Intelligence Brief - 25 November 2014
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Why China "may be approaching the zenith of its power”

A report that China is undertaking a major reclamation project at Fiery Reef in the disputed waters of the Spratly Islands has sparked a rash of commentary on Beijing’s aggressive policies in the South China Seas.  While there is little doubt about China’s expansionist intent, a new report from the Hudson Institute throws considerable doubt on its capabilities.

The Hudson Institute report, Why China will not become the dominant power in Asia, begins by analysing the flaws in China’s economic growth model.  It makes the following points:

- Most commentators focus on the spectacular success of China’s export sector, but the greater contributor to Chinese growth is domestically funded fixed-investment.

- Chinese fixed investment as a proportion of GDP is now 49%.  By comparison, during the periods of rapid industrialization in Japan, South Korea, and Japan, the ratio was around 30%.

- China’s GDP has increased by an estimated 162% over the previous decade, and of this “an enormous 135% can be attributed to fixed investment”.  This is, points out the report, “unprecedented in economic history”.

- The amount of capital input needed to produce one additional dollar of output has increased from 2:1 in the 1980s to 5.5:1 in 2012.  Capital-output ratios at this level “depict an enormously wasteful and capital-inefficient economy that is not sustainable”.

- A side-effect of this has been a huge increase in debt to 250% of GDP and an undoubtedly much-higher proportion of non-performing loans (NPLs) than the official 1%.  A truer figure is likely to be 5%, which would represent around US$2 trillion of NPLs on the balance sheets of state-owned banks.

- As a result of all this, says the report, GDP growth rates will slow significantly as “it is almost impossible, and indeed unprecedented, for consumer-driven economies to grow at the rapid rates enjoyed by China over the past few decades”.

There are further sobering points raised by the Hudson Institute report, including China’s ageing population which could lead to a situation by 2035 when “there will be barely more than two working persons for every retiree”.  China, says the report, “will be the first major economy in history to grow old before it grows rich”.

Furthermore, China’s national bias towards the state corporate sector rather than households “leaves a poor society tragically unprepared for its own ageing”.

All of this is compounded by China’s determination to become a great geopolitical power by spending an estimated 14.6% of its budget (SIPRI figures) on defence and national security.  To mitigate the twin problems of slower growth and an ageing population, a larger share of the budget will have to be allocated to social security and unemployment benefits (currently 10.5%) and to healthcare (6.1%).  “This is”, the report points out, “in addition to enormous and mounting burdens on the public purse such as existing pension liabilities and NPLs hidden in the books of state-owned banks”.

The report then goes on to assess China’s geopolitical weaknesses (few close allies other than North Korea and Pakistan and – temporarily – Russia) and its significantly lagging military capabilities (China is said to be 20 years behind the US in high-technology areas).  Added to that are China’s poor relations with the US, Japan, and India.

Putting all this (and more) together, the report reaches the startling conclusion that “China may soon be approaching the zenith of its power” as its economy encounters serious structural impediments and demographic barriers to growth.

The report describes a “lonely power”, and not surprisingly it suggests that the Communist Party leadership “will struggle to keep a lid on growing popular discontent, which may have implications for its very survival”.

From a policy point of view (the report is directed at the US and Australian governments), it says: “China is not now or foreseeably a strategic peer of America’s and any move by Washington to concede China’s so-called legitimate strategic interests would smack of appeasement; and [would be] offered unnecessarily and for little conceivable gain…China’s maritime ambitions should be firmly resisted.”

END

Why China will not become the dominant power in Asia

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