar struggles between pro- and anti-Western forces will take place in all FSU countries this decade, with Muslim FSU countries also experiencing an upsurge in Islamist militancy and radicalism, which is attractive to the impoverished. The Islamist force with the most potential to succeed is not a militant group, such as the Islamic Movement of Turkestan -- militant groups have drawn the attention of intelligence and security services and are thus more likely to be crushed. A radical organization called Hizb ut-Tahrir, which is not militant in nature, could avoid defeat as it spreads the message of overthrowing secular regimes in Central Asia during the coming decade.

As in Russia's case, various outcomes are possible in these countries -- from the disintegration of some states to armed conflict in others. In the end, when a reversed, militarily and politically stronger Russia emerges sometime in the next decade, some FSU nations will realign themselves with Russia while others will remain in the pro-U.S. camp. Though we do not forecast the re-emergence of the Soviet Union within the next 10 years, some new Russian-led alliance consisting of several FSU countries -- or parts of these states -- will emerge by 2015.

This would not be "the end of the fall" in terms of the Russian and FSU economic crisis. The region already is in freefall, and nothing can stop that immediately or even in 10 years. This reversal is about the system's structure and direction, changes in which will attempt to address the economic crisis over time -- probably beyond the coming decade.

In such a reversal, economic and other problems will intensify. But Russia has proven many times that it and its people can survive any hardship, as long as the struggle for Russia's greatness is made and is shared by its leadership and the masses.

I'm off to work right now, but I can get back to it in about 29 attention spans from now. Those first two long articles were very good.

Hours later: sorry, but those articles are so long that my eyes glazed over before Lynnyrd Skynnyrd finished Free Bird within 13 minutes. Stratfor is bearish on China because they don't believe the hype, and see political and economic problems that threaten to tear China apart before China can tear apart anything larger than Taiwan. My friend's condo in Shanghai is valued at more than $220 per square foot! Compare that with your own home, unless you live in Honolulu or Manhattan. China's east coast apparently is nearly a separate country, and the folks in Bejing are doing a balancing act with 1,300,000,000 circus spectators.

I like the part where Stratfor says that of course, the Chinese would never sell their T-bonds; they can't find a safe harbor investment in China. Still, if they simply start buying other foreign currencies, the US govt.'s finances would be seriously threatened.
I'm often wrong. But I'm not always wrong!
Fit2BThaied Wrote:I like the part where Stratfor says that of course, the Chinese would never sell their T-bonds; they can't find a safe harbor investment in China. Still, if they simply start buying other foreign currencies, the US govt.'s finances would be seriously threatened.

Not really. If they had trouble getting investors, they would just raise the dividend rate, until they did. That is all that would be required.

Stratfor seems stuck in this Cold-War mentality of dividing the world into Communist and non-Communist enclaves, and then assuming that Communism will collapse internally due to economic stagnation. This was a very good formula for understanding the Soviet Union during the Cold War, but today the equation has largely changed. A lot of Western analysts are convinced that China should have fallen after the Tiananmen square incident, and have latched onto economic growth for the reason why they haven't - and while this could be part of the story, more recent world events suggest a very different explanation.

Today, threats to global stability come from the right, not the left. Under this approach, China has more to fear from a mutant religious movement than an economic collapse. And so far, China has proven resistant to these sorts of things. This provides an alternate explanation of why China didn't collapse after Tiananmen: the (mostly religiously based) concept of human rights doesn't really exist in their culture. The more recent spate of protests shouldn't necessarily be viewed as an outgrowth of 1989 either: it could just as easily be opportunistic, seeing the wealth that others have, and it could go away if they lose that wealth.

If you talk to actual Chinese people, which is always a good place to start with these things, they seem to perceive more of a threat from Falun Gong than an economic slowdown. The US has a lot of debt as well, but most serious economic analysts (as opposed to journalistic pundits) haven't seen this as too much of a threat to us. In addition, Taiwan is a convenient escape valve they have, to divert attention away from domestic problems in case things go too badly.

Falun Gong, on the other hand, is a bone fide religion, which is something pretty new to their culture. It is blatantly unscientific (they believe that certain people among us are aliens, and that illnesses come to us from other dimensions) yet avowedly apolitical. The Communist regime hasn't dealt with them too well, which has only made them stronger. If they're not able to backtrack on this front, they will face a serious problem with moral legitimacy among their own people, which is something they have so far managed to maintain. This, IMV, is something that needs to be watched, though perhaps on a slightly longer timeframe than the Stratfor people are thinking about.
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Last week's Economist lead with the issue of China and the US, including the Special Report below.

Quote:China and US trade
Lost in translation

From The Economist print edition

If China sharply revalued the yuan, as American politicians are demanding, it could actually hurt the United States and help China

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CHINA is being cast as the villain once again. By holding its exchange rate artificially low, it is stealing jobs and causing the United States to run a huge trade deficit. Beijing must therefore be forced to revalue the yuan. These are the arguments behind an increasingly protectionist mood in Washington. Yet they are largely flawed. A stronger Chinese currency would not much reduce America's trade deficit. Indeed, the irony is that China, not America, has more to gain from setting the yuan free. Without a more flexible exchange rate, there is a growing risk that China's sizzling economy will boil over.

America's anger at China is clearly growing. In February it filed a complaint to the World Trade Organisation (WTO) against Chinese export subsidies. In late March the Department of Commerce announced tariffs of 10-20% on glossy paper imported from China, to offset the impact of alleged government subsidies. This reversed a 23-year-old policy of not imposing countervailing duties on a non-market economy. Then in early April the Bush administration filed two more complaints: one on Chinese pirating of DVDs and CDs, and the other over restrictions on the sale of foreign films and music in China.

Although by themselves these actions are trivial, together they point to an increasing appetite for tougher action against China. The Bush administration is under increasing pressure, particularly from Congress.

Congressmen complain that the so-called China-US Strategic Economic Dialogue (a series of high-level talks between the two countries launched last year by Hank Paulson, the treasury secretary) has so far failed to produce results. The recent deterioration in trade relations does not bode well for the next meeting, which begins on May 22nd. Many commentators now reckon that Congress will inevitably pass some kind of China-bashing legislation later this year. A sharp economic slowdown in America as a result of the collapsing housing market would make this even more likely.

The biggest risk comes from measures linked to China's supposed exchange-rate misalignment. The infamous Schumer-Graham bill, which proposed a 27.5% tariff on all Chinese goods to offset the yuan's alleged undervaluation, was withdrawn last year. But the two senators behind it are working with others on a new WTO-compatible version that could soon appear. Although the new bill is unlikely to include across-the-board tariffs, it could have sharp teeth.

Meanwhile, the target of all this hostility looms ever larger: China's trade surplus with America increased to $233 billion last year, accounting for almost 30% of America's total deficit. China's total current-account surplus reached an estimated $250 billion, or 9% of GDP, up from only 1% in 2001. Worse still, in the first four months of 2007, its trade surplus jumped by 88% compared with the same period in 2006.

The making of myths

China officially abandoned its decade-long policy of pegging the yuan to the dollar in July 2005. Since then it has risen by only 8% against the greenback. Because the dollar itself has weakened, the yuan's trade-weighted exchange rate has barely budged. In real trade-weighted terms it is about 10% cheaper than at the dollar's peak in 2002. As a result, it is not just the usual protectionist suspects that demand action, but many mainstream American economists are now calling on China to revalue by 20% or more. Yet the standard arguments for a revaluation are based partly on a series of myths.

The first myth is that there is overwhelming evidence that the yuan is grossly undervalued. China's large bilateral trade surplus with America proves nothing. It largely reflects Asia's changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America's bilateral deficit with China shrinks by more than half. Even so, China's overall current-account surplus is also huge. The surge in its foreign-exchange reserves, to over $1.2 trillion, also suggests that the yuan is undervalued: without those massive purchases of dollars, the currency would have risen.

However, not all economists agree that the yuan needs to be sharply revalued. At one extreme is Morris Goldstein, of the Peterson Institute for International Economics, who argues that the yuan is undervalued by 40% or more against the dollar and should immediately be revalued by 10-15%. In the other corner many highly respected economists, including Robert Mundell, an economics Nobel prize-winner, and Ronald McKinnon, of Stanford University, strongly argue against a big appreciation of the yuan.

The devil to measure

Economists find it devilishly hard to define the “correct value” for a currency. On purchasing-power parity (PPP), the yuan is clearly undervalued against the dollar. Perhaps by as much as 50%. But PPP is not useful for determining the optimal exchange rate between two countries of such different levels of income. It is natural for average prices to be lower in poorer countries because wages are lower. As countries get richer and their productivity rises, their real exchange rates appreciate. And although the depreciation in the yuan's real trade-weighted value since 2002 looks perverse, this follows a real appreciation of 50% between 1994 and 2001 (see chart 1).
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A study by two IMF economists, Steven Dunaway and Xiangming Li, found that estimates for the undervaluation of the yuan ranged from zero to nearly 50%, depending on which method was used. Another recent study, by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii, concluded that using conventional statistical methods it is hard to prove that the yuan is much undervalued. Such uncertainty may partly explain why America's Treasury Department has so far ducked labelling China as a currency manipulator in its twice-yearly report to Congress. Another reason is that it is loth to give ammunition to the protectionist lobby.

Myth number two is that the sharp increase in China's trade surplus is due to an explosion in cheap exports. Until 2004 China's surplus was relatively modest, but it soared over the next two years (see chart 2). Jonathan Anderson, chief Asia economist at UBS, points out that export growth actually slowed between 2004 and 2006 (see chart 3). The main reason for the bigger trade surplus was a sharp slowdown in the annual real growth rate in imports, from more than 30% in early 2004 to less than 15% last year.

The entire increase in China's trade surplus since 2004 has come from trade in heavy industrial materials and equipment. China used to import increasing amounts of steel, aluminium, chemicals and machinery, but import growth collapsed after 2004 when the government started to tighten policy, causing a sharp slowdown in construction, one of the biggest importers of machinery and materials. At the same time China continued to invest heavily in metals and equipment, creating substantial excess capacity, so import growth remained relatively weak last year. Mr Anderson argues that imports should recover as overcapacity is used up.

The third fallacy is that imports from China destroy jobs and harm the American economy. It is hard to see how China can be blamed for job losses when America's unemployment rate (4.5%) is close to its lowest for decades. Trade with China may affect the composition of jobs in America, but it has little impact on total employment. It is true that some workers are harmed by trade with China, just as there are some losers from all international trade. But the American economy overall is better off, so in theory there is ample room to compensate any losers.

Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher. Commentators often refer to the “cheap” yuan as being an unfair subsidy for Chinese exporters. But it is a moot question who exactly is subsidising whom. Not only do cheap imports subsidise American consumers, but China's large purchases of Treasury bonds also hold down American interest rates, thereby subsidising home buyers. Suppose that overnight the yuan rose by 30%, what would happen? American interest rates would rise as China needed to buy fewer Treasury securities and prices at Wal-Mart would increase. If consumer spending and imports then collapsed, this would certainly reduce America's trade deficit, but in a much more painful way than most Americans have in mind.

Wishful thinking

The biggest myth of all is that a revaluation of the yuan would greatly reduce America's trade deficit. The real cause of the deficit is that Americans spend too much and save too little. This means that the country has to import surplus savings from abroad by running a current-account deficit. If a stronger yuan did not cause Americans to save more, it would do little by itself to reduce the trade deficit.

Another reason why even a big rise in the yuan would do little to reduce America's deficit is that there is little overlap between American and Chinese production, so American goods cannot replace Chinese imports. Instead, other countries, such as Indonesia and Vietnam, would probably replace the Chinese. Shifting purchases to higher-cost producers amounts to imposing a tax on American consumers, says Stephen Roach, chief economist of Morgan Stanley.

Even where America and China do compete, as in electronics, the high import content of China's exports blunts the impact of exchange-rate movements on export prices, because a rise in the yuan reduces input costs. About half of China's exports consist of goods that have been assembled from imported components. And domestic wages and materials account for about 30% of the cost of those re-exports. Mr Anderson estimates that a 10% rise in the yuan would increase average export prices by only 3-5%.

If a yuan revaluation encouraged other Asian economies to follow suit, the impact on America's trade deficit would be larger, but still modest. If a 10% revaluation of the yuan were matched by all other Asian currencies, the dollar's trade-weighted index would fall by 4%. Yet, the 19% decline in the dollar's trade-weighted index since early 2002 has failed to trim the deficit.

None of this means that a yuan revaluation leaves America's trade deficit unchanged, simply that any change would probably be small. Nouriel Roubini, of Roubini Global Economics, finds evidence that China's trade balance is affected by movements in its exchange rate: the yuan has fallen sharply against the euro since 2002 as a result of the dollar's decline, and China's exports to Europe have consequently grown at a faster rate than its exports to America. A stronger yuan might therefore curb China's exports to America, but America's deficit would continue to loom large if imports from China were simply replaced by those from elsewhere.

Chinese whispers

Many of the arguments heard in America in favour of a big revaluation of the yuan are flawed or at least exaggerated. However, many of the arguments used in Beijing for why a revaluation would endanger China's economy are equally suspect. For instance, the common claim that a big jump would seriously harm China's growth and employment contradicts the argument (also favoured by Beijing) that an appreciation would have little effect on China's trade surplus with America.

Or take another popular line of defence: it is often asserted that China cannot afford a more flexible exchange rate until its dodgy banking system is reformed and strengthened. Eswar Prasad, an economist at Cornell University, says this argument has it completely backwards. The distortions caused by today's rigid exchange-rate regime may themselves be the biggest threat to Chinese financial stability. A sound banking system requires an independent monetary policy, which uses interest rates rather than blunt directives, to guide credit. And a country cannot control its monetary policy unless it accepts a more flexible exchange rate.

By tying the yuan closely to the dollar, China has been forced to hold its interest rates lower than is prudent: higher rates would attract more “hot money” from abroad, putting upward pressure on the currency. The real rate of interest paid on bank deposits is negative and lending rates are far too low for such a fast-growing economy. Cheap money results in excessive bank lending and poor investment decisions, which could lead to an increase in non-performing loans. Excessively low interest rates are also fuelling stockmarket and property bubbles.

News that China's real GDP surged by a breathtaking 11.1% in the year to the first quarter and that consumer-price inflation had risen to 3.3% in March (it eased to 3% in April), stoked fears that the economy is out of control. But concerns about overheating in the usual sense of excess demand are exaggerated. China's widening current-account surplus and its strong investment imply excess supply. Excluding food, the inflation rate is only 0.9%. Instead, the real concern is that excess liquidity, as a result of the surge in foreign-exchange reserves and low interest rates, is flooding into shares (see article). Households are withdrawing money from low-yielding bank accounts to bet on the stockmarket. China needs much higher interest rates to cool its asset markets. To regain control over its monetary policy China needs to let the yuan rise.

A revaluation could also help the government succeed in shifting the balance of growth away from investment and net exports towards consumption. A stronger exchange rate would boost consumers' purchasing power, allowing them to buy more foreign goods. Excess saving in China is as much to blame for global imbalances as inadequate saving in America.

Most of the increase in saving has come from Chinese companies, which are earning record profits. But household saving is also kept high by the poor public provision of health, education and pensions. Partly as a result, consumption accounts for an unusually low share of GDP.

The good news is that the mix of growth is starting to become more balanced: over the past year, investment has slowed while retail sales have quickened, rising by 15.5% in the year to April. In other words, consumer spending is now growing faster than GDP. Dragonomics, a Beijing-based research firm, estimates that consumption rose from 37% to 40% of China's nominal GDP growth in 2006 and is set to rise again this year.

The stronger growth in Chinese consumer spending has got much less attention in America than the sharp increase in the country's trade surplus. The contribution of net exports to China's growth has increased so far this year. However, the near doubling of its trade surplus in the first four months of the year was probably a one-off, because firms brought forward their shipments so as to avoid an expected reduction in export-tax rebates. Exporters are also thought to be overstating their export revenues in order to dodge capital controls and bring in foreign money to invest in Chinese assets. If so, the trade surplus should stabilise in coming months.

In the long run, stronger domestic consumption could trim China's trade surplus. The government can encourage this by spending more. Its spending on health care and education rose by an average of 50% last year and it is budgeted to rise by more than 60% this year—but from such low levels that it could take years to increase social spending by enough to encourage households to save a lot less. Meanwhile, a stronger yuan would help to rebalance the mix of China's growth.

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This turns the whole debate about China's exchange-rate policy on its head. It is China that has the most to gain from allowing the yuan to rise. If the spat between America and China were to ignite protectionism or financial instability, it could endanger the whole world economy. All the more foolish, therefore, that economic relations are based on misperceptions on both sides. America needs to stop making China a scapegoat for the failures of American policy. Only if it gets its own economic house in order, by boosting domestic saving, will its “advice” to Beijing seem credible. Likewise, China has no right to criticise American policy when its own economy remains unbalanced.

America is right that China needs to revalue, but for the wrong reasons. And arguing that a revaluation helps America's economy makes it less likely that Beijing will act. Moreover, if George Bush foolishly slapped harsh trade sanctions on China, America's economy would be the biggest loser. Likewise, China is foolish to resist a more flexible exchange rate partly because it does not want to be seen as caving in to America's demands, when it is in its own interest. If the world's two leading engines of growth remain at loggerheads, everyone will pay the price.
"Common sense is not so common" - Voltaire
All of these sorts of issues are resolving themselves, slowly...remember that sheer momentum keeps things in the Chinese economy rolling for longer than what we might otherwise expect.

The currency problem is fundamentally an issue between producers, who don't want to be outsourced, vs. the consumers, who just want cheap shit. Current US policy comes down on the side of the producers, which AFAICT is classic worry about the goods and services, and then usually just that will be complicated enough that you will have simultaneously taken care of your labor problem as well.

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